MACROECONOMICS I

CLASS 1: INTRODUCTION (M0)

1. ECONOMIC GROWTH AND DEVELOPMENT

How do we measure economic growth?

- GDP: everything that is produced in a country in a year
- Real GDP:
i Take out any price effects only to look at real terms (use deflator)
ii Transform to logarithms to make smoother series and and easier interpretation
- Growth: Difference between to different years of GDP. We take the log of GDP in a year minus the log of the
year before and then multiply it to 100 or take the percentage of GDP in a year and divided by the percentage
of the year before.
- A double-dip recession is definite by two negative periods

Why do some countries grow faster than others?

- Real GDP per cápita (Y/N). If population growth and GDP maintains, GDP per capita is lower.

Why should we care about long-run growth?

Is income per capita correlated with well-being? Yes, a positive correlation. This relation is concave, at the
beginning having more money increases happiness (SWB), but later, at some point, it stabilizes and more money
does not make you happier.

What are the drivers of growth (how to grow)?

1. Population growth
2. Capital accumulation (HUMAN and physical)
3. Technological process
4. Role for institution (education, corruption, etc.)

What should/ shouldn’t governments do to foster growth?

Positive correlation between income per capita and years of schooling.
Negative correlation between ipc and corruption

2. ECONOMIC FLUCTUATIONS

What are Economic Fluctuations?

Deviation from trend: %Ycyclet= (logYt - logYtrendt) * 100
Cycle: Sometimes we are above (expansion; peak) the trend and sometimes under (contraction; trough) the trend
(fluctuations).

Long vs. Medium vs. Short Run

- Long-run is about what affects the trend (e.g. innovations, education, institutions,…)
- Short-run is about Temporary deviations from trend (Expansions and contractions)
- Medium-run Situation when economy is at the trend. We normalize trend to a constant - Call it “natural level”
(the amount of output that the economy can produce at normal times; at the trend) of Y or Y n
3. POLICY INTERVENTIONS

1) Private markets are efficient (they will correct the market itself)
➡ No reason for policy intervention
2) Private markets are inefficient, but public policies...
• Are largely ineffective (small and temporary effects)
• Could be inefficient themselves (government could make things worse)
3) Private markets are inefficient, but public policies..
• Are effective and efficient to correct market imperfections

VIDEO: IS-LM MODEL IN CLOSED ECONOMY (M0)

M0: REVIEW

IS-LM Model

The IS-LM model is a formal framework that will allow us to study short-run (prices are FIXED) fluctuations in the
economy. It is the reference framework used by central banks and police institutions to study the effects of
macroeconomic policies.
The model has 2 key components:
- The IS equation: equilibrium in the goods market
- The LM equation: equilibrium in the financial market
Together they describe the equilibrium in the goods and financial market. In particular the 2 variables of interest:
output/GDP (Y) and interest rate (i).

1. THE “IS” CURVE → SHIFTS

IS Equation: Equilibrium in goods market

GDP: Total of goods and services that are produced in an economy in a given year

Demand for Goods:

Y - T=Disposable income
Supply of Goods (production): Y
Equilibrium in Market for Goods (Demand=Supply): Z = Y IS CURVE:

IS Equation: Graphical Representation

2. THE LM CURVE → MOV. ALONG CURVE

LM Equation: Equilibrium in FINANCIAL Market

Money Demand:

• P = Price Level
• Y = Real Income
• L (i) = Liquidity Preference (negative relation between interest rate and L), i (increase) – opportunity cost
(increase)

Interest Rate (i): Opportunity cost of holding money rather than Bonds

Money supply: Central bank controls money supply to keep interest rate at desire level:

Equilibrium in money market:

LM Equation: Graphical Representation

3. IS-LM TOGETHER

.
A

Point A: Income (Y) and interest rate (i) at which both the market for goods and the financial market are in
equilibrium.

The intersection between the financial market and goods market is where they both are in equilibrium.
What changes this equilibrium:
• Along the curve: Y, i
• Shifts a curve: T, G, P, C0, I0

EXAMPLES

1. Fiscal expansion (= higher level of output)

2. Monetary expansion
VIDEO: CONCEPTS OF THE OPEN ECONOMY (M1+M2)

M1: BASIC CONCEPTS

1. THE BALANCE OF PAYMENTS (Net Exports, CA, KA)

It’s the record of goods and financial flows with rest of the world.

Two components:
- Current Account (CA): record of transactions of goods and services
- Capital Account (KA): record of financial transactions

Double-entry book-keeping: entry in CA → entry in KA

Balance of Payments: An Example

A country has performed the following transactions with the rest of the world:
(#1) Sold goods for 100€, paid with foreign currency
(#2) Purchased goods from abroad for 150€, paid with domestic currency
(#3) Receive income on investment abroad for 25€, in domestic currency .

+/-

+/-

→ ALWAYS!

Implications of Balance of Payment

A country with:
• Current Account DEFICIT (e.g. with Imports >> Exports) is reducing its foreign assets/ increasing its debt with
the rest of the world
• Current Account SURPLUS (e.g. with Exports >> Imports) is increasing its foreign assets/ reducing its debt
with the rest of the world.

Large TRADE imbalances → INSTABILITY (debt with foreigners keeps increasing)

2. EXCHANGE RATES (Nominal vs. Real)

• Nominal Exchange Rate (E)

Price of domestic currency in terms of foreign currency

E ↑:︎ Nominal Exchange Rate Appreciates (our currency is more expensive)

E ↓: Nominal Exchange Rate Depreciates (our currency is cheaper)

• Real Exchange Rate (ε︎ )

Price of domestic GOODS in terms of foreign GOODS

where:

P: Price of domestic goods (in domestic currency)

P*: Price of foreign goods (in foreign currency)
E: Nominal exchange rate
P x E : Price of domestic goods expressed in foreign currency
ε ↑: Real Exchange Rate Appreciates
ε ↓ : Real Exchange Rate Depreciates

M2: THE GOODS MARKET

1. GOODS MARKET IN AN OPEN ECONOMY – IS Curve

Market for Goods in an Open Economy

Closed Economy:

Open Economy:
In the Market for Goods in an Open Economy it must be that:

- How to get Z (Demand for Domestic Goods)?

STEP 1: Find A (domestic demand satisfied by domestic goods)

STEP 2: Add X (Exports)

We need to correct small imprecision:

C+I+G: measured in domestic goods
X: measured in domestic goods
IM: measured in foreign goods

... need to express imports in terms of domestic goods

IM x 1/ε︎: imports measured in domestic goods

The Demand for Domestic Goods

1) Domestic Demand (D)

2) Demand for Imports

3) Demand for Exports

Demand: Graphical Representation

DD : C ( Y - T ) + I ( Y, r ) + G
• Increasing in Y

AA : DD - IM ( Y , ε︎ )
• Flatter than DD

ZZ : AA+ X ( Y*, ε︎ )
• Parallel to AA

Trade Balance (Net Exports)

NX = X – IM/ε

CLASS 2: TRADE STATISTICS (M1+M2)

THE OPEN ECONOMY

International flows has shaped history...

Some examples:
1. Silk road
2. America’s “discovery”
3. British Empire
4. Creation of the European Union (we want free trade of goods services and people)

Large international flows of

- Goods and Services (Trade)
- Capital (Financial Flows)
- People (Migration)
• Trade of Goods and Services

- Spain has a much more open economy than USA

- USA has a huge trade deficit, local consumption is most of their GDP, which means they don’t depend
that much of other countries (closed economy).
- China’s exports has grown 5 times the last 50 years but it is just a 20%, so it is still a pretty closed
economy

• Not All Countries are Equally Open…

Openness = (Exports + Imports) / GDP, not the same as X-IM (trade balance)

• Other indicators of globalization:

- Foreign direct Investment → volatile, movements of capital (K)
- Foreign residents in spain → movements of labor (L)

GDP growth: △%Yt= ln Yt - ln Yt-1

≈ (Yt - Yt-1) / Yt-1
VIDEO: FISCAL POLICIES AND EXCHANGE RATE POLICIES (M3+M4)

THE OPEN ECONOMY

M3: THE EFFECTS OF FISCAL STIMULUS PACKAGES (Fiscal Policies)

Motivation

• Many countries respond to economic crisis with stimulus packages “or fiscal expansion (increasing
Government expenditure or reducing Taxes). What happens when economies are OPEN to trade?
• Two examples:
• Example 1: Domestic country implements stimulus
• Example 2: Foreign country implements stimulus

Equilibrium in the Open Economy

IMPORTANT: For now we assume that the interest rate and the exchange rate are fixed

Equilibrium: Graphical Representation

Equilibrium: Y = Z
Equilibrium point
1. Draw the 45⁰ line (where Y=Z)
2. Determine Y0 where ZZ crosses the 45⁰ line
3. Determine Net Exports (NX) in Equilibrium

Demand for domestic goods: ZZ

Domestic Demand: DD

Equilibrium can feature:

NX=0 (Balance trade)
NX<0 (trade deficit IM>EX)
NX>0

EX. 1: Stimulus in Domestic Country

1. Suppose Initial point is Y0= YTB (balance trade)

2. The government increases public expenditure G (purchases more) → increase in demand for domestic
goods → (increase in production)
 Parallel Shift of DD and ZZ: effect of G↑ on
total and domestic demand is the same!

RESULT:
• Output increases.
• Trade Balance DETERIORATES
• Now we have a trade DEFICIT

Effect is smaller than in CLOSED Economy: because we spend in both domestic and foreign goods

EX. 2: Stimulus in Foreign Country

1. Suppose Initial point is Y0= YTB

Increase in Foreign Demand: Y*

• Demand for Domestic Goods shifts upward (ZZ )

• Domestic Demand (DD) does not change!
• Net Exports shifts upward (NX )

RESULT:
• Output increases.
• Trade Balance IMPROVES
• Trade balance SURPLUS
 M4: EXCHANGE RATE POLICIES (Currency intervention)

Motivation

So far we assumed the exchange rate was kept constant (exogenous)… but sometimes countries alter the
exchange rates.

Examples
• The failure of the Gold Standard, Bretton Woods, EMS, etc
• These days: US-China currency war (???)

Question: How do currency appreciations (exchange rate goes up, countries can but more of the goods and
currency of other countries) /depreciations affect net exports and GDP?
*In these cases, we talk about real exchange rate because it’s equal to the nominal exchange rate.

Net Exports and Real Exchange Rates

- Exports (X) depend positively on foreign income (Y*) and

negatively on the real exchange rate (ε)—> our goods are
more expensive than foreign goods (ours can purchase more
of foreign goods; increases imports)
- Imports (IM) depend positively on domestic income (Y) and
positively on he real exchange rate (ε).

AMBIGUOUS EFFECT of changes in the real exchange rate. Suppose ε︎ ↓ (real depreciation)
A. Domestic goods are cheaper, so X ↑ and NX ↑
B. Foreign goods are more expensive, so IM ↓ and NX ↑
C. Foreign goods are worth more in terms of domestic goods, 1/ε︎ ↑ , so NX ↓

ASSUMPTION: Marshall-Lerner Conditions (ML)

Elasticities of Demand for Imports and Exports with respect to ε︎ are such that:
• When ε︎ ↓ then NX ↑
• When ε︎ ↑ then NX ↓

Marshall-Lerner condition (ML) currency appreciations worsen Net Exports!

IN REALITY: THE J-EFFECT

Timing of Adjustment: the J-Curve

Effects A and B take time to realize. Effect C happens immediately.
Example: Chinese Currency Intervention

1. Suppose we are considering the U.S. economy. The initial point is Y0= YTB
2. Suppose the dollar appreciates (because of China’s intervention) i.e. ε︎↑

• Demand for Domestic Goods shifts downward (ZZ↓)

• Domestic Demand (DD) does not change!
• Net Exports shifts downward (NX↓)

RESULT:
• Output decreases.
• Net Exports deteriorate

CLASS 3: FISCAL COORDINATION + CURRENCY WARS (M3+M4)

THE OPEN ECONOMY

M3+M4: STIMULUS PACKAGES AND EXCHANGE RATE POLICIES

Effects of Policies in the Open Economy

1. Fiscal expansion in home country (higher expenditure or lower taxes)

➢ Increase in Domestic Output (Y↑)
➢ DETERIORATION of Trade Balance (NX↓)

2. Fiscal expansion in foreign country → increase in foreign output (Y*↑)

➢ Increase in Domestic Output (Y↑)
➢ IMPROVEMENT of Net Exports (NX↑)

Domestic would prefer Foreigners to Stimulate Demand and viceversa (free-rider problem)
Practice Question 1

Suppose that the open economy is in equilibrium in the market for goods at output Y0 = , but the trade
balance is in deficit (NX0<0).

Suppose also that the government of this country has two policy objectives:
1. Keep output equal to a target level (Y=Y ) 2.
Keep Trade Balance equal to zero (NX=0).

The appropriate combination of policies to reach simultaneously these two objectives are a fiscal
contraction and a real exchange depreciation.

Note: any policy combination should leave ZZ unchanged. NX needs to shift to the right.

Explanation: We make a real exchange depreciation, so that net exports increase (objective 2), making
ZZ shift up. As a result, the government has to shift the DD curve down in orden to lower the ZZ curve
again to keep it at the same point (objective 1).

ANSWER: decreasing domestic demand (G↓) AND depreciation (ε↓).

Practice Question 2

Suppose a country is initially in a situation with balanced trade (NX=0).

Suddenly, the government decides to increase import tariffs, so that other things equal, the price of
imported goods increases.

In the following graph, indicate the level of output in the initial (Y0) and final point (Y1), as well as the
initial and final position of the NX curves (NX0 and NX1).
Note: We assume perfect substitution between domestic and foreign
goods, both in consumption and production.

Explanation: *If import taxes go up, P* goes up (imports become more

expensive so we will import less and substitute foreign goods with
domestic goods), which will make ε go up and also increase NX (move
NX curve up), which makes ZZ go up.

U.S. vs China

U.S. raises import tariffs China depreciates its currency (ε↓ low)

Let’s consider what would happen in the U.S. economy

1) Because of increase in import tariffs

• Imports decrease, Net Exports improve NX↑, Output increases Y↑

2) Because of appreciation of the U.S. dollar

• Exports decrease, Net Exports worsen NX↓, Output decreases Y↓