Macroeconomics readings: 2007 Textbook (Macroeconomics: A Modern Approach)

Transcription

1 Macroeconomics readings: 2007 Textbook (Macroeconomics: A Modern Approach) This posting gives precise guidance for study of the 2007 Macroeconomic textbook.! What pages to read, and what to skip (i.e., not tested on the final exam).! What pages are used for the homework assignments.! Which lines or paragraphs to focus on, and which equations to know well. Skip chapter 1, which is an introduction to the textbook. It says what the book covers, and it is worth reading, but it is not tested on final exam. The term skip in these postings means not tested on the final exam. We are not judging the quality of the material.! We skip historical details, since the final exam does not test them. These summaries are brief, and they help you understand the concepts in the textbook. We recommend that you skim these section to understand how the macroeconomic principles affected the U.S. economy in recent decades, but you need not recall the facts.! We skip most current interest stories. Barro relates his conversations with Bono about helping developing countries. It is a nice story, but we don t test it. Many of these sections explain how we validate the model with empirical data. These sidebars are interesting, but they are not tested on the final exam.! We skip sections that are not generally accepted by economists. Barro fully accepts the Ricardian Equivalence Theorem. Other economists do not, so we skip the details of this theorem.! We skip sections that are critiques of other macroeconomic theories. We skip the chapters on the price mis-perceptions model and on sticky prices. Barro presents them only to say they are not persuasive. The mathematics in this textbook is simple, since the book is geared to college students, not to actuarial candidates. The book derives the equations at length, and it repeats the equations several times. You can skim many of these derivations. Focus your study on which variables are dependent variables and which are independent variables.

2 Chapter 2: National Income Accounting (Module 1) Read pp16-20; focus on Table 2.1 and the calculation of the chain-weighted real GDP. The final exam may give other goods and other prices, and real GDP calculated two ways. Read Real Gdp as a Measure of Welfare on page 20. GDP does not always measure social welfare. The Communist countries of Eastern Europe and Asia destroyed their environments, but Western European countries enforced strict air and water codes. GDP alone does not measure full social welfare. Read pages Focus on the three alternative views of GDP on pages Know the pieces of GDP according to each definition. Skip table 2.6 on page 28. This table shows GDP by sector. This table shows that the production of goods (agriculture, mining, construction, manufacturing, etc.) are about 45% of GDP; the rest is professional services (finance, health care, etc.). Skip the By the Numbers box on page 29 and table 2.7 on page 30. These are state figures, which are not tested on the final exam. Read Back to Reality on page 31. The final exam tests why the consumer price index was misleading (until it was changed). Review Question A.1 on page 32; know the difference between a stock and a flow.

3 Chapter 3: Introduction to Economic Growth (Modules 2 and 3) Read the introduction on pages Read pages until so that real GDP per person fell over time in the middle of page 39. Skip from To measure economic growth on page 39 through end of page 41. Read pages 42-44: World Poverty and Income Inequality. Income inequality has become a political byword. The textbook shows that slow economic growth, not income inequality, is keeping people poor. The final exam does not test the historical details in Long-term Growth in the United States and Other Rich Countries on pages Read Patterns of Economic Growth on page 46 to know what this chapter deals with. Read pages Focus on the production function on pages and the Solow growth model on pages The final exam tests the diminishing marginal product of labor and marginal product of capital. Understand the difference between the transition period and the steady state. Skip appendices A and B on page Read appendix C on the Cobb-Douglas production function on pages Review Questions B.7, B.8, and B.9 on page 63.

4 Chapter 4: Working with the Solow Growth Model (Module 4) Read pages 68-78; skip Extending the Model on page 71. Know the effects of changes in the savings rate, technology level, labor, and population growth on steady state output and capital. Convergence: read pages Skim Extending the Model on page 79. Know the last two paragraphs in the box on page 79, and the effect of the declining population growth rate in European countries on their capital and real GDP per worker. Skim Facts about Convergence on pages The final exam does not test historical details, but the theory of conditional convergence was developed to explain the difference between Figure 4.9 on page 83 (upward sloping curve) and Figures 4.10 and 4.11 on pages 84 and 85 (downward sloping curve). Read Conditional Convergence in the Solow Growth Model from bottom of page 83 to end of page 89. Review Questions B.5.b and c and B.6.b and c, which deal with variations in the savings rate and population growth rate. The final exam may ask one of these scenarios, such as if population growth rate declines, what happens to real GDP per worker? Skip the appendix on the rate of convergence on pages The homework assignment for this module has a final (non-required) part that asks about the rate of convergence. This topic is not tested on the final exam and is not required for the homework assignment.

5 Chapter 5: Conditional Convergence and Long-run Economic Growth (Module 5) Read pages 95-96, and know key equation 5.1 on the top of page 96. The addition and subtraction signs (plus and minus signs) under the independent variables give the sign of the partial derivative: if the independent variable increases, does the dependent variable increase or decrease? Read Recent Research on the Determinants of Economic Growth on pages and Examples of Conditional Convergence on pages , skipping Back to Reality on pages Much of the recent research has been done by Barro, which is why Bono wanted to speak to him (see the Back to Reality box). The final exam may ask which characteristics raise the steady state level. Read Long-run Economic Growth on pages Focus on the mathematics of steady state growth and the concepts of endogenous growth theory. Know key equations 5.9 and 5.10 on page 105. Skip Back to Reality on page 112, and skip Back to Reality on page 115. Many economists believe research and development have strong effects on long-term economic growth, and this topic is hotly debated for generic drugs, drug imports from Canada, AIDS medications in Asia and Africa, and various anti-trust cases, such as Microsoft in Europe. Economists say that intellectual property rights are essential for strong economic growth. Question B.2 on page 117 is reviewed in the homework assignment.

6 Chapter 6: Markets, Prices, Supply, and Demand (Modules 6 and 7) If you have taken the microeconomics on-line course (or any good college course), you know these concepts. You may skim this chapter. The discussion of supply and demand curves is the same as in the microeconomic on-line course. If you have not taken microeconomics, spend more time on the basic concepts of supply and demand, which are used throughout this textbook. Note the following items: Microeconomics courses deal with the goods market. Barro s textbook has four markets: goods (prices), labor (real wage rates), capital (rental market and interest rates), and bonds. Skip the Back to Reality on page 127. Know key equation 6.6, which links the rental market (capital) to the bond market. Understand the difference between real and nominal prices and returns. Many equations in the textbook convert nominal prices (or rates) to real prices (or rates). See key equation 6.11 on page 135 and key equation 6.12 on page 136. Skip Extending the Model on page 135; this is covered in the corporate finance course. Read Clearing of the Markets for Labor and Capital Services on pages This section is written in detail. The formulas for the two markets are similar. Both assume an inelastic (vertical) supply curve. Focus on equation 6.14 on page 141 and equation 6.16 on page 144. These equations use the marginal product of labor and capital. Note that depreciation enters the equation for the marginal product of capital. Skip Back to Reality on page 145. This topic is covered in the corporate finance course. Review Questions A.4 and A.5 on page 147. Distinguish between a change in the demand curve and a change in the quantity demanded. Review Question B.7.a and B.7.b on page 147. Skip the appendix on pages

7 Chapter 7: Consumption, Saving, and Investment (Module 8) Read pages , and know key equation 7.9 on page 156. Read pages Focus on the income effect on pages and the intertemporal substitution effect on pages Skip By the Numbers sections on pages 160. Read pages Figure 7.4 shows the basic effects. The multi-year model is an extension of the two year model. Key equation 7.12 on page 163 extends the two year budget constraint to a multi-year budget constraint. Understand the meaning of permanent income on page 164 and the propensities to save and consume on pages Skip the By the Numbers boxes on pages 165 and 166. Read pages Know especially equation 7.13 on page 167. The mathematics in this chapter derives the key equations; the final exam does not test the derivations. Review Questions A.4 and B.6 on page 169. Skip the appendix on pages

8 Chapter 8: An Equilibrium Business-Cycle Model (Modules 9 and 10) Business cycles are explained in two ways: real business cycle theory and IS-LM curve analysis. This course covers only the real business cycle interpretation. Pages explain trend and standard deviation. You know these terms, and the final exam does not test them. Understand the model from the bottom on page 177 through the top of page 185. Skip By the Numbers on page 177. From the section on Matching the Theory with the Facts on pages , know which items are pro-cyclical and which are contra-cyclical. Barro verifies the macroeconomic model with empirical evidence from recessions. The relation of theory with facts is not perfect; know the conclusions that Barro draws. Pages deal with changes in technology. Read this section, and focus on Barro s conclusions in the top two paragraphs on page 191. This relation makes sense: most technological changes are long-lasting, not temporary, but they are not permanent. Read pages , which deal with changes in the labor supply and labor productivity. Skip By the Numbers on page 194. Know the three effects: income effect, substitution effect, and intertemporal substitution effect, and know how they relate to temporary vs permanent changes in the real wage rate. Focus on the conclusions on pages Review Question A.1 on page 199. This topic is covered in the text. Review Questions B.4 and B.5 on pages These topics are covered in the homework assignments. Review Questions B.6 and B.7 on page 200. These questions change a parameter in the equations.

9 Chapter 9: Capital Utilization and Unemployment (Module 11) Read pages Focus on key equation 9.4 at the bottom of page 204 and the market clearing equations 6.6 and 6.7 on page 209. Read pages The final exam tests the model for unemployment. Pages describe the empirical data. Some results are obvious: for example, Figure 9.8 on page 213 shows that when employment is high, real GDP is high (a correlation of 88%). Pages is model of unemployment. Unemployment is a contentious topic. You hear about voluntary unemployment, involuntary unemployment, structural unemployment, natural unemployment, and other varieties. But it is hard to distinguish voluntary from involuntary unemployment, and the model in this textbook does not try to do so. Focus on the job finding rate, the job separation rate, and the effects of unemployment insurance. The homework assignment deals with seasonal fluctuations, as discussed in Back to Reality on page 228. Review Question B7 on page 230. The final exam tests how various government programs, such as unemployment insurance, affects the natural unemployment rate. Politicians once denied that these programs have the effects described in this chapter. Now France and Germany are trying to reform their social programs and unemployment benefits to reduce their unemployment rates. Review Question B.8. The homework assignment considers seasonal unemployment, by algebra and by Excel s solver built-in function.

10 Chapter 10: the Demand for Money and the Price Level (Modules 12 and 13) Read pages Skip the Back to Reality boxes on pages 233 and 234 and the tables on pages 235 and 236. Focus on the monetary base, M 1 and M 2 (pages ). Know what fiat money, commodity money, and legal tender mean, but the specific examples are not tested on the final exam. Read The Demand for Money on pages ; skip the sub-section on the empirical evidence on the demand for money on pages The homework assignment deals with the effects of interest rates and transaction costs. Know how interest rates, real GDP, transaction costs, and other items affect the demand for money. Key equation 10.2 on the bottom of page 239 gives the nominal demand for money. This equation uses the nominal interest rate, not the real interest rate, so it differs from other equations in the textbook. Read pages Focus on the two subsections on pages : the neutrality of money, a change in the nominal quantity of money (i.e., in the supply of money), and a change in the demand for money. Skip Back to Reality on page 248. Key equation 10.5 on page 242 looks like key equation 10.2 on page 239.! For equation 10.2, the real demand for money changes to satisfy the relation.! For equation 10.5, the price level changes to satisfy the relation. The homework assignment covers the seasonal fluctuation in the price level caused by changes in the demand for money. Understand the concept of general equilibrium on page 242. Barro develops several results on pages 245 and 247. Know how changes in various input variables affect the price level, inflation, nominal wage rates, and nominal interest rates. Read pages Focus on the two subsections on pages : cyclical behavior of money and seasonal variations in money. The homework assignment covers the seasonal fluctuation in the price level caused by changes in the demand for money. The FED varies the money supply to offset this seasonal fluctuation, so you don t notice it. Review Question A.2 on pages Explain how each of these variables affects the real demand for money. Part A.2.e refers to the price level, not the inflation rate. The inflation rate affects the nominal interest rate (in Part A.2.a); the price level does not. Review Question A.3 on page 255. This question says that money is neutral. Review Questions B9, B10, B11, B12, and B13 on pages The homework assignments and the final exam problems cover these topics.

11 Chapter 11: Inflation, Money Growth, and Interest Rates (Modules 14 and 15) Read the introduction on pages Skim the section on cross-country data on inflation and money growth on pages The homework assignment uses the data in Table For two decades, economists made the error highlighted in the homework assignment. Milton Friedman put forth the theory in this textbook. Know well the last bullet point on pages , which is tested on the final exam. Read the section on Inflation and Interest rates on pages Focus on the differences between actual and expected inflation and between the real and nominal interest rates. Skip the sections on Measuring Expected Inflation on page 268, U.S. Expected Inflation and Interest Rates since World War II, on pages , and Indexed Bonds, Real Interest Rates, and Expected Inflation Rates on pages Know the sub-section Interest Rates on Money at the top of page 273. The real interest rate on money is the negative of the inflation rate. Read Inflation in the Equilibrium Business Cycle Model on pages Focus on key equation on page 274, which is repeated throughout the textbook. The rental market and the bond market determine the same item: the real interest rate. Note the important point on the top of page 275, and the result at the bottom of page 276. Barro explains the conclusion in the second paragraph on page 277. He uses this result to derive monetary policy. Read pages Know the key equation at the top of page 279, which says that the price level is the dependent variable, or the balancing item that equates money supply and the demand for money. Barro summarizes the conclusions in five bullet points on page 279. These are tested on the final exam. Skip the section A Shift in the Money Growth Rate on pages Barro shows a discontinuity in the price level. The final exam does not test this. Skip Government Revenue from Printing Money on pages ; skip By the Numbers on page 285; skip Table 11.3 on page 286. The By the Numbers box is fascinating, and it recurs time and again. Zimbabwe now has hyper-inflation, with similar problems. But the final exam does not test these historical facts, so you can skip the box. Review Question A.1 on page 287. Distinguish between a rise in the price level and a rise in the inflation rate (or nominal interest rate).

12 Review Question A.5 on page 287. Which affects the value of bonds vs money: the real interest rate or the nominal interest rate? The homework assignment covers Question B.7 on page 288. Review Question B.8 on page 288. The text discusses this, and the final exam covers it. Question B.9 on page 288 is covered in a homework assignment. Review Question B.11 on page 289. This question covers the relation of interest rates to the market value of bonds (or other fixed-income securities).

13 Chapter 12: Government Expenditure (Modules 16 and 17) Skip pages These pages show the size of government expenditure in the United States. Skip Figures 12.1 to 12.4 on pages and Table 12.1 on page 297. The final exam does not test the historical facts. Read the text from the bottom of page 295 through the middle of page 301. Know Equation 12.1 on page 298 (the government budget constraint), and focus on equation 12.4 on page 300, which adds government transfers and taxes to the household budget constraint. The macroeconomic model assumes that people anticipate future transfers and taxes. Key equation 12.6 at the bottom of page 300 is a multi-year version, with present values. Read pages The conclusions in italics at end of the paragraphs show that a permanent change in government expenditures has little or no effect on GDP. Read Extending the Model on pages ; focus on the last paragraph on page 306. Previous economists assumed that the crowding out effect depended on the usefulness of the government services; Barro says that it does not. Know this result; the final exam does not test the derivation (Equation 12.10), but it tests the conclusion. Read pages , which has different results for temporary changes in government expenditures. It is hard to test this result in peace-time, since even temporary government programs are renewed each year and may never end. Barro uses wartime expenditures to test the model, but even war expenditures seem to drag on year after year. Vietnam lasted decades. Afghanistan and Iraq were short bombing expeditions that still continue. Read Extending the Model on page 309, which suggest that government spending patterns affect the term structure of interest rates. This box assumes that we can identify which government programs are temporary, and that temporary programs actually end. Skip pages Barro s model predicts the effects of wars on the labor supply, the real wage rate, and the interest rate. The facts don t fit the simple model. Barro suggests various reasons for the discrepancy. This is speculation; the final exam does not test it. Review Question B.3.a on page 316. Review the discussion of National Income Accounting in the first module of this course. Review Question B.7.a on page 317. The homework assignment asks how the usefulness of government services varies among groups of citizens (wealthy vs poor).

14 Chapter 13: Taxes (Module 18) Skip pages Barro shows the types of taxes and their sizes in the United States. The final exam does not test any of the details in the textbook. As actuaries, you will pay the highest tax rates for most of your careers. The high tax rates after 1945 are depressing. The silver lining is that other countries have even higher taxes. Only people in Hong Kong, Bermuda, Singapore, Eastern Europe, and a few other places avoid high taxes. Read pages The homework assignment computes actual tax rates and marginal tax rates for three tax systems. Flat tax rates over large deductibles are perhaps the best way to combine social policy (low taxes for the poor) with economic efficiency (low marginal tax rates). The final exam tests marginal tax rates and their effects on labor supply. Read Taxes in the Model on pages , including Extending the Model on page 331. Focus on the after-tax real wage rate on page 327, and the implications for the macroeconomic model. Read page 329 carefully. The tax on labor income affects the rental market as well. The decline in labor and capital reduces real GDP. The box Extending the Model on page 331 examines a consumption tax, like the value added tax in Europe or state sales taxes in the United States. A goal of macroeconomics is to identify the optimal tax system which least hinders the economy. Some tax reformers want to switch to a consumption tax instead of a labor tax, assuming that a consumption tax does not diminish the labor supply. Barro shows this is not true. A flat consumption tax is like a flat income tax, and a consumption tax that depends on the type of good bought (higher for luxury items, lower for essentials) is like a progressive income tax. Read An Increase in Government Purchases Financed by a Labor Income Tax on pages , including Back to Reality on pages The Laffer curve was ridiculed when it was introduced in the early 1980 s. It is now accepted by many economists and governments, especially in the nearly emerging economies of Asia and Eastern Europe. Some Western European countries have marginal tax rates so high that reducing the tax rate would increase total tax revenue. Read Transfer Payments on page 337. This section has only three paragraphs, and Barro does not discuss the details of Social security or other transfer payments. Focus on the first line of the second paragraph. Many transfer programs have the same effect as high marginal tax rates. Welfare discourages work, since $100 dollars of work income may reduce welfare benefits by $100. The reduction of the U.S. welfare system in the 1990 s was probably the best way to help poor people re-join American society. Review Questions A.1 and A.2 on page 338. For Question A.1, consider a flat tax of 20% on income above $10,000 a year and a flat tax of zero on income below $10,000 a year.

15 For Question A.2, what if the government increases the tax rate to 100%? What would the total tax revenue be? Marginal tax rates above 100% are clearly detrimental to the economy, but occur every so often. Review questions B.4 on page 338 and B.8 on page 339. What is the effect of a tax on nominal interest income on the propensity to save? Life insurance is one of the most tax advantaged assets in the United States. How might the demand for permanent life insurance change in the marginal tax rate on asset income increases?

16 Chapter 14: Public Debt (Modules 19 and 20) Skip pages , which gives a brief history of government debt. The U..S. government was not always as profligate as it is now, but this fact is not tested on the final exam.! The United States began as a reaction to high British taxes on the colonies. From its th inception until the early 20 century, Americans were wary of government taxes. The American pioneers valued frugality, and they did not like debt. Statesmen were proud if the government ran a surplus. th! In the mid-20 century, economists believes that government spending could lift the economy out of a recession. The government had a rationale for spending more than it takes in, so spending rose and the deficit increased. Politicians ran a deficit to help the American people. Barro shows that a permanent rise in government spending has little or no effect on GDP. The economic rationale from previous generations was an error. The section on characteristics of government bonds is not tested on the final exam, but the notation in the middle of page 345 is used in later sections. The superscript g on bonds, g B, means government bonds. Read pages Know key equation 14.1 on page 346. Skip figure 14.3 on page 348. Understand the meaning of real national saving on page 349. If government savings increases, private savings decreases, and national savings tends to remain the same. Skim pages Read from the middle of page 351, In our simple example to the top of page 352, does not affect real national saving. Barro s textbook uses the Ricardian Equivalence Theorem. Other economists do not agree with this theorem in the strict form that Barro presents. Know the general result, which is used in the macroeconomic model, but the mathematics is not tested on the final exam. Skip pages These pages generalize the Ricardian Equivalence Theorem, and they are not tested on the final exam. Read Economic Effects of a Budget Deficit on pages , including the Back to Reality box on page 359. The effect of a budget deficit is much debated. Newspapers and magazines say that the profligacy of our generation must be paid by our children, and that we are enslaving our children to pay our debts. Economists debate the true effects of a budget deficit. Note the discussion of strategic budget deficits on the bottom on page 359. Read The Standard View of a Budget Deficit on pages For the public as a whole, Barro does not presume that finite lifetimes affect optimal decisions. The homework assignment examines the relative preferences of families with many or few children.

17 Skip Imperfect Credit Markets on pages Barro rejects this hypothesis, and you are unlikely to encounter it elsewhere. Read Social Security from the bottom of page 363 through page 365, skipping the By the Numbers box on page 364. Read open market operations on page 366, along with Table 14.2 at the bottom of this page. Focus on the last paragraph on page 366, which summarizes the conclusions. Raising or lowering the money supply affect inflation and the price level, not real variables. The textbook focuses on macroeconomic theory, not on the specifics of monetary policy. Other textbooks often devote a whole chapter to open market operations and other ways that the Federal Reserve Board changes the money supply. You may read in the papers that the FED met yesterday and increased interest rates a quarter of a point to (i) forestall inflation, (ii) stimulate the economy, (iii) reduce unemployment, or some other policy goal. Barro concludes that monetary policy does not change real economic variables. It changes the price level, the nominal wage rate, and nominal prices, and it may change expected inflation and the nominal interest rate. (Be sure you can explain these effects.) But it does not accomplish the goals it seeks. The Wall Street Journal and other newspapers mention the response of financial markets to the FED actions. If the FED action raises the price level, bond values fall, since the fixed dollar returns are worth less. The FED action cause immediate changes in the bond and stock markets, even if they do not affect the real economy. Read the summary on page 367, and review Question B.4.a,b,c, and d on page 368. For part (b) of this question, Barro assumes people are rational, so people without children may differ from people with children. Part (e) uses a section that is skipped in this course.

18 Chapters 15 and 16 (No Modules) Chapter 15 is the old school of macroeconomics. If people are rational and have good information about government policies, inflation rates, and interest rates from news magazines, the price-misperceptions model (which is based on consumer ignorance) is not valid. Barro does not accept the price-misperceptions model (this chapter is a critique of the model), and the macroeconomics on-line course does not cover it. Chapter 16 on sticky prices and nominal wage rates was (perhaps) more important when labor was unionized and wage rates could not decline to clear the labor market. Barro does not believe the theory in this chapter (he criticizes it), and it is not covered in the course. Chapter 17: World markets in goods and credit (Modules 21 and 22) Chapter 17 is perhaps the most important chapter in this book for the coming years. Most economists say the United States and all countries gain from international trade. Many politicians in both western countries and developing countries try to restrict free trade. Read the introduction on pages Read the Balance of International Payments on pages Know the terms listed in bold face, and know key equations 17.4, 17.5, and 17.6 on pages 419 and 420. Know the differences between GNP and GDP, and how each variable affects the current-account balance. Skim the History of the U.S. Current-Account Balance on page The final exam does not test these figures, so you need not recall any facts in this section. Understand how positive vs negative values in Figure 17.3 affect the current-account balance, though you are not tested on the actual figures. To understand why some countries have a positive current-account balance and others have a negative current-account balance, and to judge which balance is better, review the U.S. history. Think of several scenarios as you read the textbook:! Country Y makes cars; Country Z has farms and does not produce for export. Country Y sells cars to wealthy land owners in Country Z.! Country Y makes cars; Country Z mines iron. The two countries trade, with a zero current-account balance for each country. In 20X5, Country Y learns to make cars from aluminum. In 20X6, Country Z still buys cars from Country Y, but Country Y no longer buys iron from Country Z. (The market price of iron may fall, which also affects the terms of trade.)! Countries Y and Z produce cars, which they sell in their home countries for the same real price. Country Y makes good cars and Country Z makes shoddy cars. Country Y also exports cars to Country Z, but Country Z does not export cars to Country Y. (If purchasing power parity holds, this scenario may occur if one country under-values its currency.

19 The homework assignment examines the social welfare effects when one country undervalues its currency. Read pages Know key equation on page 427, and focus on the three results at the bottom of page 427 and the top of page 428. Read Economic Fluctuations on pages Know the conclusion in italics at the bottom of page 428: the model predicts that the real current-account balance will be counter-cyclical Page 429 gives examples. Read Harvest Failures, Government Purchases, Developing Countries on page 430. The final exam tests the scenarios in this section, in addition to the results in the previous section stemming from economic fluctuations. Given any scenario, know if the expected current-account balance is positive or negative. Read International Borrowing and Lending on page 431. Understand the scenarios in this section affecting Australia, Poland, Europe, the U.S., Mexico, and Brazil. You need not recall the specifics of any country, but the final exam may give a similar scenario. Read The Current-Account Deficit and the Budget Deficit on page 432, but skip the Back to Reality box on page 433. Articles in newspapers often assume that a budget deficit causes a current-account deficit. Barro says this is mistaken, but both deficits may stem from other government actions. Know the line in italics: a budget deficit does not create a current-account deficit in the middle of page 432. Know also the empirical data results at the bottom of page 432, and how a temporary increase in government expenditures may cause both deficits. Read the terms of trade on pages Focus on the relations among the terms of trade, the current-account balance, and investment. Know equations and on page 435, and the summary in the last paragraph of this sub-section Equation (17.13) shows that an increase in the terms of trade moves toward surplus. Read The Terms of Trade and Investment on pages Know equation at the top of page 436 and the four paragraphs that follow (to the end of the sub-section). Skip Empirical Evidence from Oil Producers on pages Read The Volume of International Trade on page , and the summary on page 439. Reviews Questions A.2, B.3, and B.4 on page 440. Question B.4 combines marginal tax rates and the current-account balance. Review Question B.5 on page 440.! A disturbance in the rest of the world affects the demand curve for coffee; the supply curve does not change.

20 ! A disturbance in Brazil affects the supply curve for coffee; the demand curve does not change. Review the chapter on supply and demand curves. In both scenarios, the price of coffee increases.! If the demand curve increases, the quantity of coffee sold increases.! If the supply curve decreases, the quantity of coffee sold decreases. Relate this difference to the movement in the current-account balance.

21 Chapter 18 Exchange Rates (Modules 23 and 24) Read pages , including By the Numbers on page 442. The homework assignment examines foreign currency forward exchange rates. The By the Numbers box defines forward rates. They are covered in detail on the financial economics portions of the joint SOA/CAS actuarial exams. The table on page 443 shows forward rates for four countries: Canada, Japan, Switzerland, and the United Kingdom. Rank these four countries by the risk-free rate in each of them: which has the highest risk-free rate, which has the second highest, and so forth. The answer is given by the formulas in this chapter (interest rate parity). Read Purchasing Power Parity on pages Understand the difference between absolute purchasing power parity and relative purchasing power parity (key equations 18.2 on page 446 and 18.5 on page 450). You might wonder what goods are used for absolute purchasing power parity. Many years ago, we used gold bars, since some countries offered to redeem their currencies for gold. The Economist (an international news weekly focusing on politics, finance, economics, and technology) now uses a good that is sold throughout the world in almost identical form: MacDonald s Big Macs. Each year, the dollar price of a Big Mac is given for each country. Know the explanation for the differing real exchange rates among the countries on the bottom of page 447. The final exam tests this Balassa-Samuelson hypothesis. The final exam gives a scenario with different interest rates and inflation rates in two countries, and asks about future exchange rates. Read Interest Rate Parity on pages Know key equations on page 453 and on page 454. These relations are also on the actuarial exam syllabus. Read Fixed Exchange rates on pages The first two pages are a historical introduction. You must understand how the exchange rate system works to understand the concepts in the text, such as devaluation and sterilization, but the final exam does not test the historical details. Know the conclusion in the first paragraph on page 457. Know the conclusion in the last sentence of the first paragraph on page 459, the last sentence in the second paragraph on page 459, and the two ill effects in the third paragraph. The final exam does not test the Back to Reality box on page 461. But the box highlights how people are quick to blame outsiders (usually western banks, lenders, corporations, and money traders) for crises that stem from internal problems. Read Flexible Exchange rates on pages , and the summary on page 464. Know the four bullet points in the comparison of fixed and flexible exchange rates.

22 Review Question A.4 on page 465. Inflation, money supply, and exchange rates are linked. Be able to explain the relations as the textbook describes. Review Question B7 on page 465. China s real demand for money rises because its GDP per capita rises. The exchange rate and current-account balance effects are debated hotly in the U.S. Congress. Review Questions B10 and B11 on page 466. Transportation costs for gold (Question B10) are low. The homework assignment and the final exam problems use forward prices (Question B.11).