EC 390 – Intermediate
Macroeconomics II
Lecture Note – Chapter 1:
Introduction & Measurement
Issues
Wilfrid Laurier University
Department of Economics
Spring 2021
Learning Objectives
1.1 State the two focuses of study in macroeconomics, the
key differences between microeconomics and
macroeconomics, and the similarities between
microeconomics and macroeconomics.
1.2 Explain the key features of trend growth and deviations
from trend in per capita gross domestic product in
Canada from 1870 to 2014.
Learning Objectives
1.3 Explain why models are useful in macroeconomics.
1.4 Discuss how microeconomic principles are important in
constructing useful macroeconomic models.
1.5 Explain why there is disagreement among
macroeconomists, and what they disagree about.
Learning Objectives
1.6 List the 11 key ideas that will be covered in this book.
1.7 List the key observations that motivate questions we will
try to answer in this book.
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What is Macroeconomics?
• Macroeconomics is the study of overall or aggregate
performance of an economy.
• Macroeconomics is the behavior of large collections of
economic agents.
• It focuses on the aggregate behavior of consumers and
firms, the behavior of the governments, the overall level
of economic activity in individual countries, the economic
interactions among countries , and the effects of fiscal
and monetary policy.
What is Macroeconomics?
• We study the determination of the economy’s total
production of goods and services as measured by real
GDP.
• We analyze the break down of GDP into its major
components: consumption, investment, government
purchases and net exports.
• We also examine the aggregates of employment and
unemployment.
What is Macroeconomics?
• These terms refer to quantities of goods or labour.
• We study the prices associated with these quantities: the
general price level, the wage rate, the rental price and
the interest rate.
• We set up economic models which allow us to study how
the various quantities and prices are determined.
What is Macroeconomics?
In macroeconomics, as in the rest of macroeconomic
study, we build economic models, which embody the
theory that we use to understand problems of interest.
In macro, the key phenomena we are interested in are
long-run growth and business cycles.
The particular approach taken in this text is a so-called
microfoundations approach. Using this approach, we build
macro models on micro principles.
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What is Macroeconomics?
• In macroeconomics, we are interested in the
determination of macroeconomic-that is, economy-wide
aggregate variables, such as real GDP.
• However, to construct a useful macroeconomic model,
we will find it helpful to build on a microeconomic
approach to the action of individual households and
businesses.
• This microeconomic approach investigates individual
decision about how much to consume and save, how
much to work, and so on.
• Then we can add up, or aggregate, the choices of
individual to construct a macroeconomic model. This
underlying microeconomic analysis is called
microeconomic foundations.
What is Macroeconomics?
General equilibrium model: how prices and quantities are
simultaneously determined in all markets.
Key Macroeconomic Questions
• Growth: What drives per capita output growth?
• Business Cycles: Why does economic activity fluctuate?
• Heterogeneity: What are the causes and consequences
of inequality? How does government policy effect the
three above?
• Fiscal policy: taxes and spending
• Monetary policy: supply of money
Gross Domestic Product, Economic
Growth, and Business Cycles
• Gross Domestic Product (GDP): the quantity of goods and
services produced within a country’s borders over a
particular period of time.
• The time series of GDP can be separated into trend and
business cycle components.
• Growth rate of real GDP for year t = ( Yt− Yt−1)/ Yt−1
-Multiply by 100 to get the growth rate of real GDP
in percent per year.
Gross Domestic Product, Economic Growth,
and Business Cycles
The year- to- year growth rates of real GDP varied around
their mean.
These variations are called economic fluctuations or
business cycles.
When GDP falls toward a low point or trough, the economy
is in a recession or an economic contraction.
Recession: commonly accepted definition is two
consecutive quarters of negative growth in real GDP.
When real GDP expands toward a high point of peak, the
economy is in a boom or an economic expansion.
Natural Logarithm Scale
• Chapter 1 provides a brief description of the important
macroeconomic aggregates in the context of Canadian
economic performance.
• Historical data on Canadian GDP, business cycles,
inflation, and unemployment are examined.
• Similar data is provided for US economy.
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Per Capita Real GDP (in 2009 dollars) for
the United States, 1900–2014
Natural Logarithm of Per Capita Real
GDP
Natural Logarithm of Per Capita Real
GDP and Trend
Percentage Deviations from Trend in Per
Capita Real GDP
Per Capita Real GDP for Canada, 1870–2014 (2007 dollars)
Natural Logarithm of Per Capita Real GDP
Natural Logarithm of Per Capita GDP and Trend
Percentage Deviations from Trend in Per Capita GDP
Natural Logarithm Scale
• The graphs for per capita real GDP show the data in
logarithmic scale.
• In logarithmic scale, the slope of GDP is the growth
rate of GDP.
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Natural Logarithm Scale
• Since, logarithmic scale is very useful in
representing growth rates, it is worthwhile to
understand how it works.
• In economics, we always use natural
logarithm, which is the logarithm with base e.
• The number e is defined as e=
• To see how this is useful, think putting an
amount $A in an saving account to earn
interest at rate r.
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Natural Logarithm Scale
• If the bank calculates interest yearly, at the
end of one year, an individual will receive
$A*(1+r) and at the end of t year $A*(1+r)t.
• If the interest is calculated quarterly (4 times
per year), the account will have $A*(1+(r/4))4
and at the end of t years $A *((1+(r/4)) 4t.
• More generally, if the interest rate is
calculated m times per year, at the end of t
years, the account will hold $A *((1+(r/m)) mt.
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Natural Logarithm Scale
• This is same as $A *((1+(1/v) v) rt where v= m/r.
• With continuous compounding (m is infinite),
the amount in the account after t years is
$A*ert.
• To see how this relates to growth rates, we
will use some of the properties of logarithm
and exponents.
• Consider the bank account again. At the end
of t+1 years, it has $A*er(t+1).
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Natural Logarithm Scale
• Take the log and subtract the log at time t,
In (A*er(t+1))-In(A*ert).
• This can be written as In A+ In er(t+1) –InA -In ert
Note: In (xy)=Inx+InY.
In (x/y)=In x-Iny
• Now , we can write the equation as In
• This reduces to Iner, where r is the growth rate.
• On a graph with the log scale, r is the rise with
the run being the change in time.
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Economic Models
• What is a model?
A model is a set of behavioural relationships,
accounting identities, institutional rules, or
technological constraints.
All of these are simply sets of equations. We can
say that a model is a set of equations.
There are two types of variables in a model:
• Exogenous– determined outside of the model
• Endogenous– determined within the model.
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Economic Models
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Economic Models
• For example, the endogenous variables in our
macroeconomic model include real GDP,
investment, employment, the general price
level, the wage rate and the interest rate.
• A simple example of a exogenous variable is
weather. In many models, technology is treated
as an exogenous variable (Solow-Swan growth
model).
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Economic Models
The Coffee Market
• shows how various events affect price and
quantity of coffee.
• assumes the market is competitive: each buyer
and seller is too small to affect the market price
• Variables:
Qcd= quantity of coffee that buyers demand
Qcs= quantity that producers supply
Pc = price of coffee
Y = aggregate income
PT = price of tea (an input)
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Economic Models
The Coffee Market
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Economic Models
Demand equation: Qcd = D (Pc , PT , Y )
The demand curve shows that the quantity of
coffee consumers demand is related to the price of
coffee, aggregate income and the price of tea.
Supply equation: Qcs = S (Pc , weather)
The supply curve shows the relationship between
quantity supplied and price, other things equal.
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Economic Models
The Coffee Market
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Economic Models
The Coffee Market
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Economic Models
The Coffee Market
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Economic Models
The Coffee Market
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Economic Models
The Coffee Market
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Economic Models
The Coffee Market
• In this model, endogenous variables are:
Qcd , Qcs and PC .
•
Exogenous variables are: Y, PT and weather.
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A Good Economic Model
What makes for a good model?
A model is judged by the following criteria:
-are the assumptions realistic?
-is it understandable and manageable?
-does it have implications that can be tested by
empirical analysis?
-and finally when implications and the data
are compared, are they consistent?
A good macroeconomic model can replicate some
of the stylized facts of economic growth and
business cycles.
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A Good Economic Model
• How do we compare macroeconomic models?
We compare them using the statistical moments
such as means, variances, co-variances and auto
co-variances etc.
• To determine the accuracy of a model, we compare the
predicted moments, with the actual empirical moments.
Generally, the greater the number of moments we can
accurately predict the better the model.
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Classification of Macroeconomic Models
• There are many types of macro economic models.
The models are classified in various ways by different
economists. We can broadly classify them in following
categories:
• Equilibrium or disequilibrium model
• Partial or general equilibrium model
• Representative or overlapping generation model
• Full information or asymmetric information model
• Static or dynamic model
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Flexible vs. Sticky Prices
• The economy’s behavior depends partly on whether
prices are sticky or flexible:
• If prices are sticky, then demand won’t always equal
supply. This helps explain
– unemployment (excess supply of labor)
– why firms cannot always sell all the goods
they produce (inventory accumulation).
• Long run: prices flexible, markets clear, economy
behaves very differently.
• Most economists agree that , in the long run, the
market clearing frameworks provides the best guide to
how an economy operates.
• For analyses of the short run fluctuations, there is a
sharp divide among economists as to whether a
market clearing model provides useful insights.
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Classification based on Market Clearing
Condition
In this course, we will discuss two types of models that
analyze business cycles:
• New Keynesian model argues that some prices are
sticky and move only slowly to equate the quantities of
goods demanded and supplied. So, new keynesian
models are disequilibrium model.
• Real business-cycle model , on the other hand, are
basic market-clearing model of economic fluctuations.
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Macroeconomic Models
• A macroeconomic model captures the essential features
of the world needed to analyze a particular
macroeconomic problem.
• Macroeconomic models should be simple, but they need
not be realistic.
Basic Structure of a Macroeconomic
Model
• Consumers and Firms
• The Set of Goods that Consumers Consume
• Consumers’ Preferences
• The Production Technology
• Resources Available
Basic Structure of a Macroeconomic Model
• Competitive Equilibrium: Firms and consumers take all
prices as given. Prices are such that supply = demand in
all markets.
• Consumers and firms optimize.
What Do We Learn From
Macroeconomic Analysis? (1 of 4)
• What is produced and consumed in the economy is
determined jointly by the economy’s productive capacity
and the preferences of consumers.
• In free market economies, strong forces tend to produce
socially efficient economic outcomes.
• Unemployment is painful for individuals, but it is a
necessary evil in modern economies.
• Improvements in a country’s standard of living are brought
about in the long run by technological progress.
What Do We Learn From
Macroeconomic Analysis? (2 of 4)
• A tax cut is not a free lunch.
• Credit markets, banks play key roles in the
macroeconomy.
• What consumers and firms anticipate for the future has an
important bearing on current macroeconomic events.
What Do We Learn From
Macroeconomic Analysis? (3 of 4)
• Money takes many forms, and society is much better off
with it than without it. Once we have it, however, changing
its quantity ultimately does not matter.
• Business cycles are similar, but they can have many
causes.
What Do We Learn From
Macroeconomic Analysis? (4 of 4)
• Countries gain from trading goods and assets with each
other, but trade is also a source of shocks to the domestic
economy.
• In the long run, inflation is caused by growth in the money
supply.
• If there is a short-run tradeoff between output and
inflation, that has very different implications relative to the
relationship between nominal interest rates and inflation.
Understanding Recent and Current
Macroeconomics Events
• Aggregate Productivity
• Unemployment and Vacancies
• Taxes, Government Spending, and the Government
Deficit
• Inflation
• Interest Rates
• Business Cycles in the United States
• Credit Markets and the Financial Crisis
• The Current Account Surplus
Figure 1.5 Natural Logarithm of Average
Labor Productivity
Figure 1.6 The Unemployment Rate for
the United States
Figure 1.7 The Beveridge Curve
The Beveridge curve is a negative relationship between the vacancy rate – job postings by firms divided
by total employment plus vacancies – and the unemployment rate. In Chapter 6, a two-sided model of
labor search, in which firms with vacancies are matched with workers seeking jobs, is used to understand
the Beveridge curve. Basically, the number of vacancies relative to unemployment is a measure of labor
market tightness, and tightness tends to increase in economic booms and decrease in recessions. But, the
Beveridge curve has shifted out since the beginning of the 2008-2009 recession. This is sometimes
ascribed to long-run changes in the labor market – an increase in the mismatch between the skills needed
by firms, and the skills unemployed workers possess.
Figure 1.8 Total Taxes and Total
Government Spending
Figure 1.9 Total Government Surplus
Figure 1.10 The Inflation Rate
Figure 1.11 The Nominal Interest Rate
and the Inflation Rate
Figure 1.12 Real Interest Rate
Figure 1.13 Percentage Deviation From
Trend in Real GDP
Figure 1.14 Interest Rate Spread
Figure 1.15 Relative Price of Housing
Figure 1.16 Exports and Imports of
Goods and Services
Figure 1.17 The Current Account Surplus