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Macroeconomics slide

  1. 1. FOREIGN TRADE UNIVERSITY Faculty of International Economics Macroeconomics I Hoang Xuan Binh, PhD A PowerPoint™Tutorial to Accompany m a c ro e c o no m ic s , 5th ed. N. Gregory Mankiw
  2. 2. CHAPTER I:Introduction Lecture programme
  3. 3. IntroductionModule title: Macroeconomics ISemester: IYear 2011-2012Level: UndergraduateModule Convenor: Hoang Xuan BinhOffice hours: 15 -17 on MondayRoom: A703- Foreign Trade University(Hanoi Campus)Tel: 844-8345801 ext 506Cellphone: 0912782608
  4. 4. INTRODUCTIONModule Context:The module is designed especially forstudents taking Macroeconomics at FTU. Itis intended to provide students with anunderstanding of important macroeconomicfactors and variables. The course analyseshow macroeconomic variables operate;and itdevelops an understandings of theinternational money and financial market, inor outflows of capital. The course also drawson the debates in real economy and tries touse both old and new theories to understandthem.
  5. 5. IntroductionModule aims and objectives:1.To familiarise the students with some of the mostimportant macroeconomic variables in theeconomy, for example GDP,GNP,CPI,PPI…2.To introduce students to some importantmacroeconomic policies including fiscal andmonetary policies.3.To examine some different cases in term of usingmacroeconomic policies to develop economy.
  6. 6. IntroductionLearning outcomesBy the end of this module it is expected that students:1.will have an understanding of how importantmacroeconomic variables are interacting in theeconomy.2.will be able to interpret such variables and events asGDP,GNP,CPI or inflation,unemployment… and relatethem to changes of other variables and events in theeconomy.3.will be ready to explain significant events in realeconomy by using economic theories.4.will be familiar with current debates on open-economy and able to make a critical assessment of thevarious arguments which are put forward.
  7. 7. Teaching and learning methods:In class contact hours there will be lectures,discussions and assistance with students’assignmentwork,reading and using books. During the seminars thestudents will be expected to discuss the providedtopics on the problems of real economy.Assessment methods:There is a written assignment and final examination.It is worthy 30% and 60% respectively. Classparticipation is 10% .Suggested Supplementary ReadingMankiw, Principles of EconomicsMankiw, Macroeconomics 5th ed ,Sloman J., (2003), Ec o no m ic s , 5th ed
  8. 8. Lecture programmeChapter: Introduction lecture programmeChapter2:The Data of MacroeconomicsChapter3:Aggregate Demand and Fiscal policyChapter4:Money and Monetary policyChapter5:Inflation and unemployment Presentation assignmentChapter6:Economic growthChapter 7: The Open economy Revision
  9. 9. I.Introduction Everyone is concerned about macroeconomicslately. We wonder why some countries are growing fasterthan others and why inflation fluctuates. Why?Because the state of the macroeconomy affectseveryone in many ways. It plays a significantrole in the political sphere while also affectingpublic policy and social well-being.There is much discussion of recessions-- periods in which realGDP falls mildly-- and depressions, concerns with issues suchas inflation, unemployment, monetary and fiscal policies.
  10. 10. Economists use models to understand what goes on in the economy.Here are two important points about models: endogenous variablesand exogenous variables. Endogenous variables are those which themodel tries to explain. Exogenous variables are those variables thatamodel takes as given. In short, endogenous are variables within amodel, and exogenous are the variables outside the model.Price Supply This is the most famous P* economic model. It describes the ubiquitous relationship Demand between buyers and sellers in the market. The point of Q* Quantity intersection is called an equilibrium.
  11. 11. Economists typically assume that the market will go intoan equilibrium of supply and demand, which is calledthe market clearing process. This assumption is centralto the Pho example on the previous slide. But, assumingthat markets clear continuously is not realistic. Formarkets to clear continuously, prices would have toadjust instantly to changes in supply and demand. But,evidence suggests that prices and wages often adjustslowly.So, remember that although market clearing modelsassume that wages and prices are flexible, in actuality,some wages and prices are sticky.
  12. 12. Microeconomics is the study of how households and firms make decisions and how these decision makers interact in the marketplace. In microeconomics, a person chooses tomaximize his or her utility subject to his or her budget constraint. Macroeconomic events arise from the interaction of many people trying to maximize their own welfare. Therefore, when we study macroeconomics, we must consider its microeconomic foundations.
  13. 13. II. Research aims and research methods:1. Aims and objectives of macroeconomicsYield, Economic growth, unemployment,inflation, budget, Balance of Payments,2. Research method- Mathematics, general equilibrium W , alrasmethods (equilibrium in all market…
  14. 14. III. Macroeconomics system1. Inputs + Exogenous variables: weather, politics, population, technology and patents or know-how +Endogenous variables: direct impacts- fiscal policy,monetary policy, external economic policy2. Black box: AS+AD2.1. Aggregate Demand
  15. 15. * Related factors: Price, Income,Expectation…2.2.Aggregate Supply* Related factors: Price,production cost,potential output (Y* ) Y* : maximization of output which economy can produce, with full- employment and no inflation. Full-employm ent=population–outof working age - invalids -(pupils + students) – servant-unwilling to work
  16. 16. 3. Outputs Yield, employment, Average price, Inflation,interest,budget, Trade balance and balance of International payment, Economic Growth
  17. 17. Macroeconomics MacroeconomicsRecession RecessionDepression DepressionModels ModelsMacroeconomic system Macroeconomic systemInputs InputsOutputs OutputsEndogenous variables Endogenous variablesExogenous variables Exogenous variablesMarket clearing Market clearingFlexible and sticky prices Flexible and sticky pricesMicroeconomics Microeconomics
  18. 18. CHAPTER IIData of macroeconomics
  19. 19. I. Gross domestic products-GDPGross Domestic Product (GDP) is themarket value of all final goods andservices produced within an economyin a given period of time.
  20. 20. Income, Expenditure And the Circular FlowThere are 2 ways Total income of everyone in the economy of viewing GDP Total expenditure on the economy’s output of goods and services Income $ Labor Households Firms Goods Expenditure $ For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in this economy.
  21. 21. II.Computing GDP 1.Rules for computing GDP1) To compute the total value of different goods and services,the national income accounts use market prices.Thus, if $0.50 $1.00 GDP = (Price of apples × Quantity of apples) + (Price of oranges × Quantity of oranges) = ($0.50 × 4) + ($1.00 × 3) GDP = $5.002) Used goods are not included in the calculation of GDP.
  22. 22. 3) The treatment of inventories dependson if the goods are stored or if theyspoil. If the goods are stored, theirvalue is included in GDP.If they spoil, GDP remains unchanged.W hen the goods are finally sold out ofinventory, they are considered usedgoods (and are not counted).
  23. 23. 4) Intermediate goods are not counted inGDP– only the value of final goods.Reason: the value of intermediate goods isalready included in the market price.Value added of a firm equals the value ofthe firm’s output less the value of theintermediate goods the firm purchases.5) Some goods are not sold in the marketplaceand therefore don’t have market prices. We mustuse their imputed value as an estimate of theirvalue. For example, home ownership andgovernment services.
  24. 24. The value of final goods and services measured atcurrent prices is called nominal GDP. It can changeover time either because there is a change in theamount (real value) of goods and services or a change inthe prices of those goods and services.Hence, nominal GDP Y = P × y, where P is the pricelevel and y is real output– and remember we use outputand GDP interchangeably.Real GDP or, y = Y÷P is the value of goods and servicesmeasured using a constant set of prices.
  25. 25. Let’s see how real GDP is computed in our apple and orange economy.For example, if we wanted to compare output in 2002 andoutput in 2003, we would obtain base-year prices, such as 2002prices.Real GDP in 2002 would be:(2002 Price of Apples × 2002 Quantity of Apples) +(2002 Price of Oranges × 2002 Quantity of Oranges).Real GDP in 2003 would be:(2002 Price of Apples × 2003 Quantity of Apples) +(2002 Price of Oranges × 2003 Quantity of Oranges).Real GDP in 2004 would be:(2002 Price of Apples × 2004 Quantity of Apples) +(2002 Price of Oranges × 2004 Quantity of Oranges).
  26. 26. GDP Deflator = Nominal GDP Real GDPNominal GDP measures the current dollar value of the outputof the economy.Real GDP measures output valued at constant prices.The GDP deflator, also called the implicit price deflator forGDP, measures the price of output relative to its price in thebase year. It reflects what’s happening to the overall level ofprices in the economy.
  27. 27. In some cases, it is misleading to use base year prices that prevailed 10 or 20 years ago (i.e. computers and college). In 1995, the Bureau of Economic Analysis decided to use chain-weighted measures of real GDP. The base year changes continuously over time. This new chain-weightedAverage prices in 2001 measure is better than the moreand 2002 are used to measure traditional measure because itreal growth from 2001 to 2002. ensures that prices will not beAverage prices in 2002 and 2003 too out of date.are used to measure real growth from2002 to 2003 and so on. These growthrates are united to form a chain that isused to compare output between any twodates.
  28. 28. 3. Methods of computing GDP* Expenditure approach GDP = C + I + G + (X-M)
  29. 29. Y = C + II + G + NX Y = C + + G + NX Total demandTotal demand Investment Investment for domesticfor domestic is composed is composed spending by spending by output (GDP)output (GDP) of of businesses and businesses and households households Net exports Net exports or net foreign or net foreign Consumption Government demand demand Consumption Government spending by spending by purchases of goods purchases of goods households households and services and services This is the called the national income accounts identity.
  30. 30. * The Factor Incomes Approach: it measuresGDP by adding together all the incomes paidby firms to households for the services of thefactors of production they hire. According tothis approach, GDP is the sum of incomes inthe economy during a given period GDP = w + r + i + Π + D +TeW wage, r :rent fixed capital, i: interest, Π :profit, D: Depreciation, Te: indirect tax
  31. 31. 3. The output approach Total Value added = Total Revenues – Total Cost GDP = ∑ Value added in all industries=> GDP = ∑VAT. 1/ Value added taxExample:One firm gains value added is 80, 1000 firms is80,000. 80 = total revenues – total cost(production cost)
  32. 32. II.Gross national products)-GNP1. Definition:GNP is the market value of all final goodsand services produced by domestic residentsin a given period of time.2. Computing methods: GNP = GDP + TnTn: net Income from Abroad
  33. 33. * 3 cases :+ GNP > GDP (Tn>0): domestic economy hasimpacts in other economies.+ GNP < GDP (Tn<0): foreign economies haveimpacts in domestic economy.+ GNP = GDP (Tn=0): no conclusion
  34. 34. 4. Net Economic Welfare -NEW GDP, GNP doesn’t compute some goods and services which aren’t sold, or illegal transactions or activities of black market, negative externality…
  35. 35. V1 + Value of Rest+ Value of goods and services which arent sold+Revenues from transactions in black marketV2-negative externality for naturalresources,environment, such as noise traffic jam…NE reflects welfare better than GNP but it is W mvery difficult to have enough data to com puteNE ,therefore, econom W ists still use GDP andGNP .
  36. 36. NNP= GNP-D ; Y=NI=NNP-Te=GNP-D-Te Yd = NI - (Td-TR) = (C+S)Tn D D-DepreciationC NNP-Net National Te ProductI GNP Td-TRNI-National Income NNP NI Yd-Disposal IncomeG (Y TR (transfer)- Yd ) Td: Direct taxNX
  37. 37. Gross domestic product (GDP) National income accounts Consumer Price Index (CPI) ConsumptionUnemployment Rate Investment Stocks and flows Government Purchases Value added Net Exports Nominal versus real Labor forceGDP GDP deflatorGNPNEW
  38. 38. CHAPTER IIIAggregate Demand & Fiscal policy
  39. 39. Today’s lecture is the first in a series of fourlectures aimed at analysing different (separate)markets in the economy. This will then enable usto bring the various markets together and toanalyse the behaviour of the whole economy (thisis also referred to as general equilibrium analysis).Today we will introduce an analysis of theeconomy as originally described by the economistJohn Maynard Keynes. His theory of how themacroeconomy works will help us explain how theeconomy’s income (GDP) is determined. Today weanalyse the model in its simplest form and we willassume that the economy does not have agovernment and that it does not trade with therest of the world. W will relax these eassumptions.
  40. 40. The Keynesian Theory of Income Determination: the theory that will be presented hereafter was developed by the Cambridge economist John Maynard Keynes in the wake of the 1920s Great Depression. He argued that the cause of a low level of income (GDP) in the economy was given by the lack of AD.John Maynard Keynes (right) and Harry Dexter White at the Bretton Woods
  41. 41. Personal and marital lifeBorn at 6 Harvey Road, Cambridge, John Maynard Keyneswas the son of John Neville Keynes, an economics lecturerat Cambridge University, and Florence Ada Brown, asuccessful author and a social reformist. His youngerbrother Geoffrey Keynes (1887–1982) was a surgeon andbibliophile and his younger sister Margaret (1890–1974)married the Nobel-prize-winning physiologist ArchibaldHill.Keynes was very tall at 1.98 m (6 ft 6 in).In 1918, Keynes met Lydia Lopokova, a well-knownRussian ballerina, and they married in 1925. By mostaccounts, the marriage was a happy one. Before meetingLopokova, Keyness love interests had been men, includinga relationship with the artist Duncan Grant and with thewriter Lytton Strachey. For medical reasons, Keynes andLopokova were unable to have children, though both his
  42. 42. I. Aggregate Planned Expenditure and Aggregate Demand1.Assum ptions: a m odel nearly alwaysstarts with the word ‘assum or ‘suppose’. e’This is an indication that reality is aboutto be sim plified in order to focus on theissue at hand*Prices, Wages and Interest R are ateConstant
  43. 43. * The E conom Operates at less than full yE ploym m ent: this implies that firm are swilling to supply any am ount of the goodat a given price P In other words, .assum that the supply of goods is ecom pletely elastic at price P This.assum ption is generally valid only in theshort run
  44. 44. * Closed E conom and No Governm y ent: weassum that the econom does not trade with e ythe rest of the world so that both exports andim ports are equal to zero (X =0). W also =M eassum that there is no governm e ent in theeconom so that governm y ent expendituresand taxes are equal to zero (G=T=0). Thisim plies that aggregate dem and is thereforereduced to the following expression: AD ≡ C + I
  45. 45. 1. Aggregate Planned ExpenditureAPE reflects the total planned expenditureat each income, with assumption of givenprice.*H ouseholds: Consumption  C =f(Yd): the main determinant ofconsumption is surely income, or morepreciselyC = f1(Y)
  46. 46. -F s: to create the demand through their irminvestment I = f2(Y) APE = C + I = f1(Y) + f2(Y)1.1. Consumption function* The relationship between consumptionexpenditures and disposable income, other thingsremaining the same, is called consumptionfunction. The consumption function that we willuse in our model and that shows the positive linkbetween consumption and disposable income is thefollowing (figure 1): C = f1 (Y ) = + C MPC.Yd
  47. 47. * Determinants of Consumption:+Autonomous Consumption (C): this is theamount of consumption expenditure thatwould take place even if people had nocurrent disposable income+Induced Consumption: this isconsumption expenditure that is in excessof autonomous consumption and that isinduced by an increase in disposableincome
  48. 48. +Marginal Propensity to Consume(MPC): it is the fraction of a change indisposable income that is consumed. Itis calculated as the change inconsumption expenditures (DC) dividedby the change in disposable income(DYd) that brought it about. It gives theeffect of an additional pound ofdisposable income on consumption. TheMPC determines the slope of theconsumption ∆Cfunction MPC = ∆Y
  49. 49. 0 < M C< 1 :This reflects the fact that Ppeople are likely to consume only part ofany increase in income and to save therest* Example. The following is an exampleof a consumption function:C = 20 + 0.7xYdAutonomous Consumption: 20MPC = 0.7
  50. 50. +NetPrivateSavings-S: savings by consumers is equal to their disposableincome minus their consumption=> S = Yd - Cand, by using the definition of disposableincome this identity can be rewritten as:S = Y – T – C (but T = 0, no government)However, given that there is nogovernment in our simple economy, T=0and savings are equal to: S = Y - C1.2.The Saving Function: the economy’ssavings function can be derived by usingthe private savings expression and theconsumption function:
  51. 51. S = Y −CS = Y − C − MPC.Y = −C + (1 − MPC ).YS = −C + MPS .Y+The Marginal Propensity to Save (MPS):the propensity to save tells us how muchpeople save out of an additional unit ofincome. The assumption we made earlierthat MPC is between zero and one impliesthat the propensity to save is given by(1-M C) and that it is also between 0 and P1.The Saving Curve: it traces therelationship between the level of net
  52. 52. 1.3.Investment function (I): the secondexpenditure in APE that we will analysetoday is investment* Determinants of Investment: we can distinguish four major determinants of investment+Increased Consumer Demand: investmentis to provide extra capacity. This will onlybe necessary, therefore, if consumerdemand increases
  53. 53. +Expectations: since investment is made inorder to produce output for the future,investment must depend on firms’expectations about future marketconditions+Cost and Efficiency of CapitalEquipment: if the cost of capitalequipment goes down or machines becomemore efficient, the return on investmentwill increase and firms will invest more
  54. 54. +Interest rate: the higher the rate ofinterest, the more expensive it will be forfirms to borrow the money to financetheir investment expenditures and theless profitable will the investment be
  55. 55. +Level of Investment in the Economy: inthis model we will take investment asgiven or, in other words, we will regard itas an exogenous variable. The mainreason for taking investment as given isto keep our model simple. Thus we willassume that investment is given by afixed/constant amount (a bar over avariables indicates that the variable isregarded as an exogenous variable) thatdoes not change with the level of incomein the economy: I =I
  56. 56. APE = C + I = C + I + MPC .Y* The Determination of EquilibriumOutput: W hen P, w is constant,theequilibrium in the goods marketrequires that the supply of goods(GDP =Y) equals the demand for goods(APE): Y = APE =AD
  57. 57. This equation is called the equilibriumcondition. By replacing the aboveexpression for aggregate plannedexpenditure in the equilibrium conditionwe get: Y = APE Y = + + C I MPC .YAs you can see the above expression is anequation in one endogenous variable: Y.Thus we can solve this equation for Y andthis will give us the equilibrium level ofoutput (Ye)produced in the economy 1 Ye = (C + I ) 1 − MPC
  58. 58. I = 200 * Example 1. Assume that in the economy the level of autonomous consumption c0=100, the marginal propensity to consume is M C=0.5 and the investment P spending is I=200 . Determine the equilibrium level of output produced in the economy.
  59. 59. 2. APE & Ye in closed economy with aGovernment Sector-Firms invest in economyI = I-Government sector expenditure: G +G will increase APE and will shift the APE curve upwards. +Taxation reduces the level of disposable income available for consumption and will tend to reduce APE. Such a reduction in APE is reflected by a downward rotation of the APE curve. W hy?
  60. 60. This is due to the fact that taxation reduces the overall MPC by the household so that for each extra pound of income the household will now consume less since some of the extra income must be paid in taxes 2.1.Fixed taxation T =TAPE = C + I + G = C + I + G + MPC .(Y − T )Y =APEY = +I + + C G MPC .(Y − ) T 1 MPCY0 = (C +I + ) − G T 1−MPC 1− MPC
  61. 61. MPC Multiplier Effect of taxation mt = − 1 − MPC Y0 = m(C + I + G ) + mt T2.2. Taxation depends on incom T = t.Y (t:tax e:rate)C = C + MPC (Y − T ) = C + MPC (1 − t )Y I=I G =G
  62. 62. APE = C + I + G = C + I + G + MPC × (1 − t )Y =>Equilibrium point of economy: Y = APE Y = C + I + G + MPC (1 − t ) ×Y 1 Y0 = (C + I + G ) 1 − MPC (1 − t )
  63. 63. 1m′ = Multiplier of consumption 1 − MPC (1 − t ) in the closed economy with Government sector 1 1 m′ = <m = 1 − MPC (1 − t ) 1 − MPCThis reflects that the income based tax isless efficient than fixed tax.
  64. 64. 3. 2. APE & Ye in open-economy with aGovernment Sector and foreign trade* Assuption: T = t.Y (t- taxrate) Economy has 4 sector * C = C + MPC.(Y-T) = C + MPC.(1-t).Y *I=I *G= G * NX=X-M: netexportX doesn’t depend on domesticincome,therefore X =X
  65. 65. M derives from production inputs, orconsumptions of households=>M increaseswhen I or Ye rises.Ta cã: M = MPM.Y* MPM (Marginal Propensity to Import): itis the fraction of an increase in GDP that isspent on imports. It is calculated as thechange in imports ( ∆ M divided by the )change in GDP ( ∆ Y) that brought it about,other things remaining the same. The M M Pis a positive number smaller than one MPM = ∆ M ∆ Y and 0<M M<1 / P
  66. 66. APE = C + I + G + X − M APE = C + I + G + X + [ MPC (1 − t ) − MPM ] × Y * Equilibrium point of economy: Y = APE Y = C + I + G + X + [ MPC (1 − t ) − MPM ] × Y 1 Y0 = (C + I + G + X ) 1 − MPC (1 − t ) + MPM 1m′′ = open-econom m y ultiplier 1 − MPC (1 − t ) + MPMm” < m’ < m. open-econom m y ultiplier is less efficientthan closed econom m y ultiplier.
  67. 67. The Multiplier Spending Chain∆I = £1 million - Marginal Propensity to Consume: mpc = 0.8 Spending in This Round Cumulative Total ∆I Round N. 1 £1,000,000 (∆G £1,000,000 (∆G1) 2 £ 800,000(∆C2=0.8*∆G) £ 1,800,000 3 £ 640,000(∆C3=0.8*∆C2) £ 2,440,000 4 £ 512,000(∆C4=0.8*∆C3) £ 2,952,000 5 £ 409,600(∆C5=0.8*∆C4) £ 3,361,600 6 £ 327,680(∆C6=0.8*∆C5) £ 3,689,280 7 £ 262,144(∆C7=0.8*∆C6) £ 3,951,424 8 £ 209,715(∆C8=0.8*∆C7) £ 4,161,139 9 £ 167,772(∆C9=0.8*∆C8) £ 4,328,911 10 £ 134218(∆C10=0.8*∆C9) £ 4,463,129 ................... .............................................. ..................................... . 50 £ 18(∆C50=0.8*∆C49) £ 4,999,929
  68. 68. II.Fiscal policy: 1. Fiscal policy: Government use taxation and consumption to regulate aggregate demand.2. Classification of fiscal policy2.1. Expansionary fiscal policy2.2. Contractionary fiscal policy
  69. 69. 3. Fiscal policy and Budget decifit*State Budget: total sum of revenues andconsum ption of Governm in given tim ent e(one year) B= T - G + B = 0: Budget balance + B > 0: Budget surplus + B < 0: Budget deficit
  70. 70. * Classification:- R budget deficit: W eal hen consumption >revenues-Cyclic budget deficit: when econom faces yrecession due to cyclic business.-Structural budget deficit: is calculated interm of assum ptions with potential output.where Btt = Bck + Bcc =>Bcc = Btt - Bck
  71. 71. * Note: fiscal policy can reach followingobjectives:+Budget balance=>Y can fluctuate.. . +Y* => B udget deficit can happen. Whenthere is recession in econom G increase or y,T decrease or both to keep highconsum ption => Y rises to Y* but Budgetdeficit happens.
  72. 72. 4. How to reduce budget deficit -Inreasing revenues and decreasing consumption -Public debt: Government bond -Borrowings from foreign countries or international orgnizations -Printing money or using reserve from foreign currency
  73. 73. CHAPTER IVmoney and monetary policy
  74. 74. I. Money 1. The Meaning and functions of Money a.Definition of Money: money is any commodity or token that is generally acceptable as the means of payment. A means of payment is a method of settling a debt. In general terms money can be defined as the stock of assets that can be readily used to make transactions. Roughly speaking, the coins and banknotes in the hands of the public make up the nation’s stock of money
  75. 75. Stock of assetsMoney Used for transactions A type of wealth Self-sufficiency Without Money Barter economy
  76. 76. b. Development of moneyCattle, iron, gold,silver,diamond ….andbanknote todayBatter => commodity money=> cash,cheque, credit card…2. The Functions of Money: money hasthree main purposes. It is a medium ofexchange, a unit of account and a store ofvalue
  77. 77. 2.1. Medium of Exchange: it is an objectthat is generally accepted in exchange forgoods and services. Money acts as sucha medium 2.2. Unit of Account (A Means of Evaluation): a unit of account is an agreed measure for stating the prices of goods and services. It allows the value of one good to be compared with another 2.3. Store of Value: any commodity or token that can be held and exchanged later for goods and services is called a s to re o f va lue . Money acts as a store of value.
  78. 78. Functions of Money • Store of value • Unit of account • Medium of exchange • International MoneyThe ease with which money is converted into other things--goods and services-- is sometimes called money’s liquidity.
  79. 79. 3.Types of Money* Depend on the Liquidity: M 0= Cash; (W Monetary Base) = ide Cash in circulation with the public and held by banks and building societies +Banks’ balances with the Central M = Bank + Deposit (D: Deposit is unlimited 1 Cash time deposit). Liquidity of M1 is smaller than M0 but it is still good to measure the cash in circulation in economy.M = M + lim 2 1 ited tim deposit: Liquidity of M2 eis very low,therefore,there are somedeveloped economies such as US and UKwhere use to measure the cash in
  80. 80. * Money can be divided into:Fiat Money: money takes differentforms.Money that has no intrinsic value iscalled fiat money because it is establishedas money by government decree, or fiatIn the UK economy we maketransactions with an items whose solefunction is to act as money: pound coinsand banknotes. These pieces of paperwith the portrait of the queen wouldhave little value if they were not widelyaccepted as money.
  81. 81. Commodity Money: although fiat moneyis the norm in most economies today,historically most societies have used formoney a commodity with some intrinsicvalue.Money of this sort is called commoditymoney and the most widespread exampleof commodity money is gold
  82. 82. II. Central Bank and creation money ofcommercial bank1.Banks are the Financial Intermediaries.They are private firms licensed by theCentral Bank under the Banking Act to takedeposits and make loans and operate in theeconomy.Retail Banks: they specialise in providingbranch banking facilities to member of thegeneral public but they do also lend tobusinesses albeit often on a short-termbasis. They are the most important banks inthe UK for the functioning of the economyand for the implementation of monetary
  83. 83. 2. The creation of Money by commercial banks The Creation of Money: banks create money. However this does not mean that they have smoke-filled back rooms in which counterfeiters are busily working. Notice that most money is deposits, not currency. W hat banks create is deposits and they do so by making loans. But the amount of deposits they can create is limited by their reserves
  84. 84. Desired Reserver rateRequired Reserve RateExcessive Reserve Rate
  85. 85. The Deposit Multiplier: this is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits. It is given by the following formula: Change in Deposit Deposit Multiplier = Change in Reserves Alternatively, it can also be defined as: 1 Deposit Multiplier = Desired Reserve Ratioif banks want to keep 10% of their deposits asreserves, so that the desired reserve ratio is 0,10(ra), the deposit multiplier is given by the followingexpression:1/ =10. See example ra
  86. 86. Banking Desired Deposits Lending system reserve (ra) NH 1 1 1.ra (1-ra) NH 2 (1-ra) (1-ra).ra (1-ra)2 NH 3 (1-ra)2 (1-ra)2 .ra (1-ra)3 ... ... ... ... NH (n+1) (1-ra)n (1-ra)n .ra (1-ra)n+1 n+ 1 n+ 1 1 − (1 − ra ) 1 − (1 − ra )D = 1 + (1 − ra ) + (1 − ra ) + ... + (1 − ra ) = 1× 2 n = 1× 1 − (1 − ra ) ra 1− 0 1 1 0 < ra < 1 => = 1× D = 1× = = 10 (tû.®) ra ra 0,1
  87. 87. Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000. Firstbank Secondbank Thirdbank Balance Sheet Balance Sheet Balance Sheet Assets Liabilities Assets Liabilities Assets Liabilities Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640 Loans $800 Loans $640 Loans $512Mathematically, the amount of money the original $1000 deposit creates is:Original Deposit =$1000Firstbank Lending = (1-rr) × $1000 The process of transferring funds The process of transferring fundsSecondbank Lending = (1-rr)2 × $1000 from savers to borrowers is called from savers to borrowers is calledThirdbank Lending = (1-rr)3 × $1000Fourthbank Lending financial intermediation. = (1-rr)4 × $1000 financial intermediation. . . .Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] × $1000 = (1/rr) × $1000 = (1/.2) × $1000 = $5000 Money and Liquidity Creation Money and Liquidity Creation
  88. 88. III. Central Bank and money supply1. Roles of Central Bank * Supervision of Monetary System: the central bank oversees the whole monetary system and ensures that banks and financial institutions operate as stably and as efficiently as possible * Government’s Bank: the central bank is the acts as the government’s agent both as its banker and in carrying out monetary policy
  89. 89. 2. Functions of Central Bank* To Issue Notes: the Central Bank is thesole issuer of banknotes. The amount ofbanknotes issued by Central Bankdepends largely on the demand for notesfrom the general publicF exam or ple, BOE issues banknotes inEngland and W ales (in Scotland andNorthern Ireland retail banks issuebanknotes).
  90. 90. * It Acts as a Bank+To the Government: the governmentdeposits its revenues from taxation in thecentral bank and uses CB in order to borrowmoney from the market+To other Recognised Banks: all bankslicensed by CB hold operational balances inthe CB. These are used for clearing purposesbetween the banks and to provide them witha source of liquidity+To Overseas Central Banks: these aredeposits in sterling held by overseasauthorities as part of their official reservesand/ purposes of intervening in the foreign orexchange market in order to influence theexchange rate of their currency.
  91. 91. * It Manages the Government’s BorrowingProgramme: whenever the governmentruns a budget deficit (it spends more thanwhat it receives in taxes) it will have tofinance that deficit by borrowing. It canborrow by using bonds (gilts), NationalSavings certificates or Treasury bills. TheCB organises this borrowing* It Supervises the Financial System: itadvises banks on good banking practice.It discusses government policy with themand reports back to the government. Itrequires banks to maintain adequateliquidity: this is called prudential control.
  92. 92. * It Provides Liquidity to Banks – Lenderof Last Resort: it ensures that there isalways an adequate supply of liquidity tomeet the legitimate demands ofdepositors in recognised banks* It Operates the Government’s Monetaryand Exchange Rate Policy+Monetary Policy: the CB manipulatesthe interest rate in the economy andinfluence the size of the money supply+Exchange Rate Policy: the CB managesthe country’s gold and foreign currencyreserves
  93. 93. 3. The Supply of Money* Definition of Money Supply: the quantityof money available is called the m oneysupply. In an economy that uses fiat money,such as most economies today, thegovernment controls the supply of money:legal restrictions give the government amonopoly on the printing of money* Monetary Policy: the control over themoney supply is called monetary policy
  94. 94. 4. Implement of money supplya.Measures of Money Supply:Recall that we can denote money supply asthe sum of currency and deposits M = C + D Money Currency Demand DepositsCentral Bank issues H0, (Basic M oney, H ighPowered M oney), H0 < M0. Ho is divided intoU and R
  95. 95. + Sectors keep a part of Ho, denote as U. Ucan’t create other means of payment and itcan be decrease due to damages..in thecirculation. Assuption, U is constant.+ The rest of Ho denote as R (Ho = U +R).The banking system will use R to createmoney as followings:
  96. 96. 1 D= ×R ra Basic Money (H0) U R U D Money supply : MSWhere: H0 = U + R and MS = U + DMS >Ho due to the creation of money fromcommercial banks.
  97. 97. b.The Central Banks Policy Tools: there arethree main tools that the Central Bank canuse to control money supply and implementmonetary policy* Reserve Requirements: these areregulations by the central bank that imposeon banks a minimum reserve-deposit ratio.An increase in reserve requirements raisesthe reserve-deposit ratio and thus lowers themoney multiplier and the money supply
  98. 98. * Discount Rate: it is the interest rate thatthe central bank charges when it makesloans to banks. Banks borrow from thecentral bank when they find themselveswith too few reserves to meet reserverequirements. The lower the discount rate,the cheaper are borrowed reserves and themore banks borrow at the central bank’sdiscount window.=> discount rate decreases =>the monetarybase and the money supply go up.
  99. 99. * Open-Market Operations: they are thepurchases and sales of government bondsby the central bank.W hen the central bank buys (sells) bondsfrom (to) the public, the pounds it pays(receives) for the bonds increase (decrease)the monetary base and thereby increase(decrease) the money supply.The term Open Market refers to commercialbanks and the general CB conducts an openmarket operation, it does a transaction witha bank or some other business but it doesnot transact with the government
  100. 100. Example of US economy?In the United States, monetary policy isconducted in a partially independent institutioncalled the Federal Reserve, or the Fed.
  101. 101. • To expand the Money Supply: re Bond ansituySrptaymilseed tes The Federal Reserve buys U.S. Treasury BondsUS. T f the U ereb incip it ed ro eb er o is e p ay h e T r re st the ue plu rough h pr Th asury ment in tere erms e ear bon d of th st wh t ated the t ich s tly re p ay and pays for them with new money. val ur s th jus c w ill an d in reof. tes rety th e Sta s en ti r any ed nit n it nde e U rers i ault u Th bea def . its l n ot nces a ent wil umst sid rc Pre • To reduce the Money Supply: ci th e of ___ ure ___ nat ___ Sig ___ _ ___ ___ The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them.
  102. 102. The Federal Reserve controls the money supply in three ways. 1) Open Market Operations (buying and selling U.S. Treasury bonds). es d at n d U riyedBroise it asun t y p ipl St m e . Tre the herebprinchichted o 2) ∆ Reserve requirements (never reallyUS w of is the st st a used). er d re s y ar bon t of nte erm pa be i t re e sury ymen he e lyTh ea pa s t gh t h st and Tr re lu ou ju ty e p r ll e th ue th wi tir ny l va urs f. s n te s e er a 3) ∆ Discount rate which member banks c a in reo St n it und e ed th it s i lt Un rer efau t e a Th be t d ces. en ts no a n id i l t es il ums Pr w e (not meeting the reserve requirements) rc th ci of _ re __ tu __ a __ gn __ Si __ __ __ __ pay to borrow from the Fed. __
  103. 103. IV. Money market1. Money Demand: the dem and for m oneyrefers to the desire to hold money: to keep yourwealth in the form of m oney, rather thanspending it on goods and services or using it topurchase financial assets such as bond orshares2.Reasons for Holding Money The Transactions Motive: since money is a medium of exchange it is required for conducting transactions.
  104. 104. The Precautionary Motive: unforeseencircumstances can arise, such as a carbreakdown. Thus individuals often holdsome additional money as a precautionThe Speculative Motive: certain firmsand individuals who wish to purchasefinancial assets such as bonds or sharesmay prefer to wait if they feel that theirprice is likely to fall. In the meantimethey will hold idle money balancesinstead
  105. 105. 3.The Demand for Money Function: therelationship between the demand for moneyand the interest rate is described by thedemand for money function + − M d = (Y , i ) fThis expression simply states that thedemand for money is a function (f) of incomeY and the interest rate I d M = denotes the nominal money demandY = denotes nominal income (GDP) and itcaptures the overall level of transactions inthe economy.
  106. 106. In fact, it is reasonable to assume that theoverall level of transactions is roughlyproportional to nominal income. Thepositive sign above Y denotes that there is apositive relationship between income anddemand for money: the higher the level ofincome (transactions) the higher thedemand for moneyi = is the interest rate and the negative signabove it denotes the negative relationshipbetween the interest rate and the demandfor money. The higher the interest rate, thesm aller the demand for money sinceindividuals prefer to hold their wealth inbonds
  107. 107. d. Determinant of money demand*Level of price:M n (nom D inal M oney Demand com putingbased on researched price (usually higherthan based price)M r (real M D oney Dem and, com puting dependon based price (constant price).   MDn ↑ P↑  →   MDr = MD = const  MDn ↓ P↓  →  MDr =MD =const
  108. 108. * Interest rate (i)i increases (decreases) => MD decreases(increases)* Income (Y)Y increases (decreases) => MD increases(decreases)Money demand function can be written: MD = k.Y–h.i k-income-elasticity of MD h-interest rate –elasticity of MD.
  109. 109. ikY1 hkY0 h MD1 MD0 M 0 kY0
  110. 110. Note:+ i change=>quantity demanded move alongMD, otherthings being equal.+ Y change=>MD shift rightwards orleftwards. Depends on income-elastricity ofmoney demand (k).+ Slope of MD depends on the interest rate –elastricity of money demand (h). kY 1 i= − MD h h
  111. 111. 2. Money supply* The Determinants of Money supply-The level of price: no m ina l M d o e s n’t Sd e p e nd o n P but re a l M d o e s be c a us e : S MS n MS n = m × H 0 MS r = P-Central Bank: i can change but MS maybeconstant If CentralBank doesn’t want tochange MS.
  112. 112. i MSoio Eo MDo0 M
  113. 113. 3. Equilibrium in the Money Market: theequilibrium in the money marketrequires that money supply be equal tomoney demand, that M d s=M M = M = f (Y , i ) This s dequilibrium condition tells us that theinterest rate must be such that peopleare willing to hold and amount of moneyequal to the existing supply. Thisequilibrium relation is also called LMand will be discussed in more detail inthe next lecture
  114. 114. * Note:+ If I # i0 =>imbalance between supplyand demand which puts pressure to pushI up or down to equilibrium point i0.W hen MS, MD changes =>quilibriumpoint (E) changes which leads to changesof i0.
  115. 115. V. Monetary policy:1. Expansionary monetary policy2.Contractionary monetary policy
  116. 116. CHAPTER VIInflation and unemployment
  117. 117. I.unemployment:Unemployment is the number of peopleof working age who are without work,but who are available for work atcurrent wage rates. If the figure is to beexpressed as a percentage, then it is apercentage of the total labour force.
  118. 118. -The labour force is defined as: those inem ploym ent (including the self-employed,those in the arm forces and those on edgovernm ent training schemes) plus thoseunem ployed.-The labour force doesn’t include peoplewho are out of working age, students,pupils, invalids. People who are atworking age but unwilling to work doen’tbelong to labour force
  119. 119. Labour force Labour employment force In unemploymen W orkingPopulat age tion Out of labour force Out
  120. 120. 2. Computing unemployment rate u - Unem ploym R ent ate): to be expressed by fraction of unemployment with the total labour force. It can be expressed by percentage as the formula below: U (Unemployed): L (Labour Force): U u = ×100% L
  121. 121. Unemployment is a problem for theeconomy because:Output and incomes are lost.Human capital depreciates.Crime may increase.Human dignity suffers.
  122. 122. 3. Types and causes of unemployment: Frictional unem ploym ent occurs when people leave their jobs, either voluntarily or because they are sacked or m ade redundant, and are then unem ployed for a period of tim while they are looking for a e new job. They m not get the first job ay they apply for, despite a vacancy existing. The em ployer m ay continue searching, hoping to find a better-qualified person.
  123. 123. Likewise, unem ployed people m choose aynot to take the first job they are offered.Instead, they m ay continue searching,hoping that a better job will turn up. Theproblem is that inform ation is im perfect.E ployers are not fully inform about m edwhat labour is available; workers are notfully inform ed about what jobs areavailable and what they entail. B othem ployers and workers, therefore, have tosearch: em ployers searching for the rightlabour and workers searching for the rightjobs.
  124. 124. Structural Unemployment refers tounemployment arising because there is amismatch of skills and job opportunitieswhen the pattern of demand andproduction changes. Examples in the UKinclude unemployment resulting from adecline in the production of textiles,shipbuilding, cars, coal and steel. Thoseworkers who become structurallyunemployed are available for work but theyhave either the wrong skills for the jobsavailable or they are in the wrong location.
  125. 125. Demand-deficient Unemployment is alsoreferred to Keynesian unemployment.Demand-deficient unemployment occurswhen aggregate demand falls and wagesand prices have not yet adjusted to restorefull employment. Aggregate demand isdeficient because it is lower than full-employment aggregate demand whichimplies that output is less than fullemployment output.
  126. 126. Classical Unemployment describes theunemployment created when the wage isdeliberately maintained above the levelat which the labour market clears. It canbe caused either by the exercise of tradeunion power or by minimum wagelegislation which enforces a wage inexcess of the equilibrium wage rate.
  127. 127. II.Inflation1. Definition Inflation is a rise in the average price of goods over time. The term deflation is used to describe a fall in the average price of goods over time. Deflation is very rare, but when it occurs it can cause serious problems in the economy. The inflation rate is the percentage change in the price level. The formula for the annual inflation rate is:
  128. 128. 2. Computing inflationGp:price growth rate Pt − Pt −1 gp = × 100% Pt −1t-tim eP : at previous tim t-1 eP: : at current tim (research time) t eP is to be expressed as follows: P Q1 + P2 Q2 +... + Pn QnP= 1 Q1 +Q2 +... +Qn
  129. 129. Actually, P is difficult to compute, we cancompute inflation as below: k ∑i P t Qi0 CPI = i =1 k ∑i P 0Qi0 i =1W here CPI is the consumer price index and tis time. The consumer price index measureshow much more a basket of goods thatrepresents goods purchased by the averagehouseholder costs today compared with someprevious time period.
  130. 130. Name CPI (I 2005/2004) % A 1,2 30% B 1,4 25% C 0,9 15% E 1,5 30%CPI2005=1,2x30%+1,4x25%+0,9x15%+1,5x30%=1,295 CPI t − CPI t −1 CPIt-1:gp = × 100% CPI t −1 CPIt:Note: CP doesnt reflect changes in quality of Igoods and services or of new goods and services.
  131. 131. + GDP (D: Deflator) n GDP ∑i P t Qit D= n ×100% = i= n 1 ×100% GDPr ∑i P 0Qit i=1D-GDP reflects changes in prices of totalfianl goods and services compare with basedprice,therefore, this describes inflation rate. Dt − Dt −1 gp = × 100% Dt −1
  132. 132. W hy is inflation a problem?: W heninflation is present in the economy,money is losing its value. The higher theinflation rate, the higher is the rate atwhich money is losing value and this factis the source of the inflation problem.Inflation is said to be good for borrowersand bad for lenders, and so inflation cancause inequalities in the economy. Peopleon fixed incomes (e.g. pensioners andstudents) tend to suffer most frominflation.
  133. 133. 2. Types of inflation*M oderate Inflation: inflation rate < 10%/ m n¨ ,prices increases slowly..M oderate inflation can spur productionbecause price increases leading to highetprofit for enterprises,therefore, firm will sincreases quantity.* Galloping Inflation: inflation rate is from 10%to 99% per year. This type will destroyeconom and curb engines of econom y y.
  134. 134. *Hyper Inflation: is defined as inflationthat exceeds 100% percent per year.Costs such as shoe-leather and menu costsare much worse with hyperinflation– andtax systems are grossly distorted.Eventually, when costs become too greatwith hyperinflation, the money loses itsrole as store of value, unit of account andmedium of exchange. Bartering or usingcommodity money becomes prevalent.In 1920s (1922-12/ 1923) W eimarGermany, CPI increased from 1 to 10millions
  135. 135. * Expected inflation: depends on expectationof individuals about gp in the future. Itsim pacts is sm but help to adjust production allcost.+Unexpected inflation: derives fromexogenous shocks and unexpected factorsinside economy.
  136. 136. The inconvenience of reducing moneyholding is metaphorically called theshoe-leather cost of inflation, becausewalking to the bank more often inducesone’s shoes to wear out more quickly.When changes in inflation require printingand distributing new pricing information,then, these costs are called menu costs.Another cost is related to tax laws. Oftentax laws do not take into considerationinflationary effects on income.
  137. 137. Unanticipated inflation is unfavorable because it arbitrarilyredistributes wealth among individuals.For example, it hurts individuals on fixed pensions. Often thesecontracts were not created in real terms by being indexed to aparticular measure of the price level.There is a benefit of inflation– many economists say that someinflation may make labor markets work better. They say it“greases the wheels” of labor markets.
  138. 138. 3. Causes of inflation•Dem and-pull inflation is Pcaused by continuing rises in ASAD in the econom y. Theincrease in AD m be caused ayby either increases in them oney supply or increases in P1G-expenditure when the AD1econom is close to full y P0em ploym ent. In general,dem and-pull inflation is AD0typically associated with a Y*boom econom ing y. 0 Y
  139. 139. * Cost-push inflation is associated withcontinuing rises in costs. Rises in costs mayoriginate from a number of different sourcessuch as wage increases and other highercosts of production (e.g. raw materials). P AS1 AS0 P1 P0 AD 0 Y Y1 Y0 Y*
  140. 140. * Structural (demand-shift) inflation ariseswhen the pattern of demand (or supply)changes in the economy which results I nsome industries experiencing increaseddemand whilst others experience decreaseddemand. If prices and wage rates areinflexible downwards in the contractingindustries, and prices and wage rates risein the expanding industries, the overallprice and wage level will rise. The problemwill be made worse, the less elastic issupply to these shifts.
  141. 141. * Expectations are crucial determinants ofinflation. W orkers and firms take accountof the expected rate of inflation whenmaking decisions. Generally, the higher theexpected rate of inflation, the higher will bethe level of pay settlements and price rises,and hence the higher will be the resultingactual rate of inflation.* Inflation and Money: equilibrium point ofmoney market MS n = MS r = MDr = kY − hi P
  142. 142. In other words, if Y is fixed (from Chapter 3) because it depends on the growth in the factors of production and on technological progress, and we just made the assumption that velocity is constant, MV = PY or in percentage change form:% Change in M + % Change in V = % Change in P + % Change in Y% Change in M + % Change in V = % Change in P + % Change in Y if V is fixed and Y is fixed, then it reveals that % Change in M is what induces % Changes in P. The quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the inflation rate. If the central bank keeps the money supply stable,the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.
  143. 143. The revenue raised through the printing of money is called The revenue raised through the printing of money is called seigniorage. When the government prints money to finance seigniorage. When the government prints money to finance expenditure, it increases the money supply. The increase in expenditure, it increases the money supply. The increase inthe money supply, in turn, causes inflation. Printing money to the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax. raise revenue is like imposing an inflation tax.
  144. 144. * Inflation and interest rateEconomists call the interest rate that thebank pays the nom inal interest rate and theincrease in your purchasing power the realinterest rate. r=i–πThis shows the relationship between thenominal interest rate and the rate ofinflation, where r is real interest rate, i is thenominal interest rate and p is the rate ofinflation, and remember that p is simply thepercentage change of the price level P.
  145. 145. The Fisher Equation illuminates the distinction betweenthe real and nominal rate of interest.Fisher Equation: i = r + π The one-to-one relationship between the inflation rate and the nominal interest rate is the Fisher Effect. Actual (Market) Nominal rate of Real rate Inflation interest of interest It shows that the nominal interest can change for two reasons: because the real interest rate changes or because the inflation rate changes.
  146. 146. +gp is high=>i is up to keep equality of r.+Economy has high i lead to high gp or i canexplains gp of economy.+If real gp > expected gp => borrowers getadvantages+If real gp < expected gp => lenders getadvantages
  147. 147. 4.Policies to deal with inflation:4.1.Fiscal policy comprises changes ingovernment expenditure and/ taxation. orThe aim is to affect the level of ADthrough a policy known as demandmanagement. In the case of controllinginflation, this involves reducinggovernment expenditure and/ increasing ortaxation in what is called a deflationaryfiscal policy. Such policies are likely to beeffective if inflation has been diagnosedas dem and-pull since a reduction ingovernm ent expenditure or an increase inincom tax will reduce aggregate dem e and in
  148. 148. 4.2.Monetary policy is concerned withinfluencing the money supply and theinterest rate. In terms of controllinginflation, the government can aim toreduce the money supply thus reducingspending and, therefore, the aggregatedemand, or it can increase the interestrate so as to increase the cost ofborrowing. Both policies can be seen asdeflationary monetary policy. Sincemonetarists view the growth of the moneysupply as being the main cause ofinflation, any control of inflation from amonetarist viewpoint must involve controlof the money supply.
  149. 149. 4.3.Prices and incomes policy aim to limitand, in certain cases, freeze wage and priceincreases. In the past they have either beenstatutory or voluntary. Statutory prices andincomes policies have to be enforced bygovernment legislation, such as the EUminimum wage legislation. W a voluntary ithprices and incomes policy the governmentaims to control prices and incomes throughvoluntary restraint, possibly by obtainingthe support of the unions and employers.
  150. 150. 4.4. Supply-side policy is concerned withinstituting measures aimed at shifting theaggregate supply curve to the right. Supply-side economics is the use of microeconomicincentives to alter the level of fullemployment and the level of potentialoutput in the economy. If inflation is causedby cost-push pressures, supply-side policycan help to reduce these cost pressures intwo ways:
  151. 151. (1) by reducing the power of trade unionsand/ or firms (e.g. by anti-monopolylegislation) and thereby encouraging morecompetition in the supply of labour and/ orgoods, (2) by encouraging increases inproductivity through the retraining oflabour, or by investment grants to firms, orby tax incentives, etc.
  152. 152. 4.5.Learning to live with inflation involvesaccepting the fact that inflation is here tostay when standard anti –inflationarypolicy measures appear ineffective. Insuch a situation we just have to learn tolive with inflation. Learning to live withinflation involves the government,employers and workers taking inflationinto account in their everydaytransactions. For example, thegovernment/ employers may useindexation in wage/ pensions contracts.Indexation is when wages or pensions areincreased in line with the current rate ofinflation. Indexation is aimed at nullifyingthe effects of inflation.
  153. 153. CHAPTER VIEconomic growth
  154. 154. I. DefinitionAn increase on potential output Economic growth or developments?
  155. 155. II.Computing of economic growth* Computed by % changes in real GDP Yt − Yt −1 gt = × 100% Yt −1+gt: according to real GDP* gpct : by GDP per capita ( Ýn casepopulation increases faster than GDP) y t − y t −1 g pct = ×100% y t −1
  156. 156. II. Sources of economic growth1.Human capital2. Capital accumulation3. Natural resource4.Technological knowledge
  157. 157. III.Theories of economic growth:1. Classical theory of Adam Smith vµ MalthusLand plays an important role foreconomic growth.+Adam Smith: gold age+Malthus: dull age
  158. 158. 2. Economic growth theory of Keynes I increases => outputs and income increase=> capital .acc is up=> G should invest to push AD, lead to ecnomic growth. ICOR (Incremental Capital-Output Ratio ) ∆K I ICOR = ICOR = ∆Y ∆Y ∆Y swhere S=I = Y ICOR
  159. 159. Harrod- Domar model: explains the role ofcapital accumulation for economic growth. s S (s = ) g= Y ICOR* If ICOR is constant, g increases at the rateof savings rate.* Debates: +ICOR is not constant +Model ignores technology andhuman resources
  160. 160. 3. Neo-classical economic growth theorySolow model or Solow-Swan Model3.1. Introduction: paper of economicgrowth were issued in 2/1956 and 11-1956 of two economists are Solow andSwan* W it is neo-classical theory: use the hyrole of market and government
  161. 161. The Solow Growth Model is designed to show howgrowth in the capital stock, growth in the labor force,and advances in technology interact in an economy,and how they affect a nation’s total output ofgoods and services.Let’s now examine how themodel treats the accumulationof capital.
  162. 162. Let’s analyze the supply and demand for goods, and see how much output is produced at any given time and how this output is allocated among alternative uses. The Production Function The Production Function The production function represents the transformation of inputs (labor (L), capital (K), production technology) into outputs (final goods and services for a certain time period). The algebraic representation is: zY = F (zK ,zL ) Income is some function of our given inputsKey Assumption: The Production Function has constant returns to scale.
  163. 163. This assumption lets us analyze all quantities relative to the size ofthe labor force. Set z = 1/L. Y/ L = F ( K / L , 1 ) Output is some function of the amount of Per worker capital per workerConstant returns to scale imply that the size of the economy asmeasured by the number of workers does not affect the relationshipbetween output per worker and capital per worker. So, from now on,let’s denote all quantities in per worker terms in lower case letters.Here is our production function: y = f ( k ) , where f(k)=F(k,1).
  164. 164. This assumption lets us analyze all quantities relative to the size ofthe labor force. Set z = 1/L. Y/ L = F ( K / L , 1 ) Output is some function of the amount of Per worker capital per workerConstant returns to scale imply that the size of the economy asmeasured by the number of workers does not affect the relationshipbetween output per worker and capital per worker. So, from now on,let’s denote all quantities in per worker terms in lower case letters.Here is our production function: y = f ( k ) , where f(k)=F(k,1).
  165. 165. MPK = f (k + 1) – f (k) The production function showsy how the amount of capital per worker k determines the amount f(k) of output per worker y=f(k). MPK The slope of the production function 1 is the marginal product of capital: if k increases by 1 unit, y increases by MPK units. k
  166. 166. 1) y = c + ii y=c+ 2) c = (1- )y c = (1-ss)y consumption Output per worker investment per worker per workerconsumption depends on savings per worker rate 3) y = (1-ss)y + ii y = (1- )y + (between 0 and 1) Investment = savings. The rate of saving s 4) ii = ssy = y is the fraction of output devoted to investment.
  167. 167. Here are two forces that influence the capital stock: • Investment: expenditure on plant and equipment. • Depreciation: wearing out of old capital; causes capital stock to fall.Recall investment per worker i = s y.Let’s substitute the production function for y, we can express investmentper worker as a function of the capital stock per worker: i = s f(k)This equation relates the existing stock of capital k to the accumulationof new capital i.
  168. 168. The saving rate s determines the allocation of output betweenconsumption and investment. For any level of k, output is f(k),investment is s f(k), and consumption is f(k) – sf(k). y Output, f (k) c (per worker) Investment, s f(k) y (per worker) i (per worker) k
  169. 169. Impact of investment and depreciation on the capital stock: ∆k = i –δk Change in Capital Stock Investment Depreciation Remember investment equals δk δk savings so, it can be written: ∆k = s f(k)– δk Depreciation is therefore proportional to the capital stock. k
  170. 170. Investmentand Depreciation Depreciation, δ k At k*, investment equals depreciation and capital will not change over time. Below k*, investment exceeds Investment, s f(k) depreciation,i* = δk* so the capital stock grows. Above k*, depreciation exceeds investment, so the capital stock shrinks. k1 k* k2 Capital per worker, k
  171. 171. The Solow Model shows that if the saving rate is high, the economy will have a large capital stock and high level of output. If the saving Investment and rate is low, the economy will have a small capital stock and aDepreciation low level of output. Depreciation, δ k Investment, s 2f(k) Investment, s 1 f(k) i* = δk* An increase in An increase in the saving rate the saving rate causes the capital causes the capital stock to grow to stock to grow to aanew steady state. new steady state. k 1* k 2* Capital per worker, k
  172. 172. c*= f (k*) - δ k*.According to this equation, steady-state consumption is what’s leftof steady-state output after paying for steady-state depreciation. Itfurther shows that an increase in steady-state capital has two opposingeffects on steady-state consumption. On the one hand, more capitalmeans more output. On the other hand, more capital also means that moreoutput must be used to replace capital that is wearing out. The economy’s output is used for consumption or investment. In the steady state, investment equals depreciation.δk δk Therefore, steady-state consumption is the Output, f(k)difference between output f (k*) and depreciation δ k*. Steady-state consumption c *gold is maximized at the Golden Rule steady state. The Golden Rule capital stock is k*gold k denoted k*gold, and the Golden Rule consumption is c*gold.
  173. 173. 3.2. Conclusions of Solow model+The role of savings for economicsgrowth+Capital accumulation is good for short-run economic growth+Techonology is the determinant oflong-run economic growth
  174. 174. 4. Policies for economic growth4.1. Increasing domestic savings andinvestment4.2. Attracting FDI4.3. Improving human resources4.4. R&D of new techonology
  175. 175. 4.5. Stability of politics and economy4.6. The open-door policy4.7. Curbing growth of population
  176. 176. CHAPTER IVThe Open Economy
  177. 177. Y = C + I + G + NX Total demand Investment is composed spending by Net exports for domestic of businesses and or net foreign output households demand Consumption Government spending by purchases of goods households and servicesNotice we’ve added net exports, NX, defined as EX-IM. Also, note thatdomestic spending on all goods and services is the sum of domesticspending on domestics goods and services and on foreign goods andservices.
  178. 178. Y = C + I + G + NXAfter some manipulation, the national income accounts identity can bere-written as: NX = Y - (C + I + G) Domestic Spending Domestic Spending Net Exports Net Exports Output OutputThis equation shows that in an open economy, domestic spending neednot equal the output of goods and services. If output exceeds domesticspending, we export the difference: net exports are positive. If outputfalls short of domestic spending, we import the difference: net exportsare negative.
  179. 179. Start with the national income accounts identity. Y=C+I+G+NX.Subtract C and G from both sides and obtain Y-C-G = I+NX. Let’s call this S, national saving.So, now we have S=I+NX. Subtract I from both sides to obtain the newequation, S-I=NX.This form of the national income accounts identity shows that aneconomy’s net exports must always equal the difference between itssaving and its investment. S-I=NX Trade Balance Net Foreign Investment
  180. 180. Net Capital Outflow = Trade S-I=NX BalanceIf S-I and NX are positive, we have a trade surplus. We would be netlenders in world financial markets, and we are exporting moregoods than we are importing.If S-I and NX are negative, we have a trade deficit. We would be netborrowers in world financial markets, and we are importing moregoods than we are exporting.If S-I and NX are exactly zero, we have balanced trade since the valueof imports equals the value of exports.
  181. 181. We are now going to develop a model of the international flows of capital and goods. Then, we’lladdress issues such as how the trade balance responds to changes in policy.
  182. 182. Recall that the trade balance equals the net capital outflow, whichin turn equals saving minus investment, our model focuses on savingand investment. We’ll borrow a part of the model from Chapter 3, butwon’t assume that the real interest rate equilibrates saving andinvestment. Instead, we’ll allow the economy to run a trade deficitand borrow from other countries, or to run a trade surplus and lendto other countries.Consider a small open economy with perfect capital mobility inwhich it takes the world interest rate r* as given, denoted r = r*.Remember in a closed economy, what determines the interest rate is theequilibrium of domestic saving and investment--and in a way, the worldis like a closed economy-- therefore the equilibrium of world saving andworld investment determines the world interest rate.
  183. 183. Y = Y = F(K,L) The economy’s output Y is fixed by the factors of production and the production function. C = C (Y-T) Consumption is positively related to disposable income (Y-T). I = I (r) Investment is negatively related to the real interest rate. NX = (Y-C-G) - I The national income accounts identity, or NX = S - I expressed in terms of saving and investment.Now substitute our three assumptions from Chapter 3 and the conditionthat the interest rate equals the world interest rate, r*. NX = (Y-C(Y-T) - G) - I (r*) NX = S - I (r*)This equation suggests that the trade balance is determined by thedifference between saving and investment at the world interest rate.
  184. 184. Real interest S In a closed economy, r adjusts to rate, r* equilibrate saving and investment. NX In a small open economy, the r* interest rate is set by world financial markets. The difference between saving and investment rclosed determines the trade balance. r* I(r) NX Investment, Saving, I, SIn this case, since r* is above rclosed and saving exceeds investment,there is a trade surplus.If the world interest rate decreased to r* , I would exceed S andthere would be a trade deficit.
  185. 185. An increase in government purchases or a cut in taxes decreasesnational saving and thus shifts the national saving schedule to the left.Realinterest S S NX = (Y-C(Y-T) - G) - I (r*)rate, r* NX = S - I (r*) The result is a reduction in national saving which leads to a trade deficit, r* where I > S. NX I(r) Investment, Saving, I, S
  186. 186. A fiscal expansion in a foreign economy large enough to influence world saving and investment raises the world interest rate from r1* to r2*.Realinterest Srate, r* The higher world interest rate reduces investment in this small open economy, causing a trade surplus r2* where S > I. r1 * NX I(r) Investment, Saving, I, S
  187. 187. An outward shift in the investment schedule from I(r)1 to I(r)2 increasesthe amount of investment at the world interest rate r*. As a result, investment nowReal exceeds saving I > S, whichinterest S means the economy israte, r* borrowing from abroad and running a trade deficit. r1 * I(r)2 NX I(r)1 Investment, Saving, I, S
  188. 188. In the next few slides, we’ll learn about the foreign exchange market, exchange rates and much more!
  189. 189. Let’s think about when the US and Japan engage in trade. Each countryhas different cultures, languages, and currencies, all of which couldhinder trade. But, because of the foreign exchange market, tradetransactions become more efficient. The foreign exchange market is aglobal market in which banks are connected through high-techtelecommunications systems in order to purchase currencies for theircustomers.The next slide is a graphical representation of the flow of the tradebetween the U.S. and Japan, and how the mix of traded things might bedifferent, but is always balanced. Also, notice how the foreign exchangemarket will play the middle-man in these transactions. For instance, theforeign exchange market converts the supply of dollars from the U.S.into the demand for yen, and conversely, the supply of yen into thedemand for dollars.
  190. 190. In order for the U.S to pay for its imports of goods and services and securities from Japan, it must supply dollars which are then converted into yen by the VICES foreign & SER & Securities OOD S exchange G market. DemandYEN Supply$ Foreign Foreign Exchange Exchange Market Market SupplyYEN Demand$ Goods and Services S & SECURITIEIn order for Japan to pay for its imports ofgoods and services and securities from theU.S., it must supply yen which are then convertedinto dollars by the foreign exchange market.
  191. 191. The exchange rate between two countries is the price at which residents of those countries trade with each other.
  192. 192. -relative price of the currency of two countries -denoted as e-relative price of the goods of two countries-sometimes called the terms of trade-denoted as ε
  193. 193. The nominal exchange rate is the relative price of the currency oftwo countries. For example, if the exchange rate between the U.S.dollar and the Japanese yen is 120 yen per dollar, then you canexchange 1 dollar for 120 yen in world markets for foreign currency.A Japanese who wants to obtain dollars would pay 120 yen for eachdollar he bought. An American who wants to obtain yen would get120 yen for each dollar he paid. When people refer to “the exchangerate” between two countries, they usually mean the nominal exchangerate.
  194. 194. Suppose that there is an increase in the demand for U.S. goods andservices. How will this affect the nominal exchange rate? e S$ D$ shifts rightward and increases the nominal exchange rate, e. e1 This is known as appreciation B A of the dollar. e0 Events which decrease the demand for the dollar, and thus D ′ decrease e would be a $ D$ depreciation of the dollar. $ Dollar Value of Transactions
  195. 195. εThe real exchange rate is the relative price of the goods of twocountries. That is, the real exchange rate tells us the rate at which wecan trade the goods of one country for the goods of another.To see the difference between the real and nominal exchange rates,consider a single good produced in many countries: cars. Suppose anAmerican car costs $10,000 and a similar Japanese car costs 2,400,000yen. To compare the prices of the two cars, we must convert them intoa common currency. If a dollar is worth 120 yen, then the Americancar costs 1,200,000 yen. Comparing the price of the American car(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), weconclude that the American car costs one-half of what the Japanesecar costs. In other words, at current prices, we can exchange 2American cars for 1 Japanese car.
  196. 196. εWe can summarize our calculation as follows:Real Exchange Rate = (120 yen/dollar) × (10,000 dollars/American car) (2,400,000 yen/Japanese Car) = 0.5 Japanese Car American CarAt these prices, and this exchange rate, we obtain one-half of a Japanesecar per American car. More generally, we can write this calculation asReal Exchange Rate = Nominal Exchange Rate × Price of Domestic Good Price of Foreign GoodThe rate at which we exchange foreign and domestic goods depends onthe prices of the goods in the local currencies and on the rate at whichthe currencies are exchanged.
  197. 197. NominalReal Exchange Exchange Ratio of Price Rate Rate Levels ε = e × (P/P*)Note: P is the price level of the domestic country (measuredin the domestic currency) and P* is the price level of theforeign country (measured in the foreign currency).
  198. 198. Real Exchange Nominal Exchange Ratio of Price Rate Rate Levels ε = e × (P/P*)The real exchange rate between two countries is computed from thenominal exchange rate and the price levels in the two countries. If thereal exchange rate is high, foreign goods are relatively cheap, anddomestic goods are relatively expensive. If the real exchange rate islow, foreign goods are relatively expensive, and domestic goodsare relatively cheap.

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