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00206BBA28D1200309114938 Slide 1 Assessment 2 Assessments Due 7014 8014 Mid-Semester test Week 7 in class 25% 25% Essay (hand in+turnitin) Week 9 in class 10% -- Mini Research Workshop Week 12 in class 10% 20% Final exam TBA 55% 55% 3 Topics ❖ Topic 1 (Week 1-3). Quick refresher on ISLM, ASAD and dynamic macroeconomic models ❖ Topic 2 (Week 4-5). The design and implementation of monetary policies; unconventional monetary policy instruments; the optimal monetary policy; ❖ Topic 3 (Week 6). The design and implementation of macroprudential regulation ❖ Topic 4 (Week 8-9). The design and implementation of fiscal policies; government debt and inflation; the intertemporal government budget constraint. ❖ Topic 5 (Week 10-11). The design and implement of exchange rate policies; The impossible trinity; Optimal currency areas and the euro; 4 Week 1 Refresher of the IS- LM model, and the role of expectations PowerPoint to accompany: Think macroeconomics as… 6 Questions: What are the things come to your mind when you think about macroeconomics? Think macroeconomics as… 7 Questions: What are the things come to your mind when you think about macroeconomics? • How output (GDP) is determined? • What drives inflation? • Is 5% of population unemployed a problem? • How GDP is related to inflation? • Why central bank lowers interest rate and government consolidate budget? Think macroeconomics as… • Markets: • Goods market • Money market • Labour market • Financial market 8 • Decisions: • Consumption decisions • Investment decisions • Fiscal/Monetary decisions • Export/Import decisions Questions: What are the things come to your mind when you think about macroeconomics? • How output (GDP) is determined? • What drives inflation? • Is 5% of population unemployed a problem? • How GDP is related to inflation? • Why central bank lowers interest rate and government consolidate budget? The Goods Market The total demand for goods is written as: Z C I G X IM + + + − 9 or in a closed economy: Z C I G + + Australian investment (23% of GDP) is less than half of consumption (60%) but much more volatile Investment is more volatile than consumption. Consumers do not increase consumption more than one for one with increases in income. Investment, on the other hand, may exceed an increase in current sales. Consumption and investment usually move together. Both components contribute roughly equally to fluctuations in output over time. Questions • What are the key factors drive consumption? • What are the key factors drive investment? 11 Questions • What are the key factors drive consumption? • What are the key factors drive investment? 12 C C YD= ( ) ( )+ Y Y TD − ( , )I I Y r= The effects of two factors affecting investment: ▪The level of sales (+) ▪The real interest rate (-) ▪We shall assume that G and T are also exogenous. Questions: What is real interest rate? Nominal Versus Real Interest Rates it = nominal interest rate for year t. rt = real interest rate for year t. (1+ it): Lending one dollar this year yields (1+ it) dollars next year. Alternatively, borrowing one dollar this year implies paying back (1+ it) dollars next year. Pt = price this year. Pet+1= expected price next year. expected rate of inflation equals 13 e t e t t t P P P −+1 Consequently, ( )1 1 1 + = + + r i t t e t If the nominal interest rate and the expected rate of inflation are not too large, a simpler expression is: e t t tr i − Nominal and Real Interest Rates in Australia since 1976 • Central banks can only control the short-run nominal interest rate • For the time being lets assume ?? ? = 0 so i = r for simplicity --- = nominal interest rate – actual future inflation rate 2019 Goods market equilibrium: IS curve Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z: Y Z= Then: ? = ?(? − ?) + ?(?, ?) + ? An increase in taxes (or a decrease in G) shifts the IS curve to the left. A fall in business confidence reduces investment and shifts IS curve to the left Shifts of the IS Curve ? = ?(? − ?) + ?(?, ? − ??) + ? 0.09 0.11 0.13 0.15 0.17 0.19 0.21 0.23 0.25 4.00 6.00 8.00 10.00 12.00 14.00 16.00 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 M /$ Y . R a tio o f m o n e y to a n n u a l n o m in a l in c o m e . i. I n te re s t R a te ( % ) Ratio of money to nominal income (M/$Y) Interest Rate (i) The Demand for Money ▪ Money, which can be used for transactions, pays no interest. There are two types of money: *currency *current account deposits ▪ Bonds, pay a positive interest rate, i, but they cannot be used for transactions. (Term deposits are equivalent) Money Market Type of Asset M YL id = $ ( ) The demand for money: ▪ increases in proportion to nominal income ($Y), and ▪ depends negatively on the interest rate (L(i)). Questions: Why money demand is important? Money Supply, Monetary Policy and Open-Market Operations The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open-market operation in which the central bank buys (sells) bonds and issues(withdraws) money increases(reduces) both assets and liabilities by the same amount. Monetary Policy and Open-Market Operations An increase in the supply of money leads to a decrease in the interest rate. The Effects of an Increase in the Money Supply on the Interest Rate Equivalently, if the central bank wants to lower the interest rate, it must increase the supply of money Equilibrium in the money market: LM relation The interest rate is determined by the equality of the supply of and the demand for money: M = nominal money stock $YL(i) = demand for money $Y = nominal income P = price level i = nominal interest rate $ ( ) ( )dM M YL i PYL i= = The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i: M P YL i= ( ) Deriving the LM Curve Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping. Shifts of the LM Curve An increase in money leads the LM curve to shift down. M P YL i= ( ) Putting the IS and the LM Relations Together ▪ Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. ▪ Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. ▪ When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium. IS relation: Y = − + +C Y T I Y i G( ) ( , ) LM relation: M P = YL i( ) The IS-LM Model Questions: How fiscal and monetary may affect the economy? Fiscal Policy, Activity, and the Interest Rate ▪ Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit. ▪ An increase in the deficit is called a fiscal expansion. An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate. Monetary Policy, Activity, and the Interest Rate ▪ Monetary contraction, or monetary tightening, here refers to a decrease in the money supply. ▪ An increase in the money supply is called monetary expansion. Monetary expansion leads to higher output and a lower interest rate. Using a Policy Mix ▪ Monetary and fiscal policy is never conducted in complete isolation.The combination of monetary and fiscal policies is known as the monetary-fiscal policy mix. ▪ To see the importance, consider fiscal contraction (G or ↑T), with 2 alternative approaches to monetary policy: 1. Central bank keeps M constant 2. Central bank keeps i constant at i0 (Most central banks use 2. They decide on i and allow M to be determined endogenously in market equilibrium) Five Australian Policy Mixes, 1986-2012 3. Howard-Macfarlane Tight fiscal, easy monetary. 2. Keating-Fraser Easy fiscal, easy monetary. 1. Hawke- Johnston/ Fraser Tight fiscal, tight monetary. 4. Howard- Macfarlane/ Stevens Tight fiscal, tight monetary 5. Rudd/Gillard- Stevens Easy fiscal, easy monetary. Expectations 28 Ben Wang 2013 Questions: • How do you form your expectations, say on interest rate? inflation? • Do people’s expectations about future matter to the performance of the economy? • If yes, in what way? The Stock Market Standard & Poor’s ASX 200 Stock Price Index, in Nominal and Real Terms, 1980-2012 Australian nominal stock prices have been multiplied by about 9 since 1980. Real stock prices have only multiplied by almost 2.5. After the October 1987 stock-market crash, real stock prices went through a slump until 1993.The upward trend ended in Australia in September 2007, and the nominal index fell by 45 per cent in the next 1.5 years, while the real index fell by 49 per cent. Stock prices follow a random walk if each step they take is as likely to be up as it is to be down. Their movements are therefore unpredictable. Major movements in stock prices cannot be predicted. But we can look back and explain how macro news has affected the market. Questions: How do you think the share price of Apple is determined? Stock Prices as Present Values The price of a stock should equal the present value of future expected dividends $ $ ( ) $ ( )( ) Q D i D i it e t t e t t e t = + + + + + + + + 1 1 2 1 1 11 1 1 ▪ In real terms, 1 2 1 1 1 1(1 ) (1 )(1