MACROECONOMICS
Unit of analysis: economy as a whole
Variables of interest: Level of economic
activity, unemployment, inflation, currency
exchange….
Basic Definitions
Open vs Closed Economy
presence of foreign sector
Private Vs. Mixed
presence of government sector
Economic Growth
per capita GDP based on PPP
Measuring Economic Activity
• Stock
point in time
wealth, debt, unemployment, account balance
• Flow
over a period of time
income, GDP
•Gross Domestic Product
the total market value of all final goods and services produced
by factors of production located within a nation’s borders over a
period of time (usually one year)
•Gross National Product
the total market value of all final goods and services produced
by factors of production owned by a nation over a period of time
(usually one year)
R eal GD P , R eal GN P , R eal N N P , all fo r
1992
1998
1999
Gro ss do mestic pro duct
6,880.00 8,508.90 8,859.00
Plus: Income receipts from the rest of the
world
165.1
279.3
304.4
Less: Income payments to the rest of the
world
139.1
279.8
279.6
Equals: Gro ss natio nal pro duct
6,905.80 8,508.40 8,883.70
Less: Consumption of fixed capital
825.6
1,081.00
1,156.40
Private
667.9
894.7
962.2
Government
157.9
186.4
194.4
Equals: N et natio nal pro duct
6,080.50 7,428.30 7,729.70
US
2000
9,191.40
2001
9,214.50
2002
9,440.20
359
292
---
333.6
9,216.20
1,226.10
1,024.00
202.5
7,994.40
269.2
9,237.30
1,320.80
1,110.70
210.9
7,928.10
----1,399.90
1,184.50
216.6
---
Nominal vs Real
adjusting for inflation
• Nominal GDP is measured at current prices
• Real GDP is measured at constant prices
(like 1992)
i N
GDP  i 1 PiQi
Real GDP
Nominal GDP
1992
6,880.00
6,318.90
1998
8,508.90
8,781.50
1999
8,859.00
9,274.30
2000
2001
2002
9,191.40 9,214.50 9,440.20
9,824.60 10,082.20 10,445.60
other important statistics
• Unemployment
the total number of adults (16 and up) who are
willing and able to work and who are actively looking
for work, but have not found a job
• Labor Force
adults who are either employed or unemployed
• Unemployment rate = Unemployed / Labor
Force
• Structural, Cyclical, Frictional, Seasonal
Inflation vs deflation
• Inflation – the situation in which the average of all
prices in the economy is rising
• GDP deflation, CPI, PPI, Core CPI, Core PPI
cost of market basket today
Price Index 
100
cost of market basket in base year
costs of inflation and the business cycle
• menu costs
• redistribution of wealth
• forward looking arrangements and the real
interest rate
• currency depreciation and the standard of
living
• RECESSION
two consecutive quarters of negative growth
Components of the GDP
• Personal Consumption
– Goods
• Durable
• Non-durable
– Services
• Gross Private Domestic Investment
– Fixed Investment
• Non-residential
– Structure
– Equipment and software
• Residential
– Business Inventories
Components of the GDP
• Government Spending
– Federal and State and Local level
• Exports of goods and services
• Imports of goods and services
GDP = C + I + G + x - m
macro picture of the US economy
stunning growth of the late 1990’s
and
now
7.0
6.5
6.2
6.0
5.9
5.6
5.6
nom inal and real GDP grow th
5.1
5.6
5.6
4.9
5.0
4.4
4.3
4.0
4.0
4.1
3.8
3.6
3.0
3.0
2.7
2.7
2.6
2.0
1.0
0.3
0.0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Average Growth Rates by
Component, 1996-2000
8%
4
Consumption
Investment
Government
Exports
Imports
grow th of components (current dollars)
20
15
10
Consumption
5
Gross Private Domestic Investment
Exports
Imports
0
1994
-5
-10
-15
1995
1996
1997
1998
1999
2000
2001
Government
unemployment rate (annual as average of 12 months)
8.00
7.49
7.00
6.91
6.10
6.00
5.59
5.41
5.00
4.94
4.79
4.51
4.23
4.02
4.00
3.00
2.00
1.00
0.00
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Growth In Real GDP and its' components
GD P
P e rs o na l c o ns um pt io n
e xpe ndit ure s
Durable go o ds
No ndurable go o ds
Services
G ro s s priv a t e do m e s t ic
inv e s t m e nt
Fixed investment
No nresidential
Structures
Equipment and so ftware
Residential
2000
2000
2000
2000
2001
2001
2001
2001
2002
2002
2002
2002
I
2 .6
II
4 .8
III
0 .6
IV
1 .1
I
- 0 .6
II
- 1 .6
III
- 0 .3
IV
2 .7
I
5
II
1 .3
III
4
IV
1 .4
5 .3
17.8
2.2
4.4
3
-3.7
4.9
3.6
3 .8
8.1
2
3.9
2 .1
-5.3
2.7
3.3
2 .4
11.5
2.3
0.6
1 .4
5.3
-0.3
1.5
1 .5
4.6
1.3
0.9
6
33.6
3.6
2.1
3 .1
-6.3
7.9
2.9
1 .8
2
-0.1
2.7
4 .2
22.8
1
2.3
1 .5
-8.5
5.1
1.9
2 .3
13.3
15
13.8
1 7 .3
6.7
10.2
8.2
-6
0.2
3.5
12.1
- 3 .4
-2.4
-3.2
3.6
- 1 9 .7
-2.2
-5.4
-3.1
- 1 7 .6
-11.1
-14.5
-8.4
- 5 .2
-4.3
-6
2.9
- 1 7 .3
-8.9
-10.9
-30.1
1 8 .2
-0.5
-5.8
-14.2
7 .9
-1
-2.4
-17.6
3 .6
-0.3
-0.8
-21.4
6 .2
4.5
2.5
-9.8
15.5
8.3
10.9
-3
0.9
-9.3
-5.4
0
-6.3
8.2
-16.7
-0.5
-9.2
0.4
-2.5
-3.5
-2.7
14.2
3.3
2.7
6.7
1.1
6.6
9.4
Seasonally adjusted unemployment
rate
6.2
5.8
5.6
month (2002-2003)
Ja
n
No
v
Se
p
Ju
l
ay
M
M
ar
5.4
Ja
n
rate
6
Can Euro be yet another
problem?
• Price of oil
• International reserve currency
• Competition for investment funding
Simple view of the business cycle
• Business cycle
Real GDP
(per capita)
time
Predicting the future
The magical art of forecasting
Coincident indicators
•
•
•
•
Total hours worked
Value of unemployment claims
Total tax revenues
Corporate income tax receipts
Leading indicators
• Average work hours in manufacturing
• Average weekly claims for unemployment
insurance
• Business inventories
• New orders for non-defense capital goods
• Sales tax receipts
• Stock index (index futures)
• Construction Employment
• Residential permits
More leading indicators
• Growth in wage rate
• Money supply (velocity)
• Interest rate spread (10 year bond – federal
funds rate) or (10 year bond – 1 year bond)
Economy in the short-run
Keynesian view
IS/LM
AD/AS
Understanding Keynesian Consumption
Function
C
C = a + c (Y-T)
S
C
autonomous
induced
MPC vs APC
C = f ( Y, T, W, i,…)
Saving = S = (Y-T) – C = - a + (1-c)(Y-T)
MPS vs MPC
Y-T
Investment Spending
business sector
I
I
Y
I = f (expected Y, i)
Government Spending
government sector
G
G
G = f ( policy )
Y
Closed Mixed Economy
C+I+G
EXP
C+I
C
Y1
Y
Foreign sector
• Exports = f (foreign Y, exchange rate)
• Imports = f (domestic Y, exchange rate)
NX
Y
Equilibrium expenditures
Actual expenditures and total income are always
equal to each other.
In EQUILIBRIUM: households, businesses,
government, and the foreign sector want to
spend (planned expenditures) exactly the
amount of income that is being generated by
the current level of production.
If the economy is out of equilibrium, then production
(income) is out of alignment with planned
expenditures, hence businesses are forced to
change production.
Planned
Expend.
Iu – inventory
accumulation
C+Ip+G+NX
Ep = C+Ip+G+NX =
=a+c(Y-T)+Ip+G+NX
NOTE that MPC is the slope
Ap=a+Ip+G+NX (autonomous)
Ep=Ap+c(Y-T)
In equilibrium Ep=Y, hence,
Y=Ap/(1-c)-cT/(1-c)  multiplier
What is the relationship between the interest rate and
the equilibrium level of income?  derivation of IS
Y
IS (Investment and savings)
CURVE
Components of aggregate
expenditures:
C, I, G, x, m
The IS curve shows a set of combinations of
interest rate (i) and income levels (Y) for which
the commodity market is in equilibrium
IS curve
(equilibrium in goods markets)
i
IS = f (i; taxes, consumer conf., wealth, fiscal
policy, foreign Y, exchange rate….)
IS
Y
LM
liquidity and money
• LM curve is defined as a set of different
combinations of interest rate (i) and income
level (Y) such that the money market is in
equilibrium.
Understanding Money Demand
• Why hold money (medium of exchange)?
transaction (liquidity) demand
store of value demand
• Opportunity cost of holding money: interest rate
• Real money demand (Md) vs nominal money
demand (Mdn)
Md = Mdn/P
Md = f (i, Y), Mdn = f (i, Y, P)
No Money Illusion
Money demand
i
Y2>Y1
Md (Y1)
Md (Y2)
Real money balances
Nominal Money Supply
monetary policy
• Reserve requirements ratio
• Discount Rate
• Open Market Operations
Real Ms = (nominal Ms)/P
i
Real Ms
Deriving LM curve
i
i
MS
LM
Md(Y2)
Md(Y1)
Real money balances
Y1
Y2
Y
IS-LM
LM = f(i; policy, P)
IS = f (i; taxes, consumer conf.,
wealth, fiscal policy,
foreign Y, exchange
rate….)
TAX CUT
i
IS1
IS2
LM
i
IS1
IS2
LM1
LM2
Y
Fed holds money supply constant
Y
Fed holds interest rate constant
Fiscal multiplier and IS curve
• MPS and MPC, Saving as a leakage.
• APS and APC
• Multiplier and changes in autonomous
expenditures
as MPS decreases (i.e. the multiplier
increases) the IS CURVE BECOMES
FLATTER
Slope of the LM curve
• Real money demand:
D
•
•
•
•
M 
   aY  bi
 P
As income increases, the interest rate has to increase in
order to maintain equilibrium in the money market
Velocity = Y/ (real money supply) changes along LM
The more sensitive the demand for money is with respect
to the interest rate, the flatter is the LM curve
The more sensitive the demand for money is with respect
to income, the steeper the LM curve becomes
SHIFTS in LM
• Changes in nominal supply of money
• Inflation
Weak monetary policy
• Steep IS (large MPS; weak dependency of
C and I on the interest rate…)
• Flat LM curve (money demand is very
sensitive to interest rate changes)
LIQUIDITY TRAP and flat LM curve
(modern Japan and USA in the 1930’s).
Modern Japan and Liquidity trap
Japan, short-term interest rate fell below 1%
in 1995 and remained under 1% since then.
Possible solution: Fiscal and monetary
expansion at the same time (same shift in
LM and IS), GDP will increase and no
crowding out, since the CB can purchase
the bonds
Weak fiscal policy
• Vertical LM curve (interest responsiveness
of money demand is zero) Crowding out
and IS
• Flat IS curve
• Note that fiscal policy is strong when IS
curve is vertical (zero interest
responsiveness of autonomous planned
spending) i.e. there is no crowding out.
Conclusion
Policy mix is needed
From IS-LM to Aggregate Demand
i
LM(P1)
LM(P2)
IS
Y
P
P1
P2
AD
Y
Why is AD downward sloped
•
•
•
•
Wealth effect (real balances effect)
Interest rate effect
Open economy effect
Multiplier effect
FACTORS THAT SHIFT AD
• interest rate
• consumer (business) confidence
• economic conditions in trading partners
(foreign Y)
• tax
• money supply
• exchange rate
• government expenditures
Classical view
•
•
•
•
Say’s law
Invisible hand (Adam Smith)
Full flexibility in prices
Competitive markets
Aggregate Supply
classical view
P
LRAS
Y*
Y
Keynesian View
• Sticky wages and prices and institutional
constraints
• Thrift paradox and investment
Short-run aggregate supply
Keynesian view
P
Y
AD&AS
P
LRAS
SRAS
AD
Y
FISCAL POLICY
• Instruments: G, T, Tr. (changes personal
disposable income)
• Drawbacks of FP:
crowding-out effects
direct
indirect
open-economy effect
Time lags (decision, recognition, effect)
Monetary Policy
• Instruments
discount rate
OMO
RRR
• Drawbacks: inflation?, exchange rate
regime.
• Monetary Rule
Role of government debt
• Interest payments to foreigners
• Burden on future generations
• Crowding out of domestic investment and
reduction in capital stock
• Cost vs benefit
Foreign sector
us and them
•Trade in goods and services
•Trade in financial assets
•Trade in currencies
Balance of Payments
measuring international activity
• Current account (trade balance, income
flows)
• Financial Account (investment flows)
• Reserves (central bank activity)
• Net Errors and Omissions
CA + FA + NEO = change in Reserves
Forex Market
$/R
Supply of Roubles
Russian investors
Russian Central Bank
Russian import firms
Russian tourists
Demand for Roubles
Foreign investors
Foreign Central Banks
Foreign import firms
Foreign tourists
Volume of Roubles
History of Forex
• Gold Standard 1880’s-1914
• Benefits:
Hume’s correction mechanism
Ease of trade
No need for forward looking instruments
• Spain vs England
• No Monetary Policy!
CA + FA = change in gold
1918-1939
• Gold Standard revised
US on Gold since June 1919, UK is since 1925 (pre-war)
By 1931 the British Pound is inconvertible, by 1933 the
USD.
• The Great Depression and monetary
expansion, competition for export markets
1944-1970
Gold Exchange Standard
IMF and WB
USD=1/35 oz. All currencies are specified in gold.
Role of the IMF
August 1971 the USD is no longer convertible into
gold
Smithsonian Agreement of December 1971.
March 1973 FLOAT BEGINNS
FLOAT
• Spot market vs future markets
• Forward looking instruments: options,
futures, swaps, forward contracts.
• Need and importance of forecasting!
Forecasting
two forecasts for 6 month period. Current spot is 9.5 R = 1 USD. Assume
that you owe a payment to a Russian firm in Roubles.
Forecast I
Forecast II
10 R = 1 USD
15 R = 1 USD
6 month forward rate is 11 R = 1 USD
Forward
wait
The spot market in 6 months is 11.5 R = 1 USD
Float vs fixed
FLOAT
FIXED
Large economy
Small economy
Closed economy
Open economy
Divergent inflation Harmonious inflat
Diversified trade
Concentrated trade
Policy and exchange rate regime
FLOAT
strong open economy effect, thus weak fiscal policy.
Monetary expansion causes depreciation in the value of the currency,
thus strong monetary policy
FIXED
no open economy effect, weak indirect crowding out effect, thus strong
fiscal policy
no currency depreciation, inability to change domestic interest rate due
to international capital mobility
Determinants of exchange rate
under float
•
•
•
•
•
Inflation (purchasing price parity)
Interest rate (interest rate parity)
Economic growth
Microstructure approach
Political news
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