Microeconomics and Macroeconomics

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BIS Working Papers No 395 The financial cycle and macroeconomics: What have we learnt? by Claudio Borio Monetary and Economic Department December 2012 JEL classification: E30, E44, E50, G10, G20, G28, H30, H50 Keywords: financial cycle, business cycle, medium term, financial crises, monetary economy, balance sheet recessions, balance sheet repair. BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2012. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) iii The financial cycle and macroeconomics: What have we learnt? Claudio Borio Abstract It is high time we rediscovered the role of the financial cycle in macroeconomics. In the environment that has prevailed for at least three decades now, it is not possible to understand business fluctuations and the corresponding analytical and policy challenges without understanding the financial cycle. This calls for a rethink of modelling strategies and for significant adjustments to macroeconomic policies. This essay highlights the stylised empirical features of the financial cycle, conjectures as to what it may take to model it satisfactorily, and considers its policy implications. In the discussion of policy, the essay pays special attention to the bust phase, which is less well explored and raises much more controversial issues. JEL Classification: E30, E44, E50, G10, G20, G28, H30, H50 Keywords: financial cycle, business cycle, medium term, financial crises, monetary economy, balance sheet recessions, balance sheet repair. iv Contents Introduction 1 1. The financial cycle: core stylised features 2 1.1 Feature 1: it is most parsimoniously described in terms of credit and property prices 2 1.2 Feature 2: it has a much lower frequency than the traditional business cycle 3 1.3 Feature 3: its peaks are closely associated with financial crises 4 1.4 Feature 4: it helps detect financial distress risks with a good lead in real time 5 1.5 Feature 5: its length and amplitude depend on policy regimes 6 2. The financial cycle: analytical challenges 8 2.1 Essential features that require modelling 8 2.2 How could this be done? 10 2.3 The importance of a monetary economy: an example 12 3. The financial cycle: policy challenges 13 3.1 Dealing with the boom 14 3.2 Dealing with the bust 16 4. Conclusion 23 References 25 1 Introduction 1 Understanding in economics does not proceed cumulatively. We do not necessarily know more today than we did yesterday, tempting as it may be to believe otherwise. So-called “lessons” are learnt, forgotten, re-learnt and forgotten again. Concepts rise to prominence and fall into oblivion before possibly resurrecting. They do so because the economic environment changes, sometimes slowly but profoundly, at other times suddenly and violently. But they do so also because Microeconomics and Macroeconomics Microeconomics and Macroeconomics By: OpenStaxCollege Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes Economics acknowledges that production of useful goods and services can create problems of environmental pollution It explores the question of how investing in education helps to develop workers’ skills It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others It looks at how government spending, taxes, and regulations affect decisions about production and consumption It should be clear by now that economics covers a lot of ground That ground can be divided into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses; Macroeconomics looks at the economy as a whole It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake Another person might take an overall view and instead consider the entire ecosystem of the lake from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance Both approaches are useful, and both examine the same lake, but the viewpoints are different In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint 1/3 Microeconomics and Macroeconomics Whether you are looking at lakes or economics, the micro and the macro insights should blend with each other In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy; for example, firms will be more likely to hire workers if the overall economy is growing In turn, the performance of the macroeconomy ultimately depends on the microeconomic decisions made by individual households and businesses Microeconomics What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How people decide whether to work, and if so, whether to work full time or part time? How people decide how much to save for the future, or whether they should borrow to spend beyond their current means? What determines the products, and how many of each, a firm will produce and sell? What determines what prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomic part of this book, we will learn about the theory of consumer behavior and the theory of the firm Macroeconomics What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay workers off? Finally, what causes the economy to grow over the long term? An economy's macroeconomic health can be defined by a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important How can macroeconomic policy be used to pursue these goals? Monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets, is conducted by a nation’s central bank For the United States, this is the Federal Reserve Fiscal policy, which involves government spending and taxes, is determined by a nation’s legislative body For the United States, this is the Congress 2/3 Microeconomics and Macroeconomics and the executive branch, which originates the federal budget These are the main tools the government has to work with Americans tend to expect that government can fix ...TMD DISCUSSION PAPER NO. 58 Updating and Estimating a Social Accounting Matrix Using Cross Entropy Methods Sherman Robinson Andrea Cattaneo And Moataz El-Said International Food Policy Research Institute Trade and Macroeconomics Division International Food Policy Research Institute 2033 K Street, N.W. Washington, D.C. 20006, U.S.A. August 2000 TMD Discussion Papers contain preliminary material and research results, and are circulated prior to a full peer review in order to stimulate discussion and critical comment. It is expected that most Discussion Papers will eventually be published in some other form, and that their content may also be revised. This paper is available at http://www.cgiar.org/ifpri/divs/tmd/dp.htm Updating and Estimating a Social Accounting Matrix Using Cross Entropy Methods * by Sherman Robinson Andrea Cattaneo and Moataz El-Said 1 International Food Policy Research Institute Washington, D.C., U.S.A. August 2000 Published in: Economic Systems Research, Vol. 13, No.1, pp. 47-64, 2001. * The first version of this paper was presented at the MERRISA (Macro-Economic Reforms and Regional Integration in Southern Africa) project workshop. September 8 -12, 1997, Harare, Zimbabwe. A version was also presented at the Twelfth International Conference on Input- Output Techniques, New York, 18-22 May 1998. Our thanks to Channing Arndt, George Judge, Amos Golan, Hans Löfgren, Rebecca Harris, and workshop and conference participants for helpful comments. We have also benefited from comments at seminars at Sheffield University, IPEA Brazil, Purdue University, and IFPRI. Finally, we have also greatly benefited from comments by two anonymous referees. 1 Sherman Robinson, IFPRI, 2033 K street, N.W. Washington, DC 20006, USA. Andrea Cattaneo, IFPRI, 2033 K street, N.W. Washington, DC 20006, USA. Moataz El-Said, IFPRI, 2033 K street, N.W. Washington, DC 20006, USA. Abstract The problem in estimating a social accounting matrix (SAM) for a recent year is to find an efficient and cost-effective way to incorporate and reconcile information from a variety of sources, including data from prior years. Based on information theory, the paper presents a flexible “cross entropy” (CE) approach to estimating a consistent SAM starting from inconsistent data estimated with error, a common experience in many countries. The method represents an efficient information processing rule—using only and all information available. It allows incorporating errors in variables, inequality constraints, and prior knowledge about any part of the SAM. An example is presented applying the CE approach to data from Mozambique, using a Monte Carlo approach to compare the CE approach to the standard RAS method and to evaluate the gains in precision from utilizing additional information. KEYWORDS: Entropy, cross entropy, social accounting matrices, SAM, input- output, RAS, Monte Carlo simulations Table of Contents 1. Introduction 1 2. Structure of a Social Accounting Matrix (SAM) 2 3. The RAS Approach to SAM Updating 3 4. A Cross Entropy Approach to SAM estimation 4 4.1. Deterministic Approach: Information Theory 5 4.2. Types of Information 7 4.3. Stochastic Approach: Measurement Error 9 5. Updating a SAM: RAS and Cross-Entropy 13 6. From Updating to Estimating Using the Cross-Entropy Approach 15 7. Conclusion 18 1 1. Introduction There is a continuing need to use recent and consistent multisectoral economic data to Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Essays in international finance and macroeconomics Guo, Kai ProQuest Dissertations and Theses; 2008; ProQuest Central pg. n/a Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Essays on finance and macroeconomics Nosbusch, Marc Yves ProQuest Dissertations and Theses; 2006; ProQuest Central pg. n/a Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 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What determines the salary offered by Citibank to Cherie Camajo, a new Columbia MBA? What determines the overall salary levels paid to workers in a given year? Macroeconomics vs Microeconomics MICROECONOMIC QUESTION What determines the cost to a university or college of offering a new course? MACROECONOMIC QUESTION What determines the overall level of prices in the economy as a whole? What government policies should What government policies should Macroeconomics vs Microeconomics Microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions  Ex.: How much it would cost for a university or college to offer a new course ─ the cost of the instructor’s salary, the classroom facilities, the class materials, and so on Having determined the cost, the school can then decide whether or not to offer the course by weighing the costs and benefits Macroeconomics vs Microeconomics aggregate behavior of the economy (i.e how the actions of all the individuals and firms in the economy interact to produce a particular level of economic performance as a whole)  Macroeconomics examines the Ex.: Overall level of prices in the economy (how high or how low they are relative to prices last year) rather than the price of a particular good or service The whole is greater than the sum of its parts • Combined effects of individuals decisions can have unintended effects – Effects that are different from what any one individual intended Macroeconomic Policy • In Microeconomics Government intervention in the market usually leaves society worse off • In Macroeconomics there is a much wider role for Government – Fiscal Policy – Monetary policy Long-Run Growth • Macro considers the Long-run growth rate • Micro focuses on the amount of output the economy is capable of producing as given • Long-run growth depends on Economic Aggregates Economic Aggregates • Aggregate Output: • Aggregate Price Levels: Four Principal Ways that Macroeconomics Differs from Microeconomics: 1.In macroeconomics, the behavior of the whole macroeconomy is, indeed, greater than the sum of individual actions and market outcomes 2.Macroeconomics is widely viewed as providing a rationale for continual government intervention to manage short-term fluctuations and adverse events in the economy  monetary policy  fiscal policy 3.Macroeconomics is the study of longrun growth: What factors lead to a higher long-run growth rate? And are there government policies capable of increasing the long-run growth rate? 4.The theory and policy implementation focus on economic aggregates -economic measures that summarize data across many different markets for goods, services, workers, and assets [...]... Ways that Macroeconomics Differs from Microeconomics: 1.In macroeconomics, the behavior of the whole macroeconomy is, indeed, greater than the sum of individual actions and market outcomes 2 .Macroeconomics is widely viewed as providing a rationale for continual government intervention to manage short-term fluctuations and adverse events in the economy  monetary policy  fiscal policy 3.Macroeconomics ... individual households and businesses Microeconomics What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given... Concepts and Summary Microeconomics and macroeconomics are two different perspectives on the economy The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries... between microeconomics and macroeconomics? What are examples of individual economic agents? What are the three main goals of macroeconomics? Critical Thinking Questions A balanced federal budget and