Chapter 1 Introduction Copyright © 2010 Pearson Education Canada

Chapter 1 Topics What is macroeconomics? GDP, economic growth, business cycles. Macroeconomic models. Understanding recent and current macroeconomic events. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

What Is Macroeconomics? It is the study of the behaviour of large collections of economic agents. It focuses on the aggregate behaviour of consumers and firms, the behaviour of governments, the overall economic activity in individual countries, the economic interactions among nations, and the effects of fiscal and monetary policy.

What Is Macroeconomics? Macro is distinct from micro in that it deals with the overall effects on economies of the choices that all economic agents make, rather than the choices of individual consumers and firms. Since the 1970s, however, the distinction between micro and macro has blurred. Because microeconomists and macroeconomists now use much the same kind of tools.

What Is Macroeconomics? What continues to make macro distinct is the issues on which it focuses, particularly long-run growth and business cycles. Long-run growth refers to the increase in a nation’s productive capacity and average standard of living that occurs over a long period Business cycles are the short-run ups and downs, or booms and recessions, in aggregate economic activity.

What Is Macroeconomics? Approach in this book is to build up macroeconomic analysis from microeconomic principles. There is some effort required in taking this type of approach, but the effort is well worth it The result will be that you better understand how the economy works and how to improve it.

We must first understand what facts we are trying to explain. Gross Domestic Product, Economic Growth, and Business Cycles We must first understand what facts we are trying to explain. The most basic set of facts in macro has to do with the behaviour of aggregate economic activity over time. One measure of aggregate economic activity is Gross Domestic Product (GDP). Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Gross Domestic Product, Economic Growth, and Business Cycles GDP is the quantity of goods and services produced within a country’s borders over a particular period of time. Figure 1.1 (next figure) shows real GDP per capita for Canada for the period 1870-2007. This is a measure of aggregate output that adjusts for inflation and population growth rate, and the unit of measure is 2002 dollars per person

Per Capita Real GDP in Canada Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Gross Domestic Product, Economic Growth, and Business Cycles In analyzing economic data to study economic growth and business cycles, it often proves useful to transform the data in various ways, so as to obtain sharper insights. A useful transformation is take the natural logarithm of the time series data (such as, per capita real GDP)

Natural Log of Per Capita Real GDP Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Gross Domestic Product, Economic Growth, and Business Cycles A second useful transformation to carry out on an economic time series is to separate the series into two components: the growth or trend component, and the business cycle component. In Figure 1.3 trend GDP was computed using a Hodrick-Prescott filter. The deviations between the actual GDP and trend GDP represent business cycles.

Natural Log of Per Capita Real GDP and Trend Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Percentage Deviations From Trend in Per Capita Real GDP Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Macroeconomic Models Economics is a scientific pursuit involving the formulation and refinement of theories that can help us better understand how economies work and how they can be improved. In macroeconomics, most experiments that could be informative are simply too costly to carry out, and in this respect macroeconomics is much like meterology or astronomy. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Macroeconomic Models A macroeconomic model captures the essential features of the world needed to analyze a particular macroeconomic problem. Macroeconomic models should be simple. Simplicity requires that we leave out some “realistic” features of actual economies.

Basic Structure of a Macroeconomic Model The basic structure of a macro model is a description of following features: Consumers and firms The set of goods that consumers consume Consumers’ preferences The production technology Resources available Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Two additional Features of a Macroeconomic Model Once we have a description of the main actors in a model, we want to then use the model to make predictions. This step requires that we specify two additional features of the model. Specify the goals of the consumers and firms in the model – in all the models in this book it is assumed that consumers and firms optimize.

Two additional Features of a Macroeconomic Model 2. Specify how consistency is achieved in terms of the actions of consumers and firms. In economic models, this means that the economy must be in equilibrium. Several different concepts of equlibrium We will use the concept of competitive equilibrium

Competitive equilibrium In a competitive equilibrium, we assume that goods are bought and sold on markets in which consumers and firms are price-takers. The economy is in equilibrium when market prices are such that the quantity of each good offered for sale ( quantity supplied) is equal to the quantity that economic agents want to buy (quantity demanded) in each market.

Economic Model is an Experimental Apparatus Once we have a working economic model, with a specification of the economic environment, optimizing firms and consumers, and a notion of equilibrium, we can then begin to ask the model questions. Economic model is an experimental apparatus, and we want to run experiments using this apparatus.

Economic Model is an Experimental Apparatus Typically, we begin by running experiments for which we know the answers. Ultimately, once we are satisfied that a model reasonably and accurately captures the economic phenomenon we are interested in, we can start running experiments on the model for which we do not know the answers.

Different Models for Different Purposes In keeping with the principle that models should be simple and designed specifically for the problem at hand, we will not stick to a single all-purpose model. Instead, we will use an array of different models for different purposes, though these models will share a common approach and some of the same principal building blocks.

Microeconomic Principles This book emphasizes building macroeconomic models on sound microeonomic principles. Why? Rational Expectations Revolution in the 1970s Lucas Critique (Robert E. Lucas, Jr., 1976)

Disagreement In Macroeconomics There is little disagreement in macro concerning the general approach to be taken to constructing models of economic growth Solow Growth Model (Ch 6) Endogenous Growth Model (Ch 7)

Disagreement In Macroeconomics There is much controversy among macroeconomists concerning business cycle theory and the role of government in smoothing business cycle over time. In Ch 11 and 12 we will study four competing theories of business cycle: Real Business Cycle Theory Market Segmentation Theory Keynesian Coordination Failure Theory New Keynesian Model

What Do We Learn from Macroeconomic Analysis What is produced and consumed in the economy is determined jointly by the economy’s productive capacity and the preferences of consumers. (Ch 4 and 5) In free-market economies, there are strong forces that tend to produce socially efficient economic outcomes. (Ch 5) Improvements in a country’s standard of living are brought about in the long run by technological progress. (Ch 6 and 7)

What Do We Learn from Macroeconomic Analysis 4. A tax cut is not a free lunch. (Ch 8) 5. What consumers and firms anticipate for the future will have an important bearing on current macroeconomic events. (Ch 5) 6. Money takes many forms, and having it is much better than not having it. Once we have it, however, changing its quantity ultimately does not matter. (Ch 10 and Ch 15).

What Do We Learn from Macroeconomic Analysis 7. Business cycles are similar, but they can have many causes. (Ch 11 and 12) 8. Countries gain from trading goods and assets with each other, but trade is also a source of shocks to the domestic economy. (Ch 13 and 14) 9. In the long run, inflation is caused by growth in the money supply. (Ch 15)

What Do We Learn from Macroeconomic Analysis 10. Unemployment is painful for individuals, but it is a necessary evil in modern economies. (Ch 16) 11. There may be a short-run trade off between aggregate output and inflation, but no such tradeoff exists in the long run. (Ch 17)

Understanding Recent and Current Macroeconomic Events Aggregate productivity Taxes, Government Spending and the Government Deficit Interest Rates Business Cycles in Canada The Current Account Surplus and the Government Surplus Inflation Unemployment The Financial Crisis Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Average Labour Productivity FIGURE 1.5 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Government Outlays/Income Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Government Surplus Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Money Growth and Inflation Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Nominal Interest Rate and Inflation Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Real Interest Rate Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Relative Price of Energy Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Percentage Deviations From Trend in Real GDP Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Exports and Imports Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Current Account Surplus Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Unemployment Rate Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada

Fluctuations in Real GDP and the Unemployment Rate Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Copyright © 2010 Pearson Education Canada