Fall Semester 10-11 Akila Weerapana

Lecture 1: Introduction to Macroeconomics

I. INTRODUCTION
Economics 102 is the rst course in macroeconomic analysis. The course is designed to introduce you to basic concepts and tools required to study the overall economy, and to prepare you for taking 200-level electives as well as intermediate-level theory courses. In macroeconomics, we tend to ask big questions; as a result macroeconomists (as well as you and I) may not always agree on what the answer should be. Over the next 13 weeks you will learn basic concepts about measurement of prices and quantities for the whole economy, economic growth, business cycles, unemployment, ination, scal and monetary policy, trade decits, etc. All of these are topics you stumble across when you read newspapers and follow policy debates on T.V. The success of this course will be determined partially by your ability to intelligently assess articles on current economic issues in publications like the Wall Street Journal and the Economist at the end of the quarter. You do not need a license to be an economist: instead you need to be curious enough about the world around to identify relevant issues, you need to have analytical skills and economic intuition to study these issues and then identify appropriate policy responses. This class will begin to develop both the intuition and the analytical skill. How you choose to apply those skills depends on your natural curiosity and on my diligence in pointing out the relevance of the material. Administrative details about the course, such as the breakdown of grades, an outline of lectures, a listing of oce hours etc. can be found in the syllabus.

II. COURSE OUTLINE

Look at a graph of real GDP (output) for the United States plotted over time. What can we see? 1. Output grows over time: economic growth 2. Along the growth path there are periods of uctuations, seemingly in a cyclical pattern: economic uctuations.

Billions of Chained 2005 Dollars 5000 10000

15000

Real GDP for the United States

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Real GDP Growth (% Change over Past 4 Quarters)

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10

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This provides a roadmap for where we are headed. You should always be aware of the existence of a roadmap for this class: keep track of the big picture! Every lecture should be a logical progression from the lecture before and should lead into the lecture that comes next. So the roadmap for this class includes a) an introduction to key macroeconomic variables, how they are dened and what their limitations are; b) the study of economic growth, i.e. what determines the long-run growth path of the economy; c) the study of economic uctuations, i.e. what determines the movements of the economy around this long-run growth path, why economic downturns occur, how policymakers should respond to those downturns, and how to minimize the severity of those downturns. Finally, we close with d) a closer examination of the current economic downturn, which has been the most severe downturn to hit the U.S. economy (at least in terms of unemployment) since the Great Depression. The rst 4 lectures will introduce you to key macroeconomic variables. We begin with National Income Accounting, the methods used to determine the quantity of goods produced by the economy and to measure the overall price level. This section will help you understand what exactly terms like Real GDP in Chained 2005 dollars means. As you may have guessed by the appearance of the word accounting, this is not exactly the kind of stu that will keep you at the edge of your seat hanging on my every word. Nevertheless, this section is very important; by teaching you about how aggregate measures of price and quantity are constructed, and what some of their potential aws are, leaves you in better shape to relate the concepts you learn about in class to the real economy. It will also help you better read and understand news about the economy. We then move on to more foundational stu in the next 6 lectures. These will focus on other important macroeconomic variables and institutions - ination, unemployment, money,

interest rates, the Fed, banks, nancial markets. By the end of these lectures you will be able to get your rst glimpse at the power of macro - a better understanding of topics such as current labor market conditions, what caused Zimbabwes hyper-ination, why is the Fed so important to our economy etc. This will takes us through to our rst mid-term where we get a chance to evaluate how well you have grasped the fundamentals of the fundamentals of macro before moving on to the analytical portion of the course. Our long-run section begins with two lectures that discuss how some of the important national income accounting variables - GDP, consumption, investment, exports, imports, government purchases, saving, investment - are all inter-related in the long run. These lectures will also expose you to your rst macroeconomic model, a very simple graphical framework that lets us understand some very important relationships that hold in the macroeconomy. We then spend four lectures on economic growth, material designed to provide you with an understanding of what determines an economys ability to produce more and more output over time. In these lectures we will discuss the importance of economic growth, the role played by the accumulation of labor and capital, and the importance of technological progress - the creation of new ideas over time. In addition to the three major drivers of economic growth - labor, capital and technology - we will also discuss other factors - conict, institutions, resources and geography - all of which have proved to be important in explaining why some countries are rich and other countries poor. We then move on to the second major area of macroeconomics, the study of economic uctuations: why does the size of the economy change over time, often in a periodic manner, moving from bad times to good times and vice versa. This will be particularly salient this semester because of the depth and severity of the current economic slowdown in the United States. Understanding why recessions occur, and how to get out of them will have important implications for understanding ongoing macroeconomic developments in the U.S. To study economic uctuations, we employ a model known as the Keynesian Cross. This simple model will also help introduce you to the concept of the spending multiplier - a term you are likely to hear a lot about as Congress and the President debate the specics of the stimulus package and what its eects might be. Then we further develop the Keynesian Cross into a more complete model known as the Aggregate Demand/Price Adjustment model. This is the most important model we study in Econ 102 and will form the basis of most of your understanding of economic uctuations and the role of policy in minimizing those uctuations. Accordingly, we discuss the role that scal (government decisions on taxing and spending) and monetary (the Federal Reserves decision to change interest rates) policy have to play in minimizing economic uctuations. This takes us to our second midterm, just before Thanksgiving break. Following the second midterm, we enter the home stretch of the course where we will apply the knowledge we have gained to cover a range of topical issues from the policy responses to the current recession to the impact of globalization on the current worldwide slowdown to the long-term scal and economic challenges facing the United States.

 By the end of the semester, you should be a) comfortable enough with the material do well on a nal exam, b) eager to go on to further study of economics either at a more applied (200-level electives) or a more theoretical (intermediate theory) setting, and c) able to read and understand developments going on in the world around you.

III. KEY ISSUES IN ECONOMIC GROWTH

We already showed that the United States has been steadily growing since the end of the second World War, with the overall economy growing at about 3.2% per year over the past 50 years. There is nothing automatic about such steady growth - if we look at other countries in the world over this period we see very dierent patterns. The gure below shows the growth trajectories of ve countries - China, India, Korea, Nigeria (all four of which were similar in terms of how much output per person was being produced back in 1960) and Zimbabwe, which was the most auent. Fifty years later, the dierences are startling. Korea grew extremely fast over this period and this rapid long run trend growth meant that they were far better o than the other four countries as of 2008. In contrast Zimbabwe ran in place and then declined so that they are actually worse o than they were in 1960. China was stagnant in the 1960s and 1970s before embarking on a new rapid growth path, India started even later than China and Nigeria is just beginning to show signs of joining this new growth path.
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Divergent Paths

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The gure below (which leaves out Korea) shows the paths of China, India, Nigeria and Korea more clearly. In the economic growth section, we will try and understand why Korea grew so rapidly, why Chinas path changed so dramatically in the 1980s, and why countries like Nigeria and Zimbabwe have been unable to follow that path.
Per Capita Real GDP in Dollars at PPP 0 2000 4000 6000 8000

Divergent Paths

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1980 year China Nigeria

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India Zimbabwe

IV. KEY ISSUES IN ECONOMIC FLUCTUATIONS

Consider the following gure, which shows how the size of the U.S. economy has uctuated year by year in the post-WWII period. As you can see, the current recession is the most signicant downturn in the entire postwar period. Notice also that the 25 years preceding the current downturn were among the best years the U.S. economy has had. Only a small downturn in 2001 interrupted a quarter century of economic prosperity. Why did the U.S. economy have such a long period of uninterrupted (or rarely interrupted) growth. What changed to drive the economy into recession in 2008? Why was the subsequent downturn so severe? How much longer will the downturn last? These are some of the questions that we will be seeking to answer in this section on economic uctuations.
Fluctuations in the U.S. Economy
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Growth Rate of Economy (percent) 0 2 4 6

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The severity of the current downturn is even more pronounced if we look at what has happened to unemployment in recent years. The unemployment rate is higher than almost any other period in recent history (with the exception of the early 1980s recession) and the rise in unemployment is the highest the U.S. economy has ever seen (the early 1980s run up from 6 to 11 percent was smaller than the current run up from 4 to 10 percent).
The Unemployment Rate in the United States
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V. KEY ISSUES IN THE CURRENT DOWNTURN

Last but not least we will be focusing on the current recession and some of the unusual features that have distinguished it from past recessions. These features greatly complicate the economic recovery from, and also the policy response to, this substantial downturn. Without getting too deep into the data and denitions, take a look at the gures below which show the path of ination in the United States as well as the path of interest rates in the

United States. Ination has actually become negative, a rare phenomenon known as deation, while interest rates have fallen to a level of zero and cannot go any lower.
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Interest Rates in the United States

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Federal Funds Rate, Target 2 4 6 8

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By the end of the semester, I expect you to be able to intelligently converse about why the above two diagrams are of signicant concern to U.S. policy makers. That type of comfort and familiarity with economic data is what I am looking to achieve in this class.