MACRO REVIEW in preparation for API 120 API Macroeconomic Policy Analysis I, Prof.J.Frankel, Harvard Kennedy School (I)DEFINITIONS & ACCOUNTING (i) National income & product accounts (ii) Balance of Payments accounts (II)THE KEYNESIAN MODEL

(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 Macroeconomic Policy Analysis I, Prof.J.Frankel, Harvard Kennedy School

Ways to decompose GDP To whom the goods & services (GDP) are sold: –C–C –I–I –G–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 Macroeconomic Policy Analysis I, Prof.J.Frankel, Harvard Kennedy School

(ii) Balance of Payments accounts 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. Definition: T he balance of payments is the year’s record of economic transactions between domestic & foreign residents. API-120, Prof.J.Frankel, Harvard Kennedy School

† † Now also called “financial account”

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; Exchange rate E adjusts to clear private market 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.

API Macroeconomic Policy Analysis, Prof.Jeffrey Frankel, Harvard Kennedy School End of: Definitions & Accounting

API Macroeconomic Policy Analysis I, Professor Jeffrey Frankel, 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

Imports & exports depend on income: Y TB as does consumption: Keynesian consumption function assuming E & Y* fixed, for now. where slope = -m ≡ - marginal propensity to import TB falls in expansions… …and rises in contractions

Determination of equilibrium income in open-economy Keynesian model whereand Now solve:

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Derivation of National Saving Identity Income ≡ Output (assuming no transfers) Y ≡ GDP S + (T-G) ≡ I + X – M / / NS ≡ S + BS ≡ I + TB National Saving Identity C + S + T ≡ C + I + G + X -M

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University } National savings = Private savings } + Budget surplus

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University US National Saving, Investment, & Current Account as Shares of GDP, Gap widened, as NS fell relative to I

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Keynesian Consumption Function: or, expressed as a saving function: where s ≡ 1 – c }

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Closed economy: NS – I = 0 Fiscal Expansion 1 < Closed-economy multiplier 1/s < ∞

Open economy: NS – I = TB = X – M Imports: for simplicity Exports: for simplicity

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Open economy Fiscal Expansion slope = s

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Part 2: KEYNESIAN MULTIPLIERS The multiplier for an increase in, e.g., due to a fiscal expansion. The multiplier for an increase in, e.g., due to a devaluation.

SUMMARY OF MULTIPLIERS + Keynesian model of S + M => Fiscal Expansion open-ec. multiplier = 1/(s+m)<1/s Devaluation Equation (17.11). Note misprint in 10 th ed. of WTP.)

API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Part 3: MACROECONOMIC INTERDEPENDENCE International transmission under fixed vs. floating exchange rates of a disturbance originating domestically. of a disturbance originating abroad.

Fix Float Fix International Transmission ↓ ↓ Floating increases effect on Y Floating decreases effect on Y => appreciation => depreciation = “insulation”

API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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:. –Disturbances are transmitted from one country to another:.

API 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:.. – The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy:.

Goals and Instruments Policy goals: Internal balance & External balance Policy instruments Parts 4 & 5: 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

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Goals and instruments Policy Instruments Expenditure-reduction, e.g., G ↓ Expenditure-switching, e.g., E ↑ Policy Goals Internal balance: e.g., Y = ≡ potential output Y unemployment > Y > ≡ ED => “overheating” => inflation and/or asset bubbles External balance: e.g., BP=0 or CA=0

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University In 2009, after the global financial crisis, most countries suffered much larger output gaps than in preceding recessions: Y <<. Source: IMF, via Economicshelp, 2009 UK US France Output gap, as percentage of GDP, 2009 Ir Jpn Internal balance

Output gap in eurozone periphery Source: IMF Economic Outlook, September 2011 (note: data for 2012 are predictions ) Greece & Ireland overheated by 2007: Y >> and crashed in : Y << Like Italy, Spain & Portugal in 1992, but the devaluation option is now gone.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University 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 = ? => Need 2 independent instruments: expenditure-reduction & expenditure-switching.

Financing By borrowing or running down reserves. RESPONSES TO CURRENT ACCOUNT DEFICIT Adjustment Expenditure-reduction (“belt-tightening”) e.g., fiscal or monetary contraction vs. or Expenditure-switching e.g., devaluation.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Starting from current account deficit at point N, policy-makers can adjust either by (a)cutting spending, or (b) devaluing. ● ● ● ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API 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. => recession ● ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API 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 ● ●

Devaluation Experiment: increase in Ă (e.g. G↑) Only by using both sorts of policies simultaneously can both internal & external balance be attained, at point A. Expansion moves economy rightward to point F. Some of higher demand falls on imports. => TB<0. DERIVATION OF SWAN DIAGRAM What would have to happen to reduce trade deficit? ● ● ● ● ● ●

At F, TB<0. What would have to happen to eliminate trade deficit? Again, If depreciation is big enough, restores TB=0 at point B. E ↑. ● ● ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University. 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. To repeat, at F, some of higher demand falls on imports. ● ● ●

Now consider internal balance. Return to point A. Expansion moves economy rightward to point F. What would have to happen to eliminate excess demand? Some of higher demand falls on domestic goods => Excess Demand. Y > ● ● ● ● Experiment: increase E ↓. ●

Experiment: Fiscal expansion, cont. At F, Y >. What would have to happen to eliminate excess demand? If appreciation is big enough, restores Y= at point C. E ↓. ● ● ●

What would have to happen to eliminate excess demand? E ↓. We have just derived downward-sloping internal balance line, YY. At F, some of higher demand falls on domestic goods. If appreciation is big enough, restores at C. ● ● ●

Swan Diagram has 4 zones: I.ED & TD II.ES & TD III.ES & TB>0 IV.ED & TB>0 ●

Summary: combination of policy instruments to hit one goal slopes up, to hit the other slopes down.

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Example: Emerging markets in 1990s Excgange rate E YY: Internal balance Y=Potential ED & TD ED & TB>0 ES & TD ES & TB>0 Mexico 1994 or Korea 1997 Mexico 1995 or Korea 1998 Spending A BB: External balance CA=0 Classic response to a balance of payments crisis: Devalue and cut spending ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Example: China in the past decade Excgange rate E YY: Internal balance Y = Potential ED & TD ES & TD ES & TB>0 China 2010 BB: External balance CA=0 China 2002 ED & TB>0 Spending A At the end of 2008, an abrupt loss of X, due to the US crisis, shifted China into ES. By 2007, rapid growth had pushed China into ED. But by 2010, a strong recovery, due in part to G stimulus, shifted China again into ES. ●

Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I 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 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). i Y LM E.g., Taylor Rule sets i. E.g., Quantitative Easing sets MB.

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.

New equilibrium: At point D if monetary policy is accommodating. Fiscal expansion shifts IS out. D. At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓  Rise in Y < full Keynesian multiplier.

API Macroeconomic Policy Analysis, Prof.Jeffrey Frankel, Harvard Kennedy School End of: Introduction to the Keynesian Model