Introduction To Macroeconomics PDF

Studocu is not sponsored or endorsed by any college or university Downloaded by Eline Jacobs ([email protected]) Introduction to Macroeconomics (Vrije Universiteit Brussel) Introduction To Macroeconomics lOMoARcPSD|11463819 Downloaded by Eline Jacobs ([email protected]) Mac...

Studocu is not sponsored or endorsed by any college or university Downloaded by Eline Jacobs ([email protected]) Introduction to Macroeconomics (Vrije Universiteit Brussel) Introduction To Macroeconomics lOMoARcPSD|11463819 Downloaded by Eline Jacobs ([email protected]) Macroeconomics Introduction To lOMoARcPSD|11463819 lOMoARcPSD|11463819 Chapter 1: What is Economics? Chapter 2: Thinking Like an Economist How the Economy As a Whole Works Microeconomics: the study of how households and firms make decisions and how they interact in markets Economic Methodology Endogenous variable: a variable whose value is determined within the model Exogenous variable: a variable whose value is determined outside the model Macroeconomics: the study of economy-wide phenomena, including inflation, unemployment and economic growth Economic growth: the increase in the amount of goods and services in an economy over a period of time Impact individual agents The Economist as Policy Advisor Positive statement: claims that attempt to describe the world as it is Normative statement: claims that attempt to prescribe how the world should be L Microeconomic: individual agents - households - firms Macroeconomics: economy as a whole - income, production - prices - labor market; unemployment - interest rate - exchange rates Module 1: Ch1:What is Economics? Ch2: Thinking Like an Economist Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 Chapter 20: Measuring a Nation's Well-being and the Price Levels e The Economy's Income ad Expenditures Circular flow Revenue > Market for goods and services > Goods and services sold : real Flows : payment flows e Spending on goods and services Goods and services bought v v Households Firms i Factors of production n > Wages Profits Rent Markets for factors of production e - labor, L - Capital, K - Land Also includes: - spending on infrastructures - Estimate market value of government services = wages of government unemployment Does not include: transfer payments: a payment for which no good or service is exchanged e.g. unemployment benefits, state pensions, subsidies 4. Net Exports Spending on domestically produced goods and services by foreigners (exports) minus spending on foreign goods by domestic residents (imports) Real Versus Nominal GDP Changes in total expenditure on goods and services from one year to another can be looked at in two ways: 1. The economy is producing a larger output of goods and services (a real increase); or 2. Goods and services are being sold at higher prices (a nominal increase) Income Real GDP: the production of goods and services valued at constant prices GDP at constant prices gross: domestic product calculated using prices that existed at a particular base year, which takes into account changes in inflation Module 2: GDP at current or market prices: gross domestic product calculated by Ch20: Measuring a multiplying the output of goods and services by the price of those goods The Measurement of Gross Domestic Product Gross Domestic Product (GDP): the market value of all final goods and services Nation's Well-being and services in the reporting year produced within a country in given period of time Nominal GDP: the production of goods and services valued at current prices Final goods: bread and flower; bread is the final good not flower; avoid double counting Produced: does not include second-hand goods traded The Limitations of GDP A a Measure of Well-being Within a country: geographical area The GDP does not take into account: In a given period of time: "flow variable"; quantity per unit of time: per quarter, per year • Informed activities; work in the home and volunteer work • Leisure The Components of GDP • The quality of the environment • Distribution of income; poverty 1. Consumption Spending by households on goods and services, with the exception of purchases of new GDP is a useful but imperfect measur of economic well-being housing The GDP Deflator 2. Investment Spending on capital equipment, inventories and structures, including household purchases GDP deflator: a measure of the price level calculated as the ratio of nominal GDP to of new housing real GDP times 100 • Physical capital (e.g. machine, equipment, tools) - Measures by which factor prices have increased compared to the base • Structures buildings year • Changes in inventories - Has no unit: index Car produced in 2020 but not sold in 2020 should not be included in 2020 consumption - Is 1 in base year Change in inventory in 2020: + €20 000 2021: car sold; included in consumption 2021 -Is usually expressed with base: 100 C: + €20 000 2021 change in inventory: - €20 000 = €0 3. Government spending (purchases of goods and services) Spending on goods and services by local and national governments Production = Income = Expenditures Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 Measuring The Cost Of Living Correcting Economic Variables For The Effects Of Inflation The Consumer Prices Index (CPI) Consumer Prices Index: a measure of the overall prices of the goods and services bought by a typical consumer Money Figures from Different Times (e.g star-wars) When comparing money figures over a period of time, we need to know the level of prices in both the historical year and the level of prices today; to do this: we need to inflate the historical figure into today's currency 5 steps to calculate the CPI: Index has no unit!! π = inflation rate Indexation Indexed: the automatic correction of a money amount for the effects of inflation by law or contract Real and Nominal Interest Rates Nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation Real interest rate: the interest rate corrected for the effects of inflation Inflation rate: the percentage change in the price index from the preceding period i = interest rate Problems In Measuring the Cost Of Living (CPI) Module 3: 1. Substitution Bias Ch20: Measuring The When prices rise or fall, consumers will substitute; when price index is computed Cost Of Living assuming a fixed basket of goods, it ignores the possibility of substituting; overstates the increase in the cost of living from one year to the next The real interest rate in a particular time period (rt ) = nominal interest rate in that 2. New Goods time period (it ) - inflation rate in the same time period (pt ) When a new good is introduced, consumers have more variety from which to choose; which makes euro more valuable; consumers need fewer units of currency to maintain any standard of living; CPI is based on fixed basket of goods and does not reflect this change The nominal interest rate tells you how fast the number of euros in your bank account in purchasing power rises over time The real interest rate tells you how fast the purchasing power of your bank account rises over time 3. Unmeasured Quality Change When quality of goods rise from one year to the next, the effective value of a euro rises; the price is adjusted to account for the quality change; this remains a problem because quality is hard to measure; CPI interprets increase in price as inflation and not quality 4. Relevance of the CPI People don't see the reported CPI measure of inflation as relevant to their particular situation; their spending patterns are individual; this can have an effect on expectations; e.g. diapers Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 Overview Micro: Production Function: "the relationship between the quantity of inputs used to make a good and the quantity of output of that good" L: labor K: physical capital H: human capital N: natural resources A: technology Production function: Diminishing Marginal Product: "the property whereby the marginal product of an input declines as the quantity of the input increases" Marginal Product (MP): "the increase in output that arises from an additional unit of input" Output = A x f(L, K, H, N) Assume: production function has constant returns to scale; when we scale up the factors of production by some factor Z: Z x L, Z x K, Z x H, Z x N, then the output is also scales up to Z: A x f(Z x L, Z x K, Z x H, Z x N) = Z x Y Set Z = 1/L: Y/L = A x f (L/L, K/L, H/L, N/L) ✓ Labor productivity = technology x f(factors of production per worker) Productivity How Productivity is Determined; Determinants of Growth Productivity: the quantity of goods and services that GDP per worker takes the level of real GDP GDP per capita takes the level of real a worker can produce in a specified time at a point in time and divides it by the GDP at a point in time and divides it by Module 4: period number of people employed to get a the population to get a measure of Ch21: Production income per head of the population; useful measure of income per head of the and Growth working population basis for comparison across countries A: Technology Society's understanding of the best ways to produce goods and services; investment in knowledge (RandD) A Chapter 21: Production and Growth ^ > Technical progress improves the quality of physical and human capital; for any given quantity of capital and labour, the average productivity of both is higher; technical progress can help counterbalance the effects of diminishing marginal product The Magic of Compounding and The Rule of 70 Robert Solow 1957: A is exogenous (given) Paul Romer 1990: A is a result of economic incentives (endogenous) K: Physical Capital Stock op equipment and structures used to produce goods and services; a produced factor op production; input into the production process that in the past was an output from the production process Saving + net-inflow of saving = I (investment) Saving rate (s = s/y) The rule of 70 is helpful to understand growth rates and the effects of compounding; if some variable grows at a rate of x % per year, then that variable doubles in approximately 70/x years ^ , S ^ , I ^ ^ , K Solow: assume that K has a diminishing marginal product then: • effect of higher saving rate on growth is temporary • poor countries can catch up Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 H: Human Capital Knowledge and skills that workers acquire through education, training and experience; the skills accumulated in early childhood programmes, primary school, secondary school, .. Investment in education H ^ > Endogenous Growth Theory The Solow growth model suggests that investment in capital alone cannot increase growth per capita because of diminishing marginal product, and that capital accounts for only around a third of contribution to output; long-run growth is generated by changes in technology N: Natural Resources Inputs into the production of goods and services that are provided by nature, such as land, In the Solow model, technology is exogenous in that the level of technology is not affected by either capital accumulation or changes in the population; it's given rivers and mineral deposits The Solow model does not explain as to what determines the level of technology and technological changes Two forms: renewable and non-renewable Renewable: forest; possible to create more Non-renewable: oil; one limited supply Paul Romer investigated why improvements in technology occur; Endogenous growth theory: the rate of economic growth in the long run is determined Natural resources are important but not necessary for an economy to be highly productive by the rate of growth in total factor productivity, and this total factor productivity in producing goods and services; Japan is one of the richest countries in the world, despite is dependent on the rate at which technology progresses having few natural resources. International trade makes Japan's success possible. Economic Growth and Public Policy "Resource curse": failure of many resource rich countries to benefit fully from their What can government policy do to raise growth? natural resource wealth e.g. Nigeria: institutions have not been strong enough to efficiently manage the oil 1. Remove barriers to savings and investments revenue to have a positive impact on the economy Causes of Growth The Solow model provides a way of predicting that the capital–output ratio of economies will eventually converge to the steady state Saving + net-inflow of saving = I (investment) Taxes, property rights, political stability, good governance Changes in the Savings Rate An increase in the savings rate can increase investment and the capital–output ratio; if the economy starts at the steady-state equilibrium shown as K* ; investment will be higher than spending on depreciation and this will increase the capital–output ratio moving the economy to a new steady-state equilibrium at K ** 2. Correct market failures: H: education has positive externalities subsidies A: knowledge is a public good subsidies; patents : 3. Promote Openness: Net inflow of savings International trade An Increase in Population If the population grows at the same rate as income, then GDP per capita will remain constant; the reality is that population growth varies depending on the country I K K, A : 4. Reduce Population Growth (?); controversial point Robert Maltheus 1798: L N/L Y/L Neo-malthusians reduce population growth > > An Increase in technology Increases in technology can be a public good (not excludable and nor rival); The aggregate production function shows that even if capital and labour remain constant, an increase in technology will increase income because both capital and labour become more productive ✓ ✓ > : A ^ ^ Michael Kremer 1993: L A Y/L Does not agree with Neo-malthusians > Downloaded by Eline Jacobs ([email protected]) > lOMoARcPSD|11463819 Unemployment and Labor Market What is unemployment ? Unemployed: the number of people of working age who are able and available for work at current wage rates and who do not have a job Labour force: the total number of workers, including both the employed and the unemployed Geographical immobility: where people are unable to take work because of the difficulties associated with moving to different regions 2. Minimum Wage Laws Minimum wage laws are a price floor applied to the labour market When a minimum wage law forces the wage above the equilibrium, it raises the quantity of labour supplied and reduces the quantity of labour demanded compared to the equilibrium level: a surplus of labour; there are more workers willing to work than there are jobs Unemployment rate: the percentage of the labour force that is unemployed measured by dividing the number of unemployed by the labour force and multiplying by 100 =u Labour force participation rate: (or economic activity rate) the percentage of the adult population that is in the labour force 3. Unions and Collective bargaining Union density: a measure of the proportion of the workforce that is unionized The Causes of Unemployment Natural rate of unemployment (Un) = average around which u fluctuates Natural rate of unemployment: the normal rate of unemployment around which the unemployment rate fluctuates Cyclical U = U - Un Cyclical u Frictional Unemployment Un = frictional U + structural U : Sectoral shocks Unemployed Search (matching) Structural unemployment: unemployment that results because the number of jobs available in some labour markets is insufficient to provide a job for everyone who wants one A result of wages set above the equilibrium wage 4. The Theory of Efficiency Wages Worker Health; Better paid workers eat a more nutritious diet, and workers who eat a better diet are healthier and more productive Sick leave : when someone is sick the government/insurance pays a wage; if normal wage is above sick wage less people will take sick leave Wage S W1 Frictional unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills A union is a type of cartel. Like any cartel, a union is a group of sellers Module 5: acting together in the hope of exerting their joint market power. Ch22: Unemployment Workers in a union act as a group when discussing their wages, benefits and The Labor Market and working conditions with their employers Collective bargaining: the process by which unions and firms agree on the terms of employment : Cyclical unemployment: the deviation of unemployment from its natural rate Employed ! Causes of Structural Unemployment 1. Occupational and Geographic Immobility Occupational immobility: where workers are unable to easily move from one occupation to another due to lack of skills, knowledge We 0 Worker Turnover : The more a firm pays its workers, the less often its workers will choose to leave; reduce turnover among its workers by paying them a high wage; reducing turnover is important for firms; it is costly to hire and train new workers. Worker Effort : High wages make workers more eager to keep their jobs and provide an incentive to put forward their best effort. ^ Worker Quality : When a firm hires new workers, it cannot perfectly gauge the quality of the applicants. By paying a high wage, the firm attracts a better pool of workers to apply for its jobs. D > Ld Le Ls Quantity Structural labor (L) unemployment > We by Eline Jacobs ([email protected]) W1 Downloaded lOMoARcPSD|11463819 e.g. Waterwell Company needs one worker Two workers, X and Y, are interested in the job; X, is proficient and willing to work for eu10 per hour (reservation wage); Y, is incompetent and willing to work for anything above eu2 per hour. If firm pays < eu10 per hour: 0% probability to hire to more efficient one If firm pays < eu10 per hour: 50% probability to hire to more efficient one The Costs of Unemployment to Society and the Economy The Opportunity Cost of Unemployment An individual who is willing and able to work represents a unit of productive output. If that person is unemployed the opportunity cost to society is the value of the goods and services that the individual could have produced. This 'lost output' can be considerable and represents a lower standard of living for society as a whole The Cost of Unemployment The Costs of Unemployment to the Individual The Tax and benefits effect People who are unemployed have lower incomes and may rely solely on government welfare payments to support their standard of living. If people lose their jobs, then they do not pay as much in income taxes, and if they also reduce spending, they do not Loss of Earnings Many countries provide some form of unemployment insurance, but the sums given to the pay consumption taxes at the same level as if they were in employment. The higher the level of unemployment in a country, the greater the impact on tax revenue for the unemployed are relatively small and in most cases nowhere near the earnings that the government. Not only is government revenue adversely affected, but government individual would have earned in work spending is also likely to be higher. The unemployed will claim additional benefits, and governments may also incur costs in having to deal with the social problems caused by De-Skilling unemployment such as drug and alcohol abuse, family breakdown and the increase in The longer someone is out of work the more they lose touch with changes in the crime workplace and the labour market in general, and the more likely it is that they might be viewed as being unemployable or not favourable candidates for employment. Changes in The Reverse Multiplier Effect, Vicious Circle the workplace, in technology and in the skills needed for employment change rapidly Unemployment people cut back their spending on luxuries; may also switch to substitute goods/ inferior goods; firms who produce these different goods may see a change in spending patterns, which can have an effect on cash flows and ultimately Stress, Self-esteem and Health Problems Being unemployed can lead to significant mental health problems. The process of becoming profits unemployed is stressful and can be a life-changing event for some people. The feeling of Goods with high income elasticity of demand are affected more significantly; if sales fall, firms earn lower incomes and adjust business to manage cash flows; might involve rejection can lead to feelings of guilt and a reduction in self-esteem. These experiences cutting back on orders from suppliers, building up stocks as goods remain unsold; firms may have to either lay off workers, or make workers redundant or close down the can bring on stress-related illnesses and the incidences of health problems in the business if it becomes insolvent; if workers are made redundant or lose their jobs; unemployed can increase the longer that the unemployment continues those workers receive lower incomes and so the process continues Drug and Alcohol Abuse and Crime The boredom that can result from being unemployed and the feeling of worthlessness Firms may see falling profit levels; pay lower corporate taxes; puts pressure on that many unemployed people say they experience, is the increased potential to turn to government budgets alcohol and illegal drugs as a means of escape Some firms might see demand for their services actually increase in periods of high unemployment: unemployed people switch spending to inferior goods, the producers of Family Breakdown those goods see demand rise Families who have an experience of unemployment are more prone to break up In the aftermath of the Financial Crisis 2007 to 2009 and beyond, low-cost supermarkets across the UK and Europe reported seeing an increase in sales, while traditional supermarkets reported reduced sales The effect of unemployment, if more than simply frictional unemployment, is to produce a multiplied impact on economic activity as a whole. If there are a lot of workers losing their jobs, such as a major employer in an area, then the effect of this reverse multiplier effect can be considerable. There are areas of the UK and Europe where the decline in industries concentrated in particular areas has led to considerable regional deprivation which has lasted for many years. Once an area is caught in the cycle of economic decline, it is extremely hard to recover. Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 Chapter 23: Saving, Investment, and the Financial System T - G > 0 government budget surplus In a closed economy, S = I T - G < 0 government budget deficit Net Taxes ≡ T ≡ tax revenue - transfer payments (G) Budget surplus: where government tax revenue is greater than spending because it receives more money than it spends Budget deficit: where government tax revenue is less than spending and the government has to borrow to finance spending National saving: the total income in the economy that remains after paying for consumption and government purchases Private saving: the income that households have left after paying for taxes and consumption Public saving: the tax revenue that the government has left after paying for its spending The Bond Market Bond: a certificate of indebtedness Firm (debtor) issues a bond; I owe you (IOU) Principal: amount 100eu Date of maturity (due date) : 18 March 2030 Interest rate: 5% Bond issued by Tesla Principal: 100 dollars i: 5% Maturity date: 18 March 20230 2030 .. .. .. 2022 2021 .. .. Coupon: Worth 5% of 100 dollars • short terms bonds; few months • long terms bonds 30 years • interest rate on a bond depends on its term; long-term bonds are riskier than shortterm bonds; holders of long-term bonds wait longer for repayment of the principal Tradable security (secondary bond market): holder of a long-term bond needs their money earlier than the maturity date they sell the bond to someone else, perhaps at a reduced price Module 6: Credit risk: the probability that the borrower will fail to pay some of the Ch23: Saving, Investment, and the interest or principal; called a default Financial System Borrowers can default on their loan National saving = S = private saving + public saving = (Y - T - C) + (T - G) National income identity for closed economy (NX = 0) S=Y-C-G National governments issue bonds when in need to borrow money to finance public spending; sovereign debt; some are considered as safe credit risk; Germany; tend to pay low interest rate; UK government bonds are referred to as gilt edged bonds; credit risk they are as good as gold Y=C+I+G Solve for I: Y - C - G = I " S=I Financial Institutions In the Economy Financial system: the group of institutions in the economy that help to match one person's saving with another person's investment Financial System Funds DIRECT Funds Financial markets (Bonds, shares) 7 ] I S > Funds INDIRECT Financial Intermediaries (Banks, investment funds) Funds , Important to note is the relationship between a bond's price and its yield: Yield = Coupon/price of bond x 100% Yield when bond was issued = 5 dollars/100dollars x 100% = 5% Suppose that market interest rate i increases to 5.1% holders of bond with 5dollars want to sell; to get the 5.1% interest rate but no one wants to buy the 5dollar coupon • Price of bond in secondary market decreases • Yield increases until yield = i Price of bond needs to decrease to 98dollars: yield = 5dollars/98dollars x 100% = 5.1% i increases ; price of bond decreases i decreases ; price of bond increases Financial Markets Financial markets: financial institutions through which savers can directly provide funds to borrowers Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 The Stock Market Stock (or share or equity): a claim to partial ownership and the future profits in a firm If a company sells a total of one million shares of stock, then each share represents ownership of 1/1,000,000 of the business • the sale of stock is called equity finance; whereas the sale of bonds is called debt finance • if a company is profitable, the shareholders enjoy the benefits of these profits, whereas the bondholders get only the interest on their bonds • if the compant has financial difficulty, the bondholders are paid before shareholders • stocks offer the holder both higher risk and potentially higher return • corporations can issue stock by selling shares to the public through organized stock exchanges • first-time sales are referred to as the primary market • tradable security: shares that are traded among stockholders on stock exchanges (stock market) are referred to as the secondary market • price of shares: determined by the supply and demand for the stock in these companies reflects people's perception of the corporation's future profitability • stock market index: an average of a group of share prices; reflects price of basket of shares (Dow Jones, SandP500) Financial Intermediaries Financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers Banks • owner of a small business wants to finance an expansion of their business, they finances their business expansion with a loan from a bank • banks are the financial intermediaries with which people are most familiar • banks take in deposits from people who want to save and use these deposits to make loans to people who want to borrow • banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans • difference between these rates of interest covers the banks' costs and returns some profit to the owners of the banks • they facilitate purchases of goods and services by allowing people to draw against their deposits; debit cards to transfer money electronically • banks help create a special asset that people can use as a medium of exchange • medium of exchange is an item that people can easily use to engage in transactions; this distinguishes it from many other financial institutions Investment or Mutual Fund Investment or mutual fund : an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds • advantage: allow people with small amounts of money to diversify • 'Don't put all your eggs in one basket'; the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky • people with a diverse portfolio of shares and bonds face less risk because they have only a small stake in each company • investment funds make this diversification easy • with a few hundred euros, a person can buy shares in an investment fund and, indirectly, become the part owner or creditor of hundreds of major companies • the company operating the investment fund charges shareholders a fee • unit trusts: when people put money into a unit trust, more 'units' or shares are issued, whereas the only way to buy into an investment fund is to buy existing shares in the fund The Market For Loanable Funds Market for loanable funds: the market in which those who want to save supply funds, and those who want to borrow to invest demand funds In a closed economy, S = I S: supply of loanable funds I: demand for loanable funds S = S(r) r: interest rate Positive relation between S and r r S ^ ^ , Downloaded by Eline Jacobs ([email protected]) I = I(r) Negative relation between I and R r I ^ > ✓ lOMoARcPSD|11463819 1. Saving Incentives A change in the tax laws to encourage more saving would shift the supply of loanable funds to the right from s1 to s2 . As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 per cent to 4 per cent, and the equilibrium quantity of loanable funds saved and invested rises from € 500 billion to € 600 billion 3. Government Budget Deficits and Surpluses Interest elasticity of demand and supply: the responsiveness of the demand and supply of loanable funds to changes in the interest rate 2. Investment Incentives When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it 'crowds out' households and firms who otherwise would borrow to finance investment. Here, when the supply shifts from s1 to s2 , the equilibrium interest rate rises from 5 per cent to 6 per cent, and the equilibrium quantity of loanable funds saved and invested falls from € 500 billion to € 300 billion. Crowding out: a decrease in investment that results from government borrowing Government increases goods and services (G): G ^ ^ > S ✓ If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 per cent to 6 per cent, and the equilibrium quantity of loanable funds saved and invested rises from € 500 billion to € 600 billion Downloaded by Eline Jacobs ([email protected]) > r > I u lOMoARcPSD|11463819 Present Value: Measuring the Time Value of Money Present value: the amount of money today that would need to be invested using prevailing interest rates, to produce a given future amount of money Future value: the amount of money in the future that an amount of money invested today will yield, given prevailing interest rates Question: If you put €100 in a bank account today, how much will it be worth in N years? What will be the future value of this €100? Answer: r is the interest rate expressed in decimal form (an interest rate of 5 per cent means r = 0.05). The interest is paid annually and the interest paid remains in the bank account to earn more interest – a process called compounding. Then the €100 will become: I What determines the price of a share? Intrinsic value of a share = present value of future profits = EPS0 + EPS1/(1+R) + EPS2/(1+R)^2+.. Managing Risk Risk: the probability of something happening which results in a loss or some degree of hazard or damage Utility: a person's subjective measure of Risk Aversion well-being or satisfaction Risk averse: exhibiting a dislike of uncertainty This utility function shows ' how utility, depends on wealth; as wealth rises, the utility function becomes flatter, reflecting the property of diminishing marginal utility. Because of diminishing marginal utility, a €1,000 loss decreases utility by more than a €1,000 gain increases it Module 7: Ch23: Financial Future value after N years = (present value) x (1+r)^N Economies Compounding: the accumulation of a sum of money (in a bank account), where the interest earned remains in the account to earn additional interest in the future Present value = (Future value after n years) EPS = earnings per share The Markets for Insurance (Insurance Spread Risk) 10,000 homeowners; each house is worth €100,000 (Probability that house is destroyed by fire in current year) = 1/10,000 Applying the concept of Present value The present value is useful when companies face decisions when investment projects. Example: Citroen is thinking about building a new car factory. Suppose that the factory will If house does not burn If house burn cost €100 million today and will yield the company €200 million in 10 years. Should Citroen Expectation for one homeowner = (- €100,000 x 1/10,000)+(€0 x 9999/10,000) undertake the project? The company will compare the present value of the €200 million = -€10 + 0 (small expected loss) return to the €100 million cost. The decision will depend on the interest rate. If the interest rate is 5 per cent, then the present value of the €200 million return from the They form an insurance company: each homeowner pays a €10 premium; factory is €123 million, and the company will choose to pay the €100 million cost. (€200/ insurance company takes on the risk; risk does not change or disappear; it is spread (1+0.05)^10 more effectively If the interest rate is 8 per cent, then the present value of the return is only €93 million, Problems: and the company might decide to forgo the project. • adverse selection: people who pay insurance are does with high risk of burning down the house, careful, low risk people don't pay insurance • moral hazard: once insured people are less careful Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 The Trade-off Between Return and Risk Diversification Reduces Risk Diversification: the reduction of risk achieved by replacing a single risk with a large number • The first asset class is a diversified group of risky stocks, with an average return of of smaller unrelated risks 8 per cent and a standard deviation of 20 per cent (20 per cent risk) This figure shows how the risk of a portfolio, measured here with a statistic called • The second asset class is a safe alternative; with a return of 3 per cent and a standard deviation, depends on the number of shares in the portfolio. standard deviation of zero; the safe alternative can be either a bank savings account The investor is assumed to put an equal percentage of their portfolio in each of the or a government bond shares. Increasing the number of shares reduces the amount of risk in a stock portfolio, but it does not eliminate it. The Trade-Off Between Risk and Return When people increase the percentage of their savings that they have invested in shares, they increase the average return they can expect to earn, but they also increase the risks they face. Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 The Meaning Of Money Money: the set of assets in an economy that people regularly use to buy goods and services from other people The Functions of Money 1. Medium of Exchange An item that buyers give to sellers when they want to purchase goods and services 2. Unit of Account The measure people use to post prices and record debts 3. Store of Value An item that people can use to transfer purchasing power from the present to the future Wealth: the total of all stores of value, including both money and non-monetary assets Open market operations: the purchase and sale of non-monetary assets from and to the banking sector by the central bank e.g. the central bank wants to increase the money supply; it does this by 'creating currency' through buying bonds in the bond market; after the purchase, the extra currency is in the hands of former bond holders; an open market purchase of bonds by the central bank increases the money supply; if the central bank decides to decrease the money supply; it does this by selling bonds from its portfolio; after the sale, the currency it receives for the bonds leads to a reduction in bank accounts; open market sale of bonds by the central bank decreases the money supply M M monetary policy : :: loose tight monetary policy Eurosystem: the system made up of the ecB plus the national central banks of each of the 19 countries comprising the european monetary union European Central Bank European Central Bank (ECB):the overall central bank of the 19 countries comprising the european monetary union Liquidity Liquidity: the ease with which an asset can be converted into the economy's medium of exchange Money is the economy's medium of exchange; it is the most liquid asset available; other assets vary widely in their liquidity; most stocks and bonds can The primary objective of the ECB is to maintain price stability (inflation < 2%) be sold easily with small cost; they are relatively liquid assets; selling a car or a and maximize employment Module 8: piece of artwork requires more time and effort, these assets are less liquid Ch24: The Monetary In Frankfurt; System Money in the Economy The implementation of monetary policy by the ECB is under the control of the Money stock: the quantity of money circulating in the economy Executive Board; which comprises the President, Christine Lagarde, and Vice President Currency: the paper banknotes and coins in the hands of the public (outside the bank) of the ECB and four other members, heads of central banks of countries in the euro area; they meet every 6 weeks to decide the monetary policy Currency is the most widely accepted medium of exchange in a modern economy Balance Sheet ASSETS LIABILITIES Demand deposits: balances in bank accounts that depositors can access on demand, for example by using a debit card What you owe to others What you own What other owe you M = currency + demand deposits Banks and The Money Supply The Role of Central Banks The Simple Case of 100 Per Cent Reserve Banking ECB drops 100 euros from helicopter; you pick up the banknote; M = €100 (currency); Central bank: an institution designed to regulate the quantity of money in the economy you deposit banknote with your bank: M = €100 (demand deposit) Money supply: the quantity of money available in the economy Two of the most important central banks in Europe are the European Central Bank and the Bank of England The Functions of Central Banks Most central banks have two main functions; 1. macroeconomic stability is the maintenance of stable growth and prices and the avoidance of excessive and damaging swings in economic activity 2. the maintenance of stability in the financial system To achieve the first function, central banks have the power to increase or decrease the amount of currency in that economy Monetary policy: the set of actions taken by the central bank to affect the money supply 100 percent reserve banking: : When depositing the 100 euros Reserves: deposits that banks have received but have not loaned out Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged; if banks hold all deposits in reserve, banks do not influence the supply of money Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 Money Creation With Fractional-Reserve Banking Fractional-reserve banking: a banking system in which banks hold only a fraction of deposits as reserves If the 81 euros is eventually deposited in the Third Bank, who also has a 10 percent reserve rate; an additional 72.90 euros will be made The process goes on and on: Eventually the Fist European Bank may consider using the money to make loans; people would be happy to pay interest to borrow some money; the bank has to keep some reserves for depositors wanting to withdraw; if the flow of deposits is roughly the sale as the flow of withdrawals, the bank only needs to keep a fraction of its deposits in reserve Reserve ratio: the fraction of deposits that banks hold as reserves • this ratio is determined by a combination of government regulation and bank policy • a reserve minimum: minimum on the amount of reserves that banks hold • excess reserves: banks who hold reserves above the legal minimum First European Bank has a reserve ratio of 10 percent; banks keeps 10 percent as reserves and lends out the remaining 90 percent M = 100 + 90 Deposits Currency Money creation; not a net increase; owe money back Before the bank makes any loans, the money supply is the 100 euros of deposits in the bank; when the bank makes these loans, the money supply increases; the depositors still have demand deposits totaling 100 euros, but now the borrowers also hold 90 euros in currency; the money supply equals 190 euros; when banks hold only a fraction of deposits in reserve, banks create money Money multiplier = 1/reserve ratio Money multiplier: the amount of money the banking system generated with each unit of reserves How The Central Bank Controls The Money Supply 1. Open Market Transactions: When Central Bank buys or sells bond in secondary market Suppose ECB buys a 100 euro bond from an insurance company: (Quantitative Easing, QE) • insurance company receives 100 euros and deposits it with its bank • First Eu Bank: reserves increase by 100 euros; keep 10 euros in reserves and loans remaining 90 euros • Money supply increases by at most 1000 euros: money multiplier 2. Policy Rate: interest rate that Central Bank charges for short term loans to banks ECB: refinancing rate (Refi); when banks borrow short term liquidity from ECB > Suppose ECB lowers policy rate: Banks decrease their reserves; increase loans, reserve rate decreases; money multiplier increase; money supply increase The ECB's refi has been 0 percent since 2016; meaning no interest rate; refi can't be When a bank lends out its reserves and creates money, it does not create wealth; loans from the bank give the borrowers currency and thus the ability to buy goods and services; used to loosen the monetary policy yet they are also taking on debts; the loans do not make them any richer; as the bank 3. Reserve Requirements: Central Bank requires banks to maintain a minimal reserve creates assets of money, it also created liabilities for its borrowers; at the end of this ratio ECB: > 1% process, the economy is more liquid in the sense that there is more of the medium Central bank of china > 13.5% exchange, but the economy is not wealthier Suppose Chinese banks have a desired reserve ratio of 5% The Money Multiplier Central Bank lowers reserve requirements to 10% The borrower from the First Bank uses Chinese banks lower reserve; money multiplier increases, loans increase, M increases the 90 euros to buy something from Unconventional Tools of Monetary Policy someone who then deposits the currency in the Second Bank; who also • Quantitative easing p.549 has a reserve ratio of 10 percent; have an account with • Deposit rate for banks creating an additional 81 euros of Central Bank money M = €100 + €90 + € 81 Deposits Deposits Currency Negative deposit rate to banks who deposit reserves with Central Bank Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 What is Inflation Inflation: an increase in the price level over a period of time Deflation: a fall in the price level over a period occurring when the inflation rate is less than 0 per cent Purchasing power of one euro: Money Growth and Inflation: π M Price Level, P = how many euros are needed to buy an average basket of goods and services: P2016 = €8/basket P2017 = €14/basket Purchasing power of one euro = 1/P = How many baskets can you buy with one euro In 2016: 1/8 of a basket/euro = 1/P2016 In 2017: 1/14 of a basket/euro = 1/P2017 P increases; 1/P decreases Classical Theory of Inflation Suppose that the central bank doubles Ms through purchases of government bonds from the public in open market operations; demand for goods and services increases; but supply is fixed; P increases; 1/P decreases Money Growth causes inflation Movement along the demand curve the money supply curve shifts from Ms1 to Ms2; the value of money and the price level adjust to bring supply and demand back into balance; The equilibrium moves from point A to point B; when an increase in the money supply makes euros more plentiful, the price level increases, making each euro less valuable Money Supply, Money Demand and Monetary Equilibrium; Money Market in the Long Run Purchasing power of one euro = 1/P Module 9: Money supply (Ms): set by central banks Ch24: Inflation Money demand (Md): short run: Md = f(i,y Quantity Theory of Money: long run: md f(1/P) Quantity theory of money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate Velocity of money: the rate at which money changes hands e.g. Q = 100 pizzas/year; P = €10/pizza; M = €500 At which rate does money change hands? = ((€10/pizza) x (100 pizza/year))/ €500 = (€1000/year)/500 = 2/year we divide the nominal value of output (nominal GDP) by the quantity of money; If P is the price level (the GDP deflator), Y the quantity of output (real GDP) and M the quantity of money, then velocity is: > Quantity equation: the equation (M x V = P x Y ), which relates the quantity of money, the velocity of money and the currency value of the economy's output of goods and services the supply curve for money is vertical because the quantity of money supplied is assumed to be fixed by the central bank; the demand curve for money is downwards sloping; people want to hold a larger quantity of money when each euro buys less; at the equilibrium, the value of money and the price level have adjusted to bring the quantity of money supplied and the quantity of money demanded into balance Assumption 1: V is constant in the long run Assumption 2: M does not influence the long run output leven Money increases; price increases; because V and Y are constant Quantity Theory of Money: Money growth causes inflation Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 The Classical Dichotomy Nominal variables: variables measured in monetary units Real variables: variables measured in physical units M Does not influence Does influence The Costs Of Inflation 1. Shoe Leather Costs: the resources wasted when inflation encourages people to reduce their money holding You can avoid the inflation tax by holding less money and going to the bank more often; the opportunity cost of carrying out the trips to the bank 2. Menu Costs: the costs of changing prices Real variables; Nominal variables: 3. Distorts Consumer Decisions y, W/P, r, Pi/Pj nomGDP, W, i, Pi, Pj, P When inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use. both prices are 4. Confusion and inconvenience; Cost of Computing nominal variables, Inflation makes investors less able to sort out successful from unsuccessful firms, because we are Relative prices: price expressed in terms of how which in turn impedes financial markets in their role of allocating the economy's referring to the much of one good must be given up in purchasing saving to alternative types of investment number of units another; which is a real variable 5. Inflation-Induced Tax Distortions: of a currency Saving is less attractive in Real wages: the money wage adjusted for inflation, measured by the ratio of the wage a highrate to price W/P r inflation π e.g. a consumer only buys bananas; the price of a banana is 2 euros; the consumer's wage economy; is is 10 euros per hour; the consumer can buy five bananas; ten euros per hour is the nominal bad for long wage rate measured in money terms; if the consumer works one hour he can afford 5 run growth bananas; if the wage rate changes to 12 euros an hour and the price of a banana rises to 3 euros; the real wage would be 4 bananas per hour : The real wage is a real variable because it measures the rate at which the economy exchanges goods and services for each unit of labour; the real interest rate is also a real variable 6. Unexpected Inflation Redistributes Wealth P = €1/basket of goods and services Monetary neutrality: the proposition that changes in the money supply do not affect real • Debtor borrows today €10 for one year variables • Real value of debt = €10/(1/basket) = 10 baskets • One year later the debtor pays back €10: the real interest rate adjusts to balance the supply and demand for loanable funds; the real wage adjusts to balance the supply and demand for labour; unemployment results If π = 0%: real value of debt = 10 baskets when the real wage is kept above its equilibrium level If π = 100% real value of debt = 5 baskets • Unexpected inflation redistributes wealth; debtor gains; creditor loses changes in the supply of money affect nominal variables but not real variables; When the central bank doubles the money supply, the price level doubles, the euro wage doubles; real • If expected: principal is indexed; adjusted for inflation variables, such as production, employment, real wages and real interest rates, are • Government have an incentive to cause inflation; reason why central banks are not unchanged. allowed to buy bonds directly from the government The Inflation Tax Inflation tax: the revenue the government raises by creating money When the government raises revenue by printing money it imposes an inflation tax; when the printing money, the price level rises, and the value of money falls, if wages stay constant; the printing of money acts like a tax The Fisher Effect Deflation Can Be Harmful, Too 1. Consumer postpone of durable; cars, refrigerator, tv current consumption decreases; current output decreases; recession 2. Unexpected deflation redistributes the wealth Opposite of inflation Creditor gains; debtor loses Current consumption decreases; current output decreases; recession Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate money growth should not affect the real interest rate; for the Deflation can cause recession real interest rate not to be affected, the nominal interest rate must adjust one for one to changes in the inflation rate; when the central bank increases the rate of money growth there is a higher inflation and nominal interest rate Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 The International Flows Of Goods and Capital An open economy interacts with other economies in two ways: 1. it buys and sells goods and services in world product markets 2. it buys and sells capital assets such as stocks and bonds in world financial markets NX = 4million dollars Ends up on bank account of cote d'or with bank in New York = NCO NCO = NX Open Economy Cross-border flows of: 1. People (migration) 2. Goods and services (imports, export) 3. Saving (bond domestic, international) The Flow of Goods and Services: Exports, Imports and Net Exports The net exports (NX) of any country are the value of its exports (X ) minus the value of its imports (M): NX = X - M Trade Balance: the value of a nation's exports minus the value of its imports; also called Net Exports trade: surplus an excess of exports over imports Trade Deficit: an excess of imports over exports Balanced Trade: a situation in which exports equal imports Saving and Investment, and Their relationship to the International Flows The economy's gross domestic product (Y) is divided among four components: consumption (C), investment (I), government purchases (G) and net exports (NX): National saving is the income of the nation that is left after paying for current consumption and government purchases; National saving (S): Y - C - G Model 10: Ch25: The Open Expenditures: Y = C + I + G + NX Economy: Basic Y C G = I + NX Concepts NCO S 3. Saving Saver in belgium buys a new American government bond Domestic resident Foreign asset I = Outflow of saving from Belgium Foreign resident buys domestic asset = inflow of saving into belgium 7 Net outflow of saving = outflow of saving - inflow of saving r :NCO % (-) r :NCO (+) σ :NCO (+) σ :NCO (-) 1 > Net Capital Outflow (NCO) = f(r,r*, σ, σ*) Suppose cote d'or: imports 1million dollars worth of cacao from Ghana exports 5million dollars worth of chocolate to the US 7 ^ 7 L The Flow of Financial Resources: Net Capital Outflow Net Capital Outflow: the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners The Equality of Net Exports And Net Capital Outflow Net exports and net capital outflow each measure a type of imbalance in the goods and financial markets: • Net exports measure an imbalance between a country's exports and its imports in the goods market • Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners 7 S = (Y - T - C) + (T - G) Private saving Public saving > Supply of loanable funds Demand for loanable funds • In closed economy: net capital outflow is zero; saving equals investment • In open economy saving has two uses: domestic investment and net capital outflow e.g. suppose the Singh family decides to save some of its income for retirement; this contributes to national saving, the left side of our equation; if the Singh's deposit their saving in an investment fund, the fund may use some of the deposit to buy shares issued by BP, which uses the proceeds to build an oil refinery; the investment fund may use some of the Singh's deposit to buy shares issued by Toyota, which uses the proceeds to build a factory in Osaka; these transactions show up on the right side of the equation • The BP expenditure on a new oil refinery is domestic investment • The purchase of Toyota stock by a UK resident is net capital outflow • All saving in the UK economy shows up as investment in the UK economy or as UK net capital outflow An important fact of accounting states that, for an economy as a whole, these two imbalances must offset each other. That is, net capital outflow (NCO) always equals net exports (NX ): Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 Nominal Exchange Rates (of euro) Nominal Exchange Rate: the rate at which a person can trade the currency of one country for the currency of another 1 euro = 120 yen International traders: buy wheat cheaply in Belgium (p converted to lira increases) and sell wheat at a profit in turkey (more supply in turkey, p* decreases) Arbitrage: the process of buying a good in one market at a low price and selling it in another market at a higher price in order to profit from the price difference e = 120 yen/euro Nominal exchange rate = e = units of foreign currency / unit of domestic currency Arbitrage will continue until p converted to lira = p* p x e = p* Suppose e increases to 130 yen/euro; appreciation of euro Suppose e decreases to 110 yen/euro; depreciation of euro Law of one price Suppose: price of basket of goods P,P* Appreciation: an increase in the value of a currency as measured by the amount of foreign tradable, perfect substitutes currency it can buy Depreciation: a decrease in the value of a currency as measured by the amount of foreign Arbitrage ensures that: currency it can buy P converted to lira = P* Real Exchange Rates Purchasing power parity Real Exchange Rate: the rate at which the goods and services of one country trade for the Take the inverse: goods and services of another 1 / P converted to lira = 1 / P* Purchasing power of 1 lira in Belgium = Purchasing power of 1 lira in Turkey Real exchange rate = number of foreign baskets / domestic basket PPP-Theory Arbitrage ensures that: P = 5 euro / domestic basket P* = 3 dollar / US basket P converted to lira = P* Divide by P: e = 1.20 dollar / euro P x e = P* (1.20 dollar/euro) x (5 euro/domestic basket) Convert P to P in dollars: exP Purchasing power parity as a theory of e: P* increases e will appreciate = 6 dollar/domestic basket Inflation in Turkey Turkish lira depreciates and euro appreciates You can trade one domestic basket for two foreign baskets Limitations of the theory: Real exchange rate = 2 US baskets / domestic basket (e x P) / P* = (6 dollars/dom. basket) / (3 dollars/US basket) 1. Trade restrictions; tariffs, quotas, ch.19 = (6 dollars/dom. basket) x (US basket/3 dollars) 2. Some goods and services are hard or not tradable; haircuts, eggs 3. Some goods may be similar, but not perfect substitutes; arbitrage will not work if = 2 US basket/domestic basket = real exchange rate not substitutes ) A First Theory of Exchange Rate Determination: Purchasing Power Parity Purchasing Power Parity: a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries Suppose: wheat prices: TR: pwheat = p*= 150 lira/ton BE: pwheat = p = 50 euro/ton exchange rate: 2 lira/ton Convert P to lira = (50 euro/ton) x (2 lira/euro) = 100 lira/ton Note that: • 100 lira/ton < 150 lira/ton • P converted to lira < p* Downloaded by Eline Jacobs ([email protected]) lOMoARcPSD|11463819 a; Market for loanable funds A Macro-Economic Theory of The Open Economy The Model: b; Net capital outflow a; Market for loanable funds c; Foreign exchange market Net Capital Outflow Market For Loanable Funds r Supply of loanable funds = S = f(r) NCO = f(r,r*, σ, σ*) + -+ +Exogeneous Demand for loanable funds = I + NCO b; Net capital outflow; NCO = f(r) r NCO = f(r) - I = f(r), NCO = f(r) NCO = f(r) - =S = I + NCO S1 I1 + NCO1 NCO1 S I +NCO E Supplied and demanded S, I + NCo Module 11: Ch25: The Open Economy: a Macro-Economic Model Foreign Exchange Market Supply of domestic currency in forex market: = NCO = f(r,r*, σ, σ*) is not a function of real exchange rate NX Demand for domestic currency in forex market: = NX = f(E): - E increases; EX decrease; IM increase; NX decrease NCO1 c; Foreign exchange market E NCO = supply of domestic currency in forex market NX = demand for domestic currency in forex market Quantity of domestic currency supplied and demanded in forex market Downloaded by Eline Jacobs ([email protected]) NX NCO lOMoARcPSD|11463819 What if? What if government purchases of goods and services increase? S=Y-C-G ^^ > S ✓ NCO2 G ^ > r ^ > ✓ E ^ I > ✓ NX What If Capital Flight? Capital Flight: a large and sudden reduction in the demand for assets located in a country ✓ "Twin deficits": T-G<0 NX < 0 NCO2 " • open economy; gover