TERM 2
Learning and
Development Council, Global Economics
CAC
CONTENTS
1. Introduction
5. Exchange Rates
8. International Trade
9. Monetary Policy
Introduction
Gross Domestic Product
Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country
in a given period of time
Measures of GDP
Total output
Total expenditure
Total income
Total value added of all firms
Total income = total expenditure because for every buyer there is a seller.
Expenditure Account:
Y = C + I + G + NX
Y = GDP
C = Private Consumption
I = Private Investment
G = Government Purchases of Goods and Services
NX = Net exports
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Calculating CPI :
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The Labor Bureau and the CSO produce several monthly CPI series
Differ in the basket of consumption goods considered.
Four groups
o Urban non-manual
manual employees (UNME)
o Industrial workers (IW)
o Agricultural labor (AL)
o Rural labor (RL)
Also a wholesale price index (WPI)
GDP methodology
Weekly
Two methods
Use market exchange rates
Indias GDP per capita in 2009 was $1192 using the market rupeerupee-dollar
dollar exchange rate
Misses fact that many goods cheaper in India than the US
Ideal would be to calculate GDP in all countries using a single set of prices very expensive
Purchasing Power Parity adjustment
Indias GDP per capita in 2009 was $3280 using a PPP exchange rate
Aggregate production:
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Investment:
Savings
National saving may be divided into private saving and government saving
Private saving determined by households
Greater saving today implies
Lower consumption today
Higher consumption tomorrow
Why Save:
Consumption smoothing
Smooth out fluctuations in income
Retirement
Bequests may be thought of as smoothing across generations
Inability to borrow against future income
Save to purchase a house, go to school or start a business
Precautionary motive
Save as a buffer against future risk
High return to saving : real interest rate, taxes
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Key Points:
Investment decision depend on the difference between current and desired capital
Desired capital depends on the rental rate
Saving depends on the desired mix of current and future consumption
In a closed economy saving equals investment
Shocks to one affect the other.
The interest rate brings about equilibrium in the capital market by affecting the cost of investment
and the reward for saving
An increase in government spending crowds out investment
National saving Y C G falls
A reduction in taxes also tends to redu
reduce Y C G, as consumers tend to send some of the
tax windfall.
Government budget deficits crowd out investment in a closed economy
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Key Point: The modern theory of trade flow focuses on investment and saving rather than exchange rates.
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Current Account:
The current account measures the net accumulation of foreign assets by Indians.
CA = net purchases of foreign assets.
GNP version of NX = NCO above
Net foreign asset (NFA) position improves if:
CA>0
Asset revaluations > 0.
The common view is that trade surpluses sign of national strength and trade deficits sign of weakness.
MV = PY
M = money supply
P = price level
Y = real GDP
V is the velocity of money the number of times that the average dollar is used over the period in
question rate of circulation
Three assumptions turn this identity into a theory of the price level
The money supply (M) is controlled by the central bank
The velocity of money is constant
Output depends on tastes and technology and is independent of the money supply
Inflation:
According to the quantity theory inflation occurs when too much money chases after too few goods.
Milton Friedman:
Inflation is always and everywhere a monetary phenomenon.
The real interest rate (r) measures the rate of return in terms of goods
One unit of output today yields 1+r units tomorrow.
The nominal interest rate (i) measures the rate of return in terms of money
One rupee today yields 1+i rupees tomorrow.
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Money Market:
Money Multiplier:
There are several ways in which the central bank manipulates the money supply
Open market operations
Interest rates
Reserve requirements
Repo Rate
Repo = repurchase agreement
Repo rate is the rate at which the central bank lends to banks against government securities.
Essentially the same as an open market operation.
Difference is between leasing and buying
The ECB and India primarily
rily use repos
Reserve Requirements
Changes in reserve requirements affect the multiplier
The RBI and the Bank of China both use alter reserve requirements to alter M1
In India it is called the cash reserve ratio (CRR)
The US Federal Reserve rarely alters reserve requirements.
If the central bank controls the money supply and inflation is everywhere and always a monetary
phenomenon.
.Why do we see inflation?
Fiscal distress
Price stability is costly
Fiscal Distress:
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A government that has trouble raising taxes or borrow may resort to printing money
Print too much and get inflation
Print far to much and get hyperinflation
Conventional definition of hyperinflation is two consecutive months in excess of 50% per
month.
Examples of hyperinflation
Weimar Germany in the 1920s
Latin American countries in the 1980s
Zimbabwe in the 2000s
Takeaways:
Exchange Rates
Purchasing power parity (Extends law of one price logic to the entire consumption basket)
PIND = E*PUS or E = PIND/PUS
where E is the rupee price of a dollar
Recall that the RER is the ratio of the basket values
PPP assumes that the RER = 1
NCO = NX
What price balances NCO and NX?
The real exchange rate
When prices of domestic goods rise relative to foreign goods, exports fall and imports rise
NX falls
No obvious reason that NCO should be affected by the real exchange rate.
Currency Crisis:
Something happens that causes the domestic currency to weaken in the minds of market
participants.
In a fixed exchange rate system, the government keeps its currency from depreciating by selling
foreign exchange.
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Reduces the supply of the domestic currency and increases the supply of the foreign
currency.
The government needs foreign exchange to do this.
Foreign exchange reserves
A currency crisis occurs when a government runs out of reserves.
Can be self-fulfilling like a bank run.
Greece:
Greeces problem is that it needs the
relative price of its basket to fall so
that its net exports can rise.
Since it is in the Euro zone, it cannot
devalue its currency.
It must reduce its price level, and
reducing wages and prices is painful.
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Definitions in Unemployment:
In the US, each person over sixteen assigned to one of three categories (all figures are for
May 2011):
Employed: worked full or part time during the past week (139.8M)
Unemployed: did not work the past week, but looked for work during the past four weeks (13.9M)
Not in the labor force: did not work the past week and did not look for work during the past four
weeks (85.6M)
Participation rate: Labor force as a percentage of adult population; (153.7 / (153.7 + 85.6)) = 64.2%
Unemployment rate: Percentage of labor force that is unemployed; 13.9 / 153.7 = 9.1%
Long run unemployment rate (natural rate) is never zero. Always some frictional unemployment as matches
between firms and employees form and dissolve
Summary :
A firm hires labor up to the point where MPL = W/P; the MPL curve is the labor demand curve
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The individual labor supply curve is upward sloping if the substitution effect of change in wages
dominates;aggregate curve slopes upward because of an additional effect more people enter
labor force as wages increase
Classical view of unemployment: with negative productivity shock wages adjust downward and
people voluntarily drop out. Keynesian view: wage is sticky and imbalance between supply and
demand
Minimum wage laws can cause unemployment hurting individuals they seek to protect
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Growth Accounting
Output, capital, and labor can be directly measured. Productivity (TFP) growth can only be inferred.
A/A is the TFP growth rate. Captures growth in output over and beyond what can be accounted for by
measurable inputs. Backed out as a residual.
Labor Productivity
Labor productivity is output per worker or worker hour (depending on how L is measured).
Given Y = A K0.3L0.7,
Al=Y/L = A(K/L)0.3
Al can increase due to increase in TFP or in capital per worker. Since it nets out all inputs,
TFP growth (A/A) is a purer measure of efficiency increase than labor productivity growth (Al/Al ).
To answer these questions, we need to go beyond accounting and study theories of growth.
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To gauge improvements in standard of living, we are interested in the growth rate of per
capita GDP (y)
Growth Dynamics:
Capital accumulation:
Steady State (SS): Long-run position of the economy. At this point k = 0, and investment is just
enough to offset depreciation.
k* is used to denote steady state capital stock.
y*, c* = (1-s) y*, are steady state output and consumption.
The economy ends up with the steady-state level of capital, regardless of the level of capital with which it
begins.
If k < k*, investment > depreciation, and capital stock (and output) rises till you approach k*.
If k > k*, investment < depreciation, and capital is wearing out faster than it is replaced, and capital
stock decreases till you approach k*.
The steady state is never reached in finite time. But, it is useful for long run analysis such as growth.
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A sudden decrease in capital per worker (say due to a disaster) will trigger sudden growth back to steady
state.
An increase in the saving rate (say from s1 to s2 >s1) increases the steady-state capital stock and output. In
data, countries with higher saving (=investment in equilibrium) rates do have higher levels of income.
An increase in the saving rate leads to faster growth only temporarily (i.e. in the short run) -- the economy
grows until the new steady state level of capital and income is reached.
Therefore, increasing the saving rate alone is not the answer to having long-term, sustained growth.
Diminishing return to capital prevents sustained growth.
Convergence Effect:
In Solow framework convergence is absolute; that is all countries become rich and grow at the same rate.
For dissimilar countries to converge, fundamental change other than capital growth alone has to occur.
That is, TFP (which includes institutions) has to increase.
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International Trade
Comparitive Advantage:
Key Prediction: Countries tend to produce the goods in which they have a comparative (but not necessarily
an absolute) advantage.
While all countries can gain from trade in the aggregate, not everyone within a country will necessarily
benefit
Trade encourages specialization and so some industries will disappear from a country while others will
expand
Hence, there are winners and losers. This explains opposition to trade by some groups within the country
In developed countries, the gains from trade are experienced by most consumers but each benefits
by only a small amount
By contrast, the costs of trade are concentrated in industries that cannot compete with cheap
imports
While the gains of many outweigh the losses of a few, the few who lose substantially are more vocal
than the majority who gain only a little
In developing countries, calls for infant industry protection. Never helps productivity
What about trade deficits? Trade deficits are symptoms of an economy at different stages of
development. They depend on savings and investment decisions. They are not necessarily bad.
Trade Restrictions:
Governments impose tariffs
to minimize adverse distributional effects of trade
to raise revenue
Tools used
Tariffs
Quantitative restrictions (quotas)
Voluntary Export Restrictions (VERs)
Trade barriers like administrative and technical standards
Domestic content requirements
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Monetary Policy
When a change in a nominal quantity (e.g. M, i) affects a real quantity (e.g. output), the
change is said to have a non-neutral effect. (Neutral if only the nominal price changes.)
Given that money is only a unit of value, expect changes in money to be neutral unit changes
Recall Quantity Theory implied that an increase in the money supply is accompanied by a one-to-one
increase in the price level (inflation). % M = % P.
Long-run change in output (growth) is driven by changes in technology and factor inputs, and not by
changes in money supply.
Long-run neutrality of money well-supported by evidence. Even Keynesians believe in long-run neutrality.
Original evidence for non-neutrality was presented by A. W. Phillips (1958). Negative relationship between
inflation and unemployment (the Phillips curve).
Summary :
Clear evidence on long-run neutrality of money. All economists agree on LR neutrality. Broad theoretical
support.
If classical economists do not believe in systematic non-neutrality of money, how do they explain
fluctuations?
The cornerstone of the new classical approach to fluctuations is the Real Business Cycle (RBC) model
1. Fluctuations in technology (technology shocks or supply shocks). Temporary, but serially correlated
technology shocks (positive shock today positive one tomorrow with high probability), hit the economy.
2. The neutrality of money. The money supply, if anything, responds to change in output and not the other
way around. So, study fluctuations in a real model with no monetary variables.
3. People willingly substitute labor from times when wage or real interest rate is low to when they are high
(intertemporal substitution of labor)
4. Prices and wages are fully flexible. The economy is always in equilibrium.
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Let us trace the effects of this negative productivity shock on the behavior of firms and households.
1. The output Y decreases, even if the current levels of capital and labor are utilized.
2. However, MPL and MPK are both decreased, decreasing the firms desired amount of labor and capital,
which further decreases the output.
3. From the labor market equilibrium we can see that the shift in labor demand real wages, and the
equilibrium labor supplied. (Note hours and employment are procyclical, and unemployment is
countercyclical.)
4. The in MPK, Kd and the I curve shiZs leZ. Even if the S curve does not shift, this is enough to
decrease equilibrium investment. Also, the shock is likely to be negative tomorrow. So, these are not times
to expand business! (Note investment is procyclical.)
5. How do households react to a temporary loss in income? The permanent income hypothesis suggests
that people, in an urge to maintain smooth consumption, consump\on only slightly because they either
borrow or cut down on savings. (Note consumption is not too volatile.) This means that the saving curve S
shifts leftward.
6. This reinforces the previous effect of in investment. Investment drops even further. (Investment is the
most volatile component.)
7. The effect on the real interest rate is ambiguous. The leftward shift of S tends to real interest rates (as
loanable funds have become scarcer), but this is offset by a leftward shift of I, due to the in MPK. (Real
interest rate is acyclical in data.)
In summary, a negative productivity (technology) shock output, employment, saving, investment and
leaves the real interest rate virtually unchanged, nailing most facts of cycles.
Policy Implications:
The presumption that the government can play an active role in countering business cycles and
stabilizing the economy is at the heart of Keynesian macroeconomics
But in the RBC theory, fluctuations in output, employment, consumption, etc. are natural responses
of individuals to inevitable and unpredictable changes in the environment
So, classical economists would argue that the government cannot stabilize the economy
The arguments parallel the ones for rules regarding the Feds monetary policy
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FISCAL POLICY
The governments policy on expenditures, taxes, and thus its borrowing is called fiscal policy.
A governments revenues typically come from: individual income tax, corporate profit tax, excise and
customs, property tax, sales tax, and social insurance levies
Traditional view: a tax cut of $1 disposable income by $1, part of which is consumed and the rest
saved.
Spvt by < $1, while decit Sgov by $1. National saving, S, . Therefore, equilibrium real interest
rate and investment .
With persistent deficits, the accumulation of domestic capital slows down, and future generationswill
experience a lower standard of living. (Solow model predicts a lower steady state level of capital and per
capita income when the saving rate decreases.)
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Ricardian equivalence says consumers save the entire tax break that they get because they anticipate
increase in future taxes to pay off the debt. During period 1, in government saving is completely oset by
the increase in public saving. There is no change in national saving!
In the Ricardian view, deficits do not matter, since the national saving is unaltered and the timing of taxes
and debt is irrelevant.
Implication: A balanced budget every year is not necessarily good. e.g., during a war instead of raising taxes
on an already overburdened public, it might be welfare improving to run a deficit; it does not S.
Tax cut is for present generations, tax hike is for future ones. (But older generations might be
altruistic and leave bequests.)
Borrowing constrained individuals (those who would like to consume more than Y1, but cannot get
loans) would consume more when tax is cut.
Fiscal Stimulus:
Keynesians advocate tax cuts (to stimulate consumption spending) to revive an economy in recession.
Potential problems with this:
If tax cut saved (Ricardian view), no in C
Huge lags between enactment of policy and effect on the economy
Another suggestion is to G (to spend on infrastructure, create jobs, etc.). Since Keynesians believe
deficits are bad, they would eventually have to increase taxes to make up for G. Problem with this:
distortionary income taxes decrease labor supply!