Macro Study 0.5 (2) PDF

Macro study 12, 13, 14 Chapter 12 Business Cycles Short-run economic activity fluctuates from year to year. Recession is a period of falling incomes and rising unemployment (Expansion is the opposite). Depression is a severe recession. Explaining what causes these fluctuations is diffi...

Macro study 12, 13, 14 Chapter 12 Business Cycles Short-run economic activity fluctuates from year to year. Recession is a period of falling incomes and rising unemployment (Expansion is the opposite). Depression is a severe recession. Explaining what causes these fluctuations is difficult. The theory of business cycles remains controversial. Theory of Business Cycles Classical economics The Classical theory on business cycle describes money is a veil. Real variables (like real GDP) and the economic forces that determine them are more important than nominal variables. Most economists think this theory is useful for the long-run behaviour of the economy but not too useful in explaining business cycles. Business Cycles The model of aggregate demand and aggregate supply is often used by economists to model and analyze these short-run fluctuations in the economy. This model focuses on how real and nominal variables interact. Most of the variables used in the model are those we have studied in previous chapters (GDP, unemployment, prices). The Model of Aggregate Demand and Aggregate Supply Aggregate Demand is the total demand for all goods and services in the economy. Aggregate Demand curve (AD) is a curve that shows the relationship between the overall price level and the level of demand in the economy. AD is made up of the four categories describing all the ways that people can spend in the economy. Y = C + I + G + NX AD Curve Slopes Downward There exists a negative relationship between price level and national expenditure for three of its four components (C, 1 and NX) but assumes no relationship between the price level and G. The price level and consumption: The Wealth Effect The price level and investment: The Interest Rate Effect The price level and net exports: The Exchange Rate Effect The Wealth Effect If prices increase but incomes do not, purchasing power of income will fall (people feels poorer) so consumption spending will fall. The Interest Rate Effect As prices increase, the price of borrowing tends to rise as well so investment spending will fall. The Exchange Rate Effect Increased prices of Canadian goods mean higher export prices and lower sales while imports into Canada will rise so net exports will fall. Position of the AD curve The AD curve can shift in response to non-price changes in any of the four components of AD. AD curve can shift left or right in response to non-price changes in any of the four components of AD which make AD rise or fall at any given price. That mean market confidence and government policy can shift the AD curve. These shifts may also have a multiplier effect - each dollar of expenditure in the economy leads to more than a dollar of output. Aggregate Supply The Aggregate Supply curve shows the relationship between the overall price level in the economy and total production (output). It is similar to market supply curve in microeconomics, with two key differences: 1\. AS represents production in the economy as a whole rather than just one good or service. 2\. Time horizon - AS represents difference between how the economy operates in the short-run and how the economy operates in the long-run. These differences yield two aggregate supply curves: LRAS and SRAS. Short-Run Aggregate Supply (SRAS) In the short-run, changes in the price level affect the economy\'s output. When prices increase, not all input prices increase immediately - some are sticky, meaning they adjust slowly in response to changes in the economy - this tends to raise the quantity of goods and services supplied. If wages are sticky (e.g. labour contracts), firms have an incentive to increase production when the prices of their output are rising. This gives rise to a SRAS that is upward sloping. Long-Run Aggregate Supply (LRAS) In the long-run, an economy\'s production of goods and services depends on its resource endowments (supplies of labour, capital, natural resources) and available technology used to turn these inputs into goods and services. Macroeconomics considers how long it takes for prices to adjust through the whole economy, rather than the flexibility of quantities within an individual firm. A change in price level does not affect output. This gives rise to a LRAS that is vertical at its potential or full-employment output. Position of the SRAS/LRAS curves Any non-price changes in factors of production or technology will shift SRAS and LRAS in the same direction EXCEPT changes in expectations about future price levels (the expected price level). The expected price level influences the wages that are sticky, the prices that are sticky, and the perceptions about relative prices. If expected cost of production increases (e.g. wages), this will cause a leftward shift of the SRAS but no change in the LRAS and vice versa. Macroeconomic Equilibrium Equilibrium in the national economy is the point at which AD equals AS. The economy\'s long-run trend is described by the intersection of AD and LRAS. Short-run equilibrium is given by the intersection of AD and SRAS and it may not be along the LRAS. Economic Fluctuations Business cycles are fluctuations of GDP either above or below the potential level of GDP in the economy. Boom (or expansion) - output is higher than potential output, which may intensify the demand for labour/capital and drive their prices upward. Recession - output is below potential output, which may put downward pressure in wages and costs of inputs. Two Sources of Business Cycles 1\. Instability of AD - significant expansions and contractions in the components of AD. 2\. Supply shock - significant events that directly affect production and the aggregate supply in the short run. 1\. Instability of AD To keep the analysis simple, we assume an economy starts in the long-run equilibrium (EL). Suppose a wave of consumers optimism overtakes the economy - this leads to a rise in consumption and AD shifts to the right (AD, to AD,). It results in a new short-run equilibrium at E 1\. Instability of AD At this new equilibrium (E,), output and prices are higher. The output gap (horizontal difference between Y, and Y,) is called an inflationary gap. How would this economy return back to its long-run equilibrium? Return to LR equilibrium Given the inflationary gap, it put upward pressure on wages (more costly to produce goods) and the SRAS shifts to the left (SRAS, to SRAS,) until it reaches E This brings production back to its original level (Ya) but prices rise further to P 3° The Role of Public Policy It can take a long time for the economy to fully adjust to aggregate demand (and aggregate supply) shocks. Waiting for adjustment is often difficult on producers and consumers. Voters often call upon politicians to respond during a recession. The government can try to boost the economy out of a recession through government spending. Role of Public Policy In order to restore equilibrium output, one way is to have government increase spending (G), this will shift the AD to the right. The new equilibrium is at a higher price level (P3) but may still below the levels under the long-run equilibrium. The Effects of a Shift in AD To sum up, here are three important points to remember: 1\. In the short-run, shifts in AD cause fluctuations in the economy\'s output of goods and services. 2\. In the long-run, shifts in AD affect the overall price level but do not affect the level of output (stays at potential output). 3\. Policymakers who intervene AD can potentially mitigate that severity of business cycles. Supply Shock Temporary supply-side shocks - only SRAS shifts. Permanent supply-side shocks - both LRAS and SRAS shift. The macroeconomic impact of such event is the result of stagflation. Stagflation is a period of decreasing output and increasing prices. 2\. Supply Shock To keep the analysis simple, we assume an economy starts in the long-run equilibrium (E,). Suppose there is a temporary increase in the price of oil - this leads to a rise in production cost and SRAS shifts to the left (SRAS, to SRAS 22 It results in a new short-run equilibrium at E2\'  Supply Shock At this new equilibrium (E,), output is lower and prices are higher (stagflation). The output gap (horizontal difference between Y 2 and Y.) is called a recessionary gap. How would this economy return back to its long-run equilibrium? Supply Shock Given the recessionary gap, it put downward pressure on wages (due to higher unemployment) and the SRAS shifts to the right (SRAS, to SRAS,) until it reaches back to E1 This brings production back to its original level (Y,) and prices return to P1: Role of Public Policy Another way to restore equilibrium output is to have government increases spending (TG), this will shift the AD to the right. The new equilibrium is at a higher price level (P) and output returns to the long-run equilibrium (1). The Effects of a Shift in AS To sum up, here are two important points to remember: 1\. Shifts in AS can cause stagflation. 2\. Policymakers who intervene AD (via G) can potentially mitigate the adverse impact on output but at the cost of exacerbating the problem of inflation. Government spending is a short-term policy action used to address short-term shocks. Chapter 13  Fiscal Policy Fiscal policy is government decisions about the level of taxation and public spending. To combat recession, government enacts expansionary fiscal policy: an overall effect of decisions about government spending and taxation intended to increase AD. To combat inflation, government enacts contractionary fiscal policy: an overall effect of decisions about government spending and taxation intended to decrease AD. Expansionary fiscal policy In the short-run, if there exists a recessionary gap (-,) in the Price level economy (I.e. leftward shift of AD\*); The short-run equilibrium has a price level and output lower than before. Expansionary fiscal policy Government can increase its spending\*; shifts AD curve to the right (AD, to AD3) The amount of the shift depends on the spending and the MPC Contractionary fiscal policy In the short-run, if there exists an inflationary gap (YaY) in the economy (i.e. rightward shift of AD); The short-run equilibrium has a price level and output higher than before. Contractionary fiscal policy \(B) Contractionary fiscal policy lowers prices and output Price level LRAS To slow down the economy, government can cut its spending; shifts AD curve to the left (AD, to AD3). Prices and output fall, although the economy (Y) is still above its long-run equilibrium (Y). Discretionary fiscal policy Given the above two scenarios, the discretionary choices often amount to no more than educated guesses as they are made without the benefits of all the relevant information. Keynesian economists emphasized that the government should actively stimulate AD when AD appeared insufficient to maintain production at Ye Discretionary fiscal policy However, even with good intention, time lags in policy decisions and implementation can mean sometimes it is too late to do any good. By the time the change in fiscal policy is passed and ready to implement, the condition of the economy may well have changed. In addition, fiscal policy is open to political interference that may cause efforts at economic stimulus to not be aimed to where it is needed the most. Autonomous fiscal policy Classical economists suggest the economy should be left to deal with short-run fluctuations on its own. They believe there are programs that are already in place to deal with these fluctuations. Automatic stabilizers are changes in fiscal policy that stimulate AD when the economy goes into a recession, without government having to take any deliberate action. These include the tax system and some government spending programs like El and welfare benefits. Ricardian equivalence The other important tool of fiscal policy is the level of taxation. Ricardian equivalence is a theory predicts if governments cut taxes but not spending, people will not change their behaviour. Under this situation, government will have to borrow money to cover the financial shortfall from cutting taxes. People believe this will lead to future tax increases so their consumption spending may not increase as intended by the tax reduction. Government budget Budget deficit is the amount of money a government spends beyond the revenue it brings in. Budget surplus it the amount of revenue a government brings in beyond what it spends. Spending increases can lead to larger deficit, but so can decreases in tax revenues. During recession, budget deficit arises as government spending often increases as part of an expansionary fiscal policy (and due to automatic stabilizers) couple with a fall in tax revenue as people are earning less and spending less. Public debt Public debt is the total amount of money government owes at a point in time and it increases with deficits (and decreases with surpluses). Debt is the cumulative sum of all deficits and surpluses. Deficit is how much the government revenues fall short of spending each year. Government can finance its debt by issuing treasury securities (Treasuries) and treasury bills (T-bills) to people and banks. Benefits and costs of public debt Two main benefits Financial flexibility when something unexpected happens. It can pay for investments that lead to long-run economic growth, prosperity and tax revenues. Two main costs Direct cost of debt: the interest government pays on its debt (\$24.5b in 2021-22). Indirect cost of debt: it can distort the credit market and slow economic growth. Public debt can crowd out private borrowing as it decreases national saving that leads to increase in interest rate. Chapter 14 Basics of Finance Financial market is where people trade future claims on funds or goods. Financial market may subject to Information asymmetry - when one participant in a transaction knows more than another participant. Adverse selection - when buyers and sellers have different information about the quality of a good or the riskiness of a situation. Moral hazard - tendency for people to behave in riskier ways or to renege on contracts when they do not face the full consequences of their actions. Market for loanable funds Real-world financial markets involve many products with different prices. This analysis simplifies all savings and borrowing into one market with one price. Market for loanable funds: the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Saving is the source of supply for loanable funds. Investment is the source of demand for loanable funds. The real interest rate (r) is the price of money. Savings-Investment Identity Y = C+1 +G+ NX In a closed economy: NX = 0 Y = C+ I+G Savings-Investment Identity Y - C -G=1 S= I National saving (S) is the total income in the economy that remains after paying for consumption and government purchases. Savings-Investment Identity Let T denote the taxes collected by government minus transfer payments. National saving can then be expressed in either of two ways: S = Y - C - GorS = (Y - T - C) + (T - G) Private saving is the income that households have left after paying for taxes and consumption. Y -T - C Public saving is the tax revenue that the government has left after paying for its spending. T ---G IfT \> G, we have budget surplus and if T \< G, we have budget deficit. Market for loanable funds Interest rate Typical market for loanable funds is at equilibrium where national savings intersects with investment. The intersection determines equilibrium interest rate (r\*) and the amount of money traded in the market (Q\*). The factors determining how much people want to save and invest change over time and between countries. These factors shift the supply and demand in the market for loanable funds. As these factors change, the equilibrium interest rate and quantity changes. Determinants of savings Savings decisions reflect trade-off faced between spending now or saving, including factors of: Wealth - richer households tend to save more Economic conditions Expectations about future economic conditions Uncertainty Borrowing constraints Social welfare policies Culture Determinants of investment Investment decisions reflect trade-off faced between potential profits that could be generated by investment and cost of borrowing money for that investment considering: Expectations about future profitability and future economic conditions Uncertainty Changes in the government\'s budget deficit/surplus Investment decisions are affected by external forces that determine supply of loanable funds and interest rate. Market for loanable funds In the above analysis, there is a single interest rate - a rate that is paid by all prospective borrowers and received by all lenders. In reality, there is not a single interest rate paid by all prospective borrowers. There are two basic factors driving differences in interest rates. 1\. The loan term: the opportunity cost of lending money. 2\. The riskiness of the transaction: a default occurs when a borrower fails to pay back a loan according to the loan terms. Realistic look at interest rates The risk of a borrower defaulting on a loan is referred to as credit risk. The risk-free rate is the interest rate that would prevail if there were no risk of default. Credit risk is measured against the risk-free rate. The risk premium is the difference between the risk-free rate and the interest rate an investor must pay. Functions of the financial system There are several ways that financial institutions help fill the three basic roles of financial markets. Match buyers and sellers: Financial intermediaries channel funds from people who have them to people who want them. Provide liquidity: Liquidity is a measure of how easily an asset can be converted quickly to cash without much loss of value. Diversify risk: Diversification is when risks are shared across many different assets or people. Major financial assets: Equity The financial system fulfill its roles of intermediation, providing liquidity, and diversifying risk by creating financial assets that can be bought and sold. For example, owning part of a company permits the holder to have a share in its profits, or an equity stake in the company. A stock is a financial asset that represents partial ownership of a company. Stockholders are entitled to receive a portion of a company\'s profits. A dividend is a payment made periodically to all shareholders of a company. Major financial assets: Debt A loan is issued when a lender provides funds to a borrower in exchange for future repayment of the amount loaned plus interest. Loans are generally less risky and less rewarding than buying a stock. A bond is a form of debt where the bond issuer promises to repay the loan plus scheduled interest payments. The interest payments on bonds are called coupons. Major financial assets: Derivatives Derivatives are financial assets that are based on the value of some other asset. The most common example of a derivative is a futures contract. The buyer of a futures contract agrees to pay the seller based on the future price of some asset. Futures contracts allow sellers to transfer risks relating to future prices to the contract partner. Major players in the financial system A well-functioning financial system would not exist without four key players. 1\. Banks and other financial intermediaries. 2\. Savers and their proxies: ---A mutual fund is a portfolio of stocks and other assets managed by a professional who makes decisions on behalf of clients. -A pension fund is a professionally managed portfolio intended to provide income to retires. Major players in the financial system 3\. Entrepreneurs and businesses: They are often looking to borrow money to finance their latest ventures. Without these borrowers, much of the financial system would not exist. 4\. Speculators: A speculator is anyone who buys and sells financial assets purely for financial gain. Valuing assets There are several ways to classify risk: Market (systemic) risk refers to risk that is broadly shared by the entire market or economy. Idiosyncratic risk refers to risk that is unique to a particular company or asset. Standard deviation is a measure of how spread out a set of numbers are. This is the most commonly used measure of risk in financial markets. The efficient-market hypothesis The principle of asset valuation assists savers to decide on which assets to purchase. There are three basic approaches used to pick stocks that are most likely to increase in value. 1\. Fundamental analysis: Estimate how much money a company will earn in the future. The net present value (NPV) is a measure of the current value of a stream of expected future cash flows. 2\. Technical analysis: Analyze movements in a stock\'s prices to predict future movements. 3\. Efficient-market hypothesis - market prices use all available information to represent true value. The efficient-market hypothesis The efficient-market hypothesis states that market prices always incorporate all available information, and therefore represent stock value as correctly as possible. Fundamental and technical analysis only work if the current price differs from the \"correct\" price. Arbitrage is the process of taking advantage of market inefficiencies to earn a profit.