Download interest rates

Macroeconomics
5/23/2017
1
Macro topics covered
• Big Issues
– Business cycles
– Unemployment
– Inflation
• Effects of fiscal policy and role of government
– Keynesian “activist” approach
• Problems with fiscal policy
– New classical “supply-side” approach
• Money and monetary policy
– money creation and tools of monetary policy
– money models
– activist and non-activist approach
5/23/2017
Business Cycles
… pattern of rising real GDP followed by falling real GDP
Recession
… a period in which real GDP falls
– Usually at least 2 successive quarters
Depression
… a severe and prolonged economic contraction
“the great depression in the 30’s”
– Around 25% of the labor force was unemployed.
5/23/2017
3
Real GDP
begins to
fall
Real GDP
begins to
increase
Trend growth has been around 3% per year (on average)
5/23/2017
4
Expansion (boom) – real GDP is increasing
Contraction – real GDP is decreasing.
5/23/2017
5
Unemployment
Official Unemployment Rate
… the percentage of the labor force that is not working
Unemployment rate = [number of people unemployed /
number of people in the labor force]
•
Notice: It is not the unemployment rate of the population.
5/23/2017
6
Labor Force
Labor force = all US residents – residents under 16 years
– institutionalized adults – adults not
looking
for work
• To be in the labor force an individual must be either
looking for a job or in work
Therefore (alternative measure)
Labor Force = Employed + unemployed
– E.g. housemen/women are not included in the labor force.
– Retired people are also not in the labor force.
– In 2006 the labor force was 152.8 Million
5/23/2017
7
Other Labor Statistics
• Labor Force Participation = Labor Force / population
16 and over
• Employment/population ratio = employed people
/ population 16 and
over
• Given we have unemployment LFP>EP ratio
5/23/2017
8
Hypothetical Example
(1)Number of people
unemployed
4 million
(2)Number of people employed
145 million
(3) Non-institutional civilian
Population (16 and older)
200 million
(4) Labor Force
149 million
Unemployment rate
(1)/(4) = 2.68%
Labor force participation
(4)/(3) = 74.5%
Employment/population ratio
(2)/ (3) = 72.5%
5/23/2017
9
3 Types of Unemployment
• Frictional Unemployment
– A product of the short-term movement of workers
between jobs, and of first-time workers.
– “Short-run” unemployment
 E.g. time between leaving one job and taking another, or
students graduating college and now looking for a job.
– Sometimes called “search unemployment”
 Often seen as a “good thing”
– Generally low when in a recession
 People “stay put”
5/23/2017
10
• Structural Unemployment
– A product of technological change and other changes in
the structure of the economy
Therefore certain skill sets are no longer required
 E.g. Coal Miners losing their jobs as the economy moves to a
service-based economy.
 Car assembly workers laid off as factories use more robots.
• Any dynamic economy has some frictional and structural
unemployment
5/23/2017
11
• Cyclical Unemployment
– A product of business cycle fluctuations
– E.g. a temporary fall in demand for a good/service leads
to a reduction in employment levels.
– E.g. construction workers.
5/23/2017
12
Natural Rate of Unemployment
… the unemployment rate that exists in the absence of
cyclical unemployment.
– All economies will have some “natural” rate of
unemployment.
– Frictional plus structural
– Can vary over time.
• Estimated to be between 4-6%
• US it is approximately 5% (at the moment)
Full Employment
…. The level of employment when the economy is at its
natural rate of unemployment
– For the US it is assumed to be 95%
– Sustainable level of employment
13
Inflation
… a sustained increase in the average level of prices
• The higher the price level the lower the real value of
money
– Purchasing power of a dollar is eroded.
– Standard argument with parents and allowances….
Hyperinflation
… an extremely high rate of inflation
E.g. Zimbabwe.
– Can cause a “flight from money”.
5/23/2017
14
Calculating Inflation
Year
5/23/2017
Price Index (CPI)
Inflation Rate (%)
2001
88 -
2002
93
5.68
2003
100
7.53
2004
104
4.00
2005
106.5
2.40
2006
110
3.29
2007
118
7.27
15
Unanticipated and Anticipated Inflation
• Unanticipated Inflation
– When the increase in prices is a “surprise” for
most decision makers
– Usually happens when inflation rates vary
significantly.
• Anticipated Inflation
– When the increase in prices was “expected” by
most decision makers
– Usually happens when Central Banks have a good
control on inflation
5/23/2017
16
Costs of Inflation
• Businesses generally avoid long term projects
– Difficult to estimate the profitability of a project if
prices (costs) are varying a lot in the future.
• Prices no longer reflect relative scarcity
– As some prices change slower (sticky) than others
– Price no longer reflects all (current) information
– More difficult for firms/individuals to make
informed decisions.
5/23/2017
17
• “Shoe leather and Negotiation Costs”
– Individuals spend time acquiring information
– Cause higher transaction costs when negotiating
– Business divert resources from “normal business
practices “ to developing methods/forecasts to
deal with inflation
5/23/2017
18
Keynesian Economics
• Government should alter Aggregate Demand (AD)
through manipulating government spending (G) and
taxation (T)
• Budget Surplus – government revenue (T) greater than
government spending (G)
• Budget Deficit – government revenue (T) less than
government spending (G)
• Multiplier effect: A $1 change in spending/taxation causes
real GDP to increase by more than $1
5/23/2017
19
Keynesian Economics: All about AD
5/23/2017
20
Crowding Out
… a drop in consumption and/or investment caused by changes in
government spending.
•
If Government Spending rises it may drive up interest rates
– Running a budget deficit => government borrows the funds
•
This may reduce Consumption, net exports and particularly
Investment
•
Thus public spending may “crowd out” private sector spending
– Public spending replaces private spending…
•
Multiplier effect is lowered – potentially even zero if there is
complete crowding out.
5/23/2017
21
Problems with Fiscal Policy
• Keynesian Economists argue the supply side is too
slow to react to solve an economy’s problems
• BUT Fiscal policy has timing issues.
– Takes time for policy makers to realize there is a
problem with the economy
– Takes time for a policy to be implemented
– Takes time for a policy to have an effect.
5/23/2017
22
Automatic Stabilizers
• Element of fiscal policy that changes automatically as
income (real GDP) changes
• E.g. Income tax revenue falls in recessions (when real GDP
is falling) and increase during a boom (when real GDP
increases)
– Unemployment benefits are another example.
5/23/2017
23
New Classical View of Fiscal Policy
• Suppose the government cuts taxes to stimulate the
economy
– Runs a budget deficit.
• Individuals recognize that taxes will have to go up in
the future.
• Therefore rather than spending the tax cut they
merely save it- to pay the higher tax bill in the future
• Therefore no change in AD.
5/23/2017
24
Fiscal Policy and the Supply side: Laffer curve
• Captures the dis-incentive effect of taxation.
Tax rate
t
Rmax
5/23/2017
Tax Revenue
25
Supply-Side effect of Fiscal Policy
• The supply-side of the economy (LRAS) is
determined by the quantity and quality of resources
• Taxes create a disincentive to work, accumulate
capital and invest in higher education
• Therefore high tax rates can cause to the LRAS to
decrease
5/23/2017
26
What is Money?
• Money
… anything that is generally acceptable to sellers in
exchange for goods and services
• Examples
– $
– Cigarettes in WW2 POW camps
• Fiat Money
– Money that has no intrinsic value and is not
backed by a commodity
5/23/2017
27
Liquidity
• Liquid Asset
… an asset that can easily be exchanged for goods and
services
• Higher liquidity implies lower returns
• Money is the most liquid asset
– Therefore has the lowest (zero return).
5/23/2017
28
Functions of Money
‘Money is a matter of functions four
– a medium, a measure, a standard and a store’
5/23/2017
29
• Medium of exchange
– It lowers transactions costs
– Do not need the “double coincidence of wants”
• Measure of value
– All goods and services are priced in common
monetary units
– Allows us to compare relative prices easily.
– Only need one set of prices.
5/23/2017
30
• Store of value
– An asset that allows people to shift purchasing
power from one period to another
– Money retains its value through time usually
– Need to control inflation.
• Standard of deferred payment
– Money may be used to make future payments.
– Debt is written in dollar amounts.
5/23/2017
31
Reserve Requirements
• The central bank “the Fed” requires banks to keep a
certain percentage of their deposits available as cash
reserves
– Available for immediate withdrawal.
• This percentage is called the reserve requirement (rr)
– E.g. the bank has to keep 10% of all their deposits as cash
reserves.
32
Initial Position
•
Assumed the reserve requirement was 10% of all
33
deposits
After New $100,000 cash Deposit
First National Bank has $90,000 (in cash) it can lend
34
out.
Balance Sheets After a $90,000 Loan Made by
FNB Is Spent and Deposited at SNB
Cash has fallen by $90k
Loans have increased by $90k
Cash is deposited at
SNB
•Now SNB has $81,00 it can lend out……
35
New deposit of $100,000 turns into $1,000,000!
Bank
New
Deposit
Required
Reserves
New Loans
1
$100,000
$10,000
$90,000
2
$90,000
$9,000
$81,000
3
$81,000
$8,100
$72,900
4
$72,900
$7,290
$65,610
…
…
…
….
$100,000
$900,000
Total at end $1,000,000
of process
•A new deposit of $100k causes the money supply to
increase by $1million.
36
Deposit Expansion Multiplier
• In our example $100,000 turns into $1,000,000 – why?
• Potential Deposit expansion multiplier (DEM)
DEM = 1/Reserve Requirement (leakage)
Example
– If Reserve Requirement is 10%
– Deposit expansion multiplier:
1/0.1 = 10
• Note: we are assuming no “currency drain” i.e. all cash is redeposited with a bank.
• We are also assuming that all excess reserves are lent out.
5/23/2017
37
How does the Fed control the Money Supply?
• Reserve Requirements
• An increase in the reserve requirement reduces the deposit
expansion multiplier and vice versa
– Alters the ability of banks to “create money”.
– If rr = 10% then DEM = 10
– If rr = 20% then DEM = 5
5/23/2017
38
How does the Fed control the Money Supply?
• The Discount Rate
… the rate of interest the Fed charges commercial banks when they
borrow from it
•
Sometimes commercial banks borrow to finance lending
– Or borrow when they are in financial difficulty.
•
If the discount rate increases commercial banks will borrow less and
the money supply will be reduced
•
Federal funds rate
– The interest rate that a bank charges when it lends excess reserves
to another bank.
– The discount rate is typically 1-1.5% points above the federal fund
rate
– “form of punishment”
39
How does the Fed control the Money Supply?
• Open Market Operations
… the buying and selling of government bonds by the Fed.
– Affects the federal funds rate.
•
Swapping illiquid (bonds) for liquid assets (cash)
– Selling bonds for cash reduces the money supply
 Excess reserves fall => ability to create money falls.
– Buying bonds in exchange for cash raises the money supply
 Excess reserves increases => ability to create money
increases.
5/23/2017
40
Money Supply
Interest rate
(%)
Ms
Quantity of money
5/23/2017
41
Money Demand
• Transactions Demand
… the demand to hold money to buy goods and services
– Hold money to finance daily purchases.
In the form of cash or in checking account.
• Precautionary Demand
… the demand for money to cover unplanned transactions or
emergencies.
– “Saving for a rainy day”
42
• Asset (Speculative) Demand
… the demand for money created by the uncertainty about the
value of other assets.
– Hold money in expectation that a profitable opportunity
will arise.
• E.g. stocks and bonds.
• If you think bond prices are going fall soon will hold
cash today rather than bonds.
5/23/2017
43
Money Demand
Interest rate
(%)
Md
Quantity of money
5/23/2017
44
Why does Money demand slope-downwards.
• Interest rate represents the opportunity cost of holding
money.
– It is the return that is foregone by holding money.
– Therefore the lower the interest rate the higher the
quantity demanded of money.
• Link with Bond prices (speculative demand)
– Remember if the bond price is high (IR is low)
therefore people expect bond prices to fall thus prefer to
hold money.
5/23/2017
45
Determinant of Money Demand
Nominal GDP
– An increase in Nominal GDP (due to price increases or
increase in goods and services) causes Money demand
to increase.
5/23/2017
46
Shifts in Money Demand
Interest rate
(%)
Md1
Md2
Md3
Quantity of money
47
Equilibrium
Interest rate
(%)
Ms
i2
i*
i1
Md
Quantity of money
48
Getting to Equilibrium
•
Suppose we have an interest rate of i1. There is a shortage of money.
– Therefore people begin to sell bonds to convert to money.
– As the supply of bonds increases, the price of bonds decreases and
the interest rate increases.
• Until we get to I*
•
Suppose we have an interest rate of i2. There is a surplus of money.
– Therefore people begin to buy bonds.
– As the demand of bonds increases, the price of bonds increases
and the interest rate decreases.
• Until we get to I*
5/23/2017
49
Expansionary Monetary Policy and Equilibrium
Income
Interest rate
(%)
Ms1
Ms2
i1
i2
Md
Quantity of money
↑MS => i↓ => Investment ↑ => AD ↑
↑MS => i↓ => $↓ => NX ↑ => AD ↑
↑MS => i↓ => asset prices ↑ => wealth ↑ => C ↑ => AD ↑
Unanticipated Monetary policy
A -> D (in short run)
51
The Equation of Exchange
• Simply:
MV = PY
Expenditure ($) = nominal GDP
M = money supply
V = velocity of circulation
P = price level
Y =real GDP
Velocity of circulation: the average number of times each
dollar is spent on final goods and services.
52
Anticipated expansion in Monetary Policy
A -> B
- No change in real output
53
Economic Stability
• Keep unemployment low and inflation low.
• Smooth out the business cycle
• Activist:
– Intervention into the market through Fiscal and
Monetary policy to correct recessions/booms
• Non-activist:
– Maintain steady fiscal and monetary policy
– Do not engage in discretionary fiscal policy etc.
5/23/2017
54
Index of Leading Indicators
Leading Indicator
… a variable that changes before real output changes
– Used to forecast changes in output
– Not always successful!
•
Examples: consumer expectations and Stock prices
– “stock prices have predicted 9 of the last 5 recessions.”
• Index of leading Indicators
– 10 key indicators
• Includes: length of average work week, permits
for new housing starts, consumer expectations,
change in the index of stock prices
55
Index of Leading Indicators
• If the index falls for three consecutive months it is
taken as a warning the economy is going into a
recession
– Not always accurate!
– Forecasted 12 out of the last 7 recessions
5/23/2017
56
Discretionary Policy: Activists
• Argue there are enough signals/signs available to
determine if/when the economy is facing difficulties
– Alter G, T and interest rates as and when needed
• Problem – remember the lags!
– Recognition Lag: Takes time for policy makers to
realize there is a problem with the economy
– Administrative Lag: Takes time for a policy to be
implemented
– Impact lag: Takes time for a policy to have an
effect.
• Non-activists ague these lags will cause bigger
business cycle swings!
57
Expectations
• Adaptive: Future will look like the past
– E.g. best guess of future inflation is what it is has
been recently.
• Tend to make systematic forecasting errors.
– If inflation is increasing over time will continually
under-estimate future inflation due to focusing on
the past
• Tend to adapt/react slower to policy changes
5/23/2017
58
• Rational-Expectations Hypothesis: use all available
information about variables and incorporate any
policy changes.
– E.g. if the government increases the Money supply
individuals will built this into their expectation
about inflation.
– Still will make mistakes due to error/uncertainty
5/23/2017
59
Adaptive Vs Rational expectations: Expansion
in Monetary policy
A-> D : Adaptive
A-> B : Rational Expectations
60
Non-Activists: Monetary Policy
• Follow rules rather than discretionary (activist
polices)
• Monetary Growth rule
– Increase the money supply by 3% each year
(approx equal to increase in real GDP)
• Price Level Rule
– Maintain a certain (low) level of inflation
5/23/2017
61
Non-Activists: Fiscal Policy
• Maintain a balanced budget over the business cycle
• Some years it will be in surplus, other years a deficit.
• Difficult to determine if the budget will be balanced
over the business cycle given that it is difficult to
forecast!
• Potentially limit the size of budget
deficits/government spending.
5/23/2017
62