Professional Documents
Culture Documents
2011/2012
Gianluigi Vernasca
Room: 5B.217
Office hours: Wednesday 2pm to 4pm
Email: gvern@essex.ac.uk
Lecture Outline:
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Essential reading:
Mankiw: Ch. 1
1) What is Macroeconomics?
Macroeconomics is the study of the behaviour of large collections of economic agents
(aggregates). It focuses on the aggregate behaviour of consumers, firms, governments,
the economic interactions among nations and the effects of fiscal and monetary
policy. By contrast, microeconomics deals with the economic decisions of individuals
(a typical consumer, a single firm, etc. etc.).
For example: the decision by a firm to buy or not a particular machine used in its
production process is a microeconomic problem. The effect of a decrease in the
interest rate on the saving decisions of UK households is a macroeconomic problem.
Some of the questions that are addressed in Macroeconomics:
- What causes recessions?
- Can the government do anything to combat recessions? Should it?
- Why does the cost of living keep rising?
- Why are millions of people unemployed, even when the economy is booming?
- What is the government budget deficit? How does it affect the economy?
- Why there are poor countries? What policies might help them grow out of poverty?
In this Figure we have the real GDP per capita. (Example: if the real GDP in year
2000 is 4,000,000 $, and the total population in US in 2000 is 100, than the real GDP
per person is 4,000,000/100=40,000). We can say that: the real GDP per capita is
increasing over time; this fact tells us that today people enjoy a higher standard of
living than people in the past. Furthermore, the behaviour of the series in the figure
says that the real GDP does not grow aver time steadily. There are periods, for
example during the great depression, where the real GDP falls, while there other
periods where it raises. Periods where the real GDP falls are called recessions, while
periods where the real GDP raises are called expansions. In practice, the real GDP
series fluctuate over time, and the fluctuations are called Cycles. Obviously, it would
be very interesting to have a model that explains why real GDP fluctuates, since in
that case, for example, we may be able to understand how to smooth recessions using
economic policy.
The first thing we can notice is that the inflation rate varies substantially over time,
especially in the first half of the last century. When inflation is decreasing, we call
that a Deflation. We can notice that after the second oil shock in the 70s, the inflation
rate in US has decreased and it has become more stable.
Furthermore, you can see that there is not a trend as in the case of the real GDP,
meaning that inflation does not tend to grow steadily over time.
The final series is the Unemployment rate:
Notice first of all, that unemployment is never zero in the economy (it cannot be
negative by definition). As for the inflation rate series, there is not a trend over time;
however, unemployment rate tends to fluctuate quite substantially from year to year.
Below is the graph of the unemployment rate in US (% annual) from 2000 to 2010.
This is to show the effect of the credit crunch on the unemployment rate in US.
% Unemp
Credit crunch
6000
10
property crime
(right scale)
%
8
6
4
per
100,000
5000 population
4000
unemployment
(left scale)
3000
2
0
1970
2000
1980
1990
2000
While the correlation is clearly not perfect, there is a strong, visible association
between unemployment, an economic indicator, and crime, a social indicator.
Another example:
Unemployment & inflation in election years
year
U rate
1976
7.7%
1980
7.1%
1984
7.5%
1988
5.5%
1992
7.5%
1996
5.4%
2000
4.0%
2004
5.5%
From this table, we can see that the state of the economy (summarised by the inflation
rate and the unemployment rate) has a huge impact on election outcomes. When the
economy is doing poorly, there tends to be a change in the party that controls the
White House. For example, in 1976, the rates of inflation and unemployment were
both high, the incumbent (Ford, R) loses. In 1980, unemployment is still high,
inflation is even higher and the incumbent (Carter, D) loses.
And so on.
3) Economic Models
Once we know some aspects of the reality that we want to explain (for example, why
real GDP fluctuates over time, etc. etc.), we need to develop some theory that can
help us. To that aim we construct macroeconomic models. A macroeconomic model is
an extremely simplified imaginary economy where irrelevant details are stripped
away and where simplifying assumptions are imposed to keep the model manageable.
It is a simplified picture of the world that addresses the particular question we want to
analyse. Normally the model is constructed using the language of mathematics. When
we do that, we describe the model economy in terms of a few variables. Variables are
symbols representing economic quantities and prices. For example Y stands for
production or aggregate income, P for the price level and i for the interest
rate. Y, P and i are called variables because they can take different values. The
economic system is a system of relations between economic variables.
We use models to
Y = aggregate income
PS= price of steel (an input)
Demand equation: QD = D (P,Y )
shows that the quantity of cars consumers demand is related to the price of
cars and aggregate income.
Price
of cars
equilibrium
price
equilibrium
quantity
Quantity
of cars
Using our simple model we can now ask: what happens to the equilibrium if there is
an increase in income Y?
From the way we have written our model we know that Y will affect only the demand
function. In particular, when aggregate income increases, there are more resources to
spend and therefore the demand of goods (in this case the demand for cars) increases.
Graphically:
Price
of cars
P2
P1
D2
D1
Q1 Q2
Quantity
of cars
An increase in income increases the quantity of cars consumers demand at each price,
which increases the equilibrium price and quantity.
Now we can ask: what happens if there is an increase in the price of steel?
We know that the price of steel affects only the supply function. An increase in the
price of an input, increases the costs of the suppliers, and therefore increases the final
price charged by the suppliers. The result is the following:
S2
Price
of cars
S1
P2
P1
D
Q2 Q1
Quantity
of cars
Notice that we have considered the effects of changes in aggregate income and the
price of steel. In our simple model those two variables are called exogenous.
In every economic model we distinguish between exogenous and endogenous
variables and this distinction is very important.
The values of endogenous variables are determined in the model.
The values of exogenous variables are determined outside the model: the model takes
their values and behaviour as given.
In our model the endogenous variables were:
QD QS and P
While the exogenous variables were: Y and PS
No model can address all the issues we care about. For example, our supply-demand
model of the car market:
can tell us how a fall in aggregate income affects price and quantity of
cars.
its assumptions
In the first part of the course, in most of the cases, we will not model explicitly the
microeconomic structure behind our macroeconomic analysis. Meaning that the
microeconomic decisions will be implicit in the models we will use.
Another important distinction in macroeconomics:
Prices: flexible vs. sticky
Market clearing: An assumption that prices are flexible, adjust to equate supply and
demand in every market.
We normally assume that in the long run prices in the economy are fully flexible and
all markets clear.
However, in the short run, many prices are sticky adjust sluggishly in response to
changes in supply or demand. For example,
-
many labour contracts fix the nominal wage for a year or longer (the wage is a
price, in particular is the price of a good called labour)
many magazine publishers change prices only once every 3-4 years
The economys behaviour depends partly on whether prices are sticky or flexible. If
prices are sticky, then demand wont always equal supply. This helps explaining
unemployment (excess supply of labor) or why firms cannot always sell all the goods
they produce. On the other hand in the long run we normally assume that prices are
flexible, markets clear, and therefore economy behaves very differently.
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