Intermediate Macro

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Intermediate Macro. Introduction. Current Events. Great Recession Survival of the Euro “Lost Decade” Developing World China India Sub-Saharan Africa. What’s it all about?. National Economy Micro: consumer/firm behavior Macro variables GDP Inflation Unemployment Interest rates - PowerPoint PPT Presentation

Text of Intermediate Macro

Intermediate Macro

Intermediate MacroIntroduction

Current EventsGreat RecessionSurvival of the EuroLost DecadeDeveloping WorldChinaIndiaSub-Saharan AfricaWhats it all about?National EconomyMicro: consumer/firm behaviorMacro variablesGDPInflationUnemployment

Interest ratesDebt/deficitexchange ratesEtc.GoalsExplain movements of and connections between macro variables.

PolicyWhat can the govt do?What should the govt doMacro is hardGeneral Equilibriummany variablesmedia coverage (yuck)Short run vs. Long RunEx. new machines eliminate jobsMany approaches to economics

Plan of classShort run1 to 2 yearsBooms and recessionsMedium runWhy / how fast does GDP growequilibriumLong runDecadesWhat makes rich countries rich?Development

Our focusDomestic economyShort Run Keynesian storyClassical ideas to connect to the long run

Macro Flow ChartFirms & consumersIncome and ConsumtionGovernmentSpendingTaxes & transfersSavings & InvestmentsImports and ExportsFiscal PolicyGovernment SpendingDefenseHealth, Education & WelfareTax policyIncome taxCapital gains tax etc.Debt/Deficit

President and CongressMonetary PolicyThe Federal Reserve controlsMoney supplyInterest rates (one of them)Affects firm/consumer decisionsGross Domestic ProductWhy do we care so much?GDP per capita across countries is correlated w/PovertyHealthEducationCrude measure, GDP ignoresQuality of lifeEnvironmental degradationHappinessGrowth rate shows change

GDP basic factsRisesPopulation risesProductivity risesExcept when it doesntRecessionsCauses?MeasurementGDP value of all final goods and services produced over a given timeIntermediate good used as part of the production of another goodFinal good sold for use by consumer/business/govt

Note: all exports count as final goods

Multiple ways to measure GDPFinal or Intermediate?Goodrich sells a tire to Ford for its new cars.Joe buys a new tire to replace a flat on his used car.Jean sells an extra tire in her garage to Sam.GDP exampleFarmerRevenuecorn $150Costsseed $40fertilizer $60wages $25Profit$25

Supply storeRevenueseed $40fertilizer $60Cost (wholesale)$70Profit$30

GDP?

3 ways to measure GDPFinal goodsadd value of all final good$150 in cornValue addedSum value added for all intermediate and final goods$40+$60+$50 = $150$50 is value added by farmerIncomeSum all incomes from all production$30+$25+$25+$70

Nominal vs. Real GDPEconomy produces only cornQuantityPrice20066000 bushels$420078000 bushels$5

NominalGDP(2006) = $24,000GDP(2007) = $40,000

Growth rate = 66.6%

Whats wrong with this measure?Real GDPMeasure of goodsadjusted for price changesin constant dollarsUsing prices from 2006real GDP(2006) = $24,000real GDP(2007) = $32,000

Growth rate 33.3%

Note: if prices rise, real GDP < nominal GDP

GDP deflatorDeflator = nominal GDP/real GDPChange in the deflator is a measure of inflation

Deflator (2006) = 1Deflator(2007) = 1.25

Inflation 25%

Obvious with one good..ProblemAn island country in the Indian Ocean produces zebu steaks and canoes. They produced the following quantities at the following prices in the last two years.

20052006Quantity Price Quantity PriceSteaks 800 $20 1000$30Canoes 600 $40 600$50

Find the growth rates for nominal and real GDP, using 2005 prices as the base.Find the rate of inflation.CPI and inflationInflation also measured as an average of pricesGovt surveysWeighted according to typical household expenditureInflationWhy do we care?Wages rise with inflationIncomes not erodedExceptionsPensionsAlimonyDisabilityDistorts relative pricesSome prices adjusted fasterUncertaintyHigh inflation come with volatilityInvestment/consumption decisions are more difficultUnemploymentUnemployed + employed = Labor force

Unemployed looking for a job

Unemployment rateU = unemployed/labor force

High unemployment:Unused resourcesSkills erode

Not measuredDiscouraged workers / underemployedReal vs. Nominal GDPReal GDPChanges in price dont affect it.Measured in prices from a single year.

GDP Deflator =

Nominal GDPReal GDP

- measures the effect of pricesModel of DemandBuild a ModelHow do elements on the flow chart fit?How do changes affect GDP?How do policy changes affect the economy?

Start with Demand- goods sector- financial sectorDemandZ aggregate demand

Z = C + I + G + X IMEquilibrium condition: Z=Y

Assume: X = IM (no trade imbalance)

Z = C + I + G; Z=Y

Does Y affect C, I, G?Consumption FunctionC increasing in YSlope less than 1Some income savedAutonomous consumption

Algebraically,C = c0 + c1YD

c0>0 autonomous consumption0I?35Money S&DDemand for money slopes downSupply of Money is verticalDecision of the FedDoesnt respond to i Fed can shift S to change equilibrium i

What shifts Demand?Nominal GDPReal GDP or pricesBondsDiscount bonds pays $100 in one year.price?i - yield

ex. P = $8080(1+i) = 100so i = 25%

P = 100/(1+ i)

If P rises, i fallsEquilibriumWhat if i > i* ?

excess money buy bondsP i

i falls to equilibrium.QuestionsHow would an increase in prices affect equilibrium interest rates?

What would the Fed do to lower equilibrium interest rates?LM curveFor a given MS, how are Y and i related?

If Y rises, MD shifts out, i* rises

If Y falls.

In the financial market, Y and i are directly relatedLM relationGoods marketHow does a change in the interest rate affect aggregate expenditure?

Not G decision of govtNot C income and substitution effectsInvestment is affected by iDeriving ISi rises, I falls, expenditure function shifts downEquilib. GDP (Y) falls

Goods market: i and Y are inversely related

IS relation

Note: IS for Investment Savings relationFor a given Y, i adjusts so that S=I. Shifts in IS?

IS - LMTogether, they determine equilibriumY* and i*

Combines goods and financial markets

Can discuss fiscal and monetary policy.Shifts in ISConsumer confidencePreferencesFuture employmentBusiness confidenceProfit opportunitiesChanges in technologyFiscal policyShifts in LMChange in pricesMonetary PolicyFiscal PolicyIncrease in G

Expenditure shifts up

IS shifts right

Y* and i* rise

MD shifts right

Does LM shift?No, MD shifts due to a change in Y- movement along LM

Monetary PolicyFed increases MS

LM shifts right

Y* rises and i* falls

Expenditure function shifts up

Does IS shift? No, Exp shifts due to a change in imovement along ISProblemA tax cut changes consumption. Show how a tax cut would affect the IS-LM, expenditure and MS MD diagrams.Fiscal vs. Monetary PolicyMonetary PolicyAdvantagesQuick decisions/implementationFine tuneDisadvantagesTakes time to have an effectundirectedFiscal PolicyAdvantagesImmediate impactDirected spendingDisadvantagesTakes time to decide (politics)Changes tend to lastReal Money S&DEquilib i determined by real money S&DGraph looks the sameChange in PShifts supply of real moneyShifts demand for nominal moneyP rises, i rises in both cases

Note: Fed controls interest rates in the short term.Long run: prices changes affect i*IS - LMC = 100 + 0.75YDI = 100 1000iG = 200T = 200(M/P)d = 3Y 18,000i(M/P)s = 1500

Find the IS and LM relations.Find equilibrium Y* and i*.Impulse responseDecrease in Fed funds

Takes 4-8 quarters to have an effectPractice ProblemAn island country in the Indian Ocean produces zebu steaks and canoes. They produced the following quantities at the following prices in the last two years.

20052006Quantity Price Quantity PriceSteaks 800 $20 1000$30Canoes 600 $40 600$50

Find the growth rates for nominal and real GDP, using 2005 prices as the base.Find the rate of inflation.Practice Problemc0 = 100; c1=0.8I = $150; G = $200; T = $200

Using the above, find equilibrium output/income.If autonomous consumption falls by $50, find the new level of equilibrium output.What is the multiplier?What is savings before and after the change in C?

Practice ProblemLet the consumption function be C = 100 + 0.9YD

If autonomous consumption falls by $15, how does equilibrium output change?Show the changes on a Keynesian cross diagram.Practice ProblemC = 100 + 0.75YDI = 100 1000iG = 200T = 200(M/P)D = 3Y 10,000iM/P = 1500

Find ISFind LMFind equilibrium i and YPractice ProblemWhen Clinton took office in 1992, he raised taxes, and the Fed agreed to increase the money supply as long as government spending stayed constant.

Show the changes on an IS-LM diagram. What happens to equilibrium output and the interest rate? When would equilibrium output rise?ProblemShow the impact of a decrease in the price level on a graph of real money supply and demand and an IS-LM graph. What is the relationship between output/income and the price level?Review ProblemGiven the following information find the equilibrium level of output Y*. If government spending and taxes both fall by $50, how does Y* change? Show on a graph of the expenditure function with the equilibrium condition.Autonomous consumption = $300MPC = 0.9Investment = $100Taxes = $150Government spending = $150What is savings both before and after the change in spending?

Review ProblemThe recent recession has seen a large drop in business confidence affecting autonomous investment. The Federal Reserve has responded by increasing by increasing the money supply. Show the effect on the equilibrium on an IS-LM graph, and show the initial effects on an expenditure graph and a money S&D graph.Labor MarketU.S. Labor MarketLarge movements in and out