Macro Economics. Presented By: Priyank Patwari Shikha Rawat F IN G Y A A N S E S S I O N 2

Transcription

1 and present Macro Economics Presented By: Priyank Patwari Shikha Rawat F IN G Y A A N S E S S I O N 2 1

2 Basic Introduction Overall Demand and Capacity of an Economy Slowdown, Recession, and Depression Slowdown inflation rate decreases and unemployment rate increases (Philips curve!!) If AD> LRAS, it means boom and a rise in inflation Measure of Inflation in India WPI (one of the price indices) CPI is used to measure cost of living changes in the economy.

3 What is GDP? GDP refers to what is totally produced and not what is sold Nominal GDP vs. Real GDP (base year for India ); GDP Deflator = Nominal GDP*100/Real GDP 3 methods of measuring GDP Expenditure method - total spending on domestically produced goods and services in economy C+I+G+X-M - GDP at market prices Income method - adds the incomes accrued to all factors of production - GDP at factor cost Output method - adds the value added at each stage of production Net Factor Income from abroad = Factor incomes earned by Residents abroad Factor Incomes earned by foreigners here. GNP = GDP + NFIA

4 More about GDP GDP at market prices = GDP at factor cost?? GDP (mp) = GDP (fc) (Indirect taxes-subsidies) GDP response to investment is called Incremental Capital Output Ratio (ICOR India Vs. China); crucial determinant of rate of increase in GDP NDP = GDP Depreciation National Income is factor incomes accrued to residents of country. National Income = GNP (fc) Depreciation Disposable Personal Income What about transfer payments, transactions in Black market and second hand market, unorganized sector, domestic work, etc.

5 Famous Twin Deficit Theory NI = C+I+G+X-M; DP = C+S; DP = NI - T Investment is sum of private savings, government savings, and foreign savings I = S + T-G + M-X X>M implies investment abroad by using excess foreign exchange. M>X implies decrease in forex which decreases opportunities for investing abroad T-G is called fiscal balance while M-X is current accounts balance (when +ve, then deficit, when ve then surplus)\ Twin Deficit: Higher the fiscal deficit, more it will spill over to current account deficit, if I and S are stable (1991 economic crisis)

6 Introduction to Interest rates and Money Supply Interest Rates price of money Real money demanded = Transaction demand (+ve function of GDP and ve function of interest rates) + precautionary demand (for unseen future) + speculative demand (varies inversely with interest rates) If interest rates are high, people expect them to go low i.e. bond prices will rise from current low position, so invest in bonds (hence demand less money). Real Interest rates = Nominal interest rates inflation rate In a period of slowdown, interest rates fall as demand for money is low as well as expected inflation rate. In booming economy reverse happens.

7 Interest Rates (continued) Call Money market rates: rates at which one bank borrows from other bank in the short-term, ranging from call (repayable on demand) to 72 hours Repo Rate: Discount rate at which a central bank repurchases government securities from the commercial banks, depending on the level of money supply it decides to maintain in the country's monetary system. Reverse Repo Rate Rates on Treasury bills and long term government bonds refer to yields on short term and long term government securities Prime Lending Rate (PLR) is rate at which banks lend to their favored customers

8 Inflation Inflation is caused by 3 factors: Demand Pull inflation rise in C, I, G, and X-M makes price and output rise. If economy is operating near full capacity then price rise is steeper Cost Push Inflation rise in costs for firms without rise in productivity like labor costs, material costs. This will raise prices along with decrease output. Expectation Driven If people expect inflation to happen, they revise their prices which lead to actual inflation. Inflation refers to continuous rise in prices, not one shot increase in prices. Increase in money supply by government help in rising inflation Inflation leads to distribution of wealth from fixed income to those having real incomes and from lenders to borrowers. High inflation lowers savings and people invest money in gold, land, etc. which keep pace with inflation.

9 Philips Curve Philips Curve Unemployment and inflation are inversely related Exceed Full employment tight labour market higher wages higher prices

10 Introduction to economic linkages As X decreases, so I for X decreases => less people are employed => C decreases. Since C,I, and X are all slowing so government is collecting less tax revenue and hence G will also slow down (East Asian Crisis, 1997) Marginal propensity to consume (mpc) = change in C in response to change in Disposable Income C has 2 components: induced component, which can be induced by macroeconomic policy variables like interest rates and tax rates, and autonomous component driven by sentiment (not affected by policies) Troubles of Japanese economy (due to manufacturing burst) US slowdown (due to IT bubble burst) of 2001

11 Fiscal Policy Government expenditure (G) and T (taxes) most important policy variables of fiscal policy Fiscal Deficit = Total Expenditure Total Revenue Expenditure: Infrastructure, Defence etc Revenue: Taxes, Fines, Toll collection etc Primary deficit = fiscal deficit - interest payments (a better measure of fiscal profligacy) Increase in G and lowering of T fiscal stimulants (effect on aggregate demand)

12 Some concepts related to Fiscal Policy Multiplier- Final effect on Output more than the initial change in G Crowding Out Phenomenon: G can crowd out I. An increase in G leads to an increase in Y which in turn leads to an increase in Money Demand. Therefore Interest Rates rise and I falls. Hence effect on Output mitigated.

13 Monetary Policy Interest rates, exchange rates and money supply important monetary policy variables Monetary policy changes first impact financial variables like interest rates, exchange rates. They then affect C and I which then affect GDP and Prices

14 Linkages related to Monetary Policy If money supply increases, then interest rates go down. Why? People will demand bonds more and hence bond prices go up, hence. Vice versa is also true Decrease in interest rates causes prices of long lived assets like stocks, bonds and real estate to rise and hence people become wealthier. The collateral which can be given against loan suddenly increase. Increase in asset prices makes individual feel wealthier and hence C rises. Depreciation of local currency makes imports expensive and hence domestic spending increases (X-M as a whole increases)

15 More Concepts Fall in interest rates encourages more investment by companies. Due to rise in value of collateral, bank loans become easy (I increases) High powered money/reserve money = monetary base = currency in circulation with public + reserves Money Supply = Currency + Deposits Money Multiplication by Banks : concept of money multiplier M = MB. m

16 Liquidity Trap Liquidity Trap: When interest rates are close to zero, a further cut is not possible Hence, Monetary Policy to raise I and hence AD by cutting rates is not possible

17 Problems for RBI Targets for RBI: interest rates or money supply or exchange rates The Impossible Trinity When rupee is appreciating against dollar and RBI stabilizes that, money supply goes up and vice versa. So both cannot happen simultaneously. If it wants stable exchange rate, it has to tolerate more inflation. Targets of RBI have been dynamic depending upon the economic conditions

18 External Account Balance of Payments is the difference between receipts of residents of country from foreigners and payments by residents to foreigners Trade account: balance from export and import of merchandise Invisibles: services, investment income & transfer payments Current account = trade account + invisibles Capital account includes export and import of capital

19 Introduction to Exchange Rate Demand for exports and imports exchange rate Real Exchange rate = Nominal Exchange Rate * Foreign price / Domestic price. Real Exchange Rate captures the competitiveness of a country s trade by considering relative price changes between countries. Net Exports go down if home GDP increases, go up as foreign GDP increases or real exchange rate depreciates

20 Exchange Rate Exchange rate can be determined by purchasing power parity (PPP) theory: in long run, exchange rates adjust to reflect differences in countries inflation rates. Exchange rate will be in equilibrium when their domestic purchasing powers at that rate are equivalent. Interest rate parity theory says that differential of interest rates determine future expected exchange rates. Fixed Rate Regimes and Floating Rate Regimes In managed float exchange rate regime, RBI allows initial rate to be determined by market forces but later steps in to maintain its orderly behavior.

21 Important Linkages Fixed Rate Regime & External Account is negative: pressure on rupee to depreciate -> RBI will sell forex to stop that -> monetary base decreases -> interest rates rise -> GDP slows down ->imports come down ->X-M improves Rise in interest rates attracts more capital from outside, so balance improves Sensitive issue of Capital Account Convertibility in India

22 Yield Curve and Recessions It plots the yield of a bond against the time to maturity Usually upward sloping because people feel the long term bonds are riskier and hence demand higher rate of interest When short rates rise above long rates the yield curve is said to be inverted Inverted yield curves are widely considered as an indicator of recession. Why? They have successfully predicted 7 out of 8 recessions since 1960 in the US economy