Macroeconomics I
Lecture 1. September 4, 2007
Robert TCHAIDZE
Logistics
TAs:
Bakari Baratashvili, Anastasia Shchepetova
 Emails:

– robert@iset.ge
– b.baratashvili@iset.ge
– a.shchepetova@iset.ge

Office hours:
– RT: Wednesday 2-4.
– BB and AS: to be announced …
Textbook: Mankiw
 Weekly problem sets

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Economics as a science






Economics is not about making money.
It does help though.
Economics is about human behavior, incentives,
interactions, and outcomes.
Economics is about setting “the rules of the
game” that ensure appropriate (but what exactly
is appropriate?) outcomes.
Economics is a growing science, not all the
interaction channels are studied well enough. Not
even clear if we know about all channels.
Given the goals of society, what policies and in
what manner can/should the government pursue?
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What is Macroeconomics about?

What determines and causes movements
in the important economic variables:
– Output (real GDP) and its growth rate
– Inflation
– Unemployment

Other variables:
–
–
–
–
Interest rates
Budget balance
Current account balance
Level of debt (external, public, …)
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U.S. Real GDP per capita
(2000 dollars)
40,000
9/11/2001
First oil
price shock
30,000
long-run upward trend…
20,000
Great
Depression
Second oil
price shock
10,000
World War II
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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U.S. inflation rate
(% per year)
25
20
15
10
5
0
-5
-10
-15
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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U.S. unemployment rate
(% of labor force)
30
25
20
15
10
5
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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Questions asked:






Why does the cost of living keep rising?
Why are millions of people unemployed,
even when the economy is booming?
What causes recessions? Can the
government do anything to combat
recessions? Should it?
What is the government budget deficit?
How does it affect the economy?
Why does the U.S. have such a huge trade
deficit?
Why are so many countries poor? What
policies might help them grow out of
poverty?
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Caveats:

Short-run implications may be different
from long-run ones:
– If government cuts income taxes than
consumption increases in the short run. In the
long run government will have to cut its
expenditures or raise taxes.

What instruments to use:
– Fiscal policy: taxes, government expenditures
– Monetary policy: interest rates, exchange rate
policy, reserve requirements
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Economic models
 …are
simplified versions of a more
complex reality
– irrelevant details are stripped away
 …are
used to
– show relationships between variables
– explain the economy’s behavior
– devise policies to improve economic
performance
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Economic models





One model cannot address all the issues.
Different models are used for studying different
issues.
For each model, one should keep track of
– its assumptions;
– which variables are endogenous (determined within
the model) and which are exogenous (determined
outside the model);
– what questions can the model address and what
questions it cannot.
Different models can give different and even opposite
answers.
Models need to be tested empirically, i.e. it needs to
be checked whether actual data patterns coincide with
predictions of the model.
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Output





Nominal GDP – money value of final output of all
goods and services produced during a period of
time within the borders of a country.
Value added=value of the output minus value of
inputs. Instead of adding up value of final goods,
GDP can be obtained as a sum of economy wide
value added.
GDP measures total output, total income, total
expenditure.
Other concepts – GNP, NNP, National Income (net
of indirect business taxes).
More appropriate to look at GDP per capita.
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Problems with the concept of GDP
Ignores …
–…
–…
–…
–…
–…
–…
–…
distribution;
household work;
underground economy;
leisure;
ecological costs;
quality of life;
technological improvements.
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Real GDP
n
GDPt  p1,tY1,t  p2,tY2,t  ...  pn ,tYn ,t   pi ,tYi ,t
N
i 1
n
GDPt R  p1, 0Y1,t  p2, 0Y2,t  ...  pn , 0Yn ,t   pi , 0Yi ,t
i 1



Roughly speaking measures today’s production at
yesterday’s prices.
U.S. nominal GDP in 1996 was about 14 times higher than
in 1959. But prices have increased 5 times. Hence, real
GDP grew only about 3 times.
Population grew by about 50 percent. Hence, real GDP per
capita increased only twice.
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Inflation




GDP deflator (implicit price deflator)
= Nominal GDP / Real GDP.
It includes all the goods produced in the
economy.
It includes only domestically produced goods.
It is a weighted average of changes in prices.
IPDt  1
p1,t
p1,0
 2
p2 ,t
p2 , 0
 ...  n
pn ,t
pn , 0
1  2  ...  n  1
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Consumer Price Index
Includes domestic and imported goods.
 Is based on an average basket of goods.
 Is an average but with fixed weights

IPDt  1,t
p1,t
p1, 0
  2 ,t
p 2 ,t
p2 , 0
 ...  n ,t
p n ,t
pn , 0
1,t  2,t  ...  n ,t  1
CPIt  1
p1,t
p1, 0
 2
p 2 ,t
p2 , 0
 ...  k
p k ,t
pk , 0
1  2  ...  k  1
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Problems with CPI
It overstates inflation because it is based
on a fixed basket; does not reflect
properly introduction of new goods; does
not reflect properly changes in quality of
goods.
 One more problem from policymakers’
point of view is that it includes very
volatile components that are beyond their
control. Hence, core CPI, e.g. CPI less
food and energy.

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Unemployment
 Unemployment
is a fraction of those
who would like to work but cannot
find job.
 Labor force participation is a fraction
of those who work or want to work.
 What is optimal level of
unemployment?
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Types of unemployment



Frictional unemployment –due to normal turnover
in the labor market. It includes people who are
temporarily between the jobs, because they are
moving or changing occupations for similar
reasons. It is voluntary.
Structural unemployment refers to workers who
have lost their jobs because they have been
displaced by automation, because their skills are
no longer in demand, or for other similar
reasons.
Cyclical unemployment is attributable to a decline
in the economy’s total production. It is positive
during recessions and negative during booms.
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Basic Demand-Supply Model
A snapshot of the economy. I.e. levels of
inputs are fixed and fully utilized.
Y=F(K,L)
 F exhibits constant returns to scale:
F(zK, zL)=z F(K,L)
 F exhibits decreasing marginal product of
labor and capital.
 MPL = F (K, L +1) – F (K, L)
For a given K, MPL decreases as L
increases

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MPL and the production function
Y
output
F (K , L )
1
MPL
MPL
As more labor is
added, MPL 
1
MPL
Slope of the production
function equals MPL
1
L
labor
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Determining Supply
 Profit
= Revenue – Labor Cost –
Capital Cost = PY – WL – RK
 ΔProfit =
= ΔRevenue – ΔCost =
= MPL P – W
 If MPL > W/P hire more
 MPL = W/P (MPL=real wage)
 MPK = R/P (MPK = real capital rent)
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MPL and the demand for labor
Units of
output
Each firm hires
labor
up to the point
where MPL = W/P.
Real
wage
MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
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The equilibrium real wage
Units of
output
Labor
supply
equilibrium
real wage
L
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The real wage
adjusts to
equate
labor demand
with supply.
MPL,
Labor
demand
Units of labor, L
24
The equilibrium real rental rate
Units of
output
Supply of
capital
equilibrium
R/P
K
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The real rental
rate adjusts to
equate
demand for capital
with supply.
MPK,
demand for
capital
Units of capital, K
25
Determining Demand






Y = C + I + G + NX
This is an identity. It always holds.
C – private consumption. Depends on disposable
income Y – T. C=C(Y – T)
G – government consumption. Assume to be
fixed. Assume taxes T are fixed too.
Investment is not a purchase of financial
instruments. It is construction of new plants,
purchases of new equipment, new housing, etc.
Investment depends inversely on real interest
rate. I = I(r).
Assume a closed economy, where NX=0.
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Equilibrium
Y=F(K,L)
 NX = 0
 C = C(Y – T)
 I = I(r)
 K, L, G, T are fixed. Hence, Y is fixed.
Hence, C is fixed.
 Y – C – G = I(r)
 (Y – C – T) + (T – G) = I(r)
 Private Saving + Public Saving =
Investment

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Loanable funds market
equilibrium
r
S  Y  C (Y  T )  G
Equilibrium real
interest rate
I (r )
S, I
Equilibrium level
of investment
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Government spending increases…
Logically:
 As supply of loans decreases, their
price (real interest rate) increases.
Crowding out.
Mathematically:
 Y – C – G = I(r)
 As G increased, Y – C – G decreases
 In order for I(r) to decrease, r should
rise.
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Government spending increases…
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Homework:
 Chapter
2, problem 7 (a, b, c, d)
 Chapter 3, problem 1
 Chapter 3, problem 9
 Due
next Tuesday at 9 a.m. in class
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