1. The macro-economy: a theoretical model

2. Controlling the economy: fiscal policy

3. Money and the macro-economy

4. Inflation and unemployment

5. An open economy: international macroeconomics

MACROECONOMICS

MACROECONOMICS

What is the purpose of macroeconomics?

• to explain how the economy as a whole “works”• to predict the consequences of policy action• to understand why macro variables behave in the way they do (trends and fluctuations)

What factors determine national income and employment?

Can the government affect national income through fiscal and monetary policy?

How do interest rate decisions reached by the central bankaffect the economy?

What factors determine national savings and investment?

What factors determine the exchange rate?

Why is the trade balance important?

THE CIRCULAR FLOW OF INCOME

Households

Tax

Firms

Wages, profits

Exports Imports

Demand for goods

Government

Investment

A MACROECONOMIC MODEL: THE DEMAND SIDE

Building blocks

• consumption 65%• investment 15%• government spending 20%• exports 25%• imports -25%

These five variables play a critical role in determining national income and employment.

Hence: need to be explained.

What determines aggregate consumption?

• disposable income (Y - T) • interest rates (investment) • uncertainty (confidence in future income stream) • wealth (asset prices, house prices) • expected future income (e.g. pensions) • age structure of population

Investment

• new capital equipment; not savings/ shares

What determines investment? • initial cost of investment • interest rate (cost of borrowing) • expected future income from investment

The investment decision

Present value of investment > 0

Cost of capital: increases as level of investment increases • internal funds (retained profits) • borrowing from financial institutions

• selling equity stock in business

How would a reduction in interest rates affect investment?

• lower borrowing costs

• lower mortgage rates (higher demand for houses)

• increase in saving (lower expenditure)

Determination of national income: a demand-based model

Assumptions1. Aggregate supply of goods responds to demand

- unlimited supplies of labour and capital

2. Aggregate demand for goods and services is determined as follows:

AD = C + I + G + X - M

Model (see figure)Predictions:

- if AS > AD, stocks increase, output falls- if AD> AS, stocks decrease, output rises- if AD = AS, economy is in equilibrium

Factors causing national income to change

1. If expenditure increases, so will income

2. Why might AD increase?

• consumption responds to- fall in prices (e.g. production costs fall) - wealth increases (house prices, stock market)- interest rates fall (monetary authorities)- lower taxes (govt. policy)

• investment- increase in expected profits (business optimism)- fall in borrowing costs

• government spending

- transfer payments increase

- capital spending increases

- expenditure on education/ health increases • net exports

- fall in exchange rate

- increase in competitiveness

- increase in world income

The supply side

So far assumed that AD alone determines national income

What about supply-side constraints?

• capital stock is limited in the short run

• supply of labour is limited

• skills shortages may arise

Implications of a limited supply of factor inputs• wages increase as labour demand increases

• diminishing marginal productivity (fixed supply of capital) • producers willing to supply more output only at higher prices • supply can be increased over the long run (increase in capital stock)

Revised model• interaction between AD and AS determines the economy’s income and price levels

Revised model

• interaction between AD and AS determines the economy’s income and price levels

Consider the effects of: - an increase in production costs

- an increase in the supply of resources (e.g. capital stock, technology)

- an increase in the demand for goods

Extended model

Assumption: AS is fixed by the economy’s output capacity

• labour market is assumed to clear (full employment)

• AD negatively related to price level

- fall in price leads to higher demand (real money balances increase, spending increases)

- fall in price reduces demand for money, interest rates fall(lower interest rate, higher spending)

• AD positively related to aggregate spending- investment increases as business expectations improve

• AD positively related to money supply

- if money supply increases, interest rate falls (investment increases)

A further modification

• AS may not be fixed at the full employment level

• AS may be upward sloping in the short run:

- sticky prices

- unemployed labour willing to work at current wages( costs do not rise as more labour is employed)

MACROECONOMIC POLICY

Objectives of macro policy:

• full employment

• stable prices

• steady growth

• equitable distribution of income

• balance of payments equilibrium (medium term)

Policy instruments

Fiscal policy• govt spending (health, education, etc)

• taxation (income, expenditure, excise duties)

• income transfers (pensions, welfare)

Monetary policy• interest rates

• money supply

Exchange rate policy• fixed v floating

FLUCTUATIONS IN BUSINESS ACTIVITY

Historical record• recessions can be very severe

• all countries experience booms /slumps

• recessions are usually shorter than expansions

• business cycles are highly synchronised between ‘partners’ - inter-country linkages

• business cycles are less severe than in past - govt spending is stable - automatic stabilzers have ‘worked’ - active monetary policies (Greenspan after Asian crash)

Causes of business fluctuations• unexpected ‘shocks’ - wars, oil-prices, financial crises

• shifts in AD - investment is volatile (unpredictable behaviour) - price stickiness causes changes in ‘real’variables

• technology shifts - new products / new processes

• govt-induced shocks - poor management of fiscal / monetary policy - time lags

FISCAL POLICY

What is fiscal policy? - govt’s attempt to control AD via G and T

Role and importance of fiscal policy• fiscal activism - fine-tuning of AD to achieve full employment - fine-tuning to reduce amplitude of business fluctuations

• fiscal balance has replaced fiscal activism - fine-tuning via fiscal policy has failed - monetary policy has replaced fiscal policy

• how could govt ‘pay for’ fiscal expansion in a recession? - increasing G causes income to increase - increase in income leads to higher taxes

• problems with fiscal activism

- fiscal activism involves discretionary action - govt has to decide how much stimulus is needed - need to know effect of fiscal injections (macro models used to predict effects) - budget deficits can easily get out of hand

• automatic stabilisers

- ‘kick in’ when economy moves into recession

- welfare payments increase

- tax revenue falls in recessions (to maintain C)

• fiscal policy stance

- budget deficit does not necessarily mean that fiscal stance is expansionary; recessions cause deficits

- fiscal stance may be ‘tight’ at full employment

Reasons for the decline of fiscal activism

• difficult to predict effects - inadequate knowledge of how economy works

- macro models are inadequate

- poor data

- long time lags in policy effects

- poor timing of policy changes

• political interference results in wrong policy action

- political cycles

- systematic bias towards deficits (popularity of low taxes)

• fiscal activism results in increasing debt - debt/gdp ratio increases (debt has to financed)

Dedt / gdp ratios

%1990 2000

EU 41 69Japan 10 113USA 32 60

Germany 42 64France 40 64UK 39 50Italy 104 113

Government spending / gdp

%1960 1970 1990 2000

EU 32 37 48 44Japan 17 19 32 32USA 27 32 37 33

Germany 33 39 45 44UK 32 34 53 44France 35 39 51 48Italy 30 34 53 44

Reducing debt may have expansionary effects

• cut in G can lead to: - lower interest rates - more confidence in govt’s macro policy - inflow of private FDI

• greater consumer / investor confidence

• fiscal activism is useless due to ‘crowding out’

- ‘crowding out’ of private I via high interest rates

- households reduce spending due to expectation of higher taxes in future

But:

- households may not make link between budget deficit and future taxes

- households may not care about the distant future

- not much evidence to support negative impact of ‘crowding out’

Sustainability of debt: govts worry about debt/gdp:

• many developing countries get into trouble (Mexico) - desire for growth

• non-tax payers / taxpayers increasing due to ‘demographic time bomb’ e.g. % 65+ 2000 2050

USA 12 21 Japan 17 30 EU 16 28

• need to keep interest rates below gdp growth rate to get debt / gdp down (or to run a deficit while keeping debt / gdp constant)

Conclusions

• fiscal policy has become more conservative

• debt burden too big; need for surpluses to repay debt

• inflationary consequences of expansionary policies

• financial markets ‘nervous’ of increases in govt debt (Can the govt meet its debt repayments?)

• pressure to reduce size of public sector - efficiency gains from privatisation - lower interest rates

• automatic stabilisers essential for macro stability

• fine-tuning replaced by coarse-tuning sustainability of debt

- discretionary fiscal policy still has a role to play

- co-ordinated policies macro-policy between G7 (G3?) needed to keep world economy stable (due to high rate of transmission of economic shocks)

MONEY AND THE ECONOMY

What is money?

What does money do?

How does money affect the economy?

What determines the money supply?

What determines the demand for money?

What determines interest rates?

What is monetary policy?

What is money?

What counts as money?• depends on its accessibility (degree of liquidity) - cash - bank deposits - interest-bearing deposits - time-deposits (savings) - short-term Treasury bills (near money)

What does money do? - medium of exchange - store of wealth - unit of account (measure of relative value) - relates the future to the present (wage contracts, repayment of debt)

How does money affect the macro economy?

Money affects the economy via interest rates:

• r affects expenditure (C and I)

• exchange rates (and therefore X and M)

• property prices

• bonds and shares

The financial sector: the central bank

• issues cash

• banker to commercial banks

• banker to govt (manages govt borrowing)

• regulates commercial banks

• controls liquidity position of commercial banks

• operates monetary policy

• operates exchange rate policy

The financial sector: the money market

Organisations

- commercial banks

- large firms

- pension funds

- building societies

- foreign exchange market

Intruments

- govt bonds / gilts

- certificates of deposit

- loans to households

- overdrafts

- mortgages

Monetary policy

Central bank controls monetary conditions:

• controls liquidity through lending rate (‘repo’)

- commercial banks can borrow at the repo rate

- repo rate is a ‘signal’ (determines all other interest rates)

- low repo encourages banks to borrow and lend

- high repo discourages banks from borrowing

Determination of interest rates

Demand for money

• transactions purposes - price level - income - interest rate (opportunity cost)

• precautionary purposes

• speculative purposes - expected change in price of bonds - bond price inversely related to r - hold money if bond prices are expected to fall - hence: demand for money high when r is low

Causes of changes in money supply

• banks can reduce their liquidity ratios - switch / direct debit has reduced demand for cash - banks borrow from each other (overnight) to achieve a satisfactory liquidity position

• surplus in balance of payments - inflow of foreign exchange

• govt creates high-powered money to finance a deficit - multiplier effects on ‘broad’ money (M)

M = k (H)M = broad moneyH = high-powered moneyk = money multiplier

• govt sells short-term Treasury bills (‘near money) - commercial banks expand loans to customers • govt buys long-term bonds and sells short-term Treasury bills to increase liquidity (‘funding’)

Determination of interest rates

Govt sets the money supplyPrivate sector determines demand for money

r

Demand / supply for money

r1

M1

Md = f(P, r, y)

Ms = M1What happens if:- money supply increases- income increases- prices increase

Monetary policy in practice

Central bank• does not control the money supply directly• controls interest rates via open market operations

How does the CB control interest rates?• announces an interest rate - base rate/repo rate paid by banks for borrowing money from the CB

• follows this up with OMO - buys gilts from banks to increase liquidity (results in lower r) - sells gilts to banks to decrease liquidity (banks earn an income from gilts)

Independence of central bank

• USA and Germany: long history of CB independence• other countries followed in 1990s (e.g. UK in 1997)

Advantages of independence• monetary policy free from manipulation• strengths credibility (inflation targets more ‘believable’• CB free to achieve its specific objectives

Disadvantages• low inflation is not the only policy goal• govt deflects blame for failure of economic policies

Performance• lower inflation achieved• tight monetary policy has led to higher unemployment in EU

The European Central Bank

• sets interest rate for all member states

• most independent CB in world; not accountable to any single country

• sets target inflation rate for whole Eurozone

• sets 3 interest rates- lender of last resort (e.g. 5%)- loans to banks (e.g. 4%)- borrowing from banks (e.g.3%) to mop up surplus liquidity

• sets minimum reserve ratio (to keep banks under control)

INFLATION AND UNEMPLOYMENT

What is inflation?

Some facts• inflation varies over time within countries• inflation varies between countries

What causes inflation?

• quantity theory of money• excess demand model of inflation• cost-push factors (wages, imported inflation)• a dynamic model of inflation

Quantity theory of money

Expenditure = Sales

quantity x velocity = price level x output of money

MV = Py

Suppose V and y are constant

then P = (V/y)M

or

rate of change in P = rate of change in M

Excess demand model of inflation

If AD > AS……….prices riseif AD < AS……….prices fall

AS

AD1

AD2

P2

P1

y1 y2

AD can increase for several reasons:• consumption suddenly increases • investment increases (expectations improve)• money supply increases (fall in r)• exports increase (world trade expands)

Inflation is self-perpetuating:• wage-price spiral• expectations of inflation

Cost-push shocks:• triggered by wage push, oil price hikes

A dynamic model of inflation: the augmented Phillips curve

• wage inflation = f (expected price inflation, XD)

• expected price inflation: - based on forecasts of macro-economy (e.g. capacity utilisation, monetary growth)

Does a trade-off exist? - short-run - long-run

Costs of inflation

• inflation increases uncertainty - consumers get confused signals about prices (essential information for optimal resource allocation)

• menu costs

• shoe-leather costs: searching for best buy

• adverse effects on fixed income groups

• adverse effects on savings

• adverse effects on growth of gdp/capita - lower in vestment due to uncertainty - shortens investors time horizon (quick returns)

• costly to reduce inflation: dis-inflation = unemployment

• hyper-inflation is economically and politically disasterous

Costs of deflation

• borrowers find their real debts increasing - discourages borrowing - fall in asset prices reduces consumption

• lenders lose if debtors go bankrupt

• prices decline but wages are sticky - decline in demand for labour - fall in profits and investment

• real interest rates increase - discourages investment

• leads to persistent recession: consumers delay spending

Control of inflation

• requires a powerful commitment to stable prices - implies strict control over G

• control over inflation in hands of CB - inflation is lower in countries with independent CB

• govt needs to set clear inflation targets - avoids govt pressure to relax monetary policy

• govt not permitted to borrow from CB to finance deficits - must borrow from private sector

• supply-side policies needed - labour market flexibility - anti-monopoly policy to increase competition

• high level of scrutiny of CB needed - openness of how decisions are reached - subject to scrutiny / questioning by elected body • increasing emphasis placed on controlling interest rates - less emphasis on controlling money supply - use open market operations to control interest rates

• accurate forecasts of macro-economy needed - lagged effect of monetary policy on economy - need forecasts of turning points - need to forecast ‘leading indicators’ (change in stock, long-term bond yields, commodity prices, overtime working)

• stopping hyper-inflation - nominal exchange rate ‘anchor’(e.g. dollarisation) (to restrain cost-push inflation, including imported inflation)

- restrictive fiscal policies (balanced budget) - tight monetary policies (e.g. via independent CB) - structural reforms (liberalise financial markets, flexible labour markets, free trade, privatisation of public enterprise, anti-monopoly policies)

Argentina 1989-94

Fiscal balance Inflation Growth (% GDP)

1988 -5.6 340 -1.91989 -0.6 3000 -6.21990 +1.4 2300 0.11991 +1.7 170 8.01992 +2.2 24 8.71993 +2.2 10 6.01994 +1.1 3 4.5

Short-term pain = long-term gain?

Has inflation been beaten?• strong public support for price stability - ageing population prefers low inflation

• financial markets strongly averse to inflation - govt keeps close eye on financial markets - pre-emptive action taken v. inflation

• greater price competition - supply-side changes (labour markets, privatisation, internet trading, creation of new markets) - erosion of trade union power

• less vulnerable to oil price hikes - more alternative sources of energy - diversification in use of energy

UNEMPLOYMENT

• varies between countries

• varies within countries over time

• varies within countries at any point in time

Causes of unemployment

• collapse in aggregate demand

Policy action: need for fiscal / monetary policy action

• mismatch between labour demand and labour supply - geographical immobility of labour - skill/occupational mismatch

Policy action:need for spatial policies / re-training programmes

• welfare benefits ‘too high’ Policy action: creation of work incentives (New Deal)

• hiring / firing costs too high - employment legislation ‘too tough on employers’

Policy action: reduce fixed costs of employing labour

• wages too high (trade union power) - wages are sticky downwards - efficiency wage v. nominal wage

Policy action: more flexible wages needed (especially with fixed exchange rate e.g. euro)

What is the natural rate of unemployment?

Definition: unemployment existing when the economy is in equilibrium (AD =AS)

Determinants:

• job search

• structural factors (mismatch)

• voluntary unemployment

• unemployment benefit

• hysteresis and long-term unemployment

THE OPEN ECONOMY: INTERNATIONAL ASPECTSOF THE MACRO-ECONOMY

• the balance of payments

• the exchange rate

• economic and monetary union (EMU)

What is the balance of payments?

Why are policy makers concerned about the BP?

How can govts ‘correct’ a BP problem?

How are exchange rates determined?

How can the CB affect the exchange rate?

Is a single currency for Europe desirable?

Should the G3 (G7) co-ordinate their macro-policies?

How should world debt problems be tackled?

The balance of payments

• records all flows of money between countries

• BP = current acc + capital acc

Current account (or financial account) - exports minus imports of goods / services - govt transfers (e.g. EU taxes / subsidies)

Capital account - fixed investment (FDI) - bonds, equities, deposits (portfolio investment)

Current accountExports +165Imports -192Services +11Net income +7Net govt transfers -4 Balance -13

Capital accountFDI (net) +173Portfolio (net) -143Short-term flows (net) -23Balance +10

Reserves +1Error -2Balance of payments 0

Surpluses and deficits in the BP

Surplus: BP > 0 - foreign exchange reserves increase - accumulation of foreign assets - exchange rate ‘too high’ Deficit: BP < 0 - foreign exchange reserves decline - loss of foreign exchange reserves - deficit has to be financed (borrowing) - loss of control over domestic assets - downward pressure on exchange rate; inflationary

Determinants of the BP

BP = exports - imports + net capital flows

• exports = f (exch rate, competitiveness, world income)

• imports = f (exch rate, competitiveness, income)

• net capital flows = f (r / world r, country risk)

Model: BP = f ( e, w/w*, y*, y, r/r*)

e = exchange rate (£/$)w = real wage; w* = world real incomey = income y* = world incomer = interest rate r* = world interest rate

Govt intervention

• exchange rate policy: buying / selling domestic currency

• fiscal / monetary policy to control AD - raise / lower r (capital account) - change G or T (trade account)

• supply-side policies - improve competitiveness via labour market flexibility

The exchange rate

e = £ per $ (or s = $ per £)

Determination of e: a simple model

Demand for £s (= supply of $s)• importers of UK goods / services• tourists visiting UK• foreign students in UK universities• foreigners investing in UK• UK citizens with foreign income

Supply of £s (= demand for $s)• opposite to above

Model: e = f ( x - m, r - r*)

When will exchange rate appreciate?

Current account:• demand for exports increases• demand for imports decreases• competitiveness increases (w / w* increases)

Capital account:• inflow of foreign investment (r / r* increases)

Fixed or floating exchange rates?

Advantages of a fixed exchange rate

• certainty for exporters / importers/ investors

• no speculation (e.g. between countries with common currency)

•imposes constraints on govt macro policy - constrained by effect on BP - constrained by effect of policies on inflation - govt has to achieve BP equilibrium over medium term

Disadvantages of a fixed exchange rate

• economic policy will be constrained by fixed exchange rate - chronic BP deficit requires deflationary policy - conflict between full employment and BP equilibrium

• sudden ‘shocks’ cannot be absorbed by ER adjustment - shocks affect ‘real’ economy

• fixed ER encourages ‘protectionism’ - due to impact of shocks on ‘real’ variables

• speculators cause political crises

Advantages of floating exchange rates

• govt ignores ER; no intervention needed

• no need to worry about BP

• economy is insulated from shocks (absorbed by ER)

• govt can concentrate on internal policy objectives (inflation, unemployment, income distribution)

Disadvantages of floating exchange rates

• exchange rate can be volatile in the short run - causes uncertainty (harmful to investment / trade)

• capital flows can cause ER to get ‘out of line’ with its underlying (fundamental) value

• loss of BP constraint on macro-policy may lead to inflationary bias - with a fixed ER, govt has to respond to BP deficits

Advantages of a single currency

• lower transactions costs (currency conversions)

• increased price competitiveness - transparent pricing across countries • elimination of exchange rate uncertainty - encourages trade - encourages investment (inc. FDI)

• lower inflation and interest rates - central bank independent of member govts - member states have to keep wage increases in line to maintain competitiveness

Disadvantages of a single currency

• surrenders economic sovereignty to supra-national authority - no control over monetary policy - no control over exchange rate

• deflationary effects in countries with high wage pressures

• increase in regional disparities due to greater factor mobility

• potential loss of control over fiscal policy (cannot use monetary expansion to pay for increase in G)

Why might the Euro Zone not be an optimal currency area?

• labour markets are not flexible enough - wages may be sticky downwards - labour is not sufficiently mobile to respond to changes in demand - effects of changes in euro ER will vary between member states / regions

• But: alternative methods of dealing with adverse effects of structural change - structural funds for re-training - structural funds for encouraging indigenous growth - infrastructure policies to revive declining regions

Globalisation and macroeconomic policy

Interdependence• world’s economies increasingly inter-dependent

• steadily increasing world trade - dependent on each other’s demand for exports

• vast increase in financial flows due to liberalisation of financial markets - abolition of controls on currency movements - financial markets affect each other (instantaneously) - Fed has profound effect on rest of world’s economies

Co-operation between G7: policy harmonisation

• need for policy harmonisation to prevent worldwide recession / inflation

- exchange rates should not be ‘out of line’ (need to keep current accounts in reasonable balance)

- inflationary pressures are easily transmitted to other countries

- co-ordination of interest rates may be needed to prevent adverse capital flows

• G7 need to deal with the problem of developing country debt