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CFA Level I Macroeconomics - 2
Presented by: Aditya Ahluwaliawww.finstructor.in
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UNEMPLOYMENT AND
INFLATION
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Unemployment
Frictional Structural
Cyclical
Considered unemployed if actively searchingfor work
Labor force = employed + unemployed
Underemployed
Participation ratio = % working age who are
employed or seeking employment
Discouraged workers
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Inflation
CPI basket
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PPI , GDP deflator as measures
Headline and core inflation (excludes food and
energy)
Problems with Laspeyres index
>New goods
> Quality changes
> Substitution
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Cost push inflation
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Demand pull inflation
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MONETARY AND FISCAL
POLICIES
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Fiscal policyuse of taxation and spending toaffect economic activity
> Budget surplus or deficit
Monetary policyactions that affect quantityof money and credit in an economy in order to
influence economic activity
> Expansionary (accomodative) or contractionary(restrictive)
Aim is to keep moderate inflation and good
economic growth
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Functions of money
Medium of exchange
Unit of account
Store of value
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Fractional reserve banking
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Narrow moneyNotes and coins incirculation, plus checkable bank deposits
Broad moneynarrow money plus money in
liquid assets
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Quantity Theory of Money
> Money supply x velocity = price x real output
> MV = PY
> Velocity represents the average number of times
each unit of money is used to buy goods andservices
> Monetarists believe that velocity and the real
output change slowly, hence increase in moneysupply, will lead to a proportionate increase in
inflation
> Money neutralityreal variables are not affected
by monetary variables
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Demand for money
Transaction demand: Money held to meet theneed for undertaking transactions
Precautionary demand: for unforeseen future
needs Speculative demand: to take advantage of
investment opportunities that arise in the future
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Supply of money is determined by the central
bank and is independent of demand
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Increase in money supply
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Fischer effect
Real rates are stable, changes in interest ratesare driven by changes in expected inflation
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Role of central bank
Sole supplier of currency
Banker to the government and other banks
Regulator and supervisor of payments system
Lender of last resort
Holder of gold and foreign exchange reserves
Conductor of monetary policy
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Objectives of the central bank
Primary objective is to control inflation> Menu costsbusiness need to change prices
> Shoe leather costsfrequent trips to the bank to
withdraw depreciating cash
> Unexpected inflation is more costly than expected
inflation
Stability in exchange rates
Employment
Economic growth
Moderate long term rates
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Monetary policy tools
Policy rate
Reserve requirements
Open market operations
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Effective central banks
Independence> Operational independencecentral bank can
independently determine the policy rate
> Target independenceCentral bank defines howinflation is computed, sets the target and
determines the horizon over which it has to be
achieved
Credibility
> Should follow through on their stated intentions
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Transparency> Periodic disclosure about views on inflation,
economy etc.
> Aids credibility
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Transmission mechanism
Suppose economy is in a recession, steps in transmission would be as follows:
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Expansionary or contractionary
policy rate > neutral ( contracionary monetary policy)
policy rate < neutral ( expansionary monetary policy)
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Monetary policy limitations
Transmission may not work as expected
> Cut in rates, may increase inflationary
expectations, may increase long term rates
> Tightening may reduce growth expectations,
reducing long term rates
Liquidity trappersistent holding of cash,
such that rates dont decrease
Cannot stimulate once interest rate reacheszero
Quantitative easing may not work if perceived
credit risk is high
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Additional issues in developing economies
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Fiscal policy
Discretionary Automatic stabilizers
> Unemployment claims,
> Taxes
OBJECTIVES
> Influencing economic activity
> Redistributing wealth and income
> Allocation resources amongst sectors
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Fiscal policy tools
Spending tools> Transfer payments
> Current spending (ongoing expenditure)
> Capital spending
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Revenue tools
Revenue tools> Direct taxes
> Indirect taxes
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Fiscal multiplierpotential increase inaggregate demand, resulting from an increase
in government spending
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Balanced budget multiplier
If the government increases taxes to offset a$100 increase in spending, the net impact
should still be positive
100 * .8 * 2.5 = 200 250200 = 50
Ricardian equivalencepeople anticipate
future pressures from current deficits and startsaving more, hence budget deficit does not
stimulate demand
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Problems with fiscal deficit
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Arguments against being concerned with fiscal deficit
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Difficulties in implementation
Recognition lag Action lag
Impact lag
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Additional problems
Misreading statistics Crowding out
Supply shortages
Limits to deficits
Multiple targets
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Fiscal policyexpansionary or contractionary> Changes in surplus or deficit
> Structural (cyclically adjusted) budget deficit
I i f d fi l li
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Interaction of monetary and fiscal policy
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