1 Important issues in macroeconomics Macroeconomics, the study of the economy as a whole, addresses many topical issues:Why does the cost of living keep rising?Why are millions of people unemployed, even when the economy is booming?What causes recessions? Can the government do anything to combat recessions? Should it?
2 Important issues in macroeconomics Macroeconomics, the study of the economy as a whole, addresses many topical issues:What is the government budget deficit? How does it affect the economy?Why does the U.S. have such a huge trade deficit?Why are so many countries poor? What policies might help them grow out of poverty?
3 U.S. Real GDP per capita (2000 dollars) 9/11/2001First oil price shocklong-run upward trend…Second oil price shockGreat DepressionWorld War II
6 Why learn macroeconomics? 1. The macroeconomy affects society’s well-being.Each one-point increase in the unemployment rate is associated with:920 more suicides650 more homicides4000 more people admitted to state mental institutions3300 more people sent to state prisons37,000 more deathsincreases in domestic violence and homelessness
7 Why learn macroeconomics? 2. The macroeconomy affects your well-being.change from 12 mos earlierpercent change from 12 mos earlier
8 Why learn macroeconomics? 3. The macroeconomy affects politics.Unemployment & inflation in election yearsyear U rate inflation rate elec. outcome% 5.8% Carter (D)% 13.5% Reagan (R)% 4.3% Reagan (R)% 4.1% Bush I (R)% 3.0% Clinton (D)% 3.3% Clinton (D)% 3.4% Bush II (R)% 3.3% Bush II (R)
9 A multitude of modelsSo we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth).For each new model, you should keep track ofits assumptionswhich variables are endogenous, which are exogenousthe questions it can help us understand, and those it cannot
10 Prices: flexible vs. sticky Market clearing: An assumption that prices are flexible, adjust to equate supply and demand.In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. For example,many labor contracts fix the nominal wage for a year or longermany magazine publishers change prices only once every 3-4 years
11 Prices: flexible vs. sticky The economy’s behavior depends partly on whether prices are sticky or flexible:If prices are sticky, then demand won’t always equal supply. This helps explainunemployment (excess supply of labor)why firms cannot always sell all the goods they produceLong run: prices flexible, markets clear, economy behaves very differently
12 Outline of this course: Introductory material (Chaps. 1 & 2) and the Classical Theory (Chaps. 3, 4, & 6) How the economy works in the long run, when prices are flexibleBusiness Cycle Theory (Chaps. 9-12) How the economy works in the short run, when prices are stickyPolicy debates (Chaps ) Should the government try to smooth business cycle fluctuations? Is the government’s debt a problem?Growth Theory (Chaps. 7 & 8) The standard of living and its growth rate over the very long run
15 Do you remember……the meaning and measurement of the most important macroeconomic statistics?Gross Domestic Product (GDP)The Consumer Price Index (CPI)The unemployment rate
16 Gross Domestic Product: Expenditure and Income Two definitions:Total expenditure on domestically-produced final goods and services.Total income earned by domestically-located factors of production.Expenditure equals income because every dollar spent by a buyer becomes income to the seller.
17 The Circular Flow Households Firms Income ($) Labor Goods Expenditure ($)HouseholdsGoodsFirms
18 The expenditure components of GDP consumptioninvestmentgovernment spendingnet exports
19 Consumption (C)definition: The value of all goods and services bought by households. Includes:durable goods last a long time ex: cars, home appliancesnondurable goods last a short time ex: food, clothingservices work done for consumers ex: dry cleaning, air travel.
20 U.S. consumption, 2007 (Q3) Services Nondurables Durables Consumption % of GDP$ billions$9,785.770.0%5,857.82,846.31,081.641.920.47.7source: Bureau of Economic Analysis, U.S. Department of Commerce
21 Investment (I) Includes: Definition 1: Spending on [the factor of production] capital.Definition 2: Spending on goods bought for future useIncludes:business fixed investment Spending on plant and equipment that firms will use to produce other goods & services.residential fixed investment Spending on housing units by consumers and landlords.inventory investment The change in the value of all firms’ inventories.
22 U.S. investment, 2007 (Q3) Inventory Residential Business fixed % of GDP$ billions$2,162.915.5%35.4627.31,500.20.34.510.7source: Bureau of Economic Analysis, U.S. Department of Commerce
23 Investment vs. Capital Note: Investment is spending on new capital. Example (assumes no depreciation):1/1/2007: economy has $31,818b worth of capitalduring 2007: investment = $2,163b1/1/2008: economy will have $33,981b worth of capital
24 Government spending (G) G includes all government spending on goods and services..G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services.
25 U.S. government spending, 2007 (Q3) $ billions% of GDPGovt spending$2,716.519.5%Federal990.31,762.2673.5322.214.171.124.82.3Non-defensesource: Bureau of Economic Analysis, U.S. Department of CommerceDefenseState & local
26 Net exports, 2007 (Q3) NX = EX – IM $ billions % of GDP Net Exports - $694.7- 5.0%Exports1,685.712.0Imports2,380.417.0
27 aggregate expenditure An important identityY = C + I + G + NXvalue of total outputaggregate expenditure
28 A question for you: Suppose a firm produces $10 million worth of final goodsbut only sells $9 million worth.Does this violate the expenditure = output identity?
29 Why output = expenditure Unsold output goes into inventory, and is counted as “inventory investment”……whether or not the inventory buildup was intentional.In effect, we are assuming that firms purchase their unsold output.
30 GDP: An important and versatile concept We have now seen that GDP measurestotal incometotal outputtotal expenditureThis is why economists often use the terms income, output, expenditure, and GDP interchangeably.
31 GNP vs. GDPGross National Product (GNP): Total income earned by the nation’s factors of production, regardless of where located.Gross Domestic Product (GDP): Total income earned by domestically-located factors of production, regardless of nationality.
32 In your country, which would you want to be bigger, GDP, or GNP? Discussion question:In your country, which would you want to be bigger, GDP, or GNP?Why?
33 (GNP – GDP) as a percentage of GDP selected countries, 2002 For the U.S., GDP and GNP are very close. Thus, students may not realize why we bother teaching them the difference.The data on this slide makes clear that the difference is very important for many countries.Source: World Bank.
34 Real vs. nominal GDPGDP is the value of all final goods and services produced.nominal GDP measures these values using current prices.real GDP measure these values using the prices of a base year.
35 Practice problem, part 1 Compute nominal GDP in each year. 200620072008PQgood A$30900$311,000$361,050good B$100192$102200205Compute nominal GDP in each year.Compute real GDP in each year using 2006 as the base year.
36 Answers to practice problem, part 1 nominal GDP multiply Ps & Qs from same year 2006: $46,200 = $30 $100 : $51, : $58,300real GDP multiply each year’s Qs by 2006 Ps 2006: $46, : $50, : $52,000 = $30 $100 205
37 Real GDP controls for inflation Changes in nominal GDP can be due to:changes in prices.changes in quantities of output produced.Changes in real GDP can only be due to changes in quantities,because real GDP is constructed using constant base-year prices.
38 U.S. Nominal and Real GDP, 1950–2006 Real GDP (in 2000 dollars)Source:Nominal GDP
39 GDP DeflatorThe inflation rate is the percentage increase in the overall level of prices.One measure of the price level is the GDP deflator, defined as
40 Practice problem, part 2Nom. GDPReal GDPGDP deflatorInflation rate2006$46,200n.a.200751,40050,000200858,30052,000Use your previous answers to compute the GDP deflator in each year.Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.
41 Answers to practice problem, part 2 Nominal GDPReal GDPGDP deflatorInflation rate2006$46,200100.0n.a.200751,40050,000102.82.8%200858,30052,000112.19.1%
42 Consumer Price Index (CPI) A measure of the overall level of pricesPublished by the Bureau of Labor Statistics (BLS)Uses:tracks changes in the typical household’s cost of livingadjusts many contracts for inflation (“COLAs”)allows comparisons of dollar amounts over time
43 How the BLS constructs the CPI 1. Survey consumers to determine composition of the typical consumer’s “basket” of goods.2. Every month, collect data on prices of all items in the basket; compute cost of basket3. CPI in any month equals
44 Exercise: Compute the CPI Basket contains 20 pizzas and 10 compact discs.For each year, computethe cost of the basketthe CPI (use 2004 as the base year)the inflation rate from the preceding yearprices:pizza CDs2004 $10 $152005 $11 $152006 $12 $162007 $13 $15
46 The composition of the CPI’s “basket” Each number is the percent of the “typical” household’s total expenditure.source: Bureau of Labor Statistics,
47 Reasons why the CPI may overstate inflation Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen.Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights.Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured.
48 The size of the CPI’s bias In 1995, a Senate-appointed panel of experts estimated that the CPI overstates inflation by about 1.1% per year.Now, the CPI’s bias is probably under 1% per year.
49 CPI vs. GDP Deflator prices of capital goods included in GDP deflator (if produced domestically)excluded from CPIprices of imported consumer goodsincluded in CPIexcluded from GDP deflatorthe basket of goodsCPI: fixedGDP deflator: changes every year
50 Two measures of inflation in the U.S. Percentage change from 12 months earliersource:
52 Categories of the population employed working at a paid jobunemployed not employed but looking for a joblabor force the amount of labor available for producing goods and services; all employed plus unemployed personsnot in the labor force not employed, not looking for work
53 Two important labor force concepts unemployment rate percentage of the labor force that is unemployedlabor force participation rate the fraction of the adult population that “participates” in the labor force
54 Exercise: Compute labor force statistics U.S. adult population by group, December 2007Number employed = millionNumber unemployed = 7.7 millionAdult population = millionsource: Bureau of Labor Statistics, U.S. Department of Labor.Use the above data to calculatethe labor forcethe number of people not in the labor forcethe labor force participation ratethe unemployment rate
55 Answers: data: E = 146.2, U = 7.7, POP = 233.2 labor force L = E +U = = 153.9not in labor force NILF = POP – L = – = 79.3unemployment rate U/L x 100% = (7.7/153.9) x 100% = 5.0%labor force participation rate L/POP x 100% = (153.9/233.2) x 100% = 66.0%
56 Exercise: Compute percentage changes in labor force statistics Supposepopulation increases by 1%labor force increases by 3%number of unemployed persons increases by 2%Compute the percentage changes inthe labor force participation rate:the unemployment rate:2%1%
57 Two measures of employment growth Percentage change from 12 months earlierSource:
58 A Long Run Model:Where Income Comes Fromand Where it Goesmacro
59 Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price)determination of output/incomeDemand sidedeterminants of C, I, and GEquilibriumgoods marketloanable funds marketIt’s useful for students to keep in mind the “big picture” as they learn the individual components of the model in the following slides.59
60 The production function denoted Y = F (K, L)shows how much output (Y ) the economy can produce from K units of capital and L units of laborreflects the economy’s level of technologyexhibits constant returns to scale
61 Returns to scale Initially Y1 = F (K1 , L1 ) Scale all inputs by the same factor z:K2 = zK1 and L2 = zL1(e.g., if z = 1.25, then all inputs are increased by 25%)What happens to output, Y2 = F (K2, L2 )?If constant returns to scale, Y2 = zY1If increasing returns to scale, Y2 > zY1If decreasing returns to scale, Y2 < zY1This material has been improved and expanded from the previous edition of these PowerPoints. However, it is longer: 7 slides instead of 2. To shorten your presentation, you might consider omitting one or two of the following three examples, and/or eliminating one of the two “now you try” in-class exercises.
62 Returns to scale: Example 1 constant returns to scale for any z > 062
63 Returns to scale: Example 2 decreasing returns to scale for any z > 163
64 Returns to scale: Example 3 increasing returns to scale for any z > 164
65 NOW YOU TRY: Returns to Scale Determine whether each of these production functions has constant, decreasing, or increasing returns to scale:(a)(b)
66 NOW YOU TRY: Answers, part (a) constant returns to scale for any z > 0
67 NOW YOU TRY: Answers, part (b) constant returns to scale for any z > 0
68 Assumptions of the model Technology is fixed.The economy’s supplies of capital and labor are fixed atEmphasize that “K” and “L” (without bars on top) are variables - they can take on various magnitudes. On the other hand, “Kbar” and “Lbar” are specific values of these variables. Hence, “K = Kbar” means that the variable K equals the specific amount Kbar.Regarding the assumptions:In chapters 7 and 8 (the Economic Growth chapters), we will relax these assumptions: K and L will grow in response to investment and population growth, respectively, and the level of technology will increase over time.
69 Determining GDPOutput is determined by the fixed factor supplies and the fixed state of technology:Again, emphasize that “F(Kbar,Lbar)” means we are evaluating the function at a particular combination of capital and labor. The resulting value of output is called “Ybar”.69
70 The distribution of national income determined by factor prices, the prices per unit firms pay for the factors of productionwage = price of Lrental rate = price of KRecall from chapter 2: the value of output equals the value of income. The income is paid to the workers, capital owners, land owners, and so forth. We now explore a simple theory of income distribution.70
71 Notation W = nominal wage R = nominal rental rate P = price of output W /P = real wage (measured in units of output)R /P = real rental rateIt might be worthwhile to refresh students’ memory about nominal and real variables.The nominal wage & rental rate are measured in currency units.The real wage is measured in units of output.To see this, suppose W = $10/hour and P = $2 per unit of output.Then, W/P = ($10/hour) / ($2/unit of output) = 5 units of output per hour of work.It’s true, the firm is paying the workers in money units, not in units of output. But, the real wage is the purchasing power of the wage - the amount of stuff that workers can buy with their wage.71
72 How factor prices are determined Factor prices are determined by supply and demand in factor markets.Recall: Supply of each factor is fixed.What about demand?Since the distribution of income depends on factor prices, we need to see how factor prices are determined.Each factor’s price is determined by supply and demand in a market for that factor. For instance, supply and demand for labor determine the wage.72
73 Demand for laborAssume markets are competitive: each firm takes W, R, and P as given.Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit.cost = real wagebenefit = marginal product of labor73
74 Marginal product of labor (MPL ) definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed):MPL = F (K, L +1) – F (K, L)74
75 NOW YOU TRY: Compute & graph MPL L Y MPL0 0 n.a.1 10 ?2 19 ?3 27 84 34 ?5 40 ?6 45 ?7 49 ?8 52 ?9 54 ?10 55 ?a. Determine MPL at each value of L. b. Graph the production function. c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis.This exercise is pretty basic review. It’s good for students who have not had principles of economics in a few years, and students whose graphing skills could benefit from some remedial attention. Many instructors could probably “hide” or omit this and the next slide from their presentations.
76 NOW YOU TRY: AnswersThis exercise is pretty basic review. It’s good for students who have not had principles of economics in a few years, and students whose graphing skills could benefit from some remedial attention.
77 MPL and the production function Youtput1MPLAs more labor is added, MPL 1MPL(Figure 3-3 on p.52)It’s straightforward to see that the MPL = the prod function’s slope: The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL.Slope of the production function equals MPLMPL1Llabor77
78 Diminishing marginal returns As a factor input is increased, its marginal product falls (ceteris paribus).Intuition: Suppose L while holding K fixed fewer machines per worker lower worker productivityTell class: Many production functions have this property.This slide introduces some short-hand notation that will appear throughout the PowerPoint presentations of the remaining chapters:The up and down arrows mean increase and decrease, respectively.The symbol “” means “causes” or “leads to.”Hence, the text after “Intuition” should be read as follows:“An increase in labor while holding capital fixed causes there to be fewer machines per worker, which causes lower productivity.”Many instructors use this type of short-hand (or something very similar), and it’s much easier and quicker for students to write down in their notes.78
79 NOW YOU TRY: Identifying Diminishing Marginal Returns Which of these production functions have diminishing marginal returns to labor?Answers:(a) does NOT have diminishing MPL; MPL = 15, regardless of the value of L.(b) and (c) both feature diminishing MPLTo get the answers:- using calculus: take the derivative of F( ) with respect to L. The resulting expression is the MPL. Looking at this expression, determine whether MPL falls as L rises. (Or, take derivative of your MPL function w.r.t. L and see whether it’s positive, negative, or zero.)- using algebra: plug in any value for K and another value for L. See what happens if you increase L, then increase it again, and again. This may require a calculator.- finally, you can sketch the graph of these production functions (Y on the vertical, L on the horizontal, assuming a given value of K). If you know the general shape of the square root function, then it’s easy to tell that (b) and (c) have diminishing marginal returns.
80 NOW YOU TRY: MPL and labor demand L Y MPL0 0 n.a.2 19 93 27 84 34 75 40 66 45 57 49 48 52 39 54 2Suppose W/P = 6.If L = 3, should firm hire more or less labor? Why?If L = 7, should firm hire more or less labor? Why?If L=3, then the benefit of hiring the fourth worker (MPL=7) exceeds the cost of doing so (W/P = 6), so it pays the firm to increase L.If L=7, then the firm should hire fewer workers: the 7th worker adds only MPL=4 units of output, yet cost W/P = 6.The point of this slide is to get students to see the idea behind the labor demand = MPL curve.
81 MPL and the demand for labor Units of outputUnits of labor, LEach firm hires labor up to the point where MPL = W/P.MPL, Labor demandReal wageQuantity of labor demandedIt’s easy to see that the MPL curve is the firm’s L demand curve.Let L* be the value of L such that MPL = W/P.Suppose L < L*. Then, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by hiring one more worker.Instead, suppose L > L*. Then, the benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should reduce labor to increase its profits.When L = L*, then firm cannot increase its profits either by raising or lowering L.Hence, firm hires L to the point where MPL = W/P.This establishes that the MPL curve is the firm’s labor demand curve.81
82 The equilibrium real wage Units of outputUnits of labor, LLabor supplyThe real wage adjusts to equate labor demand with supply.MPL, Labor demandequilibrium real wageThe labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, Lbar, regardless of whether the real wage is high or low.Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined.82
83 Determining the rental rate We have just seen that MPL = W/P.The same logic shows that MPK = R/P :diminishing returns to capital: MPK as K The MPK curve is the firm’s demand curve for renting capital.Firms maximize profits by choosing K such that MPK = R/P .In our model, it’s easiest to think of firms renting capital from households (the owners of all factors of production). R/P is the real cost of renting a unit of K for one period of time.In the real world, of course, many firms own some of their capital. But, for such a firm, the market rental rate is the opportunity cost of using its own capital instead of renting it to another firm. Hence, R/P is the relevant “price” in firms’ capital demand decisions, whether firms own their capital or rent it.83
84 The equilibrium real rental rate Units of outputUnits of capital, KSupply of capitalThe real rental rate adjusts to equate demand for capital with supply.MPK, demand for capitalequilibrium R/PThe previous slide used the same logic behind the labor demand curve to assert that the capital demand curve is the same as the downward-sloping MPK curve.The supply of capital is fixed (by assumption), so the supply curve is vertical.The real rental rate (R/P) is determined by the intersection of the two curves.84
85 The Neoclassical Theory of Distribution states that each factor input is paid its marginal producta good starting point for thinking about income distribution85
86 How income is distributed to L and K total labor income = ________ = _________total capital income = _______ = __________If production function has constant returns to scale, thenThe last equation follows from Euler’s theorem, discussed in text on p. 55.national incomelabor incomecapital income86
87 The ratio of labor income to total income in the U.S., 1960-2007 Labor’s share of total incomeLabor’s share of income is approximately constant over time. (Thus, capital’s share is, too.)This graph appears in the textbook as Figure 3-5 on p.59.Source:87
88 The Cobb-Douglas Production Function The Cobb-Douglas production function has constant factor shares: = capital’s share of total income:capital income = MPK x K = Ylabor income = MPL x L = (1 – )YThe Cobb-Douglas production function is:where A represents the level of technology.88
89 The Cobb-Douglas Production Function Each factor’s marginal product is proportional to its average product:These formulas can be derived with basic calculus and algebra.89
90 Labor productivity and wages Theory: wages depend on labor productivityU.S. data:periodproductivity growthreal wage growth2.1%2.0%2.8%1.4%1.2%2.5%2.4%The table shows the average annual rates of productivity and real wage growth in each time period.Source: Economic Report of the President 2008and US Department of Commerce90
91 A closed economy, market-clearing model Outline of modelA closed economy, market-clearing modelSupply sidefactor markets (supply, demand, price)determination of output/incomeDemand sidedeterminants of C, I, and GEquilibriumgoods marketloanable funds marketDONE DONE We’ve now completed the supply side of the model.Next 91
92 Demand for goods & services Components of aggregate demand:C =I =G =(closed economy: no NX )
93 Consumption, Cdef: ________________ is total income minus total taxes: Y – T.Consumption function: C = C (Y – T )Shows that (Y – T ) Cdef: ___________________________ is the increase in C caused by a one-unit increase in disposable income.
95 Investment, I The investment function is I = I (r ), where r denotes the __________________, the nominal interest rate corrected for inflation.The real interest rate is________________________________________________________________.So, r I
97 Government spending, G G = govt spending on goods and services. G excludes _______________________ (e.g., social security benefits, unemployment insurance benefits).Assume government spending and total taxes are exogenous:
98 The market for goods & services Aggregate demand:Aggregate supply:Equilibrium:The ___________________ adjusts to equate demand with supply.
99 The loanable funds market A simple supply-demand model of the financial system.One asset: “loanable funds”demand for funds: _________________supply of funds: _________________“price” of funds: __________________
100 Demand for funds: Investment The demand for loanable funds…_____________________________: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses._____________________________, the “price” of loanable funds (cost of borrowing).
101 Loanable funds demand curve IThe investment curve is also the demand curve for loanable funds.
102 Supply of funds: Saving The supply of loanable funds comes from saving:________________________________
103 Types of saving private saving = public saving = national saving, S =
104 EXERCISE: Calculate the change in saving Suppose MPC = 0.8 and MPL = 20.For each of the following, compute S :a. G = 100b. T = 100c. Y = 100d. L = 10
105 digression: Budget surpluses and deficits If T > G, budget ______ = (T – G ) = public saving.If T < G, budget ______ = (G – T ) and public saving is negative.If T = G , “_______________,” public saving = 0.The U.S. government finances its deficit by ________________________.
107 The special role of rr adjusts to equilibrate the _______ market and the _______________ market simultaneously:This slide establishes that we can use the loanable funds supply/demand diagram to see how the interest rate that clears the goods market is determined.Explain that the symbol means each one implies the other. The thing on the left implies the thing on the right, and vice versa.More short-hand: “eq’m” is short for “equilibrium” and “LF” for “loanable funds.”
108 Mastering the loanable funds model Things that shift the saving curve:Things that shift the investment curveContinuing from the previous slide, let’s look at all the things that affect the S curve. Then, we will pick one of those things and use the model to analyze its effects on the endogenous variables. Then, we’ll do the same for the I curve.
109 CASE STUDY: The Reagan deficits Reagan policies during early 1980s:____________________________Both policies reduce national saving: