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EC201 Intermediate Macroeconomics 2011/2012

EC201 Intermediate Macroeconomics Contact details:

• Gianluigi Vernasca • Room: 5B.217 • Office hours: Wednesday 2pm to 4pm • Email: gvern@essex.ac.uk

Lecture Outline:

- What do we study in macroeconomics? - some important concepts in macroeconomic analysis;

Essential reading: Mankiw: Ch. 1 1) What is Macroeconomics? Macroeconomics is the study of the behaviour of large collections of economic agents

(aggregates). It focuses on the aggregate behaviour of consumers, firms, governments,

the economic interactions among nations and the effects of fiscal and monetary

policy. By contrast, microeconomics deals with the economic decisions of individuals

(a typical consumer, a single firm, etc. etc.).

For example: the decision by a firm to buy or not a particular machine used in its

production process is a microeconomic problem. The effect of a decrease in the

interest rate on the saving decisions of UK households is a macroeconomic problem.

Some of the questions that are addressed in Macroeconomics:

- What causes recessions?

- Can the government do anything to combat recessions? Should it?

- Why does the cost of living keep rising?

- Why are millions of people unemployed, even when the economy is booming?

- What is the government budget deficit? How does it affect the economy?

- Why there are poor countries? What policies might help them grow out of poverty?

Lecture 1: Introduction to Macroeconomics

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Therefore, the objective of macroeconomics is to explain some features of an

economy as a whole, and toward this end, macroeconomists collects data on many

aggregate variables and try to create theoretical models that can explain the behaviour

of such variables. For example, Karl Marx (one of the first macroeconomists) saw the

following feature of a capitalist economy after the Industrial Revolution. There was a

persistent accumulation of wealth by one class of the society and the persistent

impoverishment of another. How could this be possible in an economic system

characterised by voluntary trade? In order to explain that feature Marx came out with

his theory of class exploitation well outlined in his book The Capital.

Another example is John Maynard Keynes that wrote his General Theory after he saw

the Great Depression of 1929. In macroeconomics 3 aggregate variables are normally

very important to describe the economic situation in a given economy/country: Real

GDP (Real Gross Domestic Product: the value of goods and services produced in a

country in a given period of time, measured using a constant price level), the

Inflation Rate (the percentage change of the general level of prices from one period

to another) and the Unemployment Rate (how many people in the labour force are

unemployed in a given period of time, in percentage). We will provide a more

rigorous definition of those variables in Lecture 2. In the next 3 figures we plot those

variables for the US economy:

Figure 1.1 Real GDP per Person in the U.S. EconomyMankiw: Macroeconomics, Sixth EditionCopyright © 2007 by Worth Publishers

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In this Figure we have the real GDP per capita. (Example: if the real GDP in year

2000 is 4,000,000 $, and the total population in US in 2000 is 100, than the real GDP

per person is 4,000,000/100=40,000). We can say that: the real GDP per capita is

increasing over time; this fact tells us that today people enjoy a higher standard of

living than people in the past. Furthermore, the behaviour of the series in the figure

says that the real GDP does not grow aver time steadily. There are periods, for

example during the great depression, where the real GDP falls, while there other

periods where it raises. Periods where the real GDP falls are called recessions, while

periods where the real GDP raises are called expansions. In practice, the real GDP

series fluctuate over time, and the fluctuations are called Cycles. Obviously, it would

be very interesting to have a model that explains why real GDP fluctuates, since in

that case, for example, we may be able to understand how to smooth recessions using

economic policy.

The second series is the Inflation Rate:

Figure 1.2 The Inflation Rate in the U.S. EconomyMankiw: Macroeconomics, Sixth EditionCopyright © 2007 by Worth Publishers

The first thing we can notice is that the inflation rate varies substantially over time,

especially in the first half of the last century. When inflation is decreasing, we call

that a Deflation. We can notice that after the second oil shock in the 70’s, the inflation

rate in US has decreased and it has become more stable.

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Furthermore, you can see that there is not a trend as in the case of the real GDP,

meaning that inflation does not tend to grow steadily over time.

The final series is the Unemployment rate:

Figure 1.3 The Unemployment Rate in the U.S. EconomyMankiw: Macroeconomics, Sixth EditionCopyright © 2007 by Worth Publishers

Notice first of all, that unemployment is never zero in the economy (it cannot be

negative by definition). As for the inflation rate series, there is not a trend over time;

however, unemployment rate tends to fluctuate quite substantially from year to year.

Below is the graph of the unemployment rate in US (% annual) from 2000 to 2010.

This is to show the effect of the credit crunch on the unemployment rate in US.

Credit crunch

% Unemp

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2) Why to learn Macroeconomics?

The main answer is: because macroeconomics affects the well-being of societies.

Think about the recent credit crunch. Overall production in many countries is

contracted because of the reduced access to credit by firms. Lower production means

more unemployment. Moreover, it means fewer vacancies in the labour market and

therefore it is more difficult finding a job, etc. etc. Think about the debt crisis in the

EURO zone, etc. etc. Here are some other examples. In the following graph we plot

two series together, the unemployment rate and the numbers of property crime in US

between 1970 and 2004.

While the correlation is clearly not perfect, there is a strong, visible association

between unemployment, an economic indicator, and crime, a social indicator.

Another example:

Unemployment & inflation in election years

year U rate inflation rate elec. outcome

1976 7.7% 5.8% Carter (D)

1980 7.1% 13.5% Reagan (R)

1984 7.5% 4.3% Reagan (R)

1988 5.5% 4.1% Bush I (R)

1992 7.5% 3.0% Clinton (D)

1996 5.4% 3.3% Clinton (D)

2000 4.0% 3.4% Bush II (R)

2004 5.5% 3.3% Bush II (R)

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2

4

6

8

10

1970 1980 1990 20002000

3000

4000

5000

6000

% per 100,000 population

U.S. Unemployment and Property Crime Rates

unemployment (left scale)

property crime (right scale)

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From this table, we can see that the state of the economy (summarised by the inflation

rate and the unemployment rate) has a huge impact on election outcomes. When the

economy is doing poorly, there tends to be a change in the party that controls the

White House. For example, in 1976, the rates of inflation and unemployment were

both high, the incumbent (Ford, R) loses. In 1980, unemployment is still high,

inflation is even higher and the incumbent (Carter, D) loses.

And so on.

3) Economic Models

Once we know some aspects of the reality that we want to explain (for example, why

real GDP fluctuates over time, etc. etc.), we need to develop some theory that can

help us. To that aim we construct macroeconomic models. A macroeconomic model is

an extremely simplified imaginary economy where irrelevant details are stripped

away and where simplifying assumptions are imposed to keep the model manageable.

It is a simplified picture of the world that addresses the particular question we want to

analyse. Normally the model is constructed using the language of mathematics. When

we do that, we describe the model economy in terms of a few variables. Variables are

symbols representing economic quantities and prices. For example Y stands for

“production” or “aggregate income”, P for “the price level” and i for “the interest

rate”. Y, P and i are called variables because they can take different values. The

economic system is a system of relations between economic variables.

We use models to

show relationships between variables

explain the economy’s behavior

devise policies to improve economic performance

Example of a model: the market for cars

Suppose we want to understand how various events affect price and quantity of cars in

the market. First we need to make some simplifying assumptions.

We assume that the market for cars is competitive: each buyer and seller is too small

to affect the market price (this is not true in reality, but it simplifies the analysis and

can provide useful and testable results anyway)

The variables in the model are

QD = quantity of cars that buyers demand

QS = quantity that producers supply

P = price of new cars

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Y = aggregate income

PS= price of steel (an input)

Demand equation: QD = D (P,Y )

shows that the quantity of cars consumers demand is related to the price of

cars and aggregate income.

An important digression about notation:

General functional form: shows only that the variables are related.

QD = D (P,Y )

We know that P and Y are related to the variable Q d through the function D, but we

don’t know what the function D is (linear, non-linear, etc. etc.).

On the other hand, a specific functional form shows

the precise quantitative relationship (= what is function D). Example: D (P,Y ) = 60 –

10P + 2Y

Supply equation: QS = S (P,Ps )

The supply curve shows the relationship between quantity supplied and price, other

things equal. The equilibrium in the market is given when demand is equal to supply

QD = QS

Using our simple model we can now ask: what happens to the equilibrium if there is

an increase in income Y?

QQuantity of cars

P Price

of cars

QQuantity of cars

P Price

of cars SS

DD

equilibrium price

equilibrium price

equilibriumquantity

equilibriumquantity

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From the way we have written our model we know that Y will affect only the demand

function. In particular, when aggregate income increases, there are more resources to

spend and therefore the demand of goods (in this case the demand for cars) increases.

Graphically:

An increase in income increases the quantity of cars consumers demand at each price,

which increases the equilibrium price and quantity.

Now we can ask: what happens if there is an increase in the price of steel?

We know that the price of steel affects only the supply function. An increase in the

price of an input, increases the costs of the suppliers, and therefore increases the final

price charged by the suppliers. The result is the following:

QQuantity of cars

P Price

of cars S

D1

Q1

P1

QQuantity of cars

P Price

of cars

QQuantity of cars

P Price

of cars SS

D1D1

Q1

P1

P2

Q2

P2P2

Q2Q2

D2D2

QQuantity of cars

P Price

of cars S1

D

Q1

P1

QQuantity of cars

P Price

of cars

QQuantity of cars

P Price

of cars S1S1

DD

Q1

P1

P2

Q2

P2P2

Q2Q2

S2S2

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Notice that we have considered the effects of changes in aggregate income and the

price of steel. In our simple model those two variables are called exogenous.

In every economic model we distinguish between exogenous and endogenous

variables and this distinction is very important.

The values of endogenous variables are determined in the model.

The values of exogenous variables are determined outside the model: the model takes

their values and behaviour as given.

In our model the endogenous variables were:

QD QS and P

While the exogenous variables were: Y and PS

No model can address all the issues we care about. For example, our supply-demand

model of the car market:

can tell us how a fall in aggregate income affects price and quantity of

cars.

cannot tell us why aggregate income falls.

So we will learn different models for studying different issues.

For each new model, you should keep track of

its assumptions

which variables are endogenous, which are exogenous

the questions it can help us understand, and those it cannot

Another digression about macroeconomic models:

Macroeconomics is normally distinct from microeconomics in that it deals with the

overall effects on economies of the choices that all economic agents make, rather than

on the choices of individual consumers and firms.

However, because economy-wide events arise from the interaction of many

consumers and many firms, macroeconomics and microeconomics are clearly linked.

In particular, nowadays, macroeconomic models are built from microeconomic

principles, starting from the description of consumers and firms, their objectives and

constraints and how they interact.

The main idea is to derive “explicitly” macroeconomic predictions from a model that

starts from the optimizing behaviour of individual agents (firms and consumers do the

best they can for themselves giver their objectives and the constraints they face).

This is what we call “microfoundations” of macroeconomics (you will see something

about it in the second term).

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In the first part of the course, in most of the cases, we will not model “explicitly” the

microeconomic structure behind our macroeconomic analysis. Meaning that the

microeconomic decisions will be “implicit” in the models we will use.

Another important distinction in macroeconomics:

Prices: flexible vs. sticky

Market clearing: An assumption that prices are flexible, adjust to equate supply and

demand in every market.

We normally assume that in the long run prices in the economy are fully flexible and

all markets clear.

However, in the short run, many prices are sticky – adjust sluggishly in response to

changes in supply or demand. For example,

- many labour contracts fix the nominal wage for a year or longer (the wage is a

price, in particular is the price of a good called labour)

- many magazine publishers change prices only once every 3-4 years

The economy’s behaviour depends partly on whether prices are sticky or flexible. If

prices are sticky, then demand won’t always equal supply. This helps explaining

unemployment (excess supply of labor) or why firms cannot always sell all the goods

they produce. On the other hand in the long run we normally assume that prices are

flexible, markets clear, and therefore economy behaves very differently.