Macro - Carol Scotese, Lessons 1-5 PDF

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Carol Scotese, Lessons 1-5...

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Macroeconomics Virginia Commonwealth University

Lesson 1 Microeconomics vs Macroeconomics Microeconomics  

Decisions of individual consumers and firms Market structure

Macroeconomics  

How those individual decisions aggregate to national outcomes o Recessions, inflations, unemployment, long-run growth trends How decisions interact, how one field affects the others

Goods Market  

Quantity: Real GDP Price: aggregate price level (and inflation)

Labor Market  

Quantity: employment Price: wage rate

Credit market (financial markets)  

Real interest rate Saving and Investment

Long-run Growth  

Measure: Real GDP per capita Determinants- Factors of production o Physical capital per worker o Human capital o Innovation/technological change- determines productivity

Short-run fluctuations Shocks   

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Economic events that cause temporary movements of output away from long-run growth trend Fiscal and monetary policy shocks can also be used to help speed the economy’s return to the long-run growth trend if other shocks have moved the economy off the long-run growth path Examples o House price and credit market shocks: Great Recession o Monetary policy shock: caused 1982 recession o Monetary policy shocks in 2008 initiated to help the economy return to long-run trend Economic events that cause spending plans to change Examples

Macroeconomics Virginia Commonwealth University o o

Housing prices fall- consumption declines Capital becomes more productive- investment rises

The power of markets 

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Well-functioning markets and the price mechanism direct scarce resources to their best use – efficient! o Firms are producing what consumers value o The producing firms are the low-cost (most efficient!) The role of prices in allocating resources

Well-functioning markets Market Failures 

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When one of the conditions for efficiency is not met o Imperfect information o Too little competition o Price doesn’t reflect full value: externalities If one or more occurs, markets will not yield the most efficient outcome Depending on the nature and size of the inefficiency, market failures may suggest a role for government intervention

Lesson 2 The big three   

GDP Unemployment rate Inflation rate

GDP 

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Value of final goods and services produced in the country o Real GDP values production using constant prices o Nominal GDP values using current prices Importance of real GDP in tracking production rather than prices

Real GDP per capita  

Measure of standard of living Appropriate for comparing across countries

Income and expenditures  

National income = expenditures on U.S. goods and services Y = output, income

Unemployment/employment

Macroeconomics Virginia Commonwealth University    

Not working but actively looked for work in the past 4 weeks Labor force Unemployment rate: percentage of the labor force that is unemployed Labor force participation o Labor force/working age population

Inflation 

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How to measure overall prices o Price index o GDP Deflator o CPI Inflation is the rate of change of a price index o Hyperinflation- very high inflation o Deflation- prices are going down o Monetary policy aims for inflation close to 2%

GDP Deflator = Real GDP =

Nominal GDP RealGDP

Nominal GDP GDP Deflator

Nominal GDP = GDP Deflator * Real GDP Inflation ≈ %∆(Nominal GDP) - %∆(Real GDP) Comparing measures of inflation 

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GDP Deflator o Quarterly o Reflect the weighted average of all final goods and services o First estimate available 3+ weeks after end of quarter o Better estimate available 7-8 weeks after end of quarter CPI (Consumer Price Index) o Monthly o Reflects fixed basket of consumer goods o Basket composition reflects purchases of an average household o Released about 2 weeks after months end

PCE (Personal Consumption Expenditures) Deflator   

Measure of consumer prices Not a fixed basket Monthly (Released about 4 weeks after month end)

Core CPI and PCE vs “headline” measures 

Core measures eliminate food and energy prices from the measure

Macroeconomics Virginia Commonwealth University  

Core measures better for judging underlying supply and demand pressures Food and energy prices are very volatile and may change for reasons unrelated to macroeconomic

Current dollars = Past dollars *

Current price level Past price level

Lesson 3 Potential Output: output level when using capital and labor inputs efficiently   

Unemployment is the nature rate (allows for frictional and structural unemployment) Operating below potential output: inefficient Operating above potential output: generates too much inflation

Production Function Y = AF(K, H, L)  

A = total factor productivity driven by tech change Marginal products of labor or capital o Positive o Diminishing  Graph shifts up when A, H or L increases  Graph shifts down when A, H or L decreases

Productivity: Output per input 

Labor productivity o Output/labor hours o Most often used measure of productivity o Will increase when there is more K

Sustained economic Growth 

GDP per capita has averaged about 2% growth per year since the industrial revolution o This is true for the US, UK, Canada, Australia, Western Europe

Generating sustained economic growth – K Y = AF(K, H, L) Increasing the capital stock 

 

Policies that encourage saving o Will increase the level of capital and output (income) permanently o Will increase the growth rate of capital and output temporarily Above occurs because of diminishing returns to capital Labor productivity will increase

Macroeconomics Virginia Commonwealth University Generating sustained economic growth – L Y = AF(K, H, L) Increasing the labor force   

Population growth via births or immigration Will increase the level of output (income) permanently o BUT if you get more workers, you will NOT get more output per person Diminishing returns to L

Generating sustained economic growth – L Y = AF(K, H, L) 

This may be possible o Depends on the returns to H o If H has diminishing returns, the it’s just like adding K o If H has increasing returns, then it can be a source of sustained growth o Increasing returns means that increasing H gives increasing increments of output  This could occur if there are positive externalities to human capital accumulation

Generating sustained economic growth – L Y = AF(K, H, L)  

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Technological change (and the increased TFP it brings) is THE primary source of long-run sustained growth Productivity differences are also the most important source for the different levels of output across countries o Richer countries have higher productivity than poorer countries There are no diminishing returns to technology

Why don’t poorer countries adopt the existing technology and raise the standards of living? 

Incentives

Institutions: formal and informal rules and policies that shape incentives 

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Non-economic examples: o Class seats o Marriage o Driving on the right hand side of the road Economic examples: o Property rights o Corruption/rule of law Political examples o Democracy o Voting rights

Macroeconomics Virginia Commonwealth University Good institutions ill create proper incentives      

Incentive to develop business Inventive to innovate Incentive to educate Incentives must be broad-based and decentralized (inclusive) Political institutions that do not provide for a safe environment and rile of law will not generate proper economic change that would benefit the country Vested interests may block economic change that would benefit the country

Lesson 4 Financial System 

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Functions of the financial system o Channels funds from savers to borrowers o Evaluates and pools risk o Monitors borrowers Important symbiosis between financial sector and “real” sectors

Saving and Investment   

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Saving = supply of loanable Investment = demand for loanable funds All funds for investment come from saving o Investment decision comes from firm’s profit maximizing decision o Marginal benefit = marginal cost Loanable funds model gives long-run equilibrium interest rate

Practice working with the loanable funds model Y = C + I + G +NX  

 

First pass; consider a closed economy: NX = 0 o Equivalent to saying there is no borrowing or lending to foreigners Closed economy: Y = C + I + G o Y–C–G=I o Y–T–C+T–G=I  (Y-T-C)= Private saving; (T-G)= Public saving Private saving + Public saving = I National Saving = I

SAVING: S= (Y – T – C) + ( T – G)   

Movement along the curve: interest rates increase – consumption declines, so S increases Economic events OTHER THAN A CHANGE IN INTEREST RATES, that increase S, shift the supply of loanable funds curve to the right Economic events OTHER THAN A CHANGE IN INTEREST RATES, that decrease S, shift the supply of loanable funds curve to the left

Macroeconomics Virginia Commonwealth University Tax Incentives for Saving  

In the above example, income taxes were changing What happens if there are tax incentives for saving? o E.g. retirement or college savings accounts that allow the earnings to accumulate tax free o No CHANGE in public saving o Private saving increases o Saving increases and the supply of loanable funds shifts to the right

Investment   

Movement along the curve: interest rates increase – the cost of purchasing physical capital rises (marginal cost of investment rises), investment declines Economic events OTHER THAN A CHANGE IN INTEREST RATES, that increase I, shift the demand for loanable funds curve to the right Economic events OTHER THAN A CHANGE IN INTEREST RATES, that decrease I, shift the demand for loanable funds curve to the left

Lesson 5 Potential output growth   

Remember the production function: Y = AF(K, H, L) Denote full employment with L (using labor efficiently) Denote potential output by Y = AF(K, H, L)

Economic fluctuations    

Output movements away from potential output Caused by economic shocks Price mechanism (adjustment) returns the economy to potential output and full employment Price adjustment can be slow – wages and prices are sticky

Keynesian vs Classical Economics 

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Classical o Laissez-faire policy o Through prices adjustment was quick enough, markets will self-adjust Keynesian economics o John Maynard Keynes: observed markets during the Great Depression o Prices are so slow to adjust; recession for a prolonged period o Rationale for monetary or fiscal policy

Sticky wage and price adjustment 

Reasons for price stickiness: o Menu costs o Uncertainty about competitors price adjustments

Macroeconomics Virginia Commonwealth University 

  

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Reasons for wage stickiness o Implicit and explicit contracts o Downward rigidity: firms believe that would lower morale and productivity There are some firms that will adjust prices, some won’t. Equal in the end Economic fluctuations bring changes in inflation and employment Output falls below potential output o Unemployment is above the natural rate- excess supply of labor o Downward pressure on wages and ultimately prices Output rises o Unemployment is below the natural rate o Downward pressure on wages and ultimately prices...