ECON5002_Topic02

PowerPoint to accompany

Chapter 3

The Goods Market

2Blanchard, Sheen Macroeconomics 3e © 2009 Pearson Australia

Section 3.1: The Composition of GDP

• Consumption (C) refers to the goods and services purchased by consumers.

• Investment (I), sometimes called fixed investment, is the purchase of capital goods. It is the sum of non-residential investment and residential investment.


The Composition of Australian GDP, 2008


The Composition of GDP

• Government Spending (G) refers to the purchases of goods and services by the federal, state, and local governments. It does not include government transfers, nor interest payments on the government debt.

• Imports (IM) are the purchases of foreign goods and services by consumers, business firms, and the Australian government.

• Exports (X) are the purchases of Australian goods and services by foreigners.


The Composition of GDP

E xports > im ports trade surp lus

E xports < im ports trade defic it

E xports = im ports trade ba lance

• Net exports (X IM) is the difference between exports and imports, also called the trade balance.

• Inventory investment is the difference between production and sales.


Z C I G X IM

Z C I G

Section 3.2: The Demand for Goods

• The total demand for goods is written as:

• The symbol “” means that this equation is an identity, or definition.

• Under the assumption that the economy is closed, X = IM = 0, then:


Consumption (C)

• The function C(YD) is called the consumption function. It is a behavioural equation, that is, it captures the behaviour of consumers.

• Disposable income, (YD), is the income that remains once consumers have paid income taxes and received transfers from the government.

C C YD ( )( )

Y Y TD


Consumption (C)

Consumption and Disposable Income

Consumption increases with disposable income, but less than one for one.

C C YD ( )

Y Y TD

C c c Y T 0 1 ( )


Investment (I)

• Investment is taken as given (until Chapter 5), or treated as an exogenous variable:

I I


Government Spending (G)

• Government spending, G, together with taxes, T, describes fiscal policy—the choice of taxes and spending by the government.

• We shall assume that G and T are also exogenous.


Y c c Y T I G 0 1 ( )

Y ZThen:

• The equilibrium condition is that, production, Y, be equal to demand. Demand, Z, in turn depends on income, Y, which itself is equal to production.

Section 3.3: The Determination of Equilibrium Output

• Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z:


Using Algebra

• The equilibrium equation can be manipulated to derive some important terms:• Autonomous spending and the multiplier:

Y c c Y T I G 0 1 ( )

1 0 1(1 )c Y c I G c T

Yc

c I G c T

1

1 10 1[ ]

multiplier autonomous spending


Using a Graph

• The multiplier is the sum of successive increases in production resulting from an increase in demand.

• When demand is, say, $1 billion higher, the total increase in production after n rounds of increase in demand equals $1 billion multiplied by:

• This sum is called a geometric series.

1 1 12

1 c c c n. . .


Using a Graph

The Effects of an Increase in Autonomous Spending on Output

An increase in autonomous spending has a more than one-for-one effect on equilibrium output.


Using Words

• To summarise:• An increase in demand leads to an increase in

production and a corresponding increase in income. The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier.

• To estimate the value of the multiplier, and more generally, to estimate behavioural equations and their parameters, economists use econometrics—a set of statistical methods used in economics.


S Y CD S Y T C

Y C I G Y T C I G T S I G T I S T G ( )

• If T > G, the government is running a budget surplus—public saving is positive.

• If T < G, the government is running a budget deficit—public saving is negative.

This equilibrium condition for the goods market is called the IS relation.

Section 3.4: Investment = Saving: An Alternative Approach to Goods-Market Equilibrium

• Saving is the sum of private plus public saving. Private saving (S), is saving by consumers.


The Paradox of Saving

• When consumers save more, spending decreases and equilibrium output is lower.

• Attempts by people to save more lead both to a decline in output and to unchanged saving. This surprising pair of results is known as the paradox of saving (or the paradox of thrift).


• Changing government spending or taxes may be far from easy.

• The responses of consumption, investment, imports, etc, are hard to assess with much certainty.

• Anticipations are likely to matter – e.g. do consumers think a tax cut is temporary or permanent?

• Achieving a given level of output may come with unpleasant side effects – e.g. inflation.

• Budget deficits and accumulating public debt may have adverse implications in the long run.

Section 3.5: Is the Government Omnipotent? A Warning


Y C Y T I G ( )

Section 5.1: The Goods Market and the IS Relation

• Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z.

• In the simple model developed in chapter 3, the interest rate did not affect the demand for goods. The equilibrium condition was given by:


Investment, Sales and the Interest Rate

I I Y i ( , )

• In this chapter, we capture the effects of two factors affecting investment:• The level of sales (+)• The interest rate (-)


I I Y i ( , )

Y C Y T I Y i G ( ) ( , )

The Determination of Output

• Taking into account the investment relation above, the equilibrium condition in the goods market becomes:


Deriving the IS Curve

An increase in the interest rate decreases the demand for goods at any level of output.

The Effects of an Increase in the Interest Rate on Output


Deriving the IS Curve

Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping.


Shifts of the IS Curve

An increase in taxes shifts the IS curve to the left.


Chapter 4

Financial Markets


Section 4.1: The Demand for Money

• Money, which can be used for transactions, pays no interest. There are two types of money: * currency; and * current account deposits (accessed by EFTPOS or cheques).

• Bonds, pay a positive interest rate, i, but they cannot be used for transactions. Term deposits are equivalent – they pay interest and cannot be accessed at any time.

• The proportions of money and ‘bonds’ you wish to hold depend on your level of transactions and the interest rate on bonds.


Semantic Traps: Money, Income and Wealth

• Income is what you earn from working plus what you receive in interest and dividends. It is a flow—that is, it is expressed per unit of time.

• Saving is that part of after-tax income that is not spent. It is also a flow.

• Savings is sometimes used as a synonym for wealth (a term we will not use in this course).


Semantic Traps: Money, Income and Wealth

• Your financial wealth, or simply wealth, is the value of all your financial assets minus all your financial liabilities. Wealth is a stock variable—measured at a given point in time.

• Financial assets that can be used directly to buy goods are called money. Money includes currency and current account deposits – but NOT credit cards (= a type of loan).

• Investment is a term economists reserve for the purchase of new capital goods, such as machines, plants, or office buildings. The purchase of shares of stock or other financial assets is financial investment.


• The demand for money:• increases in proportion

to nominal income ($Y), and

• depends negatively on the interest rate (L(i)).

M Y L id $ ( )

Deriving the Demand for Money


• In this section, we assume that only the central bank supplies money, in an amount equal to M, so M = Ms. People hold only currency as money.

• The role of banks as suppliers of money (and current account deposits) is introduced in the next section.

• Equilibrium in financial markets requires that money supply be equal to money demand:

M Y L i $ ( )

Section 4.2: Money Market Equilibrium and the Interest Rate: I


The interest rate must be such that the supply of money (which is independent of the interest rate) be equal to the demand for money (which does depend on the interest rate).

The Determination of the Interest Rate

Money Demand, Money Supply and the Equilibrium Interest Rate


The Demand for Money and the Interest Rate

The ratio of money (M1) to nominal income decreased from 1960 to 1985, & increased from 1985 to 2008. The interest rate (ten-year Treasury bonds) moved in the opposite direction.


The Demand for Money and the Interest Rate


Monetary Policy and Open-Market Operations

An increase in the supply of money leads to a decrease in the interest rate.

The Effects of an Increase in the Money Supply on the Interest Rate

Equivalently, if the central bank wants to lower the interest rate, it must increase the supply of money


An increase in nominal income leads to an increase in the interest rate, if the central bank keeps the money supply constant.

The Effects of an Increase inNominal Income on the Interest Rate i′ A′

Md for Y′>Y

Money Demand, Money Supply and the Equilibrium Interest Rate



• Open-market operations, which take place in the “open market” for bonds, are the standard method central banks use to change the money stock in modern economies.


The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open-market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount.

Monetary Policy and ExpansionaryOpen-Market Operations



• In an expansionary open market operation, the central bank buys $1 million worth of bonds, increasing the money supply by $1 million – the interest rate falls.

• In a contractionary open market operation, the central bank sells $1 million worth of bonds, decreasing the money supply by $1 million – the interest rate rises.



iP

PB

B

$ 1 0 0 $

$ $

$ 1 0 0P

iB 1

• Bonds issued by the government, promising a payment in a year or less, are called Treasury bills, or T-bills.

• When the central bank buys bonds, the demand for bonds goes up, increasing the price of bonds. Equivalently, the interest rate on bonds goes down.


Section 5.2: Financial Markets and the LM Relation

• Taking into account the investment relation above, the equilibrium condition in the goods market becomes:

• For now, assume the central bank keeps M constant. Therefore i is market-determined. When we study policy mixes in 5-4, we will look at the more realistic policy where the central bank chooses i.

M Y L i $ ( )

M = nominal money stock$YL(i) = demand for money$Y = nominal incomei = nominal interest rate


Real Money, Real Income and the Interest Rate

M

PY L i ( )

• The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:


Deriving the LM Curve

An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this leads to an increase in the equilibrium interest rate.

The Effects of an Increase in Income on the Interest Rate


Deriving the LM Curve

Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping.


Shifts of the LM Curve

An increase in money leads the LM curve to shift down.


Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate.When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.

IS re la tio n : Y C Y T I Y i G( ) ( , )

L M rela tio n: M

PY L i( )

The IS-LM Model

Section 5.3: Putting the IS and the LM Relations Together


Fiscal Policy, Activity and the Interest Rate

• Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit.

• An increase in the deficit is called a fiscal expansion.

• Taxes affect the IS curve, not the LM curve.


Fiscal Policy, Activity and the Interest Rate

An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

The Effects of an Increase in Taxes


Monetary Policy, Activity and the Interest Rate

• Monetary contraction, or monetary tightening, here refers to a decrease in the money supply.

• An increase in the money supply is called monetary expansion.

• Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down.

NB: We are still assuming the central bank keeps M fixed at some value


Monetary expansion leads to higher output and a lower interest rate.

The Effects of a Monetary Expansion

Monetary Policy, Activity and the Interest Rate


In Summary


Section 5.4: Using a Policy Mix

• Monetary and fiscal policy is never conducted in complete isolation.

• The combination of monetary and fiscal policies is known as the monetary-fiscal policy mix, or simply, the policy mix.

• To see the importance, consider fiscal contraction (G or ↑T), with 2 alternative approaches to monetary policy:

1. Central bank keeps M constant2. Central bank keeps i constant at i0

(Most central banks use 2. They decide on i and allow M to be determined endogenously in market equilibrium)


Using a Policy Mix

Fiscal contraction leads to lower output (Y´´<Y´) if central bank keeps the interest rate constant.

Using a Policy Mix


Howard-Macfarlane

Tight fiscal,

easy monetary.

Keating-Fraser

Easy fiscal,

easy monetary.

Hawke-

Johnston/ Fraser

Tight fiscal,

tight monetary.

Howard- Macfarlane

/Stevens

Tight fiscal,

tight monetary.

Rudd-

Stevens

Easy fiscal,

easy monetary.

Five Australian Policy Mixes, 1986-2008


Tight fiscal and tight monetary policy has severe adverse effects on output. Created the 1990-91 recession.Equilibrium went from A to A′ in the figure.

Deficit Reduction and Monetary Contraction

1. The Hawke-Johnston/Fraser Policy Mix, 1986-1991


2. The Keating-Fraser Policy Mix, 1991-1996

Easy fiscal and easy monetary policy helped Australia out of the 1991 recession. Equilibrium went from A′ back to A in the figure.

Deficit and Monetary Expansion


3. The Howard-Macfarlane Policy Mix,1996-2002

Tight fiscal and easy monetary policy allowed Australian output to continue to grow modestly.Equilibrium went from A to A′ in the figure.

Fiscal Contraction and Monetary Expansion


LM'

LM

IS’

With the global economy growing pushing out the IS curve, tight fiscal (pushing it in a little) and monetary policy allowed Australian output to continue to grow without hitting capacity constraints.

Fiscal Contraction and Monetary Contraction

Output, Y

Inte

res

t R

ate

. i

IS

i2

Y2

i1´

Y1´

4. The Howard-Macfarlane Policy Mix,2002-2008


LM3

Y2

LM2

IS1

The global financial crisis pushed the IS curve far to the left. Monetary and fiscal stimulus packages lowered the interest rate and shifted the IS curve to the right (a little?)

BIG Fiscal Deficit and BIG Monetary Expansion

Output, Y

Inte

res

t R

ate

. i

IS2

Y3

i3

i2

5. The Rudd-Stevens Policy Mix, 2008-?


Policy Responses to the U.S. Recession of 2001


Policy Responses to the U.S. Recession of 2001


• Financial intermediaries are institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms.

Section 4.3: Money Market Equilibrium and the Interest Rate: II


What Banks Do

• Banks keep as reserves some of the funds they have received, for three reasons:• To honour depositors’ withdrawals.• To pay what the bank owes to other banks.• In some countries (but not Australia), to maintain

the legal reserve requirement:• The actual reserve ratio (which we will define as )

is currently about 10.5% in Australia.• The required reserve ratio is currently about 10% in

the United States.


The Balance Sheet of Banks and the Balance Sheet of the Central Bank Revisited


What Banks Do

• In Australia today, loans represent 63% of banks’ non-reserve assets. Bonds account for the other 37%.

• The assets of a central bank are the bonds it holds. The liabilities are the money it has issued, central bank money, which is held as currency by the public, and as reserves by banks.


Bank Runs

• Rumours that a bank is not doing well and some loans will not be repaid, will lead people to close their accounts at that bank. If enough people do so, the bank will run out of reserves—a bank run.

• To avoid bank runs, the U.S. government provides federal deposit insurance.

• Until recently, there has been no deposit insurance in Australia – instead, Australia relied on high quality supervision of banks by APRA.

• In response to the global financial crisis in 2008, the Australian government (like most others) guaranteed all bank deposits up to $1m at APRA-regulated banks until 2011.

• An alternative solution is narrow banking, which would restrict banks to holding liquid, safe, government bonds, such as T-bills.


]

]

Determinants of the Demand and the Supply of Central Bank Money


Demand for currency: C U cMd d

Demand for current account deposits: D c Md d ( )1

Relation between deposits (D) and reserves (R):

Demand for reserves by banks:

Demand for central bank money: H C U Rd d d

Then:

M Y L id $ ( )Since then:

R = D

Rd = (1-c) Md

Hd = c Md + (1-c) Md = [ c + (1-c) ] Md

Hd = [ c + (1-c) ] $Y L(i)

The Demand for Money, Reserves and Central Bank Money


• In equilibrium, the supply of central bank money (H) is equal to the demand for central bank money (Hd):

H H d

• Or restated as:

H = [ c + (1-c) ] $Y L(i)

The Determination of the Interest Rate


Figure 4.8 The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money.

4-4: Two Alternative Ways to Think About The Equilibrium


The Interbank Overnight Market and The Cash Rate

• This is a market for bank reserves. In equilibrium, demand (Rd) must equal supply (H-CUd).

• The interest rate determined in the market is called the cash rate.

• This market is under the control of the RBA. By varying H, it can obtain the interest rate it desires.

• For more details on monetary policy implementation, read Ch26-3


• We saw earlier that the overall supply of money is equal to central bank money times the money multiplier:

Then

• High-powered money is the term used to reflect the fact that the overall supply of money depends in the end on the amount of central bank money (H), or monetary base.

Supply of money = Demand for money

H = [ c + (1-c) ] $Y L(i)

1$ ( )

[ (1 )]H Y L i

c c

The Supply of Money, the Demand for Money and the Money Multiplier

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ECON5002_Topic02