Professor Margaret Levenstein Stephen M. Ross School of Business University of Michigan

1. MACROECONOMICS FUNDAMENTALS Professor Margaret Levenstein Stephen M. Ross School of Business University of Michigan

2. Agenda • Defining key concepts • GDP • Recessions • Inflation • Exchange Rate • Trade Deficit • What do central banks do? • Monetary policy • Regulate banks • What’s going on now? • Asset bubbles and financial stability • Decline of the dollar • Inflation targeting at the Fed

3. World All Developing countries United States GDP (current US$) 48.5 trillion 11.0 trillion 13.4 trillion Per capita GDP growth (annual %) 4.0 7.3 3.3 GNI per capita, (current US$) 7,439 2,000 44,970 US and World GDP 2006 Source: World Bank World Development Indicators

4. What are those numbers? • Gross Domestic Product • Total value of goods & services produced for the market in a single year • Gross National Income • GDP plus income received from abroad • How much should GDP grow every year? • In the U.S., at least 3% • US grew at 3.9 % in 3rd Q 2007 • In developing countries, much faster

5. What is a Recession? • A “significant decline in economic activity” • Usually – but not always – means two quarters of declines in GDP • In US, GDP calculated by Bureau of Economic Analysis • Reported 4 times a year, as required by law • http://www.bea.gov/

6. U.S. Business Cycles Quarterly Growth in Real GDP, 1981-2006

7. Inflation • Inflation is the rate of increase in the general price level • Based on surveys of thousands of goods • Different inflation rates are calculated for different groups of goods and different geographical areas • CPI and WPI reported by Bureau of Labor Statistics • Annual rate of increase in CPI for Q3 2007 was 1.7% • http://www.bls.gov/

8. Exchange Rates • Foreign exchange rate: the amount of one nation’s money that can be obtained in exchange for a unit of another nation’s money • Example: How many yen will you receive for one dollar? 111 yen • Example: How many dollars will you receive for 100 yen? $0.90 • The price of dollars in terms of yen is the reciprocal of the price of yen in terms of dollars

9. Exchange Rates • A currency is said to appreciate when its value goes up relative to other currencies. • A currency is said to depreciate when its value goes down relative to other currencies. • Example: Today the dollar is worth 111 Yen In March 2003 it was worth 125 ¥. Has the dollar appreciated or depreciated? Depreciated Has the Yen appreciated or depreciated? Appreciated What about the Euro-Dollar exchange rate? Today 1 US$ is worth 0.68 € One euro is worth $1.46 In March 2003 $US = 0.91 € One euro was worth $1.10

10. What Determines Exchange Rates? • Most exchange rates for large countries are set in markets without direct government intervention • China is an obvious exception • Many other smaller and developing countries either fix their exchange rates or keep their exchange rates in band relative to USD, Euro, or Yen

11. What Determines Exchange Rates? • Differences in interest rates • Increase in domestic interest rates relative to other countries raises value of domestic currency • Differences in inflation rates • Increase in domestic inflation relative to other countries lowers value of domestic currency

12. What Determines Exchange Rates? • Differences in demand for exports and foreign investment • If foreigners want to buy your goods, they need your currency • If foreigners want to invest in your country, they need your currency • Increases in exports and inward foreign investment increase the value of the domestic currency • Increases in imports and outward foreign investment decrease the value of the domestic currency

13. What is the Trade Deficit? • Trade deficit is the difference between what a country exports and what it imports • In September the US trade deficit was $56.5B • The trade deficit for all of 2006 was $758.5B • The trade deficit is smaller this year than in recent years • Because the dollar is cheaper than in previous years • A cheap dollar makes US exports cheaper for foreigners • A cheap dollar makes imports more expensive for Americans, creating inflation in the US

14. U.S. Trade Deficit, 1946-2007 • Balance in goods was positive from 1946-1970 • Consistently negative since 1976 • Balance in services was positive and growing from 1971 to 1997 • Has declined in recent years • Balance in goods and services has been negative every year since 1976

16. Trade Balance as a percentage of GDP

17. What do central banks do? • Three responsibilities • Manage the money supply • Ensure the safety and soundness of the banking and financial system • Clearing house for the payments system

18. What do central banks do? • Manage the money supply • Buy and sell bonds • These are existing bonds issued by the US treasury • When the Fed buys bonds, it pays with “high powered money” • Increases the money supply • When the Fed sells bonds, it receives “high powered money” • Decreases the money supply

19. What do central banks do? • What about interest rates? • Almost all interest rates in the US are set in private markets by borrowers and lenders • The Fed sets the “discount rate” • The rate at which it lends to banks • The Fed generally discourages borrowing at the discount window • Fed recently lent a lot at the discount window to calm financial markets in turmoil because of the sub prime lending crisis • Previously, Fed lent a lot at the discount window right after September 11th and right around Y2K

20. What do central banks do? • The target rate that is reported in the media is the “Fed Funds rate” • This is the rate at which banks lend to each other overnight to meet reserve requirements • Fed buys and sells bonds, increasing and decreasing the money supply, as necessary to get the Fed Funds rate to its target rate

21. What do central banks do? • Regulate banks • Set and enforce rules to assure the “safety and soundness” of the banking system • Banks and other financial institutions are interconnected, so when one institution goes bad it can bring others down with it • This can undermine the credit system, causing economic difficulties in other sectors of the economy

22. Markets today: Three issues • Asset bubbles and financial stability • Decline of the dollar • Inflation targeting at the Fed

23. Asset bubbles and financial stability • Subprime lending crisis • Unfortunately this is nothing new • What happened? • Rapid increase in price of housing • Loans made outside “regular” mortgage regulations • Loans bundled and sold, with investors and regulators buying into the idea that this lowered risk • Risk is lowered by diversification, but if the returns on the assets are correlated then bundling does not lower risk • The bursting of the housing bubble affected all mortgages, so it affected the value of assets derived from bundled mortgages

24. Asset bubbles and financial stability • Why does this matter? • People lose their homes • Banks lose money • When banks lose money, the payment system and the credit system are undermined • Lending is reduced because banks are scared and broke • Reduces both housing and non-housing investment • This is what threw Japan into a decade long recession

25. Decline of the dollar • Dollar has fallen a lot • Will fall more until imbalances in international markets are rectified • The US has been able to maintain a trade deficit for so long because the US was considered a safe haven for investments • Other countries wanted large US dollar reserves to prevent crises (like in East Asia in late 1990s)

26. Decline of the dollar • Decline in US manufacturing, lowering of US interest rates, and strength of Euro mean that the dollar will continue to fall • Whether this is good or bad for the US and the global economy depends on the speed of the adjustment – slow is better – and whether other countries can substitute domestic consumption for US exports

27. Bernanke’s new policy • Inflation targeting: two components • Increased transparency by Central Bank • More frequent announcements of numbers that Fed uses to make its decisions • Fed decisions made by Open Market Operations Committee • Commitment to reduce money supply growth to keep inflation low • Fed’s “preferred” inflation measure • Personal Consumption Expenditure index • Similar to CPI but includes more types of expenditures and different weights • Unwritten target is 1.75%

28. Bernanke’s new policy • Inflation targeting • ECB has explicit inflation targets • Legacy of German hyperinflation, compromise between Germany and France and Italy • US requires Fed to consider rate of growth of economy, unemployment, and inflation • So Bernanke cannot adopt explicit inflation targeting without change in law

29. HIGHLIGHTS • Macroeconomics is a source of continual excitement • Financial stability is critical to economic growth • Economic growth is the regular increase in GDP • GDP is the total output of goods and services produced in the economy