ECO 6716 Macroeconomics Fall 2024 PDF

1 What is macroeconomics? Goods Market Loanable funds Labor (input) Market (credit) Market 2 Business cycle: The normal fluctuations of production in the econom...

1 What is macroeconomics? Goods Market Loanable funds Labor (input) Market (credit) Market 2 Business cycle: The normal fluctuations of production in the economy. ◦ Expansion ◦ Peak ◦ Recession ◦ Trough Simplify by ignoring economic growth. We start by studying how we measure production as well as prices. 3  GDP Gross domestic product (GDP) is the market value of all final goods and services produced within the United States during a year. GDP = ∑ Pi × Qi “market value” “final goods and services” “produced within the United States” “during a year” GDP was $28.3 trillion in 2024-I (GDP was $26.5 trillion in 2023-I) 4  Consumption (C ) Personal Consumption Expenditure Goods and services purchased by households for their consumption; this measure excludes housing. Consumption was $19.2 trillion in 2024-I or 67.8% of GDP (Consumption was $18.1 trillion, 68.3% of GDP in 2023-I) Investment (I ) Gross Private Domestic Investment Durable capital goods purchased (generally) by businesses to help produce goods and services; housing is included in investment and is about 18% or 19% of investment. Investment was $5.0 trillion in 2024-I or 17.7% of GDP (Investment was $4.6 trillion, 17.4% of GDP in 2023-I) 5  Government purchases (G ) Government Consumption Expenditure and Gross Investment Goods and services purchased by all levels of government; federal government purchases is about 40% of this expenditure. Government purchases were $4.9 trillion in 2024-I or 17.3% of GDP (Government purchases were $4.6 trillion, 17.4% of GDP in 2023-I) Net exports (NX ) Net Exports of Goods and Services The value of exports of U.S.-produced goods and services minus the value of U.S. imports – Exports were $3.1 trillion in 2024-I or 11.0% of GDP – Imports were $3.9 trillion in 2024-I or 13.8% of GDP Net exports were −$0.8 trillion in 2024-I or −2.8% of GDP (Net exports were ─$0.9 trillion, ─3.3% of GDP in 2023-I) 6 The net result is GDP = C + I + G + NX. 7  GDP = ∑ Pi × Qi so GDP can change because: Prices change Quantities change We want to split these changes apart …we’ll start with prices. 8 CPI: A monthly measure of the average of prices paid by urban consumers for a fixed market basket of consumer goods. GDP Deflator: An average of current prices of goods and services in GDP expressed as a percentage of base-year prices. PCE Deflator: An average of current prices of goods and services in consumption expressed as a percentage of base-year prices. Core Price Level: The price level excluding prices of energy and food. 9 Inflation Rate: The growth rate of the price level. Inf = [(Pt - P t-1)/(P t-1)] × 100 Year Price Level 2023 200 [(220 – 200)/(200) × 100 = 10% 2024 220 2025 242 [(242 – 220)/(220) × 100 = 10% Federal Reserve: The Fed looks at the PCE deflator inflation rate 10 11 12 Real GDP: Real Gross Domestic Product (GDP) is the quantity of all final goods and services produced within the United States during a year. } Real GDP was $22.7 trillion in 2024-I (Nominal GDP) (Real GDP) = (GDP price deflator) 13  2023 2024 Price Quantity Price Quantity Beef $6 100 $8 120 Chicken $5 80 $8 60 – Nominal GDP 2023: ($6 × 100) + ($5 × 80) = $1,000 – Nominal GDP 20234 ($8 × 120) + ($8 × 60) = $1,440 – Nominal GDP growth rate: 44% } Old Method: Make 2023 the base year. Base year prices are used to value the quantities. Use base year prices to value 2023 quantities – Real GDP 2023: ($6 × 100) + ($5 × 80) = $1,000 Use base year prices to value 2024 quantities – Real GDP 2024: ($6 × 120) + ($5 × 60) = $1,020 – Real GDP growth rate: 2% 14  2023 2024 Price Quantity Price Quantity Beef $6 100 $8 120 Chicken $5 80 $8 60 } New Method: (Make 2023 the base year) Step 1: Step 2: Calculate GDP in both years Calculate GDP in both years using 2023 prices1%and then using 2024 prices and then calculate growth rate: calculate growth rate: Step GDP 2023 $1,000 4: GDP 2023 $1,440 GDP 2024 $1,020 GDP 2024 $1,440 Apply this growth rate to the 4previous year’s real GDP. Growth rate: 0% Growth rate: 2% ($1,000)×(1.01)=$1,010 Step 3: Average the two growth rates Growth rate: 15 16  (Nominal GDP) (Real GDP) = (GDP Price Deflator) (Nominal GDP) (GDP Price Deflator) = (Real GDP) Nominal GDP 2024: $1,440 Real GDP 2024: $1,010 $1,440 Typically, the price level is GDP price deflator: = 1.42 $1,010 made into an index number by multiplying it by 100: P = 1.42 × 100 = 142 17 18 Employed worker: ◦ Did any work for pay in survey week ◦ Did not work due to illness, vacation, maternity or paternity leave, on strike ◦ Worked 15 or more hours on family farm or business Unemployed worker: ◦ Without a job ◦ Actively looked for work in the past 4 weeks ◦ Currently available for work Labor force = Employed + Unemployed workers 19 Unemployment rate Unemployed people are those who are without jobs and have actively looked for work within the past four weeks. 20 Labor Force Participation Rate The percentage of the population [16 years and older] that is either employed or unemployed (that is, either working or actively seeking work). 21 Types of Unemployment: 1. Structural: Workers whose skills do not match available job vacancies. 2. Frictional: The normal ebb and flow of unemployed workers searching for jobs. 3. Cyclical: Unemployment due to the business cycle. Natural Unemployment Natural unemployment equals the sum of structural plus frictional unemployment. 22 Natural Unemployment Natural unemployment equals the sum of structural plus frictional unemployment. Full employment When the economy is at the natural rate of unemployment, there is full employment of labor. 23 Natural Unemployment Rate 24 Potential GDP: What real GDP equals when the economy is at full employment. 25 Potential GDP and Natural Rate 26 27 Remember … Goods Market Loanable funds Labor (input) Market (credit) Market 28 Labor demand Change in labor demand Demand increases when: Production (GDP) and price level (P) increase Technology advances 29 Labor supply 30  Two changes in labor supply Supply increases when: Supply decreases when: Labor force grows Price level rises Income taxes decrease 31 If these are the “permanent” labor demand and labor supply curves, then 135 million workers is Full Employment 32 Suppose the government cuts income tax rates. Looking at the labor market in isolation, the cut in income tax rates increases employment and lowers the (pre-tax) wage. (It raises the post-tax wage.) Full Employment increases. 33 Suppose Price Level, P, increases: Short Run Long Run RESULT: P Employment RESULT: P Employment But what about the effect on the supply of labor? 34 Two simplifications: Remember that we ignore economic growth Initially we also simplify by ignoring net exports For the goods market we will use an (aggregate) demand and supply model. – The first step is an aggregate demand curve 35 Aggregate demand is the total demand Consumption demand (C ) Investment demand (I ) Government spending (G ) AD = C + I + G Aggregate demand curve 36 Shift versus Movement Along Aggregate Demand curve Shift of Aggregate Demand Curve What Causes a Shift? Change in taxes (affects consumption and/or investment) Change in interest rate (affects investment and some consumption) Change in government purchases (affects government) HINT: These are important! 37 Aggregate supply is the total supply of goods and services Short run differs from the long run Assume in the short run, costs (wages) do not respond to a change in prices Short-run aggregate supply Start with the price level equal to 106 and real GDP equal to potential GDP of $22 trillion. Prices rise to 110. Firms hire unemployed workers and wages do not change much. Employment increases, unemployment falls and real GDP increases to $24 trillion. Consequently, we have an upward sloping short-run aggregate supply curve, SRAS. 38  Shift in Aggregate Supply Suppose the population grows or the labor force participation rate increases (full) employment increases And the aggregate supply curve shifts to the right This is economic These shifts would also growth! occur if the capital stock increases or technology advances. 39 Shift in Short-Run Aggregate Supply Suppose wage rates rise Short-run aggregate supply shifts 40 In the short run, wages and other costs do not adjust to a change in the price level. As real GDP increases, this affects the demand for labor. In the long run, wages and other costs adjust (fully) to a change in the price level. And this adjustment affects the aggregate supply curve. Short-run Long-runimpact impactfrom from a Long-run Short-runimpact impactfrom fromaa a higher price level (AS) higher price level (L) RESULT: P LD L LS L SRAS LONG RUN 41 42  Increase in aggregate demand Goods Market Labor Market In the short run, GDP and employment both increase But this is before wages fully adjust to the higher price level After this adjustment, there is no change in GDP or employment 43 44  3 Policy Goals 1. Smooth the business cycle 2. Stay close to potential GDP 3. Keep inflation rate low 45  Types of Policy Fiscal Policy Changes in government purchases of goods and services, transfer payments, and/or taxes. Government budget constraint plays an important role: G = Tax + Deficit Monetary policy Changes in the interest rate engineered by the Federal Reserve. 46 Very quick introduction: G ↑ means Aggregate demand increases But G↑ also means the government budget deficit increases In turn that means we need to explore the loanable funds market … 47 Remember … Goods Market Loanable funds Labor (input) Market (credit) Market 48 The markets where borrowers borrow and savers save, that is, lending takes place. – Bond market – Stock market – Mortgage market – Etc … We “collapse” these markets into one market, and so we need to look at demand and supply in this market. 49 Demanders: Households Firms Government (deficit) Foreigners 50  Suppliers: Households* Government (surplus) Foreigners * Via financial intermediaries, such as banks 51 Equilibrium 52 1. G ↑ (Holding taxes constant => Budget deficit rises) 2. Aggregate demand increases: Now we can determine the effect of the budget deficit 53  3. Loanable Funds market Increase in demand for loanable funds due to a larger budget deficit: A $2 trillion deficit Crowding out—the higher interest rate will reduce Investment (and some Consumption). 54 4. Effect from loanable funds market 55 Long-Run Regardless of the effect from the loanable funds market, in the long run we are back to where we were before...at least GDP (and employment) is. The issue is that the long-run incentives to work (or invest) do not change. 56 Income taxes affect incentives to consume, save, and invest. work. 57 1. Taxes↓ (so the government budget deficit increases) 2. The AD curve shifts right. Loanable funds effect: The shift is partially offset by a higher interest rate. 58 1. Taxes↓ People increase their supply of labor because they now keep more of their income. 2. The SRAS curve shifts right. 59 1. Taxes↓ (so the government budget deficit increases) 2. The AD curve shifts right. Loanable funds effect: The shift is partially offset by a higher interest rate. 2. AND the SAS curve shifts right. 3. Long-run effect differs. Why? Incentives matter. https://www.youtube.com/watch?v=O77G0SaJv5M 60 Monetary policy Changes in the interest rate engineered by the Federal Reserve. Also playing a role is the banking system commercial banks savings and loans credit unions and, more generally, other financial institutions insurance companies mortgage companies etc 61  Banking System Balance Sheet (July 2024) Assets Liabilities and net worth (billions) (billions) Government securities $5,172 Deposits $17,246 Loans 12,110 Borrowings 2,386 Cash assets 3,284 Other liabilities and net worth 1,047 Other assets 2,286 Net worth 2,173 Total assets 22,852 Total liabilities and net worth 22,852 “Cash Assets” are largely reserves held at the Federal Reserve The largest assets are government securities and loans. The largest liability is deposits. 62 The Fed is a “quasi-public/quasi-private” organization. Its organizational structure is like a pyramid: Base: 3,000 member commercial banks Middle: 12 Federal Reserve Banks Top: 7 members of the Board of Governors The Federal Open Market Committee (FOMC) is the group within the Fed that is responsible for setting the nation’s monetary policy. The FOMC is comprised of the 7 Board of Governors, the President of the NY Fed, and on a rotating basis, 4 Presidents of the other regional Fed banks. 63 The current Chair of the Board of Governors is Jerome Powell https://www.youtube.com/watch?v=s07VmIFPpTc https://www.youtube.com/watch?v=b2_4NlSnmus&ab_ channel=CNNBusinessCNNBusinessVerified 64  Assets Liabilities and net worth (billions) (billions) Gold $11 Federal Reserve notes $1,739 Government securities 2,110 Deposits at Fed (reserves) 1,537 Federal agency securities 2 U.S. Treasury 223 Loans to “banks” 0 Foreign official 5 Federal Reserve Balance Sheet Mortgage backed securities 1,755 Other liabilities and net 391 (July 2019) worth Other assets 12 Total assets 3,895 Total 3,895 Assets Liabilities and net worth (billions) (billions) Gold $11 Federal Reserve notes $2,353 Government securities 4,466 Deposits at Fed (reserves) 3,408 Federal agency securities 2 U.S. Treasury 0 Loans (largely) to (failed) 117 Foreign official 377 Federal Reserve Balance Sheet “banks” (June 2024) Mortgage backed securities 2,354 Reverse repurchase 792 agreements Other assets 360 Other liabilities and net 380 worth Total assets 7,310 Total 7,310 Discount rate Interest rate paid on Reserve Balances (IORB) 65 Reverse Repurchase Agreement (Reverse Repo): The Fed sells securities to non-bank financial institutions BUT has an agreement to buy them back the next day at a higher price. The companies pay for these securities using reserves. The higher price the financial institutions receive is effectively the interest rate, (ON RPP, for “Overnight Reverse Repurchase”). 66  Banks want to hold a certain desired amount of their liabilities as liquid reserves. Assets that are the most liquid reserves are deposits at the Federal Reserve and currency in the bank’s vault. The key market is the federal funds market. The federal funds market is where banks and others borrow and lend reserves (most lending is done by non-bank holders of reserves, eg, money market funds) for extremely short loans, typically overnight. The interest rate on these loans is the federal funds rate. 67 Monetary policy works by changing the interest rate. The federal funds rate is the interest rate the Fed can closely influence: 68 The Fed has a two major methods it uses to change the interest rate: The “classic” method is by using open market operations (the purchase or sale of government securities). The “new method” is by changing the interest rate paid on reserve balances (IORB) and the discount rate, the interest rate the Fed charges banks for loans. 69 Federal funds market: 70 By reducing the supply of reserves, the Fed can raise the federal funds rate: 71 Fed’s actions: Bank Federal Reserve Assets Liabilities Assets Liabilities Reserves $100 DD $1,000 Gov. Securities $10,000 Reserves $2,000 Gov. Securities $400 Owed on FF $0 FRN $8,000 Loans $600 NW $100 Total $10,000 Total $10,000 Total $1,100 Total $1,100 Total reserves: $100 Now the Fed sells $50 of government Desired reserves: $100 securities to the bank, which are paid Excess reserves: $0 for using the bank’s reserves Bank Federal Reserve Assets Liabilities Assets Liabilities Reserves $50 DD $1,000 Gov. Securities $9,950 Reserves $1,950 Gov. Securities $450 Owed on FF $0 FRN $8,000 Loans $600 NW $100 Total Total $9,950 $9,950 Total $1,100 Total $1,100 Total reserves: $50 The Fed’s action decreases Desired reserves: $100 the supply of reserves Excess reserves: −$50 72 Using an open market operation, the Fed raises the federal funds rate by selling a government security to a bank and accepting payment in the form of some of the bank’s reserves: 73  Next, the bank borrows the necessary reserves Bank Federal Reserve Assets Liabilities Assets Liabilities Reserves $100 DD $1,000 Gov. Securities $9,950 Reserves $1,950 Gov. Securities $450 Owed on FF $50 FRN $8,000 Loans $600 NW $100 Total $9,950 Total $9,950 Total $1,150 Total $1,150 Total reserves: $100 Eventually the bank calls in or does not roll Desired reserves: $100 over a $50 loan to a firm and repays its FF debt Excess reserves: $0 Bank Federal Reserve Assets Liabilities Assets Liabilities Reserves $100 DD $1,000 Gov. Securities $9,950 Reserves $1,950 Gov. Securities $450 Owed on FF $0 FRN $8,000 Loans $550 NW $100 Total $9,950 Total $9,950 Total $1,100 Total $1,100 Total reserves: $100 Desired reserves: $100 Excess reserves: $0 74 Loanable funds market: From here Investment (and Consumption) decrease, thereby affecting GDP. 75 Summary of Fed’s open market operations: Buy security Pay with reserves Increase reserves Lower the federal funds rate Sell security Accept reserves as payment Decrease reserves Raise the federal funds rate 76 Fed’s actions: Bank Federal Reserve Assets Liabilities Assets Liabilities Reserves $300 DD $1,000 Gov. Securities $10,000 Reserves $2,000 Gov. Securities $300 Owed on FF $0 FRN $8,000 Loans $500 NW $100 Total $10,000 Total $10,000 Total $1,100 Total $1,100 Total reserves: $300 Now the Fed sells $50 of government Desired reserves: $100 securities to the bank, which again Excess reserves: $200 pays for them using its reserves Bank Federal Reserve Assets Liabilities Assets Liabilities Reserves $250 DD $1,000 Gov. Securities $9,950 Reserves $1,950 Gov. Securities $350 Owed on FF $0 FRN $8,000 Loans $500 NW $100 Total Total $9,950 $9,950 Total $1,100 Total $1,100 Total reserves: $250 The Fed’s action decreases Desired reserves: $100 the supply of reserves Excess reserves: $150 But so what?? There are ample reserves 77 The effect in the Federal Funds market: 78 The “new” method uses two interest rates to change the Federal Funds interest rate: 1. Interest rate the Fed pays on reserves—if the Federal Funds rate is below this, the demand for reserves is essentially infinite. 2. Discount rate (interest rate the Fed charges for loans)—if the Fed Funds rate is above this, the demand for reserves in the federal funds market is zero. Consequently, the demand curve for reserves has an odd appearance: 79 With this demand curve, the equilibrium is still the same as always, where the demand and supply curves interest. 80 Now when the Fed wants to change the interest rate, it changes the two interest rates: 81 The Fed changes the interest rate it pays for reserves. The initial interest rate paid for reserves is 1 percent, so the interest rate in the loanable funds market is 2 percent. The Fed raises the interest rate paid for reserves to 2.33 percent, so the interest rate in the loanable funds market rises to 3 percent.. 82 1. The Fed raises the interest rate. 2. Investment (also some consumption) decreases and therefore aggregate demand decreases. 83 3. Eventually wages and other costs fall. 84 AKA: Sit back and relax. 85 1. Social distancing and closing non-essential businesses. Aggregate supply decreases 86 2. Massive fall in income decreases consumption, which decreases aggregate demand. 3. Massive decrease in investment. Aggregate demand decreases The picture can't be displayed. 87  Three Massive Policies 1. CARES (Coronavirus Aid, Relief, and Economic Security) Act. (3-2020) $2.3 trillion dollars 2. Stimulus and Relief Package. (12-2020) $0.9 trillion dollars 3. The American Rescue Plan. (3-2021) $1.9 trillion dollars Goals: Increase consumption, investment, and even government purchases 88  Policies started in 3-2020 1. Federal funds rate cut to near 0% (3-2020) 2. Massive purchases of government securities and mortgage-backed securities (MBS) (3-2020) Goals: Increase consumption and investment by keeping the interest rate low and financial markets (particularly MBS market) stable 89 4. Effect of government policy. Aggregate demand increases Aggregate supply increases The price which means level rises … there is inflation. 90  INFLATION: Indicators of economic activity and employment have strengthened. … Inflation has risen, largely reflecting transitory factors. The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation having run persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. Oops …. 91  INFLATION: With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective … INTEREST RATE: support of these goals, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent and anticipates that ongoing increases in the target range will be appropriate. 92