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Introduction to
Macroeconomics
Macroeconomic Analysis
1
• Microeconomics
• Decisions of individual units
• No matter how large
• Macroeconomics
• Behavior of entire economies
• No matter how small
• Economic aggregates
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Macroeconomics & Microeconomics
2
• Aggregation
• Combine many individual markets
• Into one overall market
• Composition of demand & supply
• In various markets
• Important for microeconomics issues
• Not important for macroeconomics issues
• During economic fluctuations
• Markets – move up or down together
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Macroeconomics & Microeconomics
3
• Macroeconomics
• Assume most details
• Resource allocation & income distribution
• Relatively unimportant
• Microeconomics
• Ignore macroeconomics issues
• Focus – individual markets
• Allocate resources
• Distribute income
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Macroeconomics & Microeconomics
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What is Macroeconomics
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• Macroeconomics examines economies at the aggregate
(international, national, regional) level.
• Some aspects of macroeconomics are about comparing two
aggregate economies at the same time.
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• Much of macroeconomics is concerned with
policies such as money supply or tax policy
which is national in scope.
• Equilibrium effects means that outcomes are
different when we consider the economy in
aggregate.
• There are certain phenomenon like economic
growth and business cycles which affect the
aggregate economy equally.
• We can consider interesting dynamic questions.
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Why study the economy at the
aggregate level?
6
Amateur History of
Macroeconomics/Macroeconomic History
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• Around 1930, a major worldwide contraction occurred in
virtually every developed economy. For example, output in the
USA fell by more than 20% and unemployment rose to 25%.
• Decline in output continued for the better part of a decade.
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Supply & Demand in Macroeconomics
• Aggregate demand curve
• Quantity of domestic product – demanded
• Each possible value of price level
• Quantity of domestic product – supplied
• Each possible value of price level
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• Aggregate supply curve
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Figure 1
Two interpretations of a shift in the demand curve
S
Price
D
Price
D1
S
D0
A
P1
E
E
P0
P0
S
S
D1
D
0
Q0
D0
0
Quantity
Quantity
(a)
(b)
Supply & Demand in Macroeconomics
• Inflation
• Sustained increase in price level
• Outward shift of aggregate demand curve
• Total output – declines
• Production falls
• People lose jobs
• Leftward shift of aggregate demand curve
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• Recession – period of time
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Figure 2
An economy slipping into a recession
S
D0
D2
Price Level
E
P0
B
P2
S
D2
0
Q2
Domestic Product
Q0
D0
Supply & Demand in Macroeconomics
• Macroeconomists study
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• Inflation
• Recession & unemployment
• Economic growth
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Figure 3
Economic growth
D1
S0
D0
S1
Price Level
C
E
D1
S0
0
D0
S1
Q0
Domestic Product
Q1
US Great Depression
USA GDP (1992 Prices)
1000
900
800
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700
600
500
400
300
200
100
0
1929
1930
1931
1932
1933
1934
1935
Billiions US$
1936
1937
1938
1939
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• UK economist Lord Keynes developed a theory in
which prices failed to adjust quickly so that a fall
in corporate investment or a rise in savings leads
to a decline in output.
• Hicks developed IS-LM model, a mathematical
version of Keynes thinking which is still the
baseline framework for thinking about business
cycles.
• For 20-30 years, most macro was about
measuring the gap between demand and
potential output and stimulating demand
sufficiently to reach potential.
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Macro theory
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Much of Macroeconomics is about comparing one
economy at different points in time.
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• Two phenomenon can be observed in single data series.
• First, economy is growing with a secular trend over time.
• Second, economy is growing unevenly across time.
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Gross Domestic Product
• Gross domestic product (GDP)
• Sum: money values
• All final goods & services
• Produced - domestic economy
• Sold – organized markets
• Usually a year
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• Specified period of time
17
Gross Domestic Product
• Nominal GDP
• GDP in current dollars
• Value outputs – current prices
• Real GDP
• Value outputs of different years
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• Common prices
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Gross Domestic Product
• GDP - particular year
• Add up money value of things
• Goods & services
• Final goods & services
• Production: geographic boundaries of U.S.
• Organized markets
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• Produced within the year
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Gross Domestic Product
• Final goods and services
• Purchased by their ultimate users
• Intermediate good - purchased
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• For resale
• For use in producing another good
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Gross Domestic Product
• Limitations of GDP
Not measure: nation’s economic well-being
Includes only market activity
Places no value on leisure
Counted: “Bads” and “Goods”
Ecological costs
• Not deducted from GDP
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•
•
•
•
•
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Japan Post-war GDP
600000
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500000
400000
300000
200000
100000
0
55
60
65
70
75
80
85
90
95
00
JAPAN_GDP
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Trend and Cycle
(Hodrick-Prescott Detrending)
600000
500000
300000
20000
200000
10000
100000
0
0
-10000
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400000
-20000
55
60
65
70
75
JAPAN_GDP
80
85
Trend
90
95
00
Cycle
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The Economy on a Roller Coaster
• The Great Depression, 1929-1933
Decline in economic activity
Rapid deflation
Production – declined 30%
Unemployment rate
• Increased from 3% to 25%
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•
•
•
•
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The Economy on a Roller Coaster
• The Great Depression, 1929-1933
• Revolution in economic thought
• Before: economy corrects itself
• After: decrease in aggregate demand
• Monetary & fiscal policy
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• Ended: early 1940s
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The Economy on a Roller Coaster
• From WWII to 1973
• Increased government spending
Increased aggregate demand
Accidental fiscal policy
Price controls
Shortage: consumer goods
• 1960s – strong growth
• Vietnam war – increased spending
• Inflation & high unemployment
• Wage & price controls
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•
•
•
•
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Macro Progresses
• Long-term growth which would be studied in models in which
prices adjust perfectly to economic conditions.
• Business Cycles which would be studied in models in which they
would not. Advances in computation and statistics meant that
large models could be constructed meant to represent large
economies.
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• During the 1950’s, macro conceptually split changes in output
into two parts:
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• Internationally, 1950’s and 1960’s were a period when output
growth was at a faster pace than before the war.
• Also a period in which there was relatively little international
trade in goods and capital compared to pre-WWI period.
• Fixed exchange rates under Bretton Woods agreement.
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Golden Era of Growth
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The Economy on a Roller Coaster
• Fiscal policy
• Government spending & taxation
• Used to steer aggregate demand
• Inflation
• While economy
• Growing slowly (“stagnating”)
• Or recession
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• Stagflation
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The Economy on a Roller Coaster
• The Great Stagflation, 1973-1980
• OPEC – 1973 oil prices quadrupled
• Poor harvests
• Recession
• Stagflation
• Inward shift of aggregate supply
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• Inflation rate: 12%
• High unemployment
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The Economy on a Roller Coaster
• The Great Stagflation, 1973-1980
• Economy recovered
• Government actions
• Natural economic forces
• Stagflation
• Inflation: 16%
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• 1979 – OPEC soaring oil prices
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Figure 4
The effects of an adverse supply shift
D
S1
S0
Price Level
A
E
S1
S0
0
Real GDP
D
The Economy on a Roller Coaster
• Reaganomics and its aftermath
• Recovery – underway
• High inflation
• Federal Reserve
• Monetary policy
• Monetary policy
• Actions – Federal Reserve
• Change interest rates
• Influence aggregate demand
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• High interest rate
33
The Economy on a Roller Coaster
• Reaganomics and its aftermath
1981-1982 recession
Large budget deficits
Recovery started 1982-1983
President Bush
•
•
•
•
Inflation
Deficit-reduction package
Spike in oil prices
1990-1991 recession
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•
•
•
•
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The Economy on a Roller Coaster
• Clintonomics: deficit reduction
• Deficit-reduction package, 1993 & 1997
•
•
•
•
Large surplus
Economy boomed
Lower inflation
Aggregate supply curves
• Pushed outward – rapid pace, 1996 – 1998
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• Tax increase & spending cuts
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Figure 5
The effects of a favorable supply shift
D1
S0
D0
S1
Price Level
C
B
E
D1
S0
S1
S2
0
Real GDP
D0
S2
The Economy on a Roller Coaster
• Tax cuts and the Bush economy
• 2001 recession
• First in 10 years
• War on terror
• Aggregate demand – shift outward
• Federal Reserve
• Lowered interest rate
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• Tax cut 2001
• Budget deficit
• Burst of government spending
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Problem of Macroeconomic Stabilization
• Stabilization policy
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• Government programs
• Prevent or shorten recessions
• Counteract inflation, stabilize prices
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Problem of Macroeconomic Stabilization
• Fight unemployment
• Increase aggregate demand
• Government - Fiscal policy
• Increase spending
• Cut taxes
• Lower interest rates
• Increase output
• Reduce unemployment
• Raise prices
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• Federal Reserve - Monetary policy
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Figure 9
Stabilization policy to fight unemployment
D1
S0
D0
Price Level
A
E
D1
D0
Increase in output
S0
0
Real GDP
Problem of Macroeconomic Stabilization
• Fight inflation
• Decrease aggregate demand
• Government - Fiscal policy
• Cut spending
• Increase taxes
• Increase interest rates
• Decrease inflation (decrease prices)
• Decrease output
• Increase unemployment
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• Federal Reserve - Monetary policy
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Figure 10
Stabilization policy to fight inflation
S
D0
D2
Price Level
E
B
Decrease
in prices
S
D2
0
Real GDP
D0
Stabilization policy
• Prewar data
• Fluctuations – unmanaged economy
• Booms & recessions
• “Natural” economic reasons
• Little government intervention
• Economy - managed by government policy
• Successfully or unsuccessfully
• Recessions - less severe
• More inflation-prone
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• Postwar data
43
• Growing prominence of optimization theory and marginal
analysis in microeconomics led to incorporation into
macroeconomic models.
• Optimal models of saving, investment and demand for
liquidity were used to describe a medium term equilibrium
around which the economy would fluctuate in the short-run.
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Neo-classical synthesis
44
• Simple principal of optimization of smooth functions is the
first derivative of function should equal zero at extremum.
• Economists consider the costs C and benefits B of some
activity A. Net benefit of activity is B(A)-C(A).
• Optimal level of A is B’(A*) = C ’(A*) , i.e. where the marginal
benefit equals the marginal cost.
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Marginal Analysis
45
• Long-term: Take prices as flexible and solve for potential level
of output.
• Medium Term: Take output as given and solve for optimal
decisions of agents.
• Short-term: Take dollar prices or wages as given solve for
output.
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Models by “Term”
46
• In 1960’s, monetarists led by Milton Friedman
began to emphasize the role of the money
supply (as opposed to real demand factors) as
determinants of fluctuations in output and
especially inflation.
• In particular, Friedman pointed out the way that
demand stimulus, once it becomes expected
may lose its effectiveness.
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Monetarism
47
Inflation and Deflation in China
CN: Consum er Price Index: PY=100
PY = 100
125
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120
115
110
105
100
95
1985
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1987
1989
1991
1993
1995
1997
1999
2001
2003
• During 1970’s, oil price shocks led to rapid price rises and low
production levels called stagflation.
• In many country’s, inflationary expectations led to wage-price
spirals and historically high inflation rates.
• Developed economies begin 20 year slowdown in productivity
growth rates.
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Stagflation 70’s
49
• In early 1970’s, US abandons Bretton Woods,
and exchange rates start to float. After a few
years of relative stability, exchange rates become
one of the most volatile variables.
• International trade increases.
• Oil price rises damaging to developing countries,
a problem partly solved when OPEC oil revenues
are recycled as loans to 3rd World.
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International Economics
50
Volatile Exchange Rate
JP: FOREX: Inter-Bank: Spot Rate
JPY/USD
320
300
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280
260
240
220
200
180
160
140
120
100
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80
Jun-1976
Jun-1980
Jun-1984
Jun-1988
Jun-1992
Jun-1996
Jun-2000
Jun-2004
• Lucas develops economic theories which
rigorously incorporate the formation of
expectations of future in economic models.
• Rational expectations models offer theoretical
challenges but also explanations for rise of
inflationary spirals and seeming ineffectiveness
of monetary policy.
• Expectations based models also offer
explanation for volatility of exchange rates.
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Rational Expectations
52
• Kydland and Prescott develop real business cycle models
which unify long-run, medium run, and short-run into single
coherent model.
• One shortcoming of these models is that money plays no role
in short-run.
• RBC models are small and do not capture short-run dynamics
well.
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Real Business Cycles
53
• U.S. central bank cuts the money supply to
counter-act inflation. Deep recession in USA and
elsewhere.
• Latin American countries default on their debts
leading to persistent financial crisis.
• Most developing economies begin long period of
stagnation and even shrinking income levels.
• Only East Asia continues to grow. China reforms
agricultural system and India institutes structural
reforms that spark growth.
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Eighties
54
• Using rigorous models of monopoly, a number of
economists develop rigorous models in which
prices are sticky because of adjustment costs.
• Unlike RBC models, these models can explain
why monetary policy has significant effects on
output.
• These models are typically static and cannot
explain dynamics or long-run at all.
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New Keynesian Models
55
• Productivity slowdown generates interest in models which can
explain which policies are likely to lead to fastest or most
welfare enhancing growth levels.
• Two competing schools. “Brains” school emphasizes role of
education and human capital. “Ideas” school emphasizes R &
D and invention of new goods and technologies.
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Endogenous Growth
56
• Globalization: Big expansion in international
trade, international lending and direct
investment.
• Productivity Takeoff: After 20 years of slow
growth, in 1995 productivity growth takes off
again.
• Financial crisis in a number of developing
economies in Latin American and East Asia.
• Rise of Unemployment in Europe, Inequality in
USA, Economic Stagnation in Japan
• Central Banks Choose Monetary Policies meant to
lead to steady inflation: Inflation Targeting.
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1990’s
57
Structural Unemployment in
HK
HK: Unem ploym ent Rate
%
9
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8
7
6
5
4
3
2
Jun-1996
58
Jun-1997
Jun-1998
Jun-1999
Jun-2000
Jun-2001
Jun-2002
Jun-2003
Jun-2004
New Neo-classical Synthesis
• These models explain which type of policies can offset
effects of price-stickiness which might lead to
underemployment without leading to wage-price
spirals.
• Economists also incorporate models of financial
market imperfections into unified framework to
explain financial crises in emerging markets.
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• Economists begin to incorporate New Keynesian
models of price stickiness into unified RBC
framework.
59
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60
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