Macro Mid Term 3
Appreciating
(or "strengthening") - an increase in the value of a currency relative to other currencies EXAMPLE $1 = €1 → $1 = €1.10 means that the dollar has appreciated relative to the euro. -One dollar can now buy €1.10, so that the dollar is more valuable. -Note: the euro has depreciated relative to the dollar
Depreciating
(or "weakening") - a decrease in the value of a currency relative to other currencies Example $1 = €1 → $1 = €0.90 means that the dollar has depreciated relative to the euro. - One dollar can now buy only €0.90, so that the dollar is less valuable. -Note: the euro has appreciated relative to the dolla
Strengthening and Weakening Currency
-A stronger currency exports more expensive / imports less expensive -A weaker currency exports less expensive / imports more expensive -A weak currency can spur exports and economic growth
to default on a debt
-Failure to pay debt
Budget Deficits and Exchange Rates
-Imagine that the U.S. government increases its borrowing and the funds come from selling U.S. government bonds to European financial investors. - Those European investors will need more U.S. dollars in Forex markets to buy the bonds, causing the demand for U.S. dollars to shift to the right.
Types of investments that require exchanging currency
1)Foreign direct investment (FDI) 2)Portfolio investment
When governments borrow more (higher G-T), there are 3 possible sources of these funds:
1)households might save more (higher S) 2)private firms might invest (borrow) less (lower I) 3)more foreign financial investors (higher M-X)
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Reasons a government or central bank will be concerned about exchange rates:
>Trends in the exchange rate will affect aggregate demand -Strong currency ->more exports, less imports ->less AD -Weak currency ->less exports, more imports ->more AD >Large short-run fluctuations in the exchange rate can: -Produce an unstable business climate -Cause problems in the banking sector -Leaves banks vulnerable to sudden depreciation of their home currency
surplus
A situation in which quantity supplied is greater than quantity demanded
If the theory of Ricardian equivalence held completely true, then...
Any change in budget deficits would be completely offset by a corresponding change in private saving. Changes in government borrowing would have no effect at all on either physical capital investment or trade balances. Also implies countercyclical fiscal policy could have limited impact if private consumption is completely crowded out. Thinking: government spends more then fiscal policy people will also spend more, if Ricardian true then this wouldn't happen bc they would be saving Reality, private sector only sometimes and partially adjusts its savings behavior to offset government budget deficits and surpluses.
Government Budgets
Budget deficit, Budget surplus, Balanced budget
If a government decides to finance an investment in public physical capital by borrowing (e.g., deficit spending), it may be at the cost of crowding out investment in private physical capital.
But could still be more productive investment to society than the private investment crowded out
Sovereign debt
Debt of a country's govt. Sovgn debt rating depends on govt's willingness and ability to repay debt.
Public investment in physical capital can increase the economy's output and productivity.
Examples of public physical capital: • Transportation (roads, bridges, airports) • Electricity plants and grids • Water supply and sewers • Schools and hospitals • Telecommunication facilities
However, government spending can also encourage certain elements of long-term growth.
Examples: spending on roads or water systems, on education, or on research and development that creates new technology.
Have Federal Tax Revenues Been Growing?
Federal tax revenues have been about 17-20% of GDP during most periods in recent decades.
Fiscal vs. Monetary Policy
Fiscal: gov't decisions about taxation and spending Monetary: decisions about printing/circulating money and interest rates, used to control inflation The 2 main tools available for a gov't to manage an economy and to interfere with domestic economy Ex: EU, the member states have individual fiscal policies but many of them have a common monetary policy because they share the Euro currency.
Fiscal Policy
Government policy that attempts to manage the economy by controlling taxing and spending.
monetary policy
Government policy that attempts to manage the economy by controlling the money supply and thus interest rates.
Forex market is the largest market in the world economy.
Groups that participate in forex markets: • International firms/corporations • Demand foreign currency to pay costs (e.g., workers) • Supply foreign currency to convert sales revenue back to home currency
Supply, Demand, and the Exchange Rate
Higher exchange rate -> more people willing to supply dollars Higher exchange rate -> less people demanding dollars
When government runs a budget deficit, I might think...
I'll need to pay higher taxes later Might also push up interest rates ● ->increase my current saving
When government runs a budget surplus, I might think...
I'll need to pay less taxes later Might also push down interest rates ● ->decreasemycurrentsaving
In 2021, the Canadian Dollar appreciated relative to the U.S. Dollar. Which of the following actors benefit and which are hurt from this movement in the exchange rate? I. A U.S. firm exporting goods to CanadaII. A Canadian tourist visiting the USIII. U.S. companies that previously invested in Foreign Direct Investment in CanadaIV. A U.S. tourist visiting Canada
I. Benefit, II. Benefit, III. Benefit, IV. Hurt
Relative Inflation
If a country experiences a relatively high inflation rate compared with other economies: • then the buying power of its currency is eroding • will tend to discourage anyone from wanting to acquire or to hold the currency
How can we interpret the $4 million value associated with the Loans assets?
If the bank were to sell the loans in the secondary loan market, other financial institutions would be willing to pay $4 million for them
A Portfolio Investor Trying to Benefit from Exchange Rate Movements
Important implication: expectations of the future value of a currency can drive present demand and supply of that currency in foreign exchange markets. EXAMPLE Suppose today's dollar-euro exchange is $1 per euro - If I expect the exchange rate next month will be $1.10 per euro... - Buy 100 euros today for $100 - Sell my 100 euros next month for $110 - $10 profit!!
Fighting Inflation with Fiscal Contraction
In inflationary booms, the Keynesian policy response would be fiscal contraction (contractionary fiscal policy) to shift AD left and close the inflationary gap
Fighting Recession with Fiscal Stimulus
In recessions, the Keynesian policy response would be fiscal stimulus (expansionary fiscal policy) to shift AD right and close the recessionary gap
2018 US Tax Brackets:
Income bracket (Single) Tax rate $0 - $9,525 - 10% $9,526 - $38,700. - 12% $38,701 - $82,500. - 22% $82,501 - $157,500. - 24% $157,501 - $200,000 - 32% $200,001 - $500,000. - 35% $500,001+ - 37%
If the investment is financed with higher taxes or lower government spending in other areas, it may not be directly crowding out private investment.
Indirectly however, higher household taxes could cut down on the level of private savings available.
Long and Variable Time Lags
It can take time to enact fiscal policy.
● Trade deficits imply a net inflow of foreign financial capital
Likewise, a trade surplus = international lending (outflow of financial capital) ● So, one way to fund an increase in the government deficit is an increase in the trade deficit
Eurozone
Monetary union of 19 countries that have adopted the euro• European Central Bank controls money supply, so each country has very limited control over monetary policy
If pegs eliminate exchange rate fluctuations, why doesn't everybody use them? Pegging trade off/neg
Money supply must be used to maintain exchange rate ● Monetary policy no longer focused only on unemployment and inflation ● Defending an exchange rate takes foreign currency reserves (e.g., US dollars), which can run out ● Can lead to speculative attacks that the peg will fail to hold and huge outflows of international capital ● Some countries have tried to limit capital flows, but very difficult in practice can't use monetary policy or use that money for something else(unemployment & inflation) can't have 3 things at once
Cross-Country Rates of Return
Motivation for investment, is to earn a return. -If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. -Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. -Changes in the expected rate of return will shift demand and supply for a currency.
Government Spending and Taxation
Net interest, Health care(medicaid), social security, National defense, All other spending)
Taxes collected by the Federal Government
Personal Income Taxes, Payroll Taxes, Corporate, Excise tax, Estate and gift tax
Tax Features
Proportional tax, Progressive tax, Regressive tax
Private savings + Inflow of foreign savings = Private investment + Gov't deficit
S + (M - X) = I + (G - T)+
The underpinnings of economic growth are investments in physical capital, human capital, and technology.
Set in an economic environment where firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. ● Government borrowing can reduce the financial capital available for private firms to invest.
The national saving and investment identity always holds:
Supply of financial capital = Demand for financial capital the amount saved in an economy will be the amount invested in new physical machinery, new inventories, and the like. ; public saving and private saving.
ex)
The U.S. budget deficit rises, and foreign financial investment provides the source of funds for the deficit. This causes a stronger exchange rate. Makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results.
The U.S. Debt
The U.S. has the largest debt in the world, should we be worried? ● The U.S. government is in the privileged position of being able to borrow in its home currency. ● This means the U.S. should never be forced to default ● Could chose to default (e.g., not raise the debt ceiling) ● The interest rate on U.S. debt is also extremely low ● But some economists still argue the U.S. should be concerned with debt because: ● Government borrowing and interest payments will likely increase with the aging U.S. population which could pull resources away from investments in human/physical capital ● Interest rates may eventually rise, making borrowing and repayment more painful ● Just printing money to pay off debt could have serious inflationary consequences
Exchange Rates
The exchange rate is a price -It may be the price of one currency in units of another, but it is still a price -And people buy and sell currencies just like they trade other goods and services
Ricardian equivalence
Theory that rational private households might shift their saving to offset government saving or borrowing. -Thinking:If government is spending more money then taxes will probably go up in the future so we should save more.
A series of large budget deficits over time can become a cause for concern among international investors. ● Will the country be forced to default on its debt? ● Most countries are not able to borrow funds denominated in their home currency (must borrow USD, euros, or Yen)
This could lead to: an outflow of international financial capital ->depreciating the home currency ->further reducing government's ability to repay debt ->possible default on debt• usually accompanied by falling AD and deep recessions
Wait, so why doesn't the Fed just use monetary policy to keep interest rates low and avoid crowding out?
To some extent they can... ● If the economy is in deep recession, increased fiscal deficit spending may stimulate AD without much inflationary pressure ● Fed can use expansionary monetary policy to keep interest rates low and avoid crowding out ● But if the economy is near potential output, increased fiscal deficit spending may cause large inflationary pressure ● Fed may use contractionary monetary policy to deal with inflation, further increasing interest rates and crowding out ● In short, crowding out tends be less of a concern in recession but a larger concern in booms
PPP exchange rate has two functions:
Used for international comparison of GDP and other economic statistics • better sense of living standard differences than actual exchange rates • Can use for long-run predictions of exchange rate movements • actual exchanges rates will often get closer to PPP over time
Merged currency
When a nation chooses to use another nation's currency .• Eliminates foreign exchange risk. • A nation has completely given up control of domestic monetary policy.
Floating exchange rate
a country lets the Forex market determine its currency's value. • The U.S. dollar uses a floating exchange rate, as do the currencies of about 40% of the countries in the world economy. • The major concern with this policy is that exchange rates can move a great deal in a short time.
Individual income tax
a tax based on a person's earnings
Payroll tax
a tax based on the pay received from employers. • These taxes provide funds for Social Security and Medicare.
corporate income tax
a tax imposed on corporate profits.
Regressive tax
a tax in which people with higher incomes pay a smaller share of their income in tax. - Taxes on tobacco, gasoline, and alcohol - Sales tax if you're rich you pay less regressive tax
Estate and gift tax
a tax on people who pass assets to the next generation - either after death or during life in the form of gifts.
Excise tax
a tax on the production or sale of a good a tax on a specific good, like on gasoline, tobacco, and alcohol.
Progressive tax
a tax that collects a greater share of income from those with high incomes than from those with lower incomes. • What the U.S. income tax is. if you're rich you pay more taxes
Proportional tax
a tax that is a flat percentage of income earned, regardless of level of income
Soft peg
an exchange rate system that is fixed but that allows some fluctuation within a set range or that is periodically adjusted to reduce changes in the real exchange rate
Portfolio investment
an investment in another country that is purely financial and does not involve any management responsibility. ex- US investor buys UK government bonds• Speculative portfolio investments - betting an exchange rate will move in a certain direction (<10% of ownership, not managing)
Dollarize
another country that uses the U.S. dollar as its currency• E.g., Ecuador, Zimbabwe, Marshal Islands, Panama
if debt is 100% it means
company has more debt than asset
an increase in deficit spending by the government can raise interest rates bc there is a higher demand for money(pushes interest up), can lead to:
crowd out private investment Studies have suggested that an increase of 1% in the budget deficit will lead to a rise in interest rates of between 0.5 and 1.0%.
Contractionary fiscal policy
fiscal policy that decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. ● Fiscal Contraction
Expansionary fiscal policy
fiscal policy that increases the level of aggregate demand, either through increases in government spending or cuts in taxes. ● Fiscal Stimulus
Crowding out
occurs when a government deficit drives up the interest rate and leads to reduced investment spending
Automatic stabilizers
tax and spending rules that have the effect of slowing down the rate of decrease in aggregate demand when the economy slows down and restraining aggregate demand when the economy speeds up, without any additional change in legislation. EX) during recessions:• Unemployment benefit payments increase• Welfare/food stamp payments increase• Income tax revenues fall
standardized employment budget
the budget deficit or surplus adjusted for what it would have been if the economy were producing at potential GDP .● Effectively eliminates the impact of automatic stabilizers ● Estimated by the Congressional Budget Office (CBO)
Foreign direct investment (FDI)
the buying of permanent property and businesses in foreign nations (>10% of business/big ownership)
Annual budget deficit (or surplus)
the difference between the tax revenue collected and spending over a fiscal year. • Fiscal year starts October 1 and ends September 30 of the next year.
Purchasing power parity (PPP)
the exchange rate that equalizes the prices of internationally traded goods across countries. For example: the price of an apple (after exchanging currency) should (in theory) cost the same in the U.S. and Mexico, Otherwise, could buy apples in Mexico and sell in U.S. at a profit (called arbitrage)
Discretionary fiscal policy
the government passes a new law that explicitly changes overall tax or spending levels with the intent of influencing the level of overall economic activity.• The 2009 stimulus package is an example.
Foreign exchange market
the market in which people use one currency to buy another currency.(biggest market in world)
Marginal tax rate
the tax rate an individual would pay on one additional dollar of income; the tax percentage on the last dollar earned.
Implementation lag
the time it takes for the funds relating to fiscal policy to be dispersed to the appropriate agencies to implement the programs.
Recognition lag
the time it takes to determine that a recession has occurred
Legislative lag
the time it takes to get a fiscal policy bill passed
National debt
the total accumulated amount the government has borrowed, over time, and not yet paid back. • The sum of all past deficits and surpluses.• The dollar value of all the outstanding Treasury bonds on which the federal government owes money.
Hedge
using a financial transaction as protection against risk. - Example: guaranteeing a certain exchange rate in the future
Balanced budget
when government spending and taxes are equal.
Budget deficit
when the federal government spends more money than it receives in taxes in a given year.- refers to how much the government has borrowed in one particular year. The deficit is not the debt.
Budget surplus
when the government receives more money in taxes than it spends in a year
Fiscal Policy and Interest Rates
• Expansionary fiscal policy shifts AD right but also increases demand for money •-> shifts money demand curve to the right •-> interest rate rises •->crowds out consumer and business borrowing and spending (shifts AD somewhat back to the left)
The revenue sources for state and local governments are:
• sales taxes • property taxes • revenue passed along from the federal government • personal and corporate income taxes • a variety of fees and charges
Comparison of Actual Budget Deficits with the Standardized Employment Deficit
● Automatic stabilizers account for some of the deficit, but not a whole lot ● Historically, they have been estimated to offset about 10% of any initial fall in output - so not huge, but still helpful during a recession
What shifts the supply and demand curves in the Forex market?
● Expectations about future exchange rates ● Cross-country differences in rates of return ● Relative inflation
Practical Problems with Discretionary Fiscal Policy
● Fiscal policy and monetary policy are interconnected. ● Crowding out - where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.
The Question of a Balanced Budget
● In the short term, economists would expect budget deficits and surpluses to fluctuate up and down with the economy and automatic stabilizers. • Recessions ->larger deficits or smaller surpluses • Economic booms ->smaller deficits or larger surpluses. • Requiring a balanced budget every year makes little sense from an economic policy perspective ● Even in the long-term, running large budget deficits, through long-term investments in human capital and physical infrastructure could build the country's long-term productivity. • This could not be done with a required balanced budget.
Is the Federal Government Growing?
● Maybe a little, but federal spending has been about 18% to 22% of GDP for a while ● Though the categories of spending has shifted some
Political Realities and Fiscal Policy
● Political realities can also make fiscal policy difficult to implement ● Some politicians feel we should tighten fiscal spending when in a downturn and lower taxes or increase spending in a boom ● Exact opposite of countercyclical fiscal policy!! ● It is also hard politically to reverse spending during booms to curb inflation or run-down national debt
Budget Deficits, Exchange Rates, and Trade Deficits
● So, exchange rates can also help to explain why budget deficits are linked to trade deficits. ● A budget deficit can result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.
In order to avoid fluctuations in exchange rates many countries peg their currencies
● Soft peg - an exchange rate policy in which the government usually allows the market to set the exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene. ● Hard peg - an exchange rate policy in which the central bank sets a fixed and unchanging value for the exchange rate.
It is hard to quantify how much government investment in physical capital will benefit the economy, because government responds to political and economic incentives.
● Spending could be inefficient (e.g., driven by political factors) ● But these projects are generally too costly for private companies and often have massive positive externalities to society
What about State and Local Spending?
● State and local spending ● is less than federal but still significant ● has increased somewhat over the past decades ● biggest spending category is public education
U.S. Budget Deficits and Private Savings
● There is no clear strong correlation between budget deficits and private savings ● Studies have estimated that, on average, when government borrowing increases by $1, private savings rise by about 30 cents
Trade Deficit = International Borrowing
● Trade deficit: ● Value of imports > value of exports ● This requires domestic residents to borrow the amount of the trade deficits from foreign residents ● Suppose there are only two countries, Anne and Bob. Anne's exports to Bob equal $100 and Anne's imports from Bob equal $125. This is possible only if Anne borrows $25 from Bob.
