Macroeconomics (Part 2)

Marshall-Lerner condition

A depreciation has two good effects (substitution of imports , more demand for exports) and one bad effects (imports are more expensive). Marshall-Lerner condition is real depreciation leads to an increase in NX if sum of export and import elasticity is > 1. Initially, the condition is not met, devaluation worsens the trade balance. In the long run, trade balance will improve, it is called the  J curve effect.

PED (x-m) > 1, devaluation improves current account balance.

PED: price elasticity of demand

Mundell-Fleming model

An extension of IS-LM model, the Mundell–Fleming model describes the short-run relationship between an economy's nominal exchange rate, interest rate, and output. It is used in open economy. This model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," or the "Mundell–Fleming trilemma."

It is also known is IS-LM-BoP model. BoP is (Balance of Payments).
In perfect capital mobility, the BoP curve is horizontal.

In perfect capital mobility and fixed exchange rate, the increase in gov spending (expansionary fiscal policy) forces the central bank to supply more local currency, to keep the interest rate unchanged. At the same interest rate, the output has increased.

In perfect capital mobility and fixed exchange rate, the increase in local currency  (expansionary monetary policy) will drop the exchange rate. It forces the government to buy local currency to maintain fixed exchange rate. This reduces the money supply. This means monetary policy has no effect.

So it is impossible to have fixed exchange rate, perfect capital movement, and independent monetary policy.

Minimum wage policy

Why minimum wage is not good for the country?
If wage > productivity,
1) πe ↑ => P↑
w ↑ => C ↑, Pe ↑
Pe => πe ↑ => P ↑

2) P ↑ => X ↓ & IM ↑ => NX ↓
P ↑ => ε = EP/P* => ε↑ => NX ↓

Purchasing power of currency and Purchasing power parity

The purchasing power of a currency refers to the quantity of the currency required to purchase a unit of a good, or basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries.

Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences. The basis of PPP is law of one price. In the absence of transportation and other transaction costs, competitive markets will make the price of an identical good the same in two countries, expressed in the same currency.

For example, a particular TV set that sells for 400Rp in India should cost 800Rp in Pakistan if the exchange rate between India and Pakistan is 2 Pak/India. If the price of the TV in Pakistan was only 700 Rp, consumers in India would prefer buying the TV set in Pakistan. If this process (called "arbitrage") is carried out at a large scale, the India consumers buying Pakistan goods will bid up the value of the Pakistan Dollar, thus making Pak goods more costly to them. This process continues until the goods are again the same price.

For example again, if we convert GDP in China to US dollars using market exchange rates, relative purchasing power is not taken into account. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.

Money illusions and Money neutrality

The illusions of money : people think of money in nominal terms, the nominal value of money is mistaken for its purchasing power.

Neutrality of money : change in stock of money affects nominal variables, such as price, wages, exchange rate, doe not affect real variables, such as employment, GDP, consumption.

Microfoundations in Macroeconomics

It is a macro model that is built up from a formal analysis of the behaviour of individual agents in a consistent way. There may be just a single representative agent, or increasingly heterogeneous agents. So this way of macro analysis will involve lots of optimisation by individual agents, to derive aggregate relationships.

Differences between Micro and Macroeconomics
The difference between micro and macro economics is easy to tell. Microeconomics is the study of economics at an individual, group or company level. Microeconomics focuses on issues that affect individuals and companies. Micro looks at supply and demand and the setting of price level.

Macroeconomics, on the other hand, is the study of a national economy as a whole. Macro studies the GDP and how it is affected by national income, unemployment, growth rate.