Lecture 4 Basics of Macroeconomics II Dr Rajeev

Lecture 4: Basics of Macroeconomics - II Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class South Class Room #600 January 20, 2007

Chapter 26 Saving, Investment and the Financial System

Tax Cuts have Eased the Oil Price Shock This Time Source: Prof. Larry J. Kimbell, Nov. 2004

Copyright © 2004 Tatum CFO Partners, LLP and Tatum CIO Partners, LLP

Savings And National Income Math ¨ GDP (as the sum of expenditures) has been defined as: Y = C + I + G + NX In a closed economy: Y = C + I + G ¨ Rearranging terms gives: Y - C - G = I ¨ The left-hand side, which is the nation's income (GDP) leftover after consumption and government spending, is defined as National Savings. Since Y - C - G is defined as being equal to "S": S = I

Continued. . ¨ This relationship must hold for the economy as a whole (when the economy is closed). Now, with S = Y - C - G ¨ Add and subtract the government's tax revenue (T) to the right-hand side S = Y - C - G + T - T ¨ Then rearrange terms on the right hand side to get S = (Y - T - C) + (T - G)

Continued. . ¨ This expression breaks down national savings into two components: private savings and public savings. ¨ Private savings (Y - T - C) is the income left in the economy after taxes and consumption have each been paid for. ¨ Public savings (T - G) is equal to the taxes collected by the government, minus government spending. This is also an expression for the government surplus/deficit (surplus if T > G, deficit if T < G).

Market For Loanable Funds Interest Rate Supply 5% Demand 0 $1, 200 Loanable Funds (in billions of dollars)

Increase in Supply of Loanable Funds Interest Rate Policy 1: Saving Incentives Supply, S 1 S 2 1. Tax incentives for saving increase the supply of loanable funds. . . 5% 4% 2. . which reduces the equilibrium interest rate. . . Demand 0 $1, 200 $1, 600 3. . and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars)

Increase in Demand of Loanable Funds Interest Rate Policy 2: Investment Incentives Supply 1. An investment tax credit increases the demand for loanable funds. . . 6% 5% 2. . which raises the equilibrium interest rate. . . 0 D 2 Demand, D 1 $1, 200 $1, 400 3. . and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars)

Effect Of A Government Budget Deficit Policy 3: Budget Deficit Interest Rate S 2 Supply, S 1 1. A budget deficit decreases the supply of loanable funds. . . 6% 5% 2. . which raises the equilibrium interest rate. . . Demand 0 $800 $1, 200 3. . and reduces the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars)

The U. S. Government Debt Percent of GDP 120 World War II 100 80 60 Revolutionary War 40 Civil War World War I 20 0 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 Copyright© 2004 South-Western

Chapter 28 Unemployment & Its Natural Rate

Article: Why do Americans Work More Than Europeans? WSJ; by: Edward Prescott ¨ Americans aged 15 -64, on a per-person basis, work 50% more than French. The French, for example, prefer leisure more than do Americans or on the other side of the coin, that Americans like to work more. This is silliness !! ¨ Germans and Americans spend the same amount time working, but the proportion of taxable market time vs. nontaxable home work time is different ¨ But marginal tax rates explain virtually all of this difference. Labor supply is not fixed. People be they European or American, respond to taxed on their income. – Spanish labor supply increased by 12% in 1988 when taxes were cut

Identifying Unemployment ¨ Natural Rate of Unemployment – The natural rate of unemployment is unemployment that does not go away on its own even in the long run. – It is the amount of unemployment that the economy normally experiences. ¨ Cyclical Unemployment – Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. – It is associated with short-term ups and downs of the business cycle.

Unemployment Rate Since 1960 Percent of Labor Force 10 Unemployment rate 8 6 Natural rate of unemployment 4 2 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 Copyright© 2003 Southwestern/Thomson Learning

How Is Unemployment Measured? ¨ Based on the answers to the survey questions, the Bureau of Labor Statistics (BLS) places each adult into one of three categories: – Employed – Unemployed – Not in the labor force ¨ Labor Force – The labor force is the total number of workers, including both the employed and the unemployed. – The BLS defines the labor force as the sum of the employed and the unemployed.

Breakdown Of The Population In 2004 Employed (139. 3 million) Adult Population (223. 4 million) Unemployed (8. 1 million) Not in labor force (76. 0 million) Labor Force (147. 4 million)

Unemployment - What is it? ¨ The unemployment rate is calculated as the percentage of the labor force that is unemployed. ¨ Labor Force Participation Rate

Example ¨ In 2001, 135. 1 million people were employed and 6. 7 million people were unemployed. – Labor Force = 135. 1 + 6. 7 = 141. 8 million – Unemployment Rate = (6. 7 / 141. 8) X 100 = 4. 7 percent – Labor Force Participation Rate = (141. 8 / 211. 9) X 100 = 66. 9 percent

The Labor-Market Experiences of Various Demographic Groups (2004) Copyright© 2004 South-Western

Participation Rates for Men and Women Since 1950 Labor-Force Participation Rate (in percent) 100 80 Men 60 40 Women 20 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Questions About Unemployment ¨ Does the Unemployment Rate Measure What We Want It To? ¨ How Long Are the Unemployed without Work? ¨ Why Are There Always Some People Unemployed?

Article: The Double Benefit of Tax Cuts WSJ; by: Becker, Lazear & Murphy ¨ The sum of present and future spending, discounted by the rate of interest on government bonds, must equal the sum of present and discounted future tax revenues - David Ricardo in 19 th century ¨ Typically, economists take government spending as given by the needs of society, and assume that taxes adjust to this spending. Yet empirical evidence suggest that spending often adjusts to available tax revenue rather than the other way around. ¨ The Reagan tax cuts of the ’ 80 s increased federal deficits and subsequent interest payments on the debt. The need to meet these interest payments helped pressure Congress and the Clinton administration to enact welfare reform, cut defense spending on Social Security and health. ¨ Politics: Democrats are worried about the effects of deficits and a growing debt on future spending programs. Republicans appear to be favoring a fiscal stimulus so it limits future spending on entitlement and other programs favored by Democrats ¨ Starve the Beast: Tax cuts will keep government spending in check and will provide the incentives necessary to produce a highly skilled, productive work force that enables high economic growth and rising standards of living (the WSJ/Conservative agenda)

Article: The $366 Billion Outrage Fortune Magazine; by: Janice Revell v. Pension plans of 16 million state and local government workers are taking up a huge share of the budgets. In the 90’s elected officials allowed workers to dramatically spike their pre-retirement compensation, to retire on more than 100% of their pay, and to draw both their salaries and pensions, with guaranteed market returns, simultaneously. v. San Diego deferred retirement option plan, or DROP allows pension, deposited into a special account earn a guaranteed 8% annual rate of interest, plus a 2% annual cost-of-living adjustment. When the employee actually decides to retire he can either collect the amount that has accumulated in his special pension account or let it keep compounding at that generous rate or return indefinitely. v Result: v The pension fund is short by billions and counting ($366 Billion so far!). The generosity of the plan means workers (e. g. in Houston 44% of the city workforce) can quit without taking a major financial hit => early retirement by qualified employees. v Solution: Solution v Raise property tax (is happening) v. Cut in city services (is happening) v. Cut benefits (? )

Chapter 29 The Monetary System

Money–What is it and what does it do? Money is the set of assets in an economy that people regularly use to buy goods and services from one another ¨ Medium of Exchange –what sellers accept from buyers as payment for goods and services. Eliminates inefficiencies of barter. ¨ Unit of Account – When there is one unit of account, like the ($) in the United States, you don't have to think in relative terms when valuing goods and services. ¨ Store of Value – people have the option to hold money over time as one way of storing their assets. Money is an important store of value, because it is the most liquid asset in the economy

Types of Money ¨ Commodity Money money that takes the form of a commodity with intrinsic value. ¨ Fiat Money money without intrinsic value that is used as money because of government decree

How to Measure Money Stock: The quantity of money circulating in the economy Q: Suppose you want to know the size of the U. S. money stock. What should you count as money? A: Currency and demand deposits, and a few other items (detailed below) but not credit cards. Currency - the paper bills and coins in the hands of the public Demand Deposits - balances in bank accounts that depositors can access on demand by writing a check (or by using a debit card)

Two Measures of the Money Stock for the U. S. Economy (2004) Billions of Dollars M 2 $6, 398 • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($5, 035 billion) $1, 363 0 M 1 • Demand deposits • Traveler’s checks • Other checkable deposits ($664 billion) • Currency ($699 billion) • Everything in M 1 ($1, 363 billion)

Continued… Q: How is the U. S. money stock measured and reported? A: Two most important measures – M 1 and M 2 M 1 = Currency, Traveler's checks, Demand Deposits and Other Checkable Deposits Here is a breakdown of M 1 for 1996: Item$ (Billions) % of total Currency Traveler's Checks Demand Deposits Other Checkable Deposits $1076. 8 100. 0% 395. 7 36. 7 8. 6 0. 8 400. 7 37. 2 271. 8 25. 3 M 2 = Everything in M 1 plus Savings deposits, Small Time Deposits, Money Market Mutual Funds and a few minor categories. M 2 for 1996 was $3657. 4 billion.

Banks & Money Supply Q: How do banks operate? A: Banks accept deposits from people. That money is in an account until the depositor makes a withdrawal or writes a check on their account. Q: Do banks keep all of your money in their vault? A: No. Our banking system is called fractional reserve banking. Bankers understand that it is not necessary to keep 100 percent of a depositors money on hand at all times. As a result, bankers take some of your money and loan it out to other people.

Continued. . ¨ Fractional reserve banking - a banking system in which banks hold only a fraction of deposits as reserves ¨ Reserve ratio - the fraction of deposits that banks hold as reserves. Minimum reserve ratios are set by the Fed.

Money Creation with Fractional. Reserve Banking ¨ When a bank makes a loan from its reserves, the money supply increases. ¨ The money supply is affected by the amount deposited in banks and the amount that banks loan. – Deposits into a bank are recorded as both assets and liabilities. – The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. – Loans become an asset to the bank.

Money Creation with Fractional. Reserve Banking ¨ This T-Account shows a bank that… – accepts deposits, – keeps a portion as reserves, – and lends out the rest. – It assumes a reserve ratio of 10%. First National Bank Assets Reserves $10. 00 Liabilities Deposits $100. 00 Loans $90. 00 Total Assets $100. 00 Total Liabilities $100. 00

Money Creation with Fractional. Reserve Banking ¨ When one bank loans money, that money is generally deposited into another bank. ¨ This creates more deposits and more reserves to be lent out. ¨ When a bank makes a loan from its reserves, the money supply increases.

The Money Multiplier Suppose that the Fed requires banks to keep 20 percent of their demand deposits on reserve. Q: What happens when somebody brings in $100 and deposits it in a bank? A: The bank is required to keep $20 (20 percent) on reserve. Q: What does the bank do with the remaining $80? A: The bank will turn around and lend it to somebody else, earning interest income for the bank. Q: What did that $80 loan do to the size of the money supply? A: The money supply increased by $80 when the loan was made. Here's how:

Continued… ¨ When the first depositor arrived with $100 in cash, the money supply included that $100 of currency in the depositor's wallet ¨ After the deposit, the currency was in the bank vault and not circulating (so out of the money supply) ¨ However, demand deposits increased by $100, so the money supply was unchanged (currency fell by $100, deposits increased by $100) ¨ When the bank made the $80 loan, $80 in currency reentered the money supply ¨ Added to the $100 demand deposit, that original $100 has grown to $180.

Continued… ¨ Now suppose that the person who received the $80 loan deposits that money into their checking account. ¨ Q: What does the bank have to do with the $80? ¨ A: Keep 20 percent on reserve (20 percent of $80 = $16). ¨ ¨ Q: What does the second bank do with the remaining $64? ¨ A: They can lend that out to somebody else

The Money Multiplier First National Bank Assets Liabilities Reserves $10. 00 Deposits $100. 00 Loans $90. 00 Total Assets Total Liabilities $100. 00 Second National Bank Assets Reserves $9. 00 Liabilities Deposits $90. 00 Loans $81. 00 Total Assets $90. 00 Total Liabilities $90. 00 Money Supply = $190. 00!

Money Multiplier Q: How far does this process of money creation go? A: The process of bank money creation continues until there are no more excess reserves to be lent out. Money multiplier - the amount of money the banking system generates with each dollar of reserves. The money multiplier is the reciprocal of the reserve ratio: M = 1/R With a reserve requirement, R = 20% or 1/5, The multiplier is 5. Therefore, the original $100 deposit will eventually turn into $500 of deposits. Q: The banking system can create money, but can it also create real wealth? A: No. Each loan has two parts. Recall that the first $80 loan generated $80 in new money. At the same time, that $80 loan also created a new $80 liability for the person borrowing the money. The banking system cannot create real wealth.

The Federal Reserve System ¨ The Federal Reserve (Fed) serves as the nation’s central bank. – It is designed to oversee the banking system. – It regulates the quantity of money in the economy. ¨ The primary elements in the Federal Reserve System: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee

The Federal Reserve System Copyright© 2003 Southwestern/Thomson Learning

The Fed’s Organization ¨ The Federal Open Market Committee (FOMC) – Serves as the main policy-making organ of the Federal Reserve System. – Meets approximately every six weeks to review the economy. ¨ The FOMC is made up of the following voting members: – The chairman and the other six members of the Board of Governors. – The president of the Federal Reserve Bank of New York. – The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis).

The Fed’s Tools of Monetary Control ¨ The Fed has three tools in its monetary toolbox: – Open-market operations – Changing the reserve requirement – Changing the discount rate

The Fed’s Tools of Monetary Control Open-Market Operations – The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: – When the Fed buys bonds, the money supply is increased. Here is why: The Fed pays for the bonds it buys with money that was not currently a part of the money supply, hence, when the Fed buys bonds it simply increases the total amount of money in circulation. – When the Fed sells bonds, the money supply is decreased. Here is why: The Fed sells bonds in the market and receives cash in return for the bonds it sells. Once the Fed receives the cash, this cash is taken out of circulation – therefore, the size of the money supply is decreased.

The Fed’s Tools of Monetary Control ¨ Reserve Requirements – The Fed also influences the money supply with reserve requirements. – Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

The Fed’s Tools of Monetary Control ¨ Changing the Discount Rate – The discount rate is the interest rate the Fed charges banks for loans. ¨Increasing the discount rate decreases the money supply. ¨Decreasing the discount rate increases the money supply.

Problems in Controlling the Money Supply ¨ The Fed must wrestle with two problems that arise due to fractional-reserve banking. – The Fed does not control the amount of money that households choose to hold as deposits in banks. – The Fed does not control the amount of money that bankers choose to lend.

Chapter 30 Money Growth and Inflation

The Classical Theory of Inflation ¨ Inflation is an increase in the overall level of prices. ¨ Hyperinflation is an extraordinarily high rate of inflation. ¨ Historical Aspects – Over the past 60 years, prices have risen on average about 5 percent per year. – In the 1970 s prices rose by 7 percent per year. – During the 1990 s, prices rose at an average rate of 2 percent per year. – Deflation, meaning decreasing average prices, occurred in the U. S. in the nineteenth century. – Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920 s.

The Classical Theory of Inflation ¨ Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. ¨ When the overall price level rises, the value of money falls.

Money Supply, Money Demand Monetary Equilibrium ¨ The money supply is a policy variable that is controlled by the Fed. – Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. ¨ Money demand has several determinants, including interest rates and the average level of prices in the economy. ¨ People hold money because it is the medium of exchange. – The amount of money people choose to hold depends on the prices of goods and services. ¨ In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Money Supply, Money Demand, and the Equilibrium Price Level Value of Money, 1/P (High) Price Level, P Money supply 1 1 (Low) 3 1. 33 /4 / 12 Equilibrium value of money (Low) A 2 Equilibrium price level 4 / 14 Money demand (High) 0 Quantity fixed by the Fed Quantity of Money Copyright © 2004 South-Western

Figure 2 The Effects of Monetary Injection Value of Money, 1/P (High) MS 1 MS 2 1 (Low) 1 1. An increase in the money supply. . . 3 2. . decreases the value of money. . . Price Level, P /4 12 / 1. 33 A 2 B / 14 3. . and increases the price level. 4 Money demand (High) (Low) 0 M 1 M 2 Quantity of Money Copyright © 2004 South-Western

The Classical Theory of Inflation ¨ The Quantity Theory of Money – How the price level is determined and why it might change over time is called the quantity theory of money. ¨The quantity of money available in the economy determines the value of money. ¨The primary cause of inflation is the growth in the quantity of money.

The Classical Dichotomy and Monetary Neutrality ¨ Nominal variables are variables measured in monetary units. ¨ Real variables are variables measured in physical units. ¨ According to Hume and others, real economic variables do not change with changes in the money supply. – According to the classical dichotomy, different forces influence real and nominal variables. ¨ Changes in the money supply affect nominal variables but not real variables. ¨ The irrelevance of monetary changes for real variables is called monetary neutrality.

Velocity and the Quantity Equation ¨ The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P Y)/M Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money ¨ Rewriting the equation gives the quantity equation: M V=P Y

Velocity & Quantity Equation ¨ Velocity ( V ) = Nominal GDP/ Money Supply = ( P x Y ) / M ¨ Example: V = ($10 x 100 ) / $ 50 = 20

Velocity & Quantity Equation ¨ The quantity equation relates the quantity of money (M) to the nominal value of output (P Y). ¨ The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: – the price level must rise, – the quantity of output must rise, or – the velocity of money must fall.

Nominal GDP, the Quantity of Money, and the Velocity of Money Indexes (1960 = 100) 2, 000 Nominal GDP 1, 500 M 2 1, 000 500 Velocity 0 1965 1970 1975 1980 1985 1990 1995 2000 2005

Velocity and the Quantity Equation ¨ The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money – The velocity of money is relatively stable over time. – When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P Y). – Because money is neutral, money does not affect output.

The Inflation Tax ¨ When the government raises revenue by printing money, it is said to levy an inflation tax. ¨ An inflation tax is like a tax on everyone who holds money. ¨ The Fisher effect refers to a one-to-one adjustment of the nominal interest rate to the inflation rate.

The Nominal Interest Rate and the Inflation Rate Percent (per year) 15 12 Nominal interest rate 9 6 Inflation 3 0 1965 1970 1975 1980 1985 1990 1995 2000

Costs of Inflation 1. 2. 3. 4. Shoeleather Costs – resources wasted when inflation encourages people to reduce their holdings of money. Menu Costs – the costs involved in actually changing prices around the economy. Relative Price Variability and the Misallocation of Resources – If firms only occasionally change their prices (like once per year), then they have to guess at the future level of inflation. Their prices will be too high early in the year and too low late in the year, resulting in sales that are artificially low early in the year and artificially high late in the year. Inflation-Induced Tax Distortions – Taxes like capital gains and interest income taxes are imposed on the nominal value of assets or on interest income. From studying real versus nominal interest rates, you know that part of the nominal interest rate exists to compensate people for the effects of inflation. The higher is the rate of inflation, the higher is this distortion caused by these taxes.

Continued. . 5. Confusion and Inconvenience – Money, being the economy's unit of account, is used to quote prices for goods and services throughout the economy. Confusion and inconvenience arise as a cost of inflation because inflation makes valuing dollars over time difficult. Many important items in the economy are measured over time (like the value of a firm, for instance), and inflation creates difficulties in the valuation of assets or debts that occur over time. 6. Arbitrary Redistributions of Wealth – "Inflation is good for borrowers and bad for lenders" is a common phrase that rings out in economics principles courses. Here's a personal example for you to consider (and a personal example for your website author as well). When you graduate from college, you will likely owe money on student loans that you took out during your college years. Between the time you borrowed the money and the time when you repay the loan, you will be better off if inflation is high.