EC 102.01 Review Session for Midterm II

Midterm 2July 21, 2011 @ 13:15 @ Hisar Campus

HKD 201 : ACAR – ISIKHKD 101 : INAM – YILDIZ

Business CycleStylized Facts – important but not always literally

true!Fact 1: During an economic downturn (recession,

contraction), unemployment increases.Rule of thumb: Okun’s LawEmpirical inverse relationship btw unemployment

rate and real GDP growth. (e.g. 1 per cent drop in unemployment rate is associated with approx. 3 per cent boost to real GDP)

Not always perfect relation! e.g. jobless recoveries

Business CycleFact 2: An economic recovery or expansion, if it is

very strong, may lead to an increase in the inflation rate.

Why? As economy “heats up”, more competition over the resources -> prices/wages increase, intensifying inflation.

Remember: Philips curveEvidence: business-cycle-led

variations in competition is only one cause of variationsin inflation – will discuss later!

Business CycleStylized business cycle – based on overall growth

trend in GDP.Full employment outputAssumed to correspond

to a case of no excessiveunemployment

The goal of stabilizationpolicy is to keep the economy in this “band”, avoiding the threats of inflation and unemployment

Macroeconomic Modeling and ADY = output/income (will be used interchangeably)Incomes from productiongive rise to spending that stimulates producers to produce the original levelof outputEquilibrium->income=spendingC = consumption decisions by hhII = intended investment by biz.AD = C + II

Macroeconomic Modeling and ADSuppose businesses decide to cut back future

plans for expansion (reduce II) or households decide to consume less (increase S).

Leakages exceed injections (S > II => Y > AD)Planned spending is not sufficient to support

existing level of output (or vice versa)Need for adjustment!Solution??? Classical vs. KeynesianDifferent solutions for adjustment

Macroeconomic Modeling and ADClassical Solution to LeakagesQ: how does an economy (assumed to run in FE)

keep leakages into saving exactly equal to the injections coming from intended investment?

Flexible markets! Which market??Market for loanable funds: supply comes from

households (S), demand comes from firms (II); price = interest rate

Equilibrium = FE balance

Macroeconomic Modeling and ADClassical Solution to LeakagesImbalance: suppose firms decide to cut back II,

demand for loanable funds decrease, excess supply of funds at the equilibrium rate, price falls, households choose to save less and consume more until new demandequates supply.

AD still equal to FE level, S = IILess II balanced by more CSelf-sustaining economy at FE level thanks to price adjustment

leakage

injection

Production generates income

Spending stimulates firms to produce

Saving (S )

Equilibrium in the market for loanable funds

Intended Investment (II ) is equal to S

Output (Y* )

Consumption (C )

Income (Y* )

Spending sufficient to sustain full

employment

AD = Y*

Aggregate Demand and Economic Fluctuations

Remember: Classical view on macroeconomic equilibrium

Movement to equilibrium – will cut back production until excess inventories are used up

When economy arrives at equilibrium, balance between S & I has been restored – due to changes in income!!

Persistent unemployment? Keynesian view: there is no automatic mechanism that settles the economy

Great Depression: stock market crash, cut back investment spending, contraction, low income high unemployment equilibrium – need for stimulus

Keynesian Model of AD

Output (Y* )

Income (Y* )

Insufficient Spending

AD < Y*

Production generates income

Income goes to households

If leakages are larger than injections…

Lower Income

Lower Spending

AD = lower YLower Output

Keynesian Model of AD

Keynesian Model - The Multiplier at WorkChange in Intended

Investment

Change in Aggregate Demand(as C or II change)

and in Output and Income(as firms respond to changes in AD)

Change in ConsumptionΔC = mpc Δ Y

= .8 Column (2)

1. Investors lose confidence.Δ II = 80

2. Reduced investment spending leads directly to Δ AD = 80.Producers respond to reduced demand for their goods by cutting back on production.Δ Y = 80

3. Less production means less income. With income reduced by 80, households cut consumptionby mpc Δ Y= .8 80ΔC = 64

4. Lowered consumption spending means lowered ADΔ AD = 64Producers respond.Δ Y = 64

5. Households cut consumptionby mpc Δ Y= .8 64ΔC = 51.2

6. Δ Y = 51.2 7. mpc Δ Y = .8 51.2ΔC = 40.96

8. Δ Y = 40.96 9. ΔC = 32.77

10. Δ Y = 32.77 11. ΔC = 26.21

etc. etc.

Sum of changes in Y= 80 + 64 + 51.2 + 40.96 + 32.77 +. . . .= 400

Fiscal PolicyFiscal policy - government spending and taxation

policiesAdding up the government sector to the Keynesian

modelAD = C + II + G

G: government spendingE.g. construction of new roads by the government

– government money spent on goods and payments to workers: creating new AD, multiplier effect adding to the original stimulus by G

Fiscal PolicyQ: How do the changes in taxes and transfer

payments affect equilibrium level of output and income?

not similar to the changes in G!G – directly affects AD and GDPT – indirectly affect AD and GDP (through C or II)Depends on the type of tax and transfer payment

introduced or altered.Focus on effects of changes in income taxes and

transfers to individuals.

Fiscal PolicyE.g. assume tax cut of 50 – not fully reflected in

increasing spending by 50 but rather works through “marginal propensity to consume”!mpc * amount of tax cut = change in consumption

E.g. assume transfer payment of 50 – same mechanism!

mpc * amount of transfer = change in consumptionDisposable income – income available to consumers

after paying taxes and receiving transfersYd = Y – T + TR

Fiscal PolicyLump-sum taxes : fixed at a level irrespective of the

income levelTax multiplier -> impact of a change in a lump sum

tax on equilibrium level of income/output.Works in two stages: (i) consumption is reduced by

mpc * change in lump sum tax(ii) The reduction in consumption has multiplier

effect on equilibrium incomemultiplier * (mpc * change in lump sum tax)

Fiscal PolicyTax increase – reduces Yd; contractionary effectTax cut – increases Yd; expansionary effectTransfer payments – some sort of negative tax;

works in the same logic as tax cuts.In reality – income taxes are generally proportional

or progressive (i.e. increase with income levels)Effect on AD – flattening AD curve because higher

impact on high levels of incomeBalanced budget – governments may intend to

offset the effect of increase in G by increase in T

Fiscal PolicyExpansionary Fiscal Policy – use of government

spending, transfer payments or tax cuts to stimulate higher levels of economic activityincrease G, increase TR, decrease T

How to finance?? borrowing or increased taxation. Second option is likely to offset the impact

Too much spending may have inflationary effect – increase in G may overshoot the FE level of output, excess demand -> “overheating”

Fiscal PolicyContractionary Fiscal Policy – reductions in

government spending, transfer payments or tax cuts leading to lower levels of economic activitylower G, lower TR, increase T

Could be regarded as a cure for inflation to overcome the excessive aggregate demand.

Unwise to use at times of unemployment – may lead to further stagnation by overshooting in the downward direction!

Budgets, Deficits and Policy IssuesFiscal policy - government spending and taxationGovernment expenditures = government outlays

G + TRBudget => revenues and expendituresRevenue side = taxes (T)When revenues are not sufficient to cover

expenditures => borrowingInternal borrowing: sale of government bonds or

treasury bills to the public, interest-bearing securities with a promise to pay in future

Budgets, Deficits and Policy IssuesRevenues, 2009 Expenditures, 2009

Balance = deficit (revenues fall short of expenditures)

Budgets, Deficits and Policy Issues

Budget Balance = Surplus (+) /Deficit (-) = T – (G+TR)Generally shown as a % of GDP - larger the economy,

easier to handle a given deficit as the fiscal impacts of the deficit would be relatively small

Budgets, Deficits and Policy Issues

Deficit vs. Debt? Deficit is a flow variable for the current period but debt is a stock variable hich shows accumulated deficits over the years!

Debt increases when there is deficit !Commonly held view: “Debt as a burden on future generations” ??

Budgets, Deficits and Policy IssuesKeynesian idea: Government spending is an

important part of the economic policies to prevent recession.

Recently – controversies over use of fiscal policies especially in relation to the impacts on inflation and deficits

Evidence shows that government budget moderates fluctuations in AD without any other intervention

Automatic stabilizers – tax and spending institutions tend to increase government revenues and lower expenditures during expansions and vice versa during recessionary periods.

Budgets, Deficits and Policy IssuesAutomatic stabilization but HOW?Suppose there is recession => AD falls, government

deficit increases as tax revenues are decreasing due to declining incomes and expenditures increase as there is more receipt of welfare payments (unemployment benefit etc.), decline in C is prevented, therefore recession is moderated.

Suppose there is expansion => tax revenues increase as incomes increase, expenditures fall as fewer people receive welfare benefits, disposable income does not rise as fast as national income, C slows down, limiting inflationary overheating

Discretionary Fiscal PolicyControversies on the use of fiscal policy but still

an important policy toolOften criticized due to the problems of time lags

that make fiscal policies counterproductive.Time lag: elapse btw the design of a policy and its

actual effects on the economic activity- Data lag: related to collection of data for policy- Recognition lag: policy makers fail to diagnose the

problem right away- Legislative lag: must be instituted in the form of legal

changes- Transmission lag: legal changes take time to show up

in actual spending or taxation.

Balanced Budgets and Deficit SpendingSupply side economics: emphasis on policies to

stimulate production, i.e. tax-cuts.Q: Is balanced budget possible?- If there is a rule for BB, it may not be easy for the

government to respond to emergencies (i.e. Natural disasters)

- At times of recession, BB brings further stagnation because deficit↑matched by tax↑=> AD↓

- Policy may not be able to respond to severe recession such as Great Depression

The International SectorTrade balance = net exports (NX) = X - M

AD = C + II + G + NXExports as a positive contribution to AD – injectionImports as a leakage from national ADMultiplier effectsIncrease in Exports – same as in G or II

change in Y = multiplier * change in exportsIncrease in Imports – a bit complicated, changes in

income induces import demand as well (through marginal propensity to import - mpm)

The International SectorIncrease in Imports – a bit complicated, changes in

income induces import demand as well (through marginal propensity to import - mpm)similar to the logic of proportional tax – will flatten the AD curve

change in Y = multiplier*mpm* change in importsAny portion of AD increase goes to simulate

another economy via imports.Trade deficits may not be sustainable for longer

term horizon, how to finance???

Output (Y) Income (Y)

Spending (AD)

consumption (C)

taxes (T)

savings (S)

imports (IM)

intended investment (II)

government spending (G)

exports (X)

Production generates income to

households

leakages

injections

What is Money?Money = banknotes and coins in our wallets; such

cash money could not be regarded as the only form!

Three main uses of money- as a medium of exchange: when sell sth, accept

money in return; without this, barter system!- as a store of value: even hold for a while, it is still

useful for transactions when needed; a way of holding wealth; different from other assets because “liquid” – could easily be used in exchange

- as a unit of account: monetary value is assigned to things which are not actually sold or bought

What is Money?Money is a stock variable – kind of an asset (whereas

income is a flow variable over a period of time) but different from wealth (could constitute different forms of assets including real estate, corporate shares etc.)

Types of Money - Commodity money: a good that is used as money

because it is also valuable itself. E.g. coins made up of silver and gold. (value depends on the context!)

Must be generally acceptable, standardized, durable, portable, scarce, easily divisible!

What is Money?Types of Money Gold and silver coins fairly portable but inconvenient

to carry around in large quantities – certificates used, during gold standard era international transactions based on gold reserves

- Fiat money: “let it be done”. Legal authority declares that the bill is money. Some kind of a social construct – accepted in society because of how people think &act but not because it intrinsically is!

The basis of value is the expectation that the banknote will be acceptable in exchange.

Monetary PolicyRemember: use of money (as a medium of

exchange, store of value and unit of account)Types of money (commodity vs. fiat money)Measures of MoneyVarying degrees of liquidity across assets - need to

measure the amount of money in circulationChecking accounts also liquid – use of checks or

debit cards and electronic transfers.M1 – currency + demand/checkable deposits +

traveller’s checksM2 – M1 + saving deposits + some other funds

Monetary PolicyUse of credit cards? Taking out temporary loan

from the bank, payment of the credit card from your account is the monetary transaction itself.

Banking SystemQ: How does the currency finds its way into

people’s wallets? Central Bank – sole authority to issue currency;

decides on the amount and printsPrivate Banks – actions with CB create the

economy’s volume of checkable/demand deposits.

Banking SystemRemember: Classical model - market for loanable

funds with suppliers and demandersNeed for financial intermediaries to bring lenders

and borrowers together.Individuals deposit funds at intermediaries for safe

keeping, to be able to write checks or earn interest -> intermediaries use these deposited funds to lend to those willing to borrow.

Private bank – for profit: seeking to make earnings on its activities simply via interest charged on the loans made.

Banking SystemPlease do take a look at these short animations

Tale of Goldsmith – history of banking systemhttp://www.youtube.com/watch?v=3HdmA3vPbSU&feature=fvwrel

Money as debt - critical perspective http://www.youtube.com/watch?feature=player_detailpage&v=sanOXoWl0kc

Banking SystemBalance Sheet of A Private Bank

Assets Liabilities

Loans $ 70 million Deposits $ 100 million Government bonds $ 20 million Reserves $ 10 million

Balance Sheet of A Central Bank

Assets Liabilities Government bonds

$ 750 billion Currency in circulation

$ 700 billion

Bank reserves $ 50 billion

“banker’s bank” – holds deposits made by the private banks; required reserves – amount held at CB

Monetary PolicyCB has various ways of changing the volume of

money and credit in the economyMost commonly used: OMO (open market operations)Buying or selling of government bonds – assets of CBRemember: liabilities on CB balance sheet: currency

in circulation and bank reserves (vault cash and deposits of banks at CB)

Suppose open market purchase of bonds (usually from other banks) – bonds at CB ↑, payment by crediting the bank reserves

Monetary PolicyOpen market purchase – increase in monetary base

(currency + bank reserves)(a) Change in the CB Balance Sheet

Assets Liabilities Government bonds +$ 10 mio Bank reserves +$ 10 mio (b) Change in Commercial Bank’s Balance Sheet

Assets Liabilities Government bonds $ 10 mio Reserves +$ 10 mio So far the open market purchase of bonds did not change the volume of money in circulation (M1)

Remember: banks are for-profit organizations

Monetary PolicyCommercial bank would seek for profit by increasing

the volume of loans available, gives out loans to a private company which deposits it in another bank

A Loan by Commercial Bank1 Becomes a Deposit in Commercial Bank2 (a) Next Change in the Commercial Bank1’s Balance Sheet

Assets Liabilities Loans +$ 10 mio Reserves $ 10 mio (b) Change in Commercial Bank2’s Balance Sheet

Assets Liabilities Reserves +$ 10 mio Deposits +$ 10 mio

Monetary PolicyMoney supply is now increased

1. amount of demand deposits increased by 10 mio.2. Commercial Bank2 now has excess reserves to be given out as fresh loans (after reserve requirement is deposited at CB)

Multiplier effect operates!Money multiplier = Money Supply / Monetary BaseShowing the change in money supply as a response to

change in monetary base or high-powered money – related to the reserve requirement ratio

OM purchase => MS↑; OM sale => MS↓

Monetary PolicyRemember: use of money (as a medium of

exchange, store of value and unit of account)Banking system – CB, private banks,

individuals+businesses => money creationTools of monetary policy: open market operations

(sale or purchase of government bonds) Multiplier effect operating through balance sheets

of CB and private/commercial banksSale = MS↓, purchase = MS↑Now focusing on other tools of monetary policy

Tools of Monetary Policy- Reserve requirement ratio: CB may lower the rr

ratio so that more funds are available for commercial banks to give out as fresh loans, thus MS↑

- Discount rate: rate of interest charged on the loans that commercial banks are borrowing from CB from “discount window”. CB may lower discount rate (lowering the cost of borrowing) and commercial banks become more aggresive about making fresh loans, thus MS↑.

Monetary PolicyRemember: WHY MP is used to change the level of

money and credit available in the economy?Case 1: fairly stable inflation rate + healthy banking

system and primal concern is the level of outputConcern about MS is related with interest rates,

availability of credit and the level of output/AD.Expansionary MP => MS↑, lower interest rates,

raise intended investment, AD ↑, output↑Contractionary MP => MS↓, higher interest rates,

lower intended investment, AD ↓, output ↓

Monetary Policy

Suppliers and demanders = comercial banksUpward sloping S, downward sloping D

Quantity of Federal Funds Borrowed and Lent

Fede

ral F

unds

Rat

e

6 %

Supply of Federal Funds

Demand for Federal Funds

E

Monetary Policy

A drop in one large market will tend to carry over to other markets

MS↑ => expands credit and lowers interest rateMS↓ => shrinks credit and raises interest rates

Fede

ral F

unds

Rat

e

6 %

New Supply of Federal Funds

Demand for Federal Funds

E1

E0

5 %

Original Supply of Federal Funds

Quantity of Federal Funds Borrowed and Lent

Monetary Policy and Aggregate DemandExpansionary monetary policy => the use of MP

tools to increase money supply, lower interest rates and stimulate higher level of economic activity

Accomodating monetary policy => especially in cases of recession, loose or expansionary MP is intended to counterbalance the recesionary tendencies in the economy

Contractionary monetary policy => the use of MP tools to limit money supply, raise interest rates and encourage a levelling-off in economic activity

Theory of Money, Prices and Inflation

Now Case 2: main concern is to control inflationQuantity Theory of Money

M x V = P x Ymoney balances = nominal output

V: velocity of money => number of times a coin has to change hands in a year to support the level of output and exchange

V = (P x Y)/ MClassical and monetarist perspectives assume thay

V is constant => MS and nominal GDP are related

Theory of Money, Prices and Inflation

Classical Monetary Theory M x V = P x Y

Two assumptions: V is constant, Y is at FE level.Thus change in MS does not effect the level of

output, but only prices = monetary neutralityNo need for a discretionary MP:

if economy is non-growing, stable MS to keep price levels stableif economy is growing, MS should grow at the same rate with GDP to avoid inflation -> MS rule

Theory of Money, Prices and Inflation

MonetarismFriedman and Schwarz: “Great Depression is

caused by drastic contraction in MS” – macroeconomic objectives are best met when MS grows at a steady rate

“bad monetary policy could have bad effects on the economy”

GD: both MS and the level of nominal GDP fell sharply – contraction in MS causing reductions in real GDP => CBs should follow a simple monetary rule

Theory of Money, Prices and Inflation

Hyperinflation?Suppose: output stagnant or staggering + CB

causing MS grow quickly.Money becomes “hot potato” – people hold it for a

short time as it loses its value! => V ↑M x V = P x Y

M ↑, V ↑, Y constant => inflation!!Monetization of deficit: case when CB buys

government debt as soon as it is issued, thus injects new money into the economy.

Theory of Money, Prices and Inflation

Importing inflation?Inflation could be triggered by international

economic developmentsSuppose: devaluation or depreciation of domestic

currency – more domestic currency is required to purchase foreign currency.

Price of imports ↑, relative prices change, distruptions in production.

Strictly anti-inflationary position: prices of other goods should ↓ => deeper recession

Loose MP: accomodating, prices may ↑ but output ↓