office hours: 8:00AM – 8:50AM tuesdays LUMS C85 ECON 102 Tutorial: Week 22 Ayesha Ali www.lancaster.ac.uk/postgrad/alia10/econ102.html a.ali11@lancaster.ac.uk office hours: 8:00AM – 8:50AM tuesdays LUMS C85

Today’s Outline Week 22 worksheet – Fiscal Deficits, Sovereign Debt and Base Money Additional Slides at the end contain material from past exams, and last year’ tutorial material – these might be helpful for your revision, so I’ve included them. Exam 3 will be available for pick up at the end of class, if you have not already collected it.

Question 1 What magnitudes were set by the Maastricht Treaty as maxima within the Eurozone for the: sovereign fiscal deficit ratio? The ratio of the annual general government deficit relative to gross domestic product (GDP) at market prices, must not exceed 3% at the end of the preceding fiscal year and neither for any of the two subsequent years. sovereign debt-to-GDP ratio? The ratio of gross government debt relative to GDP at market prices, must not exceed 60% at the end of the preceding fiscal year. Note: To join the Eurozone, countries had to show fiscal responsibility (meaning their government deficits and debt were under control). To do this, they basically had to meet certain debt and deficit benchmarks for a certain amount of time before being able to join. Joining the Eurozone meant that certain responsibilities of the country’s central bank are replaced by the Eurozone central bank. http://en.wikipedia.org/wiki/Euro_convergence_criteria

Question 2 What is the distinction between a narrow money aggregate and a broad money aggregate? Narrow money includes only the most liquid assets, the ones most easily used to spend (currency, checkable deposits). Broad money adds less liquid types of assets (certificates of deposit, etc.).

Sovereign debt is monetised if: there is a fiscal deficit Question 3 Sovereign debt is monetised if:  there is a fiscal deficit the Treasury issues new bonds the central bank buys sovereign bonds all of the above The process of financing government spending by selling government bonds (sovereign bonds) to a central bank is called 'monetizing the debt'. The central bank may purchase government bonds by conducting an open market purchase, i.e. by increasing the monetary base through the money creation process. If government bonds that have come due are held by the central bank, the central bank will return any funds paid to it back to the treasury. Thus, the treasury may 'borrow' money without needing to repay it.

Base money is also known as: exogenous money narrow money Question 4 Base money is also known as: exogenous money narrow money outside money all of the above Base money is defined as notes and coins in circulation, in bank vaults, and national bank reserve credit. For this reason base money can also be called outside or exogenous (they both mean the same thing) – these terms refer to money that’s formed outside of the private banking sector, that is just a physical unit of account (i.e. cash). Because base money does not include other types of money, it is also called narrow. Here’s an article I found that talks about exogenous/outside money: http://www.pragcap.com/understanding-inside-money-and-outside-money

banknotes and bank reserves Question 5 Base money comprises:  banknotes banknotes and bank reserves banknotes, bank reserves and commercial bank deposits none of the above The supply of base money is the monopoly of the central bank. In tangible form it is Bank of England banknotes (in the UK).  More generally, it is now mostly made up of bank reserves (sometimes called ‘electronic money’).  Together banknotes and reserves are base money (also called ‘narrow’ money, ‘outside’ money and ‘exogenous’ money)  When ‘credit money’ is added (starting with commercial bank deposits), we move up the liquidity range where the various money aggregates are called ‘broad money’) http://www.economicshelp.org/macroeconomics/inflation/money-supply/

In the fiscal year that follows Question 6(a-b) At year zero national income is £1000bn base money is £10bn sovereign debt is £500bn In the fiscal year that follows government expenditure is £50bn tax revenue is £30bn annual interest on sovereign debt is 3 pc annual economic growth is 2 pc Assume that interest is calculated on sovereign debt at the end of each fiscal year a)What is magnitude of the primary fiscal deficit? fiscal deficit = government expenditure – tax revenue fiscal deficit = £50bn - £30bn fiscal deficit = £20bn b) What value of sovereign bonds must be sold by UK Treasury in order to finance the primary fiscal deficit plus interest? fiscal deficit + interest = fiscal deficit + annual interest rate on debt*sovereign debt = £20bn + 0.03(£500bn) = £35bn (note: for the gov’t to say their budget is balanced, it must have no deficit and pay off interest on any government bonds issued.) b) What’s going on in part b: The gov’t can’t have a deficit – it has to pay for what it spends. So, if there is a deficit (i.e. they spend more than they get from taxes), then, the gov’t will sell bonds to pay for what it owes. The bonds are an i.o.u. saying you give me $X and in the future I’ll pay you back your $X plus y% interest on what I borrowed. Anyone can buy these bonds. Why does the central bank buy these bonds? Usually because nobody else is and the gov’t needs the cash. So (b) is saying, the gov’t has a deficit – how much does it actually need to deal with that deficit.

In the fiscal year that follows Question 6(c-d) At year zero national income is £1000bn base money is £10bn sovereign debt is £500bn In the fiscal year that follows government expenditure is £50bn tax revenue is £30bn annual interest on sovereign debt is 3 pc annual economic growth is 2 pc Assume that interest is calculated on sovereign debt at the end of each fiscal year c) If the Bank of England buys one-fifth of the sovereign bonds sold by the UK Treasury (in part B), by how much does base money increase? The bank monetizes 1/5 of the £35bn in bonds that the gov’t had to issue in part b. So: £35bn/5 = £7bn d) How much annual interest does the Bank of England receive on the bonds it holds (in part c)? So, the bank lends £7bn to the gov’t. In return it gets interest of 3% on that money: 0.03(£7bn) = £0.21bn = £210 million

In the fiscal year that follows Question 6(e-f) At year zero national income is £1000bn base money is £10bn sovereign debt is £500bn In the fiscal year that follows government expenditure is £50bn tax revenue is £30bn annual interest on sovereign debt is 3 pc annual economic growth is 2 pc Assume that interest is calculated on sovereign debt at the end of each fiscal year e) What happens to the interest received by the Bank of England? It is returned to the Treasury as seigniorage. f) What is seigniorage? Seigniorage is a term that Prof. Steele likes to ask about. Make sure you check your lecture notes to see how he defines it and what he says about it. Seigniorage is the difference between the value of money and the cost to produce it - in other words, the economic cost of producing a currency within a given economy or country.  Seigniorage may be counted as revenue for a government when the money that is created is worth more than it costs to produce it; Prof Steele’s definition: it is the monopoly profit received by the issuer of base money. 

In the fiscal year that follows Question 6(g-i) At year zero national income is £1000bn base money is £10bn sovereign debt is £500bn In the fiscal year that follows government expenditure is £50bn tax revenue is £30bn annual interest on sovereign debt is 3 pc annual economic growth is 2 pc Assume that interest is calculated on sovereign debt at the end of each fiscal year g) At the end of the fiscal year, what is the UK’s national income? At the end of the year we use the annual economic growth rate to calculate NI NI at year 1 = NI at year 0 *(1 + annual econ. growth rate) NI at year 1 = £1000bn (1.02) = £1020bn h) fiscal deficit to GDP ratio? Fiscal deficit/GDP = £35bn/£1020bn = 0.034 i) debt-to-GDP ratio? At the end of the year debt is year zero debt plus deficit, so: debt at year 1 = £500bn + £35bn = £535bn debt-to-GDP ratio at year 1 = £535bn/£1020bn = 0.525

Question 7 Y = C + I + G 𝐶=200+0.5 𝑌−𝑇 𝐼=600−50𝑟 𝐺=200 T = 0.2(Y) 𝐿 𝑟,𝑌 =𝑌−100𝑟 𝑀/𝑃=800 Solve the following equations for a Keynesian model, and evaluate: the interest rate (r): real income (Y): Check your answers here: http://www.lancs.ac.uk/staff/ecagrs/Kmodel.xlsx Y = C + I + G 𝐶=200+0.5 𝑌−𝑇 𝐼=600−50𝑟 𝐺=200 T = 0.2(Y) 𝐿 𝑟,𝑌 =𝑌−100𝑟 𝑀/𝑃=800 Equilibrium in the money market gives the LM curve, To get this equilibrium, set L(r,y) = M/P So: Y – 100r = 800 => Y = 800 + 100r To find the IS curve, we plug all of our information into Y = C + I + G So: Y = 200 + 0.5(Y – 0.2 Y) + 600 - 50r + 200 Y = 1000 + 0.5Y – 0.1Y – 50r Y = 1000 + 0.4Y – 50r Y - 0.4Y = 1000 – 50r 0.6Y = 1000 – 50r Y = 1667 – 83r No plug in our LM curve: 800 + 100r = 200 + 0.5(800 + 100r – 0.2 (800 + 100r)) + 600 - 50r + 200 800 + 100r = 200 + 0.5(800 + 100r – 260 + 30r) + 600 - 50r + 200 800 + 100r = 200 + 400 + 50r – 230 + 25r + 600 - 50r + 200 800 + 100r = 1170 + 25r 75r = 370

Question 7 Y = C + I + G 𝐶=200+0.5 𝑌−𝑇 𝐼=600−50𝑟 𝐺=200 T = 0.2(Y) 𝐿 𝑟,𝑌 =𝑌−100𝑟 𝑀/𝑃=800 Solve the following equations for a Keynesian model, and evaluate: First, find the IS curve; plug into Y = C + I + G: So: Y = 200 + 0.5(Y – 0.2 Y) + 600 - 50r + 200 Y = 1000 + 0.5Y – 0.1Y – 50r Y = 1000 + 0.4Y – 50r Y - 0.4Y = 1000 – 50r 0.6Y = 1000 – 50r Y = 1667 – 83r This is our IS Curve equation. Next, find the LM Curve. We know that Equilibrium in the money market gives the LM curve, To get this equilibrium, set L(r,y) = M/P So: Y – 100r = 800 Y = 800 + 100r This is our LM Curve equation. In equilibrium IS = LM, so 1667 – 83r = 800 + 100r 867 = 183r r = 867/183 = 4.73 Y = 800 + 100r = 800 + 100(4.73) = 1273 Y = C + I + G 𝐶=200+0.5 𝑌−𝑇 𝐼=600−50𝑟 𝐺=200 T = 0.2(Y) 𝐿 𝑟,𝑌 =𝑌−100𝑟 𝑀/𝑃=800 Equilibrium in the money market gives the LM curve, To get this equilibrium, set L(r,y) = M/P So: Y – 100r = 800 => Y = 800 + 100r To find the IS curve, we plug all of our information into Y = C + I + G So: Y = 200 + 0.5(Y – 0.2 Y) + 600 - 50r + 200 Y = 1000 + 0.5Y – 0.1Y – 50r Y = 1000 + 0.4Y – 50r Y - 0.4Y = 1000 – 50r 0.6Y = 1000 – 50r Y = 1667 – 83r No plug in our LM curve: 800 + 100r = 200 + 0.5(800 + 100r – 0.2 (800 + 100r)) + 600 - 50r + 200 800 + 100r = 200 + 0.5(800 + 100r – 260 + 30r) + 600 - 50r + 200 800 + 100r = 200 + 400 + 50r – 230 + 25r + 600 - 50r + 200 800 + 100r = 1170 + 25r 75r = 370

Question 7 ctd. Use the above spreadsheet to give the following answers:   c) What is the fiscal deficit as a percentage of GDP? G = 200, so what is tax revenue? T = 0.2Y = 0.2*1273 = 254.6 So the government surplus is 254.6 – 200 = 54.6 As a percent of GDP we have 54.6 / 1273 = .04 = 4% d) Assuming: (i) zero economic growth, and (ii) a constant annual interest rate of 3%, ascertain the sovereign-debt-to-GDP ratio after 5 years. 23% e) If government expenditure is doubled (G = 400) and the income tax rate (t) halved (T = 0.1Y), ascertain the magnitudes after 5 years of: (i) the fiscal deficit as a percentage of GDP (ii) the sovereign-debt-to-GDP ratio? 16% 89%

Next Class Schedule Change for Monday Tutorials Week 23: T01/01 (M 4PM) → Tuesday 2:00PM Fylde D31 T01/02 (M 5PM) → Friday 3:00 PM Fylde D31 T01/03 (M 6PM) → Wednesday 11:00 AM Fylde D31 T01/34 (T 9AM) → Wednesday 9:00 AM Fylde D31 Week 23 Worksheet: IS-LM and Aggregate Demand Gerry Steele posts materials & slides on Moodle – use these to help get through the tutorial worksheet.

Practice Past Exam Questions (And Questions from Last Year’s Tutorials) Please Note: Solutions are not given to tutors for these questions. The solutions I’ve prepared are only suggestions only – I cannot guarantee they are correct.

UK National Debt comprises: (a) the sum of trade deficits over past years (b) sterling currency notes and coins in circulation, plus commercial bank deposits (c) outstanding loans to the state, excluding sterling currency notes and coins in circulation (d) outstanding loans to the state, including sterling currency notes and coins in circulation 2012 Exam Q32

Problem From Last Year This problem from last year is very similar to Q7, but is written up as a word problem. See if you can solve it and check your answers against mine in the following slides. You are given the following information about an economy: autonomous consumption is £100 billion; autonomous investment is £500 billion; the marginal propensity to consume is 0.75; the coefficient on interest in the marginal efficiency of investment function is 10; the demand for money function takes the form: MD = 0.5Y – 15r, where Y is the economy's real output and r is the interest rate expressed as a percentage; and the real money supply is £850 billion. Find the equilibrium interest rate (r) and the equilibrium income (Y).

Problem From Last Year You are given the following information about an economy: autonomous consumption is £100 billion; autonomous investment is £500 billion; the marginal propensity to consume is 0.75; the coefficient on interest in the marginal efficiency of investment function is 10; the demand for money function takes the form: MD = 0.5Y – 15r, where Y is the economy's real output and r is the interest rate expressed as a percentage; and the real money supply is £850 billion. Find the equations of the IS curve In the product market, equilibrium occurs when Y = C + I and so: C = 100 + 0.75Y I = 500 -10r We can plug these in to Y = C + I Y = 100 + 0.75Y + 500 – 10r 0.25Y = 600 -10r Y = 2400 – 40r This is equation of the IS curve. 2013/2014 Week 18 Note: The coefficient on r is negative here because the lower the interst rate, the cheaper it is to invest, so investment will increase. There is an inverse relationship between the two.

Problem From Last Year You are given the following information about an economy: autonomous consumption is £100 billion; autonomous investment is £500 billion; the marginal propensity to consume is 0.75; the coefficient on interest in the marginal efficiency of investment function is 10; the demand for money function takes the form: MD = 0.5Y – 15r, where Y is the economy's real output and r is the interest rate expressed as a percentage; the real money supply is £850 billion. Find the equations of the LM curve. In the money market, equilibrium occurs when MD = MS and so: MD = MS 0.5Y – 15r = 850 0.5Y = 850 + 15r Y = 1700 + 30r This is the equation of the LM curve. 2013/2014 Week 18

Problem From Last Year In part (a) we found: IS curve: Y = 2400 – 40r LM curve: Y =1700 + 30r What are the equilibrium income and rate of interest in the economy given the information above? To find the equilibrium, set IS equal to LM: IS = LM 2400 – 40r = 1700 + 30r 70r = 700 r = 10% This is the equilibrium interest rate. To find the equilibrium income, we can plug this value of r into either expression for Y and obtain Y = £2,000 billion. 2013/2014 Week 18

IS Curve is Equilibrium in the Goods Market To solve for the IS curve set Output (Y) equal to Expenditure (C+I+G). I is usually a function of interest rate (r). To the up and right of the IS-curve, output is greater than Expenditure, while to the bottom and left of the IS-Curve, Output is less than Expenditure. 2013/2014 Week 18 To shift the IS curve to the right, we need to increase Expenditure (usually, I or G). Likewise, to shift IS to the left, we would need to decrease Expenditure.

LM Curve is Equilibrium in the Money Market To solve for the LM-curve set Money Supply (Ms) equal to Money Demand (Md). Money Supply is usually constant and Money Demand is usually a function increasing in output (Y) and decreasing in interest rates (r). 2013/2014 Week 18 To shift the LM curve to the right, we need to increase Money Supply or decrease Money Demand (this could be done through increasing interest rates). Likewise, to shift LM to the left, we would need to decrease Money Supply or increase Money Demand (again, by using interest rates).