Lecture 4: Basics Of Macroeconomics & Macroeconomic Model Given to the EMBA 8400 Class January 19, 2008 Dr. Rajeev Dhawan Director

Chapter 26 Saving, Investment and the Financial System

Savings And National Income Math  GDP (as the sum of expenditures) has been defined as: Y = C + I + G + NX In a closed economy: Y = C + I + G  Rearranging terms gives: Y - C - G = I  The left-hand side, which is the nation's income (GDP) leftover after consumption and government spending, is defined as National Savings. Since Y - C - G is defined as being equal to "S": S = I

Continued..  This relationship must hold for the economy as a whole (when the economy is closed). Now, with S = Y - C - G  Add and subtract the government's tax revenue (T) to the right-hand side S = Y - C - G + T - T  Then rearrange terms on the right hand side to get S = (Y - T - C) + (T - G)

Continued..  This expression breaks down national savings into two components: private savings and public savings.  Private savings (Y - T - C) is the income left in the economy after taxes and consumption have each been paid for.  Public savings (T - G) is equal to the taxes collected by the government, minus government spending. This is also an expression for the government surplus/deficit (surplus if T > G, deficit if T < G).

Market For Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200

Increase in Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600 Policy 1: Saving Incentives

Increase in Demand of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Supply Demand,D1D1 D2D2 5% $1,200 6% $1,400 Policy 2: Investment Incentives

Effect Of A Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate and reduces the equilibrium quantity of loanable funds. S2S which raises the equilibrium interest rate... Supply,S1S1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable funds... Policy 3: Budget Deficit

The U.S. Government Debt Percent of GDP Revolutionary War 2010 Civil War World War I World War II Copyright©2004 South-Western

Chapter 28 Unemployment & Its Natural Rate

How Is Unemployment Measured?  Based on the answers to the survey questions, the Bureau of Labor Statistics (BLS) places each adult into one of three categories: –Employed –Unemployed –Not in the labor force  Labor Force –The labor force is the total number of workers, including both the employed and the unemployed. –The BLS defines the labor force as the sum of the employed and the unemployed.

Breakdown Of The Population In 2004 Adult Population (223.4 million) Labor Force (147.4 million) Employed (139.3 million) Not in labor force (76.0 million) Unemployed (8.1 million)

Unemployment - What is it?  The unemployment rate is calculated as the percentage of the labor force that is unemployed.  Labor Force Participation Rate

Example  In 2001, million people were employed and 6.7 million people were unemployed. –Labor Force = = million –Unemployment Rate = (6.7 / 141.8) X 100 = 4.7 percent –Labor Force Participation Rate = (141.8 / 211.9) X 100 = 66.9 percent

The Labor-Market Experiences of Various Demographic Groups (2004) Copyright©2004 South-Western

Unemployment Rate Since 1960 Copyright©2003 Southwestern/Thomson Learning Percent of Labor Force Natural rate of unemployment Unemployment rate

Identifying Unemployment  Natural Rate of Unemployment –The natural rate of unemployment is unemployment that does not go away on its own even in the long run. –It is the amount of unemployment that the economy normally experiences.  Cyclical Unemployment –Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. –It is associated with short-term ups and downs of the business cycle.

Questions About Unemployment  Does the Unemployment Rate Measure What We Want It To?  How Long Are the Unemployed without Work?  Why Are There Always Some People Unemployed?

Article: Why do Americans Work More Than Europeans? WSJ; by: Edward Prescott  Americans aged 15-64, on a per-person basis, work 50% more than French. The French, for example, prefer leisure more than do Americans or on the other side of the coin, that Americans like to work more. This is silliness !!  Germans and Americans spend the same amount time working, but the proportion of taxable market time vs. nontaxable home work time is different  But marginal tax rates explain virtually all of this difference. Labor supply is not fixed. People be they European or American, respond to taxed on their income. –Spanish labor supply increased by 12% in 1988 when taxes were cut

Article: The $366 Billion Outrage Fortune Magazine; by: Janice Revell  Pension plans of 16 million state and local government workers are taking up a huge share of the budgets. In the 90’s elected officials allowed workers to dramatically spike their pre-retirement compensation, to retire on more than 100% of their pay, and to draw both their salaries and pensions, with guaranteed market returns, simultaneously.  San Diego deferred retirement option plan, or DROP allows pension, deposited into a special account earn a guaranteed 8% annual rate of interest, plus a 2% annual cost-of-living adjustment. When the employee actually decides to retire he can either collect the amount that has accumulated in his special pension account or let it keep compounding at that generous rate or return indefinitely.  Result:  The pension fund is short by billions and counting ($366 Billion so far!). The generosity of the plan means workers (e.g. in Houston 44% of the city workforce) can quit without taking a major financial hit => early retirement by qualified employees.  Solution  Solution:  Raise property tax (is happening)  Cut in city services (is happening)  Cut benefits (?)

Chapter 29 The Monetary System

Money–What is it and what does it do? Money is the set of assets in an economy that people regularly use to buy goods and services from one another  Medium of Exchange –what sellers accept from buyers as payment for goods and services. Eliminates inefficiencies of barter.  Unit of Account – When there is one unit of account, like the ($) in the United States, you don't have to think in relative terms when valuing goods and services.  Store of Value – people have the option to hold money over time as one way of storing their assets. Money is an important store of value, because it is the most liquid asset in the economy

Types of Money  Commodity Money money that takes the form of a commodity with intrinsic value.  Fiat Money money without intrinsic value that is used as money because of government decree

How to Measure Money Money Stock: The quantity of money circulating in the economy Q: Suppose you want to know the size of the U.S. money stock. What should you count as money? A: Currency and demand deposits, and a few other items (detailed below) but not credit cards. Currency - the paper bills and coins in the hands of the public Demand Deposits - balances in bank accounts that depositors can access on demand by writing a check (or by using a debit card)

Two Measures of the Money Stock for the U.S. Economy (2004) Billions of Dollars Currency ($699 billion) Demand deposits Traveler’s checks Other checkable deposits ($664 billion) Everything in M1 ($1,363 billion) Savings deposits Small time deposits Money market mutual funds A few minor categories ($5,035 billion) 0 M1 $1,363 M2 $6,398

Banks & Money Supply Q: How do banks operate? A: Banks accept deposits from people. That money is in an account until the depositor makes a withdrawal or writes a check on their account. Q: Do banks keep all of your money in their vault? A: No. Our banking system is called fractional reserve banking. Bankers understand that it is not necessary to keep 100 percent of a depositors money on hand at all times. As a result, bankers take some of your money and loan it out to other people.

Continued..  Fractional reserve banking - a banking system in which banks hold only a fraction of deposits as reserves  Reserve ratio - the fraction of deposits that banks hold as reserves. Minimum reserve ratios are set by the Fed.

Money Creation with Fractional-Reserve Banking  When a bank makes a loan from its reserves, the money supply increases.  The money supply is affected by the amount deposited in banks and the amount that the bank loans. –Deposits into a bank are recorded as both assets and liabilities. –The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. –Loans become an asset to the bank.

Money Creation with Fractional- Reserve Banking  This T-Account shows a bank that… –accepts deposits, –keeps a portion as reserves, –and lends out the rest. –It assumes a reserve ratio of 10%. AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $100.00

Money Creation with Fractional-Reserve Banking  When one bank loans money, that money is generally deposited into another bank.  This creates more deposits and more reserves to be lent out.  When a bank makes a loan from its reserves, the money supply increases.

The Money Multiplier Suppose that the Fed requires banks to keep 10 percent of their demand deposits on reserve. Q: What happens when somebody brings in $100 and deposits it in a bank? A: The bank is required to keep $10 (10 percent) on reserve. Q: What does the bank do with the remaining $90? A: The bank will turn around and lend it to somebody else, earning interest income for the bank. Q: What did that $90 loan do to the size of the money supply? A: The money supply increased by $90 when the loan was made. Here's how:

Continued…  When the first depositor arrived with $100 in cash, the money supply included that $100 of currency in the depositor's wallet  After the deposit, the currency was in the bank vault and not circulating (so out of the money supply)  However, demand deposits increased by $100, so the money supply was unchanged (currency fell by $100, deposits increased by $100)  When the bank made the $90 loan, $90 in currency reentered the money supply  Added to the $100 demand deposit, that original $100 has grown to $190.

Continued…  Now suppose that the person who received the $90 loan deposits that money into their checking account.  Q: What does the bank have to do with the $90?  A: Keep 10 percent on reserve (10 percent of $90 = $9).   Q: What does the second bank do with the remaining 81?  A: They can lend that out to somebody else

The Money Multiplier AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00 Money Supply = $190.00!

Money Multiplier Q: How far does this process of money creation go? A: The process of bank money creation continues until there are no more excess reserves to be lent out. Money multiplier - the amount of money the banking system generates with each dollar of reserves. The money multiplier is the reciprocal of the reserve ratio: M = 1/R With a reserve requirement, R = 10% or 1/10, The multiplier is 10. Therefore, the original $100 deposit will eventually turn into $1000 of deposits. Q: The banking system can create money, but can it also create real wealth? A: No. Each loan has two parts. Recall that the first $90 loan generated $90 in new money. At the same time, that $90 loan also created a new $90 liability for the person borrowing the money. The banking system cannot create real wealth.

The Federal Reserve System  The Federal Reserve (Fed) serves as the nation’s central bank. –It is designed to oversee the banking system. –It regulates the quantity of money in the economy.  The primary elements in the Federal Reserve System: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee

The Federal Reserve System Copyright©2003 Southwestern/Thomson Learning

The Fed’s Tools of Monetary Control  The Fed has three tools in its monetary toolbox: –Open-market operations –Changing the reserve requirement –Changing the discount rate

Open-Market Operations –The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: –When the Fed buys bonds, the money supply is increased. Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the money supply, hence, when the Fed buys bonds it simply increases the total amount of money in circulation. –When the Fed sells bonds, the money supply is decreased. Here is why: The Fed sells bonds in the market and receives cash in return for the bonds it sells. Once the Fed receives the cash, this cash is taken out of circulation – therefore, the size of the money supply is decreased. The Fed’s Tools of Monetary Control

 Changing the Discount Rate –The discount rate is the interest rate the Fed charges banks for loans.  Increasing the discount rate decreases the money supply.  Decreasing the discount rate increases the money supply. The Fed’s Tools of Monetary Control

Chapter 30 Money Growth and Inflation

The Classical Theory of Inflation  Inflation is an increase in the overall level of prices.  Hyperinflation is an extraordinarily high rate of inflation.  Historical Aspects –Over the past 60 years, prices have risen on average about 5 percent per year. –In the 1970s prices rose by 7 percent per year. –During the 1990s, prices rose at an average rate of 2 percent per year. –Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. –Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.

Money Supply, Money Demand and Monetary Equilibrium  The money supply is a policy variable that is controlled by the Fed. –Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied.  Money demand has several determinants, including interest rates and the average level of prices in the economy.  People hold money because it is the medium of exchange. –The amount of money people choose to hold depends on the prices of goods and services.  In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Money Supply, Money Demand, and the Equilibrium Price Level Copyright © 2004 South-Western Quantity of Money Value of Money, 1/ P Price Level, P Quantity fixed by the Fed Money supply 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / Equilibrium value of money Equilibrium price level Money demand A

Figure 2 The Effects of Monetary Injection Copyright © 2004 South-Western Quantity of Money Value of Money, 1/ P Price Level, P Money demand 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / M1M1 MS 1 M2M2 MS decreases the value of money and increases the price level. 1. An increase in the money supply... A B

The Classical Theory of Inflation  The Quantity Theory of Money –How the price level is determined and why it might change over time is called the quantity theory of money.  The quantity of money available in the economy determines the value of money.  The primary cause of inflation is the growth in the quantity of money.

Velocity and the Quantity Equation  The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P  Y)/M Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money

Velocity & Quantity Equation  Velocity ( V ) = Nominal GDP/ Money Supply = ( P x Y ) / M  Example: V = ($10 x 100 ) / $ 50 = 20

Velocity & Quantity Equation  Rewriting the equation gives the quantity equation: M  V = P  Y  The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y).  The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: –the price level must rise, –the quantity of output must rise, or –the velocity of money must fall.

Nominal GDP, the Quantity of Money, and the Velocity of Money Indexes (1960 = 100) 2,000 1, , Velocity M2 Nominal GDP

Velocity and the Quantity Equation  The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money –The velocity of money is relatively stable over time. –When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y). –Because money is neutral, money does not affect output.

world interest rate world GDP IMPORTS price level lag 1 world price money government tax rate capital stock lag 1 EXCHANGE RATE INTEREST RATE INVESTMENT TAX REVENUES investment lag 1 EXPORTS NET EXPORTS REAL GDP CONSUMPTION DISPOSABLE INCOME CAPITAL STOCK inflation lag 1 PRICE LEVEL INFLATION EXPECTED INFLATION UNEMPLOYMENT POTENTIAL GDP labor force ~Typical Macro-Model~

Macroeconomic Model The Macroeconomic Model simulates the working of the US Economy using explicit equations to model consumption, investment, exports, imports, exchange rate, price level and inflation rate.

Classification and Listing of Equations 1.Accounting Identities: Real GDP (GDP); Tax Revenues (T) Disposable Income (YDP), Net Exports (NETEX) Price Level (P) Example: Disposable Income (YDP) = GDP – Tax Revenues (T) Accounting Identities have the following properties:  As forecasting equations, they are PERFECT!  Don’t have parameters to be fitted  No error term  No theoretical disputes about their truth, only about their relevance

2. Behavioral Equations: Consumption (C), Real Interest Rate (R), Investment (I), Exchange Rate (EXCH), Exports (EX), Imports (IM), Inflation (P%) Example: Consumption (C) = α 0 * Disposable income (YDP) (Where α 0 = marginal propensity to consume = ) Behavioral Equations have the following properties:  Estimated parameter values change as behavior changes  Source of all forecasting errors  Theoretical disputes concerning these equations, e.g., are consumers myopic or forward looking?

Endogenous and Exogenous Variables  Define: A = B + C ……………………(1)  Where B = A/2 ………………..…..(2)  and C = 5 (given)  Then equation (1) becomes A = B +5 which using definition of B becomes the following:  A = (A/2) + 5  Thus, A/2 = 5 or A = 10 and using (2) B=5  In the above example, A & B are endogenous variables and C is an exogenous variable Accounting Identity Behavioral Equation

Macroeconomic Model The Exogenous Factors in the model are: – GDP Potential which is GDP value at full employment level –Domestic Policy Variables:  Money Supply (M)  Government Spending (G)  Tax Policy (T%) –Rest-of-the-World (ROW) factors such as  Foreign Interest Rate  Foreign Price Level  ROW GDP Potential

Model Simulation Approach 1.State macroeconomic theory as a complete set of algebraic equations. 2.Estimate/postulate numerical values of all parameters. 3.Assume initial conditions for the history of all lagged variables. 4.Assume “base case” values over future time periods for all exogenous variables. 5.Solve the model under base case assumptions. 6.Change some of the exogenous variable assumptions. 7.Solve the model again under alternative assumptions. 8.Compare model solutions  Base Case and the alternative policy Simulation.

1.Integrates short run and long run analysis into one coherent story of the dynamic reactions of an economy to macroeconomic policy. 2.Traces the complete logic of the model, step-by-step, instead of trying to condense model into a two-dimensional diagram, such as IS-LM diagram. 3.Extends to real-world macroeconomic policy issues. 4.Same process applies to realistic models of actual economies, such as U.S. forecasting models, oil shocks, or world slowdown. Advantages of the Model Simulation Approach

 12 Endogenous Variables –GDP, C, I, EX, IM, NETEX, R, P, YDP, T, EXCH, P% (requires 12 equations in 12 unknowns)  7 Exogenous Variables –3 Policy Variables: M, G, TAX% –3 ROW Variables: –1 Other Variable: Listing Of Variables in the Model

Listing of 12 Equations in the Model  12 Endogenous Variables –One GDP Equation/Accounting Identity –Three Consumption Related Equations –Two Interest Rate and Investment Equations Accounting Identity Behavioral Equation Accounting Identity

–Four Exchange Rate, Export, Import and Net Export Equations –Two Price Inflation Equations Accounting Identity Behavioral Equation

Glossary of Variables

Additional Definitions The model variables are in real terms (except of course the price variable). We need three other variables in nominal terms to complete our understanding. These are like “derived” accounting identities.

Econ 101 Rule

“Given the values of exogenous variables for a given economy, if the values of inflation (P%) = 0.00% & nominal exchange rate (EXCH) = 1.00, then the economy is in equilibrium or steady state in such a way that actual GDP is exactly equal to potential GDP”. Equal

Base Case The Base Case is the state of the economy where for the given values of exogenous variables, the ECON 101 rule applies and the values of endogenous variables solved in the first year remain constant for all subsequent years

Base Case This means that GDP will be equal to its potential value for all the years in the base case. Inflation will be equal to ZERO percent And the exchange rate will be at one for all the years

Cont… This also implies that values of all other endogenous variables will also be constant for the subsequent years. Why? Endogenous variables P and P% from today become the exogenous variables for subsequent years’ endogenous value calculations as seen from equations 11 and 12.

Data Table 1

Second half of the data Table 1

4 Important Guidelines to Use the Model 1.Tools/Options/Calculations/Iterations=100 2.Use Graph Button to Generate New Graphs for the experiment performed 3.Use Print Button for Printing the Results 4.To Reset the Model, Press the Base Case Button, and run the model once using the Calculations Button