© 2008 Pearson Addison-Wesley. All rights reserved Introduction to Macroeconomics Chapter 1

© 2008 Pearson Addison-Wesley. All rights reserved 1-2 What are your top macro issues? Based on your understanding about the current economic condition, what is your ranking of the following issues? (1) unemployment; (2) inflation; (3) economic growth; (4) stagnant incomes; (5) the trade deficit; (6) social security; (7) the government budget; and (8) income inequality. YOU answered: inflation, unemployment, income, budget

© 2008 Pearson Addison-Wesley. All rights reserved 1-3 Let’s Forecast! Current Key Macro Variables (from ): –GDP growth rate: 2 nd Q08 1.9% 1 st Q08, 0.9%, 4 th Q07, -0.2% 2007 Annual, 2%; 2006 Annual, 2.8% –Inflation: CPI (1 st half 08) 6% 2007, 4.4%; 2006, 2% –Unemployment rate: 5.7% as of 7/1/2008 6/1/08, 5.5%, 4/1/08, 5.0%;1/1/08, 4.9%;1/1/07, 4.6% –Fed Funds Target Rate: 2% 4/29/2008, 2.25%; 12/31/2007, 4.25%; 6/30/ % –What are your forecasts for this year? –WILL COMPARE TO PROFESSIONAL ESTIMATES LATER

© 2008 Pearson Addison-Wesley. All rights reserved 1-4 Chapter Outline What Macroeconomics Is About What Macroeconomists Do (skip) Why Macroeconomists Disagree

© 2008 Pearson Addison-Wesley. All rights reserved 1-5 What Macroeconomics Is About Macroeconomics: the study of structure and performance of national economies and government policies that affect economic performance Issues addressed by macroeconomists: –Long-run economic growth (ch6) –Business cycles (ch8) –Unemployment (ch3,12) –Inflation (ch12) –The international economy (ch13) –Macroeconomic policy (ch14,15) Aggregation: from microeconomics to macroeconomics

© 2008 Pearson Addison-Wesley. All rights reserved 1-6 What Macroeconomics Is About Long-run economic growth –Figure 1.1: Output of United States since 1869

© 2008 Pearson Addison-Wesley. All rights reserved 1-7 Figure 1.1 Output of the U.S. economy,

© 2008 Pearson Addison-Wesley. All rights reserved 1-8 What Macroeconomics Is About Long-run economic growth –Figure 1.1: Output of United States since 1869 –Decline in output in recessions; increase in output in expansion or war –Two main sources of growth Population growth Increases in average labor productivity –Driving forces: technology, education (human capital) –Other resources: saving rate (next page), investment, R&D, human capital

© 2008 Pearson Addison-Wesley. All rights reserved 1-9 Saving Rate of the U.S

© 2008 Pearson Addison-Wesley. All rights reserved 1-10 What Macroeconomics Is About Average labor productivity –Output produced per unit of labor input (employed worker) –Figure 1.2 shows average labor productivity for United States since 1900

© 2008 Pearson Addison-Wesley. All rights reserved 1-11 Figure 1.2 Average labor productivity in the United States,

© 2008 Pearson Addison-Wesley. All rights reserved 1-12 What Macroeconomics Is About Average labor productivity growth: –About 2.5% per year from 1949 to 1973 –1.1% per year from 1973 to 1995 –2.0% per year from 1995 to 2005 In analyzing macroeconomic data during the past year, you have discovered that average labor productivity fell, but total output increased. What was most likely to have caused this? A) There is nothing unusual in this outcome because this is what normally occurs. B) The capital/output ratio probably rose. C) There was an increase in labor input. D) Unemployment probably increased.

© 2008 Pearson Addison-Wesley. All rights reserved 1-13 What Macroeconomics Is About Business cycles –Business cycle: Short-run contractions and expansions in economic activity –Downward phase is called a recession –Upward phase: expansion or boom –Great Depression ( ): 30% –WWII ( ): 100%

© 2008 Pearson Addison-Wesley. All rights reserved 1-14 What Macroeconomics Is About Unemployment –Unemployment: the number of people who are available for work and actively seeking work but cannot find jobs –U.S. experience shown in Fig. 1.3 –Recessions cause unemployment rate to rise Question: Can unemployment rate reach zero?

© 2008 Pearson Addison-Wesley. All rights reserved 1-15 Figure 1.3 The U.S. unemployment rate, %

© 2008 Pearson Addison-Wesley. All rights reserved 1-16 What Macroeconomics Is About Inflation –General and sustained increase in prices of most goods and services –How to measure? Change in CPI –U.S. experience shown in Fig. 1.4

© 2008 Pearson Addison-Wesley. All rights reserved 1-17 Figure 1.4 Consumer prices in the United States,

© 2008 Pearson Addison-Wesley. All rights reserved 1-18 What Macroeconomics Is About Inflation: –Deflation: when prices of most goods and services decline –Inflation rate: the percentage increase in the level of prices –Hyperinflation: an extremely high rate of inflation How high is hyper? Yogolsavia dinar: 1993, 500billion. now (1$ around 50dinar) Theory and whose fault? MV=PY

© 2008 Pearson Addison-Wesley. All rights reserved 1-19 What Macroeconomics Is About The international economy –Open vs. closed economies Open economy: an economy that has extensive trading and financial relationships with other national economies Closed economy: an economy that does not interact economically with the rest of the world –Trade imbalances U.S. experience shown in Fig. 1.5 Trade surplus: exports exceed imports Trade deficit: imports exceed exports

© 2008 Pearson Addison-Wesley. All rights reserved 1-20 Figure 1.5 U.S. exports and imports,

© 2008 Pearson Addison-Wesley. All rights reserved 1-21 What Macroeconomics Is About Macroeconomic Policy –Fiscal policy: government spending and taxation U.S. experience in Fig. 1.6 Relation to trade deficit? “Twin deficits” –Monetary policy: growth of money supply; determined by central bank; the Fed in U.S.

© 2008 Pearson Addison-Wesley. All rights reserved 1-22 Figure 1.6 U.S. Federal government spending and tax collections, NEW DEAL: FHA, FDIC, SEC, Social Security

© 2008 Pearson Addison-Wesley. All rights reserved 1-23 What Macroeconomics Is About Aggregation –Aggregation: summing individual economic variables to obtain economywide totals –Distinguishes microeconomics (disaggregated) from macroeconomics (aggregated)

© 2008 Pearson Addison-Wesley. All rights reserved 1-24 What Macroeconomists Do (SKIP) Macroeconomic forecasting Macroeconomic analysis Macroeconomic research Data development “Economics is the only field in which two people can get a Nobel Prize for saying exactly the opposite thing.” "Economics is the only field in which two people can get a Nobel Prize for saying the opposite thing" "Economics is the only field in which two people can share a Nobel Prize for saying opposing things." Specifically, Gunnar Myrdal (social democracy/intervention) and Friedrich Hayek (libralism) shared one.

© 2008 Pearson Addison-Wesley. All rights reserved 1-25 Why Macroeconomists Disagree –Often macro analysis tends to be of “on the one hand, on the other hand”. –If you laid all macroeconomists on the earth end to end, they still wouldn’t reach an conclusion. Positive vs. normative analysis –Positive analysis: examines the economic consequences of a policy (Ms  pi) –Normative analysis: determines whether a policy should be used (often disagreement)

© 2008 Pearson Addison-Wesley. All rights reserved 1-26 Why Macroeconomists Disagree Classicals vs. Keynesians –The classical approach (Adam Smith) Assumptions: (1) rationally purse self interest (2) wages and prices adjust rapidly to get to equilibrium Mechanism: the “invisible hand”, or the price system –changes in wages and prices are signals that coordinate people’s actions The “invisible hand”: the idea that if there are free markets and individuals conduct their economic affairs in their own best interests, the overall economy will work well Policy implications: Government should have only a limited role in the economy Important!

© 2008 Pearson Addison-Wesley. All rights reserved 1-27 Why Macroeconomists Disagree Classicals vs. Keynesians –The Keynesian approach (John M. Keynes) Why this theory? The Great Depression: Classical theory failed because high unemployment was persistent Assumption: price rigidity or stickiness –Prices and wages adjust slowly, markets remain out of equilibrium for long periods. Mechanism: (1) long-term contracts (2) firms are slow to adjust wages (3) menu costs Policy implications: Government should intervene to restore full employment.

© 2008 Pearson Addison-Wesley. All rights reserved 1-28 Why Macroeconomists Disagree Classicals vs. Keynesians –The evolution of the classical-Keynesian debate Classicals: pre-depression 1930’s Keynesians dominated from WWII to 1970 Stagflation led to a classical comeback in the 1970s Last 30 years: excellent research with both approaches –Monetarists, new classicals, new keynesians… –New classicals: work on business cycles –New keyesians: work on microfoundations, stagflation

© 2008 Pearson Addison-Wesley. All rights reserved 1-29 Why Macroeconomists Disagree A unified approach to macroeconomics –Textbook uses a single model to present both classical and Keynesian ideas –Three markets: goods, assets, labor –Model starts with microfoundations: individual behavior –Long run: wages and prices are perfectly flexible –Short run: Classical case—flexible wages and prices; Keynesian case—wages and prices are slow to adjust