Macroeconomics - lecture notes (Basile Grassi) PDF

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These are notes on the lectures. The last few chapters are missing, but for the first partial this covers the material needed....

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MACROECONOMICS When macroeconomists study an economy they first look at 3 variables: Output, Unemployment rate, Inflation rate. Aggregate Output is the measure of economic activity. National income and product accounts is an accounting system used to measure aggregate economic activity Developed at the end of World War II. The measure of aggregate output in the national income accounts is the Gross Domestic Product (GDP). There are 3 ways of defining GDP:

1.

GDP is the value of final goods and services produced in the economy during a given period. A final good is a good that is intended for final consumption. An intermediate good is a good used in the production of another good.

2.

GDP is the sum of value added in the economy during a given period. Value added by a firm is the value of its production minus the value of the intermediate goods used in production.

3.

GDP is the sum of incomes in the economy during a given period Value added is used to remunerate. Workers → labor income; Firms → capital income or profit income; Government → indirect taxes (such as VAT or a sale tax), it is a tax collected by an intermediary (such as a retail store) from the subject who bears the economic burden of the tax (such as the consumer)

NOMINAL GDP is the sum of the quantities of final goods produced multiplied by their current prices. Nominal GDP increases over time because of 2 reasons:  

First, production of most goods increases over time. Second, prices of most goods also increase over time.

REAL GDP Real GDP is constructed as the sum of the quantities of final goods multiplied by constant prices (rather than current). Real GDP increases over time because production of most goods increases over time. With more than one good, relative prices of the goods (in the base year) are used as natural weights. The level always changes with the base year. The growth rate does not change with one good, but it does with many goods. Real GDP level in period t, Yt Real GDP growth:

Periods of positive GDP growth are called expansions. Periods of negative GDP growth (at least 2 consecutive quarters) are called recessions. The level of real GDP has no economic interpretation (index number); the rate of change has a clear interpretation (output growth). With one good, the growth rate of real GDP is unaffected by the base year. INFLATION RATE General level of prices Average price of goods and services in the economy, Pt Inflation rate=Rate at which the general price level grows, πt

Inflation=Raise in the price level; corresponds to a positive inflation rate. Deflation=Decline in the price level; corresponds to a negative inflation rate. In an economy with one final good it is straightforward to measure the price level; with many final goods it is more difficult. Economists use 2 definitions of the aggregate price level, 2 price indexes, the GDP deflator and Consumer price index. The level of prices has no economic interpretation (index number); the rate of change has a clear interpretation (inflation). GDP deflator, Pt GDP deflator in t is defined as the ratio of nominal GDP to real GDP in t. GDP deflator is an index number, set equal to 1 in the base year.

The inflation rate depends on the base year chosen. The growth rate of a real GDP depends on the base year chosen. Note that the rate of growth of nominal GDP is approximately equal to the rate of growth of real GDP plus the rate of inflation.

The GDP deflator measures the average price of output, i.e., of the final goods produced in the economy. The consumer price index, or CPI, measures the average price of consumption, i.e., of the goods consumed by the households. The CPI gives the cost in dollars of a specific list of goods and services over time, which attempts to represent the consumption basket of a typical urban consumer. The CPI measures the cost of living. The set of goods produced in the economy is not the same as the set of goods purchased by consumers, for two reasons: Some of the goods are sold to firms, to the government or to foreigners and some of the goods are not produced domestically but are imported from abroad. HICP indicator (harmonized index of consumer prices) The inflation rates, computed using either the HICP or the GDP deflator, are largely similar. Pure inflation: proportional increase in all prices and wages. All relative prices unaffected. Real wages, for example, are unaffected. Economists care about inflation for two reasons:  

during periods of inflation, not all prices and wages rise proportionately inflation affects relative prices and income distribution (no pure inflation).

Inflation leads to other distortions due to uncertainty, prices that are fixed by law or regulation, and interaction with taxation. Measuring whether a person is employed is straightforward; measuring whether a

person is unemployed is less obvious. Until recently, the only available source to measure unemployment was the number of people registered at unemployment offices. This was a poor measure of unemployment: it depends on the generosity of unemployment benefit systems and on the exhaustion of benefits. Most countries now rely on Labor Force Surveys (LFS): interviews of representative samples of individuals. Working age population=Number of people who can work, P Employment=Number of people who have a job, N Unemployment=Number of people who don’t have a job but are looking for one, U Labor force=Sum of employment and unemployment, L

UNEMPLOYMENT RATE Ratio of unemployed people to the number of people in the labor force, u  PARTICIPATION RATE Ratio of people in the labor force to the working age population  Economists care about unemployment for two reasons: 1. Because of its direct effects on the welfare of the unemployed, especially the long-term unemployed 2. Because it provides a signal that the economy may not be using some of its resources efficiently.

Output growth higher than usual associated with a reduction in unemployment rate. Output growth lower than usual associated with an increase in unemployment rate.

A low unemployment rate leads to an increase in the inflation rate. A high unemployment rate leads to a decrease in the inflation rate.

Level of aggregate output in an economy is determined by:   

Demand in the short run (a few years) Level of technology, the capital stock and the labor force in the medium run (a decade or so) Factors such as education, research, saving and the quality of government in the long run (half a century or more)

Consumption (C):  

purchases of goods and services by consumers sum of durables (cars) and non-durable consumption (food)

Investment (I):  

purchases of capital goods sum of residential investment (housing by people) and non- residential investment (plants and machines by firms)

Government spending (G):   

purchases of goods and services by the government does not include government transfers, nor interest payments on government debt different from total government spending

Imports (IM): purchases of foreign goods and services by domestic consumers, business firms, and the government. Exports (X): purchases of domestic goods and services by foreigners. Net exports (X  IM): difference between exports and imports, also called the trade balance.

Inventory investment: difference between production and sales (some of the goods produced in a given year are not sold in the same year, but in later years; some of the goods sold in a given year have been produced in earlier years).

THE DEMAND OF GOODS

To determine Z and Y, we make 3 simplifying assumptions:  



Assume that all firms produce the same good, which can then be used by consumers for consumption, by firms for investment or by the government → we can look at only one market. Assume that firms are willing to supply any amount of the good at given price P and meet the demand in that market → we focus on the role of demand and disregard (for now) the role of supply. Assume that the economy is closed, that it does not trade with the rest of the world, then both exports and imports are zero, that is, X=IM=0 → we disregard (for now) the role of trade

CONSUMPTION Disposable income (YD):

 

income that remains once consumers have paid taxes and received transfers from the government Y is gross income; T is taxes net of transfers

Consumption function:

 

behavioral equation capturing the behavior of consumer consumption depends positively

LINEAR CONSUMPTION FUNCTION

This function has 2 parameters, c0 and c1: c1 is called the marginal propensity to consume   

measures effect of 1 additional euro of disposable income on consumption slope of the consumption function in (C,YD) plan 00 is the

markup, W is the marginal cost (the cost of producing one additional unit of output). Under perfect competition, prices would be given by where the markup m = 0. If A is not 1:

where m>0 is the markup, w/a is the marginal cost (the cost of producing one additional output). NATURAL RATE OF UNEMPLOYMENT Assume for now that nominal wages depend on the actual price level, P, rather than on the expected price level, Pe. Wage setting and price setting relations determine the equilibrium rate of unemployment.

This negative relation between the real wage and the unemployment rate is called the WAGE-SETTING RELATION. The wage setting relation gives the real wage targeted by workers.

This is called the PRICE-SETTING RELATION The price setting relation gives the real wage that firms are willing to pay.

In equilibrium: real wage targeted by workers (from wage-setting relation) equals real wage firms are willing to pay (from price-setting relation). This determines the equilibrium unemployment rate. The equilibrium unemployment rate (un) is called the natural rate of unemployment.

The natural rate of unemployment (un) will depend on factors like unemployment benefits (z) and product market regulation (m). EFFECTS OF AN INCREASE IN Z A raise in z shifts the wage-setting relation up. Effect: The unemployment rate increases and wages remain constant. Economic intuition: workers demand higher real wages; the wage firms are willing to pay is unchanged; unemployment rate increases to restore equilibrium.

EFFECTS OF AN INCREASE IN M A raise in m shifts the price-setting relation down. Effect: The unemployment rate increases and wages decrease. Economic intuition: real wage paid by firms decreases; unemployment rate increases so that people accept lower wages.

So far only unemployment, how about employment? . Therefore, rearranging N=L(1-u). The natural level of unemployment, Nm, is given by Nn=L(1-un). The natural level of output

satisfies the following:

.

We have focused on the labor market and we have assumed that the price level is equal to the expected price level. In the short run, the price level may well turn out to be different from what is expected when nominal wages are set, so that unemployment is not necessarily equal to the natural rate or output equal to its natural level. In the short run output continues to be determined by factors such as fiscal and monetary policy. Because expectations are unlikely to be systematically wrong, in the medium run, output tends to return to its natural level. The next chapter will relax the assumption that the price level is equal to the expected price level and derive a relation between unemployment an inflation. THE PHILLIPS CURVE In 1958, Phillips drew a diagram plotting the rate of inflation against the rate of unemployment in the UK for each year from 1861 to 1957. He found clear evidence of a negative relation between inflation and unemployment. In 1960, Samuelson and Solow replicated the exercise of the US from 1900 to 1960. They also found evidence of a negative relation and labelled it the Phillips curve. In the 1970s the relation broke down but a new negative relation between the change in inflation and unemployment emerged. THE PHILLIPS CURVE DERIVATION

The price, P, depends on the expected price, Pe , and the unemployment rate, u (and also on m and z). We have:

. Now assume that

. Combine

. Add time indexes by the price level at t-1

. Divide both sides . Rewrite using the definition of inflation

. We have obtained approximately equal to

. This is .

PRICE AND WAGE SETTING A higher expected price Pet causes a higher price Pt. Higher expected price leads to higher wage (workers care about real wages). Higher wage leads to higher price (markup over marginal cost). A lower unemployment rate ut causes a higher price Pt. Lower unemployment leads to higher wage (bargaining).Higher wage leads to higher price (markup over marginal cost).

A higher z causes a higher price Pt. A higher z raises wages (bargaining). Higher wages lead to higher prices (markup over marginal costs). A higher markup m causes a higher price Pt Firms charge higher prices for given wages. THE PHILLIPS CURVE EQUATION

When workers expect higher inflation πe t, then inflation πt is higher because workers bargain higher nominal wages  firms set higher prices inflation this period is higher for given price last period. When the markup m is higher, then inflation πt is higher. Higher markup firms charge higher prices for given wages inflation this period is higher for given price last period. When z is higher then inflation πt is higher. Workers bargain higher wages  firms set higher prices  inflation this period is higher for given price last period. When the unemployment rate ut is higher, then inflation πt is lower. Workers bargain lower wages firms set lower price  inflation this period is lower for given price last period Note that the parameter α captures the strength of the effect of unemployment on bargained wages. THE PHILLIPS CURVE AND ITS MUTATION-EARLY INCARNATION We saw that before 1970 Inflation was sometimes positive, sometimes negative, and not very persistent. If inflation is not very persistent, then inflation last year is not a good predictor of inflation this year. Assume inflation varies from year to year around some average value pi-bar and is not very persistent. Then, it makes sense for wage setters to assume that, whatever inflation was last year, inflation this year will simply be equal to its average value:

. The Phillips curve before the 1970s can then be written as

. This is precisely the negative relation between unemployment and inflation holding until the 1970s. This relation has a striking implication: a country can sustain a low unemployment rate if it is willing to tolerate a high inflation rate; vice versa, a country can achieve a low inflation rate as long as it is willing to tolerate a high unemployment rate; it just needs to choose a point on the Phillips curve. After 1970 inflation is always positive and more persistent. Workers need to predict prices when they bargain for the wage. If inflation is always positive and persistent, then workers will expect prices to rise in the future and bargain for higher wages. Suppose workers look at the past year when forming expectations: . Expected inflation this year depends partly on a constant average value, with weight (1-θ), and partly on inflation last year, with weight θ. The higher is θ the more inflation last year leads workers to revise their expectations of what inflation will be this year. We can think of what happened in the 1970s as an increase in the value of teta over time (01). The Phillips curve then becomes . To distinguish it from the Phillips curve without expectations, this is often called the expectations-augmented Phillips curve. When q =1, the relation becomes:

. Moving last year inflation rate to the

left side of the equation, we get .Then, when q =1, the unemployment rate affects not the inflation rate, but the change in the inflation rate. This is the negative relation emerging between the unemployment rate and the change in inflation since the 1970s.

THE PHILLIPS CURVE AND THE NATURAL UNEMPLOYMENT RATE The history of the Phillips curve is closely related to the concept of the natural unemployment rate. The original Phillips curve implied that there is no natural unemployment rate: if policymakers were willing to tolerate a higher inflation rate, they could maintain a lower unemployment rate forever. In the 1960s two economists, Friedman and Phelps, predicted that the trade-off between inflation and unemployment would disappear and unemployment could not be sustained below a certain level, which they called the natural unemployment rate. They were right!. Let’s now make explicit the relation between the Phillips curve and the natural unemployment rate. REMEMBER the natural unemployment rate is the level at which expectations are correct (workers get the inflation right). The natural unemployment rate emerges when pi-t=pi-t-e. Thus, the Phillips curve becomes

which implies

. We can put this back into the Phillips curve to get

then

then

.

If teta = 1 and expected inflation equals last year inflation we have . when u is lower than un , the inflation rate increases. when u is higher than un , the inflation rate decreases. when u equals un the inflation rate is constant (this is why the natural rate of unemployment is also called the nonaccelerating inflation rate of unemployment-NAIRU).

Back to the natural rate of unemployment:  

. Factors raising un:

Labor market rigidities (high z) (high minimum wages. high unemployment benefits. strict employment protection legislation (high layoffs costs)) Low degree of product market competition (high m)

The factors that affect the natural rate of unemployment, m and z, differ across countries and over time There is no reason to expect all countries to have the same natural rate of unemployment. The natural rate of unemployment of one country may also vary over time as m and z may vary, though slowly. HIGH INFLATION, WAGE INDICATION AND THE PHILLIPS CURVE So far, workers form expectations about inflation and then wait for their next chance to renegotiate their contracts. When inflation is higher than expected, wages are too low and they ask for more. When inflation is lower than expected, wages are too high and employers renegotiate a lower wage. But what if inflation is high and volatile? Then workers and firms become reluctant to enter into labor contracts that set nominal wages for long time, as workers (firms) may experience large losses if inflation turns out to be much higher (lower) than expected. Wage indexation becomes prevalent. Wage indication allows wages to adjust to inflation automatically (no need to bargain). Assume that a fraction lambda of contracts is automatically renegotiated, so every year a fraction lambda of wages moves together with inflation.

The Phillips curve with indexation becomes:

Assume

Then obtain

. We have

This can be rearranged as

.

. Finally

When a high fraction of wages is indexed (lambda is high), a change in unemployment has a bigger effect on inflation. Without wage indexation, when unemployment decreases, wages raise and prices as well; but then, because wages do not respond to prices right away (need to revise expectations and renogotiate), there is no further increase in prices within the year. With wage indexation, an increase in prices leads to a further increase in wages (some workers get a raise automatically, with no bargaining), which in turn leads t...