Macroeconomics for Business

• Microeconomics

• Macroeconomics

–Living Standards (y/pop.)

–Inflation (P)

–Unemployment (U)

.

Living Standards

• Cross-Sectional Data– North America, Western Europe, Japan vs.

– South America, Eastern Europe, South Asia, Africa

• Time-Series Data– US over time; Sub-Saharan Africa

– China; Singapore

China’s Per Capita GDPand the Open Door Policy$

1500 1600 1700 1800 1900 2000

5000

3000

10000

Singapore 1959

Singapore 2000

Inflation

• Rule of 72

• Cross-Sectional Data--Venezuela vs. Japan

• Time-Series Data--Germany Then and Now; USA

Consumer Prices 1800 - 2000price level

1800 1860 1910 1940 1970 2000

Unemployment

• Cross-Sectional Data:– Switzerland vs.

Belgium

• Time-Series Data: – The U.S. today

vs. 1933

Y, y: Gross Domestic Product

• GDP vs. GNP

• Market Value

• Final Goods

• Produced

• Year

Value Added = Sales - Cost of Purchased Materials

Cotton $5 5-0 = 5

Shirt-Wholesale 15 15-5 = 10

Shirt-Retail 30 30-15 = 15 30

Sales Value Added

Nominal GDP, Real GDP & the GDP Deflator

Nominal (Y) = (P2005 x Q2005) - (P2005 x Q2005) [sales] [materials]

Real (y) = (P1997 x Q2005) - (P1997 x Q2005)

GDP Deflator = Nominal GDP/Real GDP

Base Year? Chain-Weighted Real GDP

Alternative Measures of Y,y

• NDP, NNP

• National Income

• Personal Income

• DPI

• Personal Consumption

• Personal Savings

• Size Distribution

• Functional Distribution

Alternative Measures of P

• GDP Deflator

• Consumer Price Index

• Producer Price Index

• Inflation vs. the Price Level

U = (unemployed/LF) x 100%

• LF

• Actively looking

• Discouraged workers

• “Unemployed but with a job”

• Age

• Paid work

•GDP Gap = Yp - Y

•Spending components of GDP C (70%)I (17%)G (19%)(X-M) (-6%)

The Federal Reserve System

• Board of Governors– Chairman

• District Banks

• FOMC (12) = 7 + 5

• Lender of Last Resort

• Targeting of Federal Funds Rate

Money Supply Definitions

• Monetary Base

• M1

• M2

The Money Supply:Central Bank Impacts

• Open Market Operations

• Discount Rate

• Reserve Requirements

The Money Supply:Private Impacts

• Currency/Deposit Ratio

• Excess Reserves

• Account Shifting

CLASSICAL MACROECONOMICS

VS. MERCANTILISM

• Real Assets vs. Money

• Openness vs. Balance of Trade

• Free Markets/Free Trade vs. Barriers, Subsidies

Adam Smith

COMPETITIVENESS

1. USA

2. Switzerland

3. Denmark

4. Sweden

5. Germany

Advantages of Backwardness

• Copy existing technology

• Small absolute gains constitute big percentages (1 2 = 100%)

Competitiveness:Main Factors

• Openness

• Role of Govt

– Tax Rates

– Regulation

• Labor

• Financial Sector

China’s PerCapita GNPand the OpenDoor Policy $

1500 1600 1700 1800 1900 2000

5000

3000

1000 0

Classical View of Production (y)

• Background

• y = F(K,N)

• N: ND & NS

• K = K

y

N

Slope = y/ N = MPN

MPN

N

Rule: Proceed as long as MR > MC

Here: MR = P x MPNMC = W

N

VMP = P x MPN

W0

ND

STOP

View ofEmployment(N)

What if W Changes?

W, VMP

N

W0

W0’

NDND’

VMP

At ND...

• W = P x MPN = VMP

• W/P = MPN

• Real Wages Around the World

NS: Labor Supply

• Upward Slope Not a Straightforward Matter

• Immigration

• LFP: The Changing Nature of Household Production

• Leisure Time in the USN

WNS

Labor Market Equilibrium

W

N

NS

ND(P x MPN)

WE

NE

Full Employment?

Overall Equilibrium for y, N

y

NW

N

y

NS

ND

yE

NE

What if P Rises?

• Labor Demand Shifts Right

• Labor Supply Shifts Left

• ‘N’ is Unaffected

• So ‘y’ Is Also Unaffected y

P ys

P0

P1

y

A

B

Key Classical Assumptions

• Wages Adjust Flexibly to Equilibrium– Contracts?

– Incomplete Information--Inertia?

• Workers Understand Their Real Wage and Base Their Labor Supply Decisions on It

View of Inflation

• Equation of Exchange

– MV = PT

– MV = Py

• Quantity Theory of Money

Consumer Prices 1800 - 2000price level

1800 1860 1910 1940 1970 2000

Classical View of yd

P

y

yd

Monetary vs. Nonmonetary Factors

The Classical Theory of Interest Rates

R

NPS, I

ERE

NPS

Key Factors:1) Net Private Saving2) Gross Investment

I

Suppliers and Demanders of Loanable Funds

• Households

• Businesses

• Government

• Foreigners

The Impact of the Government’s Budget

R

RB

RA A

B

S (NPS)

D (I + PSBR)

I

LF IA

IB

Budget Surplus

NPS S (NPS + SURPLUS)R

I

RA

RB

A

B

LFIA IB

3-Month Interbank Rates (S$ and SIBOR-US$)

0

2

4

6

8

10

1985 1990 1995 2000 2005

Year

Inte

rest

Rat

e (%

)

Series1

Series2

Role of R: Classical View

• Coordinate Present vs. Future

• Prevent Nonmonetary Events from Affecting V, Total Spending, yD

• yD = c + i + g; suppose deficit spending

– “Crowding Out”

J.M. Keynes (1883-1946)

• View of Capitalism

• WE? RE?

• S = I (ex ante)• Uncertainty, herd

mentality, animal spirits, instability

Keynesian View (cont’d.)

• Quantity Adjustment vs. Price Adjustment

• Y = E (Keynesian equilibrium)

• E = C + I + G• Y = C + I + G• Fiscal Policy vs.

Monetary Policy

Simple Keynesian Multipliers:No Crowding Out

kE = 1/1-b

kT = -b/1-b

kBB = 1

Closing the GDP Gap

Housing Bubble

1975 1995 2005

HOUSING

CONSUMER GOODS

Keynesian ys Curve

P

yyd

yd’

ys

A B

yA yB=yp

P

What if P Rises?

• Labor Demand Shifts Right

• Labor Supply Shifts Left

• ‘N’ is Unaffected

• So ‘y’ Is Also Unaffected y

P ys

P0

P1

y

A

B

Classical, but with W = W

P

y

ys

P0

P1

y0 y1

The Liquidity Preference Theory of Interest Rates

R

M

MS

MD = L(R,Y)

REE

Note Bond Market and LF

The Federal Reserve: June 2004

R

M

MD

MSMS’

E

E’

1.00%

1.25%

yD-yS Analysis

• yS slope*

• yD shifts (IS-LM events)*

• yS shifts

• yD slope

What if P Rises?

• Labor Demand Shifts Right

• Labor Supply Shifts Left

• ‘N’ is Unaffected

• So ‘y’ Is Also Unaffected y

P ys

P0

P1

y

A

B

Keynesian ys Curve

P

yyd

yd’

ys

A B

yA yB=yp

P

Classical, but with W = W

P

y

ys

P0

P1

y0 y1

yS Shifts: Note Production Costs

• Transition from SR to LR– Wage

adjustment

– Disappearance of money illusion (Pe)

• Supply shocks (energy, strikes, etc.)

• Supply-side economics? (tr, regulation)

• VLR: K, population, tech.

Restrictive Monetary Policy

yD

yD’

ySSR

yS’SR

ySLR

P

y

A

B

C

Stimulative Monetary Policy

P

yyD

yD’

ySSR

yS’SR

ySLR

A

B

C

Monetarism

• MS-->YSR and LR

• MS-->ySR

• MS-->PLR

• Fiscal Policy?

– yD? (Note slopes)

– LR yS (role of govt)Milton Friedman (1912- )

Name That Economist

• Classical

• Keynesian

• Neo-Keynesian

• Supply-Sider

• Monetarist

Robert MundellSupply-Sider

The Phillips Curve

Phillips Meets Friedman

PCSR

U

P

The Natural Rate of Unemployment

PCLR

Why Increased InflationCan Only TemporarilyReduce Unemployment

.

A

BC

Phillips Curve Movements

SR LR

Stimulative NW NE

Restrictive SE SW

Types of Unemployment

• Natural

– Frictional

– Structural• Skills

• Location

• Labor Market Restrictions

• Cyclical

P, U: Long Run Policies

• Target Low Inflation

• Caution on Labor Market Restrictions, Welfare

• Education & Training; Lifelong Learning

.

Austrian Business Cycle Theory

• Nonneutral Injections of Money, Misdirection

• i: Capital Goods vs. Consumption Goods

• Later Reversal in Relative Prices and Resource Allocation

• Frictions, UnemploymentFriedrich Hayek

Austrian Business Cycle Theory

R

NPS, I

NPSNPS + MS

I

I0 I1

Natural

Market PV & Duration;Misdirection

E

E’

A Metaphor: Pour in Honey

PK PC

Share Prices: Japan vs. US

CPI-Japan

Updating the Theory

• Responsiveness of C to R

– Durable Goods, Housing

– Proceeds from Refi’s

• Wealth Effects on C

• Duration of High-Tech Company Investments (dot.com cash flows)

• “R” vs. “Cost of Capital”

Housing Price Bubble?

1975 1995 2005

HOUSING

CONSUMER GOODS

Long Run Growth

• System

• Culture

• Saving (K)

• Education (Human K)

• Technology

$40000

5000

1500

$500

Competitiveness:Main Factors

• Openness

• Role of Govt

– Tax Rates

– Regulation

• Labor

• Financial Sector

Singapore $ per US $

0

0.5

1

1.5

2

2.5

1980 1985 1990 1995 2000 2005Year

Exch

ange

Rat

e

BALANCE OF PAYMENTS

• CREDITS (+) DEBITS (-)

• CURRENT ACCOUNT:– Exports Imports

– Investment Income Investment Income Received Paid

– Transfer Income Transfer Income Received Paid

• CAPITAL ACCOUNT:– Capital Inflow Capital Outflow

Flexible ER, Trade Deficit, BP = 0

foreign currency/$

$

Q

(Q + CO) (S)

EERE

X

(X + CI) (D)

(X-Q)<0

ER(X-Q=0)

Flexible ER, Trade Surplus, BP=0

X(X + CI) (D)

foreign currency/¥

EERE

Q(Q + CO) (S)

ER(X-Q)=0

¥

PURCHASING POWER PARITY?

• The Big Mac Test

• Short Run

• Long Run? Role of Inflation

• Barriers

• Sustained Capital Flows?

Major Reasons for Currency Movements

• Short-term: Expected IRRs, Central Bank intervention Long-term: – PPP?

– Reversal of Current Account Balance?

• Recent US

$