Chapter 1 An Introduction to Macroeconomics Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Introduce three linked macroeconomic models that explain the behavior of the economy Explain the long-run growth in productive capacity Use the concepts of aggregate supply and aggregate demand to explain what determines the rate of inflation Introduce the concept of the business cycle to explain variations from the long-run growth path Outline the two main schools of thought that have influenced the economic policy debate in the past 50 years Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 1.1 Macroeconomics Encapsulated in Three Models 1.2 To Reiterate . . . 1.3 Schools of Thought 1.4 Outline and Preview of the Text 1.5 Prerequisites and Recipes Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

1.1 Three Models Macroeconomics is organised around three models. Each model is concerned with different time frames: The long run The medium run The short run. Let’s consider each in more detail. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Very Long Run Economic Growth The long run is a period of decades or more over which potential output is expected to grow. The time period is usually measured in multiples of decades (e.g. 20 years or more). Growth theory describes the long-run behaviour of the economy. Short-run fluctuations in important variables like employment, investment and output are ignored, on the assumption that changes in these variables average out over time. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Very Long Run Economic Growth The long-run level of output is determined solely by supply-side considerations. Output is determined by the productive capacity of the economy. All factors of production (land, labour, capital and technology) are assumed to be fully employed. The economy is operating at its ‘potential output’. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Very Long Run Economic Growth Economic growth is a function of increases in productive capacity. Major causes of economic growth are: Development of new technology Accumulation of physical and human capital Appropriate provision of infrastructure Higher rates of domestic saving. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Very Long Run Economic Growth Economic growth determines the changes in the standard of living. A country growing at an average of 4% per year instead of 2% will have a 50% higher standard of living over a generation of 20 years. This higher 4% average annual growth rate will lead to a seven-fold increase in the standard of living over 100 years! Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Productive Capacity In the long run the productive capacity of the economy is assumed to be constant or fixed. The productive capacity of the economy determines output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Productive Capacity This is represented by a vertical aggregate supply schedule at real output level Y0 (potential output). P Y0 Y AS Price Level Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Productive Capacity This level of output is associated with a certain rate of growth in prices. What determines the change in the overall price level (the inflation rate)? The aggregate supply (AS)–aggregate demand (AD) model explains short- to medium-run determination of inflation and real output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Productive Capacity The AD schedule represents, for each price level, the level of output where both the goods and money markets are in equilibrium. The intersection of the AS and AD schedules determines the price (P0) and real output (Y0). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Fixed Productive Capacity AD and AS in the long run. What happens when AD shifts rightwards? P Y0 Y AD Price Level AS P0 Price increases What happens when AS shifts rightwards? Price decreases Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Short Run The short run is a period of time short enough that markets are unable to clear. In the short run actual output can deviate from potential output. Short-run fluctuations in real output are important. AD is the major determinant of these variations. In the short run the price level is pegged, making the short-run AS schedule horizontal. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

What happens when AD shifts rightwards? The Short Run AD and AS in the short run. What happens when AD shifts rightwards? P Y0 Y AD Price Level P0 Price unchanged AS Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Medium Run How do we describe the transition between the short run and the long run? High AD pushes real output above Y0 (according to the long-run model). Over time, firms will increase prices and the AS curve will move upwards. The medium run will give an upward-sloping AS curve. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Medium Run The relative steepness of the AS curve is a major controversy in macroeconomics. P Y0 Y AD Price Level AS P0 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 1.1 Macroeconomics Encapsulated in Three Models 1.2 To Reiterate . . . 1.3 Schools of Thought 1.4 Outline and Preview of the Text 1.5 Prerequisites and Recipes Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

1.2 To Reiterate … Growth theory and the AS–AD framework can be used to analyse many macroeconomic issues. These two models provide a basis for the further analysis of: Growth and GDP The business cycle. Let’s consider each in turn. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Growth and GDP Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Growth and GDP Table 1.1 compares the per capita real income growth rates in various countries. Note the very large differences ranging from 0.3% for Ghana to 3.1% for Japan. Brazil (2.2%), China (3.1%) and France (2.0%) are the next band. Note the lower but similar growth rates for Australia (1.6%) and New Zealand (1.5%). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Business Cycle and GDP The business cycle describes the variation of economic activity around the path of trend growth. Inflation, growth and unemployment all demonstrate cyclical patterns that contribute to this variation. The output gap measures cyclical variations in output from the trend growth path. It measures the difference between actual and potential output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Business Cycle and GDP Output gap = potential output – actual output. During a recession, actual output falls below potential output. A negative gap is associated with unemployment. During a boom, actual output rises above potential output. A positive gap is associated with over employment. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

The Business Cycle and Inflation The cost of the cycle above trend is inflation and the cost below trend is unemployment. The costs of inflation are less obvious than those of unemployment. Unemployment is associated with a loss in potential output. Inflation upsets price relationships and reduces the efficiency of the price system. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features Business cycles have common characteristics. Business cycles are associated with a pattern of expansion (recovery) and contraction (recession). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features Economic variables can indicate something of the nature of the business cycle. Procyclical variables rise with expansionary business activity (e.g. output, employment, interest rates and money supply). Countercyclical variables (like inventories and bankruptcies) move in the opposite direction to business activity. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features Some variables exhibit more variability (volatility) than others. For example, inventories are volatile while consumption is smooth, especially relative to output. Business cycles do not occur as regular fluctuations in the level of economic activity. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features The impulse-propagation model can be used to explain what causes actual output to deviate from the trend. The impulse-propagation model explains: How shocks (impulses) disturb the economy from its long-run trend How this leads to effects that last (propagate) over time. Economists disagree over possible propagation mechanisms. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features There are three broad types of shocks: Policy shocks, which affect fiscal expenditure and interest rates (e.g. fiscal and monetary policies) Supply shocks, which affect production and price-setting (e.g. technology advances) Private sector shocks, which affect aggregate demand (e.g. changes in private investment). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features There is debate about the several aspects of Australian business cycles. What is a business cycle? How are variations in economic activity separated from the trend? Which indicators should be used to measure the business cycle? Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features Various economic indicators can be used to measure the course of the business cycle: Leading indicators, like firms’ profitability and building approvals precede changes in GDP. Lagging indicators, like unemployment lag changes in real GDP. Variables can be aggregated into a composite index that will give a coincident index to measure turning points in the business cycle. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Business Cycle Features Two types of business cycle can be identified: The classical business cycle considers actual levels so that a fall in GDP describes negative growth. Two consecutive quarters of negative growth in real GDP is called a (classical) recession. The growth cycle considers fluctuations in growth rates of the economy around the trend growth rate. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 1.1 Macroeconomics Encapsulated in Three Models 1.2 To Reiterate . . . 1.3 Schools of Thought 1.4 Outline and Preview of the Text 1.5 Prerequisites and Recipes Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

1.3 Schools of Thought During the 1960s there were two main views: The monetarists believed the economy is best left to itself. The Keynesian’s argued that government intervention could improve economic performance. Two schools have developed since then: The New Classical school in the 1970s The New Keynesian school in the 1980–90s. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

New Classical School Three central assumptions of the New Classical school are: Economic agents optimise Decisions are made rationally use all available information (rational expectations) Markets are assumed to clear. These assumptions ensure there is no involuntary unemployment. They also lead to a further assumption that markets are continuously in equilibrium. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

New Keynesian School Extends the earlier Keynesian view that markets will not always clear even if agents are maximising. Reasons are varied and include: There is incomplete information. Institutions affect the workings of markets. Costs of changing wages and prices lead to price rigidities. These reasons explain fluctuations in output and employment. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Economic Controversies The two main competing views of modern macroeconomics are highlighted in real-world political and media discussions. These differences are frequently exaggerated in debate. There are significant areas of agreement. Debate and research continually evolve new areas of consensus e.g. there is increasing agreement on information problems with wage-price setting. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 1.1 Macroeconomics Encapsulated in Three Models 1.2 To Reiterate . . . 1.3 Schools of Thought 1.4 Outline and Preview of the Text 1.5 Prerequisites and Recipes Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

1.4 Text Outline and Preview The key overall concepts of this book are growth, aggregate supply and demand. Chapters 3 and 4 consider long-run economic growth. Chapters 5–6 explore the AS curve and wage/price impacts. Chapters 7–9 explore models of income and expenditure. Chapters 10–11 analyse international adjustment in an integrating global economy. Chapters 12–16 examine individual sectors that make up an economy. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

1.4 Text Outline and Preview The key overall concepts of this book are growth, aggregate supply and demand. Chapters 17–19 consider big issues in economics and related policy applications in an uncertain world. Chapter 20 introduces briefly some frontiers of macroeconomic research. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Chapter Organisation 1.1 Macroeconomics Encapsulated in Three Models 1.2 To Reiterate . . . 1.3 Schools of Thought 1.4 Outline and Preview of the Text 1.5 Prerequisites and Recipes Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

1.5 Prerequisites and Recipes The text requires no mathematical prerequisite beyond high school algebra. There are a number of helpful websites, including: www.mcgraw-hill.com.au/mhhe/econ/ dornbusch (for chapter summaries and problems) www.rba.gov.au www.treasury.gov.au www.abs.gov.au www.asx.com.au www.ecosoc.org.au/ www.economist.com www.economist.about.com rfe.wustl.edu Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.