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– Debt/deficit– exchange rates– Etc.

Goals

• Explain movements of and connections between macro variables.

• Policy– What can the gov’t do?– What should the gov’t do

Macro is hard

• General Equilibrium– many variables– media coverage (yuck)

• Short run vs. Long Run– Ex. new machines eliminate jobs

• Many approaches to economics

Plan of class

• Short run– 1 to 2 years– Booms and recessions

• Medium run– Why / how fast does GDP grow– equilibrium

• Long run– Decades– What makes rich countries rich?– Development

Our focus

• Domestic economy• Short Run – Keynesian story• Classical ideas to connect to

the long run

Macro Flow Chart

• Firms & consumers• Income and Consumtion• Government

– Spending– Taxes & transfers

• Savings & Investments• Imports and Exports

Fiscal Policy

• Government Spending– Defense– Health, Education & Welfare

• Tax policy– Income tax– Capital gains tax etc.

• Debt/Deficit

President and Congress

Monetary Policy

The Federal Reserve controls• Money supply• Interest rates (one of them)• Affects firm/consumer

decisions

Gross Domestic Product

• Why do we care so much?• GDP per capita across

countries is correlated w/– Poverty– Health– Education

• Crude measure, GDP ignores– Quality of life– Environmental degradation– “Happiness”

• Growth rate shows change

GDP – basic facts

• Rises– Population rises– Productivity rises

• Except when it doesn’t– Recessions– Causes?

Measurement

GDP – value of all final goods and services produced over a given time

Intermediate good – used as part of the production of another good

Final good – sold for use by consumer/business/gov’t

Note: all exports count as final goods

Multiple ways to measure GDP

Final 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 example

FarmerRevenue corn $150Costs seed $40

fertilizer $60wages $25

Profit $25

Supply storeRevenue seed $40

fertilizer $60Cost (wholesale) $70Profit $30

GDP?

3 ways to measure GDP

• Final goods– add value of all final good– $150 in corn

• Value added– Sum value added for all

intermediate and final goods– $40+$60+$50 = $150– $50 is value added by farmer

• Income– Sum all incomes from all

production– $30+$25+$25+$70

Nominal vs. Real GDP

Economy produces only cornQuantity Price

2006 6000 bushels $42007 8000 bushels $5

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

Growth rate = 66.6%

What’s wrong with this measure?

Real GDP

• Measure of goods– adjusted for price changes– “in constant dollars”

Using prices from 2006real GDP(2006) = $24,000real GDP(2007) = $32,000

Growth rate 33.3%

Note: if prices rise, real GDP < nominal GDP

GDP deflator

Deflator = nominal GDP/real GDP

Change in the deflator is a measure of inflation

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

Inflation – 25%

Obvious with one good…..

Problem

An 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.

2005 2006Quantity 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 inflation

• Inflation also measured as an average of prices– Gov’t surveys– Weighted according to “typical”

household expenditure

Inflation

• Why do we care?• Wages rise with inflation

– Incomes not eroded– Exceptions

• Pensions• Alimony• Disability

• Distorts relative prices– Some prices adjusted faster

• Uncertainty– High inflation come with volatility– Investment/consumption

decisions are more difficult

Unemployment

Unemployed + employed = Labor force

Unemployed – looking for a job

Unemployment rateU = unemployed/labor force

High unemployment:– Unused resources– Skills erode

Not measuredDiscouraged workers / underemployed

Real vs. Nominal GDP

• Real GDP– Changes in price don’t affect it.– Measured in prices from a single

year.

GDP Deflator =

Nominal GDPReal GDP

- measures the effect of prices

Model of Demand

Build a Model

• How 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 sector

Demand

Z – 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 Function

• C increasing in Y• Slope less than 1

– Some income saved• Autonomous consumption

Algebraically,C = c0 + c1YD

c0>0 – autonomous consumption0<c1<1 –marginal propensity to

consume (MPC)

Solving

Assume (for now) I and G are fixed

Y = c0 + c1YD + I + GOrY = c0 + c1(Y–T) + I + GWith Y=Z

Y* = (1/(1-c1))(c0 - c1T + I + G)

Example

c0 = 100; c1=0.75I = $250; G = $200; T = $200

(balanced budget, for now)

Y* = (1/0.25)400 = 1600

What if G rises by $50?Y* = $1800

DY > DG Why?(Keynesian

cross)

Multiplier

• Increase in G, Yh, Ch, Yh etc……

• Why doesn’t Y explode?– Some saved every step

Multiplier = 1/(1-c1)measures the extra impact on Y of a change in autonomous spending.

Money Supply and Demand

Liquidity Preference2 assets: Money and Bonds

W = M + BHold bonds: better returnHold money: for transactions

(liquidity)

Demand for Money vs. interest rate ?

Higher i greater demand for bondslower demand for money

Money S&D

• Demand for money slopes down

• Supply of Money is vertical– Decision of the Fed– Doesn’t respond to i – Fed can shift S to change

equilibrium i

What shifts Demand?• Nominal GDP

– Real GDP or prices

Bonds

Discount bonds pays $100 in one year.

price? i - yield

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

P = 100/(1+ i)

If P rises, i falls

Equilibrium

What if i > i* ?

excess money buy bonds

P i

i falls to equilibrium.

Questions

• How would an increase in prices affect equilibrium interest rates?

• What would the Fed do to lower equilibrium interest rates?

LM curve

For 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 related

LM relation

Goods market

How does a change in the interest rate affect aggregate expenditure?

Not G – decision of gov’tNot C – income and substitution

effectsInvestment is affected by i

Deriving IS

• i rises, I falls, expenditure function shifts down

• Equilib. GDP (Y) falls

Goods market: i and Y are inversely related

IS relation

Note: IS for Investment – Savings relation

For a given Y, i adjusts so that S=I. Shifts in IS?

IS - LM

Together, they determine equilibrium

Y* and i*

Combines goods and financial markets

Can discuss fiscal and monetary policy.

Shifts in IS

• Consumer confidence– Preferences– Future employment

• Business confidence– Profit opportunities– Changes in technology

• Fiscal policy

Shifts in LM

• Change in prices• Monetary Policy

Fiscal Policy

Increase 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 Policy

Fed 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 IS

Problem

A tax cut changes consumption. Show how a tax cut would affect the IS-LM, expenditure and MS – MD diagrams.

Fiscal vs. Monetary Policy

Monetary Policy• Advantages

– Quick decisions/implementation– Fine tune

• Disadvantages– Takes time to have an effect– undirected

Fiscal Policy• Advantages

– Immediate impact– Directed spending

• Disadvantages– Takes time to decide (politics)– Changes tend to last

Real Money S&D• Equilib i determined by real money

S&D• Graph looks the same• Change in P

– Shifts supply of real money– Shifts demand for nominal money– P rises, i rises in both cases

Note: Fed controls interest rates in the short term.

Long run: prices changes affect i*

IS - LM

C = 100 + 0.75YD

I = 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 response

Decrease in Fed funds

Takes 4-8 quarters to have an effect

Practice Problem

An 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.

2005 2006Quantity 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 Problem

c0 = 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 Problem

Let 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 Problem

C = 100 + 0.75YD

I = 100 – 1000iG = 200T = 200(M/P)D = 3Y – 10,000iM/P = 1500

Find ISFind LMFind equilibrium i and Y

Practice Problem

When 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?

Problem

Show 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 Problem

Given 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 Problem

The 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 Market

U.S. Labor Market

• Large movements in and out of labor force and employed– Hires– Quits– Layoffs– Discouraged workers

• Continental Europe - slower change– Stronger unions– More firing restrictions– Higher wages and more

unemployment

Wage determination

Firms seem to pay higher than “competitive” wages.

Why are wages higher than necessary?

• Efficiency wages– Get more effort– Reduce turnover

• Bargaining power– Worker skills– Depends on other options– unions

Firm decision

Competitive labor marketW = MRP

if W < MRP then firm hires more (more

profit)

MRP = P x MPL so

marginal product = real wage (W/P)

Simple version

Production function: Y=L

Implies MPL = 1

real wage W/P = 1P = W

“price equals marginal cost”

Too simple???- firms have “pricing power”- workers have bargaining power

Wage determination - formally

Nominal wages negotiated according to expected prices Pe

W = PeF(u,z)

F(u,z) “bargaining power”u – unemployment ratez – other factors

ex. labor lawsworker skill

Price determination

Output prices also tend to be higher than wages.

• Other costs• Firms have market power

- monopolistic competition- monopoly- oligopoly

P = W(1 + m) “markup”or

W/P = 1/(1 + m)

Natural rate of unemployment

If price = expectations, combine equations

F(u,z) = 1/(1 + m)

relates the wage and price markups

Determines un – natural rate of unemployment

Medium run concept

Graph

• Price & wage determination• unemployment vs. real wage• Price setting equation constant

according to markup• Wage setting, higher u means

lower real wage (bargaining)

Compare U.S. and France• more firing restrictions• More benefits required by law• WS curve to the right• higher un

Natural rate

• Medium run concept• 0% cyclical unemployment• Associated with

– natural rate of employment– Natural rate of output– NAIRU

• Natural rate can change over time with– labor laws– unemployment benefits– tax policy?

Problem

• Unions give workers extra bargaining power, but have declined in membership over the last 25 year in the U.S. Use the wage / price determination graph to show the effect on real wages and the natural rate of unemployment.

Problem

• Online retailing has increased competition for goods, lowering the markup firms can charge. Show how this affects the labor market and the natural rate of unemployment.

Review Problem

A proposed law in France would make it easier for firms to fire people. Show the effect on the natural rate of unemployment on the wage/price setting graph.