MACROECONOMICS
Unit of analysis: economy as a wholeVariables of interest: Level of economic
activity, unemployment, inflation, currency exchange….
Basic DefinitionsOpen vs Closed Economy
presence of foreign sector
Private Vs. Mixedpresence of government sector
Economic Growthper capita GDP based on PPP
Measuring Economic Activity
• Stockpoint in timewealth, debt, unemployment, account
balance• Flow
over a period of timeincome, GDP
1992 1998 1999 2000 2001 2002 Gross domestic product 6,880.00 8,508.90 8,859.00 9,191.40 9,214.50 9,440.20P lus: Income receipts from the rest of the world 165.1 279.3 304.4 359 292 --- Less: Income payments to the rest of the world 139.1 279.8 279.6 333.6 269.2 --- Equals: Gross national product 6,905.80 8,508.40 8,883.70 9,216.20 9,237.30 --- Less: Consumption of fixed capital 825.6 1,081.00 1,156.40 1,226.10 1,320.80 1,399.90 P rivate 667.9 894.7 962.2 1,024.00 1,110.70 1,184.50 Government 157.9 186.4 194.4 202.5 210.9 216.6Equals: Net national product 6,080.50 7,428.30 7,729.70 7,994.40 7,928.10 ---
Real GDP, Real GNP, Real NNP, all for US
•Gross Domestic Product
the total market value of all final goods and services produced by factors of production located within a nation’s borders over a period of time (usually one year)
•Gross National Product
the total market value of all final goods and services produced by factors of production owned by a nation over a period of time (usually one year)
Nominal vs Realadjusting for inflation
• Nominal GDP is measured at current prices• Real GDP is measured at constant prices
(like 1992)
Nii iiQPGDP 1
1992 1998 1999 2000 2001 2002 Real GDP 6,880.00 8,508.90 8,859.00 9,191.40 9,214.50 9,440.20Nominal GDP 6,318.90 8,781.50 9,274.30 9,824.60 10,082.20 10,445.60
other important statistics
• Unemploymentthe total number of adults (16 and up) who are
willing and able to work and who are actively looking for work, but have not found a job
• Labor Force adults who are either employed or unemployed
• Unemployment rate = Unemployed / Labor Force
• Structural, Cyclical, Frictional, Seasonal
Inflation vs deflation
• Inflation – the situation in which the average of all prices in the economy is rising
• GDP deflation, CPI, PPI, Core CPI, Core PPI
100year basein basket market ofcost
aybasket todmarket ofcost Index Price
costs of inflation and the business cycle• menu costs• redistribution of wealth• forward looking arrangements and the real
interest rate• currency depreciation and the standard of
living• RECESSION
two consecutive quarters of negative growth
Components of the GDP• Personal Consumption
– Goods• Durable• Non-durable
– Services• Gross Private Domestic Investment
– Fixed Investment• Non-residential
– Structure– Equipment and software
• Residential– Business Inventories
Components of the GDP
• Government Spending– Federal and State and Local level
• Exports of goods and services• Imports of goods and services
GDP = C + I + G + x - m
macro picture of the US economy
stunning growth of the late 1990’sandnow
5.6
5.1
6.2
4.9
5.6
6.5
5.6 5.65.9
2.6
3.02.7
4.0
2.7
3.6
4.4 4.34.1
3.8
0.3
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
nom
inal
and
rea
l GDP
gro
wth
Average Growth Rates by Component, 1996-2000
44
8%8%
ConsumptionConsumption InvestmentInvestment GovernmentGovernment ExportsExports ImportsImports
growth of components (current dollars)
-15
-10
-5
0
5
10
15
20
1994 1995 1996 1997 1998 1999 2000 2001
ConsumptionGross Private Domestic InvestmentExportsImportsGovernment
unemployment rate (annual as average of 12 months)
7.49
6.91
6.10
5.595.41
4.944.51
4.234.02
4.79
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
2000
2000
2000
2000
2001
2001
2001
2001
2002
2002
2002
2002
I II III IV I II III IV I II III IVGDP 2.6 4.8 0.6 1.1 -0.6 -1.6 -0.3 2.7 5 1.3 4 1.4Personal consumption expenditures 5.3 3 3.8 2.1 2.4 1.4 1.5 6 3.1 1.8 4.2 1.5 Durable goods 17.8 -3.7 8.1 -5.3 11.5 5.3 4.6 33.6 -6.3 2 22.8 -8.5 Nondurable goods 2.2 4.9 2 2.7 2.3 -0.3 1.3 3.6 7.9 -0.1 1 5.1 Services 4.4 3.6 3.9 3.3 0.6 1.5 0.9 2.1 2.9 2.7 2.3 1.9Gross private domestic investment 2.3 17.3 -6 -3.4 -19.7 -17.6 -5.2 -17.3 18.2 7.9 3.6 6.2 Fixed investment 13.3 6.7 0.2 -2.4 -2.2 -11.1 -4.3 -8.9 -0.5 -1 -0.3 4.5 Nonresidential 15 10.2 3.5 -3.2 -5.4 -14.5 -6 -10.9 -5.8 -2.4 -0.8 2.5 Structures 13.8 8.2 12.1 3.6 -3.1 -8.4 2.9 -30.1 -14.2 -17.6 -21.4 -9.8
Equipment and software 15.5 10.9 0.9 -5.4 -6.3 -16.7 -9.2 -2.5 -2.7 3.3 6.7 6.6 Residential 8.3 -3 -9.3 0 8.2 -0.5 0.4 -3.5 14.2 2.7 1.1 9.4
Growth In Real GDP and its' components
Seasonally adjusted unemployment rate
5.4
5.6
5.8
6
6.2
month (2002-2003)
rate
Can Euro be yet another problem?
• Price of oil• International reserve currency• Competition for investment funding
Simple view of the business cycle
• Business cycleReal GDP(per capita)
time
Predicting the future
The magical art of forecasting
Coincident indicators
• Total hours worked• Value of unemployment claims• Total tax revenues• Corporate income tax receipts
Leading indicators
• Average work hours in manufacturing• Average weekly claims for unemployment
insurance• Business inventories• New orders for non-defense capital goods• Sales tax receipts• Stock index (index futures)• Construction Employment• Residential permits
More leading indicators
• Growth in wage rate• Money supply (velocity)• Interest rate spread (10 year bond – federal
funds rate) or (10 year bond – 1 year bond)
Economy in the short-run
Keynesian viewIS/LMAD/AS
Understanding Keynesian Consumption Function
C = a + c (Y-T)
autonomous induced
MPC vs APC
Saving = S = (Y-T) – C = - a + (1-c)(Y-T)MPS vs MPC
Y-T
C
C
C = f ( Y, T, W, i,…)
S
Investment Spending business sector
Y
I
I
I = f (expected Y, i)
Government Spending government sector
Y
G
G
G = f ( policy )
Closed Mixed Economy
C
C + I
C + I + G
Y
EXP
Y1
Foreign sector
• Exports = f (foreign Y, exchange rate)• Imports = f (domestic Y, exchange rate)
Y
NX
Equilibrium expendituresActual expenditures and total income are always
equal to each other.In EQUILIBRIUM: households, businesses,
government, and the foreign sector want to spend (planned expenditures) exactly the amount of income that is being generated by the current level of production.
If the economy is out of equilibrium, then production (income) is out of alignment with planned expenditures, hence businesses are forced to change production.
Y
PlannedExpend.
C+Ip+G+NX
Iu – inventory accumulation
Ep = C+Ip+G+NX ==a+c(Y-T)+Ip+G+NXNOTE that MPC is the slopeAp=a+Ip+G+NX (autonomous)Ep=Ap+c(Y-T)In equilibrium Ep=Y, hence,Y=Ap/(1-c)-cT/(1-c) multiplier
What is the relationship between the interest rate and the equilibrium level of income? derivation of IS
IS (Investment and savings) CURVE
Components of aggregate expenditures:C, I, G, x, m
The IS curve shows a set of combinations of interest rate (i) and income levels (Y) for which
the commodity market is in equilibrium
IS curve (equilibrium in goods markets)
IS
Y
i
IS = f (i; taxes, consumer conf., wealth, fiscalpolicy, foreign Y, exchange rate….)
LM liquidity and money
• LM curve is defined as a set of different combinations of interest rate (i) and income level (Y) such that the money market is in equilibrium.
Understanding Money Demand• Why hold money (medium of exchange)?
transaction (liquidity) demandstore of value demand
• Opportunity cost of holding money: interest rate• Real money demand (Md) vs nominal money
demand (Mdn)Md = Mdn/PMd = f (i, Y), Mdn = f (i, Y, P)No Money Illusion
Money demand
Real money balances
i
Md (Y1) Md (Y2)
Y2>Y1
Nominal Money Supplymonetary policy
• Reserve requirements ratio• Discount Rate• Open Market Operations
Real Ms = (nominal Ms)/P
Real Ms
i
Deriving LM curve
Real money balances
MS
Md(Y1)
Md(Y2)
i i
YY1 Y2
LM
IS-LM
IS = f (i; taxes, consumer conf., wealth, fiscal policy, foreign Y, exchange rate….)
LM = f(i; policy, P)
TAX CUT
LMIS1 IS2 IS1 IS2 LM1
LM2
Fed holds money supply constant Fed holds interest rate constant
i i
Y Y
Fiscal multiplier and IS curve
• MPS and MPC, Saving as a leakage.• APS and APC• Multiplier and changes in autonomous
expendituresas MPS decreases (i.e. the multiplier
increases) the IS CURVE BECOMES FLATTER
Slope of the LM curve
• Real money demand:
• As income increases, the interest rate has to increase in order to maintain equilibrium in the money market
• Velocity = Y/ (real money supply) changes along LM• The more sensitive the demand for money is with respect
to the interest rate, the flatter is the LM curve• The more sensitive the demand for money is with respect
to income, the steeper the LM curve becomes
biaYPM D
SHIFTS in LM
• Changes in nominal supply of money• Inflation
Weak monetary policy
• Steep IS (large MPS; weak dependency of C and I on the interest rate…)
• Flat LM curve (money demand is very sensitive to interest rate changes) LIQUIDITY TRAP and flat LM curve (modern Japan and USA in the 1930’s).
Modern Japan and Liquidity trap
Japan, short-term interest rate fell below 1% in 1995 and remained under 1% since then. Possible solution: Fiscal and monetary expansion at the same time (same shift in LM and IS), GDP will increase and no crowding out, since the CB can purchase the bonds
Weak fiscal policy
• Vertical LM curve (interest responsiveness of money demand is zero) Crowding out and IS
• Flat IS curve• Note that fiscal policy is strong when IS
curve is vertical (zero interest responsiveness of autonomous planned spending) i.e. there is no crowding out.
Conclusion
Policy mix is needed
From IS-LM to Aggregate DemandLM(P1) LM(P2)
IS
AD
Y
Y
i
P
P1
P2
Why is AD downward sloped
• Wealth effect (real balances effect)• Interest rate effect• Open economy effect• Multiplier effect
FACTORS THAT SHIFT AD• interest rate• consumer (business) confidence• economic conditions in trading partners
(foreign Y)• tax• money supply• exchange rate• government expenditures
Classical view
• Say’s law• Invisible hand (Adam Smith)• Full flexibility in prices• Competitive markets
Aggregate Supplyclassical view
P
Y
LRAS
Y*
Keynesian View
• Sticky wages and prices and institutional constraints
• Thrift paradox and investment
Short-run aggregate supply Keynesian view
P
Y
AD&AS
AD
SRASLRASP
Y
FISCAL POLICY
• Instruments: G, T, Tr. (changes personal disposable income)
• Drawbacks of FP:crowding-out effects
directindirect
open-economy effectTime lags (decision, recognition, effect)
Monetary Policy
• Instrumentsdiscount rateOMORRR
• Drawbacks: inflation?, exchange rate regime.
• Monetary Rule
Role of government debt
• Interest payments to foreigners• Burden on future generations• Crowding out of domestic investment and
reduction in capital stock• Cost vs benefit
Foreign sectorus and them
•Trade in goods and services•Trade in financial assets
•Trade in currencies
Balance of Paymentsmeasuring international activity
• Current account (trade balance, income flows)
• Financial Account (investment flows)• Reserves (central bank activity)• Net Errors and Omissions
CA + FA + NEO = change in Reserves
Forex Market
$/R
Volume of Roubles
Supply of RoublesRussian investorsRussian Central BankRussian import firmsRussian tourists
Demand for RoublesForeign investorsForeign Central BanksForeign import firmsForeign tourists
History of Forex
• Gold Standard 1880’s-1914• Benefits:Hume’s correction mechanismEase of tradeNo need for forward looking instruments• Spain vs England• No Monetary Policy!CA + FA = change in gold
1918-1939
• Gold Standard revisedUS on Gold since June 1919, UK is since 1925 (pre-war)By 1931 the British Pound is inconvertible, by 1933 the USD.
• The Great Depression and monetary expansion, competition for export markets
1944-1970Gold Exchange Standard
IMF and WBUSD=1/35 oz. All currencies are specified in gold.Role of the IMFAugust 1971 the USD is no longer convertible into
goldSmithsonian Agreement of December 1971.March 1973 FLOAT BEGINNS
FLOAT
• Spot market vs future markets• Forward looking instruments: options,
futures, swaps, forward contracts.• Need and importance of forecasting!
Forecastingtwo forecasts for 6 month period. Current spot is 9.5 R = 1 USD. Assume
that you owe a payment to a Russian firm in Roubles.
Forecast I Forecast II10 R = 1 USD 15 R = 1 USD6 month forward rate is 11 R = 1 USDForward waitThe spot market in 6 months is 11.5 R = 1 USD
Float vs fixed
FLOAT FIXED
Large economy Small economy
Closed economy Open economy
Divergent inflation Harmonious inflat
Diversified trade Concentrated trade
Policy and exchange rate regime
FLOATstrong open economy effect, thus weak fiscal policy. Monetary expansion causes depreciation in the value of the currency, thus strong monetary policy
FIXEDno open economy effect, weak indirect crowding out effect, thus strong fiscal policyno currency depreciation, inability to change domestic interest rate due to international capital mobility
Determinants of exchange rate under float
• Inflation (purchasing price parity)• Interest rate (interest rate parity)• Economic growth• Microstructure approach• Political news
Currency board
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