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Written Assignment Essay Answer all of the following questions. Title your assignment Written Assignment 4, unless your mentor directs otherwise. This assignment covers text chapters 18 through 23. 1. Explain the relationship among savings, investment, and net capital outflow. Savings are equal to domestic investment + net capital outflow. In an open economy, both net capital outflow ( which is the purchase of foreign assets by domestic investors minus the purchase of domestic investments by foreigners) and savings and domestic investments are both ways of saving, and are both used to get the full picture of total saving. 2. Describe the economic logic behind the theory of purchasing-power parity (PPP). What factors might prevent PPP from holding true? The purchasing power parity tells us the a unit of any given currency should be able to buy the same quantity of goods in all countries. This principle is based on the fact that prices should remain constant for goods no matter where the goods are purchased, otherwise there is an opportunity for profit that was left un-exploited. The theory has 2 holes in it. Firstly, some goods are not easily traded, and secondly, some goods cannot easily be substituted for another. 3. Describe supply and demand in the market for loanable funds and the market for foreign currency exchange. How are these markets linked? Supply and demand of loanable funds is determined by the real interest rate. A higher interest rate causes people to save and raises supply where a lower real interest rate does the opposite. In the market for foreign currency exchange, the real exchange rate balances out supply and demand. A higher U.S. real exchange rate increases U.S. goods compared to foreign goods, and exports fall. These 2 markets are linked because between the 2 of them, they determine national saving, domestic investment, net capital exports and net exports. 4. What is capital flight? When a country experiences capital flight, what is the effect on the countrys interest rate and exchange rate? Capital flight is a large and sudden reduction in the demand for assets located in a country. The currency of the country depreciates in value and the interest rate rises. 5. List and explain the three theories for why the short-run aggregate-supply curve is upward sloping. Sticky wages. Wages are slow to adjust and may not be able to be changed. Steady wages can be harmful to a company and cause them to have lower production levels. Nominal wages are based on expected prices and are slow to respond when the actual prices ends up being different. Sticky price. Prices for some goods and services also are â€Å"sticky† and take time to adjust. This is due in part to â€Å"menu costs†, or the administrative costs incurred by changing the prices of a product in a firm. Misperceptions. Different businesses read the market different ways. A misperception in the trend of the market can cause suppliers to supply more product, even when the demand is not truly there. 6. What might shift the aggregate-demand curve to the left? Use the model of aggregate demand and aggregate supply to trace through the short-run and long-run effects of such a shift on output and the price level. Use the following diagram to help explain your answer. Point A is the short-run equilibrium point whereas Point C is the long run equilibrium point. Higher prices lower costs and shift demand to the left (lower). If for say, the current market price of this item is at Point C, and the market price drops, the demand for the item will rise, shifting the curve to the left. 7. Suppose the Fed expands the money supply, but because the public expects this Fed action, it simultaneously raises its expectation of the price level. What will happen to output and the price level in the short run? Compare this result to the outcome if the Fed expanded the money supply but the public didn’t change its expectation of the price level? Use the diagram below to explain your answer. The output should remain constant if the FED had raised its expectation of the price level over time, but immediately, the raise is price would cause in increase in production. The equilibrium point should shift from point a, to point c temporarily, then up to point out as it balances out. If the FED did not change it’s expectations in the price levels, than the equilibrium should move to pint c from pint a, and stay there. 8. What is the theory of liquidity preference? How does it help explain the downward slope of the aggregate-demand curve? This is the theory that the interest rate adjust to bring the money supply and demand into equilibrium. A higher price level increases the demand for money, as people will carry more to pay the higher prices. Higher prices in turn causes a higher interest rate. The higher interest rate reduces goods demanded, and supply will also shift downward. 9. Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the country. If policymakers do nothing, what will happen to aggregate demand? Explain what the Fed should do if it wants to stabilize aggregate demand. If the Fed does nothing, explain what Congress might do to stabilize aggregate demand. If policy makers do nothing, demand will fall, so will production and employment. Eventually, recession and possible depression afterwards. The Fed can do things such as lowering the interest rate to help stimulate the economy. Congress may decide to cut taxes in an attempt to simulate the economy, but they can also increase government spending to stabilize the economy. 10. What is natural about the natural rate of unemployment? Explain why the natural rate of unemployment might differ across countries. The natural means that it is beyond the influence of monetary policy. Different countries have different abilities, laws and demand for employment. For instance, the country may not be able to organize in the same fashion as a union shop here is the US. might. 11. What causes the lags in the effect of monetary and fiscal policy on aggregate demand? What are the implications of these lags for the debate over active versus passive policy? Aggregate demand has lags in policy due to the time it takes for the policy to take affect. Additionally, the spending plans are set in advance so it also takes time for changes to affect spending. The biggest issue is the ability to time the policy correctly, since it takes time for everything to adjust. 12. Some economists say that the government can continue running a budget deficit forever. How is that possible? Since population and technological progress grow over time, so do a nation’s ability to repay the interest on it’s debt. As long as the debt grows slower than the nation’s income, this is possible. Reference: Mankiw, N. G. (2008). Principles of Macroeconomics. Fifth Edition. Ohio: South-Western Cengage Learning.