Revision Lectures: Macro

Luca Metelli

 For information about the exam, look

at the slides Micro revision lecture
Today well go through some past
exam questions and some theory,
regarding macro

Macro long question, 2014 exam

Govt decides to reduce the stamp duty on car
purchase. Does the tax change have an impact on
aggregate demand, and if so how would you
represent it in the aggregate-demand/aggregatesupply diagram? Explain (5 points)
AD=C+I+G (+X-M)
Describe what C, I, G are. (1 point)
When tax on stamp duty , consumption
Therefore AD (1 point)

 Diagram: Demand shifts to the right. (1

point)
Details: the diagram, axis, show that AD shifts to
the right and not upwards (1 point)

You could expand:

However, it depends on how the tax decrease
it is financed: (1 point)
If with G..
If with debt.
As C , firms might be willing to invest less as
there is less demand I as well (2nd order
effect) (1 point)

Example 2
Discuss the mechanisms leading from the
change in aggregate demand to changes
in GDP and in inflation. (5 points)
GDP is determined by AD and AS.
In the short run AS is horizontal, because
of price- sticky assumption. Explain
In the long run AS is vertical, because of
flexible prices. Explain. (1+ point)

 Diagram (1 point)

Explain what happens to:

GDP. Short run and long run (1 point)
Prices/inflation: short run and long run (1 point)

Summary of the Lent term material

GDP and National Accountings

Economic Growth (Solow model)
Economic Fluctuations (AS-AD model)
Policies to address Econ. Fluctuations
Inflation
Unemployment
Financial system
Euro Crisis

National
Accountings

GDP
3 definitions:
1) Production Approach:
Value of final goods and services produced

2) Expenditure Approach:
Total expenditure on C,I,G and NX.
Y

NX

3) Income Approach:
Total income earned by factors of production for
domestic production (Return on labor, return on
capital and economic profit)

QUESTION: Income
approach
Suppose a woman marries her butler.
After the marriage, the man keeps to
wait on her (but not as an employee).
Does the marriage affect GDP?
Yes, GDP decreases. Total labor
income falls by the amount of butler
salary
GDP is an imperfect measure!

QUESTION: Expenditure approach.

The following transactions are to
be consideredC,I,G,X or M?

Boeing sells an airplane to the Air

ForceG
Boeing sells an airplane to American
AirlinesI
Boeing sells an airplane to Air France
X
Boeing sells an airplane to Warren
Buffet C
Boeing builds an airplane, but it is not
sold I (as inventories!)

QUESTION: Production approach

Calculate nominal/real GDP, GDP
deflator, CPI
NomGDP 2000
=(100*50.000)+(500.000*10)=10.000.000
NomGDP 2010
=(120*60.000)+(400.000*20)=15.200.000
Real GDP 2000=Nom GDP 2000
Real GDP 2010 (with base year 2000)= (120
50,000 $) + (400,000 $10 )=10.000.000
GDP Deflator 2010=
=15.200.000/10.000.000=1.52

CPI 2010=

=1.6

Solow Model

The Solow model

Solow model is a Long Run model
to explain growth (i.e. GDP per
worker growth)
We have seen 3 versions:
1) Simple version
2) With TFP growth
3) With TFP growth and human capital

1) Simple version
The models features:
1. Output p.w. depends on capital p.w.
2. Output can be either consumed or
invested
3. Constant rate of saving (investment), s
4. Constant rate of capital depreciation,

Capital is crucial for growth!

Capital evolves:

 Easily represented through a

diagram
Steady state when
== =0

Prediction of the Solow

model
Other things equal, poor countries (i.e
countries with lower K) should grow
faster than rich ones
In the long run, poor and rich countries
are expected to converge to the same
steady state (conditional convergence)
No growth in steady state. Capital does
not grow, therefore Output does not
grow

QUESTION: Effect of change in (

)

2) Solow model with TFP

growth
TFP=efficiency with which
capital is used
TFP is important because:
TFP increases Y directly
TFP increases Y stimulating growth in K

 TFP:
Growth in the long run
TFP is not subject to limits

TFP growth is crucial. It is achieved

through:
Innovation (basic research, R&D). Subsidies
and patents might be a good idea
Imitation (in developing countries)
Other ways ?

3) TFP and Human capital

Human capital (schooling, health)
Direct effect on GDP and indirect
effects

AS-AD Model

AS-AD model
Useful to explain economic fluctuations
In AS-AD model fluctuations stem from
demand shocks (AD shifts) and supply
shocks (AS shifts)
GDP is given by the equilibrium b/w AD and
AS
Main assumption of the model:
Prices are sticky in the SR, Flexible in LR

AD=C+I+G+NX

Short run AS (sticky prices)

Long run AS (flexible prices)

 GDP in the short run is where

AD=SRAS

GDP in the long run is where

AD=LRAS

QUESTION: Effect of a reduction in

money supply on GDP and inflation
Money

implies interest rate .

Investment , consumption
As then AD shifts to the left
In the SR we are in B
In the LR in C

QUESTION: Effect of a reduction in

money supply on the interest rate
In the coursepack:
When M/P falls, money holdings in portfolio too small
Interest rates increase to make the smaller holdings
optimal again

You can see this through a diagram, representing

the Money market
Real money supply=
Real money demand
When Money supply
Interest rate .

QUESTION: Why does the aggregate

demand slope downwards?
Sloping downward means that for
high P, AD is low , for low P AD is
high

 Can answer focusing on the money market

In the money market, P means a reduction
in real money supply (M/P)

higher P is associated with higher interest rate

 As high interest rate means lower C

and I, this implies lower AD
Summing up:
Higher prices are associated with lower
AD,
Lower prices are associated with
higherAD
...therefore AD is downward sloping

QUESTION: Effect of increase in oil

price & Fed reaction
As production costs increase, SRAS
shifts upward, equilibrium in B
If the Fed cares about keeping output
at natural level, it increases AD by
increasing M
The economy immediately reaches a new
equilibrium at point C. The price level is
permanently higher, butno loss in output

If the Fed cares about keeping prices

stable, then there is no policy response
it can implement.
Hence, the Fed must simply wait, holding
AD constant. Eventually, prices fall and
end back in point A. Butprolonged
recession.

Inflation and
Hyperinflation

 Inflation: percentage increase in the

overall level of prices
Inflation, 2 measures:
GDP deflator=100 x Nominal GDP/Real
GDP
CPI index: Price of a fixed bundle of
consumer goods

Costs of inflation

Relative price distortions

Misperceptions of relative prices
Fiscal drag
Increased uncertainty
Redistribution of purchasing power
Menu costs

If you want to end (moderate)

inflation
Money supply has to grow less than
expected
but this leads to a recession
(unless the central bank is fully
credible)

Deflation
At the opposite of inflation, there is
deflationi.e. negative change in the
price level
Very actual topic
Deflation can be dangerous
To stop deflation, the central bank
needs to stimulate the economy and
let the money supply grow more than
expected (e.g. QE)

QUESTION:
Q: Is expected inflation a possible
problem for an indexed lending/borrowing
contract? What about unexpected
inflation?
Sketch:
Explain what is an indexed contract
Expected Inflation does not affect this
contract. It never does.
Unexpected inflation does not matter as well,
because of the indexing.

QUESTION: What is the inflation

tax? Who pays for that?
The holders of money pay the
inflation tax.
That is, a given amount of money
buys fewer goods and services since
prices are higher
Also holder of nominal bonds pay for
the inflation tax

QUESTION: Inflation is
repudiation, a finance ministry
said. What does it mean?

By increasing inflation, the government reduces

the value of its outstanding debt in real terms
Eventually, when the government pays back
lenders (i.e. private citizens), lenders can buy less
with that amount of money because of inflation.
In this sense we can say that the government
repudiates the debt.
This holds only when inflation is unexpected. If
inflation is expected, lenders demand a higher
nominal interest rate when buying govt bonds.

Hyperinflation and policies to

end it
Hyper-inflation is when inflation is
higher than 50% per month
Hyperinflation is caused by excessive
money supply growth
Usually when a government cannot
raise taxes or sell bonds, it start
finance spending by printing money
(seignioraige), causing hyperinflation

To end hyperinflation
1. Fiscal reform (spending less/taxing more)
2. Stop printing money
Fixed rate of M growth (choose and keep a
constant and lower money supply growth)
Inflation target (adjust money supply
growth to achieve the desired inflation rate)
Fixed exchange rate (central bank needs to
maintain a money supply growth compatible
with a fixed exchange rate. If M grows too
much exch rate depreciates!

The Financial
system

The story of the financial

crisis
Housing
Excessive optimism + lax lending standards
made house prices to boom
Over time, housing boom unsustainable, many
homebuyers fell behind their debt payments
Prices fell by over 30%

From housing to banks

As the house is a collateral, value of collateral
falls
Bank not able to recover its money
Fear of bank insolvencies

 From banks to the economy

Confidence in financial institution
dropped
Investor started to withdraw their funds
from banks
Banks, to be able to fulfill the
withdrawing requests, started to firesale
and to cut on lending
Credit crunch
Recession
Vicious circle

How to respond:

Conventional monetary policy

Unconventional monetary policy
Conventional fiscal policy
Injections of govt funds (make loans,
buying banks)
Lender of last resort

What does it mean for a Central

bank to act as Lender of Last Resort?
When a central bank acts as a lender of last
resort, it helps to alleviate a liquidity crisis.
A liquidity crisis occurs when the financial
institution has insufficient funds to satisfy the
withdrawal needs of its creditors (but still the
institution is solvent)
If the central bank lends funds to the financial
institution, the creditors claims can be met.
These actions help to restore and maintain the
publics confidence in the banking system.

QUESTION: What is a shadow bank?

Shadow banks include investment banks,
hedge funds, private equity firms, and
insurance companies. (Everything but
commercial banks)
Their deposits are not federally insured, so
they are not heavily regulated like
traditional banks and can take on much
more risk.
After the crisis policymakers suggest
limiting the risk they can take

QUESTION: How does the leverage ratio influence the

stability of a financial institution in response to a crisis?
The leverage ratio is the ratio of a banks assets to its
bank capital.
Here
Leverag
e ratio =
20

The higher its leverage ratio, the less stable the

financial institution during a time of bad economic
news.
If a bad economic news reduces the value of the bank
assets by 5%, this is equivalent to the $50 of bank
capital. Beyond this point, the financial institution has
no funds with which to pay off future creditors.

The Euro crisis: causes

Very high government debt&deficit: to
stimulate economy in 2008/2009 and/or to
save banks
Ireland, Spain: low debt, high deficit
Italy: high debt, low deficit
Greece: high debt, high deficit

Low growth b/c 2008/09 crisis debt/gdp

Loss of confidence in peripheral countries:
fear of default
Difficult to bailout a government

Consequences
Govt interest rates spiked:
more expensive (and difficult) for the govt to finance its
expenses
Loans more expensive for firms and consumersless
investment
As value of bonds , banks balance sheets distress

b/c more expensive to finance expenses and b/c of

political pressure, govts cut budget austerity
Austerity caused negative growth
Negative growth Debt/GDP (despite deficit :
govt multiplier > 1)
Negative spiral!

How to solve
Very much a political issue: Euro area has
different countries with different needs.
North vs South. Possible solutions:
Bailout: direct help from North/new
vehicles . Difficult to achieve; moral hazard
risk.
Through the ECB:
Secondary market operations
LTRO,OMT
ECB statements, forward guidance