Macro CFA review
1
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
2
Gross Domestic Product
• Objective: Estimate the amount of economic
activity
• Approaches
– measure output
– measure expenditure
– measure income
• These all measure the SAME THING!
3
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
4
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
5
Income and output
GDP = output of the economy
– Output produced using land, labor and capital
Payment to resources
– Wages – payment to labor
– Interest and profits – payment to capital
– Rent - payment to land
(includes dividends)
GDP = wages + interest & profits + Rent
6
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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8
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
9
Calculating the inflation rate
Inflation rate is found by calculating the percent change in the price index
year
Consumer Price Index #
1977
62.1
1978
67.7
2007
210
2008
210.2
Inflation rate 1977-1978 =
Inflation rate 2007-2008 =
Source: BLS, base year 1984-1982 average. End of period
10
CPI inflation record, USA
Source: Bureau of Labor Statistics
11
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
13
Business Cycles
14
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
15
Unemployment rate
The labor force = employed + unemployed persons
– Interpret as the number of available workers
The unemployment rate = unemployed divided by labor
force
16
Example, USA
Employment 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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18
Types of Unemployment
• Frictional – Unemployment caused by shortterm 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
21
Potential GDP
When unemployment = natural rate
– real GDP = potential
– No cyclical unemployment
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Potential GDP
23
Model of GDP determination
GDP = output = expenditure
• Output: Everything produced by land, labor
and capital
– Aggregate supply
• Expenditure: C + I + G + NX
– Aggregate demand
24
Model of GDP determination
GDP = 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
26
Long-run Aggregate Supply Curve
Price
level
LRAS
Yp
Real
GDP
The long-run Aggregate Supply curve is a vertical line at Potential GDP (Yp)
27
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
Price
level
LRAS
Yp
SAS
Real
GDP
There is a positive relationship between SAS and price level
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Aggregate Demand
Aggregate 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
30
Aggregate Demand
Price
level
AD
Real
GDP
There is a negative/inverse relationship between price level and Aggregate demand
31
Equilibrium
Price
level
LRAS
SAS
AD = C + I + G + NX
Yp
Real
GDP
Long-run equilibrium, all curves meet at potential
32
Recession
SAS
Price
level
AD
Y’
Yp
Real
GDP
During recession, real GDP may be less than potential
33
Responses to recessions
Activist/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
34
Response to recession
SAS
Price
level
AD
Y’
Yp
AD’
Real
GDP
Increase AD to fight recession
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Discretionary/automatic stabilizers
Discretionary 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
37
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
SAS
Price
level
AD = AD’
Y’
Yp
Real
GDP
No increase in AD as result of increase in G or reduction in taxes
39
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
SAS
Price
level
AD ‘’
Y’
Yp
AD’
Real
GDP
Increase in AD caused by increase in G offset by decrease in I
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Financing with Tax Revenue
Eventually, 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
42
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
43
Taxes and hours worked 2004
26
Hours worked per week
USA
Japan
24
22
Spain
Germany
20
Italy
18
France
16
20%
25%
30%
35%
40%
45%
50%
Effective tax on labor income
Sources:
Taxes: McDaniel 2007, Hours worked: GGDC and OECD
55%
60%
44
Taxation on LRAS
Price
level
LRAS’
LRAS
Yp’
Yp
Real
GDP
Increasing income tax rates leads to a decrease in potential GDP
45
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 Money
Money 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 Money
There are two official measures of the U.S.
money supply
1. M1 = Currency + checking deposits +
travelers checks
2. 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
51
Example
Cascade Bank
Assets
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 = ______
52
Example
Cascade Bank
Assets
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.
53
Deposit expansion multiplier
The 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
54
S
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
1959
Billions of Current Dollars
Combined excess reserves of U.S. Banks
1800
1600
1400
1200
1000
800
600
400
200
0
55
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 GDP
PY: Nominal GDP
Equation of Exchange is an identity, it always holds
56
Tools of Monetary Policy
How does the Federal Reserve control the money
supply?
Federal Reserve tools:
– The reserve requirement
– Discount rate/discount loans
– Open market operations
57
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
58
Example
Cascade Bank
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
59
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
Cascade Bank
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
total after discount loan
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
61
reserves ___________
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
62
Example
Cascade Bank
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
total after open market purchase
total 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 purchase
Recalculate excess reserves ______
Calculate the maximum possible expansion of the money supply if Cascade loans out excess
63
reserves ___________
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
64
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
65
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 GDP
PY: Nominal GDP
Equation of Exchange is an identity, it always holds
66
Quantity Theory
Assume velocity is constant.
In the long-run, a change in M only influences price
level
MV = PY
P
In the short-run, changes in the money supply
influences Nominal GDP ?
MV = PY
67
Money Demand
Why 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
The Money Market
interest
rate
Md
Quantity
of Money
69
Money supply
Suppose 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
interest
rate
Ms
i*
Md
Quantity
of Money
71
The Money Market
interest
rate
Ms
i
i’
Md
Quantity
of Money
72
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
73
Monetary expansion – best case
interest
rate
Ms
LRAS
Price
level
SAS
i
i’
Md
AD
Quantity
of Money
Y
Yp
Real
GDP
74
Short-run and long-run
Monetary policy can be used to influence AD
• Short-run
– Influence price level and real GDP
• Long-run
– Influence price-level only - inflation
75
Activists and non-activists
Activists:
– 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
76
Recession
SAS
Price
level
AD
Y’
Yp
Real
GDP
Result: higher price level - inflation
77
Recap - activists
Active 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
78
Recap – non-activist
Little 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
79