Macroeconomics Final

Link between Fiscal and Monetary Policy

When public debt is growing faster than GDP, then the government can only do a few things: 1. Contractionary fiscal policy: Cut G (not politically popular, could cause recession) or increase T (not politically popular, could cause recession) 2. Make the Central Bank less independent: force the Central Bank to buy public debt with their reserve and hence increase B and, in turn, M. The increase in M causes the increase in P. 3. Competitive devaluations: money printing to devalue domestic currency make experts more competitive so that GDP grows faster.

The Investment Demand Curve and its negative relationship with r

When the benefits of increasing capital are greater than the costs (MPK>r), firms will invest more. - the lower the interest rate, the more capital a firm will want. vice versa, the higher the interest rate the higher is the cost of acquiring capital so the less investment - there is a negative relationship between investment (I) and the real interest rate (r) - this gives rise to the Investment Demand curve often also called the Demand for Loanable Funds in the financial market - in this class, borrowing rates = lending rates = r

Budget Debt (Bt)

When the budget deficit accumulates year after year without being repaid the government accumulates a budget debt. Let the budget debt in period t be denoted by Bt, and recall that the nominal interest rate is simply denoted by i = r + π then: Bt = DEt + (1 + i)∗Bt-1 or Bt = G+SS+u∗(Yn−Y)−τ∗Y + (1 +r+π)∗Bt−1 - this says that the current level of debt is determined by the current actual primary deficit plus the outstanding debt (Bt-1) on which interest needs to be paid - we are assuming that the nominal interest rate is fixed over time even though this is not necessarily the case in reality

The Output Gap

When the current level of output is not on target (i.e. at its natural rate) then we have a deviation called the output gap - Output Gap = Y - Yn The output the economy would achieve at the natural rate of unemployment is - natural rate of output (Yn) = A∗ F(Ln, K,H,N) - fiscal policy can be thought as the manipulation of G and T to induce output gap = 0 --> Y = Yn

Fiscal policy as an automatic stabilizer

Why in practice do we get countercyclical deficits? Welfare payments, Unemployment insurance, and Tax system dampen the effects of consumption over the business cycle - T goes up when times are good - G and Tr go up when times are bad (welfare payments especially) We refer to such policies that dampen consumption as automatic stabilizers - Given the presence of automatic stabilizers and potentially proactive governmental fiscal policies, cyclical deficits seem to be an inherent characteristic of our economy

Net exports (NX)

X - M = value of the exported goods and services - value of the imported goods and services

Productivity

a country's standard of living depends on its ability to produce goods and services - when productivity is high and grows rapidly, so do living standards - living standards are measured at each point in time by Y/Pop. - L = number of workers, L is a subset of labor force, which is a subset of total population - when the workers of a nation are very productive, real GDP is large and incomes are high - high workers' productivity = higher wage = higher labor income = higher RGDP - (average) labor productivity = the average quantity of goods and services produced per unit of labor input - Y = RGDP = output produced - L = number of workers or hours worked = quantity of labor - Y/L = (average labor) productivity Example: 1. Workland has a population of 10k, of whom 7k work 8 hrs a day to produce a total of 224k final goods. Laborland has a population of 5k, of whom 4k work 12 hrs a day to produce a total of 120k final goods. --> Workland productivity = Y/L --> 224000/7000 = 32 Laborland productivity = 120000/4000 = 30 --> Workland RGDP per person = 224000/10000 = 22.4 ---> Laborland RGDP per person = 24 2. Suppose that Chile total annual output is worth $600 million and people work 70 million hours. In Argentina, total annual output is worth $450 million and people work 40 million hours. Productivity is higher in Argentina. Most variation in the standard of living across countries is due to differences in productivity.

Consumer Price Index (CPI)

a measure of the average change over time in the prices paid by urban consumers for a typical market basket of consumer goods and services - based on expenditures of almost all residents of metro areas, including professionals, the self-employed, the poor, unemployed, retired, as well as urban wage earners and clerical workers. - no included: spending patterns of rural areas, farm families, people in Armed Forces, and those in institutions Biases: 1. substitution bias 2. fails to introduce new goods 3. unmeasured quality change 4. outlet bias Converting dollar figures across time: CPInew/CPIold = Amountnew/Amountold Correcting real variables for inflation: real waget = 100 x (nominal waget/CPIt) - If the real variable is expressed in rates, typically one can correct for inflation by subtracting the inflation rate: real interest rate t = nominal interest rate t - inflation t How to calculate: 1. fix the basket 2. find the prices 3. compute the basket cost (BK) 4. choose a base period (BP) 5. compute the index according to the following formula: (CPIt = 100 x (BKt/BKbp) Example: Suppose the CPI for 2010 is not necessarily 233.2. Then Megan's 2010 salary represents more purchasing power than her 2008 salary as long as the CPI for 2010 is less than 240. (Salaryold/CPIold) = (Salarynew/CPInew)

Money

a non interest bearing asset that is widely used and accepted as a mean of payment - without money, trade would require barter, the exchange of one good or service for another - every transaction would require a double coincidence of wants, the unlikely occurrence that two people have a good the other wants. - most people would have to spend time searching for others to trade with a huge waste of resources. - this searching is unnecessary with money, the set of assets that people regularly use to buy goods & services from other people - that's why some economists believe that money does affect Y in the short run --> it facilitates C Money has 4 functions 1. Medium of exchange: an item buyers give to sellers when they want to purchase goods & services (i.e. you use money to buy stuff). A medium of exchange is anything that is readily acceptable as payment. 2. Unit of account: the yardstick people use to post prices and record debts. Key is the fact that you can use money as a numeraire good (i.e. you can give a price for all goods and services in terms of money) 3. Store of value: an item people can use to transfer purchasing power from the present to the future. You can store wealth in money. 4. Money provides liquidity services: the easy with which an asset can be converted into the economy's medium of exchange. Money allows a person to buy (or sell) on a short notice without a penalty. If you own an asset such as a bond, a stock or a house you know that money is more liquid. 2 Kinds of Money 1. Commodity money: takes the form of a commodity wiwth intrinsic value (i.e. the commodity would have value even if it weren't being used as money) 2. Fiat money: money without intrinsic value, used as money because of government decree (i.e. Fiat money is worthless except as mean of payment)

Asset

a piece of capital that is used to produce a flow of housing services

Price index

a weighted average of relative prices for a given class of goods and services in a given region, during a given interval of time - GDP Deflator (GDPD) - Consumer Price Index (CPI) - Personal Consumption Expenditures Deflator (PCED) Example: On its website, your bank posts the interest rates it is paying on savings accounts. Those posted rates and a price index are both nominal variables.

Production Function

an equation that describes the mathematical relationship between output and inputs (or factor of productions) - Y = A x F(K,L,H,N) - at least one (typically more) input is essential because we can't create something out of nothing - F(*) is the production function that shows how inputs are combined to produce output - the more the inputs we put in, the more the output we obtain - K = physical capital = the stock of equipment, tools, machines and structures used to produce goods and services - L = labor (affects both the numerator and the denominator of productivity) - H = h x L = human capital = the knowledge and skills workers acquire through education, training, and experience. h is the average efficiency of workers. - N = natural resources = the inputs into production that nature provides. These resources can be renewable or not.

The income approach (GDI)

approach to measuring GDP - it adds together all the income that is generated from and in the production process - according to the circular flow diagram, all the expenditures in the economy go eventually to pay for the factors of production - households and firms will receives these expenditures in the form of wages, profits, interest, and rent at some point - GDI = GDP = (wages = labor income) + (rent + profits + interest = capital income)

The expenditure approach (GDP)

approach to measuring GDP - it adds together the spending on goods and services of the different agents of the economy coming from households, firms, the government and foreigners Y = C + I + G - NX

The production/value added approach (VA)

approach to measuring GDP - it adds together the value of production in all different sectors and industries in the economy - value added (VA) = the increase in the value of goods/services as a result of the production process - if we keep summing the VA coming from all firms, industries of every sector at every stage of production, we then obtain the definition of GDP itself - VA = value of final goods and services sold - value of intermediate goods and services bought

Wage rigidities

arises because wages are sometimes above the market clearing level w*, - motivated by the fact that unemployment is being caused by the inability of employers to offer or employees to accept wages below a certain rigid level - even though if they had been able to do so, some of the workers would accept this employment opportunity

Total Factor Productivity (TFP)

catch-all term for anything that affects output other than K,L,H,N - society's understanding of the best ways to produce goods and services. it is not only tech progress in terms of faster computer, higher-definition TV, etc. more broadly refers to the knowledge that allows producers to transform inputs into output - improvements in tech (higher A), allow more output Y to be produced from any given combination of inputs - A = Y/ (F(K,L,H,N)) = TFP

Labor demand

comes from firms that hire workers for production - in a perfectly competitive labor market, optimizing firms will pay a marginal worker the value of the worker's marginal product = real wage - the value of the marginal product of the worker declines with the total number of workers at the firms, so labor demand is downward sloping real wage (w) = a - b x Ld (# of workers/hours of work needed at firm) Example: Since government spending increases employment by shifting the labor demand curve to the right, is it always a good idea for the government to increase government spending? No. 1. The presence of long and variable lags associated with government expenditures suggest that their use to adjust labor demand with precision will be difficult. 2. Continual increases in government expenditures may result in projects that are not socially desirable. 3. Continual increases in government expenditures will soak up resources that would otherwise be used by households and firms.

Personal Consumption Expenditure (C)

comes from households

Inventories

components that will be used in the future for producing other goods or produced goods held in storage in anticipation of later sales - goods held in inventories are counted for the year produced, not the year sold

Purchasing Power Parity (PPP)

convert GDP of the country you are interested in by using the prices of goods and services in that country relative to the prices of the same goods and services in the US

Personal Consumption Expenditures Deflator (PCED)

does the same thing as the GDPD but only uses consumption goods rather than the price of all the goods and services in the domestic economy PCEDt = 100 x (value of consumption component of NGDPt/value of consumption component of RGDPt)

Expenditure

expenditure = income

Optimizing Firms

firms maximize profits. they set the marginal benefit of purchasing capital equal to the marginal cost of purchasing capital the marginal benefits of purchasing capital = MPK - those are decreasing in K (because of the law of diminishing returns) the marginal cost associated with purchasing capital = r - we ignore the maintenance costs of capital

Government Spending (G)

government spending both at federal/state/local level, it does not include transfer payments such as social security and unemployment insurance benefits

Deflation

if the growth rates of prices is negative, we have deflation

Gross National Product

if you are interested in studying what is the production of the citizens of a certain country rather than the production of that country, then you are interested in measuring GNP and not GDP - GNP of country A = GDP of country A + income earned by its citizens located abroad - income of non-residents located in that country - production by an enterprise located outside the country, but owned by one of its citizens, counts as part of its GNP but not its GDP

The Discount Rate

interest rate on direct loans from the Fed to private bans - the Fed sets the discount rate - changing the discount rate affects the money supply because it induces banks to hold less (or more) "excess reserves" hence changing the discrepancy between rr and rr* and thus potentially also affecting the money multiplier - the Fed uses discount lending to provide extra liquidity when financial institutions are in trouble - indeed , the Fed is a "lender of last resort" and it used to be the case that it didn't make discount loans to banks on demand. the Fed is not inn the business of giving banks cheap money to subsidize their profits. at least this used to be the case before the crisis

Consumer goods and services

no investment goods. no stocks, bonds, real estate, and life insurance. These items relate to savings and not to day-to-day consumption expenses.

Efficiency wages

paying wages above the market value to increase worker productivity - in a purely competitive labor market, paying wages above the market wage would be consistent with profit maximization 1. improve workers' health 2. decrease workers' turnover 3. improve workers' quality 4. increase workers' effort - they can also create a form of wage rigidity, though. contributes to unemployment.

GDP Deflator

price index that can be used to compute inflation (Π) - GDPDt= (100∗NGDPt/RGDPt) Example: In 2011, this country's GDPD was --> NGDP = 1380 RGDP = 800 --> 1380/800 x 100 = 172.5

Production

production = expenditure

Inflation (Π)

represents the growth rate of the national price level over time inflation rate according to GDPD: - treatment of capital/investment goods - Πt = 100 x (GDPDt - GDPDt-1)/GDPDt-1 inflation rate according to the CPI: - treatment of imported goods - Πt = 100 x (CPIt - CPIt-1)/CPIt-1 inflation rate according to PCED: - 100 x (PCEDt - PCEDt-1/PCEDt-1) Example: 1. Wealth is redistributed from creditors to debtors when inflation was expected to be low and it turns out to be high. 2. (172.5 - 128.6)/128.6 x 100 = 34.1

Gross private domestic investment (I)

spending on goods that will be used in the future to produce more goods, comes mainly from firms (but not only)

Present value of a future sum (PV)

the amount that would be needed today to yield that future sum at prevailing interest rate Example: You want to have $100000 in five years. If the interest rate is 8 percent, about how much do you need to have today? FV = PV x (1 + r/m)^(m∗T) --> 100000 = PV x (1 + .08/1)^(5) --> PV = 68058.32

The future value of a current sum (FV)

the amount the current sum will be worth at a given future date, when allowed to earn interest at the prevailing rate

K

the capital stock in our production function - the sum of all past investment decisions (less any depreciation) - stock variable (measured at a point in time) - capital stock next period is a function of how much we invest this period. if we invest more today, the capital stock tomorrow will increase - equation suggests that capital stock next period is affected by the undepreciated capital stock of this period - δ is the depreciation rate Kt+1 = It + (1-δ)Kt

Debt to GDP ratio

the debt to GDP ratio gives us a sense of whether the government of a country is going to be able to repay its debt or not. Let the GDP grow at a given rate o: - Yt = (1 + o)∗ Yt-1 Then the expression for the budget debt as a fraction of GDP is simply: (Bt/Yt) = ((DEt/Yt) + (1+i)∗Bt-1)/Yt (Bt/Yt) = ((DEt/Yt) + ((1+i)∗Bt-1)/(1+o)∗Yt-1)

Money Demand function

the demand for nominal money (balances) is a function of P, Y, and i: Md = P∗ Ld(Y,i) = P x Ld(Y,r + π) Where: - Md = demand for nominal money balances - P = aggregate price level (CPI or GDP deflator) - Ld = demand for liquidity function (liquidity preferences) - Y = RGDP - i = nominal interest rate on non-monetary assets = real interest rate + inflation

Budget Deficits and Surpluses

the economy is running an actual primary budget surplus when we have an excess of tax revenue over government spending T > G + Tr - in this case public savings are positive: (Spub > 0) T < G + Tr - in this case public savings are negative: (Spub < 0)

(physical) Capital Share

the fraction of national income that goes to capital income - capital income/national income - the % of output that goes back to capital = capital share is (r∗K)/Y = α

Labor Share

the fraction of national income that goes to labor income - labor income/national income - the % of output that goes back to labor = labor share is (w∗L)/Y = 1 - α

Disposable Income (Yd)

the income left over after paying taxes (T) and receiving welfare transfers such as social security and unemployment benefits (Tr) - disposable income can either be privately saved (Spr) or consumed (C) - Yd = C + Spr - Yd = Y - T + Tr

Gross Domestic Product (GDP)

the market value of all final goods and services produced within a country in a given period of time - production within a country's borders, but by an enterprise owned by somebody outside the country, counts as part of its GDP but not its GNP

Nominal exchange rate (e)

the number of units of foreign currency that can be purchased with one unit of domestic currency - convert all GDPs of all countries into dollars using the nominal exchange rates to make comparisons - however, 1. prices of goods and services can vary across economies (usually lower in lower income countries) 2. exchange rates fluctuate throughout the year due to reasons beyond price changes - (units of foreign currency/1 unit of domestic currency) Example: A ton of scrap iron sells for $150 in the US and 1400 yuan in China. The nominal exchange is 6.7 yuan per dollar. --> 1400/150 > 6.7 so A profit could be made by buying scrap iron in the US and selling it in China. This would tend to drive down the price of scrap iron.

Private savings (Spr)

the part of income that is NOT used for consumption or for the paying of taxes (T) by the private sector - Spr = (Y - T + Tr = Yd) - C Personal Savings Rate: Spr = (Spr/Yd)

Public savings (Spub)

the public sector can contribute to (dis)savings. - a tax revenue less the government spending and transfers Spub = T - (G +Tr) or T - G - Tr

Money supply (M)

the quantity of money available in the economy The distinction between monetary and non-monetary assets is controversial and a bit blurred nowadays. What assets should be considered part of the money supply? Two candidates: 1. Currency (C): the paper bills and coins in the hands of the (non-bank) public 2. Demand Deposits (D): balances in bank accounts that depositors can access on demand --> with a bank account you can make a withdrawal or write a check - M = C + D Example: If people decide to hold more currency relative to deposits, the money supply falls. The larger the reserve ratio is, the less the money supply falls. (cr+1/cr+rr)B = M

Real exchange rate (E)

the rate at which the goods and services of one country trade for the goods and services of another Example: which of the following would both raise the US exchange rate? capital flight from other countries to the US occurs and US moves from budget surplus to budget deficit.

Labor supply

the schedule that represents the quantity of labor supplied for every value of the real wage by workers - derived from utility maximization of workers - when market wages are higher, it makes sense for workers to spend more time at work and less time at home - take less leisure, particularly if the worker believes that the period of higher wages is only temporary real wage (w) = c + d x Ls (# of workers/hours of work supplied)

Macroeconomics

the study of economic-wide phenomena, including inflation, unemployment, economic growth

Efficient Markets Hypothesis (EMH)

the theory that each asset price reflects all publicly available information about the value of the asset 1. Stock market is informationally efficient: each stock price reflects all available information about the value of the company 2. Stock prices follow a random walk: news about the situation of a firm cannot be predicted, so stock price movements should be impossible to predict. 3. It is impossible to systematically beat the market. By the time the news reaches you, mutual/hedge fund managers will have already acted on it.

Cyclical unemployment

unemployment that arises from a decline in economic activity from a downturn in the business cycle (recession)

NGDP

values output using current prices

RGDP

values output using prices of a base period (BP) - main indicator of the average person's standard of living: life expectancy, adult literacy, internet users - Limits of RGDP: quality of environment, leisure, nonmarket activities, income distribution

Natural rate of unemployment

what the unemployment rate would be if the economy was operating at its potential - Natural rate of unemployment = (U - Cyclically unemployed)/(LF) x 100

Financial risk (ρ)

ρ is present whenever there is some probability of earning a return on an investment that is less than the amount expected. In general, the greater the probability of a return far below that anticipated, the greater the risk. In statistical terms, you can think of ρ as variance (a measure of dispersion around the mean). The risk component embeds at least two terms: 1. Term or liquidity premium: e.g. the spread between the return of long term and short term bonds. Short term bonds are more liquid (easy to sell) than longer term bonds, so they are less risky. 2. Default or credit risk premium --> role of credit rating agencies.

Factors Affecting the Debt to GDP ratio

(Bt/Yt) = ((DEt/Yt) + ((1+i)∗Bt-1)/(1+o)∗Yt-1) - This equation is very useful and informative because it says that a country is in debt trouble (i.e. it will likely not be able to repay its debt) if: 1. deficit growth outpace GDP growth. (i.e. as a percentage of GDP, government expenditures are increasing very fast and/or taxes are declining steeply or a combination of both) 2. we are in a recession --> GDP growth is low (o is low) 3. the nominal interest rate is high <-- inflation is high

Stats for the labor market

- Adult population or working age population (AP) = people 16+ - Employed (E) = paid employees, self-employed, and unpaid workers in a family business - Unemployed (U) = people not working who have actively looked for work sometimes during previous 4 weeks (but could not find it) - Actively looking for work = activities such as contacting possible employer, having a job interview, sending out resumes, etc

Banks: how do they work?

- Bank's assets = Reserves (R) and Loans (L) (nowadays OA = purchase of other institutions, stocks, bonds, etc.) - Reserves (R) = required reserves (RR) + excess reserves (ER) - Bank's Liabilities = Deposits (D) - Own Financial Capital = banks issue their own stocks and can also receive loans themselves from other banks or the FED

Monetary Policy and Exchange Rates

- If the PPP holds, monetary policy affects nominal exchange rates. - If M increases, then P increases, in the long run, then it must also be the case that, if E = 1, and M increases, then e = Pf/P decreases. - So one important implication of PPP is that when the central bank of a country prints large quantities of money, the money of that country loses value both in terms of the goods and services it can buy (1/P, the value of money) and also in terms of the amount of other currencies it can buy (e) - It is possible in principle for countries to manage their exchange rates through monetary policy and achieve Competitive Devaluations.

Labor market

- L* = (a-c)/(b+d) - w* = (ad + bc)/(b+d)

Measure of Money Supply

- M = C + D There are many official measures of money supply, called monetary aggregates. In these notes, we will consider two that depend on how narrow is the definition for D: 1. M1: the most narrow definition, includes mainly currencies and balances held in checking accounts (= demand deposits) 2. M2: includes everything in M1 plus other "money like" components: saving deposits, small time deposits, MMMFs (money market mutual funds), MMDAs (money market deposit accounts), etc. The distinction between M1 and M2 will usually not matter when we talk about "the money supply" in this course, but it is in practice quantitatively significant.

Present Discounted Value Formula (PDVF)

- Often we think that interest compounds only once a year. This is typically not the case though. - If the interest is not compounded annually, but more often we need to use the following formula: FV = PV x (1 + r/m)^(m∗T) - FV = future value - PV = present value - r = annual (real) rate of return - m = # of time the interest rate is compounded in a year - T = # of years in our time horizon The PV formula helps us understand even better the negative slope of the Investment demand curve: as the interest raises, everything else equal, Investment decreases.

Fed's peculiarity

- The Fed receives interests on its assets (U.S. government bonds + loans to banks) - The Fed pays no (actually now a little) interest on its liabilities (currency and FF) - The Fed is highly profitable, which fosters its independence - The Fed returns its profits to the Treasury - Hence, the interest that the Treasury pays on bonds held by the Fed is not a cost for the Government: that portion of public debt is effectively monetized (pays 0 interest). This is going to be an important channel that again can help explain hyperinflation.

Price in the currency exchange market

- The price in this market is represented by the real exchange rate. - Recall that the US real exchange rate (E) measures the quantity of foreign goods nad services that trade for one unit of US goods and services. - What matters for assets exchange is the nominal exchange rate (e), not the real one (E). If E rises, we do not know whether it is due to a change in foreign/domestic prices or e. When buying assets, what individuals/firms really care about is the rate of return on domestic vs. foreign assets (r, and r*), not E. Those rates are already net of the nominal exchange rates. - E is the real value of a dollar in the market for foreign currency. - An increase in E makes US goods more expensive for foreigners, reduces foreign demand for US goods (EXP decrease) and demand for US dollars (NX decrease) - An increase in E has little effect on saving or investment, so it does not affect NCO or the supply of dollars

A Reinterpretation of the Currency Exchange Market

- This market is represented by the balance of payment identity: NX = NCO - NX = net demand of dollars --> foreigners need dollars to buy US exports. US residents need foreign currencies to buy imports - NCO = net supply of dollars --> foreigners need dollars to buy US assets, US residents need foreign currencies to buy foreign assets

Money and Inflation

- We are now going to introduce the quantity theory of money to explain why: "prices rise when the government prints too much money" - most economists believe the quantity theory is a good explanation of the long run behavior of inflation: "inflation is always and everywhere a monetary phenomenon" - data show that there is actually a long run correlation of .95 between inflation and money supply

(Expected) Interest Rate and Risk

- We know that the nominal interest rate (i) is approximately equal to the real interest rate (r) plus inflation π. In this course, π does not denote the mathematical constant, but rather inflation. - Suppose a firm thinks interest rates will be lower tomorrow. Suppose they have a project that they expect will have a high, profitable return. A forward looking firm may wait until tomorrow before they undertake the investment decision. The reason is that when tomorrow comes, borrowing will be cheaper! So, it is not only current interest rates that affect firm investment decisions, it is also their expectations about future interest rates and prices.

Trade Restrictions Consequences

- a common reason to advocate this policy of trade restriction, besides for the reduction of trade deficit (which does not occur), is that it saves jobs in the domestic industries that have difficulty competing with imports - the quota reduces imports of manufactured goods from China: US consumers buy more US manufactured goods. US manufacturing firms may hire more US workers to produce these goods. So the policy saves jobs in the manufacturing industry. - however as E rises, the demand for US exports declines. export industries will lay off workers - so the net effect of this policy on jobs is not clear at all

The Nature of Deficits

- deficits are typically countercyclical (they rise when Y falls and fall when Y rises) - even if the government has a fiscal policy (combination of G and T) that would lead to no deficits at Yn (the target level of output for the economy), deficits could still occur - the reason is simple: Y does not always equal Yn. Example: Which of the following contains a list only of things that decrease when the budget deficit of the US increases? US NX, US domestic investment, US NCO (CO - CI)

Minimum wages

- first source of wage rigidity and unemployment is the presence of a legislated price floor that prevents the market price from falling to the equilibrium price. minimum wage laws can create such a floor in the labor market - if above the equilibrium level, minimum wages prevent the quantity supplied from equaling the quantity demanded --> the market does not clear

Types of unemployment

- frictional: unemployment arising from job search, arises from people entering and leaving the labor force, from quitting jobs to find better ones, and from the process of matching workers with jobs, can also occur as a result of a layoff or termination with cause - structural: arises from a mismatch between the skills and attributes of workers and the requirements of jobs, it can be created when there are technological advances or other changes in the quantity of labor demanded/supplied in a specific industry

The Cost of Capital: the first channel

- if the real interest rate rises, borrowing is more expensive - the real interest rate represents a revenue/profit to lenders: they charge r for individuals/firms to have access to funds - this is a cost to borrowers. if a firm borrows, it has to pay the lender the interest rate for allowing it to borrow money - as the real interest rate increases, the cost to borrow increases. - firms should want to borrow less (and, as a result, invest less) in this case.

Housing in GDP

- most economists consider a house to be an asset - both consumption and investment - housing related rent enters C - when someone buys a newly constructed house to live in, she is both a producer (made an investment that will produce future housing services, housing price enters I in this case) and a consumer

Saving Supply and its positive relationship with r

- national savings are put into the "banking system" - firms looking to borrow for investment purposes, go to the "bank" - firms can only borrow what is in the "bank" The reason why National Savings constitute the Supply of Loanable Funds and have a positive relation with r is simple - recall that individuals can only consume or save (for future consumption) their disposable income - If r goes up, then the opportunity cost of consuming today increases, because by putting saving into the "bank" and accruing the higher interest rate you can buy more consumption goods tomorrow. - the market is in equilibrium when investment demand and saving supply are equalized

International Trade

- one of the most obvious reasons why countries are linked together is because of the flow of goods and services across countries. - Imports (IMP) = foreign-produced goods & services sold domestically - Exports (EXP) = domestically-produced goods & services sold abroad - Net Exports or Trade Balance (NX) = value of exports - value of imports

Cobb-Douglas production function

- one of the most used production function in economics Takes the form: Y = AK^(α)L^(1−α) Step 1: A∗(λ∗K)^(α)(λ∗L)^(1−α) Step 2: A∗(λ∗K)^α(λ∗L)^1−α =A∗λ^α∗K^α∗λ^(1−α)∗L^(1−α)=λ^(α+1−α)∗A∗K^α∗L^(1−α) Hence --> λ∗(A∗K^α∗L^(1−α)= Y) Step 3: - outcome of step 2 is in this case λ∗(A∗K^α∗L^(1−α)= Y) - outcome of λ∗Y = λ∗A∗K^α∗L^(1-α) because of the definition of Y The two expressions are then clearly identical, so we can conclude that the Cobb Douglas production function is CRS. Example: Depict this situation (i.e. moving away from the one child policy, and into the new policy) using the Solow Diagram. (a) What happens to the growth rate and to the levels of per capita variables? This is an example of a policy that changes the population growth rate n; will change the slope of "break even investment" line in the solow diagram. if we increase the population growth from a. level n1 to n2 there will be a new line for "break even investment" In the graph we will reach a new steady state where there is lower physical capital per person and output per person than before (k2<k1) (b) what happens to the growth rate of aggregate variables in the new steady state? in the long run equilibrium (steady-state), the growth rate of aggregate variables is equal to the population growth rate, so there's an increase in the growth rate of aggregate variables in this new steady state. (c) what happens during the transition from the old steady state to the new steady state? in the short run, the growth rate of the per capita variables will be negative (y and k falling). again, this growth rate approaches 0 as the economy approaches the new steady state, until, in the end, we're back to the same growth rate as before.

Percentage versus percentage point

- percentage point change = when a variable is expressed as a percentage rate, the percentage point change of that variable is simply the difference between the final and initial values - percentage change = when a variable is expressed as a percentage rate, the percentage change is the difference between the final and initial values divided by the initial value (as usual). Example: - the percentage point change = 5 - 4 = 1 - the percentage change = 100 x (5-4)/4 = 25%

Taxes

- sales and excise taxes are directly associated with the prices of specific goods and services - income and social security taxes are not directly associated with the purchase of consumer goods and services

The Cost of Capital: the second channel

- suppose now the firm has some retained earnings instead of borrowing - the firm can do two things with these retained earnings 1. it can stick it in a checking account 2. it can use it to directly fund an investment project - if they stick it in a checking account, they can earn some return on their retained earnings. - if they use it for investment, they give up the interest they could have earned. - the opportunity cost of investing is the real interest rate that they could have earned on their retained earnings

Policies and their effects on the macroeconomy: Trade Restrictions

- the immediate effect is that IMP decreases. This induces NX increase. The net demand for dollars increases (curve shifts) and hence we will observe an appreciation of the real exchange rate. - This appreciation eventually induces exports to decrease and net exports to decrease. - nothing happens to S, I, and hence to NCO. This policy only induced a shift in the equilibrium value of E. - in equilibrium, nothing happens to the value of NX

Saving Supply and Equilibrium

- the supply of loanable funds comes from national savings, mostly through banks and other financial intermediaries - in a closed economy, we must have that in the financial market: saving supply = investment demand Example: In the last few years, the US government has gone from a surplus to a deficit. Other things the same, this means that the supply of loanable funds shifted left.

Unemployment rate (u-rate)

- u-rate fluctuates as the overall economy fluctuates - good indicator of how healthy the labor market is - when the economy is healthy and expanding, the u-rate tends to be low - most spells of unemployment are short - most observed unemployment in US is long term - when the overall economy suffers a recession (2 consecutive quarters of negative GDP growth) the u-rate tends to rise - countercyclical variable: moves in the opposite direction of the GDP Limits of u-rate: - marginally attached workers: persons not in the labor force who want and are available for work, and who have looked for a job sometime in the prior 12 months, but were not counted as unemployed because they had not actively searched for work in the past 4 weeks - discouraged workers: persons not in the labor force who want and are available for work and who have looked for a job sometime in the past 12 months, but who did not actively look in the previous 4 weeks because they believe there are no jobs available or there are none for which they would qualify - does not distinguish between full-time and part-time work - misreporting for benefits

Unconventional Monetary Policy: Bank Runs and the central bank

- when people suspect their banks are in trouble, they may "run" to the bank to withdraw their funds, holding more currency and less deposits. - banks may make fewer loans and hold more reserves to satisfy those depositors. - if depositors really start to panic and run in masses to the banks, since R < D, banks don't have enough reserves to pay off ALL depositors at the same time, hence banks may have to close - for this reason the FED started to buy assets of commercial banks directly

What variables influence NX?

1. Consumers' preferences for foreign and domestic goods. 2. Prices of goods at home (P) and abroad (Pf) 3. Nominal exchange rates (e) at which foreign currency trades for domestic currency 4. Incomes of consumers at home and abroad 5. Transportation costs 6. Government policies toward trade

Consequences of CRS Production Function

1. Expressing productivity as a function of per capita factors - if we know that the production is CRS, we can actually choose that number λ (that in principle could be any positive number except 1) to be a very specific number. - let's set λ = 1/L. - because then, if the production function is CRS: - Y/L = A x F(K/L,L/L,H/L,N/L) = A x F(K/L,1,H/L,N/L) Y/L= A x F(K/L,H/L,N/L) - makes it clear that productivity depends on: TFP or A, the average physical capital per worker (K/L), average human capital per worker (H/L), average amount of natural resources per worker (N/L) 2. We must have diminishing returns to a particular input - if there are CRS by increasing all inputs together by a certain amount, then there must be diminishing returns by increasing each input by itself only - holding labor constant, the production function exhibits diminishing returns to capital. - holding capital constant, the production function exhibits diminishing returns to labor. 3. There is a link between CRS and Perfectly Competitive Markets - under perfect competition, the profit maximization condition for a firm is: price = MC - inputs must be paid their marginal products - w = MPL and r = MPK - economic profits are 0 in the long run - payments made to the factors of production must exactly equal total sales revenues under constant returns to scale - if we normalize prices to be 1, and assume there are only capital and labor as factors of productions, this implies that when profits are 0: ((w∗L = labor income) + (r∗K = capital income) = total capital) = (Y = total income)

Trade Surplus, Deficit, Balanced Trade

1. If NX < 0 --> Trade Deficit 2. If NX > 0 --> Trade Surplus 3. If NX = 0 --> Balanced Trade

Model and Predictions

1. M = C+ D and divide it by 2. B = C + R --> (M/B) = (C+D/C+R) = (C+D/D)/(C+R/D) = cr+1/cr+rr --> M/B = (cr+1/cr+rr) In other words, rearranging, the money supply is: M = (cr+1/cr+rr)B And (cr+1/cr+rr) is what we call the money multiplier. Note: - if rr increases above rr* then M decreases --> Role played by commercial banks is now clear! M will fall if banks start holding excess reserves (rr increases above rr*) - if cr increases then M decreases --> role played by the public is now clear! holding the base constant, the money supply, M, falls if people prefer holding cash outside of banking system (cr increases) Example: The monetary base, B, is 1500. The reserve requirement, rr, is 1/8, and the currency to deposit ratio, cr, is 1/7. 1. Find the money multiplier and money supply. Money multiplier is cr+1/cr+rr = (1/7 + 1)/(1/7 +1/8) = 64/15 --> money supply = M = (cr+1/cr + rr) x B = 64/15 x 1500 = 6400 2. Find the currency, deposits, and reserves. From currency to deposit ratio, cr, we know: cr = C/D = 1/7 --> D = 7c --> M = C + D --> M = c + 7c = 8c --> 6400 = 8c and c = 800 --> D = 7(800) = 5600 --> From reserve requirement we know that rr = R/D = 1/8 --> R = D/8 = 5600/8 = 700 3. What should the FED do in order to have a money supply of 4800? Mnew = cr+1/cr+rr x Bnew --> 4800 = 64/15 x Bnew --> Bnew = 1125 --> Bold=1500. The FED needs to sell bonds to decrease the monetary base by 1500 - 1125 = 375 4. What level of the reserve requirement should the FED set in order to have a money supply of 4800? Mnew = cr+1/cr+rrnew x B --> 4800 = (1/7 +1)/(1/7+rrnew)x (1500) --> rrnew = .2143

What are the tools the FED can use to affect Money Supply (and thereby interest rates)?

1. Open Market Operation (changes the monetary base directly_ 2. Change the Reserve Requirement (not used very much, affects the money multiplier) 3. Paying Interest on Excess Reserves (change the money multiplier) 4. Discount Rate (change the money multiplier) 5. Unconventional Monetary Policy

What variables influence NCO?

1. Real interest rates paid on foreign assets. Interpretation of this as net of nominal exchange rate is key! 2. Real interest rates paid on domestic assets. Interpretation of this as net of nominal exchange rate is key! 3. Perceived risks (economic and political) of holding foreign assets 4. Government policies affecting foreign ownership of domestic asssets

The Quantity Theory in 5 Steps

1. V is relatively stable --> gV = 0 2. So, a percentage change in M causes NGDP (P xY) to change by the same percentage according to our equation --> gM = π + gY 3. A change in M does not affect Y. Money is neutral. We are in the LR, and Y is determined by technology and the factors of production (the production function) --> gM does not --> gY 4. So, if M changes by a given percentage it must follow that P must change by the same percentage. --> gM = π 5. Conclusion: rapid money supply growth causes rapid inflation The main intuition behind the Quantity Theory is that inflation (rising P) is caused by too much money chasing too few goods --> by M rising too much relative to Y (controlling for how much M we need to use in transactions to sell Px Y, which is V) V is not always fixed in reality for all countries, V does rise with: - financial innovations - with i (the nominal interest rate)

Chain weight method

1. calculate RGDP growth for an adjacent pair of years choosing one of the years as a base year 2. calculate RGDP growth between the same pair of adjacent years using the other year as a base year 3. average these two numbers and obtain the growth rate between the two years 4. repeat those steps for every pair of adjoining years in your time series. this will give you a table of growth rates for each pair of years for the time series period you are interested in 5. find/choose/you are given a base year that you want the new chain-weighted series to be based on. for the base year, we know that NGDP = RGDP 6. obtain the RGDP for the other years in your time series just applying appropriately the growth rates you found with the procedure above.

Unions

1. unionization occurs when workers vote to have a union bargain on their behalf with their employer over wages, benefits, and working conditions 2. the process by which unions and firms agree on the terms of employment is called collective bargaining 3. a strike will be organized if the union and the firm cannot reach an agreement. a strike refers to when the union organizes a withdrawal of labor from the firm. - when unions raise the wage above equilibrium, unemployment results -> insiders vs. outsiders outcomes

Deficit Terminology

3 types of deficits: 1. Actual Primary Budget Deficit: simply the accounting figure we observe when government outlays are higher than its revenues - DE = G + (SS + u∗(Yn - Y) = Tr) - (τ∗Y= T) > 0 = G + Tr - T > 0 2. Structural Primary Budget Deficit: the deficit that would exist if the economy was at the government output target Yn (i.e. when output gap is zero --> Y = Yn): - DE* = G + SS - τ∗Yn > 0 3. Cyclical Primary Budget Deficit = Actual Primary Budget Deficit - Structural Primary Budget Deficit = DE - DE* - this occurs anytime Y does not equal Yn

Investment and the real interest rate

As interest rates increase, it is more expensive for firms to invest. Firms can obtain the funds from the financial markets to invest from 4 channels: 1. Loanable funds (i.e. borrowing from banks) 2. Retained earnings 3. Issues of stocks/bonds 4. Venture Capital (think of Shark Tank) Example: Interest rates fall and investment falls. Maybe the government repeals an investment tax credit.

Money Demand (short run)

As we learned, when agents make portfolio allocation decisions, usually 3 characteristics matter: 1. expected return of the asset 2. risk associated with the asset 3. liquidity of the asset Money is just another asset: agents need to choose how much of their wealth to keep as money. Clearly, money as an asset is the most liquid, little risky (there is inflation so the risk is not zero), but it has also the lowest return usually. Other important factors affecting the demand for money are: - income (and wealth_ - payment technologies available - overall price level

Two Identities

By definition we have that: M = C + D B = C + R - define cr = C/D to be the currency to deposit ratio. Thus cr depends on the amount of money the public wants to hold as currency vs. deposits. The public can increase or reduce cr, by withdrawing as cash or depositing currency. - Recall R/D = rr = reserves to deposits ratio. This is determined by commercial banks + regulation.

Capital Flights and Political Instability

Capital flight: a large and sudden reduction in the demand for assets located in a country - As people sell their assets and pull out their capital CO increases, foreign residents stop buying domestic assets so CI decrease. Hence, NCO increases for each value of r. The demand for LF increases. And it generates a spike in the interest rate. This can partially counteract the increase in NCO, but if the risk and fear are widespread, NCO will increase. - The increase in NCO, induces an increase in the supply of euros (everyone is dumping them) and a depreciation of the real exchange rate. - this situation can escalate really quickly in a currency crisis

Open Market Operations

Central bank purchases and sales of government securities on the open market from/to commercial banks and financial institutions - open market purchase (sale) = central bank purchases (sells) government securities. the seller (buyer) receives (uses) FF as payment - The FED does buy/sell government bonds from/to private commercial banks and these transactions are doing using the FF. Those by definition affect the reserves which in turn affect the monetary base first (recall that B = C + R) and potentially the reserve to deposit ratio and the money multiplier too as a second order effect. Example: In December 1999 people feared that there might be computer problems at banks as the century changed. Consequently, people wanted to hold relatively more in currency and relatively less in deposits. In anticipation, banks raised their reserve ratios to have enough cash on hand to meet depositors' demands. These actions by the public would reduce the multiplier. If the Fed wanted to offset the effect of this on the size of the money supply, it could have bought bonds.

Returns to scale (CRS)

Constant returns to scale (CRS): if we observe that by increasing all the inputs by λ we observe that also increases output by λ Increasing returns to scale (IRS): if increasing all the inputs by a certain amount λ (λ>1) then we observe that output increases by more than λ. Decreasing returns to scale (DRS): if increasing all the inputs by a certain amount λ (λ>1) then we observe that output increases by less that λ. 3 Steps to Check for IRS, DRS, or CRS 1. Consider first only the right-hand side of the production function and multiply each and every factors of production only by a certain number λ 2. Manipulate algebraically the expression you obtained in step 1 to factor out λ 3. Compare the outcome of step 2 with the expression obtained multiplying λ by output, Y. if you find that the two expressions λ x Y and the outcome of step 2 are exactly equal, then the production function is CRS. If not, then it is not (could be IRS or DRS according to whether the expression you got in part 2 is greater or smaller than λ x Y)

Assumptions behind Government Spending Multiplier > 1

Crucial assumptions behind this result to hold: 1. Y needs to be well below Yn. Deep recession. Because resources need to be sitting idle. And crowding out of private investment needs to be small. 2. Consumers need to be liquidity constrained: 0<b<1 3. Government spending must be NON wasteful and efficient

Balance of Payment

Definition: NX = NCO - Balance of Payments (BoP): Current account + Capital Account = 0 - Since the most important component of the current account is NX, we will make the simplifying assumption that Current account = NX. - Then it must be the case that accounting purposes, by the two definitions above: Current Account = - Capital Account --> NX = NCO

PPP implications

E = (P/Pf/e) = (P∗e/Pf) - Suppose PPP holds and the real exchange rate is equal to 1: E = 1 - Then, if we continue the example: e∗P = pF - Solving for e: e = Pf/P PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels in the countries. Hence, if the two countries have different inflation rates, then e will change over time. Example: According to the purchasing power parity, if over the course of a year the price level in the US rises more than in Japan, then which of the following falls? The U.S. nominal exchange rate, but not the US real exchange rate.

Relationship between interest rates in the financial market

E(r) = E(i) - E(π) - ρ - E(r) = expected real interest rate - E(i) = expected nominal interest rate - E(π) = expected inflation - ρ = financial risk

Market Failure

Even though a firm wishes to borrow, lenders may not allow the firm to do so. Banks are operating in environments with only partial information and this can lead to market failures. - Even if your firm wanted to invest, it may be prevented from doing so because a bank (optimally) chooses not to lend to it. Banks only have partial information and, as a result, will sometimes restrict credit to firms with worthy projects. - Sometimes, the banking system can dramatically reduce lending because they are facing uncertainty. This is called a credit crunch. In this case, interest rates are low and firms want to invest, it just so happens that there is no one who is willing to lend firms funds. Then investment will be low.

How does NCO depend on r?

Everything else the same, an increase in r makes domestic assets more attractive relative to foreign assets: - domestic residents purchase less foreign assets (hence Capital Outflow (CO) decreases) - foreign residents purchase more US assets (hence Capital Inflow (CI) rises) Bottom line: if r increases since NCO = CO - CI, NCO decreases

The Market for Loanable Funds in an Open Economy

Expenditure approach: Y = C + I + G + NX Y - C - G = I + NX - The left hand side in the expression is simply our definition of Total National Savings: S = I + NX - Using the balance of payment identity we have just seen NX = NCO S = I + . NCO

Limitations of PPP

Few reasons why exchange rates do not always adjust to equalize prices across countries: 1. Many goods cannot easily be traded and thus price differences on such goods cannot be arbitraged away. 2. Taste matters: foreign and domestic goods not perfect substitutes. 3. Tax differences across countries. 4. Market power and other frictions.

Fiscal Policy

Fiscal policy usually has 2 main objectives: 1. generate government revenues to be used for various reasons with a minimum deadweight loss (DWL) and under a set of constraints 2. use of government spending and taxes to try to stabilize the economy (moving the economy toward its targets using fiscal policy) Governments could have: - output targets - unemployment targets - price targets

Appreciation and Depreciation of a Currency

For simplicity, take the US dollar to be the domestic currency: Appreciation (or "strengthening of the dollar"): when there is an increase in the value of a currency as measured by the amount of foreign currency it can buy (e increases) - typically imports increase and exports decrease when currency appreciates (NX fall, trade deficit arises) Depreciation (or "weakening of the dollar"): when there is a decrease in the value of a currency as measured by the amount of foreign currency it can buy (e decreases) - typically imports decrease and exports increase (NX increase, trade deficit falls) A STRONG CURRENCY IS BAD FOR EXPORTERS, AND GOOD FOR IMPORTERS. THE REVERSE IS TRUE FOR A WEAK CURRENCY.

Government Spending Multiplier

GDP: Y=a+b∗(Y−τ∗Y+SS+u∗(Yn−Y))+i0−i1∗r+G Solving for Y: Y=a+b∗Y−b∗τ∗Y+b∗SS+b∗u∗Yn−b∗u∗Y+i0−i1∗r+G Y−b∗Y+b∗τ∗Y+b∗u∗Y=a+b∗SS+b∗u∗Yn+i0−i1∗r+G Y(1−b+b∗τ+b∗u)=a+b∗SS+b∗u∗YN+i0−i1∗r+G Y = (a+b∗SS+b∗u∗YN+i0−i1∗r+G)/(1-b∗(1−τ−u)) - a marginal increase of government spending G by $1 induces a marginal increase in output by $(1/(1-b∗(1-τ-u)). It is the Government Spending Multiplier for this case.

Portfolio

How do you minimize risk? 1. buy insurance 2. build a portfolio of assets and diversify Diversification reduces risk by replacing a single risk with a large number of smaller, uncorrelated risks. - If you have a collection of securities/projects, then you are interested in the overall return of ALL securities/projects not just one particular security or project. You are also interested in the overall risk of ALL securities/projects. --> mean and variance of the portfolio's return

Understanding the Value of Money = inverse of the price index

If P = the aggregate price level (GDP Deflator, CPI). You can think of this as the price of a basket of goods, measured in money. - Then 1/P = value of $1, measured in goods. - If there is inflation this means P increases and hence the value of $1 is driven down - the value of money falls with inflation because money can buy less goods/services

Asymmetric Information

In general, there is asymmetric information if one side of the market is better informed than the other e.g. the used car market, the labor market, insurance market, and the financial market as well. Those concepts can be best explained in the context of the insurance market. When there is asymmetric information, two class of problems arise: 1. Adverse selection: a high-risk person benefits more from insurance, so is more likely to purchase it. 2. Moral hazard: people with insurance have less incentive to avoid risky behavior.

The Real Exchange Rate (E)

In making a profit maximization decision, we are focusing on the real exchange rate: - Real Exchange Rate (E): E = (P/Pf/e) = (P∗e/Pf) P = domestic price (CPI, GDPD) e = nominal exchange rate Pf = foreign price - The real exchange rate basically tells the rate at which the goods and services of one country trade for the goods and services of another Example: Consider an identical basket of goods in both the US and India. If the nominal exchange rate is unchanged, which of the following will definitely decrease the US real exchange rate with India? The price of the basket of goods falls in the US and rises in India. (P x e/Pf)

Who affects the Money Supply?

In modern economies, money supply is affected by: - Depository institutions: deposit institutions are privately owned banks and thrift institutions that accept deposits from and make loans directly to the public. - The public: the public includes every person or firm (except banks) that holds money in currency or deposits (think of money in your pocket or money in firms' "petty cash" drawer) - Central Banks (the Federal Reserve System in the US): the central bank is a government institution responsible for monetary policies within an economy

Fed's Interest Rate Policy: the dual mandate

In setting the nominal interest rate, the Fed's goal is to affect the demand side of the economy. This is sometimes called Aggregate Demand. In particular: 1. When π is high: Fed increases interest rates to keep aggregate demand low and stabilize inflation. 2. When Y is low: Fed decreases interest rates to boost aggregate demand and stabilize output

Money Market in the Long Run (LR)

In the Long Run we know that income/production/RGDP (Y) is not determined by money. 1. In the LR the FED perfectly and precisely controls Money Supply and sets it at some fixed amount. 2. With a given and set level of income (determined by the production function) the Money Demand only depends on P. As we have seen previously, the higher P the higher is the Md. 3. Thus, in the Long Run, the quantity of money demanded is negatively related to the value of money and positively related to P, other things equal.

Labor Force (LF), and many stats

LF = E + U - not in the labor force = everyone else unemployment rate = 100 x U/LF employment rate = 100 x E/LF Labor Force Participation Rate (LFPR) = 100 x LF/AP Employment to population ratio = 100 x E/AP

Money Market Equilibrium

Money market is no exception to other markets: it is in equilibrium when the money supply equals the money demand. In particular: - Md/P=Ms/P --> Md = Ms The real money demand = the real money supply The real interest rate is the price in this market. Note: - The money supply curve does not change with interest rates (it is vertical) - M and P can shift the real money supply - Y and π can shift the real money demand Example: Suppose there is a surplus in the money market. This could have been created by an increase in the money supply. The value of money will fall.

The Costs of Inflation

Most common issue heard by people complaining about inflation: inflation erodes real incomes. While this might be true in the short run, inflation is a general increase in prices of the things people buy and the things they sell (e.g., labor) 1. shoe-leather costs 2. menu costs 3. misallocation of resources due to relative-price variability 4. confusion and inconvenience (PDV formula) 5. arbitrary redistribution of wealth (from savers to borrowers) 6. tax distortions

Open Economy

Most economies nowadays are open. - An open economy interacts freely with other economies around the world. In particular, 1. It buys and sells goods and services in the world product markets. 2. It buys and sells assets in the world financial markets. Example: A US company wants to buy yen in order to buy Japanese bonds. In the open economy macroeconomic model presented in class, this transaction would be part of the supply of currency in the foreign exchange market, and part of the demand for loanoable funds.

Interpreting Trade Deficits as Assets Movements

NX = NCO = S - I - Hence when in the US NX<0 --> S< I This means that the domestic supply of national savings is not enough to match the domestic investment demand and we need to borrow from abroad. - In this view, a trade deficit is not necessarily a problem, but might be a symptom of a problem. - In fact, in this optic, trade deficit could be due to: 1. low savings (at the private level or because the government is running a budget deficit like in the 80s or 00s or now). The good new is in this case that there are foreign countries still willing to lend money to US borrowers. 2. Or it could be due to a boom in investment (like in the 90s)

Application of PDV formula

Often times, a firm/individuals has a stream of revenue/costs to consider over a certain time horizon in order to decide whether a project is worth or not. Recall, subscripts with t represent time/period: - TRt = revenue at time t of the project - TCt = cost at time t of the project If we want to find out the PDV coming from undertaking this project when the interest is constant and compounds only once every period the formula is: - PV = TR0 - TC0 + (TR1-TC1/1+r) + (TR2-TC2/(1+r)^2) + (TR3-TC3/(1+r)^3) This formula offers a crucial insight: in the financial markets, firms/individuals do care a lot about future interest rates and future prices when making their investment/loaning/savings decisions.

Hyperinflation

Printing money causes inflation, which is like a tax on everyone who holds money (inflation or seignorage tax) The third option to repay the debt is usually the politically preferred by the government because if the Central Bank monetizes some of the government debt: - Public debt pays interest, Federal Funds held at the Central Bank do not. The government always would like to decrease the interest paid and use the Federal Funds to do so. - Fixed nominal debt is easier to pay off the higher is P (country with high debt tend to like inflation) Bottom line about the link between fiscal and monetary policy: 1. Large budget deficits are typically the underlying cause of hyperinflations. 2. Central Bank independence from fiscal authorities can insulate it from pressure to monetize the public debt.

Loans as Money Supply

R = liquid assets held by the bank at the Central Bank (usually to meet the demand for withdrawals by depositors or to pay checks) Then, since accounting dictates Assets = Liabilities and Capital: - RR + ER + L + OA = D + FC - The central bank establishes reserve requirements (rr*) = RR/D regulations on the minimum amount of reserves that banks must hold against deposits (currently 10% in the US) - Commercial Banks may hold more than this minimum amount if they so choose. - Let me define rr = R/D as the reserve to deposit ratio (rr). - Commercial banks can influence the quantity of money supply through loans and excess reserves Example: A bank loans Greg's Ice Cream $250,000 to remodel a building near campus to use as a new store. On their respective balance sheets, this loan is an asset for the bank and a liability for Greg's Ice Cream. The loan increases the money supply (M = C + D, V = (P x Y/M))

Fisher Effect and hyperinflation

Recall that i = r + π - The Fisher Effect says that there is a one to one adjustment of the nominal interest rate to changes in inflation rate: if π increases by 1 pct. point then i increases by 1 pct. point too. This is crucial for the following perverse mechanism: - suppose M rises - then inflation, π rises (by quantity equation) - higher π translates one-for-one into higher i according to the Fisher Effect - But we know that higher i implies higher V - and higher V - everything else the same - implies higher P (quantity equation) - and hence even higher inflation, The beast feeds itself and things get out of control --> hyperinflation phenomena

Policies and their effects on the macroeconomy: Investment incentives

Suppose the government provides new tax incentives to encourage investment - if there are tax incentives to invest, then I increases - this in turn means that r increases, and NCO decreases - a decline in the supply of dollars, everything else constant, induces an appreciation of the real exchange rate. and a decline of NX in equilibrium. - key difference with budget deficit: investment tax incentive increases investment, which increases productivity growth and living standards in the long run. Budget deficit reduces investment (crowding out), which reduces productivity growth and living standards.

(Income) Tax revenues (T)

T=τ∗Y τ = average marginal tax rate on income - it is a %. this equation says that the tax code of the country is proportional to its earnings (which is typically true for most countries) - tax revenues are proportional to GDP because when Y increases (decreases), tax revenues increase (decreases) because there are more (less) earnings in the economy

The Federal Funds Rate

The Fed does target the interest rate by affecting indirectly both the Federal Funds rate and the Discount Rate. Example: When the Fed decreases the discount rate (change the money multiplier), banks will borrow more from the Fed and lend more to the public. The money supply increases.

The Capital Account

The accounting system that records the asset purchases that domestic residents and foreigners make to and from abroad. Defined so that the net flows in the capital account exactly offset the net flows in the current account. Capital account = change in domestic assets held by foreigners (CI) - Change in foreign assets held domestically (CO) 1. CI = Capital inflow = new purchase of domestic assets made by foreign residents 2. CO = Capital outflow = new purchase of foreign assets made by domestic residents Net Capital Outflow (NCO): NCO = CO - CI = - capital account . Example: If US citizens decide to purchase more foreign assets at each interest rate, the US real interest rate increases, the real exchange rate of the dollar depreciates, and US net capital outflow increases. (CO - CI)

The Central Bank's trade off in the short run

The central bank faces a key trade off in the short run. - If the money supply curve shifts right (left), the interest rate of equilibrium decreases (increases) - this, in turn, could induce an increase (decrease) in investment and thus output - more (less) output is followed by more (less) consumption which in turn generates an increase (decrease) in the price level - central bank needs to choose whether to have higher output or lower inflation! both objectives cannot be achieved at the same time.

The Current Account

The current account adds together these different sources of payments into and out of a country. The current account is the net flow of payments made to domestic residents from foreigners (or vice versa): Current Account = net exports + net factor payments from abroad + net transfers from abroad 1. next exports = exports - imports 2. net factor payments from abroad = factor payments from abroad - factor payments to foreigners 3. net transfers from abroad = transfers from abroad - transfers to foreigners It is important to bear in mind that any of these net flows could be negative, which would correspond to a net flow of payments to foreigners.

Real Money Balances

The demand for real money (balances) can be obtained by dividing both sides of the prior expression by the Price level (recall the discussion about nominal vs. real variables) - Md/P = Ld(Y, r+π) - the left-hand-side of this equation is the demand for nominal balances divided by the aggregate price level (the real purchasing power of money) - the right-hand side is the liquidity demand function

Market for Loanable Funds (Financial Market)

The expression S = I + NX is the IS (international savings) curve. It documents the relationship between Saving and Investment (holding NX fixed). - this expression says that in a world where NX = 0 (a closed economy), interest rates will always adjust such that savings equal investment (S=I) This is the financial market or the market for loanable funds.

Inflation and tax distortions

The fact that inflation can induce tax distortions should be clearer when you understand this simple formula. after tax real interest rate: - (1 - τ)r = (1-τ)i - π τ is the tax rate. This formula assumes there is no rise (i.e. ρ = 0) so all variables are known. The distortion is induced because tax on interest is computed and paid on the nominal interest rate! Example: 1. You bought some shares of stock and, over the next year, the price per share increased by 5 percent, as did the overall price level. Before taxes were paid, you experienced a nominal gain, but no real gain, and you paid taxes on the nominal gain. 2. Given a nominal interest rate of 5 percent, in which of the following cases would you earn the highest after-tax real rate of interest? (1-.20)2 = 1.6 (1-.4)3 = 1.8 (1-.6)4 = 1.6

Interaction between Fiscal and Monetary Policy

The interaction between public debt, taxes, and monetary policy can be seen by improving on the budget debt equation we studied earlier for fiscal policy: Bt = DEt + ((1+i) ∗ Bt-1 = old debt + interest) Central banks can finance the debt by printing new money supply, so a better equation to define the debt is: Bt = DEt + (1+i)∗Bt-1 - (Mt+1 - Mt = seignorage=∆M) - Seignorage = new printing of money from central bank to finance the debt and allowing the government to make profits from this operation. It can quickly create inflation and lead to hyperinflation.

International Financial Markets

The international financial market can be decomposed in two sub-markets: 1. The market for loanable funds at the international level. 2. The market for currencies. Those markets interact and influence each other. - The first market we are going to focus on is the market for loanable funds in an open economy. It is represented by the following equation: S = I + NCO - national savings = supply of loanable funds in the market - domestic investment and net capital outflow = demand of loanable funds in the market - a dollar of US savings can be used to finance the purchase of US capital or to purchase a foreign asst. same symmetrically holds true for foreign countries.

The Law of One Price and PPP

The law of one price (or Purchasing Power Parity) suggests the notion that, everything else the same, a good should sell for the same price in all markets across the world. - There is an opportunity for arbitrage here (e.g., making a quick profit by buying coffee in Seattle and selling it in Vancouver) Purchasing-power parity (PPP) = a theory of long run exchange rates determination based on the law of one price whereby a unit of any currency should be able to buy the same quantity of goods in all countries, E = 1

A More Realistic Model of Money Supply

The money supply is also affected by the fact that households and firms do hold money (and do not necessarily deposit all of it in banks) --> this realistic assumption yields a different model that is only here in the slides and not in the book. Let: - M = money supply (M1) - Currency (C) = the total $ bills held by households and firms (but not banks) - Reserves (R) = total $ bills held by banks - Monetary base (B) = the sum of total $ bills held by the non bank public (firms + consumers) plus commercial banks' reserves (held at the central bank)

The Fed

The most important player in the economy that affects money supply is the central bank. In the US it is the FED. - The Central Bank is The Banks' Bank. The Central Bank operates a clearinghouse for bank checks. Each member bank has an account with the Central Bank. In the U.S. the deposits that commercial banks have with the Fed are called federal funds (FF) (= required reserves (RR) + excess reserves (ER) + inter-banks short term loans). - A check written against private bank A and deposited with private bank B reduces bank A's FF and increases bank B's FF. Thus banks want federal funds so they can honor check withdrawals. Upshot: banks need reserves to honor withdrawals/loans - The interest rate which the overnight loans across banks pay is called the federal funds rate

Velocity of Money

The number of transactions in which the average dollar is used. - For small percentage changes, we can also approximate the quantity equation above with growth rates of each variable. gM + gV = π + gY or money growth + velocity growth = inflation + growth or RGDP Example: During the recent financial crisis velocity decreased. This means that the rate at which money changed hands decreased. Other things the same, a decrease in velocity decreases the price level. (V = P x Y/M)

The Quantity Equation

The quantity theory of money says that the Money supply determines the price level. And changes in the growth of the money supply determine inflation. This comes from the quantity equation. - V = (P∗Y)/M or, reshuffling M∗V = (P∗Y= NGDP) M = money supply (controlled by the FED) P = GDP deflator (or CPI) Y = RGDP V = Velocity of Money --> the number of transactions in which the average dollar is used. Example: Suppose the money supply tripled, but at the same time velocity fell by half and real GDP was unchanged. According to the quantity equation, the price level... Velocity = (Price level x RGDP)/Money Supply--> 1/2V = XP xY/3M --> XY/3 = 1/2 --> 3/2 = 1.5

Policies and their effects on the Macroeconomy: a budget deficit

The real interest rate is determined in the market for loanable funds while the real exchange rate is determined in the market for currencies. The critical linking variable between the two markets is NCO! - If G>T because of budget deficit, then Spub < 0, then S decreases. - This in turn means that r increases, and NCO decreases - A decline in the supply of dollars, everything else constant, induces an appreciation of the real exchange rate. And a decline of NX in equilibrium. That's why a budget deficit can induce a trade deficit.

Hyperinflation

There are 2 definitions for when the economy experiences hyperinflation: 1. Inflation exceeding 50% per month 2. Inflation exceeding 500% per year Example: There is evidence that the rate at which money changed hands rose during the German hyperinflation. This means that velocity rose. If monetary neutrality holds the rise in velocity decreased the ratio M/P. ( V = (P x Y / M)

Income-based payments from foreigners

There are three ways that domestic residents can receive income-based payments from foreigners: 1. Receiving income from the sale of goods and services to foreigners --> exports 2. Receiving income (e.g. dividends, interest, rents) from assets that they own in foreign countries --> factor payments from foreigners 3. Receiving transfers from individuals who reside abroad (remittances) or from foreign governments (international aid) --> transfers from foreigners

Income-based payments to foreigners

There are three ways that foreigners can receive income-based payments from domestic residents: 1. Paying income to foreigners in return for their goods and services --> imports 2. Paying income on assets that foreign residents own in the domestic economy --> factor payments to foreigners 3. Making transfers to individuals who reside abroad or to foreign governments --> transfers to foreigners Example: Foreign citizens earn more income in Ireland than Irish citizens earn in foreign countries. Ireland's net factor payments from abroad are negative, and its GDP is larger than its GNP.

Currencies and nominal exchange rates

There is not a one-for-one exchange between the various international currencies. Nominal exchange rate (e): the number of units of foreign currency that can be purchased with one unit of domestic currency. - e = (units of foreign currency/1 unit of domestic currency) Example: 1. Use table to compute the cost in dollars of a McDonald's Big Mac and the cost of a US Big Mac in terms of foreign Big Macs. The cost of 1 big mac = cost of 1 big mac in foreign currency/e; real exchange rate: E = (P x E)/Pf 2. You are the minister of finance of Mexico. The Mexican government has decided to peg the dollar to keep the Mexican peso stronger than what the market equilibrium would imply. ~ The Mexican government would need to supply dollars to purchases pesos to keep the peg. The quantity of dollars that must be purchased is given in the figure by the difference between the quantity of dollars demanded and the quantity of dollars supplied at the pegged nominal exchange rate. The Mexican authorities may want to keep the peso strong with respect to the dollar because: Mexico has lots of imports from the US and they do not want import inflation from the US. Mexico has received a lot of international loans denominated in dollars and they want to use less pesos to repay these loans. The public perceives a weak currency as a failure of government policies and weak govt in general. Politicians do not want to give that impression. The defense of an overvalued currency is limited: the Mexican government needs to sell U.S. dollars to purchase pesos in the foreign exchange market to keep the exchange rate pegged. Because they can't create new dollars, the Mexican authorities have to use their pre-existing dollar reserves, which are limited. When it becomes clear that dollar reserves are going to run out, defending the overvalued peso becomes impossible. Whatever their public announcements were, the Mexican authorities will then have to give up the peg and allow the peso to depreciate and re-establish the market equilibrium.

Bilateral Trade

There is nothing necessarily wrong with the fact that the US as a whole sells relatively little to China and still buys a lot from China. Bilateral trade - trade between two specific countries - will rarely be balanced.

The Taylor Rule

This is a monetary policy rule of how the Fed actually behaves: it = E(πt+1) +

National Savings (S)

Total National Savings are simply the sum of private and public savings then: S = Spr + Spub = ((Y-T+Tr)=Yd-C)=Spr) + (T - (G+Tr)) = Spub = Y - C - G - national savings are the portion of income that is not used for private or public consumption - defined as: s = S/Y Combining the expression for national savings with our GDP definition according to the expenditure approach, we get: S = Y - C - G = C + I + G + NX - C - G = I + NX

Transfer Payments (Tr)

Tr = SS + (u∗(Yn - Y = output gap)) = unemployment benefits >/= 0 - u = average unemployment benefit transfer rate. It is a %. This equation says that part of transfers, namely Social Security (SS), do not necessarily fluctuate with GDP; but unemployment benefits do move in the opposite direction to GDP (are counter-cyclical like the unemployment rate) - When Y increases (decreases) and is different than the government output target Yn, transfer payments fall (increase) because less (more) people are on welfare (unemployment benefits). This is built into our social programs. We transfer more money to people when their income is low.

Asset Evaluation

Value of an asset today = PDV of any dividends the asset will pay in the future + PDV of the price you get when you re-sell the asset - If current asset price > current value, the asset is overvalued. - If current price < current value, the asset is undervalued. - If current price = current value, the asset is fairly valued. Problem: usually, when you buy the asset, you don't know what future dividends or price of that asset will be. One way to try to value a stock is using fundamental analysis = the study of a company's accounting statements/balance sheets and future prospects to determine its current value and what the perspective for future profits are.

How does NCO depend on r?

We now want to graph the market for LF in an Open Economy. To this end recall: 1. S is upward sloping with respect to r. 2. I is downward sloping with respect to r. - Think of domestic real interest rate, r, as the real return on domestic assets. Everything else the same, a fall in r makes domestic assets less attractive relative to foreign assets: - Domestic residents purchase more foreign assets (hence Capital Outflow (CO) rises) - Foreign residents purchase fewer US assets (hence Capital Inflow (CI) decreases) Bottom line: if r decrease since NCO = CO - CI, NCO rises