Macroeconomics Review

Agenda GDP, Money Demand, and International Capital Flows Interest rates Monetary vs fiscal policy Currency rates and devaluation

GDP and International Capital Flows What is the national accounts identity?

GDP and International Capital Flows What is the national accounts identity? Output (or GDP) = Total income of everybody in the economy = Total expenditure on the country’s output of goods and services Y = C + I + G + X – M GDP = Private Consumption + Gross Investment + Government Spending + Exports - Imports

GDP and International Capital Flows GDP (or Y) can be measured in real or nominal terms. What is the difference? Nominal GDP: The value of output at today’s prices  Nominal GDP = (Price Good1 )*(Quantity Good1 ) + (Price Good2 )*(Quantity Good2 ) + … Real GDP: The value of output at a constant set of prices from a base year  Real GDP = (Base Year Price Good1 )*(Today’s Quantity Good1 ) + (Base Year Price Good2 )*(Today’s Quantity Good2 )) + …

GDP and International Capital Flows The GDP deflator is the price index for all final goods and services used to adjust the nominal GDP into real GDP.  GDP Deflator= (Nominal GDP/Real GDP)*100  GDP Deflator is a substitute for the Consumer Price Index (CPI), which is an index measuring the prices of a fixed market basked of consumer goods bought by a typical consumer.

International Capital Flows and Trade Balance In an open economy:  spending need not equal output  saving need not equal investment This is because countries can import and export goods and capital. As we’ve seen, the national income identity in an open economy is:  Y=C+I+G+X-M, which is equivalent to Y=C+I+G+NX  Rearranging we get Y-C-G=I+NX  Remember also that Y-C-G=National Saving, or S  Thus S=I+NX  NX=S-I Net Exports=Savings-Investment

International Capital Flows and Trade Balance Another name for net exports is the trade balance.  Net Capital Outflow = Trade Balance S – I = NX Thus an economy’s net exports must always equal the difference between its saving and its investment. If:  S - I and NX are positive, we have a trade surplus: we are net lenders, and we are exporting more than we import  S – I and NX are negative, we have a trade deficit: we are net borrowers in world financial markets, and we are importing more goods than we are exporting  If S = I and NX are exactly zero, we are said to have balanced trade

International Capital Flows and Trade Balance In summary, there are three outcomes an open economy can experience:

Interest Rates What is an interest rate? The market price at which resources are transferred between the present and the future; or put another way, it’s the return to saving and the cost to borrowing A nominal interest rate is not adjusted for inflation – it is the rate you would pay today to borrow (or the rate you would receive to lend) A real interest rate is adjusted for inflation

Interest Rates What is the Fisher Equation? An equation that describes the relationship between the nominal interest rate, inflation, and the real interest rate: Real Interest Rate=Nominal Interest Rate-Inflation

Interest Rates What affects a borrower’s interest rate? Time value of money  Captured by the discount rate  Idea that a dollar today is worth more than a dollar tomorrow; this depends on the opportunity cost of that dollar (the return from the next best thing that a dollar could be invested in) The risk that the lender will have less purchasing power when the loan is repaid:  Systematic: Default risk, or the chance that the borrower won’t pay back the loan  Regulatory: Changes in the law which mean lender can’t collect as much (or the value of the collected amount is not as high) as originally anticipated –e.g., taxation  Inflation: Money may not have as much buying power when the loan is repaid. This is also the case with insecurity around exchange rates.

Monetary and Fiscal Policy What is monetary policy? Mankiw defines it as “The central bank’s choice regarding the supply of money” Central Banks can influence the available money supply in three ways: Open market operations (or buying and selling government bonds):  To decrease the money supply: sell bonds  less money in the economy  To increase the money supply: buy bonds  more money in the economy The discount rate: This is the rate the Fed charges when it makes loans to banks. Banks borrow from the Fed when they find themselves with too few reserves to meet reserve requirements. The lower the discount rate, the cheaper it is to borrow reserves, and the more banks borrow  making more money available and increasing the money supply. Reserve requirements: these are Fed regulations that impose on banks a minimum reserve-deposit ratio.  To decrease money supply: increase the reserve requirements  To increase money supply: decrease the reserve requirements

Monetary Policy How does monetary policy affect the economy? E.g. Central bank increases the money supply Interest rate channel  The supply of money increases  Interest rate (the price of money) falls  Stimulates investment (cheaper for investors to borrow money)  Stimulates consumption (cheaper to buy things like cars and houses) Exchange rate channel (if floating ER + no capital controls – see later slides)  Interest rate falls  Capital flows out, currency depreciates  Exports become relatively cheaper abroad  Trade balance improves Wealth /Asset price channel (Indirect, weak evidence of this)  Lower interest rates make other assets more attractive than bonds (e.g. stocks, housing)  Higher demand for stocks, housing pushes up their prices  This increases wealth of consumers  Increasing consumer spending

Monetary and Fiscal Policy What is fiscal policy? Mankiw defines it as “The government’s choice regarding levels of spending and taxation” How does it affect the economy? Spending: when the government increases its spending, it causes output (Y) to increase in order to meet this new demand. Taxes: when the government decreases taxes, it puts more money into the hands of consumers, who then want to buy more goods, which causes output (Y) to increase in order to meet this new demand.

Monetary and Fiscal Policy What happens in a liquidity trap? Liquidity trap is when a bank tries to inject money into the economy to stimulate growth, but it doesn’t work, because people hoard their money in anticipation of less demand tomorrow or war, or deflation. Interest rates are already as low as they can go (e.g., nominal interest rate = 2% so real interest rate is effectively 0%) A monetary expansion has no effect on equilibrium interest rates or output because interest rates are already at 0%. However, fiscal expansion leads to a higher level of output with no change in interest rates

Currency, FX, Devaluation What is an exchange rate? An exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. A currency will tend to become more valuable whenever demand for it is greater than the available supply There are nominal and real exchange rates.

Currency, FX, Devaluation How are exchange rates set? It depends on the currency regime: If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency.

Currency, FX, Devaluation Why would a country choose one regime over the other? There is a principle called the Impossible Trinity, which implies that a country can have only two of the following three conditions: Financial integration: Perfect capital mobility, where capital flows between countries with ease. Benefit is that it is conducive to trade. Exchange rate stability: A fixed exchange rate that is predictable and in the country’s control. Benefit is that it facilitates doing business internationally. Monetary independence: A central bank has full national sovereignty and can influence its monetary supply. Benefit is that monetary policy can be used to moderate cyclical fluctuations.

Currency, FX, Devaluation Example: Which two elements do the following countries/unions have? US: European Union:

Currency, FX, Devaluation Example: Which two elements do the following countries/unions have? US: financial integration, monetary independence, and NO exchange rate stability (US moved to a floating exchange rate) European Union: financial integration, exchange rate stability, and NO monetary independence (EU countries can’t just print more money)

Currency, FX, Devaluation What are potential benefits of devaluation? Makes export goods more attractive abroad, which can be used to stimulate economic growth. Common response to a solvency crisis - can be a source of economic growth that gets a country out of a slump. Means of overcoming coordination problems arising from downward nominal wage rigidity When a country is part of a currency union, devaluation is not an option.