1. The Fed can control the money supply with open market operations the reserve requirement the discount rate

2. Portfolio theories of money demand stress the store of value function posit that money demand depends on risk/return of money &

alternative assets

Review of the previous lecture

3. The Baumol-Tobin model is an example of the transactions theories of money demand,

stresses “medium of exchange” function money demand depends positively on spending, negatively on

the interest rate, and positively on the cost of converting non-monetary assets to money

Review of the previous lecture

Lecture 28

Review of the previous lectures

Instructor: Prof. Dr. Qaisar Abbas

The Science of Macroeconomics

• Macroeconomics is the study of the economy as a whole, including• growth in incomes

• changes in the overall level of prices

• the unemployment rate

• Macroeconomists attempt to explain the economy and to devise policies to improve its performance.

The Science of Macroeconomics

• Economists use different models to examine different issues.

• Models with flexible prices describe the economy in the long run; models with sticky prices describe economy in the short run.

• Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics.

The data of Macroeconomics- GDP, Unemployment & inflation

• Gross Domestic Product (GDP) measures both total income and total expenditure on the economy’s output of goods & services.

• Nominal GDP values output at current prices; real GDP values output at constant prices. Changes in output affect both measures, but changes in prices only affect nominal GDP.

• GDP is the sum of consumption, investment, government purchases, and net exports.

The data of Macroeconomics- GDP, Unemployment & inflation

• The overall level of prices can be measured by either1. the Consumer Price Index (CPI), the price of a fixed basket of

goods purchased by the typical consumer

2. the GDP deflator, the ratio of nominal to real GDP

• The unemployment rate is the fraction of the labor force that is not employed.

• When unemployment rises, the growth rate of real GDP falls.

National Income:Where it Comes From and Where it Goes

• Total output is determined by• how much capital and labor the economy has• the level of technology

• Competitive firms hire each factor until its marginal product equals its price.

• If the production function has constant returns to scale, then labor income plus capital income equals total income (output).

National Income:Where it Comes From and Where it Goes

• The economy’s output is used for• consumption (which depends on disposable income)• investment (depends on the real interest rate)• government spending (exogenous)

• The real interest rate adjusts to equate the demand for and supply of• goods and services• loanable funds

• A decrease in national saving causes the interest rate to rise and investment to fall.

• An increase in investment demand causes the interest rate to rise, but does not affect the equilibrium level of investment if the supply of loanable funds is fixed.

Economic Growth

• The Solow growth model shows that, in the long run, a country’s standard of living depends• positively on its saving rate.• negatively on its population growth rate.

• An increase in the saving rate leads to higher output in the long run faster growth temporarily but not faster steady state growth.

Economic Growth

• Key results from Solow model with tech progress steady state growth rate of income per person depends solely on

the exogenous rate of tech progress the U.S. has much less capital than the Golden Rule steady state

• Ways to increase the saving rate increase public saving (reduce budget deficit) tax incentives for private saving

Economic Growth

• Productivity slowdown & “new economy” Early 1970s: productivity growth fell in the U.S. and other

countries. Mid 1990s: productivity growth increased, probably because of

advances in I.T.

• Empirical studies Solow model explains balanced growth, conditional convergence Cross-country variation in living standards

due to differences in cap. accumulation and in production efficiency

Economic Growth

• Endogenous growth theory: models that examine the determinants of the rate of

tech progress, which Solow takes as given explain decisions that determine the creation of knowledge

through R&D

Unemployment

• The natural rate of unemployment the long-run average or “steady state” rate of unemployment depends on the rates of job separation and job finding

• Frictional unemployment due to the time it takes to match workers with jobs may be increased by unemployment insurance

• Structural unemployment results from wage rigidity - the real wage remains above the equilibrium

level causes: minimum wage, unions, efficiency wages

Unemployment

• Duration of unemployment most spells are short term but most weeks of unemployment are attributable to a small number of

long-term unemployed persons

Money and Inflation

• Money the stock of assets used for transactions serves as a medium of exchange, store of value, and unit of account. Commodity money has intrinsic value, fiat money does not. Central bank controls money supply.

• Quantity theory of money assumption: velocity is stable conclusion: the money growth rate determines the inflation rate.

Money and Inflation

• Nominal interest rate equals real interest rate + inflation rate. Fisher effect: nominal interest rate moves one-for-one w/ expected

inflation. is the opp. cost of holding money

• Money demand depends on income in the Quantity Theory more generally, it also depends on the nominal interest rate; if so, then changes in expected inflation

affect the current price level.

Money and Inflation

• Costs of inflation Expected inflation

shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation

Unexpected inflationall of the above plus arbitrary redistributions of wealth between debtors and creditors

Money and Inflation

• Hyperinflation caused by rapid money supply growth when money printed to finance

govt budget deficits stopping it requires fiscal reforms to eliminate govt’s need for printing

money

Open economy

• Net exports--the difference between exports and imports a country’s output (Y )

and its spending (C + I + G)

• Net capital outflow equals purchases of foreign assets

minus foreign purchases of the country’s assets the difference between saving and investment

Open economy

• Exchange rates nominal: the price of a country’s currency in terms of another country’s

currency real: the price of a country’s goods in terms of another country’s goods. The real exchange rate equals the nominal rate times the ratio of prices

of the two countries.

• How the real exchange rate is determined NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate

NX with net capital outflow

• How the nominal exchange rate is determined e equals the real exchange rate times the country’s price level relative to

the foreign price level. For a given value of the real exchange rate, the percentage change in

the nominal exchange rate equals the difference between the foreign & domestic inflation rates.

Introduction to Economic Fluctuations

• Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies.

• Short run: prices are sticky, shocks can push output and employment away from their natural rates.

• Aggregate demand and supply: a framework to analyze economic fluctuations

• The aggregate demand curve slopes downward.

• The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.

• The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.

Introduction to Economic Fluctuations

• Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run.

• The Fed can attempt to stabilize the economy with monetary policy.

Aggregate Demand

• Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income.

• IS curve comes from Keynesian Cross when planned investment depends

negatively on interest rate shows all combinations of r and Y that equate planned

expenditure with actual expenditure on goods & services

Aggregate Demand

• Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate

• LM curve comes from Liquidity Preference Theory when money demand

depends positively on income shows all combinations of r andY that equate demand for real

money balances with supply

• IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that

satisfies equilibrium in both the goods and money markets

Aggregate Demand

• IS-LM model a theory of aggregate demand exogenous: M, G, T,

P exogenous in short run, Y in long run endogenous: r,

Y endogenous in short run, P in long run IS curve: goods market equilibrium LM curve: money market equilibrium

Aggregate Demand

• AD curve

shows relation between P and the IS-LM model’s equilibrium Y.

negative slope because P (M/P ) r I Y

expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right

expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right

IS or LM shocks shift the AD curve

Aggregate Supply

• Three models of aggregate supply in the short run: sticky-wage model imperfect-information model sticky-price model

• All three models imply that output rises above its natural rate when the price level falls below the expected price level.

• Phillips curve derived from the SRAS curve states that inflation depends on

expected inflation cyclical unemployment supply shocks

presents policymakers with a short-run tradeoff between inflation and unemployment

Aggregate Supply

3. How people form expectations of inflation adaptive expectations

based on recently observed inflation implies “inertia”

rational expectations based on all available information implies that disinflation may be painless

Aggregate Supply

• The natural rate hypothesis and hysteresis the natural rate hypotheses

states that changes in aggregate demand can only affect output and employment in the short run

hysteresis states that agg. demand can have permanent effects on

output and employment

Five Debates Over Macroeconomic Policy

• Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe policy can be used to offset this inherent instability.

• Critics of active policy emphasize that policy affects the economy with a lag and our ability to forecast future economic conditions is poor, both of which can lead to policy being destabilizing.

• Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, abuse of power, and time inconsistency.

• Critics of rules for monetary policy argue that discretionary policy is more flexible in responding to economic circumstances.

Five Debates Over Macroeconomic Policy

• Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits.

• Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce inflation is quite costly.

• Advocates of reducing the government debt argue that the debt imposes a burden on future generations by raising their taxes and lowering their incomes.

• Critics of reducing the government debt argue that the debt is only one small piece of fiscal policy.

Five Debates Over Macroeconomic Policy

• Advocates of tax incentives for saving point out that our society discourages saving in many ways such as taxing income from capital and reducing benefits for those who have accumulated wealth.

• Critics of tax incentives argue that many proposed changes to stimulate saving would primarily benefit the wealthy and also might have only a small effect on private saving.

Advances in Business Cycle Theory

• Real Business Cycle theory assumes perfect flexibility of wages and prices shows how fluctuations arise in response to productivity shocks the fluctuations are optimal given the shocks

• Points of controversy in RBC theory intertemporal substitution of labor the importance of technology shocks the neutrality of money the flexibility of prices and wages

Advances in Business Cycle Theory

• New Keynesian economics accepts the traditional model of aggregate demand and supply attempts to explain the stickiness of wages and prices with

microeconomic analysis, including menu costs coordination failure staggering of wages and prices

Consumption

• Keynesian consumption theory

Keynes’ conjectures MPC is between 0 and 1 APC falls as income rises current income is the main determinant of current consumption

Empirical studies in household data & short time series: confirmation of Keynes’

conjectures in long time series data:

APC does not fall as income rises

Consumption

• Fisher’s theory of intertemporal choice

Consumer chooses current & future consumption to maximize lifetime satisfaction subject to an intertemporal budget constraint.

Current consumption depends on lifetime income, not current income, provided consumer can borrow & save.

Consumption

• Modigliani’s Life-Cycle Hypothesis Income varies systematically over a lifetime. Consumers use saving & borrowing to smooth consumption. Consumption depends on income & wealth.

• Friedman’s Permanent-Income Hypothesis Consumption depends mainly on permanent income. Consumers use saving & borrowing to smooth consumption in the

face of transitory fluctuations in income.

• Hall’s Random-Walk Hypothesis Combines PIH with rational expectations. Main result: changes in consumption are unpredictable, occur only

in response to unanticipated changes in expected permanent income.

Consumption

• Laibson and the pull of instant gratification Uses psychology to understand consumer behavior. The desire for instant gratification causes people to save less than

they rationally know they should.

Government Debt

• Relative to GDP, the U.S. government’s debt is moderate compared to other countries

• Standard figures on the deficit are imperfect measures of fiscal policy because they– are not corrected for inflation– do not account for changes in govt assets– omit some liabilities (e.g. future pension payments to current

workers)– do not account for effects of business cycles

Government Debt

• In the traditional view, a debt-financed tax cut increases consumption and reduces national saving. In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living. In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit).

• The Ricardian view holds that debt-financed tax cuts do not affect consumption or national saving, and therefore do not affect interest rates, investment, or net exports.

Government Debt

• Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations.

• Government debt can have other effects:– may lead to inflation– politicians can shift burden of taxes from current to future

generations– may reduce country’s political clout in international affairs or scare

foreign investors into pulling their capital out of the country

Investment

• All types of investment depend negatively on the real interest rate.

• Things that shift the investment function: Technological improvements raise MPK and raise business fixed

investment. Increase in population raises demand for, price of housing and

raises residential investment. Economic policies (corporate income tax, investment tax credit)

alter incentives to invest.

Investment

• Investment is the most volatile component of GDP over the business cycle.

Fluctuations in employment affect the MPK and the incentive for business fixed investment.

Fluctuations in income affect demand for, price of housing and the incentive for residential investment.

Fluctuations in output affect planned & unplanned inventory investment.

Money Supply and Money Demand

• Fractional reserve banking creates money because each dollar of reserves generates many dollars of demand deposits.

• The money supply depends on the monetary base currency-deposit ratio reserve ratio

Money Supply and Money Demand

• The Fed can control the money supply with open market operations the reserve requirement the discount rate

• Portfolio theories of money demand stress the store of value function posit that money demand depends on risk/return of money &

alternative assets

Money Supply and Money Demand

• The Baumol-Tobin model is an example of the transactions theories of money demand,

stresses “medium of exchange” function money demand depends positively on spending, negatively on

the interest rate, and positively on the cost of converting non-monetary assets to money