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Macro Economics


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Macro Economics

  1. 1. CL4 English Language and Culture for Business Module IV B2 European Economic Policy Dr. Peter Cullen
  2. 2. The Balance of the Nation State <ul><li>Aggregate Demand: </li></ul><ul><li>AD is the relationship between the quantity of aggregate output in demand and the aggregate price level. </li></ul><ul><li>It is the the quantity of goods and services that individuals want to buy at any given price level </li></ul><ul><li>Terminology: Supply </li></ul><ul><li>Demand </li></ul><ul><li>Aggregate </li></ul><ul><li>Output </li></ul><ul><li>Transaction Costs </li></ul>
  3. 3. The Balance of the Nation State <ul><li>The quantitative theory of money: </li></ul><ul><li>MV = PY </li></ul><ul><li>where M = the supply of money </li></ul><ul><li>V = the velocity of circulation </li></ul><ul><li>P = price level </li></ul><ul><li>Y = the quantity of aggregate output </li></ul><ul><li>If the velocity of circulation is constant, the supply of money determines the nominal value of the product which, in turn, is the product of the quantity of aggregate product and the price. </li></ul>
  4. 4. The Balance of the Nation State <ul><li>The quantitative theory of money can be re-written in terms of supply and demand in real money balances: </li></ul><ul><li>M/P = (M/P) d = kY </li></ul><ul><li>where K = 1/ V is a parameter that measures the quota of an income unit that individuals want to keep in liquid form (ready cash). </li></ul><ul><li>SO, the supply of real money balances M/P is equal to the demand for real money balances (M/P) d which is proportional to output Y . The velocity of money circulation V is the denominator of the parameter of real money balances k = savings/€ of income </li></ul>
  5. 5. The Balance of the Nation State <ul><li>So, for any given supply of money and any given velocity of circulation, this equation identifies an inverse relation between the price level P and the aggregate output Y. </li></ul>P AD Income, Output, Y P Income, Output, Y Reducing the money supply pushes the aggregate demand curve to the left DA 1 DA 2
  6. 6. The Balance of the Nation State <ul><li>Don’t forget: </li></ul><ul><li>Short term : price viscosity or “stickyness” resulting in less-than-full employment and capital investment </li></ul><ul><li>Price viscosity is important in explaining monthly and yearly fluctuations. </li></ul><ul><li>Long term : classic theory of money, classic theory of the open economy; hypothesised price flexibility and full employment and quantities of money, labour and technology are determinant. Time frame: a few years. Prices adjust to equilibrium while available capital, labour and technologies are relatively constant. </li></ul><ul><li>Very long term : growth theory (Solow) capital, labour and technology vary. Time frame: decades </li></ul>
  7. 7. The Balance of the Nation State <ul><li>Aggregate Supply: </li></ul><ul><li>The AS curve and the AD curve together define the price level and the volume of output. </li></ul><ul><li>AS is the relationship between the quantity of goods and services offered and the price level. BUT, given that companies have flexible prices in the long-term and viscous prices in the short-term, the AS curve depends on the time horizon. </li></ul><ul><li>It is necessary to analyse TWO types of AS curve: short term ( STAS ) and long-term ( LTAS ). </li></ul>
  8. 8. The Balance of the Nation State <ul><li>The long-term: </li></ul><ul><li>The quantity of output depends on the quantity of capital and labour – which are fixed – and on available production technologies. </li></ul><ul><li>So: Y = F ( ¯ ,¯ ) = ¯ where the ¯ symbol indicates the long-term value </li></ul><ul><li>The Long-Term Aggregate Supply curve is verticle since capital and labour are fixed. </li></ul>K L Y
  9. 9. The Balance of the Nation State <ul><li>If the money supply decreases, the aggregate demand curve shifts to the left. The economy shifts from its departure equilibrium (A) determined by the intersection of the aggregate supply curve to a new equilibrium point (B). </li></ul><ul><li>The verticle Aggregate Supply curve implies that the volume of aggregate supply is independent of the money supply. </li></ul><ul><li>The long-term volume of Aggregate Supply ¯ is called the full employment level or natural level of aggregate supply – corresponding to the level at which all resources in the economy are completely employed. </li></ul><ul><li>In real terms, this means that unemployment is at its natural rate. </li></ul>Y
  10. 10. The Balance of the Nation State <ul><li>Short-term Aggregate Supply: </li></ul><ul><li>Prices are viscous in the short-term, so they don’t instantly to variations in demand – so the short-term aggregate supply curve cannot be verticle. </li></ul><ul><li>I.E. If companies publish their catalogues, then prices are fixed at a predetermined level and companies try to sell as much as their clients wish to purchase, using labour to produce the quantity in demand. </li></ul><ul><li>This creates a horizontal Aggregate Supply Curve. </li></ul>
  11. 11. The Balance of the Nation State <ul><li>Short-term equilibrium in an economy is the point at which the aggregate demand curve intersects the short-term aggregate supply curve. </li></ul>A drop in aggregate demand P Income, output, Y STAS B A DA 1 DA 2 Viscous short-term prices Output drops
  12. 12. The Balance of the Nation State <ul><li>SO: when aggregate demand drops, aggregate output also drops, but due to viscous prices, companies are stuck with prices that are too high, causing an over-abundance of labour and: </li></ul><ul><li>Lay-offs/firing/downsizing </li></ul><ul><li>Recession </li></ul>
  13. 13. The Balance of the Nation State <ul><li>So – how to economies make the shift from short-term to long-term? </li></ul>A B C STAS DA 1 DA 2 1. A drop in aggregate demand 2. Forces down output in the short term 3. But in the long run affects only prices Y ¯ Income, output, Y
  14. 14. The Balance of the Nation State <ul><li>Stabilisation policies: </li></ul><ul><li>Economic fluctuations are caused by shifts in AS or AD. </li></ul><ul><li>Exogenous variations in these two curves are called a “shock” to the economy. </li></ul><ul><li>Shock on the AD curve is called Demand Shock </li></ul><ul><li>Shock on the AS curve is called Supply Shock </li></ul>
  15. 15. The Balance of the Nation State <ul><li>Economists try to define stabilisation policies that reduce the breadth of the fluctuations in the short term </li></ul><ul><li>Production and Labour tend to fluctuate around their respective natural long-term rates – SO stabilisation policies try to contain fluctuations as near as possible their natural levels. </li></ul><ul><li>Two types of shock: Aggregate Supply Shock </li></ul><ul><li>Aggregate Demand Shock </li></ul>
  16. 16. The Balance of the Nation State <ul><li>Aggregate Supply Shock: </li></ul><ul><li>Example: Credit Cards </li></ul><ul><li>Credit cards purchasing is easier than cash purchasing – so the spread of credit card use reduces the quantity of cash in the economy. </li></ul><ul><li>Less cash = increase velocity of circulation </li></ul><ul><li>If each individual holds less cash, the demand perameter k decreases so V (the velocity of circulation) increases because V = 1/ k </li></ul>
  17. 17. The Balance of the Nation State <ul><li>IF: the money supply remains constant </li></ul><ul><li>THEN: increase V causes and increase in nominal cost and a rightward shift of the aggregate demand curve. </li></ul><ul><li>In the short term, increase demand = increase production (demand driven) creating economic expansion or BOOM. </li></ul><ul><li>At “old” prices (the prices of the starting point), companies sell more product, hire more labour, make employees work overtime and use systems and instruments more intensely. </li></ul>
  18. 18. The Balance of the Nation State <ul><li>Over time, higher aggregate demand pushes up salaries and prices. </li></ul><ul><li>When prices go up, the demand for products decreases and the economy “slows”, tending to the natural rate of production growth. </li></ul><ul><li>During this transition to a higher price level, both production and the economy in general operate above the natural level. </li></ul>
  19. 19. The Balance of the Nation State <ul><li>What can a central bank do to mitigate expansion and bring aggregate production back to its natural level? </li></ul><ul><li>It can reduce the money supply to balance the velocity of circulation and thus stabilising aggregate demand. </li></ul><ul><li>SO – a central bank can reduce or eliminate the effects of a demand shock on production and employment by consciously controlling the money supply. </li></ul><ul><li>MONETARISM </li></ul>
  20. 20. The Balance of the Nation State <ul><li>Aggregate supply shock: </li></ul><ul><li>Since shock to supply directly affects prices, supply shock may also be called “price shock”. </li></ul><ul><li>IF: a negative shock (crop failure, etc.) causes the short term aggregate supply (STAS) to rise, </li></ul><ul><li>THEN: the price level rises and production drops – creating a situation of </li></ul><ul><li>STAGFLATION (high prices with low production) </li></ul>
  21. 21. The Balance of the Nation State <ul><li>Facing a negative supply shock, economic policy makers who wish to lever aggregate demand have a difficult choice: </li></ul><ul><li>To maintain aggregate demand = production and employment are below natural levels = recession. Prices will drop, but it hurts investment and their is a great deal of cost associated. </li></ul><ul><li>To expand aggregate demand to bring the economy quickly back to natural levels. If the increase in aggregate demand coincides (in breadth) with the supply shock, the short-term aggregate supply curve will immediately shift upwards. </li></ul><ul><li>The negative side effect is that prices permanently remain high. There is no way to act on aggregate demand and maintain both full employment and price stability. </li></ul>
  22. 22. The Balance of the Nation State <ul><li>The stagflation of the 1970’s and the euphoria of the 1980’s </li></ul><ul><li>1972-1973 – OPEC coordinates a reduction in oil supply causing a 100% increase in oil prices globally. </li></ul><ul><li>This price increase in crude oil caused stagflation in most industrial countries, paritcularly between 1974-1976 and 1979-1981. </li></ul><ul><li>Political discord among OPEC countries brought about a 44.5% drop in oil prices in 1986, causing a drop in the inflation rate and in the unemployment rate </li></ul><ul><li>Since then, changes in consumer behaviour and technological progress have made economies less sensitive to oil shocks. </li></ul><ul><li>In the last 30 years, the quantity of oil per unit of real GDP has dropped by 40% </li></ul>
  23. 23. The Goods Market <ul><li>1936: Keynes published “The General Theory of Employment, Interest, and Money”: </li></ul><ul><li>post 1929 depression. The low levels of AD caused low incomes and high unemployment – challenging the idea that aggregate supply defined national revenue. </li></ul><ul><li>This is a cultural problem: National revenue sees at its centre the balance sheet of national governments and government estimates in increasingly refined versions of Adam Smith’s “The Wealth of Nations” (1760?) – developed to account for the balance of the British Empire. </li></ul>
  24. 24. The Goods Market <ul><li>Today – general view is: </li></ul><ul><li>In the long term, prices are flexible and AS determines the level of income. </li></ul><ul><li>In the short term, prices are viscous and variations in AD determine the level of income. </li></ul><ul><li>The IS-LM model: </li></ul><ul><li>IS = Investment and Savings </li></ul><ul><li>LM = Liqidity and Money </li></ul>
  25. 25. The Goods Market <ul><li>The IS curve describes the goods market </li></ul><ul><li>The LM curve describes the money market </li></ul><ul><li>Interest rates, which influence both investment and the demand for money relate these two curves. </li></ul><ul><li>The IS curve is a graphic description of the relationship between interest rates and income level in the goods and services market. </li></ul><ul><li>The simple model for this is called The Keynesian Cross </li></ul>
  26. 26. The Goods Market <ul><li>The Keynesian Cross: </li></ul><ul><li>The total income produced by an economy in the short term is largely determined by the desire of companies, the government, and individuals to SPEND. </li></ul><ul><li>The more products companies can sell, the more they need to produce, and therefore hire employees. </li></ul><ul><li>So, according to Keynes, periods of recession represent an inadequate total expenditure . </li></ul>
  27. 27. The Goods Market <ul><li>There are two types of expenditure: </li></ul><ul><li>Actual expenditure and </li></ul><ul><li>Planned expenditure </li></ul><ul><li>Actual expenditure is the sum of money that individuals, companies and public administrations spend to purchase goods and services. It is identical to GDP </li></ul><ul><li>Planned expenditure is the amount that these actors would like to spend on goods and services. </li></ul>
  28. 28. The Goods Market <ul><li>Why is there a difference between actual expenditure and planned expenditure ? </li></ul><ul><li>Answer: unplanned investment in surplus </li></ul><ul><li>If companies do not manage to sell all of the units produced, their surplus automatically increases (back-stock) </li></ul><ul><li>Analogously, if sales exceed supply, surplus diminishes automatically. </li></ul><ul><li>These automatic fluctuations count as investment expenditure for companies, so actual expenditure may be different from planned expenditure </li></ul>
  29. 29. The Goods Market <ul><li>Suppose: </li></ul><ul><li>A closed economy with fixed interest rates: </li></ul><ul><li>Planned expenditure is the sum of consumption, planned investment, and public expenditure OR </li></ul><ul><li>E = C + I + G </li></ul><ul><li>Introducing the consumption function </li></ul><ul><li>C = C(Y-T) where disposable income (Y-T) [total income minus taxes] </li></ul>
  30. 30. The Goods Market <ul><li>Assuming that planned investments, public expenditures, and taxes are fixed </li></ul><ul><li>(I = I, G = G, and T = T) </li></ul><ul><li>We obtain E = C(Y – T) + I + G OR </li></ul>¯ ¯ ¯ ¯ ¯ ¯ E Income, Output, Y 1€ MPC Marginal Propensity of Consumption
  31. 31. The Goods Market <ul><li>Marginal Propensity of Consumption: </li></ul><ul><li>Indicates the increase in planned expenditure in relation to an increase in income of 1€ </li></ul><ul><li>The Balanced Economy: </li></ul><ul><li>Keynes considered the economy to be in equilibrium when – actual expenditure = planned expenditure </li></ul><ul><li>Indicating that total demand is satisfied because GDP = not only output, but also total income </li></ul><ul><li>SO: Y = E in an equilibrium situation (planned expenditure = GDP) </li></ul>
  32. 32. The Goods Market <ul><li>How do economies reach equilibrium? </li></ul><ul><li>Surplus plays a key role. Since surpluses fluctuate, acting on volume of production, production influences the levels of income and moves the economy towards equilibrium. </li></ul><ul><li>Fiscal policy and the multiplyer: Public expenditure </li></ul><ul><li>Since public expenditure is part of planned expenditure, an increase in public expenditure increases the level of planned expenditure for each level of income </li></ul>
  33. 33. The Goods Market <ul><li>If public expenditure increases by Δ G, planned expenditure increases by Δ G, moving equilibrium from point A to point B. </li></ul>A B Income, Output, Y E ∆ G E 1 = Y 1 E 2 = Y 2 AE PE ∆ Y
  34. 34. The Goods Market <ul><li>Why does an increase in government expenditure (fiscal policy) amplify effects on the econonmy? </li></ul><ul><li>Given the consumption function: C = C(Y-T) </li></ul><ul><li>increased income = increased consumption </li></ul><ul><li>SO – increased govt. expenditure also increases consumption – which increases income, and so on. </li></ul><ul><li>So an increase in government expenditure increases consumption disproportionally </li></ul>
  35. 35. The Goods Market <ul><li>Fiscal policy and the multiplyer: taxes </li></ul><ul><li>Lowering taxes (∆T) immediately </li></ul><ul><li>increases income, increasing </li></ul><ul><li>consumption by MPC x ∆T. So, for </li></ul><ul><li>every given level of income, planned </li></ul><ul><li>expenditure is higher. </li></ul><ul><li>So, like increase government expenditure, lowering taxes has an amplifying effect on the economy. </li></ul>
  36. 36. The Goods Market <ul><li>Interest rates: </li></ul><ul><li>The Keynesian Cross is only the first step in understanding the IS –LM model </li></ul><ul><li>The relationship between Investment and Interest rates is fundamental to this understanding </li></ul><ul><li>Investment (I) = Investment in relation to Interest rates OR </li></ul><ul><li>I = I(r) </li></ul>
  37. 37. The Goods Market E AE PE Income, Output, Y ∆ I Y 2 Y 1 Interest rate, r Investment, I Interest rate, r Income, Output, Y r 1 r 2 I(r 1 ) I(r 2 ) 1 2 3 4 5 r 1 r 2 Y 2 Y 1 IS Note: an increase in public spending pushes the PE curve up and moves the IS curve to the right
  38. 38. The Money Market <ul><li>The LM curve illustrates the relationship between interest rates and income levels in real money markets. </li></ul><ul><li>To understand this, you must understand the </li></ul><ul><li>THEORY OF PREFERENCE FOR LIQUIDITY </li></ul><ul><li>Interest rates is adjusted to balance supply and demand for the most liquid component of the economy: money </li></ul><ul><li>This theory forms the basis for the LM curve </li></ul><ul><li>Note: Liquidity = the ability of an asset to be converted into cash quickly and without any price discount </li></ul>
  39. 39. The Money Market <ul><li>It is important to consider real money balances here: </li></ul><ul><li>SO the real money balance = </li></ul><ul><li>the supply of money (M) / prices (P) </li></ul><ul><li>the Theory of Preference for Liquidity </li></ul><ul><li>maintains that real money supplies are </li></ul><ul><li>fixed </li></ul><ul><li>SO (M/P)° = M/P </li></ul><ul><li>The money supply is an exogenous variable because it is established by the central banks. </li></ul><ul><li>Prices are also exogenous because the IS-LM model is based on the short term, when prices are fixed. </li></ul>¯ ¯
  40. 40. The Money Market <ul><li>The previous hypotheses imply that the supply of real money balances is FIXED, and, specifically, does not depend on interest rates – therefore, </li></ul><ul><li>The supply curve for real money balances is VERTICLE </li></ul><ul><li>The theory for preference of liquidity states that the interest rate (r) is one of the determinants of the amount of money that individuals decide to hold on to since: </li></ul><ul><li>the interest rate represents the cost-benefit of keeping money: that which you must give up to keep a part of your wealth in a liquid activity, such as money, that holds no interest rate – as would be the case with shares, bonds, or other bank investments. </li></ul>
  41. 41. The Money Market <ul><li>When interest rates rise, there is incentive to keep less cash money, so we can write: </li></ul><ul><li>(M/P) d = L(r) where </li></ul><ul><li>(M/P) d = the demand for real money balances </li></ul><ul><li>L(r) = the relationship between liquidity and interest rates. </li></ul><ul><li>This curve is negative because increased interest rates correspond to a drop in demand for real money balances </li></ul>
  42. 42. The Money Market <ul><li>According to the theory of preference for liquidity, supply and demand for real money balances determine the prevailing interest rates in an economy – SO </li></ul><ul><li>interest rates vary so as to maintain balance in the money market. </li></ul><ul><li>Equilibrium is found when: </li></ul><ul><li>Individuals try to adjust their portfolios, thus influencing the interest rate </li></ul>
  43. 43. The Money Market <ul><li>Equilibrium in the money market: </li></ul><ul><li>If interest rates are operating higher than equilibrium levels: </li></ul><ul><li>the supply of real money balances exceeds the demand </li></ul><ul><li>Individuals who hold extra money try to get rid of it, converting part of their non-earning activities (money) into earning bank deposits or interest earning stocks and bonds </li></ul><ul><li>Banks and interest paying institutions (who sell stock and bonds) react to the increase in converted wealth by lowering the interest rates they offer – </li></ul><ul><li>Bringing the money market back into equilibrium </li></ul>
  44. 44. The Money Market M/P Real Money Balances, M/P ¯ ¯ Interest rate, r Supply Demand, L(r) Equilibrium interest rate What happens when the curve shifts to the left?