Review of the previous lecture

1. Review of the previous lecture 1. The Fed can control the money supply with • open market operations • the reserve requirement • the discount rate 2. Portfolio theories of money demand • stress the store of value function • posit that money demand depends on risk/return of money & alternative assets

2. Review of the previous lecture 3. The Baumol-Tobin model • is an example of the transactions theories of money demand, stresses “medium of exchange” function • money demand depends positively on spending, negatively on the interest rate, and positively on the cost of converting non-monetary assets to money

3. Lecture 28 Review of the previous lectures Instructor: Prof. Dr. QaisarAbbas

4. The Science of Macroeconomics • Macroeconomics is the study of the economy as a whole, including • growth in incomes • changes in the overall level of prices • the unemployment rate • Macroeconomists attempt to explain the economy and to devise policies to improve its performance.

5. The Science of Macroeconomics • Economists use different models to examine different issues. • Models with flexible prices describe the economy in the long run; models with sticky prices describe economy in the short run. • Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics.

6. The data of Macroeconomics- GDP, Unemployment & inflation • Gross Domestic Product (GDP) measures both total income and total expenditure on the economy’s output of goods & services. • Nominal GDP values output at current prices; real GDP values output at constant prices. Changes in output affect both measures, but changes in prices only affect nominal GDP. • GDP is the sum of consumption, investment, government purchases, and net exports.

7. The data of Macroeconomics- GDP, Unemployment & inflation • The overall level of prices can be measured by either • the Consumer Price Index (CPI), the price of a fixed basket of goods purchased by the typical consumer • the GDP deflator, the ratio of nominal to real GDP • The unemployment rate is the fraction of the labor force that is not employed. • When unemployment rises, the growth rate of real GDP falls.

8. National Income:Where it Comes From and Where it Goes • Total output is determined by • how much capital and labor the economy has • the level of technology • Competitive firms hire each factor until its marginal product equals its price. • If the production function has constant returns to scale, then labor income plus capital income equals total income (output).

9. National Income:Where it Comes From and Where it Goes • The economy’s output is used for • consumption (which depends on disposable income) • investment (depends on the real interest rate) • government spending (exogenous) • The real interest rate adjusts to equate the demand for and supply of • goods and services • loanable funds • A decrease in national saving causes the interest rate to rise and investment to fall. • An increase in investment demand causes the interest rate to rise, but does not affect the equilibrium level of investment if the supply of loanable funds is fixed.

10. Economic Growth The Solow growth model shows that, in the long run, a country’s standard of living depends positively on its saving rate. negatively on its population growth rate. An increase in the saving rate leads to higher output in the long run faster growth temporarily but not faster steady state growth.

11. Economic Growth • Key results from Solow model with tech progress • steady state growth rate of income per person depends solely on the exogenous rate of tech progress • the U.S. has much less capital than the Golden Rule steady state • Ways to increase the saving rate • increase public saving (reduce budget deficit) • tax incentives for private saving

12. Economic Growth • Productivity slowdown & “new economy” • Early 1970s: productivity growth fell in the U.S. and other countries. • Mid 1990s: productivity growth increased, probably because of advances in I.T. • Empirical studies • Solow model explains balanced growth, conditional convergence • Cross-country variation in living standards due to differences in cap. accumulation and in production efficiency

13. Economic Growth • Endogenous growth theory: models that • examine the determinants of the rate of tech progress, which Solow takes as given • explain decisions that determine the creation of knowledge through R&D

14. Unemployment • The natural rate of unemployment • the long-run average or “steady state” rate of unemployment • depends on the rates of job separation and job finding • Frictional unemployment • due to the time it takes to match workers with jobs • may be increased by unemployment insurance • Structural unemployment • results from wage rigidity - the real wage remains above the equilibrium level • causes: minimum wage, unions, efficiency wages

15. Unemployment • Duration of unemployment • most spells are short term • but most weeks of unemployment are attributable to a small number of long-term unemployed persons

16. Money and Inflation • Money • the stock of assets used for transactions • serves as a medium of exchange, store of value, and unit of account. • Commodity money has intrinsic value, fiat money does not. • Central bank controls money supply. • Quantity theory of money • assumption: velocity is stable • conclusion: the money growth rate determines the inflation rate.

17. Money and Inflation • Nominal interest rate • equals real interest rate + inflation rate. • Fisher effect: nominal interest rate moves one-for-one w/ expected inflation. • is the opp. cost of holding money • Money demand • depends on income in the Quantity Theory • more generally, it also depends on the nominal interest rate; • if so, then changes in expected inflation affect the current price level.

18. Money and Inflation • Costs of inflation • Expected inflationshoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation • Unexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors

19. Money and Inflation • Hyperinflation • caused by rapid money supply growth when money printed to finance govt budget deficits • stopping it requires fiscal reforms to eliminate govt’s need for printing money

20. Open economy • Net exports--the difference between • exports and imports • a country’s output (Y ) and its spending (C + I + G) • Net capital outflow equals • purchases of foreign assets minus foreign purchases of the country’s assets • the difference between saving and investment

21. Open economy • Exchange rates • nominal: the price of a country’s currency in terms of another country’s currency • real: the price of a country’s goods in terms of another country’s goods. • The real exchange rate equals the nominal rate times the ratio of prices of the two countries. • How the real exchange rate is determined • NX depends negatively on the real exchange rate, other things equal • The real exchange rate adjusts to equate NX with net capital outflow • How the nominal exchange rate is determined • e equals the real exchange rate times the country’s price level relative to the foreign price level. • For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates.

22. Introduction to Economic Fluctuations • Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies. • Short run: prices are sticky, shocks can push output and employment away from their natural rates. • Aggregate demand and supply: a framework to analyze economic fluctuations • The aggregate demand curve slopes downward. • The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. • The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.

23. Introduction to Economic Fluctuations • Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. • The Fed can attempt to stabilize the economy with monetary policy.

24. Aggregate Demand • Keynesian Cross • basic model of income determination • takes fiscal policy & investment as exogenous • fiscal policy has a multiplied impact on income. • IS curve • comes from Keynesian Cross when planned investment depends negatively on interest rate • shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

25. Aggregate Demand • Theory of Liquidity Preference • basic model of interest rate determination • takes money supply & price level as exogenous • an increase in the money supply lowers the interest rate • LM curve • comes from Liquidity Preference Theory when money demand depends positively on income • shows all combinations of randY that equate demand for real money balances with supply • IS-LM model • Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets

26. Aggregate Demand • IS-LMmodel • a theory of aggregate demand • exogenous: M, G, T,P exogenous in short run, Y in long run • endogenous: r,Y endogenous in short run, P in long run • IScurve: goods market equilibrium • LM curve: money market equilibrium

27. Aggregate Demand • AD curve • shows relation between Pand the IS-LMmodel’s equilibrium Y. • negative slope because P  (M/P )  r  I  Y • expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right • expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right • IS or LM shocks shift the AD curve

28. Aggregate Supply • Three models of aggregate supply in the short run: • sticky-wage model • imperfect-information model • sticky-price model • All three models imply that output rises above its natural rate when the price level falls below the expected price level. • Phillips curve • derived from the SRAS curve • states that inflation depends on • expected inflation • cyclical unemployment • supply shocks • presents policymakers with a short-run tradeoff between inflation and unemployment

29. Aggregate Supply 3. How people form expectations of inflation • adaptive expectations • based on recently observed inflation • implies “inertia” • rational expectations • based on all available information • implies that disinflation may be painless

30. Aggregate Supply • The natural rate hypothesis and hysteresis • the natural rate hypotheses • states that changes in aggregate demand can only affect output and employment in the short run • hysteresis • states that agg. demand can have permanent effects on output and employment

31. Five Debates Over Macroeconomic Policy • Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe policy can be used to offset this inherent instability. • Critics of active policy emphasize that policy affects the economy with a lag and our ability to forecast future economic conditions is poor, both of which can lead to policy being destabilizing. • Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, abuse of power, and time inconsistency. • Critics of rules for monetary policy argue that discretionary policy is more flexible in responding to economic circumstances.

32. Five Debates Over Macroeconomic Policy • Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits. • Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce inflation is quite costly. • Advocates of reducing the government debt argue that the debt imposes a burden on future generations by raising their taxes and lowering their incomes. • Critics of reducing the government debt argue that the debt is only one small piece of fiscal policy.

33. Five Debates Over Macroeconomic Policy • Advocates of tax incentives for saving point out that our society discourages saving in many ways such as taxing income from capital and reducing benefits for those who have accumulated wealth. • Critics of tax incentives argue that many proposed changes to stimulate saving would primarily benefit the wealthy and also might have only a small effect on private saving.

34. Advances in Business Cycle Theory • Real Business Cycle theory • assumes perfect flexibility of wages and prices • shows how fluctuations arise in response to productivity shocks • the fluctuations are optimal given the shocks • Points of controversy in RBC theory • intertemporal substitution of labor • the importance of technology shocks • the neutrality of money • the flexibility of prices and wages

35. Advances in Business Cycle Theory • New Keynesian economics • accepts the traditional model of aggregate demand and supply • attempts to explain the stickiness of wages and prices with microeconomic analysis, including • menu costs • coordination failure • staggering of wages and prices

36. Consumption • Keynesian consumption theory • Keynes’ conjectures • MPC is between 0 and 1 • APC falls as income rises • current income is the main determinant of current consumption • Empirical studies • in household data & short time series: confirmation of Keynes’ conjectures • in long time series data:APC does not fall as income rises

37. Consumption • Fisher’s theory of intertemporal choice • Consumer chooses current & future consumption to maximize lifetime satisfaction subject to an intertemporal budget constraint. • Current consumption depends on lifetime income, not current income, provided consumer can borrow & save.

38. Consumption • Modigliani’s Life-Cycle Hypothesis • Income varies systematically over a lifetime. • Consumers use saving & borrowing to smooth consumption. • Consumption depends on income & wealth. • Friedman’s Permanent-Income Hypothesis • Consumption depends mainly on permanent income. • Consumers use saving & borrowing to smooth consumption in the face of transitory fluctuations in income. • Hall’s Random-Walk Hypothesis • Combines PIH with rational expectations. • Main result: changes in consumption are unpredictable, occur only in response to unanticipated changes in expected permanent income.

39. Consumption • Laibsonand the pull of instant gratification • Uses psychology to understand consumer behavior. • The desire for instant gratification causes people to save less than they rationally know they should.

40. Government Debt • Relative to GDP, the U.S. government’s debt is moderate compared to other countries • Standard figures on the deficit are imperfect measures of fiscal policy because they • are not corrected for inflation • do not account for changes in govt assets • omit some liabilities (e.g. future pension payments to current workers) • do not account for effects of business cycles

41. Government Debt • In the traditional view, a debt-financed tax cut increases consumption and reduces national saving. In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living. In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit). • The Ricardian view holds that debt-financed tax cuts do not affect consumption or national saving, and therefore do not affect interest rates, investment, or net exports.

42. Government Debt • Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations. • Government debt can have other effects: • may lead to inflation • politicians can shift burden of taxes from current to future generations • may reduce country’s political clout in international affairs or scare foreign investors into pulling their capital out of the country

43. Investment • All types of investment depend negatively on the real interest rate. • Things that shift the investment function: • Technological improvements raise MPK and raise business fixed investment. • Increase in population raises demand for, price of housing and raises residential investment. • Economic policies (corporate income tax, investment tax credit) alter incentives to invest.

44. Investment • Investment is the most volatile component of GDP over the business cycle. • Fluctuations in employment affect the MPK and the incentive for business fixed investment. • Fluctuations in income affect demand for, price of housing and the incentive for residential investment. • Fluctuations in output affect planned & unplanned inventory investment.

45. Money Supply and Money Demand • Fractional reserve banking creates money because each dollar of reserves generates many dollars of demand deposits. • The money supply depends on the • monetary base • currency-deposit ratio • reserve ratio

46. Money Supply and Money Demand • The Fed can control the money supply with • open market operations • the reserve requirement • the discount rate • Portfolio theories of money demand • stress the store of value function • posit that money demand depends on risk/return of money & alternative assets

47. Money Supply and Money Demand • The Baumol-Tobin model • is an example of the transactions theories of money demand, stresses “medium of exchange” function • money demand depends positively on spending, negatively on the interest rate, and positively on the cost of converting non-monetary assets to money