Harvard Kennedy School - Harvard University

Macroeconomic Review

in preparation for API-120

Prof. Jeffrey Frankel MPA/ID program

August 20-21, 2015

• Lecture (i) -- GDP definitions Reading on growth accounting: Krugman, 1994, “The Myth of the Asian Miracle.”

• Lecture (ii) -- More identities: • Balance of Payments accounting

• The National Saving identity

Reading on BoP accounting: WTP, Chapter 15.

• Lecture (iii) -- The Keynesian multiplier model.

Reading on the Keynesian model: WTP, Ch. 17.1-17.3.

Lecture (i) - GDP

• Definitions of national output

• Potential output 𝑌

• Growth decomposition

• Some historic theories, as examples

• How are 𝑌 & the output gap measured in practice?

Definition of Gross Domestic Product

• GDP ≡ The value of all goods & services produced in the economy in the year.

o GNP ≡ GDP + income from investments abroad.

o Gross National Income ≡ GNP + income from unilateral transfers.

o Net National Income ≡ GNI – depreciation of capital stock.

• Real GDP ≡ Nominal GDP / GDP deflator.

• We will use Y to denote real GDP or real income.

• GDP is not a comprehensive welfare measure: – It omits environmental externalities, leisure, & lots more.

Potential output and the output gap

• 𝑌 ≡ Potential output ≡ A F(K, N, Land); – F( ) ≡ an aggregate neoclassical production function; – K ≡ the capital stock

• when operating at the capacity it was designed for;

– N ≡ labor force • when employed fully or at least at the natural rate;

– A ≡ Total Factor Productivity.

• Output gap ≡ (𝑌 - Y), as a percentage.

• 𝑌 is in the realm of growth theory or economic development.

• (𝑌 - Y) is in the realm of macroeconomics (API-120): – Goods and labor markets may not clear in the short run.

A simple functional form: Cobb-Douglas

• 𝑌 ≡ F( ) ≡ A (Kα Nβ Landγ).

• Most common special case --

– Constant returns to scale: α + β + γ = 1.

– Diminishing returns to each factor of production: α < 1; β <1; γ <1.

• Growth decomposition:

– Growth rate 𝑑𝑦

𝑑𝑡 ≡

𝑑𝑎

𝑑𝑡 + α

𝑑𝑘

𝑑𝑡 + β

𝑑𝑛

𝑑𝑡 .

Growth decomposition, continued

• K grows through fixed investment (net of depreciation).

• N grows through population growth,

• including immigration.

• Also rises in labor force participation (e.g., women entering);

• rural-urban migration; and

• human capital accumulation (education & training).

• Total Factor Productivity • grows through technological progress & economic efficiency.

Some historic theories, as examples

• Malthus (1798): A fixed supply of arable land & γ>0 => Y rises more slowly than population. – But he underestimated TFP growth.

• Solow (1957): Growth decomposition numbers say TFP explains far more than capital accumulation does.

• Endogenous growth theory, – e.g., P. Romer (1986): α = 1. – Technical change is embodied in capital.

• “The Myth of the Asian Miracle” – A.Young (1994, 1995) & Krugman (1994): – The success of Singapore & other Asian countries can

be explained by factor accumulation, not TFP growth.

How is potential output 𝑌 computed in practice ?

Three ways: 1. Aggregate production function Y = F(K,N)

– Plug in the labor force employed at natural rate: N=𝑁 , – " capital stock K working at full capacity. – Conceptually the right definition.

• But not practical for annual data.

2. Time trend – E.g., H-P filter.

3. Estimate 𝑌 as value of Y above which inflation tends to accelerate.

In 2009, after the global financial crisis, advanced countries suffered much larger output gaps than in preceding recessions: Y << . Y

Source: IMF, via Economicshelp, 2009

UK

US

France

IMF estimates of output gap, as percentage of GDP, 2009

Ir

Jpn

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

Inflation everywhere fell in 2008-09, in response to the output gap of the great recession.

World Bank, June 2014. “Exchange rate pass-through and inflation trends in developing countries,” Global Ec. Prospects.

http://www.worldbank.org/content/dam/Worldbank/GEP/GEP2014b/GEP2014b_annex.pdf

http://www.worldbank.org/content/dam/Worldbank/GEP/GEP2014b/GEP2014b_annex.pdf

Other ways to decompose GDP

• To whom the goods & services are sold (expenditure side of GDP):

– C

– + I

– + G

– + X-M .

• How the income is used: – Taxes net of transfers, T, leaving disposable income :

– Consumption C

– + Saving S.

• Allocation of income shares according to factors of production: – Wages & salaries

– Capital income.


} Yd

To be followed by: • (ii) More identities

– Balance of payments accounting

– The National Saving Identity

• (iii) The Keynesian multiplier model

End of Review Lecture (i):

• GDP definitions

Lecture (ii) – More identities

• Balance of Payments accounting

• The National Saving identity

Professor Jeffrey Frankel, Harvard University

Balance of payments accounts

• Definition: The balance of payments is the year’s record of economic transactions between domestic and foreign residents.

• The rules: – If you have to pay a foreign resident --

normally in exchange for something that you bring into the country -- then the something counts as a debit.

– If a foreign resident has to pay you for something, then the something counts as a credit.

NOW CALLED “FINANCIAL ACCOUNT”

“Primary income,” mainly investment income

≡ “secondary income”

Examples of a debit 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 => debit 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 .


Examples of debits 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 (debit) 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).


Examples of debits 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 (Debit: You have “imported” a claim against India.)

You lend to the Indian company in the form of cash dollars, which it doesn’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 some central banks now diversify international investments) => increase in US official reserve assets.


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.


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; • Exchange rate E adjusts to clear private market FX supply & demand.


The National Saving identity

• Useful for many purposes.

• In lecture (iii) we will use it to express the Keynesian multiplier model.

• To derive the national saving identity,

– first, consider two ways of decomposing GDP.

Two ways to decompose GDP

• To whom the goods & services are sold (expenditure side of GDP):

– C

– + I

– + G

– + X-M .

• How the income (Y) is used:

– Taxes net of transfers, T,

– leaving disposable income Yd: • Consumption C

• + Saving S.


} = Yd

Derivation of National Saving Identity

Income ≡ Output (assuming no transfers or investment income)

Y ≡ GDP

S + (T-G) ≡ I + X – M

/ /

NS ≡ S + BS ≡ I + CA

National Saving Identity

C + S + T ≡ C + I + G + X -M



Household savings

Corporate savings

Government savings*

Eswar Prasad, 2009, “Rebalancing Growth in Asia,” Finance and Development, IMF, December, p.21.

* Excludes govt. investment spending


End of: Definitions & Accounting

Lecture (iii) – The Keynesian

multiplier model

• Consumption function.

• Trade balance.

• Determination of income Y.

• The multipliers in an open economy

• for an increase in spending 𝐴 , – e.g., due to a fiscal expansion;

• for an increase in exports 𝑋 , – e.g., due to a devaluation.

The Keynesian consumption function:

Consumption depends less-than-proportionately on income

• C = 𝐶 + cY.

• What determines 𝐶 ? Three approaches -- – Financial approach: Wealth, spread over a lifetime. – Intertemporal optimization:

An estimate of permanent income ≡ Y in a normal year. – Behavioral economics (e.g., habit formation):

• Level of consumption to which one has become accustomed.

• Marginal propensity to consume, c, can be derived – from the probability that observed fluctuations are Y is permanent, – an impatience parameter, – and perhaps the interest rate.

Imports depend similarly on income:

Y

TB + 0 -

assuming E fixed, for now.

where slope = -m ≡ - marginal propensity to import

TB falls in expansions…

…and rises in contractions

Prof. J. Frankel, Harvard University

M = Md(E, Y)

= 𝑀 + mY

X = Xd(E)

= 𝑋

=> TB = 𝑋 − (𝑀 + mY)

That is, the trade balance is counter-cyclical.

Determination of equilibrium income in open-economy Keynesian model

where 𝐴 = 𝐶 +𝐼 +𝐺

Now solve:


Y ≡ A + TB

≡ (C + I + G) + (X – M)

= (𝐶 +cY + 𝐼 + 𝐺 ) + (𝑋 - 𝑀 - mY).

Y - cY + mY = 𝐶 + 𝐼 + 𝐺 + (𝑋 - 𝑀 )

𝑌 = 𝐶 +𝐼 +𝐺 + 𝑋 − 𝑀

1 − 𝑐 +𝑚

𝑌 = 𝐴 + 𝑋 − 𝑀

𝑠 + 𝑚 and s ≡ 1 – c.

ITF220 - Prof. J. Frankel, Harvard University

Keynesian Consumption Function: C = 𝐶 + cYd .

} I

or, expressed as a saving function: S = Yd - C

= - 𝐶 + sYd where s ≡ 1 – c.

= Yd - 𝐶 - cYd .


Closed economy: NS – I = 0

Fiscal Expansion

1 < Closed-economy multiplier 1/s < ∞


Open economy: NS – I = TB = X – M

Exports: X = Xd(E), or = 𝑋 for simplicity.

Imports: M = Md(E, Y), or = 𝑀 +mY for simplicity

=> TB = 𝑋 − (𝑀 +mY )


Fiscal Expansion

G

slope = s

Open economy

ΔY = 1

𝑠+𝑚 Δ 𝐺 <

1

𝑠 Δ 𝐺

ITF-220- Prof.J.Frankel, Harvard Kennedy School

ΔG leads to both a fiscal deficit & trade deficit (US in 1980s & 2001-07).

But if the exogenous rise is ΔI, BD & TD move opposite directions (US in 1990s).

“Twin deficits”:

𝑨 ↑, e.g., due to fiscal stimulus: 𝑮 ↑. Fiscal multiplier

Example: Eurozone fiscal austerity has been contractionary.

Source: P.Krugman May 10, 2012.

What about the critique that fiscal policy responded endogenously to the magnitude of the countries’ difficulties? See Blanchard graph in Appendices.

ITF-220- Prof.J.Frankel, Harvard Kennedy School

ΔE shifts the X-M line up by Δ𝑿 , the elasticities answer. But the rise in TB is partially offset by higher imports.

𝑿 ↑, e.g., due to a devaluation: 𝑬 ↑. Export multiplier

SUMMARY OF MULTIPLIERS

MX I NS

ms

MXA Y

G I CA where

Ams

1 Y

Ym- ΔM ΔTB

+ Keynesian model of S + M =>

Fiscal Expansion

open-ec. multiplier = 1/(s+m)<1/s

YmXΔ ΔTB

Xms

1 Y

Devaluation

Note misprint in Equation (17.11), 10th ed. of WTP.

. AΔms

m

XΔ

ms

s

. XΔ


End of Macro Review Lecture (iii):

The Keynesian Multiplier Model

Appendix 1: EU fiscal austerity, continued

The bigger the fiscal contraction, the bigger the GDP loss relative to what had been officially forecast

=> true multipliers > than multipliers that IMF had been using.

Europe: Growth Forecast Errors vs. Fiscal Consolidation Forecasts

Note: Figure plots forecast error for real GDP growth in 2010 and 2011 relative to forecasts made in the spring of 2010 on forecasts of fiscal consolidation for 2010 and 2011 made in spring of year 2010; and regression line.

Source: Olivier Blanchard & Daniel Leigh, 2014, “Learning about Fiscal Multipliers from Growth Forecast Errors,” fig.1, IMF Economic Review 62, 179–212.


Y

Policy Instruments • Expenditure-reduction, e.g., G ↓

• Expenditure-switching, e.g., E ↑ .

Policy Goals • Internal balance: Y =

Y

Y uY < ≡ ES ≡ “output gap” => unemployment >

Y > ≡ ED => “overheating” => inflation or asset bubbles.

• External balance: e.g., CA=0 or BP=0.

Appendix 2: Goals & 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 = 𝑌 ? • => You need 2 independent instruments:

expenditure-reduction & expenditure-switching.


The principle of goals & instruments

Starting from current account deficit at point N, policy-makers can adjust either by (a) cutting spending,

or (b) devaluing.

A

X

●

●

●


ADJUSTMENT DILEMMA

● Achieving both goals, CA & Y, would require both instruments.

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