FOREIGN TRADE UNIVERSITY Faculty of International Economics

Hoang Xuan Binh, Hoang Xuan Binh, PhDPhD

A PowerPointTutorialto Accompany macroeconomics, 5th ed.N. Gregory Mankiw

Macroeconomics IMacroeconomics I

CHAPTER I:Introduction Lecture programme

Introduction

Module title: Macroeconomics I

Semester: I

Year 2011-2012

Level: Undergraduate

Module Convenor: Hoang Xuan Binh

Office hours: 15 -17 on Monday

Room: A703- Foreign Trade University (Hanoi Campus)

Tel: 844-8345801 ext 506

Cellphone: 0912782608

Email:binhhx@yahoo.com

INTRODUCTION

Module Context:

The module is designed especially for students taking Macroeconomics at FTU. It is intended to provide students with an understanding of important macroeconomic factors and variables. The course analyses how macroeconomic variables operate;and it develops an understandings of the international money and financial market, in or outflows of capital. The course also draws on the debates in real economy and tries to use both old and new theories to understand them.

Introduction

Module aims and objectives:

1.To familiarise the students with some of the most important macroeconomic variables in the economy, for example GDP,GNP,CPI,PPI…

2.To introduce students to some important macroeconomic policies including fiscal and monetary policies.

3.To examine some different cases in term of using macroeconomic policies to develop economy.

Introduction

Learning outcomes

By the end of this module it is expected that students:

1.will have an understanding of how important macroeconomic variables are interacting in the economy.

2.will be able to interpret such variables and events as GDP,GNP,CPI or inflation,unemployment… and relate them to changes of other variables and events in the economy.

3.will be ready to explain significant events in real economy by using economic theories.

4.will be familiar with current debates on open-economy and able to make a critical assessment of the various arguments which are put forward.

Teaching and learning methods:

In class contact hours there will be lectures, discussions and assistance with students’assignment work,reading and using books. During the seminars the students will be expected to discuss the provided topics on the problems of real economy.

Assessment methods:

There is a written assignment and final examination. It is worthy 30% and 60% respectively. Class participation is 10% .

Suggested Supplementary Reading

Mankiw, Principles of Economics

Mankiw, Macroeconomics 5th ed ,

Sloman J., (2003), Economics, 5th ed

Lecture programme

Chapter: Introduction lecture programme

Chapter2:The Data of Macroeconomics

Chapter4:Money and Monetary policy

Chapter5:Inflation and unemployment

Chapter6:Economic growth

Chapter 7: The Open economy

Chapter3:Aggregate Demand and Fiscal policy

Presentation assignment

Revision

Everyone is concerned about macroeconomics lately. We wonder why some countries are growing faster than others and why inflation fluctuates. Why? Because the state of the macroeconomy affects everyone in many ways. It plays a significant role in the political sphere while also affecting public policy and social well-being.

I.Introduction

There is much discussion of recessions-- periods in which real GDP falls mildly-- and depressions, concerns with issues such as inflation, unemployment, monetary and fiscal policies.

Economists use models to understand what goes on in the economy.Here are two important points about models: endogenous variables and exogenous variables. Endogenous variables are those which the model tries to explain. Exogenous variables are those variables that a model takes as given. In short, endogenous are variables within a model, and exogenous are the variables outside the model.PricePrice

DemandDemand

QQ*

PP

SupplySupply

QuantityQuantity

* This is the most famous economic model. It describes the ubiquitous relationship

between buyers and sellers in the market. The point of intersection is called an

equilibrium.

Economists typically assume that the market will go into Economists typically assume that the market will go into an equilibrium of supply and demand, which is called an equilibrium of supply and demand, which is called the the market clearing process. market clearing process. This assumption is central This assumption is central to the Pho example on the previous slide. But, assuming to the Pho example on the previous slide. But, assuming that markets clear that markets clear continuously continuously is not realistic. For is not realistic. For markets to clear continuously, prices would have to markets to clear continuously, prices would have to adjust instantly to changes in supply and demand. But, adjust instantly to changes in supply and demand. But, evidence suggests that prices and wages often adjust evidence suggests that prices and wages often adjust slowly.slowly.

So, remember that although market clearing models So, remember that although market clearing models assume that wages and prices are assume that wages and prices are flexible, flexible, in actuality, in actuality, some wages and prices are some wages and prices are sticky. sticky.

Microeconomics is the study of how households and firmsmake decisions and how these decision makers interact in the

marketplace. In microeconomics, a person chooses tomaximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of manypeople trying to maximize their own welfare. Therefore, when

we study macroeconomics, we must consider itsmicroeconomic foundations.

II. Research aims and research methods:1. Aims and objectives of macroeconomicsYield, Economic growth, unemployment, inflation, budget, Balance of Payments,2. Research method

- Mathematics, general equilibrium, Walras methods (equilibrium in all market…

III. Macroeconomics system

1. Inputs

+ Exogenous variables: weather, politics, population, technology and patents or know-how+Endogenous variables: direct impacts-fiscal policy,monetary policy, external economic policy2. Black box: AS+AD

2.1. Aggregate Demand

2.2.Aggregate Supply

*Related factors: Price, Income, Expectation…

* Related factors: Price,production cost, potential output (Y*)Y*: maximization of output which economy can produce, with full-employment and no inflation.Full-employment=population–outof working age - invalids -(pupils + students) – servant-unwilling to work

Yield, employment,

Average price,

Inflation,interest,budget,

Trade balance and balance of International payment,

Economic Growth

3. Outputs

MacroeconomicsRecession

DepressionModels

Macroeconomic system Inputs Outputs

Endogenous variablesExogenous variablesMarket clearingFlexible and sticky pricesMicroeconomics

MacroeconomicsRecession

DepressionModels

Macroeconomic system Inputs Outputs

Endogenous variablesExogenous variablesMarket clearingFlexible and sticky pricesMicroeconomics

CHAPTER II

Data of macroeconomics

I. Gross domestic products-GDP

Gross Domestic Product (GDP) is the market value of all final goods and services produced within an economy in a given period of time.

There are 2 ways of viewing GDP

Total income of everyone in the economy

Total expenditure on the economy’s output of goods and services

Households Firms

Income $

Labor

Goods

Expenditure $

For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in this economy.

Income, Expenditure And the Circular Flow

1) To compute the total value of different goods and services, the national income accounts use market prices. Thus, if

$0.50 $1.00

GDP = (Price of apples Quantity of apples) + (Price of oranges Quantity of oranges)

= ($0.50 4) + ($1.00 3)GDP = $5.00

2) Used goods are not included in the calculation of GDP.

II.Computing GDP

1.Rules for computing GDP

3) The treatment of inventories depends on if the goods are stored or if they spoil. If the goods are stored, their value is included in GDP.

If they spoil, GDP remains unchanged. When the goods are finally sold out of inventory, they are considered used goods (and are not counted).

4) Intermediate goods are not counted in GDP– only the value of final goods. Reason: the value of intermediate goods is already included in the market price.

Value added of a firm equals the value of the firm’s output less the value of the intermediate goods the firm purchases.5) Some goods are not sold in the marketplace and therefore don’t have market prices. We must use their imputed value as an estimate of their value. For example, home ownership and government services.

The value of final goods and services measured at current prices is called nominal GDP. It can change over time either because there is a change in the amount (real value) of goods and services or a change in the prices of those goods and services. Hence, nominal GDP Y = P y, where P is the price level and y is real output– and remember we use output and GDP interchangeably. Real GDP or, y = YP is the value of goods and services measured using a constant set of prices.

Let’s see how real GDP is computed in our apple and orange economy.

For example, if we wanted to compare output in 2002 and output in 2003, we would obtain base-year prices, such as 2002 prices.

Real GDP in 2002 would be: (2002 Price of Apples 2002 Quantity of Apples) +(2002 Price of Oranges 2002 Quantity of Oranges).Real GDP in 2003 would be:(2002 Price of Apples 2003 Quantity of Apples) +(2002 Price of Oranges 2003 Quantity of Oranges).Real GDP in 2004 would be:(2002 Price of Apples 2004 Quantity of Apples) +(2002 Price of Oranges 2004 Quantity of Oranges).

Nominal GDP measures the current dollar value of the output of the economy.

Real GDP measures output valued at constant prices.

The GDP deflator, also called the implicit price deflator for GDP, measures the price of output relative to its price in the base year. It reflects what’s happening to the overall level of prices in the economy.

GDP Deflator = Nominal GDP Real GDP

In some cases, it is misleading to use base year prices that prevailed 10 or 20 years ago (i.e. computers and college). In 1995, the Bureau of Economic Analysis decided to use chain-weighted measures of

real GDP. The base year changes continuously over time. This new chain-weighted

measure is better than the more traditional measure because it ensures that prices will not be

too out of date.

Average prices in 2001and 2002 are used to measurereal growth from 2001 to 2002.Average prices in 2002 and 2003are used to measure real growth from2002 to 2003 and so on. These growthrates are united to form a chain that isused to compare output between any twodates.

3. Methods of computing GDP

*Expenditure approach

GDP = C + I + G + (X-M)

Governmentpurchases of goods

and services

Governmentpurchases of goods

and services

Y = C + I + G + NXY = C + I + G + NXY = C + I + G + NXY = C + I + G + NX

Total demandfor domestic output (GDP)

Total demandfor domestic output (GDP)

is composed of

is composed of

Consumptionspending byhouseholds

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds

Investmentspending by

businesses andhouseholds Net exports

or net foreigndemand

Net exportsor net foreign

demand

This is the called the national income accounts identity.

*The Factor Incomes Approach: it measures GDP by adding together all the incomes paid by firms to households for the services of the factors of production they hire. According to this approach, GDP is the sum of incomes in the economy during a given period

GDP = w + r + i + + D +Te

W: wage, r :rent fixed capital, i: interest, profit, D: Depreciation, Te: indirect tax

3. The output approach

Total Value added = Total Revenues – Total Cost

GDP = Value added in all industries

=> GDP = VAT. 1/Value added tax

Example:

One firm gains value added is 80, 1000 firms is 80,000. 80 = total revenues – total cost (production cost)

II.Gross national products)-GNP

1. Definition:GNP is the market value of all final goods and services produced by domestic residents in a given period of time.

2. Computing methods:

GNP = GDP + Tn

Tn: net Income from Abroad

*3 cases :

+ GNP > GDP (Tn>0): domestic economy has impacts in other economies.

+ GNP < GDP (Tn<0): foreign economies have impacts in domestic economy.

+ GNP = GDP (Tn=0): no conclusion

4. Net Economic Welfare -NEW

GDP, GNP doesn’t compute some goods and services which aren’t sold, or illegal transactions or activities of black market, negative externality…

V1 + Value of Rest

+ Value of goods and services which arent sold

+ Revenues from transactions in black market

V2-negative externality for natural resources,environment, such as noise traffic jam …

NEW reflects welfare better than GNPm but it is very difficult to have enough data to compute NEW,therefore, economists still use GDP and GNP.

Tn

C

I

G

NX

GNP

D

NNP

Te

NI

(Y)

Td-TR

Yd

NNP= GNP-D ; Y=NI=NNP-Te=GNP-D-Te

Yd = NI - (Td-TR) = (C+S)

D-Depreciation

NNP-Net National Product

NI-National Income

Yd-Disposal Income

TR (transfer)-

Td: Direct tax

National income accounts Consumption Investment Government Purchases Net Exports Labor force

Gross domestic product (GDP) Consumer Price Index (CPI) Unemployment Rate Stocks and flows Value added Nominal versus real GDP GDP deflatorGNPNEW

CHAPTER IIIAggregate Demand

& Fiscal policy

Today’s lecture is the first in a series of four lectures aimed at analysing different (separate) markets in the economy. This will then enable us to bring the various markets together and to analyse the behaviour of the whole economy (this is also referred to as general equilibrium analysis). Today we will introduce an analysis of the economy as originally described by the economist John Maynard Keynes. His theory of how the macroeconomy works will help us explain how the economy’s income (GDP) is determined. Today we analyse the model in its simplest form and we will assume that the economy does not have a government and that it does not trade with the rest of the world. We will relax these assumptions.

The Keynesian Theory of Income Determination: the theory that will be presented hereafter was developed by the Cambridge economist John Maynard Keynes in the wake of the 1920s Great Depression. He argued that the cause of a low level of income (GDP) in the economy was given by the lack of AD.John Maynard Keynes (right) and Harry Dexter White at the

Bretton Woods Confer..

Personal and marital lifeBorn at 6 Harvey Road, Cambridge, John Maynard Keynes was the son of John Neville Keynes, an economics lecturer at Cambridge University, and Florence Ada Brown, a successful author and a social reformist. His younger brother Geoffrey Keynes (1887–1982) was a surgeon and bibliophile and his younger sister Margaret (1890–1974) married the Nobel-prize-winning physiologist Archibald Hill.Keynes was very tall at 1.98 m (6 ft 6 in).

In 1918, Keynes met Lydia Lopokova, a well-known Russian ballerina, and they married in 1925. By most accounts, the marriage was a happy one. Before meeting Lopokova, Keynes's love interests had been men, including a relationship with the artist Duncan Grant and with the writer Lytton Strachey. For medical reasons, Keynes and Lopokova were unable to have children, though both his siblings had children of note.

I. Aggregate Planned Expenditure and Aggregate Demand

1.Assumptions: a model nearly always starts with the word ‘assume’ or ‘suppose’. This is an indication that reality is about to be simplified in order to focus on the issue at hand

*Prices, Wages and Interest Rate are Constant

*The Economy Operates at less than full Employment: this implies that firms are willing to supply any amount of the good at a given price P. In other words, assume that the supply of goods is completely elastic at price P. This assumption is generally valid only in the short run

*Closed Economy and No Government: we assume that the economy does not trade with the rest of the world so that both exports and imports are equal to zero (X=M=0). We also assume that there is no government in the economy so that government expenditures and taxes are equal to zero (G=T=0). This implies that aggregate demand is therefore reduced to the following expression:

AD C + I

APE reflects the total planned expenditure at each income, with assumption of given price.

1. Aggregate Planned Expenditure

*Households: Consumption C = f(Yd): the main determinant of consumption is surely income, or more preciselyC = f1(Y)

-Firms: to create the demand through their investment

I = f2(Y)

APE = C + I = f1(Y) + f2(Y)

1.1. Consumption function*The relationship between consumption expenditures and disposable income, other things remaining the same, is called consumption function. The consumption function that we will use in our model and that shows the positive link between consumption and disposable income is the following (figure 1):

YdMPCCYfC .)(1

*Determinants of Consumption:+Autonomous Consumption (C): this is the amount of consumption expenditure that would take place even if people had no current disposable income

+Induced Consumption: this is consumption expenditure that is in excess of autonomous consumption and that is induced by an increase in disposable income

Y

CMPC

+Marginal Propensity to Consume (MPC): it is the fraction of a change in disposable income that is consumed. It is calculated as the change in consumption expenditures (DC) divided by the change in disposable income (DYd) that brought it about. It gives the effect of an additional pound of disposable income on consumption. The MPC determines the slope of the consumption function

0 < MPC< 1 :This reflects the fact that people are likely to consume only part of any increase in income and to save the rest*Example. The following is an example of a consumption function: C = 20 + 0.7xYdAutonomous Consumption: 20MPC = 0.7

+NetPrivateSavings-S: savings by consumers is equal to their disposable income minus their consumption => S = Yd - Cand, by using the definition of disposable income this identity can be rewritten as:S = Y – T – C (but T = 0, no government)

However, given that there is no government in our simple economy, T=0 and savings are equal to: S = Y - C1.2.The Saving Function: the

economy’s savings function can be derived by using the private savings expression and the consumption function:

YMPSCS

YMPCCYMPCCYS

CYS

.

).1(.

+The Marginal Propensity to Save (MPS): the propensity to save tells us how much people save out of an additional unit of income. The assumption we made earlier that MPC is between zero and one implies that the propensity to save is given by (1-MPC) and that it is also between 0 and 1.The Saving Curve: it traces the relationship between the level of net saving and income

1.3.Investment function (I): the second expenditure in APE that we will analyse today is investment

*Determinants of Investment: we can distinguish four major determinants of investment

+Increased Consumer Demand: investment is to provide extra capacity. This will only be necessary, therefore, if consumer demand increases

+Expectations: since investment is made in order to produce output for the future, investment must depend on firms’ expectations about future market conditions+Cost and Efficiency of Capital Equipment: if the cost of capital equipment goes down or machines become more efficient, the return on investment will increase and firms will invest more

+Interest rate: the higher the rate of interest, the more expensive it will be for firms to borrow the money to finance their investment expenditures and the less profitable will the investment be

+Level of Investment in the Economy: in this model we will take investment as given or, in other words, we will regard it as an exogenous variable. The main reason for taking investment as given is to keep our model simple. Thus we will assume that investment is given by a fixed/constant amount (a bar over a variables indicates that the variable is regarded as an exogenous variable) that does not change with the level of income in the economy:

II

.APE C I C I MPC Y

*The Determination of Equilibrium Output: When P, w is constant,the equilibrium in the goods market requires that the supply of goods (GDP=Y) equals the demand for goods (APE):

Y = APE =AD

)(1

1IC

MPCYe

This equation is called the equilibrium condition. By replacing the above expression for aggregate planned expenditure in the equilibrium condition we get:

As you can see the above expression is an equation in one endogenous variable: Y. Thus we can solve this equation for Y and this will give us the equilibrium level of output (Ye)produced in the economy

.

Y APE

Y C I MPC Y

*Example 1. Assume that in the economy the level of autonomous consumption c0=100, the marginal propensity to consume is MPC=0.5 and the investment spending is I=200 . Determine the equilibrium level of output produced in the economy.

200I 200I 200I

-Firms invest in economy-Government sector expenditure: G

II

+G will increase APE and will shift the APE curve upwards. +Taxation reduces the level of disposable income available for consumption and will tend to reduce APE. Such a reduction in APE is reflected by a downward rotation of the APE curve. Why?

2. APE & Ye in closed economy with a Government Sector

TT

.( )APE C I G C I G MPC Y T

0

.( )

1( )

1 1

Y APE

Y C I G MPC Y T

MPCY C I G T

MPC MPC

This is due to the fact that taxation reduces the overall MPC by the household so that for each extra pound of income the household will now consume less since some of the extra income must be paid in taxes2.1.Fixed taxation

MPC

MPCmt

1

Multiplier Effect of taxation

TmGICmY t )(0

2.2. Taxation depends on income: T = t.Y (t:tax rate)

YtMPCCTYMPCCC )1()(

II GG

(1 )APE C I G C I G MPC t Y

0

(1 )

1( )

1 (1 )

Y APE

Y C I G MPC t Y

Y C I GMPC t

=>Equilibrium point of economy:

)1(1

1

tMPCm

Multiplier of

consumption in the closed economy with Government sector

MPCm

tMPCm

1

1

)1(1

1

This reflects that the income based tax is less efficient than fixed tax.

3. 2. APE & Ye in open-economy with a Government Sector and foreign trade*Assuption: T = t.Y (t- taxrate)

Economy has 4 sector

X doesn’t depend on domestic income,therefore

X X

*C = C + MPC.(Y-T) = C + MPC.(1-t).Y

*I = I

*G = G

*NX=X-M: netexport

M derives from production inputs, or consumptions of households=>M increases when I or Ye rises.

Ta cã: M = MPM.Y*MPM (Marginal Propensity to Import): it is the fraction of an increase in GDP that is spent on imports. It is calculated as the change in imports (M) divided by the change in GDP ( Y) that brought it about, other things remaining the same. The MPM is a positive number smaller than one MPM = M/ Y and 0<MPM <1

(1 )

APE C I G X M

APE C I G X MPC t MPM Y

0

(1 )

1( )

1 (1 )

Y APE

Y C I G X MPC t MPM Y

Y C I G XMPC t MPM

*Equilibrium point of economy:

MPMtMPCm

)1(1

1open-economy multiplier

m” < m’ < m. open-economy multiplier is less efficient than closed economy multiplier.

The Multiplier Spending ChainI = £1 million - Marginal Propensity to Consume: mpc = 0.8

Round N.Spending in This Round Cumulative Total I

1 £1,000,000 (G £1,000,000 (G1)

2 £ 800,000(C2=0.8*G) £ 1,800,000

3 £ 640,000(C3=0.8*C2) £ 2,440,000

4 £ 512,000(C4=0.8*C3) £ 2,952,000

5 £ 409,600(C5=0.8*C4) £ 3,361,600

6 £ 327,680(C6=0.8*C5) £ 3,689,280

7 £ 262,144(C7=0.8*C6) £ 3,951,424

8 £ 209,715(C8=0.8*C7) £ 4,161,139

9 £ 167,772(C9=0.8*C8) £ 4,328,911

10 £ 134218(C10=0.8*C9) £ 4,463,129

................... ...............................................

.....................................

50 £ 18(C50=0.8*C49) £ 4,999,929

................ ........................................ ..................................

“Infinity” 0 £ 5,000,000

II.Fiscal policy:

1. Fiscal policy: Government use taxation and consumption to regulate aggregate demand.

2. Classification of fiscal policy

2.1. Expansionary fiscal policy

2.2. Contractionary fiscal policy

*State Budget: total sum of revenues and consumption of Government in given time (one year)

B = T - G+ B = 0: Budget balance + B > 0: Budget surplus+ B < 0: Budget deficit

3. Fiscal policy and Budget decifit

- Real budget deficit: When consumption > revenues

*Classification:

-Cyclic budget deficit: when economy faces recession due to cyclic business.-Structural budget deficit: is calculated in term of assumptions with potential output.where Btt = Bck + Bcc =>Bcc = Btt - Bck

*Note: fiscal policy can reach following objectives:

+Budget balance=>Y can fluctuate.. .

+Y*=> Budget deficit can happen. When there is recession in economy, G increase or T decrease or both to keep high consumption => Y rises to Y* but Budget deficit happens.

4. How to reduce budget deficit

-Inreasing revenues and decreasing consumption

-Public debt: Government bond

-Borrowings from foreign countries or international orgnizations-Printing money or using reserve from foreign currency

CHAPTER IV

money and monetary policy

I. Money

1. The Meaning and functions of Moneya.Definition of Money: money is any commodity or token that is generally acceptable as the means of payment. A means of payment is a method of settling a debt. In general terms money can be defined as the stock of assets that can be readily used to make transactions. Roughly speaking, the coins and banknotes in the hands of the public make up the nation’s stock of money

MoneyStock of assetsStock of assets

Used for transactionsUsed for transactions

A type of wealthA type of wealth

Without MoneySelf-sufficiencySelf-sufficiency

Barter economyBarter economy

b. Development of money

Cattle, iron, gold,silver,diamond ….and banknote today

Batter => commodity money=> cash, cheque, credit card…

2. The Functions of Money: money has three main purposes. It is a medium of exchange, a unit of account and a store of value

2.1. Medium of Exchange: it is an object that is generally accepted in exchange for goods and services. Money acts as such a medium2.2. Unit of Account (A Means of Evaluation): a unit of account is an agreed measure for stating the prices of goods and services. It allows the value of one good to be compared with another2.3. Store of Value: any commodity or token that can be held and exchanged later for goods and services is called a store of value. Money acts as a store of value.

Functions of Money

• Store of value• Unit of account• Medium of exchange• International Money

The ease with which money is converted into other things--goods and services-- is sometimes called money’s liquidity.

3.Types of Money

*Depend on the Liquidity:

M 0= Cash; (Wide Monetary Base) = Cash in circulation with the public and held by banks and building societies +Banks’ balances with the Central Bank

M1 = Cash + Deposit (D: Deposit is unlimited time deposit). Liquidity of M1 is smaller than M0 but it is still good to measure the cash in circulation in economy.M2= M1 + limited time deposit: Liquidity of M2 is very low,therefore,there are some developed economies such as US and UK where use to measure the cash in circulation.

Fiat Money: money takes different forms. Money that has no intrinsic value is called fiat money because it is established as money by government decree, or fiat

In the UK economy we make transactions with an items whose sole function is to act as money: pound coins and banknotes. These pieces of paper with the portrait of the queen would have little value if they were not widely accepted as money.

*Money can be divided into:

Commodity Money: although fiat money is the norm in most economies today, historically most societies have used for money a commodity with some intrinsic value. Money of this sort is called commodity money and the most widespread example of commodity money is gold

II. Central Bank and creation money of commercial bank

1.Banks are the Financial Intermediaries. They are private firms licensed by the Central Bank under the Banking Act to take deposits and make loans and operate in the economy.Retail Banks: they specialise in providing branch banking facilities to member of the general public but they do also lend to businesses albeit often on a short-term basis. They are the most important banks in the UK for the functioning of the economy and for the implementation of monetary policy

2. The creation of Money by commercial banks

The Creation of Money: banks create money. However this does not mean that they have smoke-filled back rooms in which counterfeiters are busily working. Notice that most money is deposits, not currency. What banks create is deposits and they do so by making loans. But the amount of deposits they can create is limited by their reserves

Desired Reserver rate

Required Reserve Rate

Excessive Reserve Rate

The Deposit Multiplier: this is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits. It is given by the following formula:

Reservesin Change

Depositin Change MultiplierDeposit

Alternatively, it can also be defined as:

Ratio Reserve Desired

1 MultiplierDeposit

if banks want to keep 10% of their deposits as reserves, so that the desired reserve ratio is 0,10 (ra), the deposit multiplier is given by the following expression:1/ra =10. See example

Banking

system Deposits

Desired

reserve (ra) Lending

NH1 1 1.ra (1-ra)

NH2 (1-ra) (1-ra).ra (1-ra)2

NH3 (1-ra)2 (1-ra)2 .ra (1-ra)3

... ... ... ...

NH(n+1) (1-ra)n (1-ra)n .ra (1-ra)n+1

a

na

a

nan

aaa r

r

r

rrrrD

112 )1(1

1)1(1

)1(11)1(...)1()1(1

101,0

111

011

aa rrD0 < ra < 1 =>

(tû.®)

FirstbankBalance Sheet

SecondbankBalance Sheet

ThirdbankBalance Sheet

Assets Liabilities Assets Liabilities Assets LiabilitiesReserves $200 Deposits $1,000Loans $800

Reserves $128 Deposits $640Loans $512

Reserves $160 Deposits $800Loans $640

Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000.

Mathematically, the amount of money the original $1000 deposit creates is:Original Deposit =$1000Firstbank Lending = (1-rr) $1000Secondbank Lending = (1-rr)2 $1000Thirdbank Lending = (1-rr)3 $1000Fourthbank Lending = (1-rr)4 $1000

Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] $1000 = (1/rr) $1000 = (1/.2) $1000 = $5000 Money and Liquidity CreationMoney and Liquidity Creation

...

The process of transferring fundsfrom savers to borrowers is calledfinancial intermediation.

The process of transferring fundsfrom savers to borrowers is calledfinancial intermediation.

III. Central Bank and money supply

1. Roles of Central Bank

*Government’s Bank: the central bank is the acts as the government’s agent both as its banker and in carrying out monetary policy

*Supervision of Monetary System: the central bank oversees the whole monetary system and ensures that banks and financial institutions operate as stably and as efficiently as possible

2. Functions of Central Bank

*To Issue Notes: the Central Bank is the sole issuer of banknotes. The amount of banknotes issued by Central Bank depends largely on the demand for notes from the general public

For example, BOE issues banknotes in England and Wales (in Scotland and Northern Ireland retail banks issue banknotes).

*It Acts as a Bank+To the Government: the government deposits its revenues from taxation in the central bank and uses CB in order to borrow money from the market+To other Recognised Banks: all banks licensed by CB hold operational balances in the CB. These are used for clearing purposes between the banks and to provide them with a source of liquidity+To Overseas Central Banks: these are deposits in sterling held by overseas authorities as part of their official reserves and/or purposes of intervening in the foreign exchange market in order to influence the exchange rate of their currency.

*It Manages the Government’s Borrowing Programme: whenever the government runs a budget deficit (it spends more than what it receives in taxes) it will have to finance that deficit by borrowing. It can borrow by using bonds (gilts), National Savings certificates or Treasury bills. The CB organises this borrowing*It Supervises the Financial System: it advises banks on good banking practice. It discusses government policy with them and reports back to the government. It requires banks to maintain adequate liquidity: this is called prudential control.

*It Provides Liquidity to Banks – Lender of Last Resort: it ensures that there is always an adequate supply of liquidity to meet the legitimate demands of depositors in recognised banks*It Operates the Government’s Monetary and Exchange Rate Policy+Monetary Policy: the CB manipulates the interest rate in the economy and influence the size of the money supply+Exchange Rate Policy: the CB manages the country’s gold and foreign currency reserves

3. The Supply of Money*Definition of Money Supply: the quantity of money available is called the money supply. In an economy that uses fiat money, such as most economies today, the government controls the supply of money: legal restrictions give the government a monopoly on the printing of money*Monetary Policy: the control over the money supply is called monetary policy

4. Implement of money supply

a.Measures of Money Supply:

Recall that we can denote money supply as the sum of currency and deposits

sDCM

Deposit DemandCurrencyMoney

Central Bank issues H0, (Basic Money, High Powered Money), H0 < M0. Ho is divided intoU and R

+ Sectors keep a part of Ho, denote as U. U can’t create other means of payment and it can be decrease due to damages..in the circulation. Assuption, U is constant.

+ The rest of Ho denote as R (Ho = U +R). The banking system will use R to create money as followings:

Rr

Da

1

Basic Money (H0)

U R

U D

Money supply : MS

Where: H0 = U + R and MS = U + DMS >Ho due to the creation of money from commercial banks.

b.The Central Bank's Policy Tools: there are three main tools that the Central Bank can use to control money supply and implement monetary policy

*Reserve Requirements: these are regulations by the central bank that impose on banks a minimum reserve-deposit ratio. An increase in reserve requirements raises the reserve-deposit ratio and thus lowers the money multiplier and the money supply

*Discount Rate: it is the interest rate that the central bank charges when it makes loans to banks. Banks borrow from the central bank when they find themselves with too few reserves to meet reserve requirements. The lower the discount rate, the cheaper are borrowed reserves and the more banks borrow at the central bank’s discount window.

=> discount rate decreases =>the monetary base and the money supply go up.

*Open-Market Operations: they are the purchases and sales of government bonds by the central bank. When the central bank buys (sells) bonds from (to) the public, the pounds it pays (receives) for the bonds increase (decrease) the monetary base and thereby increase (decrease) the money supply. The term 'Open Market' refers to commercial banks and the general CB conducts an open market operation, it does a transaction with a bank or some other business but it does not transact with the government

Example of US economy?In the United States, monetary policy is conducted in a partially independent institution called the Federal Reserve, or the Fed.

• To expand the Money Supply:

The Federal Reserve buys U.S. Treasury Bonds and pays for them with new money.

• To reduce the Money Supply:

The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them.

The bearer of the United States

Treasury bond is hereby promised

the repayment of the principle

value plus the interest which it

incurs through the terms stated

thereof.

The United States will justly repay

its bearers in its entirety and

will not default under any

circumstances.

Signature of the President

___________________

US. Treasury Bond

The Federal Reserve controls the money supply in three ways.

1) Open Market Operations (buying and selling U.S. Treasury bonds).

2) Reserve requirements (never really used).

3) Discount rate which member banks (not meeting the reserve requirements) pay to borrow from the Fed.

The bearer o

f the United

States

Treasury bon

d is hereby

promised

the repaymen

t of the pri

nciple

value plus t

he interest

which it

incurs throu

gh the terms

stated

thereof.

The United S

tates will j

ustly repay

its bearers

in its entir

ety and

will not def

ault under a

ny

circumstance

s.

Signature of

the Preside

nt

____________

_______

US. Treasury Bond

IV. Money market

1. Money Demand: the demand for money refers to the desire to hold money: to keep your wealth in the form of money, rather than spending it on goods and services or using it to purchase financial assets such as bond or shares2.Reasons for Holding Money

The Transactions Motive: since money is a medium of exchange it is required for conducting transactions.

The Precautionary Motive: unforeseen circumstances can arise, such as a car breakdown. Thus individuals often hold some additional money as a precautionThe Speculative Motive: certain firms and individuals who wish to purchase financial assets such as bonds or shares may prefer to wait if they feel that their price is likely to fall. In the meantime they will hold idle money balances instead

3.The Demand for Money Function: the relationship between the demand for money and the interest rate is described by the demand for money function

This expression simply states that the demand for money is a function (f) of income Y and the interest rate I

= denotes the nominal money demandY = denotes nominal income (GDP) and it captures the overall level of transactions in the economy.

),(

iYfM d

dM

In fact, it is reasonable to assume that the overall level of transactions is roughly proportional to nominal income. The positive sign above Y denotes that there is a positive relationship between income and demand for money: the higher the level of income (transactions) the higher the demand for moneyi = is the interest rate and the negative sign above it denotes the negative relationship between the interest rate and the demand for money. The higher the interest rate, the smaller the demand for money since individuals prefer to hold their wealth in bonds

d. Determinant of money demand *Level of price:

n

r

n

r

MDP

MD MD const

MDP

MD MD const

MDn (nominal Money Demand computing based on researched price (usually higher than based price)

MDr (real Money Demand, computing depend on based price (constant price).

*Interest rate (i)

*Income (Y)

Y increases (decreases) => MD increases (decreases)

i increases (decreases) => MD decreases (increases)

MD = k.Y–h.i

Money demand function can be written:

k-income-elasticity of MD h-interest rate –elasticity of MD.

h

kY0

kY0

h

kY1

i

M0

MD1MD

0

Note:+ i change=>quantity demanded move along MD, otherthings being equal.+ Y change=>MD shift rightwards or leftwards. Depends on income-elastricity of money demand (k).+ Slope of MD depends on the interest rate –elastricity of money demand (h). 1kY

i MDh h

2. Money supply

* The Determinants of Money supply

-The level of price: nominal MS doesn’t depend on P but real MS does because:

0HmMSn P

MSMS n

r

-Central Bank: i can change but MS maybe constant If CentralBank doesn’t want to change MS.

i

0 M

MDo

MSo

Eoio

3. Equilibrium in the Money Market: the equilibrium in the money market requires that money supply be equal to money demand, that Ms=Md

This equilibrium condition tells us that the interest rate must be such that people are willing to hold and amount of money equal to the existing supply. This equilibrium relation is also called LM and will be discussed in more detail in the next lecture

),( iYfMM ds

*Note:

+ If I # i0 =>imbalance between supply and demand which puts pressure to push I up or down to equilibrium point i0. When MS, MD changes =>quilibrium point (E) changes which leads to changes of i0.

V. Monetary policy:

1. Expansionary monetary policy

2.Contractionary monetary policy

CHAPTER VI

Inflation and unemployment

Unemployment is the number of people of working age who are without work, but who are available for work at current wage rates. If the figure is to be expressed as a percentage, then it is a percentage of the total labour force.

I.unemployment:

-The labour force is defined as: those in employment (including the self-employed, those in the armed forces and those on government training schemes) plus those unemployed.

-The labour force doesn’t include people who are out of working age, students, pupils, invalids. People who are at working age but unwilling to work doen’t belong to labour force

employmentunemployment

Labour force

Out of labour force

Out

In Working agePopul

ation

Labour force

2. Computing unemployment rateu - Unemployment Rate): to be expressed by fraction of unemployment with the total labour force. It can be expressed by percentage as the formula below:U (Unemployed): L (Labour Force):

%100L

Uu

Unemployment is a problem for the economy because:

Output and incomes are lost.Human capital depreciates.Crime may increase.Human dignity suffers.

3. Types and causes of unemployment:Frictional unemployment occurs when people leave their jobs, either voluntarily or because they are sacked or made redundant, and are then unemployed for a period of time while they are looking for a new job. They may not get the first job they apply for, despite a vacancy existing. The employer may continue searching, hoping to find a better-qualified person.

Likewise, unemployed people may choose not to take the first job they are offered. Instead, they may continue searching, hoping that a better job will turn up. The problem is that information is imperfect. Employers are not fully informed about what labour is available; workers are not fully informed about what jobs are available and what they entail. Both employers and workers, therefore, have to search: employers searching for the right labour and workers searching for the right jobs.

Structural Unemployment refers to unemployment arising because there is a mismatch of skills and job opportunities when the pattern of demand and production changes. Examples in the UK include unemployment resulting from a decline in the production of textiles, shipbuilding, cars, coal and steel. Those workers who become structurally unemployed are available for work but they have either the wrong skills for the jobs available or they are in the wrong location.

Demand-deficient Unemployment is also referred to Keynesian unemployment. Demand-deficient unemployment occurs when aggregate demand falls and wages and prices have not yet adjusted to restore full employment. Aggregate demand is deficient because it is lower than full-employment aggregate demand which implies that output is less than full employment output.

Classical Unemployment describes the unemployment created when the wage is deliberately maintained above the level at which the labour market clears. It can be caused either by the exercise of trade union power or by minimum wage legislation which enforces a wage in excess of the equilibrium wage rate.

II.Inflation

1. Definition

Inflation is a rise in the average price of goods over time. The term deflation is used to describe a fall in the average price of goods over time.

Deflation is very rare, but when it occurs it can cause serious problems in the economy. The inflation rate is the percentage change in the price level. The formula for the annual inflation rate is:

2. Computing inflation

Gp:price growth rate

1

1

100%t tp

t

P Pg

P

t-timePt-1: at previous timePt: : at current time (research time)

n

nn

QQQ

QPQPQPP

...

...

21

2211

P is to be expressed as follows:

Actually, P is difficult to compute, we can compute inflation as below:

Where CPI is the consumer price index and t is time. The consumer price index measures how much more a basket of goods that represents goods purchased by the average householder costs today compared with some previous time period.

0

1

0 0

1

kt

i iik

i ii

P QCPI

P Q

Name CPI (I2005/2004) %

A 1,2 30%

B 1,4 25%

C 0,9 15%

E 1,5 30%

CPI2005=1,2x30%+1,4x25%+0,9x15%+1,5x30%=1,295

1

1

100%t tp

t

CPI CPIg

CPI

CPIt-1:

CPIt:

Note: CPI doesnt reflect changes in quality of goods and services or of new goods and services.

+ GDP (D: Deflator)

1

0

1

100% 100%

nt t

i in i

ntr

i ii

P QGDP

DGDP P Q

D-GDP reflects changes in prices of total fianl goods and services compare with based price,therefore, this describes inflation rate.

1

1

100%t tp

t

D Dg

D

Why is inflation a problem?: When inflation is present in the economy, money is losing its value. The higher the inflation rate, the higher is the rate at which money is losing value and this fact is the source of the inflation problem. Inflation is said to be good for borrowers and bad for lenders, and so inflation can cause inequalities in the economy. People on fixed incomes (e.g. pensioners and students) tend to suffer most from inflation.

2. Types of inflation

*Moderate Inflation: inflation rate < 10%/n¨m, prices increases slowly..

Moderate inflation can spur production because price increases leading to highet profit for enterprises,therefore, firms will increases quantity.*Galloping Inflation: inflation rate is from 10% to 99% per year. This type will destroy economy and curb engines of economy.

*Hyper Inflation: is defined as inflation that exceeds 100% percent per year. Costs such as shoe-leather and menu costs are much worse with hyperinflation– and tax systems are grossly distorted. Eventually, when costs become too great with hyperinflation, the money loses its role as store of value, unit of account and medium of exchange. Bartering or using commodity money becomes prevalent.In 1920s (1922-12/1923) Weimar Germany, CPI increased from 1 to 10 millions

*Expected inflation: depends on expectation of individuals about gp in the future. Its impacts is small but help to adjust production cost.

+Unexpected inflation: derives from exogenous shocks and unexpected factors inside economy.

The inconvenience of reducing moneyholding is metaphorically called theshoe-leather cost of inflation, becausewalking to the bank more often inducesone’s shoes to wear out more quickly.

When changes in inflation require printingand distributing new pricing information,then, these costs are called menu costs.

Another cost is related to tax laws. Oftentax laws do not take into considerationinflationary effects on income.

Unanticipated inflation is unfavorable because it arbitrarily redistributes wealth among individuals.

For example, it hurts individuals on fixed pensions. Often thesecontracts were not created in real terms by being indexed to a particular measure of the price level.

There is a benefit of inflation– many economists say that someinflation may make labor markets work better. They say it“greases the wheels” of labor markets.

3. Causes of inflation

Demand-pull inflation is caused by continuing rises in AD in the economy. The increase in AD may be caused by either increases in the money supply or increases in G-expenditure when the economy is close to full employment. In general, demand-pull inflation is typically associated with a booming economy.

AD1

AD0

P1

P0

0 YY*

PAS

* Cost-push inflation is associated with continuing rises in costs. Rises in costs may originate from a number of different sources such as wage increases and other higher costs of production (e.g. raw materials). AS

1

P

0Y* YY0

AS0

ADP0

P1

Y1

*Structural (demand-shift) inflation arises when the pattern of demand (or supply) changes in the economy which results I n some industries experiencing increased demand whilst others experience decreased demand. If prices and wage rates are inflexible downwards in the contracting industries, and prices and wage rates rise in the expanding industries, the overall price and wage level will rise. The problem will be made worse, the less elastic is supply to these shifts.

*Expectations are crucial determinants of inflation. Workers and firms take account of the expected rate of inflation when making decisions. Generally, the higher the expected rate of inflation, the higher will be the level of pay settlements and price rises, and hence the higher will be the resulting actual rate of inflation.*Inflation and Money: equilibrium point of money market

hikYMDMSP

MSrr

n

In other words, if Y is fixed (from Chapter 3) because it dependson the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant,

or in percentage change form:

MV = PY

% Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = % Change in P + % Change in Y

if V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P.The quantity theory of money states that the central bank, whichcontrols the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.

The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in

the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

The revenue raised through the printing of money is called seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in

the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.

* Inflation and interest rate

Economists call the interest rate that the bank pays the nominal interest rate and the increase in your purchasing power the real interest rate.

This shows the relationship between the nominal interest rate and the rate of inflation, where r is real interest rate, i is the nominal interest rate and p is the rate of inflation, and remember that p is simply the percentage change of the price level P.

r = i –

The Fisher Equation illuminates the distinction between the real and nominal rate of interest.Fisher Equation: i = r Fisher Equation: i = r + +

Actual (Market)Actual (Market)Nominal rate ofNominal rate of

interestinterestReal rateReal rateof interestof interest

InflationInflation

The one-to-one relationshipbetween the inflation rate and the nominal interest rate isthe Fisher Effect.

It shows that the nominal interest can change for two reasons: becausethe real interest rate changes or because the inflation rate changes.

+gp is high=>i is up to keep

equality of r .

+Economy has high i lead to high

gp or i can explains gp of economy.

+If real gp > expected gp => borrowers get advantages

+If real gp < expected gp => lenders get advantages

4.Policies to deal with inflation:

4.1.Fiscal policy comprises changes in government expenditure and/or taxation. The aim is to affect the level of AD through a policy known as demand management. In the case of controlling inflation, this involves reducing government expenditure and/or increasing taxation in what is called a deflationary fiscal policy. Such policies are likely to be effective if inflation has been diagnosed as demand-pull since a reduction in government expenditure or an increase in income tax will reduce aggregate demand in the economy.

4.2.Monetary policy is concerned with influencing the money supply and the interest rate. In terms of controlling inflation, the government can aim to reduce the money supply thus reducing spending and, therefore, the aggregate demand, or it can increase the interest rate so as to increase the cost of borrowing. Both policies can be seen as deflationary monetary policy. Since monetarists view the growth of the money supply as being the main cause of inflation, any control of inflation from a monetarist viewpoint must involve control of the money supply.

4.3.Prices and incomes policy aim to limit and, in certain cases, freeze wage and price increases. In the past they have either been statutory or voluntary. Statutory prices and incomes policies have to be enforced by government legislation, such as the EU minimum wage legislation. With a voluntary prices and incomes policy the government aims to control prices and incomes through voluntary restraint, possibly by obtaining the support of the unions and employers.

4.4. Supply-side policy is concerned with instituting measures aimed at shifting the aggregate supply curve to the right. Supply-side economics is the use of microeconomic incentives to alter the level of full employment and the level of potential output in the economy. If inflation is caused by cost-push pressures, supply-side policy can help to reduce these cost pressures in two ways:

(1) by reducing the power of trade unions and/or firms (e.g. by anti-monopoly legislation) and thereby encouraging more competition in the supply of labour and/or goods, (2) by encouraging increases in productivity through the retraining of labour, or by investment grants to firms, or by tax incentives, etc.

4.5.Learning to live with inflation involves accepting the fact that inflation is here to stay when standard anti –inflationary policy measures appear ineffective. In such a situation we just have to learn to live with inflation. Learning to live with inflation involves the government, employers and workers taking inflation into account in their everyday transactions. For example, the government/employers may use indexation in wage/pensions contracts. Indexation is when wages or pensions are increased in line with the current rate of inflation. Indexation is aimed at nullifying the effects of inflation.

CHAPTER VI

Economic growth

I. Definition

An increase on potential output

Economic growth or developments?

II.Computing of economic growth

*Computed by % changes in real GDP

%1001

1

t

ttt Y

YYg

+gt: according to real GDP

%1001

1

t

ttpct y

yyg

*gpct : by GDP per capita ( Ýn case population increases faster than GDP)

II. Sources of economic growth

1.Human capital

2. Capital accumulation

3. Natural resource

4.Technological knowledge

III.Theories of economic growth:

1. Classical theory of Adam Smith vµ Malthus

Land plays an important role for economic growth.

+Adam Smith: gold age

+Malthus: dull age

2. Economic growth theory of KeynesI increases => outputs and income increase=> capital .acc is up=> G should invest to push AD, lead to ecnomic growth.

Y

KICOR

Y

IICOR

ICOR

s

Y

Y

ICOR (Incremental Capital-Output Ratio )

where S=I

Harrod- Domar model: explains the role of capital accumulation for economic growth.

ICOR

sg )(

Y

Ss

*If ICOR is constant, g increases at the rate of savings rate.

*Debates: +ICOR is not constant

+Model ignores technology and human resources

3. Neo-classical economic growth theorySolow model or Solow-Swan Model

3.1. Introduction: paper of economic growth were issued in 2/1956 and 11-1956 of two economists are Solow and Swan*Why it is neo-classical theory: use the role of market and government

The Solow Growth Model is designed to show howgrowth in the capital stock, growth in the labor force, and advances in technology interact in an economy, and how they affect a nation’s total output of goods and services.

Let’s now examine how the model treats the accumulation of capital.

The production function represents the transformation of inputs (labor (L), capital (K), production technology) into outputs (final goods and services for a certain time period).

The algebraic representation is:

Y = F ( K , L )

The Production FunctionThe Production Function

IncomeIncome isis some function ofsome function of our given inputsour given inputs

Let’s analyze the supply and demand for goods, andsee how much output is produced at any given timeand how this output is allocated among alternative uses.

Key Assumption: The Production Function has constant returns to scale.

z zz

This assumption lets us analyze all quantities relative to the size of the labor force. Set z = 1/L.

Y/ L = F ( K / L , 1 )

OutputOutputPer workerPer worker

isis some function ofsome function of

the amount of the amount of capital per workercapital per worker

Constant returns to scale imply that the size of the economy asmeasured by the number of workers does not affect the relationshipbetween output per worker and capital per worker. So, from now on,let’s denote all quantities in per worker terms in lower case letters.Here is our production function: , where f(k)=F(k,1).y = f ( k )

This assumption lets us analyze all quantities relative to the size of the labor force. Set z = 1/L.

Y/ L = F ( K / L , 1 )

OutputOutputPer workerPer worker

isis some function ofsome function of

the amount of the amount of capital per workercapital per worker

Constant returns to scale imply that the size of the economy asmeasured by the number of workers does not affect the relationshipbetween output per worker and capital per worker. So, from now on,let’s denote all quantities in per worker terms in lower case letters.Here is our production function: , where f(k)=F(k,1).y = f ( k )

MPK = f (k + 1) – f (k)

yy

kk

f(k)

The production function shows how the amount of capital perworker k determines the amountof output per worker y=f(k).The slope of the production functionis the marginal product of capital:if k increases by 1 unit, y increasesby MPK units.

1MPK

consumptionconsumptionper workerper worker

dependsdependsonon savingssavings

raterate(between 0 and 1)(between 0 and 1)

OutputOutputper workerper worker

consumptionconsumptionper workerper worker investmentinvestment

per workerper worker

y = c + iy = c + i1)

c = (1-c = (1-ss)y)y c = (1-c = (1-ss)y)y 2)

y = (1-y = (1-ss)y + i)y + iy = (1-y = (1-ss)y + i)y + i3)

4) i = i = ssyyi = i = ssyy Investment = savings. The rate of saving sis the fraction of output devoted to investment.

Here are two forces that influence the capital stock:

• Investment: expenditure on plant and equipment.• Depreciation: wearing out of old capital; causes capital stock to fall.

Recall investment per worker i = s y.Let’s substitute the production function for y, we can express investmentper worker as a function of the capital stock per worker:

i = s f(k)

This equation relates the existing stock of capital k to the accumulationof new capital i.

Investment, s f(k)

Output, f (k)c (per worker)

i (per worker)y (per worker)

The saving rate s determines the allocation of output between consumption and investment. For any level of k, output is f(k), investment is s f(k), and consumption is f(k) – sf(k).

yy

kk

Impact of investment and depreciation on the capital stock: k = i –k

Change inCapital Stock

Investment Depreciation

Remember investment equals savings so, it can be written:k = s f(k)– k

k

kk

k

Depreciation is therefore proportionalto the capital stock.

Investment and Depreciation

Capital per worker, k

i* = k*

k*k1 k2

At k*, investment equals depreciation and capital will not change over time. Below k*,

investment exceeds

depreciation, so the capital stock grows.

Below k*, investment

exceeds depreciation, so the capital stock grows.

Investment, s f(k)

Depreciation, k

Above k*, depreciation exceeds investment, so the

capital stock shrinks.

Above k*, depreciation exceeds investment, so the

capital stock shrinks.

Investmentand

Depreciation

Capital per worker, k

i* = k*

k1* k2*

Depreciation, k

Investment, s1f(k)

Investment, s2f(k)

The Solow Model shows that if the saving rate is high, the economy will have a large capital stock and high level of output. If the saving

rate is low, the economy will have a small capital stock and alow level of output.

An increase inthe saving rate

causes the capitalstock to grow to

a new steady state.

An increase inthe saving rate

causes the capitalstock to grow to

a new steady state.

c*= f (k*) - k*.According to this equation, steady-state consumption is what’s leftof steady-state output after paying for steady-state depreciation. Itfurther shows that an increase in steady-state capital has two opposing effects on steady-state consumption. On the one hand, more capital means more output. On the other hand, more capital also means that more output must be used to replace capital that is wearing out.

The economy’s output is used for consumption or investment. In the steady state, investment equals depreciation. Therefore, steady-state consumption is the difference between output f (k*) and depreciation k*. Steady-state consumption is maximized at the Golden Rule steady state. The Golden Rule capital stock is denoted k*gold, and the Golden Ruleconsumption is c*gold.

k

kk

k

Output, f(k)

c *gold

k*gold

3.2. Conclusions of Solow model

+The role of savings for economics growth

+Capital accumulation is good for short-run economic growth

+Techonology is the determinant of long-run economic growth

4. Policies for economic growth4.1. Increasing domestic savings and investment

4.2. Attracting FDI

4.3. Improving human resources

4.4. R&D of new techonology

4.6. The open-door policy

4.7. Curbing growth of population

4.5. Stability of politics and economy

CHAPTER IV

The Open Economy

Governmentpurchases of goods

and services

Governmentpurchases of goods

and services

Y = C + I + G + NXY = C + I + G + NX

Total demandfor domestic

output

Total demandfor domestic

output

Consumptionspending byhouseholds

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds

Investmentspending by

businesses andhouseholds

Net exportsor net foreign

demand

Net exportsor net foreign

demand

Notice we’ve added net exports, NX, defined as EX-IM. Also, note that domestic spending on all goods and services is the sum of domestic spending on domestics goods and services and on foreign goods and services.

is composed of

is composed of

Y = C + I + G + NXY = C + I + G + NX

After some manipulation, the national income accounts identity can be re-written as:

NX = Y - (C + I + G)NX = Y - (C + I + G)

Net ExportsNet Exports OutputOutput

This equation shows that in an open economy, domestic spending neednot equal the output of goods and services. If output exceeds domesticspending, we export the difference: net exports are positive. If outputfalls short of domestic spending, we import the difference: net exportsare negative.

Domestic Spending

Domestic Spending

Start with the national income accounts identity. Y=C+I+G+NX.Subtract C and G from both sides and obtain Y-C-G = I+NX.

Let’s call this S, national saving.

So, now we have S=I+NX. Subtract I from both sides to obtain the newequation, S-I=NX.This form of the national income accounts identity shows that an economy’s net exports must always equal the difference between itssaving and its investment.

S-I=NX

Trade BalanceNet Foreign Investment

S-I=NXS-I=NXIf S-I and NX are positive, we have a trade surplus. We would be net lenders in world financial markets, and we are exporting more goods than we are importing.

If S-I and NX are negative, we have a trade deficit. We would be netborrowers in world financial markets, and we are importing more goods than we are exporting.

If S-I and NX are exactly zero, we have balanced trade since the valueof imports equals the value of exports.

Net Capital Outflow = Trade Balance

We are now going to develop a model of the international flows of capital and goods. Then, we’ll

address issues such as how the trade balance responds to changes in policy.

Recall that the trade balance equals the net capital outflow, which in turn equals saving minus investment, our model focuses on savingand investment. We’ll borrow a part of the model from Chapter 3, butwon’t assume that the real interest rate equilibrates saving andinvestment. Instead, we’ll allow the economy to run a trade deficitand borrow from other countries, or to run a trade surplus and lendto other countries.

Consider a small open economy with perfect capital mobility inwhich it takes the world interest rate r* as given, denoted r = r*.

Remember in a closed economy, what determines the interest rate is theequilibrium of domestic saving and investment--and in a way, the worldis like a closed economy-- therefore the equilibrium of world saving andworld investment determines the world interest rate.

C = C (Y-T)

I = I (r)

Y = Y = F(K,L)

NX = (Y-C-G) - I or NX = S - I

The economy’s output Y is fixed by thefactors of production and the productionfunction.Consumption is positively related to disposable income (Y-T).Investment is negatively related to thereal interest rate.The national income accounts identity,expressed in terms of saving and investment.

Now substitute our three assumptions from Chapter 3 and the conditionthat the interest rate equals the world interest rate, r*.

NX = (Y-C(Y-T) - G) - I (r*)NX = S - I (r*)

This equation suggests that the trade balance is determined by thedifference between saving and investment at the world interest rate.

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

rclosed

r*

NX

In a closed economy, r adjusts to equilibrate saving and investment.

In a small open economy, the interest rate is set by worldfinancial markets. The differencebetween saving and investmentdetermines the trade balance.

In this case, since r* is above rclosed and saving exceeds investment, there is a trade surplus.

r*'NX

If the world interest rate decreased to r* ', I would exceed S and there would be a trade deficit.

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

r*

S'

An increase in government purchases or a cut in taxes decreases national saving and thus shifts the national saving schedule to the left.

NX

The result is a reduction in national saving which leads to a trade deficit, where I > S.

NX = (Y-C(Y-T) - G) - I (r*)

NX = S - I (r*)

S

I(r)

Investment, Saving, I, S

Real interest rate, r*

r1*

A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r1* to r2*.

NX

The higher world interest rate reduces investment in this small open economy, causing a trade surpluswhere S > I.

r2*

An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of investment at the world interest rate r*.

NX

As a result, investment now exceeds saving I > S, which means the economy isborrowing from abroad and running a trade deficit.

S

I(r)1

Investment, Saving, I, S

Real interest rate, r*

r1* I(r)2

In the next few slides, we’ll learn about the foreign exchange market, exchange rates and much more!

Let’s think about when the US and Japan engage in trade. Each country has different cultures, languages, and currencies, all of which could hinder trade. But, because of the foreign exchange market, trade transactions become more efficient. The foreign exchange market is a global market in which banks are connected through high-tech telecommunications systems in order to purchase currencies for their customers.

The next slide is a graphical representation of the flow of the trade between the U.S. and Japan, and how the mix of traded things might be different, but is always balanced. Also, notice how the foreign exchange market will play the middle-man in these transactions. For instance, the foreign exchange market converts the supply of dollars from the U.S. into the demand for yen, and conversely, the supply of yen into the demand for dollars.

it must supply yen which are then converted into dollars by the foreign exchange market.

ForeignExchange

Market

ForeignExchange

Market

Supply$DemandYEN

Demand$SupplyYEN

In order for Japan to pay for its imports of goods and services and securities from the U.S.,

In order for the U.S to pay for its imports of goods and services and securities from Japan,it must supply dollars which are then converted

into yen by the foreign exchange market.

& SecuritiesGOODS & SERVICES

GOODS & SERVICES

Goods and Services& SECURITIES

SECURITIES

The exchange rate between two countries is the price at whichresidents of those countries trade with each other.

-relative price of the currency of two countries-denoted as e -relative price of the currency of two countries-denoted as e

-relative price of the goods of two countries-sometimes called the terms of trade-denoted as

-relative price of the goods of two countries-sometimes called the terms of trade-denoted as

The nominal exchange rate is the relative price of the currency oftwo countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange 1 dollar for 120 yen in world markets for foreign currency.A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to “the exchangerate” between two countries, they usually mean the nominal exchangerate.

The nominal exchange rate is the relative price of the currency oftwo countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange 1 dollar for 120 yen in world markets for foreign currency.A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to “the exchangerate” between two countries, they usually mean the nominal exchangerate.

D$ shifts rightward and increases the nominal exchange rate, e. This is known as appreciation of the dollar.

Be1

e

Dollar Value of Transactions

D$

Ae0

S$

$

Suppose that there is an increase in the demand for U.S. goods andservices. How will this affect the nominal exchange rate?

Events which decrease the demand for the dollar, and thus decrease e would be a depreciation of the dollar.

D$

The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us the rate at which we can trade the goods of one country for the goods of another.

To see the difference between the real and nominal exchange rates, consider a single good produced in many countries: cars. Suppose anAmerican car costs $10,000 and a similar Japanese car costs 2,400,000yen. To compare the prices of the two cars, we must convert them intoa common currency. If a dollar is worth 120 yen, then the Americancar costs 1,200,000 yen. Comparing the price of the American car(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), weconclude that the American car costs one-half of what the Japanesecar costs. In other words, at current prices, we can exchange 2American cars for 1 Japanese car.

We can summarize our calculation as follows:Real Exchange Rate = (120 yen/dollar) (10,000 dollars/American car)

(2,400,000 yen/Japanese Car) = 0.5 Japanese Car

American CarAt these prices, and this exchange rate, we obtain one-half of a Japanesecar per American car. More generally, we can write this calculation as Real Exchange Rate =

Nominal Exchange Rate Price of Domestic Good Price of Foreign Good

The rate at which we exchange foreign and domestic goods depends onthe prices of the goods in the local currencies and on the rate at whichthe currencies are exchanged.

= e × (P/P*)

Real Exchange Rate

Nominal Exchange

RateRatio of Price

Levels

Note: P is the price level of the domestic country (measured in the domestic currency) and P* is the price level of theforeign country (measured in the foreign currency).

= e × (P/P*)

The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goodsare relatively cheap.

Real Exchange Rate

Nominal Exchange Rate

Ratio of Price Levels

How does the level of prices effect exchange rates? It doesn’t. All changes in a nation’s price level will be fully incorporated into the nominal exchange rate. It is the law of one price applied to the international marketplace.

Purchasing Power Parity suggests that nominal exchange rate movements primarily reflect differences in price levels of nations. It states that if international arbitrage is possible, then a dollar must have the same purchasing power in every country. Purchasing Power Parity does not always hold because some goods are not easily traded, and sometimes traded goods are not always perfect substitutes– but it does give us reason to expect that fluctuations in the real exchange rate will be small and short-lived.

NX()

Net Exports, NX

Real exchangerate,

The law of one price applied to the international marketplace suggests thatnet exports are highly sensitive to smallmovements in the real exchange rate.This high sensitivity is reflected herewith a very flat net-exports schedule.

S-I

NX()

Net Exports, NX

Real exchangerate,

0

The real exchange rate is determined by theintersection of the vertical line representingsaving minus investment and downward-slopingnet exports schedule.

S-I

The relationship between the real exchange rate and net exports is negative: the lower the real exchange rate, the less expensive are domestic goods relative to foreign goods, and thus the greater are our net exports.

Here the quantity of dollars supplied for net foreigninvestment equals the quantity of dollars demandedfor the net exports of goods and services.

NX()

Net Exports, NX

Real exchangerate,

NX1

The fall in saving reduces the supply of dollarsto be exchanged into foreign currency, fromS1-I to S2-I. This shift raises the equilibrium realexchange rate from 1 to 2.

S1-I Expansionary fiscal policy at home, such as anincrease in government purchases G or a cut intaxes, reduces national saving.

A reduction in saving reduces the supply of dollars which causes the real exchange rate to rise and causes net exports to fall.

S2-I

NX2

2

1

NX()

Net Exports, NX

Real exchangerate,

NX2

The increase in the world interest rate reducesinvestment at home, which in turn raises thesupply of dollars to be exchanged into foreigncurrencies.

S-I (r2*)Expansionary fiscal policy abroad reduces world saving and raises the world interest rate from r1* to r2*.

As a result, the equilibriumreal exchange rate falls from 1 to 2.

NX1

1

2

S-I(r1*)

NX()

Net Exports, NX

Real exchangerate,

NX1

As a result, the supply of dollars to be exchanged into foreign currencies falls from S-I1 to S-I2.

S-I1An increase in investment demand raises the quantity of domestic investment from I1

to I2.

This fall in supply raises the equilibrium real exchange rate from 1 to 2.

NX2

1

2

S-I2