11 MACROECONOMICS

Biswa Swarup Misra

Material Covered
Discussion of Caselet-2
Frameworks for Growth Forecasting
Introduction to Business Cycles
Real Business Cycle Theory
1

Savings and Growth Rleationship,

We will study the relationship between the annual growth
rate of the economy, the available savings, the amount of
investment and the incremental capital output ratio
(ICOR) for the economy.
The incremental capital output ratio (ICOR) is the number
of units of investment needed to generate one unit of
additional income each year in the future.

2 2

Mobilizing Resources for Development (Contd)

K: change in capital stock equals new net investment
Y: change in GNP

K
ICOR =
by definition.
Y
K
Or Y =
ICOR
Or

Y K / Y
=
Y
ICOR

(Dividing both sides by Y)

But Y/Y is growth rate of income. Let it be denoted by GY.

Also K=I (Investment) Y = I / Y
Y

or G Y =

ICOR

I/ Y
Harrod Domar Growth Equation
ICOR
3 3

Business Cycles

Sessions 11-12

AGGREGATE DEMAND AND AGGREGATE SUPPLY

We address:
What are economic fluctuations? What are their
characteristics?

How does the model of aggregate demand and

aggregate supply explain economic fluctuations?

Why does the Aggregate-Demand curve slope

downward?

What shifts the AD curve?

What is the slope of the Aggregate-Supply curve in
the short run?
AGGREGATE DEMAND AND AGGREGATE SUPPLY

These two sessions address:

How does the Aggregate-Supply curve look like in
the long run?

What shifts the AS curve(s)?

Determination of equilibrium GDP and Price level
Characterizing Stagflation using AS-AD framework
Characterizing an overheated economy using AS-AD
framework

How does the self correcting mechanism work to

kick start an economy from a recession/depression

What are Inflationary Gaps and Recessionary gaps?

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Introduction
Over the long run, real GDP grows about
3% per year on average.

In the short run, GDP fluctuates around its trend.

recessions:

periods of falling real incomes

and rising unemployment

depressions:

severe recessions (very rare)

Short-run economic fluctuations are often called

business cycles.

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Three Facts About Economic Fluctuations

FACT 1: Economic fluctuations are
irregular and unpredictable.
$ 11,000

U.S. real GDP,

billions of 2000 dollars

10,000
9,000
8,000
7,000
6,000

The shaded
bars are
recessions

5,000
4,000
3,000
2,000
1965

1970

1975

1980

1985

1990

1995

2000

2005

Three Facts About Economic Fluctuations

FACT 2: Most macroeconomic
quantities fluctuate together.
$ 1,800

1,600

Investment spending,
billions of 2000 dollars

1,400
1,200
1,000
800
600
400
200
1965

1970

1975

1980

1985

1990

1995

2000

2005

Three Facts About Economic Fluctuations

FACT 3: As output falls,
unemployment rises.
12

Unemployment rate,
percent of labor force

10
8
6
4
2
0
1965

1970

1975

1980

1985

1990

1995

2000

2005

Introduction, continued
Explaining these fluctuations is difficult, and the
theory of economic fluctuations is controversial.

Most economists use the model of

aggregate demand and aggregate supply
to study fluctuations.

This model differs from the classical economic

theories economists use to explain the long run.

AGGREGATE DEMAND AND AGGREGATE SUPPLY

11

Facts about the business cycle

GDP growth averages 3-3.5 percent per year over the
long run with large fluctuations in the short run.

Consumption and investment fluctuate with GDP, but

consumption tends to be less volatile and investment
more volatile than GDP.

Unemployment rises during recessions and falls during

expansions.

Okuns Law: the negative relationship between GDP

and unemployment.

AGGREGATE DEMAND AND AGGREGATE SUPPLY

12

Growth rates of real GDP, consumption

Percent 10
change
from 4 8
quarters
earlier

Real GDP
growth rate
Consumption
growth rate

Average 4
growth
rate 2
0
-2
-4
1970

1975

1980

1985

1990

1995

2000

2005

13
2010

Growth rates of real GDP, consump., investment

Percent
change 40
from 4
quarters 30
earlier

Investment
growth rate

20

Real GDP
growth rate

10
0

Consumption
growth rate

-10
-20
-30
1970

1975

1980

1985

1990

1995

2000

2005

14
2010

Unemployment
Percent 12
of labor
force
10

0
1970

1975

1980

1985

1990

1995

2000

2005

15
2010

Okuns Law
Okuns law is an empirical relationship between
changes in aggregate output (relative to its
potential trend) and changes in the unemployment
rate (relative to its natural rate)

It tell us how much of a countrys GDP may be lost

when the unemployment rate is above its natural
rate.

Many economists have argued that Okuns law is a

useful guide for monetary policy.

http://research.stlouisfed.org/publications/es/article/
9295
AGGREGATE DEMAND AND AGGREGATE SUPPLY

16

Okuns Law
Each dot in the next chart represents the observed
changes in GDP and unemployment in a particular
year.

The vertical axis shows the percentage change in real

GDP relative to its long-run HP trend.

The x-axis shows the change in the unemployment

rate relative to its natural rate (also defined as its
long-run HP trend)

The solid line through the dots is the fitted value of

the relationship, which captures the average slope (
2) of the two variables.
AGGREGATE DEMAND AND AGGREGATE SUPPLY

17

Okuns Law
Percentage 10
change in
real GDP 8
6

1951

Y
= 3 2 u
Y

1966

1984
2003
1971

1987

2001

1975
2009

2008

-2

1991

1982

-4
-3

-2

-1

Change in unemployment rate18

Okuns Law
Thus, this empirically estimated Okuns law states
that for each 1-percentage-point increase (decrease)
in the unemployment rate from its natural rate, total
output on average will be lowered (raised) by nearly
2 percent relative to its long-run HP trend.

For example, suppose the natural rate of

unemployment is 6 percent in 2012; then the current
8.1 percent unemployment rate implies that real
GDP is about 4 percent below its potential trend.

AGGREGATE DEMAND AND AGGREGATE SUPPLY

19