BUSI97345
Macroeconomics
Roald Versteeg
Imperial College Business School
Instructor
Lecturer: Roald Versteeg
• 53 Prince’s Gate, 4.08a
• r.versteeg@imperial.ac.uk
• Office Hours: Tuesday 3-4 pm or by appointment
TA: Yi Zhang
• y.zhang17@imperial.ac.uk
• Office Hours: By appointment
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Schedule
• Monday (11am – 12:30am): Lecture 1
• Tuesday (13:00 – 14:30am): Lecture 2
• Wednesday 16:30 to Thursday 16:30:
– Participation Quizzes
• Thursday: Classes
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Assessment
• Class Participation (15%)
– Weekly, 2 MCQ Questions, start in week 2.
• Group Assignment (15%)
– Released in Week 2, Due in Week 8
• Bonus Assignment
– One new article related to module, prize: $1BN
• Final Exam (80%)
– Previous Years Exam’s are available on ISENDI
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Main Textbook
Jones, Macroeconomics, 5th ed.
Could also consult:
• NYU Stern, The Global Economy, freely available at
https://sites.google.com/site/nyusternglobal/home
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Course Aims
• Provide an overview into core Macroeconomic concepts
– Long Term Growth and Short Term Business Cycles
– Inflation and Unemployment
– Impact of Fiscal and Monetary policy
• How do macroeconomic developments affect asset prices?
• Lessons from various crises
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Follow the News
Available through Imperial College
• Economist
– This week special report on the
world economy
• Financial Times
– Also check out FT Alphaville
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This Week
• Reading
Jones, Chapter 1 - 5.
GEM
This Week:
• Introduction
– Introduction to Macroeconomics
– Measuring Economic Activity
• Long Run Model
– Cobb-Douglas
– Solow Growth Model
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• Introduction
– Introduction to Macroeconomics
– Measuring Economic Activity
• Long Run Model
– Cobb-Douglas
– Solow Growth Model
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What is Macroeconomics?
• Economics: Allocation of scarce resources
– Finance: Allocation of scarce resources through time
– Microeconomics: Study of individual people and firms
– Macroeconomics: Economy as an aggregate
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Topics Studies in Macroeconomics
• Economic Growth and Inequality
• Prices and Inflation
• Unemployment
• Stabilization Policies
– Fiscal Policy
– Monetary Policy
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• Models
– Simplify to relevant elements.
– useful if predictive power.
– often multiple equations.
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How can we use it?
Proxy new policies by changing
parameters and exogenous variables
Change in endogenous variables and
predict costs and benefits
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• Increase in income taxes
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• Increase in an input price
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The underlying model
𝐿𝑠 = 𝑓 𝑤
= 𝑎𝑤 + 𝑙
= 2𝑤 + 30
𝐿𝑑 = 𝑓 𝑤
=𝑓−𝑤
= 60 − 𝑤
𝐿𝑠 = 𝐿𝑑
2𝑤 + 30 = 60 − 𝑤
→ 𝑤 = 30, 𝐿 = 30
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• Introduction
– Introduction to Macroeconomics
– Measuring Economic Activity
• Long Run Model
– Cobb-Douglas
– Solow Growth Model
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GDP
• Production measure of GDP: The number of
goods produced in the economy
• Expenditure measure: The total purchases in the
economy
• Income measure: All the income earned in the
economy
• All three approaches should give identical
measures of GDP.
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National Income Accounting
𝑌 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
• C: Consumption
• I: Investment
• G: Government purchases
• X: Exports
• M: Imports
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US Shares of GDP
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FRED: Real GDP Per Capita (U.S.)
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Sources of National Accounts Data
• UK:
Office of National Statistics
• Europe:
Eurostat
• US:
FRED
• Developed:
OECD
• IMF:
IFS
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Stock Variables vs Flow Variables
• Stock Variables versus Flow Variables
• The capital stock is a stock variable, Investment is a flow
variable
• Think of bath tub and water running into it! The water in the
bath tub is the stock, the water running in and out is the flow
• For example, 𝐾𝑡 + 1 = (1 − 𝛿)𝐾𝑡 + 𝐼𝑡 + 1
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Logs
• Many macro series are plotted in logs or changes in logs
(an approximation to growth rates)
• Arithmetic Returns:
𝑃𝑡 −𝑃𝑡−1
𝑃𝑡−1
= 𝑟𝑡
• Log Returns: ln 𝑃𝑡 − ln 𝑃𝑡−1 = 𝑟𝑡 ≈ 𝑟𝑡
• Many advantages:
– Allows for easier econometric inference
– Additive over time
– Makes multiplicative models linear
𝑌 = 𝐴𝐾 𝛼 𝐿1−𝛼 → 𝑦 = 𝑎 + 𝛼𝑘 + 1 − 𝛼 𝑙
(where 𝑦 = ln 𝑌 etc.)
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• Introduction
– Introduction to Macroeconomics
– Measuring Economic Activity
• Long Run Model
– Cobb-Douglas
– Solow Growth Model
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Long Run Growth
Reading:
Chapters 3, 4 and 5 of Jones
• The Aggregate Production Function
–Cobb-Douglas
• The Solow Model
–Sources of economic growth
–Institutions and Policies
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Long Run vs Short Run
• Long Run is about slow-moving variables. Prices are flexible.
• Short run is quarter to quarter. Prices are sticky.
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Production Function
Cobb-Douglas
𝑌 = 𝐹 𝐾, 𝐿 = 𝐴𝐾 𝛼 𝐿1−𝛼
output
160
1. More input = more output
120
2. Diminishing MP
80
3. Constant returns to scale
𝑌 = 𝐴𝐹(𝜆𝐾, 𝜆𝐿) = 𝜆𝐴𝐹(𝐾, 𝐿)
40
0
0
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100
capital stock
200
300
400
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Capital (K)
What we mean: plant and equipment, physical capital
• Why does it change?
– Depreciation/destruction
– New investment (“capex”)
• Mathematical version:
𝐾𝑡+1 = (1 – 𝛿𝑡) 𝐾𝑡 + 𝐼𝑡
• Adjustments for quality?
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Measuring capital
• Option #1: direct surveys of plant and equipment
• Option #2: perpetual inventory method
– Pick an initial value 𝐾0 and depreciation rate 𝛿
𝐾𝑡 + 1 = (1 – 𝛿𝑡)𝐾𝑡
+
𝐼𝑡
• In practice, #2 is the norm:
– Get I from ONS or Fred (“NIPA”)
– Set 𝛿 = 0.06 [ballpark number]
– Example: 𝐾2010 = 100, 𝛿 = 0.06, 𝐼 = 13 → 𝐾2011 = ? ?
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Labor (L)
• What we mean: units of work effort
• Why does it change?
– Population growth
– Fraction of population employed
(extensive margin)
– Hours worked per worker
(intensive margin)
• Our starting point: number of people working
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Measuring labor
• Our starting point
– 𝐿 = number of people working
• Adjustments for hours worked
– Replace 𝐿 with ℎ × 𝐿 (h = hours per worker)
• Adjustments for skill, education
– Replace 𝐿 with 𝐻 × 𝐿 (𝐻 = “human capital”)
– 𝐻 commonly connected to years of school
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How to solve the model?
max(Π) = 𝑌 − 𝑟𝐾 − 𝑤𝐿
K,L
𝑑Π
𝑌
=𝛼 −𝑟 =0
𝑑𝐾
𝐾
𝑑Π
𝑌
= (1 − 𝛼) − 𝑤 = 0
𝑑𝐿
𝐿
Solution
𝑌 ∗ = 𝑤 ∗ 𝐿∗ + 𝑟 ∗ 𝐾 ∗
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UK Labour Share of Income
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US Labour Share of Income
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Mathematical Solutions
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Output per Person (Intensive Form)
• Divide output by the number of workers
𝑌
𝐾 𝐿
𝐾
=𝐹
, = 𝐹( )
𝐿
𝐿 𝐿
𝐿
• We can rewrite output per person as
𝑦 ∗ = 𝐴𝑘 1
Where 𝑦 =
𝑌
𝐿
and 𝑘 =
𝐾
;
𝐿
set 𝐴 = 1 to get
𝑦∗ = 𝑘1
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The Model’s Prediction for Per Capita GDP
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Productivity Differences: Improving the Fit of the Model
• The productivity parameter measures how efficiently
countries are using their factor inputs.
•
Total factor productivity (TFP)
•
If TFP is ≠ to 1  better model
• Data on TFP is not collected.
– It can be calculated because we have data on output
and capital per person.
– TFP is referred to as the “residual.”
• A lower level of TFP implies that workers produce less
output for any given level of capital per person.
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United States and Chinese Production Functions
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Understanding TFP Differences
•
Human capital
•
Technology
•
Institutions
•
Misallocation
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• Introduction
– Introduction to Macroeconomics
– Measuring Economic Activity
• Long Run Model
– Cobb-Douglas
– Solow Growth Model
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Growth Over the Very Long Run
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Productivity through the ages
npr.org/2022/08/31/1120401904/summer-school-8-productivity-getting-lit
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Case Study: People versus Countries
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Solow model
• How the Solow model works
– Saving finances capital accumulation
– More capital leads to greater output
– Impact eventually tails off: diminishing marginal
product of capital
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Solow model: equations
• Production function:
𝑌𝑡 = 𝐴𝐾𝑡𝛼 𝐿1−𝛼
𝑡
𝑌𝑡 =
1/3 2/3
𝐴𝐾𝑡 𝐿𝑡
• Capital accumulation:
𝐼𝑡 = 𝑆𝑡 = 𝑠𝑌𝑡
𝐾𝑡+1 − 𝐾𝑡 = Δ𝐾𝑡 = 𝐼𝑡 − 𝛿𝐾𝑡
𝑠 ∈ 0,1 , 𝛿 ∈ 0,1
• Parameters
𝐴, 𝑠, 𝛿, 𝐿, 𝐾0
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Solow model: dynamics
200
150
output
100
50
saving
depreciation
0
0
100
200
300
400
500
600
700
800
900
1000
Capital Stock
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Growth Rates in the OECD, 1960–2014
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Growth Rates around the World, 1960–2017
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Argentina: Case Study
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Is it because of huge crashes?
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Strengths and Weaknesses of the Solow Model
• The weaknesses of the Solow model:
– It focuses on investment and capital.
The much more important factor of TFP is still
unexplained.
– It does not explain why different countries have
different investment and productivity rates.
A more complicated model could endogenize the
investment rate.
– The model does not provide a theory of
sustained long-run economic growth.
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India
• Saving and investment rates well below China’s
• How important is this to India’s future?
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India
Solow model inputs (estimates for 2010)
Parameter
𝑌0
𝐾0
𝐿
𝑠
𝛿
4.08$ (trillion)
8.23$ (trillion)
0.452 (billion)
0.25
0.06
Experiments
– Raise saving rate
– Raise population growth
– Add productivity growth
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India
Scenario
GDP
2010
4.08
2050: no-growth benchmark
5.56
2050: higher saving (+5%)
6.03
2050: population growth (1%)
7.01
2050: TFP growth (2%)
15.49
2050: TFP growth (+1%)
25.94
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What have we learned?
• Solow model
– Saving and capital accumulation generate growth
– But diminishing returns kills this off quickly
– Conclusion: saving and capital formation can’t be the only
keys to prosperity (in the US, in China, in India, etc)
• If not capital, what?
– Endogenous Productivity Growth (Human Capital / Ideas)
– Institutions (Social Capital)
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What is Capital?
• Physical/Structures (Disembodied)
• Human (Embodied)
• Formal Institutions: Emphasized in book by Acemoglu and
Robinson. Institutions protect property rights and limit
powers of executive.
• Social/Civic Capital (Putnam): Culture, more informal type
of institutions. Guiso, Sapienza and Zingales (series of
papers)
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Human Capital
• Endogenous growth (Romer, 1990), Nobel in Economics,
2018
• Ideas actually can be replicated anywhere and do not suffer
from decreasing marginal product
• Therefore, increasing returns to scale
• How to measure?
• Patents, quality of universities, scientific articles produced in
a country, Research and Development expenditures relative
to sales
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Social Capital
• Trust and social capital can help overcome the problems with
devising contracts for trade
• Correlation between trust and large organizations (La Porta, R.,
Florencio, Lopez de Silanes, Andrei Shleifer, and Robert Vishny , 1997,
“Trust in large organizations", American Economic Review, 87:2, 333338).
• Using micro data from Italy: low trust areas rely more on cash
or reliance on families, therefore lower financial development
• But what is social capital?
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Definition of Social Capital
• No precise definition
• Networks, norms, trust that enable participants to act together
more effectively to pursue shared objectives
• Trust=social capital or a result of social capital?
• Precise definition and measurement not easy
• One approach: World Values Survey
• Another: participation in national referendums as measure of
civic engagement
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Role of Institutions?
• Institutions fundamental for differences in economic
development
• Property Rights
• Regulatory Institutions
• Macro Stabilization
• Conflict Management
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Correlation from Chapter in Handbook of Economic
Growth, 2005, Acemoglu, Johnson, Robinson
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A controlled experiment: Korea
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