Download Mankiw 5/e Chapter 1: The Science of Macroeconomics

macro
The Data of Macroeconomics
Important issues in macroeconomics
Macroeconomics, the study of the economy as
a whole, addresses many topical issues:
 Why does the cost of living keep rising?
 Why are millions of people unemployed,
even when the economy is booming?
 What causes recessions?
Can the government do anything to
combat recessions? Should it?
Important issues in macroeconomics
Macroeconomics, the study of the economy as
a whole, addresses many topical issues:
 What is the government budget deficit?
How does it affect the economy?
 Why does the U.S. have such a huge trade
deficit?
 Why are so many countries poor?
What policies might help them grow out of
poverty?
U.S. Real GDP per capita
(2000 dollars)
40,000
9/11/2001
First oil
price shock
30,000
long-run upward trend…
20,000
Great
Depression
Second oil
price shock
10,000
World War II
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
U.S. inflation rate
(% per year)
25
20
15
10
5
0
-5
-10
-15
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
U.S. unemployment rate
(% of labor force)
30
25
20
15
10
5
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Why learn macroeconomics?
1. The macroeconomy affects society’s wellbeing.
Each one-point increase in the unemployment rate
is associated with:
– 920 more suicides
– 650 more homicides
– 4000 more people admitted to state mental
institutions
– 3300 more people sent to state prisons
– 37,000 more deaths
– increases in domestic violence and homelessness
Why learn macroeconomics?
change from 12 mos earlier
5
5
4
3
3
1
2
1
-1
0
-3
-1
-5
-2
-3
1965
-7
1970
1975
unemployment rate
1980
1985
1990
1995
2000
2005
inflation-adjusted mean wage (right scale)
percent change from 12 mos earlier
2. The macroeconomy affects your well-being.
Why learn macroeconomics?
3. The macroeconomy affects politics.
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)
A multitude of models
 So we will learn different models for
studying different issues (e.g.,
unemployment, inflation, long-run
growth).
 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
Prices: flexible vs. sticky
 Market clearing: An assumption that prices
are flexible, adjust to equate supply and
demand.
 In the short run, many prices are sticky –
adjust sluggishly in response to changes in
supply or demand. For example,
– many labor contracts fix the nominal wage
for a year or longer
– many magazine publishers change prices
only once every 3-4 years
Prices: flexible vs. sticky
 The economy’s behavior depends partly on
whether prices are sticky or flexible:
 If prices are sticky, then demand won’t
always equal supply. This helps explain
– unemployment (excess supply of labor)
– why firms cannot always sell all the goods
they produce
 Long run: prices flexible, markets clear,
economy behaves very differently
Outline of this course:
 Introductory material (Chaps. 1 & 2) and the Classical
Theory (Chaps. 3, 4, & 6)
How the economy works in the long run, when prices are
flexible
 Business Cycle Theory (Chaps. 9-12)
How the economy works in the short run, when prices
are sticky
 Policy debates (Chaps. 13-15)
Should the government try to smooth business cycle
fluctuations? Is the government’s debt a problem?
 Growth Theory (Chaps. 7 & 8)
The standard of living and its growth rate over the very
long run
Metaphors for the Economy
 Human Body
 Machine
macro
The Data of Macroeconomics
Do you remember…
…the meaning and measurement of the
most important macroeconomic statistics?
– Gross Domestic Product (GDP)
– The Consumer Price Index (CPI)
– The unemployment rate
Gross Domestic Product:
Expenditure and Income
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.
The Circular Flow
Income ($)
Labor
Firms
Households
Goods
Expenditure ($)
The expenditure components of GDP
 consumption
 investment
 government spending
 net exports
Consumption (C)
definition: The value of all
goods and services bought
by households. Includes:
– durable goods
last a long time
ex: cars, home
appliances
– nondurable goods
last a short time
ex: food, clothing
– services
work done for
consumers
ex: dry cleaning,
air travel.
U.S. consumption, 2007 (Q3)
$ billions
Consumption
% of GDP
$9,785.7
70.0%
Durables
1,081.6
7.7
Nondurables
2,846.3
20.4
Services
5,857.8
41.9
Investment (I)
Definition 1: Spending on [the factor of production]
capital.
Definition 2: Spending on goods bought for future use
Includes:
– business fixed investment
Spending on plant and equipment that firms will
use to produce other goods & services.
– residential fixed investment
Spending on housing units by consumers and
landlords.
– inventory investment
The change in the value of all firms’ inventories.
U.S. investment, 2007 (Q3)
$ billions
Investment
Business fixed
$2,162.9
% of GDP
15.5%
1,500.2
10.7
Residential
627.3
4.5
Inventory
35.4
0.3
Investment vs. Capital
Note: Investment is spending on new capital.
Example (assumes no depreciation):
– 1/1/2007:
economy has $31,818b worth of capital
– during 2007:
investment = $2,163b
– 1/1/2008:
economy will have $33,981b worth of capital
Government spending (G)
 G includes all government spending on
goods and services..
 G excludes transfer payments
(e.g., unemployment insurance payments),
because they do not represent spending on
goods and services.
U.S. government spending, 2007 (Q3)
$ billions
Govt spending
Federal
$2,716.5
% of GDP
19.5%
990.3
7.1
Non-defense
316.8
2.3
Defense
673.5
4.8
1,762.2
12.4
State & local
Net exports, 2007 (Q3)
NX = EX – IM
$ billions
% of GDP
- $694.7
- 5.0%
Exports
1,685.7
12.0
Imports
2,380.4
17.0
Net Exports
An important identity
Y = C + I + G + NX
value of
total output
aggregate
expenditure
A question for you:
Suppose a firm
 produces $10 million worth of final goods
 but only sells $9 million worth.
Does this violate the
expenditure = output identity?
Why output = expenditure
 Unsold output goes into inventory,
and is counted as “inventory investment”…
…whether or not the inventory buildup
was intentional.
 In effect, we are assuming that
firms purchase their unsold output.
GDP:
An important and versatile concept
We have now seen that GDP measures
– total income
– total output
– total expenditure
GNP vs. GDP
 Gross National Product (GNP):
Total income earned by the nation’s factors
of production, regardless of where located.
 Gross Domestic Product (GDP):
Total income earned by domestically-located
factors of production, regardless of
nationality.
Discussion question:
In your country,
which would you want
to be bigger, GDP, or GNP?
Why?
(GNP – GDP) as a percentage of GDP
selected countries, 2002
U.S.A.
Angola
Brazil
Canada
Hong Kong
Kazakhstan
Kuwait
Mexico
Philippines
U.K.
1.0%
-13.6
-4.0
-1.9
2.2
-4.2
9.5
-1.9
6.7
1.6
Real vs. nominal GDP
 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.
Practice problem, part 1
2006
2007
2008
P
Q
P
Q
P
Q
good A
$30
900
$31
1,000
$36
1,050
good B
$100
192
$102
200
$100
205
 Compute nominal GDP in each year.
 Compute real GDP in each year using 2006
as the base year.
Answers to practice problem, part 1
nominal
2006:
2007:
2008:
GDP multiply Ps & Qs from same year
$46,200 = $30  900 + $100  192
$51,400
$58,300
real GDP multiply each year’s Qs by 2006 Ps
2006: $46,200
2007: $50,000
2008: $52,000 = $30  1050 + $100  205
Real GDP controls for inflation
Changes in nominal GDP can be due to:
– changes in prices.
– changes in quantities of output
produced.
Changes in real GDP can only be due to
changes in quantities,
because real GDP is constructed using
constant base-year prices.
U.S. Nominal and Real GDP, 1950–2006
14,000
12,000
(billions)
10,000
8,000
6,000
Real GDP
(in 2000 dollars)
4,000
Nominal GDP
2,000
0
1950
1960
1970
1980
1990
2000
GDP Deflator
 The inflation rate is the percentage
increase in the overall level of prices.
 One measure of the price level is
the GDP deflator, defined as
Nominal GDP
GDP deflator = 100 
Real GDP
Practice problem, part 2
Nom. GDP Real GDP
2006
$46,200
$46,200
2007
51,400
50,000
2008
58,300
52,000
GDP
deflator
Inflation
rate
n.a.
 Use your previous answers to compute
the GDP deflator in each year.
 Use GDP deflator to compute the inflation
rate from 2006 to 2007, and from 2007 to
2008.
Answers to practice problem, part 2
Nominal
GDP
Real GDP
GDP
deflator
Inflation
rate
2006
$46,200
$46,200
100.0
n.a.
2007
51,400
50,000
102.8
2.8%
2008
58,300
52,000
112.1
9.1%
Consumer Price Index (CPI)
 A measure of the overall level of prices
 Published by the Bureau of Labor Statistics (BLS)
 Uses:
– tracks changes in the typical household’s
cost of living
– adjusts many contracts for inflation (“COLAs”)
– allows comparisons of dollar amounts over time
How the BLS constructs the CPI
1. Survey consumers to determine
composition of the typical consumer’s
“basket” of goods.
2. Every month, collect data on prices of all
items in the basket; compute cost of
basket
3. CPI in any month equals
Cost of basket in that month
100 
Cost of basket in base period
Exercise: Compute the CPI
Basket contains 20 pizzas and 10 compact discs.
prices:
2004
2005
2006
2007
pizza
$10
$11
$12
$13
CDs
$15
$15
$16
$15
For each year, compute
 the cost of the basket
 the CPI (use 2004 as
the base year)
 the inflation rate from
the preceding year
Answers:
Cost of
basket
CPI
Inflation
rate
2004
$350
100.0
n.a.
2005
370
105.7
5.7%
2006
400
114.3
8.1%
2007
410
117.1
2.5%
The composition of the CPI’s “basket”
Food and bev.
17.4%
Housing
Apparel
6.2%
5.6%
3.0%
3.1%
3.8%
3.5%
Transportation
Medical care
Recreation
15.1%
Education
Communication
Other goods
and services
42.4%
Reasons why
the CPI may overstate inflation
 Substitution bias: The CPI uses fixed weights,
so it cannot reflect consumers’ ability to substitute toward
goods whose relative prices have fallen.
 Introduction of new goods: The introduction of new
goods makes consumers better off and, in effect, increases
the real value of the dollar. But it does not reduce the CPI,
because the CPI uses fixed weights.
 Unmeasured changes in quality:
Quality improvements increase the value of the dollar, but
are often not fully measured.
The size of the CPI’s bias
 In 1995, a Senate-appointed panel of experts
estimated that the CPI overstates inflation by
about 1.1% per year.
 Now, the CPI’s bias is probably under 1% per
year.
CPI vs. GDP Deflator
prices of capital goods
– included in GDP deflator (if produced domestically)
– excluded from CPI
prices of imported consumer goods
– included in CPI
– excluded from GDP deflator
the basket of goods
– CPI: fixed
– GDP deflator: changes every year
Two measures of inflation in the U.S.
Percentage change
from 12 months earlier
15%
12%
9%
6%
3%
0%
-3%
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
GDP deflator
CPI
Labor Market Data
 Household survey (60,000 HH)
 Employer survey (160,000 B+GA)
Categories of the population
 employed
working at a paid job
 unemployed
not employed but looking for a job
 labor force
the amount of labor available for producing
goods and services; all employed plus
unemployed persons
 not in the labor force
not employed, not looking for work
Two important labor force concepts
 unemployment rate
percentage of the labor force that is
unemployed
 labor force participation rate
the fraction of the adult population
that “participates” in the labor force
Exercise:
Compute labor force statistics
U.S. adult population by group,
December 2007
Number employed
= 146.2 million
Number unemployed
=
7.7 million
Adult population
= 233.2 million
Use the above data to calculate
– the labor force
– the number of people not in the labor force
– the labor force participation rate
– the unemployment rate
Answers:
 data: E = 146.2, U = 7.7, POP = 233.2
 labor force
L = E +U = 146.2 + 7.7 = 153.9
 not in labor force
NILF = POP – L = 233.2 – 153.9 = 79.3
 unemployment rate
U/L x 100% = (7.7/153.9) x 100% = 5.0%
 labor force participation rate
L/POP x 100% = (153.9/233.2) x 100% =
66.0%
Two measures of employment growth
Percentage change
from 12 months earlier
8%
6%
4%
2%
0%
-2%
-4%
1960
1965
1970
1975
1980
1985
Establishment survey
1990
1995
2000
Household survey
2005
macro
A Long Run Model:
Where Income Comes From
and Where it Goes
Outline of model
A closed economy, market-clearing model
 Supply side
– factor markets (supply, demand, price)
– determination of output/income
 Demand side
– determinants of C, I, and G
 Equilibrium
– goods market
– loanable funds market
The production function
 denoted Y = F (K, L)
– shows how much output (Y ) the economy
can produce from K units of capital and L
units of labor
 reflects the economy’s level of technology
 exhibits constant returns to scale
Returns to scale
Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(e.g., if z = 1.25, then all inputs are increased by 25%)
What happens to output, Y2 = F (K2, L2 )?
 If constant returns to scale, Y2 = zY1
 If increasing returns to scale, Y2 > zY1
 If decreasing returns to scale, Y2 < zY1
Returns to scale: Example 1
F (K , L) 
KL
F (zK , zL) 
(zK )(zL)

z 2KL

z 2 KL
 z KL
 z F (K , L)
constant returns to
scale for any z > 0
Returns to scale: Example 2
F (K , L) 
K L
F (zK , zL) 
zK  zL

z K z L

z


K L
z F (K , L)

decreasing
returns to scale
for any z > 1
Returns to scale: Example 3
F (K , L)  K 2  L2
F (zK , zL)  (zK )2  (zL)2
 z 2  K 2  L2 
2
 z F (K , L)
increasing returns
to scale for any
z>1
NOW YOU TRY:
Returns to Scale
 Determine whether each of these production
functions has constant, decreasing, or
increasing returns to scale:
K2
(a) F (K , L) 
L
(b) F (K , L)  K  L
NOW YOU TRY:
Answers, part (a)
K2
F (K , L) 
L
(zK )2
z 2K 2
K2
F (zK , zL) 

 z
zL
zL
L
 z F (K , L)
constant returns to
scale for any z > 0
Assumptions of the model
1. Technology is fixed.
2. The economy’s supplies of capital and
labor are fixed at
K K
and
LL
Determining GDP
Output is determined by the fixed factor
supplies and the fixed state of technology:
Y  F (K , L)
The distribution of national income
 determined by factor prices,
the prices per unit firms pay for the
factors of production
– wage = price of L
– rental rate = price of K
Notation
W = nominal wage
R = nominal rental rate
P
= price of output
W /P = real wage
(measured in units of output)
R /P = real rental rate
How factor prices are determined
 Factor prices are determined by supply
and demand in factor markets.
 Recall: Supply of each factor is fixed.
 What about demand?
Demand for labor
 Assume markets are competitive:
each firm takes W, R, and P as given.
 Basic idea:
A firm hires each unit of labor
if the cost does not exceed the benefit.
– cost = real wage
– benefit = marginal product of labor
Marginal product of labor (MPL)
 definition:
The extra output the firm can produce
using an additional unit of labor
(holding other inputs fixed):
MPL = F (K, L +1) – F (K, L)
NOW YOU TRY:
Compute & graph MPL
a. Determine MPL at each
value of L.
b. Graph the production
function.
c. Graph the MPL curve with
MPL on the vertical axis
and
L on the horizontal axis.
L
0
1
2
3
4
5
6
7
8
9
10
Y
0
10
19
27
34
40
45
49
52
54
55
MPL
n.a.
?
?
8
?
?
?
?
?
?
?
NOW YOU TRY:
Answers
MPL (units of output)
Marginal Product of Labor
12
10
8
6
4
2
0
0
1
2
3
4
5
6
7
8
9 10
Labor (L)
MPL and the production function
Y
output
F (K , L )
1
MPL
MPL
As more labor is
added, MPL 
1
MPL
1
Slope of the production
function equals MPL
L
labor
Diminishing marginal returns
 As a factor input is increased,
its marginal product falls (ceteris paribus).
 Intuition:
Suppose L while holding K fixed
 fewer machines per worker
 lower worker productivity
NOW YOU TRY:
Identifying Diminishing Marginal Returns
 Which of these production functions have
diminishing marginal returns to labor?
a) F (K , L)  2K  15L
b) F (K , L) 
KL
c) F (K , L)  2 K  15 L
NOW YOU TRY:
MPL and labor demand
Suppose W/P = 6.
 If L = 3, should firm hire
more or less labor?
Why?
 If L = 7, should firm hire
more or less labor?
Why?
L
0
1
2
3
4
5
6
7
8
9
10
Y MPL
0 n.a.
10
10
19
9
27
8
34
7
40
6
45
5
49
4
52
3
54
2
55
1
MPL and the demand for labor
Units of
output
Each firm hires labor
up to the point where
MPL = W/P.
Real
wage
MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
The equilibrium real wage
Units of
output
Labor
supply
equilibrium
real wage
L
The real wage
adjusts to equate
labor demand
with supply.
MPL,
Labor
demand
Units of labor, L
Determining the rental rate
 We have just seen that MPL = W/P.
 The same logic shows that MPK = R/P :
– diminishing returns to capital: MPK  as K 
– The MPK curve is the firm’s demand curve
for renting capital.
– Firms maximize profits by choosing K
such that MPK = R/P .
The equilibrium real rental rate
Units of
output
Supply of
capital
equilibrium
R/P
K
The real rental rate
adjusts to equate
demand for capital
with supply.
MPK,
demand for
capital
Units of capital, K
The Neoclassical Theory of Distribution
 states that each factor input is paid its
marginal product
 a good starting point for thinking about
income distribution
How income is distributed to L and K
total labor income = ________ = _________
total capital income = _______ = __________
If production function has constant returns
to scale, then
Y  MPL  L  MPK  K
national
income
labor
income
capital
income
The ratio of labor income to total income
in the U.S., 1960-2007
Labor’s 1.0
share of
total
0.8
income
0.6
0.4
0.2
Labor’s share of income
is approximately constant over time.
(Thus, capital’s share is, too.)
0.0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
The Cobb-Douglas Production Function
 The Cobb-Douglas production function has
constant factor shares:
 = capital’s share of total income:
capital income = MPK x K =  Y
labor income = MPL x L = (1 –  )Y
 The Cobb-Douglas production function is:

1
Y  AK L
where A represents the level of technology.
The Cobb-Douglas Production Function
 Each factor’s marginal product is proportional
to its average product:
MPK   AK
 1 1
L

Y
K
(1   )Y
 
MPL  (1   ) AK L 
L
Labor productivity and wages
 Theory: wages depend on labor productivity
 U.S. data:
period
productivity
growth
real wage
growth
1959-2007
2.1%
2.0%
1959-1973
2.8%
2.8%
1973-1995
1.4%
1.2%
1995-2007
2.5%
2.4%
Outline of model
A closed economy, market-clearing model
Supply side
DONE 
factor markets (supply, demand, price)
DONE 
determination of output/income
Demand side
Next   determinants of C, I, and G
Equilibrium
 goods market
 loanable funds market
Demand for goods & services
Components of aggregate demand:
C =
I =
G=
(closed economy: no NX )
Consumption, C
 def: ________________ is total income
minus total taxes: Y – T.
 Consumption function: C = C (Y – T )
Shows that (Y – T )  C
 def: ___________________________
is the increase in C caused by a one-unit
increase in disposable income.
The consumption function
C
Y–T
Investment, I
 The investment function is I = I (r ),
where r denotes the
__________________,
the nominal interest rate corrected for
inflation.
 The real interest rate is
– ________________________________
– ________________________________.
So, r  I
The investment function
r
I
Government spending, G
 G = govt spending on goods and
services.
 G excludes _______________________
(e.g., social security benefits,
unemployment insurance benefits).
 Assume government spending and total
taxes are exogenous:
G  G and T  T
The market for goods & services
 Aggregate demand:
 Aggregate supply:
 Equilibrium:
 The ___________________ adjusts
to equate demand with supply.
The loanable funds market
 A simple supply-demand model of the
financial system.
 One asset: “loanable funds”
– demand for funds: _________________
– supply of funds:
_________________
– “price” of funds: __________________
Demand for funds: Investment
The demand for loanable funds…
– _____________________________:
Firms borrow to finance spending on plant
& equipment, new office buildings, etc.
Consumers borrow to buy new houses.
– _____________________________,
the “price” of loanable funds
(cost of borrowing).
Loanable funds demand curve
r
The investment
curve is also the
demand curve for
loanable funds.
I
Supply of funds: Saving
 The supply of loanable funds comes from
saving:
– ________________________________
– ________________________________
Types of saving
private saving
=
public saving
=
national saving, S =
=
=
EXERCISE:
Calculate the change in saving
Suppose MPC = 0.8 and MPL = 20.
For each of the following, compute S :
a.  G
= 100
b. T
= 100
c. Y
= 100
d.  L =
10
digression:
Budget surpluses and deficits
 If T > G, budget ______
= (T – G )
= public saving.
 If T < G, budget ______
and public saving is negative.
= (G – T )
 If T = G , “_______________,” public
saving = 0.
 The U.S. government finances its deficit
by ________________________.
Loanable funds market equilibrium
r
S, I
The special role of r
r adjusts to equilibrate the _______ market and
the _______________ market simultaneously:
Mastering the loanable funds model
Things that shift the saving curve:
Things that shift the investment curve
CASE STUDY:
The Reagan deficits
 Reagan policies during early 1980s:
– ____________________________
– ____________________________
 Both policies reduce national saving:
CASE STUDY:
The Reagan deficits
r
S, I
Are the data consistent with these results?
variable
1970s
1980s
T–G
–2.2
–3.9
S
19.6
17.4
r
1.1
6.3
I
19.9
19.4
T–G, S, and I are expressed as a percent of GDP
All figures are averages over the decade shown.
An increase in investment demand
r
S, I
Saving and the interest rate
 Why might saving depend on r ?
 How would the results of an increase in
investment demand be different?
– Would r rise as much?
– Would the equilibrium value of I change?