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Fundamentals

Friday, October 16, 2009


9:18 AM

Four propositions of macro economics:


1. In most economies, real output(GDP) follows a rising trend determined by the supply side of the economy
2. In the short-run, fluctuations around the trend growth rate of GDP are dominated by demand side forces
3. Fluctuations around trend growth may be substantial(and costly) because economies, by themselves, don't return to full speed quickly. This is because wages and prices are "sticky".
4. Fiscal and monetary policy can, in theory, be used as discretionary instruments to adjust and stabilize fluctuations so the economy returns to its trend growth path.

SRAS

Price Level LRAS


SRAS

[3]

[1]-Increase in production without increase in prices


[2]-increase in production needs significant increase in prices
[3]-No matter what the price increase is, production cannot be improved

[2]

[1]

YNRU Real Output

SRAS is a snapshot of the following:


GDP

Trend

Actual

Snapshot of this is SRAS


Cyclica l Unemployment

Time/Year

GDP
Development comes from productivity or labor force. For Vietnam it came from productivity. Vietnam is more of capitalist type of politics. More open door. Growth becomes more easier. No
new invention required when compared to Canada. And not the labor force either.

Vietnam
GDP

Cana da

Time/Year

General Model

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Price Level LRAS LRAS’

SRAS’

SRAS

C
PB B

PA
A

AD’

AD

YNRU YB Real Output


YA

• The general model can be used to define any economy


○ World, Europe, Canada, Ontario, London, N.London, etc
• In general define the economy using GDP, unemployment and change in prices. For example, during
recession, GDP decreases, unemployment increases, prices decrease
GDP 
U
P

• YNRU is the natural rate of unemployment


○ = Zero + Frictional unemployment (i.e., between employees) + structural unemployment (i.e., changing economy) + Institutional unemployment
○ We do not account for cyclical unemployment
○ YNRU is 5.6% approx. for Canada
• LRAS
○ Is a function of labour force(L) and productivity(P)
○ Is the potential output or capacity
○ Labor force is the number of people that are currently working(excluding students and home makers)
 In China, productivity is the key
 In India, labor force is the key(more people into labor force)
○ When all the resources are employed, it is the GDP
 In Canada it is about 2.3%
○ LF: Labor force, health and life expectancy have improved over the years
○ Productivity:
 Dollar value of things produced per hour
 Education, quality of work for over time
 Capital employed is directly proportional to productivity
○ Brain drain can cause LF to diminish and decrease productivity
○ LRAS may move bothways. Can move to left despite the fact that GDP is always growing, because of short term growth-falls.
• SRAS
○ Is a function of wages(w), materials(m) and capital(k)
○ Firms costs
○ Adjusts automatically
 During recession
□ SRAS moves down(right) because of low bargaining power of employees because of unemployment(competition for jobs) and employers have more options. So firms costs
go down
 But this quite doesn't happen because, wages are sticky in the short run; having said that they are flexible in the long run
 Wages are slow to move down, but are quick to rise
 Employers have relationships with employees
 Employers sometime have contracts with employees
 Unions have significant say, sometimes
□ Adjustment in SRAS happens via labor market, most of the time
□ Demand uncertain and lack of comparability
□ Non-trivial: sociological factors come into play because people don't like wage cuts

• Aggregate demand
○ Is a function of consumption(C), Investments (I), Government spending(G), Net exports minus imports(X-M)
• Boom
○ causes inflation
○ x is the inflationary gap
GDP 
U
P
○ SRAS goes up(left)
 Adjustment via labor market
 Firms costs move up

• Recession
Price Level LRAS

SRAS


A

B
C

AD
x

AD’

YB YNRU Real Output

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Price Level LRAS

SRAS


A

B
C

AD
x

AD’

YB YNRU Real Output


○ Recession causes unemployment.
 x is the output gap
○ SRAS moves down because of adjustment in labor market
○ At B, nothing happened to nominal wages. But real wages have gone up(because goods are cheaper to buy)
GDP 
U
P
○ During recessions, Government spending goes up to shift AD up(fiscal policy to be covered later)
• Primarily recovery is done by three mechanisms
○ Auto recovery
 SRAS labor force
 AD
□ Use, decay, obsolecence
□ Prices and x-m
○ Fiscal policy
 G spending
 Taxes
 bonds
○ Monetary policy
 Interest rates
 Currencies
• Auto Recovery
○ SRAS Shift
 Economy adjusts on its own through labor market forces, Refer SRAS
○ Demand may go down
 Obsolescence(things get obsolete and demand for them decreases)
 Fleet turnover, inventory depletion(production, stop production)
○ Other reasons
 Policy response by other countries(x-m effects)
 Not all players at point B, causing other forces to recover AD
 People optimistic(least probable)
○ Use, decay and obsolescence cause AD to go down
○ Price drop may imply (x-m) and this causes AD to change
• Fiscal Policy
○ Governments increases spending during recession and decreases during booms(G)
 This boosts or busts the economy by altering the AD curve
○ Significant questions
 Where does the money for G come from?
□ Sell bonds(essentially borrowing)
 This should also increase the yield(or higher rate of return) because of the risk premium.
 Also, sovereign default risks are high
 Print money
◊ This could cause inflation
□ Increase taxes now or later
 Can G Get a dollar amount right or will it spike inflation bubble?
 Implications of deficit
○ Governments run deficits during recessions and surpluses during booms
 Italy and France had traditionally spent during all the times
 EU has enforced a fiscal cap because they don't trust Governments
 India has a very high deficit
 Eg of surplus in boom => Norway investment outside of Norway
 Problems
□ Government have trouble cutting on spending
□ Long Government periods
○ Can G do it all alone, given its proportion in economy?
○ Level and timing are two major considerations
 We might reach an inflationary state if G over spends during recession
○ Increase in G Spending and its implications
 Increase in G, say investment in roads and universities
 More capacity and more productivity
 LRAS might shift right
○ No one knows where finally one ends up. Mechanism is important as opposed to magnitude. E.g. crowding effect of G spending
○ Deficits
 Structural deficit
 Cyclical deficit
○ Problems with fiscal policies
 Crowding effect
 Bonds are more attractive because of high interest rates => high yielding => bond chasers => big scale borrowing
○ Sovereign defaults
○ Timing issue(overshoot)
• Monetary policy
○ Increase in interest rates
i C  Firms costs go up(capital budgeting) - NPV - Firms' costs now low => SRAS down
I
G
○ Lowering interest rates = loosening money supply
○ Increasing interest rates = tightening money supply
○ Unexpected increase in Interest rates may lead to stock market crash
 High interest rates => Higher cost of capital for companies => low equity valuations and earnings per share => companies less valuable => stock market crash
 There is also an opportunity cost of holding capital
 Consumptions go down as well; so companies are in trouble

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 Consumptions go down as well; so companies are in trouble
 Wealth effect
○ Government is crowding out investment
 Stimulus packages cause AD to go up. But it might as well bring AD to its position back
 E.g. If Govt introduces the surplus by increasing taxes, that would imply less money for consumers to spend on C, causing AD to shift to the left
○ Money supply
 Central banks supply money, banks low interest -> more investors(entrepreneurs as well) -> banks -> investors => money multiplier effect
□ If demand is low, money multiplier effect will collapse
□ Reducing reserve rate can also be a method to increase funds but that doesn't quite happen that way
 Hold ratio: Money that banks keep in cash(Loans vs Savings)
◊ In India it is as high as 15% and in Canada is close to zero
○ Monetary policy affects
 Consumption
 Equities, homes(assets), wealth effect, increase in spending
○ Wealth effect: Lender feels rich when interest rates rise and borrower feels poor and vice versa. Transmission mechanisms
○ Effect of stock market on economy
 Better stock market performance => increased productivity => increased investment => more spending => "Wealth effect"
□ Boom bursts => reduces C but homes are now cheap, so Loans increases
□ cyclic
○ Low interest rates => Low CAD and vice versa
• Deflation
○ Recession
 Wait strategy -> economy continues to go bad -> AD goes further down -> Wait, wait and further wait -> Deflation occurs
○ Lower interest rates, increase CGI, CAD$ depreciates, X-M; AD up
○ Can interest rates go below zero?
 No(logically)
 Int can be zero, worst case(think of services charges which will help banks survive despite zero revenue)
 Lowerint interest rate implues what is nominal or real
=> I-real=I-nominal-E(change in price)
=> I-nominal is controlled by central banks. Also called nominal short term risk free interest rate.
=> Limiations on the monetary policies
□ I-real=0-(-5%)=5%
 E.g Japan
□ IMF forecast: -5% should be the interest rates to boos the economy
 Make expected inflation positive. Create massive amounts of money
◊ Print money
◊ Expand money supply
□ Gold price rises => proof of inflation
 Prices also go down as SRAS goes down(Krugman's argument)
 SRAS shift right through labor market. Real wages go up.

• Currencies
○ Sell CAD to buy USD => USD demand increases => USD appreciates
○ USD=1.1 CAD to USD=1.20 CAD => CAD has depreciated
○ If CAD appreciates, exports go down and imports increase and vice versa
○ Low interest rates => Low CAD and vice versa
○ CAD = func(PPP, Poil, (i-CAN - i=USA) + Error
 CAD=PPP+Poil+i-CAN-i-USA+E
 PPP is for 85%
 I-CAN-i-USA is short term yield chasing drivers CAD
 Exports and imports(oil for eg) are medium
 Poil to commodity index - is the new change to equation to improve
 Probably commodities change faster than [I spread[ so they could be long run
○ Three concerns
 What causes it
 What are the implications(consequences)
□ Overall effect/impact
□ Distributional conseuqnces
 Wealth distribution
 Exp imp
 Distributional shock
 Stratford example
 Response
○ Cause
 US Prints money
 Commodities
 Oil demand increases, CAD appreciates(other trade aspects as wlel)
 Emerging markets buy Canadian goods
 Equation of CAD
 AD shift might raise interest rates
□ Aus, Norway and CAD might go up
 Unexpected rates
 High interest rates => higher demand for AUD => Value rises
 Why emerging markets buy more from CAN and not US?
□ CAN is a commodity market and more tied towards Canada as opposed to US
○ Impact/implicaiton
 Exports are more expensive. Imports are cheap.
 Exports suffer
 Regional hits
 Stratford festival example
 Richard Ivey School of business(demand side is bad but supply side is good)
• Good for acquiring international Professors but bad for attracting international students
 Jobs market
○ Response
 Monetary policy
• Decrease interest rates?
 If almost zero then what?
◊ Increase money supply
◊ Buy USD; BOC intervenes in currencies
 Also, raising interest rates may cause housing prices to go up and the bubble needed to be pricked
◊ Is housing boom better than low interest rates?
► Because Population?
► No. Population and bubble in housing are not linked
 China buying USD might save Canada
 Rates unchanged conditionally(Mark Harney's announcement)
◊ Hedging on inflation
 Fiscal policy
• Inc G spending

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○ Wak Dollar's implications
 Firms become lazy. CAD depreicates => attractive for exports.
□ As opposed to organically improving the exports
 Brain drain. Affects labor force and productivity
 Imports from say machines from Germany or US are now costly. So productivity decreases

• Misc
○ E.g. for as GDP rises, prices falling
 Scale of economy
 Consolidation of firms(aggregate)
 However, most economies believe the other way round, as GDP rises, prices increase.
○ E.g. for supply shock
 Hurricane in gulf
○ Increase in spending during elections may be good for political reasons, but probably not for economically
○ Quebec is the oldest state and growth in labor force is fast
○ Central banks must be more aggressive
○ IMF prediction: Global GDP gorwth forecast 3.9% negative
○ How USD went up when interest rates went down?
 People take time to adjust. Too late argument
 Fed keeps the rates unchanged, as much as possible
○ Quantitative easing
 Crazy things like buy mortgages or GE debt, etc
○ Leading indicators
• Existing home sales falling => people's equity in homes is going down => people save money for interests => this is a leading indicator or W phenomena
○ GDP can take shapes like L,W and V
○ CAD is proportional to price of oil. Correlation more than 0.9 historically.
○ Making money in HongKong
• US bond interest rates: 1.5% to 2%
• Borrow $780b HKD
• Xchange USD for $100b
• 1 year later, US$=$102b
• Exchange in HLD and get $795b HKD and pay $780b HKD to investors
• Profit = $1b USD
• Money supply in HK shrinks
• Arbitration
• Attractive investment
□ Overnight rates I HK go upto 280% annualized rates
• In Hong Kong, low government involvement. Canada medium and SW it's high.
○ Inflation is about 1.6% in Canada and about -.8% in US
○ Sometimes BOC increases i but CAD depreciates. Why?
• Unanticipated rate move
• Proportions in money movement not enough
○ Only central banks can increase or decrease money supply
○ Ricardian equivalence, (also known as the Barro-Ricardo equivalence proposition) is an economic theory that suggests consumers internalise the government's budget constraint and
thus the timing of any tax change does not affect their change in spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its
spending with debt or a tax increase, the effect on total level of demand in an economy will be the same.[citation needed] It was proposed, and then rejected, by the 19th-century
economist David Ricardo.
○ Laffer curve
Tax Revenues

Ma x

0 Tax Rates
100

• More labor force if optimal tax rate


• People might prefer to retire if higher income tax rate
○ CAD 1.07 in Nov 2008 where CAD was more than USD. Why did FDI in Canada increase?
• No clear answer. Research underway
○ Implications of tax cuts:
• Sales Tax, Property tax, Personal IT and Corporate IT => Arranged in the order of effects. i.e., cutting sales tax has less effect on LRAS as compared on cutting Corporate taxes
□ Ofcourse, this ignores all the effects on aggregate demand which is significant
• Unit change in Personal IT as compared to unit change in Corporate IT, which one is bigger? The one through labor market(Personal IT) or disinvestment(Corp IT)?
□ Disinv(Corp IT) is the answer, because people are not as mobile as investments are.
○ Outsourcing increases productivity. Moves RAS first here. Prices go down, sky rocketing productivity. But outsourcing might also increase unemployment.
○ Oil shocks have an impact on productivity. Higher oil cost => disinvestment => less capital employed => less productivity
○ Lower interest rates doesn't necessarily shift SRAS down because of Cost of capital
○ Actual rates are slightly > rates set by banks. Why?
• Risk premium
□ Bad loans
□ Toxic assets
□ How bad?
□ Hoarding cash
○ Inventory levels show capital
○ Reducing immigration, shifts LRAS to the left
○ Current Account balance means net exports minus imports
○ 2007-2008 saw unusual high oil prices of $150 a barrel
○ Fear among consumers(like Tsunami in NewZealand) causes consumers to decrease C. So reduce i to bring up AD
• However, you can also increase interest rates to control inflation
• Lower rates will have implications based on oil prices
○ Central banks are mandated to be inflation fighters. i went down globally as a coordinated effort of centralbanks worldwide
○ Carry trade: Borrow in countries where interest rate is cheap and earn in high yielding countries
• e.g. Borrow in Yen and invest in NZ currency
• Less carry trade => reduced demand for Kiwi currency => current A/C balance improves => higher inflaiton
• Also, NZ is an imports based country
• Risk: Exchange rate risks. Forwards market.
○ Recently: USD is a carry trade currency and AUD is a higher yielding currency
○ China is driven by exports and investments

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