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1. Why do Macroeconomics?

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Course Learning Objectives

1. To understand the workings of the modern macroeconomy in the short run

2. We will place emphasis on how a government can deal with economic shocks especially those that effect a small open economy

3. We will also emphasize the role of expectations, flexibility & the time frame in macroeconomics

4. I will provided empirical evidence to back up (or refute) the conclusions of the models

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• See Mankiw Chpt 1• Macroeconomics is about understanding the

behaviour of economic aggregates: total (national) output, employment, the general price level, etc

• Macro was invented by John Maynard Keynes• Before Keynes people tried to understand the

economy by doing micro– Micro is about understanding the behaviour of individual entities– From the bottom up

• Keynes pointed out that you could get insight from looking at the economy as a whole

The Point of Macro

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The Point of Macro

• The two are related (or ought to be) but the process of aggregating all the individual markets has the potential to make things very complicated– E.g. USSR

• Macro is basically a series of short cuts that allow us cut through the complication of aggregation

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The Point of Macro

• This is one reason why macro can be controversial– Plenty of room to disagree on the appropriateness of

short cuts in any model• There should not be disagreement because any

Model should be– “As simple as it needs to be – but no simpler”– Empirically validated i.e. it really does explain the

world (the scientific method)• This is relevant to the recent crisis

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Implication for the Course

• We will start with simple models and add to them as we need to understand more phenomena

• I will present empirical justification of each model i.e. show that it works under what circumstances (Learning Objective 4)

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Ideology and Macro

• Macro much more than macro is influenced by ideology• This is even true in the profession• This should not happen if the scientific method is

applied– Although more difficult in economics than natural science– Ambiguity facilities polemics

• See the current crisis• It is important to separate out technical economics

issues from your (and my) political biases• I will point out ideological issues as we go

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The Big Questions

• Three important Questions in Macro: 1. How do we ensure High Employment / Low

Unemployment ?2. How do we generate Price Stability / Low

Inflation?3. How do we Growth the economy?

• Our concern is with the first two (Learning Objectives 1 & 2)– Often referred to as “Stabilization policy”

• The third is more a long-run matter and is left to Macro II

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A Word on Growth• Really Important question• Why and how are some countries richer

than others?– Example of Zambia vs Korea– Ireland vs Everybody pre Celtic Tiger

• A side note: look at the dip in korea around 1997– Asian banking crisis– In the long run even extreme crises look trivial

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05

000

100

001

5000

200

00rg

dpch

1950 1960 1970 1980 1990 2000year

rgdpch rgdpch

Zambia vs Korea

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GDP per Capita

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

1862

1867

1872

1877

1882

1887

1892

1897

1902

1907

1912

1917

1922

1927

1932

1937

1942

1947

1952

1957

1962

1967

1972

1977

1982

1987

1992

1997

2002

Germany

Ireland

United States

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• Fluctuations in economic activity: GDP in Booms and Recessions • Why do they occur? (LO 1) & What do we do about them? (LO2)

0 Time

Real GDP

Actual

Trend

Recession

Boom

Our Focus: Economic Cycles

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Why Care?

• Economic Cycles may seem trivial in comparison to growth so why bother with them?

• Two reasons:1. Recessions may be short run phenomena but can

cause a lot of pain if you are in them2. Misunderstanding cycles could lead to wrong

policies that undermine long term growth

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Cyclical Misery

• Over the cycle unemployment and inflation can cause plenty of human misery– Misery index is the sum of the two

• Aside: later we will look at whether moderate unemployment and inflation are really costly

• As you know from first year– A recession will tend to increase U and lower – A boom will tend to decrease U and raise – There would seem to be a trade-off between U and – While this may be true in the short-run, it may not be so in the long-

run– Investigating the nature of this trade-off an whether we can take

advantage of it is a huge question we will spend a lot of time on it– This is all related to LO 3

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CYCLES AND UNEMPLOYMENT

Unemployment tends to fall in booms and rise in recessions

0 Time

Real GDPActual

Trend

0Time

U %Unemployment Rate (U%)

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CYCLES AND INFLATION

Inflation often falls in recessions and accelerates in booms

0 Time

Real GDPActual

Trend

0Time

+

_

Inflation Rate (%)

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STABILISATION – “NATURAL” GDP, etc.

• If cycle causes problems then we should stabilise the economy to be close to Trend GDP

• Broadly this corresponds to a level of GDP where output and employment are such that inflation is stable.

• The corresponding “natural” rate of Unemployment is a concept we shall meet later.

• It depends on structural features of the labour market: labour mobility, wage flexibility, levels of unemployment benefits, etc.

• The Natural Unemployment rate is not fixed: it can be influenced by policy (and history).

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STABILIZATION: TARGETS AND INSTRUMENTS

• A useful framework is to think in terms of – (a) policy targets or objectives – (b) policy instruments.

• A coherent policy must have at least as many targets as instruments.– Think of dart boards and darts

• Our targets in the short/medium term are – (i) Full-employment GDP (“natural” GDP)– (ii) price stability, or low inflation

• Our instruments are – Fiscal Policy – Monetary Policy

• There will be trade-offs between the targets• There will also be important questions about which policy

one assigns to which target.

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Example: The Current Crisis• Talk of targets and instruments may sound

abstract but is relevant to current situation and not understood by many authorities

• Four targets:1. Control deficits2. Re-capitalise banks3. Provide Liquidity to markets4. Boost employment

• One Instrument allowed: Fiscal policy• Others not allowed: Monetary policy