MACRO REVIEWin preparation for API 120
(I) DEFINITIONS & ACCOUNTING(II)
(i) National income & product accounts(ii) Balance of Payments accounts(iii) National Saving identity
(II) DEMAND POLICY (i) THE KEYNESIAN MODEL
(ii) TARGETS & INSTRUMENTS
(i) National income & product accounts
• Definition of macroeconomics– Aggregates– Goods (& labor) markets may not clear in short run– => Role for fiscal, monetary & exchange rate policy.
• Definition of– GDP: value of all goods & services produced domestically– GNP: includes earnings from abroad– National Income: includes unilateral transfers.– Net National Income: subtracts depreciation of capital stock
API-120 - Prof.J.Frankel, Harvard University
Ways to decompose GDP• To whom the goods & services are sold (expenditure side of GDP):
– C – + I – + G – + X-M .
• How the income (Y) is used:– Taxes net of transfers, T, leaving disposable income :– Consumption C– + Saving S.
• Allocation of shares according to factors of production:– Wages & salaries– Capital income.
API-120 - Prof.J.Frankel, Harvard University
} = Yd
(ii) Balance of Payments accounts
• Definition: The balance of payments is the year’s record of economic transactions between domestic & foreign residents.
API-120 - Prof.J.Frankel, Harvard University
API-120 - Prof.J.Frankel, Harvard University
NOW CALLED “FINANCIAL ACCOUNT”
“Primary income,” mainly investment income
≡ “secondary income”
Examples on the current account: • You, an American, buy DVDs from India
=> import appears as debit on US merchandise account.• You import services (electronically) of an Indian software firm =>
debit appears on US services account ( “overseas outsourcing”).• You buy the services, instead, from a subsidiary that the Indian
software firm set up last year in the US. This is not an international transaction, and so does not appear in the accounts.
• But assume the subsidiary then sends profits back to India => US reports payments of investment income. It is as if the US is paying for the services of Indian capital.
• Employees of the subsidiary in the US (or any other US resident entities) send money to relatives back in India => US reports paying unilateral transfers .
API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account(previously “capital account”), long-term
Instead of buying DVDs from India, you buy the company in India that makes them. => acquisition of assets (debit) under Foreign Direct Investment (FDI).
Instead of buying the entire company in India, you buy some stock in it => acquisition of portfolio investments (equities).
Instead of buying stock in the company, you lend it money for 2 years => acquisition of portfolio investments (bonds or bank loans).
API-120 - Prof.J.Frankel, Harvard University
Examples of debits on the financial account, short term:
You lend to the Indian company in the form of 30-day commercial paper or trade credit => acquisition of short term assets (Debit: You have “imported” a claim against India.)
You lend to the Indian company in the form of cash dollars, which they don’t have to pay back for 30 days => acquisition of short term assets .
You are the Central Bank, and you buy securities of the Indian company (an improbable example for the Fed – but some central banks now diversify international investments) => increase in US official reserve assets.
API-120 - Prof.J.Frankel, Harvard University
The rules, continued
• Each transaction is recorded twice: • an import of a good or security has to be paid for.
E.g., when an importer pays cash dollars, the import on the merchandise account is offset under short-term capital: the exporter in the other country has, at least for the moment, increased holdings of US assets, which counts just like any other portfolio investment in US assets.
• At the end of each quarter, credits & debits are added up within each line-item;
• and line-items are cumulated from the top to compute measures of external balance.
API-120 - Prof.J.Frankel, Harvard University
Some balance of payments identities• CA ≡ Rate of increase in net international investment position.
– A CA surplus country accumulates claims against foreigners– A CA deficit country borrows from foreigners.
• BoP ≡ CA + KA• => BoP ≡ excess supply of FX coming from private sector,
which central banks absorb into reserves (if they intervene in the FX market, e.g., to keep exchange rate fixed).– A BoP surplus country adds to its FX reserves (esp. US T bills).– A BoP deficit country runs down its FX reserves,
unless it is lucky enough (US) that foreign central banks finance its deficit.
• A floating country does not intervene in the FX market• => BP ≡ 0;• Exchange rate E adjusts to clear private market FX supply & demand.
API-120 - Prof.J.Frankel, Harvard University
(iii) Derivation of National Saving Identity
Income ≡ Output (assuming no transfers or investment income)
Y ≡ GDP
S + (T-G) ≡ I + X – M
/ /
NS ≡ S + BS ≡ I + CA
NationalSavingIdentity
C + S + T ≡ C + I + G + X -M
API-120 - Prof.J.Frankel, Harvard University
API-120 - Prof.J.Frankel, Harvard University
Household savingsCorporate savingsGovernment
savings
API-120 - Prof.J.Frankel, Harvard University
End of: Definitions & Accounting
MACRO REVIEW: DEMAND POLICY(II) THE KEYNESIAN MODEL
Part 1: Introduction to Keynesian Model
Part 2: Multipliers for spending & exports
Part 3: International transmission under fixed vs. floating exchange rates
Part 4: Adjustment of a CA deficit via expenditure-reducing vs. expenditure-switching policiesPart 5: Monetary factors
Imports & exports depend on income:
Y
TB
+ 0 -
),( YEMM d *),( YEXX dmYM X
)( mYMXTB
as does consumption: Keynesian consumption function cYCC
assuming E & Y* fixed, for now.
where slope = -m ≡ - marginal propensity to import
TB falls in expansions…
…and rises in contractions
API-120 - Prof.J.Frankel, Harvard University
Determination of equilibrium income
in open-economy Keynesian model
TBAY )()( MXGIC
)()( mYMXGIcYC
MXGICmYcYY
mcMXGICY
1
msMXAY
GICA cs 1where
and .
Now solve:
API-120 - Prof.J.Frankel, Harvard University
or, expressed as a saving function:
where s ≡ 1 – c .
dYc CC
d
ddd
Ys C- )cY C( -Y C - Y S
}I
API-120 - Prof.J.Frankel, Harvard University
Keynesian Consumption Function:
Recall National Saving identity: NS – I ≡ CA.
0 < 1 < Closed-economy multiplier 1/s < ∞ API-120 - Prof.J.Frankel, Harvard University
Fiscal Expansion
In a closed economy, NS – I = 0.
ΔY = s => ΔY = 1/ s
Open economy: NS – I = TB = X – M .
mY Mor , Y)(E,MM d
API-120 - Prof.J.Frankel, Harvard University
Imports: for simplicity.
Exports: for simplicity. Xor ),Y(E,XX *d
Open economy
Gms
Y
1
G
slope = s
API-120 - Prof.J.Frankel, Harvard University
Fiscal Expansion
Gs
1
Part 2:KEYNESIAN MULTIPLIERS
• The multiplier for an increase in , e.g., due to a fiscal expansion .
X
A
• The multiplier for an increase in , e.g., due to a devaluation .
API-120 - Prof.J.Frankel, Harvard University
API-120 - Prof.J.Frankel, Harvard University
Devaluation makes the export good cheaper for foreign consumers.
SUMMARY OF MULTIPLIERS
MX I NS
msMXA Y
G I CA where
Ams
1 Y
Ym- ΔM ΔTB
+ Keynesian model of S + M =>
Fiscal Expansion
open-ec. multiplier = 1/(s+m)<1/s
YmXΔ ΔTB
Xms
1 Y
Devaluation
Equation (17.11), 10th ed. of WTP , has a misprint.
. AΔms
m
XΔms
s
. XΔ
Part 3: MACROECONOMIC INTERDEPENDENCE
International transmission under fixed vs. floating exchange rates
• of a disturbance originating domestically.• of a disturbance originating abroad .
API-120 - Macroeconomic Policy Analysis I Prof. Jeffrey Frankel, Kennedy School, Harvard University
Fix
Fix
International Transmission
↓I ↓X
Floating increases effect on Y Floating decreases effect on Y
=> appreciation
=> depreciation
=> “insulation.” => disturbance is “bottled up” inside.
Float Float
• •• •
Conclusions regarding transmission(with no capital mobility)
• Trade makes economies interdependent (at a given exchange rate).
– TB can act as a safety valve, releasing pressure from expansion: .
– Disturbances are transmittedfrom one country to another:
.
XmsY ))/(1(
AmsY ))/(1(
API-120 - Prof.J.Frankel, Harvard University
Conclusions regarding transmission(with no capital mobility), continued
• Floating exchange rates work to isolate effects of demand disturbances within the country where they originate:– Effects of a domestic disturbance tend
to be “bottled up” within the country. In the extreme, floating reproduces the closed economy multiplier: .
– The floating rate tends to insulate the domestic economy from effects of foreign disturbances. In the extreme, floating reproduces a closed economy: .
AsY )/1(
0YAPI-120 - Prof.J.Frankel, Harvard University
Goals and Instruments• Policy goals: Internal balance & External balance
• Policy instruments: Fiscal policy, etc.
Parts 4 & 5:POLICY INSTRUMENTS
• The Swan Diagram• The principle of goals & instruments.
Introduction of monetary policy • The role of interest rates • Monetary expansion • Crowding out via interest rates ,
API-120 - Prof.J.Frankel, Harvard University
Goals and instruments
Y
Policy Instruments• Expenditure-reduction,
e.g., G ↓ • Expenditure-switching,
e.g., E ↑ .
Policy Goals• Internal balance: Y =
YY uY < ≡ ES ≡ “output gap” => unemployment >
Y > ≡ ED => “overheating” => inflation or asset bubbles.
• External balance: e.g., CA=0 or BP=0.
Potential output
Three ways of computing :1. Aggregate production function Y = F(K,N)
– Substitute labor force employed at natural rate: N=,– capital stock K working at full capacity, etc…– Conceptually the right definition. But very hard to implement.
• For one thing, most of the action is in TFP.
2. Time trend– E.g., H-P filter.
3. Estimate as value of Y above which inflation tends to accelerate.
In 2009, after the global financial crisis, advanced countries suffered much larger output gaps than in preceding recessions: Y << .Y
Source: IMF, via Economicshelp, 2009
UK
US
France
Output gap, as percentage of GDP, 2009
Ir
Jpn
Internal balance
API-120 - Prof.J.Frankel, Harvard University
Output gap in eurozone peripherySource: IMF Economic Outlook, September 2011 (note: data for 2012 were predictions)
http://im-an-economist.blogspot.com/p/eurozone-sovereign-debt-crisis.html
Greece & Ireland overheated by 2007: Y >>and crashed in 2009-12: Y <<
Y
Y
API-120 - Prof.J.Frankel, Harvard University
Inflation everywhere fell in 2008-09,in response to the output gap of the great recession.
World Bank, June 2014.“Exchange rate pass-through and inflation trends in developing countries,” Global Ec. Prospects.
THE PRINCIPLE OF TARGETS AND INSTRUMENTS
• Can’t normally hit 2 birds with 1 stone
• Do you have n targets? • => Need n instruments,
and they must be targeted independently.
Y• Have 2 targets: CA = 0 and Y = ?• => Need 2 independent instruments:
expenditure-reduction & expenditure-switching.
API-120 - Prof.J.Frankel, Harvard University
Financing• By borrowing • or running down reserves.
RESPONSES TO CURRENT ACCOUNT DEFICIT
Adjustment• Expenditure-reduction (“belt-tightening”)
• e.g., fiscal or monetary contraction
vs.
• or Expenditure-switching • e.g., devaluation.
Starting from current account deficit at point N,policy-makers can adjust either by (a) cutting spending,
or (b) devaluing.
A
X
●
●
●
API-120 - Prof.J.Frankel, Harvard University
ADJUSTMENT DILEMMA
●
Devaluation
• Experiment: increase in Ă
(e.g. G↑)
• Only by using both sorts of policies simultaneously
can both internal & external balance be attained, at point A.
Expansion moves economy rightward to point F.Some of higher demand falls on imports. => TB<0 .
XE
DERIVATION OF SWAN DIAGRAM
What would have to happento reduce trade deficit?
●●
●●
●
●
A
API-120 - Prof.J.Frankel, Harvard University
Now consider internal balance.Return to point A.
A
Expansion moves economy rightward to point F.
Y
What would have to happen to eliminate excess demand?
Some of higher demand falls on domestic goods => Excess Demand. Y >
●
●
●
●
Experiment: increase
E ↓ . ●API-120 - Prof.J.Frankel, Harvard University
Swan Diagramhas 4 zones:
I. ED & TDII. ES & TDIII. ES & TB>0IV. ED & TB>0
●
API-120 - Prof.J.Frankel, Harvard University
Example: Emerging market crises
Excgange rate E
YY: Internal balance
Y=potential
ED & TD
ED & TB>0
ES & TD
ES & TB>0Mexico 1994
or Korea 1997
Mexico 1995
or Korea 1998
Spending A
BB:External balance
CA=0
Classic response to a balance of payments crisis:Devalue and cut spending
●
API-120 - Prof.J.Frankel, Harvard UniversityCould be the “Fragile 5” in 2013-14: India, Turkey, Indonesia, S.Africa, Brazil.
Example: China in the last decade
Exchange rate E
ED & TD
ES & TD
ES & TB>0
China2010
China2002
ED & TB>0
Spending AIn 2008-09, an abrupt loss of X, due to the global crisis, shifted China to ES.
By 2007, rapid growth pushed China into ED. By 2010, a strong recovery, due inpart to G stimulus, moved into ED.In 2015, back into ES.
●
Spending A
YY: Internal balance Y=
BB: External balance CA=0.
Part 5: Monetary policy• is another instrument to affect the level of spending.
• It can be defined in terms of the interest rate i, which in turn affects i-sensitive components such as I & consumer durables.
• Or it can be defined in terms of money supply M.– In which case an expansion is a rightward shift of the LM curve– which itself slopes up (because money demand depends
negatively on i and positively on Y).
iY
LM
E.g., Taylor Rule sets i.
API-120 - Prof.J.Frankel, Harvard University
Monetary expansion lowers i,stimulates demand, shifts NS-I down/out.
New equilibrium at point M.In lower diagram, which shows i explicitly on the vertical axis, We’ve just derived IS curve.
If monetary policy is defined by the level of money supply,then the same result is viewed as resulting from a rightward shift of the LM curve.
New equilibrium:
At point D if monetary policy is accommodating.
Fiscal expansion shifts IS out.
D.At point F, if the money supply is unchanged, so we get crowding out: i↑ => I↓Þ Rise in Y < full Keynesian multiplier.
API-120 - Prof.J.Frankel, Harvard University
End of: Introduction to the Keynesian Model
(a) If they cut spending,CA deficit is eliminated at X;
but Y falls belowpotential output . Y
=> recession
●
●
API-120 - Prof.J.Frankel, Harvard University
APPENDIX: ELABORATION ON TARGETS & INSTRUMENTS
{WITH 1 GRAPH PER PAGE}.
ADJUSTMENT DILEMMA
API-120 - Prof.J.Frankel, Harvard University
(b) If they devalue,CA deficit is again eliminated, at B,
but with the effect of pushing Y abovepotential output.
=> overheating
●
●
At F, TB<0 .
What would have to happen to eliminate trade deficit?
ELABORATION ON DERIVATION OF SWAN DIAGRAM:EXTERNAL BALANCE
If depreciation is big enough, restores TB=0 at point B.
E ↑ .
A
●
●●
API-120 - Prof.J.Frankel, Harvard University
.
What would have to happen to eliminate trade deficit?
E ↑ . If depreciation is big enough, restores TB=0 at point B.
We have just derived upward-sloping external balance line, BB.
To repeat, at F, some of higher demand falls on imports.
●
●
●
API-120 - Macroeconomic Policy Analysis I Prof.Jeffrey Frankel, Kennedy School, Harvard University API-120 - Prof.J.Frankel, Harvard University
At F, Y > .
What would have to happen to eliminate excess demand?
If appreciation is big enough, restores Y= at point C.
E ↓ .
●
●●
ELABORATION ON DERIVATION OF SWAN DIAGRAM, cont.:INTERNAL BALANCE
API-120 - Prof.J.Frankel, Harvard University
What would have to happen to eliminate excess demand?
E ↓.
We have just derived downward-sloping internal balance line, YY.
At F, some of higher demand falls on domestic goods.
If appreciation is big enough, restores at C.
● ●
●
API-120 - Prof.J.Frankel, Harvard University
Summary: the combination of policy instruments to hit one goal slopes up; the combination to hit the other slopes down.
ITF-220, Prof.J.Frankel
Fiscal expansion (G↑) (or monetary expansion),at a given exchange rate => Y ↑ and TB↓.
Devaluation (E ↑) => Y ↑ and TB ↑.
If we are to maintain:Internal balance,
Y=External balance,
TB=0
then G & E must vary: inversely. together.
=> Internal balanceline slopes down.
=> External balanceline slopes up.
Derivation of the Swan Diagram