macro review in preparation for api 120

MACRO REVIEWin preparation for API 120

(I) DEFINITIONS & ACCOUNTING(II)

(i) National income & product accounts(ii) Balance of Payments accounts(iii) National Saving identity

(II) DEMAND POLICY (i) THE KEYNESIAN MODEL

(ii) TARGETS & INSTRUMENTS

(i) National income & product accounts

• Definition of macroeconomics– Aggregates– Goods (& labor) markets may not clear in short run– => Role for fiscal, monetary & exchange rate policy.

• Definition of– GDP: value of all goods & services produced domestically– GNP: includes earnings from abroad– National Income: includes unilateral transfers.– Net National Income: subtracts depreciation of capital stock

API-120 - Prof.J.Frankel, Harvard University

Ways to decompose GDP• To whom the goods & services are sold (expenditure side of GDP):

– C – + I – + G – + X-M .

• How the income (Y) is used:– Taxes net of transfers, T, leaving disposable income :– Consumption C– + Saving S.

• Allocation of shares according to factors of production:– Wages & salaries– Capital income.


} = Yd

(ii) Balance of Payments accounts

• Definition: The balance of payments is the year’s record of economic transactions between domestic & foreign residents.



NOW CALLED “FINANCIAL ACCOUNT”

“Primary income,” mainly investment income

≡ “secondary income”

Examples on the current account: • You, an American, buy DVDs from India

=> import appears as debit on US merchandise account.• You import services (electronically) of an Indian software firm =>

debit appears on US services account ( “overseas outsourcing”).• You buy the services, instead, from a subsidiary that the Indian

software firm set up last year in the US. This is not an international transaction, and so does not appear in the accounts.

• But assume the subsidiary then sends profits back to India => US reports payments of investment income. It is as if the US is paying for the services of Indian capital.

• Employees of the subsidiary in the US (or any other US resident entities) send money to relatives back in India => US reports paying unilateral transfers .


Examples of debits on the financial account(previously “capital account”), long-term

Instead of buying DVDs from India, you buy the company in India that makes them. => acquisition of assets (debit) under Foreign Direct Investment (FDI).

Instead of buying the entire company in India, you buy some stock in it => acquisition of portfolio investments (equities).

Instead of buying stock in the company, you lend it money for 2 years => acquisition of portfolio investments (bonds or bank loans).


Examples of debits on the financial account, short term:

You lend to the Indian company in the form of 30-day commercial paper or trade credit => acquisition of short term assets (Debit: You have “imported” a claim against India.)

You lend to the Indian company in the form of cash dollars, which they don’t have to pay back for 30 days => acquisition of short term assets .

You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed – but some central banks now diversify international investments) => increase in US official reserve assets.


The rules, continued

• Each transaction is recorded twice: • an import of a good or security has to be paid for.

E.g., when an importer pays cash dollars, the import on the merchandise account is offset under short-term capital: the exporter in the other country has, at least for the moment, increased holdings of US assets, which counts just like any other portfolio investment in US assets.

• At the end of each quarter, credits & debits are added up within each line-item;

• and line-items are cumulated from the top to compute measures of external balance.


Some balance of payments identities• CA ≡ Rate of increase in net international investment position.

– A CA surplus country accumulates claims against foreigners– A CA deficit country borrows from foreigners.

• BoP ≡ CA + KA• => BoP ≡ excess supply of FX coming from private sector,

which central banks absorb into reserves (if they intervene in the FX market, e.g., to keep exchange rate fixed).– A BoP surplus country adds to its FX reserves (esp. US T bills).– A BoP deficit country runs down its FX reserves,

unless it is lucky enough (US) that foreign central banks finance its deficit.

• A floating country does not intervene in the FX market• => BP ≡ 0;• Exchange rate E adjusts to clear private market FX supply & demand.


(iii) Derivation of National Saving Identity

Income ≡ Output (assuming no transfers or investment income)

Y ≡ GDP

S + (T-G) ≡ I + X – M

/ /

NS ≡ S + BS ≡ I + CA

NationalSavingIdentity

C + S + T ≡ C + I + G + X -M



Household savingsCorporate savingsGovernment

savings


End of: Definitions & Accounting

MACRO REVIEW: DEMAND POLICY(II) THE KEYNESIAN MODEL

Part 1: Introduction to Keynesian Model

Part 2: Multipliers for spending & exports

Part 3: International transmission under fixed vs. floating exchange rates

Part 4: Adjustment of a CA deficit via expenditure-reducing vs. expenditure-switching policiesPart 5: Monetary factors

Imports & exports depend on income:

Y

TB

+ 0 -

),( YEMM d *),( YEXX dmYM X

)( mYMXTB

as does consumption: Keynesian consumption function cYCC

assuming E & Y* fixed, for now.

where slope = -m ≡ - marginal propensity to import

TB falls in expansions…

…and rises in contractions


Determination of equilibrium income

in open-economy Keynesian model

TBAY )()( MXGIC

)()( mYMXGIcYC

MXGICmYcYY

mcMXGICY

1

msMXAY

GICA cs 1where

and .

Now solve:


or, expressed as a saving function:

where s ≡ 1 – c .

dYc CC

d

ddd

Ys C- )cY C( -Y C - Y S

}I


Keynesian Consumption Function:

Recall National Saving identity: NS – I ≡ CA.

0 < 1 < Closed-economy multiplier 1/s < ∞ API-120 - Prof.J.Frankel, Harvard University

Fiscal Expansion

In a closed economy, NS – I = 0.

ΔY = s => ΔY = 1/ s

Open economy: NS – I = TB = X – M .

mY Mor , Y)(E,MM d


Imports: for simplicity.

Exports: for simplicity. Xor ),Y(E,XX *d

Open economy

Gms

Y

1

G

slope = s


Fiscal Expansion

Gs

1

Part 2:KEYNESIAN MULTIPLIERS

• The multiplier for an increase in , e.g., due to a fiscal expansion .

X

A

• The multiplier for an increase in , e.g., due to a devaluation .


Devaluation makes the export good cheaper for foreign consumers.

SUMMARY OF MULTIPLIERS

MX I NS

msMXA Y

G I CA where

Ams

1 Y

Ym- ΔM ΔTB

+ Keynesian model of S + M =>

Fiscal Expansion

open-ec. multiplier = 1/(s+m)<1/s

YmXΔ ΔTB

Xms

1 Y

Devaluation

Equation (17.11), 10th ed. of WTP , has a misprint.

. AΔms

m

XΔms

s

. XΔ

Part 3: MACROECONOMIC INTERDEPENDENCE

International transmission under fixed vs. floating exchange rates

• of a disturbance originating domestically.• of a disturbance originating abroad .

API-120 - Macroeconomic Policy Analysis I Prof. Jeffrey Frankel, Kennedy School, Harvard University

Fix

Fix

International Transmission

↓I ↓X

Floating increases effect on Y Floating decreases effect on Y

=> appreciation

=> depreciation

=> “insulation.” => disturbance is “bottled up” inside.

Float Float

• •• •

Conclusions regarding transmission(with no capital mobility)

• Trade makes economies interdependent (at a given exchange rate).

– TB can act as a safety valve, releasing pressure from expansion: .

– Disturbances are transmittedfrom one country to another:

.

XmsY ))/(1(

AmsY ))/(1(


Conclusions regarding transmission(with no capital mobility), continued

• Floating exchange rates work to isolate effects of demand disturbances within the country where they originate:– Effects of a domestic disturbance tend

to be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier: .

– The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy: .

AsY )/1(

0YAPI-120 - Prof.J.Frankel, Harvard University

Goals and Instruments• Policy goals: Internal balance & External balance

• Policy instruments: Fiscal policy, etc.

Parts 4 & 5:POLICY INSTRUMENTS

• The Swan Diagram• The principle of goals & instruments.

Introduction of monetary policy • The role of interest rates • Monetary expansion • Crowding out via interest rates ,


Goals and instruments

Y

Policy Instruments• Expenditure-reduction,

e.g., G ↓ • Expenditure-switching,

e.g., E ↑ .

Policy Goals• Internal balance: Y =

YY uY < ≡ ES ≡ “output gap” => unemployment >

Y > ≡ ED => “overheating” => inflation or asset bubbles.

• External balance: e.g., CA=0 or BP=0.

Potential output

Three ways of computing :1. Aggregate production function Y = F(K,N)

– Substitute labor force employed at natural rate: N=,– capital stock K working at full capacity, etc…– Conceptually the right definition. But very hard to implement.

• For one thing, most of the action is in TFP.

2. Time trend– E.g., H-P filter.

3. Estimate as value of Y above which inflation tends to accelerate.

In 2009, after the global financial crisis, advanced countries suffered much larger output gaps than in preceding recessions: Y << .Y

Source: IMF, via Economicshelp, 2009

UK

US

France

Output gap, as percentage of GDP, 2009

Ir

Jpn

Internal balance


Output gap in eurozone peripherySource: IMF Economic Outlook, September 2011 (note: data for 2012 were predictions)

http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html

Greece & Ireland overheated by 2007: Y >>and crashed in 2009-12: Y <<

Y

Y


Inflation everywhere fell in 2008-09,in response to the output gap of the great recession.

World Bank, June 2014.“Exchange rate pass-through and inflation trends in developing countries,” Global Ec. Prospects.

http://www.worldbank.org/content/dam/Worldbank/GEP/GEP2014b/GEP2014b_annex.pdf

http://www.worldbank.org/content/dam/Worldbank/GEP/GEP2014b/GEP2014b_annex.pdf

THE PRINCIPLE OF TARGETS AND INSTRUMENTS

• Can’t normally hit 2 birds with 1 stone

• Do you have n targets? • => Need n instruments,

and they must be targeted independently.

Y• Have 2 targets: CA = 0 and Y = ?• => Need 2 independent instruments:

expenditure-reduction & expenditure-switching.


Financing• By borrowing • or running down reserves.

RESPONSES TO CURRENT ACCOUNT DEFICIT

Adjustment• Expenditure-reduction (“belt-tightening”)

• e.g., fiscal or monetary contraction

vs.

• or Expenditure-switching • e.g., devaluation.

Starting from current account deficit at point N,policy-makers can adjust either by (a) cutting spending,

or (b) devaluing.

A

X

●

●

●


ADJUSTMENT DILEMMA

●

Devaluation

• Experiment: increase in Ă

(e.g. G↑)

• Only by using both sorts of policies simultaneously

can both internal & external balance be attained, at point A.

Expansion moves economy rightward to point F.Some of higher demand falls on imports. => TB<0 .

XE

DERIVATION OF SWAN DIAGRAM

What would have to happento reduce trade deficit?

●●

●●

●

●

A


Now consider internal balance.Return to point A.

A

Expansion moves economy rightward to point F.

Y

What would have to happen to eliminate excess demand?

Some of higher demand falls on domestic goods => Excess Demand. Y >

●

●

●

●

Experiment: increase

E ↓ . ●API-120 - Prof.J.Frankel, Harvard University

Swan Diagramhas 4 zones:

I. ED & TDII. ES & TDIII. ES & TB>0IV. ED & TB>0

●


Example: Emerging market crises

Excgange rate E

YY: Internal balance

Y=potential

ED & TD

ED & TB>0

ES & TD

ES & TB>0Mexico 1994

or Korea 1997

Mexico 1995

or Korea 1998

Spending A

BB:External balance

CA=0

Classic response to a balance of payments crisis:Devalue and cut spending

●

API-120 - Prof.J.Frankel, Harvard UniversityCould be the “Fragile 5” in 2013-14: India, Turkey, Indonesia, S.Africa, Brazil.

Example: China in the last decade

Exchange rate E

ED & TD

ES & TD

ES & TB>0

China2010

China2002

ED & TB>0

Spending AIn 2008-09, an abrupt loss of X, due to the global crisis, shifted China to ES.

By 2007, rapid growth pushed China into ED. By 2010, a strong recovery, due inpart to G stimulus, moved into ED.In 2015, back into ES.

●

Spending A

YY: Internal balance Y=

BB: External balance CA=0.

Part 5: Monetary policy• is another instrument to affect the level of spending.

• It can be defined in terms of the interest rate i, which in turn affects i-sensitive components such as I & consumer durables.

• Or it can be defined in terms of money supply M.– In which case an expansion is a rightward shift of the LM curve– which itself slopes up (because money demand depends

negatively on i and positively on Y).

iY

LM

E.g., Taylor Rule sets i.


Monetary expansion lowers i,stimulates demand, shifts NS-I down/out.

New equilibrium at point M.In lower diagram, which shows i explicitly on the vertical axis, We’ve just derived IS curve.

If monetary policy is defined by the level of money supply,then the same result is viewed as resulting from a rightward shift of the LM curve.

New equilibrium:

At point D if monetary policy is accommodating.

Fiscal expansion shifts IS out.

D.At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓Þ Rise in Y < full Keynesian multiplier.


End of: Introduction to the Keynesian Model

(a) If they cut spending,CA deficit is eliminated at X;

but Y falls belowpotential output . Y

=> recession

●

●


APPENDIX: ELABORATION ON TARGETS & INSTRUMENTS

{WITH 1 GRAPH PER PAGE}.

ADJUSTMENT DILEMMA


(b) If they devalue,CA deficit is again eliminated, at B,

but with the effect of pushing Y abovepotential output.

=> overheating

●

●

At F, TB<0 .

What would have to happen to eliminate trade deficit?

ELABORATION ON DERIVATION OF SWAN DIAGRAM:EXTERNAL BALANCE

If depreciation is big enough, restores TB=0 at point B.

E ↑ .

A

●

●●


.

What would have to happen to eliminate trade deficit?

E ↑ . If depreciation is big enough, restores TB=0 at point B.

We have just derived upward-sloping external balance line, BB.

To repeat, at F, some of higher demand falls on imports.

●

●

●

API-120 - Macroeconomic Policy Analysis I Prof.Jeffrey Frankel, Kennedy School, Harvard University API-120 - Prof.J.Frankel, Harvard University

At F, Y > .


If appreciation is big enough, restores Y= at point C.

E ↓ .

●

●●

ELABORATION ON DERIVATION OF SWAN DIAGRAM, cont.:INTERNAL BALANCE



E ↓.

We have just derived downward-sloping internal balance line, YY.

At F, some of higher demand falls on domestic goods.

If appreciation is big enough, restores at C.

● ●

●


Summary: the combination of policy instruments to hit one goal slopes up; the combination to hit the other slopes down.

ITF-220, Prof.J.Frankel

Fiscal expansion (G↑) (or monetary expansion),at a given exchange rate => Y ↑ and TB↓.

Devaluation (E ↑) => Y ↑ and TB ↑.

If we are to maintain:Internal balance,

Y=External balance,

TB=0

then G & E must vary: inversely. together.

=> Internal balanceline slopes down.

=> External balanceline slopes up.

Derivation of the Swan Diagram

macro review in preparation for api 120

Documents

indian company

us merchandise account

abroadnational income

disposable income

income y

us offi

services of indian capital

acquisition of assets