Macroeconomics - Argomenti PER Esame Orale PDF

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Riassunti macroeconomics degli argomenti principali per l'esame orale...

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MACROECONOMICS: ARGOMENTI PER ESAME ORALE Inflation Rate and another Index Inflation is a sustained rise in the general level of prices—the price level. The inflation rate is the rate at which the price level increases. (Symmetrically, deflation is a sustained decline in the price level. It corresponds to a negative inflation rate.) The GDP Deflator We saw how increases in nominal GDP can come either from an increase in real GDP, or from an increase in prices. Put another way, if we see nominal GDP increase faster than real GDP, the difference must come from an increase in prices. This remark motivates the definition of the GDP deflator. The GDP deflator in year t, Pt, is defined as the ratio of nominal GDP to real GDP in year t: Pt = Nominal GDPt / Real GDPt = $Yt / Yt. One advantage to defining the price level as the GDP deflator is that it implies a simple relation between nominal GDP, real GDP, and the GDP deflator. To see this, reorganize the previous equation to get: $Yt = PtYt Nominal GDP is equal to the GDP deflator times real GDP. Or, putting it in terms of rates of change: The rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of real GDP. To measure the average price of consumption, or, equivalently, the cost of living, macroeconomists look at another index, the Consumer Price Index, or CPI. The Consumer Price Index (CPI) The GDP deflator gives the average price of output: the final goods produced in the economy. But consumers care about the average price of consumption: the goods they consume. Keynesian cross diagram (The expenditure – output model) Keynesian economics was usually explained with a different model, known as the expenditureoutput approach. This approach is strongly rooted in the fundamental assumptions of Keynesian economics: it focuses on the total amount of spending in the economy, with no explicit mention of aggregate supply or of the price level. The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced. The axes of the Keynesian cross diagram presented in the figure show real GDP on the horizontal axis as a measure of output and aggregate expenditures on the vertical axis as a measure of spending. In the graph, the aggregate expenditure-output model shows aggregate expenditures on the vertical axis and real GDP on the horizontal axis. A vertical line shows potential GDP where full employment occurs. The 45-degree line shows all points where aggregate expenditures and output are equal. The aggregate expenditure schedule shows how total spending or aggregate expenditure increases as output or real GDP rises. The intersection of the aggregate expenditure schedule and the 45-degree line will be the equilibrium. Equilibrium occurs at E0, where aggregate expenditure AE0 is equal to the output level Y0. Remember that GDP can be thought of in several equivalent ways: it measures both the value of spending on final goods and also the value of the production of final goods. All sales of the final goods and services that make up GDP will eventually end up as income for workers, for managers, and for investors and owners of firms. The sum of all the income received for contributing resources to GDP is called national income (Y). 1

At some points in the discussion that follows, it will be useful to refer to real GDP as “national income.” Both axes are measured in real (inflation-adjusted) terms. The Keynesian cross diagram contains two lines that serve as conceptual guideposts to orient the discussion. The first is a vertical line showing the level of potential GDP. Potential GDP means the same thing here that it means in the AD/AS diagrams: it refers to the quantity of output that the economy can produce with full employment of its labor and physical capital. The second conceptual line on the Keynesian cross diagram is the 45-degree line, which starts at the origin and reaches up and to the right. A line that stretches up at a 45-degree angle represents the set of points (1, 1), (2, 2), (3, 3) and so on, where the measurement on the vertical axis is equal to the measurement on the horizontal axis. In this diagram, the 45-degree line shows the set of points where the level of aggregate expenditure in the economy, measured on the vertical axis, is equal to the level of output or national income in the economy, measured by GDP on the horizontal axis. When the macroeconomy is in equilibrium, it must be true that the aggregate expenditures in the economy are equal to the real GDP—because by definition, GDP is the measure of what is spent on final sales of goods and services in the economy. Thus, the equilibrium calculated with a Keynesian cross diagram will always end up where aggregate expenditure and output are equal—which will only occur along the 45-degree line. Finally, the formulas are: Y = C + I + G and Z = C + I + G.

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IS-LM model in close economy The IS-LM model is used for study the Equilibrium in the Goods Market means that the demand for goods is an increasing function of output and the equilibrium requires that the demand for goods be equal to output. The formula for the output is: Y = C (Y – T) + I (Y, i) + G. IS curve The IS curve represents the relation between the interest rate (i) and output (Y); in fact, The IS Curve an increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output. So, also the equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. In fact, the IS curve is therefore downward sloping because Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This relation is represented by the downward-sloping IS curve.

Shifts of the IS Curve An increase in taxes shifts the IS curve to the left. Put another way, the IS curve shifts to the left: At a given interest rate, the equilibrium level of output is lower than it was before the increase in taxes. LM relation The LM Curve is fixed by the central bank that chooses the interest rate (and adjusts the money supply so as to achieve it) and the formula is: M = $Y L (i). Hence, we can restate our equilibrium condition as the condition that the real money supply, that is, the money stock in terms of goods, not dollars, be equal to the real money demand, which depends on real income, Y, and the interest rate, i. So, the central bank as choosing the interest rate (and doing what it needs to do with the money supply to achieve this interest rate) and this will make for an extremely simple LM curve, namely, a horizontal line in the figure, at the value of the interest rate, i, chosen by the central bank.

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Putting the IS and the LM Relations Together The IS relation follows from goods market equilibrium. The LM relation follows from financial market equilibrium. The formula, IS relation: Y = C (Y – T) + I (Y, i) + G LM relation: i = i Together they determine output. The figure plots both the IS curve and the LM curve on one graph. Output, equivalently, production or income, is measured on the horizontal axis. The interest rate is measured on the vertical axis. Any point on the downward-sloping IS curve corresponds to equilibrium in the goods market. Any point on the horizontal LM curve corresponds to equilibrium in financial markets. Only at point A are both equilibrium conditions satisfied. That means point A, with the associated level of output Y and interest rate is the overall equilibrium—the point at which there is equilibrium in both the goods market and the financial markets. The IS and LM relations that underline the figure contain a lot of information about consumption, investment, and equilibrium conditions. So, this is the IS-LM model. The IS-LM Model represents the equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This is represented by the IS curve. Equilibrium in financial markets is represented by the horizontal LM curve. Only at point A, which is on both curves, are both goods and financial markets in equilibrium.

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Fiscal Policy Suppose the government decides to reduce the budget deficit and does so by increasing taxes while keeping government spending unchanged. Such a reduction in the budget deficit or a reduction in taxes is often called a fiscal contraction or a fiscal consolidation. Instead, an increase in the deficit, either due to an increase in government spending or to a decrease in taxes, is called a fiscal expansion. Before the increase in taxes, the equilibrium is given by point A, at the intersection of the IS and LM curves. After the increase in taxes and the shift to the left of the IS curve from IS to IS’, the new equilibrium is given by point A’. Output decreases from Y to Y’. By assumption, the interest rate does not change. Thus, as the IS curve shifts, the economy moves along the LM curve, from A to A’. The reason these words are italicized is that it is important always to distinguish between the shift of a curve (here the shift of the IS curve) and the movement along a curve (here the movement along the LM curve). Many mistakes come from not distinguishing between the two. So, an increase in taxes shifts the IS curve to the left. This leads to a decrease in the equilibrium level of output. But, at the same time, the increase in taxes shifts the IS curve. The LM curve does not shift because the economy moves along the LM curve.

Monetary Policy Now turn to monetary policy. Suppose the central bank decreases the interest rate. Recall that, to do so, it increases the money supply, so such a change in monetary policy is called a monetary expansion. (Conversely, an increase in the interest rate, which is achieved through a decrease in the money supply, is called a monetary contraction.) In other words, a decrease in i leads an increase in M, so there is a monetary expansion; instead, an increase in i leads a decrease in M, so there is a monetary contraction. Also, A monetary expansion shifts the LM curve down, and leads to higher output. Finally, the lower interest rate leads to an increase in investment and, in turn, to an increase in demand and output. Looking at the components of output: The increase in output and the decrease in the interest rate both lead to an increase in investment. The increase in income leads to an increase in disposable income and, in turn, in consumption. So, both consumption and investment increase.

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Using a Policy Mix We have looked so far at fiscal policy and monetary policy in isolation. Our purpose was to show how each worked. In practice, the two are often used together. The combination of monetary and fiscal policies is known as the monetary-fiscal policy mix, or simply the policy mix. So, the initial equilibrium is given by the intersection of IS and LM at point A, with corresponding output Y. Expansionary fiscal policy, say through a decrease in taxes, shifts the IS curve to the right, from IS to IS’. Expansionary monetary policy shifts the LM curve from LM to LM’. The new equilibrium is at A’, with corresponding output Y’. Thus, both fiscal and monetary policies contribute to the increase in output. Higher income and lower taxes imply that consumption is also higher. Higher output and a lower interest rate imply that investment is also higher. Also, a fiscal expansion means either an increase in government spending, or an increase in taxes, or both. This means an increase in the budget deficit. Finally, the fiscal expansion shifts the IS curve to the right. A monetary expansion shifts the LM curve down. Both lead to higher output.

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IS-LM model in open economy Nominal versus Real interest rate Interest rates expressed in terms of dollars (or, more generally, in units of the national currency) are called nominal interest rates. The interest rates printed in the financial pages of newspapers are typically nominal interest rates. For example, when we say that the one-year T-bill rate is 4.2%, we mean that for every dollar the government borrows by issuing one-year T-bills, it promises to pay 1.042 dollars a year from now. More generally, if the nominal interest rate for year t is it, borrowing 1 dollar this year requires you to pay 1 + it dollars next year. (I shall use interchangeably “this year” for “today” and “next year” for “one year from today.”) Interest rates expressed in terms of a basket of goods are called real interest rates. If we denote the real interest rate for year t by rt, then, by definition, borrowing the equivalent of one basket of goods this year requires you to pay the equivalent of 1 + rt baskets of goods next year. Also, note that the real interest rate (i – πe) is based on expected inflation. If actual inflation turns out to be different from expected inflation, the realized real interest rate (i – π) will be different from the real interest rate. Extending the IS-LM model The IS-LM in open economy considers that the LM relation remains the same because the central bank still controls the nominal interest rate. But there are two changes to the IS relation, the presence of expected inflation, πe, and a new term that we shall call the risk premium and denote by x. Also, In an open economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment, public spending and net exports. This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by: Y = C (Y- T) + I + G + NX. We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. Now, in addition to what we have in the IS-LM model, since we have net exports, we have also to take into account the exchange rates, which directly affect net exports. Let’s say e is the domestic price of foreign currency or, in other words, how many units of our own currency have to be given up to receive 1 unit of the foreign currency. The new relationship is expressed as follows (where i is the interest rate): Y = C (YT) + I (Y, i) + G + NX(e). If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate. An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship. As stated before, we also need to analyze changes in exchange rates (here, e). If e decreases, then we’ll be able to buy more foreign currency with less of our own currency. On the other hand, foreigners we’ll need to pay more of their currency to buy our own. Therefore, when e decreases, also called an appreciation under flexible exchange rates or a revaluation under fixed exchange rates, domestic residents have more purchasing power, thus being able to buy the same amount of goods using less domestic currency. 7

The opposite works in the same way: if e increases (also called a depreciation under flexible exchange rates or a devaluation under fixed exchange rates), domestic residents will pay more for the same good from. To sum up, an increase in e causes net exports to increase (IS curve shifts to the right) and a decrease in e causes net export to decrease (IS curve shifts to the left). Bond prices and Bond yields Bonds differ in two basic dimensions: Maturity: The maturity of a bond is the length of time over which the bond promises to make payments to the holder of the bond. Risk: This may be default risk, the risk that the issuer of the bond (it could be a government or a company) will not pay back the full amount promised by the bond. Or it may be price risk, the uncertainty about the price you can sell the bond for if you want to sell it in the future before maturity. Both risk and maturity matter in the determination of interest rates. As I want to focus here on the role of maturity and, by implication, the role of expectations. Bonds of different maturities each have a price and an associated interest rate called the yield to maturity, or simply the yield. Yields on bonds with a short maturity, typically a year or less, are called short-term interest rates. Yields on bonds with a longer maturity are called long-term interest rates. On any given day, we observe the yields on bonds of different maturities, and so we can trace graphically how the yield depends on the maturity of a bond. This relation between maturity and yield is called the yield curve, or the term structure of interest rates (the word term is synonymous with maturity). Also, there are bonds that promise a single payment at maturity are called discount bonds. The single payment is called the face value of the bond. Instead, bonds that promise multiple payments before maturity and one payment at maturity are called coupon bonds. The payments before maturity are called coupon payments. The final payment is called the face value of the bond. The ratio of coupon payments to the face value is called the coupon rate. The current yield is the ratio of the coupon payment to the price of the bond. Bond Prices as Present Values The Bond price with one-year interest rate is: P = 100 / (1 + i). The price of the one-year bond varies inversely with the current one-year nominal interest rate. This means that there is a negative relation between the bond price and the interest rate. In fact, much higher is the interest rate, much lower will be the bond price. Also, the formula for the interest rate is: i = (100 – P) / P. Liquidity Trap For understand the liquidity trap, we have to know that the central bank can, by choosing the supply of central bank money, choose the interest rate that it wants. If it wants to increase the interest rate, it decreases the amount of central bank money. If it wants to decrease the interest rate, it increases the amount of central bank money. This section shows that this conclusion comes with an important caveat: The interest rate cannot go below zero, a constraint known as the zerolower bound. When the interest rate is down to zero, monetary policy cannot decrease it further. So, when the interest rate is equal to zero, people and banks are indifferent to holding money or bonds. An increase in the money supply leads to an increase in money demand, an increase in reserves by banks, and no change in the interest rate. This case is known as the liquidity trap. In the liquidity trap monetary policy no longer affects the interest rate.

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Money Demand, Money Supply, and the Liquidity Trap When the interest rate is equal to zero, and once people have enough money for transaction purposes, they become indifferent between holding money and holding bonds. The demand for money becomes horizontal. This implies that, when the interest rate is equal to zero, further increases in the money supply have no effect on the interest rate, which remains equal to zero.

Solow’s Model (Growth theory) The starting point for any theory of growth must be an aggregate production function, which is a specification of the relation between aggregate output and the inputs in production. In this case, this function implies that output per worker is constant, ruling out growth (or at least growth of output per worker) altogether. From now on, we will assume that there are two inputs: capital and labor, and that the relation between aggregate output and the two inputs is given by: Y = F (K, N). In this case, Y is aggregate output. K is capital (the...