Macroeconomic Diagnostic

Macroeconomic Diagnostics (MDSx)
Module 1
Supply and Productivity
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Course: MDSx
Module: 1
Section: 1
Video #: 1
Video Title: About Module 1
Video Type: Text
Key Idea
What determines capacity to produce goods and

services?
 Constraint on production
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notes.)
 Change in production constraint over time
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text field positions.
 Analytical tool – what are the supply side drivers of

growth?
Course: MDSx
Module: 1
Section: 2
Video #: 1
Video Title: The Production Function Approach
Video Type:
Production Function Approach
Capital – Labor –
Total Factor
Total Output Value of Number of Workers
Productivity
Plant/Equipment Employed
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Y = A * f ( K , L)
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notes.)

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Capital – Labor –
Total Factor
Total Output Value of Number of Workers
Productivity
Plant/Equipment Employed
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Y = A * f ( K , L)
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notes.)


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Course: MDSx
Module: 1
Section: 2
Video #: 2
Video Title: Investment and Capital Accumulation
Video Type: Text
Investment and Capital Accumulation
Investment
Capital Stock Capital Stock Depreciation Flow
Expenditures Flow
Current Period Previous Period Current Period
Current Period
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K t = K t -1 + I t − DEPt
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notes.)


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Investment and Capital Accumulation
Yesterday’s
Today’s
Capital Stock Gross Investment
Capital Stock
Net of Depreciation
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K= − δ +
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notes.)
t K t -1 (1 ) I t

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Course: MDSx
Module: 1
Section: 2
Video #: 3
Video Title: Investment and Capital Accumulation in Excel
Video Type: Excel
EXCEL
Placeholder to insert full canvas diagram or chart.
(Step 1)
(Draft in PowerPoint and within the guides.)
Course: MDSx
Module: 1
Section: 2
Video #: 4
Video Title: The Labor Force and Employment
Video Type: Text
The Labor Force and Employment
Labor – Working Age Labor Force

Labor Force Population Participation Rate
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LF = WAP * LFPR
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notes.)


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The Labor Force and Employment
Labor –
Number of Workers Labor Force Employment Rate
Employed
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L = LF * ER
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notes.)


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Course: MDSx
Module: 1
Section: 2
Video #: 5
Video Title: The Labor Force and Employment in Excel
Video Type: Excel Demo
EXCEL
(Step 2)
Course: MDSx
Module: 1
Section: 2
Video #: 6
Video Title: Total Factor Productivity
Video Type:
Total Factor Productivity
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A = f (Technology, Institutions, and Policies) notes.)


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Output Per Capita, Average Yearly Growth

(In percent)
0.04
0.04 United States
0.03 Selected European Countries Required Negative

(average)
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0.03
(Not for instructor
0.02 notes.)
0.02 Please do not adjust

0.01
0.01 to the left.
0.00
-0.01
-0.01
Source: New Maddison Project Database (2013)
Total Factor Productivity: Key Innovations
Key innovations of the 19th and 20th centuries:

Energy
Transportation Required Negative

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notes.)

Communication text field positions.
Health and sanitation

"Doing Business" and Total Factor Productivity - 2014

0.50
0.00
ln(Total Factor Productivty)
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-0.50
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notes.)
-1.00 Please do not adjust

y = 1.216x - 5.6199
-1.50 Insert visual content

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-2.00
3.00 3.20 3.40 3.60 3.80 4.00 4.20 4.40 4.60 4.80
Ln("Doing Business Indicator -- Distance to Frontier")
Sources: World Bank, Penn World Tables

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Course: MDSx
Module: 1
Section: 3
Video #: 1
Video Title: The Cobb-Douglas Production Function
Video Type:
The Cobb-Douglas Production Function
Total Factor
Total Output Capital Labor
Productivity
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α 1-α
Y = A* K * L
notes.)


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0 <α <1
α 1-α
Y = A* K * L
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The exponential terms are growth elasticities. (Not for instructor
notes.)

⍺ = Growth elasticity for capital text field positions.
⍺ = 0.3
α 1-α
Y = A* K * L
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About the share of output… (Not for instructor
notes.)

⍺ = Capital’s share of output text field positions.
(1-⍺) = Labor’s share of output

Course: MDSx
Module: 1
Section: 3
Video #: 2
Video Title: The Growth Decomposition Approach
Video Type:
The Growth Decomposition
Total Factor
Total Output Capital Labor
Productivity
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%∆Y = %∆A(res ) + α *%∆K + (1- α ) *%∆L

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notes.)


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%∆A(res ) = %∆Y − α *%∆K − (1- α ) *%∆L

The Growth Decomposition: Activity
%∆Y = %∆A(res ) + α *%∆K + (1- α ) *%∆L
Step 1: Calculate capital stock K using ‘perpetual inventory’ method
Step 2: Calculate employment (L) using employment rate and labor force data
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Step 3: Calculate growth rates for Y, K, and L
(Not for instructor
notes.)
Step 4: Calculate contributions for K and L
Step 5: Calculate contributions for A as a residual
Step 6: Calculate averages for several periods
Step 7: Interpret results

Course: MDSx
Module: 1
Section: 3
Video #: 3
Video Title: The Growth Decomposition Approach in Excel
Video Type: Excel
EXCEL
(Steps 3, 4, 5)
Course: MDSx
Module: 1
Section: 4
Video #: 1
Video Title: Capital Stock Growth with Excel
Video Type: Text, Excel
Capital Stock Growth
K t = K t -1 + I t - DEPt = K t -1 + I t − δ K t -1
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Divide capital dynamic equation by previous period’s capital – obtain Space
(Not for instructor
GROWTH RATE of capital: notes.)

Kt K + I - DEPt K + I − δ K t -1 I − δ K t -1 I
%∆K ≡ − 1 ≡ t -1 t − 1 ≡ t -1 t −1 ≡ t ≡ t −δ Insert visual content
K t -1 K t -1 K t -1 K t -1 K t -1 to the left.
EXCEL
It = Investment/GDP ratio * Yt Required Negative

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notes.)

= Investment/GDP ratio * AK ⍺L1-⍺ Insert visual content
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α 1−α
Y = AK L
Short-run / direct (Not for instructor
notes.)
effect of TFP

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α 1−α
Y = AK L
Long-run / induced (Not for instructor
notes.)
investment effect of
TFP Please do not adjust

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Course: MDSx
Module: 1
Section: 4
Video #: 4
Video Title: Calculating Averages for Several Periods in Excel
Video Type: Excel
EXCEL
(Step 6)
Course: MDSx
Module: 1
Section: 4
Video #: 2
Video Title: Per Capita Approach
Video Type: Text
Standard of Living
Output Total Factor

Capital Per Worker
Per Worker Productivity
Required Negative
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(Not for instructor
notes.)
α
α 1-α Y  K 
Y = A* K * L
 L  = A  L 

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Standard of Living
Total Factor
Growth of Output Growth of Capital
Productivity –
Per Worker Per Worker
Residual Growth
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[%∆Y − %∆L] = %∆A(res ) + α [%∆K − %∆L]

notes.)


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Standard of Living: Bottom Line
TFP is important to raise the standard of living.
Even if capital accumulation speeds up, the elasticity will

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mean growth of per-worker output of less than one-to- (Not for instructor
notes.)
one (since alpha is less than one). Please do not adjust
Course: MDSx
Module: 1
Section: 4
Video #: 3
Video Title: The Growth Decomposition: Interpreting Results with Excel
Video Type: Text, Excel
EXCEL
(Step 7)
Course: MDSx
Module: 1
Section: 4
Video #: 5
Video Title: The Growth Decomposition: Looking Forward with Excel
Video Type: Excel
The Growth Decomposition: Looking Forward
%∆Y = %∆A(res ) + α *%∆K + (1- α ) *%∆L

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(Not for instructor
notes.)
Are future values…
Consistent with past economic behavior? Insert visual content
to the left.
Supported by other analysis?
Realistic – not too optimistic or pessimistic?

The Growth Decomposition: Looking Forward
Implied Total Prospective Prospective Prospective

Factor Productivity Total Output Capital Labor
Required Negative
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(Not for instructor
%∆A(res ) = %∆Y − α *%∆K − (1- α ) *%∆L

notes.)


to the left.
EXCEL
Course: MDSx
Module: 1
Section: 5
Video #: 1
Video Title: Summarizing What We Learned
Video Type: Text
Course: MDSx
Module: 1
Section: 5
Video #: 2
Video Title: ** Conversation
Video Type: n/a
Course: MDSx
Module: 1
Section: 6
Video #: 1
Video Title: Revealing the Results of Diagnostica
Video Type: Excel
Module 2
Potential Output and Output Gaps
Any reuse requires the permission of the ICD.
Course: Macroeconomic Diagnostics (MDSx)

Module: 2
Section: 1
Video #: 1
Video Type: Presenter Only

Module: 2
Section: 2
Video #: 1
Video Title: Aggregate Supply in the Short Run
Video Type: PPT
Short-Run Aggregate Supply
In the short run
Aggregate supply is not fixed
Production inputs can vary
Some production inputs are fixed

Aggregate Supply in the Short Run
Remember: aggregate supply is typically expressed as:
𝑌𝑌 = 𝐹𝐹(𝑇𝑇𝑇𝑇𝑇𝑇, 𝐾𝐾, 𝐿𝐿)

To alter aggregate supply in the short run:
Increase/decrease labor (L)

Increase/decrease capital (K)
TFP typically cannot vary in the short run
Aggregate Supply in the Short Run – Changing Inputs
Higher capital and labor needed by firms:
Higher labor input… Higher capital input…
Hiring unemployed workers Using idle machines
Overtime of employed workers Increasing capacity utilization

Increasing Inputs and Costs
To increase the inputs of production:
Need higher wages to attract workers/pay for overtime
Higher capacity utilization of capital (more depreciation)
This leads to higher per unit costs of production:
In the short run: more aggregate supply ⇒ higher costs

Short Run Aggregate Supply Curve
AS
P2
P1
Y1 Y2

Module: 2
Section: 2
Video #: 2
Video Title: Aggregate Demand in the Short Run
Video Type: PPT
Introducing Concept: Aggregate Demand
Defined as…
The total final demand for all goods and services in an

economy, in a given period (quarter, year).
Aggregate Demand in the Short Run
Aggregate demand can vary in two ways:
It can vary with the aggregate price level
It can vary due to other factors (besides aggregate prices)

Aggregate Demand and Prices
If prices of all goods and services drop…
Households feel richer (wealth effect) and demand more
If prices of all goods and services increase…
Households feel poorer (wealth effect) and demand less

Aggregate Demand Curve
P1
P2
AD1
Y1 Y2 Real GDP
Aggregate Demand Curve Shift
Aggregate demand can increase at the same price level if:
Households change their preferences and demand

more at any given price
Government economic policy changes (fiscal, monetary)

Aggregate Demand Curve Shift
P1
AD1 AD2
Y1 Y2 Real GDP

Module: 2
Section: 2
Video #: 3
Video Title: Short Run Equilibrium, Shift in Aggregate Demand Curve
Video Type: PPT
Building Blocks of Economic Equilibrium
Recall…
Short-run aggregate supply curve
Short-run aggregate demand curve

Short Run Economic Equilibrium
P AS
P1
AD
Y1
Real GDP
Characteristics of Economic Equilibrium
Short run economic equilibrium consists of
Price level (the aggregate price level)
Quantity (aggregate output)
At the given price level, aggregate supply equals

aggregate demand, corresponding to aggregate output
Change in Short Run Economic Equilibrium
In the short run economic equilibrium can change if…
Aggregate supply curve shifts
Aggregate demand curve shifts

Aggregate Supply Curve Shift and Equilibrium
P AS1
AS2
P1
P2
AD
Y1 Y2 Real GDP
Aggregate Demand Curve Shift and Equilibrium
P AS
P2
P1
AD2
AD1
Y1 Y2 Real GDP

Module: 2
Section: 3
Video #: 1
Video Title: Potential Output
Video Type: PPT
Potential Output
Defined as…
The highest level of output that is consistent with non-

accelerating level of inflation (stable inflation).
Potential Output – Concept
It captures the notion that…
Short run aggregate supply varies with the price level
Above a certain level of output, the economy is running

too “hot”, generating inflation
Potential Output
Some equivalent concepts:
Full employment
(employment at potential output)
Natural rate of unemployment

(unemployment at potential output)
Full capacity utilization

(capital utilization at potential output)
Potential Output
Some caveats of the concept of potential output:
Not the maximum level of output
Full employment and full capacity utilization do not imply the

maximum employment or capacity utilization possible
Higher output will lead to accelerating inflation


Module: 2
Section: 3
Video #: 2
Video Title: Output Gap
Video Type: PPT
Output Gap
An economic measure of…
…the difference between actual output and potential output
It is defined as…
...percentage deviation from potential output

Computing Output Gap
∗
(𝑌𝑌𝑡𝑡 −𝑌𝑌𝑡𝑡 )
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐺𝐺𝐺𝐺𝐺𝐺𝑡𝑡 = ∗
𝑌𝑌𝑡𝑡
Yt* – denotes real level of potential output at time t.

Potential Output
P AS
P2
P1
AD2
AD1
Y1 Y* Y2 Real GDP
Positive and negative output gap and potential output
Output
Positive Negative
Potential
output gap output gap
output
Actual
output
Time

Module: 2
Section: 3
Video #: 3
Video Title: Use and Interpretation of Output Gap
Video Type: PPT
Use of Output Gap
Estimating Potential Output and Output Gap provides:
Short Run:
Guidance in calibration of macroeconomic policy
Medium and Long Run:

Guidance in formulating macroeconomic structural reforms
Interpretation of Output Gap
Output above potential level

Strong growth in aggregate demand
Employment above full employment
Capacity utilization above full level
Accelerating inflation
The level of production is too high.
Negative Gap No Gap Positive Gap

Output at potential level

The level of output is consistent with:
full employment
full capacity utilization
stable inflation
The level of production is sustainable.

Output below potential level

Implication of negative output gap
High unemployment and low capacity utilization
Weak demand
Low and/or falling inflation
The level of production is too low.


Module: 2
Section: 3
Video #: 4
Video Title: Overview of measurement of output gap
Video Type: PPT
Estimation of Potential Output
Measuring potential output is no easy task
We do not observe potential output directly from data
There is no indicator that tells us what the output gap is
Necessary to use statistics and economic theory for estimation

Estimating Potential Output
Univariate methods… Multivariate methods…
Linear Trend Production Function Approach
Hodrick-Prescott (HP) Filter Multivariate Filters
Band-Pass Filter DSGE Models

Tools for Estimation
Two steps in reaching an estimate:
Use diagnostic tools to estimate the output gap.
Compare across different methods to select the best estimate.


Module: 2
Section: 4
Video #: 1
Video Title: Linear Trend Method
Video Type: PPT
Estimation Tool 1 – Linear Time Trend
Key aspects:
Assumes that potential output grows at a constant rate.
Estimates the average growth rate over the sample period.

Estimation Tool 1 – Linear Time Trend
Real GDP in
Constant Trend
logs
yt = α + β t + ε t
y = α + βt
ˆ *
t
ˆ
Estimated Estimated Estimated
Potential Output Constant Trend
Diagnostic Tool 1 – Estimated Potential Output
Country B: Real GDP and Potential GDP

351000
Real GDP Potential Output
301000
251000
201000
151000
101000
51000
1000
Diagnostic Tool 1 – Shortcomings
Shortcomings of the deterministic trend:
Assumes constant growth rate of potential output.
Growth of potential output varies over time.


Module: 2
Section: 4
Video #: 2
Video Title: Linear Trend in Excel
Video Type: Excel
EXCEL

Module: 2
Section: 4
Video #: 3
Video Title: Hodrick-Prescott (HP) Filter
Video Type: PPT
HP Filter Method
Key aspects of the Hodrick-Prescott (HP) Filter:
Decomposes the time series into trend and cyclical component.
Allows for variation of growth rate of trend

HP Filter Mathematical Formula
∞ ∞
∗ ∗
𝑚𝑚𝑚𝑚𝑚𝑚𝑦𝑦𝑡𝑡∗ � 𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡∗ + 𝜆𝜆 � 𝑦𝑦𝑡𝑡+1 − 𝑦𝑦𝑡𝑡∗ − 𝑦𝑦𝑡𝑡∗ − 𝑦𝑦𝑡𝑡−1 2
𝑡𝑡=0 𝑡𝑡=2
Diagnostic Tool 2 – Potential Output with HP Filter
Country B: Real Output and Potential Output

351000
Real GDP HP Filter (λ=1600)
301000
251000
201000
151000
101000
51000
1000
Diagnostic Tool 2 – Varying Parameter λ
Country B: Real GDP and Potential GDP

351000
Real GDP HP Filter (λ=infinity)
301000
251000
201000
151000
101000
51000
1000
Diagnostic Tool 2 – Shortcomings
Shortcomings of the HP Filter:
HP filter decomposition does not have a theoretical

foundation.
If growth rate of potential output exhibits cycles – our

estimate may contain trend AND cycle
End-point problem

Module: 2
Section: 4
Video #: 4
Video Title: Hodrick-Prescott Filter in Excel
Video Type: Excel
EXCEL

Module: 2
Section: 4
Video #: 5
Video Title: Production Function Approach
Video Type: PPT
Main features:
Uses Cobb-Douglas production function
Requires several economic data series as inputs

Production Function Approach – Inputs
To use this approach we need to compute
An estimate of full employment
An estimate of capital at full capacity utilization
An estimate of trend TFP

Cobb-Douglas Production Function
∗ ∗𝛼𝛼 ∗1−𝛼𝛼
𝑌𝑌𝑡𝑡 = 𝐾𝐾𝑡𝑡 𝐿𝐿𝑡𝑡
Use potential output values of the inputs:

L* – Labor at full employment
K* – Capital at full utilization
TFP* – TFP at potential output
Diagnostic Tool 3 – Production Function Approach
Main Steps:
1) Use series on output, capital and labor into production

function to compute a series for TFP
2) Estimate capital at full utilization - K*
3) Estimate labor at full employment - L*
4) Estimate trend TFP – TFP*
5) Plug in TFP*, K*, L* into Cobb-Douglas function - Y*
Production Function Approach – Caveats
Some of the disadvantages of this approach
Requires multiple data series
Relies on estimates of the inputs at potential output
Requires us to make an assumption about the exact form

of the aggregate production function.

Module: 2
Section: 4
Video #: 6
Video Title: Production Function Approach in Excel
Video Type: Excel
EXCEL

Module: 2
Section: 5
Video #: 1
Video Title: Selecting an Estimate and Interpreting Results
Video Type: PPT
Selecting the Best Estimate to Use
There are two considerations:
Judging the characteristics and properties of each tool
Analyzing their estimates of potential output

Properties of Methods for Estimation
Variation in Trend of Requires Capital

Endpoint Problem
Potential Output and Labor Data
Linear
Trend
No No No
Hodrick-Prescott
Filter
Yes Yes No
Production Function
Approach
Yes Yes Yes
Interpreting Results for Country X
GDP and Potential Output Growth
Real GDP Growth (%Δ,) Potential Growth (%Δ)

8.0
6.0
4.0
2.0
0.0
Q1-1981 Q1-1984 Q1-1987 Q1-1990 Q1-1993 Q1-1996 Q1-1999 Q1-2002 Q1-2005 Q1-2008 Q1-2011 Q1-2014
-2.0
-4.0
-6.0
-8.0
Interpreting Results for Country X
Output Gap
(in percent)
6.0
4.0
2.0
0.0
Q1-1980 Q1-1983 Q1-1986 Q1-1989 Q1-1992 Q1-1995 Q1-1998 Q1-2001 Q1-2004 Q1-2007 Q1-2010 Q1-2013 Q1-2016
-2.0
-4.0
-6.0
-8.0
-10.0
Course: Macroeconomics Diagnostics (MDSx)

Module: 2
Section: 6
Video #: 1
Video Type: PPT
Module Wrap-Up
Tools estimating potential output:
Deterministic Trend
Hodrick-Prescott (HP) filter


Module: 2
Section: 7
Video #: 1
Video Title: Revelation Video
Video Type: PPT
Module 3
Analyzing Aggregate Demand
Course: MDSx
Module: 3
Section: 1
Video #: 1
Video Type:
Course: MDSx
Module: 3
Section: 2
Video #: 1
Video Title: Aggregate Demand and the Economy
Video Type: Standard
Aggregate Demand
Let us recall that …
… it is the total final demand of all goods and services in

an economy.
… it can shift in the short-run and cause fluctuations in

economic activity.
Aggregate Demand Curve Shift and Equilibrium
P AS
P2
P1
AD2
AD1
Y1 Y2 Real GDP
Aggregate Demand and the Business Cycle
In the short-run, shifts in aggregate demand affect the

level of output and inflation.
Recognizing the level of aggregate demand requires

analyzing its components.
Course: MDSx
Module: 3
Section: 2
Video #: 2
Video Title: Components of Aggregate Demand
Components of Aggregate Demand
AD ≡ C p + I p + G + NX
Aggregate Private Private Government Net
Demand Consumption Investment Expenditures Exports
Aggregate Demand
GDP Component Shares (% of Real GDP)

70
60
50
40
30
20
10
-10
Private Private Public Public Inventory Net Exports
Consumption Investment Consumption Investment
1998-2001 2002-2005 2006-2009 2010-2015
Aggregate Demand
The Economic Impact:

Consumption
Investment impacts on capital accumulation
Net exports
Government spending
Course: MDSx
Module: 3
Section: 3
Video #: 1
Video Title: Growth Decomposition of Aggregate Demand
Growth in Aggregate Demand
Computing what led to demand growth:
How much growth in each component
Proportion/weight of each component relative to total

aggregate demand
Contributions to Growth
Aggregate Demand analysis tells us…

… the component that is driving short-term growth.
 Household consumption
 Private investment
 Government spending
 External demand
Change in Components of Aggregate Demand
∆GDP ≡ ∆C p + ∆I p + ∆G + ∆NX
Contribution to Growth
∆𝐺𝐺𝐺𝐺𝐺𝐺 ∆(𝐶𝐶𝑝𝑝 + 𝐼𝐼𝑝𝑝 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁)

=
𝐺𝐺𝐺𝐺𝐺𝐺 𝐺𝐺𝐺𝐺𝐺𝐺
∆𝐶𝐶𝑝𝑝 𝐶𝐶𝑝𝑝 ∆𝐼𝐼𝑝𝑝 𝐼𝐼𝑝𝑝 ∆𝐺𝐺 𝐺𝐺 ∆𝑁𝑁𝑁𝑁 𝑁𝑁𝑁𝑁

= × + × + × + ×
𝐶𝐶𝑝𝑝 𝐺𝐺𝐺𝐺𝐺𝐺 𝐼𝐼𝑝𝑝 𝐺𝐺𝐺𝐺𝐺𝐺 𝐺𝐺 𝐺𝐺𝐺𝐺𝐺𝐺 𝑁𝑁𝑁𝑁 𝐺𝐺𝐺𝐺𝐺𝐺
Course: MDSx
Module: 3
Section: 3
Video #: 2
Video Title: Growth Decomposition in Excel
Video Type: Excel
EXCEL
Place at the beginning and end of planned video segments.
Course: MDSx
Module: 3
Section: 3
Video #: 3
Video Title: Analysis and Interpretation of Contributions to Growth
Demand Side Growth Decomposition
Past/Historical Perspective:
Identifies which sectors accounted for the growth
Provides insight into the weaknesses and strengths
Reveals vulnerabilities
Sustainability
Present Perspective:
Identifies the sector that is driving growth at present
Assists analysis of boom/recession/crisis

Future/Predictive Perspective:
Helps predict sector that may perform best
Tells us if it is sufficient to drive growth in demand
Identify sustainability of domestic and/or external demand

Contributions to GDP Growth
Contributions to Growth: Investment vs. Consumption

10
-2
-4
-6
-8
-10
-12
Q1-1999 Q1-2001 Q1-2003 Q1-2005 Q1-2007 Q1-2009 Q1-2011 Q1-2013 Q1-2015
Investment Consumption Real GDP Growth

Growth Decomposition
Within a recession/crisis:
Before Possible During

Recovery
Crisis Reasons Crisis
Unsustainable Too much Consumption Which sectors

growth in consumption, and investment account for
demand investment plummet. Net recovery
exports rise
Growth Decomposition Applied
In application to the case study country:
Calculate the contributions to growth from the demand side
Evaluate your findings using the different perspectives we

have discussed
Course: MDSx
Module: 3
Section: 4
Video #: 1
Video Title: Analysis of Consumption
Consumption
Some key aspects:

The largest component of aggregate demand
Fluctuations in household consumption can impact GDP
Recognize the determinants of consumption and its behavior

over the business cycle
Consumption
Durables Non-Durables Services
Are highly cyclical Not very cyclical Not very cyclical
Examples: Examples: Examples:

 Automobiles  Food  Haircuts
 Furniture  Clothing/Shoes  Transportation
 Household  Fuel
Appliances
Determinants of Consumption
Higher current income, leads to…

Current Income
… Higher current consumption and Higher saving
Expected Future Higher future income, leads to…

Income … Higher current consumption and Lower saving
Higher uncertainty about future income, leads to…

Uncertainty …Higher saving due to precautionary motive
Higher wealth, leads to…

Wealth … Higher current consumption, Lower saving
Higher interest rates typically leads to…

Interest Rate … Lower current consumption, Higher saving
Durables Consumption
≠
Spending on
Consumption of
consumer
durable goods
durables
Some notes:
Tends to be volatile
Often more pro-cyclical than other consumption spending
Consumption, Savings, and Disposable Income
The Household’s Budget Constraint:
Consumption
+ Savings
= Disposable
Income
Course: MDSx
Module: 3
Section: 4
Video #: 2
Video Title: Determinants of Consumption in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 3
Section: 5
Video #: 1
Video Title: Analysis of Investment
Components of Investment
Private Fixed Inventory Government

Investment Investment Investment
Firms’ capital Change from previous Public Capital

formation period
Examples:
Examples: Examples:
 Highways
 Nonresidential  Car inventories
 Ports
structures
 Unsold merchandise
 Firms’ machines and
equipment
Determinants of Private Investment
Some key aspects:

Includes spending by businesses and households on fixed
assets.
More volatile than consumption, and depends on…

 Rate of Return
 Expected future income
 Cost of finance
 Access to financing
 Uncertainty
Investment and the Capital Stock
Demand for capital, derived from the Production Function:

Technical Labor Capital
Progress Supply Stock
Y = f ( A, L, K )
K t =( K t −1 − δ K t −1 ) + It
Gross
Capital Stock Depreciation
Investment
Investment OECD Averages
Investment
(In percent of GDP, 2004–08 average)
Source: Asia and Pacific REO (April 2010, Ch. 3)

Course: MDSx
Module: 3
Section: 5
Video #: 2
Video Title: Determinants of Investment in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 3
Section: 6
Video #: 1
Video Title: Aggregate Demand and the External Sector
Aggregate Demand
GDP = C p + I p + Cg + I g + ( X − M )

G
GDP = C p + Cg + I p + I g + ( X − M )

  
C I
External Sector and Current Account Balance
Gross National Disposable Income add net factor income and net
transfers to GDP:
GNDI =GDP + Y f + TR f =C + I + ( X − M ) + Y f + TR f
 
CAB
=
GNDI − (C + I ) CAB =
GNDI − A CAB

A
Course: MDSx
Module: 3
Section: 6
Video #: 2
Video Title: Aggregate Demand and Savings
Savings
Key attributes:
Purpose is to increase resources for future consumption
Protect against an unexpected loss of household income
Allows financial assets to be channeled into productive

investments
Aggregate Demand Savings and Investment
Aggregate relationship:
GDP = C + I + NX
GDP + Y f + TR f =C + I + ( NX + Y f + TR f )
⇒ GNDI − C = I + CAB
⇒S−I = CAB
Aggregate Saving (Private and Public):
S − I= (S p − I p ) + ( S g − I g )= CAB
⇒ S p = I p − ( S g − I g ) + CAB
Course: MDSx
Module: 3
Section: 7
Video #: 1
Video Title: Aggregate Demand and the Business Cycle
The Business Cycle
Key features:
Defined as the repeated process of economic expansion,
decline/contraction, and recovery.
Temporary deviations from a ‘normal growth path’.
All are different in terms of length, deviation.
All have common features in their patterns.

Business Cycle
20
Private Consumption Public Consumption
Public Investment Private Investment
15 Change In Inventory Net Exports
10
-5
-10
-15
-20
Q1-1999 Q1-2001 Q1-2003 Q1-2005 Q1-2007 Q1-2009 Q1-2011 Q1-2013 Q1-2015
Course: MDSx
Module: 3
Section: 7
Video #: 2
Video Title: Business Cycle and Co-movements
Co-Movements and the Business Cycle
Direction:
Procyclical – Move the same direction
Countercyclical – Move the opposite direction
Acyclical – No clear movement
Timing:
Leading – Move in advance of aggregate economic activity
Coincident – Move at the same time
Lagging – Move later
Leading Economic Indicators
Variable Direction Timing
Production
Industrial Production Procyclical Coincident
Expenditure
Consumption Procyclical Coincident
Business Fixed Investment Procyclical Leading
Labor Market
Unemployment Countercyclical Not classified by NBER
Financial
Stock prices Procyclical Leading

High Frequency Indicators
Some attributes:
Economic indicators that co-move with GDP
Can be used to now-cast GDP based on a dynamic factor
model
Example – Federal Reserve System in US uses:
 Employment
 International Trade
 Retail and consumption
Assessing the State of the Economy
Familiarity with cyclical patterns of key macro variables:

Can help detect when the economy may be off track
Can help give insight to current quarter and year
Can help direct investigation and diagnosis

Course: MDSx
Module: 3
Section: 8
Video #: 1
Summarizing What We Learned
How to identify the components of aggregate demand.
How to compute contributions to growth of aggregate demand.
How to analyze main drivers of consumption and investment.
How to analyze aggregate demand over the business cycle.

Course: MDSx
Module: 3
Section: 9
Video #: 1
Video Title: Assessing Diagnostica
Module 4
Analyzing Inflation
An Example of CPI Basket
Hotels and Others , 5

Restaurants, 7
Food and
Education, 3 Beverages, 29
Recreation and Culture, 4
Communications, 4
Transport, 15
Clothing, 7
Health, 3 Housing, 16
Furnishings, 8
Various Rates of Inflation
CPIt − CPIt−i
𝜋𝜋t =
CPIt−i
𝐶𝐶𝐶𝐶𝐶𝐶𝑄𝑄𝑄 2016
• Year−on−year inflation = −1
𝐶𝐶𝐶𝐶𝐶𝐶2016
• Annual average = −1
𝐶𝐶𝐶𝐶𝐶𝐶2015
• Quaterly inflation = −1
4
• Annualized inflation = −1
Sources of Bias in the CPI
Analyzing Inflation
A Contribution Approach:
Contribution of an item i to inflation:
𝑖𝑖 𝑖𝑖
𝑃𝑃𝑡𝑡−1 𝑃𝑃𝑡𝑡𝑖𝑖 − 𝑃𝑃𝑡𝑡−1
= 𝑤𝑤𝑖𝑖 × 𝑖𝑖
× 𝑖𝑖
𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡−1 𝑃𝑃𝑡𝑡−1
Alternative aggregation schemes:

Traded / non-traded goods
Administered / Non-administered goods
Food / non-food goods
Goods / Services
From Headline to Core Inflation
1. Limits of the headline inflation
2. Concept of core inflation
3. Common measures of core inflation:
Permanent exclusion methods
Variable exclusion methods
4. Characteristics of a good core inflation measure

Measuring the General Price Level
The GDP deflator is a Paasche or current weighted index:
𝐺𝐺𝐺𝐺𝐺𝐺 𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

GDP deflator = × 100
𝐺𝐺𝐺𝐺𝐺𝐺 𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Money and Inflation in the Long-run
150 LAS
140
130
Price level
120
110
100
90 Potential
Output AD0
80
600 700 800 900 1000 1100 1200
Real GDP
Correlation between Money Growth and Inflation, 1955 - 2014
150
Inflation Rate (percent)
100
50
0
0 50 100 150
Money Growth Rate (percent)
Source: IMF. Data are the 10-year average growth rate in M2 and the 10-year average inflation rate
from 1955 through 2014. Countries with inflation rates or money(M2) growth rates in excess of 200
percent are excluded. Data are from IMF International Financial Statistics
Demand-Pull Inflation
A Demand-Pull Inflation Process

150 LAS
140
130
120
Price level
SAS2
AD2
110
SAS1
100
AD1
90 SAS0
AD0
80
600 700 800 900 1000 1100 1200
Real GDP
Demand-Pull Inflation
A Cost-Push Inflation Process

150 LAS
140
130
120
Price level
SAS2
AD2
110
SAS1
100
AD1
90 SAS0
AD0
80
600 700 800 900 1000 1100 1200
Real GDP
Factors that affect the magnitude of the impact
1. Share of food in household consumption
2. Energy intensity of the economy
3. Credibility of the central bank
4. Prevalence of administered prices
5. Degree of competition in the economy

Inflation and Unemployment Rate in the US, 1960 - 1969
6
1969
5
Inflation rate (percent)
1968
4
3 1967
1966
2 1965
1960
1963
1 1964 1961
1962
0
3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0
Unemployment rate (percent)
Short-run Tradeoff between Inflation and Unemployment
𝜋𝜋𝑡𝑡 = 𝛾𝛾 𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡𝑃𝑃 + 𝜉𝜉𝑡𝑡
𝜋𝜋𝑡𝑡 = 𝛼𝛼 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑡𝑡𝑁𝑁 + 𝜀𝜀𝑡𝑡

Inflation and Unemployment Rate in the US, 1970 - 2016
16
14
1980
12
Inflation rate (percent)
1974 1979
10 1981
1975
8 1978
1970 1977
6 1973
1976
1982
1990
4 1971 1991 1984

2000 2005 1987 1985
2006 1972 1993 1992 2011 1983
1995 1994
2 1999 1997 2012
1998 2002 2014 1986 2010
2013
2016
0 2015
2009
-2
3 4 5 6 7 8 9 10 11
Expectation Augmented Phillips Curve
Tradeoff between unanticipated inflation and unemployment
𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝐸𝐸 + 𝛾𝛾 𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡𝑃𝑃 + 𝜉𝜉𝑡𝑡
→ 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝐸𝐸 = 𝛾𝛾 𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡𝑃𝑃 + 𝜉𝜉𝑡𝑡
𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝐸𝐸 + 𝛼𝛼 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑡𝑡𝑁𝑁 + 𝜀𝜀𝑡𝑡
→ 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝐸𝐸 = 𝛼𝛼 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑡𝑡𝑁𝑁 + 𝜀𝜀𝑡𝑡

Expectation Augmented Phillips Curve
Tradeoff between unanticipated inflation and unemployment
𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝐸𝐸 + 𝛾𝛾 𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡𝑃𝑃 + 𝜉𝜉𝑡𝑡
→ 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝐸𝐸 = 𝛾𝛾 𝑦𝑦𝑡𝑡 − 𝑦𝑦𝑡𝑡𝑃𝑃 + 𝜉𝜉𝑡𝑡
𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝐸𝐸 + 𝛼𝛼 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑡𝑡𝑁𝑁 + 𝜀𝜀𝑡𝑡
→ 𝜋𝜋𝑡𝑡 − 𝜋𝜋𝑡𝑡𝐸𝐸 = 𝛼𝛼 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑡𝑡𝑁𝑁 + 𝜀𝜀𝑡𝑡

Change in Inflation and Unemployment in the US, 1970 - 2016
5
Change in the inflation rate (percent)
3 4 5 6 7 8 9 10
-1
-3
-5
5
3 4 5 6 7 8 9 10
-1
-3
-5
y = -0.5x + 3.0
3 4 5 6 7 8 9 10
-1
-3
-5
Module 5
Analyzing Monetary Policy

Module: 5
Section: 1
Video #: 1
Video Type: Presenter Only

Module: 5
Section: 2
Video #: 1
Video Title: Introducing Monetary Policy Objectives
Video Type: PPT
Ultimate Objective of Monetary Policy
Low and stable inflation
A characteristic of general macroeconomic stability.
Required Negative
Space
(Not for instructor
Helps more efficient resource allocation. notes.)

Primacy of the Inflation Objective
Policy mandates might assume other objectives:
Unemployment / output
Required Negative
Space
(Not for instructor
Exchange rate notes.)

Good practice is…
Primacy of the Inflation Objective

Operating and Intermediate Targets
Required Negative
Space
(Not for instructor
notes.)


to the left.

Module: 5
Section: 2
Video #: 2
Video Title: Diagnosing the Problem
Video Type: PPT
To achieve the objective the central bank…
Adjusts policy instruments to affect:

 Cost of domestic reserve money
 Supply of domestic reserves
Required Negative
Space
(Not for instructor
notes.)
Alters aggregate real monetary conditions:
 Real market interest rates text field positions.
 Real exchange rate

Key Diagnostic Questions
How are the policy operating/intermediate variables

aligned with a target?
Required Negative
Space
(Not for instructor
notes.)

What are the resulting real monetary conditions?
Diagnostic Characterizations
Neutral
Required Negative
Space
Expansionary (Not for instructor
notes.)

Contractionary
Policy stance - Neutral
Operating and intermediate variables –

Are at ‘targets’ consistent with…
 … output at the potential; and
 … inflation and inflation expectations at the objective. Required Negative
Space
(Not for instructor
notes.)
Real Monetary Conditions and Demand and Inflation Please do not adjust
Constrained Neutral Stimulated

Policy stance - Expansionary

 Are not aligned with the ‘neutral’ level.
Real Monetary Conditions –
 Undervalued domestic currency Required Negative
Space
 Cheap credit (Not for instructor
notes.)
Demand and Inflation – Please do not adjust

Policy stance - Contractionary

 Are not aligned with the ‘neutral’ level.
Real Monetary Conditions –
 Overvalued domestic currency Required Negative
Space
 Expensive credit (Not for instructor
notes.)
Demand and Inflation – Please do not adjust


Module: 5
Section: 3
Video #: 1
Video Title: Policy Frameworks and Transmission Mechanism - 1
Video Type: PPT
Selecting Diagnostic Tools
To diagnose monetary policy stance…
Decide which tools are better suited for a given policy

framework.
Required Negative
Space
(Not for instructor
notes.)
Draw the relation between diagnostic tools and the policy Please do not adjust
transmission mechanism. text field positions.
Monetary Policy Frameworks Around the Globe
Required Negative
Space
(Not for instructor
notes.)


to the left.
Source: Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER), 2016
Impossible Trinity Informs the Choice of the Framework – 1
Required Negative
Space
(Not for instructor
notes.)


to the left.
Required Negative
Space
(Not for instructor
notes.)


to the left.
Required Negative
Space
(Not for instructor
notes.)


to the left.
Required Negative
Space
(Not for instructor
notes.)


to the left.
Required Negative
Space
(Not for instructor
notes.)


to the left.

Module: 5
Section: 3
Video #: 2
Video Title: Policy Frameworks and Transmission Mechanism - 2
Video Type: PPT
Policy Transmission
Channels of Transmission:
Asset price
(1) Wealth and (2) Cost of equity
Credit Required Negative

Space
(1) Bank lending and (2) Balance sheet (Not for instructor
notes.)
Interest rate Please do not adjust

Exchange rate
Transmission Mechanism – Autonomous Monetary Policy
Required Negative
Space
(Not for instructor
notes.)


to the left.
Transmission Mechanism – No Autonomous Monetary Policy
Required Negative
Space
(Not for instructor
notes.)


to the left.

Module: 5
Section: 3
Video #: 1
Video Title: Classifying Diagnostic Tools
Video Type: PPT
Diagnostic Tools – 1
Two levels of evaluation:
Operating and intermediate targets
Required Negative
Space
(Not for instructor
Aggregate real monetary conditions notes.)

Tools presented:
Forward-looking version of the Taylor Rule
Required Negative
Space
(Not for instructor
Money overhang and money targets notes.)

Real monetary conditions index (MCI)

Required Negative
Space
(Not for instructor
notes.)


Module: 5
Section: 4
Video #: 7
Video Title: Forward-looking Taylor Rule
Video Type: PPT
Taylor Rule
Short-term Trend Real Interest Rate Actual Inflation Policy Shock
it = r + π t + c1 (π t − π ) + c2 yˆ t + ε t Required Negative
Space
(Not for instructor
notes.)

CB or short-term Interest Rate Inflation Target Output Gap
to the left.
Taylor’s original parametrization:
it = 2 + π t + 0.5(π t − 2) + 0.5 yˆ t
Inflation Forecast Targeting
CB implements flexible inflation forecast targeting:

Inflation forecast is an intermediate target.
Required Negative
Space
(Not for instructor
“Flexible” in that… notes.)
 CB smooths the economic cycle Please do not adjust

 Lets the actual inflation temporarily deviate from the target.
Forward-looking Version of the Taylor Rule
“Neutral” level of the Deviation of expected

Output Gap
nominal interest rate inflation from the objective
it = g1it −1 + (1 − g1 ){itn + g 2 (π te+ N − π t ) + g 3 yˆ t } + ε ti Required Negative

Space
(Not for instructor
notes.)

i = rt + π
n e Insert visual content
to the left.
t t+N
“Neutral” (equilibrium) Real Expected

Interest Rate Inflation

Module: 5
Section: 4
Video #: 2
Video Title: Forward-looking Taylor Rule in Excel
Video Type: Excel
EXCEL

Module: 5
Section: 4
Video #: 3
Video Title: Money Overhang and Money Targets
Video Type: PPT
Money Overhang and Money Targets
Required Negative
Space
(Not for instructor
notes.)


to the left.
Equation of Exchange
Money Velocity Price Level Output
MV = PY Required Negative
Space
(Not for instructor
…in logs and rearranged for real balances: notes.)
m = m− p = y−v
R text field positions.

to the left.
When y and v are in equilibrium:
m = y −v
R
Long-Run Target and Overhang
The long-run money growth objective:
∆m = ∆y − ∆v + π Required Negative
Space
(Not for instructor
notes.)
Money overhang: The Deviation….
mt = (mt − mt ) = (mt − pt ) − ( yt − vt )
ˆ R R R Insert visual content
to the left.
mˆ tR > 0 indicates inflationary pressures going forward

Short-Run Target
CB sets the short-run intermediate objective for the next period:
∆mtS+1 = ∆m − mˆ tR Required Negative

Space
(Not for instructor
mˆ tR > 0 ⇒ the CB should restrict money growth below ∆m notes.)


to the left.
if ∆mt > ∆mtS+1 ⇒ the CB has to tighten policy instruments to

slow money growth

Module: 5
Section: 4
Video #: 4
Video Title: Money Overhang and Money Targets in Excel
Video Type: Excel
EXCEL

Module: 5
Section: 4
Video #: 5
Video Title: Monetary Conditions Index - 1
Video Type: PPT
Real Monetary Conditions Index
RMCI t ≡ α rˆt + (1 − α ) qˆt

Required Negative
Space
(Not for instructor
notes.)

Real Interest Real Exchange
Rate Gap Rate Gap
to the left.
Measuring Real Interest Rate
The Fisher Equation:
Real interest rate Nominal interest rate Expected inflation
Required Negative
rt = it − π
Space
e (Not for instructor
notes.)
t+N Please do not adjust

Real Interest Rate Gap – 2
Contractionary Conditions Accommodative Conditions
Real Interest Rate

(in percent)
7.0
rr rr-bar
6.0
5.0 Required Negative
4.0 Space
3.0 (Not for instructor
notes.)
2.0
1.0
0.0 text field positions.

to the left.
Source: Haver Analytics, Fund staff calculations
Real Interest Rate Gap Equilibrium (“neutral”) Level
rˆt = rt − rt

Module: 5
Section: 4
Video #: 6
Video Title: Monetary Conditions Index - 2
Video Type: PPT
Measuring Real Exchange Rate
Bilateral Real Exchange Rate (RER):

Domestic
Price Level
Nominal Exchange Et Pt
Rate in units of FC
per 1 unit of LC
Qt = f
Pt Foreign Price
Required Negative
Space
Level
(Not for instructor
notes.)

In natural logs… text field positions.
qt = et + pt − ptf
Real Exchange Rate Gap
Strong domestic currency Weak domestic currency

Real Exchange Rate
(in percent)
-290.0
-300.0
q q-bar
-310.0
-320.0 Required Negative
-330.0 Space
-340.0 (Not for instructor
-350.0 notes.)
-360.0
-370.0 Please do not adjust
-380.0 text field positions.

to the left.
Source: Haver Analytics, Fund staff calculations
Real Exchange Rate Gap Equilibrium Level
qˆt = qt − qt
Aggregation
Real Interest Real Exchange

Rate Gap Rate Gap
Required Negative
Space
(Not for instructor
RMCI t ≡ α rˆt + (1 − α ) qˆt

notes.)


to the left.

Module: 5
Section: 4
Video #: 7
Video Title: Real Monetary Conditions in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 5
Section: 5
Video #: 1
Video Title: What is seen in Diagnostica
Video Type: Conversation

Module: 5
Section: 6
Video #: 1
Video Title: Wrapping Up Monetary Policy
Video Type: Text
Module Wrap-Up
The Diagnostic Tools applied:
Forward-looking version of the Taylor Rule
Required Negative
Space
(Not for instructor
Money overhang and money targets notes.)

Monetary Conditions Index (MCI)

Module 7
Fiscal Policy
Course: MDSx
Module: 7
Section: 1
Video #: 1
Course: MDSx
Module: 7
Section: 2
Video #: 1
Video Title: An Overview of Fiscal Policy
Fiscal Policy and the Economy
Demand conditions affect fiscal position
Fiscal Policy Economy

Fiscal Policy affects demand in short-term
Objective (short-term): Counter-cyclical Fiscal Policy

Fiscal Policy affects macro stability in medium-term
Objective (medium-term): Sustainable public debt level

Fiscal Policy affects supply

Course: MDSx
Module: 7
Section: 2
Video #: 2
Video Title: Outline of What Comes Next
Topics Covered
Headline Fiscal Indicators
Cyclically-adjusted Fiscal Balance
Fiscal Stance and Fiscal Impulse
Fiscal Multiplier
Course: MDSx
Module: 7
Section: 3
Video #: 1
Video Title: Headline Fiscal Indicators
Stylized Fiscal Account
Revenue (T): Expenditure (E):

 Tax revenue  Current expenditure
 Non-tax revenue (including interest)
 Capital spending
 Policy loans
T – E = Overall Balance (OB)

Stylized Fiscal Account
Revenue (T): Expenditure (E):

 Tax revenue  Current expenditure
 Non-tax revenue (including interest)
 Capital spending
 Policy loans
T – (E – interest spending) = Primary Balance (PB)

Course: MDSx
Module: 7
Section: 3
Video #: 2
Video Title: Headline Fiscal Indicators in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 7
Section: 3
Video #: 3
Video Title: Headline Fiscal Indicators Limitations
Factors Affecting Fiscal Balances
Discretionary  Tax measures

Policy Measures  Expenditure measures
Cyclical
 Automatic stabilizers
Factors
Factors beyond  Commodity price effects

the Business Cycle  Other asset price effects
Interpreting Headline Fiscal Indicators
Potentially misleading signals:

Deficit ≠ fiscal expansion
Surplus ≠ fiscal tightening
Focus is to assess the discretionary fiscal policy

Discretionary Fiscal Policy Changes
Primary Balance vs. Output Gap, Country Z, 2003-15

3.00
2.00
1.00
0.00
-1.00
-2.00
-3.00
-4.00
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Output gap Primary balance

Course: MDSx
Module: 7
Section: 4
Video #: 1
Video Title: Cyclically Adjusted Fiscal Balance
Cyclically-Adjusted and Structural Balances
=
Cyclically- Overall Balance
adjusted Overall net of cyclical
Balance (CAOB) factors
Reflects changes in discretionary policy measures
Main adjustment to be done in most countries
Cyclically-adjusted Primary Balance (CAPB) = Primary Balance

net of cyclical factors
Cyclically-Adjusted and Structural Balances
Overall Balance net
=
of cyclical factors
Structural and
Balance (SB)
Factors beyond the
business cycle
Definition varies from country to country and depends on
what is important/relevant.
Course: MDSx
Module: 7
Section: 4
Video #: 2
Video Title: Cyclically Adjusted Fiscal Balance Continued
Fiscal Policy Analysis Using CAOB
Two application areas:
Assessing current fiscal policy stance
Assessing fiscal sustainability

Assessing Current Fiscal Policy Stance
Changes in CAOB:
Fiscal policy more expansionary or tightening?
Pro-cyclical or counter-cyclical?
Automatic stabilizers are counter-cyclical but not enough
Discretionary policy may be pro-cyclical

Fiscal Policy is Not Always Counter-Cyclical
Primary Balance vs. Output Gap, Country Z, 2003-15

3.00
2.00
1.00
0.00
-1.00
-2.00
-3.00
-4.00
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Output gap Primary balance

Assessing Fiscal Sustainability
Some points:
CAPB enough to keep debt at sustainable level?
Comparison of the CAPB against a certain benchmark
Short-term and Medium-term goals are interrelated

Course: MDSx
Module: 7
Section: 4
Video #: 3
Video Title: Computing Cyclically Adjusted Fiscal Balance
Removing the Impact of the Business Cycle
= Cyclically-
Overall
Balance (OB)
Cyclical
Factors + adjusted
Overall Balance
(CAOB)
Cyclical Adjustment
The Aggregated Approach:
Cyclically-
= -
Cyclically- Cyclically-
adjusted
adjusted Overall adjusted
expenditure
Balance (CAOB) revenue (TCA)
(GCA)
ε T ,Y ε G ,Y
Y P
 Y P

T CA
= T   G CA
= G 
 Y   Y 
T: Actual revenue
Y: Output ; YP: Potential Output G: Actual expenditure
ɛT,Y : Revenue elasticity, ɛG,Y : Expenditure elasticity
- If >0, T is procyclical - If <0, G is counter-cyclical
Course: MDSx
Module: 7
Section: 4
Video #: 5
Video Title: Computing Cyclically Adjusted Fiscal Balance Continued
The Aggregated Approach
Elasticities:
Are generally acquired from…
 Econometric estimation
 More detailed breakdown of revenues and expenditures
(disaggregated approach)
IF data/time scarce, THEN use judgment/approximate values.

Elasticities:
Usual assumption: εT,Y=1 (or a bit higher)
Cyclically-adjusted revenue is lower in booms, and higher in

recessions.
 Proportional taxes
 Progressive taxes
 Social security contributions
Elasticities:
Usual assumption: εG,Y=0 (or small negative)
Expenditure does not depend on output
Except unemployment benefits

Interpreting the Cyclically-Adjusted Balance
Boom:
𝑌𝑌 > 𝑌𝑌 𝑃𝑃 → 𝑇𝑇 > 𝑇𝑇 𝐶𝐶𝐶𝐶 , 𝐺𝐺 ≤ 𝐺𝐺 𝐶𝐶𝐶𝐶 =>
The actual balance > CAOB
Recession:
𝑌𝑌 < 𝑌𝑌 𝑃𝑃 → 𝑇𝑇 < 𝑇𝑇 𝐶𝐶𝐶𝐶 , 𝐺𝐺 ≥ 𝐺𝐺 𝐶𝐶𝐶𝐶 =>
The actual balance < CAOB

Course: MDSx
Module: 7
Section: 4
Video #: 5
Video Title: Cyclically Adjusted Fiscal Balance in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 7
Section: 4
Video #: 6
Video Title: Adjusting the Fiscal Balance: Extensions
Adjusting the Fiscal Balance
Extensions…
Disaggregated approach to cyclical adjustment:

 Adjust each revenue/expenditure category separately
Factors beyond the business cycle:

 Commodity prices effects
 Other asset prices effects
 Output composition
Course: MDSx
Module: 7
Section: 5
Video #: 1
Video Title: Fiscal Stance and Fiscal Impulse
Fiscal Stance
Defined as:
FSt = – CAOBt
CAOBt < 0 Expansionary (FSt > 0)

CAOBt = 0 Neutral (FSt = 0)
CAOBt > 0 Contractionary (FSt < 0)
Fiscal Impulse
Measures the change in Fiscal Stance:
=
FI FSt − FSt −1
FI < 0
Fiscal Policy is either less expansionary or more contractionary
FI > 0
Fiscal Policy is either more expansionary or less contractionary
Course: MDSx
Module: 7
Section: 5
Video #: 2
Video Title: Interpreting Fiscal Stance and Fiscal Impulse
Fiscal Stance and Impulse in Hungary
4.0 Fiscal policy more

2.0 expansionary in
0.0 2005-2006
-2.0 More contractionary

-4.0 in 2007-2009, 2011-
-6.0 2012
-8.0 Fiscal impulse
-10.0
-12.0 Net lending/ borrowing
-14.0
2004 2006 2008 2010 2012 Structural balance
Data: IMF WEO

Course: MDSx
Module: 7
Section: 5
Video #: 3
Video Title: Fiscal Stance and Fiscal Impulse in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 7
Section: 6
Video #: 1
Video Title: Fiscal Multipliers
Fiscal Multiplier
Defined by:
How much output changes (ΔY) following a discretionary
change in government spending (ΔG) or revenue (- ΔT).
Impact ΔYt
=
multiplier ΔGt
Fiscal Multiplier
General Features:
Change is unnecessary one-to-one
Private and Government saving may offset each other
In reality can be much larger than 1; or negative
Highly dependent on circumstances

Course: MDSx
Module: 7
Section: 6
Video #: 2
Video Title: Fiscal Multipliers in Practice
Size of Multiplier
Recent Empirical Estimates:

Overall Range
~0-40% less ~0-60% more
0.1-1 in normal times
during booms during recessions
FM closer to the lower boundary if:

 Public debt is high
 Capacity to administer government finance is low
 Economy is open
 Exchange rate is flexible
 Labor market is flexible
Source: Weber A., L. Eyraud, and N. Batini, 2014, “A Simple Method to Compute Fiscal Multipliers”, IMF Working Paper 14/93
Course: MDSx
Module: 7
Section: 7
Video #: 1
Video Title: Summarizing What We Have Learned
Summarizing the Module
Headline Fiscal Indicators can be misleading
Need to adjust Fiscal Balances for the effects of the business

cycle and other factors
Fiscal Impulse explains contraction or expansion of Fiscal

Policy
Fiscal Multiplier measures the short-term impact of

discretionary Fiscal Policy on output
Course: MDSx
Module: 7
Section: 8
Video #: 1
EXCEL
Module 6
Macrofinancial Linkages
Course: MDSx
Module: 6
Section: 1
Video #: 1
Video Title: Introduction to macrofinancial linkages
Video Type: Text
Introduction to macrofinancial linkages
Macrofinancial linkages
 Have not always been recognized
Required Negative
 Are bi-directional Space
(Not for instructor
notes.)
 Can be positive, negative, or neutral
 Our focus:
(Highly) negative finance to macro linkages
Force us to consider macro to finance
Not always recognized
“Traditional” or “Idealized” view
Required Negative
“Surplus Units” “Deficit Units” Space
(Not for instructor
Savers Capital notes.)
Households investors Please do not adjust
Firms
 No role for finance: meeting, contracting,

agreeing, and complying is costless
Role of finance in macro is now clearer
Real World: with frictions
“Surplus Units” “Deficit Units”

Savers Capital investors Required Negative
Space
Households Firms (Not for instructor
notes.)
Uncertainty
Imperfect competition text field positions.
Imperfect information
Opportunistic behavior
Agency problems
Finance
Course: MDSx
Module: 6
Section: 1
Video #: 2
Video Title: Roadmap and motivation
Video Type: Text
Roadmap for this Module
 What is a banking crisis?

 Our diagnostic goal Required Negative
 Introducing FSIs—levels Space

(Not for instructor
notes.)
 One step further: variability Please do not adjust
 A peek at stress testing text field positions.
 Wrap-Up
Why should we care?
Diagnosis of financial sector→ take corrective

action if needed
1. Financial accelerator: mutual reinforcement of Required Negative

Space
macro & finance (Not for instructor
notes.)

2. Macro-financial vulnerabilities: identify early text field positions.
on, to avoid negative repercussions

 Can financial sector withstand shocks in
other sectors?
Course: MDSx
Module: 6
Section: 2
Video #: 1
Video Title: What is a banking crisis?
Video Type: Text
What is a banking crisis?
 Signs of banking system distress

 Bank runs
 Losses Required Negative
Space
(Not for instructor
 Liquidations notes.)

 Banking policy intervention measures text field positions.
 Liquidity support
 Bank restructuring or nationalizations
 Guarantees or deposit freezes/bank holidays
 Asset purchases
Two cases (all figures in %)

120
Argentina 2001-03 Thailand 1997-2000
100 Required Negative
Space
(Not for instructor
80 notes.)

60 text field positions.
40
20
0
Peak NPLs Fiscal costs Increase in public Liquidity support Output loss
debt
Our focus:
 Losses
Required Negative
 NPLs Space
(Not for instructor
notes.)
 Liability runs Please do not adjust
But, ultimately it boils down to:

 Insolvency/Loss of bank capital
Course: MDSx
Module: 6
Section: 2
Video #: 2
Video Title: Our diagnostic goal
Video Type: Text
Our diagnostic goal
To detect vulnerabilities, early signs of

distress before a crisis actually happens
Required Negative
Space
“How did you go bankrupt?” (Not for instructor
notes.)

“Two ways. Gradually, then all of a
sudden”
Ernest Hemingway, The Sun Also Rises

Our diagnostic goal
To detect the possibility that bank capital

could be wiped out (default):
K =A – L Required Negative
Space
(Not for instructor
notes.)
 Insolvency occurs when A < L
 How likely is this?
 How close are we to this possibility?

Graphical representation
Value of
Assets, Distribution of Asset value at T
Liabilities, Expected Required Negative
Capital asset Space
growth (Not for instructor
notes.)

Liabilities
A0
K0
L0
Probability of default
T Time
Our diagnostic goal
What determines probability of default?
 How much capital you have today: K0

Required Negative
 The volatility of A Space
(Not for instructor
notes.)
 By how much you expect A and L to grow Please do not adjust
Note:
 A is measured imprecisely (Book Value)
 We’ll focus on different balance sheet items
 FSIs give first approximation
Our diagnostic goal
We’ll highlight the relevance of selected

Financial Soundness Indicators (FSIs)
 Capital adequacy Required Negative
Space
(Not for instructor
 Asset quality notes.)

 Earnings and profitability text field positions.
 Liquidity
 Sensitivity to exchange rates
Course: MDSx
Module: 6
Section: 3
Video #: 1
Video Title: Capital adequacy
Video Type: Excel demo
Course: MDSx
Module: 6
Section: 3
Video #: 2
Video Title: Asset quality 1
Course: MDSx
Module: 6
Section: 3
Video #: 3
Video Title: Asset quality 2
Course: MDSx
Module: 6
Section: 4
Video #: 1
Video Title: Earnings
Course: MDSx
Module: 6
Section: 4
Video #: 2
Video Title: Liquidity runs
Course: MDSx
Module: 6
Section: 4
Video #: OPT
Video Title: Interest rate risk
Course: MDSx
Module: 6
Section: 4
Video #: 3
Video Title: Exchange rate risk
Course: MDSx
Module: 6
Section: 5
Video #: 1
Video Title: Variability and Z-score
Video Type: Power Point/Excel demo
Now we introduce variability
Will help assess whether a given FSI level

is appropriate
 First, combine capital adequacy and Required Negative
Space
profitability (Not for instructor
notes.)

K
+ ROA text field positions.
 Z-score: z= A
σ ROA
 Often called “distance to distress”

Now we introduce variability
For Bankistan
Required Negative
 K/A = 8.1%, ROA = 1.3% Space
(Not for instructor
notes.)
 From historical series (1996-2010): σROA = 2.3%
 It would take a (negative) profitability shock equal to
4.16 σ’s to wipe out capital
 How likely?
 If ROA follows normal distribution, p = 0.002%

Course: MDSx
Module: 6
Section: 5
Video #: 2
Video Title: Variability and further questions
Video Type: Power Point/Excel demo
Alternative ways of looking at this
 Probability that a (-) earnings shock will:

 Bankrupt the system: 0.002%
 Push the system below K/RWA = 8% Required Negative
Space
(Not for instructor
notes.)

 What is the minimum amount that I text field positions.
should expect to lose x% of the time?
 Value at Risk (VaR)
Course: MDSx
Module: 6
Section: 6
Video #: 1
Video Title: A Peek at Stress Testing
Video Type: Text
A peek at stress testing
Surprise: you’ve already gotten it!

What would happen to the banking system
if: Required Negative
Space
(Not for instructor
 All NPLs have to be written off notes.)

 NPLs increase rapidly text field positions.
 There is a run on deposits (or other liabilities)
 Earnings fall (by a multiple of σ)
 There is a large depreciation

Course: MDSx
Module: 6
Section: 6
Video #: 2
Video Title: Wrap-Up
Video Type: Excel
Wrap-Up
We’ve assessed:
 Capital adequacy Shocks to:

 Asset quality And  Borrower defaults Required Negative
 Earnings vulnerabilities  Earnings fall Space
(Not for instructor
 Liquidity to:  Deposit run notes.)
 Sensitivity to ER  Exchange rates
 Government default
Other
 Loan concentration
vulnerabilities we  Bank interlinkages
could analyze:  Off-balance sheet
 Non-bank institutions
Wrap-Up
 MF linkages: not obvious, bi-directional,

good, bad, neutral
 Amplification: financial accelerator Required Negative

Space
 Tail (rare) events: banking crises (Not for instructor
notes.)
 Analysis of crisis/distress Please do not adjust

 Boils down to capital
 FSIs: 1st approximation, then complement:
 Volatilities (Ex: z-score)
 Stress Tests
 Value at Risk
Module 8
Fiscal Sustainability
Course: MDSx
Module: 8
Section: 1
Video #: 1
Course: MDSx
Module: 8
Section: 2
Video #: 1
Video Title: Fiscal Sustainability
A definition…
A situation in which a government is expected to be able
to continue servicing its debt without an unrealistically

Required Negative
Space
(Not for instructor
large adjustment to its balance of revenues and notes.)

expenditure, without debt restructuring or default text field positions.
Key Concepts for Assessment:
Solvency
Ability to repay debt
Required Negative
Space
(Not for instructor
Liquidity notes.)
Ability to rollover debt Please do not adjust
Realistic adjustment
Plausible primary balance path
Solvency
Key Points:
Current debt stock is fully covered by expected future

primary balances
Required Negative
Space
(Not for instructor
notes.)
Government able to service debt without renegotiating or
defaulting Please do not adjust
Debt ratio stabilizes or declines

Liquidity
Key Points:
Financing is sufficient to meet maturing obligations

Required Negative
Space
(Not for instructor
notes.)
Continued market access and low risk of rollover
Well balanced debt profile and debt level is “not too high”
Realistic Adjustment
Key Points:
Realistic macroeconomic assumptions and projections

Required Negative
Space
(Not for instructor
notes.)
Adjustment is economically and politically feasible
Potential growth is preserved at a satisfactory level

Debt Sustainability Analysis
The International Monetary Fund (IMF) Framework:
Market Access Countries (MAC) DSA

Required Negative
For high income countries Space
(Not for instructor
notes.)

Low Income Countries (LIC) DSF
For low income countries
Course: MDSx
Module: 8
Section: 2
Video #: 2
Video Title: Public Debt Burden Indicators
Gross Debt
A definition…
All liabilities that require future payment of interest and/or
principal by the debtor to the creditor, or all liabilities held

Required Negative
Space
(Not for instructor
in debt instruments. notes.)

Gross Financing Needs
A definition…
Overall new borrowing requirement (budget deficit) plus
debt maturing during the year.

Required Negative
Space
(Not for instructor
notes.)

Gross
Primary Debt
Financing
Needs
= Deficit + Service
Debt Burden Indicators
Used by IMF DSA Frameworks:
Gross Financing
Debt Stock
Needs Required Negative
Space
(Not for instructor
notes.)

Export Fiscal
GDP
Proceeds Revenue
Course: MDSx
Module: 8
Section: 3
Video #: 1
Video Title: Closed Economy Public Debt Dynamics
Government Budget Constraint
Government Expenditure Government Revenues

 non-interest (Gt) =  tax and non-tax (Tt) Required Negative
Space
 interest (it Dt) (Not for instructor
New debt (Dt - Dt-1) notes.)

𝑮𝑮𝒕𝒕 + 𝒊𝒊𝒕𝒕 𝑫𝑫𝒕𝒕−𝟏𝟏 = 𝑻𝑻𝒕𝒕 + (𝑫𝑫𝒕𝒕 − 𝑫𝑫𝒕𝒕−𝟏𝟏 )

to the left.
i = nominal interest rate

Government Primary Balance
The primary balance, PB is the difference between
revenue (T) and non-interest expenditure (G):

Required Negative
Space
(Not for instructor
notes.)
𝑷𝑷𝑷𝑷𝒕𝒕 = 𝑻𝑻𝒕𝒕 − 𝑮𝑮𝒕𝒕 Please do not adjust


to the left.
Public Debt Dynamics
In a Closed Economy:
𝑫𝑫𝒕𝒕 = 𝟏𝟏 + 𝒊𝒊𝒕𝒕 𝑫𝑫𝒕𝒕−𝟏𝟏 − 𝑷𝑷𝑷𝑷𝒕𝒕 Required Negative

Space
(Not for instructor
notes.)

𝑫𝑫𝒕𝒕 𝑫𝑫𝒕𝒕−𝟏𝟏 𝑷𝑷𝑷𝑷𝒕𝒕

= 𝟏𝟏 + 𝒊𝒊𝒕𝒕 −
𝒀𝒀𝒕𝒕 𝒀𝒀𝒕𝒕 𝒀𝒀𝒕𝒕
Required Negative
Space
𝐷𝐷𝑡𝑡−1 is divided by 𝑌𝑌𝑡𝑡 (Not for instructor
notes.)
We can express: 𝑌𝑌𝑡𝑡 = 𝑌𝑌𝑡𝑡−1 1 + 𝑔𝑔𝑡𝑡 (1 + 𝜋𝜋𝑡𝑡 ) Please do not adjust

We can also write: (1 + 𝑖𝑖𝑡𝑡 ) = 1 + 𝑟𝑟𝑡𝑡 (1 + 𝜋𝜋𝑡𝑡 )
r = real interest π = inflation rate based g = real growth

rate on GDP deflator rate
(1 + 𝑟𝑟𝑡𝑡 ) Required Negative

𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡 Space
(1 + 𝑔𝑔𝑡𝑡 ) (Not for instructor

notes.)

Course: MDSx
Module: 8
Section: 3
Video #: 2
Video Title: Closed Economy Public Debt Dynamics in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 8
Section: 3
Video #: 3
Video Title: Interest Rate - Growth Differential
Interest Rate - Growth Differential
The differential between the average interest rate paid on
government debt and the growth rate of the economy.
Required Negative
Space
(1 + 𝑟𝑟𝑡𝑡 ) (Not for instructor
𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡 notes.)
(1 + 𝑔𝑔𝑡𝑡 ) Please do not adjust
𝑟𝑟𝑡𝑡 − 𝑔𝑔𝑡𝑡
𝑑𝑑𝑡𝑡 − 𝑑𝑑𝑡𝑡−1 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡
1 + 𝑔𝑔𝑡𝑡
Key to assess government debt sustainability.

Positive: unfavorable debt dynamics
Negative: favorable debt dynamics
Required Negative
Space
(Not for instructor
notes.)

The higher the Interest Rate - Growth Differential (i > g), the text field positions.
larger the fiscal effort necessary to put the debt ratio on a

downward path.
An Example:
Projections
Required Negative
Space
(Not for instructor
notes.)

An Example:
Projections
Required Negative
Space
(Not for instructor
notes.)

Course: MDSx
Module: 8
Section: 3
Video #: 4
Video Title: Open Economy Public Debt Dynamics
In an Open Economy:
Dt = D + et ⋅ Dt
t
d f
Required Negative
Space
Debt stock at time t Exchange rate at time t (Not for instructor
notes.)

Dynamics of total debt in an Open Economy:
𝑓𝑓
𝐷𝐷𝑡𝑡 = 1 − 𝛼𝛼𝑡𝑡−1 1 + 𝑖𝑖𝑡𝑡 𝐷𝐷𝑡𝑡−1 + 𝛼𝛼𝑡𝑡−1 1 + 𝑖𝑖𝑡𝑡 1 + 𝜀𝜀𝑡𝑡 𝐷𝐷𝑡𝑡−1 − 𝑃𝑃𝑃𝑃𝑡𝑡
Required Negative
Space
(Not for instructor
notes.)
α - share of if- nominal ε – change in Please do not adjust
foreign interest rate on the exchange text field positions.
currency debt debt in foreign rate (+

in total debt currency depreciation)
In an Open Economy:
𝑓𝑓
1 − 𝛼𝛼𝑡𝑡−1 1 + 𝑖𝑖𝑡𝑡 𝛼𝛼𝑡𝑡−1 1 + 𝑖𝑖𝑡𝑡 1 + 𝜀𝜀𝑡𝑡
𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 + 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡
1 + 𝑔𝑔𝑡𝑡 1 + 𝜋𝜋𝑡𝑡 1 + 𝑔𝑔𝑡𝑡 1 + 𝜋𝜋𝑡𝑡
Required Negative
Space
(Not for instructor
notes.)
𝑖𝑖𝑓𝑓 nominal interest rates on foreign currency debt Please do not adjust
𝑖𝑖 nominal interest rates on domestic currency debt text field positions.
g rate of real GDP growth

π rate of inflation
α share of foreign currency debt in total debt
ε change in nominal exchange rate of local currency
In an Open Economy:
𝑓𝑓
1 − 𝛼𝛼𝑡𝑡−1 1 + 𝑟𝑟𝑡𝑡 + 𝛼𝛼𝑡𝑡−1 1 + 𝑟𝑟𝑡𝑡
𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡
(1 + 𝑔𝑔𝑡𝑡 )
Required Negative
Space
(Not for instructor
notes.)

1 + 𝑖𝑖 1+ 𝑖𝑖 𝑓𝑓
1 + 𝜀𝜀 text field positions.
𝑟𝑟 = −1 𝑟𝑟 𝑓𝑓 = −1
1 + 𝜋𝜋 1 + 𝜋𝜋
𝑟𝑟 is real effective interest rate 𝑟𝑟 𝑓𝑓 is real effective interest rate

on domestic currency debt on foreign currency debt
In an Open Economy:
1 + 𝑟𝑟𝑡𝑡𝑤𝑤
𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡
Required Negative
Space
(Not for instructor
𝑟𝑟𝑤𝑤 weighted average of domestic and foreign real effective notes.)
interest rates: Please do not adjust
𝑓𝑓
𝑟𝑟𝑡𝑡𝑤𝑤 = 𝛼𝛼𝑡𝑡−1 𝑟𝑟𝑡𝑡 + 1 − 𝛼𝛼𝑡𝑡−1 𝑟𝑟𝑡𝑡
Course: MDSx
Module: 8
Section: 3
Video #: 5
Video Title: Open Economy Public Debt Dynamics in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 8
Section: 4
Video #: 1
Video Title: Debt-Stabilizing Primary Balance
Debt-Stabilizing Primary Fiscal Balance
Is used…
To assess whether current fiscal policy is consistent with

a stable debt-to-GDP ratio.
Required Negative
Space
(Not for instructor
notes.)

To indicate how much effort is required to achieve a

stable debt ratio.
Derivation:
(1 + 𝑟𝑟𝑡𝑡 )
Closed economy: 𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡
(1 + 𝑔𝑔𝑡𝑡 ) Required Negative
Space
(Not for instructor
notes.)
1 + 𝑟𝑟𝑡𝑡𝑤𝑤 text field positions.
Open economy: 𝑑𝑑𝑡𝑡 = 𝑑𝑑𝑡𝑡−1 − 𝑝𝑝𝑝𝑝𝑡𝑡

Derivation:
𝑑𝑑𝑡𝑡 = 𝜙𝜙𝑡𝑡 𝑑𝑑𝑡𝑡 − 1 − 𝑝𝑝𝑝𝑝𝑡𝑡

Required Negative
Space
(Not for instructor
notes.)
𝑝𝑝𝑝𝑝 ∗ = 𝑑𝑑𝑡𝑡−1 (𝜙𝜙𝑡𝑡 − 1)

Course: MDSx
Module: 8
Section: 4
Video #: 2
Video Title: Debt-Stabilizing Primary Balance in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 8
Section: 4
Video #: 3
Video Title: Baseline Scenario
Baseline Scenario
Built around the Macroeconomic Framework:
The most likely scenario for countries based on current

and projected government policies.
Required Negative
Space
(Not for instructor
notes.)

The programmed macroeconomic adjustment for
program (or near-program) countries.
Medium-Term Projections
Assumptions in the Baseline Scenario:

Macroeconomic assumptions –
Growth projections
Cost of financing
Required Negative
Inflation Space
(Not for instructor
notes.)
Exchange rate
Fiscal projections –
Primary balance
Medium-Term Projections
GDP growth:
Cyclical position of the economy
Other medium-term factors
Cost of financing: Required Negative

Space
(Not for instructor
Inflation forecast and monetary policy stance notes.)

Developments in the global financial markets
Primary balance path:

Projected government policies
Course: MDSx
Module: 8
Section: 4
Video #: 4
Video Title: Baseline Scenario in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 8
Section: 5
Video #: 1
Video Title: Debt Level
High Debt
Related Risks:
Large primary fiscal surpluses to service it
Exacerbates vulnerability to shocks Required Negative

Space
(Not for instructor
notes.)
Exposure to a higher risk of a rollover crisis Please do not adjust

May be detrimental to economic growth

Debt Burden Indicators
Benchmarks:
Country specific definition of “low” and “high” levels of debt. Required Negative
Space
(Not for instructor
notes.)
Some countries run into difficulties at relatively low levels of Please do not adjust
debt.
IMF MAC Benchmarks for Classification
Public debt level (ratio to GDP):

50% for emerging markets
60% for advanced economies
Required Negative
Space
(Not for instructor
notes.)
Public growth financing needs (ratio to GDP):
10% for emerging markets
15% for advanced economies
Course: MDSx
Module: 8
Section: 5
Video #: 2
Video Title: Macro-Fiscal Stress Testing
Macro-Fiscal Stress Tests
Identifying Fiscal Risks:
Potential impact of adverse shocks on the debt path
Required Negative
Space
(Not for instructor
Macroeconomic risks comprise shocks to: notes.)

Economic growth text field positions.
Interest rates
Exchange rate
Primary balance
Contingent Liabilities
A definition…
Obligations of the government, whose timing and
magnitude depend on the occurrence of some uncertain

Required Negative
Space
(Not for instructor
future event outside the government’s control. notes.)

Contingent Liabilities
Arise from explicit or implicit guarantees to:

Public entities
Public-private partnerships
Required Negative
Space
(Not for instructor
notes.)
Depositors
Support to private companies deemed too big to fail

Course: MDSx
Module: 8
Section: 5
Video #: 3
Video Title: Macro-Fiscal Stress Testing in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 8
Section: 6
Video #: 1
Course: MDSx
Module: 8
Section: 7
Video #: 1
Module 9
The External Position
Opportunities and Risks of Globalization
A country’s position with respect to the rest of the world: trade

in goods and services, borrowing/lending
Reflection of underlying macroeconomic concerns
Adverse shocks
Topic Linkages
From Net Exports to the Current Account
National Accounts – Constant (or chained) prices:
NX = X - IM
NX CA
NOT
Comprehensive Comprehensive
National accounts Balance of

– Real domestic Payments
currency Nominal units –
US$
CA = NX + Primary
Primary and SecondaryIncome
+ Secondary Income
Primary Income § Cross-border compensation of employees

§ Investment Income
Secondary Income § Transfers

Savings-Investment Perspective
GNDI º Gross National Disposable Income
GNDI º Y + Primary
Primaryand
+ Secondary
SecondaryIncome
Income
NX = Y - C - I -
14 2 43 G
Domestic absorption
CA = GNDI - C - I - G
S = GNDI - C - G (cons )
CA = S - I
Residual measure of savings:
S{ = CA
{ + {I
Residual BoP National
Measure Accounts
CA < 0
Investment funded by saving from
rest of the world.
CA > 0
Investment in ROW funded by our
saving.
Concerns about Current Account Deficit:
Will foreign savers be repaid?
Are investment projects of sufficient quality?

Concerns about Current Account Surplus:
High Savings
Low confidence; uncertainty; pension systems doubts
Low Investment
Political uncertainty; structural impediments
Thailand: Current Account/GDP Thailand: Savings and
(in percent ) Investment/GDP (in percent)
45.0%
20.0%
40.0%
Savings
15.0%
Investment
10.0% 35.0%
5.0%
30.0%
0.0%
-5.0% 25.0%
-10.0% 20.0%
Source: Bank of Thailand / Haver Source: Bank of Thailand / Haver

Twin Deficits – Fiscal and External
CA = S - I
CA = S - I + S - IP P G G
CA = S - I P P
+ OB
{
Overall Balance
from Fiscal
Indonesia: Government Balance and Current Account

(in percent of GDP)
6.0%
Current Account
4.0%
Gov't Overall Balance
2.0%
0.0%
-2.0%
-4.0%
-6.0%
-8.0%
Q1.2005 Q1.2006 Q1.2007 Q1.2008 Q1.2009 Q1.2010 Q1.2011 Q1.2012 Q1.2013 Q1.2014 Q1.2015 Q1.2016
Source: Bank of Indonesia / Haver

Warning Signs:
Deterioration in current account reflects deterioration in public

S-I gap
Unsustainable public spending boom
Returns in public sector may be low

Terms of Trade
Terms of Trade
X = P *VOL( X )
$ $
X
IM = P VOL( IM )
$ $
IM
Small country: Bigger country:

Prices determined in world markets Can affect world price
Terms of Trade
PX$
$
= External Terms of Trade (TOT)
PIM
Terms of Trade by region
(index, 2010=100)
130
120
110
100
90
80
70 Western Hemisphere Europe Middle East Asia Africa
60
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Haver / IMF staff calculations

Terms of Trade
Impact of price changes on value (in DOLLARS):
Export side impact =(D%PX$ ) * X initial

$
Import side impact =(D%PIM$ ) * IM initial

$
The Real Exchange Rate (RER)
Real cost of domestic currency in terms of foreign currency
A market signal for resource allocation:
Producers – Export versus Home Goods
Purchasers – Imports versus Home Goods

Bilateral Real Exchange Rate:
Domestic Price
Et Pt Level
Qt = *
Nominal Exchange
Rate in units of FC
per unit of LC
Pt Foreign Price
Level
qt = et + pt - pt*
CA = NX ( RER) + Primary
Primaryand SecondaryIncome
+ Secondary Income
Net exports sensitive to movements in the RER
Primary and secondary income assumed exogenous

Current Account and Real Exchange Rate

115
110
Real exchange rate index
105
(app +, base=100)
100
95
90
-4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0%
← Current Account (CA) deficit Current Account (CA) surplus →

Current Account and Real Exchange Rate

115
110
CA
D( ) = -h * %DRER
Real exchange rate index
105 Y
(app +, base=100)
100
95
90
-4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0%
← Current Account (CA) deficit Current Account (CA) surplus →

The External Financial Account
General principle:
Flow balance (receipts – outlay) and financing must correspond
one-to-one.
CA = FA
CA < 0 Deficit: receive financing from rest

of world.
FA < 0 Incurring obligations (liabilities).
CA > 0 Surplus: provide financing to rest

of world.
FA > 0 Acquiring claims (assets).

Elements of Financial Account (Asset plus – BPM6):

Foreign Direct Investment (FDI)
Portfolio
Equity Shares
Marketable Debt
Other
Loans
Derivatives
Reserves and Related Items (Accumulation Plus)

Shifting Financial Conditions
Non-Reserve Financial Account:

A function of home and foreign interest rates (all else held
equal).
FA (non - res) = f (r , r ;other factors)

FA (Non-reserve)
*
Shifting Financial Conditions
FROM THE MONETARY MODULE

Domestic monetary policy Tighter Looser
External financing More Less
CONSISTENT WITH MONETARY MODULE

External financial conditions Tighter Looser
External financing Less More

Financial Account Balance
Signals of inappropriate levels of financial inflows:

Shift away from more stable and productive FDI flows
Toward more volatile debt flows
Temporary abundance of debt financing –may not last
High or rising country risk premiums
Prolonged drawdown of reserves

Module 10
The Real Exchange Rate and Competitiveness
Course: MDSx
Module: 10
Section: 1
Video #: 1
Key Ideas
Prices are key in external position analysis:

Real exchange rate sends important signals to market
participants
Policy makers must often take a view on the real exchange rate
Need to analyze whether the real exchange rate is correctly

valued
Course: MDSx
Module: 10
Section: 2
Video #: 1
Video Title: Nominal Effective Exchange Rates
Nominal Effective Exchange Rates
The bilateral exchange rate shows the price at which a
currency is exchanged for another.
ω1 ω2
 Domestic Currency Units   Domestic Currency Units 
Nominal Effective Exchange Rate =   *  Country 2 Currency Units  ...
 Country 1 Currency Units   
ω1 +ω2 +ω3 +.....=1
ω ' s : country weights

Example: Country A vis-à-vis US and Euro area

ωUS ωEURO
 Country's A currency   Country's A currency 
Nominal Effective Exchange Rate =   * 
 US Dollars  Euro
ωUS =0.7
ωEuro =0.3
X i + IM i
ωi =
X TOTAL + IM TOTAL
70
80
90
100
110
120
2006 - Jan
2006 - Apr
2006 - Jul
2006 - Oct
2007 - Jan
2007 - Apr
2007 - Jul
2007 - Oct
2008 - Jan
2008 - Apr
2008 - Jul
Source: IFS IMF / Haver Analytics

2008 - Oct
2009 - Jan
2009 - Apr
2009 - Jul
2009 - Oct
2010 - Jan
Nominal Eff. Exchange Rate Index(App +) = 
2010 - Apr
2010 - Jul
2010 - Oct
2011 - Jan
2011 - Apr
2011 - Jul
2011 - Oct
(2010=100)
2012 - Jan
2012 - Apr
2012 - Jul
2012 - Oct
2013 - Jan
2013 - Apr
ω1
2013 - Jul
Nominal Effective Exchange Rate Country A
 *
2013 - Oct
2014 - Jan
2014 - Apr
2014 - Jul
2014 - Oct
2015 - Jan
2015 - Apr
2015 - Jul
2015 - Oct
2016 - Jan
2016 - Apr
2016 - Jul
 Domestic Currency   Domestic Currency 
 Country 1 Currency Units   Country 2 Currency Units 
ω2
2016 - Oct
 ...
Course: MDSx
Module: 10
Section: 2
Video #: 2
Video Title: Real Effective Exchange Rates
Real Effective Exchange Rates
ω1 ω2
 Domestic Currency Units   Domestic Currency Units 
Nominal Effective Exchange Rate  Country 1 Currency Units  *  Country 2 Currency Units  + ...
   
ω ω
 Country 1 Price Index   Country 2 Price Index 
1 2
Relative Price Ratios -- weighted average  Domestic Price Index  *  Domestic Price Index  + ...
Real Effective Exchange Rate = Nominal Effective Exchange Rate * Weigthed Average Relative Price Ratios
65
75
85
95
105
115
125
2006 - Jan
2006 - Apr
2006 - Jul
2006 - Oct
2007 - Jan
2007 - Apr
2007 - Jul
2007 - Oct
2008 - Jan
2008 - Apr
2008 - Jul
2008 - Oct

2009 - Jan
2009 - Apr
2009 - Jul
2009 - Oct
2010 - Jan
2010 - Apr
2010 - Jul
2010 - Oct
Real Effective Exchange Rates
2011 - Jan
2011 - Apr
2011 - Jul
(2010=100)
2011 - Oct
2012 - Jan
2012 - Apr
2012 - Jul
2012 - Oct
2013 - Jan
2013 - Apr
2013 - Jul
2013 - Oct
2014 - Jan
Nominal and Real Effective Exchange Rate Country A
2014 - Apr
2014 - Jul
2014 - Oct
2015 - Jan
2015 - Apr
NEER
2015 - Jul
2015 - Oct
2016 - Jan
2016 - Apr
2016 - Jul
REER
2016 - Oct
EXCEL
Course: MDSx
Module: 10
Section: 3
Video #: 1
Video Title: External Balance Assessment
85
95
105
115
125
135
145
155
165
1980 - Jan
1980 - Oct
1981 - Jul
1982 - Apr
1983 - Jan
1983 - Oct
1984 - Jul
1985 - Apr
1986 - Jan
1986 - Oct
1987 - Jul

1988 - Apr
1989 - Jan
1989 - Oct
1990 - Jul
1991 - Apr
1992 - Jan
1992 - Oct
1993 - Jul
1994 - Apr
1995 - Jan
External Balance Assessment
1995 - Oct
1996 - Jul
1997 - Apr
1998 - Jan
(2010=100)
1998 - Oct
1999 - Jul
2000 - Apr
2001 - Jan
2001 - Oct
2002 - Jul
2003 - Apr
Real Effective Exchange Rate Country W
2004 - Jan
2004 - Oct
2005 - Jul
2006 - Apr
2007 - Jan
2007 - Oct
2008 - Jul
2009 - Apr
2010 - Jan
2010 - Oct
2011 - Jul
2012 - Apr
2013 - Jan
2013 - Oct
2014 - Jul
85
95
105
115
125
135
145
155
165
1980 - Jan
1980 - Oct
1981 - Jul
1982 - Apr
1983 - Jan
1983 - Oct
1984 - Jul
1985 - Apr
1986 - Jan
1986 - Oct
1987 - Jul

1988 - Apr
1989 - Jan
1989 - Oct
1990 - Jul
1991 - Apr
1992 - Jan
1992 - Oct
1993 - Jul
1994 - Apr
1995 - Jan
1995 - Oct
1996 - Jul
1997 - Apr
1998 - Jan
(2010=100)
1998 - Oct
1999 - Jul
2000 - Apr
2001 - Jan
2001 - Oct
2002 - Jul
2003 - Apr
Real Effective Exchange Rate Country W
2004 - Jan
2004 - Oct
2005 - Jul
2006 - Apr
2007 - Jan
2007 - Oct
2008 - Jul
2009 - Apr
2010 - Jan
2010 - Oct
2011 - Jul
2012 - Apr
2013 - Jan
2013 - Oct
2014 - Jul
Estimates whether a country’s exchange rate is in line with

macro fundamentals.
Plays central role in IMF surveillance:

Exchange rate overvaluations typically prelude sudden
stops
High CA deficit implies country is borrowing from abroad
Complementary approaches:
CA Approach
REER Approach
External Sustainability Approach
Analysis:
Positive (descriptive) analysis, to understand factors that affect the
Current Account (CA) and Real Effective Exchange Rate (REER).
Normative evaluation of current account and exchange rates.
Focus on role of policy distortions.
Course: MDSx
Module: 10
Section: 3
Video #: 2
Video Title: Current Account Approach
Current Account Approach
CA Actual CA Norm
REER
REER
gap
CA
CA (REER)
gap
CA
Course: MDSx
Module: 10
Section: 3
Video #: 3
Video Title: Current Account Approach, Step 1
Estimate regression for the CA balance:

^
CA
( ) = αˆ + X ' βˆ + Pol' γˆ
Y
Decompose CA norm and policy gaps contribution:
^
CA
( ) = αˆ + X ' βˆ + Pol * ' γˆ + ( Pol − Pol * )' γˆ
Y
EBA CA norm Contribution of Policy gaps

(CA predicted at Pol*) into deviation from CA norm
Pol* - recommended/desired level of policy variables

Total CA gap:
^
CA CA
CA gap = −[ − ( Pol − Pol * ) ' γˆ ] = Rgr.resid + ( Pol − Pol * ) ' γˆ
Y Y
Actual CA EBA CA norm Contribution of Policy gaps
( Pol − Pol * )' γˆ policies’ contribution into deviation of CA from the norm
Calculate REER gap:

1
REER gap = − ( CA gap )
η
Main regression for the CA balance:
^
CA
( ) = αˆ + X ' βˆ + Pol' γˆ
Y
Country W | CA, Step 1: Estimation
(3)
(1) (2)
Variables used in CA regression Contribution =
Coefficient Value
Coef*Value, (1)*(2)
Lagged Net Foreign Assets (NFA)/GDP 0.02 -33.98% -0.51%
Dependency Ratio -0.06 0.58% -0.03%
Population Growth -0.57 0.18% -0.10%
GDP Growth Forecasts in 5 years -0.43 -0.74% 0.31%
Lagged Public Health Spending /GDP -0.50 1.63% -0.82%
Cyclically Adjusted Fiscal Balance 0.47 -1.52% -0.72%
Constant -0.01 100.00% -1.40%
Other Factors 1.57%
Source: IMF Research Department / EBA CA dataset

Country W | CA, Step 1: Estimation
(1) Predicted CA (% of GDP) -1.7%
(2) Actual CA (% of GDP) -2.4%
(3) Unexplained Residual = (2) – (1) -0.7%

Course: MDSx
Module: 10
Section: 3
Video #: 4
Country W | CA, Step 2: Calculating Policy Gaps
1. Fiscal Policy Gap
Domestic Policy Gap (P-P*) -2.2%
World Policy Gap (P-P*)w -1.9%
Total Gap -0.2%
Contribution (Gap * Reg Coeff) -0.1%
2. Public Expenditure on Health Gap
Domestic Policy Gap (P-P*) 0.4%
Total Gap 0.6%
Contribution (Gap * Reg Coeff) -0.3%
3. Change in Reserve Gap
Contribution (Gap * Ref Coeff) -0.1%
4. Private Credit Gap
Contribution (Gap * Ref Coeff) 0.0%
5. Capital Control
Total Policy Gap contribution -0.6%
EXCEL
Course: MDSx
Module: 10
Section: 3
Video #: 5
Country W | CA, Step 3: Calculating the CA norm
(1) Predicted CA (% of GDP) -1.7%
(2) Total policy gap contribution -0.6%
(3) CA norm = (1) – (2) -1.1%

Course: MDSx
Module: 10
Section: 3
Video #: 6
NORM
   
CA CA
CA= gap  − 

   Y   Y 
−1.3%    
−2.4% −1.1%
1
REER gap = − ( CA gap )
η
Country W | CA, Step 4: Computing the REER adjustment necessary to close the CA gap
(1) Elasticity of current account to REER 0.13
(2) Inverse Elasticity = 1/(1) 7.7
(3) CA gap = actual – norm (% of GDP) -1.3%
(4) REER Gap = -(2) * (3) 10%

Source: IMF Research Department / EBA REER dataset
A negative CA gap (positive REER gap) indicates an overvaluation.

The exchange rate is 10% overvalued.
CA Actual CA Norm
REER
REER
gap
CA
CA (REER)
gap
-2.4% -1.1%
CA
Course: MDSx
Module: 10
Section: 4
Video #: 1
Video Title: Real Effective Exchange Rate Approach
REER Approach
Analysis for the REER gap based on EBA-REER is analogous
In EBA-REER the dependent variable is REER:

The regression excludes the cyclically adjusted fiscal balance.
The regression includes the interest rate differential as an indicator
of monetary policy .
Calculate REER gap:

REER gap = REER − [ REER − ( Pol − Pol * ) ' γˆ ]
Country W | REER, Step 1: Estimation
(3)
(1) (2)
Variables used in REER regression Contribution =
Coefficient Value
Coef*Value, (1)*(2)
Real interest rate differential interacted with

0.66 -0.01 -0.01
K openness
Private credit/GDP (rel to TRD PRT) 0.13 -0.07 0.01
Expected GDP growth in 5 years (rel to

1.86 -0.01 -0.02
TRD PRT)
Other factors … 4.53
Country W | REER, Step 1: Predicted REER

(1) Predicted REER (in log) 4.51
(2) Actual REER (in log) 4.53
Source: IMF Research Department / EBA REER Dataset

Country W | REER, Step 2: Calculating Policy Gaps
1. Change in Reserve
World Policy Gap (P-P*)w 0.1%
Total Gap -0.1%
Contribution (Gap * Reg Coeff) 0.2%
2. Public Expenditure on Health
Total Gap 0.8%
Contribution (Gap * Reg Coeff) 1.0%
3. Private Credit
Total Gap -0.9%
4. Real Interest Rate
Total Gap 0.1%
5. Capital Control
Total Policy Gap contribution 2.7%
Country W | REER, Step 3: Calculating the REER Gap
(1) Predicted REER (in log) 4.51
(2) Actual REER (in log) 4.53
(3) Total Policy Gap 2.7%
(4) Total REER Gap = (2)-(1)+(3) 4.0%
A positive REER gap indicates an overvaluation.

Course: MDSx
Module: 10
Section: 5
Video #: 1
Video Title: External Sustainability
NFAt − NFAt −1 = CAt + KGt + EOt
Capital gains from KA transfers,

valuation changes errors/omissions
KGt = EOt = 0
g + π (1 + g )
cat =nfat − nfat −1 + nfat −1
(1 + g )(1 + π )
g + π (1 + g )
ca = nfa
(1 + g )(1 + π )
Country W | ES, Step 1: Computing the CA which stabilizes NFA/GDP
GDP Growth 2.4%
Inflation 2.0%
NFA Benchmark -0.34
CA/GDP norm -1.4%
Source: IMF Research Department

Country W | ES, Step 2: Computing the REER Adjustment
(1) Elasticity of current account to REER 0.13
(2) Inverse Elasticity = 1/(1) 7.7%
(3) CA Gap = actual – norm (% of GDP) -1.0%
(4) REER Gap = -(2)*(3) 8%
Source: IMF Research Department
A negative CA gap (positive REER gap) indicates an overvaluation.

The exchange rate is 8% overvalued.
Course: MDSx
Module: 10
Section: 6
Video #: 1
Video Title: Overall Assessment
Country W External Balance Assessment Results
REER gap in Percent
CA Approach 10%
REER Approach 4%
ES Approach 8%
Course: MDSx
Module: 10
Section: 7
Video #: 1
Summarizing What We Have Learned
An exchange rate appreciation stimulates imports and leads to a

deterioration of the current account.
An exchange rate depreciation stimulates exports and leads to an

improvement of the current account.
External balance assessment:
 Tool used to assess the degree of exchange rate misalignment
 Indirect methods: focusing on the CA
 Direct method: focusing on the REER

Course: MDSx
Module: 10
Section: 8
Video #: 1
Module 11
External Sustainability and External Vulnerability
Course: MDSx
Module: 11
Section: 1
Video #: 1
Key Ideas
External financing tightening / “sudden stops” / currency crises
Output drop, high unemployment, import compression
Insolvent and illiquid countries are the most vulnerable

Course: MDSx
Module: 11
Section: 2
Video #: 1
Video Title: Balance of Payments and Debt Creating Flows
Balance of Payments and Debt Creating Flows
= NX + Primary and Secondary Income

CA
Primary Income Cross-border compensation of employees
Investment Income:
Receipts minus payments, including dividends,
repatriated profits and interest paid on foreign
debt
Secondary Income Transfers, including:

Government donations/aid
Worker’s remittances
Taxes, social contributions, other items.
Primary Income =-i f D f + other primary income
i f D f = interest payments on debt
i f = external (dollar) interest rate
D f = (gross) outstanding debt

The primary current account (CAP):
= NX + "Other primary income" + secondary Income

CAP
Primary Income = ioa t − idt f


Income on other
assets,labor
Secondary Income = trt


Transfers
Financial account:
Non-debt financing items (FDI, equity) and debt creating
flows.
Financial account = oaft − ∆dt f


Other net asset flows
Course: MDSx
Module: 11
Section: 2
Video #: 2
Video Title: Debt and the NFA
Debt and the NFA
Net Foreign Assets (NFA) –

also called the “Net International Investment
Position (NIIP)
Comprehensive measure –
NFA ALL accumulated claims on ROW minus ALL

ROW’s accumulated claims on us
What the rest of the world owes us minus

what we owe them.
Debt and the NFA
Let us recall:
NFA=
t NFAt −1 + CAt + KGt + EOt
KGt Capital gains from valuation changes
EOt KA transfers, errors/omissions
Assume for simplicity: KGi ,t = EOi ,t = 0

Debt and the NFA
NFA < 0 We owe rest of the world more

than it owes us.
NFA > 0 Rest of the world owes us

more than we owe it.
Debt and the NFA
Composition of NFA:
Course: MDSx
Module: 11
Section: 2
Video #: 3
Video Title: External Debt Dynamics
External Debt Dynamics
(1 + rt ) f
=
dt f
dt −1 − capt + oaft
(1 + gt )
Today’s foreign debt increases when:

Interest rate increase
Growth decreases
Primary current account increases
Other asset flows increase (borrowing to financing
outward FDI”)
Steps to get debt-GDP ratio dynamics:
1. Derive in dollar (or other currency) terms.
2. Scale by GDP.
CABt = FAt = (Non-debt creating inflows OAFt ) − Dt f − Dt f−1

    
Asset + Debt creating flows
Dt f − Dt f−1 =
−CABt + ( Non - debt creating inflows OAFt )
  
Asset+
Derive in dollar (or other currency) terms:

Split up FA – debt/non debt
Solve for change in debt
Dt − D = it D − CAPt + OAFt
f f
t −1
f f
t −1
Dt =
(1 + it ) D − (CAPt − OAFt )
f f f
t −1
Derive in dollar (or other currency) terms:

Split up FA – debt/non debt
Solve for change in debt
Split out primary current account and interest payments
Dt =
(1 + it ) D − CAPt + OAFt
f f f
t −1
Today’s foreign debt equals :

Yesterdays foreign debt capitalized
Minus primary current account balance
Plus other asset flows increase (borrowing to finance
outward FDI)
Course: MDSx
Module: 11
Section: 2
Video #: 4
Video Title: External Debt to GDP Ratio
External Debt/GDP Ratio
Steps to get debt-GDP ratio dynamics:
1. Derive in dollar (or other currency) terms.
2. Scale by GDP.
Dt =
f
(1 + it ) D − (CAPt − OAFt )
f f
t −1
Et * Dt f E D f
Et *(CAPt − OAFt )
=
(1 + it )
f t t −1
−
Pt Yt Pt Yt Pt Yt
Today’s exchange rate equals yesterday’s times one plus

growth rate.
Et Et −1 (1 + ε t )
=
Today’s nominal output equals yesterday’s times one plus

growth rate.
Pt Yt = Pt −1Yt −1 (1 + gt ) *(1 + π t )
(1 + it f ) Et Dt f−1 (1 + it f )(1 + ε t ) Et −1 Dt f−1

=
Pt Yt (1 + π t )(1 + gt ) Pt −1Yt −1
Et * Dt f (1 + it f )(1 + ε t ) Et −1 Dt f−1 Et *(CAPt − OAFt )

−
Pt Yt (1 + π t )(1 + gt ) Pt −1Yt −1 Pt Yt
Today Yesterday Today

Effective NOMINAL
(1 + it f )(1 + ε t )
interest factor =
Effective REAL (1 + it f )(1 + ε t )

(1 + rt ) =
interest factor = (1 + π t )
Growth adjusted REAL (1 + it f )(1 + ε t ) (1 + rt )

=
interest factor = (1 + π t )(1 + gt ) (1 + gt )
Final expression – debt dynamics in percent of GDP:
(1 + rt ) f
=
dt f
(1 + gt )
capt =nxt + ioat + trt

(1 + r ) (1 + r )
=dt dt −1 − pbt =f
dt d f
t −1 − capt + oaft
(1 + g ) (1 + g )
Fiscal External
Course: MDSx
Module: 11
Section: 2
Video #: 5
Video Title: Debt Dynamics and Stabilization in Excel, Part 1
Video Type: Excel
Debt Dynamics and Stabilization
(1 + rt ) f
=
dt f
(1 + gt )
EXCEL
Course: MDSx
Module: 11
Section: 2
Video #: 6
Video Title: Debt Dynamics and Stabilization in Excel, Part 2
Video Type: Excel
EXCEL
Course: MDSx
Module: 11
Section: 2
Video #: 7
Video Title: External Debt Sustainability
External Debt Sustainabilty
How we close the gap:

Exchange rate adjustment (“expenditure
switching”) –
As discussed in previous module
Caution –
If RER depreciates, debt ratio by itself also rises
(effective real interest rate).
Course: MDSx
Module: 11
Section: 3
Video #: 1
Video Title: Benefits and Costs of International Reserves
Benefits and Costs of International Reserves
Benefits and Costs of International Reserves
Benefits:
Insurance/buffer – as we will discuss
Higher reserves – more market confidence,
less speculation
Costs:
Opportunity cost/alternative use: retire public
debt, finance capital expenditure
Sterilized intervention – interest rate costs
Course: MDSx
Module: 11
Section: 3
Video #: 2
Video Title: Reserves and Financial Shocks
Reserves and Financial Shocks
External financial tightening:

Sterilized foreign exchange intervention
Prevent depreciation by selling reserves and purchasing

domestic money
Stabilize liquidity and interest rates through “sterilization”

which is offsetting increase in net domestic assets
Shield economy from disruptive short-term financial

volatility
The perils of foreign exchange intervention:

An risky but attractive option
Keeping interest rates low may encourage more financial

outflows
Financial tightening may last longer than expected
Reserves loss can be worse than originally envisaged

Speculation may hasten the depletion of reserves:

Speculators would like to buy foreign exchange while cheap
Anticipating a devaluation they will purchase reserves even

faster
Higher reserve holdings can help to buttress confidence
Even so sterilized intervention is only a short-run option

Course: MDSx
Module: 11
Section: 3
Video #: 3
Video Title: Reserves and Trade Shocks
Reserves and Trade Shocks
Decrease in Terms of Trade (ToT):

Similar logic to financial case
Shortfall originates in current account (not

financial account).
Lower export prices without intervention lead

to exchange depreciation
Sterilized intervention performs the same

smoothing over function
More perils of intervention:

Terms of trade decline temporary vs. permanent
Failure to adjust exchange rate may delay

needed shifts in composition of production
and spending
Once again sterilized intervention is not a

long-run option
Speculative dangers lurk here as well

Course: MDSx
Module: 11
Section: 3
Video #: 4
Video Title: The Reserve Adequacy Metric
Assessing Reserve Adequacy
Traditional Metrics:
Import cover for countries with relatively
closed capital accounts
Short-term debt for countries with large short-

term cross-border financial transactions
Broad money (M2) for countries with large

banking sectors and very open capital
accounts
IMF’s Assessment Method:
Short-term Other Broad

Percent (%) Exports
debt liabilities money
Revised Fixed 30% 20% 10% 10%
Float 30% 15% 5% 5%

Course: MDSx
Module: 11
Section: 3
Video #: 5
Video Title: The Reserve Adequacy Metric in Excel
Video Type: Excel
EXCEL
Course: MDSx
Module: 11
Section: 4
Video #: 1
Summarizing What We Have Learned
Different perspectives of External Vulnerabilities
Previous modules:
Composition of current and financial account.
External balance assessment of current account and
real exchange rate.
This module:
Debt sustainability
Reserves adequacy
Course: MDSx
Module: 11
Section: 4
Video #: 2
Video Title: [CONVERSATION]
Course: MDSx
Module: 11
Section: 5
Video #: 1
CA = FA(non - res)+ ΔInt'l Reserves

WE MAY NOT NEED THIS.
Stock / flow relationships – foreign exchange intervention.
Peg exchange rate more valuable than the market – spend

reserves.
Peg exchange rate that is cheap relative to the market –

accumulate reserves.
Increase in Terms of Trade (ToT):

Intervention to keep RER from appreciating
Financial inflows remain constant
Central bank must sell international reserves
Central bank will eventually run out of reserves

Key Ideas
Assess capacity to:

Service external obligations – external debt sustainability
Smooth currency fluctuations and weather headwinds –

reserve adequacy
Debt and the NFA
Fiscal sustainability:
Will public sector be able to cover principle and interest on debt – no

default, restructuring, or high inflation.
External debt sustainability:
Will country be able to cover principle and interest on debt – no

default, restructuring, or high inflation.
Debt and the NFA
Contractural Debt Elements of NFA:

Debt and the NFA
Resources to service debt come from:

Net exports
Inward transfers
Other asset income
Elements of the ‘primary current account’.

0%
100%
150%
200%
250%
300%
350%
400%
450%
50%
URY
BOL
PHL
PER
THA
ALB
BRA
MDA
CHN
COL
RUS
POL
ROM
IND
ARM
GEO
CHL
MYS
HUN
BGR
MEX
CRI
BIH
GTM
MKD
JOR
IDN
ZAF
TUR
KAZ
HRV
MAR
TUN
LVA
SLV
LTU
JAM
DOM
UKR
PAK
EGY
BLR
MUS
PAN
ECU
IMF’s Assessment Method:
Short-term Other Broad

Percent (%) Exports
debt liabilities money
Revised Fixed 30% 20% 10% 10%
Float 30% 15% 5% 5%
Note: Existence of capital controls allows for judgment in reducing

weights on “broad money” and “other liabilities”.
Module 12
Risks and Vulnerabilities
Course: MDSx
Module: 12
Section: 1
Video #: 1
Key Ideas
Assessing risks and weaknesses:

Events and outcomes that may happen
Bad shocks –
Source: Domestic/Homegrown versus External
Assessing the likelihood
Antecedents: Sowing seeds of future troubles
Transmission of shocks
Risk Assessment Matrix (RAM) to gauge dangers

Course: MDSx
Module: 12
Section: 2
Video #: 1
Video Title: A Taxonomy For Risks
A Rough Taxonomy for Classifying Risks
Likelihood Transmission/Expected
Nature of Risk
(High/Medium/Low) Impact
Qualitative and Quantitative

Source of Main Threat Time Horizon
Assessment
A Rough Taxonomy for Classifying Risks
Types of Risk:
Domestic Risks
Structural, monetary/inflation, financial, fiscal
Homegrown: perhaps sowing seeds of risk
External Risks
Global goods markets, world finance
External position: resilient or vulnerable

Course: MDSx
Module: 12
Section: 2
Video #: 2
Video Title: Homegrown Structural/Growth Risks in Excel
Video Type: Excel
Domestic/Homegrown Risks
World Output
(Index 2007=100)
Fall 2007 Fall 2008 Fall 2014
130
125
120
115
110
105
100
95
90
2007 2008 2009 2010 2011 2012 2013
Classifying Risks - Domestic/Homegrown
Structural/Growth:
EXCEL
Course: MDSx
Module: 12
Section: 2
Video #: 3
Video Title: Homegrown Monetary/Inflation Risks
Video Type: Excel
Monetary/Inflation:
Example: Ghana 2016, Article IV

Monetary/Inflation:
Inflation and/or inflation expectations off track
 Rising output gap
Possible antecedents –
 Central bank not seen as vigilant
 Monetary policy repeatedly fails respond to inflationary threats.
Course: MDSx
Module: 12
Section: 2
Video #: 4
Video Title: Homegrown Fiscal Risks
Fiscal:
Example: Zambia 2015, Article IV

Fiscal:
Without adjustment, public debt ratio on track to rise
If delayed, debt-stabilizing primary balance may be politically unattainable
r−g
pb(debt − stabilizing ) = d
1+ g
When adjustment occurs, austerity can mean lower demand output

Course: MDSx
Module: 12
Section: 2
Video #: 5
Video Title: Downturns in External Trade
Downturns in External Trade
Example: Philippines 2016, Article IV
Example: Belarus 2016, Article IV

Downturns in External Trade
Drop in export price – lower global demand/increase in commodity supply
Initial impact – lower net exports / current account
Broader impact – lower domestic demand, lower output
Lower employment
Exchange rate depreciation

Course: MDSx
Module: 12
Section: 2
Video #: 6
Video Title: Tighter External Finance
Tighter External Finance
Example: Guatemala 2016, Article IV

Increase in world interest rates or risk premium, due to…

Tighter monetary policy in advanced economies, or
Response to external deficit, real exchange rate overvaluation
Shocks may be related
Domestic financial system cannot be isolated
Both shocks tighten financial conditions and reduced demand at home.

Risk –
Increase in interest rate, risk premium
Transmission to core macroeconomic variables –

Higher interest rates mean lower domestic demand, output inflation
Partly offset by exchange rate depreciation, forced improvement in net

exports
Course: MDSx
Module: 12
Section: 3
Video #: 1
Video Title: Monetary to Fiscal and Financial Feedback
Feedback from Monetary to Fiscal/Financial

Course: MDSx
Module: 12
Section: 3
Video #: 2
Video Title: External to Fiscal and Financial Feedback
Feedback from External to Fiscal/Financial
Example: Philippines 2016, Article IV
Example: Belarus 2016, Article IV

Course: MDSx
Module: 12
Section: 3
Video #: 3
Video Title: Domestic Financial Fragilities
Domestic Financial Fragilities

Domestic Financial Fragilities
Fragilities based in domestic financial sector cannot be left out of the picture.
Potential weaknesses discussed in “Macrofinancial Linkages” can intensify

financial feedback.
Shock can also be based in the financial system as well.

Course: MDSx
Module: 12
Section: 4
Video #: 1
Video Title: The Risk Assessment Matrix
Risk Assessment Matrix (RAM)
Likelihood Transmission/Expected
Nature of Risk
(High/Medium/Low) Impact
Qualitative and Quantitative

Source of Main Threat Time Horizon
Assessment
Course: MDSx
Module: 12
Section: 4
Video #: 2
Video Title: Building a Risk Assessment Matrix
Building a Risk Assessment Matrix (RAM)
Course: MDSx
Module: 12
Section: 4
Video #: 3
Video Title: Risk Assessment Matrix Interpretations
Interpreting the Risk Assessment Matrix (RAM)

Macroeconomic Diagnostic

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Macroeconomic Diagnostic

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Macroeconomic Diagnostics (MDSx)

Supply and Productivity

What determines capacity to produce goods and

 Analytical tool – what are the supply side drivers of

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Labor – Working Age Labor Force

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Output Per Capita, Average Yearly Growth

0.04 United States

0.03 Selected European Countries Required Negative

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Key innovations of the 19th and 20th centuries:

Transportation Required Negative

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Health and sanitation

"Doing Business" and Total Factor Productivity - 2014

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Ln("Doing Business Indicator -- Distance to Frontier")

Sources: World Bank, Penn World Tables

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(1-⍺) = Labor’s share of output

%∆Y = %∆A(res ) + α *%∆K + (1- α ) *%∆L

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%∆A(res ) = %∆Y − α *%∆K − (1- α ) *%∆L

%∆Y = %∆A(res ) + α *%∆K + (1- α ) *%∆L

Step 1: Calculate capital stock K using ‘perpetual inventory’ method

Step 6: Calculate averages for several periods

Step 7: Interpret results

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It = Investment/GDP ratio * Yt Required Negative

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Output Total Factor

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[%∆Y − %∆L] = %∆A(res ) + α [%∆K − %∆L]

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TFP is important to raise the standard of living.

Even if capital accumulation speeds up, the elasticity will

%∆Y = %∆A(res ) + α *%∆K + (1- α ) *%∆L

Realistic – not too optimistic or pessimistic?

Implied Total Prospective Prospective Prospective

%∆Y = %∆A(res ) + α %∆K + (1- α ) %∆L

%∆A(res ) = %∆Y − α %∆K − (1- α ) %∆L

%∆Y = %∆A(res ) + α %∆K + (1- α ) %∆L

%∆Y = %∆A(res ) + α %∆K + (1- α ) %∆L

%∆A(res ) = %∆Y − α %∆K − (1- α ) %∆L