Intermediate Macro
Introduction
Current Events
•
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•
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Great Recession
Survival of the Euro
“Lost Decade”
Developing World
– China
– India
– Sub-Saharan Africa
What’s it all about?
• National Economy
• Micro: consumer/firm behavior
• Macro variables
– GDP
– Inflation
– Unemployment
– Interest rates
– Debt/deficit
– exchange rates
– Etc.
Goals
• Explain movements of and
connections between macro
variables.
• Policy
– What can the gov’t do?
– What should the gov’t do
Macro is hard
• General Equilibrium
– many variables
– media coverage (yuck)
• Short run vs. Long Run
– Ex. new machines eliminate jobs
• Many approaches to
economics
Plan of class
• Short run
– 1 to 2 years
– Booms and recessions
• Medium run
– Why / how fast does GDP grow
– equilibrium
• Long run
– Decades
– What makes rich countries rich?
– Development
Our focus
• Domestic economy
• Short Run – Keynesian story
• Classical ideas to connect to
the long run
Macro Flow Chart
• Firms & consumers
• Income and Consumtion
• Government
– Spending
– Taxes & transfers
• Savings & Investments
• Imports and Exports
Fiscal Policy
• Government Spending
– Defense
– Health, Education & Welfare
• Tax policy
– Income tax
– Capital gains tax etc.
• Debt/Deficit
President and Congress
Monetary Policy
The Federal Reserve controls
• Money supply
• Interest rates (one of them)
• Affects firm/consumer
decisions
Gross Domestic
Product
• Why do we care so much?
• GDP per capita across
countries is correlated w/
– Poverty
– Health
– Education
• Crude measure, GDP ignores
– Quality of life
– Environmental degradation
– “Happiness”
• Growth rate shows change
GDP – basic facts
• Rises
– Population rises
– Productivity rises
• Except when it doesn’t
– Recessions
– Causes?
Measurement
GDP – value of all final goods
and services produced over a
given time
Intermediate good – used as part
of the production of another
good
Final good – sold for use by
consumer/business/gov’t
Note: all exports count as final
goods
Multiple ways to measure GDP
Final or Intermediate?
• Goodrich sells a tire to Ford for
its new cars.
• Joe buys a new tire to replace
a flat on his used car.
• Jean sells an extra tire in her
garage to Sam.
GDP example
Farmer
Revenue
Costs
Profit
Supply store
Revenue
corn $150
seed $40
fertilizer $60
wages $25
$25
seed $40
fertilizer $60
Cost (wholesale)
$70
Profit
$30
GDP?
3 ways to measure
GDP
• Final goods
– add value of all final good
– $150 in corn
• Value added
– Sum value added for all
intermediate and final goods
– $40+$60+$50 = $150
– $50 is value added by farmer
• Income
– Sum all incomes from all
production
– $30+$25+$25+$70
Nominal vs. Real GDP
Economy produces only corn
Quantity
Price
2006
6000 bushels
$4
2007
8000 bushels
$5
Nominal
GDP(2006) = $24,000
GDP(2007) = $40,000
Growth rate = 66.6%
What’s wrong with this measure?
Real GDP
• Measure of goods
– adjusted for price changes
– “in constant dollars”
Using prices from 2006
real GDP(2006) = $24,000
real GDP(2007) = $32,000
Growth rate 33.3%
Note: if prices rise,
real GDP < nominal GDP
GDP deflator
Deflator =
nominal GDP/real GDP
Change in the deflator is a
measure of inflation
Deflator (2006) = 1
Deflator(2007) = 1.25
Inflation – 25%
Obvious with one good…..
Problem
An island country in the Indian Ocean
produces zebu steaks and canoes. They
produced the following quantities at the
following prices in the last two years.
2005
Quantity Price
Steaks 800
$20
Canoes 600
$40
2006
Quantity Price
1000
$30
600
$50
Find the growth rates for nominal and real
GDP, using 2005 prices as the base.
Find the rate of inflation.
CPI and inflation
• Inflation also measured as an
average of prices
– Gov’t surveys
– Weighted according to “typical”
household expenditure
Inflation
• Why do we care?
• Wages rise with inflation
– Incomes not eroded
– Exceptions
• Pensions
• Alimony
• Disability
• Distorts relative prices
– Some prices adjusted faster
• Uncertainty
– High inflation come with volatility
– Investment/consumption
decisions are more difficult
Unemployment
Unemployed + employed =
Labor force
Unemployed – looking for a job
Unemployment rate
U = unemployed/labor force
High unemployment:
– Unused resources
– Skills erode
Not measured
Discouraged workers /
underemployed
Real vs. Nominal GDP
• Real GDP
– Changes in price don’t affect it.
– Measured in prices from a single
year.
GDP Deflator =
Nominal GDP
Real GDP
- measures the effect of prices
Model of Demand
Build a Model
• How do elements on the flow
chart fit?
• How do changes affect GDP?
• How do policy changes affect
the economy?
Start with Demand
- goods sector
- financial sector
Demand
Z – aggregate demand
Z = C + I + G + X – IM
Equilibrium condition: Z=Y
Assume: X = IM (no trade
imbalance)
Z = C + I + G; Z=Y
Does Y affect C, I, G?
Consumption Function
• C increasing in Y
• Slope less than 1
– Some income saved
• Autonomous consumption
Algebraically,
C = c0 + c1YD
c0>0 – autonomous consumption
0<c1<1 –marginal propensity to
consume (MPC)
Solving
Assume (for now) I and G are
fixed
Y = c0 + c1YD + I + G
Or
Y = c0 + c1(Y–T) + I + G
With Y=Z
Y* = (1/(1-c1))(c0 - c1T + I + G)
Example
c0 = 100; c1=0.75
I = $250; G = $200; T = $200
(balanced budget, for now)
Y* = (1/0.25)400 = 1600
What if G rises by $50?
Y* = $1800
DY > DG Why?
(Keynesian
cross)
Multiplier
• Increase in G, Yh, Ch, Yh
etc……
• Why doesn’t Y explode?
– Some saved every step
Multiplier = 1/(1-c1)
measures the extra impact on
Y of a change in autonomous
spending.
Money
Supply and Demand
Liquidity Preference
2 assets: Money and Bonds
W=M+B
Hold bonds: better return
Hold money: for transactions
(liquidity)
Demand for Money vs. interest rate ?
Higher i
greater demand
for bonds
lower demand for
money
Money S&D
• Demand for money slopes
down
• Supply of Money is vertical
– Decision of the Fed
– Doesn’t respond to i
– Fed can shift S to change
equilibrium i
What shifts Demand?
• Nominal GDP
– Real GDP or prices
Bonds
Discount bonds pays $100 in
one year.
price?
i - yield
ex. P = $80
80(1+i) = 100 so i = 25%
P = 100/(1+ i)
If P rises, i falls
Equilibrium
What if i > i* ?
excess money
buy bonds
P i
i falls to equilibrium.
Questions
• How would an increase in
prices affect equilibrium
interest rates?
• What would the Fed do to
lower equilibrium interest
rates?
LM curve
For a given MS, how are Y and i
related?
If Y rises, MD shifts out, i* rises
If Y falls…….
In the financial market, Y and i
are directly related
LM relation
Goods market
How does a change in the
interest rate affect aggregate
expenditure?
Not G – decision of gov’t
Not C – income and substitution
effects
Investment is affected by i
Deriving IS
• i rises, I falls, expenditure function
shifts down
• Equilib. GDP (Y) falls
Goods market: i and Y are inversely
related
IS relation
Note: IS for Investment – Savings
relation
For a given Y, i adjusts so that S=I.
Shifts in IS?
IS - LM
Together, they determine
equilibrium
Y* and i*
Combines goods and financial
markets
Can discuss fiscal and monetary
policy.
Shifts in IS
• Consumer confidence
– Preferences
– Future employment
• Business confidence
– Profit opportunities
– Changes in technology
• Fiscal policy
Shifts in LM
• Change in prices
• Monetary Policy
Fiscal Policy
Increase in G
Expenditure shifts up
IS shifts right
Y* and i* rise
MD shifts right
Does LM shift?
No, MD shifts due to a change in Y
- movement along LM
Monetary Policy
Fed increases MS
LM shifts right
Y* rises and i* falls
Expenditure function shifts up
Does IS shift?
No, Exp shifts due to a change in i
movement along IS
Problem
A tax cut changes consumption.
Show how a tax cut would
affect the IS-LM, expenditure
and MS – MD diagrams.
Fiscal vs. Monetary
Policy
Monetary Policy
• Advantages
– Quick decisions/implementation
– Fine tune
• Disadvantages
– Takes time to have an effect
– undirected
Fiscal Policy
• Advantages
– Immediate impact
– Directed spending
• Disadvantages
– Takes time to decide (politics)
– Changes tend to last
Real Money S&D
• Equilib i determined by real money
S&D
• Graph looks the same
• Change in P
– Shifts supply of real money
– Shifts demand for nominal money
– P rises, i rises in both cases
Note: Fed controls interest rates in
the short term.
Long run: prices changes affect i*
IS - LM
C = 100 + 0.75YD
I = 100 – 1000i
G = 200
T = 200
(M/P)d = 3Y – 18,000i
(M/P)s = 1500
Find the IS and LM relations.
Find equilibrium Y* and i*.
Impulse response
Decrease in Fed funds
Takes 4-8 quarters to have an
effect
Practice Problem
An island country in the Indian Ocean
produces zebu steaks and canoes. They
produced the following quantities at the
following prices in the last two years.
2005
Quantity Price
Steaks 800
$20
Canoes 600
$40
2006
Quantity Price
1000
$30
600
$50
Find the growth rates for nominal and real
GDP, using 2005 prices as the base.
Find the rate of inflation.
Practice Problem
c0 = 100; c1=0.8
I = $150; G = $200; T = $200
Using the above, find equilibrium
output/income.
If autonomous consumption falls
by $50, find the new level of
equilibrium output.
What is the multiplier?
What is savings before and after
the change in C?
Practice Problem
Let the consumption function be
C = 100 + 0.9YD
If autonomous consumption falls
by $15, how does equilibrium
output change?
Show the changes on a
Keynesian cross diagram.
Practice Problem
C = 100 + 0.75YD
I = 100 – 1000i
G = 200
T = 200
(M/P)D = 3Y – 10,000i
M/P = 1500
Find IS
Find LM
Find equilibrium i and Y
Practice Problem
When Clinton took office in 1992,
he raised taxes, and the Fed
agreed to increase the money
supply as long as government
spending stayed constant.
Show the changes on an IS-LM
diagram. What happens to
equilibrium output and the
interest rate? When would
equilibrium output rise?
Problem
Show the impact of a decrease
in the price level on a graph of
real money supply and demand
and an IS-LM graph. What is the
relationship between
output/income and the price
level?
Review Problem
Given the following information find the
equilibrium level of output Y*. If government
spending and taxes both fall by $50, how
does Y* change? Show on a graph of the
expenditure function with the equilibrium
condition.
Autonomous consumption = $300
MPC = 0.9
Investment = $100
Taxes = $150
Government spending = $150
What is savings both before and after the
change in spending?
Review Problem
The recent recession has seen a
large drop in business
confidence affecting autonomous
investment. The Federal
Reserve has responded by
increasing by increasing the
money supply. Show the effect
on the equilibrium on an IS-LM
graph, and show the initial
effects on an expenditure graph
and a money S&D graph.
Labor Market
U.S. Labor Market
• Large movements in and out of
labor force and employed
– Hires
– Quits
– Layoffs
– Discouraged workers
• Continental Europe - slower
change
– Stronger unions
– More firing restrictions
– Higher wages and more
unemployment
Wage determination
Firms seem to pay higher than
“competitive” wages.
Why are wages higher than
necessary?
• Efficiency wages
– Get more effort
– Reduce turnover
• Bargaining power
– Worker skills
– Depends on other options
– unions
Firm decision
Competitive labor market
W = MRP
if W < MRP then
firm hires more (more profit)
MRP = P x MPL
so
marginal product = real wage
(W/P)
Simple version
Production function: Y=L
Implies MPL = 1
real wage W/P = 1
P=W
“price equals marginal cost”
Too simple???
- firms have “pricing power”
- workers have bargaining
power
Wage determination formally
Nominal wages negotiated
according to expected prices
Pe
W = PeF(u,z)
F(u,z)
“bargaining power”
u – unemployment rate
z – other factors
ex. labor laws
worker skill
Price determination
Output prices also tend to be
higher than wages.
• Other costs
• Firms have market power
- monopolistic competition
- monopoly
- oligopoly
P = W(1 + m) “markup”
or
W/P = 1/(1 + m)
Natural rate of
unemployment
If price = expectations, combine
equations
F(u,z) = 1/(1 + m)
relates the wage and price
markups
Determines un – natural rate of
unemployment
Medium run concept
Graph
• Price & wage determination
• unemployment vs. real wage
• Price setting equation constant
according to markup
• Wage setting, higher u means
lower real wage (bargaining)
Compare U.S. and France
• more firing restrictions
• More benefits required by law
• WS curve to the right
• higher un
Natural rate
• Medium run concept
• 0% cyclical unemployment
• Associated with
– natural rate of employment
– Natural rate of output
– NAIRU
• Natural rate can change over
time with
– labor laws
– unemployment benefits
– tax policy?
Problem
• Unions give workers extra
bargaining power, but have
declined in membership over
the last 25 year in the U.S.
Use the wage / price
determination graph to show
the effect on real wages and
the natural rate of
unemployment.
Problem
• Online retailing has increased
competition for goods, lowering
the markup firms can charge.
Show how this affects the labor
market and the natural rate of
unemployment.
Review Problem
A proposed law in France would
make it easier for firms to fire
people. Show the effect on the
natural rate of unemployment on
the wage/price setting graph.