Notes on Chapter 9 - Economic Fluctuations

Introduction

In the long run, the economy, measured by GDP, is constantly growing. You can see the long-term GDP growth trend in the graph of US GDP from 1947 through the end of 2008.

However, if you look at the graph carefully, you'll see that there are short-term periods in which the economy grows at a slower pace, stays level or even contracts. These periods of falling real national income are known as recessions. Eventually, the economy recovers and continues on its growth path.

Short-run fluctuations in output and employment are often correlated and known as the business cycle.

In our study of economic fluctuations, we seek to:

1. Obtain a more complete understanding of the data, primarily GDP and unemployment rate, that are used to measure the economy and describe the short-run fluctuations.

2. Understand differences between short-run and long-run economic behavior.

3. Develop a model which can be used to describe and predict economic behavior in the short-run. We will call this model the AD-AS model and base it on the concepts of aggregate demand and aggregate supply which will be developed in our analysis.

Our ultimate goal is to understand the economic variables well enough to control the cycle of economic fluctuations through effective fiscal and monetary policies. We're not trying to eliminate the cycle entirely. That would likely be impossible. Rather, we are attempting to minimize the severity of the peaks and troughs in the cycle.

GDP, Unemployment and Okun's Law

Some notes on GDP:
Average annual GDP growth in the US is 3.5%.
Officially, the NBER Business Cycle Dating Committee determines when recessions begin and end.
NBER's rule of thumb is that a recession is defined as two consecutive quarters of declining real GDP. This is a rule of thumb and not a strict definition. Other economic factors are taken into account in the final analysis.

Note: It's unclear to me whether the rule of thumb is defined by declining growth in GDP or by negative growth in GDP. I.e. is it enough for the growth to be slowing down, or does the growth rate have to actually be less then zero?
Another interesting question is whether we compare GDP growth from quarter to quarter or from one quarter to the same quarter 4 quarters ago. The later method would take into account seasonal changes to some degree.

GDP = Y = C + I + G + NX

So we might expect all the components of GDP to decline during a recession. That is the case for consumption (C) and investment (I). However, we find that recessions have a more dramatic impact on investment (I = equipment, structures, housing, inventories, etc) than on household consumption (C).

Some notes on unemployment:
During recessions, unemployment generally increases. Economic growth slows when more workers are unemployed. The unemployment rate is related to the decline in GDP by Okun's Law:

%ΔGDP = 3.5% - 2 x Δ%Unemployment

This formula essentially means that the economy, measured by GDP, will grow by 3.5% when the unemployment rate is stable. If unemployment increases, GDP will drop by 2% for every 1% that unemployment increases, and vice versa.

Edward S. Knotek, an economist at the Federal Reserve Bank of Kansas City, has written an interesting article entitled How Useful is Okun's Law?

Notes on Chapter 14 - Stabilization Policy

Chapter 14 - Stabilization Policy

We learned about the business cycle in Chapter 9. We also learned about shocks to the economy, both demand shocks which shift the aggregate demand curve and supply shocks which shift the aggregate supply curve. We also discussed ways in which policymakers can react to these shocks in order to dampen their effects and return the economy to natural levels.

In this chapter, we discuss stabilization policy in more detail to answer some fundamental questions about how government policymakers should respond to the business cycle:

1. Should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive?
2. Should policymakers be free to use their discretion in responding to changing economic conditions, or should they be committed to following a fixed policy rule?

Should Policy Be Active or Passive?

Monetary and fiscal policy have a significant impact on aggregate demand, inflation and unemployment. Use of monetary and fiscal policy to stabilize the economy is relatively recent, beginning with the Employment Act of 1946. Economists differ in their opinions as to whether government should actively use policy to stabilize the economy or whether they should take a hands-off approach.

There are three major criticisms of active government intervention in using monetary and fiscal policy to stabilize the economy:

1. Lags in the Implementation and Effect of Policy
2. Difficulty in Economic Forecasting
3. Lucas Critique

Policy Implementation and Effect Lags. Implementation lag, also called inside lag, occurs when there is a lag in time between the economic shock and the implementation of policy. This lag occurs because it takes some time for economists to recognize the shock and for government to implement the policy. Policy effect lag, also called outside lag, occurs when there is a lag in time between the implementation of a policy and the effect that it has on the economy. Both inside and outside lag can be long and variable in length.

Fiscal policy suffers from a long inside lag because it takes a significant amount of time for Congress to pass legislation that affects taxes or government spending. Mankiw recently posted an article that noted that changes in fiscal policy, specifically through government spending, also suffer from an inside lag between the time the policy is passed by Congress and when it is implemented by the funds becoming available.

Although the central bank can adjust its policies quickly, monetary policy suffers from a long outside lag. Changes to money supply and interest rates influence investment and aggregate demand. Since many investment decisions are planned in advance, changes to monetary policy generally have a lag of about 6 months before their effect is felt in the general economy.

Automatic stabilizers are policies which stabilize the economy automatically without any changes to monetary or fiscal policy. Examples of automatic stabilizers are taxes and transfer payments. Taxes increase when the economy grows and income increases, thus having a dampening effect on the growing economy. Transfer payments increase as unemployment increases and income falls, thereby having a stimulating effect on the economy.

Economic Forecasting is Difficult
Because of the outside lags noted above, setting economic policy requires governments and central banks to forecast economic conditions six months in the future or more. Economists use both leading indicators and economic models to forecast economic conditions.

By their nature, economic models are limited in their ability to predict the future. In this respect, they are similar to the models that weather forecasters use to predict the weather and are often inaccurate. Two examples are the Great Depression of the 1930s and the recession of 1982.

The Lucas Critique
Robert Lucas is a Nobel Prize-winning economist who is currently associated with the University of Chicago. Lucas developed a theory, known as the Lucas Critique, which posits that the economy is influenced by people's expectations and those expectations are influenced by economic policy. Therefore, the very act of changing economic policy may influence the economy to more or less of a degree than anticipated by economic models due to the effect of the policy change on the public's expectations. In order to account for these effects, economic models should be modified to account for the influence of policy on expectations and economic activity.

The History of Stabilization Policy
In trying to determine whether stabilization policy should be active or passive, you would think that we could look back at history and see whether active or passive policy has been more successful. A few reasons are given why historical review doesn't give us a definitive answer.

1. When examining policy failures, i.e. large shocks, it's not always clear which policy would have been better. For example, concerning the Great Depression, some economists believe that a more active policy would have been the best way to address the situation. Other economists believe that a passive policy may have avoided the Great Depression in the first place.

2. Some economists look at the long term economic data and note that the economic shocks after the 1930s, when Keynes's theory was published and governments started instituting active policy, have been much less severe than the shocks prior to that time. This would seem to point in favor of active stabilization policy. However, Christina Romer, a UC-Berkeley professor and currently nominated for Chair of the Council of Economic Advisors, has noted that since the 1930s we have been gathering more and better economic data. Therefore, it may just be that we have better data in recent years, not that the active policy has made the shocks less severe.

Recent Stability
Throughout the 1990s and 2000s the GDP growth and inflation have been relatively less volatile than in prior years. Mankiw attributes this stability to 3 factors:
1. The US economy is now more service-based which is more stable.
2. Shocks just happen to have been less severe.
3. Fed Chairman Greenspan's management of interest rates and money supply stabilized the economy.

Economics Think Tanks

Some of the institutions that I came across during my research for our group project for ECO 509:
OECD
Organisation for Economic Co-operation and Development.
www.oecd.org

NBER
Cato Institute
Economic Policy Institute
Hoover Institution
Brookings Institution
Urban Institute

A really big list of econ resources from 1999 that should be updated.

Prominent Contemporary US Economists

I'm very interested in the history of science, both natural sciences and social sciences. I also consider understand important current events an integral part of understanding history as it unfolds. Therefore, now that the official course is over, I'll take some time on this blog to learn about contemporary economists, their backgrounds and their approaches.

I heard so many economists' names mentioned during the class and I constantly see more in the news on a daily basis. I rarely know who's a supply-sider, who's from the "Chicago School" or who's involved with a liberal think tank. So I'll try to categorize the biographies without, hopefully, unfairly pigeon-holing anyone.

I'm including:
Policymakers
Academic economists
Major banking officials

I'm not sure of the best way to structure these entries, so I'll just start jotting things down and hope I can make sense of them in the end.

Board Governors of Federal Reserve System
Ben S. Bernanke (chairman)
Donald L. Kohn (vice chairman)
Kevin M. Warsh
Randall S. Kroszner
Frederic S. Mishkin

There are two vacant positions on the board. President Bush nominated Elizabeth Duke and Larry Klane to fill those positions in 2007, but the Senate has not held confirmation hearings to confirm them.

Randall S. Kroszner's term expired on January 31st, 2008, but he continues to serve on the Board until he is either reconfirmed or a successor is named.

Frederic S. Mishkin recently (May 28th, 2008?) resigned his position, effective August 31st, 2008. Related articles:
MarketWatch
TheBulletin

The Final Exam

Yipes!

I'll comment on the final exam after it's graded, grades are posted and I have a chance to review it with Professor Woo.

Lecture 10 - Learning from Japan

See packet page 8

Key Questions
1. Is it possible to recognize when an economy is moving to a phase of sustained deflation?

Japan had bad forecasting. (See graph on packet page 7) Monetary policy is usually based on forecasts. Therefore, their monetary policy was too tight.

Use the Taylor Rule, developed by John B Taylor, (see page 16 and graph on pg 17). Greenspan is criticized for keeping the interest rates below the taylor rule during 2004-6.

More factors depressing AD further (need this slide)

Bursting of the asset price bubble
Weakened banking system
Deflationary expectation: as people anticipate the deflation to continue, tehy postpone their...

Was the Fiscal Policy Stance Appropriate?
See packet page 10
Tax cuts vs. spending increase
Temporary vs permanent

Fiscal packages depend heavily on public works programs (G up) (such as Kansai airport) and temporary income tax cuts (such as 5.9 trillion yen income tax rebate in FY 1994)

It seems that this heavy reliance on public works programs is politically driven (political connection of construction companies). See "bridge to nowhere". Many projects such as bridges and roads in remote areas failed to lead to second-, third-round private spending increase.

Temporary income tax... (see rest of slide in packet)



Fiscal packages depend heavily

Lecture 10 - AD-AS Model

Final Exam Prep

Final starts from the "Money and Inflation" lecture.

The final will be predominantly multiple choice, less analysis.

Boom Cycle

See AD-AS Diagram on page 12 of packet.

How does a stock/housing boom cycle work?

Initially, we're at equilibrium (point 1). When a boom occurs, C and I go up, leading to a rightward/upward shift in AD. In the short run, you end up at point 2 and you have an inflationary gap. We have close to full employment (or at least the lower theoretical unemployment, considering that some ppl are always out of work).

At point 2, Y is greater than Ybar (expected output). There may even be unemployment less than the "natural" minimum, U^N. The labor market tightens and labor demand goes up, leading to upward pressures on wages (which are 70% of cost of production), leading to increased cost of production.

Over time, more and more firms raise their prices and the SRAS curve shifts upward. And we end up at equilibrium point 3: output is lower and prices are higher. But there still may be an inflationary gap. The SRAS curve should continue moving upward until it eliminates the gap at point 5 (where did point 4 go?).

At this point you're at full employment level. No extra workers. In the absent of any monetary of fiscal policy intervention, you just end up with higher prices and no other changes. :( This is the wage and price spiral. Policy tries to push the AD curve down buy other mechanisms.

This is illustrated in the diagram on page 14 of the packet.

Recession Cycle

Take the case of Japan: 1992-

They had full level of employment in the 1990s. Before 1990, there was an asset price bubble. At the height of the bubble, a commonly-quoted claim was that the land beneath the Imperial Palace in Tokyo was worth more than the entire state of California.Between 1990 and 1992, there was a massive asset price collapse. The Nikkei 225 (like S&P 500) dropped from almost 40,000 to 20,000.

(i) Balance-sheet channel. This led to bankruptcies of households and firms. There was no longer appetite for consumption or investment. C down, I down.
(ii) Bank-lending channel. Led to loan losses, banks went bankrupt and were acquired by the government. They were nationalized. Credit to households and firms were severely reduced. It became very difficult to borrow from banks. Consumption and investment (C and I) both went down.
(iii) Deflationary effects. If prices are going down, people will postpone purchases, thereby pushing down consumption and investment. (C and I down).

Due to all these channels, the AD went down, creating a recessionary gap. Deflation doesn't necessary result in lower prices, but it could be that prices are growing less quickly.

This results in U greater than U^N and then downward pressure on wages, lower cost of production. SRAS curve shifts downward and over time, lower prices. A new equilibrium at point 3, yet still Y is less than Ybar until over time, firms cut prices and SRAS meets LRAS and AD. Eventually, the economy returns to potential GDP, yet prices are now permanently lower.

The Japenese tried to push the AD back up through policy, but it didn't work. Bernanke is trying to do that now in the US also.

Supply shocks

A supply shock to aggregate supply is a shock to the economy that alters the cost of production and as a result the prices that firms charge.

(1) Positive supply shock (would shift SRAS to the right)
Ex: Productivity gains from new technology such as IT revolution.

(2) Negative supply shock (would shift SRAS to the left)
Examples:
Drought that destroy crops
New environmental protection law
Labor strike, increased wages
Oil price shocks

Consider adverse supply shocks (ex: oil price shock) - SRAS curve shifts upward. The result is higher prices and lower output (P up, Y down). This is called stagflation.

Fed options:
(i) Do nothing. Go through the recession until prices return to P1 and Y returns to Ybar.
(ii) Push the AD outward with monetary expansion. But this comes at the cost of higher prices. But this restores the output back to Ybar more quickly.

Which is worse - unemployment (recession) or inflation?

Fiscal Policy

2008 Tax Rebate and Oil Price Effects on the US in the Near Term

2008 Tax Rebate = $110 bln (compared to $38 blin on 2001 tax rebates)

1975 and 2001 tax rebates: 12-25% and 22% were spent in the first quarter (Poterba 1988 AER; Shapiro-Slemrod 2003 AER)

Thus, 20% of rebates are spent. C rises by $22 bln = 0.8% quarterly = 3.2% annually
C is 70% of GDP, so Y rises by 2.2%

Rising oil price acts as a tax on consumers (trnasfer income to oil producers). US import of oil per year = 4.5 bln barrels.
Oil prices rose by 40% in 2008. Oil "tax" = $180 blin a year (greater than tax rebates!)

Income effects of tax rebates will be larger in shorter period, but high oil prices (if this oil tax remains) will reduce income and consumption in near term, dragging the economic recovery in the near term.

Lecture 9 - The Business Cycle (continued)

See graph (packet page 8) on the Volatility of Investment and the correlation with GDP.

Investment Volatility

(i) Investment accelerator factor
I (gross investment) = ΔK + λK
where
ΔK is net investment
λK is depreciation
Depreciation is usually about 10%

ΔK = α (K*-K_-1)
where
K* = desired level of K
K_-1 = capital at the end of previous period
α = speed adjustment

If Y, output/GDP, falls by 1-2% in a year. Then K* goes down by 1% (huh?), which is worth about $275 billion.

How does that impact investment? It's nearly 15% of I, investment, because I is about $1800 billion.

So, GDP falling by 1% translates to a 15% decline in investment. That explains the wild fluxuation that we see in the Volatility of Investment graph.

(ii) Postponability

In the real world, you can always adjust and adapt to the circumstances. You don't have to do anything. You can always change direction if there are unfavorable conditions.

Story: 5th ave thrived and 6th ave had nothing, until BB&Y moved in. When BB&Y was successful ("Miracle on 6th St."), it was a signal to the market that the business conditions were ripe for success there.

The moral: When there's investment, they invest a lot. When there's little, there's very little.

The Aggregate Demand Curve

See graph in notes i vs M/P.

What shifts the aggregate demand curve?

(i) Fiscal expansion/contraction: T down or G up
(a) G up leads to AD up (since AD = C+I+G+NX)
(b) T down leads to (Y-T) up leads to C up leads to AD up

In the P vs. AD graph, this is an outward shift of the AD curve.

Fiscal contractions do the exact opposite in the inward direction.

(ii) Monetary expansion/contraction

Let's understand the Monetary Transmission Mechanism

Money supply up leads to Ms/P up which shifts the Ms/P vertical to the right and leads to lower interest rates. Under sticky price assumptions, this leads to r down. C, I and NX go up, and AD goes up - an outward shift.

2 addition channels related to monetary policy:
1. Bank-lending channel. Our consumption is tied to how willing banks are to lend. When banks are risk-averse, they tighten their lending policy and raise lending standards. This is supply side - the supply of loans.
2. Balance sheet channel (financial accelerator effect - Bernanke's term). (Warren Buffet: "When the tide is out, we can see who's swimming naked.") There can be financial distress when there are cash flow problems. Consumption spending will be effected by this liquidity problem.

"Jingle Mail" = mailing the bank the key to the house in lieu of continuing to pay the mortgage.

Aggregate Supply

Long Run Aggregate Supply (LRAS) curve.

Key LR assumption is flexible prices. If you have enough time, prices will adjust. Implications: (W/P) vs L graph in notes.

There is downward rigidity to wages. If the market were fully flexible, we would be at equilibrium and at full employment and full output. This is the U of Chicago view - Robert Lucas.

See graph of P vs Y in notes. Ybar is vertical. Add AD curve. With monetary contraction, AD shifts inward and prices decline.

This theory was tested in the early 1980s by Paul Volcker. Inflation fever was eventually broken, but it wasn't so simple.

Short-run aggregate supply curve (SRAS)

This view is supported by Mankiw (which is strange since he supports Republicans who are usually associated with the U of Chicago economists).

Prices are sticky: Pbar. See graph of P vs Y in notes. Pbar is horizontal.
Prices don't change with change in demand. Rather, supply increases if demand increases.

The truth may be somewhere in between, with P not being constant. It probably slopes upward.

Why are prices sticky?
(i) Menu cost. There's some overhead (cost, inconvenience) associated with increasing the prices and changing menus or shelf price or price stickers or cash register programming.
(ii) Long-term relationship with customers. Customers don't like it when prices go up (or down) frequently.
(iii) Contracts. Companies may be contractually bound to a certain price.
(iv) Strategic pricing decision. In highly competitive markets, one company may wait for the other company to make the first move - leading to stalemate.

Frequency of Price Adjustment
10.2% - less than once a year
39.3% - once
15.6% - 2-3 times

Lecture 9 - The Business Cycle

The Business Cycle

We graphed GDP (potential and actual) vs. time.

Potential GDP is at full employment and output. Ybar = AF(Kbar, Lbar)

The Business cycle is the regular repetition of the cycle of contraction, recession, recovery and expansion. There's no set amount of time for each of these phases. We want to know: What drives the actual GDP around the potential GDP.

Output gap = Y - Ybar, where Ybar is the potential GDP

Output gap is positive during boom and negative during recession.

How can actual output, Y, be greater than the potential Ybar? Because employment may be greater than the theoretical "potential" by working more hours or if unemployment is lower than the "natural" unemployment. Natural unemployment is the theoretical minimum given that at any point in time some people aren't working because they're changing jobs or just taking some time off for personal reasons.

Business Cycle Indicators

(1) Leading Indicators
(2) Coincident Indicators
(3) Lagging Indicators

(I need some more information about these indicators)

Short Run vs. Long Run

In the long run, prices are flexible and can respond to changes in supply and demand.
In the short run, many prices are stuck at the predetermined level.

Consumer prices do not change immediately after changes in monetary policy from the Fed.

In the short run, prices are stick. (Slow to adjust). Recall the quantity theory of money:
MxVbar = Pbar x Y

If M (money supply) goes up, Y (output) must go up. So monetary policy can be used to affect output activity.

But is the sticky price assumption (in the short run) correct? We will see some data on this.

See the graph: Great Moderation (packet page 6). The business cycle peaks and troughs are much smaller after 1950. Why? Do we have better monetary policy since then? Or perhaps we haven't had severe shocks? Or perhaps pre1950 has less accurate data. (Christian Romer)

See table: Key Characteristics of Recessions in the US (packet page 7). Shows duration and severity of recessions since 1960. Data comes from NBER. The 2001 period is in question whether there was a recession or not.

Unemployment and real personal disposable income and industrial production data indicate that we are now in a recession. See GDP Growth bar graph (pg 9), house-price indices (pg 10, Case-Shiller includes jumbo and sub-prime sales) OFHEO only includes conforming loans (Fannie Mae and Freddie Mac)) and residential investment-GDP ratio graph (pg 11).

Most recessions bottom out with a 2% GDP growth. (is that right? that slide went by way too fast)

When will the recovery happen? U shaped or V shaped or L shaped? Will depend on housing market stabilization/recovery and also how effective fiscal and monetary policies are.

See the table on packet page 8 of the US Economic Outlook.

The AD-AS Model

(1) Aggregate Demand Curve: relationship between P and AD
AD = C + I + G + NX

(i) C = C(Y-t, (y-t)^f, wealth, r)
(ii) I = I(r, Y, Y^f, tax policy)
(iii) NX = NX(ε (minus),Y (minus), Y^foreign(plus))

More on C & I

(1) C - Consumption
In general, disposable personal income is strongly correlated with consumption. But marginal propensity to consume, MPC, may be influenced by age and other factors as well - how much they expect to earn in the future, how much they have now, etc.

Lifecycle hypothesis
forward looking rational consumers will look at all their lifetime potential earnings.
MPC^permanent < MPC^temporary

So, for example, are tax rebates and the "stimulus package" likely to have a big impact? It's $110 billion going to households. In 2001, it was only $38 billion. The 2008 package is temporary. The 2001 rebate was made "permanent" through tax cuts.

With temporary stimulus, we should only expect a 20% MPC. 20% of $110 is $20 billion. This is a 0.8% quarterly increase in the overall consumption, 3.2% annually. This would lead to an increase in Y of 2.2% (Recall that C is 70% of GDP)

Lecture 9 - Exchange Rates (continued)

Some General Notes

Study notes for the final will be distributed next week.

Some reading links on the course web page are broken and will be fixed

PPP Conditions (cont.):

excahnge rate can be viewed as purchasing power ratio between countries

As a percentage, the %Δe = difference in the inflation rates differencials of the countries

Fixed exchange rate + PPP condition

Fixed exchange rate is a shortcut to fighting inflation.
See chart: Argentina: Exchange Rate and Inflation Rate, 1992-2004.
New president appointed new economist who introduced a currency board: e =1 (Argentine peso/$). A currency board is the strongest form of a fixed exchange rate. It requires the Central Bank to have a $ for every Peso that they circulate.

Under PPP conditions, %Δe = 0 = Π^Argentina - Π^US and therefore the Argentine inflation rate must match the US inflation rate.

Many countries fix their currency exchange rate against the dollar. Some also fix the exchange rate with the Euro as well.

(You can download The Economist screensaver from their web site. It looked pretty cool in class. :)

In Argentina, after they fixed the currency to the $, the eventually (after 3-4 yrs) achieved a low inflation rate.

In the late 1990s, Argentina couldn't sell very much and developed a significant trade deficit. So they decoupled the exchange rate which led to an immediate spike in inflation in 2002. Eventually, the economy stablized and inflation fell back down again.

The Euro

In 1999, the Euro was introduced. 1 € = 1.96 DM = 6.56 FF
ebar = DM/FF = 3.xx
ebar = 0. So, Π^France = Π^Germany

See graph "Convergence of Inflation Rates in the Eurozone: 1970-2007. (packet page 14) Inflation in Germany has historically been low. By pegging to the German currency, other countries "import" the low inflation rate.

Foreign Exchange Background from the Federal Reserve Bank of NY

For additional reading on the foreign exchange market, I found the following two resources at the NY Fed:

All About…The Foreign Exchange Market in the United States
Discusses in detail the operations, participants and instruments in the U.S. segment of the global foreign exchange market.

All About…The Foreign Exchange Market in the United States
Discusses in detail the operations, participants and instruments in the U.S. segment of the global foreign exchange market.

Lecture 8 - Foreign Exchange Rates (cont.)

China holds 31% of the US trade deficit. Compare to the appreciation of their currency.
Euro Areas holds about 11%. Japan 10.4%. Mexico 9.5%.

Spot Exchange Rate vs Forward Exchange Rate

Spot exchange rate: Executed immediately.
Forward exchange rate: A future date is specified for delivery of funds.

Why use forward exchange rates?

Suppose you need to make a payment of 1 million Yen in 3 months. If there's a concern that in 3 months the Yen will appreciate, you may want to use a forward contract.

(i) Suppose e = 100 yen/$; you have to pay $10k.
(ii) Suppose the rate appreciates to e = 80 yen/$; you will have to pay $12.5k.
Now,
(iii) If you lock into a forward exchange rate of f = 90 yen/$; you will then pay $11.1k and can be sure of the price. This is a foreign exchange hedge.

This situation involves a zero-sum game. One party always wins and the other loses. There is also a default risk. The futures exchanges reduce the risk of one party running away by requiring a deposit and margin calls (additional deposits) when the chances of losing increase on one side. Transaction costs are reduced by having fixed, standard contracts and regular delivery dates. CME is a major player in this market.

Foreign Exchange Market

We graphed exchange rate (euro/$) vs foreign exchange mkt for $. The supply of dollars is fixed, regardless of the exchange rate and is therefore vertical. The demand for dollars slopes downward since the demand goes up as the (future) exchange rate goes down (relative to today's rate).

What shifts the supply and demand curves?

Demand-shift factors

(i) interest rate differential: iUS-iEuro
If iUS goes up relative to iEuro, then US$ assets become more attractive and the demand for the dollar will rise and the demand curve shifts out (to the right).

(ii) inflation differential: ΠUS - ΠEuro
If ΠUS goes up relative to ΠEuro, US$ assets become less attractive and the demand for the dollar will fall and the demand curve shifts in (to the left).

(iii) (very important) expected future exchange rate
Arbitrage can take place between two places or between two points in time.
Say, for example, the current exchange rate is e=1 euro/$ and you expect the future rate to be 0.5. In such a case, you should by Euros.

In general, if you believe a currency will rise (relative to another), you should buy that currency. Caveat: Since we live in the US, we need dollars for daily living. The above strategy is only for investment purposes.

George Soros profited from currency speculation in UK pound when it collapse on Black Wednesday - Sept 16, 1992.

(iv) Risk of US$ relative to foreign assets

If risk increases, demand for the US$ falls.

* Page 3 of articles: Greenback continues its dramatic slide
*Page 2 of articles: Economic data proves saving grace for yen

100 basis points = 1 percentage point

Carry-trade is a form of arbitrage. In Japan, the interest rate is almost 0%. You can practically borrow money for free. Then you can lend in another place at a profit. (need additional explanation here.)

Purchasing Power Parity (PPP)

Purchasing power parity is a long-run equilibrium condition for exchange. Assume no tariff barriers & no transaction costs.

Arbitrage situation in sweater market between US ($45) and UK (27 pounds). If exchange rate e = 0.7 (pound/$), then 45$ x 0.7 pound/$ = 31.5 pounds. It's cheaper in London!

Buy in London & resell in Chicago. Eventually price in UK will fall and price in US will increase and the arbitrage will stop.

After arbitrage, price will be the same. Equilibrium. No arbitrage condition. e x P-US = P-UK

e = P-UK/P-US

Generalize this to any market, not just sweaters. P-UK and P-US are a price index, like CPI, for a common basket.

%De = %DP-UK - %DP-US
= ΠUK - ΠUS

Higher inflation leads to currency depreciation

Lecture 8 - Foreign Exchange Rates

As of 5/15/2008,

exchange rate, e = euro/$ = 0.6469

Dollar depreciation makes US products less expensive in Japan, if other things are equal. I.e. for given domestic and foreign price levels.

Real exchange rate ε (epsilon) = e P^US / P^Japan, where e = yen/$.

Ex: Assume Ford Taurus and Toyota Camry are essentially equivalent products.
Taurus: $20,000
Camry: 2.5m Yen

(i) e = 100
ε = e P^US / P^Japan = 100(20,000)/(2.5m) = 2m/2.5m = 0.8

Therefore, the Taurus is cheaper than the Camry.

(ii) e=90
ε = e P^US / P^Japan = 90(20,000)/2.5 = 1.8m/2.5m = 0.72

Nominal depreciation of the exchange rate, makes US products cheaper.

(iii) e=100, but the price of the Taurus goes down to 15k due to innovations and increase labor productivity
ε = 100(15,000)/(2.5m) = 1.5m/2.5m = 0.6

Even without depreciation, US producers can make their products cheaper.

A strong dollar policy was favored by Robert Rubin when he was Secretary of the Treasury and Larry Summers who succeeded him in that position. But a high exchange rate is not always desirable. Italy and Spain are experiencing a recession and do not want a strong Euro.

In general, a strong Euro policy makes sense for them now. It hurts European manufacturing in the short term, but it will help them advance their productivity, which is currently lagging, in the long run. It will force them to innovate. Japan had a similar experience.

Trade balance depends on the real exchange rate, not the nominal exchange rate.

Lecture 8 - Financial Markets (Bond and Stock Markets)

See packet page 26.

A bond is one specific kind of security.

Bonds are issued by corporations and the government. Fed govt bonds are much lower risk. But corporations and state and local govts can default (Orange County CA, Alabama?).

Stock is partial ownership. It gives the right to vote and may pay dividends. Synonymous with equity financing. The stock market is relatively volatile.

Stock price earnings do not always match corporate earnings. Some justify the stock prices because they reflect future earnings. But that didn't pan out.

Bond holders get paid first, before equity (stock) holders.

Bonds vs Stocks (missing slide?)
The main disadvantage of owning an equity rather than bond is that equity holder is residual claimant. The firm must pay all its debt holders before it can pay its equity holders.

Advantage of holding an equity is that equity holders benefit directly from any increase in the corp's profits or asset value. Debt holders do not share in this benefit beccuase their payments are fixed.

Market capitalization of stocks in the US fluctuates between $1 and $20 trillion, depending...

Financial Intermediaries

Financial Intermediaries pool savings and channel them as loans. Ex: Banks, S&L, credit unions. Fixed rate loans and increasing interest rates (along with the 90-92 recession) caused the S&L crisis. Mutual S&L - depositors are owners. Insurance, pension funds and mutual funds.

Loans account for 55% of business external financing. Small and mid sized businesses don't have the good reputation required to sell stocks or bonds.

There has been many banking innovations in recent years. Regulation Q, commercial paper (now dried up), etc.

Section #4 on packet page 28 was not covered at this time

Bond Markets and Interest Rates

A bond is a debt instrument that promises to make periodic payments (interest payments) until the maturity date, when a specified final amount (face value) is repaid. A bond is essentially an IOU.

3 pieces of information on (coupon) bond certificates: (i) issuing agency or institutions (ii) maturity date (iii) coupon rate & face value.

Most important examples: Treasury securities: T-bills (maturity < 1 year), T-notes (maturity < 10 yrs), T-bonds (10<maturity<30).

General Rule: Bond prices and interest rates always move in opposite direction.

Present Discount Value (PDV)

If you have $1 today and you deposit it for 1 year at 10%. At the end of the year, you have 1+0.10 = 1.10.

Therefore, $1.10 in 1 year is equivalent to $1 today. We say that the present discount value of $1.10 in 1 year is $1.

1.10/(1+0.1) = 1

At the end of the second year, you have $1.10+0.10*1.10 = 1.10(1+0.1) = 1.10²=1.21. Therefore, the PDV of 1.21 in 2yrs is 1.

Generally, PDV of $F in N years = F/(1+i)^N

The larger N is, the smaller the PDV. The value of a billion dollars in 200 years is very little today.

N up, PDV down. i up, PDV down.

Bond Pricing

Consider a three-year bond with a face value of $100 and a coupon rate of 10%. How do we determine the bond pricing?

(i) Assume market interest rate = i = 10%

P_b = 10/(1+0.1) + 10/(1+0.1)² + 110/(1+0.1)³ = 100

Why is the bond price, in this case, the same as the face value? Because the coupon rate is the same as the market interest rate.

Next, assume a case where 1 year has passed. In this case,

P_b = 10/(1+0.1) + 110/(1+0.1)² = 100!

(ii) Now, assume the market interest rate has gone up to i=12%

P_b = 10/(1+0.12) + 110/(1+0.12)² = 96.62

Since the market interest rate is higher than the coupon rate, the bond is worth less.

This supports our general rule: When interest rates go up, bond prices fall.

(iii) If the market interest rate falls to i=8%,

P_b = 10/(1+0.08) + 110/(1+0.08)² = 103.57

As interest rates rise, bond prices fall.

Clearly, if you think interest rates are going up, you shouldn't buy bonds. The longer the maturity, the more you will lose if rates go up. Thus, long term bonds carry a risk in the case where you want to sell before maturity. Even if you keep it to maturity, there is an opportunity loss - you could have done something better with the money.

Lecture 7 - The Federal Reserve System

The Federal Reserve System (the central bank of the US)

The Federal Reserve System was created by Congress in 1913.

Federal Open Market Committee FOMC, consists of 7 members of the Board of Governors (14 year terms, appointed by the president and confirmed by the senate) and the presidents of 5 of the 12 Federal Reserve District Banks. The NY district is always on the FOMC because they run two important operations: The Open Market Desk and the Foreign Market Desk.

They meet eight times a year (about every 6 weeks) and make decisions regarding the conduct of open market operations, which influence the monetary base. Statements and minutes from their meetings are posted on the web.

Primary responsibility includes controlling inflation or stable price as well as stabilizing economic activity: Humphrey Hawkins Act of 1978

Fed attempts to achieve low inflation by controlling the money supply and short-term interest rates: setting M or i but not both independently.

The Fed's Balance Sheet

Assets:
Securities: US Treasury bonds
Discount loans
Gold and SDR (special drawing rights from IMF)
Coin (Treasury currency held by the Fed)
Cash in the process of collection
Fed's other assets such as foreign currencies, foreign govt bonds, real estates.

Liabilities:
Federal reserve notes outstanding (currency held by the public)
Bank deposits (reserves)
US Treasury deposits
Foreign and other deposits
Other liabilities

Open Market Operations

The Fed increases or decreases the monetary base by selling or buying Treasury bonds through open market operations.

Expansionary monetary policy = open market purchase of Treasury bonds
Contractionary monetary policy = open market sale of Treasury bonds

Open market purchase from a bank has the same effect as purchase from an individual

Fed
Assets +10k bond
liability +10k cash

Individual
assets: -10k bond, +10k cash

What really happens?

After the Fed decides to cut interest rates, they call the open market operations desk (VP of NY fed). They call 30 major bond dealers and tell them that the Fed wants to buy bonds. They keep buying bonds until the interest rate reaches their target. They continue to intervene to keep the interest rate where they want it. They get market feedback every morning, meet around 10 to plan their strategy. After their meeting, they execute their plan and take the afternoon off.

Reserve Requirements

As of Dec 2006, the reserve requirement on demand deposits was 0% on the first 8.5 million, 3% on those between 8.5 million and 45.8 million and 10% on those in excess of 45.8 million.

If the Fed reduces the reserve requirement, then the money stock will rise and vice versa.

However, the Fed rarely changes this because it would require significant alterations in banks' portfolios, so it would be disruptive if it changes frequently.

Discount Rate

Suppose that a bank finds itself temporarily with fewer reserves than those required by the Fed. Instead of forcing the banks to reduce loans or investments, the Fed could lend money to the bank to meet the required reserve ratios, and charge interest on the loan. The process is called borrowing at the discount window and the interest rate is called the discount rate.

Two ways to use this tool: change the discount rate or limit how much they can borrow at the given discount rate. today this is used mostly to help or discipline a particular bank.

Banks have developed their own way to meet their reserve requirements. Rather than borrowing from the Fed (and possibly being subject to increased scrutiny), banks short of reserves can borrow from other banks that have excess reserves. This market for reserves is called the "Federal Funds Markets" and the interest rate charged is called the "Federal Funds Rate" - interbank loan interest rate. (counterpart in London, LIBOR (London interbank offered rate)).

Fed's Activity during credit crisis of 2007-08

Fed cut interest rates seven times to 2% (as of May 12, 008) from 5.25% in September 2007. With rescue of Bear Stearns in mid-March, Fed started lending to prime dealers and investment banks against collateral of martgage-backed securities. Fear of financial market meltdown easing.

2 functions of the Fed:
(1) Monetary policy: change the size of money supply (i.e., federal funds rate) - expansion & contraction of Fed's balance sheet

Three important assets:
1. Securities held outright (system of open market account SOMA - entirely Treasury securities $703bn out of $898bn total assets of Fed)
2. Securities held under repo agreement (treasuries, GSE-agency bonds and agency MBS, $77bn)
3. Discount window lending ($60bn)

(2) Lender of last resort (liquidity and financial stability): To promote liquid and functioning markets, Fed can change the composition of Fed's balance sheet, not the size. Take out of favor assets into its balance in exchange for Fed liabilities.

Examples: (i) TAF (term auction facility - discount window): Fed lent funds to depository institutions against a broad range of collateral that the borrowing institutions have pledged to the Fed ($100bn for 28 or 35 days in March 2008). To offset the increase in the balance sheet, Fed has had to reduce Treasuries under SOMA.

(ii) TSLF (term securities lending facility): Under the new facility, the 20 primary dealers will be allowed to exchange mortgages (GSE agency mortgages or private label RMBS) for Treasuries that the Fed holds in the SOMA ($200bn for 28 days).

(iii) Expansion of term repos: On March 7 Fed announced an intention to ...

Hyperinflation

Hyperinflation is defined to be inflation that exceeds 50% per month, which is just over 1% per day.

Why central banks in countries having hyperinflation chose to print so much money in the first place?

Govt can finance its spending mainly through 3 ways:
1. tax revenues
2. borrowing from the public: issuing govt bonds
3. seigniorage: monetary finance. simlpy print more money to finance the spending

Most hyperinflation begins with...

Primary budget deficit = G-T
Total budget deficit = G-T-i x D_-1(interest payments on existing debt outstanding)

D-D_-1 is the new issues of govt bonds.

(i) who buys bonds? D = D^{Central bank} + D^public
(ii) D = M^h - B^CB/e + D^public
see derivation

The Central Bank Independence and Politics

Rapid increase in money supply can produce high inflation that destabilizes the economy.

Controlling the money supply is the crucial job of the central bank.

Yet the central bank faces many powerful political forces that put continued pressures on it to extend cheap credits, or to help finance a large budget deficit. Thus it may be hard for the Central Bank to resist these political pressures unless it has some institutional independence from the government executive and legislative branches.

Therefore, in the pursuit of low inflation, there are advantages to having an independent Central Bank. Also, an independent Central Bank may possess greater credibility once it commits to lower inflation, compared to a Central Bank that is heavily under the influence of elected policymakers.

Data (graph, page 23) shows inverse relationship between avg inflation and index of central-bank independence among major countries. I.e. lower independence is associated with higher inflation.

Lecture 7 - Money (continued)

Some preferatory remarks:
To have a low interest rate, you need a larger money supply. You can't change one without the other. Increased money supply always shows up as inflation. We will see how the money supply is controlled.

Velocity of Money

V = PY/M = nominal GDP / M

Recall: GDP deflator (P) = Nominal GDP / Real GDP (Y)
Therefore, nominal GDP = PxY

Velocity is how many times the money changes hands to get to GDP.

Latest data: 2006 nominal GDP 13.2Tr. V or M1 = 9.6. V of M2 = 1.96.

Quantity equation: M x V = P x Y

Assume V is constant

(i) M x Vbar = P x Y
(ii) In the long run, Y = AxF(K,L)

If the money supply M increases, it must show up in an increase in P, prices. (Unless K and/or L work to increase Y)

This is known as the quantity theory of money.

In %Δ - %DM + %DV = %DP + %DY

%DP is inflation, denoted at Π

Therefore, Π = %DM - %DY

%DY has historically been about 3% in the US.

Any money supply increase over the GDP growth rate will show up as inflation. This is the primary driver of inflation - excessive monetary growth. Other sources of inflation are: Cost-push inflation, demand-pull inflation (seen after the collapse of Soviet Union).

The assumption was that the velocity of money is constant. Data shows (Table 1) that %DY is about 0.1% on average from 1960-2006. Monetary innovations such as debit cards and ATM
machines have impacted the velocity of money.

Friedman: Inflation is always and everywhere monetary phenomenon.

So why can't we easily control inflation through monetary policy?
Forecasting - We'd need to know the growth rate accurately in order to control the money supply correspondingly.
Time Lag - money supply changes effect the economy with about a year lag

Cross-country data supports the connection between money supply and inflation.

Nominal and Real Interest Rates

Fisher Equation: i = r + Π
i = nominal interest rate
r = real interest rate
Π = actual inflation rate

In practice, i = r + Π^e, where Π^e = expected inflation rate, since Π is not known in real time

The Fisher effect: one-for-one relationship between the inflation and niominal interest rates.

Using the Fisher equation, we see that monetary growth leads to inflation which leads to interest rates rising. Data since 1980 shows this correlation.

Liquidity Preference Theory

Determinants of money demand: (i, Y)
(i) i = opportunity cost of holding cash (nominal interest rate). We can graph this relationship - negative correlation between i and Md (money demand) If interest rates go down, money demand goes up.

What's the main purpose of holding cash? As a medium of exchange.

Dividing M by P (price level) makes this graph more meaningful.

If Y goes up, income goes up, and real money demand goes up and the (M/P)^d curve shifts to the right.

Money Market Equilibrium

See graph 3

Equilibrium is achieved when (M/P)^s = (M/P)^d
This occurs at interest rate i*.

At i₁, there are high interest rates and there is excess supply of money. Eventually, this excess supply will drive interest rates down.

Similarly, at i₂, there are low interest rates there is excess demand.

Notation: Real Monday Demand = L (i,Y)

If the Fed increases the money supply, the money supply vertical shifts to the right (monetary expansion). A new equilibrium point is achieved, with a lower interest rate. (see graph 4)

Timeline: Over time, other things will change and interest rates will not remain low after a monetary expansion.
(i) in the intermediate run (around 5 yrs), low interest rate will encourage consumption up, net exports up(via e down) and investments up. Therefore, output Y will increase because Y = C+I+G+NX. This causes a rightward shift to the money deman curve and a new equilibrium (3) is achieved.
(ii) in the long run, MxV=PxY and the ultimate result of increase money supply will show up in increased prices, P. This will drive interest rates even higher (i4 on graph).

Monetary policy is used to control and prevent these escalating interest rates in the intermediate and long run.

Refer to US Monetary Aggregate M2 (annual percent change) vs Federal Funds Rates 1960-2007 graph. It shows that they move in opposite directions.

Midterm Answers

I hope everyone did well on the midterm. My thoughts are that some questions were fairly straightforward, especially part 1, but others really made you think and analyze. I thought it was pretty tough overall, but I think/hope I did pretty well. The analysis and short-essay format was fairly new to me. I usually do better on objective tests where it's clear right/wrong answer, but this essay format is more challenging.

I won't be posting the answers to the midterm. If you have questions or want to see my answers, send me an email.

Lecture 6 - Money, Inflation and Interest Rates

Introduction

See graph of inflation in industrial countries. It peaked in 70s at 8.7%, but has subsided since then to less than 3%.

Greenspan kept interest rates low in 2002 and 2003. Fueled the housing bubble. Interest rates were way below what the Taylor Rule would indicate.

Money supply is directly related to interest rate. Low interest rates require more money supply which leads to inflation.

Fed mandate: control inflation and control business cycle (overheating). European Central Bank (ECB) is more obsessed with maintaining a low (~2%) inflation rate because that is their sole objective.

Discussion of two types of bonds: nominal (which don't adjust for inflation, but are purchased at a discount) and TIPS inflation-adjusted bonds. The gaps between them represents what the public anticipates in inflation. (??)

What is the function of money?

(1) Medium of exchange. Without it, we only have barter which requires a "double coincidence of wants".
(2) Store of value. non-perishable.
(3) Unit of account. It makes it easy to compare prices. It's a common good against which all other goods are valued.

Other things can be a store of value (#2), but these are not equally easily exchangeable for other goods.

Therefore economists measure the liquidity of an asset = ease and speed with which an asset can be traded for other goods.

The Measures of Money (in the US)

Very liquid assets = cash or anything "close" to cash should be considered as money

C = currency
M1 = currency + demand deposits + traveler's checks + other checkable deposits
M2 = M1 + money market mutual funds shares (checking acct against mutual fund shares) + savings and small time deposits (<$100k CDs) + overnight repurchase agreements (overnight loans collateralized by treasury bonds)
M3 = M2 + large time deposits + term repurchase agreements
(+ Euro dollars - i.e. dollars circulating outside the US, not just Europe) short discussion of regulation Q.
L = M3 + short-term Treasury Securities + other liquid assets

Lecture 6 - Productivity and Growth (cont.)

Productivity slowdown and real wage slowdown in 1970s and 1980s

Compared to 1950-1972, all OECD nations experienced a slowdown after 1973 until 1994. See table 3, page 9.

Key questions:
Why did this happen?
Why did the US pick up after 1995 and other European nations didn't?

Labor Productivity Model

We graphed real wages (W/P) against labor supply and demand, L. L_S is assumed constant against wages and is therefore vertical. Labor demand increases with decreasing wages. There's an equilibrium point between the L_S vertical and the L_D line.

Labor demand is represented by MPL - the marginal productivity of labor. MPL=ΔY/ΔL. Average labor productivity is Y/L. MPL moves, in general, with Y/L. If Y/L is down, as it was in the 70s and 80s, MPL will shift down too.

What happens to the equilibrium when MPL shifts downward? There are two possibilities:

If the labor market keeps the labor supply at the same size, wages will go down. This is the case in the US.

However, if the labor market is more interested in wages staying the same, then the labor supply will shrink, i.e. unemployment will increase. This is the case in Europe. In Europe, the strong labor unions demand constant high wages. This comes at the expense of increased unemployment in Europe, as the data in the graph shows. High hiring costs tend to keep the unemployment rate somewhat permanent.

Look at the annual turnover of firms in manufacturing. From 1989-1994, the rate in France and the UK was 22-23%. Very dynamic. US was 18.5%. Italy and Germany were lower than the US. US is not an outlier.

In net employment gain in manufacturing after 2 yrs, US is at 134%; while European countries are around only 5-23%. This is due to the barriers to hiring in Europe. These hiring barriers may also impact the willingness of European firms to adopt new technology since they would need to hire more and more skilled workers.

Why was there a worldwide slowdown in productivity?

1. Composition of labor force has been changing. Babyboomers entered the workforce. They are less experienced and therefore less productive.
2. Increasing government regulations. For example, environmental protection and workplace safety. These both impact productivity, even though they are good causes.
3. Oil price shock. Sharp increases in oil prices may have made some of the capital stock permanently obsolete. However, since 1985 until recently, there have been large oil price decreases, yet the productivity growth revived only in manufacturing sector. (So this is not a satisfactory answer on its own.)
4. Could it be that the world has run out of new ideas about how to produce? Although computers and IT technology are significant innovations, it seems that they are only beginning to yield significant productivity gains, mainly in the manufacturing sector. Computer/IT technology only show up in the data after around 1995. This lag between invention and higher productivity is not unusual. (See the stages of technological revolution below.)
5. Mis-measurement of output growth and productivity. Perhaps we should measure the quality of products instead of the number of products. Health care and financial services have improved, but how do we capture that?
6. Lower saving? Less investment in new innovations.

Information Technology and the New Economy in the 1990s and 2000s

Labor productivity growth in the non-farm business sector increased from about 1.5% in 1973-95 to 2.5% in 1995-2000. Since 2000 (through 2004), it averaged about 3.4% per year. Perhaps as much as half of the acceleration came through increasing IT capital per worker - capital deepening - and about a quarter of it through improvements in the efficiency with which IT goods were produced.

Nominal IT investment increased from 1987-95 to 1995-1999 (9.3 to 16.6). Some connect this investment to the growth in labor productivity and conclude that IT caused an increase in labor productivity throughout the economy. Examples: Dell, Amazon. It changed retail purchasing and delivery model. See graphs on page 12 of packet, based on McKinsey (2002) "How IT Enables Productivity Growth".

But it's not so simple. See "How IT Changes US Productivity" by McKinsey (2002) (I could not locate this publication online) and the graph page 13 in packet. They found only 6 "jumping" industries that benefit greatly from the IT investment. But others, such as agriculture, may actually see negative growth despite increased IT investment.

Historical Perspective

How does Information and Communication Technology (ICT) compare to the greatest inventions of the 20th century: steam power, railway, electricity, etc.?

The recent boom and collapse in ICT stock prices and in spending on goods embodying new technology is typical of technological revolutions.

Example: the railway system in London in 1840s. The expansion was fueled by stock investment boom, followed by stock market crash, but the late 19th century continued to benefit from this innovation.

3 typical stages of technological revolution:
Stage 1: Productivity growth in innovating sector (e.g. computer manufacturing industry)
Stage 2: A fall in price of innovation that encourages its wide use by business or consumers (also accompanied by wage increases since workers are more productive)
Stage 3: Production in all sectors reorganize around the innovation that embody new technology
leading to broader-based surge in productivity. (this may be where we are today with IT)

It seems that the US is now just entering the 3rd stage.

Comparing Countries

See table 4 on page 16 of packet, comparing GDP per capita (PPP) of selected countries in 1950 and 2000. Look at Ireland and Japan. Rapid growth rate enabled them to close the gap. The beauty of compound interest!

Notes on these data: Comparing GDP based on exchange rates can be misleading because the CPI in one country may be different than another. Therefore the PPP takes this into account to calculate a "purchasing power parity" statistic.

Absolute Convergence Hypothesis

Poor nations have lower (K/L), but higher MPL.
Two reasons for absolute convergence:
1. Law of diminishing marginal product of capital stock
2. don't need to reinvent wheeel: advantages to second comers. take advantage of foreign advanced tech (copy, adopt and assimilate...): improve A

conversely, rich countries would eventually

Plotting GDP per capita growth vs. GDP per capita, we would expect a negative correlation, but the scatter plot doesn't support this theory. There's no correlation. We need to reexamine the hypothesis.

BTW, among OECD countries, Korea, Ireland and Portugal have highest real per capita GDP growth.

Conditional Convergence Hypothesis

Whether poorer countries can grow faster and hence catch up with richer countries or not: It turned out to be conditional on having good policies and institutions in place such as:
- investment in education, see panel 3
- investment in physical capital stock, see panel 4
- trade openness, see panel 5 (there are other geographical factors)
- stable macroeconomic management (low inflation, low budget deficits, stable exchange rates)
- quality of public institution, see panel 6, related to expropriation risk

We actually find poor nations lending to richer nations (like China to US). Why not just invest it internally? Because of all the risks involved. Even though returns in US may be less, the risk is less too. The risk-adjusted rate of return in poorer nations is actually pretty low.

Global imbalances and capital flows graph shows that the US and G7 nations (except Japan) are borrowing heavily and the loans are coming from emerging and developing nations. The e&d nations don't have enough capital flows that would help them grow because of all the risks they have.

Lecture 5 - Productivity and Growth

Productivity and Growth

Graph of potential GDP and actual GDP. Actual dipped during the great depression, but went above the line during and after WW2.

Used logarithmic scale to create a linear graph, but the actual graph is exponential. Rapid growth or decline is even more dramatic in reality.

Rule of 70:
Number of years to take to double in size = 70/annual growth rate (in percent)

Example: If an economy grows at 2% each year, then it would take about 35 years to double. or equivalently, every 35 years it would double. If this economy grew just 1 percentage point faster, at 3% each year, then it would take just 23 years to double.

Einstein called the discovery of the power of compounding is the greatest discovery.

Growth and Living Standards

What matters for living standards is per capita GDP = GDP/population

Let Z=X/Y
Then %dZ = %dX - %dY

Therefore, %d percapita GDP = GDP growth (3.09%) - population growth (1.27%)

What drives our standard of living? Is per capita GDP a perfect measure of living standards?

How about crime, pollution, the beauty of the landscape, income distribution across the population? Nonetheless, GDP per capita is the best measure of economic well-being for practical reasons.

The key is labor productivity. So the question is: what drives labor productivity growth?

Power of compounding:

In 1870, UK GDP per capita > US GDP per capita by 18%
In 1990, US GDP per capita > UK GDP per capita by 50%

This dramatic shift in living standards came about with less than 0.5% difference! In 1870-1990 UK growth rate of per capita GDP - 1.37%, US growth rate - 1.85%.

In 1950, UK GDP per capita > German GDP per capita by 57% (due to WW2)
In 2000, German GDP per capita > UK GDP percapita by 3%

It came from 1% point difference in growth.

Growth Accounting Equation

Y = AxF(K,L)

The production function can be influenced either by increasing capital K or labor L. The technology (overall efficiency) factor A might also go up, which would increase output Y.

Corruption diverts the talents and resources from improving overall efficiency A. This is what is causing several Latin American countries from maximizing output despite an abundance of capital stock K and human resources L.

A is also called TFP = total factor productivity.

See Mankiw (p 244) for the derivation of the growth accounting equation.

Y = AxF(K,L) ~ production function (level form)

How do we express this in terms of % change?

%dY = %dA + α%dK + (1-α)%dL

where
α = capital income share = 0.3 in US
1-α = labor income share = 0.7 in US

This equation can be used to explain the percentage contribution of each factor to the overall output growth. See table 1 in the handout. Surprisingly, TFP declined in 70s and 80s. Labor growth grew due to the baby boomers, women and teenagers entering the labor market.

Labor Productivity: The Key to Rising Living Standards

Productivity of labor = Y/L (the quantity of output per unit of labor)

Consider living standard as measured by Consumption/person.

Assume consumption is only some %age of total output: C = (1-s)Y, where s = savings.
Then,
C/person = (1-S)(Y/person) = (1-s)(L/person)(Y/L), where L is labor.

How can we increase C/person?
(i) reduce S (savings rate). but this is at a cost of future consumption. (Recall S=I, therefore S down leads to I down leads to K down leads to future consumption down)
(ii) raise (L/person) - the labor participation ratio. But this is not always desirable. It's limit to 100%. It comes at the expense of leisure time.
(iii) raise (Y/L) - labor productivity. This is the key!

See Paul Krugman's Age of Diminished Expectations. He understood this.

What determines labor productivity growth?

Recall: %dY = %dA + α%dK + (1-α)%dL

Let's rewrite this in terms of %d(Y/L) = %dY - %dL

So %dY/L = %dA + α%dK + (1-α)%dL - %dL
= %dA + α%dK + -α%dL

Regrouping,
= %dA + α(%d(K/L))

K/L is capital stock per worker

So labor productivity can be improved by:
(i) increasing K/L - capital stock per worker. This explains why well-equipped Americans have higher productivity than poorly-equipped African workers.
We can achieve K up through increasing I. Recall that S=I, so increase I by encouraging increasing savings, S.

Feldstein-Horioka puzzle found that S and I move closely together as if they're in a closed economy.

S^g is the fiscal burden from population aging.
Social Security benefit is a pay-as-you-go/funded program. Elders are paid as young ones are paying.

(ii) increase productivity A
1 - one way to increase productivity is to improve the inputs through education and training - investment in human capital. A year of schooling tends to increase income by 8%. MBA, even more so. :)
2 - another way to do increase productivity is to improve production technology

See Table 2 in handout (page 8).

Rapid productivity growth in US in 60s, but then it fell for 3 decades due to falling TFP and captial per worker.

Lecture 5 - The Great Thrift Shift

The US trade deficit of >$800 billion seems unsustainable. It requires the US to borrow from foreign nations. At some point they may not want to continue funding our trade deficit.

Ben Bernanke argued that we don't need to worry about it because foreigners have a lot of money to lend.

It now appears that he was wrong due to the financial markets crisis. Perhaps we can't pay it back, just like the housing crisis shows.

Why didn't interest rates rise?

Around 2000 in the US:
(i) Fed cut interest rate very aggressively
(ii) Bush administration: Taxes down, Govt spending up
Decline in private savings and govt budget deficit

Since US is 1/4 of world economy, it should have a major impact - an inward shift of world savings. See Economist article.

This should have caused an increase in interest rates, but it didn't!

The explanation is that world investment collapsed much more than the world savings fell.

Now the question remains:
Why did Investments, I, collapse more than Savings, S?

(i) Look to East Asia

Recall: S-I = NX

Since this region was growing rapidly (10%) in the 1990s, investors were happy to invest (despite risks). Example: Samsung going into auto manufacturing. However, the investment market reached a peak in 1996 and the beginning of 1997. 40-50 companies went bankrupt every day. It was bad quality investing. Default risk was high and came about. The risk of changing currencies and interest rates also caused insolvency.

After the financial crisis in 1997, investment has gone down by 10% of GDP in the region.

(ii) Japan: they're in a >10 year economic slump. Due to consumer and corporate default on loans. Investment remains low. Their engine of growth is foreign exports.

Economic strategy: Japan grew spectacularly after WW2 due to increasing exports. To sustain this, they made sure their currency wasn't overvalued. They intervened in foreign markets by buying foreign assets and selling domestic currency.

East Asia and China learned from this lesson of Japan. China's consumption is only about 38% of GDP.

(iii) US & Europe: IT investment boom collapsed around 2000-01.

8% (trade deficit of GDP??) is the dividing line for risk to foreign investors.

Why the global imbalances?

i.e. How does the US trade deficit boom while many nations are running a trade surplus? The US trade deficit has only gone over 3% over the last 5-6 years.

A - US
(i) Fed's low interest rate
(ii) Taxes down, govt spending up
1 personal savings is way down, consumption up: on the back of low interest rates, low taxes - causing housing boom and stock market investment increase
2 Govt savings way down. therefore overall S is way down and I is down, leading to NX down. i.e. increase in trade deficit

B - East Asia and Japan: investment collapse, I down. So, S-I=NX and NX is down too.

It started from the US policy reaction, but was fueled by the foreign willingness to invest.

Since 2000, two new elements:

1. China. In 2000, S=12% of GDP. In 2004, I=46% of GDP, S=50% of GDP. China invests a tremendous amount, but they save even more! They run a massive trade surplus.

2. Middle East and Latin America. Oil revenue and other commodities (raw materials) boomed. They learned from other countries not to squander the windfall gains.

Question: How do we define a global economic balance?
Answer: When every country has more or less balanced trade. But the extremes that we are experiencing these days is very imbalanced.

Midterm

The midterm exam was distributed tonight in class.

Directions/Guidance:

• It is a take home exam.
• Due next week - May 7 at 5pm - via email.
• Must be typed, not handwritten.
• Save as MS Word doc (not 2007 though).
• Refer to any textbook, handouts, any other sources, but not other students. It must be from your own thinking. Do not discuss the exam with anyone under any circumstance.
• Warning: Sources available on the Internet are not always reliable! Use caution with them. It's better to rely on the information conveyed in class, in the readings and from your own thoughts.
• Be reasonable in the length of your answers. The quality of the answer is what matters.
• Expectation is to spend about a half day on this exam. That's what it should take if you've kept up with the readings.
• It will take more than one week for the exam to be graded.
• The number of points possible is 95. The midterm counts for 40% of the final grade.
• Sources of common information from class (S-I model) do not need to be quoted. But if you are making an argument based on some other material, you may quote it. But it's risky! It's better to base your arguments on standard theory.