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MACROECONOMICS. 1. The macro-economy: a theoretical model 2. Controlling the economy: fiscal policy 3. Money and the macro-economy 4. Inflation and unemployment 5. An open economy: international macroeconomics. MACROECONOMICS. What is the purpose of macroeconomics?
MACROECONOMICS 1. The macro-economy: a theoretical model 2. Controlling the economy: fiscal policy 3. Money and the macro-economy 4. Inflation and unemployment 5. An open economy: international macroeconomics
MACROECONOMICS • What is the purpose of macroeconomics? • to explain how the economy as a whole “works” • to predict the consequences of policy action • to understand why macro variables behave in the • way they do (trends and fluctuations) • What factors determine national income and employment? • Can the government affect national income through • fiscal and monetary policy?
How do interest rate decisions reached by the central bank affect the economy? What factors determine national savings and investment? What factors determine the exchange rate? Why is the trade balance important?
THE CIRCULAR FLOW OF INCOME Exports Imports Investment Demand for goods Households Firms Government Tax Wages, profits
A MACROECONOMIC MODEL: THE DEMAND SIDE • Building blocks • consumption 65% • investment 15% • government spending 20% • exports 25% • imports -25% • These five variables play a critical role in determining • national income and employment. • Hence: need to be explained.
What determines aggregate consumption? • disposable income (Y - T) • interest rates (investment) • uncertainty (confidence in future income stream) • wealth (asset prices, house prices) • expected future income (e.g. pensions) • age structure of population
Investment • new capital equipment; not savings/ shares • What determines investment? • initial cost of investment • interest rate (cost of borrowing) • expected future income from investment • The investment decision • Present value of investment > 0
Cost of capital: increases as level of investment increases • internal funds (retained profits) • borrowing from financial institutions • selling equity stock in business • How would a reduction in interest rates affect investment? • lower borrowing costs • lower mortgage rates (higher demand for houses) • increase in saving (lower expenditure)
Determination of national income: a demand-based model Assumptions 1. Aggregate supply of goods responds to demand - unlimited supplies of labour and capital 2. Aggregate demand for goods and services is determined as follows: AD = C + I + G + X - M Model (see figure) Predictions: - if AS > AD, stocks increase, output falls - if AD> AS, stocks decrease, output rises - if AD = AS, economy is in equilibrium
Factors causing national income to change • 1. If expenditure increases, so will income • 2. Why might AD increase? • consumption responds to • - fall in prices (e.g. production costs fall) • - wealth increases (house prices, stock market) • - interest rates fall (monetary authorities) • - lower taxes (govt. policy) • investment • - increase in expected profits (business optimism) • - fall in borrowing costs
government spending • - transfer payments increase • - capital spending increases • - expenditure on education/ health increases • net exports • - fall in exchange rate • - increase in competitiveness • - increase in world income
The supply side • So far assumed that AD alone determines national income • What about supply-side constraints? • capital stock is limited in the short run • supply of labour is limited • skills shortages may arise
Implications of a limited supply of factor inputs • wages increase as labour demand increases • diminishing marginal productivity • (fixed supply of capital) • producers willing to supply more output only at higher • prices • supply can be increased over the long run • (increase in capital stock) • Revised model • interaction between AD and AS determines the • economy’s income and price levels
Revised model • interaction between AD and AS determines the • economy’s income and price levels • Consider the effects of: • - an increase in production costs • - an increase in the supply of resources • (e.g. capital stock, technology) • - an increase in the demand for goods
Extended model • Assumption: AS is fixed by the economy’s output capacity • labour market is assumed to clear (full employment) • AD negatively related to price level • - fall in price leads to higher demand • (real money balances increase, spending increases) • - fall in price reduces demand for money, interest rates fall • (lower interest rate, higher spending) • AD positively related to aggregate spending • - investment increases as business expectations improve
AD positively related to money supply • - if money supply increases, interest rate falls (investment increases) • A further modification • AS may not be fixed at the full employment level • AS may be upward sloping in the short run: • - sticky prices • - unemployed labour willing to work at current wages • ( costs do not rise as more labour is employed)
MACROECONOMIC POLICY • Objectives of macro policy: • full employment • stable prices • steady growth • equitable distribution of income • balance of payments equilibrium (medium term)
Policy instruments • Fiscal policy • govt spending (health, education, etc) • taxation (income, expenditure, excise duties) • income transfers (pensions, welfare) • Monetary policy • interest rates • money supply • Exchange rate policy • fixed v floating
FLUCTUATIONS IN BUSINESS ACTIVITY • Historical record • recessions can be very severe • all countries experience booms /slumps • recessions are usually shorter than expansions • business cycles are highly synchronised between ‘partners’ • - inter-country linkages • business cycles are less severe than in past • - govt spending is stable • - automatic stabilzers have ‘worked’ • - active monetary policies (Greenspan after Asian crash)
Causes of business fluctuations • unexpected ‘shocks’ • - wars, oil-prices, financial crises • shifts in AD • - investment is volatile (unpredictable behaviour) • - price stickiness causes changes in ‘real’variables • technology shifts • - new products / new processes • govt-induced shocks • - poor management of fiscal / monetary policy • - time lags
FISCAL POLICY • What is fiscal policy? • - govt’s attempt to control AD via G and T • Role and importance of fiscal policy • fiscal activism • - fine-tuning of AD to achieve full employment • - fine-tuning to reduce amplitude of business fluctuations • fiscal balance has replaced fiscal activism • - fine-tuning via fiscal policy has failed • - monetary policy has replaced fiscal policy • how could govt ‘pay for’ fiscal expansion in a recession? • - increasing G causes income to increase • - increase in income leads to higher taxes
problems with fiscal activism • - fiscal activism involves discretionary action • - govt has to decide how much stimulus is needed • - need to know effect of fiscal injections • (macro models used to predict effects) • - budget deficits can easily get out of hand
automatic stabilisers • - ‘kick in’ when economy moves into recession • - welfare payments increase • - tax revenue falls in recessions (to maintain C) • fiscal policy stance • - budget deficit does not necessarily mean that fiscal • stance is expansionary; recessions cause deficits • - fiscal stance may be ‘tight’ at full employment
Reasons for the decline of fiscal activism • difficult to predict effects • - inadequate knowledge of how economy works • - macro models are inadequate • - poor data • - long time lags in policy effects • - poor timing of policy changes
political interference results in wrong policy action • - political cycles • - systematic bias towards deficits • (popularity of low taxes) • fiscal activism results in increasing debt • - debt/gdp ratio increases (debt has to financed)
Dedt / gdp ratios % 1990 2000 EU 41 69 Japan 10 113 USA 32 60 Germany 42 64 France 40 64 UK 39 50 Italy 104 113
Government spending / gdp % 1960 1970 1990 2000 EU 32 37 48 44 Japan 17 19 32 32 USA 27 32 37 33 Germany 33 39 45 44 UK 32 34 53 44 France 35 39 51 48 Italy 30 34 53 44
Reducing debt may have expansionary effects • cut in G can lead to: • - lower interest rates • - more confidence in govt’s macro policy • - inflow of private FDI • greater consumer / investor confidence
fiscal activism is useless due to ‘crowding out’ • - ‘crowding out’ of private I via high interest rates • - households reduce spending due to expectation of • higher taxes in future • But: • - households may not make link between budget deficit • and future taxes • - households may not care about the distant future • - not much evidence to support negative impact of • ‘crowding out’
Sustainability of debt: govts worry about debt/gdp: • many developing countries get into trouble (Mexico) • - desire for growth • non-tax payers / taxpayers increasing due to • ‘demographic time bomb’ • e.g. % 65+ • 2000 2050 • USA 12 21 • Japan 17 30 • EU 16 28 • need to keep interest rates below gdp growth rate • to get debt / gdp down (or to run a deficit while keeping • debt / gdp constant)
Conclusions • fiscal policy has become more conservative • debt burden too big; need for surpluses to repay debt • inflationary consequences of expansionary policies • financial markets ‘nervous’ of increases in govt debt • (Can the govt meet its debt repayments?) • pressure to reduce size of public sector • - efficiency gains from privatisation • - lower interest rates • automatic stabilisers essential for macro stability
fine-tuning replaced by coarse-tuning • sustainability of debt • - discretionary fiscal policy still has a role to play • - co-ordinated policies macro-policy between G7 (G3?) • needed to keep world economy stable • (due to high rate of transmission of economic shocks)
MONEY AND THE ECONOMY What is money? What does money do? How does money affect the economy? What determines the money supply? What determines the demand for money? What determines interest rates? What is monetary policy?
What is money? • What counts as money? • depends on its accessibility (degree of liquidity) • - cash • - bank deposits • - interest-bearing deposits • - time-deposits (savings) • - short-term Treasury bills (near money) • What does money do? • - medium of exchange • - store of wealth • - unit of account (measure of relative value) • - relates the future to the present • (wage contracts, repayment of debt)
How does money affect the macro economy? • Money affects the economy via interest rates: • r affects expenditure (C and I) • exchange rates (and therefore X and M) • property prices • bonds and shares
The financial sector: the central bank • issues cash • banker to commercial banks • banker to govt (manages govt borrowing) • regulates commercial banks • controls liquidity position of commercial banks • operates monetary policy • operates exchange rate policy
The financial sector: the money market Intruments - govt bonds / gilts - certificates of deposit - loans to households - overdrafts - mortgages Organisations - commercial banks - large firms - pension funds - building societies - foreign exchange market
Monetary policy • Central bank controls monetary conditions: • controls liquidity through lending rate (‘repo’) • - commercial banks can borrow at the repo rate • - repo rate is a ‘signal’ • (determines all other interest rates) • - low repo encourages banks to borrow and lend • - high repo discourages banks from borrowing
Determination of interest rates • Demand for money • transactions purposes • - price level • - income • - interest rate (opportunity cost) • precautionary purposes • speculative purposes • - expected change in price of bonds • - bond price inversely related to r • - hold money if bond prices are expected to fall • - hence: demand for money high when r is low
Causes of changes in money supply • banks can reduce their liquidity ratios • - switch / direct debit has reduced demand for cash • - banks borrow from each other (overnight) to • achieve a satisfactory liquidity position • surplus in balance of payments • - inflow of foreign exchange • govt creates high-powered money to finance a • deficit • - multiplier effects on ‘broad’ money (M) • M = k (H) • M = broad money • H = high-powered money • k = money multiplier
govt sells short-term Treasury bills (‘near money) • - commercial banks expand loans to customers • govt buys long-term bonds and sells short-term • Treasury bills to increase liquidity (‘funding’)
Determination of interest rates Govt sets the money supply Private sector determines demand for money What happens if: - money supply increases - income increases - prices increase Ms = M1 r r1 Md = f(P, r, y) Demand / supply for money M1
Monetary policy in practice • Central bank • does not control the money supply directly • controls interest rates via open market operations • How does the CB control interest rates? • announces an interest rate • - base rate/repo rate paid by banks for borrowing • money from the CB • follows this up with OMO • - buys gilts from banks to increase liquidity • (results in lower r) • - sells gilts to banks to decrease liquidity • (banks earn an income from gilts)
Independence of central bank • USA and Germany: long history of CB independence • other countries followed in 1990s (e.g. UK in 1997) • Advantages of independence • monetary policy free from manipulation • strengths credibility (inflation targets more ‘believable’ • CB free to achieve its specific objectives • Disadvantages • low inflation is not the only policy goal • govt deflects blame for failure of economic policies • Performance • lower inflation achieved • tight monetary policy has led to higher unemployment in EU
The European Central Bank • sets interest rate for all member states • most independent CB in world; not accountable to any • single country • sets target inflation rate for whole Eurozone • sets 3 interest rates • - lender of last resort (e.g. 5%) • - loans to banks (e.g. 4%) • - borrowing from banks (e.g.3%) to mop up • surplus liquidity • sets minimum reserve ratio (to keep banks under control)
INFLATION AND UNEMPLOYMENT • What is inflation? • Some facts • inflation varies over time within countries • inflation varies between countries • What causes inflation? • quantity theory of money • excess demand model of inflation • cost-push factors (wages, imported inflation) • a dynamic model of inflation
Quantity theory of money Expenditure = Sales quantity x velocity = price level x output of money MV = Py Suppose V and y are constant then P = (V/y)M or rate of change in P = rate of change in M
Excess demand model of inflation If AD > AS……….prices rise if AD < AS……….prices fall AS P2 P1 AD2 AD1 y1 y2
AD can increase for several reasons: • consumption suddenly increases • investment increases (expectations improve) • money supply increases (fall in r) • exports increase (world trade expands) • Inflation is self-perpetuating: • wage-price spiral • expectations of inflation • Cost-push shocks: • triggered by wage push, oil price hikes
A dynamic model of inflation: the augmented • Phillips curve • wage inflation = f (expected price inflation, XD) • expected price inflation: • - based on forecasts of macro-economy • (e.g. capacity utilisation, monetary growth) • Does a trade-off exist? • - short-run • - long-run