1. Introduction to Macroeconomics Macroeconomic Analysis All rights reserved by www.gyanbigyan.com 1

2. Macroeconomics & Microeconomics Microeconomics Decisions of individual units No matter how large Macroeconomics Behavior of entire economies No matter how small Economic aggregates All rights reserved by www.gyanbigyan.com 2

3. Macroeconomics & Microeconomics Aggregation Combine many individual markets Into one overall market Composition of demand & supply In various markets Important for microeconomics issues Not important for macroeconomics issues During economic fluctuations Markets – move up or down together All rights reserved by www.gyanbigyan.com 3

4. Macroeconomics & Microeconomics Macroeconomics Assume most details Resource allocation & income distribution Relatively unimportant Microeconomics Ignore macroeconomics issues Focus – individual markets Allocate resources Distribute income All rights reserved by www.gyanbigyan.com 4

5. What is Macroeconomics Macroeconomics examines economies at the aggregate (international, national, regional) level. Some aspects of macroeconomics are about comparing two aggregate economies at the same time. All rights reserved by www.gyanbigyan.com 5

6. Why study the economy at the aggregate level? Much of macroeconomics is concerned with policies such as money supply or tax policy which is national in scope. Equilibrium effects means that outcomes are different when we consider the economy in aggregate. There are certain phenomenon like economic growth and business cycles which affect the aggregate economy equally. We can consider interesting dynamic questions. All rights reserved by www.gyanbigyan.com 6

7. Amateur History of Macroeconomics/Macroeconomic History Around 1930, a major worldwide contraction occurred in virtually every developed economy. For example, output in the USA fell by more than 20% and unemployment rose to 25%. Decline in output continued for the better part of a decade. All rights reserved by www.gyanbigyan.com 7

8. Supply & Demand in Macroeconomics Aggregate demand curve Quantity of domestic product – demanded Each possible value of price level Aggregate supply curve Quantity of domestic product – supplied Each possible value of price level All rights reserved by www.gyanbigyan.com 8

9. Two interpretations of a shift in the demand curve Figure 1 0 Quantity Price (a) D D 0 Quantity Price (b) Q0Q0 S S P0P0 E D0D0 D0D0 S S P0P0 D1D1 D1D1 P1P1 E A

10. Supply & Demand in Macroeconomics Inflation Sustained increase in price level Outward shift of aggregate demand curve Recession – period of time Total output – declines Production falls People lose jobs Leftward shift of aggregate demand curve All rights reserved by www.gyanbigyan.com 10

11. An economy slipping into a recession Figure 2 0 Domestic Product Price Level D0D0 D0D0 Q0Q0 S S P0P0 D2D2 D2D2 P2P2 Q2Q2 E B

12. Supply & Demand in Macroeconomics Macroeconomists study Inflation Recession & unemployment Economic growth All rights reserved by www.gyanbigyan.com 12

13. Economic growth Figure 3 0 Domestic Product Price Level D0D0 D0D0 Q0Q0 S0S0 S0S0 D1D1 D1D1 Q1Q1 E S1S1 S1S1 C

14. US Great Depression All rights reserved by www.gyanbigyan.com 14

15. Macro theory UK economist Lord Keynes developed a theory in which prices failed to adjust quickly so that a fall in corporate investment or a rise in savings leads to a decline in output. Hicks developed IS-LM model, a mathematical version of Keynes thinking which is still the baseline framework for thinking about business cycles. For 20-30 years, most macro was about measuring the gap between demand and potential output and stimulating demand sufficiently to reach potential. All rights reserved by www.gyanbigyan.com 15

16. Much of Macroeconomics is about comparing one economy at different points in time. Two phenomenon can be observed in single data series. First, economy is growing with a secular trend over time. Second, economy is growing unevenly across time. All rights reserved by www.gyanbigyan.com 16

17. Gross Domestic Product Gross domestic product (GDP) Sum: money values All final goods & services Produced - domestic economy Sold – organized markets Specified period of time Usually a year All rights reserved by www.gyanbigyan.com 17

18. Gross Domestic Product Nominal GDP GDP in current dollars Value outputs – current prices Real GDP Value outputs of different years Common prices All rights reserved by www.gyanbigyan.com 18

19. Gross Domestic Product GDP - particular year Add up money value of things Goods & services Produced within the year Final goods & services Production: geographic boundaries of U.S. Organized markets All rights reserved by www.gyanbigyan.com 19

20. Gross Domestic Product Final goods and services Purchased by their ultimate users Intermediate good - purchased For resale For use in producing another good All rights reserved by www.gyanbigyan.com 20

21. Gross Domestic Product Limitations of GDP Not measure: nation’s economic well-being Includes only market activity Places no value on leisure Counted: “Bads” and “Goods” Ecological costs Not deducted from GDP All rights reserved by www.gyanbigyan.com 21

22. Japan Post-war GDP All rights reserved by www.gyanbigyan.com 22

23. Trend and Cycle (Hodrick-Prescott Detrending) All rights reserved by www.gyanbigyan.com 23

24. The Economy on a Roller Coaster The Great Depression, 1929-1933 Decline in economic activity Rapid deflation Production – declined 30% Unemployment rate Increased from 3% to 25% All rights reserved by www.gyanbigyan.com 24

25. The Economy on a Roller Coaster The Great Depression, 1929-1933 Revolution in economic thought Before: economy corrects itself After: decrease in aggregate demand Monetary & fiscal policy Ended: early 1940s All rights reserved by www.gyanbigyan.com 25

26. The Economy on a Roller Coaster From WWII to 1973 Increased government spending Increased aggregate demand Accidental fiscal policy Price controls Shortage: consumer goods 1960s – strong growth Vietnam war – increased spending Inflation & high unemployment Wage & price controls All rights reserved by www.gyanbigyan.com 26

27. Macro Progresses During the 1950’s, macro conceptually split changes in output into two parts: Long-term growth which would be studied in models in which prices adjust perfectly to economic conditions. Business Cycles which would be studied in models in which they would not. Advances in computation and statistics meant that large models could be constructed meant to represent large economies. All rights reserved by www.gyanbigyan.com 27

28. Golden Era of Growth Internationally, 1950’s and 1960’s were a period when output growth was at a faster pace than before the war. Also a period in which there was relatively little international trade in goods and capital compared to pre-WWI period. Fixed exchange rates under Bretton Woods agreement. All rights reserved by www.gyanbigyan.com 28

29. The Economy on a Roller Coaster Fiscal policy Government spending & taxation Used to steer aggregate demand Stagflation Inflation While economy Growing slowly (“stagnating”) Or recession All rights reserved by www.gyanbigyan.com 29

30. The Economy on a Roller Coaster The Great Stagflation, 1973-1980 OPEC – 1973 oil prices quadrupled Poor harvests Recession Inflation rate: 12% High unemployment Stagflation Inward shift of aggregate supply All rights reserved by www.gyanbigyan.com 30

31. The Economy on a Roller Coaster The Great Stagflation, 1973-1980 Economy recovered Government actions Natural economic forces 1979 – OPEC soaring oil prices Stagflation Inflation: 16% All rights reserved by www.gyanbigyan.com 31

32. The effects of an adverse supply shift Figure 4 0 Real GDP Price Level D D S0S0 S0S0 E S1S1 S1S1 A

33. The Economy on a Roller Coaster Reaganomics and its aftermath Recovery – underway High inflation Federal Reserve Monetary policy High interest rate Monetary policy Actions – Federal Reserve Change interest rates Influence aggregate demand All rights reserved by www.gyanbigyan.com 33

34. The Economy on a Roller Coaster Reaganomics and its aftermath 1981-1982 recession Large budget deficits Recovery started 1982-1983 President Bush Inflation Deficit-reduction package Spike in oil prices 1990-1991 recession All rights reserved by www.gyanbigyan.com 34

35. The Economy on a Roller Coaster Clintonomics: deficit reduction Deficit-reduction package, 1993 & 1997 Tax increase & spending cuts Large surplus Economy boomed Lower inflation Aggregate supply curves Pushed outward – rapid pace, 1996 – 1998 All rights reserved by www.gyanbigyan.com 35

36. The effects of a favorable supply shift Figure 5 0 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 D1D1 D1D1 E S1S1 S1S1 C S2S2 S2S2 B

37. The Economy on a Roller Coaster Tax cuts and the Bush economy 2001 recession First in 10 years Tax cut 2001 Budget deficit Burst of government spending War on terror Aggregate demand – shift outward Federal Reserve Lowered interest rate All rights reserved by www.gyanbigyan.com 37

38. Problem of Macroeconomic Stabilization Stabilization policy Government programs Prevent or shorten recessions Counteract inflation, stabilize prices All rights reserved by www.gyanbigyan.com 38

39. Problem of Macroeconomic Stabilization Fight unemployment Increase aggregate demand Government - Fiscal policy Increase spending Cut taxes Federal Reserve - Monetary policy Lower interest rates Increase output Reduce unemployment Raise prices All rights reserved by www.gyanbigyan.com 39

40. Stabilization policy to fight unemployment Figure 9 0 Real GDP Price Level D0D0 D0D0 S0S0 S0S0 D1D1 D1D1 E A Increase in output

41. Problem of Macroeconomic Stabilization Fight inflation Decrease aggregate demand Government - Fiscal policy Cut spending Increase taxes Federal Reserve - Monetary policy Increase interest rates Decrease inflation (decrease prices) Decrease output Increase unemployment All rights reserved by www.gyanbigyan.com 41

42. Stabilization policy to fight inflation Figure 10 0 Real GDP Price Level D0D0 D0D0 S S D2D2 D2D2 E B Decrease in prices

43. Stabilization policy Prewar data Fluctuations – unmanaged economy Booms & recessions “Natural” economic reasons Little government intervention Postwar data Economy - managed by government policy Successfully or unsuccessfully Recessions - less severe More inflation-prone All rights reserved by www.gyanbigyan.com 43

44. Neo-classical synthesis Growing prominence of optimization theory and marginal analysis in microeconomics led to incorporation into macroeconomic models. Optimal models of saving, investment and demand for liquidity were used to describe a medium term equilibrium around which the economy would fluctuate in the short-run. All rights reserved by www.gyanbigyan.com 44

45. Marginal Analysis Simple principal of optimization of smooth functions is the first derivative of function should equal zero at extremum. Economists consider the costs C and benefits B of some activity A. Net benefit of activity is B(A)-C(A). Optimal level of A is B’(A * ) = C ’(A * ), i.e. where the marginal benefit equals the marginal cost. All rights reserved by www.gyanbigyan.com 45

46. Models by “Term” Long-term: Take prices as flexible and solve for potential level of output. Medium Term: Take output as given and solve for optimal decisions of agents. Short-term: Take dollar prices or wages as given solve for output. All rights reserved by www.gyanbigyan.com 46

47. Monetarism In 1960’s, monetarists led by Milton Friedman began to emphasize the role of the money supply (as opposed to real demand factors) as determinants of fluctuations in output and especially inflation. In particular, Friedman pointed out the way that demand stimulus, once it becomes expected may lose its effectiveness. All rights reserved by www.gyanbigyan.com 47

48. Inflation and Deflation in China All rights reserved by www.gyanbigyan.com 48

49. Stagflation 70’s During 1970’s, oil price shocks led to rapid price rises and low production levels called stagflation. In many country’s, inflationary expectations led to wage-price spirals and historically high inflation rates. Developed economies begin 20 year slowdown in productivity growth rates. All rights reserved by www.gyanbigyan.com 49

50. International Economics In early 1970’s, US abandons Bretton Woods, and exchange rates start to float. After a few years of relative stability, exchange rates become one of the most volatile variables. International trade increases. Oil price rises damaging to developing countries, a problem partly solved when OPEC oil revenues are recycled as loans to 3 rd World. All rights reserved by www.gyanbigyan.com 50

51. Volatile Exchange Rate All rights reserved by www.gyanbigyan.com 51

52. Rational Expectations Lucas develops economic theories which rigorously incorporate the formation of expectations of future in economic models. Rational expectations models offer theoretical challenges but also explanations for rise of inflationary spirals and seeming ineffectiveness of monetary policy. Expectations based models also offer explanation for volatility of exchange rates. All rights reserved by www.gyanbigyan.com 52

53. Real Business Cycles Kydland and Prescott develop real business cycle models which unify long-run, medium run, and short-run into single coherent model. One shortcoming of these models is that money plays no role in short-run. RBC models are small and do not capture short-run dynamics well. All rights reserved by www.gyanbigyan.com 53

54. Eighties U.S. central bank cuts the money supply to counter-act inflation. Deep recession in USA and elsewhere. Latin American countries default on their debts leading to persistent financial crisis. Most developing economies begin long period of stagnation and even shrinking income levels. Only East Asia continues to grow. China reforms agricultural system and India institutes structural reforms that spark growth. All rights reserved by www.gyanbigyan.com 54

55. New Keynesian Models Using rigorous models of monopoly, a number of economists develop rigorous models in which prices are sticky because of adjustment costs. Unlike RBC models, these models can explain why monetary policy has significant effects on output. These models are typically static and cannot explain dynamics or long-run at all. All rights reserved by www.gyanbigyan.com 55

56. Endogenous Growth Productivity slowdown generates interest in models which can explain which policies are likely to lead to fastest or most welfare enhancing growth levels. Two competing schools. “Brains” school emphasizes role of education and human capital. “Ideas” school emphasizes R & D and invention of new goods and technologies. All rights reserved by www.gyanbigyan.com 56

57. 1990’s Globalization: Big expansion in international trade, international lending and direct investment. Productivity Takeoff: After 20 years of slow growth, in 1995 productivity growth takes off again. Financial crisis in a number of developing economies in Latin American and East Asia. Rise of Unemployment in Europe, Inequality in USA, Economic Stagnation in Japan Central Banks Choose Monetary Policies meant to lead to steady inflation: Inflation Targeting. All rights reserved by www.gyanbigyan.com 57

58. Structural Unemployment in HK All rights reserved by www.gyanbigyan.com 58

59. New Neo-classical Synthesis Economists begin to incorporate New Keynesian models of price stickiness into unified RBC framework. These models explain which type of policies can offset effects of price-stickiness which might lead to underemployment without leading to wage-price spirals. Economists also incorporate models of financial market imperfections into unified framework to explain financial crises in emerging markets. All rights reserved by www.gyanbigyan.com 59

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