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Transcript
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