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Introduction to Macroeconomics
MSc Induction
Simon Hayley
[email protected]
What is Macroeconomics?
• Macroeconomics looks at the economy as a
whole. It studies aggregate effects, such as:
• Business cycles
• Living standards (real incomes)
• Inflation
• Unemployment
• The balance of payments.
• It also asks how governments can use their
monetary and fiscal policy instruments to help
stabilise the economy.
Key Issues
• Why analyse macroeconomics?
• Measuring economic activity
• Building a macroeconomic model
• Macroeconomic problems and policy
solutions
Real GDP at 1985 prices, United Kingdom 1885-2005, £ billion
700
600
billions 1985 £s
500
400
300
200
100
0
1885
1895
1905
1915
1925
1935
1945
1955
1965
1975
1985
1995
2005
Real GDP growth rate, United Kingdom 1886-2005
20
Annual rate of change per cent
15
10
5
0
-5
-10
1886
1896
1906
1916
1926
1936
1946
-15
Year
1956
1966
1976
1986
1996
UK GDP Gap, 1970-2006
8
4
2
0
-2
-4
20
00
19
85
-6
19
70
percent of Y*
6
Year
UK Claimant Count Unemployment, 1885-2005
20
18
Per cent of workforce
16
14
12
10
8
6
4
2
0
1885
1895
1905
1915
1925
1935
1945
1955
1965
1975
1985
1995
2005
UK Inflation (% per annum)
30
25
20
15
10
5
0
1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
How Can We Measure National Output?
• Key concepts:
– Gross domestic product (GDP)
– Gross national income (GNI - used to be
called GNP)
– in a closed economy GDP = GNI
• Aggregate supply and demand:
– Controlling inflation and unemployment
– Fiscal and monetary policy
Avoiding Double Counting
• To avoid double counting, when measuring national
output via spending on goods, the goods that count
as part of the economy’s output are called final
goods; all others are called intermediate goods.
• Each firm’s contribution to total output is equal to its
value added: the gross value of the firm’s output
minus the value of all intermediate goods and
services (the outputs of other firms) that it uses.
• The sum of all the values added produced in an
economy is called gross value added at basic prices
(the prices received by producers net of taxes on
products, plus subsidies).
Three Routes to GDP
•
All output is owned by someone, and all output is
bought by someone. Thus gross domestic product,
[GDP] can be calculated in three different ways:
1) As the sum of value added by all producers of
both intermediate and final goods
2) As the income claims generated by the total
production of goods and services
3) As the expenditure needed to purchase all final
goods and services produced during the period.
•
These three methods reach the same total, so long
as we add taxes on products [minus subsidies] to the
first two in order to measure GDP at market prices.
The Circular Flow of Income, Output, and Expenditure
Domestic
households
Financial
System
Abroad
Government
Domestic
producers
An Example
• Suppose an economy has two firms:
– Firm A mines ore; it sell £300 worth to firm B, pays
£200 to its workers, and makes £100 profit.
– Firm B makes consumer goods; it buys materials
for £300 from firm A, pays £300 to its workers,
sells it output for £800 and makes profit of £200.
• What is GDP?
• Value of final goods sold = £800
• Value added of two firms: Firm A = £300, Firm B =
£500 so total = £800
• Sum of incomes: Wages = £200 + £300; profits =
£100 + £200 so total = £800
Types of Final Expenditure
From the expenditure side of the national accounts:
• GDP = C + I + G + [X - M].
• C is private consumption expenditures.
• I is investment in fixed capital [including residential
construction], inventories, and valuables.
• G is government consumption.
• (X -M) represents net exports, or exports minus
imports; it will be negative if imports exceed
exports.…also referred to as NX
Gross value added at current basic prices, by sector, UK, 2005
£ million
% of GDP
Agriculture, hunting, forestry and fisheries
10,241
0.8
Mining and quarrying
25,458
2.1
148,097
12.2
Electricity, gas and water supply
24,953
2.0
Construction
65,923
5.4
132,113
10.8
Hotels and restaurants
33,730
2.8
Transport and communications
81,059
6.6
266,485
21.8
Public administration and defence
54,935
4.5
Education
62,316
5.1
Health and social work
81,518
6.7
Other services
58,807
4.8
Sector
Manufacturing
Wholesale and retail trade
Financial intermediation and real estate
Gross value added at current basic prices
Plus adjustment to current basic prices (taxes minus subsidies
on products)
= GDP at market prices
1,086,859
137,856
11.3
1,224,715
100
Expenditure-based GDP and its components, UK, 2005
Expenditure Categories
Individual consumption
Household final consumption
£ million
% of GDP
760,777
62
30,525
2.5
Individual government final consumption
165,655
13.5
Total actual individual consumption
956,957
78.1
Collective government final consumption
101,875
8.3
Total final consumption
1,058,832
86.5
Gross fixed capital formation
205,843
16.8
3,721
0.3
-337
0
209,187
17.1
322,298
26.3
Less imports of goods and services
-366,540
-29.9
External balance of goods and services (net exports)
-44,242
-3.6
Final consumption of non-profit institutions serving households
Change in inventories
Acquisition less disposals of valuables
Total gross capital formation
Exports of goods and services
Statistical discrepancy
Gross domestic product at market prices (money GDP)
938
1,224,715
100
GDP and GNI by Income type 2005
Income type
£ million
% of GDP
312,026
25.5
76,112
6.2
Compensation of employees
684,618
55.9
Taxes on production and imports
162,267
13.2
-9,391
-0.8
-917
0.0
1,224,715
100
Operating surplus, gross (profits)
Mixed incomes
Less subsidies
Statistical discrepancy
GDP at market prices
Employees’ compensation
Receipts from rest of world
1,211
Less payment to rest of world
Total
-1,137
74
Less taxes on production paid to rest of world Plus subsidies received from
rest of world
-4,243
Other subsidies on production
Property and entrepreneurial income
Receipts from rest of world
Less payments to rest of world
Total
Gross national income (GNI) at market prices
3,216
185,826
-156,029
29,797
1,253,561
• Real GDP is calculated to reflect changes in
real volumes of output and real income.
Nominal GDP reflects changes in both prices
and quantities.
• Thus growth in nominal GDP can be split into
real GDP growth plus inflation.
• Gross means that no allowance has been
made for depreciation.
• Personal disposable income is the amount
actually available for individuals to spend or to
save (after taxes).
Building a Macro Model
• Assumptions used in building a macro
model
• Key relationships:
– consumption
– investment
• The determination of GDP
• The multiplier
• The “big idea”: the Keynesian revolution
Key Assumptions
• Economy assumed to be one big industry
• Final spending is demand for output of this one
industry
• Government purchases, consumption, investment
and exports are all demands for the same output.
Labour
Output of
goods
Consumer
spending
Investment
Government
purchases
Exportsimports
More Assumptions
• Temporary assumptions:
– Prices don’t change, so all changes are in real (volume)
terms
– There is excess capacity in production so output is
demand determined
– Closed economy with no government
• Focus first on:
– GDP = C + I [+ G + (X-M)]
– Use symbol Y for GDP
– So first explain GDP using determinants of C and I.
– C is an endogenous variable determined within the model
– I is an exogenous variable determined outside the model
The Circular Flow of Income, Output, and Expenditure
Domestic
households
Financial
System
Abroad
Government
Domestic
producers
Consumption and Saving
• If personal disposable income rises, households
spend some of the increase and save the rest. This is
measured by the marginal propensity to consume
[MPC] and the marginal propensity to save [MPS],
which are both positive and sum to one.
• Relation between consumption and income might be:
– C = a + bY
– “a” is referred to as “autonomous consumption”. It is the
amount that consumers spend when income is zero.
– “b” is the marginal propensity to consume.
– This implies a relation for saving:
– S = -a + (1-b)Y
Consumer spending and personal disposable income, UK, quarterly,
1955-2005 (£M at constant 2002 prices)
250000
£ million at 2002 prices
200000
Disposable income
150000
100000
Consumer spending
50000
0
1955
Q1
1960
Q1
1965
Q1
1970
Q1
1975
Q1
1980
Q1
1985
Q1
1990
Q1
1995
Q1
2000
Q1
2005
Q1
Consumption and Saving
Relationships: empirical example
• C = 100 + 0.8Y
– where C is consumer spending in a period, Y is
personal disposable income (which in absence of
taxes and retained profit = GDP). Autonomous C =
100; Marginal propensity to consume = 0.8.
• S = -100 + 0.2Y
– Marginal propensity to save = 0.2
Consumption and Saving Schedules [£ Million]
Disposable
Income
0
100
400
500
1000
1500
1750
2000
3000
4000
Desired
consumption
100
180
420
500
900
1300
1500
1700
2500
3300
Desired
saving
-100
-80
-20
0
+100
+200
+250
+300
+500
+700
The Consumption and Saving Functions
450
2000
C
1500
500
S
1000
250
500
0
-100
450
500
-500
1000
1500
2000
Real Disposable Income
(i). Consumption Function[£ million]
500
1000
1500
2000
Real Disposable Income
(ii). Saving Function[£ million]
Investment
• Here we treat investment as an exogenous
variable, that is, it is determined outside the
model.
• Later we can make investment depend on the
interest rate.
• In general investment will depend on expectations
of future demand growth as well as interest rates.
• For our numerical example investment is constant
at 250.
The Aggregate Expenditure Function in a Closed Economy
With No Government [£ Million]
GDP
[National Income]
[Y]
100
400
500
1000
1500
1750
2000
3000
4000
Desired
consumption
expenditure
[C = 100 +0.8Y]
Desired
investment
expenditure
[I = 250]
180
420
500
900
1300
1500
1700
2500
3300
250
250
250
250
250
250
250
250
250
Desired aggregate
expenditure
[AE = C + I]
430
670
750
1150
1550
1750
1950
2750
3550
Equilibrium GDP
• At the equilibrium level of GDP, purchasers wish to buy
exactly the amount of national output that is being produced.
– At GDP above equilibrium, desired expenditure falls short of
national output, and output will sooner or later be curtailed.
– At GDP below equilibrium, desired expenditure exceeds
national output, and output will sooner or later be increased.
• In a closed economy with no government, desired saving
equals desired investment at equilibrium GDP.
• Equilibrium GDP is represented graphically by the point at
which the aggregate expenditure curve cuts the 450 line, that
is, where total desired expenditure equals total output.
• This is the same level of GDP at which the saving function
intersects the investment function.
The Determination of Equilibrium GDP
GDP
[National Income]
[Y]
100
400
500
1000
1500
1750
2000
3000
4000
Desired aggregate
expenditure
[AE = C + I]
430
670
750
1150
1550
1750
1950
2750
3550
Shortage of goods.
Pressure on Y to rise
Equilibrium Y
Surplus production.
Pressure on Y to fall
Equilibrium GDP
450
[AE = Y]
3000
E0
Desired saving (£m)
2000
1000
350
0
S
500
450
I
250
0
-100
-500
1000
Y0 2000
3000
Real National Income [GDP] [£m]
1000
Y0
2000
3000
Real National Income [GDP] [£m]
[i]. An Aggregate Expenditure Function[AE = Y] [ii]. Saving Function[S = I]
How Does the Equilibrium Come About?
• For GDP to remain unchanged injections of spending
and leakages must be just equal; otherwise GDP
would be changing
• Imagine a bath with the tap running and no plug. For
the water level to be stable the water flowing in and
the water flowing out must be the same.
The Model “Solution”
• The model is:
Y=C+I
C = a + bY
• Solve for Y by substituting for C in first equation
Y = a + bY + I
so: Y - bY = a + I
or Y = (a + I)/(1-b)
• Numerical example: C = 100 + 0.8Y & I = 250
So Y = 100 + 0.8Y + 250
Or Y = (100 + 250)/ (1- 0.8)
= 350 x 5
= 1750
Changes in GDP
• Equilibrium GDP is increased by a rise in exogenous
spending or “injections” or a fall in “withdrawals”.
• Equilibrium GDP is decreased by a fall in injections or a
rise in withdrawals.
• The magnitude of the effect on GDP of shifts in
autonomous expenditure is given by the multiplier. It is
defined as K = Y/A, where A is the change in
“autonomous” or “exogenous” expenditure.
• It is equal to 1/(1 - z), where z is the marginal propensity
to consume. Thus the larger z is, the larger is the
multiplier. In the absence of taxes and foreign trade the
multiplier is:
• 1/(1-b) where “b” is the marginal propensity to consume
• If b = 0.8 then the multiplier = 5.
The Simple Multiplier
AE = Y
AE0
e0
E
0
450
0
Y0
Real National Income [GDP]
The Simple Multiplier
AE = Y
AE1
E1
e1
a
e’1
AE0
A
e0
E0
Y
450
0
Y0
Y1
Real National Income [GDP]
New solution when I rises from 250 to 350
•
•
•
•
•
•
Old level of GDP was 1750
Y=C+I
Y = 100 + 0.8Y + 350
Y - 0.8Y = 450
Y = 450 x 5
Y = 2250
•
•
•
•
Increase in Y is change in I times the multiplier
Change in I is £100 and multiplier is 5
So change in Y is £500.
At new level of GDP: S= -100 + (.2 x 2250)
= 350
The Multiplier: Intuition
• If there is an increase of exogenous spending of
£100, this generates £100 of extra income and £80
gets spent.
• The £80 generates extra income of £80 and 0.8 of
this gets spent---creating £64 of extra income. 0.8 of
this gets spent generating £51.20 of extra income.
• Total income generated is:
£100 + £80 + £64 + £51.2 + £40.96 + £32.768 +
£26.21 + £20.97 +£16.78 + £13.43 + £10.74 + £8.59
+ £6.87 + £5.5 + £4.4 + £3.52 + £2.82 + £2.25 + £1.8
+ £1.44 + £1.15 + £0.92 + £0.74 + £0.59 + £0.47 +
£0.38 + £0.3 + £0.24 + £0.19 + £0.15 + £0.12 + £0.1
+ £0.08 + £0.064
This sum converges to £500.
The Multiplier: a Numerical Example
500
400
300
200
100
0
1
2 3 4 5
6
7 8 9 10
Spending round
15
20
Implications of the Multiplier
• The multiplier comes about because consumer
spending is a function of household incomes,
but household incomes are themselves
affected by consumer spending! (the circular
flow of income)
• The result is that a small change in one part of
our model (eg. I, G, or the MPC) can have a
large impact on GDP by the time the economy
has reached a new equilibrium.
The “Classical” View of Unemployment
• Economists used to regard the labour market
as just like any other market. If there was an
excess supply of labour, this must mean that
the “price” (wages) is too high.
• But this theory left economists unable to
come up with a satisfactory explanation of the
great depression...
• ...let alone come up with any solutions!
The Classical View of Unemployment
S
D
Z
Z
Y
Y
X
X
W
W
V
V
U
U
Employment
The “Big Idea”: Keynesian Revolution
• Unemployment is mainly determined by
aggregate spending. Thus the economy can
get stuck in a vicious circle (low aggregate
spending => low GDP => high unemployment
=> low aggregate spending).
• Cutting wages would make matters worse by
further reducing consumer demand!
• One “solution” is for government to use its own
spending (and tax changes) to boost demand.
The budget then became a tool for managing
the economy (discretionary fiscal policy).
The Circular Flow of Income, Output, and Expenditure
Domestic
households
Financial
System
Abroad
Government
Domestic
producers
The Keynesian Revolution
AE = Y
AE0
e0
E0
450
0
Y0
Y*
Real National Income [GDP]
Effect on GDP of change in exogenous spending
AE = Y
AE1
E1
e1
a
e’1
AE0
A
e0
E0
Y
450
0
Y0
Y1
Real National Income [GDP]
Aggregate Demand and Supply
• So far we have assumed that GDP is determined
by demand. This is the case if there is excess
capacity in the economy (no supply-side
constraints).
• Our model also has no role for prices, so it
cannot explain inflation. So next we incorporate
the price level and derive the aggregate demand
curve.
• We then add the aggregate supply curve, which
enables us to determine both real GDP and the
price level.
Aggregate Demand
What happens to AE as we change the price level?
– A fall in the price level shifts the AE curve upwards
– A rise in the price level shifts the AE curve downwards.
The reasons:
– A rise in the price level lowers exports because it raises
the relative price of domestic goods
– A rise in the price level lowers private consumption
spending because it decreases the real value of
consumers’ wealth.
– Both of these changes lower equilibrium GDP and cause
the aggregate demand curve to have a negative slope.
• The AD curve plots the equilibrium level of GDP that
corresponds to each possible price level. A change in
equilibrium GDP following a change in the price level is
shown by a movement along the AD curve.
The AD Curve and the AE Curve
AE0
AE = Y
Desired Expenditure
E0
AE1
E1
AE2
E2
45o
0
Y2
Y1
Y0
Real National Income [GDP]
[i]. Aggregate expenditure
E2
P2
E1
P
1
E0
P
0
AD
0
Y2
Y1
Y0
[ii]. Aggregate Demand
Real National Income (GDP)
AD Meaning and Shifts
• The AD curve is drawn for given values of all
exogenous expenditures and other parameters
• Each point on AD shows, for each P, the level
of real GDP that is consistent with:
– desired spending = actual output
(as determined by spending decisions)
– injections = withdrawals
• When an exogenous variable changes, the AD
curve shifts at each price level by the shift in
spending times the multiplier.
Shifts in Aggregate Demand
• The AD curve shifts when any element of
exogenous expenditure changes.
• The multiplier times the shift in exogenous
spending measures the magnitude of the shift.
• An increase in a, G, I, X, or a fall in T shift AD
to the right.
• A fall in a, G, I, X, or a rise in T shift AD to the
left.
The Simple Multiplier and Shifts in the AD Curve
AE = Y
AE1
Desired Expenditure
E1
AE0
E0
A
45o
[i]. Aggregate Expenditure
0
Y0
Real GDP
Y1
E0
E1
P0
Y
AD0
[ii]. Aggregate Demand
0
Y0
Y1
AD1
Real GDP
Aggregate Supply
• The short-run aggregate supply (SRAS) curve is
drawn for given input prices, given technology
and fixed capital stock.
• It is positively sloped because unit costs rise with
increasing output and because rising product
prices make it profitable to increase output.
• An increase in productivity or a decrease in input
prices shifts the SRAS curve to the right.
• A decrease in productivity or an increase in input
prices shifts the SRAS curve to the left.
A Short-run Aggregate Supply Curve
SRAS
Price
level
P1
P
0
Y0
Y1
Real GDP
Macroeconomic Equilibrium
• Macroeconomic equilibrium is where the AD and
SRAS curves intersect.
• Shifts in the AD and SRAS curves, called
aggregate demand shocks and aggregate supply
shocks, change the equilibrium values of real GDP
and the price level.
• When the SRAS curve is positively sloped, an
aggregate demand shock causes the price level
and real GDP to move in the same direction, the
division between these effects depending on the
shape of the SRAS curve.
• The main effect is on real GDP when the SRAS
curve is flat and on the price level when it is steep.
Macroeconomic Equilibrium
AD
SRAS
E0
P0
0
Y0
Real GDP
Supply Shocks
• An aggregate supply shock moves equilibrium real
GDP along the AD curve, causing the price level and
output to move in opposite directions.
• A leftward shift in the SRAS curve causes stagflation:
rising prices and falling output.
• A rightward shift causes an increase in real GDP and
a fall in the price level.
• The division of the effects of a shift in SRAS between
a change in real GDP and a change in the price level
depends on the shape of the AD curve.
Aggregate Supply Shift
AD
SRAS
E0
P0
P
1
0
Y0
Y
1
Real GDP
Starting from AD = SRAS there can be two types of shock:
• Aggregate demand shock involves a change in some
exogenous spending category: a, I, G (or T) and X.
– An increase in a, I, G, or X shifts AD left or right by
size of change times the multiplier.
– Price level then changes and makes multiplier
smaller, but P and Y respond to AD shock in same
direction.
• When there is an aggregate supply shock, P and Y move
in opposite directions.
• There are some special cases.
Keynesian SRAS Curve
AD
E0
SRAS
P0
0
Y0
Real GDP
Classical or Monetarist SRAS
AD
SRAS
P0
0
Y0
Real GDP
General Case
AD
SRAS
P0
0
Y0
Real GDP
Lessons of the 1970s and 1980s
Inflation is persistent
– Expected inflation rises, so workers demand
higher wage increases (wage-price spiral).
– If inflation is high, employees demand high wage
rises. Firms then raise prices to maintain margins.
– Inflation expectations are important.
Unemployment is persistent
– The long-term unemployed become less attractive
to employers.
– Hence wage inflation tends to increase even when
unemployment relatively high.
What About The Money Supply?
• Monetarists argued that “inflation is always and
everywhere a monetary phenomenon”, so if you
can control the money supply, you can control
inflation.
• But although money is involved in every
transaction, it is seldom the cause of the
transaction. The relationship between money
and inflation is not stable, so it is not a reliable
means of controlling inflation.
• Furthermore, in a modern economy, the money
supply (largely in the form of bank accounts) is
hard to control, or even measure.
Evolution of macro-economic policymaking
• Classical (1776 - 1930s)
– Free markets with no government interference
• Keynesian (1930s – 1970s)
– Discretionary demand management used to regulate economy
• Monetarist (1970s – 1980s)
– Control money supply to control inflation
– Supply-side measures to help markets move to equilibrium
– Markets should then clear to achieve full employment
– Instead the economy entered deep recession in early 1980s.
Monetarist theory discredited.
• Current pragmatic system
– Inflation expectations are important, so objectives must be
clear and credible
– Independent central bank avoids political motives
Stabilisation Policies
• Fiscal policy
– Budget deficit boosts demand
– But cyclical adjustment is needed to be sure
– Substantial lags: obtaining data, implementation
and impact of policy shift. Hence net effect could be
destabilising.
• Monetary policy
– Interest rates affect investment and consumer
spending
• Governments now generally set fiscal policy and leave
the central bank to use monetary policy to stabilise the
economy.
Macroeconomics: summary
Measuring GDP:
– Value added
– Income
– Expenditure
Circular flow of income
– Keynesianism overthrows classical view of unemployment
Model building:
– Multiplier
– Supply and demand shocks
– Different view of aggregate supply
Macroeconomic policy:
–
–
–
–
Classical
Keynesianism
Monetarism
Pragmatic view. Independent central banks
Reading
Lipsey + Chrystal “Economics” Eleventh
Edition, Oxford University Press, 2007.
This is the source of most of the material
presented in these lectures.