MACROECONOMICS
UNIT OF ANALYSIS
ECONOMY AS A WHOLE
VARIABLES OF INTEREST
OUTPUT
PRODUCTIVITY
INFLATION
UNEMPLOYMENT
METHOD OF ANALYSIS
ECONOMIC MODELING
ECONOMIC MODELING
• HYPOTHESIS
– Relationship of interest
• Level of sales and the price
• THEORETICAL FORMULATION
– Mathematical relationship
• Quantity sold = f (price) = constant – coefficient*Price
•
-EMPIRICAL ANALYSIS – ESTIMATION
-EXPERIMENTAL ANALYSIS
-THEORETICAL FORMULATION ONLY
ATTENDANCE IN CLASS AS MODEL
• Hypothesis
– Penalty for missing a class leads to increased attendance
• Theoretical formulation
– Attendance (A) is a function of many factors
• Attendance penalty (X)
• Alternative uses of time, and other costs of being in class (difficult
to measure and identify, as they differ from student to student)
• Quality of lectures (Q)
• % of the students in the class majoring in Economics (E)
– A=f(X,Q,E)=constant+a*X+b*Q+c*E
• A – an endogenous to the model variable
• X,Q,E – exogenous to the model variables
• Next stage is either empirical or experimental
Example II – Modeling Demand
(another microeconomic model)
• Quantity = f (Price, other relevant factors)
• Consider demand for gasoline at a gas
station, other relevant factors will include
– Population density/car ownership rate
– Fuel efficiency of an average car in the area
– State of public transit in the area
– Proximity of another gas station
– Price charged by a competing gas station
– ….and many many more….
Modeling Demand
• Assume that we can only observe the price
charged by the competitor: Pc (Note: assumptions
simplify the reality, but reduce applicability)
• Hypothesis
– Quantity sold = constant – a*Price + b*Pc
• Quantity sold is determined by the model (endogenous)
• Price, Pc are inserted into the model (exogenously given)
• a, b represent the effects of Price and Pc on Quantity sold; these
are the research objectives
• Signs on a and b are also part of the hypothesis. a is assumed
to be negative because of the law of demand, while b is positive
due to the substitution, but this is not always known in advance.
model
• Simplification of reality and limitations of the
model
• Analysis of relationships
• Dynamically changing society and the need for
evolution of economic thought
– From Adam Smith to Karl Marx to John Keynes
Measuring Economic Activity
• OUTPUT
• EMPLOYMENT
• INFLATION
MEASURING OUTPUT
• Gross Domestic Product
the total market value of all final goods and
services produced by factors of production
located within a nation’s borders over a
period of time (usually one year)
• Gross National Product
the total market value of all final goods and
services produced by factors of production
owned by a nation over a period of time
(usually one year)
Output
• Measuring production
–
–
–
–
Time period (flow vs. stock)
Final goods and services (value added)
Market prices
Defining an economy (geographical boundaries
versus resource ownership)
• Gross Domestic Product
• Gross National Product
• www.bea.gov Table 1.7.5
http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=43&FirstYear=2003&LastYear=2005&Freq=Qtr
Main Categories of Expenditures
• Consumption
• Investment
• Government Spending
• Imports
• Exports
National Income Accounts statistics are available online on the website of
The US Bureau of Economic Analysis: www.bea.gov
% share of expenditures in GDP
Personal consumption expenditures
Durable goods
2004
70
8.4
Nondurable goods
20.2
Services
41.4
Gross private domestic investment
Fixed investment
16.4
16
Nonresidential
10.2
Structures
2.5
Equipment and software
7.7
Residential
Change in private inventories
Net exports of goods and services
Exports
5.7
0.5
-5.3
10
Goods
7
Services
3
Imports
15.3
Goods
12.7
Services
Government consumption expenditures and gross investment
Federal
2.6
18.9
7.1
National defense
4.7
Non-defense
2.3
State and local
11.8
OUTPUT = INCOME
• GNP = GDP + NET PAYMENTS FROM
ABROAD (Table 1.7.5)
• NNP = GNP – DEPRECIATION
• NI = NNP – INDIRECT BUSINESS TAXES
• NI represents total payments to nation’s factors
of production (profits, rents, wages…). (Table 2.1.
Personal Income and Its Disposition)
Real versus Nominal
i N
GDP  i 1 PiQi
Nominal GDP growth rate = output growth rate + price level growth rate
Growth in Nominal vs Real GDP
Nominal GDP
Real GDP
8.0
7.0
6.0
level of growth
5.0
4.0
3.0
2.0
1.0
0.0
1995
1996
1997
1998
1999
2000
year
2001
2002
2003
2004
Measuring Inflation
• CPI, PPI, Core Index, GDP Deflator
– Data available on BLS website (www.bls.gov)
– Construction of an index “indexed average
price”
• Characteristics of recent US inflation
– Low level
– Non-uniform
– International effect on the US inflation
employment
• Labor force and labor force participation
• Measuring unemployment
– Current Population Survey
• Measuring current employment
– Survey of businesses
Employment data: Bureau of Labor Statistics
(www.bls.gov)
Statistics for the US economy
For March-July 2003 (seasonally adjusted). Source: BLS
Emploment values are in 000's
Total nonfarm Employment in 000's
Total Employment
Total Unemployed
Civilian Labor Force
Labor Force Participation Rate
Unemployment Rate
March
130084
137348
8445
145793
66.2
April
130062
137687
8786
146473
66.4
May
129986
137487
8998
146485
66.4
June
129914
137738
9358
147096
66.6
July
129870
137478
9062
146540
66.2
0.05792459 0.05998375 0.06142608 0.06361832 0.06183977
Discouraged Worker Phenomenon
%
Labor Force
Participation Rate
1997
67
For the month of January
1998
1999
2000
2001
2002
2003
67.1
66.4
66.3
67.3
67.3
67.2
Real Output and Unemployment
• Okun’s Law
– Unemployment increase  reduction in Real GDP
growth
– Estimates suggest that a 1% increase in
unemployment rate leads to a 2% decline in Real GDP
growth rate:
Change in Real GDP growth rate = constant – 2 * change in Unemployment rate
• 2001-2003: Jobless Recovery?
– 2001-2003: unemployment and real GDP increase at
the same time
Classical Economic Theory
• Historical roots of the theory
– From Adam Smith’s Invisible Hand to XX
century economics
• Flexibility of all prices
– Price adjustment rather than output
adjustment
• Economy at the capacity equilibrium
– The long-run nature of the model
The economy as a self-perpetual system
• Spending creates income; income creates means for
spending…. The circular flow concept
• An important classical assumption: no leakages from the
flow: for example, savings immediately translate into
investment
– Keynes’ Trust Paradox
closed economy: Y = C
+I +G
Output markets
C
Revenues
I
Private S
Financial market
G
households
Taxes
income
firms
Pub.S
Government
Wages, profits, rents = Y
Input markets
Demand for Output
• Income identity from the Circular Flow Model:
Y=C+I+G
• Disposable income (after-tax/transfer PI) = Y – T
– (Y-T) = C + S
• Consumption function (autonomous, induced)
– Consumption is induced by disposable income:
C = C(Y-T)
– Some consumption may be autonomous to disposable income, and be
influenced by other factors (expected future Y, interest rate..)
C = a + c (Y-T)
• Consumption and Saving are the only allocations of disposable
income
– MPC, MPS
• G, T are policy driven and hence not induced by current income.
Demand for output
• Investment
– Function of real interest rate I(r)
– Investment is a decreasing function of the real
interest rate (investment is spending by firms
on final goods such as capital goods)
– The economic measure of the user cost of
capital
• Interest rate
• Economic depreciation
Equilibrium in the output market
• Production of output (supply) depends on two factors:
– Composition of inputs
• Physical capital (K)
• Labor (L)
– State of production technology
• Y = F ( K, L )
• Equilibrium in the classical model (long-run, or capacity equilibrium)
Y ( K , L )  a(r )  c(Y  T )  I (r )  G
If the inputs and the state of production technology are fixed, the supply
of goods in the economy is limited by its fixed capacity (recall fixed
LRAS from 2105)
Note that r, the real interest rate, is not yet determined by the model.
Interest rate is simply the price of loanable funds, and the Classical
model assumes full flexibility of prices, however there is only one
interest rate at which the output market will be in an equilibrium –
that equilibrium interest rate must be determined in another market.
Determining the equilibrium interest
rate: the financial market
• Real interest rate is the real cost of borrowing
(investment). Recall that even if investment is cash
financed, interest rate is still the cost of borrowing.
• GDP identity: Y = C + I + G  I = Y – C – G = S (national
savings)
– National savings: output – expenditures: Y – C – G
• Public savings: T – G
– Public savings do not depend on the interest rate
• Private savings: (Y-T)-C
– If we treat C as NOT a function of the interest rate, then private savings
are not affected by the interest rate (Mankiw Textbook)
– If we assume that autonomous consumption is a function of the interest
rate, and is a decreasing function of the interest rate, then the private
savings will be an increasing function of the interest rate
Financial market equilibrium
r
S
S, when a(r)
I(r)
Loanable funds
I = (T-G) + [(Y-T) – a – c (Y-T)] = public savings + private savings
Weakness of fiscal expansion in the
classical world
• Equilibrium in the output market
1
Y
(a  cT  I  G )
1 c
• Equilibrium in the loanable funds market
I = (T-G) + [(Y-T) – a – c (Y-T)]
– Any increase in G will be offset by equal drop in I (or
I+a, if a(r)) – indirect crowding-out
– Any decrease in T will be offset by a drop in I = cT (or
I+a, if a(r)) – indirect crowding-out
Indirect Crowding-out effect in
Fiscal Expansion
• Expansionary fiscal policy:
• Public Savings decrease
r
S
T-G
Investment declines, offsetting
Increase in G.
I(r)
Loanable funds
The microeconomics
• Determination of factor prices
• Marginal productivity
– The benefit of hiring an additional worker is the
change in the total revenues that results from hiring
that worker
• Value of the marginal product of labor = wage
– Similarly, VMPK=R - cost of capital
• Constant returns to scale and zero economic
profits
• Changes in input ratio and changes in input
costs
example
• Assume the following:
• C=100+0.8*(Y-T)
• I=1000-100*r
• Y=f(L,K)=L^(0.5)*K^(0.5)
• L=10000; K=400
• G=T=0
-------------------------------------• What is the equilibrium level of output?
• What is the level of national, public, and private savings?
• What is the equilibrium interest rate?
-------------------------------------• Set G=T=200 (balanced budget)
-------------------------------------• Set =200, T=100 (budget deficit)
-------------------------------------• Set G=200, but increase I to I=1100-100r
-------------------------------------• Set G=T=0, original I function, but C=100-10r+0.8*(Y)
money
• Functions
– Medium of exchange – definition of money
– Unit of account
– Store of value
• Historical forms of money
– Commodity money
• Gold standard: 1880’s-1914; revised standard in
post WWII era
• Fiat money
Supply of Fiat Money
• Central Bank and money supply
– Open market operations
• Expansion
• Contraction
• Recent history of US OMO
– http://www.federalreserve.gov/fomc/fundsrate.htm
• For more expanded discussion of money supply
read appendix at the end of Chapter 18 (p. 482)
Money Market
• Real Supply: M/P=f( monetary policy )
• Real Money Demand: Md/P
– Transaction demand for money
• Function of Y
– Opportunity cost of holding M2 assets
• Nominal interest rate
– Md/P = L( i, Y ) = k Y – a i
M/P - supply
i
Md/P
M-balances
Quantity Theory of Money
• Transaction need for money
– Price*Number of Transactions
• Money Supply (Quantity of Money): M
• Transaction Velocity of Money: V
• Quantity equation (transaction):
M*V=P*T
--------------------------------------------------------• Income Velocity of Money
• Quantity equation (income):
M*V=GDP Deflator * Real GDP
demand for money and quantity
theory of money
• Money demand: Md
– Transaction based: function of nominal GDP
(PY): Md=PkY
• PY=Md(1/k)  V (income velocity) = (1/k)
– Real Money Demand: Md/P=kY
• Real money balances
• In equilibrium real money demand (Md/P)
must equal real money supply (M/P)
– M/P = k Y  M(V=1/k)=PY
inflation
• Quantity of money equation: MV = PY

inflation  %P  %M  %V  %Y
• Assumption of constant velocity of money
– Inflation
• Money supply growth
– Russia in the 90’s, Germany in the 20’s
• Drop in productive capacity (output)
• Monetary Rule
– Money supply growth = real GDP growth
Money neutrality
• Classical economic theory:
– Changes in money supply have no impact on
real economic variables: output, real wages,
relative prices…
Inflation and nominal rates
• Fisher Equation:
– Nominal rate = real rate + inflation
• For past arraignments: observed inflation
– ex post real interest rate
• For forward looking: expected inflation
– ex ante real interest rate determination
• Real Money Demand:
– Md/P = L ( i , Y ) = L ( r + exp infl , Y )
• Expectation of future inflation can affect current
money demand
Seigniorage
or
Inflationary Tax
• Printing money as source of government
revenue
– Main source of hyper inflation
– Dollarization
Costs of inflation
• Expected (and unexpected) inflation
– Menu Costs
– Shoe-Leather Costs
– Instability in relative prices
• Unexpected inflation
– Redistribution of wealth
– Uncertainty of future inflation and forward
looking arraignments
Open Economy
• Presence of foreign sector
– Trade
– Investment
2001 data. Source: WDI, WorldBank, 2003
Exports % of Imports %
GDP
of GDP
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
China
Japan
Russian Federation
Switzerland
United Kingdom
United States (2004:BEA)
52.21
84.42
40.38
27.91
34.97
..
52.58
81.09
31.58
26.35
33.07
..
95.39
28.27
..
80.49
26.67
..
65.06
31.63
29.92
59.73
41.24
31.40
25.83
10.44
36.81
45.47
27.12
10.00
23.41
9.81
24.15
41.13
29.28
15.32
Croatia
Czech Republic
Denmark
Iceland
Sweden
Hungary
Latvia
Lithuania
Poland
Exports % Imports %
of GDP
of GDP
46.72
71.05
45.59
40.48
46.45
60.47
45.52
50.41
29.12
52.77
73.79
39.18
40.95
40.56
62.61
54.19
55.85
33.01
Trade
•
•
•
•
X – exports
m – imports
Net Exports: NX = X – m
Y = C + I + G + NX
– At any given time period a country’s spending
need not equal its output
• NX<0  a country spends more than it produces,
i.e. borrowing
• NX>0  a country’s production exceeds its
spending, i.e. lending
National Savings in Open Economy
•
•
•
•
NS = Y – C – G = I + NX
NX = NS – I
Trade balance = net capital flow
US BoP (www.bea.gov)
– Current Account – Trade
– Financial Account – Investment
Small Open Economy
• Incapable of causing changes in the
world’s financial markets, i.e. is a price
taker in financial markets, unable to
influence the price of loanable
internationally funds – interest rate.