1. Why do Macroeconomics? 1

Course Learning Objectives 1.To understand the workings of the modern macroeconomy in the short run 2.We will place emphasis on how a government can deal with economic shocks especially those that effect a small open economy 3.We will also emphasize the role of expectations, flexibility & the time frame in macroeconomics 4.I will provided empirical evidence to back up (or refute) the conclusions of the models 2

See Mankiw Chpt 1 Macroeconomics is about understanding the behaviour of economic aggregates: total (national) output, employment, the general price level, etc Macro was invented by John Maynard Keynes Before Keynes people tried to understand the economy by doing micro – Micro is about understanding the behaviour of individual entities – From the bottom up Keynes pointed out that you could get insight from looking at the economy as a whole The Point of Macro 3

The two are related (or ought to be) but the process of aggregating all the individual markets has the potential to make things very complicated – E.g. USSR Macro is basically a series of short cuts that allow us cut through the complication of aggregation 4

The Point of Macro This is one reason why macro can be controversial – Plenty of room to disagree on the appropriateness of short cuts in any model There should not be disagreement because any Model should be – “As simple as it needs to be – but no simpler” – Empirically validated i.e. it really does explain the world (the scientific method) This is relevant to the recent crisis 5

Implication for the Course We will start with simple models and add to them as we need to understand more phenomena I will present empirical justification of each model i.e. show that it works under what circumstances (Learning Objective 4) 6

Ideology and Macro Macro much more than macro is influenced by ideology This is even true in the profession This should not happen if the scientific method is applied – Although more difficult in economics than natural science – Ambiguity facilities polemics See the current crisis It is important to separate out technical economics issues from your (and my) political biases I will point out ideological issues as we go 7

The Big Questions Three important Questions in Macro: 1.How do we ensure High Employment / Low Unemployment ? 2.How do we generate Price Stability / Low Inflation? 3.How do we Growth the economy? Our concern is with the first two (Learning Objectives 1 & 2) – Often referred to as “Stabilization policy” The third is more a long-run matter and is left to Macro II 8

A Word on Growth Really Important question Why and how are some countries richer than others? – Example of Zambia vs Korea – Ireland vs Everybody pre Celtic Tiger A side note: look at the dip in korea around 1997 – Asian banking crisis – In the long run even extreme crises look trivial 9

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Fluctuations in economic activity: GDP in Booms and Recessions Why do they occur? (LO 1) & What do we do about them? (LO2) 0 Time Real GDP Actual Trend Recession Boom Our Focus: Economic Cycles 12

Why Care? Economic Cycles may seem trivial in comparison to growth so why bother with them? Two reasons: 1.Recessions may be short run phenomena but can cause a lot of pain if you are in them 2.Misunderstanding cycles could lead to wrong policies that undermine long term growth 13

Cyclical Misery Over the cycle unemployment and inflation can cause plenty of human misery – Misery index is the sum of the two Aside: later we will look at whether moderate unemployment and inflation are really costly As you know from first year – A recession will tend to increase U and lower  – A boom will tend to decrease U and raise  – There would seem to be a trade-off between U and  – While this may be true in the short-run, it may not be so in the long- run – Investigating the nature of this trade-off an whether we can take advantage of it is a huge question we will spend a lot of time on it – This is all related to LO 3 14

CYCLES AND UNEMPLOYMENT Unemployment tends to fall in booms and rise in recessions 0 Time Real GDP Actual Trend 0 Time U % Unemployment Rate (U%) 15

CYCLES AND INFLATION Inflation often falls in recessions and accelerates in booms 0 Time Real GDP Actual Trend 0 Time + _  Inflation Rate (  %) 16

STABILISATION – “NATURAL” GDP, etc. If cycle causes problems then we should stabilise the economy to be close to Trend GDP Broadly this corresponds to a level of GDP where output and employment are such that inflation is stable. The corresponding “natural” rate of Unemployment is a concept we shall meet later. It depends on structural features of the labour market: labour mobility, wage flexibility, levels of unemployment benefits, etc. The Natural Unemployment rate is not fixed: it can be influenced by policy (and history). 17

STABILIZATION: TARGETS AND INSTRUMENTS A useful framework is to think in terms of – (a) policy targets or objectives – (b) policy instruments. A coherent policy must have at least as many targets as instruments. – Think of dart boards and darts Our targets in the short/medium term are – (i) Full-employment GDP (“natural” GDP) – (ii) price stability, or low inflation Our instruments are – Fiscal Policy – Monetary Policy There will be trade-offs between the targets There will also be important questions about which policy one assigns to which target. 18

Example: The Current Crisis Talk of targets and instruments may sound abstract but is relevant to current situation and not understood by many authorities Four targets: 1.Control deficits 2.Re-capitalise banks 3.Provide Liquidity to markets 4.Boost employment One Instrument allowed: Fiscal policy Others not allowed: Monetary policy 19