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MACRO REVIEW in preparation for API 120

MACRO REVIEW in preparation for API 120. DEFINITIONS & ACCOUNTING (i) National income & product accounts (ii ) Balance of Payments accounts (iii) National Saving identity DEMAND POLICY (i ) THE KEYNESIAN MODEL (ii) TARGETS & INSTRUMENTS.

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MACRO REVIEW in preparation for API 120

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  1. MACRO REVIEWin preparation for API 120 • DEFINITIONS & ACCOUNTING • (i) National income & product accounts (ii) Balance of Payments accounts (iii) National Saving identity • DEMAND POLICY (i) THE KEYNESIAN MODEL (ii) TARGETS & INSTRUMENTS

  2. (i) National income&product accounts • Definition of macroeconomics • Aggregates • Goods (& labor) markets don’t clear in short run • => Role for fiscal, monetary & exchange rate policy. • Definition of • GDP • GNP (includes earnings from abroad) • National Income (includes unilateral transfers) API-120 - Prof.J.Frankel, Harvard University

  3. Ways to decompose GDP • To whom the goods & services (GDP) are sold: • C • + I • + G • + X-M . • How the income (Y) is used: • Taxes net of transfers, leaving disposable income: • Consumption • + Saving . • Allocation of shares according to factors of production: • Wages & salaries • Capital income • Self-employed & other. API-120 - Prof.J.Frankel, Harvard University

  4. (ii) Balance of Payments accounts • Definition: The balance of payments is the year’s record of economic transactions between domestic & foreign residents. API-120 - Prof.J.Frankel, Harvard University

  5. “Primary income,” mainly investment income ≡ “secondary income” NOW CALLED “FINANCIALACCOUNT” API-120 - Prof.J.Frankel, Harvard University

  6. 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=> import 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. API-120 - Prof.J.Frankel, Harvard University

  7. Examples 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 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). API-120 - Prof.J.Frankel, Harvard University

  8. Examples 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 (under “other investments”).You have acquired 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 other central banks, and especially “Sovereign Wealth Funds,” now diversify into international investments of this sort)=> increase in US official reserve assets. API-120 - Prof.J.Frankel, Harvard University

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

  10. 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; Exchangerate E adjusts to clear privatemarket FX supply&demand. API-120 - Prof.J.Frankel, Harvard University

  11. (iii) Derivation of NationalSaving Identity Income ≡ Output(assuming no transfers) Y ≡ GDP / / C + S + T ≡ C + I + G + X -M S + (T-G)≡ I + X – M NS ≡ S + BS ≡ I + CA National Saving Identity API-120 - Prof.J.Frankel, Harvard University

  12. Household savings Corporate savings Governmentsavings API-120 - Prof.J.Frankel, Harvard University

  13. End of: Definitions & Accounting API-120 - Prof.J.Frankel, Harvard University

  14. MACRO REVIEW: DEMAND POLICY(II) THE KEYNESIAN MODEL Part 1: Introduction to Keynesian Model: Derivation, and National Saving Identity. 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 policies Part 5: Monetary factors

  15. TB + 0 - Y Imports & exports depend on income: assuming E & Y* fixed, for now. …and rises in contractions where slope = -m ≡ - marginal propensity to import TB falls in expansions… as does consumption: Keynesian consumption function API-120 - Prof.J.Frankel, Harvard University

  16. Determination of equilibrium incomein open-economy Keynesian model Now solve: where and . API-120 - Prof.J.Frankel, Harvard University

  17. Keynesian Consumption Function: or, expressed as a saving function: where s ≡ 1 – c . } API-120 - Prof.J.Frankel, Harvard University

  18. Recall National Saving identity: NS – I ≡ CA. In a closed economy, NS – I = 0. Fiscal Expansion ΔY = s => ΔY= 1/ s 0 < 1 <Closed-economy multiplier 1/s< ∞ API-120 - Prof.J.Frankel, Harvard University

  19. Open economy: NS – I = TB = X – M . Imports: for simplicity. Exports: for simplicity. API-120 - Prof.J.Frankel, Harvard University

  20. Open economy Fiscal Expansion slope = s API-120 - Prof.J.Frankel, Harvard University

  21. Part 2:KEYNESIAN MULTIPLIERS • The multiplier for an increase in , e.g., due to a fiscal expansion . • The multiplier for an increase in , e.g., due to a devaluation .

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

  23. Devaluation makes the export good cheaper for foreign consumers. API-120 - Prof.J.Frankel, Harvard University

  24. SUMMARY OF MULTIPLIERS + Keynesian model of S + M => Fiscal Expansion Devaluation open-ec. multiplier = 1/(s+m)<1/s Equation (17.11). Note misprint in 10th ed. of WTP.

  25. 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

  26. International Transmission ↓ ↓ Fix Float Float Fix => depreciation => appreciation Floating increases effect on Y Floating decreases effect on Y => disturbance is “bottled up” inside. => “insulation”

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

  28. 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 tendto 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: . API-120 - Prof.J.Frankel, Harvard University

  29. Parts 4 & 5: POLICY INSTRUMENTS Goals and Instruments • Policy goals: Internal balance & External balance • Policy instruments: Fiscal policy, etc. • The Swan Diagram • The principle of goals & instruments. Introduction of monetary policy • The role of interest rates • Monetary expansion • Crowding out via interest rates ,

  30. Goals and instruments Policy Goals • Internal balance: Y = Y< ≡ ES ≡ “output gap” => unemployment > Y > ≡ED => “overheating” => inflation or asset bubbles • External balance: e.g.,CA=0 or BP=0. Policy Instruments • Expenditure-reduction, e.g.,G ↓ • Expenditure-switching, e.g.,E ↑ . API-120 - Prof.J.Frankel, Harvard University

  31. Potential output Three ways of computing : • 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. • Estimate as value of Y above which inflation tends to accelerate.

  32. Internal balance Output gap, as percentage of GDP, 2009 US Jpn France UK Ir In 2009, after the global financial crisis, advanced countries suffered much larger output gaps than in preceding recessions: Y << . API-120 - Prof.J.Frankel, Harvard University Source: IMF, via Economicshelp, 2009

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

  34. 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. • Have 2 targets: CA = 0 and Y = ? • => Need 2 independent instruments: expenditure-reduction & expenditure-switching. API-120 - Prof.J.Frankel, Harvard University

  35. RESPONSES TO CURRENTACCOUNT DEFICIT Financing • By borrowing • or running down reserves. vs. Adjustment • Expenditure-reduction(“belt-tightening”) • e.g., fiscal or monetary contraction • or Expenditure-switching • e.g., devaluation.

  36. ADJUSTMENT DILEMMA Starting from current account deficit at point N, policy-makers can adjust either by • cutting spending, ● ● or (b) devaluing. ● ● API-120 - Prof.J.Frankel, Harvard University

  37. DERIVATION OF SWAN DIAGRAM • Only by using both sorts of policies simultaneously can both internal & external balance be attained, at point A. ● ● • Experiment: increase in Ă (e.g. G↑) ● Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0 . ● What would have to happento reduce trade deficit? ● ● Devaluation API-120 - Prof.J.Frankel, Harvard University

  38. Now consider internal balance. Return to point A. Experiment: increase Expansion moves economy rightward to point F. ● ● Some of higher demand falls on domestic goods => Excess Demand. Y > What would have to happen to eliminate excess demand? ● ● ● E ↓ . API-120 - Prof.J.Frankel, Harvard University

  39. Swan Diagramhas 4 zones: • ED & TD • ES & TD • ES & TB>0 • ED & TB>0 ● API-120 - Prof.J.Frankel, Harvard University

  40. ED & TB>0 Excgange rateE Mexico 1995 or Korea 1998 ED & TD Mexico 1994 or Korea 1997 ES & TB>0 YY:Internal balance Y=potential ES & TD Example: Emerging market crises Classic response to a balance of payments crisis: Devalue and cut spending BB: External balance CA=0 ● Spending A Could be the “Fragile 5” in 2013-14: India, Turkey, Indonesia, S.Africa, Brazil. API-120 - Prof.J.Frankel, Harvard University

  41. ED & TB>0 BB: External balance CA=0 Excgange rate E China 2010 China 2002 ED & TD ES & TB>0 YY: Internal balance Y = Potential ES & TD Example: China in the past decade ● By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery, due in part to G stimulus, shifted China again into ES. Spending A At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES. API-120 - Prof.J.Frankel, Harvard University API-120 - Macroeconomic Policy Analysis I Prof. J.Frankel, Kennedy School, Harvard University

  42. 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). E.g., Taylor Rule sets i. LM i Y API-120 - Prof.J.Frankel, Harvard University

  43. 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.

  44. Fiscal expansion shifts IS out. New equilibrium:At point D if monetary policy is accommodating. . At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓ • Rise in Y < full Keynesian multiplier. D

  45. End of: Introduction to the Keynesian Model API-120 - Prof.J.Frankel, Harvard University

  46. APPENDIX: ELABORATION ON TARGETS&INSTRUMENTS {WITH 1 SLIDE PER PAGE}. ADJUSTMENT DILEMMA • If they cut spending, CA deficit is eliminated at X; but Y falls below potential output . ● ● => recession API-120 - Prof.J.Frankel, Harvard University

  47. (b) If they devalue, CA deficit is again eliminated, at B, but with the effect of pushing Yabove potential output. ● ● => overheating API-120 - Prof.J.Frankel, Harvard University

  48. ELABORATION ON DERIVATION OF SWAN DIAGRAM: EXTERNAL BALANCE At F, TB<0 . What would have to happen to eliminate trade deficit? ● ● E ↑ . ● If depreciation is big enough, restores TB=0 at pointB. API-120 - Prof.J.Frankel, Harvard University

  49. To repeat, at F, some of higher demand falls on imports. . What would have to happen to eliminate trade deficit? ● E ↑ . If depreciation is big enough, restores TB=0 at pointB. ● ● We have just derived upward-sloping external balance line, BB. API-120 - Prof.J.Frankel, Harvard University API-120 - Macroeconomic Policy Analysis IProf.Jeffrey Frankel, Kennedy School, Harvard University

  50. ELABORATION ON DERIVATION OF SWAN DIAGRAM, cont.: INTERNAL BALANCE At F, Y > . What would have to happen to eliminate excess demand? ● ● ● E ↓ . If appreciation is big enough, restores Y= at pointC. API-120 - Prof.J.Frankel, Harvard University

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