1. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 1 Chapter One Introduction

2. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 2 Chapter Objectives  Introduce three linked macroeconomy models  Explain the long run growth in productive capacity  Explain the medium-term determination of inflation using aggregate demand and supply  Compare the short run fixed price changes in real output

3. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 3 1.1Macroeconomics Encapsulated in Three Models 1.2To Reiterate... 1.3Schools of Thought 1.4Outline and Preview of the Text 1.5Prerequisites and Recipes Chapter Organisation

4. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 4 1.1 Three Models  Macroeconomics is organised around three models  Each model is concerned with different time frames  The long run  The medium run  The short run  Let’s consider each in more detail

5. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 5 Very Long Run Economic Growth  Growth theory describes the long run behaviour of the economy  The time is usually measured in multiples of decades (e.g. 20 years or more)  The focus is on the average growth in important macroeconomic variables  Short-run fluctuations in important variables like employment, investment and output are ignored

6. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 6 Very Long Run Economic Growth  The long run level of output is determined solely by supply-side considerations  That is, output is determined by the productive capacity of the economy  All factors of production are assumed to be fully employed  Economic growth is, therefore, a function of increases in productive capacity

7. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 7 Very Long Run Economic Growth  Differences in average growth rates of economies are important  Chapters 3 and 4 examine the causes of economic growth and the differences between countries growth rates  Major causes of economic growth are  Development of new technology  Accumulation of physical and human capital  Appropriate provision of infrastructure  Higher rates of domestic saving

8. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 8 Very Long Run Economic Growth  Economic growth determines the changes in the standard of living  A country growing at an average of 4% per year instead of 2% will have a 50% higher standard of living over a generation of 20 years  This higher 4% average annual growth rate will lead to a seven fold increase in the standard of living over 100 years!  Let’s now introduce a model which will be useful for our analysis

9. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 9 Fixed Productive Capacity  What determines the change in the overall price level (the inflation rate)?  The aggregate supply (AS)–aggregate demand (AD) model explains short- to medium-run determination of inflation and real output  In the long run the productive capacity of the economy is assumed to be constant

10. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 10 Fixed Productive Capacity  This is represented by a vertical AS schedule at real output level Y 0 P Y0Y0 Y AS Price Level

11. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 11 Fixed Productive Capacity  The AD schedule represents, for each price level, the level of output where both the goods and money markets are in equilibrium  These schedules will be fully explained in Chapters 5 and 6  The intersection of the AS and AD schedules determines the price (P 0 ) and real output (Y 0 )

12. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 12 Fixed Productive Capacity  AD and AS in the long run P Y0Y0 Y AD Price Level AS P0P0 What happens when AS shifts rightwards? What happens when AD shifts rightwards? Price increases Price decreases

13. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 13 The Short Run  Short-run fluctuations in real output are important  AD is the major determinant of these variations  In the short run the price level is pegged at P 0 making the short-run AS schedule horizontal

14. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 14 AS The Short Run  AD and AS in the short run P Y0Y0 Y AD Price Level P0P0 What happens when AD shifts rightwards? Price unchanged

15. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 15 The Medium Run  How do we describe the transition between the short run and long run?  High AD pushes real output above Y 0 (according to the long-run model)  Over time, firms will increase prices and the AS curve will move upwards  The medium run will give an upsloping AS curve

16. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 16 The Medium Run  The relative steepness of the AS curve is a major controversy in macroeconomics P Y0Y0 Y AD Price Level AS P0P0

17. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 17 1.1Macroeconomics Encapsulated in Three Models 1.2To Reiterate... 1.3Schools of Thought 1.4Outline and Preview of the Text 1.5Prerequisites and Recipes Chapter Organisation

18. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 18 1.2 To Reiterate …  What follows fills in the details  Growth theory, AS and AD form a very important framework for the further analysis of  Growth and GDP  The business cycle  Let’s consider each in turn

19. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 19 Growth and GDP

20. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 20 Growth and GDP  Table 1.1 compares the per capita real income growth rates in various countries  Note the very large differences ranging from 0.1% for Ghana to 3.5% for Japan and China (3.0)  Brazil (2.4%), Ireland (2.3), France (2.1) and Spain (2.0) are the next band  Note the lower but similar growth rates for Australia and NZ

21. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 21 The Business Cycle and GDP  The business cycle describes the variation of economic activity around the path of trend growth  Inflation, growth and unemployment all demonstrate cyclical patterns  The output gap measures the difference between actual and potential output: Output gap = potential output – actual output

22. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 22 The Business Cycle and Inflation  Increases in inflation are inversely related to the output gap  Expansionary AD policies tend to produce inflation when unemployment is relatively low  The cost of the cycle above trend is inflation and the cost below trend is unemployment

23. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 23 Business Cycle Features  Business cycles have common characteristics  Procyclical variables rise with expansionary business activity (e.g. output, employment, interest rates and money supply)  Countercyclical variables (like inventories and bankruptcies) move in the opposite direction to business activity

24. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 24 Business Cycle Features  Some variables exhibit more variability than others (e.g. inventories are volatile while consumption is smooth, especially relative to output)  The impulse-propagation model describes:  how a shock (impulse) disturbs the economy from a long-run trend  which lasts (propagates) over time  Economists disagree over possible propagation mechanisms

25. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 25 Business Cycle Features  There are three broad types of shocks  Policy shocks which affect fiscal expenditure and interest rates (e.g. fiscal and monetary policies)  Supply shocks which affect production and price-setting (e.g. technology advances)  Private sector shocks which affect aggregate demand (e.g. changes in private investment)

26. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 26 Business Cycle Features  There is debate about the actual timing of Australian business cycles  Which measure should be used?  Variables like unemployment lag changes in real GDP (called lagging indicators)  Leading indicators like firms’ profitability and building approvals precede changes in GDP  Aggregating variables into a composite index will give a coincident index to measure turning points in the business cycle

27. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 27 Business Cycle Features  Another debate concerns separating the cycle from trend  The classical business cycle considers actual levels so that a fall in GDP describes negative growth  Two consecutive quarters of negative growth in real GDP is called a (classical) recession  The growth cycle considers fluctuations in growth rates of the economy around the trend growth rate

28. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 28 1.1Macroeconomics Encapsulated in Three Models 1.2To Reiterate... 1.3Schools of Thought 1.4Outline and Preview of the Text 1.5Prerequisites and Recipes Chapter Organisation

29. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 29 1.3 Schools of Thought  During the 1960s there were two main views  The monetarists believed the economy is best left to itself  The Keynesian’s argued that government intervention could improve economic performance  Two schools have developed since then  the new classical school in the 1970s  the Keynesian school in the 1980–90s

30. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 30 New Classical School  Consistent with the monetarist view  Economic agents optimise  Decisions rationally use all available information (rational expectations)  Markets are assumed to clear  These assumptions ensure there is no involuntary unemployment  The real business cycle extension argues that real supply side shocks are the major causes of fluctuations in economic activity

31. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 31 New Keynesian School  Extends the earlier Keynesian view that markets will not always clear even if agents are maximising  Reasons are varied and include  There is incomplete information  Institutions affect the workings of markets  Costs of changing wages and prices lead to price rigidities  These reasons explain fluctuations in output and employment

32. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 32 Economic Controversies  The two main competing views of modern macroeconomics are highlighted in real- world political and media discussions  Frequently these differences are exaggerated in debate  There are significant areas of agreement  Debate and research continually evolve new areas of consensus e.g. there is increasing agreement on information problems with wage-price setting

33. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 33 1.1Macroeconomics Encapsulated in Three Models 1.2To Reiterate... 1.3Schools of Thought 1.4Outline and Preview of the Text 1.5Prerequisites and Recipes Chapter Organisation

34. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 34 1.4 Text Outline and Preview  The key overall concepts of this book are growth, aggregate supply and demand  Chapters 3 and 4 consider long-run economic growth  Chapters 5–7 explore the AS curve  Chapters 8–10 explore the AD curve  Chapters 11–12 explore international adjustment in an integrating global economy  Chapters 13–17 examine individual sectors which make up an economy

35. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 35 1.4 Text Outline and Preview  The key overall concepts of this book are growth, aggregate supply and demand  Chapters 18–19 consider Australian macroeconomic policy applications  Chapter 20 introduces briefly some frontiers of macroeconomic research

36. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 36 1.1Macroeconomics Encapsulated in Three Models 1.2To Reiterate... 1.3Schools of Thought 1.4Outline and Preview of the Text 1.5Prerequisites and Recipes Chapter Organisation

37. Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 37 1.5 Prerequisites & Recipes  The text requires no mathematical prerequisite beyond high school algebra  There are helpful websites  www.mcgraw-hill.com.au/mhhe/econ/ dornbusch (for chapter summaries and problems)  www.rba.gov.auwww.treasury.gov.au  www.abs.gov.auwww.asx.com.au  www.ecosoc.org.au/www.economist.com  www.bloomberg.com/au/rfe.wustl.edu