Slides for my macroeconomics course to be used alongside video Many of pictures taken out to accomodate size

1. Unit 3
Investments and Financial Markets
• Decision rules: present value and internal rate of return decision
rules
• The role of interest rates in firms investment decisions
• How Tobin’s Q affects investment decisions
• Do suppliers of finance create ‘short-termism’?
• Financing hierarchy
• Limitations of simplified models of the links between finance and
investment

2. Present value and internal rate
of return decision rules
• Firms use capital budgeting to
determine if a new project is
worth pursuing
• NPV=Future value/(1+i)^𝑛
(n is number of years, i is interest
rate or wacc; weighted cost of
capital )
• IRR is the discount rate at
which the present value
becomes zero

3. Tobin’s Q
Market value of a firm/
Book value or total assets of a firm
Buy when q ratio is low and sell when q ratio is high

4. Hierarchy of
Finance

6. Capital Accumulation
• In economics, capital accumulation
is often seen as the same as
investment. Real investment in
tangible means of production.
• Basis of wealth in any country that
wants to develop
• Calculated by Gross investment-
Depreciation of physical assets =
Capital accumulation

7. Unit 4
Monetary Policy and Central Bank
• Inflation targeting
• Money supply
• Taylor rule
• The LM Curve: the relationship between interest rate and output
• Monetary policy transmission mechanisms

8. Monetary Policy Tools
Discount rate
Reserve
requirement
OMO

9. Inflation targeting and money supply
• Inflation targeting is a monetary policy where the central
bank sets a specific inflation rate as its goal
• The money supply (or money stock) is the total value of
money available in an economy at a point of time.
• M0 and M1, for example, are also called narrow money
and include coins and notes that are in circulation and
other money equivalents that can be converted easily to
cash.
• M2 includes M1 and, in addition, short-term time
deposits in banks and certain money market funds. M3
includes M2 in addition to long-term deposits.

10. Taylor Rule
• The Taylor rule guides how central banks should alter interest rates due
to changes in the economy.
• Taylor's rule was created to adjust and set prudent rates for the short-term
stabilization of the economy while maintaining long-term growth.
Key Factors of the Taylor Rule
The Taylor rule is based upon three factors:
• The targeted rate of inflation in relation to the actual inflation rates
• The real levels of employment, as opposed to full employment
• An interest rate consistent with full employment in the short term
• According to the rule, central banks should increase short-term interest
rates when one or both of the following occurs: the expected inflation rate
exceeds the target inflation rate, or the anticipated GDP rate of growth
exceeds its long-term rate of growth. Conversely, when inflation rates and
GDP growth rates are below what was expected, interest rates are
expected to decrease.
• Critics believe that the Taylor principle cannot account for sudden jolts in
the economy.
r* = real federal funds rate (usually 2%)
pi = rate of inflation
p* = target inflation rate
Y = logarithm of real output
y* = logarithm of potential output
i = nominal fed funds rate

11. Monetary Policy Transmission Mechanism

13. Unit 5
Fiscal Policy and Government Finance
• Recent trends in budget policy
• Problems in designing institutions that coordinate fiscal and monetary
policy
• Crowding out
• Factors that determine the effectiveness of fiscal policy
• Fiscal policy in the UK and Eurozone
• Desirable principles for the design of fiscal policy rules

14. Structural Balance
(Structural deficit or surplus)
Primary Balance
(Primary deficit or surplus)

16. • The government intertemporal budget
constraint means that the current stock of
debt is equal to the present value of future
primary surpluses
• Contingent liabilities that have not yet
crystallized like pensions and healthcare for
the elderly are also important
• The debt-relief Laffer curve. Beyond some
point the rise in a country’s debt is so large
that it reduces growth and reduces its
capacity to service that debt

17. • Depending on fiscal or monetary in isolation is insufficient
• Coordination is defined as the necessary arrangements that assure that the decisions taken by
both authorities are not contradictory
• The New Zealand stance: The fiscal and monetary policy authorities are independently
responsible for their respective areas of policy, but within a framework which leaves room - and,
indeed, establishes a strong incentive for - each to have regard for the actions of the other. The
existing institutional arrangements certainly do not preclude consultation between the Reserve
Bank and the Government/Treasury aimed at achieving co-ordination of monetary and fiscal
policy, and generally, there is active consultation. However, that consultation and co-ordination
takes place within a framework which attaches importance to long-term objectives not being
compromised by pursuit of short-term stabilisation objectives.

18. Unit 6
Expectations, Inflation and Interest Rates
• Yield curve
• Philips curve
• Natural rate of unemployment
• Meaning of time inconsistency and the role of expectations in the
effectiveness of monetary policy

19. Ricardian Equivalence
What Is Ricardian Equivalence?
• Ricardian equivalence is an economic theory that
argues that attempts to stimulate an economy by
increasing debt-financed government spending are
doomed to failure because demand remains
unchanged. The theory argues that consumers will
save any money they receive in order to pay for the
future tax increases they expect to be levied in order
to pay off the debt.
• In many ways, monetary policy is a more useful tool
for stabilization. Central banks can change interest
rates at very short notice.

20. Phillips Curve
• Phillips observed an empirical
regularity between unemployment and
inflation. Specifically, he documented a
negative correlation between the level
of unemployment and the rate of
increase in prices and wages. The lower
unemployment, the higher inflation
tended to be.
• Adverse supply shocks cause inflation
and unemployment to rise together.

21. Yield Curve
A yield curve is a line that plots yields (interest rates) of bonds having equal credit
quality but differing maturity dates
• A normal yield curve is one in which longer maturity bonds have a higher yield
compared to shorter-term bonds due to the risks associated with time.
• An inverted yield curve is one in which the shorter-term yields are higher than
the longer-term yields, which can be a sign of an upcoming recession.
• In a flat or humped yield curve, the shorter- and longer-term yields are very
close to each other, which is also a predictor of an economic transition.

22. NRU
• The unemployment rate that exists when an economy is producing the full employment output; when an economy is in a
recession, the current unemployment rate is higher than the natural rate. During expansions, the current unemployment
rate is less than the natural rate.
• Types of unemployment are structural, frictional, cyclical, and seasonal
• NRU is equal to the sum of frictional and structural unemployment. When an economy is producing an efficient amount of
output the unemployment rate will be equal to the natural rate of unemployment. Even though an economy may be
operating efficiently, there will still be some unemployment. Because of that, the natural rate of unemployment is never
equal to zero.
• The overall unemployment rate is calculated by dividing the total number of unemployed people (U) by the total number
of people in the labor force (LF). The labor force includes working-age adults who want to be employed.
U ÷ LF = Total unemployment
• In order to calculate the natural rate, first add the number of frictionally unemployed (FU) to the number or people who
are structurally unemployed (SU), then divide this number by the total labor force.
(FU + SU) ÷ LF = Natural rate of unemployment

23. Unit 7
• Foreign exchange markets and foreign exchange
• Difference between nominal and real exchange rates
• Purchasing power parity theory of exchange rates
• How foreign trade affects aggregate demand
• Relationship between exchange rates and macroeconomics policy
• Central bank inflation targeting and stabilization of exchange rates

24. Globalisation
• Globalization refers to the way in which national economies are becoming
increasingly interconnected with one another
• The nominal exchange rate is the rate at which the currencies of two
countries can be exchanged, whereas the real exchange rate is the ratio of
what a specified amount of money will buy in one country compared with
what it can buy
• Law of one price. This states that identical commodities should sell at the
same price wherever they are sold. Applies to tradables, not services
• The PPP exchange rate is the exchange rate such that the same basket of
goods costs the same in each country once allowance is made for different
currencies.

25. The Big Mac
Index &
Purchasing
Power Parity

26. Balance of Payments
The balance of payments is a statistical record, covering a particular time, of a country’s economic transactions with the rest of the
world. The current account records the net transactions in goods and services, while the capital account records transactions in assets
between countries
1. Current account
This is a record of all payments for trade in goods and services plus income flow it is divided into four parts.
• Balance of trade in goods (visibles)
• Balance of trade in services (invisibles) e.g. tourism, insurance.
• Net income flows. Primary income flows (wages and investment income)
• Net current transfers. Secondary income flows (e.g. government transfers to UN, EU)
2. Financial account
This is a record of all transactions for financial investment. It includes:
• Direct investment. This is net investment from abroad. For example, if a UK firm built a factory in Japan it would be a debit item on
UK financial account)
• Portfolio investment. These are financial flows, such as the purchase of bonds, gilts or saving in banks. They include
• Short-term monetary flows known as “hot money flows” to take advantage of exchange rate changes, e.g. foreign investor saving
money in a UK bank to take advantage of better interest rates – will be a credit item on financial account
3. Capital Account
• This refers to the transfer of funds associated with buying fixed assets such as land

27. Banonomics? Foreign exchange & aggregate
demand
AD=GDP
GDP= G+I+C+NX
The exchange rates seen on the internet are the nominal exchange rate, exports and imports however are determined by real
exchange rates

28. Unit 8
International capital
inflows and markets
• International capital inflows and markets
• Uncovered interest parity
• Foreign exchange crises: 1st & 2nd generation models
• Benefits and costs of capital controls

29. Covered and uncovered interest parity
Returns
on foreign
exchange
Covered
Interest
Parity
Uncovered
Interest
Parity
• Covered interest parity considers the situation where an
investor is investing in a foreign currency with the exchange rate
locked in via a forward.
• Uncovered interest parity is when forwards aren’t used to lock
in the rate for an investor investing in foreign currency. UIP says
that currencies with high interest rates should see their value
depreciate, therefore should not offer superior performance.
• But this doesn’t hold when subject to empirical testing. In
actual fact, they currencies with high interest rates ACTUALLY
tend to appreciate

30. Forex Crisis
First
Generation
Crisis
Second
Generation
Refers to the different types of thinking around foreign
exchange crisis’s
First generation blames governments for conflicting fiscal
and exchange rate policy. For example, when the
government fixes the exchange rate,
Second generation thinking is more nuanced. It highlights
the role of foreign investors and their expectations .

31. Capital Controls
• Capital control represents any measure taken by a government,
central bank or other regulatory bodies to limit the flow of foreign
capital in and out of the domestic economy.
• Policies may restrict the ability of domestic citizens to acquire foreign
assets, referred to as capital outflow controls.
• They may restrict the ability of domestic citizens to acquire foreign
assets, referred to as capital outflow controls, or foreigners' ability to
buy domestic assets, known as capital inflow controls. Tight controls
are most often found in developing economies where the capital
reserves are lower and more susceptible to volatility.