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Introduction to Macroeconomics

A presentation of key concepts of macroeconomics directed to an undergraduate audience

Stefano Visintin

on 20 May 2013

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Transcript of Introduction to Macroeconomics

Macroeconomics National Account and Circular Flow Growth and Potential Growth Employment and Unemployment Inflation Money and monetary policy Fiscal Policy The Open Economy Economic Crisis The object of study is the entire economy It (aims to) explain the economic changes that affect households, firms and markets simultaneously Why It helps understanding the world It helps understanding how the world affects our dayly life It helps understanding our policymakers Objectvives Explain the economic changes that affect people Help in shaping the way toward stable growth avoiding fluctuations and inequalities History 1850 Classics Adam Smith David Ricardo Karl Marx 1900 Arthur Pigou 1930 Sir. John Maynard Keynes The birth of Macroeconomics 1945 Paul Samuelson 1970 Robert Solow Neoclassicals 1980 Monetarism 1990 Milton Friedman Rational expectations Robert Lucas Edward Prescott Business Cycles Thomas Sargent today ?? the Human Factor? George Ackerlof Why is average income high in some countries and low in others?
Why do prices rise rapidly in some time periods while they are more stable in others?
Why do production and employment expand in some years and contract in others? Introduction In order to understand whether an economy is doing well or poorly we must be able to count its present and future capacity of producing goods and services
We need figures and models Gross Domestic Product Circular Flow Introduction Probably the most relevant argument of all macroeconomic discipline
Growth = well being
Why are there rich and poor countries?
How can a country's economy grow?
What is the difference between short and long run? so far Introduction Very hot topic, especially in these days
Why are we concerned with unemployment?
What are the causes of unemployment?
How can it be reduced? Introduction The rise of the general level of prices in an economy over a period of time
Why should we worry?
What is the magnitude of this phenomenon?
How does it work?
Who’s in charge of controlling inflation? How? the financial system Introduction What is money? Why do we use money?
Who creates money?

What is the monetary policy?
How does it work? Introduction This is not about what you can do for your country, but about what your country can do for (the economy and therefore for ) you

The most capable policy instrument
Short vs Long run policies
Does it work?
Why should we worry in these days? Introduction We live in a globalised word
and economy is the lead of globalisation

Balance of payments

Exchange rates 1776 Introduction Today's hot topic in

Is it possible to prevent crisis?
Is it possible to forsee crisis?
What are the possible cures?

The present economic situation GDP - Definition The GROSS DOMESTIC PRODUCT is
the market value of all

final goods and services

produced in a given period of time

within a country we compare apples and oranges
just by considering their market prices GDP aims at being comprehensive so it accounts for all items produced and sold in markets
nevertheless there are some limitations (see later) It includes only the values of final goods!
since intermediate products value is included in the prices of the final product don't forget that almos 80% of our economy is made up by intangible products (services) such as transportation, retail, telecomunication or heath provision GDP refers to given period of times, years or quarters production that took place within national boundaries (regadless of the nationality of the producer) The circular flow 3 perspectives:

if the flow is measured
at the Firms = GDP
at the Market for Goods and services = Aggregate Demand
at the Households = Income

GDP=Aggregate Demand = National Income Aggregate Demand Y
Y = C + I + G + X - M

National Income = C + S + T -Tr

I = S + ( T - G -Tr ) + ( M - X ) Private investment Private savings Public savings Foreign savings Nominal vs Real GDP Nominal GDP =
items produced * prices (every year) Real GDP =
items produced * prices (reference year) Copyright © 2004 South-Western GDP - Shortcomings 1 - Accounting
Estimations, prices, new products, ... 2 - Scope
It does not take into account non-market production 3 - Sustainability
It's the measure of the income, but it does not take into consideration the capital "Too much and too long, we seem to have surrendered community excellence and community values in the mere accumulation of material things. Our gross national product ... if we should judge America by that - counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for those who break them. It counts the destruction of our redwoods and the loss of our natural wonder in chaotic sprawl. It counts napalm and the cost of a nuclear warhead, and armored cars for police who fight riots in our streets. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.
"Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans."
Robert Kennedy how was it produced? how was it producedconsumed? how was it paid? Practical session GAPMINDER
Today's world - population

Income and Life expectancy 200y of history NATIONAL ACCOUNT
All the rules and techniques implemented in order to produce a STATISTICAL PICTURE of the economy http://www.bit.ly/cfCgzu http://www.bit.ly/aL3obw Who grew faster?

Who experimented the highest inflation?

Where is external trade more relevant? The consecuences for human welfare in [economic growth] are simply staggering: once one starts to think about them, it is hard to think about anything else"
Robert Lucas www.bit.ly/TEb4Mq http://www.bit.ly/aeWMrb Growth and potential growth Spanish GDP 1850 - 2003
1995 constant pesetas GDP Grows
growth is not constant over time
PATTERNS appear over long periods (e.g. 1850-1935; 1960-1990)
there are FLUCTUATIONS around the pattern during these periods these patterns correspond to the POTENTIAL GROWTH of the economy
they change slowly over LONG periods of time
their level is influenced by the potentiality of the economy (to produce goods and services)
potential growth is therefore the growth experimented over the LONG TERM FLUCTUATIONS around the potential growth are called BUSINESS CYCLES
fluctuations are irregular and unpredictable
normally all macro quantities fluctuate together
business cycles are therefore the growth experimented over the SHORT TERM Spanish GDP growth rate
annual 1970-2011 (quarterly data) The LONG RUN What are the determinant of potential (long run) growth?


Factors affecting productivity
TECHNOLOGICAL KNOWLEDGE http://www.bit.ly/XAmwRA the quantity of goods and services that a worker can produce for each hour of work What can we do to foster potential growth?


STRUCTURAL CHANGES also called Long Term policies The SHORT RUN What are the determinant of BUSINESS CYCLES?

Difficult to identify factors producing fluctuations in the short run
They occur mainly because of lack of synchronicity between demand and supply
Consumption, savings, investments and production do not adjust to each others simultaneously
The economy is hardly in equilibrium over a stable path
Growth leads to more growth – Decreases lead to more decreases What can BE DONE to foster stabilise growth?


MONETARY POLICY also called Short Term policies Potential growth inflation and unemployment Potential growth When the economy grows faster than its potential growth it heats = inflation When the economy grows slower than its potential growth rate there is abundance of productive factos = unemployment Unemployment: definition Some words about the present situation Spain, September 2010 unemployed is a person not currently working and currently looking for a job Unemployment rate = unemployed labour force Unemployment costs To the society
not produced GDP
unemployment insurances
lower levels of consumption
loss of social development
loss of social cohesion To the person
not perceived salary
lost opportunity for personal development
loss of social relations Reasons behind Unemployment Salaries Employment S D Classical vision

it's all about salaries:
in A salaries are at market prices (S) and supply of labour = demand of labour => no unemployment
if for any reasons salaries are above market prices supply of labour > demand of labour => unemployment A S Why should salaries be above their market clearing level?
minimum wages, unions

theory of efficiency wages: higher salaries correspond to
lower levels of turnover
higher workers' efforts
higher workers quality According to this vision, during the Great Depression salaries were cut in order to face unemployment. Wages cuts leaded toward lower consumptions levels and therefore toward less production and increase in unemployment Keynesian vision

it's all about the aggregate demand:
the problem is a lack of demand
policies increasing the aggregate demand need to be implementes ATTENTION Different kinds of Unemployment Frictional unemployment the economy is always changing
people change job, city, sector, consumption habits

no policy actions NAIRU non accelerating inflation rate of unemployment
also called structural unemployment

long term (supply) policies Cyclical keynesian unemployment, depending on the business cycles

short term (demand) policies Inflation A raise in the level of prices
A raise in the general level of prices of goods and services in an economy over a period of time reflecting an erosion in the purchasing power of money The speed at which this raise takes place Inflation rate How do we measure it? CPI Consumer Price Index 1 - a sample of goods and services purchased by final consumers is chosen and weighted (the Basket) Spanish basket composition 2007-2010 2 - prices for each good and services are computed 3 -the whole basket cost is calculated for a base year (and the value of 100 is given to that reference year) 4- the relation between the cost of the basket in each year and the cost of it in the reference year represent the rate of inflation Other indexes are used in order to measure the price level evolution
GDP deflator
PPI Producer Price Indexes Why do we fear inflation? Moderate inflation 0 - 2 %. Not a big deal Inflationary Cycle a mechanism that can turn moderate inflation into
Hiperinflation Hiperinflation monthly rate > 50% (12.900 % annual rate)
an economic tragedy no one wants money
(market) economy PARALISIS social conflicts

the cost of reducing (hiper)inflation is very high Central Bank Credit cuts Economy cools down Prices decrease ATTENTION Possible recessions here! activity rate = labour force tot. population 16 or older employemnt rate = n. of employed labour force unemployement rate = n. of unemployed labour force The meaning of money By CONVENTION, as social costume, we decided to use MONEY as

medium of exchange
unit of account
store of value A monetarist vision GDP GDP GDP The more money around the less the portion of GDP that can be bought (the higher the prices)

=> controlling the quantity of money we can control the level of prices ATTENTION Several studies confirmed that this relation is unstable. Using the quantity of money to control prices it's not so straight forward How was money born? Once upon a time...
there were no banks, financial systems and there was no money. People used to exchange goods with goods Than it seemed to be a good idea to decide that one of these goods could be the "base" good on which all the exchanges could be based the present tar system The need to deposit some of this commodity money arose commondity money with intrinsic value The Holder sooner become a lender and understood that he could lend commodity money as well as "promises" in pieces of papers The present fiat money was born The process of money creation the present Money is created by the Financial System: The Central Bank and financial intermediaries Commercial Banks Central bank Balance Sheet Foreign currencies Bank loans Bonds
(public and private) other assets ASSETS LIABILITIES MONEY currencies and liquid assets Commercial bank Balance Sheet Reserves
liquid assets
bonds, stocks,... Loans ASSETS LIABILITIES MONEY creation Deposits Other liabilities Bonds emitted
Capital new Deposits corresponding to the loan 2% 98% This value is the legal limit of the reserve and it's set up by the Central Bank
Banks will always lend money for the remaining 98% (it's their business!) This 2 - 98 relation works as a multiplier.
The central bank can then lend money to the banks and the banks will lend more money

e.g. a bank holds 2 millions in deposits
therefore it can lend 98 millions

CB gives the bank 1 extra million
the bank can lend 150 millions (2% of 150 is 3) MONEY => The Central Bank can CONTROL
the AMOUNT of money in the economy
the LOANS in the economy
the PRICE at which money is lent in the economy REMEMBER This affects the inflationary processes This affects the level of investments in the economy and therefore the aggregate demand = GDP Monetary policy How can inflation be moderated This is the role of the Central Bank
The ECB European Central Bank aims at maintaining inflation between 0 and 2%
By the means of the Monetary Policy Central Banks aims at moderating inflation (and help the economy to grow at its potential growth rate)
This is done by the means of Monetary Policy REMEMBER The Central Bank can boost or cool down the economy The level of the economic activity affect the prices level Potential growth Long and Short run Policies Growth rate Long Run Policies aim at increasing the potential growth rate Short run policies aim at STABILISING the growth rate as close as possible to its potential TRANSPARENCY! The role of the state What is the role of the state in the economy?
Why do we pay taxes Providing goods and services of public interest
Fostering potential growth
Stabilizing the economy around its potential growth rate Fiscal Policies Short term policies implemented by the country administration
Aimed at stabilizing the GDP growth around its potential growth rate
By the means of influencing the aggregate demand Y=C+I+G+X-M Public expenditure Taxes Public expenditure when G => Y when Y => Income when Income => C Income = C + S when C => Y again THE MULTIPLIER EFFECT An expansionary fiscal policy has a much larger effect on the aggregate than the initial impulse the effect of the multiplier depends on the marginal propensity to consumption and on the propensity for imported consumption
it's only useful when the economy is below its potential growth rate
basically an increase in G today means a decrease of G sometime in the future
public expenditure is not flexible SHORTCOMINGS very low margins of increasing G
very slow process
when G => Y ? most of public expenditure cannot be changed overnight Taxes when t => C when C => Y less direct that public expenditure
tax changes are not flexible at all
no changes in taxes represent an automatic stabiliser SHORTCOMINGS someone says that new tax collection due to the rise of Y could overcome the cuts induced by a reduction of t (Laffer curve) More Shortcomings Incentives exist for political leaders to implement policies that disperse costs widely over large groups of people and benefit relatively small, politically powerful groups of people.

Incentives exist for political leaders to favor programs that entail immediate benefits and deferred costs. Few incentives favor programs promising immediate costs and deferred benefits, even though the latter programs are sometimes economically more effective than the former programs => Monetary policy instruments
discount rate
open market operations
required reserves ratio The balance of payments all transactions between one country and the rest of the world are recorded here Good and services


Capitals Current Account Financial Account 2 BASIC RULES 1. When money comes in + when money go out -
2. Sum of G&S, Income and Capital are always 0 it's the instrument we use to keep the account of exchanges If you buy something you pay for it
+value of the product received
- value of money payed
= 0 CURRENT ACCOUNT Balance of trade -80
exports 140
imports -220 Factors income -20
Cash Transfers -10 -110 FINANCIAL ACCOUNT Financial account 50
inflow FDI 20
outflow FDI -40
Financial assets 70
exchange BALANCE OF PAYMENTS 0 Reserve account 60 earnings from foreign investments
-payments to foreign investors gifts, immigrant cash transfers we consumed 110 of GDP we did not produce
how can this happen? Caveats Balance surplus
Balance deficit Reserves
Reserves since Reserves Money Prices
Prices remember the Central Bank Account since Money Prices Balance surplus
Balance deficit => there is a "natural" force acting balancing trade imbalances but it's slow and unpredictable The exchange rate => the balance of payments influence the level of prices today we live in a world with mainly flexible exchange rates (and capital movement)
it's a recent phenomenon! we can buy and sell Foreign Currencies
their price is set by the market
the prices of currencies are given by
the bilateral foreign exchange rates Definition
The € $ exchange rate is the quantity of $ that can be bought with 1 € http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html Factors affecting exchange rates PRIVATE SECTOR INSTITUTIONS Central Banks International
Trade International
Investments In a world with no capital movement
only trade affects exchange rates

Current Account surplus => evaluation
Current Account deficit => devaluation when the amount of $ we can buy with 1€
the € APPRECIATES (evaluation) when the amount of $ we can buy with 1€
the € DEPRECIATE (devaluation) that started around the 70s-80s In today's world, where capitals face less and less barriers in crossing borders
CAPITALS MOVEMENTS is the most important factor influencing the exchange rate

Financial account surplus => evaluation
Financial account deficit => devaluation 80-90% 10-20% Factors influencing international investments
national i foreign i
capital inflow
currency evaluation Interest rate EXPECTATIONS play an important role here ATTENTION RISK plays an important role here Inflation
if inflation the return on investments (in real terms)
capital outflows
currency devaluation Growth and Productivity
when the country GDP it attracts investments
capital inflows
currency evaluation It can affect foreign exchange mainly controlling i (and i affects the interest rate of national investments) WHAT CAN WE DO? WHAT CAN WE DO? WHAT CAN WE DO? Costs of inflation
Shoeleather Costs
Menu Costs
Misallocation of resources
Inflation-induces Tax distortions Y = C + I + G + X - M Country % of GDP
Norway 47,7
France 42,9
Netherlands 41,3
Belgium 40,7
Luxembourg 38,5
Denmark 38,2
Greece 38,1
Italy 37,8
Portugal 37,4
Slovenia 36,9
Finland 36,7
Austria 36,4
United Kingdom 36,2
Israel 35,3
Sweden 33,2
Ireland 32,5
Romania 31,0
Uruguay 30,6
Iceland 30,2
Poland 30,0
Czech Republic 28,7
Germany 28,6
Slovak Republic 27,9
Russian Federation 26,7
Brazil 26,2
Spain 25,2
Egypt, Arab Rep. 24,8
Turkey 24,5
Australia 23,6
Korea, Rep. 22,7
Chile 21,6
Canada 17,2
United States 17,0
China 11,9
India 11,7
Japan 11,2

World 22,9
European Union 35,1
North America 17,1
High income 23,0
Upper middle income 19,8
Low & middle income 18,7

Revenue is cash receipts from taxes, social contributions, and other revenues such as fines, fees, rent, and income from property or sales. Grants are also considered as revenue but are excluded here.
2010 data What is the weight of the state worldwide? if taxes are progressively set (rich pay more)
an increase in GDP will make more people better off; but these people will have to pay more taxes and therefore cool down their consumption
a decrease in GDP will make people worse off; but these people will pay less taxes and therefore limit the reduction in consumption 100% 80% 60% 40% 20% Exports
(to GDP) Equity investment Direct investment Immigrants
(to Population) Telephone calls Levels of Internationalization © 2010Pankaj Ghemawat We're not so globalised ATTENTION Goods and services Income Capitals Two ways of international interaction International Trade Goods and Services Goods and Services Exports X Imports M Money Money Trade balance
X > M Trade Surplus
X < M Trade Deficit International Capital Flows Assets Capital Inflow Capital outflow Money Money 2 kinds of capital Flows
Financial asset exchange Assets Want to know something more about economic wealth? Check this out (growth) Crisis and Bubbles Crisis is the situation of a complex system (family, economy, society) when the system functions poorly, an immediate decision is necessary, but the causes of the dysfunction are not known. Definition of Crisis Economic The dot-com bubble NASDAQ index 1994 - 2005 Financial short term phenomena of sudden RISE & FALL (Minsky) 5 Phases

1- Displacement

2 - Boom / Overtrading

3 - Euphoria

4 - Profit taking - distress

5 - Panic An asset get trendy (fairly or not...), people want it, its price start rising Speculation
It seems reasonable to BORROW money to buy the asset FIRST WARNINGS No caution at all
Crazy prices People start selling
Fears appears, people dislike the asset (and other assets too) Displacement Boom Euphoria Distress Panic House prices in Spain € per sq.m Can we prevent Bubbles? Yes, with a restrictive monetary policy, but
affects negatively the GDP
could increase unemployment takes away the punch bowl just as the party gets going Can we "cure" Bubbles? Yes, with a expansionary monetary policy, but
a functioning financial systems is needed
moral hazard (we save the bad guys)
fostering other bubbles Is Spain different? From Wall st. to Main st. Financial crisis (real) Economic crisis Commercial bank Balance Sheet Reserves
liquid assets
bonds, stocks,...
toxic assets Loans ASSETS LIABILITIES Deposits Other liabilities Bonds emitted
Capital 2% 98% Toxic asset value
Loans Investments
Other assets Example: Housing bubble People and companies borrow money to buy houses and land at high prices (the asset is the collateral, guarantee)
People and companies cannot pay back
The bank get the house
But the prices are falling, the value is lower than expected the bank lost money the bank lost lending capacity, Loans , Investments , GDP CREDIT CRUNCH households lost their consumption capacity, Consumption , GDP 110
when the country productivity
export rise
currency evaluation btw
if we want to have an idea of the evolution of the housing market we might have a look at the evolution of the gdp too House prices in Spain and GDP left, € per sqm rigth, ten thousands of € AKA:
speculative bubble
market bubble
price bubble
financial bubble Defaulting people leave the bank with toxic assets Banks' assets Contagion: several assets Financial institution lend the money and accept the asset as guarantee
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