Macroeconomics

Introduction

Standard open-economy models with complete financial markets and frictionless goods markets do not fit data well in several aspects. For example, the macroeconomic models have a hard time explaining (1) why households tend to consume less when the local consumption basket is relatively cheap; (2) why consumptions are less correlated across countries than outputs; and (3) why real exchange rates appear excessively volatile relative to consumptions. Long-run news is a slowly-moving signal that alters the market's expectations about future changes in driving variables. By definition, news has no instantaneous impacts on driving variables but can affect asset prices like real exchange rate and forward-looking macro variables like consumption on impact. For instance, upon receiving good news about future endowment growth, households tend to consume more due to a positive wealth effect and a positive substitution effect. For the sake of hedging against long-run risks, however, it may be desirable to consume less. The changed consumption-saving decision then triggers movements in asset prices. All these adjustments take place before news materializes in actual endowment changes. There are two topics of macroeconomics which will be discussed in the topic that is monetary and fiscal policy. The two policies will be based on the current developments that have taken place in USA. Therefore, all the issues related to macroeconomics will be discussed in detail.

Discussion of the monetary policy in USA

The economic outlook of USA clearly deteriorated last year. In the initial phase of 2011, many forecasters had an idea that the recovery had gained grip and there will be increase in the economic activities. This might not happen at a rapid pace but will certainly have some momentum. The commercial repair procedure was thought of going well, and there were many big large companies who had access with the money market, bond market, but the interest rates were lower. The news in the last few months has made many forecasts wrong. There has been a positive trend in employment which has decreased an unemployment rate to a very large extent. The significant improvement in labor seems to have created a favorable impact on the overall level of output in the country. In addition, a change in figures now specifies that real GDP started to decrease in late 2010 and then increased quite sharply in the first half of this year. Consumer spending was mainly lethargic (Davidson, 45).

News does not function, however, in a model featuring complete markets and standard time-additive power utilities. In that situation both real exchange rates and consumptions are tied to contemporaneous driving forces. News plays no role at the time of arrival and all puzzles remain. The theoretical model is a two-country two-good endowment-driven general equilibrium model. The world is composed of two symmetric countries, referred to as Home (H) and Foreign (F), each producing a non-durable tradable good. There exists a representative household in each country who consumes both goods with a preference toward the local good. Except for the preference home bias, any good-market friction or ...