Macroeconomics

1. Macroeconomics

2. Macro topics covered • Big Issues • Business cycles • Unemployment • Inflation • Effects of fiscal policy and role of government • Keynesian “activist” approach • Problems with fiscal policy • New classical “supply-side” approach • Money and monetary policy • money creation and tools of monetary policy • money models • activist and non-activist approach

3. Business Cycles … pattern of rising real GDP followed by falling real GDP Recession … a period in which real GDP falls • Usually at least 2 successive quarters Depression … a severe and prolonged economic contraction “the great depression in the 30’s” • Around 25% of the labor force was unemployed.

4. Real GDP begins to fall Real GDP begins to increase Trend growth has been around 3% per year (on average)

5. Expansion (boom) – real GDP is increasing Contraction – real GDP is decreasing.

6. Unemployment Official Unemployment Rate … the percentage of the labor force that is not working Unemployment rate = [number of people unemployed / number of people in the labor force] • Notice: It is not the unemployment rate of the population.

7. Labor Force Labor force = all US residents – residents under 16 years – institutionalized adults – adults not looking for work • To be in the labor force an individual must be either looking for a job or in work Therefore (alternative measure) Labor Force = Employed + unemployed • E.g. housemen/women are not included in the labor force. • Retired people are also not in the labor force. • In 2006 the labor force was 152.8 Million

8. Other Labor Statistics • Labor Force Participation = Labor Force / population 16 and over • Employment/population ratio = employed people / population 16 and over • Given we have unemployment LFP>EP ratio

9. Hypothetical Example

10. 3 Types of Unemployment • Frictional Unemployment • A product of the short-term movement of workers between jobs, and of first-time workers. • “Short-run” unemployment • E.g. time between leaving one job and taking another, or students graduating college and now looking for a job. • Sometimes called “search unemployment” • Often seen as a “good thing” • Generally low when in a recession • People “stay put”

11. Structural Unemployment • A product of technological change and other changes in the structure of the economy • Therefore certain skill sets are no longer required • E.g. Coal Miners losing their jobs as the economy moves to a service-based economy. • Car assembly workers laid off as factories use more robots. • Any dynamic economy has some frictional and structural unemployment

12. Cyclical Unemployment • A product of business cycle fluctuations • E.g. a temporary fall in demand for a good/service leads to a reduction in employment levels. • E.g. construction workers.

13. Natural Rate of Unemployment … the unemployment rate that exists in the absence of cyclical unemployment. • All economies will have some “natural” rate of unemployment. • Frictional plus structural • Can vary over time. • Estimated to be between 4-6% • US it is approximately 5% (at the moment) Full Employment …. The level of employment when the economy is at its natural rate of unemployment • For the US it is assumed to be 95% • Sustainable level of employment

14. Inflation … a sustained increase in the average level of prices • The higher the price level the lower the real value of money • Purchasing power of a dollar is eroded. • Standard argument with parents and allowances…. Hyperinflation … an extremely high rate of inflation E.g. Zimbabwe. • Can cause a “flight from money”.

15. Calculating Inflation

16. Unanticipated and Anticipated Inflation • Unanticipated Inflation • When the increase in prices is a “surprise” for most decision makers • Usually happens when inflation rates vary significantly. • Anticipated Inflation • When the increase in prices was “expected” by most decision makers • Usually happens when Central Banks have a good control on inflation

17. Costs of Inflation • Businesses generally avoid long term projects • Difficult to estimate the profitability of a project if prices (costs) are varying a lot in the future. • Prices no longer reflect relative scarcity • As some prices change slower (sticky) than others • Price no longer reflects all (current) information • More difficult for firms/individuals to make informed decisions.

18. “Shoe leather and Negotiation Costs” • Individuals spend time acquiring information • Cause higher transaction costs when negotiating • Business divert resources from “normal business practices “ to developing methods/forecasts to deal with inflation

19. Keynesian Economics • Government should alter Aggregate Demand (AD) through manipulating government spending (G) and taxation (T) • Budget Surplus – government revenue (T) greater than government spending (G) • Budget Deficit – government revenue (T) less than government spending (G) • Multiplier effect: A $1 change in spending/taxation causes real GDP to increase by more than $1

20. Keynesian Economics: All about AD

21. Crowding Out … a drop in consumption and/or investment caused by changes in government spending. • If Government Spending rises it may drive up interest rates • Running a budget deficit => government borrows the funds • This may reduce Consumption, net exports and particularly Investment • Thus public spending may“crowd out” private sector spending • Public spending replaces private spending… • Multiplier effect is lowered – potentially even zero if there is complete crowding out.

22. Problems with Fiscal Policy • Keynesian Economists argue the supply side is too slow to react to solve an economy’s problems • BUT Fiscal policy has timing issues. • Takes time for policy makers to realize there is a problem with the economy • Takes time for a policy to be implemented • Takes time for a policy to have an effect.

23. Automatic Stabilizers • Element of fiscal policy that changes automatically as income (real GDP) changes • E.g. Income tax revenue falls in recessions (when real GDP is falling) and increase during a boom (when real GDP increases) • Unemployment benefits are another example.

24. New Classical View of Fiscal Policy • Suppose the government cuts taxes to stimulate the economy • Runs a budget deficit. • Individuals recognize that taxes will have to go up in the future. • Therefore rather than spending the tax cut they merely save it- to pay the higher tax bill in the future • Therefore no change in AD.

25. Fiscal Policy and the Supply side: Laffer curve • Captures the dis-incentive effect of taxation. Tax rate t Tax Revenue Rmax

26. Supply-Side effect of Fiscal Policy • The supply-side of the economy (LRAS) is determined by the quantity and quality of resources • Taxes create a disincentive to work, accumulate capital and invest in higher education • Therefore high tax rates can cause to the LRAS to decrease

27. What is Money? • Money … anything that is generally acceptable to sellers in exchange for goods and services • Examples • $ • Cigarettes in WW2 POW camps • Fiat Money • Money that has no intrinsic value and is not backed by a commodity

28. Liquidity • Liquid Asset … an asset that can easily be exchanged for goods and services • Higher liquidity implies lower returns • Money is the most liquid asset • Therefore has the lowest (zero return).

29. Functions of Money ‘Money is a matter of functions four – a medium, a measure, a standard and a store’

30. Medium of exchange • It lowers transactions costs • Do not need the “double coincidence of wants” • Measure of value • All goods and services are priced in common monetary units • Allows us to compare relative prices easily. • Only need one set of prices.

31. Store of value • An asset that allows people to shift purchasing power from one period to another • Money retains its value through time usually • Need to control inflation. • Standard of deferred payment • Money may be used to make future payments. • Debt is written in dollar amounts.

32. Reserve Requirements • The central bank “the Fed” requires banks to keep a certain percentage of their deposits available as cash reserves • Available for immediate withdrawal. • This percentage is called the reserve requirement (rr) • E.g. the bank has to keep 10% of all their deposits as cash reserves.

33. Initial Position • Assumed the reserve requirement was 10% of all deposits

34. After New $100,000 cash Deposit First National Bank has $90,000 (in cash) it can lend out.

35. Balance Sheets After a $90,000 Loan Made by FNB Is Spent and Deposited at SNB Cash has fallen by $90k Loans have increased by $90k Cash is deposited at SNB • Now SNB has $81,00 it can lend out……

36. New deposit of $100,000 turns into $1,000,000! • A new deposit of $100k causes the money supply to increase by $1million.

37. Deposit Expansion Multiplier • In our example $100,000 turns into $1,000,000 – why? • Potential Deposit expansion multiplier (DEM) DEM = 1/Reserve Requirement (leakage) Example • If Reserve Requirement is 10% • Deposit expansion multiplier: 1/0.1 = 10 • Note: we are assuming no “currency drain”i.e. all cash is re-deposited with a bank. • We are also assuming that all excess reserves are lent out.

38. How does the Fed control the Money Supply? • Reserve Requirements • An increase in the reserve requirement reduces the deposit expansion multiplier and vice versa • Alters the ability of banks to “create money”. • If rr = 10% then DEM = 10 • If rr = 20% then DEM = 5

39. How does the Fed control the Money Supply? • The Discount Rate … the rate of interest the Fed charges commercial banks when they borrow from it • Sometimes commercial banks borrow to finance lending • Or borrow when they are in financial difficulty. • If the discount rate increases commercial banks will borrow less and the money supply will be reduced • Federal funds rate • The interest rate that a bank charges when it lends excess reserves to another bank. • The discount rate is typically 1-1.5% points above the federal fund rate • “form of punishment”

40. How does the Fed control the Money Supply? • Open Market Operations … the buying and selling of government bonds by the Fed. • Affects the federal funds rate. • Swapping illiquid (bonds)for liquid assets (cash) • Selling bonds for cash reduces the money supply • Excess reserves fall => ability to create money falls. • Buying bonds in exchange for cash raises the money supply • Excess reserves increases => ability to create money increases.

41. Money Supply Interest rate (%) Ms Quantity of money

42. Money Demand • Transactions Demand … the demand to hold money to buy goods and services • Hold money to finance daily purchases. • In the form of cash or in checking account. • Precautionary Demand … the demand for money to cover unplanned transactions or emergencies. • “Saving for a rainy day”

43. Asset (Speculative) Demand … the demand for money created by the uncertainty about the value of other assets. • Hold money in expectation that a profitable opportunity will arise. • E.g. stocks and bonds. • If you think bond prices are going fall soon will hold cash today rather than bonds.

44. Money Demand Interest rate (%) Md Quantity of money

45. Why does Money demand slope-downwards. • Interest rate represents the opportunity cost of holding money. • It is the return that is foregone by holding money. • Therefore the lower the interest rate the higher the quantity demanded of money. • Link with Bond prices (speculative demand) • Remember if the bond price is high (IR is low) therefore people expect bond prices to fall thus prefer to hold money.

46. Determinant of Money Demand Nominal GDP • An increase in Nominal GDP (due to price increases or increase in goods and services) causes Money demand to increase.

47. Shifts in Money Demand Interest rate (%) Md2 Md1 Md3 Quantity of money

48. Equilibrium Interest rate (%) Ms i2 i* i1 Md Quantity of money

49. Getting to Equilibrium • Suppose we have an interest rate of i1. There is a shortage of money. • Therefore people begin to sell bonds to convert to money. • As the supply of bonds increases, the price of bonds decreases and the interest rate increases. • Until we get to I* • Suppose we have an interest rate of i2. There is a surplus of money. • Therefore people begin to buy bonds. • As the demand of bonds increases, the price of bonds increases and the interest rate decreases. • Until we get to I*

50. Expansionary Monetary Policy and Equilibrium Income Interest rate (%) Ms1 Ms2 i1 i2 Md Quantity of money ↑MS => i↓ => Investment ↑ => AD ↑ ↑MS => i↓ => $↓ => NX ↑ => AD ↑ ↑MS => i↓ => asset prices ↑ => wealth ↑ => C ↑ => AD ↑