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					 MACROECONOMICS

UNIT OF ANALYSIS
      -      ECONOMY AS A WHOLE

VARIABLES OF INTEREST
      -     OUTPUT
      -     PRODUCTIVITY
      -     INFLATION
      -     UNEMPLOYMENT

METHOD OF ANALYSIS
     -     ECONOMIC MODELING
        ECONOMIC MODELING
• HYPOTHESIS
    – Relationship of interest
       • Level of sales and the price
• THEORETICAL FORMULATION
    – Mathematical relationship
       • Quantity sold = f (price) = constant – coefficient*Price
        -EMPIRICAL ANALYSIS – ESTIMATION
•       -EXPERIMENTAL ANALYSIS
        -THEORETICAL FORMULATION ONLY
    ATTENDANCE IN CLASS AS MODEL
• Hypothesis
  – Penalty for missing a class leads to increased attendance
• Theoretical formulation
  – Attendance (A) is a function of many factors
     • Attendance penalty (X)
     • Alternative uses of time, and other costs of being in class (difficult
       to measure and identify, as they differ from student to student)
     • Quality of lectures (Q)
     • % of the students in the class majoring in Economics (E)
  – A=f(X,Q,E)=constant+a*X+b*Q+c*E
     • A – an endogenous to the model variable
     • X,Q,E – exogenous to the model variables
• Next stage is either empirical or experimental
  Example II – Modeling Demand
  (another microeconomic model)
• Quantity = f (Price, other relevant factors)
• Consider demand for gasoline at a gas
  station, other relevant factors will include
  – Population density/car ownership rate
  – Fuel efficiency of an average car in the area
  – State of public transit in the area
  – Proximity of another gas station
  – Price charged by a competing gas station
  – ….and many many more….
              Modeling Demand
• Assume that we can only observe the price
  charged by the competitor: Pc (Note: assumptions
  simplify the reality, but reduce applicability)
• Hypothesis
  – Quantity sold = constant – a*Price + b*Pc
     • Quantity sold is determined by the model (endogenous)
     • Price, Pc are inserted into the model (exogenously given)
     • a, b represent the effects of Price and Pc on Quantity sold; these
       are the research objectives
     • Signs on a and b are also part of the hypothesis. a is assumed
       to be negative because of the law of demand, while b is positive
       due to the substitution, but this is not always known in advance.
                     model

• Simplification of reality and limitations of the
  model
• Analysis of relationships
• Dynamically changing society and the need for
  evolution of economic thought
  – From Adam Smith to Karl Marx to John Keynes
Measuring Economic Activity


          • OUTPUT
      • EMPLOYMENT
        • INFLATION
        MEASURING OUTPUT

• Gross Domestic Product
 the total market value of all final goods and
 services produced by factors of production
 located within a nation’s borders over a
 period of time (usually one year)
• Gross National Product
 the total market value of all final goods and
 services produced by factors of production
 owned by a nation over a period of time
 (usually one year)
                                         Output
• Measuring production
      –   Time period (flow vs. stock)
      –   Final goods and services (value added)
      –   Market prices
      –   Defining an economy (geographical boundaries
          versus resource ownership)
• Gross Domestic Product
• Gross National Product
• www.bea.gov Table 1.7.5
http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=43&FirstYear=2003&LastYear=2005&Freq=Qtr
  Main Categories of Expenditures
• Consumption                           • Government Spending
• Investment                            • Imports
                                        • Exports




 National Income Accounts statistics are available online on the website of
            The US Bureau of Economic Analysis: www.bea.gov
                             % share of expenditures in GDP   2004
Personal consumption expenditures                             70
 Durable goods                                                8.4
 Nondurable goods                                             20.2
 Services                                                     41.4
Gross private domestic investment                             16.4
 Fixed investment                                             16
   Nonresidential                                             10.2
     Structures                                               2.5
     Equipment and software                                   7.7
   Residential                                                5.7
 Change in private inventories                                0.5
Net exports of goods and services                             -5.3
 Exports                                                      10
   Goods                                                       7
   Services                                                    3
 Imports                                                      15.3
   Goods                                                      12.7
   Services                                                   2.6
Government consumption expenditures and gross investment      18.9
 Federal                                                      7.1
   National defense                                           4.7
   Non-defense                                                2.3
 State and local                                              11.8
         OUTPUT = INCOME
• GNP = GDP + NET PAYMENTS FROM
  ABROAD (Table 1.7.5)
• NNP = GNP – DEPRECIATION
• NI = NNP – INDIRECT BUSINESS TAXES
• NI represents total payments to nation’s factors
  of production (profits, rents, wages…). (Table 2.1.
  Personal Income and Its Disposition)
                                       Real versus Nominal
                                                i N
                                         GDP  i 1 PiQi
Nominal GDP growth rate = output growth rate + price level growth rate
                                               Growth in Nominal vs Real GDP

                                                        Nominal GDP     Real GDP

                   8.0



                   7.0



                   6.0



                   5.0
 level of growth




                   4.0



                   3.0



                   2.0



                   1.0



                   0.0
                         1995   1996    1997     1998     1999          2000       2001   2002   2003   2004
                                                                 year
          Measuring Inflation
• CPI, PPI, Core Index, GDP Deflator
  – Data available on BLS website (www.bls.gov)
  – Construction of an index “indexed average
    price”
• Characteristics of recent US inflation
  – Low level
  – Non-uniform
  – International effect on the US inflation
              employment
• Labor force and labor force participation
• Measuring unemployment
  – Current Population Survey
• Measuring current employment
  – Survey of businesses


Employment data: Bureau of Labor Statistics
 (www.bls.gov)
                          Statistics for the US economy
              For March-July 2003 (seasonally adjusted). Source: BLS


Emploment values are in 000's        March        April        May        June       July
Total nonfarm Employment in 000's     130084      130062       129986     129914     129870
Total Employment                      137348      137687       137487     137738     137478
Total Unemployed                        8445        8786         8998       9358       9062
Civilian Labor Force                  145793      146473       146485     147096     146540
Labor Force Participation Rate           66.2        66.4        66.4        66.6       66.2

Unemployment Rate                   0.05792459 0.05998375 0.06142608 0.06361832 0.06183977



                             Discouraged Worker Phenomenon


                                          For the month of January
         %                1997       1998   1999     2000      2001          2002      2003
Labor Force
Participation Rate          67        67.1      67.3        67.3   67.2       66.4     66.3
Real Output and Unemployment
• Okun’s Law
  – Unemployment increase  reduction in Real GDP
    growth
  – Estimates suggest that a 1% increase in
    unemployment rate leads to a 2% decline in Real GDP
    growth rate:
     Change in Real GDP growth rate = constant – 2 * change in Unemployment rate



• 2001-2003: Jobless Recovery?
  – 2001-2003: unemployment and real GDP increase at
    the same time
closed economy: Y = C    +I +G




                                Output markets

               C                                        Revenues
                                    I

                 Private S                         G
                                Financial market
 households
                                                                        firms
                        Taxes
                                           Pub.S

                income                     Government


                                                         Wages, profits, rents = Y


                                  Input markets
            Microeconomics of the Model
•Aggregate Demand: GDP = C +I + G
•Aggregate Supply: Production  GDP= f ( L, K )
•Cobb-Douglas Production Function
•Input cost determination process
   –MPL, MPK, VMPL, VMPK
   –The benefit of hiring an additional worker is the change in the total
   revenues that results from hiring that worker
   –Nominal wage versus real wage
   –Dependency of input costs on relative resource endowment: labor
   abundant economy versus capital abundant economy
•Role of Economic Profits
   –Classical versus Keynesian formulation
   –Zero economic profits under Classical formulation
   –CRTS in production
       •CRTS versus IRTS versus DRTS under Cobb-Douglas function
       •Zero economic profits under CRTS production function
   CRTS and Economic Profits
• Profit = P*Y – w*L-r*K
• Competitive markets:
  – w = VMPL = P*MPL
  – r = VMPK = P*MPK
• Real profits=Profit/P = Y – MPL*L-MPK*K
• Using the Cobb-Douglas function
    Classical Economic Theory
• Historical roots of the theory
  – From Adam Smith’s Invisible Hand to XX
    century economics
• Flexibility of all prices
  – Price adjustment rather than output
    adjustment
• Economy at the capacity equilibrium
  – The long-run nature of the model
  The economy as a self-perpetual system


• Spending creates income; income creates means for
  spending…. The circular flow concept
• An important classical assumption: no leakages from the
  flow: for example, savings immediately translate into
  investment
   – Keynes’ Trust Paradox
              Demand for Output
• Income identity from the Circular Flow Model:
  Y=C+I+G
• Disposable income (after-tax/transfer PI) = Y – T
    – (Y-T) = C + S
• Consumption function (autonomous, induced)
    – Consumption is induced by disposable income:
      C = C(Y-T)
    – Some consumption may be autonomous to disposable income, and be
      influenced by other factors (expected future Y, interest rate..)
      C = a + c (Y-T)
• Consumption and Saving are the only allocations of disposable
  income
    – MPC, MPS
• G, T are policy driven and hence not induced by current income.
          Demand for output
• Investment
  – Function of real interest rate I(r)
  – Investment is a decreasing function of the real
    interest rate (investment is spending by firms
    on final goods such as capital goods)
  – The economic measure of the user cost of
    capital
    • Interest rate
    • Economic depreciation
       Demand for Output
• Government Spending
• Exports
• Imports
         Autonomous                                    Induced Expenditures
         Expenditures
    Independent of current income                      Function of current income
•     Autonomous Consumption                       •   Induced Consumption
     –    Consumption that does not depend               – Consumption that is driven by current
          on current income but depends on               income
          other factors (like future income,       •    Imports
          confidence, subsistence needs)                 – note that imports do depend on the
•     Domestic Investment                                current income level. We will buy more of
     –    Is not a function of current income,           all goods, domestic or foreign in our
          but may be a function of future                incomes increase. Thus, it is an induced
          income, expected profitability,                expenditure, but we will ignore this in our
          relative profitability, interest rate…         class and treat it as autonomous! There
•     Government Spending                                are also other factors (other than income)
     –    Function of policy, and hence                  that influence imports: relative prices, and
          should not be considered as                    hence the exchange rate, preferences…)
          induced spending
•     Exports
     –    Exports tend to be a function of
          economic condition of the importing
          country. The wealthier it is, the
          more likely it is to purchase more
Equilibrium in the output market
• Production of output (supply) depends on two factors:
    – Composition of inputs
        • Physical capital (K)
        • Labor (L)
    – State of production technology
        • Y = F ( K, L )
• Equilibrium in the classical model (long-run, or capacity equilibrium)
                Y ( K , L )  a(r )  c(Y  T )  I (r )  G

If the inputs and the state of production technology are fixed, the supply
    of goods in the economy is limited by its fixed capacity (recall fixed
    LRAS from 2105)
Note that r, the real interest rate, is not yet determined by the model.
    Interest rate is simply the price of loanable funds, and the Classical
    model assumes full flexibility of prices, however there is only one
    interest rate at which the output market will be in an equilibrium –
    that equilibrium interest rate must be determined in another market.
Determining the equilibrium interest
     rate: the financial market
• Real interest rate is the real cost of borrowing
  (investment). Recall that even if investment is cash
  financed, interest rate is still the cost of borrowing.
• GDP identity: Y = C + I + G  I = Y – C – G = S (national
  savings)
   – National savings: output – expenditures: Y – C – G
      • Public savings: T – G
          – Public savings do not depend on the interest rate
      • Private savings: (Y-T)-C
          – If we treat C as NOT a function of the interest rate, then private savings
            are not affected by the interest rate (Mankiw Textbook)
          – If we assume that autonomous consumption is a function of the interest
            rate, and is a decreasing function of the interest rate, then the private
            savings will be an increasing function of the interest rate
     Financial market equilibrium
r
                                          S
                                                                S, when a(r)




                                                                 I(r)




                                                                        Loanable funds

    I = (T-G) + [(Y-T) – a – c (Y-T)] = public savings + private savings
     Weakness of fiscal expansion in the
             classical world
• Equilibrium in the output market
      1
  Y      (a  cT  I  G )
     1 c

• Equilibrium in the loanable funds market
  I = (T-G) + [(Y-T) – a – c (Y-T)]
  – Any increase in G will be offset by equal drop in I (or
    I+a, if a(r)) – indirect crowding-out
  – Any decrease in T will be offset by a drop in I = cT (or
    I+a, if a(r)) – indirect crowding-out
     Indirect Crowding-out effect in
            Fiscal Expansion
• Expansionary fiscal policy:           T-G
• Public Savings decrease
 r               S           Investment declines, offsetting
                             Increase in G.




                     I(r)

                     Loanable funds
                           example
• Assume the following:
• C=100+0.8*(Y-T)
• I=1000-100*r
• Y=f(L,K)=L^(0.5)*K^(0.5)
• L=10000; K=400
• G=T=0
--------------------------------------
• What is the equilibrium level of output?
• What is the level of national, public, and private savings?
• What is the equilibrium interest rate?
--------------------------------------
• Set G=T=200 (balanced budget)
--------------------------------------
• Set =200, T=100 (budget deficit)
--------------------------------------
• Set G=200, but increase I to I=1100-100r
--------------------------------------
• Set G=T=0, original I function, but C=100-10r+0.8*(Y)
                     money
• Functions
  – Medium of exchange – definition of money
  – Unit of account
  – Store of value
• Historical forms of money
  – Commodity money
     • Gold standard: 1880’s-1914; revised standard in
       post WWII era
     • Fiat money
        Supply of Fiat Money

• Central Bank and money supply
  – Open market operations
     • Expansion
     • Contraction
     • Recent history of US OMO
        – http://www.federalreserve.gov/fomc/fundsrate.htm



• For more expanded discussion of money supply
  read appendix at the end of Chapter 18 (p. 482)
                  Money Market
• Real Supply: M/P=f( monetary policy )
• Real Money Demand: Md/P
  – Transaction demand for money
     • Function of Y
  – Opportunity cost of holding M2 assets
     • Nominal interest rate
  – Md/P = L( i, Y ) = k Y – a i
                               M/P - supply
         i




                                              Md/P

                                          M-balances
       Quantity Theory of Money
• Transaction need for money
    – Price*Number of Transactions
• Money Supply (Quantity of Money): M
• Transaction Velocity of Money: V
• Quantity equation (transaction):
    M*V=P*T
---------------------------------------------------------
• Income Velocity of Money
• Quantity equation (income):
   M*V=GDP Deflator * Real GDP
  demand for money and quantity
        theory of money
• Money demand: Md
  – Transaction based: function of nominal GDP
    (PY): Md=PkY
    • PY=Md(1/k)  V (income velocity) = (1/k)
  – Real Money Demand: Md/P=kY
    • Real money balances
• In equilibrium real money demand (Md/P)
  must equal real money supply (M/P)
  – M/P = k Y  M(V=1/k)=PY
                         inflation
• Quantity of money equation: MV = PY

  inflation  %P  %M  %V  %Y
• Assumption of constant velocity of money
   – Inflation
      • Money supply growth
          – Russia in the 90’s, Germany in the 20’s
      • Drop in productive capacity (output)
      • Monetary Rule
          – Money supply growth = real GDP growth
           Money neutrality


• Classical economic theory:
  – Changes in money supply have no impact on
    real economic variables: output, real wages,
    relative prices…
    Inflation and nominal rates
• Fisher Equation:
  – Nominal rate = real rate + inflation
     • For past arraignments: observed inflation
        – ex post real interest rate
     • For forward looking: expected inflation
        – ex ante real interest rate determination
• Real Money Demand:
  – Md/P = L ( i , Y ) = L ( r + exp infl , Y )
     • Expectation of future inflation can affect current
       money demand
                  Seigniorage
                        or
                Inflationary Tax


• Printing money as source of government
  revenue
  – Main source of hyper inflation
  – Dollarization
            Costs of inflation
• Expected (and unexpected) inflation
  – Menu Costs
  – Shoe-Leather Costs
  – Instability in relative prices
• Unexpected inflation
  – Redistribution of wealth
  – Uncertainty of future inflation and forward
    looking arraignments
   Open Economy


• Presence of foreign sector
  – Trade
  – Investment
                               2001 data. Source: WDI, WorldBank, 2003
                           Exports % of Imports %                           Exports % Imports %
                              GDP        of GDP                              of GDP    of GDP

Austria                          52.21        52.58        Croatia              46.72     52.77
Belgium                          84.42        81.09        Czech Republic       71.05     73.79
Finland                          40.38        31.58        Denmark              45.59     39.18
France                           27.91        26.35        Iceland              40.48     40.95
Germany                          34.97        33.07        Sweden               46.45     40.56
Greece                     ..            ..                Hungary              60.47     62.61
Ireland                          95.39        80.49        Latvia               45.52     54.19
Italy                            28.27        26.67        Lithuania            50.41     55.85
Luxembourg                 ..            ..                Poland               29.12     33.01
Netherlands                      65.06        59.73
Portugal                         31.63        41.24
Spain                            29.92        31.40

China                            25.83        23.41
Japan                            10.44         9.81
Russian Federation               36.81        24.15
Switzerland                      45.47        41.13
United Kingdom                   27.12        29.28
United States (2004:BEA)         10.00        15.32
                      Trade
•   X – exports
•   m – imports
•   Net Exports: NX = X – m
•   Y = C + I + G + NX
    – At any given time period a country’s spending
      need not equal its output
      • NX<0  a country spends more than it produces,
        i.e. borrowing
      • NX>0  a country’s production exceeds its
        spending, i.e. lending
National Savings in Open Economy

•   NS = Y – C – G = I + NX
•   NX = NS – I
•   Trade balance = net capital flow
•   US BoP (www.bea.gov)
    – Current Account – Trade
    – Financial Account – Investment
       Small Open Economy
• Incapable of causing changes in the
  world’s financial markets, i.e. is a price
  taker in financial markets, unable to
  influence the price of loanable
  internationally funds – interest rate.

				
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