MACRO REVIEW
in preparation for API 120
(I) DEFINITIONS & ACCOUNTING
(II)
(i) National income & product accounts
(ii) Balance of Payments accounts
(iii) National Saving identity
(II) DEMAND POLICY
(i) THE KEYNESIAN MODEL
(ii) TARGETS & INSTRUMENTS
• Definition of macroeconomics
– Aggregates
– Goods (& labor) markets may not clear in short run
– => Role for fiscal, monetary & exchange rate policy.
(i) National income & product accounts
• Definition of
–
–
–
–
GDP: value of all goods & services produced domestically
GNP: includes earnings from abroad
National Income: includes unilateral transfers.
Net National Income: subtracts depreciation of capital stock
API-120 - Prof.J.Frankel, Harvard University
Ways to decompose GDP
• To whom the goods & services are sold (expenditure side of GDP):
–
–
–
–
C
+I
+G
+ X-M .
• How the income (Y) is used:
– Taxes net of transfers, T, leaving disposable income :
– Consumption C
= Yd
– + Saving S.
}
• Allocation of shares according to factors of production:
– Wages & salaries
– Capital income.
API-120 - Prof.J.Frankel, Harvard University
(ii) Balance of Payments accounts
• Definition:
The balance of payments is the year’s
record of economic transactions
between domestic & foreign residents.
“Primary income,” mainly investment income
≡ “secondary income”
NOW CALLED “FINANCIAL ACCOUNT”
API-120 - Prof.J.Frankel, Harvard University
Examples on the current account:
• You, an American, buy DVDs from India
=> import appears as debit on US merchandise account.
• You import services (electronically) of an Indian software firm =>
debit appears on US services account ( “overseas outsourcing”).
• You buy the services, instead, from a subsidiary that the Indian
software firm set up last year in the US. This is not an
international transaction, and so does not appear in the accounts.
• But assume the subsidiary then sends profits back to India
=> US reports payments of investment income.
It is as if the US is paying for the services of Indian capital.
• Employees of the subsidiary in the US (or any other US resident
entities) send money to relatives back in India
=> US reports paying unilateral transfers .
API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account
(previously “capital account”), long-term
 Instead of buying DVDs from India,
you buy the company in India that makes them.
=> acquisition of assets (debit) under Foreign Direct Investment (FDI).
 Instead of buying the entire company in India,
you buy some stock in it
=> acquisition of portfolio investments (equities).
 Instead of buying stock in the company,
you lend it money for 2 years
=> acquisition of portfolio investments (bonds or bank loans).
API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account, short term:
 You lend to the Indian company in the form of 30-day
commercial paper or trade credit
=> acquisition of short term assets
(Debit: You have “imported” a claim against India.)
 You lend to the Indian company in the form of cash dollars,
which they don’t have to pay back for 30 days
=> acquisition of short term assets .
 You are the Central Bank, and you buy securities of the
Indian company (an improbable example for the Fed –
but some central banks now diversify international investments)
=> increase in US official reserve assets.
API-120 - Prof.J.Frankel, Harvard University
The rules, continued
• Each transaction is recorded twice:
• an import of a good or security has to be paid for.
E.g., when an importer pays cash dollars, the import on
the merchandise account is offset under short-term capital:
the exporter in the other country has, at least for the
moment, increased holdings of US assets, which counts
just like any other portfolio investment in US assets.
• At the end of each quarter, credits & debits
are added up within each line-item;
• and line-items are cumulated from the top
to compute measures of external balance.
API-120 - Prof.J.Frankel, Harvard University
Some balance of payments identities
• CA ≡ Rate of increase in net international investment position.
– A CA surplus country accumulates claims against foreigners
– A CA deficit country borrows from foreigners.
• BoP ≡ CA + KA
• => BoP ≡ excess supply of FX coming from private sector,
which central banks absorb into reserves
(if they intervene in the FX market, e.g., to keep exchange rate fixed).
– A BoP surplus country adds to its FX reserves (esp. US T bills).
– A BoP deficit country runs down its FX reserves,
unless it is lucky enough (US) that foreign central banks finance its deficit.
• A floating country does not intervene in the FX market
• => BP ≡ 0;
• Exchange rate E adjusts to clear private market FX supply & demand.
API-120 - Prof.J.Frankel, Harvard University
(iii) Derivation of National Saving Identity
Income ≡ Output
(assuming no transfers or investment income)
Y ≡ GDP
/C + S + T ≡ C/ + I + G + X -M
S + (T-G) ≡ I + X – M
NS ≡
S + BS ≡ I + CA
API-120 - Prof.J.Frankel, Harvard University
National
Saving
Identity
Household savings
Corporate savings
Government savings
API-120 - Prof.J.Frankel, Harvard University
End of: Definitions & Accounting
API-120 - Prof.J.Frankel, Harvard University
MACRO REVIEW: DEMAND POLICY
(II) THE KEYNESIAN MODEL
Part 1: Introduction to Keynesian Model
Part 2: Multipliers for spending & exports
Part 3: International transmission
under fixed vs. floating exchange rates
Part 4: Adjustment of a CA deficit via
expenditure-reducing vs. expenditure-switching policies
Part 5: Monetary factors
Imports & exports depend on income:
M  M d ( E, Y )
 M  mY
X  X d ( E, Y *)
X
assuming E & Y* fixed, for now.
 TB  X  (M  mY)
TB
…and rises in contractions
+
0
-
Y
TB falls in expansions…
where slope = -m ≡
- marginal propensity
to import
as does consumption:
Keynesian consumption function C C  cY
API-120 - Prof.J.Frankel, Harvard University
Determination of equilibrium income
in open-economy Keynesian model
Y  A  TB
 (C  I  G)  ( X  M )
 (C  cY  I  G)  ( X  M  mY)
Now solve:
Y  cY  mY  C  I  G  X  M
C  I G X M
Y
1 c  m
A X  M
Y
sm
where A  C  I  G and
API-120 - Prof.J.Frankel, Harvard University
s  1 c.
Keynesian Consumption Function: C  C  cYd
or, expressed as a saving function:
S  Yd - C  Yd - ( C  cYd )
 - C  s Yd where s ≡ 1 –
c.
}I
API-120 - Prof.J.Frankel, Harvard University
Recall National Saving identity: NS – I ≡ CA.
In a closed economy, NS – I = 0.
Fiscal Expansion
∆ 𝐺 /ΔY = s
=> ΔY /∆ 𝑮 = 1/ s
0 < 1 < Closed-economy multiplier 1/s < ∞
API-120 - Prof.J.Frankel, Harvard University
Open economy: NS – I = TB
=X–M
.
Imports: M  Md (E, Y) , or  M  mY for simplicity.
Exports: X  Xd (E,Y* ), or  X
for simplicity.
API-120 - Prof.J.Frankel, Harvard University
Open economy
Fiscal Expansion
slope = s
G
1
1
Y 
G  G
s
sm
API-120 - Prof.J.Frankel, Harvard University
Part 2:
KEYNESIAN MULTIPLIERS
• The multiplier for an increase in A ,
e.g., due to a fiscal expansion .
• The multiplier for an increase in X,
e.g., due to a devaluation .
API-120 - Prof.J.Frankel, Harvard University
Devaluation makes the export good cheaper for foreign consumers.
API-120 - Prof.J.Frankel, Harvard University
SUMMARY OF MULTIPLIERS
NS  I  X  M
+
Keynesian model of S + M
AXM
Y 
sm
Fiscal Expansion
1
Y 
A
sm
=>
where A C  I  G
Devaluation
1
Y 
X
sm
open-ec. multiplier = 1/(s+m)<1/s
ΔT B  ΔM  - m Y
m

ΔA .
sm
ΔTB  ΔX  m Y
s

ΔX  Δ X .
sm
Equation (17.11), 10th ed. of WTP , has a misprint.
Part 3: MACROECONOMIC INTERDEPENDENCE
International transmission
under fixed vs. floating exchange rates
• of a disturbance originating domestically.
• of a disturbance originating abroad .
API-120 - Macroeconomic Policy Analysis I Prof. Jeffrey Frankel, Kennedy School, Harvard University
International Transmission
I
Fix
↓
Float
=> appreciation
•
•
Floating increases effect on Y
=> disturbance is “bottled up” inside.
X↓
Float =>
Fix
depreciation
•
•
Floating decreases effect on Y
=> “insulation.”
Conclusions regarding transmission
(with no capital mobility)
• Trade makes economies interdependent
(at a given exchange rate).
– TB can act as a safety valve,
releasing pressure from expansion:
Y  (1 /(s  m)). A
– Disturbances are transmitted
from one country to another:
Y  (1 /(s  m)) X .
API-120 - Prof.J.Frankel, Harvard University
Conclusions regarding transmission
(with no capital mobility), continued
• Floating exchange rates work to
isolate effects of demand disturbances
within the country where they originate:
– Effects of a domestic disturbance tend
to be “bottled up” within the country.
In the extreme, floating reproduces the closed
economy multiplier:
Y  (1 / s) A .
– The floating rate tends to insulate the
domestic economy from effects of
foreign disturbances. In the extreme,
floating reproduces a closed economy:
API-120 - Prof.J.Frankel, Harvard University
Y  0 .
Parts 4 & 5:
POLICY INSTRUMENTS
Goals and Instruments
• Policy goals: Internal balance & External balance
• Policy instruments: Fiscal policy, etc.
• The Swan Diagram
• The principle of goals & instruments.
Introduction of monetary policy
• The role of interest rates
• Monetary expansion
• Crowding out via interest rates ,
Goals and instruments
Policy Goals
• Internal balance: Y = Y
Y < Y ≡ ES ≡ “output gap” => unemployment > u
Y > Y ≡ ED => “overheating” => inflation
or asset bubbles.
• External balance:
e.g., CA=0 or BP=0.
Policy Instruments
• Expenditure-reduction,
e.g., G ↓
• Expenditure-switching,
e.g., E ↑ .
API-120 - Prof.J.Frankel, Harvard University
Potential output 𝑌
Three ways of computing 𝑌:
1. Aggregate production function Y = F(K,N)
– Substitute labor force employed at natural rate: N=𝑁,
–
capital stock K working at full capacity, etc…
– Conceptually the right definition. But very hard to implement.
• For one thing, most of the action is in TFP.
2. Time trend
– E.g., H-P filter.
3. Estimate 𝑌 as
value of Y above
which inflation
tends to accelerate.
Internal balance
Output gap, as percentage of GDP, 2009
Jpn
UK
US
France
Ir
In 2009, after the global financial crisis, advanced countries suffered
much larger output gaps than in preceding recessions: Y << Y .
Source: IMF, via Economicshelp, 2009
API-120 - Prof.J.Frankel, Harvard University
Output gap in eurozone periphery
Source: IMF Economic Outlook, September 2011 (note: data for 2012 were predictions)
http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html
Greece & Ireland overheated by 2007: Y >> Y
and crashed in 2009-12: Y << Y
API-120 - Prof.J.Frankel, Harvard University
Inflation everywhere fell in 2008-09,
in response to the output gap of the great recession.
World Bank,
June 2014.
“Exchange rate passthrough and inflation
trends in developing
countries,” Global Ec.
Prospects.
THE PRINCIPLE OF TARGETS AND INSTRUMENTS
• Can’t normally hit 2 birds with 1 stone
• Do you have n targets?
• => Need n instruments,
and they must be targeted independently.
• Have 2 targets: CA = 0 and Y = Y ?
• => Need 2 independent instruments:
expenditure-reduction &
expenditure-switching.
API-120 - Prof.J.Frankel, Harvard University
RESPONSES TO CURRENT ACCOUNT DEFICIT
Financing
• By borrowing
• or running down reserves.
vs.
Adjustment
• Expenditure-reduction
(“belt-tightening”)
• e.g., fiscal or monetary contraction
• or Expenditure-switching
• e.g., devaluation.
ADJUSTMENT
DILEMMA
Starting from
current account deficit
at point N,
policy-makers can
adjust either by
(a) cutting spending, 
●
A
●
or
(b) devaluing.
 X 
●
API-120 - Prof.J.Frankel, Harvard University
●
DERIVATION OF SWAN DIAGRAM
• Only by using both sorts
of policies simultaneously
can both internal & external
balance be attained, at point A.
• Experiment: increase in Ă
A
(e.g. G↑)
●
Expansion moves economy
rightward to point F.
Some of higher demand falls
on imports. => TB<0 .
What would have to happen
to reduce trade deficit?
Devaluation
E  X 
API-120 - Prof.J.Frankel, Harvard University
●
●
●
● ●
Now consider internal balance.
Return to point A.
Experiment: increase A
Expansion moves economy
rightward to point F.
●
●
Some of higher demand
falls on domestic goods
=> Excess Demand. Y > Y
What would have to happen to
eliminate excess demand?
E↓.
API-120 - Prof.J.Frankel, Harvard University
● ●
●
Swan Diagram
has 4 zones:
I.
II.
III.
IV.
●
ED & TD
ES & TD
ES & TB>0
ED & TB>0
API-120 - Prof.J.Frankel, Harvard University
Example: Emerging market crises
Classic response to a balance of payments crisis:
Devalue and cut spending
Excgange rate E
ED & TB>0
BB:
External balance
CA=0
Mexico
1995
or Korea
1998
ED & TD
●
Mexico
1994
or Korea
1997
ES & TB>0
YY: Internal
balance
ES & TD
Y=potential
Spending A
Could be the “Fragile 5” in 2013-14: India, Turkey, Indonesia, S.Africa, Brazil.
API-120 - Prof.J.Frankel, Harvard University
Example: China in the last decade
ED & TB>0
Exchange rate E
China
2010
ES & TB>0
China
2002
●
ES & TD
BB: External
balance CA=0.
ED & TD
YY: Internal
balance Y=𝑌
Spending A
By 2007, rapid growth pushed China into ED.
In 2008-09, an abrupt loss of X,
due to the global crisis, shifted China to ES.
By 2010, a strong
recovery,
Spending
A due in
part to G stimulus, moved into ED.
In 2015, back into ES.
Part 5: Monetary policy
• is another instrument to affect the level of spending.
• It can be defined in terms of the interest rate i,
which in turn affects i-sensitive components
E.g., Taylor Rule sets i.
such as I & consumer durables.
• Or it can be defined in terms of money supply M.
– In which case an expansion is a rightward shift of the LM curve
– which itself slopes up (because money demand depends
negatively on i and positively on Y).
LM
i
Y
API-120 - Prof.J.Frankel, Harvard University
Monetary
expansion
lowers i,
stimulates demand,
shifts NS-I down/out.
New equilibrium at point M.
In lower diagram,
which shows i explicitly
on the vertical axis,
We’ve just derived IS curve.
If monetary policy is defined
by the level of money supply,
then the same result is viewed
as resulting from a rightward
shift of the LM curve.
Fiscal expansion
shifts IS out.
New equilibrium:
At point D if monetary
policy is accommodating.
At point F, if the money
supply is unchanged,
so we get crowding out:
i↑ => I↓
 Rise in Y < full
Keynesian multiplier.
.
D
End of: Introduction to the Keynesian Model
API-120 - Prof.J.Frankel, Harvard University
APPENDIX: ELABORATION ON TARGETS & INSTRUMENTS
{WITH 1 GRAPH
PER PAGE}.
ADJUSTMENT
DILEMMA
(a) If they
cut spending,
CA deficit is
eliminated at X;
●
but Y falls below
potential output Y.
●
=> recession
API-120 - Prof.J.Frankel, Harvard University
(b) If they
devalue,
CA deficit
is again
eliminated, at B,
●
but with
the effect of
pushing Y above
potential output.
●
=> overheating
API-120 - Prof.J.Frankel, Harvard University
ELABORATION ON
DERIVATION OF SWAN
DIAGRAM:
EXTERNAL BALANCE
A
At F, TB<0 .
What would
have to happen
to eliminate
trade deficit?
E↑.
●
●
●
If depreciation
is big enough,
restores TB=0
at point B.
API-120 - Prof.J.Frankel, Harvard University
To repeat, at F,
some of higher demand
falls on imports.
.
What would have to
happen to eliminate
trade deficit?
●
E↑.
If depreciation is big
enough, restores TB=0
at point B.
●
●
We have just derived
upward-sloping
external balance line,
BB.
API-120 - Prof.J.Frankel, Harvard University
API-120 - Macroeconomic Policy Analysis I Prof.Jeffrey Frankel, Kennedy School, Harvard University
ELABORATION ON
DERIVATION OF
SWAN DIAGRAM,
cont.:
INTERNAL BALANCE
At F, Y > 𝒀 .
What would
have to happen
to eliminate
excess demand?
E↓.
●
●
●
If appreciation
is big enough,
restores Y= 𝒀
at point C.
API-120 - Prof.J.Frankel, Harvard University
At F, some of higher
demand falls on
domestic goods.
What would have to
happen to eliminate
excess demand?
●
E ↓.
If appreciation is big
enough, restores at C.
●
●
We have just derived
downward-sloping
internal balance line, YY.
API-120 - Prof.J.Frankel, Harvard University
Derivation of the Swan Diagram
Summary: the combination of policy instruments to hit one
goal slopes up; the combination to hit the other slopes down.
Fiscal expansion (G↑)
(or monetary expansion),
at a given exchange rate =>
Y↑
Devaluation (E ↑)
Y↑
=>
and
and
TB↓.
TB ↑.
If we are to maintain:
Internal balance,
Y=𝑌
External balance,
TB=0
then G & E must vary:
inversely.
together.
=>
Internal balance
line slopes down.
=>
External balance
line slopes up.
ITF-220, Prof.J.Frankel