UGBS 204: Macroeconomics for Business Lecture Notes PDF

UGBS 204: MACROECONOMICS FOR BUSINESS INTRODUCTION TO MACROECONOMICS Jan/Feb, 2017 UGBS 204 (slide 1) Jan/Feb, 2017 1 / 34 In the News The Monetary Policy Committee of the Bank of Ghana press release of January 2017 Monetary policy rate maintained at 25.5% What does this mean for businesses and households? Inflation rate for December 2016: 15.4% Compared with 17.7% a year ago Is this deflation or disinflation? What factors are driving this reduction? Current gov’t promised to remove “nuisance taxes” Special Import Levy; 17.5% VAT on imported medicines not produced in Ghana; 17.5% VAT on Financial Services etc How can removal of these taxes “increase in production” and “more than compensate for any temporary revenue shortfall” and create jobs for the youth? UGBS 204 (slide 2) Jan/Feb, 2017 2 / 34 Macroeconomics Macroeconomics studies the economy as an aggregate unit It is unlike micro which focuses on individuals markets macro focuses on all markets aggregated into one Typical issues studied in Macro Gross Domestic Product, Employment and Unemployment Inflation & interest rates Fiscal and Monetary policy Economic growth and business cycles UGBS 204 (slide 3) Jan/Feb, 2017 3 / 34 Two main issues in Macro 1 Long-run economics Growth: 1 What determines long-term per capita income? 2 Why are some countries rich and some poor? 2 Business Cycle: 1 These are the short-term fluctuations in output 2 What causes recessions? Are they all alike? Can they be avoided? 3 How can monetary and fiscal policy minimize the effects of economic fluctuations? UGBS 204 (slide 4) Jan/Feb, 2017 4 / 34 Big Themes 1 Growth: What determines long-term growth? Why are some countries rich and some poor? 2 Business Cycle: What causes recessions? Are they all alike? Can they be avoided? Is there an economy’s speed limit? 3 Inflation: What causes inflation (hyperinflation)? Why do we care? 4 Monetary and fiscal policy: Can monetary and fiscal policy stabilize the economy? How? Why does the BoG targets inflation ? When do budget deficits become a concern? 5 Financial Markets: Why do financial markets respond to macroeconomic news? UGBS 204 (slide 5) Jan/Feb, 2017 5 / 34 Why Do We Study Macroeconomics? Understand the impact of government policy The MPC recently maintained the MPR at 25.5%, what does this mean for your cost of borrowing? Impact of exchange rate movements Interest rate fluctuations and cost of borrowing Financial markets and investors responds to macroeconomic news Sales forecast UGBS 204 (slide 6) Jan/Feb, 2017 6 / 34 Some Basic Concepts (1) GDP: It is the market value of final goods and services newly produced within a fixed period of time, within the geographic boundaries of a country Unemployment is the number of people who are available for work and actively looking for work but cannot find jobs the unemployment rate is the fraction of the labour force that without employment Inflation: it is the rate at which the general/average level of prices in an economy increases Deflation refers to decreases in the general level of prices in an economy UGBS 204 (slide 7) Jan/Feb, 2017 7 / 34 Some Basic Concepts (2) Business cycles: refer to the short-run contractions and expansions in economic activity in an economy It refers to the cycles of recessions and recoveries that characterizes economies in the short run UGBS 204 (slide 8) Jan/Feb, 2017 8 / 34 Some Basic Concepts (2) Business cycles: refer to the short-run contractions and expansions in economic activity in an economy It refers to the cycles of recessions and recoveries that characterizes economies in the short run Macroeconomic policies: these are the two main sets of policy tools available to the government (central bank) for affecting short-term economy activity Fiscal policy refers to the use of government spending and taxes to affect economic activity Monetary policy refers to changes in money supply that are used to affect the level of economic activity and/or control the rate of inflation UGBS 204 (slide 8) Jan/Feb, 2017 8 / 34 Classicals vs Keynesian Approaches Most of the disagreements in positive macroeconomics have their roots in the disagreements between the Classical and Keynesian schools of thought At the heart of this disagreement is the speed of adjustment of prices in various markets Classicals, following Adam Smith’s Invisible Hand, believe that markets adjusts almost instantly so all markets are always in equilibrium this gives no room for fiscal and monetary policy Keynesians believe that adjustments can take a long time, the economy can be in disequilibrium for a while “in the long run, we are all dead” UGBS 204 (slide 9) Jan/Feb, 2017 9 / 34 Circular-flow model The circular flow model is a simple way to visually show the economic transactions that occur between households and firms in the economy Firms hire and use factors of production from households for use in the production process Firms then produce and sell the goods and services to households UGBS 204 (slide 10) Jan/Feb, 2017 10 / 34 Circular-Flow UGBS 204 (slide 11) Jan/Feb, 2017 11 / 34 Households in the Circular-Flow Households are the owners of factors of production They sell these factors of production to firms in return for wages and rents With these incomes (wages and rents) they buy and consume goods and services produced by firms UGBS 204 (slide 12) Jan/Feb, 2017 12 / 34 Markets in the Circular-Flow Market for factors of production households supply (sell) factors of production firms buy the factors of production The factors of production land, labor and capital Market for goods and services firms sell the goods and services (supply side) households buy the goods and services (demand side) UGBS 204 (slide 13) Jan/Feb, 2017 13 / 34 What is National Income Accounting? National income accounting refers to the framework for measuring the current level of economic activity By current level of economic activity we mean GDP In Ghana the calculation is done by the Ghana Statistical Service Three main approaches to the calculation amount of output produced, excluding output used up in intermediate stages incomes received by the producers of output amount of spending by the ultimate purchases of output UGBS 204 (slide 14) Jan/Feb, 2017 14 / 34 Measuring GDP We defined GDP as the market value of final goods and services newly produced within a fixed period of time, within the geographic boundaries of a country We are interested in market value so we value each good at the price at which they are sold we cannot add oranges to taxi services we convert physical quantities into cedi value We are also interested in final goods only we exclude intermediate goods and services Finally, we are interested only newly produced goods and services in that period purchases of goods and services produced in the previous periods are excluded. UGBS 204 (slide 15) Jan/Feb, 2017 15 / 34 Three approaches to calculating GDP Product approach/value-added approach measures economic activity by adding up the market value of all newly produced goods and services, excludes intermediate inputs to avoid double counting also computes economic activity by summing up value-added at each stage of production Income approach measures GDP by summing up all incomes received by factors of production wages/salaries of workers, rents paid to fixed assets, profits received by business owners, interest accruing to capital Expenditure approach measures GDP by adding all spending by ultimate users of final output household expenditures, firms’ investment expenditures government purchases of goods and services UGBS 204 (slide 16) Jan/Feb, 2017 16 / 34 All Three approaches are Equivalent The Fundamental Identity total income=total production=total expenditures Income=expenditures: what sellers of the total output receive must be equal to what buyers spend Production=expenditures: the market value of total production equals the amount spent on it Income=production: Market value of production should equal what is paid to factors of production This identity means that the all the three approaches to measuring GDP are equivalent UGBS 204 (slide 17) Jan/Feb, 2017 17 / 34 Computation of GDP (expenditure approach) The expenditure approach is the most common (most important) approach used in computing GDP sums up four main sources of expenditure on GDP: Y = C + I + G + NX C: consumption expenditures: durables, non-durables, services I: Gross domestic private investment: business fixed investment residential investment (houses) inventories (produced but not sold) UGBS 204 (slide 18) Jan/Feb, 2017 18 / 34 Computation of GDP (expenditure approach) sums up four main sources of expenditure on GDP: Y = C + I + G + NX Government expenditures on goods and services expenditures on law enforcement, defense, salaries of govt workers etc capital expenditures on roads and other infrastructure Excludes transfer payments eg SSNIT pensions, interest payments on debts NX: net exports total exports minus total imports UGBS 204 (slide 19) Jan/Feb, 2017 19 / 34 GDP vs GNP Gross National Product (GNP) is the market value of final goods and services newly produced by domestic factors of production during the current period This is the total final output produced by the nationals/citizens of a country The difference between GDP and GNP is called the Net Factor payments from abroad (NFP) NFP is incomes/earnings paid to domestic factors of production by the rest of the world less income paid to foreign-owned factors of production by the domestic economy GDP=GNP-NFP UGBS 204 (slide 20) Jan/Feb, 2017 20 / 34 From GDP to Disposable Income (private) Disposable income is the amount of income available to the private sector to spend (and save) This is income after deductions (taxes, SSNIT, etc) plus transfer payments NFP is incomes/earnings paid to domestic factors of production by the rest of the world less income paid to foreign-owned factors of production by the domestic economy For the economy as a whole, total private disposable income is: Disposableincome = Y + NFP + TR + INT − T TR is transfer payments from government, INT is interest payments T is taxes UGBS 204 (slide 21) Jan/Feb, 2017 21 / 34 Aggregate Savings Total savings in an economy is the sum of private and government savings Private savings is disposable income less consumption Spriv = Disposableincome − C = Y + NFP + TR + INT − T − C Government savings is the government net income less government purchases Sgovt = (T − TR − INT ) − G national (aggregate savings) is the sum of the two S = Spriv + Sgovt = Y + NFP − C − G (1) UGBS 204 (slide 22) Jan/Feb, 2017 22 / 34 Uses of Private Savings Starting with the equation for national savings (1) we can substitute the expression for Y S = Y + NFP − C − G = C + I + G + NX + NFP − C − G We can simplify this expression to obtain: S = I + (NX + NFP) (2) The sum of NX and NFP is called the Current Account balance from the balance of payments accounts S = I + CA This equation states that national savings are used to finance national investment and the current account balance It also means that the CA balance is the excess of national savings over investment UGBS 204 (slide 23) Jan/Feb, 2017 23 / 34 The Twin Deficits The national income accounting identities can also be used to illustrate the so-called twin deficits This is the relationship between the government budget deficit and current account deficit From our previous definitions, GNP is given by Y = C + I + G + NX + NFP=> Y − C − I = G + CA If we subtract taxes from both sides, we have Y − C − I − T = G + CA − T => S − I = CA − (T − G ) UGBS 204 (slide 24) Jan/Feb, 2017 24 / 34 Economic Performance Over Time Typically, we calculate GDP per capita (per capita income) GDP population How well is the Ghanaian economy doing today compared with three years ago? Ghana is now a lower middle income country! Really?? UGBS 204 (slide 26) Jan/Feb, 2017 26 / 34 Economic Activity or Economic Wellbeing? GDP calculates the level of economic activity within an economy Some use GDP as a measure of economic wellbeing higher GDP per capita means higher income; ability to meet basic needs and more UGBS 204 (slide 27) Jan/Feb, 2017 27 / 34 Economic Activity or Economic Wellbeing? Several limitations to using GDP (GDP per capita) as a measure of economic wellbeing Distributional issues Does not matter if only the president owns/uses all the economic resources and the rest of us starve Non-welfare elements add to GDP: high military spending does not mean our standard of living is improving Non-market production: Not every good/service is counted Baby-sitting is not counted but the employing a nanny to do the same is counted UGBS 204 (slide 28) Jan/Feb, 2017 28 / 34 Real vs Nominal GDP? Real GDP measures actual physical volumes of economic activity GDP at constant prices excludes changes in prices Nominal GDP is the cedi value of the all economic activity measures value of GDP in current cedis includes changes in both physical quantities and prices The difference between growth of nominal and real GDP is solely due to changes in prices UGBS 204 (slide 29) Jan/Feb, 2017 29 / 34 Real vs Nominal GDP: example Assume the economy of Ghana produces only Kelewele and Pure water Our goal is to compare GDP between 2010 and 2014 Nominal GDP 2010 Nominal GDP 2014 Real GDP 2014 Kelewele 15 @ GHC 10 20 @ GHC 15 20 @ GHC10 Pure water 50 @ GHC 2 60 @ GHC 2.50 60 @ GHC 2 Total GHC 250 GHC 450 320 UGBS 204 (slide 30) Jan/Feb, 2017 30 / 34 Real vs Nominal GDP: example In the example above, what is the growth rate of nominal GDP between 2010 and 2014? 450−250 250 ∗ 100% = 80% In the example above, what is the growth rate of real GDP between 2010 and 2014? 320−250 250 ∗ 100% = 28% In this example, we call 2010 the base year, as the prices from this year are used for calculating changes in real GDP In Ghana, the real GDP is now calculated using 2006 as the base year UGBS 204 (slide 31) Jan/Feb, 2017 31 / 34 Price indexes: GDP deflator A price index is a measure of the average level of prices for a specified set of goods and services relative to the prices in a specified base year The GDP deflator is a price index that measures the overall level of prices goods and services included in the GDP GDPdeflator = GDP nominal GDPreal ∗ 100 In our example, the GDP deflator is 450 320 ∗ 100 = 140.63 UGBS 204 (slide 32) Jan/Feb, 2017 32 / 34 Consumer Price Index and Inflation The GDP deflator can be used to measure the rate of inflation The Consumer Price Index (CPI) is a more common measure of inflation The CPI is a price index of consumer goods it contains a fixed typical market basket of goods and services but may be revised as needed We use the CPI to calculate inflation rate as follows: Pt+1 −Pt πt+1 = Pt ∗ 100% UGBS 204 (slide 33) Jan/Feb, 2017 33 / 34 Economic Growth Long-Run Economic Growth The University of Ghana Business School UGBS 204: Macroeconomics for Business UGBS 204: Lecture two Economic Growth Outline 1 Economic Growth Meaning of Economic Growth Importance of long-term Growth Sources of Economic Growth Economic growth and income distribution UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Outline 1 Economic Growth Meaning of Economic Growth Importance of long-term Growth Sources of Economic Growth Economic growth and income distribution UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution What is Economic Growth? Economic growth relates to long-term changes in real GDP Can be defined as expansion of the country’s potential GDP or national output It is sustained expansion in the production of goods and services in an economy over time A steady increase in the market value of goods and services produced by an economy overtime Economic growth can also be seen as expansion of a country’s production possibilities frontier UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Economic Development Economic development is close related to economic growth Broadly speaking,the process of economic development refers to sustained expansion in the capacity of an economy to provide for the material wellbeing of its members above and beyond the level of subsistence While growth of income per capita is an essential for economic development, economic growth does not necessarily lead to economic development Economic development can be seen as economic growth accompanied by material changes in peoples standards of living UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Importance of long-term growth rate According to World Bank’s World Development Indicators, Ghana GDP per capita in 1960 was $182.98 In the 50 years since 1960, annual per capita GDP growth rate was 4.036% so the per capita GDP in 2010 was $1323.1 GDP per capita2010 = $182.98(1 + 0.04036)50 If the growth rate of per capita income over the subsequent 50 years had been only 1 percentage point higher, what will GDP per capita be in 2010? GDP per capita2010 = $182.98(1 + 0.05036)50 = 2134.6 UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Growth and standards of living Rapid economic growth allows countries to more of everything to their citizens better food and bigger homes more resources for health care universal education for children better pensions for retirees UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution.....“Many roads lead to Rome” There are many different successful strategies to sustained economic growth Britain became world economic leader in the 19th century by pioneering the Industrial Revolution Japan became world economic superpower by initially imitating foreign technologies it then developed high level of expertise in manufacturing and electronics UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution The four wheels of growth Although there different individual paths to sustained economic growth, there are common fundamental factors the underlie all sustained economic expansion Aggregate production/ GDP (Q) is produced using the following technological relationship: Q = AF (K , L, R) where A: level of technology in the economy K is productive services of capital L is labour units R is raw material inputs If GDP is produced with these inputs, growth rate of GDP will come from growth rate of these inputs UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Human Resources and Economic growth Human resources refer to the quantity and quality of labour inputs The quantity of human resources refer to the labour supply The quality of the labour resources depend on education, skills, discipline motivation etc Many economists believe that the quality of labour inputs is the single most important element of economic growth UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Natural Resources and Economic growth Important natural includes arable land, oil, gas, forests, water and mineral deposits Some currently developed countries have grown primarily on the basis of their ample resource base prime examples are Canada and Norway However, as the example of many African countries show, possession of abundant resources is neither necessary nor sufficient for economic success UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Technology, innovation and Economic growth Technological change denotes changes int he processes of production or introduction of new products and services Technological change promotes growth by enhancing productivity process inventions such as steam engine, internal combustion engine, microprocessor greatly increased productivity According neoclassical growth models, technological progress is the main source of sustained long-term growth in living standards Technological progress is however a complex and multifaceted process and there is not clear formula for acheiving success UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Growth and income distribution When we use per capita income as the yardstick we ignore the effect of growth on income distribution Not everyone benefits from growth equally because growth is normally distributed through increased wages and higher profits; The poorest who are unemployed therefore do not share in the growth When growth is driven mainly by technological change it leads to loss of jobs, and thus not everyone shares in the growth UGBS 204: Lecture two Meaning of Economic Growth Importance of long-term Growth Economic Growth Sources of Economic Growth Economic growth and income distribution Growth and income distribution Thus we should note that in even in periods of high growth, the distribution may be unequal Some will face extreme poverty and hardships and so there will be need for redistribution policies to avert the hardships Empirically the relationship between economic growth and income distribution is not clear Redistribution policies are pro-poor policies to make growth share growth. Here the increment in real GDP is redistributed through gov’t. intervention UGBS 204: Lecture two UGBS 204:Macroeconomics for Business Lecture three National Income Determination LECTURER: 1 16-Jun-21 Demand-determine Output in the Keynesian System Introduction Equilibrium in the Simple Keynesian System 16-Jun-21 2 Introduction We consider output determination in the Keynesian model Output is demand-determined – Factors of aggregate demand play a key role in the determination of the level of equilibrium output – the determinants of aggregate demand determines the equilibrium level of output. This explains determination of output in the short-run 16-Jun-21 LECTURER: 3 Aggregate Demand Aggregate demand shows the total quantities of goods and services demanded by households, firms, governments and the external sector at various price levels – also called the aggregate expenditures Aggregate demand tells us where the GDP we have produced go = + +G+NX – where is desired consumption, and is desired investment 16-Jun-21 LECTURER: 4 Determinants of Aggregate Demand To understand the determinants of aggregate demand, we need to understand the determinants of the various components of AD To start with the level of government purchases, it is plausible that this depends on the level of economic activity – If the level of economic activity is low, the government might spending more to boost the level of AD We will assume that the level of government purchases is fixed at an exogenous level 16-Jun-21 LECTURER: 5 Determinants of Consumption The main determinants of consumption are ? Current income – Future income – Wealth – Interest rates – Taxes 16-Jun-21 LECTURER 6 The Keynesian Consumption Function (1) The Keynesian consumption function specifies consumption as a function of current disposable income: – = α + β – where is disposable income We call α autonomous consumption: – It is the level of consumption that does not depend on income – i.e. the consumption when income is zero β is the marginal propensity to consume (MPC) – It measures the change in consumption per unit change in income 16-Jun-21 LECTURER 7 The Keynesian Consumption Function (2) The Keynesian consumption function as specified has a number of properties The MPC is constant The Average Propensity to Consume (APC) decreases with income: – The APC is the fraction of income that is spent on consumption α – APC=C/ = +β 8 16-Jun-21 LECTURER The Keynesian Savings Function Recall that the part of disposable income that is not spent on consumption is saved We can use this fact to derive the savings function ? – S= - C= - α - β = - α +( 1- β ) – - α is the autonomous dissaving – ( 1- β ) is called the marginal propensity to saves 16-Jun-21 LECTURER 9 Investment The level of desired investment depends on – The user cost of capital (real interest rate) – Business expectation about the future prospects of the economy – Taxes – Investment tax credit In our simplified model, we will assume that the level of investment is exogenously fixed at 16-Jun-21 LECTURER 10 Net Exports (NX) Recall that net export is total exports minus total imports Net exports depends on – domestic income – foreign income – real exchange rate In our simplified model, we will assume that net exports is exogenously fixed at 16-Jun-21 LECTURER: 11 Equilibrium in the Simple Keynesian System We start with a basic model by assuming a closed economy with no government – i.e. we assume G=0 and NX=0 Then AD=C+I This economy will reach equilibrium when Y=AD 16-Jun-21 LECTURER: 12 Basic Model in Pictures. 16-Jun-21 LECTURER: 13 Basic Model: Algebraic Solution The basic relationships in this economy are: – C=a+bY – I= The equilibrium condition requires that Y=AD That is: – Y=AD=a+bY+ – Y-bY=a+ => Y( 1-b )=a+ 1 – = ( + 0 ) 1− In addition to the above significance, it will help portfolio investors to know how to allocate their investment depending the perceived risk in that country. 16-Jun-21 LECTURER: 14 Autonomous Spending multiplier The term: 1 1− is called the autonomous expenditure multiplier It is a multiple by which a change in any component of autonomous expenditures increases equilibrium output In this simplified framework, the components of autonomous spending are – a, 16-Jun-21 LECTURER: 15 Adding government to the Basic Model Our model changes in two main ways when we add government to it – The government make purchases – The government also taxes We therefore have to make the changes to our basic relationships to reflect these We will continue to assume that government purchases are exogenously determined We will make the same assumption about government taxes 16-Jun-21 LECTURER: 16 Adding government to the Basic Model The basic relationships in this economy are: – C=a+b – I= – G= The equilibrium condition requires that Y=AD That is: – Y=AD=a+b( Y-T )+ + – Y-bY=a+ => Y( 1-b )=a-b + + a−b + + – = 1− 16-Jun-21 LECTURER: 17 Adding government to the Basic Model 16-Jun-21 LECTURER: 18 Fiscal Policy Fiscal Policy in Simple Keynesian System UGBS 204: Macroeconomics for Business UGBS 204: Lecture four Fiscal Policy Outline 1 Fiscal Policy Meaning of Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Outline 1 Fiscal Policy Meaning of Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy What is Fiscal Policy? Fiscal policy refers to changes in the level of government spending and/or taxes meant to inuence the level of economic activity Reading of the budget statement is announcement of gov't scal policy Fiscal policy may be expansionary or contractionary Expansionary policy: also scal loosening refers to increases in govt spending or reduction taxes UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Types of Fiscal Policy Fiscal policy may be expansionary or contractionary Expansionary policy: (scal loosening) refers to increases in govt spending and/or reduction taxes Contrationary policy: (scal tightening) refers to increases in govt taxes and/or reduction in govt spending scal austerity UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Fiscal Policy in the Simple Keynesian System Recall from last week: basic relationships in this economy are: C = a + bY d I = I0 G = Go , T = T0 The equilibrium condition requires that Y=AD That is: Y = AD = a + b(Y − T ) + I0 + G0 Y − bY = a + I0 => Y (1 − b) = a − bT0 + I0 + G0 Y e = a−bT10−b +I0 +G0 UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Autonomous Spending Multipliers 1 Recall from last week: 1−b is called the autonomous expenditure multiplier It is a multiple by which a change in any component of autonomous expenditures increases equilibrium output In this framework, the components of autonomous spending are a, I0 , G0 UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Autonomous Tax Multipliers a−bT0 +I0 +G0 Ye = 1−b From the previous example, what is the eect on an increase in taxes (T0 ) on equilibrium income Y e If we dierentiate Y e with respect to T0 we have: ∂Y e −b ∂ T0 = 1−b This is the autonomous tax multiplier that shows the eect of changes in autonomous taxes on equilibrium the negative shows that an increase in tax will reduce equilibrium income UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Balanced-budget Multiplier (1) What will be multiplier be if government increased its spendingby raising an equal amount in autonomous tax? The balanced-budget multiplier shows the eect on income of an increase in government spending and autonomous taxes by equal amounts The balanced budget multiplier is 1, this means that equilibrium income will increase by the same amount of the increase in government spending and taxes UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Balanced-budget Multiplier(2) To see this, note that if G increases by 4G , the overall eect 1 on Y will be 4G ∗ 1−b If T increases by 4T the eect on Y will be −4T ∗ 1−bb Note that since taxes and spending increase by the same amount, 4G = 4T , Add the two eects up gives: 1 4G ∗ 1−b b − 4G ∗ 1−b = 4G ( 11−b −b ) = 4G UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Example (1) Consider the following: C = 100 + 0.8Y d I = 200 G = 80, T = 70 In this example, the marginal propensity to consume is 0.8 80% of any additional income goes to consumption UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Example (3) We can now solve for the equilibrium In equilibrium Y=AD Y = 100 + 0.8(Y − 70) + 200 + 80 Y = 324 + 0.8Y 0.2Y = 324 Y=1620 UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Actual GDP, Potential GDP and Output Gap Actual GDP (Y ∗ ) refers to what the economy does produce, whilst Potential GDP (Yp ) refers to what the economy could produce if all the resources in the economy are fully utilized The dierence between what the economy could have produced and what actually is produced is referred to as the Output (GDP) Gap Output gap = Yp − Y ∗ If output gap is positive ie Yp > Y ∗ we have recessionary gap If output gap is negative ie Yp < Y ∗ we have ination gap If output gap is zero ie Yp = Y ∗ we have full employment UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Recessionary Gap UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Inationary Gap UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Fiscal Policy as Stabilization Tool A major goal of scal policy is to stabilize actual output close to the potential output If actual output is greater than potential output (inationary gap), contractionary scal policy can be used reduce output to the potential output If actual output is less than potential output (recessionary gap), expansionary scal policy can be used to increase output to the full employment output. UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Fiscal Policy as Stabilization Tool Consider our previous example: C = 100 + 0.8Y d I = 200 G = 80, T = 70 We saw that the equilibrium income or actual output 1620 Suppose the potential output is 2000 in this example we have a recessionary gap UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Fiscal Policy as Stabilization Tool The government can use an expansionary scal policy to remove this gap Since the output gap is 380=2000-1620 and the autonomous spending multiplier is 5 government does not have to increase spending by 380 Government can increase spending by only 76 380 4G = 5 = 76 If government alternatively chose to reduce taxes, by how much should taxes be reduced?? UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Outline 1 Fiscal Policy Meaning of Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Autonomatic Stabilizes Autonomatic stabilizers refer to in-built scal mechanisms within an economy that dampens eects of uctuations in aggregate demand on actual output They ensure that during recessions, when loss of jobs lead to loss of incomes, consumption expenditures do not fall so much to deepen the recession Examples include unemployment insurance/compensation Autonomatic stabilizers are more prominent in developed countries than in developing countries UGBS 204: Lecture four Meaning of Fiscal Policy Fiscal Policy Fiscal Policy As StabilizationTool Other Issues Related to Fiscal Policy Crowding-out Eect Expansionary scal policy stimulates aggregate demand for goods and services but also raises interest rates Governments borrows when it runs expansionary scal policy The additional borrowing raises interest rate Higher interest rate increases the cost of investment, reducing investment Higher interest rates may also reduce private consumption Crowding-out refers oset in aggregate demand that results when expansionary scal policy raises the interest rate and thereby reduce investment spending UGBS 204: Lecture four UGBS 204:Macroeconomics for Business Lecture four Money, Financial System and Monetary Policy LECTURER: 1 16-Jun-21 Outline Money Fractional Reserve Banking – Financial System – Deposit Creation Central Banking and Monetary Policy – Monetary Policy – Equilibrium in the Money Market – Transmission Mechanism of Monetary Policy 16-Jun-21 2 Barter system and evolution of money Before the discovery of money (and the alternative to money system) economies rely on a barter system A barter system is characterized by direct exchange of one good for another The key problem that made barter inefficient was the need for double coincidence of want 16-Jun-21 LECTURER: 3 What is Money? Definition: “Money is anything that serves as a commonly accepted medium of Exchange” Throughout history, a number of different commodities have been used as money These include – cigarettes, ivory, gold, oil, beer, copper, cowries, etc. 16-Jun-21 LECTURER: 4 Paper versus Commodity Money The main disadvantage of commodity money is that they the items used as money had intrinsic value – they could be in high demand for reasons other than their money functions they were limited in supply – These limitations led to the use of paper money, which is not wanted for its own sake They are fiat money: declared legal tender by government 16-Jun-21 LECTURER: 5 Functions of Money Money performs three main functions: As a medium of exchange As a unit of account – Money allows us to value all things and compare how valuable things are As a store of value – we can easily convert perishable items into money and store them for future 16-Jun-21 LECTURER: 6 Monetary Aggregates (Components of Money Supply) Monetary aggregates can be classified into two main groups: Narrow money or M1 which consists of – Paper currency and coins with the public – Demand deposits (checking) accounts Broad money or M2 – M1 – Savings accounts – Time deposit accounts In Ghana there is also M2+ which is M2 plus foreign currency – deposits 16-Jun-21 LECTURER: 7 Demand for Money The demand for money is the demand for real money balances – this is the demand for the most liquid form of money rather than other interest-bearing assets The demand for money refers the quantity of money – individuals want to hold for transactions and other purposes There are two sources of demand for money: – transactions demand for money – asset demand for money 16-Jun-21 LECTURER 8 Transactions Demand for Money This derives from the need to have money to make purchases of good and services The transactions demand for money is the amount of money held for the purchases of goods and services Example: Suppose your parents give you GHC 100 per month for your up keep in school and you use GHC80 for purchases of goods and services and save GHC20 – What will be your transactions demand for money? 16-Jun-21 LECTURER 9 Transactions Demand for Money The transactions demand for money is affected by a number of factors such as interest rate – The interest rate is the opportunity cost of holding – This is what you forgo by holding assets in money rather than interest- bearing assets Other determinants of the transactions demand for money are the level of prices and incomes – If prices double, holding other things constant, you need twice as much money to buy the same quantity of goods and services 10 16-Jun-21 LECTURER Asset Demand for Money The asset demand for money arises out of money's function as a store of value When households allocate their wealth/income among various financial assets, their portfolio typically includes less liquid high-interest bearing assets and some very safe and very liquid assets – money is the safest and most liquid asset The asset demand for money refers to the need to hold some supersafe and very liquid financial asset in portfolio allocation 16-Jun-21 LECTURER 11 The Financial System The financial system captures all the activities involving finance in an economy – it is responsible for linking the other markets within the economy (goods market and factor markets) Financial systems link the economic agents within an economy: households, firms and governments carrying our their financial decisions Financial systems are made up of financial intermediaries and financial markets 16-Jun-21 LECTURER 12 What are Financial Markets Financial markets are markets that trade financial instruments – these instruments include stocks, bonds, currencies Financial markets include bond markets, stock markets and foreign exchange markets 16-Jun-21 LECTURER 13 What are Financial Intermediaries Financial intermediaries are institutions that provide financial services and products The most important financials institutions are banks (commercial, investment, central) Others include mutual funds, mortgage buyers, derivative firms, etc. 16-Jun-21 LECTURER 14 Role of financial systems Mobilizing and allocating resources Managing risks within an economy Acting as clearing houses Transfer of resources across space and time 16-Jun-21 LECTURER 15 Deposit Creation Central Banks determine the level of money supply in almost all economies – They print money, both literary and figuratively Commercial banks do not print money and they contribute to money supply through deposit creation They receive deposits from customers and are able to create more money by making loans available to other clients. 16-Jun-21 LECTURER 16 Commercial Banks Balance Sheet There are two sides to the balance sheets of commercial banks: assets and liabilities The asset side include cash in their vaults, loans, securities and reserves with central banks, investments The liabilities include demand deposits, savings accounts and time deposits 16-Jun-21 LECTURER 17 Commercial Banks Balance Sheet Assets Liabilities Reserves: GHC 200 Deposits: GHC 1000 Loans and investment: 800 Total: GHC 1000 Total: GHC 1000 16-Jun-21 LECTURER 18 Deposit Creation Process (1) Consider the case of a new bank whose rst client makes a GHC 100 deposit We assume that the required reserve ratio is 10% – this is the fraction of deposits commercial banks are required by central banks to keep as reserves 16-Jun-21 LECTURER 19 Deposit Creation Process (2) With the 10% reserve requirement, this bank is required to hold only GHC 10 as reserves Since reserves traditionally pay no interest, the bank has an incentive to make loans out of the 90 excess reserves We assume that it makes a loan of GHC 90 to another client in by issuing a cheque of GHC 90 We further assume that this person deposits the check in another bank, bank 2 16-Jun-21 LECTURER 20 Balance sheet: Bank 1 Assets Liabilities Reserves: GHC 10 Deposits: GHC 100 Loans: GHC 90 Total: GHC 100 Total: GHC 100 16-Jun-21 LECTURER 21 Deposit Creation Process (3) When bank 2 receives this GHC 90 deposit, it is required by law to keep GHC 9 as reserves can make loans out of or invest the remaining GHC 81 We will assume that this bank to will make loans worth GHC 81 of the deposits it receives It issues a cheque for GHC 81 to its client which is then deposited in another bank 16-Jun-21 LECTURER 22 Balance sheet: Bank 2 Assets Liabilities Reserves: GHC 9 Deposits: GHC 90 Loans: GHC 81 Total: GHC 90 Total: GHC 90 16-Jun-21 LECTURER 23 Deposit Creation Process (4) When bank 3 receives this GHC 81 deposit, it is required to keep GHC 8.1 as reserves can make loans out of or invest the remaining GHC GHC 72.9 At this point, the total amount of additional demand deposits created out of the initial GHC 100 deposit is GHC 243.9 (90+81+72.9) We can allow this process to continue and we can show that total additional amount of demand deposits that can be created out of this initial deposit is GHC 900 – And the total amount including the initial deposit is GHC 1000 This is the total amount of demand deposits that can be supported by GHC 100 when the required reserve ratio is 10% 16-Jun-21 LECTURER: 24 Money Supply Multiplier The money supply multiplier is the ratio of change in new money created to the change in reserves Δ money-supply multiplier= = 1/RRR Δ – where RRR is the required reserve ratio The money-supply multiplier summarizes how the commercial banks create money In our example, the money supply multiplier is 10, which means that the amount of additional loans that can be created out of any new deposit is 10 times the initial deposit 16-Jun-21 LECTURER: 25 Deposit Creation Process (5) Our example make many simplifying assumptions It is assumed that all money is kept within the banking system – in practice, the public keep some money as cash out of the banking system – banks cannot make loans out of such money It is not always the case that banks only keep the required reserve, in practice some banks keep excess reserves Since the last financial crises, some central banks have started paying interest on reserves 16-Jun-21 LECTURER: 26 What is Monetary Policy? Changes in money supply that influence the level of economic activity Monetary policy conducted by central banks In Ghana it is conducted by the Monetary Policy Committee of the Bank of Ghana 16-Jun-21 LECTURER: 27 Monetary Policy Monetary policy may be expansionary or contractionary Expansionary monetary policy (loosening): increase in money supply – mostly communicated as a reduction in policy interest rate Contractionary monetary policy (tightening): reduction in money supply – communicated as an increase in policy interest rate 16-Jun-21 LECTURER: 28 Money Supply (1) The supply of money in an economy is determined by the banking system – Directly controlled by the central bank through monetary policy – Indirectly influenced by commercial banks (and the public) through the deposit creation process The Central Bank controls the supply of money through the conduct of monetary policy 16-Jun-21 LECTURER: 29 Money Supply (2) Central banks are responsible to conducting monetary policy In some countries, the central bank is independent of the central government to conduct monetary policy Recall that monetary policy refers to changes in a country’s stock of money supply that seeks to stabilize the level of economic activity and price level In most advanced countries, stable prices means inflation rate are very close to 2% and output as close as possible to the full employment level of output 16-Jun-21 LECTURER: 30 Tools of Monetary Policy Central banks usually have an array instruments for conducting monetary policy The main ones are: – open market operations – reserve requirement policy – discount rate policy 16-Jun-21 LECTURER: 31 Open Market Operations (1) Open market operations (OMO) refer to the purchase or sale of government securities in the open market – the open market here refers to dealers in government bonds and individuals – government securities are government bonds/treasury bills Open market purchases (sales) are meant to increase (reduce) the money supply 16-Jun-21 LECTURER: 32 Open Market Operations (2) To see how OMO affects the money supply, consider open market purchase of government securities worth GHC 100m The central banks issues the initial check worth GHC 100m which can be drawn as cash or deposited into an account with a commercial bank – Note that either of these actions will increase the money supply – If the check is deposited in an account, the commercial bank can create additional loans out of it, increasing the money supply further An open market sale will have the opposite effect on the money supply 16-Jun-21 LECTURER: 33 Open Market Operations (3) In Ghana the Bank of Ghana's Monetary Policy Committee announces the direction of monetary policy after its meeting In general the policy is announced as a target policy interest rate – in Ghana, the monetary policy rate – in the US, the federal funds rate Open market activities are then carried out to meet the target policy rate 16-Jun-21 LECTURER: 34 Discount Rate Commercials can borrow from central banks when they are short of reserves The interest rate charged on commercial banks borrowing from the central bank is the discount rate Central banks raise (lower) the discount rate to signal tightening (loosening) of monetary policy 16-Jun-21 LECTURER: 35 Reserve Requirements For the purposes of prudence commercial banks keep a small fraction of their deposits as cash or its close equivalent to pay depositors who desire to withdraw Part of these reserves are required by regulators (central banks) – The required reserve ratio is the fraction of deposits required by banks to keep as reserves Banks may in addition to the required reserves, keep additional excess reserves An increase in the required reserve ratio signals a tightening of monetary policy 16-Jun-21 LECTURER: 36 Demand for Money Recall the demand for money is made of transactions demand and asset demand The major determinants of demand for money are real interest rate, level of income and expected inflation rate The quantity of money demanded falls when the interest rate rises – When interest rate rises, there is a higher incentive to allocate more wealth to other interest-bearing assets and reduce the holding of money balances 16-Jun-21 LECTURER: 37 Money Market Equilibrium 16-Jun-21 LECTURER: 38 How does Monetary Policy Work? A change in money supply shifts the money supply curve in the money market This changes the real interest rate A change in the real interest rate affects consumption and investment demand This reduces the aggregate demand and affects the general price level 16-Jun-21 LECTURER: 39 Transmission Mechanism: Monetary Tightening Let us look at recent monetary policy in Ghana Refer to the MPC Press Statement of November 2015 In the release the Committee indicates that it was concern by inflation and inflation expectation – see points 4 and 6 and summary (point 11) The MPC therefore announces an increase in monetary policy rate from 25% to 26% (point 2) How does this tightening of monetary policy stance help fight inflation 16-Jun-21 LECTURER: 40 Transmission Mechanism: Monetary Tightening How does tight monetary policy help fight inflation? An decrease in money supply increases the real interest rate Higher real interest rate reduces investment and consumption demand In the AD-AS framework, AD falls and the price level falls, which help slow down the pace of inflation 16-Jun-21 LECTURER: 41 Effect of Monetary Policy 16-Jun-21 LECTURER: 42 UGBS 204:Macroeconomics for Business Lecture Seven The IS-LM Model LECTURER: 1 16-Jun-21 Outline IS Curve: Equilibrium in the Goods Market – What is an IS curve? – Derivation of the IS LM Curve: Money Market Equilibrium – What is an LM Curve? – Derivation of LM curve Policy Analysis in IS-LM framework 16-Jun-21 2 Goods Market Equilibrium An IS curve denotes equilibria in the goods market Points on an IS curve denote real interest rate and income combinations that constitute an equilibrium in the goods market – The goods market is the market for goods and services Recall equilibrium condition from the simple Keynesian system: – Y=AD 16-Jun-21 LECTURER: 3 Goods Market Equilibrium In a closed economy, the equilibrium condition can be rewritten as an equality of savings and desired investment To see this note that – Y= = + +G − −G= The LHS of the last equation is national savings – to see this add and subtract T (taxes from the LHS) Thus the goods market equilibrium condition Y=AD can be rewritten as I=S 16-Jun-21 LECTURER: 4 Savings-Investment Equilibrium Recall from earlier the theory of consumption is a theory of savings – consumption is negatively related to the real interest rate (and positively related to disposal income) – An increase in real interest rate increases the opportunity consumption current consumption and increases savings Savings increases with both real interest rate and income Recall also that desired investment is negatively related to the real interest rate – An increase in the real interest rate reduces the real cost of investment and reduces investment demand 16-Jun-21 LECTURER: 5 IS Curve: Equilibrium in the Goods Market Derivation of the IS 16-Jun-21 LECTURER: 6 Derivation of the IS Curve 16-Jun-21 LECTURER: 7 “One -Line” Intuition How changes in GDP affect the Saving Market Negative relationship between r and Y – Channel: Y more saving r Represent this intuition with IS Curve 16-Jun-21 LECTURER 8 The IS Curve IS curve shifters – Anything other than a change in Y that changes the saving and investment market equilibrium r Example: “Expansionary Fiscal Policy” – Increasing G (or cutting T) decreases desired national saving Equilibrium r rises, for given level of Y IS curve shifts up 16-Jun-21 LECTURER 9 Example: Increase in G 10 16-Jun-21 LECTURER “IS Curve Shifters” When Y , equilibrium r in saving and investment market – A movement along the IS curve Anything else is a shift Higher G IS shifts up Higher T IS shifts down Higher IS shifts up Higher IS shifts up 16-Jun-21 LECTURER 11 LM Curve: Money Market Equilibrium What is an LM Curve? 16-Jun-21 LECTURER 12 Money Market equilibrium An LM curve denotes equilibria in the money market It shows various interest rate and income combinations that ensure equilibrium in the money market Recall downward-sloping demand for money curve: L for liquidity preference Also, a vertical real money supply curve – money supply is a policy variable under control of the central bank 16-Jun-21 LECTURER 13 Money Demand as Portfolio Choice Money is a financial asset Money demand is part of portfolio choice Portfolio choice: how to divide total financial assets into 16-Jun-21 LECTURER 14 Why Demand Money? Benefit: transaction (or liquidity) services. Real income (Y): Y↑ more and larger transactions need more liquidity Prices (P): If prices double, same transaction requires twice as much money Cost: nominal interest rate: = + Opportunity cost of holding money Opportunity cost of holding money i↑ more costly to hold money 16-Jun-21 LECTURER 15 The Money Demand Function 16-Jun-21 LECTURER 16 The Real Money Demand Curve 16-Jun-21 LECTURER 17 Money Supply Nominal quantity of money supplied controlled by Central Bank Control mechanism: open market operations Assume a vertical money supply curve 16-Jun-21 LECTURER 18 Money Market Equilibrium: /P?= =P LM Curve: Money Market Equilibrium What is an LM Curve? Money Market Equilibrium: Deriving the LM Curve 16-Jun-21 LECTURER 21 The LM Curve 16-Jun-21 LECTURER 22 “One-Line” Intuition 16-Jun-21 LECTURER 23 Why Demand Money? How changes in GDP affect the Money Market Y↑ more transactions /P ↑ r↑ Positive relationship between r and Y Represent this intuition with LM Curve LM curve shifters – Anything other than a change in Y that changes the money market equilibrium 16-Jun-21 LECTURER 24 Example: Increase in the Money Supply 16-Jun-21 LECTURER 25 Example: Bottom Line An increase in money supply leads to a decrease in the interest rate for a given level of output Y For given Y, /P↑ r So the LM curve shifts down 16-Jun-21 LECTURER: 26 LM Curve “Shifters” When Y , equilibrium r in the money market – A movement along the LM curve, anything else shifts the LM curve Higher money supply LM shifts down Higher price level LM shifts up Financial turmoil increases demand for liquidity LM shifts up Higher expected inflation decreases demand for Higher expected inflation decreases demand for liquidity LM shifts down 16-Jun-21 LECTURER: 27 Monetary policy in the IS-LM framework Consider the effect of monetary tightening – Example: consider the increase in monetary policy rate from 25% to 26% in November 2015 The increase in policy rate represents a decrease in money supply Given the price level, real money supply falls, shift the curve to the left in the money money 16-Jun-21 LECTURER: 28 Monetary policy in the IS-LM framework In the IS-LM framework, the LM curve shifts up and to the left Equilibrium income increases and real interest rate falls 16-Jun-21 LECTURER: 29 Monetary policy in the IS-LM framework 16-Jun-21 LECTURER: 30 UGBS 204:Macroeconomics for Business Lecture 8a Unemployment and Inflation LECTURER: 1 16-Jun-21 Outline Unemployment – Measurement – Types of Unemployment – Impact/Cost of Unemployment Inflation – Meaning and Measurement – Causes/Types of inflation – Impact of inflation – The Phillips Curve: inflation and Unemployment 16-Jun-21 2 Unemployment Measurement 16-Jun-21 LECTURER: 3 The Labour Force Understanding the labour force is a crucial step for understanding the measurement of unemployment The labour force is made up of the employed and the unemployed The employed are those who work for pay but includes those temporarily absent from work due to illness or leave The unemployed refers to those who are not employed but are actively looking for work – this refers to those who have made specific efforts to and work in a defined period 16-Jun-21 LECTURER: 4 Discouraged Workers Discouraged workers are people without employment who have given up the search for employment They are people who have searched for jobs for long period without success and have given up the search Discouraged workers and not part of the labour force and therefore are not accounted as unemployed 16-Jun-21 LECTURER: 5 The Unemployment Rate The unemployment rate is the fraction of the labour force that is unemployed Unemployment rate = = + 16-Jun-21 LECTURER: 6 Unemployment Spell and Duration The period of time that an unemployed person remains continuously unemployed is called an unemployment spell – For example an individual who starts the year with a job but loses it around march, finds a new one in June and holds on to it until October when he loses that job for and remains unemployed until the end of the year will have had two spells of unemployment during the year The length of time an unemployment spell lasts is called the duration of that spell 16-Jun-21 LECTURER: 7 Types of Unemployment There are three main types of unemployment – frictional unemployment – structural unemployment – cyclical unemployment The distinction between these types of unemployment is useful for understanding the underlying causes and policies for dealing with them 16-Jun-21 LECTURER 8 Frictional Unemployment Frictional unemployment is the unemployment that results from constant movement of workers between jobs – At every point in time, some workers are changing jobs and location – Since people do not always walk from one job to another, some people will be unemployed because of this Frictional unemployment cannot be reduced to zero – Even if the economy is at full employment, there will be some frictional unemployment It is a type of voluntary employment 16-Jun-21 LECTURER 9 Structural Unemployment Structural unemployment results from a mismatch between the demand for and supply of labour It results when the set of available jobs do not match skills of available workers It can arise from structural changes within the economy – eg the rise of new industries that renders some old industries obsolete 10 16-Jun-21 LECTURER Cyclical Unemployment Cyclical unemployment is associated with the business cycle It arises out of low demand for labour across many sectors of the economy 16-Jun-21 LECTURER 11 The Natural Rate of Unemployment The unemployment rate in an economy will not be zero even if that economy is producing at its maximum potential The unemployment rate that prevails when output and employment are at full employment level is called the natural rate of unemployment Because frictional and structural unemployment are never zero, there will always be positive unemployment even if an economy is producing at its potential level – This is the natural rate of unemployment 16-Jun-21 LECTURER 12 Unemployment Impact / Cost of Unemployment 16-Jun-21 LECTURER 13 Economic Cost of Unemployment (1) The main impact of employment can be classified into the economic impact and social impact The economic impact of unemployment refers to the loss of income/output associated with unemployment – This is the output the could have been produced if those unemployed were employed According to Okun's law for every 2% fall in GDP relative to the potential (or full employment GDP) the unemployment rate rises by about 1 percentage point. 16-Jun-21 LECTURER 14 Unemployment and Output Algebraically, Okun's law state that − = 2(u- ) Where – Y is actual output; is full employment output – u is actually and, is the natural rate of employment – Note that the term (u- ) is called the cyclical unemployment Okun's law states that for if the cyclical unemployment rate is 1%, output will be 2% lower then the full employment output 16-Jun-21 LECTURER 15 Economic Cost of Unemployment (2) The economic cost of unemployment is equally borne by the entire labour force – The cost is disproportionately borne by those who lose their jobs mainly in the form of loss of income – Even in advanced countries which pay unemployment insurance, this income fall short of wages Beside loss of income, extended periods of unemployment may lead to loss of skill The loss output also reflects in the loss to gov't tax revenues, which may have implications for the broader economy 16-Jun-21 LECTURER 16 Social Impact of Unemployment The impact of unemployment goes beyond the economic costs Extended periods of involuntary unemployment is associated with human and psychological costs Unemployment can lead to poor mental health of affected individuals – Unemployed youth can lead to increases in social vices and social unrests 16-Jun-21 LECTURER 17 Inflation Meaning and Measurement 16-Jun-21 LECTURER 18 What is Inflation? Inflation refers to rising general level of prices Inflation does not mean price of every single item is rising – some prices may be unchanged and some may even be falling – but the general/average price level if rising Rising inflation means the rate at which general price increase is rising – falling inflation means the rate at which prices rise is falling but NOT that prices are falling – When the general price level is falling, we have deflation 16-Jun-21 LECTURER 19 How is inflation Measured? The rate of inflation is measured as the percentage change in the consumer price index (CPI) − −1 Inflation = −1 The CPI measures the cost of a market basket of consumer goods and services relative to the cost of the same bundle in abase year The items that make the basket in the CPI are chosen to reflect goods and services typically consumed 16-Jun-21 LECTURER 20 Core versus Headline Inflation When inflation is calculated by counting all items in the CPI, we have headline inflation It is generally recognized that prices of some items are more volatile than others – prices of food and energy are known to be particularly volatile – in Ghana energy and utilities Core inflation refers to inflation calculated excluding the prices of food and energy 16-Jun-21 LECTURER 21 Levels of inflation In general, single-digit inflation is considered low inflation – Low is inflation is predictable (less volatile) and generally desirable for economies Inflation rate is said to be galloping if it is in double and triple digits Inflation rates above 1000% are called Hyperinflation 16-Jun-21 LECTURER 22 Anticipated vs Unanticipated inflation Economic agents tend to have an expectation about the rate of inflation Anticipated inflation is the inflation rate that is expected Unanticipated inflation occurs when inflation rates deviates from expectation – that is surprise inflation For example if economic agents expects the inflation rate to be 8% for next month and the actual inflation turns out to be 10%, then there is a 2% unanticipated inflation 16-Jun-21 LECTURER 23 Inflation Causes/Types of inflation 16-Jun-21 LECTURER: 24 Cost-Push inflation (1) Economist identify two categories of shocks that give rise to inflation: shocks to aggregate demand and shocks to aggregate supply Cost-Push inflation refers to aggregate-supply induced inflation They result from shocks due to rising production costs that shifts the aggregate supply curve Definition: Cost-Push inflation results from rising costs during periods of high unemployment and slack resource utilization 16-Jun-21 LECTURER: 25 Cost-Push inflation (2) Rising wages is a common source of cost-push inflation but there are other sources The 1973 oil price shock is commonly-cited example of cost-push inflation In Ghana, the triple digits inflation of 1983 is commonly traced to the droughts and poor harvest of that year 16-Jun-21 LECTURER: 26 Demand-Pull inflation (1) Demand-pull inflation refers to aggregate-demand driven inflation – That is, shifts in aggregate demand that induces increases the price level – It occurs when aggregate demand rises more rapidly than aggregate output One of the most important drivers of demand-driven inflation is growth in the money supply The most famous monetarist Milton Friedman declared: “inflation is always and everywhere a monetary phenomena...” 16-Jun-21 LECTURER: 27 Demand-Pull inflation (2) The Friedman quote illustrate the notion that most of the time inflation is results from excessive growth in money supply over growth of output Recall the monetary transmission mechanism growth in money supply>-fall in real interest rate>-increased investment and consumption>-expansion in aggregate demand>-price level increases. 16-Jun-21 LECTURER: 28 Inflation The impact of inflation 16-Jun-21 LECTURER: 29 Economic Consequences of inflation (1) Why do consumers and businesses hate inflation the way they do? Why do governments spend so much resources and energy to fight inflation? Inflation imposes non-trivial costs on economic agents The cost of inflation depends on whether it is anticipated or unanticipated 16-Jun-21 LECTURER: 30 Cost of Anticipated inflation (1) Inflation is anticipated when is it consistent with expectation – that is when actual inflation does not deviate substantially from expected inflation When all inflation is anticipated, economic agents are able to plan on the inflation and its effect tend to be minimal – lenders can accurately incorporate expected inflation into their nominal interest rates The main costs of anticipated inflation are menu and shoe leather costs 16-Jun-21 LECTURER: 31 Cost of Anticipated inflation (2) Shoe leather cost of inflation: – because money loses its value during inflation, individuals tend to hold less money during periods of high inflation and are forced to make more visits to the bank for withdrawal – The increased cost of making frequent withdrawals is the shoe leader cost inflation forces producers to continuously change prices – eg they price to print more price tags and catalogues – this is the menu cost associated with anticipated inflation 16-Jun-21 LECTURER: 32 Cost of Unanticipated inflation Unanticipated inflation, the surprise element of inflation, is more costly than anticipated inflation It redistributes income – inflation redistributes real wealth from lenders to borrowers – inflation also reduces the real incomes of recipients of fixed incomes 16-Jun-21 LECTURER: 33 Inflation The Phillips Curve: inflation and Unemployment 16-Jun-21 LECTURER: 34 The Phillips Curve The Phillips Curve shows the relationship between inflation and unemployment The basic relationship is that at high levels of output (and low levels of unemployment), wages and prices tend to rise rapidly Inflation expectation plays a crucial role in this relationship Economists distinguish between short-run and long-run Phillips Curve 16-Jun-21 LECTURER: 35 The Short-run Phillips Curve The Short-run (SR) Phillips Curve is downward-sloping which says society faces a short-run tradeoff between unemployment and inflation. Thus, it depicts a negative relationship between inflation and unemployment If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. The SR Phillips curve is drawn for a given level of expected inflation When expected inflation changes, the SR Phillips Curve shifts 16-Jun-21 LECTURER: 36 Short run Phillips Curve MPhil In Finance (UGBS) 16-Jun-21 37 Proposal Presentation The Long-run Phillips Curve The Long-run Phillips Curve vertical – there is no trade-off between unemployment and inflation The vertical LR Phillips curve is fixed by the NAIRU or the natural rate of unemployment NAIRU is the nonaccelerating inflation rate of unemployment – NAIRU is the unemployment rate consistent with maintaining stable inflation. – Thus, the natural rate and the NAIRU are often viewed as two names for the same thing 16-Jun-21 LECTURER: 38 MPhil In Finance (UGBS) 16-Jun-21 39 Proposal Presentation Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How E xpected Inflation Shifts the Short-Run Phillips C urve... Inflation Long-run Rate Phillips curve 2. …but in the long-run, expected inflation rises, and the short-run Phillips B C curve shifts to the right. Short-run Phillips curve with high expected inflation 1. Expansionary policy moves the economy up A Short-run Phillips curve with along the short- low expected inflation run Phillips curve... 0 Natural rate of Unemployment unemployment Rate MPhil In Finance (UGBS) 16-Jun-21 40 Proposal Presentation UGBS 204:Macroeconomics for Business Lecture 9 Balance of Payment and Exchange Rates LECTURER: 1 16-Jun-21 Outline Balance of Payments Account – Measurement Exchange Rates – Meaning and Types – Determinants of Nominal Exchange Rates 16-Jun-21 2 Balance of Payments Account Measurement 16-Jun-21 LECTURER: 3 Balance of Payments Account A country's balance of payments (BOP) accounts is a systematic statement of all economic transactions between that country and the rest of the world It records all economic transactions of goods and services and movements of financial assets between a country and the rest of the world 16-Jun-21 LECTURER: 4 Balance of Payments Account The BOP records each transaction as either a credit or a debit Transactions that the earns a country foreign currency is entered as a credit Transactions that involve spending foreign currency are entered as debits This means that in general exports enter the BOP as credits while imports enter as debits 16-Jun-21 LECTURER: 5 Components of the BOP The BOP consist of two main accounts: the Current Account (CA) and Financial accounts (FA) – in some textbooks, the FA is called capital and financial accounts (KFA) The CA records all income and expenditures related to imports and exports of goods and services, investment income and unilateral transfers The FA records transactions of assets between a country and the rest of the world A last component is Official Settlements Accounts 16-Jun-21 LECTURER: 6 The Current Account (1) The CA is subdivided into the trade balance, services, investment income and unilateral transfers The trade balance is the difference between merchandize imports and exports – that is the trade in goods The services component include shipping & freight, financial services and foreign travel 16-Jun-21 LECTURER: 7 The Current Account (2) Investment income records earnings on foreign investments – this includes interest rate payments, dividends, royalties and other returns on assets eg return on stocks and patents Unilateral transfers refer to payments that made but not in return for goods or services – examples include official foreign aid, gifts from residents of one country to another 16-Jun-21 LECTURER: 8 Financial Account The KFA records asset transactions between the country and the rest of the world In general transactions that increases a country's assets and/or decreases its liabilities are entered as debits – If a country borrows to finance a CA deficit it will show up as a credit It is subdivided into the capital accounts and financial accounts The capital account encompasses unilateral transfer of assets between countries – items included in the capital account include debt forgiveness, remittances from international migrants 16-Jun-21 LECTURER 9 Financial Account The financial account (previously called the capital account) records other transactions of assets between countries Sales of a country's assets results in financial inflow into the country and is recorded as a credit in the financial account Transactions that results in a financial outflow is recorded as a debit Transactions recorded in the financial accounts include direct and portfolio investments, and purchases of sovereign bonds 10 16-Jun-21 LECTURER Official Settlements Balance The official settlements balance refers to financial transactions by the central bank It includes changes in official reserve assets – Items in the balance include gold reserves, holdings of foreign gov't securities by the central bank and special assets created by the IMF The official settlements balance is the net change in a country's official reserve assets When a country runs a BOP surplus, its net holdings of reserve assets will increase 16-Jun-21 LECTURER 11 The BOP always Balances The balance of both CA and FA must add up to zero – i.e. CA+FA=0 – when a country runs a CA deficit, the deficit is financed by borrowed or reducing its holdings of foreign assets, which is a surplus on the FA If the BOP balances, why do we hear BOP deficits? – It is common to hear BOP deficit when people actually mean a CA or trade deficit 16-Jun-21 LECTURER 12 Exchange Rates Meaning and Types 16-Jun-21 LECTURER

UGBS 204: Macroeconomics for Business Lecture Notes PDF

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