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