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Macro ―refresh‖ course Economics PhD 2012/13
Macro ―refresh‖ course: Introduction
Giovanni Di Bartolomeo
Note: These lecture notes are incomplete without having attended lectures
Macro ―refresh‖ course Economics PhD 2012/13
Some Key Questions of Macroeconomics
• Why do incomes grow? Why are some countries
richer than others? Why do some grow faster than
others?
• Why do incomes fluctuate? Can policy do anything
about it?
• Why is there unemployment? Is it a necessary part of
economic life? How is it affected by policy?
• What determines inflation?
Macro ―refresh‖ course Economics PhD 2012/13
To address these questions we need to know…
• How individuals behave (―microfoundations‖)
• How individuals interact (―market structure‖)
• How government enters the picture (both the
feasibility of policy and the incentives facing policy
makers)
Macro ―refresh‖ course Economics PhD 2012/13
Methodology
• Models embody assumptions about individual
behavior, market structure and what is exogenous
(including policy regime).
• Solution gives us the endogenous variables in
terms of the exogenous factors.
• Models should be simple and focus on issue at hand.
Do not need to be ―realistic‖, but should be consistent
with the facts.
• Can switch between models according to context; no
grand ―true‖ model.
Macro ―refresh‖ course Economics PhD 2012/13
Stocks vs. Flows - examples
the Government
Budget Deficit
the Government
Debt
# of new college
graduates this year
# of people with
college degrees
a person’s
annual saving a person’s wealth
flow stock
Capital Investment
Macro ―refresh‖ course Economics PhD 2012/13
Real vs. Nominal Variables
• GDP is the value of all final goods and
services produced.
• Nominal GDP measures these values using
current prices.
• Real GDP measure these values using the
prices of a base year.
• Always (YR real var, YN nominal var, P price)
YR = YN/P
YN=YR P
Macro ―refresh‖ course Economics PhD 2012/13
Common Strands:
• Individuals and firms optimize
• Rational Expectations in the long run
• Prices flexible in the long run
Also frequently:
• Perfect Competition: May be unrealistic, but often a
useful simplification
Macro ―refresh‖ course Economics PhD 2012/13
Important Concepts…
• Gross Domestic Product (GDP)
• Components of GDP
• Gross National Product (GNP)
• Price Indices:
GDP Deflator
The Consumer Price Index (CPI)
• The Unemployment Rate
Macro ―refresh‖ course Economics PhD 2012/13
Aggregate Output
• National income and product accounts are an
accounting system used to measure of aggregate
economic activity.
• The measure of aggregate output in the national
income accounts is gross domestic product, or
GDP.
• In the United States, the Bureau of Economic
Analysis calculates GDP and components of the
National Accounts.
Macro ―refresh‖ course Economics PhD 2012/13
GDP: Production and Income
There are three ways of defining GDP: 1. GDP is the value of the final goods and services produced in
the economy during a given period.
A final good is a good that is destined for final consumption.
An intermediate good is a good used in the production of
another good.
2. GDP is the sum of the incomes in the economy during a
given period.
3. GDP is the sum of value added in the economy during a
given period.
Value added equals the value of a firm’s production minus the value of
the intermediate goods it uses in production.
Macro ―refresh‖ course Economics PhD 2012/13
GDP: Expenditure and Income
For first two definitions:
Total expenditure on domestically-produced
final goods and services.
Total income earned by domestically-located
factors of production.
Expenditure equals income because
every dollar spent by a buyer
becomes income to the seller.
Macro ―refresh‖ course Economics PhD 2012/13
The Circular Flow
Households Firms
Goods
Labor
Expenditure ($)
Income ($)
Macro ―refresh‖ course Economics PhD 2012/13
The Expenditure Components of GDP
• Consumption
• Investment
• Government spending
• Net eXports
Macro ―refresh‖ course Economics PhD 2012/13
An important identity
Y = C + I + G + NX
Aggregate
Expenditure Value of
Total
Output
Macro ―refresh‖ course Economics PhD 2012/13
The Components of GDP
• Consumption: Approximately 70% of US GDP
• Investment: 20% of GDP
• Government Consumption: 15.8% of GDP
• Exports: 11% of GDP
• Imports: 16.9% of GDP
Macro ―refresh‖ course Economics PhD 2012/13
The Business Cycle
Giovanni Di Bartolomeo
Note: These lecture notes are incomplete without having attended lectures
Macro ―refresh‖ course Economics PhD 2012/13
The Business Cycle
• What is a Business Cycle?
The business cycle is the periodic but irregular up-and-down movement in production and jobs.
• The NBER defines the phases and turning points of the business cycle as follows:
A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.
A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion.
Macro ―refresh‖ course Economics PhD 2012/13
Economic Growth and Fluctuations
Every business cycle has two phases:
1. A recession
2. An expansion
and two turning points:
1. A peak
2. A trough
• A recession is a period during which real GDP
decreases for at least two successive quarters.
• An expansion is a period during which real GDP
increases.
Macro ―refresh‖ course Economics PhD 2012/13
Economic Growth and Fluctuations
• Economic Growth in the United States
Figure 1 on the right shows real GDP in the United States from 1962 to 2007.
• The figure highlights: Fluctuations of real GDP
Smoother growth of potential GDP
Real GDP Potential
GDP
Source: Bureau of Economic Analysis
Macro ―refresh‖ course Economics PhD 2012/13
Economic Growth and Fluctuations
• Potential GDP is the value of real GDP when all the economy’s labour, capital, land, and entrepreneurial ability are fully employed.
• During the 1970s and early 1980s, real GDP growth slowed—a productivity growth slowdown.
Real GDP Potential
GDP
The long term
growth rate is …
… 4.4 percent
per year
… 2.9 percent
per year
… 3.1 percent
per year
… 2.8 percent
per year
Source: Bureau of Economic Analysis
Macro ―refresh‖ course Economics PhD 2012/13
Economic Growth and Fluctuations
• Real GDP fluctuates around
potential GDP in a
business cycle
a periodic but irregular
up-and-down movement
in production. Real GDP
Potential
GDP
The long term
growth rate is …
… 4.4 percent
per year
… 2.9 percent
per year
… 3.1 percent
per year
… 2.8 percent
per year
Macro ―refresh‖ course Economics PhD 2012/13
Economic Growth and Fluctuations
8000
9000
10000
11000
12000
1996-IV 1997-IV 1998-IV 1999-IV 2000-IV 2001-IV 2002-IV 2003-IV 2004-IV 2005-IV 2006-IV 2007-IV
Real
GD
P (
billio
ns o
f 2000 d
ollars
)
Year
• This figure shows the most recent U.S. cycles.
Real GDP
Potential
GDP Peak
Peak
Trough
Expansion Expansion
Recession
Macro ―refresh‖ course Economics PhD 2012/13
23
Economic Growth and Fluctuations
• This figure shows the long-term growth trend and cycles
Macro ―refresh‖ course Economics PhD 2012/13
Production (Real GDP) as a Benchmark
• In Macroeconomics, we compare what happens to
different variables in terms of how it relates to
production in the economy (i.e. how does inflation, or
unemployment relate to real GDP?)
• Definition:
Procyclical: the variable moves with the business cycle (i.e.
it increases when production increases and vice versa)
Countercyclical: the variable moves in the opposite
direction of the business cycle (i.e. it increases when
production decreases and vice versa)
Acyclical: does not move with the business cycle
Macro ―refresh‖ course Economics PhD 2012/13
Thinking About Cyclicality…
• As a general rule of thumb:
A variable, X, is procyclical if Correlation(X, output gap) or
Correlation (X, economic growth rate) > 0.25
A variable, X, is countercyclical if Correlation(X, output gap)
or Correlation (X, economic growth rate) < -0.25
A variable, X, is acyclical if -0.25 < Correlation(X, output
gap) < 0.25
• In general the closer the correlation is to +1 ( -1) (i.e.
the further away it is from zero), the greater the
degree of pro-cyclicality (counter-cyclicality).
Macro ―refresh‖ course Economics PhD 2012/13
Some Facts about the Business Cycle
• GDP growth averages 3–3.5 percent per year over
the long run with large fluctuations in the short run.
• Consumption and investment fluctuate with GDP, but
consumption tends to be less volatile and investment
more volatile than GDP.
Correlation of consumption and the output gap: 0.998
Correlation of investment and the output gap: 0.989
• Unemployment rises during recessions and falls
during expansions.
Correlation of unemployment and GDP is approx -0.67
• Okun’s Law: the negative relationship between
GDP and unemployment.
Macro ―refresh‖ course Economics PhD 2012/13
Growth rates of Real GDP, Consumption
-4
-2
0
2
4
6
8
10
1970 1975 1980 1985 1990 1995 2000 2005
Real GDP growth rate
Average growth
rate
Consumption growth rate
Percent
change
from 4
quarters
earlier
Macro ―refresh‖ course Economics PhD 2012/13
Growth rates of Real GDP, Consumption, Investment
-30
-20
-10
0
10
20
30
40
1970 1975 1980 1985 1990 1995 2000 2005
Percent
change
from 4
quarters
earlier
Investment growth rate
Real GDP growth rate
Consumption growth rate
Macro ―refresh‖ course Economics PhD 2012/13
Unemployment
0
2
4
6
8
10
12
1970 1975 1980 1985 1990 1995 2000 2005
Percent
of labor
force
• Unemployment rises in recessions and falls in expansions
• Unemployment rate is a lagging indicator
Macro ―refresh‖ course Economics PhD 2012/13
Okun’s Law
Percentage
change in
real GDP
Change in unemployment rate
-4
-2
0
2
4
6
8
10
-3 -2 -1 0 1 2 3 4
1975
1982 1991 2001
1984
1951 1966
2003
1987
3.5 2
Y
uY
• Okun’s Law:
the negative
relationship
between GDP
and
unemployment.
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Productivity
-600
-400
-200
0
200
400
600
1975 1980 1985 1990 1995 2000 2005
Productivity (x100)(Real) Output Gap
Cyclica
l V
ari
atio
n
• The correlation
between productivity
and real GDP is
approximately 0.9996
• This indicates that
productivity is highly
procyclical
Macro ―refresh‖ course Economics PhD 2012/13
Business Cycle Facts (Quantities)
1. Output movements persist (but not periodic)
2. Industries move together
3. Consumption, Investment and Imports are procyclical
they move with the business cycle and this is highlighted by positive correlations
4. Unemployment is countercyclical, but productivity is procyclical
Macro ―refresh‖ course Economics PhD 2012/13
Business Cycle Facts (Prices)
1. Prices/Inflation is procyclical.
2. Real wages are acyclical or mildly procyclical.
3. Short term interest rates are procyclical.
4. Money and velocity are procyclical.
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Inflation
-3
-2
-1
0
1
2
3
4
1975 1980 1985 1990 1995 2000 2005
Inflation Rate Output Gap
Pe
rce
nt
• The correlation between
the CPI and GDP is
0.979.
• The correlation between
inflation and GDP is
approximately 0.301.
• This indicates that
prices are highly
procyclical, whilst
inflation is mildly
procyclical
Macro ―refresh‖ course Economics PhD 2012/13
Inflation v. Output Gap
• This scatter plot highlights
the positive relationship
observed between inflation
and the output gap.
• The bigger output is
(above potential), the
greater the amount of
inflation!
-.01
.00
.01
.02
.03
.04
-.04 -.03 -.02 -.01 .00 .01 .02 .03 .04
Output Gap
Infla
tio
n
US 1973 - 2006
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Real Wage
• The correlation between
real wages and real GDP is
approximately 0.124
• This indicates that real
wages are acyclical (– i.e.
that they are independent of
the business cycle) or at
best, very mildly procyclical. -3
-2
-1
0
1
2
3
1975 1980 1985 1990 1995 2000 2005
(Real) Output Gap Real Wage
No
rma
lize
d V
ari
ab
les
Macro ―refresh‖ course Economics PhD 2012/13
Real Wage v. Output Gap
0.96
1.00
1.04
1.08
1.12
1.16
-300 -200 -100 0 100 200 300
(Real) Output Gap
Re
al W
ag
e
US 1973 - 2006
• This scatter plot
highlights the lack of a
relationship between
real wages and the
output gap.
• It is not possible to
figure out which
direction the line of
best fit should go!
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Short Interest Rate
• The correlation
between short term
interest rates and GDP
is approximately 0.401
• This indicates that
nominal interest rates
are procyclical 0
4
8
12
16
20
24
28
32
-.04
-.03
-.02
-.01
.00
.01
.02
.03
.04
1975 1980 1985 1990 1995 2000 2005
Federal Funds Rate Output Gap
Inte
rest R
ate
(P
erc
en
t)
Cyclic
al V
aria
tion
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Real Short Interest Rate
-4
0
4
8
12
16
20
-300
-200
-100
0
100
200
300
1975 1980 1985 1990 1995 2000 2005
Real Fed Funds Rate(Real) Output Gap
Re
al F
ed
Fu
nd
s R
ate
(P
erc
en
t)
Cyclic
al V
aria
tion
• The correlation
between short term
interest rates and Real
GDP is approximately
0.384
• This indicates that real
interest rates are
(mildly) procyclical
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Money Supply
-8
-4
0
4
8
12
65 70 75 80 85 90 95 00
Money Supply Output Gap
Perc
en
t
US 1965-2001
• The correlation
between money supply
and GDP is
approximately 0.967
• This indicates that the
money supply is highly
procyclical
Macro ―refresh‖ course Economics PhD 2012/13
Output Gap and Velocity
-10
-5
0
5
10
65 70 75 80 85 90 95 00
Velocity Output Gap
Perc
en
t
US 1965-2001
• The correlation
between velocity and
GDP is approximately
0.826
• This indicates that
velocity is highly
procyclical