Chapter 1. Macroeconomic for the long run and the short run ECON320 Prof Mike Kennedy

What is macroeconomics? A definition by subject – Macroeconomics is the study if economic growth and business cycles A definition by method – Macroeconomics is concerned with explaining observed time series like GDP, prices, unemployment, etc

Aggregation The concept of the output and the capital stock – We treat the economy as producing one good (GDP) using the capital stock and labour, both one-dimensional variables – The capital stock includes both structures and machinery and equipment. – The aggregate is measured by multiplying the quantities by the prices in some base year – need relative prices to not change – All in all a lot of simplifying assumptions are involved. Robert Solow “All theory depends on assumption that are not quite true. That is what makes it theory. The art of successful theorising is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive.”

Canadian GDP in a historical context

US GDP in a historical context

The Canadian business cycles over time have become more muted

The US business cycles over time have become more muted as well

A look at the Canadian business since 1961

Aggregate supply and demand We want to develop a framework for analysing short- term fluctuations in the economy To do this we will develop supply and demand curves as in microeconomics but there the similarity ends You are no doubt familiar with the aggregate demand curve from ECON222 The aggregate supply curve is both more challenging and more controversial In both cases, the underlying determinants of the curves are quite complicated – there is a lot going on under the surface

A closer look at changes in Canadian GDP and the unemployment rate

Canadian GDP and the unemployment rate at an annual frequency

Business cycles The message from the previous few slides is that there are virtually no periods when the economy is operating at full employment (proxied by the trend) We want to explain why this happens We start by looking at the period highlighted by the box in the previous two figures

We will be for the most part interested in explaining short-run fluctuations in key aggregates In studying economic fluctuations, we want to examine the role of: – Exogenous shocks These could arise from the supply and the demand side of the economy – not a complete explanation, especially for the reaction of the economy – Short-run nominal rigidities After the occurrence of the shock, there is a period during which some prices and wages are sticky Need imperfect competition and/or menu costs to explain this – Errors in expectations Prices/wages are different from what was expected or negotiated which can cause prices and wages to not adjust

The source of real rigidities and the natural rate Consider the following price setting equation: Suppose that a monopolizing union sets wages by maximizing: The term within the brackets is the rent earned by workers The demand for labour in sector i is where we used the price setting equation to eliminate W : where σ is the elasticity of labour demand wrt wages

The wage setting equation for the union is : Introducing unemployment we can arrive at the economy’s wage setting curve. We start by defining the outside option: Which we can substitute this into the wage setting equation to get: If the union mark-up is the same across all sectors then wages will be the same in all sectors

The natural rate of unemployment and the importance of the supply side The natural rate of unemployment is, even without nominal rigidities: We see that the natural rate of unemployment is rooted in market imperfections – that is an excess supply of labour does not put downward pressure on wages If m W =1 the ū = 0, there would be no unemployment! Note that a higher value of m P, a measure of imperfect competition, and b will also raises the natural rate Note as well that the amount of employment ( 1 – ū ) is given by the supply side of the economy – the parameters m W, m P and b characterise the supply structure

Explaining how nominal short-run rigidities can arise from optimizing behaviour: The role of menu costs We assume that unemployment benefits are related to the real wage as b = cw. The outside option now becomes The optimal wage that the union will choose is: Normalising the labour force on unity we get Labour demand in each sector will then be

Menu costs con’t Substituting the above into the union’s objective function we get The utility loss from not adjusting wages is where is the initial wage rate set by the union The utility loss in equilibrium is equal to the cost of not adjusting – the menu cost, call it C

Determining

Shocks, expectation errors and nominal rigidities How u deviates from ū