MacroEconomics Review


Summarized notes from the textbook The Economics of Money, Banking and Financial Markets by Frederic S. Mishkin
Subject: Economics
Source: These notes are drawn heavily from The Economics of Money, Banking and Financial Markets by Frederic S. Mishkin

Aggregate Price Level (P) – average price of goods and services in the economy measured by CPI or GNP Deflator

Measure of Aggregate Price Level
GNP – market value of all final goods and services produced by a country for a given time period (includes earnings by Americans and U.S. corporations abroad; excludes domestic earnings of foreign companies); a measure of the aggregate price level.
Real GNP – uses constant prices (1982)
Nominal GNP – uses current prices

GDP – market value of all final goods and services produced in a country for a given time period (excludes earnings by U.S. individuals and corporations abroad; includes domestic earnings by foreign corporations)

Measure of the Purchasing Power of Money
GNP Deflator –  (Nominal GNP / Real GNP) – most comprehensive measure of price change. Doesn’t include imports; includes costs of government services and expenditures for investment.

PPI – Producers Price Index – made up of 2800 commodities (no services) at 3 levels: crude materials, intermediate processing, and finished goods – lead indicator of CPI

CPI – market basket of 400 goods and services. Nominal figure with base 1982-4 that includes imports and services but no government purchases or general investing.

Financial intermediaries/markets – address imperfections in markets (risk, liquidity, search costs, economies of scale) and help avoid adverse selection – unequal (asymmetric) info before a transaction; and moral hazard – incentive to one party after the transaction to undermine value to other party.

Money Aggregates
Note: These are not good short-term estimates, but are good for long-term

  • M1 – currency, checking accounts and traveler’s checques
  • M2 – M1 + extremely liquid assets (e.g. savings, money mkt funds, etc.)
  • M3 – M2 + somewhat less liquid assets (RPs, institutional money mkt, etc.)
  • L – M3 + short-term securities (T-Bills, commercial paper, etc.)

Reasons for regulation:

  1. Increase information to investors
  2. Ensure soundness of financial intermediaries
  3. Improve monetary control

Asset – store of value; something that will provide future benefits.

Wealth elasticity of (asset) demand = % change demanded / % change in wealth

  • Necessity – wealth elasticity < 1 {lower risk or conservative asset}
  • Luxury – wealth elasticity > 1 {higher risk or aggressive asset}

Ceteris Paribus – everything else equal.

Fisher Effect – when expected inflation rises, interest rates rise (in=ir + πe)

Bonds (classical curve)

Bonds (as viewed by an individual)

Loanable Funds (as viewed by a corporation)

liquidity preference framework (Keynes) – determines equilibrium i in terms of Money supply and demand
loanable funds framework – determines equilibrium i in terms of supply and demand of bonds

loanable funds framework is easier to use with respect to changes in expected inflation πe; liquidity preference framework is easier to use with respect to changes in income, price level and supply of money.

Keynes – 2 categories of assets people use to store wealth:

  1. Money
  2. Bonds

Ms + Bs = wealth ⇒ Bd + Md = wealth ⇒ Ms + Bs = Bd + Md ⇒ Ms – Md = Bd – Bs

* liquidity preference framework ignores effects from changes in expected returns on real assets; Keynes assumed i=0 for money.

liquidity effect – lowering of interest rate due to increase of Ms (Milton Friedman)

3 reasons people hold money:

  1. transaction motive = f(y) {y = GNP (income)}
  2. precautionary motive = f(y)
  3. speculative motive = f(i)

* A change in price level is an after-the-fact effect not an effect of expectation:
income ↑ ⇒ Price ↑ (employees scarce ⇒ wages ⇒ prices to consumer ↑)

Effects of money on interest rates:

  • liquidity effect: Ms ↑ ⇒ i ↓ (spurs economic activity, expansion)
  • income effect: Ms ↑ ⇒ income ↑ ⇒ Md ↑⇒ i ↑
  • price level effect: Ms ↑ ⇒ P ↑ ⇒ i ↑
  • πe effect: Ms ↑ ⇒ πe ↑ ⇒ Bd ↓, Bs ↑ ⇒ i ↑

risk premium – icorp – itreasury
{risk structure – bonds of same maturity; term structure – bonds of diff. maturity}

Factors affecting bond ratings:

  • firm’s financial condition
  • industry environment
  • regulatory constraints

*risk premium reflects corporate bonds lower liquidity in addition to default risk

Term structure facts to be explained:

  1. interest rates for different maturities move together
  2. yield curves have steep slope when short rates are low, down slope when short rates are high
  3. yield curve typically upward sloping

3 theories to explain term structure attributes:

  1. expectations hypothesis – bonds of different maturities are perfect substitutes, so i for long-term bond = average of short-term rates expected over life of long-term bond.
  2. segmented markets – bonds of different maturity not perfect substitutes; explains typical upward slope but not other 2 attributes.
  3. preferred habitat theory – interest rate on long-term bond = average of short-term rates + term premium that responds to demand and supply for that bond

Yield Curves

we can use yield curves to tell what the market is predicting for future short-term rates.

Term Structure: Forward Rates

{forward rate = short-term rate for future bond}

Exchange Rates:
A stronger dollar leads to less expensive foreign goods and more expensive U.S. goods exported abroad.

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