Intermediate Macroeconomics Notes PDF

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Intermediate Macroeconomics – Revision Notes General:  Macroeconomics: A branch of economics dealing with the performance, structure, behaviour and decision-making of the entire economy.  Political influence on the economy and hence macroeconomics needs to be recognised.  The three major macroeconomic objectives are output (high economic growth); low unemployment (1 as 00.

Multiplier

Autonomous Spending

NEW Multipliers

The Demand for Money  Money pays no interest and can be used for transactions. - The two money types are currency and checkable deposits.  Bonds pay a positive interest rate but cannot be used for transactions. 10

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The proportion of money and bonds one wishes to hold depends on level of transaction and interest rate on bonds. - Level of transaction: People hold proportionate of their income – higher earners hold more cash to pay for bills/purchases. - Interest rate on bonds: The higher the interest rate on bonds, the greater the incentive to purchase because of opportunities for higher return – lower interest rate means preference to hold money as cash. Money market funds: Pool together the funds of multiple individuals and use collective funds to purchase bonds. Income: What you earn from working plus what you receive in interest and dividends – flow variable. - Flow variable: Expressed per unit of time. - Savings is another flow variable. - Policy making tends to focus on flow over stock variables. Financial wealth: The value of all your financial assets minus your financial liabilities – stock variable. - Stock variable: One that measures quantity over a period of time. Investment: The purchase of new capital goods. - Financial investment: The purchase of shares or other financial assets.

Deriving Money Demand  The demand for money is a function of nominal income and demand for liquidity, denoted as L; which is in turn a function of the interest rate.

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Demand for money increases in proportion to nominal income. Higher the interest rate, lower the liquidity and lower the demand for money. EXAMPLE: For a given level of nominal income, a lower interest rate increases the demand for money. EXAMPLE: For a given interest rate, an increase in nominal income shifts the demand for money to the right. NOTE: Changes to interest rate move along the curve and DON’T cause a shift. NOTE: Changes to nominal income cause shift of the curve.

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Money Demand and Money Supply  LM relation: The equilibrium condition within financial markets that requires money supply to equal money demand – to remember M for money and L for liquidity. - Money supply=money demand therefore Ms = Md= M. - The equation for Md can be rewritten to equal nominal money stock, denoted as M. - And the used to derive an equation for liquidity.  Velocity of money: Inverse relationship between the interest rate and ratio of money to nominal income. - Increases in the interest rate are typically associated with a decrease in the ratio of money to income and vice versa.  Because of the velocity of money and liquidity being a decreasing function of the interest, we can conclude that: - When interest rate is low, liquidity is higher and the ratio of money demand to nominal income should be high. - When interest rate is high, liquidity is low, and the ratio should be low. Determination of Interest Rate  Money supply is exogenous because it is not a function of the interest rate and instead decided by CB’s – horizontal.  The interest rate must be set so that money supply (independent of i), is equal to money demand (depends on i).

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EXAMPLE: An increase in nominal income shifts the demand for money outwards and unless CB interfere, causing interest rates to rise. - Without intervention, money supply remains constant and excess demand fuels the rise of interest rates.

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CB’s can change the money supply through open market operations. - Open market operations: The standard method CB’s use to change the money stock in modern economies – take place in the open market for bonds. - CB’s engage in expansionary OMO by purchasing bonds to expand the money supply – sell bonds to shrink the money supply. - Buying and selling gov bonds (debt) controls the stock of money supply. Base money (high powered money): Notes, coins and reserves. - CB’s act as a banker for the commercial banks who have accounts at the CB that hold legal tender. EXAMPLE: An increase in the money supply leads to a fall in the interest rate. NOTE: A change in money supply doesn’t necessarily change demand for money as this depends on nominal income. QE provides an alternative strategy for when reliance on interest rate isn’t enough.

MP and Open Market Operations  Open market operations DON’T change the net worth of the balance sheet. NOTE: CB’s assets are the bonds it holds, and liabilities are the stock of money in the economy.

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The CB can use MP without limit as they are able to print more money to buy bonds. - Treasury bills (gilts): Issued by the government promising payment in a year or less. - Treasury bills pay interest rate and a fixed amount at the end. To find the rate of return (interest rate) on holding a £100 bond for a year, use formula:

To find the price of a bond, use the formula above to derive:

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CB banks affect the interest rate through changing the money supply as the equilibrium condition (Ms = Md) must hold. EXAMPLE: CB’s wanting to lower the interest rate from i to i ’ ultimately 1. Increase the money supply through bond purchases. 2. Cause bond prices to rise. 3. Interest rate falls. NOTE: CB’s buy and sell bonds to ensure the interest rate is achieved.

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NOTE: We have made assumptions to simplify the economy:- Assumption 1: The economy only holds two assets, money and bonds. - Assumption 2: All money within the economy is currency supplied by the CB.

Role of Banks  Financial Intermediaries: Institutions that receive funds from people and firms, and use these to buy bonds/stocks, or make loans to other people/firms.  Banks receive funds from people/firms who have either deposited funds directly or sent funds to their checking accounts. - Banks’ liabilities = Value of checkable deposits.  Banks hold reserves because depositors withdraw cash; people write checks with accounts based in other banks; and because they are subject to reserve requirements. - Banks tend to hold above the level of restrictions, so investors are sure they are solid. NOTE: CB assets are what they owe, including bonds bought from governments/commercial banks. NOTE: CB liabilities are the currency they create to pay for bonds – currency in this case is debt.

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CB’s provide money to commercial banks in return for commercial bank assets, which are in this case bonds. The CB’s currency is debt to owners of the currency and is backed up by bonds. - Money is a liability as the CB return bonds to commercial banks once they give back the borrowed cash.

Bank Runs  Bank run: When banks run out of reserves following rumours that the bank isn’t doing well and that some loans won’t be repaid. - Rumours lead people to close their accounts and hence drain reserves.  To avoid bank runs, the government provides deposit insurance; or the concept of narrow banking restricts banks to only holding bonds that are liquid and safe (e.g. government bonds). Supply and Demand for CB Money  CB money is said to be high-powered because the overall supply of money depends on the amount of CB money (monetary base).  DEMAND for CB money (Hd) = the demand for currency by people + the demand for reserves by banks. - SUPPLY of CB money (H) is under direct control of the CB  The demand for money includes demand from both consumers and banks. - Consumers demand currency: NOTE: c is the proportion of money people want to hold -

Banks demand reserves:

as currency/deposits – e.g. if c is 0.2 they want to hold 20%. NOTE: θ is the proportion of deposits banks need to hold as reserves – e.g if feta is 0.1 then 10% are reserves.

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Ultimately, the demand for CB money, is derived as followed:

1. 2. 3. NOTE: Diagram provides a summary for the above equations and their linkage.

Determination of the Interest Rate  To determine the interest rate, money supply and demand must be equated.  The equilibrium condition states H=Hd, from which we are able to derive the money multiplier: NOTE: This has been derived from this form of equation H=Hd:-

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MULTIPLIER

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Money multiplier: Describes how an initial deposit leads to greater final increase in the money supply. - Depends on the percentage of deposits banks are required to hold as reserves rather than distribute as loans – the reserve ratio - Higher the reserve ratio, smaller the money multiplier. - Fall in preference for holding checkable deposits as oppose to holding currency – smaller multiplier. The multiplier reflects increases in the money supply as a result of successive bond purchases – expressed as a geometric sequence. NOTE: Money supply and - EXAMPLE: 1) CB purchase bonds in open market operations, interest rates and inversely then 2) banks purchase etc. proportionate. - Leads to a fall in interest rate. The money multiplier is greatly influenced by people’s expectations ©, and because the CB cannot control these, they cannot control the multiplier. - However, the size of the reserve ratio is crucial to the multiplier, and CB often increase in voluntarily to show evidence of stability – by doing this they are able to control the overall money supply without changing H. EXAMPLE: increase in the reserve deposits ratio  increase bank demand for reserves  rise in the demand for CB money  excess demand for CB money at the initial interest rate  increase rate rises  restores equilibrium.

REAL Money and REAL Income  In equilibrium, the REAL money supply equals the REAL money demand – which ultimately depend on real income and the interest rate. NOTE: Formula for real income has been derived from the formula for the GDP deflator. 

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The CB has power to choose the interest rate and adjust money supply in order to achieve H=Hd. - The LM curve is hence horizontal and independent of output. EXAMPLE: An increase in the money supply lowers interest rate and causes LM to shift downwards.

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The liquidity trap arises when interest rates equal 0 and the ZLB is reached. - People have enough money for transaction purposes and become indifferent between holding bonds and holding money. - Changes to the money supply are ineffective at ZLB and instead QE is used. NOTE: The demand for money becomes horizontal so that further increases in supply will not affect the interest rate, which remains at 0.

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During the financial crisis, although the CB was creating money, individuals/firms were saving and banks increasing their reserves. - Created money wasn’t reaching the real economy – ineffective if banks/households don’t absorb created supply.

Financial Markets and the LM Relation  EXAMPLE: If CB want to keep i unchanged, money supply is increased as much as necessary to keep interest rate fixed. - Provides only a short-term solution as growth in output and demand for money eventually generate inflationary pressures as money demanded keeps up with supply to achieve the equilibrium interest rate - CB will need to increase interest rates in the MR to keep demand stable.  In SUMMARY, in equilibrium, for a given real money supply an increase in the level of income increases the demand for money and leads to an increased interest rate.

NOTE: An increase in the money supply and fall in money demand shifts the LM curve down. NOTE: A decrease in the money supply and increase in money demand shift the LM curve up.

Putting IS and LM together – IS-LM Model  IS relation shows equilibrium in the goods market whereas LM in the financial market.

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NOTE: Only at point A where the two curves intersect, are both markets in equilibrium.

Fiscal Policy  Fiscal consolidation (contraction): Fiscal policy that reduces the budget deficit by increasing taxes and lowering public spending. - Fiscal expansion: Fuels the deficit.  EXAMPLE: An increase in taxes shifts the IS curve to the left, reducing consumption and the equilibrium level of output. - Interest rates remain unchanged however, as does the LM curve.

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In an open economy, fiscal contraction leads to improvements in net exports as less is imported and exports are unchanged – reduces deficit. Monetary Policy  Monetary tightening (contraction): Monetary policy that reduces the money supply through lower interest rates. - Monetary expansion increases the money supply through lower interest rates.  EXAMPLE: An increase in the money supply shifts the LM curve down as interest rates are lower, leading to higher equilibrium output. NOTE: MP doesn’t affect the IS curve as it affects only interest rates. NOTE: In an open economy, the effects of MP are ambiguous as nominal depreciation of the exchange rate boost net exports, but increased output reduces net exports.

Policy Mix  Policy mix: The combination of monetary and fiscal policies. 18

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Use of two policies in OPPOSITE directions can sometimes be the most effective mix. - More effective as policies offset the negative effects created by the other. - MP affects investment whereas fiscal consumption EXAMPLE: Use of fiscal contraction together with monetary expansion.  

Fiscal consolidation shifts the IS to the left. Monetary expansion shifts the LM down.

NOTE: The adjustment of output takes time as there is a delay when consumers/firms make changes in response to policy signals. 

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NOTE: Monetary policy is neutral because nominal money supply doesn’t affect output or the interest rate in the MR (in real terms); and output returns to its natural level. - Fiscal policy doesn’t affect output, but it does influence the position of the IS curve and investment, which ultimately determine the interest rate and so it is not neutral. Alternative policy solutions include subsidies, changing exchange rate, QE and tariffs.

Labour Markets in the Medium Run  We cannot assume constant price level in the MR as we have until now, as wages/costs etc. are never fixed in reality.  Wage price spiral: The influence of wage and price adjustments over time on output.

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The two realities of unemployment are an active and sclerotic labour force. Active labour force: One in which lots of people lose their jobs but are able to find jobs quickly – many hires and separations. - Separations: Result either from quits by the worker or involuntary layoffs by the employee. Sclerotic labour force: Poorly functioning labour market with not much movement – few hires and few separations. There is a large flow of workers as individuals move between realities of unemployment, out of the labour force and into unemployment. Non-employed: Those who aren’t looking for work because they are disabled, discouraged, stay-at-home parents etc. Fluctuations in the aggregate unemployment rate affect wages and individual workers’ welfare.

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Higher unemployment is associated with a higher risk of losing your job and a lower chance of unemployed workers finding jobs. Adjustments to shocks tend to be focused within the labour market rather than the demand side.

Wage Determination  Collective bargaining: Bargaining between firms and unions to negotiate wages.  Workers are usually paid a wage exceeding their reservation wage. - Reservation wage: The wage that makes employees indifferent between working and being unemployed.  Wages typically depend on labour market conditions – lower levels of unemployment are typically associated with higher wages.  Under efficiency wage theories, firms may want to pay more than the reservation wage, regardless of the worker’s bargaining power. - Efficiency wage theory: Suggest wages depend on the nature of the job (how costly it is for the firm to replace them) and labour market conditions (how hard it is to find another job). - Firms that see employee morale and commitment as essential to the quality of their work pay more than firms in sectors where employee activities are more routine. - Theory is supported by Henry Ford’s minimum pay regime.  The aggregate nominal wage, denoted as W, depends on 3 factors: - Expected price level, denoted as Pe. - The unemployment rate (u). - A catchall variable (z). Wage Determination – Expected Price Level  Workers and firms care about real wages, denoted as W/P, rather than nominal wages (W). - Workers care about how much they can buy with their wages NOT what they receive. - Firms care about the nominal wages they pay RELATIVE to the price of the goods they sell (P).  Wages are set dependent on the expected price level. - If prices are expected to rise by 5%, workers demand wages to increase by 5% and firms agree to increase the nominal wage by 5%; keeping the REAL wage unchanged. Wage Determination – Unemployment Rate  Wages are determined by bargaining: - Higher unemployment means workers have less bargaining power because more people are seeking employment. - Workers are forced to accept lower wages. - Firms can pay lower wages and still keep workers willing to work through threatening to let workers go if they demand higher wages. Wage Determination – Catchall Variable 20

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Catchall variable: Represents all variables that may affect the outcome of wage setting, apart from the expected price level and unemployment rate. - Any changes in labor market conditions affect z. EXAMPLE: Size of unemployment insurance, level of minimum wage, level of unemployment protection (how easy it is to fire someone). - An increase in any of these pushes wages up.

Price Determination  Production function: The relation between the inputs used in production and quantity of output produced.  Production function can be written as Y=AN, where Y is output, N employment, and A denotes output per worker (labour productivity). - This assumes firm produces goods using ONLY labour. - If we also assume one worker produces one unit of output, A=1 and function becomes Y=N.  Firms set their prices according to P=(1+m)W, where m denotes the mark-up of price/cost of production. - In perfectly competitive markets, m=0 and P=W. - Mark-up depends on the degree of market competition – regulation influences competition. - EXAMPLE: Higher regulation  Less competition  Higher mark-up.  EXAMPLE: In European markets; increased integration  higher competition  lower mark-ups  higher real wages  lower unemployment. Equilibrium Unemployment Rate  Wage and price setting determine the equilibrium unemployment rate – ASSUMING Pe=P and nominal wages depend on the actual price level.  Wage setting relation: Shows the relationship between the real wage and unemployment rate: NOTE: Derived from Pe = P, which also equals W=PF(u,z).

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- Where F is a generic function. The price setting relation given in terms of wage rate: NOTE: Derived from P=(1+m)W.

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Natural (structural) rate of unemployment: The unemployment rate in which the real wage chosen by in wage setting equals the real wage implied by price setting, denoted by un. - Function of multiple factors that differ internationally. - Governments can regulate and control these factors to ...