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Macro CFA review

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Outline • Measurement– National income (GDP) and unemployment

• Business cycles• Aggregate supply and demand model• Money• Money supply and demand• Monetary and fiscal policy – Activist versus non-activist policy

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Gross Domestic Product• Objective: Estimate the amount of economic

activity • Approaches– measure output– measure expenditure– measure income

• These all measure the SAME THING!

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Gross Domestic Product• Gross Domestic Product (GDP) is the most

common measure of economic activity

• GDP – The market value of all final goods and services produced in a year, within a country’s borders

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Expenditure

GDP = C + I + G + NX

C – Consumption expenditures

I – Investment expenditures • machines, equipment, structures, software and inventory

G – Government purchases of goods and services

NX – net exports = Exports minus imports

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Income and outputGDP = output of the economy– Output produced using land, labor and capital

Payment to resources– Wages – payment to labor– Interest and profits – payment to capital (includes dividends)

– Rent - payment to land

GDP = wages + interest & profits + Rent

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Real and Nominal GDP• Nominal value – the value in current dollars – Expenditure method: GDP = C + I + G + NX – measured in current market prices

• Real value – the value in constant dollars

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Inflation• Inflation – sustained rise in the average level

of prices• Deflation – sustained decline in average level of prices

• Price level – measured using a price index

• Price index measures average, not relative prices

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Calculating the inflation rateInflation rate is found by calculating the percent change in the price index

Inflation rate 1977-1978 =

Inflation rate 2007-2008 =

year Consumer Price Index #

1977 62.1

1978 67.7

2007 210

2008 210.2

Source: BLS, base year 1984-1982 average. End of period

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CPI inflation record, USA

Source: Bureau of Labor Statistics

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Consequences Inflation• Inflation erodes the purchasing power of

money– Results in loss of purchasing power of monetary

and fixed income assets• Bank deposits, CDs, Bonds

– Results in a decrease in debt burden as purchasing power of debts fall

– Creates confusion about future prices

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The “inflation tax”• Inflation distributes income from those with fixed

incomes to those with fixed costs.– Inflation acts as a tax on fixed income receipts

• Tax on lenders/savers

• The real value of fixed income falls as prices rise

• The real value of fixed payments fall as prices rise

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Business Cycles

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Unemployed• To be considered unemployed, a person must– not have a job– be 16 years of age or older– be actively seeking employment, or awaiting recall

• People not working and who are also not looking for work are not considered unemployed

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Unemployment rateThe labor force = employed + unemployed persons

– Interpret as the number of available workers

The unemployment rate = unemployed divided by labor force

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Example, USAEmployment Status, January 2013 Thousands of people

Employed 143,322

Unemployed 12,332

Not in labor force 89,009

Source: Bureau of Labor Statistics

Calculate the labor force

Calculate the unemployment rate

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Types of Unemployment• Frictional – Unemployment caused by short-

term movement of workers and first time job seekers.

• Structural – Unemployment caused by technological or structural changes in the economy

• Cyclical – Unemployment caused by recession

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The natural rate of unemployment

Natural Rate of Unemployment – –The unemployment rate with no

cyclical unemployment

–Frictional and structural unemployment are always present in the economy

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Unemployment rate

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Potential GDPWhen unemployment = natural rate– real GDP = potential – No cyclical unemployment

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Potential GDP

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Model of GDP determinationGDP = output = expenditure

• Output: Everything produced by land, labor and capital– Aggregate supply

• Expenditure: C + I + G + NX– Aggregate demand

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Model of GDP determinationGDP = output = expenditure

• Output: Everything produced by land, labor and capital – Aggregate supply

• Expenditure: C + I + G + NX– Aggregate demand

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Long-run Aggregate Supply• Long-run: real GDP is equal to potential GDP

• Potential GDP is the most an economy can produce with resources and technology

• Potential GDP is independent of price level

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Long-run Aggregate Supply Curve

The long-run Aggregate Supply curve is a vertical line at Potential GDP (Yp)

Pricelevel

Real GDP

LRAS

Yp

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Short-run Aggregate Supply• Short-run:– Prices of resources/input and costs of production are

assumed to be fixed– Price of output may vary– As the price of output increases, the quantity of

output supplied (real GDP) increases.

• In the short-run, there is a positive relationship between price level and output (real GDP) supplied

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Short-run Aggregate Supply Curve

There is a positive relationship between SAS and price level

Pricelevel

Real GDP

LRAS

Yp

SAS

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Aggregate DemandAggregate expenditure: – Consumption (C)• Expectations, wealth

– Investment (I)• Expectations, interest rate

– Government Purchases (G)• Policy – can deficit if tax revenue not available

– Net Exports (NX)• Exchange rate, relative prices, foreign income

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Aggregate Demand

There is a negative/inverse relationship between price level and Aggregate demand

Pricelevel

Real GDP

AD

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Equilibrium

Long-run equilibrium, all curves meet at potential

Pricelevel

Real GDP

LRAS

Yp

SAS

AD = C + I + G + NX

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Recession

During recession, real GDP may be less than potential

Pricelevel

Real GDPYp

SAS

AD

Y’

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Responses to recessionsActivist/Keynesian response to recession– Use fiscal policy to increase AD• This is counter-cyclical policy

– Increase government purchases (G)– Reduce taxes Increase consumption (C)

Keynesians are all about Aggregate Demand!!– Multiplier effects: increase in G of $1 leads to greater

increase in AD

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Response to recession

Increase AD to fight recession

Pricelevel

Real GDPYp

SAS

AD

Y’

AD’

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Discretionary/automatic stabilizersDiscretionary policy– Planned expenditures: American Recovery and

Reinvestment act (ARRA)

Automatic Stabilizers– Element of fiscal policy that changes automatically as

income (real GDP) changes• Example: progressive taxes, unemployment benefits

Result: Deficits higher during recessions

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Consequences of deficits• Richardian equivalency theory• Crowding out theory• Supply-side economics

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Ricardian Equivalence theory• AD shift is the same if government borrows or

increases taxes to finance spending

– households see government borrow– expect an increase taxes in the future– save more (spend less) to pay future taxes – Result: expansion of AD depressed

• David Ricardo (1772 – 1823)

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Richardian equivalence

No increase in AD as result of increase in G or reduction in taxes

Pricelevel

Real GDPYp

SAS

AD

Y’

= AD’

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Crowding out theory• The government issues bonds to finance spending– Businesses also issue bonds to finance investment (I)

• Government and businesses compete for the same funds– government borrowing “crowds out”, or reduces,

private investment– Depresses increase in AD from government spending

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Crowding out

Increase in AD caused by increase in G offset by decrease in I

Pricelevel

Real GDPYp

SAS

AD

Y’

AD’AD ‘’

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Financing with Tax RevenueEventually, government spending has to be financed with tax revenue

Taxes reduce incentive to work– As tax rates increase, hours worked per person

decreases• Leads to a decrease in potential GDP and decrease in

LRAS

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Supply-side Economics• The study of the effect of taxation on aggregate

supply is “supply-side economics”

• Increase tax rates reduces in economic activity– less income available to tax

• A decrease in tax rates increases economic activity– more income available to tax

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Taxes and hours worked 2004

20% 25% 30% 35% 40% 45% 50% 55% 60%16

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20

22

24

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France

Germany

Italy

USA Japan

Spain

Effective tax on labor income

Hou

rs w

orke

d pe

r wee

k

Sources:Taxes: McDaniel 2007, Hours worked: GGDC and OECD

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Taxation on LRAS

Increasing income tax rates leads to a decrease in potential GDP

Pricelevel

Real GDP

LRAS

Yp

LRAS’

Yp’

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Activists and non-activist• Keynesian/New Keynesian – Intervene to increase AD – benefits outweigh cost

• New Classical– Supply-side effects are powerful– Richardian equivalence means AD shift will be

small

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Functions of MoneyMoney must perform the following functions:– Medium of exchange• Satisfies double coincidence of wants

– Unit of account• Goods are prices in money

– Store of value• Maintains purchasing power

– Standard of deferred payment• Debts denominated in money

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Types of Money• Commodity Money– money with intrinsic value– Example: gold coins

• Fiduciary money or fiat currency– money backed by trust– U.S. dollar is a fiat currency

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Defining MoneyThere are two official measures of the U.S. money supply1. M1 = Currency + checking deposits +

travelers checks2. M2 = M1 + savings deposits + CD + retail

Money market

Money expands through the banking system

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Reserves• Banks are required to hold a fraction of

deposits in reserve– total reserves = cash in vault + deposits @Fed. bank

• The reserve requirement (rr) is set by Federal Reserve (more later)

– required reserves = rr times total deposits– Excess reserves = total reserves – required reserves

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ExampleAssets Liabilities

Cash in Vault $20,000 Deposits $1,000,000

Deposits @ Fed Bank $100,000 Loans from other banks $0

Loans $480,000 Loans from Fed $0

Securities $400,000

total total

Suppose the reserve requirement = 10%Total reserves = _________Required reserves = _______Excess reserves = ______

Cascade Bank

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ExampleAssets Liabilities

Cash in Vault $20,000 Deposits $1,000,000

Deposits @ Fed Bank $100,000 Loans from other banks $0

Loans $480,000 Loans from Fed $0

Securities $400,000

total total

Suppose the reserve requirement = 10%. Show how the balance sheet would change if the bank loans out all of its excess reserves.

Cascade Bank

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Deposit expansion multiplierThe maximum possible expansion of the money supply that results from a new deposit = value of the new deposit times deposit expansion multiplier

deposit expansion multiplier = 1/rr

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Combined excess reserves of U.S. Banks

19591962

19651968

19711974

19771980

19831986

19891992

19951998

20012004

20072010

0

200

400

600

800

1000

1200

1400

1600

1800

Billi

ons

of C

urre

nt D

olla

rs

Source: Federal Reserve Bank of St. Louis

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Equation of Exchange

MV = PY

M: Money supply, could be M1 or M2

V: Velocity of money, # of times dollar is spent in a year

P: Price level

Y: real GDPPY: Nominal GDP

Equation of Exchange is an identity, it always holds

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Tools of Monetary PolicyHow does the Federal Reserve control the money supply?

Federal Reserve tools:– The reserve requirement– Discount rate/discount loans– Open market operations

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Reserve Requirement• The reserve requirement (rr) is the fraction of

deposits banks are required to hold in reserve

• Total (legal) reserves = Cash in vault + deposits @ Fed

• Required Reserves = rr times total deposits

• Excess reserves = Total Reserves – Required

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Example

Assets Liabilities

Cash in Vault $20,000 Deposits $1,000,000

Deposits @ Fed Bank $80,000 Loans from other banks $0

Loans $500,000 Loans from Fed $0

Securities $400,000

total assets total liabilities

Suppose the reserve requirement = 10%Calculate Excess Reserves_______ Calculate the deposit expansion multiplier ______

Suppose the reserve requirement decreases to 5%Calculate excess reserves ________Calculate the deposit expansion multiplier ______Find the maximum possible expansion of the money supply if excess reserves are loaned out

Cascade Bank

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Discount loan• The Federal Reserve can make loans to banks

• These loans are called Discount Loans

• The rate banks pay is called the Discount rate

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Example

Assets Liabilities

Cash in Vault $20,000 Deposits $1,000,000

Deposits @ Fed Bank $80,000 Loans from other banks $0

Loans $500,000 Loans from Fed $0

Securities $400,000

total assetstotal after discount loan

total liabilities total after discount loan

Suppose the reserve requirement is 10%, calculate excess reserves________Show on the balance sheet above a $10,000 Discount loan to Cascade Bank Recalculate excess reserves ______Calculate the maximum possible expansion of the money supply if Cascade loans out excess reserves ___________

Cascade Bank

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Open Market Operations• The most common tool of monetary policy is open

market operations

• Open market operations are the purchase and sale of securities by the Federal Reserve

• Open market purchases increase excess reserves

• Open market sales decrease excess reserves

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ExampleAssets Liabilities

Cash in Vault $20,000 Deposits $1,000,000

Deposits @ Fed Bank $80,000 Loans from other banks $0

Loans $500,000 Loans from Fed $0

Securities $400,000

total assetstotal after open market purchase

totaltotal after open market purchase

Suppose the reserve requirement is 10%, calculate excess reserves________Show on the balance sheet above a $10,000 Federal Reserve open market purchaseRecalculate excess reserves ______Calculate the maximum possible expansion of the money supply if Cascade loans out excess reserves ___________

Cascade Bank

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Using Tools• If the Federal Reserve wants to increase the

money supply – Decrease reserve requirement• increases excess reserves and increases the deposit

expansion multiplier

– Lower discount rate and make discount loans• increases excess reserves

– Perform open market purchases of securities• increases excess reserves

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Using tools• If the Federal Reserve wants to decrease the

money supply– Increase reserve requirement• reduces excess reserves and decreases the deposit

expansion multiplier

– Increase the discount rate and reduce discount loans• reduces excess reserves

– Perform open market sales of securities• reduces excess reserves

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Equation of Exchange

MV = PY

M: Money supply, could be M1 or M2

V: Velocity of money, # of times dollar is spent in a year

P: Price level

Y: real GDPPY: Nominal GDP

Equation of Exchange is an identity, it always holds

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Quantity TheoryAssume velocity is constant.

In the long-run, a change in M only influences price level

In the short-run, changes in the money supply influences Nominal GDP ?

Money DemandWhy hold money?– transactions demand – buy stuff

• depends on nominal income

– precautionary demand – unplanned expenditures– speculative demand – money is a store of value

• speculative demand is determined by the uncertainty about the value of other assets

What do you give up when you hold money?– the return you would earn on non-monetary assets or

interest rate

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The Money Marketinterest rate

Quantity of Money

Md

Money supplySuppose the money supply is independent of interest rate– controlled by Federal Reserve in the USA today• might increase or decrease depending on policy

Interest rate is determined in equilibrium by money supply supply and demand– changes in interest rate are caused by changes in

money supply and or demand

The Money Market

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Msinterest rate

Quantity of Money

Md

i*

The Money Market

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Msinterest rate

Quantity of Money

Md

i

i’

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Interest rate and AD• When the equilibrium interest rate decreases– Investment increases*– Aggregate Demand increases

• When the equilibrium interest rate increases– Investment decreases*– Aggregate Demand decreases

Possibly consumption as well

Monetary expansion – best case

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Ms

i

interest rate

Quantity of Money

Md

i’

Real GDP

Pricelevel

AD

LRAS SAS

Y Yp

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Short-run and long-runMonetary policy can be used to influence AD• Short-run– Influence price level and real GDP

• Long-run– Influence price-level only - inflation

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Activists and non-activistsActivists:– Economy can take a long time to recover from recession– Use monetary (and fiscal) policy to increase aggregate

demand

Non-activist– Economy adjust quickly

• Agents have rational expectations

– Aggressive monetary (and fiscal) policies worsen recessions and cause inflation

– Lags associated with monetary and fiscal policies

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Recession

Result: higher price level - inflation

Pricelevel

Real GDPYp

SAS

AD

Y’

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Recap - activistsActive role for government in economy– Use monetary tools to influence short-run interest

rate– Use fiscal policy to increase G and temporary

reduce taxes when economy is in recession– Benefits of using fiscal and monetary policies

outweigh cost

Keynesian and New Keynesians are activist

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Recap – non-activistLittle government involvement– Set monetary policy rules– Keep taxes low and don’t make policy changes– Active monetary policies are inflationary– Active fiscal policies are costly and result in

declines in potential GDP

Monetarists and New Classical are non-activist