Introduction to Macroeconomics Chapter 11

Macroeconomics We will now shift perspectives We will look at the economy as a whole Micro vs. macro

Comparing Micro and Macro Perspectives

Perspectives on War – Micro:

Perspectives on War - Micro:

Perspectives on War…Macro: It’s “just” numbers … World War II death toll …

Perspectives on War…Macro:

Perspectives on the Economy Micro:

Perspectives on the Economy Micro:

Perspectives on the Economy Macro:

Perspectives on the Economy Macro:

Introduction to Macroeconomics In Micro we asked questions about individual … People – How do we optimize? Firms – How do they compete? Markets – How do they work and function, well or badly, as a system based on price signals?

Introduction to Macroeconomics In Macro we will ask questions about “aggregates” … the summation of all the micro effects

Introduction to Macroeconomics National Product: How big a pie can society sustainably produce? Why aren’t we always producing up to that full sustainable capacity … to our potential?

Introduction to Macroeconomics Unemployment: Why does it happen? What causes it to persist?

Introduction to Macroeconomics Inflation/Deflation: What causes the purchasing power of our money to fall/rise? Why are such changes a problem?

Introduction to Macroeconomics Growth: What causes the size of the economy’s potential production to grow?

Introduction to Macroeconomics Method: As with Micro, we… Define terms Construct model Develop the model’s capacity to address our questions

Macro – Defining Terms Gross Domestic Product (GDP) – Aggregate final production in a given economy (domestic…within Nation’s borders) in a given year. We’re going to use a “Y” to represent real GDP

What do you think? (Included in GDP?) A new house? A used house? The realtor's fee on the used house? All the products used to produce the new house? (nails, shingles, siding etc...)

What is included... A new house?...Yes A used house?...No The realtor's fee on the used house?...Yes All the products used to produce the new house (nails, shingles, siding etc...)?...No (secondary goods)

Macro – Defining Terms Gross Domestic Product (GDP) -We’ll distinguish between: YF – full sustainable capacity real GDP or potential GDP – how big a “pie” could sustainably be produced and… Y - actual current real GDP – how big the “pie” is

Business Cycles Period of macroeconomic expansion followed by contraction

Macro – Defining Terms Phases of Business Cycles Expansion…period of economic growth measured by a rise in real GDP (Y) Growth being a steady, long term rise in GDP (Y) Plentiful jobs, falling unemployment Recession: two consecutive quarters of declining Y Depression: extended, deep decline in Y Staglfation: decline in real GDP combined with inflation A “caveat” or warning to keep in mind: Y is not a great measure of well being Standard of living vs. quality of life

Phases of Business Cycles (cont.) Peak…height of economic expansion Contraction…economic decline marked by falling real GDP Trough…bottom of contraction

Keeping the Cycle Typically, a sharp rise or fall in a key indicator sparks a series of events 4 main indicators Business investment Interest rates and credit Consumer expectations External shocks (positive or negative)

Forecasting Business Cycles Not easy to predict…have to predict a change in real GDP Use leading indicators (economic variables) Stock market Interest rates Orders of capital goods Housing starts

Limitations of GDP

Economic Growth A change in GDP over time illustrates growth For growth to occur, it should change with population Real GDP per capita measures such growth and the standard of living

Capital Deepening The process of increasing capital per worker Goal is to increase productivity Savings and investing lead to capital deepening

Population Increased population without capital deepening will lower the standard of living Increased population without increase in production will lower the standard of living

Government Taxes can increase or decrease capital deepening It is dependant upon what the taxes are spent on

Foreign Trade Foreign trade and running a trade deficit can actually be good in some ways If the goods being trading enhance capital deepening In the long run…this capital deepening can increase productivity and help to pay back debt that results from a trade deficit

Labor Force and Unemployment

Macro – Defining Terms Labor force (LF) vs. (voluntary unemployed) LF includes all those adults who want to be participating in the market system as a worker By that standard: Who would be voluntarily unemployed?

Macro – Defining Terms LF Within the Labor force (LF) some are employed (EMP) and some are unemployed (UEMP), so… LF UNEMP EMP Unemployment Rate is the % of the LF that is UNEMP

Unemployment Within the unemployed (UEMP), there are several sources/types of unemployment: Structural Unemployment Frictional Unemployment Demand Deficient (Cyclical) Unemployment

Structural Unemployment There is a job available There is a worker looking for a job, but … the worker’s skills don’t match the job’s requirements How could this happen in significant numbers?

Structural Unemployment Due to technological change the workers’ skills become outdated … We expect this to happen in a growing, dynamic economy There will always be some structural unemployment in a healthy, growing economy It would only disappear in a stagnant economy, and we don’t want that

Frictional Unemployment There is a job available There is a worker with the right skills looking for a job, but … the worker is still searching for the job. How could this happen in significant numbers?

Frictional Unemployment Job search takes time … This time spent searching is beneficial to the individual and to a growing, dynamic economy We want individuals to find the right job for their skills, not just take the first job they find This is more productive for the individual and society.

Frictional Unemployment We can help facilitate workers’ search process But there will always be some frictional unemployment in a healthy, growing economy… It would only disappear in a stagnant economy, and we don’t want that.

Demand Deficient Unemployment Demand Deficient (Cyclical) Unemployment This represents the unemployment caused by a lack of job opportunities … Not enough jobs for the workers who want to be employed No amount of training or search will solve this problem.

Demand Deficient Unemployment Demand Deficient Unemployment is NOT a part of a healthy, growing economy It represents wasted resources and lower standard of living This is a Macro problem that urgently needs attention

Unemployment Types and Rate Recall the UR is the % of the LF that is UNEMP Of the three kinds of UNEMP two, structural and frictional, are a natural part of a healthy and growing economy. Since structural and frictional unemployment are a natural part of a healthy and growing economy… We call that part of the overall UR that consists of structural and frictional unemployment the: Natural Rate of Unemployment

Natural Rate of Unemployment So suppose the government’s reported unemployment rate is 7%... If the natural rate is 5%, that means that there’s 2% that is not part of a healthy growing economy… so that 2% must be demand deficient unemployment.

Natural Rate The Natural Rate (NR) plays a central role policy discourse for it represents the unemployment condition we’d find in a healthy, growing economy As such, by comparing the actual UR to the NR, we can see how close/far the economy is from a healthy, growing condition

Natural Rate The problem with this standard of macro economic health is that there is disagreement about the standard. Some economists argue that the NR is 4.5-5.0%... Others put it at 6.0-6.5% It’s very difficult to directly measure the NR, thus the potential for differences

Natural Rate Given these different views of the NR it’s possible for two economists to look at the same reported UR, say 5.5%, and for one to say the UR is above the NR so we have demand deficient unemployment and therefore slack in the economy … And the other to say that the UR is below the NR (which we’ll see is possible) and thus, as we will see, we are putting too much pressure on the economy

Unemployment Terms LF UNEMP EMP YF So … Demand Deficient Structural Frictional Natural Rate YF The NR is achieved when the economy is effectively using all its resources The economy is at YF when all resources are being used effectively So …

Natural Rate Natural Rate YF When the economy is at the Natural Rate then we know that it’s also at YF - Full sustainable capacity real GDP … and vice versa Thus they are proxies for one another

Macro –Arranging Terms When the economy is at the Natural Rate…at YF…it’s using its resources most efficiently and effectively There’s no “slack” There is a micro condition that must be true for this macro case to be true… What is it?? General Competitive Equilibrium (GCE)

Micro/Macro Connection Macro is just the aggregate condition that is created by all the micro conditions so it follows that for the macro economy to be healthy (NR/YF), the micro economy must be healthy (at GCE)

Macro Conditions: Y = YF UNEMP = NR The Goal (GCE) Y < YF Slack Y > YF UNEMP < NR Pressure

Inflation and Prices

Price Levels Price Level – the cost of living Measured by the market basket… The aggregate cost of the “things” we buy. When the cost of that market basket goes up, that’s inflation When the cost of that market basket goes down, that’s deflation

Inflation/Deflation - Problems Inflation – very corrosive to national “psyche” if it is too fast… many are making desperate efforts to keep up with “cost of living” discourages investment it raises interest rates because … lenders charge higher interest to cover the anticipated loss of buying power in the dollars they’ll receive in the future

Inflation/Deflation - Problems Inflation – Distributive effects There are winners and losers – those who can keep up do fine, but those who can’t see their standard of living fall

Inflation/Deflation - Problems Discourages consumption Individuals hold back on buying in anticipation of lower prices in the future Discourages investment Borrowers will have to pay back in more valuable dollars (dollars with more buying power) than the ones they borrowed Distributive effects Those who need to borrow are in a very difficult position

Measuring Price Level to Determine Inflation/Deflation Consumer Price Index (CPI) – one measure of the price level “A dollar doesn’t buy what it used to! http://www.bls.gov/data/inflation_calculator.htm

Measuring Price Level to Determine Inflation/Deflation Calculating the CPI: Government determines what’s in a “standard market basket” (food, entertainment, housing, recreation) of a “normal” family of four and it identifies a “base year” a year that will be the reference or orientation year in which a dollar is worth its full value, in real purchasing power

Measuring Price Level in a Target Year Cost basket in base year: CB Cost of basket in target year CT

Measuring Consumer Price Index in Target Year CPIT = (CT/CB) × 100 CT = 250 CB = 125 Then…CPIT = 200

Consumer Price Index Consumer Price Index (CPI) – What it represents in our example: If in the base year a dollar is worth 100 cents in purchasing power, in the target year it takes 200 cents to buy the same market basket

CPI and Inflation/Deflation Consumer Price Index (CPI) and measuring Inflation/Deflation Measuring % Change in price level from year X to year Y % Change in price level = [(CPIY – CPIX) ⁄ CPIX] × 100 If CPIX = 100 and CPIY = 125, then % Change in Price Level = [(125 – 100) ⁄ 100] × 100 = 25%

Real vs. Nominal Real values reflect what is actually so while nominal values only reflect what is apparently so… A non-economic example???

Real vs. Nominal Comparing economic data over time measured in current (nominal) dollars, these nominal values may not reflect the underlying real changes, because the dollar itself is constantly changing in value Using nominal values as a measure is like using ruler that is constantly changing length

Real vs. Nominal Comparing economic data, measured in dollars (or any currency), across time: Supposed the measured GDP changed from $5,000 to $10,000 You have to ask yourself: Does this increase really reflect a bigger pie … more actual, real GDP or does this increase simply reflect a rise in the price level that doubled the apparent, nominal GDP?

Real vs. Nominal Nominal values include both real and price effects, because … Nominal value = Real value × Price level How much of the nominal change is real depends on how much of the nominal change is caused by a change in the price level To determine that …

Real vs. Nominal We divide out the price effect: Nominal value ⁄ Price level = Real value When looking at economic data measured in dollars, you should always ask yourself: Is this real or nominal data?

Real vs. Nominal If it’s real data, intertemporal comparisons are valid because the price effects have been divided out If it’s nominal data intertemporal comparisons are meaningless because you can’t determine how much of the change is real and how much is the effect of a changing price level