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Macroeconomics

Macro topics covered

• Big Issues– Business cycles – Unemployment– Inflation

• Effects of fiscal policy and role of government– Keynesian “activist” approach

• Problems with fiscal policy– New classical “supply-side” approach

• Money and monetary policy– money creation and tools of monetary policy– money models– activist and non-activist approach

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Business Cycles

… pattern of rising real GDP followed by falling real GDP

Recession

… a period in which real GDP falls– Usually at least 2 successive quarters

Depression

… a severe and prolonged economic contraction“the great depression in the 30’s”– Around 25% of the labor force was unemployed.

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Trend growth has been around 3% per year (on average)

Real GDP begins to fall

Real GDP begins to increase

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Expansion (boom) – real GDP is increasing

Contraction – real GDP is decreasing.

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Unemployment

Official Unemployment Rate

… the percentage of the labor force that is not working

Unemployment rate = [number of people unemployed /

number of people in the labor force]

• Notice: It is not the unemployment rate of the population.

Labor Force

Labor force = all US residents – residents under 16 years – institutionalized adults – adults not looking

for work• To be in the labor force an individual must be either

looking for a job or in work

Therefore (alternative measure)

Labor Force = Employed + unemployed– E.g. housemen/women are not included in the labor force.– Retired people are also not in the labor force. – In 2006 the labor force was 152.8 Million

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Other Labor Statistics

• Labor Force Participation = Labor Force / population 16 and over

• Employment/population ratio = employed people

/ population 16 and over

• Given we have unemployment LFP>EP ratio

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Hypothetical Example

(1)Number of people unemployed

4 million

(2)Number of people employed 145 million

(3) Non-institutional civilian Population (16 and older)

200 million

(4) Labor Force 149 million

Unemployment rate (1)/(4) = 2.68%

Labor force participation (4)/(3) = 74.5%

Employment/population ratio (2)/ (3) = 72.5%

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• Frictional Unemployment– A product of the short-term movement of workers

between jobs, and of first-time workers.– “Short-run” unemployment

E.g. time between leaving one job and taking another, or students graduating college and now looking for a job.

– Sometimes called “search unemployment”Often seen as a “good thing”

– Generally low when in a recessionPeople “stay put”

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3 Types of Unemployment

• Structural Unemployment– A product of technological change and other changes in

the structure of the economyTherefore certain skill sets are no longer requiredE.g. Coal Miners losing their jobs as the economy moves to a

service-based economy.Car assembly workers laid off as factories use more robots.

• Any dynamic economy has some frictional and structural unemployment

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• Cyclical Unemployment– A product of business cycle fluctuations– E.g. a temporary fall in demand for a good/service leads

to a reduction in employment levels.– E.g. construction workers.

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Natural Rate of Unemployment… the unemployment rate that exists in the absence of cyclical

unemployment.– All economies will have some “natural” rate of

unemployment.– Frictional plus structural– Can vary over time.

• Estimated to be between 4-6%• US it is approximately 5% (at the moment)

Full Employment…. The level of employment when the economy is at its natural

rate of unemployment– For the US it is assumed to be 95%– Sustainable level of employment

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Inflation

… a sustained increase in the average level of prices

• The higher the price level the lower the real value of money

– Purchasing power of a dollar is eroded.

– Standard argument with parents and allowances….

Hyperinflation

… an extremely high rate of inflation

E.g. Zimbabwe.

– Can cause a “flight from money”.

Calculating Inflation

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Year Price Index (CPI) Inflation Rate (%)

2001 88 -

2002 93 5.68

2003 100 7.53

2004 104 4.00

2005 106.5 2.40

2006 110 3.29

2007 118 7.27

Unanticipated and Anticipated Inflation

• Unanticipated Inflation– When the increase in prices is a “surprise”

for most decision makers– Usually happens when inflation rates vary

significantly.

• Anticipated Inflation– When the increase in prices was “expected”

by most decision makers– Usually happens when Central Banks have a

good control on inflation

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Costs of Inflation

• Businesses generally avoid long term projects– Difficult to estimate the profitability of a project

if prices (costs) are varying a lot in the future.

• Prices no longer reflect relative scarcity– As some prices change slower (sticky) than

others– Price no longer reflects all (current) information– More difficult for firms/individuals to make

informed decisions.

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• “Shoe leather and Negotiation Costs”– Individuals spend time acquiring information– Cause higher transaction costs when

negotiating– Business divert resources from “normal

business practices “ to developing methods/forecasts to deal with inflation

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Keynesian Economics

• Government should alter Aggregate Demand (AD) through manipulating government spending (G) and taxation (T)

• Budget Surplus – government revenue (T) greater than government spending (G)

 • Budget Deficit – government revenue (T) less than

government spending (G)

• Multiplier effect: A $1 change in spending/taxation causes real GDP to increase by more than $1

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Keynesian Economics: All about AD

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Crowding Out

… a drop in consumption and/or investment caused by changes in government spending.

• If Government Spending rises it may drive up interest rates

– Running a budget deficit => government borrows the funds

• This may reduce Consumption, net exports and particularly Investment

• Thus public spending may “crowd out” private sector spending

– Public spending replaces private spending…

• Multiplier effect is lowered – potentially even zero if there is complete crowding out.

Problems with Fiscal Policy

• Keynesian Economists argue the supply side is too slow to react to solve an economy’s problems

• BUT Fiscal policy has timing issues.– Takes time for policy makers to realize there

is a problem with the economy– Takes time for a policy to be implemented– Takes time for a policy to have an effect.

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Automatic Stabilizers

• Element of fiscal policy that changes automatically as income (real GDP) changes

• E.g. Income tax revenue falls in recessions (when real GDP is falling) and increase during a boom (when real GDP increases)– Unemployment benefits are another example.

New Classical View of Fiscal Policy

• Suppose the government cuts taxes to stimulate the economy– Runs a budget deficit.

• Individuals recognize that taxes will have to go up in the future.

• Therefore rather than spending the tax cut they merely save it- to pay the higher tax bill in the future

• Therefore no change in AD.

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Fiscal Policy and the Supply side: Laffer curve

• Captures the dis-incentive effect of taxation.

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Tax rate

Tax RevenueRmax

t

Supply-Side effect of Fiscal Policy

• The supply-side of the economy (LRAS) is determined by the quantity and quality of resources

• Taxes create a disincentive to work, accumulate capital and invest in higher education

• Therefore high tax rates can cause to the LRAS to decrease

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What is Money?

• Money

… anything that is generally acceptable to sellers in exchange for goods and services

• Examples

– $– Cigarettes in WW2 POW camps

• Fiat Money– Money that has no intrinsic value and is not

backed by a commodity

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Liquidity

• Liquid Asset

… an asset that can easily be exchanged for goods and services

• Higher liquidity implies lower returns

• Money is the most liquid asset– Therefore has the lowest (zero return).

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Functions of Money

‘Money is a matter of functions four – a medium, a measure, a standard and a store’

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• Medium of exchange

– It lowers transactions costs– Do not need the “double coincidence of wants”

• Measure of value

– All goods and services are priced in common monetary units

– Allows us to compare relative prices easily.– Only need one set of prices.

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• Store of value– An asset that allows people to shift purchasing

power from one period to another– Money retains its value through time usually– Need to control inflation.

• Standard of deferred payment

– Money may be used to make future payments.– Debt is written in dollar amounts.

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Reserve Requirements

• The central bank “the Fed” requires banks to keep a certain percentage of their deposits available as cash reserves– Available for immediate withdrawal.

• This percentage is called the reserve requirement (rr)– E.g. the bank has to keep 10% of all their deposits as

cash reserves.

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Initial Position

• Assumed the reserve requirement was 10% of all deposits

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After New $100,000 cash Deposit

First National Bank has $90,000 (in cash) it can lend out.

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Balance Sheets After a $90,000 Loan Made by FNB Is Spent and Deposited

at SNBCash has fallen by $90k

Loans have increased by $90k

•Now SNB has $81,00 it can lend out……

Cash is deposited at SNB

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Bank New Deposit

Required Reserves

New Loans

1 $100,000 $10,000 $90,000

2 $90,000 $9,000 $81,000

3 $81,000 $8,100 $72,900

4 $72,900 $7,290 $65,610

… … … ….

Total at end of process

$1,000,000

$100,000 $900,000

New deposit of $100,000 turns into $1,000,000!

•A new deposit of $100k causes the money supply to increase by $1million.

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Deposit Expansion Multiplier

• In our example $100,000 turns into $1,000,000 – why?

• Potential Deposit expansion multiplier (DEM)

DEM = 1/Reserve Requirement (leakage)

Example– If Reserve Requirement is 10%– Deposit expansion multiplier:

1/0.1 = 10

• Note: we are assuming no “currency drain” i.e. all cash is re-deposited with a bank.

• We are also assuming that all excess reserves are lent out.

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How does the Fed control the Money Supply?

• Reserve Requirements

• An increase in the reserve requirement reduces the deposit expansion multiplier and vice versa– Alters the ability of banks to “create money”.

– If rr = 10% then DEM = 10

– If rr = 20% then DEM = 5

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How does the Fed control the Money Supply?

• The Discount Rate… the rate of interest the Fed charges commercial banks when they

borrow from it

• Sometimes commercial banks borrow to finance lending

– Or borrow when they are in financial difficulty.

• If the discount rate increases commercial banks will borrow less and the money supply will be reduced

• Federal funds rate

– The interest rate that a bank charges when it lends excess reserves to another bank.

– The discount rate is typically 1-1.5% points above the federal fund rate

– “form of punishment”

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How does the Fed control the Money Supply?

• Open Market Operations

… the buying and selling of government bonds by the Fed.

– Affects the federal funds rate.

• Swapping illiquid (bonds) for liquid assets (cash)

– Selling bonds for cash reduces the money supplyExcess reserves fall => ability to create money falls.

– Buying bonds in exchange for cash raises the money supplyExcess reserves increases => ability to create money

increases.

Money Supply

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Ms

Interest rate(%)

Quantity of money

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Money Demand

• Transactions Demand… the demand to hold money to buy goods and services

– Hold money to finance daily purchases.In the form of cash or in checking account.

• Precautionary Demand… the demand for money to cover unplanned transactions or

emergencies.– “Saving for a rainy day”

• Asset (Speculative) Demand… the demand for money created by the uncertainty about the

value of other assets.– Hold money in expectation that a profitable opportunity

will arise.• E.g. stocks and bonds.• If you think bond prices are going fall soon will hold

cash today rather than bonds.

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Money Demand

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Md

Interest rate(%)

Quantity of money

Why does Money demand slope-downwards.

• Interest rate represents the opportunity cost of holding money.– It is the return that is foregone by holding money.– Therefore the lower the interest rate the higher the

quantity demanded of money.

• Link with Bond prices (speculative demand)– Remember if the bond price is high (IR is low) therefore

people expect bond prices to fall thus prefer to hold money.

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Determinant of Money Demand

Nominal GDP– An increase in Nominal GDP (due to price increases or

increase in goods and services) causes Money demand to increase.

Shifts in Money Demand

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Md1

Interest rate(%)

Quantity of money

Md2

Md3

Equilibrium

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Md

Interest rate(%)

Quantity of money

Ms

i*

i1

i2

Getting to Equilibrium

• Suppose we have an interest rate of i1. There is a shortage of money.

– Therefore people begin to sell bonds to convert to money.

– As the supply of bonds increases, the price of bonds decreases and the interest rate increases.

• Until we get to I*

• Suppose we have an interest rate of i2. There is a surplus of money.

– Therefore people begin to buy bonds.

– As the demand of bonds increases, the price of bonds increases and the interest rate decreases.

• Until we get to I*

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Expansionary Monetary Policy and Equilibrium Income

Md

Interest rate(%)

Quantity of money

Ms1

i1

i2

Ms2

↑MS => i↓ => Investment ↑ => AD ↑↑MS => i↓ => $↓ => NX ↑ => AD ↑↑MS => i↓ => asset prices ↑ => wealth ↑ => C ↑ => AD ↑

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Unanticipated Monetary policy

A -> D (in short run)

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The Equation of Exchange

• Simply:

MV = PY

Expenditure ($) = nominal GDP

M = money supply

V = velocity of circulation

P = price level

Y =real GDP

Velocity of circulation: the average number of times each dollar is spent on final goods and services.

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Anticipated expansion in Monetary Policy

A -> B- No change in real output

Economic Stability• Keep unemployment low and inflation low.

• Smooth out the business cycle

• Activist:– Intervention into the market through Fiscal and

Monetary policy to correct recessions/booms

• Non-activist:– Maintain steady fiscal and monetary policy– Do not engage in discretionary fiscal policy etc.

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Index of Leading Indicators

Leading Indicator

… a variable that changes before real output changes– Used to forecast changes in output– Not always successful!

• Examples: consumer expectations and Stock prices– “stock prices have predicted 9 of the last 5 recessions.”

• Index of leading Indicators– 10 key indicators

• Includes: length of average work week, permits for new housing starts, consumer expectations, change in the index of stock prices 55

Index of Leading Indicators

• If the index falls for three consecutive months it is taken as a warning the economy is going into a recession– Not always accurate!– Forecasted 12 out of the last 7 recessions

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Discretionary Policy: Activists

• Argue there are enough signals/signs available to determine if/when the economy is facing difficulties– Alter G, T and interest rates as and when needed

• Problem – remember the lags!– Recognition Lag: Takes time for policy makers to

realize there is a problem with the economy– Administrative Lag: Takes time for a policy to be

implemented– Impact lag: Takes time for a policy to have an

effect.

• Non-activists ague these lags will cause bigger business cycle swings!

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Expectations

• Adaptive: Future will look like the past– E.g. best guess of future inflation is what it is

has been recently.

• Tend to make systematic forecasting errors.– If inflation is increasing over time will

continually under-estimate future inflation due to focusing on the past

• Tend to adapt/react slower to policy changes

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• Rational-Expectations Hypothesis: use all available information about variables and incorporate any policy changes.– E.g. if the government increases the Money

supply individuals will built this into their expectation about inflation.

– Still will make mistakes due to error/uncertainty

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Adaptive Vs Rational expectations: Expansion in Monetary policy

A-> D : AdaptiveA-> B : Rational Expectations

Non-Activists: Monetary Policy

• Follow rules rather than discretionary (activist polices)

• Monetary Growth rule– Increase the money supply by 3% each year

(approx equal to increase in real GDP)

• Price Level Rule– Maintain a certain (low) level of inflation

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Non-Activists: Fiscal Policy

• Maintain a balanced budget over the business cycle

• Some years it will be in surplus, other years a deficit.

• Difficult to determine if the budget will be balanced over the business cycle given that it is difficult to forecast!

• Potentially limit the size of budget deficits/government spending.

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