GLEC Gyan Kosh PDF

GYAAN KOSH
TERM 2
Learning and
Development Council, Global Economics
CAC
This document covers the basic concepts of Global Economics

covered in Term 2. The document only summarizes the main
concepts and is not intended to be an instructive material on the
subject.
Gyaan Kosh Term 2 GLEC Learning & Development Council, CAC
CONTENTS
1. Introduction
2. Production and Capital
3. International Capital Flows
4. Money and Inflation
5. Exchange Rates
6. Growth Accounting and Economic Growth
7. The Labor Market
8. International Trade
9. Monetary Policy
10. Fiscal Policy

Introduction
Gross Domestic Product
Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country
in a given period of time
Gross National Product (GNP)
Similar to GDP except that it is based on who is doing the producing

Replace within a country with by inputs owned by citizens of a country
GNP = GDP + Net factor income from abroad
Wages earned by Indians in the UAE contribute to Indias GNP.
Problems with GDP
Not everything has a market price or a price that is easily measured

Lots of important economic activity takes place outside of market
o Services of owner-occupied housing
o Household production (cleaning, cooking, fixing)
Informal Economy / black market
Government services
Investments in intangible capital
Some of these are imputed, others ignored.
Focus on flow of Income not stock of wealth

May also care about how economic activity affects well-being tomorrow
o Physical capital
o Human / Knowledge capital
o Environmental / Resource capital
o Health capital
Does not include shocks to wealth
o The destruction of the Japanese earthquake does not directly enter GDP
GDP can be measured in several ways:
Measures of GDP
Total output
Total expenditure
Total income
Total value added of all firms
Total income = total expenditure because for every buyer there is a seller.
Expenditure Account:
Y = C + I + G + NX
Y = GDP
C = Private Consumption
I = Private Investment
G = Government Purchases of Goods and Services
NX = Net exports
Real and Nominal GDP:
Nominal GDP in India in 2009-2010

2010 was 6131172 crore rupees
Often referred to as GDP at current prices
Real GDP in 2009-20102010 at 2004
2004-2005
2005 prices was 4807222 crore rupees
Often referred to as GDP at constant prices
Since GDP at current prices is larger than GDP at historical prices, prices have risen inflation
Consumer Price Index (CPI):
Second measure of inflation

To calculate real GDP fix prices and let quantities change
To calculate cost of living fix quantities and let prices change.
Answers the question: How has the cost of living changed?
Calculating CPI :
Alternative measures of inflation in India:
The Labor Bureau and the CSO produce several monthly CPI series
Differ in the basket of consumption goods considered.
Four groups
o Urban non-manual
manual employees (UNME)
o Industrial workers (IW)
o Agricultural labor (AL)
o Rural labor (RL)
Also a wholesale price index (WPI)
GDP methodology
Weekly
Comparing GDP across nations:
Two methods
Use market exchange rates
Indias GDP per capita in 2009 was $1192 using the market rupeerupee-dollar
dollar exchange rate
Misses fact that many goods cheaper in India than the US
Ideal would be to calculate GDP in all countries using a single set of prices very expensive
Purchasing Power Parity adjustment
Indias GDP per capita in 2009 was $3280 using a PPP exchange rate
National Income Accounts:

Production and Capital
Cost benefits analysis of investment:

Benefit
The additional revenue that an extra unit of capital will produce
Marginal product of capital MPK
Cost
Cost of obtaining an additional unit of capital
Opportunity cost if internal funds
Marginal cost MC
When MPK equals MC then the desired level of capital is at its equilibrium value
Aggregate production:
Marginal Product of Labor:
Marginal Product of Capital

Investments and Savings
Investment:
What Shifts Investment Demand:

Shifts in the marginal product of capital
Productivity
Taxes
Risk
Savings
National saving may be divided into private saving and government saving
Private saving determined by households
Greater saving today implies
Lower consumption today
Higher consumption tomorrow
Why Save:
Consumption smoothing
Smooth out fluctuations in income
Retirement
Bequests may be thought of as smoothing across generations
Inability to borrow against future income
Save to purchase a house, go to school or start a business
Precautionary motive
Save as a buffer against future risk
High return to saving : real interest rate, taxes
The Interest Rate:
The Interest Rate and Savings:
A higher real interest rate has two effects on saving

Consumption tomorrow becomes cheap relative to consumption today raises saving and
reduces consumption today
Alters lifetime wealth
o Effect depends on whether you are a borrower or a lender
o Borrowers see their lifetime wealth decline as cost of borrowing rises
o Lenders see their lifetime wealth rise as interest income rises
Data: first effect tends to dominate
Saving increases with r
What Shifts Savings

Risk
Taxes
Expectations of future income
Capital Market Equilibrium:

Key Points:
Investment decision depend on the difference between current and desired capital
Desired capital depends on the rental rate
Saving depends on the desired mix of current and future consumption
In a closed economy saving equals investment
Shocks to one affect the other.
The interest rate brings about equilibrium in the capital market by affecting the cost of investment
and the reward for saving
An increase in government spending crowds out investment
National saving Y C G falls
A reduction in taxes also tends to redu
reduce Y C G, as consumers tend to send some of the
tax windfall.
Government budget deficits crowd out investment in a closed economy
International Capital Flows:
Key Point: The modern theory of trade flow focuses on investment and saving rather than exchange rates.
Trade Flows and Capital Flows:
Domestic saving may be invested at home or abroad

S = I + net capital outflows (NCO)
Implies
NX = NCO
Trade flows and capital flows must balance
If export a good must either import a good or an asset in payment
Current Account:
The current account measures the net accumulation of foreign assets by Indians.
CA = net purchases of foreign assets.
GNP version of NX = NCO above
Net foreign asset (NFA) position improves if:
CA>0
Asset revaluations > 0.
Are Trade Deficits Bad?
The common view is that trade surpluses sign of national strength and trade deficits sign of weakness.
Essentially the same question as Is debt bad?

Sometimes yes, sometimes no
Trade deficit = borrowing
Harm depends on what you do with the money and your ability to pay off the loan
Capital Market Equilibrium:

Money and Inflation
Quantitative Theory of Money:
MV = PY
M = money supply
P = price level
Y = real GDP
V is the velocity of money the number of times that the average dollar is used over the period in
question rate of circulation
Three assumptions turn this identity into a theory of the price level
The money supply (M) is controlled by the central bank
The velocity of money is constant
Output depends on tastes and technology and is independent of the money supply
Inflation:
According to the quantity theory inflation occurs when too much money chases after too few goods.
Milton Friedman:
Inflation is always and everywhere a monetary phenomenon.
Real and Nominal Interest Rates:
The real interest rate (r) measures the rate of return in terms of goods
One unit of output today yields 1+r units tomorrow.
The nominal interest rate (i) measures the rate of return in terms of money
One rupee today yields 1+i rupees tomorrow.
Money Market:
The central bank directly controls the monetary base

The base (B) is equal to the total number of rupees held by the public as currency (C) and by the
banks as reserves (R)
B=C+R
Reserves are deposits that banks receive but do not lend out
Money Multiplier:
Uncertainty and bank failures

Consumers to increase their holdings of currency
o c
o Banks to increase their reserves ratios rr
Tools of Monetary Policy:
There are several ways in which the central bank manipulates the money supply
Open market operations
Interest rates
Reserve requirements
Open market operations

The buying and selling of assets (usually government bonds) for money.
Directly affects the monetary base
Federal Reserve uses open market operations to target the federal funds rate
The federal funds rate is the interest rate in the interbank market for reserves
Repo Rate
Repo = repurchase agreement
Repo rate is the rate at which the central bank lends to banks against government securities.
Essentially the same as an open market operation.
Difference is between leasing and buying
The ECB and India primarily
rily use repos
Reserve Requirements
Changes in reserve requirements affect the multiplier
The RBI and the Bank of China both use alter reserve requirements to alter M1
In India it is called the cash reserve ratio (CRR)
The US Federal Reserve rarely alters reserve requirements.
Why do we see inflation?
If the central bank controls the money supply and inflation is everywhere and always a monetary
phenomenon.
.Why do we see inflation?
Fiscal distress
Price stability is costly
Fiscal Distress:
A government that has trouble raising taxes or borrow may resort to printing money
Print too much and get inflation
Print far to much and get hyperinflation
Conventional definition of hyperinflation is two consecutive months in excess of 50% per
month.
Examples of hyperinflation
Weimar Germany in the 1920s
Latin American countries in the 1980s
Zimbabwe in the 2000s
Takeaways:
Inflation is too much money chasing too few goods.

The nominal interest rate is the opportunity cost of holding money.
Nominal interest rates equal the sum of the real interest rate and the expected rate of inflation.
The central bank controls the money supply by altering interest rates and reserve requirements.
Exchange Rates
The Real Exchange Rate:
Exchange Rate Determination:
One approach: examine the prices of goods across countries
Two related concepts:

Law of one price (Prices of similar goods should be equal when stated in the same currency)
Purchasing power parity (Extends law of one price logic to the entire consumption basket)
PIND = E*PUS or E = PIND/PUS
where E is the rupee price of a dollar
Recall that the RER is the ratio of the basket values
PPP assumes that the RER = 1
Problems with PPP:
The baskets are not the same

Indian consumption basket has more food
Failures of the law of one price
Usually impediments to the free mobility of goods
non-traded
traded goods (haircuts)
transport costs
tariffs
Monetary Theory of Exchange Rates:
Has the flavor of supply and demand

Higher output in India need (demand) more rupees rupee more valuable
Increase supply of rupees rupee less valuable
Covered Interest Parity:
Uncovered Interest Parity:

The market for foreign exchange:
NCO = NX
What price balances NCO and NX?
The real exchange rate
When prices of domestic goods rise relative to foreign goods, exports fall and imports rise
NX falls
No obvious reason that NCO should be affected by the real exchange rate.
Currency Crisis:
Something happens that causes the domestic currency to weaken in the minds of market
participants.
In a fixed exchange rate system, the government keeps its currency from depreciating by selling
foreign exchange.
Reduces the supply of the domestic currency and increases the supply of the foreign
currency.
The government needs foreign exchange to do this.
Foreign exchange reserves
A currency crisis occurs when a government runs out of reserves.
Can be self-fulfilling like a bank run.
Greece:
Greeces problem is that it needs the
relative price of its basket to fall so
that its net exports can rise.
Since it is in the Euro zone, it cannot
devalue its currency.
It must reduce its price level, and
reducing wages and prices is painful.
The Labor Market
Labor Market Equilibrium:
Aggregate the labor supplies of individual workers and the

labor demands of individual firms.
Classical (full employment) labor market equilibrium is given by

the intersection of the labor supply and demand curves.
Real wage adjusts to set labor supply equal to labor demand.
Otherwise, workers would be willing to work at a lower wage,
or firms would be willing to pay higher wage.
Shocks to the Labor Market:
Classical View of Unemployment

Keynesian view of Unemployment:
Definitions in Unemployment:
In the US, each person over sixteen assigned to one of three categories (all figures are for
May 2011):
Employed: worked full or part time during the past week (139.8M)
Unemployed: did not work the past week, but looked for work during the past four weeks (13.9M)
Not in the labor force: did not work the past week and did not look for work during the past four
weeks (85.6M)
Labor force: employed + unemployed workers (153.7M)
Participation rate: Labor force as a percentage of adult population; (153.7 / (153.7 + 85.6)) = 64.2%
Unemployment rate: Percentage of labor force that is unemployed; 13.9 / 153.7 = 9.1%
Long run unemployment rate (natural rate) is never zero. Always some frictional unemployment as matches
between firms and employees form and dissolve
Summary :
A firm hires labor up to the point where MPL = W/P; the MPL curve is the labor demand curve
The individual labor supply curve is upward sloping if the substitution effect of change in wages
dominates;aggregate curve slopes upward because of an additional effect more people enter
labor force as wages increase
Classical view of unemployment: with negative productivity shock wages adjust downward and
people voluntarily drop out. Keynesian view: wage is sticky and imbalance between supply and
demand
Wages are related to labor productivity
If technological change is biased towards skilled labor, it can increase inequality
Minimum wage laws can cause unemployment hurting individuals they seek to protect
Growth Accounting
The process of accounting for the sources of economic growth.
For our production function, Y = A K0.3L0.7:

Y/Y = A/A + 0.3 (K/K) + 0.7 (L/L)
Growth in output = TFP growth + 0.3*capital growth + 0.7*labor growth
Output, capital, and labor can be directly measured. Productivity (TFP) growth can only be inferred.
Therefore, we rewrite A/A = Y/Y - 0.3 (K/K) - 0.7 (L/L)
A/A is the TFP growth rate. Captures growth in output over and beyond what can be accounted for by
measurable inputs. Backed out as a residual.
Two notions of productivity: TFP and labor productivity.
Labor Productivity
Labor productivity is output per worker or worker hour (depending on how L is measured).
Al=Y/L, and its growth is: Al/Al = Y/Y - L/L
Given Y = A K0.3L0.7,
Al=Y/L = A(K/L)0.3
Two Notions of Productive Growth:
Al can increase due to increase in TFP or in capital per worker. Since it nets out all inputs,
TFP growth (A/A) is a purer measure of efficiency increase than labor productivity growth (Al/Al ).
Capital is hard to measure. So, labor productivity is more often reported.
Limits to growth accounting:
Does not answer:

Why is TFP growth the only path to sustained growth?
How can TFP be increased?
What policies can aid or hamper growth?
To answer these questions, we need to go beyond accounting and study theories of growth.
Growth Rate Defined:
Growth rate of GDP is the rate of change of GDP:

gt+1 = 100(Yt+1 - Yt) / Yt
To gauge improvements in standard of living, we are interested in the growth rate of per
capita GDP (y)
Growth Dynamics:
Two main components to the analysis:

Allocation of output to consumption and saving (investment)
How saving (investment) results in accumulation of capital
Allocation of the output, y = Ak0.3:
Y = C + I + G + NX. For simplicity, assume closed economy with no government (NX = 0; G = 0)

Divide by L throughout to get: y = c + i
For closed economy, investment=saving
Assume consumers save a constant fraction s of output y. Saving = i = s y.
Therefore, c = (1- s) y. Income that is not saved is eaten.
Capital accumulation:
Capital stock rises as firms invest in new equipment, structures

Capital stock drops as old capital depreciates.
Change in capital = inv. - depreciation
k =i-dk
= sy - d k
At lower levels of capital
MPK high, and the positive term dominates
k > 0, and capital increases over time
At higher levels of capital

Given diminishing MPK, depreciation effect dominates
k < 0, and capital decreases over time
Steady State (SS): Long-run position of the economy. At this point k = 0, and investment is just
enough to offset depreciation.
k* is used to denote steady state capital stock.
y*, c* = (1-s) y*, are steady state output and consumption.
The economy ends up with the steady-state level of capital, regardless of the level of capital with which it
begins.
If k < k*, investment > depreciation, and capital stock (and output) rises till you approach k*.
If k > k*, investment < depreciation, and capital is wearing out faster than it is replaced, and capital
stock decreases till you approach k*.
The steady state is never reached in finite time. But, it is useful for long run analysis such as growth.
Implications of the Solow model:
A sudden decrease in capital per worker (say due to a disaster) will trigger sudden growth back to steady
state.
An increase in the saving rate (say from s1 to s2 >s1) increases the steady-state capital stock and output. In
data, countries with higher saving (=investment in equilibrium) rates do have higher levels of income.
An increase in the saving rate leads to faster growth only temporarily (i.e. in the short run) -- the economy
grows until the new steady state level of capital and income is reached.
Therefore, increasing the saving rate alone is not the answer to having long-term, sustained growth.
Diminishing return to capital prevents sustained growth.
Convergence Effect:
In Solow framework convergence is absolute; that is all countries become rich and grow at the same rate.
In reality, only countries with similar institutions and policies converge.
For dissimilar countries to converge, fundamental change other than capital growth alone has to occur.
That is, TFP (which includes institutions) has to increase.
International Trade
Comparitive Advantage:
Key Prediction: Countries tend to produce the goods in which they have a comparative (but not necessarily
an absolute) advantage.
Wages are determined in the aggregate labor market

Unit labor costs for a given industry = Wages / labor productivity in the industry ($/person
/output/person = $/output)
Unit labor costs will be lowest in the industry which has the highest labor productivity
The highest labor productivity industries will be the comparative advantage of the country
While all countries can gain from trade in the aggregate, not everyone within a country will necessarily
benefit
Trade encourages specialization and so some industries will disappear from a country while others will
expand
Hence, there are winners and losers. This explains opposition to trade by some groups within the country
Political Economy of Trade:
In developed countries, the gains from trade are experienced by most consumers but each benefits
by only a small amount
By contrast, the costs of trade are concentrated in industries that cannot compete with cheap
imports
While the gains of many outweigh the losses of a few, the few who lose substantially are more vocal
than the majority who gain only a little
In developing countries, calls for infant industry protection. Never helps productivity
What about trade deficits? Trade deficits are symptoms of an economy at different stages of
development. They depend on savings and investment decisions. They are not necessarily bad.
Trade Restrictions:
Governments impose tariffs
to minimize adverse distributional effects of trade
to raise revenue
Tools used
Tariffs
Quantitative restrictions (quotas)
Voluntary Export Restrictions (VERs)
Trade barriers like administrative and technical standards
Domestic content requirements
Monetary Policy
The Debate on Non Neutrality:
When a change in a nominal quantity (e.g. M, i) affects a real quantity (e.g. output), the
change is said to have a non-neutral effect. (Neutral if only the nominal price changes.)
The crux of the debate is:

Is money non-neutral in the short run?
Even if it is, can and should the central bank exploit the non-neutrality to counter cycles?
Keynesians: Yes and Yes. Classical economists: Maybe and No.
Long Run Neutrality:
Given that money is only a unit of value, expect changes in money to be neutral unit changes
Recall Quantity Theory implied that an increase in the money supply is accompanied by a one-to-one
increase in the price level (inflation). % M = % P.
Long-run change in output (growth) is driven by changes in technology and factor inputs, and not by
changes in money supply.
Long-run neutrality of money well-supported by evidence. Even Keynesians believe in long-run neutrality.
Short Run Non Neutrality:
Original evidence for non-neutrality was presented by A. W. Phillips (1958). Negative relationship between
inflation and unemployment (the Phillips curve).
Theories have tried to rationalize the Phillips curve:

Burst of money growth (inflation) results in economic boom: with rigid nominal wage, real wage decreases,
employment increases, GDP increases.
Classical response to question of exploiting Short Run Non Neutrality:
Evidence on negative tradeoff not robust.

Friedman, Phelps: Long run Phillips curve is vertical.
Lucas: With rational expectations, only unanticipated changes in money matter. Cannot fool people
all the time with surprises. Even short run Phillips curve is vertical
Summary :
Clear evidence on long-run neutrality of money. All economists agree on LR neutrality. Broad theoretical
support.
Evidence on short-run non-neutrality is mixed. Theory is inconsistent.
Keynesians believe in evidence, and advocate exploitation of inflation-unemployment tradeoff.
Classical economists feel it is futile to try to exploit non-neutrality even if it exists.
Real Business Cycles
If classical economists do not believe in systematic non-neutrality of money, how do they explain
fluctuations?
The cornerstone of the new classical approach to fluctuations is the Real Business Cycle (RBC) model
It is based on four implicit or explicit assumptions:
1. Fluctuations in technology (technology shocks or supply shocks). Temporary, but serially correlated
technology shocks (positive shock today positive one tomorrow with high probability), hit the economy.
2. The neutrality of money. The money supply, if anything, responds to change in output and not the other
way around. So, study fluctuations in a real model with no monetary variables.
3. People willingly substitute labor from times when wage or real interest rate is low to when they are high
(intertemporal substitution of labor)
4. Prices and wages are fully flexible. The economy is always in equilibrium.
Let us trace the effects of this negative productivity shock on the behavior of firms and households.
1. The output Y decreases, even if the current levels of capital and labor are utilized.
2. However, MPL and MPK are both decreased, decreasing the firms desired amount of labor and capital,
which further decreases the output.
3. From the labor market equilibrium we can see that the shift in labor demand real wages, and the
equilibrium labor supplied. (Note hours and employment are procyclical, and unemployment is
countercyclical.)
4. The in MPK, Kd and the I curve shiZs leZ. Even if the S curve does not shift, this is enough to
decrease equilibrium investment. Also, the shock is likely to be negative tomorrow. So, these are not times
to expand business! (Note investment is procyclical.)
5. How do households react to a temporary loss in income? The permanent income hypothesis suggests
that people, in an urge to maintain smooth consumption, consump\on only slightly because they either
borrow or cut down on savings. (Note consumption is not too volatile.) This means that the saving curve S
shifts leftward.
6. This reinforces the previous effect of in investment. Investment drops even further. (Investment is the
most volatile component.)
7. The effect on the real interest rate is ambiguous. The leftward shift of S tends to real interest rates (as
loanable funds have become scarcer), but this is offset by a leftward shift of I, due to the in MPK. (Real
interest rate is acyclical in data.)
In summary, a negative productivity (technology) shock output, employment, saving, investment and
leaves the real interest rate virtually unchanged, nailing most facts of cycles.
Policy Implications:
The presumption that the government can play an active role in countering business cycles and
stabilizing the economy is at the heart of Keynesian macroeconomics
But in the RBC theory, fluctuations in output, employment, consumption, etc. are natural responses
of individuals to inevitable and unpredictable changes in the environment
So, classical economists would argue that the government cannot stabilize the economy
The arguments parallel the ones for rules regarding the Feds monetary policy
FISCAL POLICY
The governments policy on expenditures, taxes, and thus its borrowing is called fiscal policy.
A governments revenues typically come from: individual income tax, corporate profit tax, excise and
customs, property tax, sales tax, and social insurance levies
Traditional View of Deficits:
Traditional view: a tax cut of $1 disposable income by $1, part of which is consumed and the rest
saved.
Spvt by < $1, while decit Sgov by $1. National saving, S, . Therefore, equilibrium real interest
rate and investment .
With persistent deficits, the accumulation of domestic capital slows down, and future generationswill
experience a lower standard of living. (Solow model predicts a lower steady state level of capital and per
capita income when the saving rate decreases.)
Ricardian View of Deficits
Ricardian equivalence says consumers save the entire tax break that they get because they anticipate
increase in future taxes to pay off the debt. During period 1, in government saving is completely oset by
the increase in public saving. There is no change in national saving!
In the Ricardian view, deficits do not matter, since the national saving is unaltered and the timing of taxes
and debt is irrelevant.
Implication: A balanced budget every year is not necessarily good. e.g., during a war instead of raising taxes
on an already overburdened public, it might be welfare improving to run a deficit; it does not S.
Arguments against Ricardian equivalence:
Tax cut is for present generations, tax hike is for future ones. (But older generations might be
altruistic and leave bequests.)
Borrowing constrained individuals (those who would like to consume more than Y1, but cannot get
loans) would consume more when tax is cut.
Fiscal Stimulus:
Keynesians advocate tax cuts (to stimulate consumption spending) to revive an economy in recession.
Potential problems with this:
If tax cut saved (Ricardian view), no in C
Huge lags between enactment of policy and effect on the economy
Another suggestion is to G (to spend on infrastructure, create jobs, etc.). Since Keynesians believe
deficits are bad, they would eventually have to increase taxes to make up for G. Problem with this:
distortionary income taxes decrease labor supply!

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GYAAN KOSH

This document covers the basic concepts of Global Economics

2. Production and Capital

3. International Capital Flows

4. Money and Inflation

6. Growth Accounting and Economic Growth

7. The Labor Market

10. Fiscal Policy

Gross National Product (GNP)

Similar to GDP except that it is based on who is doing the producing

Problems with GDP

Not everything has a market price or a price that is easily measured

Focus on flow of Income not stock of wealth

GDP can be measured in several ways:

Real and Nominal GDP:

Nominal GDP in India in 2009-2010

Consumer Price Index (CPI):

Second measure of inflation

Alternative measures of inflation in India:

Comparing GDP across nations:

National Income Accounts:

Production and Capital

Cost benefits analysis of investment:

Marginal Product of Labor:

Marginal Product of Capital

Investments and Savings

What Shifts Investment Demand:

The Interest Rate:

The Interest Rate and Savings:

A higher real interest rate has two effects on saving

What Shifts Savings

Capital Market Equilibrium:

International Capital Flows:

Trade Flows and Capital Flows:

Domestic saving may be invested at home or abroad

Are Trade Deficits Bad?

Essentially the same question as Is debt bad?

Capital Market Equilibrium:

Money and Inflation

Quantitative Theory of Money:

Real and Nominal Interest Rates:

The central bank directly controls the monetary base

Uncertainty and bank failures

Tools of Monetary Policy:

Open market operations

Why do we see inflation?

Inflation is too much money chasing too few goods.

The Real Exchange Rate:

Exchange Rate Determination:

One approach: examine the prices of goods across countries

Two related concepts:

Problems with PPP:

The baskets are not the same

Monetary Theory of Exchange Rates:

Has the flavor of supply and demand

Covered Interest Parity:

Uncovered Interest Parity:

The market for foreign exchange:

The Labor Market

Labor Market Equilibrium:

Aggregate the labor supplies of individual workers and the

Classical (full employment) labor market equilibrium is given by

Shocks to the Labor Market:

Growth in output = TFP growth + 0.3capital growth + 0.7labor growth