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Professor Margaret Levenstein Stephen M. Ross School of Business University of Michigan

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MACROECONOMICS FUNDAMENTALS. Professor Margaret Levenstein Stephen M. Ross School of Business University of Michigan. Agenda. Defining key concepts GDP Recessions Inflation Exchange Rate Trade Deficit What do central banks do? Monetary policy Regulate banks What’s going on now?

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Professor Margaret Levenstein

Stephen M. Ross School of Business

University of Michigan

  • Defining key concepts
        • GDP
        • Recessions
        • Inflation
        • Exchange Rate
        • Trade Deficit
  • What do central banks do?
        • Monetary policy
        • Regulate banks
  • What’s going on now?
        • Asset bubbles and financial stability
        • Decline of the dollar
        • Inflation targeting at the Fed
us and world gdp 2006


All Developing countries

United States

GDP (current US$)

48.5 trillion

11.0 trillion

13.4 trillion

Per capita GDP growth (annual %)




GNI per capita, (current US$)




US and World GDP 2006

Source: World Bank World Development Indicators

what are those numbers
What are those numbers?
  • Gross Domestic Product
    • Total value of goods & services produced for the market in a single year
    • Gross National Income
      • GDP plus income received from abroad
  • How much should GDP grow every year?
    • In the U.S., at least 3%
      • US grew at 3.9 % in 3rd Q 2007
    • In developing countries, much faster
what is a recession
What is a Recession?
  • A “significant decline in economic activity”
    • Usually – but not always – means two quarters of declines in GDP
  • In US, GDP calculated by Bureau of Economic Analysis
    • Reported 4 times a year, as required by law
  • Inflation is the rate of increase in the general price level
    • Based on surveys of thousands of goods
    • Different inflation rates are calculated for different groups of goods and different geographical areas
  • CPI and WPI reported by Bureau of Labor Statistics
    • Annual rate of increase in CPI for Q3 2007 was 1.7%
exchange rates
Exchange Rates
  • Foreign exchange rate: the amount of one nation’s money that can be obtained in exchange for a unit of another nation’s money
  • Example: How many yen will you receive for one dollar? 111 yen
  • Example: How many dollars will you receive for 100 yen? $0.90
  • The price of dollars in terms of yen is the reciprocal of the price of yen in terms of dollars
exchange rates9
Exchange Rates
  • A currency is said to appreciate when its value goes up relative to other currencies.
  • A currency is said to depreciate when its value goes down relative to other currencies.
  • Example:

Today the dollar is worth 111 Yen

In March 2003 it was worth 125 ¥.

Has the dollar appreciated or depreciated?


Has the Yen appreciated or depreciated?


What about the Euro-Dollar exchange rate?

Today 1 US$ is worth 0.68 €

One euro is worth $1.46

In March 2003 $US = 0.91 €

One euro was worth $1.10

what determines exchange rates
What Determines Exchange Rates?
  • Most exchange rates for large countries are set in markets without direct government intervention
      • China is an obvious exception
      • Many other smaller and developing countries either fix their exchange rates or keep their exchange rates in band relative to USD, Euro, or Yen
what determines exchange rates11
What Determines Exchange Rates?
  • Differences in interest rates
    • Increase in domestic interest rates relative to other countries raises value of domestic currency
  • Differences in inflation rates
    • Increase in domestic inflation relative to other countries lowers value of domestic currency
what determines exchange rates12
What Determines Exchange Rates?
  • Differences in demand for exports and foreign investment
    • If foreigners want to buy your goods, they need your currency
    • If foreigners want to invest in your country, they need your currency
    • Increases in exports and inward foreign investment increase the value of the domestic currency
      • Increases in imports and outward foreign investment decrease the value of the domestic currency
what is the trade deficit
What is the Trade Deficit?
  • Trade deficit is the difference between what a country exports and what it imports
    • In September the US trade deficit was $56.5B
      • The trade deficit for all of 2006 was $758.5B
    • The trade deficit is smaller this year than in recent years
      • Because the dollar is cheaper than in previous years
      • A cheap dollar makes US exports cheaper for foreigners
      • A cheap dollar makes imports more expensive for Americans, creating inflation in the US
u s trade deficit 1946 2007
U.S. Trade Deficit, 1946-2007
  • Balance in goods was positive from 1946-1970
    • Consistently negative since 1976
  • Balance in services was positive and growing from 1971 to 1997
      • Has declined in recent years
  • Balance in goods and services has been negative every year since 1976
what do central banks do
What do central banks do?
  • Three responsibilities
    • Manage the money supply
    • Ensure the safety and soundness of the banking and financial system
    • Clearing house for the payments system
what do central banks do18
What do central banks do?
  • Manage the money supply
    • Buy and sell bonds
      • These are existing bonds issued by the US treasury
      • When the Fed buys bonds, it pays with “high powered money”
        • Increases the money supply
      • When the Fed sells bonds, it receives “high powered money”
        • Decreases the money supply
what do central banks do19
What do central banks do?
  • What about interest rates?
    • Almost all interest rates in the US are set in private markets by borrowers and lenders
    • The Fed sets the “discount rate”
      • The rate at which it lends to banks
      • The Fed generally discourages borrowing at the discount window
        • Fed recently lent a lot at the discount window to calm financial markets in turmoil because of the sub prime lending crisis
        • Previously, Fed lent a lot at the discount window right after September 11th and right around Y2K
what do central banks do20
What do central banks do?
  • The target rate that is reported in the media is the “Fed Funds rate”
      • This is the rate at which banks lend to each other overnight to meet reserve requirements
      • Fed buys and sells bonds, increasing and decreasing the money supply, as necessary to get the Fed Funds rate to its target rate
what do central banks do21
What do central banks do?
  • Regulate banks
    • Set and enforce rules to assure the “safety and soundness” of the banking system
    • Banks and other financial institutions are interconnected, so when one institution goes bad it can bring others down with it
      • This can undermine the credit system, causing economic difficulties in other sectors of the economy
markets today three issues
Markets today: Three issues
  • Asset bubbles and financial stability
  • Decline of the dollar
  • Inflation targeting at the Fed
asset bubbles and financial stability
Asset bubbles and financial stability
  • Subprime lending crisis
    • Unfortunately this is nothing new
  • What happened?
    • Rapid increase in price of housing
    • Loans made outside “regular” mortgage regulations
    • Loans bundled and sold, with investors and regulators buying into the idea that this lowered risk
      • Risk is lowered by diversification, but if the returns on the assets are correlated then bundling does not lower risk
      • The bursting of the housing bubble affected all mortgages, so it affected the value of assets derived from bundled mortgages
asset bubbles and financial stability24
Asset bubbles and financial stability
  • Why does this matter?
    • People lose their homes
    • Banks lose money
      • When banks lose money, the payment system and the credit system are undermined
      • Lending is reduced because banks are scared and broke
        • Reduces both housing and non-housing investment
        • This is what threw Japan into a decade long recession
decline of the dollar
Decline of the dollar
  • Dollar has fallen a lot
    • Will fall more until imbalances in international markets are rectified
    • The US has been able to maintain a trade deficit for so long because the US was considered a safe haven for investments
      • Other countries wanted large US dollar reserves to prevent crises (like in East Asia in late 1990s)
decline of the dollar26
Decline of the dollar
  • Decline in US manufacturing, lowering of US interest rates, and strength of Euro mean that the dollar will continue to fall
  • Whether this is good or bad for the US and the global economy depends on the speed of the adjustment – slow is better – and whether other countries can substitute domestic consumption for US exports
bernanke s new policy
Bernanke’s new policy
  • Inflation targeting: two components
    • Increased transparency by Central Bank
      • More frequent announcements of numbers that Fed uses to make its decisions
      • Fed decisions made by Open Market Operations Committee
    • Commitment to reduce money supply growth to keep inflation low
      • Fed’s “preferred” inflation measure
        • Personal Consumption Expenditure index
        • Similar to CPI but includes more types of expenditures and different weights
        • Unwritten target is 1.75%
bernanke s new policy28
Bernanke’s new policy
  • Inflation targeting
    • ECB has explicit inflation targets
      • Legacy of German hyperinflation, compromise between Germany and France and Italy
    • US requires Fed to consider rate of growth of economy, unemployment, and inflation
      • So Bernanke cannot adopt explicit inflation targeting without change in law
  • Macroeconomics is a source of continual excitement
  • Financial stability is critical to economic growth
  • Economic growth is the regular increase in GDP
  • GDP is the total output of goods and services produced in the economy