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

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