macro review in preparation for api 120 api-120 - macroeconomic policy analysis i, prof.j.frankel,...

MACRO REVIEWin preparation for API 120

API-120 - Macroeconomic Policy Analysis I , Prof.J.Frankel, Harvard Kennedy School

(I) DEFINITIONS & ACCOUNTING(i) National income & product accounts(ii) Balance of Payments accounts

(II) THE KEYNESIAN MODEL

(i) National income & product accounts

• Definition of macroeconomics– Aggregates

– Goods (& labor) markets don’t clear in short run

– Role for monetary & fiscal policy.

• Definition of– GDP

– GNP (includes profits of MNCs abroad)

– National Income (includes unilateral transfers)


Ways to decompose GDP• To whom the goods & services (GDP) are sold:

– C– I– G– X-M

• How the income (Y) is used:– Taxes net of transfers, gives disposable income– Saving– Consumption

• Allocation of shares according to factors of production– Wages & salaries– Capital income– Self-employed and other


(ii) Balance of Payments accounts

• The rules:– If you have to pay a foreign resident, normally in

exchange for something that you bring into the country, then the something counts as a debit.

– If a foreign resident has to pay you for something, then the something counts as a credit.

• Definition: The balance of payments is the year’s record of economic transactions between domestic & foreign residents.

API-120 , Prof.J.Frankel, Harvard Kennedy School

API-120 , Prof.J.Frankel, Harvard Kennedy School

†

† Now also called “financial account”

The rules, continued

• Each transactions is recorded twice: once as a credit and once as a debit.

– E.g., when an importer pays cash dollars, • the debit on the merchandise account is offset by • a credit under short-term capital: the exporter in the other

country has, at least for the moment, increased holdings of US assets, which counts as a credit just like any other portfolio investment in US assets.

• At the end of each quarter, credits and debits are added up within each line-item;

• and line-items are cumulated from the top to compute measures of external balance.

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.

• CA + KA + ORT ≡ 0• BoP ≡ CA + KA

• => BoP ≡ -ORT ≡ excess supply of FX coming from private sector, which central banks absorb into reserves (if they intervene in the FX market at all).– A BoP surplus country adds to its FX reserves (US Tbills)

• China, Saudi Arabia, most EMs since 2000

– A BoP deficit country • runs down its FX reserves

(Mex.1994, Thailand 1997, Russia 1998, Argentina 2001, Latvia 2008, Ukraine 2008…)• Unless it is lucky enough (US) that foreign central banks finance the deficit.

• A floating country does not intervene in the FX market• => BP ≡ 0;• Exchange rate E adjusts to clear private market FX supply & demand.

APPENDIX Examples on the current account:

• You, an American, import software CD-roms from India=> debits appear on US merchandise account.

• You import services (electronically) of an Indian software firm => debit appears on US services account. (This is the famous and controversial “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 sends profits back to India => debit appears on US investment income account. (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 => debit appears under unilateral transfers.

Examples on the long-term capital account:

Instead of buying software CD-roms from India, you buy the company in India that makes them. => debit appears on US capital account, under FDI. (You have imported ownership of the company.)

Instead of buying the entire company in India, you buy some stock in it => debit appears on US capital account, under equities. (You have imported claims against an Indian resident.)

Instead of buying stock in the company, you lend it money for 2 years => debit appears on US capital acct, under bonds or bank loans. (Again, you have imported a claim against an Indian resident.)

Examples on the short-term capital account:

You lend to the Indian company in the form of 30-day commercial paper or trade credit => debit appears on US short-term capital account. (Again, you have acquired 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 => debit appears on US short-term capital account.

You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed – but “Sovereign Wealth Funds,” from China to oil-exporting countries, now make international investments of this sort) => debit appears as a US official reserves transaction.

API-120 - Macroeconomic Policy Analysis, Prof.Jeffrey Frankel, Harvard Kennedy School

End of: Definitions & Accounting

API-120 - Macroeconomic Policy Analysis I , Professor Jeffrey Frankel,

MACRO REVIEW

(II) THE KEYNESIAN MODEL

Part 1: Introduction to Keynesian Model:Derivation, and National Saving Identity.

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:

Y

TB

+ 0 -

),( YEMM d *),( YEXX dmYM X

)( mYMXTB

as does consumption: Keynesian consumption function cYCC

assuming E & Y* fixed, for now.

where slope = -m ≡ - marginal propensity to import

TB falls in expansions…

…and rises in contractions

Determination of equilibrium incomein open-economy Keynesian model

TBAY )()( MXGIC

)()( mYMXGIcYC

MXGICmYcYY

mc

MXGICY

1

ms

MXAY

GICA cs 1where and

Now solve:

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Derivation of National Saving Identity

Income ≡ Output (assuming no transfers)

Y ≡ GDP

S + (T-G) ≡ I + X – M / /

NS ≡ S + BS ≡ I + TB

NationalSavingIdentity

C + S + T ≡ C + I + G + X -M



}National savings =

Private savings

} + Budget surplus



US National Saving, Investment, & Current Account as Shares of GDP, 1949-2010

Gap widened, as NS fell

relative to I



Keynesian Consumption Function:

or, expressed as a saving function:

where s ≡ 1 – c

dYc CC

d

ddd

Y s C-

)cY C( -Y C - Y S

} I



Closed economy: NS – I = 0

Fiscal Expansion

1 < Closed-economy multiplier 1/s < ∞

Open economy: NS – I = TB = X – M

Imports: for simplicity

Exports: for simplicity

mY Mor , Y)(E,MM d

Xor ),Y(E,XX *d



Open economyFiscal Expansion

Gs

Gms

Y

11

G

slope = s



Part 2:KEYNESIAN MULTIPLIERS

• The multiplier for an increase in , e.g., due to a fiscal expansion .

X

A

• The multiplier for an increase in , e.g., due to a devaluation .

SUMMARY OF MULTIPLIERS

MX I NS

ms

MXA Y

G I CA where

Ams

1 Y

Ym- ΔM ΔTB

+ Keynesian model of S + M =>

Fiscal Expansion

open-ec. multiplier = 1/(s+m)<1/s

YmXΔ ΔTB

Xms

1 Y

Devaluation

Equation (17.11). Note misprint in 10th ed. of WTP.)

. AΔms

m

XΔ

ms

s

. XΔ


Part 3: MACROECONOMIC INTERDEPENDENCE

International transmission under fixed vs. floating exchange rates

• of a disturbance originating domestically.• of a disturbance originating abroad .

FixFloat

FloatFix

International Transmission

↓I ↓X

Floating increases effect on Y Floating decreases effect on Y

=> appreciation

=> depreciation

= “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: .

– Disturbances are transmittedfrom one country to another:

.XmsY ))/(1(

AmsY ))/(1(


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 tendto be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier: . .

– The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy: .

AsY )/1(

0Y

Goals and Instruments• Policy goals: Internal balance & External balance

• Policy instruments

Parts 4 & 5:POLICY INSTRUMENTS

• The Swan Diagram• The principle of goals & instruments

Introduction of monetary policy • The role of interest rates • Monetary expansion • Fiscal expansion & crowding out



Goals and instruments

Y

Policy Instruments• Expenditure-reduction,

e.g., G ↓ • Expenditure-switching,

e.g., E ↑

Policy Goals• Internal balance:

e.g., Y = ≡ potential output Y < ≡ ES ≡ “output gap” => unemployment >Y > ≡ ED => “overheating” => inflation

and/or asset bubbles

• External balance: e.g., BP=0 or CA=0

YY u



In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y << .Y

Source: IMF, via Economicshelp, 2009

UK

US

France

Output gap, as percentage of GDP, 2009

Ir

Jpn

Internal balance

Output gap in eurozone peripherySource: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions)

http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html

Greece & Ireland overheated by 2007: Y >>

and crashed in 2009-12: Y <<

Y

Y

Like Italy, Spain & Portugal in 1992, but the devaluation option is now gone.



THE PRINCIPLE OF TARGETS AND INSTRUMENTS

• Can’t normally hit 2 birds with 1 stone

• Have n targets? • => Need n instruments,

and they must be targeted independently.

Y• Have 2 targets: CA = 0 and Y = ?• => Need 2 independent instruments:

expenditure-reduction & expenditure-switching.

Financing• By borrowing

• or running down reserves.

RESPONSES TO CURRENT ACCOUNT DEFICIT

Adjustment• Expenditure-reduction (“belt-tightening”)

• e.g., fiscal or monetary contraction

vs.

• or Expenditure-switching • e.g., devaluation.



Starting from current account deficit at point N,policy-makers can adjust either by (a) cutting spending,

or (b) devaluing.

A

X

●

●

●

●



(a) If they cut spending,CA deficit is eliminated at X;

but Y falls belowpotential output . Y

=> recession●

●



(b) If they devalue,CA deficit is again eliminated, at B,

but with the effect of pushing Y abovepotential output.

=> overheating

●

●

Devaluation

• Experiment: increase in Ă

(e.g. G↑)

• Only by using both sorts of policies simultaneouslycan both internal & external balance be attained, at point A.

Expansion moves economy rightward to point F.Some of higher demand falls on imports. => TB<0 .

XE

DERIVATION OF SWAN DIAGRAM

What would have to happento reduce trade deficit?

●●

●

●

●

●

At F, TB<0 .

What would have to happen to eliminate trade deficit?

Again,

If depreciation is big enough, restores TB=0 at point B.

E ↑ .

A

●

●●



.

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.

To repeat, at F, some of higher demand falls on imports.

●

●

●

Now consider internal balance.

Return to point A. A

Expansion moves economy rightward to point F.

Y

What would have to happen to eliminate excess demand?

Some of higher demand falls on domestic goods => Excess Demand. Y >

●

●

●

●

Experiment: increase

E ↓ . ●

Experiment: Fiscal expansion, cont.

At F, Y > .


Y

Y

If appreciation is big enough, restores Y= at point C.

E ↓ .

●

●●


E ↓.

We have just derived downward-sloping internal balance line, YY.

At F, some of higher demand falls on domestic goods.

If appreciation is big enough, restores at C.

● ●

●

Swan Diagram has 4 zones:

I. ED & TDII. ES & TDIII. ES & TB>0IV. ED & TB>0

●

Summary:

combination of policy instruments

to hit one goal slopes up,

to hit the other slopes down.



Example: Emerging markets in 1990s

Excgange rate

E

YY:Internal balance

Y=Potential

ED & TD

ED & TB>0

ES & TD

ES & TB>0

Mexico 1994

or Korea 1997

Mexico 1995

or Korea 1998

Spending A

BB:External balance

CA=0

Classic response to a balance of payments crisis:Devalue and cut spending

●



Example: China in the past decade

Excgange rate E

YY:Internal balance

Y = Potential

ED & TD

ES & TD

ES & TB>0

China2010

BB:External balance

CA=0

China2002

ED & TB>0

Spending AAt the end of 2008, an abrupt loss of X,

due to the US crisis, shifted China into ES.

By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery, due in part to G stimulus,

shifted China again 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 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 in i and positively on Y).

iY

LM

E.g., Taylor Rule sets i.

E.g., Quantitative Easing sets MB.

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.

New equilibrium:

At point D if monetary policy is accommodating.

Fiscal expansion shifts IS out.

D.At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓ Rise in Y < full Keynesian multiplier.

API-120 - Macroeconomic Policy Analysis, Prof.Jeffrey Frankel, Harvard Kennedy School

End of: Introduction to the Keynesian Model

macro review in preparation for api 120 api-120 - macroeconomic policy analysis i, prof.j.frankel,...

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