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Revision Lectures: MacroLuca Metelli1For information about the exam, look at the slides Micro revision lecture

Today well go through some past exam questions and some theory, regarding macro

Macro long question, 2014 examGovt decides to reduce the stamp duty on car purchase. Does the tax change have an impact on aggregate demand, and if so how would you represent it in the aggregate-demand/aggregate-supply diagram? Explain (5 points)

AD=C+I+G (+X-M) Describe what C, I, G are. (1 point) When tax on stamp duty , consumption Therefore AD (1 point)

Diagram: Demand shifts to the right. (1 point)Details: the diagram, axis, show that AD shifts to the right and not upwards (1 point)

You could expand:

However, it depends on how the tax decrease it is financed: (1 point) If with G.. If with debt.

As C , firms might be willing to invest less as there is less demand I as well (2nd order effect) (1 point)Example 2Discuss the mechanisms leading from the change in aggregate demand to changes in GDP and in inflation. (5 points)

GDP is determined by AD and AS. In the short run AS is horizontal, because of price- sticky assumption. Explain In the long run AS is vertical, because of flexible prices. Explain. (1+ point)

Diagram (1 point)

Explain what happens to:GDP. Short run and long run (1 point)Prices/inflation: short run and long run (1 point)

Summary of the Lent term materialGDP and National AccountingsEconomic Growth (Solow model)Economic Fluctuations (AS-AD model)Policies to address Econ. FluctuationsInflationUnemploymentFinancial systemEuro Crisis

National Accountings9GDP3 definitions:1) Production Approach: Value of final goods and services produced2) Expenditure Approach:Total expenditure on C,I,G and NX. Y = C + I + G + NX3) Income Approach:Total income earned by factors of production for domestic production (Return on labor, return on capital and economic profit)

QUESTION: Income approachSuppose a woman marries her butler. After the marriage, the man keeps to wait on her (but not as an employee). Does the marriage affect GDP?Yes, GDP decreases. Total labor income falls by the amount of butler salaryGDP is an imperfect measure!

QUESTION: Expenditure approach. The following transactions are to be consideredC,I,G,X or M?Boeing sells an airplane to the Air ForceGBoeing sells an airplane to American AirlinesIBoeing sells an airplane to Air France XBoeing sells an airplane to Warren Buffet CBoeing builds an airplane, but it is not sold I (as inventories!)QUESTION: Production approachCalculate nominal/real GDP, GDP deflator, CPINomGDP 2000 =(100*50.000)+(500.000*10)=10.000.000NomGDP 2010 =(120*60.000)+(400.000*20)=15.200.000Real GDP 2000=Nom GDP 2000Real GDP 2010 (with base year 2000)= (120 50,000 $) + (400,000 $10 )=10.000.000GDP Deflator 2010= =15.200.000/10.000.000=1.52CPI 2010= =1.6

Solow Model14The Solow modelSolow model is a Long Run model to explain growth (i.e. GDP per worker growth)

We have seen 3 versions:Simple versionWith TFP growthWith TFP growth and human capital

15The models features:Output p.w. depends on capital p.w.Output can be either consumed or investedConstant rate of saving (investment), sConstant rate of capital depreciation,

Capital is crucial for growth! Capital evolves:

1) Simple version16Easily represented through a diagramSteady state when == =0

17Prediction of the Solow modelOther things equal, poor countries (i.e countries with lower K) should grow faster than rich ones In the long run, poor and rich countries are expected to converge to the same steady state (conditional convergence)No growth in steady state. Capital does not grow, therefore Output does not grow

18QUESTION: Effect of change in ( )

192) Solow model with TFP growth TFP=efficiency with whichcapital is used

TFP is important because:TFP increases Y directlyTFP increases Y stimulating growth in K

20TFP:Growth in the long runTFP is not subject to limits

TFP growth is crucial. It is achieved through:Innovation (basic research, R&D). Subsidies and patents might be a good ideaImitation (in developing countries)Other ways ?3) TFP and Human capitalHuman capital (schooling, health)Direct effect on GDP and indirect effects

AS-AD Model23AS-AD modelUseful to explain economic fluctuationsIn AS-AD model fluctuations stem from demand shocks (AD shifts) and supply shocks (AS shifts)GDP is given by the equilibrium b/w AD and AS

Main assumption of the model:Prices are sticky in the SR, Flexible in LR24AD=C+I+G+NX

Short run AS (sticky prices)

Long run AS (flexible prices)

GDP in the short run is where AD=SRAS

GDP in the long run is where AD=LRASQUESTION: Effect of a reduction in money supply on GDP and inflation

29QUESTION: Effect of a reduction in money supply on the interest rateIn the coursepack:When M/P falls, money holdings in portfolio too smallInterest rates increase to make the smaller holdings optimal again You can see this through a diagram, representing the Money marketReal money supply=Real money demand

When Money supply Interest rate .

30QUESTION: Why does the aggregate demand slope downwards?Sloping downward means that for high P, AD is low , for low P AD is high

31Can answer focusing on the money marketIn the money market, P means a reduction in real money supply (M/P)

higher P is associated with higher interest rate

32As high interest rate means lower C and I, this implies lower AD

Summing up:Higher prices are associated with lower AD, Lower prices are associated with higherAD...therefore AD is downward sloping33QUESTION: Effect of increase in oil price & Fed reactionAs production costs increase, SRAS shifts upward, equilibrium in BIf the Fed cares about keeping output at natural level, it increases AD by increasing MThe economy immediately reaches a new equilibrium at point C. The price level is permanently higher, butno loss in outputIf the Fed cares about keeping prices stable, then there is no policy response it can implement.Hence, the Fed must simply wait, holding AD constant. Eventually, prices fall and end back in point A. Butprolonged recession.

Inflation and Hyperinflation35Inflation: percentage increase in the overall level of prices

Inflation, 2 measures:GDP deflator=100 x Nominal GDP/Real GDPCPI index: Price of a fixed bundle of consumer goods

36Costs of inflationRelative price distortionsMisperceptions of relative pricesFiscal dragIncreased uncertaintyRedistribution of purchasing powerMenu costsIf you want to end (moderate) inflationMoney supply has to grow less than expected

but this leads to a recession

(unless the central bank is fully credible)

DeflationAt the opposite of inflation, there is deflationi.e. negative change in the price levelVery actual topicDeflation can be dangerousTo stop deflation, the central bank needs to stimulate the economy and let the money supply grow more than expected (e.g. QE)

QUESTION:Q: Is expected inflation a possible problem for an indexed lending/borrowing contract? What about unexpected inflation?Sketch:Explain what is an indexed contractExpected Inflation does not affect this contract. It never does.Unexpected inflation does not matter as well, because of the indexing.

40QUESTION: What is the inflation tax? Who pays for that?The holders of money pay the inflation tax.

That is, a given amount of money buys fewer goods and services since prices are higher

Also holder of nominal bonds pay for the inflation tax

41QUESTION: Inflation is repudiation, a finance ministry said. What does it mean? By increasing inflation, the government reduces the value of its outstanding debt in real termsEventually, when the government pays back lenders (i.e. private citizens), lenders can buy less with that amount of money because of inflation. In this sense we can say that the government repudiates the debt.

This holds only when inflation is unexpected. If inflation is expected, lenders demand a higher nominal interest rate when buying govt bonds.Hyperinflation and policies to end itHyper-inflation is when inflation is higher than 50% per monthHyperinflation is caused by excessive money supply growthUsually when a government cannot raise taxes or sell bonds, it start finance spending by printing money (seignioraige), causing hyperinflation

43To end hyperinflationFiscal reform (spending less/taxing more)Stop printing moneyFixed rate of M growth (choose and keep a constant and lower money supply growth)Inflation target (adjust money supply growth to achieve the desired inflation rate)Fixed exchange rate (central bank needs to maintain a money supply growth compatible with a fixed exchange rate. If M grows too much exch rate depreciates!

44The Financial system45The story of the financial crisisHousing Excessive optimism + lax lending standards made house prices to boomOver time, housing boom unsustainable, many homebuyers fell behind their debt paymentsPrices fell by over 30%From housing to banksAs the house is a collateral, value of collateral fallsBank not able to recover its moneyFear of bank insolvencies

46From banks to the economyConfidence in financial institution droppedInvestor started to withdraw their funds from banksBanks, to be able to fulfill the withdrawing requests, started to firesale and to cut on lendingCredit crunchRecessionVicious circle47How to respond:Conventional monetary policyUnconventional monetary policyConventional fiscal policyInjections of govt funds (make loans, buying banks)Lender of last resort

What does it mean for a Central bank to act as Lender of Last Resort?When a central bank acts as a lender of last resort, it helps to alleviate a liquidity crisis.A liquidity crisis occurs when the financial institution has insufficient funds to satisfy the withdrawal needs of its creditors (but still the institution is solvent)If the central bank lends funds to the financial institution, the creditors claims can be met. These actions help to restore and maintain the publics confidence in the banking system.QUESTION: What is a shadow bank? Shadow banks include investment banks, hedge funds, private equity firms, and insurance companies. (Everything but commercial banks)Their deposits are not federally insured, so they are not heavily regulated like traditional banks and can take on much more risk. After the crisis policymakers suggest limiting the risk they can take

QUESTION: How does the leverage ratio influence the stability of a financial institution in response to a crisis?The leverage ratio is the ratio of a banks assets to its bank capital.

The higher its leverage ratio, the less stable the financial institution during a time of bad economic news. If a bad economic news reduces the value of the bank assets by 5%, this is equivalent to the $50 of bank capital. Beyond this point, the financial institution has no funds with which to pay off future creditors.

Here Leverage ratio = 20The Euro crisis: causesVery high government debt&deficit: to stimulate economy in 2008/2009 and/or to save banksIreland, Spain: low debt, high deficitItaly: high debt, low deficitGreece: high debt, high deficitLow growth b/c 2008/09 crisis debt/gdp Loss of confidence in peripheral countries: fear of defaultDifficult to bailout a government

ConsequencesGovt interest rates spiked: more expensive (and difficult) for the govt to finance its expensesLoans more expensive for firms and consumersless investmentAs value of bonds , banks balance sheets distressb/c more expensive to finance expenses and b/c of political pressure, govts cut budget austerityAusterity caused negative growthNegative growth Debt/GDP (despite deficit : govt multiplier > 1)Negative spiral!How to solveVery much a political issue: Euro area has different countries with different needs. North vs South. Possible solutions:Bailout: direct help from North/new vehicles . Difficult to achieve; moral hazard risk.Through the ECB:Secondary market operationsLTRO,OMTECB statements, forward guidance