Download Fundamental Analysis

Fundamental Analysis
Classical vs. Keynesian
Similarities
Both the classical approach and the
Keynesian approach are macro models
and, hence, examine the interaction
between asset, money, and labor
markets.
 Both models depend on the
“fundamentals” (GDP, price levels, etc)

Differences
Classical Analysis
Keynesian Analysis
Differences
Classical Analysis
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•
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Prices are flexible,
markets clear
Money is “Neutral”
Emphasis on Relative
Prices
Asset markets play a
minor role
Emphasis on Technology
rather that policy (Supply
side)
Keynesian Analysis
Differences
Classical Analysis
•
•
•
•
•
Prices are flexible,
markets clear
Money is “Neutral”
Emphasis on Relative
Prices
Asset markets play a
minor role
Emphasis on Technology
rather that policy (Supply
side)
Keynesian Analysis
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•
Prices are fixed in the
short run
Money can influence
output in the short run
(Phillips curve)
Asset markets play a
pivotal role
Emphasis on policy
rather than technology
(demand side)
Example: The Productivity
Slowdown

During the Mid 1970’s, productivity growth
dropped from its long run average of 1.5% to
-.27%.
Classical Analysis

How would this drop in productivity influence
capital markets?
Classical Analysis

How would this drop in productivity influence
capital markets?
 Investment demand would most likely drop
as firm’s face lower profit expectations.
Classical Analysis

How would this drop in productivity influence
capital markets?
 Investment demand would most likely drop
as firm’s face lower profit expectations.
 Lower productivity ,means shrinking
personal income. What happens to
personal savings?
Classical Analysis

How would this drop in productivity influence
capital markets?
 Investment demand would most likely drop
as firm’s face lower profit expectations.
 Lower productivity ,means shrinking
personal income. What happens to
personal savings?
 Temporary drop in income tends to
lower savings
 Permanent declines in income tend to
lower consumption
Classical Analysis

Recall that at a
(fixed) global
interest rate, the
current account
balance is the
difference between
domestic savings
and domestic
borrowing (public
and private)
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Classical Analysis

Suppose that, initially
trade was balances at
the global interest rate
of 10%.
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Classical Analysis
Suppose that, initially
trade was balances at
the global interest rate
of 10%.
 A drop in investment
demand in a closed
economy would lower
the domestic interest
rate
 In an open economy,
the economy runs a
trade surplus

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Classical Analysis

How would this drop in productivity
influence money markets?
Classical Analysis

How would this drop in productivity
influence money markets?

Recall, the demand for money is equal to
M = kPY

A drop in income (Y) without a
corresponding drop in money supply
creates rising prices
Classical Analysis

What happens to real/nominal
exchange rates?
Classical Analysis

What happens to real/nominal
exchange rates?
Recall, P=eP* (PPP)
 Assuming no change in the foreign price
level, a rise in the domestic price level
causes an equal rise (depreciation) in the
nominal exchange rate
 PPP implies a constant real exchange rate

Summary
Current account improves
 No change in domestic (real) interest
rates
 A rise in the domestic price level
 A depreciation in the nominal exchange
rate
 A constant real exchange rate

Keynesian Analysis

As before, begin in capital markets.
Investment drops while savings remains
constant
 With excess demand for credit, interest
rates fall and income falls (lower income
lowers savings) – IS shifts left

Keynesian Analysis

The shift in IS
reflects two
opposing forces in
the balance of
payments:
Keynesian Analysis

Lower income
improves the current
account, but lower
interest rates
worsen the capital
account
Keynesian Analysis
With a high rate of
capital mobility, the
interest rate effect
dominates and a
BOP deficit results
 A BOP deficit forces
a currency
depreciation

Keynesian Analysis
We know that the long run impact is a
currency depreciation
 However, lower domestic interest rates
imply a future currency appreciation
(Interest Parity)

Keynesian Analysis
We know that the long run impact is a
currency depreciation
 However, lower domestic interest rates
imply a future currency appreciation
(Interest Parity)
 Therefore, the initial currency
depreciation must be larger than the
long run result (overshooting)

Summary
Current account improves (by more in
the short run due to the sharp
depreciation)
 Domestic real interest rates fall
 No change in domestic prices
 A sharp depreciation (both real and
nominal) followed by an appreciation

Savings: 1970-1980
Consumption: 1970-1980
Investment: 1970-1980
Interest Rates: 1970-1980
Current Account: 1970-1980
GDP: 1970-1980
Prices: 1970-1980
Exchange Rate: 1970-1980
Example: Government Deficits

Currently, the US deficit is around
$500B dollars (projected to be $550B in
2004)
Classical Analysis

Suppose that the
government runs a
$500B deficit
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Classical Analysis

Suppose that the
government runs a
$500B deficit

A rise in demand for
loanable funds
increases the interest
rate
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Classical Analysis

Suppose that the
government runs a
$500B deficit

However, with higher
anticipated future
taxes, households
increase their
savings
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Classical Analysis

Suppose that the
government runs a
$500B deficit

These two effects
offset each other,
leaving savings,
investment, and the
interest rate
unchanged.
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Summary
The current account is unaffected as
are domestic interest rates
 Assuming that the deficit has no effect
on GDP, money markets are unaffected
leaving prices and exchange rates (real
and nominal) unchanged.

Keynesian Analysis


Suppose that the
government deficit
increases.
The long run impact
should be zero.
Keynesian Analysis
However, in the short
run, the IS curve shifts
right – output increases
and interest rates rise.
 In this example, the
worsening of the trade
deficit is more than
offset by higher interest
rates attracting foreign
capital. A balance of
payments surplus is
created.

Summary
In the short run, a BOP surplus is
created causing a currency appreciation
 However, interest parity suggests that
higher domestic interest rates imply a
currency depreciation
