Monetary Policy, Arbitrage, and Macroeconomics: Key Concepts
Monetary Policy Advantages and Limitations
Monetary policy offers flexibility and political acceptability. The Federal Reserve (the Fed) has effectively used it to manage inflation, mitigate recessions (e.g., 2001), stimulate economic recovery, stabilize the banking sector during the mortgage debt crisis, and foster recovery from the 2007-2009 recession. Today, most economists recognize monetary policy as a crucial stabilization tool.
However, monetary policy has limitations:
- Recognition and Operation Lags: These complicate the timing of monetary policy implementation.
- Liquidity Trap: In severe recessions, banks’ reluctance to lend excess reserves and firms’ hesitation to borrow for capital investments can create a liquidity trap, diminishing the effectiveness of expansionary monetary policy.
Arbitrage and Rate of Return Equalization
Arbitrage is the process where investors equalize the average expected rates of return on identical or nearly identical assets. If two identical assets offer different rates of return, investors will sell the lower-yielding asset and buy the higher-yielding one.
This action increases the price of the higher-yielding asset, reducing its average expected rate of return. Simultaneously, selling the lower-yielding asset decreases its price, increasing its average expected rate of return. This process continues until the average expected rates of return are equalized across the two investments.
Short Run vs. Long Run in Macroeconomics
In macroeconomics:
- Short Run: A period where nominal wages do not adjust to changes in the price level.
- Long Run: A period where nominal wages fully adjust to changes in the price level.
The short-run aggregate supply curve is upward sloping because nominal wages are unresponsive to price-level changes. Higher prices increase profits and real output, while lower prices reduce them. However, the long-run aggregate supply curve is vertical. Given sufficient time, nominal wages adjust with the price level, moving the economy along a vertical aggregate supply curve at the economy’s full-employment output.
World Trade Considerations
World trade is based on:
- Uneven distribution of economic resources among nations.
- Efficient production of goods requiring specific techniques or resource combinations.
- Differentiated products produced by different nations.
Mutually beneficial specialization and trade are possible between nations with different domestic opportunity-cost ratios for products. By specializing based on comparative advantage, nations can increase real incomes with fixed resources. The terms of trade determine how the increase in world output is shared. Increasing opportunity costs limit specialization and trade.