MACROECONOMICS I March 25th, 2014 Class 6. The Core: Financial Markets. Monetary Policy Review The short run: year-to-year changes in real GDP A fundamental identity (closed economy) Total Output = Total Expenditure = Total Income The goods’ market equilibrium: Aggregate Output (Y) = Aggregate Expenditure (AE) Supply Aggregate output Demand Aggregate expenditure Review (Cont.) John Maynard Keynes The General Theory of Employment, Interest, and Money (1936) • The economy is driven by demand (in the short-run) • Prices in the short run are fixed • Insufficient spending is the key reason behind recessions • Active government interventions Y, output AE Y* Y* Review: Equilibrium in the Goods’ Market 450 Autonomous spending Review: Fiscal Policy § Fiscal policy • Government spending (G) Total effect of the policy: • Taxes (T) Total effect of the policy: GDP in the short-run Which multiplier is bigger? Example on Multipliers TE Consider two countries: Japan The USA 1. What are the values of the government spending (G) and tax (T) multiplies in each countries? 2. In what country the fiscal policy will be more efficient The Financial Markets: Introduction • Relaxing assumption about fixed investments (I) § Interest rate (i) is the price of money • Investment depends on two factors • • • Y – level of sales; i-nominal interest rate What is money? • Funds that you can spend: Currency + Checking accounts • The most liquid asset: spend whenever you want The Financial Markets: Introduction (Cont.) § The story Not enough money in circulation (Money Supply) Money is scarce => More expensive to borrow => Higher interest rate (i) Excess of money in circulation Money is abundant => Less expensive to borrow => Low interest rate (i) Money supply => Interest rate => Output • The effect of financial markets on the goods’ markets Money Supply (MS) Who is in charge of the money supply? • • • • A Nations’ Central Bank Money Supply (Cont.) • Central Bank is a government agency • Stands at the center of the monetary and financial systems First Central Banks Bank of Sweden (1668); Bank of England (1694); Bank of France (1800) The most important today FED: The US Federal Reserve (1913). Consists of 12 Banks all over the US ECB: European Central Bank (1998) – a common CB for the Eurozone • Central banks have a monopoly for printing national currency Money Supply (Cont.) The US Federal Reserve Chairman Ben Bernanke (since 2006-2014) Janet Yellen (since Feb 2014) The Central Banking System Mission of a Central Bank: • Macroeconomic stability: low and stable inflation; stable growth of GDP and employment • Financial stability: preventing and mitigating financial panic or crises • Available tools: 1.Monetary policy – adjustment of the interest rate 2.Provision of liquidity – a “lender of the last resort” 3.Regulation and supervision of financial institutions Changes in Money Supply § Three major tools 1)Reserve ratio: a share of funds that every bank must hold at the CB Lower reserve ratio => More money to lend out => More money in circulation 2) Discount rate: Rate on the overnight loans Lower discount rate => More borrowing from CD => More money lend out => ÞMore money in circulation 3) Open market operations (OMO): Purchase of governments securities Government Bonds = Debt/Fixed-Income securities • A promise to pay a certain amount (face value) on a certain date and periodic interest payments • Free of credit risk: Trust in the government Buying bond by CB => Increase in money supply => More money in circulation Demand for Money § The amount of money people want to hold (MD) • Less liquid • Yield positive interest • Transaction costs • Full liquidity • Yield NO interest • NO transaction costs § Liquidity preferences: keep money or loan them to someone $ 20,000 Demand for Money (Cont.) MD will depends on: • Level of transactions (Y) • Bonds’ interest rate (i) • • Where Y – nominal income; i is a nominal interest rate • Demand for money increases in proportion to nominal income • The lower the interest rate, the higher is the demand for money Interest rate, i Money, M Demand for Money: Graphical Representation For a given level of nominal income Y MD M1 i1 i2 M2 Interest rate, i Money, M Shifts in MD • Increase in nominal income & fixed interest rate MD M i M`D M` • Increase in prices & fixed interest rate Interest rate, i Money, M The Equilibrium in Money Market For a given level of nominal income Y MD M* i* MS Determination of the equilibrium interest rate Interest rate, i Money, M Comparative Statics • Increase in nominal income MD M* i* M`D i`* Leads to an increase in i* • Same effect in the case of price change Interest rate, i Money, M MD M* i* MS M`S M`* i`* • Increase in money supply § Monetary policy: Central banks affect interest rate by changing money supply Comparative Statics (Cont.) Leads to a drop in i* The Goods Market and the Role of Interest Rate § Drawing the link between the goods market and financial market Linking element: Interest rate i • • The goods’ market: Modifying equilibrium condition As N!B! Monetary policy affects aggregate output (GDP) Monetary Policy and Aggregate Output TE Assume CNB increases money supply by buying government bonds • Expansionary monetary policy: increase in the amount of money in circulation leads to an increase in investment and discourages savings which cause an increase in GDP The Equilibrium AE Y, output Interest rate, i Money, M MD MS i* M* Y* Y*