ECO Session1

8/3/2019 ECO Session1

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MacroMacro--EconomicsEconomics


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Basic IntroductionBasic Introduction

y Overall Demand and Capacity of an Economy

y Slowdown, Recession, and Depression

y Slowdown inflation rate decreases and unemployment rate

increases (Philips curve!!)

y If AD>AS, it means boom and a rise in inflation

y Measure of Inflation in India WPI (one of the price indices)

y CPI is used to measure cost of living changes in the economy.


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What is GDP?What is GDP?

y GDP refers to what is totally produced and not what is sold

y Nominal GDP vs. Real GDP (base year for India -1999-2000);

GDP Deflator = Nominal GDP*100/Real GDP

y 3 methods of measuring GDP Expenditure method - total spending on domestically produced

goods and services in economy C+I+G+X-M - GDP at marketprices

Income method - adds the incomes accrued to all factors ofproduction - GDP at factor cost

Output method - adds the value added at each stage of production

y Net Factor Income from abroad = Factor incomes earned byResidents abroad Factor Incomes earned by foreigners here.

y GNP = GDP + NFIA


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More about GDPMore about GDP

y GDP at market prices = GDP at factor cost ??

GDP (mp) = GDP (fc) (Indirect taxes-Subsidies)

y GDP response to investment is called Incremental Capital Output

Ratio (ICOR India Vs. China); crucial determinant of rate ofincrease in GDP

y NDP = GDP Depreciation

y National Income is factor incomes accrued to residents of country.

y National Income = GNP (fc) Depreciation

y Disposable Personal Income

y What about transfer payments, transactions in Black market and

second hand market, unorganized sector, domestic work, etc.


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Famous Twin Deficit TheoryFamous Twin Deficit Theory

y NI = C+I+G+X-M; DP = C+S; DP = NI - T

y Investment is sum of private savings, government savings, andforeign savings I = S + T-G + M-X

y X>M implies investment abroad by using excess foreign exchange.M>X implies decrease in forex which decreases opportunities forinvesting abroad

y T-G is called fiscal balance while M-X is current accounts

balance (when +ve, then deficit, when ve then surplus)\

y Twin Deficit: Higher the fiscal deficit, more it will spill over tocurrent account deficit, if I and S are stable (1991 economic crisis)


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Introduction to Interest rates and Money SupplyIntroduction to Interest rates and Money Supply

y Interest Rates price of money

y Real money demanded = Transaction demand (+ve function of GDP and vefunction of interest rates) + precautionary demand (for unseen future) +speculative demand (varies inversely with interest rates)

y If interest rates are high, people expect them to go low i.e. bond prices will risefrom current low position, so invest in bonds (hence demand less money).

y Supply for money - M1 = currency + chequable deposits, M3 = M1 + fixed andtime deposits (broad money). M3 is money supply

y

GDP depends upon M3 and velocity of circulation if money supply exceedscapacity, then large money chasing fewer goods, when means inflation

y If GDP < capacity, then rise in money supply stimulates the economy byproviding liquidity


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Interest Rates (continued)Interest Rates (continued)

y Real Interest rates = Nominal interest rates inflation rate

y In a period of slowdown, interest rates fall as demand for money is lowas well as expected inflation rate. In booming economy reversehappens.

y Call Money market rates: rates at which one bank borrows from otherbank in the short-term, ranging from call (repayable on demand) to 72hours

y

Rates on Treasury bills and long term government bonds refer to yieldson short term and long term government securities

y Prime Lending Rate (PLR) is rate at which banks lend to their favoredcustomers


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Introduction to Exchange RateIntroduction to Exchange Rate

y Demand for exports and imports exchange rate

y Recent trends in Indian exchange rate and Chinese peg against dollar

(different exchange rate arrangements)

y Real Exchange rate = Nominal Exchange Rate * Foreign price /

Domestic price.

Gain in competitiveness vis a vis real depreciation of currency

y Real Effective Exchange Rate (REER) is a weighted geometric averageof bilateral real exchange rates with weights equal to trade shares.

y Net Exports go down if home GDP increases, go up as foreign GDP

increases or real exchange rate rises


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InflationInflation

y Inflation is caused by 3 factors:

Demand Pull inflation rise in C, I, G, and X-M makes price and outputrise. If economy is operating near full capacity then price rise is steeper

Cost Push Inflation rise in costs for firms without rise in productivity likelabor costs, material costs. This will raise prices along with decrease output.

Expectation Driven If people expect inflation to happen, they revise their

prices which lead to actual inflation.

y Inflation refers to continuous rise in prices, not one shot increase in prices.

y Increase in money supply by government help in rising inflation

y Inflation leads to distribution of wealth from fixed income to those having realincomes and from lenders to borrowers.

y High inflation lowers savings and people invest money in gold, land, etc. whichkeep pace with inflation.


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Introduction to economic linkagesIntroduction to economic linkages

y As X decreases, so I for X decreases => less people are employed => Cdecreases. Since C,I, and X are all slowing so government is collectingless tax revenue and hence G will also slow down (East Asian Crisis,1997)

y Marginal propensity to consume (mpc) = change in C in response tochange in Disposable Income

y C has 2 components: induced component, which can be induced bymacroeconomic policy variables like interest rates and tax rates, andautonomous component driven by sentiment (not affected by policies)

y US slowdown (due to IT bubble burst) of 2001 and troubles of Japanese economy (due to manufacturing burst)

y Mr Chidambrams dream budget (1997-98) failed to take off because ofstock market scam and real estate price crash preceding it


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Fiscal PolicyFiscal Policy

y Government expenditure (G) and T (taxes) most important policy variables offiscal policy

y G revenue expenditure and capital expenditure. Receipts & Payments

y Balance of receipts is what the government borrows

y Direct taxes: progressive (go up as income rises), their share increases fasterthan rate of growth in GDP

y Indirect taxes: regressive whose share in income decreases as income rises

y Primary deficit = fiscal deficit - interest payments (a better measure of fiscalprofligacy)

y Increase in G and lowering of T fiscal stimulants (effect on aggregate demand)


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Some concepts related to Fiscal PolicySome concepts related to Fiscal Policy

y When government deficit is financed through borrowings from RBI, itis called monetized deficit as it increases money supply in economy(RBI prints money)

y During times of slowdown and boom, G rises and falls automatically

due to changing number of eligible beneficiaries. T also falls and risesdue to its progressive nature. Deficit increases in slowdown due to risein G and fall in T

y In market driven economies, tax cuts are used during slowdowns whilecuts in G are used during boom. In state driven economies, increase in

G is used in slowdown and increase in taxes used in boom

y Crowding Out Phenomenon: G can crowd out I as well as X if moneysupply is fixed rise in G leads to increase in interest rates whichattracts more foreign currency, leading to appreciation of exchange rate


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Monetary PolicyMonetary Policy

y P = m-g + v where p = inflation; g = %rise in GDP v = velocity of

circulation and m = increase in money supply

y Demand will be more if person is paid weekly as compared to

monthly, i.e. the velocity with which money changes hands is more

y Financial sophistication also brings down the demand for money

y Interest rates, exchange rates and money supply important

monetary policy variables

y Monetary policy changes first impact financial variables like

interest rates, exchange rates. They then affect C and I which then

affect GDP and Prices


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Linkages related to Monetary PolicyLinkages related to Monetary Policy

y If money supply increases, then people will demand bonds more and hence bondprices go up, hence interest rates go down. Vice versa is also true

y Decrease in interest rates causes prices of long lived assets like stocks, bonds andreal estate to rise and hence people become wealthier. The collateral which can b

given against loan suddenly increase. (US consumption bubble)

y Fall in interest rates means rise in disposable income for people in debt. Forpeople not in debt, current consumption is more attractive than future, so Cincreases.

y Increase in asset prices makes individual feel wealthier and hence C rises.

y Depreciation of local currency makes imports expensive and hence domesticspending increases


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More ConceptsMore Concepts

y Fall in interest rates encourages more investment by companies.

Due to rise in value of collateral, bank loans become easy

y SLR, CRR, Repo & Reverse Repo rate, Bank rate / Call rate

y High powered money/reserve money = monetary base = currency in

circulation with public + reserves

y Money Multiplication by Banks : concept of money multiplier

y Open Market Operations y RBI: forex swaps, repo/reverse repo

transactions, buy/sell government securities


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Problems for RBIProblems for RBI

y Targets for RBI: interest rates or money supply or exchange rates

y When rupee is appreciating against dollar and RBI stabilizes that, money supplygoes up and vice versa. So both cannot happen simultaneously. If it wants stableexchange rate, it has to tolerate more inflation.

y Sterilization: FII inflow due to interest differential: RBI has to stabilizeexchange rate but inflation rises. RBI earns lower interest by deploying forex insecurities abroad as compared to what it can earn by deploying rupeedomestically.

y Problem is that if you are not allowing the money supply to rise (hence interest

rates to decrease), then balance between inflows and outflows will not beobtained as interest differential will remain there for FII to take advantage of.

y Targets of RBI have been dynamic depending upon the economic conditions


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External AccountExternal Account

y If government follows expansionist policies, increase in domestic GDPmeans increase in imports so increase in foreign GDP. But if increase inGDP is due to real depreciation in exchange rates, then domestic GDPrises but foreign GDP comes down

y Balance of Payments is the difference between receipts of residents ofcountry from foreigners and payments by residents to foreigners

y Trade account: balance from export and import of merchandise

y Invisibles: services, investment income & transfer payments

y Current account = trade account + invisibles

y Capital account includes export and import of capital

y If local interest rates fall in comparison to foreign country, capital flowsfrom that country. Demand for foreign currency will rise and hencelocal currency will depreciate.


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Exchange RateExchange Rate

y Exchange rate can be determined by purchasing power paritytheory: in long run, exchange rates adjust to reflect differences incountries inflation rates.

y Exchange rate will be in equilibrium when their domesticpurchasing powers at that rate are equivalent.

y Interest rate parity theory says that differential of interest ratesdetermine future expected exchange rates.

y In managed float exchange rate regime, RBI allows initial rate to be

determined by market forces but later steps in to maintain its orderlybehavior.

y Fixed Rate Regimes: Adjustable peg, Crawling peg, CurrencyBoard, Unified Currency


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Important LinkagesImportant Linkages

y Fixed Rate Regime & External Account is negative: pressure on rupeeto depreciate -> RBI will sell forex to stop that -> monetary basedecreases -> interest rates rise -> GDP slows down ->imports comedown ->X-M improves

y Rise in interest rates attracts more capital from outside, so balanceimproves

y Sensitive issue ofCapital Account Convertibility in India

y Fixed regime + complete mobility G rises -> GDP rises ->demand formoney rises -> interest rates rise (as supply is fixed) -> foreign capitalflows in -> pressure on rupee to appreciate -> central bank supplies

money to mop up forex entering -> interest rates will go down.y So GDP changes with no crowding out of private investment.

y If Money supply increase, interest rates fall, foreign capital goes out, tomaintain exchange rate, RBI sells forex and hence decreases M. So noeffect on GDP.


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More LinkagesMore Linkages

y With flexible regime, rupee will appreciate in first case and hence X will becrowded out, so less influence on rise in GDP. With monetary policy, rupeedepreciates and hence X increases, so increase in GDP effective.

y Capital controls and fixed regime: rise in GDP (due to rise in G) worsens X-Mas M increases. Money supply reduces to restore exchange rate -> interest rates

rise more and crowd out private investment. So 2 opposing factors at work.

y Money supply rises -> interest rates fall -> GDP rises -> imports rise -> X-Mcomes down putting pressure on currency, so RBI will decrease money supplyincreasing interest rates , so ineffective policy in influencing GDP

y Flexible exchange rate and capital controls: GDP rises, rise in interest rates.

Rise in GDP worsens net exports and so currency will depreciate restoring thebalance. Effect on GDP is rise in G less crowding out of private I due to rise ininterest rates.

y Expansionary monetary policy will lead to fall in interest rates and hence rise ofGDP implying net exports worsen, so currency will depreciate to restore

balance. So Monetary policy has increased GDP by lowering interest rates.


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Liquidity Trap and Philips CurveLiquidity Trap and Philips Curve

y When interest rates are close to zero, a further

cut is not possible

y Hence, MP to raise I and hence AD by cutting

rates is not possibley Money demand does not respond to change in

interest rate excess liquidity

y Philips Curve Unemployment and inflation are

inversely related

y Exceed Full employment tight labour market

higher wages higher prices


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USUS China Trade ProblemChina Trade Problem

y Chinese record trade surplus against US

y Yuan must appreciate against USD making

Chinese exports less competitive

y Yuan pegged against USD till July 2005y Nominal revaluation of Yuan

y Then shift to peg against basket of currencies

y

Fixing of band of 0.5% around which Yuan wouldmove

y Fundamentals point to a weak dollar


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Current Scenario in global marketsCurrent Scenario in global markets

y Asian savings being channeled to meet US Debt

y Weak dollar & high oil prices

y Growing Liquidity Crunch Risk appetite

growing lower higher ratesy Recent slump in high-yield Asian equity markets

y

Yield Curve and its signals


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Introduction to MortgagesIntroduction to Mortgages

y Pool of home loans securitized together

y Securitization: cash flows from bundle of assets are distributed to

liability owners according to some pre-determined rule

y Water Fall Structure

y Inputs to Mortgage Pricing

y Prime and Sub-Prime Mortgages


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Japan: Land of Setting SunJapan: Land of Setting Sun

Asset

Bubble

(80s)

Bank

Speculations

Crash in

asset prices

Bank Runs

Record dip

in inflation

Nominal

Rates cut to

simulateeconomy

Liquidity

Trap

Failure of

monetary

policy

Fiscal exp

stopped dueto high

deficits

Low growth

No pricepressures


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The Carry Trade

yJapanese interest rates close to 0.5%

y Borrow in Yen to invest in high yield currencies

like AUD (6.5%), NZD(7.75%) and other Asian

currenciesy Borrow to invest in high yield assets like

Chinese and Indian stock markets, sub-prime

mortgage US assets


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The Carry Trade

y Earn interest yield differential

y Also when you buy high yield currency, it

appreciates

y Yen depreciatesy Gains (Interest + Currency)

y Risks

Japanese rates rise

Global risk increases

High yield asset defaults

High oil prices, weak dollar


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Global Trade Cycle

AsiaUS

Payments

Goods

Forex Reserves/ Savings

Imports > Exports

Debt Driven

economy

Twin deficits

Exports > Imports

Excessive Savings

channeled into

dollar reserves


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Asian woesAsian woes

Capital

inflows

Pressureto

appreciate

Excessive

liquidity

Inflation

Exportsmore

expensive

Sterilized

Intervention

Lend to

US + Buy

FX

Raise CRR,

Reverse

Repo

Sell Govt.

securities

Sustainable ??


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US SubUS Sub--prime crisisprime crisis

y Low Fed rates (1999-2003) spurred excessivelending

y Sub-prime borrower

Poor credit history

Incomplete documentation

Second loan on same asset

y Defaults begin when Fed Rates get hiked

y

Mortgages floating part of payment has begun


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US Sub-Prime Crisis

y Mortgage Originators sold loan portfolios to I-

Banks

y Loans packaged into tranches and sold to

investors, hedge funds, pension fundsy Payment from home owner passed by

Originator to I Bank to investor

y Fall in asset prices defaults

y Originators go bankrupt


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US Sub-Prime Crisis

y Investors demand higher spreads or yields to

compensate for higher risk

y Crisis spreads from sub-prime to prime

securities to corporate bond marketsy LBOs more expensive

y Lower global risk appetite

y Weak dollar, bearish Asian equities

y Carry Trade adversely affected

ECO Session1

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