macroeconomics i 2009

8/8/2019 Macroeconomics i 2009

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FOREIGN TRADE UNIVERSITYFaculty of International Economics

Hoang Xuan Binh, MSc Hoang Xuan Binh, MSc

A PowerPoint Tutorial

to Accompany macroeconomics, 5th ed.N. Gregory Mankiw

Macroeconomics IMacroeconomics I


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I would like to express my deepest gratitude to Mannig J. Simidian (Harvard University) and my Supervisor Prof. Witztum(London University) for their invaluable comments.

CHAPTER I:Introduction Lecture programme


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Introduction

M odule title: M acroeconomics ISemester: I

Year 2008-2009

Level: UndergraduateM odule Convenor: Hoang Xuan Binh

Time:15:05-17:30 on M onday

Room: D102- Foreign Trade University(Hanoi Campus)

Tel: 844-8345801

Cellphone: 0912782608


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INTRODUCTION

M odule Context:The module is designed especially forstudents taking M acroeconomics at FTU. Itis intended to provide students with an

understanding of important macroeconomicfactors and variables. The course analyseshow macroeconomic variables operate;and itdevelops an understandings of theinternational money and financial market, inor outflows of capital. The course also drawson the debates in real economy and tries touse both old and new theories to understandthem.


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Introduction

M odule aims and objectives:1 .To familiarise the students with some of the most important macroeconomic variables in theeconomy, for example GDP,GNP,CPI,PPI

2.To introduce students to some important macroeconomic policies including fiscal and monetary policies .

3.To examine some different cases in term of using macroeconomic policies to develop economy.


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IntroductionLearning outcomes

B y the end of this module it is expected that students:

1.will have an understanding of how importantmacroeconomic variables are interacting in theeconomy.

2.will be able to interpret such variables and events asGDP,GNP,CPI or inflation,unemployment and relatethem to changes of other variables and events in theeconomy.

3.will be ready to explain significant events in realeconomy by using economic theories.

4.will be familiar with current debates on open-

economy and able to make a critical assessment of thevarious arguments which are put forward.


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Teaching and learning methods:

In class contact hours there will be lectures,discussions and assistance with studentsassignmentwork,reading and using books. During the seminars thestudents will be expected to discuss the provided topicson the problems of real economy.

Assessment methods:

There is a written assignment and final examination.It is worthy 30% and 60% respectively. Class

participation is 10% .

S uggested S upplementary R eadingMankiw, Principles of Economics

Mankiw, Macroeconomics 5th ed ,

Sloman J., (2003), E conomics , 5th ed


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Lecture programmeChapter: Introduction lecture programme

Chapter2:The Data of Macroeconomics

Chapter4:Money and Monetary policy

Chapter5:Inflation and unemployment

Chapter6:Economic growth

Chapter 7: The Open economy

Chapter3:Aggregate Demand and Fiscal policy

Presentation assignment

Revision


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Everyone is concerned about macroeconomicslately. We wonder why some countries are growing fasterthan others and why inflation fluctuates. Why?Because the state of the macroeconomy affectseveryone in many ways. It plays a significant

role in the political sphere while also affectingpublic policy and social well-being.

I.Introduction

Th ere is muc h discussion of re c ess ion s -- periods in w h ich

real GDP

falls mildly-- and depress ion s , concerns with

issues suc h as inflation, un emp loy me nt, m on e ta r y an d fi s cal p olici es .


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Economists use models to understand what goes on in the economy.Here are two important points about models: endogenous variablesand exogenous variables . Endogenous variables are those which themodel tries to explain. Exogenous variables are those variables thata

model takes as given. In short, endogenous are variables within amodel, and exogenous are the variables outside the model.PricePrice

DemandDemand

QQ*

PP

SupplySupply

QuantityQuantity

* This is the most famouseconomic model. It describesthe ubiquitous relationship

between buyers and sellers inthe market. The point of intersection is called an

equilibrium.


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EconomistsEconomists typicallytypically assumeassume thatthat thethe marketmarket willwill gogo intointoanan equilibriumequilibrium of of supplysupply andand demand,demand, whichwhich isis calledcalledthethe market market clearing clearing process process. . ThisThis assumptionassumption is is centralcentraltoto thethe PhoPho exampleexample onon thethe previousprevious slideslide.. But,But, assumingassuming

thatthat marketsmarkets clearclear continuouslycontinuously isis notnot realisticrealistic. . ForFormarketsmarkets toto clearclear continuously,continuously, pricesprices wouldwould havehave totoadjustadjust instantlyinstantly toto changeschanges inin supplysupply andand demanddemand. . But,But,evidenceevidence suggestssuggests thatthat pricesprices andand wageswages oftenoften adjustadjustslowlyslowly. .

So,So, rememberremember thatthat althoughalthough marketmarket clearingclearing modelsmodelsassumeassume thatthat wageswages andand pricesprices areare flexible, flexible, inin actuality,actuality,somesome wageswages andand pricesprices areare stickysticky. .


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Microeconomics is the study of how households and firmsmake decisions and how these decision makers interact in the

marketplace. In microeconomics, a person chooses tomaximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many people trying to maximize their own welfare. Therefore, when

we study macroeconomics, we must consider itsmicroeconomic foundations.


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II.R esearc h aims and researc h meth ods:

1. A ims and objectives of macroeconomics Yield, E conomic growt h ,unemployment, inflation, budget,Balance of P ayments,2. R esearc h meth od

- Math ematics, g e n er al eq uilib r iu m ,Walras met h ods (equilibrium in allmarket


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III. Macroeconomics system

1. Inputs+ Ex ogenous variables : weat h er,politics, population, tec h nology andpatents or know- h ow+E ndogenous variables : directimpacts-fiscal policy,monetarypolicy, e x ternal economic policy

2. Black bo x : A S +A D2.1. A ggregate Demand


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2.2.A ggregate S upply

*R elated factors: P rice, Income,Ex pectation

*R elated factors: P rice,production cost,potential output (Y*)

Y*: max imization of output w h icheconomy can produce, wit h full-employment and no inflation.F ull- emp loy me nt= po pulationoutof wo rk ing ag e - invali ds -( pu pil s +s tu de nt s) ser vant-unwilling to wo rk


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Yield, employment,A verage price,

Inflation,interest,budget,Trade balance and balance of International payment,

E conomic Growt h

3 . Outputs


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M acroeconomicsRecessionDepressionM odelsM

acroeconomic systemInputsOutputsEndogenous variablesExogenous variablesM arket clearingFlexible and sticky pricesM icroeconomics


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CHAPTER II

Data of macroeconomics


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I. Gross domestic products-GD P

Gross Domestic Product (GDP) is themarket value of all final goods and

services produced within an economyin a given period of time.


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There are 2 waysof viewing GDP

Total income of everyone in the economy

Total expenditure on the economysoutput of goods and services

Households Firms

Income $

Labor

Goods

Expenditure $

For the economy as a whole, income must equal expenditure .GDP measures the flow of dollars in this economy.

Income, Expenditure

And the Circular Flow


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1) To compute the total value of different goods and services,the national income accounts use market prices.Thus, if

$0.50 $1.00

GDP = (Price of apples v Quantity of apples)+ (Price of oranges v Quantity of oranges)

= ($0.50 v 4) + ($1.00 v 3)GDP = $5.00

2) Used goods are not included in the calculation of GDP.

II.C omputing GD P1.R ules for computingGDP


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3 ) Th e treatment of inventoriesdepends on if t h e goods are stored or if th ey spoil. If t h e goods are stored,th eir value is included in GD P .

If th ey spoil, GDP remains unc h anged.Wh en t h e goods are finally sold out of inventory, t h ey are considered usedgoods (and are not counted).


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4) Intermediate goods are not countedin GDP only th e value of final goods.R eason: t h e value of intermediategoods is already included in t h e marketprice.

V alu e a dded of a firm equals t h e valueof th e firms output less t h e value of t h eintermediate goods t h e firm purc h ases.5) Some goods are not sold in the marketplaceand therefore dont have market prices. We mustuse their imputed value as an estimate of theirvalue. For example, home ownership andgovernment services.


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The value of final goods and services measured atcurrent prices is called nominal GDP . It can changeover time either because there is a change in the amount

(real value) of goods and services or a change in theprices of those goods and services.Hence, nominal GDP Y = P v y, where P is the pricelevel and y is real output and remember we use outputand GDP interchangeably. R eal GDP or, y = Y z P is the value of goods and servicesmeasured using a constant set of prices.


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Lets see how real GDP is computed in our apple andorange economy.

F or example, if we wanted to compare output in 2002 and output in 2003, we would obtain base-year prices, such as 2002

prices.

Real GDP in 2002 would be:(2002 Price of Apples v 2002 Quantity of Apples) +(2002 Price of Oranges v 2002 Quantity of Oranges).Real GDP in 2003 would be:

(2002 Price of Apples v 2003 Quantity of Apples) +(2002 Price of Oranges v 2003 Quantity of Oranges).Real GDP in 2004 would be:(2002 Price of Apples v 2004 Quantity of Apples) +(2002 Price of Oranges v 2004 Quantity of Oranges).


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Nominal GDP measures the current dollar value of the outputof the economy.

R eal GDP measures output valued at constant prices.

The GDP deflator , also called the implicit price deflator forGDP, measures the price of output relative to its price in thebase year. It reflects whats happening to the overall level of prices in the economy.

GDP Deflator = Nominal GDPReal GDP


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In some cases, it is misleading to use base year prices that prevailed 10 or 20 years ago (i.e. computers andcollege). In 1995, the Bureau of Economic Analysis

decided to use chain-weighted measures of real GDP. The base year changes continuously

over time. This new chain-weightedmeasure is better than the more

traditional measure because itensures that prices will not be

too out of date.

Average prices in 2001and 2002 are used to measurereal growth from 2001 to 2002.Average prices in 2002 and 2003are used to measure real growth from2002 to 2003 and so on. These growthrates are united to form a chain that isused to compare output between any two

dates.


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3 . Meth ods of computing GD P

*Ex penditure approac h

GDP = C + I + G + (X-M)


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Government

purchases of goodsand services

Y = C + I + G + NXY = C + I + G + NX

Total demandfor domesticoutput (GDP)

is composedof

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds Net exports

or net foreign

demand

This is the called the national income accounts identity.


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*Th e Factor Incomes A pproac h : itmeasures GD P by adding toget h er all th eincomes paid by firms to h ouse h olds for th e services of t h e factors of productionth ey h ire. A ccording to t h is approac h , GDPis t h e sum of incomes in t h e economyduring a given period

GDP = w + r + i +4 + D +TeW: wag e , r : re nt fix ed ca pital, i : int eres t, 4

pr ofit, D : Depre ciation, T e : in d i re ct tax


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3 . Th e output approac h

Total Value added = Total R evenues T otal C ost

GDP = Value added in allindustries

=> GDP = VAT . 1/Value added

taxEx ample:One firm gains value added is 80, 1000 firms is80,000. 80 = total revenues total cost

(production cost)


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II.Gross national products)-GN P

1. Definition:GNP is the market value of all final goodsand services produced by domestic residentsin a given period of time.

2. C omputing met h ods:

GNP = GDP + T n

T n: net Income from A broad


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*3 cases :

+ GNP > GDP (T n>0): domestic economyh as impacts in ot h er economies.

+ GNP < GDP (T n


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4. Net Economic Welfare -NEW

GDP , GNP doesnt compute somegoods and services w h ich arent sold,or illegal transactions or activities of black market, negative e x ternality


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V1 + V alu e of R es t + V alu e of goo ds an d ser vic es which a re nt s ol d

+ R e v e nu es f r o m t r an s action s in blac k m a rke t

V 2-negative externality for natural

resources,environment, such as noise traffic jam

NE W re fl e ct s w e lfa re b e tt er than G NP m but it i s v er y d ifficult to hav e e nough d ata toco mp ut e NE W ,th ere fo re , e cono m i s t s s till u se GD P an d G NP.


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T n

C

I

G

NX

GNP

D

NNP

Te

NI(Y)

T d-TR

Yd

NNP = GNP -D ; Y=NI=NNP -Te=GNP -D-Te

Yd = NI - (T d-TR ) = (C +S )

D-Depreciation

NNP -Net NationalP roduct

NI-National Income

Yd-Disposal IncomeTR (transfer)-T d: Direct ta x


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National income accountsConsumptionInvestment

Government Purchases Net ExportsLabor force

Gross domestic product (GDP)Consumer Price Index (CPI)Unemployment Rate

Stocks and flowsValue added

Nominal versus real GDPGDP deflator GNP

NEW


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CHAPTER IIIA ggregate Demand

& Fiscal policy

d l i h fi i i f f


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Todays lecture is t h e first in a series of four lectures aimed at analysing different (separate)markets in t h e economy. Th is will th en enableus to bring t h e various markets toget h er andto analyse t h e be h aviour of t h e wh oleeconomy (t h is is also referred to as g e n er al eq uilib r iu m analysis). Today we will introducean analysis of t h e economy as originally

described by t h e economist Jo h n MaynardKeynes. H is th eory of h ow th e macroeconomyworks will h elp us e x plain h ow th e economysincome (GDP ) is determined. Today we analyseth e model in its simplest form and we willassume t h at th e economy does not h ave agovernment and t h at it does not trade wit h th erest of t h e world. We will relax th eseassumptions.


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Th e Keynesian Th eory of Income Determination: t h eth eory t h at will be presented h ereafter was developed byth e C ambridge economist Jo h n Maynard Keynes in t h ewake of t h e 1920s Great Depression. H e argued t h at t h ecause of a low level of income (GD P ) in th e economy wasgiven by t h e lack of A D.

J ohn Mayna rd K e yn es ( r ight ) an d Ha rr y D e xt er W hit e at th e Bre tton


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P ersonal and marital lifeBorn at 6 H arvey R oad, C ambridge , Jo h n MaynardKeynes was t h e son of Jo h n Neville Keynes , aneconomics lecturer at C ambridge University , andFlorence A da Brown , a successful aut h or and a socialreformist. H is younger brot h er Geoffrey Keynes (1887 1982) was a surgeon and biblioph ile and h is younger sister Margaret (1890 1974) married t h e Nobel-prize-winning p h ysiologist A rch ibald H ill.Keynes was very tall at 1.98 m (6 ft 6 in).

In 1918, Keynes met Lydia Lopokova , a well-knownR ussian ballerina , and t h ey married in 1925. By mostaccounts, t h e marriage was a h appy one. Beforemeeting Lopokova, Keynes's love interests h ad beenmen, including a relations h ip with th e artist DuncanGrant and wit h th e writer Lytton S trac h ey. For medicalreasons, Keynes and Lopokova were unable to h ave


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I. A ggregate P lanned Ex penditure andA ggregate Demand

1 .A ss u mp tion s : a m o de l n e a r ly alway s s ta r t s with th e wo rd a ss u me o r su pp o se . Thi s i s an in d ication that re ality i s about to b e s i mp lifi ed ino rder to focu s on th e i ss u e at han d

* P r ic es , W ag es an d Int eres t Rat e a re Con s tant


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* Th e E cono m y O per at es at l ess thanfull E mp loy me nt : thi s i mp li es that fi rms a re willing to s u pp ly any

a m ount of th e goo d at a giv e n pr ic eP. In oth er wo rds , a ss u me that th es u pp ly of goo ds i s co mp l e t e ly e la s tic at pr ic e P. Thi s a ss u mp tion i s

g e n er ally vali d only in th e s ho r t r un


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* Clo sed E cono m y an d N o Gov er n me nt :

w e a ss u me that th e e cono m y d o es not t r a de with th e res t of th e wo r l d s o that both e x po r t s an d i mp o r t s a re eq ual toz er o (X=M=0 ). W e al s o a ss u me that th ere

i s no gov er n me nt in th e e cono m y s o that gov er n me nt e x pe n d itu res an d tax es a reeq ual to z er o (G=T=0 ). Thi s i mp li es that agg re gat e dem an d i s th ere fo re red uc ed

to th e following e x press ion : A D | C + I


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APE reflects t h e total plannedex penditure at eac h income, wit hassumption of given price.

1. A ggregate P lanned Ex penditure

*Hou se hol ds : C onsumption C =f(Y d) : the main determinant of consumption is surely income, or morepreciselyC = f

1(Y)


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-F i rms : to create t h e demand t h roug h

th

eir investment I = f 2(Y)

APE = C + I = f 1(Y) + f 2(Y)1 . 1 . Con s u mp tionfunction*Th e relations h ip between consumptionex penditures and disposable income, ot h er th ings remaining t h e same, is calledconsumption function. Th e consumptionfunction t h at we will use in our model and t h ats h ows t h e positive link between consumptionand disposable income is t h e following (figure

1): Yd MPC C Y f C .)(1 !!


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*Determinants of C onsumption:

+A

utonomousC

onsumption ( C ): th

is isth e amount of consumption e x penditureth at would take place even if people h adno current disposable income

+Induced C onsumption: t h is isconsumption e x penditure t h at is inex cess of autonomous consumption

and t h at is induced by an increase indisposable income


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Y C

MPC (

(!

+Marginal P ropensity to C onsume(MPC ): it is th e fraction of a c h ange in

disposable income t h at is consumed.It is calculated as t h e c h ange inconsumption e x penditures ( DC )divided by t h e c h ange in disposable

income ( DY d ) th at broug h t it about. Itgives t h e effect of an additionalpound of disposable income onconsumption. Th e MPC determines

th e slope of t h e consumptionfunction


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0 < M P C < 1 :Th is reflects t h e fact t h atpeople are likely to consume only partof any increase in income and to saveth e rest

*Ex ample. Th e following is an

ex ample of a consumption function:C = 20 + 0.7x YdA utonomous C onsumption: 20MPC = 0.7


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+NetP rivateS avings- S : savings byconsumers is equal to t h eir disposableincome minus t h eir consumption=> S = Yd - Cand, by using t h e definition of disposable income t h is identity can berewritten as:S = Y T C (but T = 0, no government)H owever, given t h at th ere is nogovernment in our simple economy,T

=0 and savings are equal to: S = Y -C

1.2.Th e S aving Function: t h eeconomys savings function can bederived by using t h e private savingsex pression and t h e consumption


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Y MPS C S Y MPC C Y MPC C Y S

C Y S

.).1(.

!

!!

!

+Th e Marginal P ropensity to S ave(MP S ): th e propensity to save tells ush ow muc h people save out of anadditional unit of income. Th eassumption we made earlier t h at MPCis between zero and one implies t h atth e propensity to save is given by(1 -M P C ) and t h at it is also between 0and 1.Th e S avin C urve: it traces t h e


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1.3 .Investment function (I): t h e secondex penditure in APE th at we will analysetoday is investment

*Determinants of Investment: we candistinguis h four major determinants of investment

+Increased C onsumer Demand:

investment is to provide ex

tra capacity.Th is will only be necessary, t h erefore, if consumer demand increases


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+Ex pectations: since investment is madein order to produce output for t h e future,investment must depend on firmsex pectations about future marketconditions

+C ost and E fficiency of C apitalE quipment: if t h e cost of capitalequipment goes down or mac h inesbecome more efficient, t h e return oninvestment will increase and firms willinvest more


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+Interest rate: t h e h igh er th e rate of interest, t h e more e x pensive it will befor firms to borrow t h e money tofinance t h eir investment e x pendituresand t h e less profitable will t h einvestment be


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+Level of Investment in t h e E conomy:in th is model we will take investment

as given or, in ot h er words, we willregard it as an e x ogenous variable.Th e main reason for taking investmentas given is to keep our model simple.Th us we will assume t h at investment isgiven by a fi x ed/constant amount (abar over a variables indicates t h at th evariable is regarded as an e x ogenousvariable) t h at does not c h ange wit h th elevel of income in t h e economy:

I I !


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. APE C I C I M PC Y ! !

*Th e Determination of E quilibriumOutput: Wh en P , w is constant,t h eequilibrium in t h e goods marketrequires t h at th e supply of goods(GD P =Y ) equals t h e demand for goods ( APE ):

Y =APE =A D


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)(1

1 I C

MPC Y e !

Th is equation is called t h e equilibriumcondition. By replacing t h e above

ex pression for aggregate plannedex penditure in t h e equilibriumcondition we get:

A s you can see t h e above e x pression isan equation in one endogenous variable:Y . Th us we can solve t h is equation for Y and t h is will give us t h e equilibrium levelof output ( Y e )produced in t h e economy

.

Y A P E

Y C I M P C Y

!

!

200! I 200! I 200! I


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*Ex ample 1. A ssume t h at in t h eeconomy t h e level of autonomousconsumption c0= 1 00 , th e marginalpropensity to consume is M P C=0 .5 andth e investment spending is I=200 .Determine t h e equilibrium level of output produced in t h e economy.

2 APE & Ye in closed economy wit h a


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-Firms invest in economy-Government sector e x penditure: G I I !

+G will increase APE and will s h ift th eAPE curve upwards.+Tax ation reduces t h e level of disposable income available for

consumption and will tend to reduceAPE . S uch a reduction in APE isreflected by a downward rotation of t h eAPE curve. Wh y?

2. APE & Ye in closed economy wit h aGovernment S ector


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T T !

.( ) APE C I G C I G MPC Y T ! !

0

. ( )

1( )

1 1

Y A P E Y C I M P C Y T

M P C Y C I T

M P C M P C

!!

!

Th is is due to t h e fact t h at ta x ationreduces t h e overall MPC by th eh

ouseh

old so th

at for each

ex

tra poundof income t h e h ouse h old will nowconsume less since some of t h e e x traincome must be paid in ta x es

2.1.Fix ed ta x ation


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MPC MPC

mt ! 1Multiplier E ffect of ta x ation

T mG I C mY t ! )(0

2.2. Taxation depe n ds on inco me: T = t.Y(t:tax rate)

Y t MPC C T Y MPC C C )1()( !!

I I ! GG !


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(1 ) APE C I G C I G MPC t ! !

0

(1 )1

( )1 (1 )

Y APE

Y C I G MPC t Y

Y C I GMPC t

!

!

!

=>E quilibrium point of economy:


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)1(11

t MPC m !d Multiplier of consumption

in th e closed economywith Government sector

MPC m

t MPC m !!d

11

)1(11

Th is reflects t h at th e income based ta xis less efficient t h an fix ed ta x .


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3 . 2. APE & Ye in open-economy wit h aGovernment S ector and foreign trade

*A ssuption: T = t.Y (t- tax rate)E conomy h as 4 sector

X doesnt depend on domesticincome,t h erefore

X X !

*C = C + MPC .(Y-T ) = C + MPC .(1-t).Y

*I = I*G = G

*NX=X-M: netex port


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M derives from production inputs, or consumptions of h ouse h olds=>Mincreases w h en I or Ye rises.Ta c: M = MP M.Y

*MP M (Marginal P ropensity to Import): itis t h e fraction of an increase in GD P th atis spent on imports. It is calculated asth e c h ange in imports ( ( M ) divided by

th e c h ange in GD P (( Y ) th at broug h t itabout, ot h er th ings remaining t h e same.Th e M P M is a positive number smaller th an one

MP M =( M/ ( Y an d 0


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? A(1 )

APE C I G X M

APE C I G X MPC t MPM Y

!

! v

? A

0

(1 )

1( )

1 (1 )

Y APE

Y C I G X MPC t MPM Y

Y C I G X MPC t MPM

!

! v

!

*E quilibrium point of economy:

MPM t MPC m !dd

)1(11

o pe n- e cono m y m ulti pli er

m < m < m. o pe n- e cono m y m ulti pli er i s l esse ffici e nt than clo sed e cono m y m ulti pli er .

The Multiplier Spending Chain


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The Multiplier Spending Chain( I = 1 million - Marginal Propensity to Consume: mpc = 0.8

R ound N.S pending in Th is R ound C umulative Total ( I

1 1,000,000 (( G 1,000,000 (( G1)2 800,000(( C 2=0.8*( G) 1,800,0003 640,000(( C 3 =0.8*( C 2) 2,44 0,0004 512,000(( C 4=0.8*( C 3 ) 2,952,000

5 409,600(( C 5=0.8*( C 4) 3 ,3 61,6006 3 27,680(( C 6=0.8*( C 5) 3 ,689,2807 262,144 (( C 7=0.8*( C 6) 3 ,951,4248 209,715(( C 8=0.8*( C 7) 4,161,13 99 167,772(( C 9=0.8*( C 8) 4,3 28,91110 13 4218(( C 10=0.8*( C 9) 4,463 ,129

................... ............................................... .....................................50 18(( C 50=0.8*( C 49) 4,999,929

................ ........................................ ..................................

Infinity 0 5,000,000


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II.Fiscal policy:

1. Fiscal policy: Government usetax ation and consumption to regulateaggregate demand .

2. C lassification of fiscal policy

2.1. Ex pansionary fiscal policy

2.2. C ontractionary fiscal policy


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* Stat e Bu d g e t : total s u m of re v e nu es

an d con s u mp tion of Gov er n me nt ingiv e n ti me (on e y e a r)

B = T - G

+ B = 0: Budget balance+ B > 0: Budget surplus+ B < 0: Budget deficit

3 . Fiscal policy and Budget decifit


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- R e al bu d g e t de ficit : Wh enconsumption > revenues

* Cla ss ification :

-Cyclic bu d g e t de ficit : wh e n e cono m y fac es re c ess ion d u e to cyclic bu s in ess .

-St r uctu r al bu d g e t de ficit : i s calculat ed int erm of a ss u mp tion s with p ot e ntial out put .wh ere B tt = Bck + Bcc =>Bcc = Btt - Bck


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*Note: fiscal policy can reac h following objectives:

+Bu d g e t balanc e =>Y can fluctuat e .. .

+Y * => Bu d g e t de ficit can ha ppe n .W h e n th ere i s re c ess ion in e cono m y, G inc re a se o r T de c re a se o r both to keephigh con s u mp tion => Y rises to Y* butBudget deficit h appens.


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4. H ow to reduce budget deficit

-Inreasing revenues and decreasingconsumption

-P ublic debt: Government bond

-Borrowings from foreign countriesor international orgnizations

-P rinting money or using reservefrom foreign currency


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CHAPTER IV

money and monetary policy


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I. Money

1. Th e Meaning and functions of Money

a.Definition of Money: money is any

commodity or token t h at is generallyacceptable as t h e means of payment. Ameans of payment is a met h od of settlinga debt. In general terms money can be

defined as t h e stock of assets t h at can bereadily used to make transactions.R oug h ly speaking, t h e coins andbanknotes in t h e h ands of t h e public

make up t h e nations stock of money


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MoneyStock of assetsStock of assetsUsed for transactionsUsed for transactions

A type of wealthA type of wealth

Without MoneySelf Self--sufficiencysufficiency

Barter economyBarter economy


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b. Development of moneyC attle, iron, gold,silver,diamond .andbanknote today

Batter => commodity money=> cas h ,

ch

eque, credit card2. Th e Functions of Money: money h asth ree main purposes. It is a medium of ex ch ange, a unit of account and a storeof value


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2.1. Medium of Ex ch ange : it is an objectthat is generally accepted in exchange for goods and services. Money acts as sucha medium2.2. Unit of A ccount ( A Means of E valuation): a unit of account is anagreed measure for stating the prices of goods and services. It allows the valueof one good to be compared withanother 2.3 . S tore of Value : any commodity or token that can be held and exchangedlater for goods and services is called astore of value . Money acts as a store of

value.


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Functions of Money

Store of valu e

Unit of accou ntMedium of exchangeInternational Money

The ease with which money is converted into other things--goods and services-- is sometimes called moneys liquidity.


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*M b di id d i


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Fiat Money: money takes differentforms.Money th at h as no int r in s ic value iscalled fiat m on e y because it isestablis h ed as money by governmentdecree, or fiat

In th e UK economy we make

transactions with

an items wh

ose solefunction is to act as money: poundcoins and banknotes. Th ese pieces of paper wit h th e portrait of t h e queen

wouldh

ave little value if th

ey were not

*Money can be divided into:


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C ommodity Money: alt h oug h fiat

money is t h e norm in most economiestoday, h istorically most societies h aveused for money a commodity wit hsome intrinsic value.

Money of th is sort is called commoditymoney and t h e most widespreadex ample of commodity money is gold

II l B k d i f


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II. C entral Bank and creation money of commercial bank

1.Banks are t h e Financial Intermediaries.Th ey are private firms licensed by t h eC entral Bank under t h e Banking A ct totake deposits and make loans andoperate in t h e economy.R etail Banks: t h ey specialise inproviding branc h banking facilities tomember of t h e general public but t h eydo also lend to businesses albeit oftenon a s h ort-term basis. Th ey are t h e mostimportant banks in t h e UK for th efunctioning of t h e economy and for t h e

2 Th e creation of Money by commercial


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2. Th e creation of Money by commercialbanks

Th e C reation of Money: banks createmoney. H owever t h is does not meanth at t h ey h ave smoke-filled backrooms in w h ich counterfeiters arebusily working. Notice t h at mostmoney is deposits, not currency.Wh at banks create is deposits andth ey do so by making loans. But t h eamount of deposits t h ey can createis limited by t h eir reserves

Desired R eserver rate


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Desired R eserver rate

R equired R eserve R ate

Ex cessive R eserve R ate

Th e Deposit Multiplier: t h is is t h e


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Th e Deposit Multiplier: t h is is t h eamount by w h ich an increase in bankreserves is multiplied to calculate t h eincrease in bank deposits. It is givenby th e following formula:

R eservesinhange

epositinhange ultiplier eposit !

A lternatively, it can also be definedas:

RatioReserveDesired

1 Multiplier Deposit !

if banks want to keep 10% of th eir deposits asreserves, so t h at th e desired reserve ratio is0,10 (ra), th e deposit multiplier is given by t h e

following ex pression:1/ra =10. S ee e x ample


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Banking

systemDeposits

Desired

reserve (ra)Lending

NH1 1 1.ra (1-ra)NH2 (1-ra) (1-ra).ra (1-ra) 2

NH3 (1-ra) 2 (1-ra) 2 .ra (1-ra) 3

... ... ... ...

NH(n+1) (1-ra)n (1-ra) n .ra (1-ra) n+1

a

na

a

nan

aaa r r

r r

r r r D

112 )1(1

1)1(1)1(1

1)1(...)1()1(1 v!v!!

101,0

111

011 !!v!v!

aa r r D0 < r a < 1 => (t.)


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Firstbank Balance Sheet

Secondbank Balance Sheet

Thirdbank Balance Sheet

Assets Liabilities Assets Liabilities Assets LiabilitiesReserves $200 Deposits $1,000Loans $800

Reserves $128 Deposits $640Loans $512

Reserves $160 Deposits $800Loans $640

Assume each bank maintains a r ese rve-deposit ra tio ( rr) of 20% and that the initial deposit is $1000 .

Mathematically, the amount of money the original $1000 deposit creates is:Original Deposit =$1000Firstbank Lending = (1-rr) v $1000Secondbank Lending = (1-rr) 2 v $1000

Thirdbank Lending = (1-rr)3

v $1000Fourthbank Lending = (1-rr) 4 v $1000

Total Money Supply = [1 + (1-rr) + (1-rr) 2 + (1-rr) 3 + ] v $1000= (1/rr) v $1000= (1/.2) v $1000

= $5000 M oney and Liquidity Creation

...

The process of transferring fundsfrom savers to borrowers is called

financial intermediation .


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III.C entral Bank and money supply

1. R oles of C entral Bank

*Governments Bank : th e central bank isth e acts as t h e governments agent bot has its banker and in carrying outmonetary policy

*S upervision of Monetary S ystem : th ecentral bank oversees t h e wh ole

monetary system and ensures t h atbanks and financial institutions operateas stably and as efficiently as possible

2 Functions of C entral Bank


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2. Functions of C entral Bank

*To Issue Notes: t h e C entral Bank isth e sole issuer of banknotes. Th eamount of banknotes issued by C entralBank depends largely on t h e demandfor notes from t h e general publicF o r e xa mp l e , BO E i ss u es ban k not es inE nglan d an d W al es (in Scotlan d an d N o r th er n I re lan d re tail ban ks i ss u e

ban k not es) .

*ItA cts as a Bank


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+To th e Government: t h e governmentdeposits its revenues from ta x ation in t h e

central bank and uses C B in order toborrow money from t h e market+To ot h er R ecognised Banks: all bankslicensed by C B h old operational balances

in th e C B. Th ese are used for clearingpurposes between t h e banks and toprovide t h em with a source of liquidity+To Overseas C entral Banks: t h ese aredeposits in sterling h eld by overseasaut h orities as part of t h eir officialreserves and/or purposes of interveningin th e foreign e x ch ange market in order toinfluence t h e e x ch ange rate of t h eir

*I M h G


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*It Manages th e GovernmentsBorrowing P rogramme: w h enever t h e

government runs a budget deficit (itspends more t h an wh at it receives intax es) it will h ave to finance t h at deficitby borrowing. It can borrow by using

bonds (gilts), National S avingscertificates or Treasury bills. Th e C Borganises t h is borrowing*ItS upervises t h e Financial S ystem: it

advises banks on good bankingpractice. It discusses governmentpolicy with th em and reports back toth e government. It requires banks to

maintain adequate liquidity: th

is is

*ItP id Li idit t B k L d


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*ItP rovides Liquidity to Banks Lender of Last R esort: it ensures t h at th ere is

always an adequate supply of liquidityto meet t h e legitimate demands of depositors in recognised banks

*It Operates t h e GovernmentsMonetary and Ex ch ange R ate P olicy+Monetary P olicy: th e C B manipulatesth e interest rate in t h e economy and

influence t h e size of t h e money supply+Ex ch ange R ate P olicy: th e C Bmanages t h e countrys gold andforeign currency reserves


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3 . Th e S upply of Money*Definition of Money S upply: t h e quantity

of money available is called t h e m on e y s u pp ly . In an economy t h at uses fiatmoney, suc h as most economies today,th e government controls t h e supply of money: legal restrictions give t h egovernment a monopoly on t h e printingof money*Monetary P olicy: th e control over t h emoney supply is called monetary policy

4 Implement of money supply


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4. Implement of money supplya.Measures of Money S upply :R ecall t h at we can denote money supplyas t h e sum of currency and deposits

s DC M

DepositDemandurrencyoney!

C entral Bank issues H 0, (Ba s ic Mon e y,High P ow ered Mon e y ), H 0 < M0. H o isdivided intoU and R

k f d


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+ S ectors keep a part of H o, denote as U.U cant create ot h er means of payment

and it can be decrease due todamages..in t h e circulation. A ssuption, Uis constant.

+ Th e rest of H o denote as R (H o = U +R ).Th e banking system will use R to createmoney as followings:


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Rr

Da

v! 1

Basic Money (H 0)

U R

U D

Money supply MS

Whe r e H 0 = U +R and MS = U + DMS >H o due to t h e creation of money fromcommercial banks.

b Th e C entral Bank's P olicy Tools: there


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b.Th e C entral Bank s P olicy Tools: thereare three main tools that the Central Bank

can use to control money supply andimplement monetary policy

*R eserve R equirements: t h ese areregulations by t h e central bank t h atimpose on banks a minimum reserve-deposit ratio. A n increase in reserverequirements raises t h e reserve-depositratio and t h us lowers t h e money multiplier and t h e money supply

*Di i i i


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*Discount R ate: it is t h e interest rate t h atth e central bank c h arges w h en it makes

loans to banks. Banks borrow from t h ecentral bank w h en t h ey find t h emselveswith too few reserves to meet reserverequirements. Th e lower t h e discountrate, t h e c h eaper are borrowed reservesand t h e more banks borrow at t h ecentral banks discount window.

=> discount rate decreases =>t h emonetary base and t h e money supply goup.

*O M k O i h h


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*Open-Market Operations: t h ey are t h epurc h ases and sales of government

bonds by t h e central bank.Wh en t h e central bank buys (sells) bondsfrom (to) th e public, t h e pounds it pays(receives) for t h e bonds increase(decrease) t h e monetary base andth ereby increase (decrease) t h e moneysupply.

Th e term 'Open Market' refers to

commercial banks and t h e general C Bconducts an open market operation, itdoes a transaction wit h a bank or someoth er business but it does not transactwith th e government

Ex ample of US economy?


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p S y?In the United States, monetary policy isconducted in a partially independent institutioncalled the F eder al R eser v e , or the F ed .


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To expand the M oney Supply:

The Federal Reserve buys U.S. Treasury B ondsand pays for them with new money.

To reduce the M oney Supply:The Federal Reserve sells U.S. Treasury B ondsand receives the existing dollars and thendestroys them.


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The Federal Reserve controls the

money supply in three ways.

1) O pen Market O perations (buying andselling U.S. Treasury bonds).

2) ( R eserve requirements (never reallyused).

3) ( Discount rate which member banks(not meeting the reserve requirements)

pay to borrow from the Fed.

IV Money market


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IV. Money market1. Money Demand : th e dem an d fo r m on e y re f ers to th e des i re to hol d m on e y : tokeep you r w e alth in th e fo rm of m on e y,r ath er than spe n d ing it on goo ds an d ser vic es o r u s ing it to p u r cha se financial a sse t s s uch a s bon d o r s ha res

2.R easons for H olding MoneyTh e Transactions Motive: since moneyis a medium of e x ch ange it is requiredfor conducting transactions.

Th e P reca tionar Moti e: nforeseen


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Th e P recautionary Motive: unforeseencircumstances can arise, suc h as a car

breakdown. Th us individuals oftenh old some additional money as aprecaution

Th e S peculative Motive: certain firmsand individuals w h o wish to purc h asefinancial assets suc h as bonds or s h ares may prefer to wait if t h ey feelth at th eir price is likely to fall. In t h emeantime t h ey will h old idle moneybalances instead

3 .Th e Demand for Money Function: t h e


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. e Demand for Money Function: t erelations h ip between t h e demand for money and t h e interest rate is describedby th e demand for money function

Th is e x pression simply states t h at th e

demand for money is a function (f ) of income Y and t h e interest rate I = denotes t h e nominal money

demand

Y = denotes nominal income (GDP

) and itcaptures t h e overall level of transactionsin th e economy.

),(! iY f M d

d M

In fact it is reasonable to assume t h at


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In fact, it is reasonable to assume t h atth e overall level of transactions is

roug h ly proportional to nominal income.Th e positive sign above Y denotes t h atth ere is a positive relations h ip betweenincome and demand for money: t h eh igh er th e level of income (transactions)th e h igh er th e demand for moneyi = is th e interest rate and t h e negativesign above it denotes t h e n e gativ erelations h ip between t h e interest rate andth e demand for money. Th e high er th einterest rate, t h e sm all er th e demand for money since individuals prefer to h oldth eir wealt h in bonds

d Determinant of money


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d. Determinant of moneydemand*Lev e l of pr ic e :

n

r

n

r

M D P

M D M D c o n s t M D

P M D M D c o n s t

oo p ! !

qq p ! !

MDn (no m inal Mon e y D em an d co mp uting ba sed on rese a r ch ed pr ic e (u s ually high er than ba sed pr ic e)

MDr ( re al Mon e y D em an d , co mp uting depe n d on ba sed pr ic e (con s tant pr ic e) .

*Interest rate (i)


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( )

*Income (Y)

Y increases (decreases) => MD increases(decreases)

i increases (decreases) => MD decreases(increases)

MD = k.Y h .i

Money demand function can bewritten:

k-income-elasticity of MDh -interest rate elasticity of MD.

i


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h

k Y 0

kY 0

h

k Y 1

i

M0

MD1MD0

N


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N ot e :+ i ch ange=>quantity demanded movealong MD, oth erth ings being equal.+ Y ch ange=>MD sh ift righ twards or leftwards. Depends on income-elastricityof money demand (k).+ S lope of MD depends on t h e interestrate elastricity of money demand ( h ).

1k Y i M Dh h!

2. Money supply


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y pp y

*Th

e Determinants of Money supply-Th e l e v e l of pr ic e : nominal MS doesnt depend on P but real MS does because:

0 H mM S n v! P M S

M S n

r !

-C entral Bank: i can c h ange but M S

maybe constant If C entralBank doesntwant to c h ange MS .


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i

0 M

MDo

MS o

E

oio

3 . E quilibrium in t h e Money Market:


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th e equilibrium in t h e money marketrequires t h at money supply be equalto money demand, t h at M s =M d

Th isequilibrium condition tells us t h at th einterest rate must be suc h th at peopleare willing to h old and amount of money equal to t h e e x isting supply.Th is equilibrium relation is also calledLM and will be discussed in moredetail in t h e ne x t lecture

),( iY f M M d s !!


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*Note:

+ If I # i0 =>imbalance between supplyand demand w h ich puts pressure topus h I up or down to equilibrium pointi0. Wh en MS , MD ch anges =>quilibriumpoint (E ) ch anges w h ich leads toch anges of i0.

V. Monetary policy:


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y p y

1. Ex pansionary monetary policy

2.C ontractionary monetary policy


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CHAPTER VI

Inflation and unemployment


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Th e labour force is defined as: tho se in


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-Th e labour force is defined as: tho se inemp loy me nt (inclu d ing th e se lf-

emp loy ed , tho se in th e a rmed fo r c esan d tho se on gov er n me nt t r aining s ch emes) p lu s tho se un emp loy ed .

-Th e labour force doesnt includepeople w h o are out of working age,students, pupils, invalids. P eople w h oare at working age but unwilling towork doent belong to labour force

Labour force


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employment

unemployment

Labour force

Out of labour force

Out

InWorking

ageP

opulation

Labour force

2 C omp ting nemplo ment rate


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2. C omputing unemployment rate

u - Un emp loy me nt Rat e) : to beex pressed by fraction of unemploymentwith th e total labour force. It can beex pressed by percentage as t h e formulabelow:U (Unemployed): L (Labour Force):

%100v! LU

u


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Unemployment is a problem for t h eeconomy because:

Output and incomes are lost.H uman capital depreciates.C rime may increase.H uman dignity suffers.

3 . Types and causes of


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unemployment:F r ictional un emp loy me nt occu rs wh e n

pe o pl e l e av e th e i r j ob s , e ith er volunta r ily o r b e cau se th e y a res ac ked o r m a de red un d ant, an d a reth e n un emp loy ed fo r a per io d of ti mewhil e th e y a re loo k ing fo r a n e w j ob .Th e y m ay not g e t th e fi rs t j ob th e y a pp ly fo r , desp it e a vacancy e xi s ting .Th e emp loy er m ay continu ese a r ching, ho ping to fin d a b e tt er - q ualifi ed pers on .

Like wi se , un emp loy ed pe o ple m ay


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Li ke wi se , un emp loy ed pe o pl e m ay choo se not to ta ke th e fi rs t j ob th e y a re

off ered . Ins t e a d , th e y m ay continu ese a r ching, ho ping that a b e tt er j ob will tu r n u p . Th e pr obl em i s that info rm ation i s i mper f e ct . E mp loy ers a re

not fully info rmed about what labou r i savailabl e; wo rkers a re not fully info rmed about what j ob s a re availabl ean d what th e y e ntail . Both emp loy ers

an d wo rkers , th ere fo re , hav e to se a r ch :emp loy ers se a r ching fo r th e r ight labou r an d wo rkers se a r ching fo r th er ight j ob s .


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S tructural Unemployment refers to

unemployment arising because t h ere isa mismatc h of skills and jobopportunities w h en t h e pattern of demand and production c h anges.Ex amples in t h e UK includeunemployment resulting from a declinein th e production of te x tiles,s h ipbuilding, cars, coal and steel. Th oseworkers w h o become structurallyunemployed are available for work butth ey h ave eit h er th e wrong skills for t h e

jobs available or t h ey are in t h e wronglocation.


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Demand-deficient Unemployment is alsoreferred to Keynesian unemployment.Demand-deficient unemployment occurswh en aggregate demand falls andwages and prices h ave not yet adjustedto restore full employment. A ggregatedemand is deficient because it is lower th an full-employment aggregate demandwh ich implies t h at output is less t h anfull employment output.

C lassical Unemployment describes


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p yth e unemployment created w h en t h e

wage is deliberately maintained aboveth e level at w h ich th e labour marketclears. It can be caused eit h er by t h eex ercise of trade union power or by

minimum wage legislation w h ichenforces a wage in e x cess of t h eequilibrium wage rate.

II.Inflation


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II.Inflation1. Definition

Inflation is a rise in the average price of goods over time.

The term deflation is used to describe afall in the average price of goods over time.

Deflation is very rare, but when it occurs itcan cause serious problems in theeconomy. The inflation rate is thepercentage change in the price level. The

formula for the annual inflation rate is :

2. C omputing inflation


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p g

Gp:price growt h rate 1

1100%t t p

t

P P g P !

v

t-ti meP

t- 1:

at pre viou s ti meP t : : at cu rre nt ti me (researc h time)

n

nn

QQQQ P Q P Q P P !

......

21

2211

P is to be e x pressed as follows:

A ctually, P is difficult to compute, we can


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compute inflation as below:

Wh ere CP I is th e consumer price inde x andt is time. Th e consumer price inde xmeasures h ow muc h more a basket of goods t h at represents goods purc h ased byth e average h ouse h older costs todaycompared wit h some previous time period.

0

1

0 0

1

k

t i i

ik

i i

i

P QC P I

P Q

!

!

!

Name CPI (I 2005/2004 ) %

A 12 30%


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A 1,2 30%

B 1,4 25%

C 0,9 15%

1,5 30%

CP I2005=1,2x3 0%+1,4x 25%+0,9x 15%+1,5x3 0%=1,2951

1

100%t t pt

CPI CPI g

CPI ! v C

P It- 1 :

C P

It :

N ot e : C P I d o es nt re fl e ct chang es in q uality of goo ds an d ser vic es o r of n e w goo ds an d ser vic es .

+ GDP (D: Deflator )


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1

0

1

1 0 0 % 1 0 0 %

nt t

i in i

nt r

i ii

P QG D P DG D P P Q

!

!

! v ! v

D-GDP reflects c h anges in prices of totalfianl goods and services compare wit hbased price,t h erefore, t h is describesinflation rate.

1

1

100%t t pt

D D g D

! v

Wh y is inflation a problem?: W h en


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y pinflation is present in t h e economy,

money is losing its value. Th e h igh er th e inflation rate, t h e h igh er is t h e rateat wh ich money is losing value andth is fact is t h e source of t h e inflation

problem. Inflation is said to be goodfor borrowers and bad for lenders, andso inflation can cause inequalities inth e economy. P eople on fi x ed incomes

(e.g. pensioners and students) tend tosuffer most from inflation.

2. Types of inflation


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* Mo der at e Inflation : inflation rate < 1 0%/n m , pr ic es inc re a ses s lowly ..

Mo der at e inflation can sp u r pr o d uction

b e cau se pr ic e inc re a ses l e a d ing tohigh e t pr ofit fo r e nt erpr i ses ,th ere fo re ,fi rms will inc re a ses q uantity .

* Gallo ping Inflation:

inflation r at e i s f r o m1 0% to 99% per y e a r . Thi s ty pe will des t r oy e cono m y an d cu r b e ngin es of e cono m y .

* Hy per Inflation : is defined as inflation


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th at e x ceeds 100% percent per year.

C osts suc h as s h oe-leat h er and menucosts are muc h worse wit hh yperinflation and ta x systems aregrossly distorted. E ventually, w h encosts become too great wit hh yperinflation, t h e money loses its roleas store of value, unit of account and

medium of ex

ch

ange. Bartering or using commodity money becomesprevalent.In 1920s (1922-12/1923 ) Weimar

Germany,CP

I increased from 1 to 10

*Ex pected inflation: depe n ds on


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pected inflation: depe n ds one x pe ctation of in d ivi d ual s about g p in th e futu re . It s i mp act s i s sm all but h e l p toa dj u s t pr o d uction co s t .

+Unex pected inflation: derives fromex ogenous s h ocks and une x pectedfactors inside economy.


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The inconvenience of reducing moneyholding is metaphorically called theshoe-leather cost of inflation, becausewalking to the bank more often inducesones shoes to wear out more quickly.

When changes in inflation require printingand distributing new pricing information,then, these costs are called menu costs.

Another cost is related to tax laws. Oftentax laws do not take into considerationinflationary effects on income.


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Unanticipated inflation is unfavorable because it arbitrarilyredistributes wealth among individuals.

For example, it hurts individuals on fixed pensions. Often thesecontracts were not created in real terms by being indexed to a

particular measure of the price level.

There is a benefit of inflation many economists say that some

inflation may make labor markets work better. They say itgreases the wheels of labor markets.

3 . C auses of inflation


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yDem an d - pull inflation i scau sed by continuing r i sesin A D in th e e cono m y . Th einc re a se in A D m ay b ecau sed by e ith er inc re a sesin th e m on e y s u pp ly o r inc re a ses in G- e x pe n d itu rewh e n th e e cono m y i s clo seto full emp loy me nt . Ing e n er al, dem an d - pull inflation i s ty pically a ss ociat ed with a boo m ing e cono m y .

A D1

A D0

P 1

P 0

0 Y Y*

P

A S

* C ost-pus h inflation is associated wit hcontinuing rises in costs R ises in costs


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continuing rises in costs. R ises in costsmay originate from a number of differentsources suc h as wage increases and ot h er h igh er costs of production (e.g. rawmaterials).

A S 1P

0 Y*

Y Y0

AS 0

A DP 0P 1

Y1

*S tructural (demand-s h ift) inflation


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( )arises w h en t h e pattern of demand (or

supply) c h anges in t h e economy w h ichresults I n some industries e x periencingincreased demand w h ilst ot h ersex perience decreased demand. If prices

and wage rates are infle x ibledownwards in t h e contractingindustries, and prices and wage ratesrise in t h e e x panding industries, t h eoverall price and wage level will rise.Th e problem will be made worse, t h eless elastic is supply to t h ese s h ifts.

*Ex pectations are crucial determinantsof inflation Workers and firms take


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of inflation. Workers and firms takeaccount of t h e e x pected rate of inflationwh en making decisions. Generally, t h eh igh er th e e x pected rate of inflation, t h eh igh er will be th e level of paysettlements and price rises, and h enceth e h igh er will be th e resulting actualrate of inflation.*Inflation and Money: equilibrium point of money market

h ik Y M DM S P

M S r r

n !!!

In other words, if Y is fixed (from Chapter 3) because it dependson the growth in the factors of production and on technological


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g p g progress, and we just made the assumption that velocity is constant,

or in percentage change form:

MV = PY

% Change in M + % Change in V = % Change in P + % Change in Y

if V is fixed and Y is fixed, then it reveals that % Change in M is whatinduces % Changes in P.The quantity theory of money states that the central bank, which

controls the money supply, has the ultimate control over the inflationrate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly,the price level will rise rapidly.


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The revenue raised through the printing of money is called

seigniorage. When the government prints money to financeexpenditure, it increases the money supply. The increase in

the money supply, in turn, causes inflation. Printing money toraise revenue is like imposing an inflation tax.

* Inflation and interest rate


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E conomists call t h e interest rate t h at th ebank pays t h e no m inal int eres t r at e andth e increase in your purc h asing power th e re al int eres t r at e .

Th is s h ows t h e relations h ip between t h enominal interest rate and t h e rate of inflation, wh ere r is real interest rate, i isth e nominal interest rate and p is t h e rateof inflation, and remember t h at p issimply t h e percentage c h ange of t h e price

r = i T


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The F isher Equation illuminates the distinction betweenthe real and nominal rate of interest.

Fisher Eq u ation: i = r +Fisher Eq u ation: i = r + TT

Actual (Market)Actual (Market) Nominal rate of Nominal rate of

interestinterestReal rateReal rateof interestof interest

InflationInflation

The one-to-one relationship between the inflation rate andthe nominal interest rate isthe F isher Effect.

It shows that the nominal interest can change for two reasons: becausethe real interest rate changes or because the inflation rate changes.

+gp is h igh =>i is up to keep equality of r


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.

+E conomy h as h igh i lead to h igh gp or ican e x plains gp of economy.

+If real gp > ex pected gp => borrowersget advantages

+If real gp < ex pected gp => lenders getadvantages

4.Policies to deal with inflation:

1 Fi l li i i


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4.1.Fiscal policy comprises c h anges in

government e x penditure and/or tax ation. Th e aim is to affect t h e level of A D th roug h a policy known as demandmanagement. In t h e case of controlling

inflation, t h is involves reducinggovernment e x penditure and/or increasing ta x ation in w h at is called adeflationary fiscal policy. S uch policies

are likely to be effective if inflation h asbeen diagnosed as dem an d - pull s inc e ared uction in gov er n me nt e x pe n d itu re o r an inc re a se in inco me tax will red uc e

a re at e dem an d in th e e cono m .

4.2.Monetary policy is concerned wit hi fl i g t h l d t h


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influencing t h e money supply and t h e

interest rate. In terms of controllinginflation, t h e government can aim toreduce t h e money supply t h us reducingspending and, t h erefore, t h e aggregate

demand, or it can increase t h e interestrate so as to increase t h e cost of borrowing. Bot h policies can be seen asdeflationary monetary policy. S ince

monetarists view t h e growt h of th emoney supply as being t h e main causeof inflation, any control of inflation froma monetarist viewpoint must involve

control of t h e mone su l .

4.3 .P rices and incomes policy aim to limit


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4 p yand, in certain cases, freeze wage andprice increases. In t h e past t h ey h aveeith er been statutory or voluntary.S tatutory prices and incomes policiesh ave to be enforced by governmentlegislation, suc h as t h e E U minimumwage legislation. Wit h a voluntary pricesand incomes policy t h e government aimsto control prices and incomes t h roug hvoluntary restraint, possibly by obtainingth e support of t h e unions and employers.


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4.4. S upply-side policy is concerned wit hinstituting measures aimed at s h ifting th eaggregate supply curve to t h e righ t.S upply-side economics is t h e use of microeconomic incentives to alter t h elevel of full employment and t h e level of potential output in t h e economy. If inflation is caused by cost-pus h

pressures, supply-side policy canh

elp toreduce t h ese cost pressures in two ways:

(1) b d i g t h f t d i


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(1) by reducing t h e power of trade unions

and/or firms (e.g. by anti-monopolylegislation) and t h ereby encouragingmore competition in t h e supply of labour and/or goods, (2) by encouraging

increases in productivity t h roug h th eretraining of labour, or by investmentgrants to firms, or by ta x incentives, etc.

4.5.Learning to live wit h inflationinvolves accepting t h e fact t h atinflation is h ere to stay w h en standard


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inflation is h ere to stay w h en standard

anti

inflationary policy measuresappear ineffective. In suc h a situationwe just h ave to learn to live wit hinflation. Learning to live wit h inflation

involves th

e government, employersand workers taking inflation intoaccount in t h eir everyday transactions.For e x ample, t h e

government/employers may useinde x ation in wage/pensions contracts.Index ation is w h en wages or pensionsare increased in line wit h th e current

rate of inflation. Inde x ation is aimed at


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I. Definition

A n increase on potential output

E conomic growt h or developments?

II.C omputing of economic growt h


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*C omputed by % c h anges in real GD P

%1001

1 v!t

t t t Y

Y Y g

+gt: according to real GDP

%1001

1 v!t

t t pct y

y y g

*gpct : by GDP per capita ( n casepopulation increases faster t h an GDP )

II.S ources of economic growt h


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1.H uman capital

2. C apital accumulation

3 . Natural resource

4.Tech nological knowledge

III.Th eories of economic growt h :


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1. C lassical t h eory of A dam S mith vMalth us

Land plays an important role for economic growt h .

+A dam S mith : gold age

+Malth us: dull age

2. E conomic growt h th eory of Keynes


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I increases => outputs and incomeincrease=> capital .acc is up=> Gs h ould invest to pus h A D, lead toecnomic growt h .

Y K

I CO R ((

! Y

I

I CO R

(!

I CO R s

Y Y !

(

ICOR (Incremental Capital-Output Ratio )

wh ere S =I

H arrod- Domar model: e x plains t h e role of i l l i f i


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capital accumulation for economicgrowt h .

I CO R s

g ! )( Y S

s !

*If IC OR is constant, g increases at t h erate of savings rate.

*Debates: +IC OR is not constant

+Model ignores tec h nology andh uman resources

3 . Neo-classical economic growt h th eory


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th eory

S olow model or S olow-S wan Model

3 .1. Introduction: paper of economic

growth

were issued in 2/1956 and 11-1956 of two economists are S olowand S wan*Wh y it is neo-classical t h eory: useth e role of market and government


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The Solow Growth M odel is designed to show howgrowth in the capital stock, growth in the labor force,and advances in technology interact in an economy, and

how they affect a nations total output of goods and services.

Lets now examine how themodel treats the accumulationof capital.


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Lets analyze the supply and demand for goods, andsee how much output is produced at any given timeand how this output is allocated among alternative uses


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The production function represents the

transformation of inputs (labor ( L), capital (K), production technology) into outputs (final goodsand services for a certain time period).

The algebraic representation is:

Y = F ( K , L )

The Production Function

IncomeIncome isis some function of some function of our given inputsour given inputs

and how this output is allocated among alternative uses.

Key Assumption: The Production Function has constant returns to scale.

z zz


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This assumption lets us analyze all quantities relative to the size of the labor force. Set z = 1/ L .

Y/ L = F ( K / L , 1 )

OutputOutputPer workerPer worker

isis some function of some function of the amount of the amount of capital per worker capital per worker

Constant returns to scale imply that the size of the economy as

measured by the number of workers does not affect the relationship between output per worker and capital per worker. So, from now on,lets denote all quantities in per worker terms in lower case letters.Here is our production function: , where f(k)=F(k,1).y = f ( k )


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This assumption lets us analyze all quantities relative to the size of the labor force. Set z = 1/ L .

Y/ L = F ( K / L , 1 )

OutputOutputPer workerPer worker

isis some function of some function of the amount of the amount of capital per worker capital per worker

Constant returns to scale imply that the size of the economy as

measured by the number of workers does not affect the relationship between output per worker and capital per worker. So, from now on,lets denote all quantities in per worker terms in lower case letters.Here is our production function: , where f(k)=F(k,1).y = f ( k )


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M PK = f ( k + 1) f ( k )

yy

kk

f(k )

The production function showshow the amount of capital per worker k determines the amountof output per worker y=f( k ).The slope of the production functionis the marginal product of capital:if k increases by 1 unit, y increases

by MPK units.

1

MPK


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consumptionconsumption per worker per worker

dependsdependsonon savingssavings

raterate

(between 0 and 1)(between 0 and 1)

OutputOutput per worker per worker

consumptionconsumption

per worker per worker investmentinvestment per worker per worker

y = c + iy = c + i1)

c = (1c = (1--s s )y)yc = (1c = (1--s s )y)y2)

y = (1y = (1--s s )y + i)y + iy = (1y = (1--s s )y + i)y + i3)

4) i =i = s s yyi =i = s s yy Investment = savings . The rate of saving s is the fraction of output devoted to investment.


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Here are two forces that influence the capital stock:

Investment: expenditure on plant and equipment.Depreciation: wearing out of old capital; causes capital stock to fall.

Recall investment per worker i = s y.Lets substitute the production function for y, we can express investment

per worker as a function of the capital stock per worker:

i = s f(k )This equation relates the existing stock of capital k to the accumulationof new capital i.


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Investment, s f(k )

Output, f ( k )c (per worker)

i (per worker)y (per worker)

The saving rate s determines the allocation of output betweenconsumption and investment. For any level of k, output is f(k ),investment is s f(k ), and consumption is f(k ) sf(k ).

yy

k k


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Impact of investment and depreciation on the capital stock: ( k = i Hk

Change inCapital Stock Investment Depreciation

Remember investment equalssavings so, it can be written:

( k = s f(k ) Hk

Hk

k k

Hk

Depreciation is therefore proportionalto the capital stock.


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Investmentand Depreciation

Capitalper worker, k

i* = Hk *

k *k 1 k 2

At k *, investment equals depreciation andcapital will not change over time. Below k *,

investmentexceeds

depreciation,so the capitalstock grows.

Investment, s f(k )

Depreciation, H k

Above k *, depreciationexceeds investment, so the

capital stock shrinks.

The Solow Model shows that if the saving rate is high, the economyill h l i l k d hi h l l f If h i


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Investmentand

Depreciation

Capitalper worker, k

i* = Hk *

k 1* k 2*

Depreciation, H k

Investment, s 1f(k )

Investment, s 2f(k )

will have a large capital stock and high level of output. If the saving

rate is low, the economy will have a small capital stock and alow level of output.

An increase inthe saving rate

causes the capitalstock to grow to

a new steady state.

c*= f (k *) - H k *.According to this equation, steady-state consumption is whats left


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of steady-state output after paying for steady-state depreciation. Itfurther shows that an increase in steady-state capital has two opposingeffects on steady-state consumption. On the one hand, more capital meansmore output. On the other hand, more capital also means that more outputmust be used to replace capital that is wearing out.

The economys output is used for consumption or investment. In the steadystate, investment equals depreciation.Therefore, steady-state consumption is thedifference between output f (k *) and

depreciationH

k *. Steady-state consumptionis maximized at the Golden Rule steadystate. The Golden Rule capital stock isdenoted k *gold , and the Golden Ruleconsumption is c* gold .

Hk

k k

Hk

Output, f( k )

c *gold

k *gold

3 .2. C onclusions of S olow model


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+Th e role of savings for economicsgrowth

+C apital accumulation is good for s h ort-run economic growt h

+Tec h onology is t h e determinant of

long-run economic growt h

4. P olicies for economic growt h


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4.1. Increasing domestic savings andinvestment

4.2. A ttracting FDI

4.3 . Improving h uman resources

4.4.R

&D of new tech

onology

4.5. S tability of politics and economy


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4.6. Th e open-door policy

4.7. C urbing growt h of population


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CHAPTER IVTh e Open E conomy


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Gov er e t

rc ases of ood s

a d ser vices

Y = C + I + G + NXY = C + I + G + NX

Total dema df or dom estic

ou t ut

Consump tions pend ing by

ouse olds

Investments pend ing by

businesses a ndhou seho lds

Net ex ports

or net f oreigndemand

N otice we ve added net expo r ts, N X, defined a s EX- I M . Als o, no te thatdom estic s pend ing on all good s and ser vices is t he sum of dom estics pend ing on dom estics good s and ser vices a nd on f oreign good s and ser vices.

is compo sed

of

Y = C + I + G + NXY = C + I + G + NX


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After some manipulation, the national income accounts identity can bere-written as:

NX = Y NX = Y -- (C + I + G)(C + I + G)

Net ExportsOutput

This equation shows that in an open economy, domestic spending need

not equal the output of goods and services. I f ou

tpu

t exceeds domestic spe ndin g , we expo r t t h e diffe r ence: net expo r ts ar e positi ve. I f ou tpu t f all s s h or t of domestic spe ndin g , we impo r t t h e diffe r ence: net expo r tsar e ne g a tive.

DomesticSpending


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Start with the national income accounts identity. Y=C+ I+G+ NX .Subtract C and G from both sides and obtain Y-C-G = I+ NX .

Lets call this S, national saving .

So, now we have S=I+ NX . Subtract I from both sides to obtain the newequation, S-I= NX.This form of the national income accounts identity shows that aneconomys net exports must always equal the difference between its

saving and its investment . S-I= NX

Trade Balance Net Foreign Investment

Net Capital Outflow =Trade Balance


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S - I =NX S - I =NX If S-I and NX are positive, we have a trade surplus . We would be netlenders in world financial markets, and we are exporting more

goods than we are importing.

If S-I and NX are negative, we have a trade deficit . We would be net borrowers in world financial markets, and we are importing moregoods than we are exporting.

If S-I and NX are exactly zero, we have balanced trade since the valueof imports equals the value of exports.


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We are now going to develop a model of the international

flows of capital and goods. Then, well address issuessuch as how the trade balance responds to changes in policy.

Recall that the trade balance equals the net capital outflow, whichin turn equals saving minus investment our model focuses on saving


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in turn equals saving minus investment, our model focuses on saving

and investment. Well borrow a part of the model from Chapter 3, butwont assume that the real interest rate equilibrates saving andinvestment. Instead, well allow the economy to run a trade deficitand borrow from other countries, or to run a trade surplus and lendto other countries.

Consider a small open economy with perfect capital mobility inwhich it takes the world interest rate r* as given, denoted r = r*.

Remember in a closed economy, what determines the interest rate is theequilibrium of domestic saving and investment--and in a way, the worldis like a closed economy-- therefore the equilibrium of world saving andworld investment determines the world interest rate.

Y = Y = F(K, L) The economys output Y is fixed by thefactors of production and the production


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C = C (Y-T)

I = I (r)

NX = (Y-C-G) - Ior NX = S - I

factors of production and the production

function.Consumption is positively related todisposable income (Y-T).Investment is negatively related to thereal interest rate.

The national income accounts identity,expressed in terms of saving and investment.

Now substitute our three assumptions from Chapter 3 and the conditionthat the interest rate equals the world interest rate, r*.

NX = (Y-C(Y-T) - G) - I (r*) NX = S - I (r*)This equation suggests that t h e t ra de b alan ce is dete r mined by t h ediffer ence betwee n savin g an d investme nt a t t h e wo rl d inter est ra te.

Real


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S

I(r)

Investment, Saving, I, S

Real

interestrate, r*

r closed

r*

NX

In a closed economy, r adjusts toequilibrate saving and investment.

In a small open economy, theinterest rate is set by worldfinancial markets. The difference

between saving and investmentdetermines the trade balance.

In this case, since r* is above r closed and saving exceeds investment,there is a trade surplus .

r*' NX

If the world interest rate decreased to r* ', I would exceed S andthere would be a trade deficit .

An increase in government purchases or a cut in taxes decreases


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S

I(r)


Realinterestrate, r*

r*

S'

national saving and thus shifts the national saving schedule to the left.

NX

The result is a reduction in nationalsaving which leads to a trade deficit,where I > S.

NX = (Y-C(Y-T ) - G) - I (r*)

NX = S - I (r*)

A fiscal expansion in a foreign economy large enough to influenceworld saving and investment raises the world interest rate


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S

I(r)



r 1*

world saving and investment raises the world interest rate

from r 1* to r 2*.

NX

The higher world interest rate reducesinvestment in this small openeconomy, causing a trade surpluswhere S > I.

r 2*

An outward shift in the investment schedule from I(r) 1 to I(r)2 increasesth t f i t t t th ld i t t t *


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the amount of investment at the world interest rate r*.

NX

As a result, investment nowexceeds saving I > S, whichmeans the economy is

borrowing from abroad and

running a trade deficit.

S

I(r)1



r 1*

I(r)2


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In the next few slides, well learn about the foreignexchange market, exchange rates and much more!

Lets think about when the US and Japan engage in trade. Each countryhas different c lt res lang ages and c rrencies all of hich co ld


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has different cultures, languages, and currencies, all of which couldhinder trade. But, because of the foreign exchange market, tradetransactions become more efficient. The foreign exchange market is aglobal market in which banks are connected through high-techtelecommunications systems in order to purchase currencies for their customers.

The next slide is a graphical representation of the flow of the trade between the U.S. and Japan, and how the mix of traded things might bedifferent, but is always balanced. Also, notice how the foreign exchangemarket will play the middle-man in these transactions. For instance, theforeign exchange market converts the supply of dollars from the U.S.into the demand for yen, and conversely, the supply of yen into thedemand for dollars.

In order for the U.S to pay for its imports of goods and services and securities from Japan,it must supply dollars which are then converted

into yen by thef i


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it must supply yen which are then convertedinto dollars by the foreign exchange market.

ForeignExchange

Market

Supply $Demand YEN

Demand $SupplyYEN

In order for Japan to pay for its imports of goods and services and securities from theU.S.,

foreignexchangemarket.


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The exchange rate between two countries is the price at whichresidents of those countries trade with each other.


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-relative price of the currency of two countries-denoted as e

-relative price of the goods of two countries-sometimes called the ter ms of t ra de-denoted as I


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The nominal exchange rate is the relative price of the currency of two countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange 1 dollar for 120 yen in world markets for foreign currency.

A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to the exchangerate between two countries, they usually mean the nominal exchangerate.


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D$ shifts rightward and increasesthe nominal exchange rate, e.This is known as a pp r ecia tion of the dollar.Be1

e

Dollar Value of Transactions

D$

Ae0

S$

$

Suppose that there is an increase in the demand for U.S. goods andservices. How will this affect the nominal exchange rate ?

Events which decrease thedemand for the dollar, and thusdecrease e would be a

dep r ecia tion of the dollar.

D$ d

h h l f h d f

II


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The real exchange rate is the relative price of the goods of twocountries. That is, the real exchange rate tells us the rate at which wecan trade the goods of one country for the goods of another.

To see the difference between the real and nominal exchange rates,

consider a single good produced in many countries: cars. Suppose anAmerican car costs $10,000 and a similar Japanese car costs 2,400,000yen. To compare the prices of the

macroeconomics i 2009

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