CFA Level I Macroeconomics - 2

Presented by: Aditya Ahluwalia www.finstructor.in

UNEMPLOYMENT AND INFLATION

Unemployment
Frictional Structural Cyclical Considered unemployed if actively searching for work Labor force = employed + unemployed Underemployed Participation ratio = % working age who are employed or seeking employment Discouraged workers

Inflation
CPI basket

 PPI , GDP deflator as measures Headline and core inflation (excludes food and energy) Problems with Laspeyres index
> New goods > Quality changes > Substitution

Cost push inflation

Demand pull inflation

MONETARY AND FISCAL POLICIES

 Fiscal policy use of taxation and spending to affect economic activity

> Budget surplus or deficit

Monetary policy actions that affect quantity of money and credit in an economy in order to influence economic activity
> Expansionary (accomodative) or contractionary (restrictive)

Aim is to keep moderate inflation and good economic growth

Functions of money
Medium of exchange Unit of account Store of value

Fractional reserve banking

 Narrow money Notes and coins in circulation, plus checkable bank deposits Broad money narrow money plus money in liquid assets

 Quantity Theory of Money

> Money supply x velocity = price x real output > MV = PY > Velocity represents the average number of times each unit of money is used to buy goods and services > Monetarists believe that velocity and the real output change slowly, hence increase in money supply, will lead to a proportionate increase in inflation > Money neutrality real variables are not affected by monetary variables

Demand for money

Transaction demand: Money held to meet the need for undertaking transactions Precautionary demand: for unforeseen future needs Speculative demand: to take advantage of investment opportunities that arise in the future

 Supply of money is determined by the central bank and is independent of demand

Increase in money supply

Fischer effect
Real rates are stable, changes in interest rates are driven by changes in expected inflation

Role of central bank

Sole supplier of currency Banker to the government and other banks Regulator and supervisor of payments system Lender of last resort Holder of gold and foreign exchange reserves Conductor of monetary policy

Objectives of the central bank

Primary objective is to control inflation
> Menu costs business need to change prices > Shoe leather costs frequent trips to the bank to withdraw depreciating cash > Unexpected inflation is more costly than expected inflation

Stability in exchange rates Employment Economic growth Moderate long term rates

Monetary policy tools

Policy rate Reserve requirements Open market operations

Effective central banks

Independence
> Operational independence central bank can independently determine the policy rate > Target independence Central bank defines how inflation is computed, sets the target and determines the horizon over which it has to be achieved

Credibility
> Should follow through on their stated intentions

 Transparency
> Periodic disclosure about views on inflation, economy etc. > Aids credibility

Transmission mechanism
Suppose economy is in a recession, steps in transmission would be as follows:

Expansionary or contractionary

policy rate > neutral ( contracionary monetary policy) policy rate < neutral ( expansionary monetary policy)

Monetary policy limitations

Transmission may not work as expected
> Cut in rates, may increase inflationary expectations, may increase long term rates > Tightening may reduce growth expectations, reducing long term rates

Liquidity trap persistent holding of cash, such that rates dont decrease Cannot stimulate once interest rate reaches zero Quantitative easing may not work if perceived credit risk is high

Additional issues in developing economies

Fiscal policy
Discretionary Automatic stabilizers
> Unemployment claims, > Taxes

OBJECTIVES
> Influencing economic activity > Redistributing wealth and income > Allocation resources amongst sectors

Fiscal policy tools

Spending tools
> Transfer payments > Current spending (ongoing expenditure) > Capital spending

Revenue tools
Revenue tools
> Direct taxes > Indirect taxes

 Fiscal multiplier potential increase in aggregate demand, resulting from an increase in government spending

Balanced budget multiplier

If the government increases taxes to offset a $100 increase in spending, the net impact should still be positive 100 * .8 * 2.5 = 200 250 200 = 50 Ricardian equivalence people anticipate future pressures from current deficits and start saving more, hence budget deficit does not stimulate demand

Problems with fiscal deficit

Arguments against being concerned with fiscal deficit

Difficulties in implementation
Recognition lag Action lag Impact lag

Additional problems
Misreading statistics Crowding out Supply shortages Limits to deficits Multiple targets

 Fiscal policy expansionary or contractionary

> Changes in surplus or deficit > Structural (cyclically adjusted) budget deficit

Interaction of monetary and fiscal policy