Macro Economics

1. Macro Economics Presented By: Manish Gupta F G S 2 I N YA A N ESS I O N F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

2. What is GDP? • GDP refers to what is totally produced and not what is sold • Nominal GDP vs. Real GDP (base year for India -1999-2000) • GDP Deflator = Nominal GDP * 100 / Real GDP • 3 methods of measuring GDP : • Expenditure method - total spending on domestically produced goods and services in economy – C+I+G+X-M – ( GDP at market prices) • Income method - adds the incomes accrued to all factors of production – (GDP at factor cost ) • Output method - adds the value added at each stage of production • All these 3 equal only in a closed economy. • In an Open Economy- GNE => GDP => GNI=>GNDI=>GNE F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

3. More about GDP • GDP at market prices = GDP at factor cost ?? • GDP( mp ) = GDP( fc ) + ( Indirect taxes - Subsidies) • NDP = GDP – Depreciation • National Income is factor incomes accrued to residents of country • GNP = GDP + NFIA • National Income = GNP ( fc ) – Depreciation • Disposable Personal Income • What about transfer payments, transactions in Black market and Second hand market, unorganized sector, domestic work, etc F IN 2 :

4. Famous Twin Deficit Theory • In Equilibrium : Y = C + I + G+ ( X – M ) • Private savings = Y – C – T ; Government savings = T – G • Total savings is private + government : (Y – C – G ) = I + (X – M ) • X > M implies investment abroad by using excess foreign exchange • M > X implies decrease in forex which decreases opportunities for investing abroad • T - G is called fiscal balance while M-X is current accounts balance (when +ve, then deficit, when –ve then surplus) • Twin Deficit: Higher the fiscal deficit, more it will spill over to current account deficit, if I and S are stable (1991 crisis- Defense+ Subsidy) F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

5. Introduction to Interest rates and Money Supply • Interest Rates : Price of money • Real money demanded = Transaction demand (+ve function of GDP and –ve function of interest rates) + precautionary demand (for unseen future) + speculative demand (varies inversely with rates) • If interest rates are high, opportunity cost of holding money high i.e. bond prices will rise from current low position, so invest in bonds (hence demand less money) • Real Interest rates = Nominal interest rates – inflation rate • In a period of slowdown, interest rates fall as demand for money is low as well as expected inflation rate. In booming economy reverse happens F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

6. Interest Rates

7. Interest Rates (continued) • Call Money Market Rates : rates at which one bank borrows from other bank in the short-term, ranging from call to 72hrs • Repo Rate : Discount rate at which a central bank repurchases government securities from the commercial banks • Reverse Repo Rate : Opposite to above rates on Treasury bills and long term government bonds refer to yields on short term and long term government securities • Prime Lending Rate (PLR) : Rate at which banks lend to their favored Customers- No Longer applicable now-Base rate F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

8. Inflation • Inflation is caused by 3 factors: • Demand Pull inflation : rise in C, I, G, and X-M makes price and output rise. If economy is operating near full capacity then price rise is steeper • Cost Push Inflation – rise in costs for firms without rise in productivity like labor costs, material costs. This will raise prices along with decrease output • Expectation Driven – If people expect inflation to happen, they revise their prices which lead to actual inflation. (Contracts, menu etc.) • Inflation refers to continuous rise in prices, not one shot increase in prices • Increase in money supply help in rising inflation- Money Market Equilibrium • Inflation leads to distribution of wealth from fixed income to those having real incomes and from lenders to borrowers. • High inflation lowers savings (negative real interest rates!!!) and people invest money in gold, land, etc. which keep pace with inflation F IN G YAAN S ESSION 2 : M ACRO

10. Philips Curve • Philips Curve – Unemployment and inflation are inversely related- Keynesian wage floor • Exceed Full employment => tight labor market => higher wages => higher prices F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

11. Introduction to economic linkages • As X decreases, so does I • X decreases => less people are employed => C decreases. Since C, I, and X are all slowing so government is collecting less tax revenue and hence G will also slowdown • Marginal propensity to consume (mpc) = change in ‘C’ in response to change in ‘Disposable Income’ = delta C/ delta Y • ‘C’ has 2 components: induced component, which can be induced by macro economic policy variables like interest rates and tax rates and autonomous component driven by sentiment (not affected by policies) F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

12. Fiscal Policy • Government expenditure (G) and Taxes(T)– most important policy Variables of fiscal policy • Fiscal Deficit = Total Expenditure – Total Revenue • Expenditure : Infrastructure, Defense etc • Revenue : Taxes, Fines, Toll collection etc • Primary deficit = fiscal deficit – interest payments ( a better measure of fiscal profligacy) • Increase in G and lowering of T– fiscal stimulants ( effect on aggregate demand) F IN G YAAN 2 : M ACRO E CONOMICS

13. Some concepts related to Fiscal Policy • Multiplier-Final effect on Output more than the initial change in G .How?? • Crowding Out Phenomenon: G can crowd out I. An increase in G leads to an increase in Y which in turn leads to an increase in Money Demand. Therefore Interest Rates rise and I falls. Hence effect on Output mitigated. F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

14. Monetary Policy • Interest rates, exchange rates and money supply – important monetary policy variables • Monetary policy changes first impact financial variables like interest rates, exchange rates. They then affect C and I which then affect GDP and Prices F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

15. Linkages related to Monetary Policy • If money supply increases, then interest rates go down. Why? • Decrease in interest rates causes prices of long lived assets like stocks, bonds and real estate to rise and hence people become wealthier. The collateral which can be given against loan suddenly increase • Increase in asset prices makes individual feel wealthier and hence C rises • Depreciation of local currency makes imports expensive and hence domestic spending increases (X-M as a whole increases) F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

16. More Concepts • Fall in interest rates encourages more investment by companies. Due to rise in value of collateral, bank loans become easy (I increases) • Liquidity Trap: When interest rates are close to zero, a further cut is not possible. Hence, Monetary Policy to raise I and hence AD by cutting rates is not possible • CRR, or cash reserve ratio - refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI • Statutory liquidity ratio (SLR) - Banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements • Open Market Operations - It refers to the buying and selling of Govt. securities in the open market . During inflation RBI sells securities in the open market which leads to transfer of money to RBI. Thus money supply is controlled in the economy. F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

17. Problems for RBI • Targets for RBI: interest rates or money supply or exchange rates- when free capital mobility-‘The Impossible Trinity’ • When rupee is appreciating against dollar and RBI stabilizes that, money supply goes up and vice versa. So both cannot happen simultaneously. If it wants stable exchange rate, it has to tolerate more inflation. • Targets of RBI have been dynamic depending upon the economic conditions F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

18. External Account • Balance of Payments is the difference between receipts of residents of country from foreigners and payments by residents to Foreigners • Trade account : balance from export and import of merchandise • Invisibles : services, investment income & transfer payments • Current account = trade account + invisibles • Capital account includes export and import of capital F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

19. Introduction to Exchange Rate • Demand for exports and imports – exchange rate • Real Exchange rate = Nominal Exchange Rate * Foreign price / Domestic price • Real Exchange Rate captures the competitiveness of a country’s trade by considering relative price changes between countries • Net Exports go down if exchange rate appreciates F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

20. Exchange Rate • Exchange rate can be determined by purchasing power parity (PPP) theory: in long run, exchange rates adjust to reflect differences in countries’ inflation rates. • Exchange rate will be in equilibrium when their domestic purchasing powers at that rate are equivalent • Interest rate parity theory says that differential of interest rates determine future expected exchange rates. • Fixed Rate Regimes and Floating Rate Regimes • In managed float exchange rate regime, RBI allows initial rate to be determined by market forces but later steps in to maintain its orderly behavior. F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

21. Important Linkages • Fixed Rate Regime & External Account is negative : pressure on rupee to depreciate -> RBI will sell forex to stop that -> monetary base decreases->interest rates rise->GDP slows down -> imports come down but also currency appreciates -> Overall impact?? • Rise in interest rates attracts more capital from outside, so balance improve F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

22. Yield Curve and Recessions • It plots the yield of a bond against the time to maturity • Usually upward sloping because people feel the long term bonds are riskier and hence demand higher rate of interest • When short rates rise above long rates the yield curve is said to be ‘inverted’ • Inverted yield curves are widely considered as an indicator of recession. Why? • They have success fully predicted 7 out of 8 recessions since 1960 in the US economy F IN G YAAN S ESSION 2 : M ACRO E CONOMICS

23. EURO CRISIS

24. EURO CRISIS Effects on interest rate and output

25. EURO CRISIS Adjustment using monetary policy tools

26. Questions??