MACROECONOMICS

CHAPTER 1: Introducti on and Measurement Issues

Micro-economic vs Macroeconomic

Macroeconomics is distinct from micro in that it deals with the overall effects on economies of the
choices that all economic agents make, rather than the choices of individual consumers or firms.

Economic models: built up from micro-economic principles.

What continues to make macroeconomic distinct, is the issues it focuses on, particularly the long-
run growth and business cycle.

→ Long-run growth: refers to the increase in a nation’s productive capacity and the average
standard of living that occurs over the long period of time.
→ Business cycle: the short-turn ups and downs, or booms and recessions, in aggregate economic
activity.

Gross Domestic Product, Economic Growth and Business Cycles

→ Gross domestic product (GDP):

Is the quantity of goods and services produced within a country’s boarders during some
specified period of time, GDP also represent the quantity of income earned by those
contributing to domestic output.

Trends and business cycles

Fluctuation within an economy is called business cycles, therefore the time series of the GDP can be
separated into trends and business cycle components. The of a GDP graph is a good approximation
to the growth rate of real per capital GDP. Identifying business cycles in graphs, is the deviation from
the actual graph to the trend line.

Macroeconomic Models

All economic models are abstractions. The purpose of an economic model is to capture the essential
features of the world needed for analysing a particular economic problem.

Basic structure of a Macroeconomic Model:

1. The consumers and firms that interact in the economy

2. The set of goods that consumers wish to consume
3. Consumers’ preferences over goods
4. The technology available to firms for producing goods
5. The resources available

 Competitive equilibrium we assume that goods are bought and sold on markets which consumers
and firms are price-takers; they behave if their actions have no effect on market prices.

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Microeconomic Principles

The rational expectations revolution in the 1970’s, which introduced more microeconomics into
macro-economic. The Lucas Critique argument states that macro-economic policy analysis can be
done in a sensible way if microeconomics behaviour is taken seriously.

Disagreement in Marco-economics

What Do We Learn from Macroeconomic Analysis?

1. What is produced and consumed in the economy is determined jointly by the economy’s
productive capacity and the preferences of consumers
We do this through a one-period-model
2. In free market economies, strong forces tend to produce socially efficient economic outcomes.
3. Unemployment is painful for individuals, but it is a necessary evil in modern economies.
4. Improvements in a country’s standard of living are brought about in the long run by
technological progress.
5. A tax cut is not a free lunch.
6. Credit markets, banks play key roles in the macroeconomy.
7. What consumers and firms anticipate for the future has an important bearing on current
macroeconomic events.
8. Money takes many forms, and society is much better off with it than without it. Once we have it,
however, changing its quantity ultimately does not matter.
9. Business cycles are similar, but they can have many causes.
10. Countries gain from trading goods and assets with each other, but trade is also a source of
shocks to the domestic economy.
11. In the long run, inflation is caused by growth in the money supply.
12. If there is a short-run tradeoff between output and inflation, that has very different implications
relative to the relationship between nominal interest rates and inflation.

Understanding Recent and Current Macro-economic Events

AGGREGATE PRODUCTIVITY

A measure of productivity in the aggregate economy is average labour productivity,

Y
N
Where Y denotes the aggregate output and N denotes employment. Productivity proves to be
important, both in explaining business cycles, and in explaining long run growth in standards of living

UNEMPLOYMENT AND VACANCIES

The unemployment rate is measured as the number of people actively searching for work, as a
percentage of the labor force. In general, the unemployment rate will be affected by productivity,
the generosity of government-provided unemployment insurance and matching efficiency.

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Figure 1.7: The Beveridge curve is a
negative relationship between the vacancy
rate – job postings by firms divided by total
employment plus vacancies – and the
unemployment rate. Basically, the number
of vacancies relative to unemployment is a
measure of labor market tightness, and
tightness tends to increase in economic
booms and decrease in recessions. But the
Beveridge curve has shifted out since the
beginning of the 2008-2009 recession. This
is sometimes ascribed to long-run changes
in the labor market – an increase in the
mismatch between the skills needed by
firms, and the skills unemployed workers
possess.

TAXES, GOVERNMENT SPENDING AND THE GOVERNMENT DEFECIT

Figure 1.8: The chart shows the two sides of the government’s budget – total spending and total
taxes, as percentages of GDP. This is total
government spending and taxes, including
federal, state, and local governments. Note
the increases in spending and declines in
taxes that occur during recessions,
particularly the 2008-2009 recession.

Increased government activity in general

causes a crowding out of private economic
activity. The government can spend more
than it earns by borrowing and
accumulating debt, and it can earn more
than it spends and save the difference, thus
reducing its debt.

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Figure 1.9: The chart shows the total
government surplus – the difference
between spending and taxes in Figure 1.9,
expressed as a percentage of GDP. Note
the large decline in the surplus in the
2008-2009 recession. In the whole post-
World War II period, the government
deficit (minus the government surplus)
was at its highest point during the last
recession. This was in part due to the large
drop in GDP, but also due to the drop-in
tax revenue and the 2009 federal
government stimulus program.

What are the consequences of

government deficits?

When the government debt by borrowing from a citizen, then this is a debt that a nation owes to
ourselves. Then government deficit depends on what the source of the deficit is. If deficit is a result
of decrease in taxes, then the debt will have to be paid off ultimately by higher future taxes.
(Ricardian equivalence theorem: where government deficit doesn’t matter under some conditions)

In the case of government deficit resulting from higher government spending – crowding out of
private economic activity.

INFLATION

Is the rate of change in the average level of prices (price level).

Interest rates

Interest rates are important, as they affect the decisions of consumers as to how much they borrow
and lend, and the decisions of firms concerning how much to invest in new plant and equipment.

Movements in interest rates are an important element in the economic mechanism by which
monetary policy effects real magnitudes in the short run.

Figure 1.11: Over the long run, the Fisher

effect comes into play. The Fisher effect is
a positive relationship between the
nominal interest rate and the inflation
rate. This effect can be readily discerned in
the chart, which shows the nominal
interest rate and inflation rising through
the 1970s and then falling. Recently, the
nominal interest rate has been close to
zero for a considerable time, and inflation
has been low.

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The real interest rate is the normal interest rate minus the expected rate of inflation. The real
interest tar is the rate that a narrower expects to have to repay, adjusting for inflation that is
expected to occur over the period of time until the borrower’s debt is repaid.

Figure 1.12: The chart shows a measure of the real interest rate – the difference between the
nominal interest rate and observed inflation over a 12-month period. The real interest rate has been
quite variable and has been persistently
high and persistently low. A key
observation in the chart, which holds for
many countries in the world, is that the
real rate of interest has declined
substantially since about 1980. The low
real interest rate can create a problem for
monetary policy.

BUSINESS CYCLES IN THE UNITED STATES

Individual business cycles may have many

causes and the causes important in one
business cycle event may be very
unimportant in other. Business cycles
defined to be deviations from trend in
aggregate economic activity.

FIGURE 1.13: PERCENTAGE DEVIATION

FROM TREND IN REAL GDP

In this chart, we show quarterly real GDP,

after taking out the Hodrick-Prescott trend.
This allows us to pick out booms and
recessions.

− The chart shows the last five major

recessions, which correspond closely
to the dating provided by the National
Bureau of Economic Research, which
uses a different approach to determine
what is a major business cycle event.
− As can be seen in the chart, the 2008-
2009 recession was relatively severe,
but not as severe as the 1981-1982 recession.
− Different recessions can have different causes, and we want to look at different business cycle
models to help us understand these alternative contributing factors.

CREDIT MARKETS AND THE FINANCIAL CRISIS

A critical aspect of economic theory in understanding “frictions” or “imperfections” act to amplify

shocks to the economy

Two imperfections:

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1. Asymmetric information refers to a situation where the economic actors on one side of a market
have more information than the economic actors on the other side of the market.
2. Limited commitment refers to a borrower’s lack of incentive to repay in the credit market

FIGURE 1.14: INTEREST RATE SPREAD

− The financial crisis which coincided with

the 2008-2009 recession caused
macroeconomists to focus more on
financial factors as a cause of business
cycles.
− Financial market friction can be
reflected in interest rate spreads – the
difference between interest rates on
risky assets and safe assets.
− During a time of financial stress, such
spreads increase, as can be seen in the
chart.
− The largest spread observed was during
the Great Depression.
− The second largest was during the Great Recession – what the 2008-2009 recession is often
called.

THE CURRENT ACCOUNT SURPLUS

One measure of the balance of trade is the current account surplus, which is net exports of goods
and service plus net factor payments. When the current account is negative, there is a current
account deficit.

Important influences on the current account surplus is government spending and increase in
domestic income.

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FIGURE 1.17: THE CURRENT ACCOUNT
SURPLUS

When a country runs a negative current

account surplus -importing more than it is
exporting and pays for these net imports by
borrowing from the rest of the world.

− Since 1990, the current account surplus

in the United States has been negative,
so the U.S. has been accumulating
debts to the rest of the world.
− Not always a bad thing - as a current
account deficit (the deficit is the
negative of the surplus) allows a
country to smooth its consumption relative to its income (much like an individual) and can
permit investment in plant and equipment that can be used to produce more in the future.