1. CHAPTER 1 The Science of Macroeconomics slide 0 U.S. Gross Domestic Product in billions of chained 1996 dollars long-run upward trend…

2. CHAPTER 1 The Science of Macroeconomics slide 1

3. CHAPTER 1 The Science of Macroeconomics slide 2 Real vs. Nominal GDP  GDP is the value of all final goods and services produced.  Nominal GDP measures these values using current prices.  Real GDP measure these values using the prices of a base year.

4. CHAPTER 1 The Science of Macroeconomics slide 3 Real GDP controls for inflation Changes in nominal GDP can be due to:  changes in prices  changes in quantities of output produced Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.

5. CHAPTER 1 The Science of Macroeconomics slide 4 U.S. Real & Nominal GDP, 1967-2001

6. CHAPTER 1 The Science of Macroeconomics slide 5 How the BLS constructs the CPI 1. Survey consumers to determine composition of the typical consumer’s “basket” of goods. 2. Every month, collect data on prices of all items in the basket; compute cost of basket 3. CPI in any month equals

7. CHAPTER 1 The Science of Macroeconomics slide 6 Exercise: Compute the CPI The basket contains 20 pizzas and 10 compact discs. prices: pizzaCDs 2000$10$15 2001$11$15 2002$12$16 2003$13$15 For each year, compute  the cost of the basket  the CPI (use 2000 as the base year)  the inflation rate from the preceding year

8. CHAPTER 1 The Science of Macroeconomics slide 7 cost of inflation basket CPI rate 2000$350100.0n.a. 2001 370105.75.7% 2002 400114.38.1% 2003 410117.12.5% answers:

9. CHAPTER 1 The Science of Macroeconomics slide 8 The composition of the CPI’s “basket”

10. CHAPTER 1 The Science of Macroeconomics slide 9

11. CHAPTER 1 The Science of Macroeconomics slide 10 GDP Deflator  The inflation rate is the percentage increase in the overall level of prices.  One measure of the price level is the GDP Deflator, defined as

12. CHAPTER 1 The Science of Macroeconomics slide 11 Two measures of inflation 16 14 12 10 8 6 4 2 0 - 2 Percentage change 194819531958196319681973 Year 19781983198819931998 CPI GDP deflator

13. CHAPTER 1 The Science of Macroeconomics slide 12

14. CHAPTER 1 The Science of Macroeconomics slide 13  Employed workers help produce GDP, while unemployed workers do not. So one would expect a negative relationship between unemployment and real GDP.  This relationship is clear in the data… Okun’s Law

15. CHAPTER 1 The Science of Macroeconomics slide 14 Okun’s Law 1951 1984 1999 2000 1993 1982 1975 Change in unemployment rate 10 -3 -2 01243 8 6 4 2 0 -2 Percentage change in real GDP Okun’s Law states that a one-percent decrease in unemployment is associated with two percentage points of additional growth in real GDP

16. CHAPTER 1 The Science of Macroeconomics slide 15 Marginal product of labor (MPL) def: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F (K, L +1) – F (K, L)

17. CHAPTER 1 The Science of Macroeconomics slide 16 Exercise: compute & graph MPL a. Determine MPL at each value of L b. Graph the production function c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis LYMPL 00n.a. 110? 219? 3278 434? 540? 645? 749? 852? 954? 1055?

18. CHAPTER 1 The Science of Macroeconomics slide 17 answers:

19. CHAPTER 1 The Science of Macroeconomics slide 18 Y output The MPL and the production function L labor 1 MPL 1 1 As more labor is added, MPL  Slope of the production function equals MPL

20. CHAPTER 1 The Science of Macroeconomics slide 19 Consumption ( C ) durable goods last a long time ex: cars, home appliances non-durable goods last a short time ex: food, clothing services work done for consumers ex: dry cleaning, air travel. def: the value of all goods and services bought by households. Includes:

21. CHAPTER 1 The Science of Macroeconomics slide 20 U.S. Consumption, 2001

22. CHAPTER 1 The Science of Macroeconomics slide 21 Investment ( I ) def1: spending on [the factor of production] capital. def2: spending on goods bought for future use. Includes:  business fixed investment spending on plant and equipment that firms will use to produce other goods & services  residential fixed investment spending on housing units by consumers and landlords  inventory investment the change in the value of all firms’ inventories

23. CHAPTER 1 The Science of Macroeconomics slide 22 U.S. Investment, 2001

24. CHAPTER 1 The Science of Macroeconomics slide 23

25. CHAPTER 1 The Science of Macroeconomics slide 24 Government spending ( G )  G includes all government spending on goods and services.  G excludes transfer payments (e.g. unemployment insurance payments), because they do not represent spending on goods and services.

26. CHAPTER 1 The Science of Macroeconomics slide 25 Government spending, 2001

27. CHAPTER 1 The Science of Macroeconomics slide 26 Net exports ( NX = EX - IM ) def: the value of total exports (EX) minus the value of total imports (IM)

28. CHAPTER 1 The Science of Macroeconomics slide 27 CASE STUDY The Reagan Deficits  Reagan policies during early 1980s:  increases in defense spending:  G > 0  big tax cuts:  T < 0  According to our model, both policies reduce national saving:

29. CHAPTER 1 The Science of Macroeconomics slide 28 1. The Reagan deficits, cont. r S, I I (r )I (r ) r1r1 I1I1 r2r2 2.…which causes the real interest rate to rise… I2I2 3.…which reduces the level of investment. 1.The increase in the deficit reduces saving…

30. CHAPTER 1 The Science of Macroeconomics slide 29 Are the data consistent with these results? variable1970s1980s T – G–2.2–3.9 S19.617.4 r1.16.3 I19.919.4 variable1970s1980s T – G–2.2–3.9 S19.617.4 r1.16.3 I19.919.4 T–G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown.

31. CHAPTER 1 The Science of Macroeconomics slide 30 U.S. Unemployment, 1958-2002

32. CHAPTER 1 The Science of Macroeconomics slide 31 Natural Rate of Unemployment  Natural rate of unemployment: the average rate of unemployment around which the economy fluctuates.  In a recession, the actual unemployment rate rises above the natural rate.  In a boom, the actual unemployment rate falls below the natural rate.

33. CHAPTER 1 The Science of Macroeconomics slide 32 Example:  Each month, 1% of employed workers lose their jobs (s = 0.01)  Each month, 19% of unemployed workers find jobs (f = 0.19)  Find the natural rate of unemployment:

34. CHAPTER 1 The Science of Macroeconomics slide 33 Why is there unemployment?  If job finding were instantaneous (f = 1), then all spells of unemployment would be brief, and the natural rate would be near zero.  There are two reasons why f < 1: 1. job search 2. wage rigidity

35. CHAPTER 1 The Science of Macroeconomics slide 34 Job Search & Frictional Unemployment  frictional unemployment: caused by the time it takes workers to search for a job  occurs even when wages are flexible and there are enough jobs to go around  occurs because  workers have different abilities, preferences  jobs have different skill requirements  geographic mobility of workers not instantaneous  flow of information about vacancies and job candidates is imperfect

36. CHAPTER 1 The Science of Macroeconomics slide 35 Sectoral shifts  def: changes in the composition of demand among industries or regions  example: Technological change increases demand for computer repair persons, decreases demand for typewriter repair persons  example: A new international trade agreement causes greater demand for workers in the export sectors and less demand for workers in import-competing sectors.  It takes time for workers to change sectors, so sectoral shifts cause frictional unemployment.

37. CHAPTER 1 The Science of Macroeconomics slide 36 Industry shares in U.S. GDP, 1960

38. CHAPTER 1 The Science of Macroeconomics slide 37 Industry shares in U.S. GDP, 1997

39. CHAPTER 1 The Science of Macroeconomics slide 38 Sectoral shifts abound  more examples:  Late 1800s: decline of agriculture, increase in manufacturing  Late 1900s: relative decline of manufacturing, increase in service sector  1970s energy crisis caused a shift in demand away from huge gas guzzlers toward smaller cars.  In our dynamic economy, smaller (though still significant) sectoral shifts occur frequently, contributing to frictional unemployment.

40. CHAPTER 1 The Science of Macroeconomics slide 39 Unemployment from real wage rigidity Labor Real wage Supply Demand Unemployment Rigid real wage Amount of labor willing to work Amount of labor hired If the real wage is stuck above the eq’m level, then there aren’t enough jobs to go around.

41. CHAPTER 1 The Science of Macroeconomics slide 40 The minimum wage in the real world:  In Sept 1996, the minimum wage was raised from $4.25 to $4.75. Here’s what happened: Unemployment rates, before & after 3 rd Q 19961 st Q 1997 Teenagers16.6%17.0% Single mothers 8.5%9.1% All workers5.3%  Other studies: A 10% increase in the minimum wage increases teenage unemployment by 1-3%.

42. CHAPTER 1 The Science of Macroeconomics slide 41 Labor unions  Unions exercise monopoly power to secure higher wages for their members.  When the union wage exceeds the eq’m wage, unemployment results.  Employed union workers are insiders whose interest is to keep wages high.  Unemployed non-union workers are outsiders and would prefer wages to be lower (so that labor demand would be high enough for them to get jobs).

43. Union membership and wage ratios by industry, 2001 118.0 121.1 103.3 90.1 117.8 105.8 104.2 127.8 105.9 151.0 103.4 15.0% 41.8 6.8 2.8 5.0 5.9 23.7 25.4 15.5 19.0 12.9% 13.6 % 37.4 5.9 2.1 4.5 5.5 22.6 24.1 14.6 18.4 12.3% 119,092 19,155 34,261 7,648 20,505 4,540 2,981 4,441 18,149 6,881 531 all government services fin, insu, and real est retail trade wholesale trade comm. and pub util transportation manufacturing construction mining wage ratio RBU % of total U % of total # employed (1000s) industry RBU = nonunion workers represented by a union wage ratio = 100  (union + RBU wage)/(nonunion wage) slide 42