Macroeconomics is divided into two parts Theory of economic growth –focuses on long run trend of real GDP the source of improved living standards –the long-run trend is called potential GDP –potential GDP depends on the available supply of labor (L), capital (K), and technology (T) Theory of economic fluctuations –focuses on short-run ups and downs in the economy (recessions, Asian financial crisis

Real GDP, Potential GDP, Unemployment Rate, and the Natural Unemployment Rate

Aggregate production function Real GDP = F(labor, capital, technology) Y = F(L,K,T) Thus to explain the long term growth of real GDP we need to look at L, K, and T Today we discuss L briefly and focus mainly on K Will come back to T later

Labor (L): Factors determining growth of aggregate hours Aggregate hours = (hours per employee)  (employment to population ration)  (working age population) L = (L/E)  (E/P)  (P) Consider an example: the forecast of aggregate hours by the Council of Economic Advisers

Example: CEA Forecast of L (aggregate hours)

Two explanations of unemployment Job rationing explanation –Uses supply and demand model (see diagram) –real wage higher than market equilibrium minimum wage insider-outsider theory efficiency wages Job search explanation –job destruction and job creation creates flux –role of unemployment benefits –

Job rationing: real wage is higher than market equilibrium, hence unemployment

Job search: “flows” in and out of unemployment

Now let’s move on to capital First, note that investment increases the amount of capital (see next graph). –Hence, we will focus on what determines investment. Second, put on your big picture glasses

Look again at basic spending equation Y = C + I + G+ X Divide by Y to convert to shares of GDP: 1 = (C/Y) + (I/Y) + (G/Y) + (X/Y) for example, –if G/Y goes down, –then (C/Y + I/Y + X/Y) must go up But how? What is the incentive? What transmits the information? In other words what is the price? Answer: the interest rate.

Shares in recent U.S. history

People tend to lower consumption when the interest rate rises

Firms tend to lower investment when the interest rate rises

Three episodes in this part of the story: (1) interest rate  exchange rate (2) exchange rate  (exports-imports = net exports) (3) combine: interest rate  net exports

Sum up: “non-government” share

Finding the equilibrium interest rate

End of Lecture