Download Unemployment Rate - The University of Chicago Booth School of

Summer 2011
Macroeconomics
Starring Erik Hurst
1
Total U.S. Non Farm Employment Since 1990
2
Unemployment Rate: 1970M1 – 2011M4
3
Unemployment Rate: 1970M1 – 2011M4
Current Unemployment Rate ~9.1%
4
Unemployment Rate: 1970M1 – 2011M4
Unemployment Falls As Recession Ends
5
Unemployment Rate: 1970M1 – 2011M4
Unemployment Does Not Fall As Recession Ends
6
Unemployment Rate: Historical
7
Broad Questions of Interest About Unemployment
• What is a recession?
• How can unemployment be increasing when a recession ends?
• Why has the evolution of unemployment out of recessions
changed over time?
• Why does unemployment exist?
• Can policymakers affect the unemployment rate?
8
How is Unemployment Measured?
• Standardized Definition of the Unemployment Rate:
Unemployed
= jobless but looking for a job
Labor Force
= #Employed + #Unemployed
Unemployment Rate
= (# Unemployed) / (Labor Force)
This is the definition used in most countries, including the U.S.
U.S. data: http://stats.bls.gov/eag.table.html
U.S. measurement details: http://stats.bls.gov/cps_htgm.htm
Issues: Discouraged Workers, Underemployed, Measurement Issues
9
• Read Course Pack Readings: 25, 28
Components of Unemployment
• Flow of people into the unemployment pool
o Flow into unemployment from employment (job loss)
o Flow into unemployment from out of labor force (stop being
discouraged)
• Flow of people out of the unemployment pool
o Flow out of unemployment into employment (job finding)
o Flow out of unemployment out of labor force (discouraged workers)
10
Unemployment Duration
11
Unemployment Duration
Role of Unemployment Benefit Extension?
12
Types of Unemployment
• Frictional Unemployment: Result of Matching Behavior between Firms and
Workers.
• Structural Unemployment: Result of Mismatch of Skills and Employer Needs
Article of interest: 2 Million 'Open Jobs'? Yes, But U.S. Has Skills Mismatch
(NPR.org)
• Cyclical Unemployment: Result of output being below full-employment.
Individuals have the desire to work and the skills to work, yet cannot find a job.
• Is Zero Unemployment a Reasonable Policy Goal?
– No! Frictional and Structural Unemployment may be desirable (unavoidable).
13
Why is the Distinction Important?
• How much of the current unemployment is structural vs. cyclical?
• This is a current debate among policy makers (and a question I am trying to
answer in my own research)
• Why could there be structural unemployment?
o Some industries boomed inefficiently during the early 2000s
(construction) and need to retrench. The jobs being created now are
not in those industries (where unemployment is high).
o Some states boomed inefficiently during the early 2000s (Nevada,
Florida, California, Arizona, etc.) and need to retrench. The jobs
being created now are not in those states (where unemployment is
14
high)
0
Nevada
California
Florida
Rhode Island
Kentucky
Michigan
Georgia
Mississippi
Oregon
South Carolina
Idaho
North Carolina
Arizona
Tennessee
District of Columbia
Missouri
West Virginia
Alabama
Colorado
New Jersey
Ohio
Washington
Connecticut
Illinois
Indiana
United States (national)[5]
New Mexico
Delaware
Massachusetts
New York
Texas
Pennsylvania
Louisiana
Arkansas
Utah
Alaska
Maine
Montana
Wisconsin
Maryland
Kansas
Minnesota
Oklahoma
Virginia
Hawaii
Wyoming
Iowa
Vermont
New Hampshire
South Dakota
Nebraska
North Dakota
Spatial Variation in Unemployment Rate (March 2011)
16
14
12
10
8
6
4
2
15
Construction, Finance, Real Estate Share of Employment
16
House Price Growth (00-06) and
Change in Construction Labor Share (00-06)
.05
Construction Share from American Community Survey (ACS) –
Prime Age Men (Out of All Men in Labor Force) (R-squared=0.44)
NV
AZ
.04
FL
HI
.03
MT
CA
ID
NM
AK
TX
.02
GA
NC
CO
LA
.01
WV
IN
0
OH
ARSC UT
AL
IA
OK
TN MO
WIND
KY
MS
KS
SD
IL
MN
MA ME
VT
NY
CT
NH
DE
WA
OR
VANJ
RI
MD
PA
WY
MINE
0
.2
.4
hp_growth_00_06
delta_const_real_share_00_06
Fitted values
.6
.8
delta_const_real_share_00_06
17
Change in Construction Share (01-06) vs.
Total Employment Growth (01-06)
All Data from BEA Employment Data (R-squared=0.46)
.2
NV
WY
.15
AZ
UT
NM
.1
AK
ID
MT
HI
FL
ND
.05
TX
-.05
0
KY
-.01
SDOR
AL
GA
NC
AR
OK
NE
MN TN
WI
CO
KSMO NH
PA
ME
LA
NY
CT
IN
IL
MA
OH
0
VA
MD
SC
IA WV RI
MS
NJ
WA
CA
DE
VT
.01
.02
delta_bea_house_share_01_06
bea_totemp_gr_01_07
Fitted values
.03
bea_totemp_gr_01_07
18
Change in Construction Share (01-06) vs
Total Employment Growth (08-10)
.05
All Data from BEA Employment Data (R-squared=0.45)
ND
0
AK
-.05
TX
LA
-.1
KY
SD
NYMA
NE
PA
OK
ME
AR
KS
NH
MN
CT
CO
WI MO
IL
IN TN
NC
OH
AL
GA
IA WV
VT
VA
WA
MDWY
NJ
NM
MS
DE
RI
CA
SC
OR
MT
UT
HI
ID
-.15
AZ
FL
NV
-.01
0
.01
.02
delta_bea_house_share_01_06
bea_totemp_gr_08_10
Fitted values
.03
bea_totemp_gr_08_10
19
Change in Construction Share (01-06) vs
Population Growth (00-06)
Construction Share Data from BEA Employment Data (R-squared=0.40)
.3
NV
AZ
FL
.2
UT
TX
ID
GA
CO
.1
NC
KY
MI
MN
NH
ME
IL CTTN
WI
KS
OK
NY
AR
IN
NE
MO
MA
PA
OH AL
VA OR
AK
MD
NJ
SC
WY
VT
RI
SD
IA
MS
CA
NMWA
DE
HI
MT
0
ND WV
LA
-.01
0
.01
.02
delta_bea_house_share_01_06
delta_total_num_00_06
Fitted values
.03
delta_total_num_00_06
20
Unemployment Rate Change (06-10)
by House Price Growth Quintile (00-06)
Unemployment Rate: BLS Statistics
21
Change in Construction Labor Share (01-06) vs. Share of
Unemployment Coming From Construction (2009)(09)
.4
Unemployment Share from ACS (R-squared=0.34)
.35
HI
NV
MT
.3
NH
AK
VA
ME
WY
VT
SD
MD
SC
WV
.25
LA
.2
KY
MI
CT
CO MONE
MN
AL MANC
WI
GA
IL
TX
PA
AR
OK
TN
OH
KS
IN
NY
-.01
0
MS
IA
NJ OR
RI
WA
AZ
ID
FL
DE
UT
CA
NM
ND
.01
.02
delta_bea_house_share_01_06
share_unemp_const_real_09
Fitted values
.03
share_unemp_const_real_09
22
Why We Care About Unemployment
• Depreciation of Human Capital
• Productive Externalities
• Social Externalities
• Individual Self Worth
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Questions We Will Address In This Course
1.
2.
3.
What causes recessions? What causes unemployment?
What caused this recession? Will there be a double dip?
What is the link between housing prices and “real” economic activity
(consumption, production, unemployment, etc.)?
4. What is the link between the banking sector and “real” economic activity?
5. Should we be concerned with inflation? What about deflation?
6. What causes inflation/deflation?
7. How can policy makers (Fed/Congress/President) influence economic activity
in the short run (fight inflation and recessions) and in the long run (promote
economic growth)?
8. What are the pitfalls of government intervention?
9. What makes economies grow in the LONG RUN?!
10. How worried should we be about long run government deficits?
11. What are the costs/benefits of altering the nature of the Federal Reserve?
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12. What is the influence of China and India on the U.S. economy?
Caveat #1
• My course takes the perspective of analyzing any large macroeconomy (with
respect to the models we build).
• The examples will come from the U.S. (because that is what I study)
• However, the insights apply equally well to all large developed economies
including:
– The European Union
– Japan
– Canada, Australia, etc. (for the most part).
• The models also explains well consumer, business, and government behavior
for all economies (China, India, etc.).
25
Caveat #2
• The course takes time to build.
• Our goal is to construct and analyze the economy as a whole.
• To do that, we separately build the parts.
• After we build the parts, we put them together to see how they interact.
• At certain points in the class, you may feel that we are losing sight of the big
picture and you may yourself feel lost. That is common.
• But, I promise, by week 7 or 8 everything will come together (it always does).
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TOPIC 1
A Introduction to Macro Data
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Goals of the Lecture
•
•
•
•
•
•
•
What is Gross Domestic Product (GDP)? Why do we care about it?
How do we measure standard of living over time?
What are the definitions of the major economic expenditure components?
What are the trends in these components over time?
What is the difference between ‘Real’ and ‘Nominal’ variables?
How is Inflation measured? Why do we care about Inflation?
What have been the predominant relationships between Inflation and GDP
over the last four decades?
NOTE: This lecture will likely go into next week. This is by design. It does
not mean we will be short-changed on other material later in the class.
28
Gross Domestic Product (GDP)
• GDP is a measure of output!
• Why Do We Care?
– Because output is highly correlated (at certain times) with things we care about
(standard of living, wages, unemployment, inflation, budget and trade deficits, value
of currency, etc…)
• Formal Definition:
– GDP is the Market Value of all Final Goods and Services Newly Produced on
Domestic Soil During a Given Time Period (different than GNP)
29
“Production” Equals “Expenditure”
• GDP is a measure of Market Production!
• GDP = Expenditure = Income = Y (the symbol we will use)
(in macroeconomic equilibrium)
• What is produced in the market has to be show up as being purchased or held by
some economic agent;
• Who are the economic agents we will consider on the expenditure side?
–
–
–
–
Consumers (refer to expenditure of consumers as “consumption”)
Businesses (refer to expenditure of firms as “investment”)
Governments (refer to expenditures of governments as “government spending”)
Foreign Sector (refer to expenditures of foreign sector as “exports”)
30
A Simple Example
• What is “produced” has to be “purchased” by someone (including the
producer).
• Suppose I produce silverware (forks, spoons, etc.). If so, I could:
–
–
–
–
–
sell it to some domestic customer (Consumption)
sell it some business (Investment)
keep it in my stock room as inventory (Investment)
sell it to the city of Chicago to use in their shelters (Government spending)
sell it to some foreign customer (Export)
31
“Production” Equals “Income”
• What is Produced is Also a Measure of Income.
• If you pay a $1 for something, that $1 has to end up in someone’s pocket as:
Wages/Salary (compensation for workers who make production)
Profits (compensation for self employed)
Rents (compensation for land owners)
Interest (compensation for debt owners)
Dividends (compensation for equity owners)
• Notice, wages are only one component of income (Y does not equal wages)!
(Although, under certain production functions, they will be proportional to each
other).
32
Stop and Pause
• By definition…..
Production = Income = Expenditure = Y
• What is produced has to be purchased by someone (accounting for inventory
changes).
• What is purchased has to end up as income in somebody’s pocket!
• In our class, we realize that the terms are interchangeable in equilibrium.
33
Measuring GDP in Practice
• Production Method: Measure the Value Added summed Across Industries
(value added = sale price - cost of raw materials)
• Expenditure Method: Spending by consumers (C) + Spending by businesses
(I) + Spending by government (G) + Net Spending by
foreign sector (NX)
• Income Method:
Labor Income (wages/salary) +
Capital Income (rent, interest, dividends, profits).
• In our class, we will model the production side of economy (supply side) and
the expenditure side of the economy (demand side).
• Prices will always adjust to equate supply and demand such that Y (production)
34
always equals Y (expenditure).
What GDP is NOT!
• GDP is not, or never claims to be, an absolute measure of well-being!
– Size effects : But even GDP per capita is not a perfect measure of welfare
•
“The gross national product does not allow for the health of our children, the quality of
their education, or the joy of their play. It does not include the beauty of our poetry or
the strength of our marriages, the intelligence of our public debate or the integrity of our
public officials. It measures neither our courage, nor our wisdom, nor our devotion to
our country. It measures everything, in short, except that which makes life worthwhile,
and it can tell us everything about America except why we are proud to be Americans.”
– U.S. Senator Robert F. Kennedy, 1968
35
More on What GDP Is Not
• GDP Does Not Measure:
–
–
–
–
–
Non-Market Activity (home production, leisure, black market activity)
Environmental Quality/Natural Resource Depletion
Life Expectancy and Health
Income Distribution
Crime/Safety
• Remember how we measure GDP…(i.e., how does one measure “safety”).
• Ideally, what we would like to measure is quality of one’s life:
– Present discounted value of utility from one’s own consumption and leisure
and that of one’s loved ones.
• Read: Course Pack Readings 22-24 and 26
36
Defining the Expenditure Components (formally)
• Consumption (C):
– The Sum of Durables, Non-Durables and Services Purchased Domestically by NonBusinesses and Non-Governments (ie, individual consumers).
– Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables).
– Does Not Include Purchases of New Housing.
• Investment (I):
– The Sum of Durables, Non-Durables and Services Purchased Domestically by
Businesses
– Includes Business and Residential Structures, Equipment and Inventory Investment
– Land purchases are NOT counted as part of GDP (land is not produced!!)
– Stock purchases are NOT counted as part of GDP (stock transactions do NOT
represent production – they are saving!)
There is a difference between financial and economic investment!!!!!!!
37
More On Expenditure/Production Components
• Government Spending (G): Goods and Services Purchased by the domestic
government.
• For the U.S., 2/3 of this is at the state level (police and fire protection, school
teachers, snow plowing) and 1/3 is at the federal level (President, Post Office,
Missiles).
• NOTE: Welfare and Social Security are NOT Government Spending. These
are Transfer Payments. Nothing is Produced in this Case.
• Net Exports (NX): Exports (X) - Imports (IM);
– Exports:
– Imports:
The Amount of Domestically Produced Goods Sold on Foreign Soil
The Amount of Goods Produced on Foreign Soil Purchased
Domestically.
38
Summary of the Demand Side of Economy
• Expenditures:
Y = C + I + G + X - IM
• Only four economic agents can “spend” on domestic production
Domestic consumers (C)
Domestic firms (I)
Domestic governments (G)
Foreign consumers, firms, and governments (X)
• We will develop models for each sub component of the expenditure side of the
economy (C, I, G, and NX).
39
Measuring Expenditure (Demand Side)
• Only include expenditures for goods that are “produced”.
– If I give $10 to a movie theater to watch a movie, it is counted as expenditure.
– If I give $10 to my nephew for a birthday present, it is not counted as expenditure.
– If I give $10 to the ATM machine to put in my savings account, it is not counted as
expenditure.
• The second example would be considered a “transfer” (once I give $10 to my
nephew, he can go to the movies if he wanted to – once that $10 is spent, it will
show up in GDP).
– “Transfers” are defined as the exchange of economic resources from one economic
agent to another when no goods or services are exchanged.
• The third example is considered “saving” (I am delaying expenditure until the
future). Once I spend the $10 in the future, it will show up in GDP.
40
Some Examples of GDP Calculations
• Thinking about imports
Y = C + I + G + X – IM
• Thinking about inventories (storing production….)
Y = C + I + G + X – IM
• Distinguishing between government spending and “transfers”.
Y = C + I + G + X – IM
41
Summary of Supply Side of Economy
• Production:
Y = f(A, N, K, other inputs like oil)
where A = technology, N = labor input, K = capital (machine) input
• We will develop models/intuition for A, N, K and oil
• N will be determined in the labor market (labor demand and labor supply)
42
Where We are Headed
43
The role of “prices”
• “Prices” ensure that we are always in equilibrium
• 4 prices in our class
Price of output (CPI)
P
Price of labor (real wages)
W/P
Price of money (loans – real interest rates)
r
Price of foreign currency (exchange rate)
$ or e
• We will develop (from fundamentals) 4 markets in our class
44
The 4 Markets
1)
Labor Demand vs. Labor Supply (determines N and W/P)
Necessary to compute the supply side of economy
Key to where recessions come from (frictions in the labor market)
2)
IS-LM market (determines r and Y (via I))
Interest rates determine firm investment
Key to federal reserve policy (sets r)
Key to understanding banking crises.
3)
Aggregate Demand vs. Aggregate Supply (determines P and Y)
Key to understanding where inflation comes from!
45
The 4 Markets (continued)
4)
Foreign Exchange Market (determines value of currency and NX)
We will focus on this market in week 10
Notice, markets 1-3 help to pin down the level of Y in the economy
These four markets (and their components) will determine everything we want to
know about the macroeconomy (production, inflation, economic growth,
unemployment, interest rates, budget deficits, trade deficits, etc.)
For the next 7 weeks, we will build the underpinnings of these markets. In doing
so, we will uncover how these markets work and what factors influence those
markets!
46
An Important Equation
47
Defining Savings (Store this Away!)
Yd = Disposable Income = Y - T + Tr
• T
• Tr
= Taxes
= Transfers (ie, Welfare)
Yd = C + SHH
• SHH
(1)
(2)
= Personal (Household or Private) Saving
SHH = Y - T + Tr – C <<Combine (1) and (2)>>
(3)
• Personal Savings Rate = SHH/Yd
For simplicity, we are going to abstract from business saving (things like retained earnings and
depreciation). For those interested in more of these accounting relationships, see the text.
48
A Look at Actual U.S. Household Saving Rates:
1970Q1 – 2009Q3
Note:
Shaded areas are recessions.
49
Saving Identities (continued)
Sgovt = T - (G + Tr)
(4)
• Sgovt = Government (Public) Saving
• Includes Federal, State and Local Saving
• What government collects (T) less what they pay out (G and Tr)
S
= SHH + Sgovt = Y - C - G = I + NX
• S
(5)
= National Savings
so,
S
S
= Y-C–G
= I + NX
<<Combine (3) and (5)>>
<<Combine (6) and Y = C+I+G+NX>>
(6)
(7)
50
Summary
S = I + NX
We will use this equation for the rest of the class!
National savings, goes into a “bank”.
Firms looking to borrow, go to the “bank”.
Firms can only borrow what is in the “bank”
In a world where NX = 0, interest rates will adjust such that savings will always
equal investment (I=S – this will be our IS curve later in the course).
What is the role of NX? (International savings)
51
Understanding Prices and Inflation
52
Prices and Inflation
• Why is it important to measure “prices” of goods and services?
o Prices are a key metric of measurement (we measure GDP in prices).
- The metric changes over time!
o Changes in prices (inflation) is of independent interest in the
macroeconomy.
- Inflation is just the percentage growth rate in prices.
53
Prices as Measurement
• Measures macro prices of goods and services through “price indices”
• Price Indices track the relative change in the prices for a “basket” of many
goods (intended to representative of all goods) compared to the same basket of
goods in a “base year”.
• The base year is the anchor for the price index and all subsequent price indices
are relative to the base year.
• GDP Deflator (one prominent price index):
Value of Current Output at Current Prices /
Value of Current Output at Base Year Prices
• Another prominent price index is the CPI (consumer price index) – measures
price changes of consumer goods. I will often use the CPI as our measure54of a
price index in this class.
Example of Price Index Calculation (Continued)
• Nominal GDP is output valued at Current Prices
• Comparing Nominal GDPs over time can become problematic. Confuse
Changes in Output (production) with Changes in Prices
• Real GDP is output valued at some Constant Level of Prices (prices in a base
year).
Real GDP(t) = Nominal GDP(t) / Price Index (t)
• Growth in Real GDP:
% Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)]/Real GDP (t)
or (approximately)
% Δ in Real GDP = % Δ in Nominal GDP - % Δ in P
• See Supplemental Notes 1 (Real vs. Nominal Variables) for examples.
55
Technical Notes on Price Indices
• Need to Pick a Basket of Goods (cannot measure all prices)
• ‘Ideal/Representative’ Basket of Goods Change Over Time
– Invention (Computers, Cell Phones, VCRs, DVDs).
– Quality Improvements (Anti-Lock Brakes)
• Criticism of Price Indices: Part of the Change in Prices Represents a Change in
Quality - Actually, not measuring the same goods in your basket over time.
• How do we account for “sales”?
• Additionally - technology advances drive down the price of ‘same’ goods over
time.
56
Technical Notes on Price Indices
• Boskin Report (1996) Concludes that CPI Overstates Inflation by 1.1% per
year.
• Overstating Inflation means understated Real GDP increases - makes it appear
that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market,
Housing Prices, Wages - any Nominal Measure).
• Measures to Get Around Problems with CPI - Chain Weighting
– Read Text to get a sense of chain weighting.
• Read Course Pack Readings: 21 (difficulty measuring prices)
57
Technical Notes on Price Indices
• Which is better: Real or Nominal?
– In this class, we will focus on the ‘Real’! We are trying to measure changes
in production, expenditures, income, standard of livings, etc. We will
separately focus on the changes in prices.
– From now on, both in the analytical portions and the data portions of the
course, we will assume everything is real unless otherwise told.
• ie, Y = Real GDP, C = Real Consumption, G = Real Government
Purchases, etc...
58
Recessions and Inflation in U.S. Over Last 40 Years
59
What is a Recession?
• “Official Rule of Thumb” - 2 or more quarters of negative real GDP growth
• Most Economies are usually not in recession
– U.S. average postwar expansion: 50 months
– U.S. average postwar recession: 11 months
– Previous Recession: 7-9 months (April 2001 – December 2001)
– Previous Expansion: 121 months (March 1991- March 2001)
– The 1990s experienced the longest expansion since 1850 (the second longest was
106 months ; 1961-1969)
– For Information on Business Cycle Dates see: http://www.nber.org/cycles.html
60
A Look at U.S. Nominal GDP: 1970Q1 – 2010Q4
61
A Look at U.S. Inflation: 1970Q1 – 2010Q4
62
A Look at U.S. Real GDP: 1970Q1 – 2010Q4
63
Real GDP and Inflation Over the Last Three Decades?
High or Rising Inflation:
73-75
79-80
07-08
Low or Falling Inflation:
81-83
90-91
96-00 (sustained)
01-02
High Growth in GDP:
83-86
96-00 (sustained)
Negative Growth in GDP:
74-75
79-80
81-83
08-09
90-91
01-02
08-09
1) Sometimes Negative Growth in GDP and Rising Inflation (70s)
2) Sometimes Negative Growth in GDP and Falling Inflation (80s and 90s)
Need Theory to Explain Both Sets of Facts!!!!
64
More On Recessions
Dates
2/61 - 11/69
12/69 - 10/70
11/70 - 10/73
11/73 - 2/75
3/75 - 12/79
1/80 - 6/80
7/80 - 6/81
7/81 - 10/82
11/82 - 6/90
7/90 - 2/91
3/91 - 3/01
4/01 - 12/01
1/02 - 11/07
12/07 - 6/09
7/09 - current
Expansion
Recessions
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Length
106 months
11 months
36 months
16 months
58 months
6 months
12 months
16 months
92 months
8 months
121 months
8 months
71 months
19 months
23 months
65
Great Moderation?
Dates
2/61 - 11/69
12/69 - 10/70
11/70 - 10/73
11/73 - 2/75
3/75 - 12/79
1/80 - 6/80
7/80 - 6/81
7/81 - 10/82
11/82 - 6/90
7/90 - 2/91
3/91 - 3/01
4/01 - 12/01
1/02 - 11/07
12/07 - 6/09
7/09 - current
Expansion
Recessions
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Recession
Expansion
Length
106 months
11 months
36 months
16 months
58 months
6 months
12 months
16 months
92 months
8 months
121 months
8 months
71 months
19 months
23 months
49 months of recession in
21 years (1961-1982)
The Great Moderation
16 months of recession in
24 years (1982-2007)
66
Great Moderation! - Analysis of Real GDP (Up Through 2007)
•
•
•
Recessions have become less frequent
Recent recessions are much less severe than previous recessions
Even the expansions are more stable
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Is the Great Moderation Dead?
• I do not think so….
My interpretation:
Great Moderation refers to the fact that the economy is better at minimizing the
impact of any given shock now relative to 30 years ago.
It does not mean that:
There will not be bad shocks
There will not be “new” shocks
Why?
The economy is more flexible (inventory management, credit)
We have gotten better at conducting macroeconomic policy!
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Foreshadowing the rest of the course
• Assume aggregate demand (drawn in {Y,P} space) slopes down
I will prove this to you later in the course
• Assume short run aggregate supply (drawn in {Y,P} space) slopes up
I will prove this to you later in the course
I will also distinguish between short run and long run aggregate supply
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Foreshadowing the Rest of the Course: Demand Shocks
The relationship between inflation and output when aggregate demand shifts:
Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS)
Long Run AS
Short Run AS
P
P
P’
a
b
AD’
AD
Y
Y’ Y*
If the economy receives a negative aggregate demand shock, short run equilibrium
will move from point (a) to point (b). Output will fall (from Y* to Y’). Prices will fall
(from P to P’).
Demand shocks cause prices and output to move in the same direction.
(You should be able to illustrate a positive demand shock)
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Foreshadowing the Rest of the Course: Supply Shocks
The relationship between inflation and output when aggregate supply shifts:
Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS)
Short Run AS’’
Long Run AS
P
P’’
Short Run AS
c
a
P
AD’
AD’’
Y’’
Y*
AD
Y
If the economy receives a negative short run aggregate supply shock, short run equilibrium
will move from point (a) to point (c). Output will fall (from Y* to Y’’). Prices will rise
(from P to P’’).
Supply shocks cause prices and output to move in opposite directions.
(You should be able to illustrate a positive supply shock)
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Business Cycles vs. Long Run Growth
72
Macroeconomic Goals
Promote Economic Growth
Minimize uncertainty
Minimize distortions in the economy (create level playing field)
Create incentives for efficient economic transactions
Maximize “trend” growth
Promote Economic Stability
Keep the unemployment rate low
Keep inflation in check
Refer to this as managing “business cycles” – minimize the deviations (cycles) around
the trend.
Lower uncertainty leads to greater economic activity
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Why We Care About Inflation
74
Interest Rates
i0,1
=
the nominal interest rate between periods 0 and 1
(the nominal return on the asset)
πe0,1 =
the expected inflation rate between periods 0 and 1
re0,1 =
the expected real interest rate between periods 0 and 1
Definitions
re0,1 = i0,1 - πe0,1 (or i0,1 = πe0,1 + re0,1)
ra0,1 = i0,1 - πa0,1 (or i0,1 = πa0,1 + ra0,1)
where ra and πa are the actual real interest rate and inflation
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Interest Rate Notes
• The Formula given is approximate. The approximation is less accurate the
higher the levels of inflation and nominal interest rates. The exact formula is re
= (1 + i) / (1 + лe) - 1
• Central Banks are very interested in r since it may affect the savings decisions
of households and definitely affects the investment decisions of firms. The
press talks about Central Banks setting i, but the Central Banks are really trying
to set r.
• 3 easy ways of measuring expected inflation:
– Recent actual inflation (see http://www.clev.frb.org).
– Survey of forecasters (see http://www.phil.frb.org/econ/liv/welcom.html).
– Interest rate spread on nominal vs. inflation-indexed securities (WSJ).
• See http://www.phil.frb.org/econ/spf/spfpage.html for other macro forecasts
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Why We Care About Inflation
• Note: We will have a whole lecture on this later in the course
• Inflation is Unpredictable
• Indexing Costs (even if you know the inflation rate - you have to deal with it).
• Menu Costs (have have to go and re-price everything)
• Shoe-Leather Costs (you want to hold less cash - have to go to the bank more
often).
• Caveat: There may be some benefits to small inflation rates - more on this later.
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Why We Care About Inflation
• An Example of how inflation can affect real returns.
• Suppose we agree that a real rate of 0.05 over the next year is fair.
– borrowing rate, salary growth rate, etc.
• Suppose we also agree that expected inflation over the next year is 0.07.
• We should then set the nominal return equal to 0.12 (i = re + лe)
Summary:
i = 0.12
re = 0.05
лe = 0.07
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Why We Care About Inflation
• Suppose that actual inflation is 0.10 (лa > лe)
In this case, ra = 0.02 (ra = i - лa)
Borrowers/Firms are better off
Lenders/Workers worse off
• Suppose that actual inflation is 0.03 (лa < лe)
In this case, ra = 0.09 (ra = i - лa)
Borrowers/Firms are worse off
Lenders/Workers better off
It has been shown that higher inflation rates are correlated with more variability.
People/Firms Don’t Like the Uncertainty
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