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Introduction to Macroeconomics Prof Mike Kennedy A word about the course • Everybody wants to pass. • Question is: how do you do it? • Turns out the answer is easy and not surprising: – – – – – Study Do the assignments Come to the lectures Avoid the post mid-term drop in attendance Ask for help when you need it – we’re here for that Why study macroeconomics and why now? • If not now, when? • The world economy, and with it the Canadian economy, experienced a once-in-several-generations downturn in 2008-09. While a recovery is underway, there continue to be weak spots (like Europe and now emerging markets) • The US recovery has been gaining strength but here as well there are weak spots • But even without this, the subject remains very important – what happens to the aggregate economy affects everybody, most importantly by your chances of finding employment. What is Macroeconomics About? • Macroeconomics is the study of the structure and performance of national economies and of the policies that governments use to try to affect economic performance. • Perhaps more interestingly, it is about how markets interact – what happens in one market affects what happens in another, sometimes in surprising ways. • Microeconomics is more concerned with individual markets and how they function. • The two branches are related – macro needs good micro foundations. Issues Addressed by Macroeconomists • The subject is empirical in nature. – It seeks to answer what we observe in the economy at large. • For example: – What determines a nation’s long-run economic growth? – What causes a nation’s economic activity to fluctuate? – What causes unemployment? Issues Addressed by Macroeconomists (continued) – What causes prices to rise and to fall and does this matter? – How are interest rates determined? – How does being a part of a global economic system affect national economies? – Why do some countries do well and others not? – Can government policies be used to improve economic performance? Relevance of the course • The models studied in this course are, at their core, those used by professional and academic economists. • They are designed to try and answer the questions just raised as well as others. • Of note here is that when we use models it means some math is required. • But the advantage is that models help to organize our thinking. • Empirical verification is very important. Prior to discussing growth, a reminder: What is a growth rate? Yt Yt 1 g 100 Yt 1 Yt g 1 100 Yt 1 Yt 1 g' Yt 1 where g’ = g/100 Long-Run Economic Growth • Rich nations have experienced extended periods of rapid economic growth. • Canada’s experience is typical of many advanced economies. • Some poor nations either have never experienced them or economic growth has been offset by economic decline. • Others have managed to enter new periods of strong growth – Brazil, Russia, India and China (the BRICs) stand out, until recently. • China has set the record for lowering poverty. The Level of Canadian Output: The series is indexed at 1.0 in 1961:Q1 6 1 0.9 5 0.8 0.7 4 0.6 3 0.5 Recession Canada 2 Real GDP 0.4 0.3 Poly. (Real GDP) 0.2 1 0.1 0 0 The level of US output: The series is indexed at 1.0 in 1961:Q1 6 1 0.9 5 0.8 0.7 4 0.6 3 0.5 Recession US 2 Real GDP 0.4 0.3 Poly. (Real GDP) 0.2 1 0.1 0 0 Increased Output • Total output is increasing because of increasing population, i.e. the number of available workers. • Increasing average labour productivity: the amount of output produced per unit of labour input or per hour worked. • Productivity is key to determining living standards. • More recently, economists have been focusing on income distribution as well as political structures. Canada’s GDP over the long haul 10 ln(RGDP) 9 Trend RGDP 8 7 6 5 4 Trend estimated using Hodrick-Prescott filter Labour productivity has recently slowed with consequences for income 2.9 2.7 2.5 2.3 2.1 1.9 1.7 * Defined as log differences Labour productivity* Labour productivity has recently slowed with consequences for income 2.9 Labour productivity 2.7 Trend labour productivity 2.5 2.3 2.1 1.9 1.7 Defined as log differences, trend is calculated using a Hodrick-Prescott filter Rates of Growth of Output • Rates of growth of output (or output per worker) are determined by: – rates of saving and investment; – rates of technological change; – rates of change in factors of production. • We will be studying this in Chapter 6. Business Cycles • Business cycles are short-run (we hope) contractions and expansions of economic activity. • The most volatile period in the history of Canadian output was between 1914 and 1945. • In the post WWII period, the recessions of ’53-54, ’81-82, ‘90-92 and ’07-08 stand out. • An interesting question is whether or not the nature of the business cycle is changing. • Currently Canada, along with the world, is emerging from the most severe post-war recession on record – this one will go into the history books. A look at the Canadian business cycle in a historical context 20 15 Business cycle 10 5 0 -5 -10 -15 -20 Straight lines = +/- 2 standard deviations Another look at the most recent recession… Output gaps* 5 4 3 AUS 2 CAN 1 FRA 0 DEU ITA -1 JAP -2 ESP -3 GBR -4 USA EUR -5 OECD -6 2002 2003 2004 2005 2006 2007 2008 * OECD estimates from Economic Outlook 95 June 2014 2009 2010 2011 2012 2013 2014 2015 … and its aftermath Output gaps* 5 AUS 4 CAN 3 FRA 2 DEU 1 ITA 0 JAP -1 ESP -2 GBR -3 USA -4 -5 EUR -6 OECD 2002 2003 2004 2005 2006 2007 * OECD estimates from Economic Outlook 95 June 2014 2008 2009 2010 2011 2012 2013 2014 2015 Recessions and Recoveries • Recession is the downward phase of a business cycle when national output is falling or growing slowly. • It is measured as the distance from the previous peak to the trough. • Recovery is the period starting just after the recession trough. The 2008-09 Canadian recession (green line) compared with more recent ones (GDP from peak) 1.01 Three Canadian recessions 1 0.99 0.98 1981-82 0.97 1990-92 0.96 2007-09 0.95 -2 -1 0 1 2 3 4 5 6 Quarters 7 8 9 10 11 12 13 14 The 2007-09 US recession (green line) compared with recent downturns (GDP from peak) 1.01 Three US recessions 1 0.99 0.98 1981-82 1990-92 0.97 2007-09 0.96 0.95 -2 -1 0 1 2 3 4 5 6 Quarters 7 8 9 10 11 12 13 14 Unemployment • Recessions are usually accompanied by rising unemployment: the number of people who are available for and are actively seeking work but cannot find jobs. • Not counted are people who want to work but have stopped looking – discouraged workers. Unemployment rate = Unemployed/Labour Force Labour Force = Total Employed plus Unemployed Labour Force = Participation Rate × Source Population The Unemployment Rate • The unemployment rate can stay high even when the economy is starting to do well. • After fifteen plus years of economic growth, in mid-2007, the unemployment rate in Canada was near 6%. • Unemployment has rose in the wake of the recent recession hitting a peak of over 8½%. • Currently it has eased back to around 6.8% (Nov 2014) Unemployment Rate from the ‘60s onward 14.0 1 0.9 Recession Canada 12.0 Unemployment rate 0.8 0.7 10.0 0.6 8.0 0.5 0.4 6.0 0.3 0.2 4.0 0.1 2.0 Dec-55 0 Dec-59 Dec-63 Dec-67 Dec-71 Dec-75 Dec-79 Dec-83 Dec-87 Dec-91 Dec-95 Dec-99 Dec-03 Dec-07 Unemployment rate in the United States 14.0 1 Recession US 0.9 12.0 0.8 Unemployment rate 10.0 0.7 0.6 8.0 0.5 0.4 6.0 0.3 0.2 4.0 0.1 2.0 Dec-55 0 Dec-59 Dec-63 Dec-67 Dec-71 Dec-75 Dec-79 Dec-83 Dec-87 Dec-91 Dec-95 Dec-99 Dec-03 Dec-07 When countries suffer a banking crisis, the employment recovery is very slow The effect of the US recession on employment over past three recoveries 1.02 US employment in three recessions 1.01 1 1981-82 0.99 1990-92 0.98 2007-08 0.97 0.96 0.95 0.94 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 Months How Canadian employment did during the past three recessions 1.02 Canadian employment in three recessions 1.01 1 1981-82 0.99 1990-92 2007-08 0.98 0.97 0.96 0.95 0.94 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 Months Inflation • When prices of most goods and services are rising over time it is inflation. When they are falling it is deflation. • The inflation rate is the percentage increase in the average level of prices. • Inflation rates vary widely across countries from deflation in Japan and Switzerland to hyper inflation in Zimbabwe. • Canada has seen both deflation (in the Great Depression) and high inflation (in the late 1970s). • Recently (between June and September of 2011) Canada saw mild deflation. • Currently the rate is positive and low. Recent inflation in Canada 14.0 1 Recession Canada 12.0 0.9 Inflation rate 0.8 10.0 0.7 8.0 0.6 6.0 0.5 0.4 4.0 0.3 2.0 0.2 0.0 -2.0 Dec-55 0.1 0 Dec-59 Dec-63 Dec-67 Dec-71 Dec-75 Dec-79 Dec-83 Dec-87 Dec-91 Dec-95 Dec-99 Dec-03 Dec-07 Recent inflation in the US 14.0 1 0.9 12.0 Recession US 0.8 Inflation rate 10.0 0.7 8.0 0.6 6.0 0.5 0.4 4.0 0.3 2.0 0.2 0.0 -2.0 Dec-55 0.1 0 Dec-59 Dec-63 Dec-67 Dec-71 Dec-75 Dec-79 Dec-83 Dec-87 Dec-91 Dec-95 Dec-99 Dec-03 Dec-07 Inflation Among Developed Economies % change United States 25 Japan Germany United Kingdom 20 France Italy 15 Canada Spain Australia 10 Belgium Netherlands Sweden 5 Norway Denmark 0 y-1960y-1963y-1966y-1969y-1972y-1975y-1978y-1981y-1984y-1987y-1990y-1993y-1996y-1999y-2002y-2005y-2008y-2011 Austria Finland -5 Average Canadian Inflation vs. the Average 16.0 14.0 Inflation = 0.88×(Average) R² = 0.86 12.0 Canada 10.0 8.0 6.0 4.0 2.0 0.0 0.0 2.0 4.0 6.0 8.0 Average 10.0 12.0 14.0 US Inflation vs. the Average 14.0 Inflation = 0.83×(Average) R² = 0.71 12.0 10.0 United States 8.0 6.0 4.0 2.0 0.0 0.0 2.0 4.0 6.0 8.0 -2.0 Average 10.0 12.0 14.0 German Inflation vs. the Average 14.0 12.0 Inflation = 0.85 + 0.42×(Average) R² = 0.62 10.0 Germany 8.0 6.0 4.0 2.0 0.0 0.0 2.0 4.0 6.0 8.0 -2.0 Average 10.0 12.0 14.0 Effects of Inflation • Inflation can erode incomes, especially of those people on pensions or other fixed incomes. • When the inflation rate reaches an extremely high level, economies tend to function poorly and growth stalls due to the distortions it causes. • Inflation can also damage investment by creating uncertainty. • Determining the right level of inflation is a big policy issue but we know the right level is low. Effects of Inflation con’t The International Economy • An economy which has extensive trading and financial relationships with other national economies is an open economy. • An economy with no relationships is a closed economy. • International trade and borrowing relationships can transmit business cycles from country to country. – In the recession of 2007-09, this was an important transmission mechanism for Canada. Exports and Imports • Canadian exports are goods and services produced in Canada and consumed abroad. • Canadian imports are goods and services produced abroad and consumed in Canada. • Trade imbalances (trade surplus and deficit) affect output and employment. – Trade surplus: exports exceed imports. – Trade deficit: imports exceed exports. Exports and Imports over time 45 20 Net exports (% GDP) Right hand scale Exports (% GDP) 40 Imports (% GDP) 15 35 10 30 5 25 0 20 -5 Why Trade is Important: Shocks in the US (and the world) get transmitted quickly to Canada 4.00 1 0.9 2.00 0.8 0.7 0.00 0.6 -2.00 0.5 0.4 -4.00 0.3 Recessions in Canada -6.00 USA -8.00 0.2 Canada 0.1 0 The Exchange Rate • The trade balance is affected by the exchange rate. • The exchange rate is the amount of Canadian dollars it takes to buy a unit of foreign currency. – Relative to the US$, the rate has fluctuated widely over the past number of decades from a low of $1CAN = $0.62US in Jan 2002 to a high of $1CAN = $1.10US in Nov 2007. It is now below par with the US dollar ($0.85US as of Friday). • Some of this weakness may be due to the fall in the price of oil. Exchange rate since 1971: An increase is an appreciation 1.1 1 1.1 0.9 Canadian recession 1.0 0.8 Exchange rate: US$ per C$ 1.0 0.7 0.9 0.6 0.9 0.5 0.8 0.4 0.8 0.3 0.7 0.2 0.7 0.1 0.6 Dec-66 0 Dec-70 Dec-74 Dec-78 Dec-82 Dec-86 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 The effect of oil prices on the Canadian dollar Macroeconomic Policy • A nation’s economic performance depends on: – – – – – natural and human resources; capital stock; technology; economic choices made by citizens; and macroeconomic policies of the government. • Macroeconomic policies: – Fiscal policy: government spending and taxation at all levels. – Monetary policy: the central bank’s control of short-term interest rates and the money supply. – The two can can interact as developments by one can cause difficulties for the other and vice versa. – We now worry about something called macro-prudential policy policy, something that arose in the wake of the current recession. Budget Deficits • The economy is affected when there are large budget deficits: the excess of government spending over tax collection. • The large budget deficits of the 1980s and early 1990s were unusual. – Borrowing from the public might divert funds from more productive uses – called crowding out. – Federal budget deficits might be linked to the decline in productivity growth – firms may not want to invest because of concerns of future tax increases. – After 10 plus years of surpluses the budget is once again in deficit because of the recent recession. – The more recent projections now call for a small surplus. Canada had government surpluses until the great recession 10 1 0.9 5 0.8 0.7 0 0.6 -5 0.5 0.4 -10 0.3 Recessions -15 0.2 Government saving (% GDP) 0.1 -20 0 Components of government balances 28 1 Recessions 0.9 Government spending as % GDP 26 Government revenues as % GDP 0.8 24 0.7 0.6 22 0.5 20 0.4 0.3 18 0.2 16 0.1 14 Q1-1981 Q3-1983 Q1-1986 Q3-1988 Q1-1991 Q3-1993 Q1-1996 Q3-1998 Q1-2001 Q3-2003 Q1-2006 Q3-2008 Q1-2011 0 Q3-2013 Government debt as per cent of GDP Federal government starts aggressive deficit reduction Non-central government debt % GDP 100 Central government debt % GDP 80 60 40 20 0 y-1991 y-1993 y-1995 y-1997 y-1999 y-2001 y-2003 y-2005 y-2007 y-2009 y-2011 y-2013 Aggregation • Macroeconomists ignore distinctions between individual product markets and focus on national totals. • The process of summing individual economic variables to obtain economy wide totals is called aggregation. – We will be discussing this in the next lecture. What Macroeconomists Do? • • • • Macroeconomic forecasting Macroeconomic analysis Macroeconomic research Data development Forecasting • Macroeconomic forecasting – prediction of future economic trends - has some success in the short run. • In the long run too many factors are highly uncertain to provide anything more than an idea of trends. • Still it is useful in a ceteris paribus sense. The Forecasting Record of Business Economists Forecasters can get it wrong sometimes: A look at the record at forecasting the recession (total OECD GDP) What we said at each point in time • June/2007 “The expansion should remain on track” • Dec/2007 “The expansion should ease somewhat” • June/2008 “Growth is slowing sharply” • Dec/2008 “Growth is plunging” Forecasting long-term interest rates Another look at forecasting long-term interest rates: What markets were expecting Macroeconomic Analysis • If we’re not good at forecasting, why do it? – Perhaps because we make errors • there is information in those errors about key aspects of the economy like productivity or structure features of the economy. – This is where economic analysis comes in. • Macroeconomic analysis – analyzing and interpreting events as they happen – helps both private sector decisions and public policymaking. • Here as well there are difficulties, partly because of politics but they can be overcome. – Examples here include trade, tax policy, environment, regional concerns. Macroeconomic Research • Macroeconomic research – trying to understand the structure of the economy in general – forms the basis for macroeconomic analysis and forecasting. • There are a very wide variety of topics. • Historical experience is important. • It is the engine that pulls the train. Theory • How is research carried out? • Economic theory: a set of ideas about the economy to be organized in a logical framework. • Economic model: a simplified description of some aspects of the economy. Developing and Testing a Theory • State the research question. – Is this an interesting and useful line of enquiry? • Make provisional assumptions. – Are the assumptions reasonable and realistic? • Conduct empirical analysis. • Work out the implications of the theory. – Does the theory have implications that can be tested by looking at the real world? • Evaluate the results – here forecasting can be helpful but in addition, see how well the model fits the facts. Data Development • Macroeconomists use data to assess the state of the economy, make forecasts, analyze policy alternatives, and test theories. • Most data is provided by the public sector but more and more by the private sector as well. • Providers of data must: – Decide what types of data should be collected based on who is expected to use the data and for what purpose. – Ensure the measures of economic activity correspond to economic concepts. – Guarantee the confidentiality of data. Why Macroeconomists Disagree • A positive analysis examines the economic consequences of an economic policy or other development, but it does not address its desirability. • Normative analysis tries to determine whether a certain economic policy should be used. • Economists disagree: – on normative issues due to differences in values. – on positive issues due to different schools of thought. The Classical Approach • The invisible hand of economics: General welfare will be maximized if: – there are free markets, with no impediments/frictions to adjustments; – individuals act in their own best interest; and – importantly this view took the distribution of income as a given. Hayek has often been considered as the great classical rival to Keynes The Classical Approach (con’t) • To maintain market equilibrium – the quantities demanded and supplied must be equal: – Markets must function without impediments – there are no frictions. – Wages and prices should be flexible over a reasonably short time period. • According to the classical approach, the government should have a limited role in the economy – largely because there is no need for it to do anything except provide public goods like defense. • The “least government is the best government”. • It depends on markets not failing. The Keynesian Approach • In the Great Depression, the classical view did not seem to fit the facts – markets were failing to do their job or were taking too long to do it. • Keynes (1936) assumed that wages and prices would adjust slowly and then studied the implications. • Thus, markets could be out of equilibrium for long periods of time and unemployment can persist. • According to the Keynesian approach, it may be useful for governments to take actions to alleviate unemployment. Keynes virtually invented macroeconomics The Keynesian Approach (cont’d) • The government can purchase goods and services, thus increasing the demand for output and (hopefully) reducing unemployment. • Newly generated incomes would be spent and would raise employment even further. • His influence held sway for some time but declined in final 30 years of the 20th century. • It is now re-ascending in the wake of the great recession. Evolution of the Classical-Keynesian Debate • After stagflation – high unemployment and high inflation – of the 1970s, a modernized classical approach reappeared. • Substantial communication and crosspollination is taking place between the classical and the Keynesian approaches. Unified Approach to Macroeconomics: The strategy behind the book • Individuals, firms and the government interact in goods, asset and labour markets. • Macroeconomic analysis is based on the analysis of individual behaviour. • Keynesian and classical economists agree that in the long run prices and wages adjust to equilibrium levels. • Each group is working hard to shore up their underlying views. • The basic model can be used either with classical or Keynesian assumptions about flexibility of wages and prices in the short run. Ever since the first universities, the question on each students mind has been the same