MacroMacro-Economics

Basic Introduction
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Overall Demand and Capacity of an Economy Slowdown, Recession, and Depression Slowdown inflation rate decreases and unemployment rate increases (Philips curve!!) If AD>AS, 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.

What is GDP?
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GDP refers to what is totally produced and not what is sold Nominal GDP vs. Real GDP (base year for India -1999-2000); 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

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Net Factor Income from abroad = Factor incomes earned by Residents abroad Factor Incomes earned by foreigners here. GNP = GDP + NFIA

More about GDP

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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.

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Famous Twin Deficit Theory

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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)

Introduction to Interest rates and Money Supply

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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). Supply for money - M1 = currency + chequable deposits, M3 = M1 + fixed and time deposits (broad money). M3 is money supply GDP depends upon M3 and velocity of circulation if money supply exceeds capacity, then large money chasing fewer goods, when means inflation If GDP < capacity, then rise in money supply stimulates the economy by providing liquidity

Interest Rates (continued)

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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. 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 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

Introduction to Exchange Rate

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Demand for exports and imports exchange rate Recent trends in Indian exchange rate and Chinese peg against dollar (different exchange rate arrangements) Real Exchange rate = Nominal Exchange Rate * Foreign price / Domestic price. Gain in competitiveness vis a vis real depreciation of currency

Real Effective Exchange Rate (REER) is a weighted geometric average of bilateral real exchange rates with weights equal to trade shares.

Net Exports go down if home GDP increases, go up as foreign GDP increases or real exchange rate rises

Inflation
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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.

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Introduction to economic linkages

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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) US slowdown (due to IT bubble burst) of 2001 and troubles of Japanese economy (due to manufacturing burst) Mr Chidambrams dream budget (1997-98) failed to take off because of stock market scam and real estate price crash preceding it

Fiscal Policy
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Government expenditure (G) and T (taxes) most important policy variables of fiscal policy G revenue expenditure and capital expenditure. Receipts & Payments Balance of receipts is what the government borrows Direct taxes: progressive (go up as income rises), their share increases faster than rate of growth in GDP Indirect taxes: regressive whose share in income decreases as income rises 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)

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Some concepts related to Fiscal Policy

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When government deficit is financed through borrowings from RBI, it is called monetized deficit as it increases money supply in economy (RBI prints money) During times of slowdown and boom, G rises and falls automatically due to changing number of eligible beneficiaries. T also falls and rises due to its progressive nature. Deficit increases in slowdown due to rise in G and fall in T In market driven economies, tax cuts are used during slowdowns while cuts in G are used during boom. In state driven economies, increase in G is used in slowdown and increase in taxes used in boom Crowding Out Phenomenon: G can crowd out I as well as X if money supply is fixed rise in G leads to increase in interest rates which attracts more foreign currency, leading to appreciation of exchange rate

Monetary Policy
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P = m-g + v where p = inflation; g = %rise in GDP v = velocity of circulation and m = increase in money supply Demand will be more if person is paid weekly as compared to monthly, i.e. the velocity with which money changes hands is more Financial sophistication also brings down the demand for money 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

Linkages related to Monetary Policy

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If money supply increases, then people will demand bonds more and hence bond prices go up, hence interest rates go down. 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. (US consumption bubble) Fall in interest rates means rise in disposable income for people in debt. For people not in debt, current consumption is more attractive than future, so C increases. Increase in asset prices makes individual feel wealthier and hence C rises. Depreciation of local currency makes imports expensive and hence domestic spending increases

More Concepts
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Fall in interest rates encourages more investment by companies. Due to rise in value of collateral, bank loans become easy SLR, CRR, Repo & Reverse Repo rate, Bank rate / Call rate High powered money/reserve money = monetary base = currency in circulation with public + reserves Money Multiplication by Banks : concept of money multiplier Open Market Operations y RBI: forex swaps, repo/reverse repo transactions, buy/sell government securities

Problems for RBI

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Targets for RBI: interest rates or money supply or exchange rates 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. Sterilization: FII inflow due to interest differential: RBI has to stabilize exchange rate but inflation rises. RBI earns lower interest by deploying forex in securities abroad as compared to what it can earn by deploying rupee domestically. Problem is that if you are not allowing the money supply to rise (hence interest rates to decrease), then balance between inflows and outflows will not be obtained as interest differential will remain there for FII to take advantage of. Targets of RBI have been dynamic depending upon the economic conditions

External Account
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If government follows expansionist policies, increase in domestic GDP means increase in imports so increase in foreign GDP. But if increase in GDP is due to real depreciation in exchange rates, then domestic GDP rises but foreign GDP comes down 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 y Invisibles: services, investment income & transfer payments
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Current account = trade account + invisibles Capital account includes export and import of capital If local interest rates fall in comparison to foreign country, capital flows from that country. Demand for foreign currency will rise and hence local currency will depreciate.

Exchange Rate
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Exchange rate can be determined by purchasing power parity 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. 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. Fixed Rate Regimes: Adjustable peg, Crawling peg, Currency Board, Unified Currency

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 y Rise in interest rates attracts more capital from outside, so balance improves
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Sensitive issue of Capital Account Convertibility in India

Fixed regime + complete mobility G rises -> GDP rises ->demand for money rises -> interest rates rise (as supply is fixed) -> foreign capital flows in -> pressure on rupee to appreciate -> central bank supplies money to mop up forex entering -> interest rates will go down. y So GDP changes with no crowding out of private investment. y If Money supply increase, interest rates fall, foreign capital goes out, to maintain exchange rate, RBI sells forex and hence decreases M. So no effect on GDP.

More Linkages
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With flexible regime, rupee will appreciate in first case and hence X will be crowded out, so less influence on rise in GDP. With monetary policy, rupee depreciates and hence X increases, so increase in GDP effective. Capital controls and fixed regime: rise in GDP (due to rise in G) worsens X-M as M increases. Money supply reduces to restore exchange rate -> interest rates rise more and crowd out private investment. So 2 opposing factors at work. Money supply rises -> interest rates fall -> GDP rises -> imports rise -> X-M comes down putting pressure on currency, so RBI will decrease money supply increasing interest rates , so ineffective policy in influencing GDP Flexible exchange rate and capital controls: GDP rises, rise in interest rates. Rise in GDP worsens net exports and so currency will depreciate restoring the balance. Effect on GDP is rise in G less crowding out of private I due to rise in interest rates. Expansionary monetary policy will lead to fall in interest rates and hence rise of GDP implying net exports worsen, so currency will depreciate to restore balance. So Monetary policy has increased GDP by lowering interest rates.

Liquidity Trap and Philips Curve

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When interest rates are close to zero, a further cut is not possible Hence, MP to raise I and hence AD by cutting rates is not possible Money demand does not respond to change in interest rate excess liquidity Philips Curve Unemployment and inflation are inversely related Exceed Full employment tight labour market higher wages higher prices

US China Trade Problem

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Chinese record trade surplus against US Yuan must appreciate against USD making Chinese exports less competitive Yuan pegged against USD till July 2005 Nominal revaluation of Yuan Then shift to peg against basket of currencies Fixing of band of 0.5% around which Yuan would move Fundamentals point to a weak dollar

Current Scenario in global markets

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Asian savings being channeled to meet US Debt Weak dollar & high oil prices Growing Liquidity Crunch Risk appetite growing lower higher rates Recent slump in high-yield Asian equity markets Yield Curve and its signals

Introduction to Mortgages
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Pool of home loans securitized together Securitization: cash flows from bundle of assets are distributed to liability owners according to some pre-determined rule Water Fall Structure Inputs to Mortgage Pricing Prime and Sub-Prime Mortgages

Japan: Land of Setting Sun

Asset Bubble (80s) Crash in asset prices Record dip in inflation Liquidity Trap Nominal Rates cut to simulate economy Failure of monetary policy Low growth No price pressures

Bank Runs Bank Speculations

Fiscal exp stopped due to high deficits

The Carry Trade

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Japanese interest rates close to 0.5% Borrow in Yen to invest in high yield currencies like AUD (6.5%), NZD(7.75%) and other Asian currencies Borrow to invest in high yield assets like Chinese and Indian stock markets, sub-prime mortgage US assets

The Carry Trade

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Earn interest yield differential Also when you buy high yield currency, it appreciates Yen depreciates Gains (Interest + Currency) Risks
Japanese rates rise Global risk increases High yield asset defaults High oil prices, weak dollar

Global Trade Cycle

Payments
Forex Reserves/ Savings

US
Goods
Imports > Exports Debt Driven economy Twin deficits

Asia

Exports > Imports Excessive Savings channeled into dollar reserves

Asian woes
Pressure to appreciate Exports more expensive Lend to US + Buy FX

Capital inflows

Sterilized Intervention

Sustainable ??
Raise CRR, Reverse Repo Sell Govt. securities

Excessive liquidity

Inflation

US Sub-prime crisis Suby y

Low Fed rates (1999-2003) spurred excessive lending Sub-prime borrower

Poor credit history Incomplete documentation Second loan on same asset

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Defaults begin when Fed Rates get hiked Mortgages floating part of payment has begun

US Sub-Prime Crisis
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Mortgage Originators sold loan portfolios to IBanks Loans packaged into tranches and sold to investors, hedge funds, pension funds Payment from home owner passed by Originator to I Bank to investor Fall in asset prices defaults Originators go bankrupt

US Sub-Prime Crisis
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Investors demand higher spreads or yields to compensate for higher risk Crisis spreads from sub-prime to prime securities to corporate bond markets LBOs more expensive Lower global risk appetite Weak dollar, bearish Asian equities Carry Trade adversely affected