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MACRO REVIEW
in preparation for API 120
(I) DEFINITIONS & ACCOUNTING
(i) National income & product accounts
(ii) Balance of Payments accounts
(II) THE KEYNESIAN MODEL
API-120 - Macroeconomic Policy Analysis I , Prof.J.Frankel, Harvard Kennedy School
(i) National income & product accounts
• Definition of macroeconomics
– Aggregates
– Goods (& labor) markets don’t clear in short run
– Role for monetary & fiscal policy.
• Definition of
– GDP
– GNP (includes profits of MNCs abroad)
– National Income (includes unilateral transfers)
API-120 - Macroeconomic Policy Analysis I , Prof.J.Frankel, Harvard Kennedy School
Ways to decompose GDP
• To whom the goods & services (GDP) are sold:
–
–
–
–
C
I
G
X-M
• How the income (Y) is used:
– Taxes net of transfers, gives disposable income
– Saving
– Consumption
• Allocation of shares according to factors of production
– Wages & salaries
– Capital income
– Self-employed and other
API-120 - Macroeconomic Policy Analysis I , Prof.J.Frankel, Harvard Kennedy School
(ii) Balance of Payments accounts
• Definition: The balance of payments
is the year’s record of economic transactions
between domestic & foreign residents.
• The rules:
– If you have to pay a foreign resident, normally in
exchange for something that you bring into the country,
then the something counts as a debit.
– If a foreign resident has to pay you for something, then
the something counts as a credit.
API-120 , Prof.J.Frankel, Harvard Kennedy School
†
† Now also called “financial account”
API-120 , Prof.J.Frankel, Harvard Kennedy School
The rules, continued
• Each transactions is recorded twice: once as a credit
and once as a debit.
– E.g., when an importer pays cash dollars,
• the debit on the merchandise account is offset by
• a credit under short-term capital: the exporter in the other
country has, at least for the moment, increased holdings of
US assets, which counts as a credit just like any other
portfolio investment in US assets.
• At the end of each quarter, credits and debits are
added up within each line-item;
• and line-items are cumulated from the top to
compute measures of external balance.
Some balance of payments identities
• CA ≡ Rate of increase in net international investment position.
– A CA surplus country accumulates claims against foreigners
– A CA deficit country borrows from foreigners.
• CA + KA + ORT ≡ 0
• BoP ≡ CA + KA
• => BoP ≡ -ORT ≡ excess supply of FX coming from private sector,
which central banks absorb into reserves
(if they intervene in the FX market at all).
– A BoP surplus country adds to its FX reserves (US Tbills)
• China, Saudi Arabia, most EMs since 2000
– A BoP deficit country
• runs down its FX reserves
(Mex.1994, Thailand 1997, Russia 1998, Argentina 2001, Latvia 2008, Ukraine 2008…)
• Unless it is lucky enough (US) that foreign central banks finance the deficit.
• A floating country does not intervene in the FX market
• => BP ≡ 0;
• Exchangerate E adjusts to clear privatemarket FX supply & demand.
APPENDIX
Examples on the current account:
• You, an American, import software CD-roms from India
=> debits appear on US merchandise account.
• You import services (electronically) of an Indian software firm
=> debit appears on US services account.
(This is the famous and controversial “overseas outsourcing.”)
• You buy the services, instead, from a subsidiary that the
Indian software firm set up last year in the US. This is not an
international transaction, and so does not appear in the accounts.
But assume the subsidiary sends profits back to India
=> debit appears on US investment income account.
(It is as if the US is paying for the services of Indian capital.)
• Employees of the subsidiary in the US (or any other US
resident entities) send money to relatives back in India
=> debit appears under unilateral transfers.
Examples on the long-term capital account:
 Instead of buying software CD-roms from India, you buy
the company in India that makes them.
=> debit appears on US capital account, under FDI.
(You have imported ownership of the company.)
 Instead of buying the entire company in India,
you buy some stock in it
=> debit appears on US capital account, under equities.
(You have imported claims against an Indian resident.)
 Instead of buying stock in the company,
you lend it money for 2 years
=> debit appears on US capital acct, under bonds or bank loans.
(Again, you have imported a claim against an Indian resident.)
Examples on the short-term capital account:
 You lend to the Indian company in the form of 30-day
commercial paper or trade credit
=> debit appears on US short-term capital account.
(Again, you have acquired a claim against India.)
 You lend to the Indian company in the form of cash dollars,
which they don’t have to pay back for 30 days => debit
appears on US short-term capital account.
 You are the Central Bank, and you buy securities of the
Indian company (an improbable example for the Fed – but
“Sovereign Wealth Funds,” from China to oil-exporting countries,
now make international investments of this sort)
=> debit appears as a US official reserves transaction.
End of: Definitions & Accounting
API-120 - Macroeconomic Policy Analysis, Prof.Jeffrey Frankel, Harvard Kennedy School
MACRO REVIEW
(II) THE KEYNESIAN MODEL
Part 1: Introduction to Keynesian Model:
Derivation, and National Saving Identity.
Part 2:
Multipliers for spending & exports
Part 3: International transmission
under fixed vs. floating exchange rates
Part 4: Adjustment of a CA deficit via
expenditure-reducing vs. expenditure-switching policies
Part 5: Monetary factors
API-120 - Macroeconomic Policy Analysis I , Professor Jeffrey Frankel,
Imports & exports depend on income:
M  M d ( E, Y )
 M  mY
X  X d ( E, Y *)
X
assuming E & Y* fixed, for now.
 TB  X  ( M  mY )
TB
…and rises in contractions
+
0
-
Y
TB falls in expansions…
as does consumption:
Keynesian consumption function
where slope = -m ≡
- marginal propensity
to import
C C  cY
Determination of equilibrium income
in open-economy Keynesian model
Y  A  TB
 (C  I  G )  ( X  M )
 (C  cY  I  G )  ( X  M  mY )
Now solve:
Y  cY  mY  C  I  G  X  M
Y
C  I G X M
1 c  m
A X  M
Y
sm
where A  C  I  G and
s 1  c
Derivation of National Saving Identity
Income ≡ Output
(assuming no transfers)
Y ≡ GDP
C
/ + S + T ≡ C/ + I + G + X -M
S + (T-G) ≡
I + X–M
NS ≡
S + BS ≡ I + TB
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
National
Saving
Identity
National savings =
}
Private savings
} + Budget surplus
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
US National Saving, Investment, & Current Account
as Shares of GDP, 1949-2010
Gap widened,
as NS fell
relative to I
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Keynesian Consumption Function:
or, expressed as a saving function:
C  C  c Yd
S  Yd - C  Yd - (C  cYd )
 - C  s Yd
}I
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
where s ≡ 1 – c
Closed economy: NS – I = 0
Fiscal Expansion
1 < Closed-economy multiplier 1/s < ∞
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Open economy: NS – I = TB
=X–M
Imports:
Exports:
M  M d (E, Y) , or  M  mY
X  Xd (E, Y* ), or  X
for simplicity
for simplicity
Open economy
Fiscal Expansion
slope = s
G
1
1
Y 
 G  G
sm
s
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Part 2:
KEYNESIAN MULTIPLIERS
• The multiplier for an increase in A ,
e.g., due to a fiscal expansion .
• The multiplier for an increase in X ,
e.g., due to a devaluation .
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
SUMMARY OF MULTIPLIERS
NS  I  X  M
+
Keynesian model of S + M
AXM
Y 
sm
Fiscal Expansion
1
Y 
A
sm
=>
where A  C  I  G
Devaluation
1
Y 
X
sm
open-ec. multiplier = 1/(s+m)<1/s
ΔTB  ΔM  - m Y
m

ΔA .
sm
ΔTB  ΔX  m Y
s

ΔX  ΔX .
sm
Equation (17.11). Note misprint in 10th ed. of WTP.)
Part 3:
MACROECONOMIC INTERDEPENDENCE
International transmission
under fixed vs. floating exchange rates
• of a disturbance originating domestically.
• of a disturbance originating abroad .
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
International Transmission
I↓
Fix
Float
X↓
Float
Fix
=>
depreciation
=> appreciation
Floating increases effect on Y
Floating decreases effect on Y
= “insulation”
Conclusions regarding transmission
(with no capital mobility)
• Trade makes economies interdependent
(at a given exchange rate).
– TB can act as a safety valve,
releasing pressure from expansion:
Y  (1 /(s  m)) A
.
– Disturbances are transmitted
from one country to another:
Y  (1/(s  m)) X
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
.
Conclusions regarding transmission
(with no capital mobility), continued
• Floating exchange rates work to
isolate effects of demand disturbances
within the country where they originate:
– Effects of a domestic disturbance tend
to be “bottled up” within the country.
In the extreme, floating reproduces the closed
economy multiplier:
Y  (1 / s). A
.
– The floating rate tends to insulate the
domestic economy from effects of
foreign disturbances. In the extreme,
floating reproduces a closed economy:
.
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Y  0
Parts 4 & 5:
POLICY INSTRUMENTS
Goals and Instruments
• Policy goals: Internal balance & External balance
• Policy instruments
• The Swan Diagram
• The principle of goals & instruments
Introduction of monetary policy
• The role of interest rates
• Monetary expansion
• Fiscal expansion & crowding out
Goals and instruments
Policy Goals
• Internal balance:
e.g., Y = Y
≡ potential output
Y < Y ≡ ES ≡ “output gap” => unemployment >
u
Y > Y ≡ ED => “overheating” => inflation
and/or asset bubbles
• External balance:
e.g., BP=0 or CA=0
Policy Instruments
• Expenditure-reduction,
e.g., G ↓
• Expenditure-switching,
e.g., E ↑
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Internal balance
Output gap, as percentage of GDP, 2009
Jpn
UK
US
France
Ir
In 2009, after the global financial crisis, most countries suffered
much larger output gaps than in preceding recessions: Y << Y .
Source: IMF, via Economicshelp, 2009
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Output gap in eurozone periphery
Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions)
http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html
Greece & Ireland overheated by 2007: Y >> Y
and crashed in 2009-12: Y << Y
Like Italy, Spain & Portugal in 1992, but the devaluation option is now gone.
THE PRINCIPLE OF TARGETS AND INSTRUMENTS
• Can’t normally hit 2 birds with 1 stone
• Have n targets?
• => Need n instruments,
and they must be targeted independently.
• Have 2 targets: CA = 0 and Y = Y ?
• => Need 2 independent instruments:
expenditure-reduction &
expenditure-switching.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
RESPONSES TO CURRENT ACCOUNT DEFICIT
Financing
• By borrowing
• or running down reserves.
vs.
Adjustment
• Expenditure-reduction
(“belt-tightening”)
• e.g., fiscal or monetary contraction
• or Expenditure-switching
• e.g., devaluation.
Starting from
current account deficit
at point N,
policy-makers can
adjust either by
(a) cutting spending, 
●
A
●
or
(b) devaluing.
 X 
●
●
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
(a) If they
cut spending,
CA deficit is
eliminated at X;
but Y falls below
potential output Y.
●
●
=> recession
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
(b) If they
devalue,
CA deficit
is again
eliminated, at B,
but with
the effect of
pushing Y above
potential output.
●
●
=> overheating
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
DERIVATION OF SWAN DIAGRAM
• Only by using both sorts
of policies simultaneously
can both internal & external
balance be attained, at point A.
• Experiment: increase in Ă
(e.g. G↑)
Expansion moves economy
rightward to point F.
Some of higher demand falls
on imports. => TB<0 .
What would have to happen
to reduce trade deficit?
Devaluation
E  X 
●
●
●
●
●
●
Again,
A
At F, TB<0 .
What would
have to happen
to eliminate
trade deficit?
E↑.
If depreciation
is big enough,
restores TB=0
at point B.
●
●
●
To repeat, at F,
some of higher demand
falls on imports.
.
What would have to
happen to eliminate
trade deficit?
E↑.
If depreciation is big
enough, restores TB=0
at point B.
●
●
We have just derived
upward-sloping
external balance line,
BB.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
●
Now consider internal balance.
Return to point A.
Experiment: increase A
Expansion moves economy
rightward to point F.
●
●
Some of higher demand
falls on domestic goods
=> Excess Demand. Y > Y
What would have to happen to
eliminate excess demand?
E↓.
●
●
●
Experiment:
Fiscal expansion,
cont.
At F, Y > Y.
What would
have to happen
to eliminate
excess demand?
E↓.
If appreciation
is big enough,
restores Y= Y
at point C.
●
●
●
At F, some of higher
demand falls on
domestic goods.
What would have to
happen to eliminate
excess demand?
E ↓.
If appreciation is big
enough, restores at C.
We have just derived
downward-sloping
internal balance line, YY.
●
●
●
Swan Diagram
has 4 zones:
I.
II.
III.
IV.
ED & TD
ES & TD
ES & TB>0
ED & TB>0
●
Summary:
combination
of policy instruments
to hit one goal
slopes up,
to hit the other
slopes down.
Example: Emerging markets in 1990s
Classic response to a balance of payments crisis:
Devalue and cut spending
Excgange rate E
ED & TB>0
BB:
External balance
CA=0
Mexico
1995
or Korea
1998
ED & TD
●
Mexico
1994
or Korea
1997
ES & TB>0
ES & TD
YY:
Internal balance
Y=Potential
Spending A
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Example: China in the past decade
ED & TB>0
Excgange rate E
China
2010
ES & TB>0
China
2002
BB:
External balance
CA=0
ED & TD
●
ES & TD
YY:
Internal balance
Y = Potential
By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery,
Spending A
due in part to G stimulus,
At the end of 2008, an abrupt loss of X,
China again into ES.
due to the US crisis, shifted China into
. Policy Analysisshifted
API-120ES
- Macroeconomic
I
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Part 5: Monetary policy
• is another instrument to affect the level of spending.
• It can be defined in terms of the interest rate i,
which in turn affects i-sensitive components
E.g., Taylor Rule sets i.
such as I & consumer durables.
• Or it can be defined in terms of money supply M.
– In which case an expansion is a rightward shift of the LM curve
– Which itself slopes up (because money demand depends
negatively in i and positively on Y).
LM
E.g., Quantitative Easing sets MB.
i
Y
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Monetary expansion
lowers i,
stimulates demand,
shifts NS-I down/out.
New equilibrium at point M.
In lower diagram,
which shows i explicitly
on the vertical axis,
We’ve just derived IS curve.
If monetary policy is defined
by the level of money supply,
then the same result is viewed
as resulting from a rightward
shift of the LM curve.
Fiscal expansion
shifts IS out.
New equilibrium:
At point D if monetary
policy is accommodating.
At point F, if the money
supply is unchanged,
so we get crowding out:
i↑ => I↓
 Rise in Y < full
Keynesian multiplier.
.
D
End of: Introduction to the Keynesian Model
API-120 - Macroeconomic Policy Analysis, Prof.Jeffrey Frankel, Harvard Kennedy School