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All rights reserved by www.gyanbigyan.com 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 All rights reserved by www.gyanbigyan.com 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 All rights reserved by www.gyanbigyan.com Macroeconomics & Microeconomics 3 • Macroeconomics • Assume most details • Resource allocation & income distribution • Relatively unimportant • Microeconomics • Ignore macroeconomics issues • Focus – individual markets • Allocate resources • Distribute income All rights reserved by www.gyanbigyan.com Macroeconomics & Microeconomics 4 What is Macroeconomics All rights reserved by www.gyanbigyan.com • Macroeconomics examines economies at the aggregate (international, national, regional) level. • Some aspects of macroeconomics are about comparing two aggregate economies at the same time. 5 • 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. All rights reserved by www.gyanbigyan.com Why study the economy at the aggregate level? 6 Amateur History of Macroeconomics/Macroeconomic History All rights reserved by www.gyanbigyan.com • 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. 7 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 All rights reserved by www.gyanbigyan.com • Aggregate supply curve 8 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 All rights reserved by www.gyanbigyan.com • Recession – period of time 10 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 All rights reserved by www.gyanbigyan.com • Inflation • Recession & unemployment • Economic growth 12 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 All rights reserved by www.gyanbigyan.com 700 600 500 400 300 200 100 0 1929 1930 1931 1932 1933 1934 1935 Billiions US$ 1936 1937 1938 1939 14 • 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. All rights reserved by www.gyanbigyan.com Macro theory 15 Much of Macroeconomics is about comparing one economy at different points in time. All rights reserved by www.gyanbigyan.com • 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. 16 Gross Domestic Product • Gross domestic product (GDP) • Sum: money values • All final goods & services • Produced - domestic economy • Sold – organized markets • Usually a year All rights reserved by www.gyanbigyan.com • 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 All rights reserved by www.gyanbigyan.com • Common prices 18 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 All rights reserved by www.gyanbigyan.com • Produced within the year 19 Gross Domestic Product • Final goods and services • Purchased by their ultimate users • Intermediate good - purchased All rights reserved by www.gyanbigyan.com • For resale • For use in producing another good 20 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 All rights reserved by www.gyanbigyan.com • • • • • 21 Japan Post-war GDP 600000 All rights reserved by www.gyanbigyan.com 500000 400000 300000 200000 100000 0 55 60 65 70 75 80 85 90 95 00 JAPAN_GDP 22 Trend and Cycle (Hodrick-Prescott Detrending) 600000 500000 300000 20000 200000 10000 100000 0 0 -10000 All rights reserved by www.gyanbigyan.com 400000 -20000 55 60 65 70 75 JAPAN_GDP 80 85 Trend 90 95 00 Cycle 23 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% All rights reserved by www.gyanbigyan.com • • • • 24 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 All rights reserved by www.gyanbigyan.com • Ended: early 1940s 25 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 All rights reserved by www.gyanbigyan.com • • • • 26 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. All rights reserved by www.gyanbigyan.com • During the 1950’s, macro conceptually split changes in output into two parts: 27 • 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. All rights reserved by www.gyanbigyan.com Golden Era of Growth 28 The Economy on a Roller Coaster • Fiscal policy • Government spending & taxation • Used to steer aggregate demand • Inflation • While economy • Growing slowly (“stagnating”) • Or recession All rights reserved by www.gyanbigyan.com • Stagflation 29 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 All rights reserved by www.gyanbigyan.com • Inflation rate: 12% • High unemployment 30 The Economy on a Roller Coaster • The Great Stagflation, 1973-1980 • Economy recovered • Government actions • Natural economic forces • Stagflation • Inflation: 16% All rights reserved by www.gyanbigyan.com • 1979 – OPEC soaring oil prices 31 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 All rights reserved by www.gyanbigyan.com • 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 All rights reserved by www.gyanbigyan.com • • • • 34 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 All rights reserved by www.gyanbigyan.com • Tax increase & spending cuts 35 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 All rights reserved by www.gyanbigyan.com • Tax cut 2001 • Budget deficit • Burst of government spending 37 Problem of Macroeconomic Stabilization • Stabilization policy All rights reserved by www.gyanbigyan.com • Government programs • Prevent or shorten recessions • Counteract inflation, stabilize prices 38 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 All rights reserved by www.gyanbigyan.com • Federal Reserve - Monetary policy 39 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 All rights reserved by www.gyanbigyan.com • Federal Reserve - Monetary policy 41 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 All rights reserved by www.gyanbigyan.com • 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com Monetarism 47 Inflation and Deflation in China CN: Consum er Price Index: PY=100 PY = 100 125 All rights reserved by www.gyanbigyan.com 120 115 110 105 100 95 1985 48 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com International Economics 50 Volatile Exchange Rate JP: FOREX: Inter-Bank: Spot Rate JPY/USD 320 300 All rights reserved by www.gyanbigyan.com 280 260 240 220 200 180 160 140 120 100 51 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com 1990’s 57 Structural Unemployment in HK HK: Unem ploym ent Rate % 9 All rights reserved by www.gyanbigyan.com 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. All rights reserved by www.gyanbigyan.com • Economists begin to incorporate New Keynesian models of price stickiness into unified RBC framework. 59 THANK YOU 60 All rights reserved by www.gyanbigyan.com