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Macroeconomics
is divided into two parts
• Theory of economic growth
– focuses on long run trend of real GDP
• the source of improved living standards
– the long-run trend is called potential GDP
– potential GDP depends on the available supply
of labor (L), capital (K), and technology (T)
• Theory of economic fluctuations
– focuses on short-run ups and downs in the
economy (recessions, Asian financial crisis
Real GDP, Potential GDP, Unemployment
Rate, and the Natural Unemployment Rate
21_01
BILLIONS OF
1992 DOLLARS
7,000
6,500
Real GDP
6,000
5,500
Potential GDP
5,000
4,500
1980
1982
1984
Real GDP is below potential
GDP and unemployment
rate is above natural rate
of unemployment.
1986
1988
1990
Real GDP is near
potential GDP and
unemployment rate
is near natural rate
of unemployment.
1992
1994
Real GDP is above
potential GDP and
unemployment rate
is below natural rate
of unemployment.
PERCENT
12.5
Unemployment
rate
10.0
7.5
5.0
6 percent
2.5
0.0
1980
1982
1984
1986
1988
1990
1992
1994
Aggregate production function
• Real GDP = F(labor, capital, technology)
• Y = F(L,K,T)
• Thus to explain the long term growth of real
GDP we need to look at L, K, and T
• Today we discuss L briefly and focus
mainly on K
• Will come back to T later
Labor (L): Factors determining
growth of aggregate hours
•
•
•
•
•
•
Aggregate hours =
(hours per employee)
(employment to population ration)
 (working age population)
L = (L/E)  (E/P)  (P)
Consider an example: the forecast of
aggregate hours by the Council of
Economic Advisers
Example: CEA Forecast of L
(aggregate hours)
1973
-1990
Growth
1.7
rate of
aggregate
hours (L)
Growth
1.5
rate of
working
age
population
(P)
1990
-1997
1997
-2005
1.5
1.1
1.0
1.0
Two explanations of unemployment
• Job rationing explanation
– Uses supply and demand model (see diagram)
– real wage higher than market equilibrium
• minimum wage
• insider-outsider theory
• efficiency wages
• Job search explanation
– job destruction and job creation creates flux
– role of unemployment benefits
Job rationing:
real wage is higher than market
equilibrium, hence unemployment
21_8
REAL WAGE
1. When the real
wage is above
the intersection of supply
and demand...
3. and there is this much
unemployment, or
excess supply.
Labor supply
A
Equilibrium
wage
Labor demand
QUANTITY OF LABOR
2. firms hire this
many workers...
Job search: “flows” in and out of
unemployment
21_9
Enter or re-enter labor force
Look for
work
Find job
Drop out of labor
Leave labor force
Not in labor force
force
Move to new job directly
Lose job or quit
Find job
Become unemployed
Unemployed
Employed
Now let’s move on to capital
• First, note that investment increases the
amount of capital (see next graph).
– Hence, we will focus on what determines
investment.
• Second, put on your big picture glasses
22_01
Capital
at end of
this year
($10.5 trillion)
Capital
at end of
last year
($10 trillion)
Gross investment
during this year
($1.5 trillion)
Net investment
($.5 trillion)
Depreciation
($1 trillion)
Look again at basic spending
equation Y = C + I + G+ X
• Divide by Y to convert to shares of GDP:
• 1 = (C/Y) + (I/Y) + (G/Y) + (X/Y)
• for example,
– if G/Y goes down,
– then (C/Y + I/Y + X/Y) must go up
• But how? What is the incentive? What
transmits the information? In other words
what is the price? Answer: the interest rate.
Shares in recent U.S. history
22_02
PERCENT
90
C
Y
80
70
60
50
G
Y
40
30
20
I
Y
10
X
Y
0
–10
1930
1940
1950
1960
1970
1980
1990
22_03
People tend to lower consumption
when the interest rate rises
INTEREST RATE (R)
(PERCENT)
7.5
A higher
interest
rate...
5.0
2.5
C
Y
0.0
62.5
65.0
...lowers the
amount of
consumption.
67.5
70.0
CONSUMPTION
AS A SHARE OF
GDP (PERCENT)
22_04
Firms tend to lower investment when
the interest rate rises
INTEREST RATE (R)
(PERCENT)
7.5
A higher
interest
rate...
5.0
2.5
I
Y
0.0
12.5
...lowers the
amount of
investment.
15.0
17.5
20.0
INVESTMENT
AS A SHARE OF
GDP (PERCENT)
22_05
Three episodes in this part of the story:
(1) interest rate  exchange rate
(2) exchange rate  (exports-imports = net exports)
(3) combine: interest rate  net exports
INTEREST RATE (R)
(PERCENT)
7.5
A higher
interest
rate...
5.0
2.5
X
Y
0.0
- 4.0
- 2.5
...lowers the
amount of
net exports.
0.0
2.5
5.0
NET EXPORTS
AS A SHARE OF
GDP (PERCENT)
22_06
Sum up: “non-government” share
R
R
7.5
7.5
5.0
5.0
2.5
0.0
62.5
65.0
I
Y
2.5
C
Y
0.0
67.5
12.5
15.0
PERCENT
PERCENT
(a) Consumption Share
(b) Investment Share
R
R
7.5
7.5
5.0
5.0
2.5
0.0
X
Y
-2.5
0.0
2.5
PERCENT
(c) Net Exports Share
17.5
NG
Y
2.5
0.0
75
80
85
PERCENT
(d) Nongovernment Share
Finding the equilibrium interest rate
22_
07
3. Investment and
the remaining
shares are then
determined from
the interest rate.
2. The intersection of
these two lines
determines the
equilibrium interest
rate, which can then
be shown in all the
diagrams.
1. First mark the share
of spending available
for nongovernmental
uses; in this case 78
because the
government
purchases share is
assumed to be 22
percent.
R
R
R
R
7.5
7.5
7.5
7.5
5.0
5.0
5.0
5.0
2.5
62.5
65.0
2.5
X
Y
Y
0.0
I
2.5
C
0.0
67.5
PERCENT
(a) Consumption Share
Y
0.0
12.5
15.0
17.5
PERCENT
(b) Investment Share
-2.5
0.0
2.5
2.5
NG
Y
0.0
75
80
85
PERCENT
PERCENT
(c) Net Exports Share
(d) Nongovernment
Share
End of Lecture