1. Macro CFA review 1

2. Outline Measurement – National income (GDP) and unemployment Business cycles Aggregate supply and demand model Money Money supply and demand Monetary and fiscal policy – Activist versus non-activist policy 2

3. Gross Domestic Product Objective: Estimate the amount of economic activity Approaches – measure output – measure expenditure – measure income These all measure the SAME THING! 3

4. Gross Domestic Product Gross Domestic Product (GDP) is the most common measure of economic activity GDP – The market value of all final goods and services produced in a year, within a country’s borders 4

5. Expenditure GDP = C + I + G + NX C – Consumption expenditures I – Investment expenditures machines, equipment, structures, software and inventory G – Government purchases of goods and services NX – net exports = Exports minus imports 5

6. Income and output GDP = output of the economy – Output produced using land, labor and capital Payment to resources – Wages – payment to labor – Interest and profits – payment to capital (includes dividends) – Rent - payment to land GDP = wages + interest & profits + Rent 6

7. Real and Nominal GDP Nominal value – the value in current dollars – Expenditure method: GDP = C + I + G + NX – measured in current market prices Real value – the value in constant dollars 7

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9. Inflation Inflation – sustained rise in the average level of prices Deflation – sustained decline in average level of prices Price level – measured using a price index Price index measures average, not relative prices 9

10. Calculating the inflation rate Inflation rate is found by calculating the percent change in the price index Inflation rate 1977-1978 = Inflation rate 2007-2008 = 10 yearConsumer Price Index # 197762.1 197867.7 2007210 2008210.2 Source: BLS, base year 1984-1982 average. End of period

11. CPI inflation record, USA 11 Source: Bureau of Labor Statistics

12. Consequences Inflation Inflation erodes the purchasing power of money – Results in loss of purchasing power of monetary and fixed income assets Bank deposits, CDs, Bonds – Results in a decrease in debt burden as purchasing power of debts fall – Creates confusion about future prices 12

13. The “inflation tax” Inflation distributes income from those with fixed incomes to those with fixed costs. – Inflation acts as a tax on fixed income receipts Tax on lenders/savers The real value of fixed income falls as prices rise The real value of fixed payments fall as prices rise 13

14. Business Cycles 14

15. Unemployed To be considered unemployed, a person must – not have a job – be 16 years of age or older – be actively seeking employment, or awaiting recall People not working and who are also not looking for work are not considered unemployed 15

16. Unemployment rate The labor force = employed + unemployed persons – Interpret as the number of available workers The unemployment rate = unemployed divided by labor force 16

17. Example, USA Employment Status, January 2013Thousands of people Employed143,322 Unemployed12,332 Not in labor force89,009 17 Source: Bureau of Labor Statistics Calculate the labor force Calculate the unemployment rate

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19. Types of Unemployment Frictional – Unemployment caused by short- term movement of workers and first time job seekers. Structural – Unemployment caused by technological or structural changes in the economy Cyclical – Unemployment caused by recession 19

20. The natural rate of unemployment Natural Rate of Unemployment – – The unemployment rate with no cyclical unemployment – Frictional and structural unemployment are always present in the economy 20

21. Unemployment rate 21

22. Potential GDP 22 When unemployment = natural rate – real GDP = potential – No cyclical unemployment

23. Potential GDP 23

24. Model of GDP determination GDP = output = expenditure Output: Everything produced by land, labor and capital – Aggregate supply Expenditure: C + I + G + NX – Aggregate demand 24

25. Model of GDP determination GDP = output = expenditure Output: Everything produced by land, labor and capital – Aggregate supply Expenditure: C + I + G + NX – Aggregate demand 25

26. Long-run Aggregate Supply Long-run: real GDP is equal to potential GDP Potential GDP is the most an economy can produce with resources and technology Potential GDP is independent of price level 26

27. Long-run Aggregate Supply Curve The long-run Aggregate Supply curve is a vertical line at Potential GDP (Yp) 27 Price level Real GDP LRAS Yp

28. Short-run Aggregate Supply Short-run: – Prices of resources/input and costs of production are assumed to be fixed – Price of output may vary – As the price of output increases, the quantity of output supplied (real GDP) increases. In the short-run, there is a positive relationship between price level and output (real GDP) supplied 28

29. Short-run Aggregate Supply Curve There is a positive relationship between SAS and price level 29 Price level Real GDP LRAS Yp SAS

30. Aggregate Demand Aggregate expenditure: – Consumption (C) Expectations, wealth – Investment (I) Expectations, interest rate – Government Purchases (G) Policy – can deficit if tax revenue not available – Net Exports (NX) Exchange rate, relative prices, foreign income 30

31. Aggregate Demand There is a negative/inverse relationship between price level and Aggregate demand 31 Price level Real GDP AD

32. Equilibrium Long-run equilibrium, all curves meet at potential 32 Price level Real GDP LRAS Yp SAS AD = C + I + G + NX

33. Recession During recession, real GDP may be less than potential 33 Price level Real GDP Yp SAS AD Y’

34. Responses to recessions 34 Activist/Keynesian response to recession – Use fiscal policy to increase AD This is counter-cyclical policy – Increase government purchases (G) – Reduce taxes  Increase consumption (C) Keynesians are all about Aggregate Demand!! – Multiplier effects: increase in G of $1 leads to greater increase in AD

35. Response to recession Increase AD to fight recession 35 Price level Real GDP Yp SAS AD Y’ AD’

36. Discretionary/automatic stabilizers Discretionary policy – Planned expenditures: American Recovery and Reinvestment act (ARRA) Automatic Stabilizers – Element of fiscal policy that changes automatically as income (real GDP) changes Example: progressive taxes, unemployment benefits Result: Deficits higher during recessions 36

37. Consequences of deficits Richardian equivalency theory Crowding out theory Supply-side economics 37

38. Ricardian Equivalence theory AD shift is the same if government borrows or increases taxes to finance spending – households see government borrow – expect an increase taxes in the future – save more (spend less) to pay future taxes – Result: expansion of AD depressed David Ricardo (1772 – 1823) 38

39. Richardian equivalence No increase in AD as result of increase in G or reduction in taxes 39 Price level Real GDP Yp SAS AD Y’ = AD’

40. Crowding out theory The government issues bonds to finance spending – Businesses also issue bonds to finance investment (I) Government and businesses compete for the same funds – government borrowing “crowds out”, or reduces, private investment – Depresses increase in AD from government spending 40

41. Crowding out Increase in AD caused by increase in G offset by decrease in I 41 Price level Real GDP Yp SAS AD Y’ AD’ AD ‘’

42. Financing with Tax Revenue Eventually, government spending has to be financed with tax revenue Taxes reduce incentive to work – As tax rates increase, hours worked per person decreases Leads to a decrease in potential GDP and decrease in LRAS 42

43. Supply-side Economics The study of the effect of taxation on aggregate supply is “supply-side economics” Increase tax rates reduces in economic activity – less income available to tax A decrease in tax rates increases economic activity – more income available to tax 43

44. Taxes and hours worked 2004 44 Sources: Taxes: McDaniel 2007, Hours worked: GGDC and OECD

45. Taxation on LRAS Increasing income tax rates leads to a decrease in potential GDP 45 Price level Real GDP LRAS Yp LRAS’ Yp’

46. Activists and non-activist Keynesian/New Keynesian – Intervene to increase AD – benefits outweigh cost New Classical – Supply-side effects are powerful – Richardian equivalence means AD shift will be small 46

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48. Functions of Money Money must perform the following functions: – Medium of exchange Satisfies double coincidence of wants – Unit of account Goods are prices in money – Store of value Maintains purchasing power – Standard of deferred payment Debts denominated in money 48

49. Types of Money Commodity Money – money with intrinsic value – Example: gold coins Fiduciary money or fiat currency – money backed by trust – U.S. dollar is a fiat currency 49

50. Defining Money There are two official measures of the U.S. money supply 1.M1 = Currency + checking deposits + travelers checks 2.M2 = M1 + savings deposits + CD + retail Money market Money expands through the banking system 50

51. Reserves Banks are required to hold a fraction of deposits in reserve – total reserves = cash in vault + deposits @Fed. bank The reserve requirement (rr) is set by Federal Reserve (more later) – required reserves = rr times total deposits – Excess reserves = total reserves – required reserves 51

52. Example AssetsLiabilities Cash in Vault$20,000Deposits$1,000,000 Deposits @ Fed Bank$100,000Loans from other banks$0 Loans$480,000Loans from Fed$0 Securities$400,000 total 52 Suppose the reserve requirement = 10% Total reserves = _________ Required reserves = _______ Excess reserves = ______ Cascade Bank

53. Example AssetsLiabilities Cash in Vault$20,000Deposits$1,000,000 Deposits @ Fed Bank$100,000Loans from other banks$0 Loans$480,000Loans from Fed$0 Securities$400,000 total 53 Suppose the reserve requirement = 10%. Show how the balance sheet would change if the bank loans out all of its excess reserves. Cascade Bank

54. Deposit expansion multiplier The maximum possible expansion of the money supply that results from a new deposit = value of the new deposit times deposit expansion multiplier deposit expansion multiplier = 1/rr 54

55. Combined excess reserves of U.S. Banks 55 Source: Federal Reserve Bank of St. LouisSource: Federal Reserve Bank of St. Louis

56. Equation of Exchange MV = PY M: Money supply, could be M1 or M2 V: Velocity of money, # of times dollar is spent in a year P: Price level Y: real GDP PY: Nominal GDP Equation of Exchange is an identity, it always holds 56

57. Tools of Monetary Policy How does the Federal Reserve control the money supply? Federal Reserve tools: – The reserve requirement – Discount rate/discount loans – Open market operations 57

58. Reserve Requirement The reserve requirement (rr) is the fraction of deposits banks are required to hold in reserve Total (legal) reserves = Cash in vault + deposits @ Fed Required Reserves = rr times total deposits Excess reserves = Total Reserves – Required 58

59. Example AssetsLiabilities Cash in Vault$20,000Deposits$1,000,000 Deposits @ Fed Bank$80,000Loans from other banks$0 Loans$500,000Loans from Fed$0 Securities$400,000 total assetstotal liabilities 59 Suppose the reserve requirement = 10% Calculate Excess Reserves_______ Calculate the deposit expansion multiplier ______ Suppose the reserve requirement decreases to 5% Calculate excess reserves ________ Calculate the deposit expansion multiplier ______ Find the maximum possible expansion of the money supply if excess reserves are loaned out Cascade Bank

60. Discount loan The Federal Reserve can make loans to banks These loans are called Discount Loans The rate banks pay is called the Discount rate 60

61. Example AssetsLiabilities Cash in Vault$20,000Deposits$1,000,000 Deposits @ Fed Bank$80,000Loans from other banks$0 Loans$500,000Loans from Fed$0 Securities$400,000 total assets total after discount loan total liabilities total after discount loan 61 Suppose the reserve requirement is 10%, calculate excess reserves________ Show on the balance sheet above a $10,000 Discount loan to Cascade Bank Recalculate excess reserves ______ Calculate the maximum possible expansion of the money supply if Cascade loans out excess reserves ___________ Cascade Bank

62. Open Market Operations The most common tool of monetary policy is open market operations Open market operations are the purchase and sale of securities by the Federal Reserve Open market purchases increase excess reserves Open market sales decrease excess reserves 62

63. Example AssetsLiabilities Cash in Vault$20,000Deposits$1,000,000 Deposits @ Fed Bank$80,000Loans from other banks$0 Loans$500,000Loans from Fed$0 Securities$400,000 total assets total after open market purchase total total after open market purchase 63 Suppose the reserve requirement is 10%, calculate excess reserves________ Show on the balance sheet above a $10,000 Federal Reserve open market purchase Recalculate excess reserves ______ Calculate the maximum possible expansion of the money supply if Cascade loans out excess reserves ___________ Cascade Bank

64. Using Tools If the Federal Reserve wants to increase the money supply – Decrease reserve requirement increases excess reserves and increases the deposit expansion multiplier – Lower discount rate and make discount loans increases excess reserves – Perform open market purchases of securities increases excess reserves 64

65. Using tools If the Federal Reserve wants to decrease the money supply – Increase reserve requirement reduces excess reserves and decreases the deposit expansion multiplier – Increase the discount rate and reduce discount loans reduces excess reserves – Perform open market sales of securities reduces excess reserves 65

66. Equation of Exchange MV = PY M: Money supply, could be M1 or M2 V: Velocity of money, # of times dollar is spent in a year P: Price level Y: real GDP PY: Nominal GDP Equation of Exchange is an identity, it always holds 66

67. Quantity Theory Assume velocity is constant. In the long-run, a change in M only influences price level In the short-run, changes in the money supply influences Nominal GDP ? 67

68. Money Demand Why hold money? – transactions demand – buy stuff depends on nominal income – precautionary demand – unplanned expenditures – speculative demand – money is a store of value speculative demand is determined by the uncertainty about the value of other assets What do you give up when you hold money? – the return you would earn on non-monetary assets or interest rate

69. The Money Market 69 interest rate Quantity of Money Md

70. Money supply Suppose the money supply is independent of interest rate – controlled by Federal Reserve in the USA today might increase or decrease depending on policy Interest rate is determined in equilibrium by money supply supply and demand – changes in interest rate are caused by changes in money supply and or demand

71. The Money Market 71 Ms interest rate Quantity of Money Md i*

72. The Money Market 72 Ms interest rate Quantity of Money Md i i’

73. Interest rate and AD When the equilibrium interest rate decreases – Investment increases* – Aggregate Demand increases When the equilibrium interest rate increases – Investment decreases* – Aggregate Demand decreases 73 Possibly consumption as well

74. Monetary expansion – best case 74 Ms i interest rate Quantity of Money Md i’ Real GDP Price level AD LRAS SAS Y Yp

75. Short-run and long-run Monetary policy can be used to influence AD Short-run – Influence price level and real GDP Long-run – Influence price-level only - inflation 75

76. Activists and non-activists Activists: – Economy can take a long time to recover from recession – Use monetary (and fiscal) policy to increase aggregate demand Non-activist – Economy adjust quickly Agents have rational expectations – Aggressive monetary (and fiscal) policies worsen recessions and cause inflation – Lags associated with monetary and fiscal policies 76

77. Recession Result: higher price level - inflation 77 Price level Real GDP Yp SAS AD Y’

78. Recap - activists Active role for government in economy – Use monetary tools to influence short-run interest rate – Use fiscal policy to increase G and temporary reduce taxes when economy is in recession – Benefits of using fiscal and monetary policies outweigh cost Keynesian and New Keynesians are activist 78

79. Recap – non-activist Little government involvement – Set monetary policy rules – Keep taxes low and don’t make policy changes – Active monetary policies are inflationary – Active fiscal policies are costly and result in declines in potential GDP Monetarists and New Classical are non-activist 79