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
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 • Debt/deficit • exchange rates • Etc.
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 • General Equilibrium • many variables • media coverage (yuck) • Short run vs. Long Run • Ex. new machines eliminate jobs • Many approaches to economics
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 • Domestic economy • Short Run – Keynesian story • Classical ideas to connect to the long run
Macro Flow Chart • Firms & consumers • Income and Consumtion • Government • Spending • Taxes & transfers • Savings & Investments • Imports and Exports
Fiscal Policy • Government Spending • Defense • Health, Education & Welfare • Tax policy • Income tax • Capital gains tax etc. • Debt/Deficit President and Congress
Monetary Policy The Federal Reserve controls • Money supply • Interest rates (one of them) • Affects firm/consumer decisions
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 • Rises • Population rises • Productivity rises • Except when it doesn’t • Recessions • Causes?
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? • 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 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 • 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 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 • 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 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 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 • Inflation also measured as an average of prices • Gov’t surveys • Weighted according to “typical” household expenditure
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 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 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 • 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 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 • 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 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 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 • 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 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 • 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 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 What if i > i* ? excess money buy bonds P i i falls to equilibrium.
Questions • How would an increase in prices affect equilibrium interest rates? • What would the Fed do to lower equilibrium interest rates?
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 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 • 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 Together, they determine equilibrium Y* and i* Combines goods and financial markets Can discuss fiscal and monetary policy.
Shifts in IS • Consumer confidence • Preferences • Future employment • Business confidence • Profit opportunities • Changes in technology • Fiscal policy
Shifts in LM • Change in prices • Monetary Policy
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 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
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 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 • 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*