intermediate macro
DESCRIPTION
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 - PowerPoint PPT PresentationTRANSCRIPT
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
FarmerRevenue corn $150Costs seed $40
fertilizer $60wages $25
Profit $25
Supply storeRevenue seed $40
fertilizer $60Cost (wholesale) $70Profit $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 cornQuantity Price
2006 6000 bushels $42007 8000 bushels $5
NominalGDP(2006) = $24,000GDP(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 2006real GDP(2006) = $24,000real 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) = 1Deflator(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 2006Quantity Price Quantity
PriceSteaks 800 $20 1000
$30Canoes 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 rateU = unemployed/labor force
High unemployment:– Unused resources– Skills erode
Not measuredDiscouraged 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 GDPReal GDP
- measures the effect of prices
Model of Demand
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 – IMEquilibrium 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 consumption0<c1<1 –marginal propensity to
consume (MPC)
Solving
Assume (for now) I and G are fixed
Y = c0 + c1YD + I + GOrY = c0 + c1(Y–T) + I + GWith Y=Z
Y* = (1/(1-c1))(c0 - c1T + I + G)
Example
c0 = 100; c1=0.75I = $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 Preference2 assets: Money and Bonds
W = M + BHold bonds: better returnHold money: for transactions
(liquidity)
Demand for Money vs. interest rate ?
Higher i greater demand for bondslower 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 = $8080(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’tNot C – income and substitution
effectsInvestment 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 imovement 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*
IS - LM
C = 100 + 0.75YD
I = 100 – 1000iG = 200T = 200(M/P)d = 3Y – 18,000i(M/P)s = 1500
Find the IS and LM relations.Find equilibrium Y* and i*.
Impulse response
Decrease in Fed funds
Takes 4-8 quarters to have an effect
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 2006Quantity Price Quantity
PriceSteaks 800 $20 1000
$30Canoes 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 Problem
c0 = 100; c1=0.8I = $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 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 Problem
C = 100 + 0.75YD
I = 100 – 1000iG = 200T = 200(M/P)D = 3Y – 10,000iM/P = 1500
Find ISFind LMFind equilibrium i and Y
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?
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
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 = $300MPC = 0.9Investment = $100Taxes = $150Government spending = $150What is savings both before and after the change in spending?
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.
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
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
Competitive labor marketW = MRP
if W < MRP then firm hires more (more
profit)
MRP = P x MPL so
marginal product = real wage (W/P)
Simple version
Production function: Y=L
Implies MPL = 1
real wage W/P = 1P = W
“price equals marginal cost”
Too simple???- firms have “pricing power”- workers have bargaining power
Wage determination - formally
Nominal wages negotiated according to expected prices Pe
W = PeF(u,z)
F(u,z) “bargaining power”u – unemployment ratez – other factors
ex. labor lawsworker skill
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
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
• 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
• 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?
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.
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 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.