Chapter 1

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Course Outline. ▫ Part V. Macroeconomic Policy Debates (if time permits). Chapter 14: Stabilization Policy. Chapter 15: Government Debt ...

Macroeconomic Theory Econ 410 – Section 502

Instructor: Danilo R. Trupkin

Course Outline  Part I. Introduction Chapter 1: The Science of Macroeconomics. Chapter 2: The Data of Macroeconomics.

 Part II. Classical Theory: The Economy in the Long Run. Chapter 3: National Income. Chapter 4: Money and Inflation Chapter 5: The Open Economy

Chapter 6: Unemployment

Course Outline  Part III. Growth Theory: The Economy in the Very Long Run. Chapter 7: Economic Growth I Chapter 8: Economic Growth II

 Part IV. Business Cycle Theory: The Economy in the Short Run.

Chapter 9: Introduction to Economic Fluctuations Chapter 10: Aggregate Demand I Chapter 11: Aggregate Demand II Chapter 13: Aggregate Supply

Course Outline  Part V. Macroeconomic Policy Debates (if time permits) Chapter 14: Stabilization Policy Chapter 15: Government Debt

From yesterday’s NYT:

Responding to Recession By Paul Krugman

 … the economic consensus seems to be that the implosion of the housing market will indeed push the U.S. economy into a recession... As a result, over the next few weeks we’ll be hearing a lot about plans for economic stimulus.

 Since this is an election year, this debate is inevitably tied up with politics. And here’s a modest suggestion for political reporters. Instead of trying to divine the candidates’ characters by scrutinizing their tone of voice and facial expressions, why not pay attention to what they say about economic policy?

From yesterday’s La Nacion:

Greenspan Sees U.S. as Likely In Recession, or Soon to Be

 "The symptoms are clearly there… Recessions are usually signaled by a discontinuity in the market place, and the data of recent weeks could very well be characterized in that manner,"

 Specifically, a drop in a purchasing managers index to 47.7 in December after several months just above 50, the dividing line between expanding and contracting manufacturing activity.

 Another sign, he said, was the jump in the unemployment rate to 5% in December from 4.7% in November.

Stagflation cometh By Joseph Stiglitz

 The fallout from a combination of rising inflation and global recession seems inevitable: how can the world's economies survive it?

 For America today, the question is only whether there will be a short, sharp downturn, or a more prolonged, but shallower, slowdown.

 A recession in the world's largest economy has global consequences. If monetary authorities respond appropriately we may be able to manage our way through it… But if they raise interest rates, we should prepare for another episode of stagflation.

CHAPTER

1

The Science of Macroeconomics

Learning Objectives This chapter introduces you to

 the issues macroeconomists study

 the tools macroeconomists use  some important concepts in macroeconomic analysis

Important issues in macroeconomics Macroeconomics, the study of the economy as a whole, addresses many topical issues:

 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?

Important issues in macroeconomics Macroeconomics, the study of the economy as a whole, addresses many topical issues:

 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?

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

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

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

Why learn macroeconomics? 1. The macroeconomy affects society’s well-being. Each one-point increase in the unemployment rate is associated with:

 920 more suicides  650 more homicides  4000 more people admitted to state mental institutions  3300 more people sent to state prisons  37,000 more deaths  increases in domestic violence and homelessness

Why learn macroeconomics?

change from 12 mos earlier

5

In most years, wage growth falls 5 when unemployment is rising.

4

3

3 1

2 1

-1

0

-3

-1 -5

-2 -3 1965

-7 1970

1975

unemployment rate

1980

1985

1990

1995

2000

2005

inflation-adjusted mean wage (right scale)

percent change from 12 mos earlier

2. The macroeconomy affects your well-being.

Why learn macroeconomics? 3. The macroeconomy affects politics. Unemployment & inflation in election years year

U rate

inflation rate

elec. outcome

1976

7.7%

5.8%

1980

7.1%

13.5%

Reagan (R)

1984

7.5%

4.3%

Reagan (R)

1988

5.5%

4.1%

Bush I (R)

1992

7.5%

3.0%

Clinton (D)

1996

5.4%

3.3%

Clinton (D)

2000

4.0%

3.4%

Bush II (R)

2004

5.5%

3.3%

Bush II (R)

Carter (D)

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

Example of a model:

Supply & demand for new cars

 shows how various events affect price and quantity of cars

 assumes the market is competitive: each buyer and seller is too small to affect the market price

 Variables: Q d = quantity of cars that buyers demand Q s = quantity that producers supply P = price of new cars Y = aggregate income Ps = price of steel (an input)

The demand for cars demand equation: Q d = D (P,Y )

 shows that the quantity of cars consumers demand is related to the price of cars and aggregate income

Digression: functional notation

 General functional notation shows only that the variables are related.

Q d = D (P,Y )

 A specific functional form shows A list of the the precise quantitative relationship. variables  Example: that affect Q d D (P,Y ) = 60 – 10P + 2Y

The market for cars: Demand demand equation:

Q

d

 D (P ,Y )

The demand curve shows the relationship between quantity demanded and price, other things equal.

P

Price of cars

D

Q

Quantity of cars

The market for cars: Supply supply equation: s

Q  S (P , Ps )

The supply curve shows the relationship between quantity supplied and price, other things equal.

P

Price of cars

S

D

Q

Quantity of cars

The market for cars: Equilibrium P

Price of cars

S

equilibrium price

D

Q

equilibrium quantity

Quantity of cars

The effects of an increase in income demand equation:

Q d  D (P ,Y ) An increase in income increases the quantity of cars consumers demand at each price…

…which increases the equilibrium price and quantity.

P

Price of cars

S

P2 P1 D1 Q1 Q 2

D2

Q

Quantity of cars

The effects of a steel price increase supply equation:

Q  S (P , Ps ) s

P

S2

Price of cars

An increase in Ps reduces the quantity of cars producers supply at each price… …which increases the market price and reduces the quantity.

S1

P2 P1 D Q2 Q1

Q

Quantity of cars

Endogenous vs. exogenous variables

 The values of endogenous variables are determined in the model.

 The values of exogenous variables are determined outside the model: the model takes their values & behavior as given.

 In the model of supply & demand for cars, endogenous: exogenous:

P , Qd , Qs Y , Ps

Exercise: 1. Write down demand and supply equations for

wireless phones; include two exogenous variables in each equation. 2. Draw a supply-demand graph for wireless

phones. 3. Use your graph to show how a change in one of

your exogenous variables affects the model’s endogenous variables.

A multitude of models

 No one model can address all the issues we care about.

 e.g., our supply-demand model of the car market…

 can tell us how a fall in aggregate income affects price & quantity of cars.

 cannot tell us why aggregate income falls.

A multitude of models

 So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth).

 For each new model, you should keep track of  its assumptions  which variables are endogenous, which are exogenous  the questions it can help us understand, and those it cannot

Prices: flexible vs. sticky

 Market clearing: An assumption that prices are flexible, adjust to equate supply and demand.

 In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. For example,  many labor contracts fix the nominal wage for a year or longer  many magazine publishers change prices only once every 3-4 years

Prices: flexible vs. sticky

 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

 Long run: prices flexible, markets clear, economy behaves very differently

Outline of the textbook:  Introductory material (Chaps. 1 & 2)

 Classical Theory (Chaps. 3-6) How the economy works in the long run, when prices are flexible

 Growth Theory (Chaps. 7-8) The standard of living and its growth rate over the very long run

 Business Cycle Theory (Chaps. 9-13) How the economy works in the short run, when prices are sticky

Outline of the textbook:

 Policy debates (Chaps. 14-15) Should the government try to smooth business cycle fluctuations? Is the government’s debt a problem?

 Microeconomic foundations (Chaps. 16-19) Insights from looking at the behavior of consumers, firms, and other issues from a microeconomic perspective

Chapter Summary

 Macroeconomics is the study of the economy as a whole, including

 growth in incomes,  changes in the overall level of prices,  the unemployment rate.

 Macroeconomists attempt to explain the economy and to devise policies to improve its performance.

Chapter Summary

 Economists use different models to examine different issues.

 Models with flexible prices describe the economy in the long run; models with sticky prices describe the economy in the short run.

 Macroeconomic events and performance arise from many microeconomic transactions, so macroeconomics uses many of the tools of microeconomics.