MBA 613: ECONOMIC POLICY AND THE GLOBAL ENVIRONMENT Spring 2009

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1 MBA 613: ECONOMIC POLICY AND THE GLOBAL ENVIRONMENT Spring 2009 Stuart Allen 462 Economics Department Office hours: By appointment, after class CATALOG DESCRIPTION Prerequisite: MBA 603 (1.5 hours) Economic theory analyzes short-run and long-run effects of domestic fiscal, monetary and exchange rate policies and the international consequences of global policy changes on the domestic economy. OBJECTIVES The major objective of this course is to develop your economic understanding and analytical ability to assess the current macroeconomic environment and government policies in the United States and other countries (e.g. fiscal, monetary, and exchange rate policy). The course will utilize aggregated markets such as the output, labor, credit/financial, reserve, money and foreign exchange markets to analyze the effect of changes in monetary, fiscal and exchange policy in the context of the global economy. The lectures, discussions, readings and assignments will help to develop your ability to analyze the current economic environment, evaluate current government policies, and assess the risk facing businesses and households. Historical case studies will be employed as an important teaching tool to explain the current global economic environment.. COURSE MATERIALS Allen, Manuscript, available at the UNCG Bookstore only. Dolan, Introduction to Macroeconomics, 2nd edition, available at the bookstores. Extra Readings on-line ADDITIONAL SOURCE MATERIAL Check out government agencies such as CBO.gov, BEA.gov, and BLS.gov for additional information. The Federal Reserve Corner is at Political economic analysis of Paul Krugman and Brad DeLong and tax analysis of the Tax Foundation may be of interest. (Google) COURSE REQUIREMENTS Test 1 10% Class 2 January 29 Test 2 20% - Class 3 February 5 Test 3-25% - Class 5 February 19 Final Exam 45% Class 7 March 5 LAST DAY TO DROP CLASS WITHOUT PENALTY: FEBRUARY 11 GRADING POLICY AND SCALE Incompletes are not an option. No extra credit. A: B: C: F: Less than 65 FACULTY STUDENT GUIDELINES Can be found at

2 2 ATTENDANCE Attendance is necessary to absorb the course content. Missing class may be hazardous to your course performance. If the unexpected happens and you have to miss class, you are responsible for the night s material. If you miss Test 1 the final exam will count a maximum of 100%. You may tape record the classes. BACKGROUND KNOWLEDGE Most students will have little background or retention of macroeconomics and financial markets. There will be a minority of students who will have working knowledge of the course from their undergraduate course work. This course is meant to challenge all students regardless of one s background, with the goal of every student gaining significant insight into the workings of the macroeconomic system. CLASS TIME Lectures and class discussions will integrate economic theory, economic history, and graphical analysis with your questions of clarification and inquiry. A mixture of questions and inquiry makes for an interesting class environment for both the students and the instructor. You are encouraged to tape record the class (if this is useful for you) and to rewrite your class notes. Reading the assigned readings is extremely important prior to each class. The class meets from 6:30 9:20. SNOW POLICY If we miss a night due to weather, early in the semester we will have extended classes to make up the class time. Tests will automatically be pushed back a week if the class is cancelled. OVERVIEW OF THE MANUSCRIPT CHAPTERS 1-2: The domestic and global economic system is analyzed through a circular flow model that includes an output, labor, credit, money and foreign exchange market. This macroeconomic model provides the framework for interpreting economic data, analyzing short-run economic fluctuations, and predicting outcomes from monetary and fiscal policy changes. CHAPTERS 3-5: These chapters introduce and develop the output and labor markets that allows for the analysis of short-run economic fluctuations and the possible trade-off between inflation and unemployment. CHAPTERS 9-10: The effect of the Federal Reserve's monetary policy on economic activity and the rate of inflation are considered. The Fed's role in fighting inflation in the late 1970s and early 1980s, the resulting disinflationary environment and low inflation decades of the 1980s and 1990s are examined. The Federal Reserve use of interest rate targeting is analyzed. CHAPTER 11: The effect of fiscal policy defined as government expenditure and tax policy on short-run fluctuations and long-run economic growth are considered. The debate over appropriate fiscal policy and the effect from federal budget deficits are discussed. CHAPTER 13: The evolution of the international financial system from the gold standard and its collapse during the 1930s to the Bretton Woods system and its collapse in the early 1970s is discussed. The adjustment process for the deficit-prone and surplus-prone countries in the Bretton Woods system is a major topic as it will provide a framework for understanding China s policies. OPPORTUNITY: Thursday, January 22 Kathleen Price Bryan Lecture, Bryan Room 160 from 4:00-5:00 Dr. Lyle Gramley, former Governor of the Federal Reserve will speak on "The Financial and Economic Crisis: Where We Stand Now and How Do We Fix the Problems?"

3 3 HOW TO GET STARTED PREPARING FOR THIS COURSE: READ CHAPTERs 4, 5 and 6 BEFORE CLASS 1: Chapter 4 in the Dolan text deals with the three key macroeconomic variables (outcomes): unemployment, economic growth, and inflation with important historical references. Chapter 5 introduces the circular flow diagram which is developed in Chapter 2 (see below) of the manuscript. Chapter 6 in the Dolan text deals with the nuts and bolts of measuring economic activity. A key issue is how to compute real GDP and the price level from nominal GDP. In reading Chapter 4, you should also think about the concept of potential (full employment) real GDP and the full employment unemployment rate. Diagramming the level of potential full employment real GDP and actual real GDP will provide information about whether the economy is in a recession, or expansion, and whether inflation or deflation is a current or future problem. Such information is necessary to consider what policy change should occur with regard to monetary and fiscal policy. A brief introduction of fiscal and monetary policy can be found in Chapter 1, pp of the Manuscript. Key Policy Questions: Understand the Separate Roles of the Treasury and the Central Bank (Section II & III D) 1. What is the role of the Treasury and the Federal Reserve Board with regard to fiscal and monetary policy? 2. What are the effects on interest rates and the money supply from the Treasury and the Federal Reserve Board s operations in the bond market? The Circular Flow Model in Chapter 2 of the manuscript provides a visual model of the important economic exchanges that occur in a domestic economy (no foreign trade) as illustrated by: 1) The exchange of all resources (inputs) between households (assumed to own all resources either directly or indirectly through ownership of common stock). The most important input market is the Labor Market. The most important labor market measures are jobs in the economy and the rate jobs are created and destroyed. The unemployment rate is a popular measure of how well we are doing in the labor market. Read more about unemployment in the text and manuscript. 2) The output market represents the production of all final goods and services (production) between producers (firms) and households. Aggregate supply represents the production side and aggregate demand represents the expenditure side. Total production (= total expenditures) in the output market is nominal GDP. The two axes of the output market represent real GDP (output) and the price level in the overall economy. The growth rate of real GDP is economic growth while the growth rate of the price level is inflation if it is positive growth. 3) The credit market represents the exchange of money (credit) between savers (supply curve) and borrowers (demand curve). The price of credit is the interest rate determined by the interaction of borrowers and savers. PREPARE FOR CLASS 1 by working through Section I: The Federal Reserve and Monetary Policy.. THE ORGANIZATION OF THIS CLASS HAS BEEN CHANGED DUE TO THE RECENT FINANCIAL AND ECONOMIC EVENTS. THE CLASS WILL START WITH THE FEDERAL RESERVE, THE BANKING SYSTEM AND MONETARY POLICY. ADDITIONAL READINGS ARE LIKELY TO BE ASSIGNED AS THE WORLD WORKS THROUGH THE ECONOMIC DOWNTURN.

4 4 LEARNING OBJECTIVES Students should be able: 1. To understand the current economic news and to analyze current public policy. 2. To understand the measurement of macroeconomic data such as real GDP, economic growth, price indexes, inflation, unemployment, employment, the federal budget deficit, and the national debt. 3. To be able to convert (deflate) nominal variables to real variables. 4. To understand the measurement of a country s balance of payments, the current and capital accounts and the status of a country as a debtor or creditor nation. 5. To discuss the sources of economic growth for developed and developing countries. 6. To analyze the effect of each of the three macroeconomic policies (fiscal, monetary, and exchange rate) with regard to real GDP growth, the unemployment rate, and the rate of inflation. 7. To understand the role of exchange rates in equilibrating trade and financial flows. 8. To discuss the fiscal and monetary pressures that led to the Russian inflation during their economic transition in the early 1990s. 9. To analyze the effect of shifts in aggregate demand and aggregate supply in the output market in terms of short-run fluctuations in economic activity. 10. To analyze the effect of implementing expansionary and contractionary policy when the economy is suffering from recession or inflationary pressure. 11. To analyze the short- and long-term effects on real GDP growth and the inflation rate from the expansionary monetary policy of the late 1970s and Volcker s fight against inflation from To analyze the conduct of monetary policy (e.g. federal funds interest rate targeting) with specific reference to the interest rate targeting of the 1970s, the 1990s and the 2000s. 13. To analyze monetary policy according to Taylor s rule. 14. To analyze the effects on economy activity and economic growth from fiscal policy and deficit spending with specific reference to the Reagan budget deficits. 15. To analyze the effect of the 1980s budget deficits and monetary policy on real interest rates, the current account deficit, the value of the dollar and the status of the US as a creditor or debtor nation. 16. To understand the Bretton Woods international financial system and the adjustment process. 17. To analyze the Asian currency crisis in 1997/98 and the role of fixed exchange rates in the boom and bust cycle. 18. To analyze the current exchange rate policy of China.

5 5 MBA 613 COURSE OUTLINE I. The Federal Reserve and Monetary Policy- Part I D7-9, M9 A. Basics B. Open Market Operations 1. Balance Sheet (FED, Commercial Banks) 2. Multiplication of Reserves of Money - The Money Multiplier 3. The Federal Funds Rate and the Reserve Market Diagram C. Discount Policy D. Reserve Requirements E. The Fed as an Institution Optional web site entitled U.S. Monetary Policy: An Introduction at II. The Federal Reserve and Monetary Policy: Part II M10 A. Monetary Transmission Mechanics B. Brief Federal Reserve and Monetary Policy History C. Pro-cyclical Targeting and the 1970s Inflation 1. The Reason for Monetary Overexpansion 2. Inflationary Expectations and the Credit Market M2 (pp10-13) 3. Three Interest Rate Effects 4. The Cost to the Savings and Loan Industry D Volcker ( ) Fights Inflation 1. The Cost to the Domestic Economy 2. The Third World Debt Crisis E. Inflation Targeting F. Greenspan ( ) Legacy and Taylor s Rule 1. The Episode 2. The Episode G. Bernanke and the Fed: Go to fed.gov and move through News and Events, Testimonies and Speeches and to Speeches Read: November 21, 2002 Remarks by Governor Ben S. Bernanke, Deflation: Making Sure It Doesn t Happen Here, August 22, 2008 Chairman Ben S. Bernanke, Reducing Systematic Risk, page 1 first six paragraphs December 1, 2008 Chairman Ben S. Bernanke, Federal Reserve Policies in the Financial Crisis

6 6 III. The Macro Economy A. Measuring Economic Activity D Ch 6, M Ch3 B. The CPI vs. GDP Deflator: Two Measures of Price Indexes C. The Foreign Sector (Foreign Trade) D Ch 6, pp Current Account 2. Capital Account 3. Case 1: Trade Deficit Causing a Declining Currency 4. Case 2: Trade Deficit as a Result of a Rising Currency The Foreign Sector (International Trade and Exchange) Questions: 1. Define the current and capital accounts by the type of transactions recorded in each. 2. Why is a current account deficit (surplus) offset by a capital account surplus (deficit)? 3. What does it mean in terms of wealth when a country has a capital account deficit? 4. Under what conditions would a country have a current account deficit and a weaker currency? Why would the current account deficit be eliminated by the weaker currency? 5. Under what conditions would a country have a current account deficit and a rising currency? What conditions are necessary for a country to continue to have a current account deficit and a rising currency? D. The Output Market: Aggregate Demand D10, pp Business Cycle Stages 2. Unemployment Cycle 3. Inflation and Cycles 4. Okun s Law M Ch 5 pp The Phillips Curve M Ch5 pp 8-13 E. Potential Real GDP: AS and Economic Growth 1. The Role of Savings and Investment M Ch 2 pp The PPF Illustration F. The State of the Macroeconomy: Output Market, AD and AS D10, M5 1. Long-run AS vs. Short-run AS 2 Long-run vs. Short-run Equilibrium 3. Recession: Need for Expansionary Policy 4. Inflation: Need for Contractionary Policy 5. Assumption of Wage Flexibility: Outcomes 6. Assumption of Wage Rigidity: Outcome

7 7 IV. Fiscal Policy D11-12, M11 A. A Brief History of National Policy Towards Deficit Spending 1. The Classical Fiscal Principle 2. First Shift in Fiscal Policy: B. Second Shift in Fiscal Policy - Keynesian Economics: Discretionary Fiscal Policy: Short-run Stabilization Policy 2. Deficit Spending, Crowding Out and Crowding In 3. An Analysis of the Kennedy Tax Cuts C. Third Shift in Fiscal Policy - Reaganomics (Supply-side Economics) Tax Cut - Spur Savings and Investment 2. The Twin Deficits and the Crowding Out of the Trade Sector D p. 119, p. 287 Optional Reading: Supply-side: D. Fourth Shift in Fiscal Policy? Tax Bill and the 1990 Tax Increase and Budget Surplus 2. Clintonomics: 1993 Tax Increase and Budget Surplus E Fifth Shift in Fiscal Policy (Bush ) F. The Sixth Shift in Fiscal Policy: the Bail-out V. The Role of the Central Bank in Maintaining Fixed Exchange Rates M13 A The Gold Standard B. Fixed Exchange Rates C. The Bretton Woods System D. Pegging to the Dollar: The Asian Currency Crisis: Questions: Section V 1. Explain how current account deficits and surpluses are eliminated in a gold standard. 2. Diagram and explain the dilemma faced by current account deficit (surplus) prone countries under Bretton Woods. 3. Explain the term imported inflation. 4. Explain the Asian currency crisis in terms of the boom cycle when the currency is undervalued and the bust cycle when the currency is overvalued. To be handed out: Who s Really Pounding Asian Economies, Business Week, Sept 22, Questions from the reading 1. What role did the decision of the East Asian tigers to peg their exchange rate with the dollar have on the boom period of /I and their current account surpluses? 2. Explain (and diagram) why there was excess money created in those countries pegged to the dollar. 3. After China devalued in 1994 and the yen depreciated after 1995/I, what began to happen to the tiger s current account balance? 4. Why could the tigers not maintain a fixed exchange rate with the dollar in 1997? E. The Chinese Exchange Rate Policy

8 8 VI. The Global Environment A. Will the U.S. Bail-out Increase in Size and Scope? B. Will China s Bubble Burst? C. Will the Dollar Weaken? D. What Else Could Go Wrong? E. Fiscal Policy and Treasury Borrowing: Limits? F. The Fed s Options: Are There Any Options Left? Examples of Mid-term Questions 1. Show a time series diagram of potential and actual real GDP to discuss the business cycle of the 1990s and 2000s. What changes have occurred with regard to the rate of real potential GDP growth? What are the distinguishing characteristics of this economic expansion? 2. Demonstrate the importance of a country s consumption versus savings decision with regard to its future rate of economic growth. Use a PPF diagram and show a comparison. According to the Leapfrog article and the textbook, discuss the major reasons that some of the Asian countries have been able to sustain a high rate of economic growth for several decades. Is growth likely to continue at the same high rate? Why or why not? 3. Explain the role of the Treasury and the central bank in the United States with regard to the financing the government budget and changing the money supply? How does the Treasury and the Fed interact with the bond market in each case? 4. Explain why the Russian economy suffered from a major inflation during the attempted transition from a command to a market economy in What role did the Russian Treasury and the fiscal policymakers play relative to the role of the Russian central bank and its chair? Please discuss the role of reform or the lack thereof in your answer. 5. Under what conditions can a country have a strong (rising) exchange rate and a current account deficit or a weak (falling) exchange rate and a current account deficit? Provide full explanations of the internal policies (reasons) that will drive the exchange rate higher or lower in each case. What is the role of investors in each case?

9 9 QUESTIONS TO REVIEW FOR THE FINAL 1. Analyze the current state of the U.S. economy with regard to economic growth, employment, unemployment, wages, inflation, interest rates, and exchange rates. What is your prediction for inflation and economic growth next year? Is the U.S. in a "new economy" paradigm? 2. Explain the economic situation that could cause a country to have a current account deficit and a falling or rising exchange rate. What historical episodes can you provide for each case? 3. Why did the U.S. become a debtor nation in the 1980s? Why is this statement debatable? 4. Why should the Treasury and the Central Bank of a country be separate institutions? Relate to the case of Russia in the 1990s or other countries as may be appropriate? 5. Discuss Okun s Law with regard to the full employment rate of real GDP growth in the U.S. economy. Is the economy at full employment? Can the unemployment rate fall further? Why or why not? 6. Discuss the Phillips curve relationship and inflationary pressure in the 1990s. Is there a New Economy that has ushered in a new relationship between inflation and the business cycle? 7. When and why would you finance a home with a fixed or variable interest rate at this time? 8. Is the large current account deficit an indication of possible future currency devaluation? What risks does this create for international investors? What risks are there for bond investors? 9. Examine the role of the Federal Reserve System in affecting economic activity, interest rates, inflation rates, and short-run economic growth. 10. Compare and contrast interest rate targeting conducted by the Federal Reserve in the 1970s versus the 1990s and the 2000s. Contrast the pro-cyclical versus counter cyclical interest rate targeting procedures and explain when the Fed used each targeting process. 11. Analyze the policies of the Federal Reserve when Volcker was fighting double-digit inflation. Include in your discussion the three-interest rate effects from major changes in Fed policy. 12. Explain who wins and who loses when inflationary expectations are greater than (less than) actual rates of inflation. 13. How would your estimate of inflationary expectations affect your investment philosophy? 14. What effect did Volcker's anti-inflationary policies have on Third World countries in the early 1980s? 15. Analyze the policies of the Federal Reserve according to Taylor s Rule and the effect of these policies on the underlying rate of inflation. Analyze monetary policy in versus and use the appropriate output market diagram to show the initial and final position of the economy. 16. Analyze the monetary policy changes in with respect to Taylor s Rule. What is the prospect for future changes in interest rates given the current state of the U.S. and global economies? 17. Analyze the effect of government fiscal policy and large budget deficits on long-term economic growth and the competitive position of the U.S.Examine the movement of real interest rates during the 1970s and 1980s. What happened to the value of the dollar in the first half of the 1980s and what was the impact on U.S. manufacturing? 18. Explain the boom and bust cycle that caused the Asian Currency Crisis in 1997 and the role that exchange rate policy had in this boom and bust scenario.

10 10 Problem 1: Computing Real GDP and the Average Price Level Three Output Economy Food Consulting Services Motorcycles Total Total Total Nominal Price Quantity Revenue Price Quantity Revenue Price Quantity Revenue GDP Year 1 $ ,000 $210,000 $ $25,000 $ $50,000 $285,000 Year 2 $ ,000 $240,000 $ $36,000 $ $44,000 $320,000 Year 3 $ ,000 $ $ Compute the total revenue for each of the three outputs in year 3 and find nominal GDP in year 3. Round off each percentage change to the nearest tenth of a percent. Round off the average price level to the nearest thousandth. a. Compute real GDP for each year given that year 2 is the base year. Year 1 Year 2 Year 3 b. What is the growth rate (percentage change) of real GDP in year 2 and year 3? Year 2 Year 3 c. Compute the average price level for each year given that year 2 is the base year. Year 1 Year 2 Year 3 d. What is the rate of change (percentage change) of the average price level in year 2 and 3? Year 2 Year 3