Macroeconomics Macroeconomics this term. Text: Krugman, Wells, Au and Parkinson Macroeconomics. Why Krugman’s text? - A top economist. Interest in policy and current events (NY Times blog). A good writer. Business cycle focus. Macro-Wars: Krugman – strong advocate of Keynesian style macroeconomics.

Macroeconomics: The Big Picture SECOND CANADIAN EDITION MACROECONOMICS Paul Krugman | Robin Wells Iris Au | Jack Parkinson Chapter 6 Macroeconomics: The Big Picture © 2014 Worth Publishers

Learn to be make some sense of this:

Introduction to Macroeconomics What will we cover this term? Macroeconomic concepts: Definitions and importance. Measurement of macroeconomic variables: how? why? Macroeconomic theory and models Explaining levels and changes in macroeconomic variables. Introduce some of the competing theories. Textbook: Chapters 6 to 19. Start with Chapter 6: “Macroeconomics the Big Picture”

What makes macroeconomics different from microeconomics What is a business cycle? Long-run economic growth determines a country’s standard of living Some basic macro concepts are introduced: inflation and deflation trade deficits and trade surpluses Chapter 6: KEY POINTS

Macroeconomics versus Microeconomics Begin by looking at the difference between microeconomic and macroeconomic questions. MICROECONOMIC QUESTIONS MACROECONOMIC QUESTIONS Go to university or take a job? How many people are employed in the economy as a whole? What determines the salary offered by Royal Bank to its new CEO? What determines the overall salary levels paid to workers in a given year? What determines the price of a cup of coffee at Lakehead? What determines the overall level of prices in the economy as a whole? What policies should be adopted to make it easier for low-income students to attend college? What policies should be adopted to promote full employment and growth in the economy as a whole? What determines whether Ford produces its F-150 in Canada or Mexico? What determines the overall trade in goods, services and financial assets between Canada and the rest of the world?

Microeconomics Microeconomics focuses on decisions made by individuals and firms and the interactions of these decision-makers. Microeconomic approach: - Individual decision-makers compare the costs and benefits of some action. - Undertake the action if benefits > costs. e.g. a business supplies more output if Price > Marginal cost

Macroeconomics Macroeconomics examines aggregate economic outcomes i.e. results of the combined actions of all the decision- makers in the economy e.g. total output, average prices, etc. Why do we need macroeconomics? - aggregate outcomes are just the sum of microeconomic decisions. - why not just use microeconomic models?

Why isn’t microeconomics enough? Complexity of a microeconomic approach to macro. Millions of decision-makers, thousands of markets and their interaction give macroeconomic outcomes. This is not manageable at a practical level: too complex. Solutions typically possible only in very special cases. The behavior of the whole economy is often more than the simple sum of individual actions and market outcomes.

Macroeconomic versus Microeconomic Results Example: an increase in the money supply. Individual receives more money and is richer! (micro) Aggregate (macro): everyone has more money, all prices rise: no one is richer! Example: Paradox of thrift families and businesses are worried about possible hard times, and prudently cut spending and save more. The reduction in spending depresses the economy as consumers spend less and businesses react with layoffs. Aggregate Result? Families and businesses may end up worse off than if they hadn’t acted prudently by cutting their spending!

Macro versus Micro Examples (cont’d) Explaining aggregate economic breakdown. Recessions and depressions: microeconomic approaches have problems explaining why these occur (supply-demand and self-regulating economies). Macroeconomics arose to explain the Great Depression and suggest how to deal with it. (Keynesian macro)

Macroeconomics: What is covered? Concern with macro concepts and their measurement: What are we trying to explain? How to measure it? Aggregate economic variables: Gross Domestic Product, price level, inflation, unemployment, etc. Macroeconomic models: explain what determines levels and changes in macroeconomic variables. Used in policy: what can and should government do? Used in forecasting: how will the aggregate economy evolve?

Macroeconomics: Theory and Policy In a self-regulating economy, recessions are resolved without government intervention, through the working of the “invisible hand”. (microeconomic coordination) According to Keynesian macroeconomics: Self-regulation may not always work. Slumps are caused by inadequate spending and can be mitigated by government. Monetary policy uses changes in the quantity of money to alter interest rates and affect overall spending. Fiscal policy uses changes in government spending and taxes to affect overall spending.

A Tale of Two Recessions FENDING OFF DEPRESSION: a role for macro? In 2008, the world economy experienced a financial crisis reminiscent of the early days of the 1930s Great Depression. Spring 2009: economic historians Barry Eichengreen and Kevin O’Rourke point out that “globally, we are tracking or even doing worse than the Great Depression.” But another Depression was avoided. Why? At least part of the answer is that policy makers responded very differently.

A Tale of Two Recessions Fending off Depression In the early 1930s, some countries’ monetary authorities raised interest rates in the face of the slump, while governments cut spending and raised taxes—actions that deepened the recession. After the 2008 crisis, interest rates were slashed, and many countries, Canada included, used temporary increases in spending and reductions in taxes in an attempt to sustain spending. The result:

The Business Cycle The business cycle is the short-run alternation between economic downturns and economic upturns. A depression is a very deep and prolonged downturn. Recessions are periods of economic downturns when output and employment are falling. Expansions, sometimes called recoveries, are periods of economic upturns when output and employment are rising.

The Business Cycle The point at which the economy turns from expansion to recession is a business-cycle peak. The point at which the economy turns from recession to expansion is a business-cycle trough.

The Business Cycle Figure Caption: Figure 6(21)-4: The Business Cycle This is a stylized picture of the business cycle. The vertical axis measures either employment or total output in the economy. Periods when these two variables turn down are recessions; periods when they turn up are expansions. The point at which the economy turns down is a business-cycle peak; the point at which it turns up again is a business-cycle trough. 18

Defining Recessions: a Measurement Issue Common rule-of-thumb: a recession is a period of at least 6 months during which aggregate output falls. U.S. - panel of experts at the National Bureau of Economic Research (NBER) dates US recessions. - Examine a number of indicators, with the main focus on employment and production, and then makes a judgment call. (see: http://www.nber.org/cycles.html)

Canadian Business Cycles Cross and Bergevin (2012) “Turning Points: Business Cycles in Canada since 1926” (http://www.cdhowe.org/pdf/Commentary_366.pdf) Table 1: Historical Chronology of Canadian Recessions since 1926 Peak Trough Severity (5 worst, 1 least) April 1929 (1929:Q2) February 1933 (1933:Q1) 5 November 1937 (1937:Q3) June 1938 (1938:Q2) 5 August 1947 (1947:Q2) March 1948 (1948:Q1) 2 April 1951 (1951:Q1) December 1951 (1951:Q4) 3 July 1953 (1953:Q2) July 1954 (1954:Q2) 4 March 1957(1957:Q1) January 1958 (1958:Q1) 3 March 1960 (1960:Q1) March 1961 (1961:Q1) 3 December 1974 (1974:Q4) March 1975 (1975:Q1) 2 January 1980 (1979:Q4) June 1980 (1980:Q2) 1 June 1981 (1981:Q2) October 1982 (1982:Q4) 4 March 1990 (1990:Q1) April 1992 (1992:Q2) 4 October 2008 (2008:Q3) May 2009 (2009:Q2) 4

The Business Cycle What happens during a business cycle? The effects of recessions and expansions on employment and unemployment The effects on aggregate output The possible government policy responses. Look at period containing three major recessions: Early 1980s Early 1990s Late 2000s.

Growth, Interrupted, 1988-2010 Figure Caption: Figure 6(21)-3: Growth, Interrupted, 1961-2011 Panel (a) shows two important economic numbers, the level of real GDP and employment. Both numbers grew substantially from 1961 to 2011, but they didn’t grow steadily. Instead, both suffered from three downturns due to recessions, which are indicated by the shaded areas in the figure. Panel (b) emphasizes those downturns by showing the annual rate of change of real GDP and employment, that is, the percentage increase over the previous year. The simultaneous downturns in both numbers during the three recessions are clear. Source: Statistics Canada.

The Canadian Unemployment Rate Figure Caption: Figure 6(21)-5: The Canadian Unemployment Rate, 1960-2011 The unemployment rate, a measure of joblessness, rises sharply during recessions (which are indicated by the shaded areas) and usually falls during expansions. Source: Statistics Canada. 23

Taming the Business Cycle: a policy role? Policy efforts undertaken to reduce the severity of recessions are called stabilization policies. One type of stabilization policy is monetary policy: changes in the quantity of money or interest rates. The second type of stabilization policy is fiscal policy: changes in tax policy or government spending, or both.

Global Comparison: International Business Cycles Notes to the Instructor: This figure shows the annual rate of growth in industrial production—the percent change in each year’s production over the previous year—for four economies during 1991 to 2011: Canada, Japan, the United States, and the eurozone. Do other economies have business cycles similar to those in Canada? The answer, which is clear from the figure, is yes. Furthermore, business cycles in different economies are often, although not always, synchronized. The downturn of Canadian industrial production of 2001 was paralleled by the recesssions in the other three economies; the U.S. Great Recession 2007-2009 caused a severe slump around the world, including Canada. But not all business cycles are international phenomena. Japan suffered a fairly severe recession in 1998, even as the economies of Canada, the United States, and the eurozone continued to expand. Source: OECD. 25

Canada and the US in the Great Recession Comparing Recessions Not all business cycles are created equal and the same business cycle may have different impacts on distinct economies. Rescession 2007-2009 : United States: “Great Recession” Canada: not as severe as the U.S.

Comparison: Canada and US in the Great Recession Figure Caption: Figure 6(21)-6: Unemployment Rates and Percentage Change in Industrial Production Even though the “Great Recession” affected the economies of Canada and the United States, it had less impact on Canada than it did on the U.S. The U.S. economy experienced sharper rise in unemployment rate and a larger drop in the growth rate of industrial production than Canada. Source: International Financial Statistics. 27

Canada and US in the Great Recession The recession began in the U.S. in 2007 and in Canada in late 2008. Set off by housing price collapse (US) which lead to a crisis in U.S. mortgage and other financial markets. Lehman Brothers filed for bankruptcy in September 2008. - crisis spread to other sectors in the American economy and the rest of the world. - Canada: financial system sound. US and Canada: timing of movements similar but severity of recession quite different.

Canada and US in the Great Recession Before the recession, the U.S. had a lower unemployment rate and higher growth in industrial production than Canada When the crisis hit, the U.S. experienced a much larger increase in its unemployment rate. By end of 2011, Canada’s unemployment rate was at pre-recession level; U.S. rate remained higher until 2014. The same pattern also applied to industrial production. The recent financial crisis and the recession it spawned had less impact on Canada than it did on the U.S.

Long-Run Economic Growth Long-run economic growth is the sustained upward trend in the economy’s output over time. A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. A central concern of macroeconomics: what determines long-run economic growth?

Growth, the Long View

Growth or Cycles? What’s more important economic growth or business cycles? Previous diagram: long-term trend dominates cycles. Should macroeconomics focus on growth? What can policy-makers affect most cycles or growth?

A History of Economic Growth When Did Long-Run Growth Start? Long-run growth is a relatively modern phenomenon. From 1000 to 1800, real aggregate output around the world grew less than 0.2% per year, with population rising at about the same rate. Economic stagnation meant unchanging living standards. For example, information on prices and wages from monastery records shows that English workers weren’t much better off in the early 1700s than they had been in the 1200s.

Economic History’s Hockey Stick

The Era of Modern Economic Growth When Did Long-Run Growth Start? Long-run economic growth has increased significantly since 1800. Industrial Revolution: sustained technological progress. In the last 50 years or so, real GDP per capita in Canada has grown by about 2.1% per year.

Argentina: an unusual case A Tale of Two Colonies One of the most informative contrasts in long-run growth is between Canada and Argentina. Argentina was among the richest countries 1910-30. Economic historians believe that the average level of per capita income was about the same in the two countries as late as the 1930s.

Canada vs. Argentina: Divergence! A Tale of Two Colonies After World War II, however, Argentina’s economy performed poorly, largely due to political instability and bad macroeconomic policies. Meanwhile, Canada made steady progress. Thanks to the fact that Canada has achieved sustained long-run growth since 1930, but Argentina has not, Canada’s standard of living is about three times as high as Argentina’s. Argentina: a rare example of a country that fell from the richest group.

Inflation and Deflation A rising aggregate price level is inflation. A falling aggregate price level is deflation. The inflation rate is the annual percent change in the aggregate price level. The economy has price stability when the aggregate price level is changing only slowly. Concern of Chapters 7,8. Individual prices can move much differently than the average. Notes to the Instructor: Because inflation and deflation can cause problems, price stability is generally desirable. In reality, the inflation rate has mainly been positive for decades, though we are not too far from price stability today.

Inflation and Deflation: 1991-2011 Figure Caption: Figure 6(21)-8: Rising Prices Between 1991 and 2011, the wages of workers who were paid by the hour rose by 55% and the pay of salaried workers rose by 69%. But the prices of goods and services also rose, by varying amounts. The Consumer Price Index (CPI) rose by 45%. Consequently, real income increased for salaried workers and for workers who were paid by the hour, but by different amounts. Source: Statistics Canada. 39

ECONOMICS IN ACTION A Fast (Food) Measure of Inflation The first McDonald’s in Canada opened in 1967: a hamburger was about $0.39. By 2012, a hamburger at a typical Canadian McDonald’s was almost four times as much, about $1.39. Is this too expensive? No. In fact, a burger is, compared with other consumer goods, a better bargain than it was in 1967.

ECONOMICS IN ACTION A Fast (Food) Measure of Inflation Burger prices were almost four times as high in 2012 as they were in 1967. But most goods costing $0.39 in 1967 cost $2.65 in 2012, which is almost seven times as much.

International Imbalances An open economy is an economy that trades goods and services with other countries. A country runs a trade deficit when the value of goods and services bought from foreigners (imports) is more than the value of goods and services it sells to them (exports). It runs a trade surplus when the value of goods and services bought from foreigners is less than the value of the goods and services it sells to them. Trade balance differs substantially across countries and over time.

International Imbalances Figure Caption: Figure 6(21)-9: Unbalanced Trade In 2011, the goods and services Canada bought from other countries were worth slightly more than the goods and services we sold abroad. The United States had an even large trade deficit. Germany and China were in the reverse position. Trade deficits and trade surpluses reflect macroeconomic forces, especially differences in savings and investment spending. Source: World Trade Organization. 43

Trade Deficits and Surpluses Later (Ch. 10) will see that they trade deficits and surpluses and financial flows between countries are interdependent. A macroeconomic perspective is needed to understand them and their consequences. (text: Baltic examples – substantial trade deficits yet economies were doing well)

Summary Macroeconomics is the study of the behavior of the economy as a whole. Macroeconomics differs from microeconomics in the type of questions it tries to answer and in its strong policy focus. Keynesian economics, which emerged during the Great Depression, advocates the use of monetary policy and fiscal policy to fight economic slumps. Prior to the Great Depression, the economy was thought to be self-regulating.

Summary One key concern of macroeconomics is the business cycle, the short-run alternation between recessions, periods of falling employment and output, and expansions, periods of rising employment and output. The point at which expansion turns to recession is a business-cycle peak. The point at which recession turns to expansion is a business-cycle trough.

Summary Another key area of macroeconomic study is long-run economic growth, the sustained upward trend in the economy’s output over time. Long-run economic growth is the force behind long-term increases in living standards and is important for financing some economic programs.

Summary When the prices of most goods and services are rising, so that the overall level of prices is going up, the economy experiences inflation. When the overall level of prices is going down, the economy is experiencing deflation. In the short run, inflation and deflation are closely related to the business cycle. In the long run, prices tend to reflect changes in the overall quantity of money. Because inflation and deflation can cause problems, economists and policy makers generally aim for price stability.

Summary Although comparative advantage explains why open economies export some things and import others, macroeconomic analysis is needed to explain why countries run trade surpluses or trade deficits. The determinants of the overall balance between exports and imports lie in decisions about savings and investment spending.

Key Terms Self-regulating economy Price stability Keynesian economics Open economy Monetary policy Trade deficit Fiscal policy Trade surplus Recession Expansion Business cycle Business-cycle peak Business-cycle trough Long-run economic growth Inflation Deflation