BGIE Review: Midterm

Ted Berk James Ratcliffe February 8-11, 2001 BGIE Review: Midterm

Agenda • Review of key concepts and linkages • National income and product accounting • Fiscal policy • Monetary policy • Balance of payments • Exchange rates • Exam tips • Questions

Real vs. nominal and CAGRs • What is “nominal”? • Conceptually equivalent to the quantity (e.g. of output) multiplied by current prices • Usually BGIE data are in nominal terms, unless otherwise noted • What is “real”? • Data that have been adjusted to remove the impact of changes in the price level, i.e. the quantity multiplied by prices of some base year • You see only the impact of “real” changes in economic factors • General rule for determining real measures: Real = Nominal x (base year prices / current prices) • Choice of a base year does not really matter – the goal is to compare different years using the same price level • CAGRs can summarize trends over time and allow you to compare them • CAGR = (End Year / Beginning Year) ^ (1 / # of periods) – 1

Country example: India

National income and product accounts • National Income Equation: Y = C + I + G + (X – M) • Y = total output (production) of a country’s economy • A measure of the level of economic activity • GDP is the output created domestically (within a country’s borders) and is more commonly used • GNP is created by a country’s nationals (citizens) wherever they live in the world • C = consumption by private individuals • I = investments by private business (capital expenditures + inventories) • G = government spending on goods and services, i.e. government consumption and investment • X = exports, M = imports  (X – M) = net exports

Issues in national income accounting • Y includes only current production of new, “final” goods and services • Excludes intermediate goods or transfers of existing assets (and thus most financial transactions) • Only includes market transactions • Investment by private individuals (consumer durables) is considered C • Exception: residential construction is considered I • I includes investment by private business, while government investment is included in G • G does not include transfer payments but only government spending on goods and services

NIPA, Part Deux Y = C + I + G + (X – M) Y = C + S + Taxes – Transfers I = S + (Ta – G – Tr) + (M – X) • In words…. investment can be funded from three sources: • Domestic private savings • Government savings (i.e. surplus) • Borrowings from foreigners • current account deficit  capital account surplus • Implications include: • when the government runs a deficit, country needs to borrow from abroad or reduce investment

“Managing” the economy • Output = Y = C + I + G + X – M • Potential = ƒ (capital stock, labor force, technology/productivity) • To grow and support capital stock, must have I • Inflation when output > potential • When output < potential, should have deflation, but really have price stickiness, hence Keynes’ arguments to ward off vicious cycle Actual (Y) Actual > Potential Potential Actual < Potential

Basic drivers of actual output (Y) • Consumption and savings • Driven by personal disposable income • Basis for fiscal policy (Keynesian arguments): cut taxes or increase G, you put more money into people’s pockets to spend as C • Investment • Depends on interest rates, since companies should make only NPV-positive investments • Also depends on businesses’ confidence in future economic conditions • This is why monetary policy is so important • Net exports • Falls with appreciation of the currency, rises with depreciation • Tends to fall when C is driven up by fiscal policy • More disposable income  consumption of foreign goods, too

Fiscal policy and the income multiplier • Key tool for Keynesian fiscal policy is the income multiplier effect • If the government puts $100 in the pockets of consumers, output increases by more than $100 • as the first recipient spends the money she causes a secondary effect, which in turn drives a tertiary effect, etc. • Leakages: imports, taxes, savings… so the entire $100 does not go towards boosting national output • i.e. anything that prevents this new income from being spent on domestically-produced stuff • Overall effect of income multiplier is 1 / ( 1 – Marginal Propensity to Consume ) • Government spending (G) has a larger impact than a comparable-sized tax cut, since with the tax cut, you only get the secondary, tertiary, etc. effects, not the initial spike in GDP • The multiplier means that government action can actually have an effect on the economy – you get more bang for your buck • Government can also slow the economy by taking money out of consumers’ pockets, i.e. the multiplier works the same way with contractionary policies.

Tools of monetary policy • Monetary policy can be a more flexible tool than fiscal policy • In the United States, the independent central bank can set and change policy without all the long debates and compromises of Congress • However, the Fed remains independent only as long as everyone agrees that it should • Discount rate: the rate at which the central bank loans money to other banks • The Fed can raise the discount rate to increase the cost of funds to banks, raising the “price” of borrowing money • Open market operations • Government securities are a large portion of the central bank’s asset base • By buying or selling these securities, the central bank can put money into the economy, or take it out • Reserve requirements • % of its deposits that a bank must hold as reserves • Reserves can be held as currency or deposited with the central bank • The higher this % is, the less money banks can lend

Money multiplier • Defining the monetary base – types of money • M0 = currency (actual cash in circulation) • M1 = currency and demand deposits (most frequently used) • M2 = M1 + time deposits <$100k (i.e. CDs) • When reserve requirements change, the portion of a deposit that a bank can lend back out will change • People deposit money in banks, which then lend it out to others, who deposit in another bank, which lends it out, etc. • Level of money multiplier depends on leakages • Reserves that banks of required to hold (tool of monetary policy) • Money that people don’t deposit in banks but hold under mattress • Mathematically, 1 / (reserve ratio + other leakages) • Not to be confused with the Keynesian multiplier • Keynes’ theory focuses on the impact on Y of changes in G • Changes in G have no impact on the money supply

Inflation and monetary policy • Inflation is an increase in the overall price level • Measured by a number of indices: GDP deflator, CPI, PPI, etc. • Inflation has costs • Uncertainty: companies can’t plan effectively • Impact on savings: people want to spend, rather than save • Impact on fixed incomes: real value of fixed incomes erodes (retirees) • Hoarding: people hold assets in goods, rather than money • Speculation: can become more profitable than productive work • An increase in the supply of money may boost Y in the short run • As prices are sticky, then additional money will lead to additional activity • But if prices will adjust in the long run, then ↑M leads to inflation • Basic money identity: M x V = P x Q • Amount of money x number of times it changes hands (velocity) = nominal prices x real output level

“Managing” the economy (revisited) • Suppose policymakers believe that output is currently below potential • High unemployment, etc. • Loose fiscal policy • Increases G, cut Taxes  increase C  increase Y • As output approaches or exceeds potential  increased inflation • Increased government borrowing tends to put upward pressure on interest rates – increased demand for borrowed money • Monetary policy • Interest rate targets will be set by central bank, not by fiscal policymakers • Inflation probably leads bank to raise interest rates  decline in I • Also, all other things being equal, funds available for I would fall as government deficit rises • So, how to encourage I? One view… • Loose monetary policy (low interest rates) and tight fiscal policy (low government deficits, or even surpluses)

Principles of BoP statements • The balance of payments is essentially an accounting statement that captures a country’s international transactions • Like with NIPA, the minutiae of how the statements are created are less important than interpreting them • Transactions are divided into 2 broad categories • Current account: transactions in goods and services • Capital account: transactions in financial assets • Financial transactions by government institutions (especially the central bank) are broken out separately as “reserves” • The balance of payments always adds to 0. “+” = sources of foreign exchange, “–” = uses of foreign exchange • As accounting necessarily involves some error and estimation, the plug in the BoP is called “errors and omissions” Current account + Capital account + Errors and omissions + Δ in reserves = 0

Current account Exports are a source of foreign exchange and therefore a “+” in the BoP, and vice versa for imports Includes dividends and interest on securities, and income on direct investment (i.e. overseas assets that are owned and controlled by domestic residents) Includes foreign aid programs, military aid, etc.

Capital account Includes foreign direct investment, purchases of foreign securities (not interest or dividends; that’s in the current account) Capital account Always equal to the opposite of the overall balance, therefore a “+” change in reserves is actually a USE of foreign exchange (a decrease in reserves)

Exchange rates overview • People need to convert into foreign currencies to buy or sell foreign goods and assets • Ferrari needs to pay its workers in Italian Lira, so to import a car from them to the US, you need to pay Ferrari in Lira • The U.S. government buys goods and services in dollars, so to lend money to the government (buy Treasury bills), foreigners need dollars • Most simplistically, exchange rates should equalize the price of goods and services across all countries • Otherwise, one could buy a good in the “cheaper” country and sell at a profit in the more “expensive” (arbitrage) • Example: A Big Mac costs $2.50 in the United States. At a rate of US$1.00 = NZ$2.25, how much should a Big Mac cost in New Zealand? • NZ$ 5.63 • BUT, certain goods are not easily tradable, and competition is not always perfect in every country…. So a Big Mac in New Zealand costs NZ$3.40

Fixed vs. flexible exchange rates • Under a fixed-rate regime, countries agree to peg their currency to a known price • e.g. to the price of gold (Gold Standard) or to the dollar (Bretton Woods) • Should reduce exchange-rate risk and facilitate trade and international investment • Maintaining a fixed-rate regime requires active participation by central banks • Balance of payments deficit  central bank must raise interest rates to attract foreign exchange and restore payments balance • Under a floating-rate regime, balance of payments deficit  excess supply of dollars  dollar depreciates • Central bank can target exchange rates or interest rates but not both. • Flexible rates are determined by the supply and demand for a currency in the market • Supply is determined by monetary policy • Demand driven by: • Relative interest rates – in part determined by monetary policy • Trade balances – can be influenced by fiscal policy • Expectations of future exchange rates (and of 2 factors above) matter because they create arbitrage opportunities – self-fulfilling prophecy?

Exam tips • Read the questions carefully. • If there’s data, be sure you know if it’s in real or nominal terms. • Examine all the answers offered. • Multiple choice = seek the “best” answer • Keep it simple – think about primary effects • Don’t panic!

GOOD LUCK!!

Questions? Ted Berk (OD), eberk@mba2001.hbs.edu, 868-8577 James Ratcliffe (OC), jratcliffe@mba2001.hbs.edu, 492-2974 (slides posted at: www.mba2001.hbs.edu/jratcliffe/bgie.html)

BGIE Review: Midterm