Purchasing Power Parity Is an

Purchasing power parity is an adjustment made on an exchange rate between two currencies in order to account for the difference in purchasing power between those currencies. The result is that the good has the same price in both countries. The J-curve is the theory that after country's currency experiences a sharp depreciation, its trade deficit will worsen initially. The higher prices on imports will not be offset by a reduction in imports immediately, a reflection of the lag in consumer spending habit changes.

Eventually, however, consumer spending habits will adjust and the trade deficit will improve. The money multiplier reflects the degree to which each new dollar in the banking system creates new money in the economy. Through a cycle of investment, savings and deposit, each new dollar in the banking system is re-used several times. For example if the multiplier is 8, then an infusion of $1 billion in the banking system would mean an infusion of $8 billion in the economy.

The Phillips Curve is an explanation of the relationship between the rate of inflation and the unemployment rate. Phillips argued that when unemployment was high, wages increased slowly and when unemployment was low, wages increased quickly. This was soon adapted to focus on inflation rather than wages. Classical economists argue that the Phillips Curve does not hold in the long-run, and therefore the government cannot permanently trade more inflation for less unemployment.

This is because of the assumption that workers are rational would demand real wages increase to account for inflation, and that this holds no matter what the unemployment rate is. The policy prescription for the classical economist will not be to adjust inflation in order to deal with unemployment. In the short run, the classical economist may view that the Phillips Curve holds, but only until the point where workers become informed, at which point they would demand an increase in real wages.

In today's information-rich economy, this time lag would be small to the point where a classical economist would not view inflation as a means to dealing with unemployment. Keynesians believe that the Phillips Curve does hold and therefore government can trade inflation for unemployment. Setting interest rates low for high inflation will create economic expansion which in turn will reduce unemployment. The Keynesian would therefore adjust interest rates in order to deal with unemployment. 10. The real interest rate is 25%.