Lecture 1

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Branches of Economics. Slide 2. ▫ Microeconomics is concerned with the study of the choice problem faced by the economic agents: households and firms.
ECO 209Y

Macroeconomic Theory and Policy Lecture 1: Introduction © Gustavo Indart

Slide 1

Branches of Economics 

Microeconomics is concerned with the study of the choice problem faced by the economic agents: households and firms  e.g., how the equilibrium price for a particular commodity is determined



Macroeconomics is concerned with the study of the economy as a whole  e.g., how the general level of prices is determined (and not the price of any particular commodity)

© Gustavo Indart

Slide 2

The Object of Macroeconomics 

How the general level of prices is determined?



What determines the percentage of the labour force that is unemployed?



What determines a country’s level of aggregate output or GDP?



What determines the level of interest rates?



What determines the foreign exchange rate?



What determines a country’s balance of payments with the rest of the world?

© Gustavo Indart

Slide 3

The Rate of Inflation The inflation rate (π) is the percentage increase in the level of prices during a given period: π=

P − P-1 P-1

where P is the current price level and P-1 is the price level at the end of the previous period.

© Gustavo Indart

Slide 4

Canada: Inflation and Deflation

Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics. © Gustavo Indart

Slide 5

Canada: Inflation and Deflation January 2004 to September 2014

Annual Change on CPI

© Gustavo Indart

Slide 6

The Rate of Unemployment The unemployment rate is the fraction of the labour force that cannot find jobs: LF − N u= LF where LF is the size of the labour force and N is the number of employed workers

© Gustavo Indart

Slide 7

Canada: Unemployment Rate

Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics. © Gustavo Indart

Slide 8

Canada: Unemployment Rate January 2004 to September 2014

© Gustavo Indart

Slide 9

Aggregate Output (GDP) Gross Domestic Product (GDP) is the value of all final goods and services produced in the economy during a given period of time  Nominal GDP measures the value of output at the prices prevailing in the period the output is produced  Real GDP measures the output at the prices of some base year

© Gustavo Indart

Slide 10

Canada: Growth in Aggregate Output

Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics. © Gustavo Indart

Slide 11

Canada: Growth in Aggregate Output January 2004 to September 2014

Annual Real GDP Growth Rate

© Gustavo Indart

Slide 12

Canada: Growth in Aggregate Output

Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics. © Gustavo Indart

Slide 13

Canada: Real GDP per Capita

Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics. © Gustavo Indart

Slide 14

The Rate of Interest 

The nominal rate of interest (i) is the actual money interest charged on a loan



The real rate of interest (r) is the purchasing value of the interest charged on that loan, that is, the real interest rate is the nominal rate (i) minus the rate of inflation (π): r=i−π

© Gustavo Indart

Slide 15

Canada: Prime Rate of Interest January 1970 to September 2014

© Gustavo Indart

Slide 16

The Exchange Rate 

The exchange rate is the relative value of the currencies of two countries



We will define the exchange rate (e) to be the value of one unit of foreign currency measured in Canadian dollars  The exchange rate for US$ is today approximately e = 1.32  This means that the value of the Canadian dollar is today approximately 1/e = 0.76 i.e., Cdn$1 = US$ 0.76



The level of the exchange rate could be set by the Bank of Canada or be determined by market forces  Bank of Canada sets the value of e  fixed exchange rate system  Market forces determine the value of e  flexible or floating exchange rate system  Bank of Canada intervenes in the market to avoid sudden jumps  managed or dirty floating exchange rate system

© Gustavo Indart

Slide 17

The Exchange Rate between the Canadian Dollar and the U.S. Dollar

Source: P. Krugman, R. Wells and A. Myatt, Macroeconomics. © Gustavo Indart

Slide 18

The Exchange Rate between the Canadian Dollar and the U.S. Dollar January 2005 to September 2014

© Gustavo Indart

Slide 19

The Balance of Payments 

The balance of payments is the record of all transactions of the economy with the rest of the world



The overall balance of payments is the summation of the balance in two accounts: the current account and the capital account  The current account records all the imports and exports of goods and services, investment income, and transfer payments  The capital account records the capital flows, that is, investment and borrowing/lending

© Gustavo Indart

Slide 20

Canada’s Balance of Payments, 2010 Receipt

Payment

Balance

547,141

598,005

-50,864

Goods and services

476,086

507,844

-31,757

Investment income

61,794

78,230

-16,436

9,261

11,932

-2,671

156,883

107,176

49,707

Current account

Transfers Capital account Statistical discrepancy © Gustavo Indart

1,157 Slide 21

Canada’s Current Account Balance as Percent of GDP January 1980 to September 2013, quarterly

© Gustavo Indart

Slide 22

Economic Policy 

Policy makers use mainly two types of policies to affect the economy: fiscal and monetary policies



The government (Parliament) controls fiscal policy, while the Bank of Canada controls monetary policy  The instruments of fiscal policy are tax rates and government spending  The main instruments of monetary policy are changes in either the stock of money or the bank rate

© Gustavo Indart

Slide 23

Leading Schools of Thought 

There is a widespread belief that the government can and should take actions to influence key economic variables such as inflation and unemployment  Economists don’t agree, however, on what measures will achieve the desired results  The reason for this disagreement is that we don’t have any particularly compelling theory



There are different schools of thought and the most important ones are the Monetarist, the Keynesian, the New Classical, and the New Keynesian

© Gustavo Indart

Slide 24

The Monetarist School 

Governments should have policies towards a limited number of macroeconomic variables (e.g., growth of money supply, government expenditure, taxes, and/or the government deficit)



Governments should adopt fixed rules for the behaviour of these variables (e.g., a fixed rate of growth of money supply or balanced budget over a period of four or five years)



Policy changes should be announced as far ahead as possible to enable people to take account of them in planning their own economic affairs

© Gustavo Indart

Slide 25

The Keynesian School 

They advocate more detailed intervention to “fine tune” the economy in the neighbourhood of full employment and low inflation  Government intervention should be counter-cyclical



Policy changes should not be pre-announced in order to deter speculation

© Gustavo Indart

Slide 26

The New Classical School 

The New Classical or Rational Expectations school assumes that markets are continuously in equilibrium (particularly the labour market)



They also assume that expectations are formed “rationally”, that is, taking into account all the economically relevant information  For this reason, expected government intervention cannot affect the real variables in the economy

© Gustavo Indart

Slide 27

The New Keynesian School 

The New Keynesians assumes that wages are not fully flexible as to always equate the demand and supply of labour



They assume that wages are fixed during a period of time due to institutional constraints (e.g., minimum wage legislation or labour contracts)  Due to these rigidities in the labour market, government intervention can most effectively affect the economic variables

© Gustavo Indart

Slide 28

Macroeconomic Models 

Economists use models to help explain real world phenomena



Economic models represent simplifications of the real world  They take into account only some “endogenous” and “exogenous” variables  They also make assumptions about the behaviour of economic agents



If some determining variables are left out or some behavioural assumptions are at odds with reality, then the model represents a distortion and not a simplification of the real world



Different models help to explain the behaviour of the economy at different times and situations

© Gustavo Indart

Slide 29

Aggregate Demand 

The level of aggregate demand is the real value of the total demand for domestically produced goods and services



The aggregate demand curve (AD) shows the negative relationship between the price level and the real value of the quantity demanded of domestically produced goods and services



At each price level, the AD curve shows the value of output at which both the goods markets and the money markets are simultaneously in equilibrium (we’ll see this in more detail later on)

© Gustavo Indart

Slide 30

Aggregate Supply 

The level of aggregate supply is the real value of the output the economy can produce given the resources and technology available



The aggregate supply curve (AS) shows the relationship between the price level and the real value of the quantity supplied of goods and services and its slope depends on whether we are referring to the short run, medium run, or long run



The short run, medium run, and long run do not refer necessarily to different time-periods  They refer rather to different situations the economy goes through over time

© Gustavo Indart

Slide 31

Aggregate Supply (continued) 

In the short run the level of output can vary without affecting the price level  The economy is producing at less than full capacity and unemployment is high  The AS curve is horizontal, and the aggregate demand determines the level of output



In the medium run there is little or no excess capacity and unemployment is low, thus the AS curve has a positive slope

© Gustavo Indart

Slide 32

Aggregate Supply (continued) 

In the long run the level of output is determined by the productive capacity, and thus it is fixed at this maximum level  Therefore, in the long run the aggregate supply curve is vertical at this maximum level of output  Changes in demand can only affect the price level but not the level of output



In the very long run the productive capacity of the economy increases and thus the vertical AS curve shifts to the right

© Gustavo Indart

Slide 33

The AS Curve AS P Medium-run Long-run Short-run

Yfe © Gustavo Indart

Y Slide 34