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Intermediate Macro. Introduction. Current Events. Great Recession Survival of the Euro “Lost Decade” Developing World China India Sub-Saharan Africa. What’s it all about?. National Economy Micro: consumer/firm behavior Macro variables GDP Inflation Unemployment Interest rates

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intermediate macro

Intermediate Macro

Introduction

current events
Current Events
  • Great Recession
  • Survival of the Euro
  • “Lost Decade”
  • Developing World
    • China
    • India
    • Sub-Saharan Africa
what s it all about
What’s it all about?
  • National Economy
  • Micro: consumer/firm behavior
  • Macro variables
    • GDP
    • Inflation
    • Unemployment
    • Interest rates
    • Debt/deficit
    • exchange rates
    • Etc.
goals
Goals
  • Explain movements of and connections between macro variables.
  • Policy
    • What can the gov’t do?
    • What should the gov’t do
macro is hard
Macro is hard
  • General Equilibrium
    • many variables
    • media coverage (yuck)
  • Short run vs. Long Run
    • Ex. new machines eliminate jobs
  • Many approaches to economics
plan of class
Plan of class
  • Short run
    • 1 to 2 years
    • Booms and recessions
  • Medium run
    • Why / how fast does GDP grow
    • equilibrium
  • Long run
    • Decades
    • What makes rich countries rich?
    • Development
our focus
Our focus
  • Domestic economy
  • Short Run – Keynesian story
  • Classical ideas to connect to the long run
macro flow chart
Macro Flow Chart
  • Firms & consumers
  • Income and Consumtion
  • Government
    • Spending
    • Taxes & transfers
  • Savings & Investments
  • Imports and Exports
fiscal policy
Fiscal Policy
  • Government Spending
    • Defense
    • Health, Education & Welfare
  • Tax policy
    • Income tax
    • Capital gains tax etc.
  • Debt/Deficit

President and Congress

monetary policy
Monetary Policy

The Federal Reserve controls

  • Money supply
  • Interest rates (one of them)
  • Affects firm/consumer decisions
gross domestic product
Gross Domestic Product
  • Why do we care so much?
  • GDP per capita across countries is correlated w/
    • Poverty
    • Health
    • Education
  • Crude measure, GDP ignores
    • Quality of life
    • Environmental degradation
    • “Happiness”
  • Growth rate shows change
gdp basic facts
GDP – basic facts
  • Rises
    • Population rises
    • Productivity rises
  • Except when it doesn’t
    • Recessions
    • Causes?
measurement
Measurement

GDP – value of all final goods and services produced over a given time

Intermediate good – used as part of the production of another good

Final good – sold for use by consumer/business/gov’t

Note: all exports count as final goods

Multiple ways to measure GDP

final or intermediate
Final or Intermediate?
  • Goodrich sells a tire to Ford for its new cars.
  • Joe buys a new tire to replace a flat on his used car.
  • Jean sells an extra tire in her garage to Sam.
gdp example
GDP example

Farmer

Revenue corn $150

Costs seed $40

fertilizer $60

wages $25

Profit $25

Supply store

Revenue seed $40

fertilizer $60

Cost (wholesale) $70

Profit $30

GDP?

3 ways to measure gdp
3 ways to measure GDP
  • Final goods
    • add value of all final good
    • $150 in corn
  • Value added
    • Sum value added for all intermediate and final goods
    • $40+$60+$50 = $150
    • $50 is value added by farmer
  • Income
    • Sum all incomes from all production
    • $30+$25+$25+$70
nominal vs real gdp
Nominal vs. Real GDP

Economy produces only corn

Quantity Price

2006 6000 bushels $4

2007 8000 bushels $5

Nominal

GDP(2006) = $24,000

GDP(2007) = $40,000

Growth rate = 66.6%

What’s wrong with this measure?

real gdp
Real GDP
  • Measure of goods
    • adjusted for price changes
    • “in constant dollars”

Using prices from 2006

real GDP(2006) = $24,000

real GDP(2007) = $32,000

Growth rate 33.3%

Note: if prices rise,

real GDP < nominal GDP

gdp deflator
GDP deflator

Deflator =

nominal GDP/real GDP

Change in the deflator is a measure of inflation

Deflator (2006) = 1

Deflator(2007) = 1.25

Inflation – 25%

Obvious with one good…..

problem
Problem

An island country in the Indian Ocean produces zebu steaks and canoes. They produced the following quantities at the following prices in the last two years.

2005 2006

Quantity PriceQuantity Price

Steaks 800 $20 1000 $30

Canoes 600 $40 600 $50

Find the growth rates for nominal and real GDP, using 2005 prices as the base.

Find the rate of inflation.

cpi and inflation
CPI and inflation
  • Inflation also measured as an average of prices
    • Gov’t surveys
    • Weighted according to “typical” household expenditure
inflation
Inflation
  • Why do we care?
  • Wages rise with inflation
    • Incomes not eroded
    • Exceptions
      • Pensions
      • Alimony
      • Disability
  • Distorts relative prices
    • Some prices adjusted faster
  • Uncertainty
    • High inflation come with volatility
    • Investment/consumption decisions are more difficult
unemployment
Unemployment

Unemployed + employed = Labor force

Unemployed – looking for a job

Unemployment rate

U = unemployed/labor force

High unemployment:

  • Unused resources
  • Skills erode

Not measured

Discouraged workers / underemployed

real vs nominal gdp
Real vs. Nominal GDP
  • Real GDP
    • Changes in price don’t affect it.
    • Measured in prices from a single year.

GDP Deflator =

Nominal GDP

Real GDP

- measures the effect of prices

build a model
Build a Model
  • How do elements on the flow chart fit?
  • How do changes affect GDP?
  • How do policy changes affect the economy?

Start with Demand

- goods sector

- financial sector

demand
Demand

Z – aggregate demand

Z = C + I + G + X – IM

Equilibrium condition: Z=Y

Assume: X = IM (no trade imbalance)

Z = C + I + G; Z=Y

Does Y affect C, I, G?

consumption function
Consumption Function
  • C increasing in Y
  • Slope less than 1
    • Some income saved
  • Autonomous consumption

Algebraically,

C = c0 + c1YD

c0>0 – autonomous consumption

0<c1<1 –marginal propensity to consume (MPC)

solving
Solving

Assume (for now) I and G are fixed

Y = c0 + c1YD + I + G

Or

Y = c0 + c1(Y–T) + I + G

With Y=Z

Y* = (1/(1-c1))(c0 - c1T + I + G)

example
Example

c0 = 100; c1=0.75

I = $250; G = $200; T = $200

(balanced budget, for now)

Y* = (1/0.25)400 = 1600

What if G rises by $50?

Y* = $1800

DY > DG Why? (Keynesian cross)

multiplier
Multiplier
  • Increase in G, Yh, Ch, Yh etc……
  • Why doesn’t Y explode?
    • Some saved every step

Multiplier = 1/(1-c1)

measures the extra impact on Y of a change in autonomous spending.

money supply and demand
Money Supply and Demand

Liquidity Preference

2 assets: Money and Bonds

W = M + B

Hold bonds: better return

Hold money: for transactions (liquidity)

Demand for Money vs. interest rate ?

Higher i greater demand for bonds

lower demand for money

money s d
Money S&D
  • Demand for money slopes down
  • Supply of Money is vertical
    • Decision of the Fed
    • Doesn’t respond to i
    • Fed can shift S to change equilibrium i

What shifts Demand?

  • Nominal GDP
    • Real GDP or prices
bonds
Bonds

Discount bonds pays $100 in one year.

price? i - yield

ex. P = $80

80(1+i) = 100 so i = 25%

P = 100/(1+ i)

If P rises, i falls

equilibrium
Equilibrium

What if i > i* ?

excess money

buy bonds

P i

i falls to equilibrium.

questions
Questions
  • How would an increase in prices affect equilibrium interest rates?
  • What would the Fed do to lower equilibrium interest rates?
lm curve
LM curve

For a given MS, how are Y and i related?

If Y rises, MD shifts out, i* rises

If Y falls…….

In the financial market, Y and i are directly related

LM relation

goods market
Goods market

How does a change in the interest rate affect aggregate expenditure?

Not G – decision of gov’t

Not C – income and substitution effects

Investment is affected by i

deriving is
Deriving IS
  • i rises, I falls, expenditure function shifts down
  • Equilib. GDP (Y) falls

Goods market: i and Y are inversely related

IS relation

Note: IS for Investment – Savings relation

For a given Y, i adjusts so that S=I.

Shifts in IS?

is lm
IS - LM

Together, they determine equilibrium

Y* and i*

Combines goods and financial markets

Can discuss fiscal and monetary policy.

shifts in is
Shifts in IS
  • Consumer confidence
    • Preferences
    • Future employment
  • Business confidence
    • Profit opportunities
    • Changes in technology
  • Fiscal policy
shifts in lm
Shifts in LM
  • Change in prices
  • Monetary Policy
fiscal policy1
Fiscal Policy

Increase in G

Expenditure shifts up

IS shifts right

Y* and i* rise

MD shifts right

Does LM shift?

No, MD shifts due to a change in Y

- movement along LM

monetary policy1
Monetary Policy

Fed increases MS

LM shifts right

Y* rises and i* falls

Expenditure function shifts up

Does IS shift?

No, Exp shifts due to a change in i

movement along IS

problem1
Problem

A tax cut changes consumption. Show how a tax cut would affect the IS-LM, expenditure and MS – MD diagrams.

fiscal vs monetary policy
Fiscal vs. Monetary Policy

Monetary Policy

  • Advantages
    • Quick decisions/implementation
    • Fine tune
  • Disadvantages
    • Takes time to have an effect
    • undirected

Fiscal Policy

  • Advantages
    • Immediate impact
    • Directed spending
  • Disadvantages
    • Takes time to decide (politics)
    • Changes tend to last
real money s d
Real Money S&D
  • Equilib i determined by real money S&D
  • Graph looks the same
  • Change in P
    • Shifts supply of real money
    • Shifts demand for nominal money
    • P rises, i rises in both cases

Note: Fed controls interest rates in the short term.

Long run: prices changes affect i*

is lm1
IS - LM

C = 100 + 0.75YD

I = 100 – 1000i

G = 200

T = 200

(M/P)d = 3Y – 18,000i

(M/P)s = 1500

Find the IS and LM relations.

Find equilibrium Y* and i*.

impulse response
Impulse response

Decrease in Fed funds

Takes 4-8 quarters to have an effect

practice problem
Practice Problem

An island country in the Indian Ocean produces zebu steaks and canoes. They produced the following quantities at the following prices in the last two years.

2005 2006

Quantity PriceQuantity Price

Steaks 800 $20 1000 $30

Canoes 600 $40 600 $50

Find the growth rates for nominal and real GDP, using 2005 prices as the base.

Find the rate of inflation.

practice problem1
Practice Problem

c0 = 100; c1=0.8

I = $150; G = $200; T = $200

Using the above, find equilibrium output/income.

If autonomous consumption falls by $50, find the new level of equilibrium output.

What is the multiplier?

What is savings before and after the change in C?

practice problem2
Practice Problem

Let the consumption function be

C = 100 + 0.9YD

If autonomous consumption falls by $15, how does equilibrium output change?

Show the changes on a Keynesian cross diagram.

practice problem3
Practice Problem

C = 100 + 0.75YD

I = 100 – 1000i

G = 200

T = 200

(M/P)D = 3Y – 10,000i

M/P = 1500

Find IS

Find LM

Find equilibrium i and Y

practice problem4
Practice Problem

When Clinton took office in 1992, he raised taxes, and the Fed agreed to increase the money supply as long as government spending stayed constant.

Show the changes on an IS-LM diagram. What happens to equilibrium output and the interest rate? When would equilibrium output rise?

problem2
Problem

Show the impact of a decrease in the price level on a graph of real money supply and demand and an IS-LM graph. What is the relationship between output/income and the price level?

review problem
Review Problem

Given the following information find the equilibrium level of output Y*. If government spending and taxes both fall by $50, how does Y* change? Show on a graph of the expenditure function with the equilibrium condition.

Autonomous consumption = $300

MPC = 0.9

Investment = $100

Taxes = $150

Government spending = $150

What is savings both before and after the change in spending?

review problem1
Review Problem

The recent recession has seen a large drop in business confidence affecting autonomous investment. The Federal Reserve has responded by increasing by increasing the money supply. Show the effect on the equilibrium on an IS-LM graph, and show the initial effects on an expenditure graph and a money S&D graph.

u s labor market
U.S. Labor Market
  • Large movements in and out of labor force and employed
    • Hires
    • Quits
    • Layoffs
    • Discouraged workers
  • Continental Europe - slower change
    • Stronger unions
    • More firing restrictions
    • Higher wages and more unemployment
wage determination
Wage determination

Firms seem to pay higher than “competitive” wages.

Why are wages higher than necessary?

  • Efficiency wages
    • Get more effort
    • Reduce turnover
  • Bargaining power
    • Worker skills
    • Depends on other options
    • unions
firm decision
Firm decision

Competitive labor market

W = MRP

if W < MRP then

firm hires more (more profit)

MRP = P x MPL

so

marginal product = real wage (W/P)

simple version
Simple version

Production function: Y=L

Implies MPL = 1

real wage W/P = 1

P = W

“price equals marginal cost”

Too simple???

- firms have “pricing power”

- workers have bargaining power

wage determination formally
Wage determination - formally

Nominal wages negotiated according to expected prices Pe

W = PeF(u,z)

F(u,z) “bargaining power”

u – unemployment rate

z – other factors

ex. labor laws

worker skill

price determination
Price determination

Output prices also tend to be higher than wages.

  • Other costs
  • Firms have market power

- monopolistic competition

- monopoly

- oligopoly

P = W(1 + m) “markup”

or

W/P = 1/(1 + m)

natural rate of unemployment
Natural rate of unemployment

If price = expectations, combine equations

F(u,z) = 1/(1 + m)

relates the wage and price markups

Determines un – natural rate of unemployment

Medium run concept

graph
Graph
  • Price & wage determination
  • unemployment vs. real wage
  • Price setting equation constant according to markup
  • Wage setting, higher u means lower real wage (bargaining)

Compare U.S. and France

  • more firing restrictions
  • More benefits required by law
  • WS curve to the right
  • higher un
natural rate
Natural rate
  • Medium run concept
  • 0% cyclical unemployment
  • Associated with
    • natural rate of employment
    • Natural rate of output
    • NAIRU
  • Natural rate can change over time with
    • labor laws
    • unemployment benefits
    • tax policy?
problem3
Problem
  • Unions give workers extra bargaining power, but have declined in membership over the last 25 year in the U.S. Use the wage / price determination graph to show the effect on real wages and the natural rate of unemployment.
problem4
Problem
  • Online retailing has increased competition for goods, lowering the markup firms can charge. Show how this affects the labor market and the natural rate of unemployment.
review problem2
Review Problem

A proposed law in France would make it easier for firms to fire people. Show the effect on the natural rate of unemployment on the wage/price setting graph.