Macroeconomics I Lecture 1. September 4, 2007 Robert TCHAIDZE

Macroeconomics IMacroeconomics ILecture 1. September 4, 2007Lecture 1. September 4, 2007

Robert TCHAIDZERobert TCHAIDZE

September 4, 2007September 4, 2007 MACROECONOMICS IMACROECONOMICS I 22

LogisticsLogistics TAs: TAs:

Bakari Baratashvili, Anastasia ShchepetovaBakari Baratashvili, Anastasia Shchepetova Emails:Emails:

– [email protected]@iset.ge– [email protected]@iset.ge– [email protected]@iset.ge

Office hours: Office hours: – RT: Wednesday 2-4. RT: Wednesday 2-4. – BB and AS: to be announced …BB and AS: to be announced …

Textbook: MankiwTextbook: Mankiw Weekly problem setsWeekly problem sets

mailto:[email protected]




Economics as a scienceEconomics as a science Economics is Economics is notnot about making money. about making money. It does help though.It does help though. Economics is about human behavior, incentives, Economics is about human behavior, incentives,

interactions, and outcomes.interactions, and outcomes. Economics is about setting “the rules of the Economics is about setting “the rules of the

game” that ensure appropriate (game” that ensure appropriate (but what exactly but what exactly is appropriate?is appropriate?) outcomes.) outcomes.

Economics is a growing science, not all the Economics is a growing science, not all the interaction channels are studied well enough. Not interaction channels are studied well enough. Not even clear if we know about even clear if we know about allall channels. channels.

Given the goals of society, what policies and in Given the goals of society, what policies and in what manner can/should the government pursue?what manner can/should the government pursue?


What is Macroeconomics about?What is Macroeconomics about?

What determines and causes movements What determines and causes movements in the important economic variables:in the important economic variables:– Output (real GDP) and its growth rateOutput (real GDP) and its growth rate– InflationInflation– UnemploymentUnemployment

Other variables:Other variables:– Interest ratesInterest rates– Budget balanceBudget balance– Current account balanceCurrent account balance– Level of debt (external, public, …)Level of debt (external, public, …)

September 4, 2007 MACROECONOMICS I 5

0

10,000

20,000

30,000

40,000

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

U.S. Real GDP per capita (2000 dollars)

Great Depression

World War II

First oil price shock

Second oil price shock

long-run upward trend…

9/11/2001


U.S. inflation rate(% per year)

-15

-10

-5

0

5

10

15

20

25

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000


U.S. unemployment rate(% of labor force)

0

5

10

15

20

25

30

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000


Questions asked:Questions asked: Why does the cost of living keep rising?Why does the cost of living keep rising? Why are millions of people unemployed, Why are millions of people unemployed,

even when the economy is booming?even when the economy is booming? What causes recessions? Can the What causes recessions? Can the

government do anything to combat government do anything to combat recessions? Should it?recessions? Should it?

What is the government budget deficit? What is the government budget deficit? How does it affect the economy?How does it affect the economy?

Why does the U.S. have such a huge trade Why does the U.S. have such a huge trade deficit?deficit?

Why are so many countries poor? What Why are so many countries poor? What policies might help them grow out of policies might help them grow out of poverty?poverty?


Caveats:Caveats:

Short-run implications may be different Short-run implications may be different from long-run ones:from long-run ones:– If government cuts income taxes than If government cuts income taxes than

consumption increases in the short run. In the consumption increases in the short run. In the long run government will have to cut its long run government will have to cut its expenditures or raise taxes.expenditures or raise taxes.

What instruments to use:What instruments to use:– Fiscal policy: taxes, government expendituresFiscal policy: taxes, government expenditures– Monetary policy: interest rates, exchange rate Monetary policy: interest rates, exchange rate

policy, reserve requirementspolicy, reserve requirements


Economic modelsEconomic models

……are simplified versions of a more are simplified versions of a more complex realitycomplex reality– irrelevant details are stripped awayirrelevant details are stripped away

……are used to are used to – show relationships between variablesshow relationships between variables– explain the economy’s behaviorexplain the economy’s behavior– devise policies to improve economic devise policies to improve economic

performanceperformance


Economic modelsEconomic models One model cannot address all the issues.One model cannot address all the issues. Different models are used for studying different Different models are used for studying different

issues.issues. For each model, one should keep track of For each model, one should keep track of

– its assumptions;its assumptions;– which variables are endogenous (determined within which variables are endogenous (determined within

the model) and which are exogenous (determined the model) and which are exogenous (determined outside the model);outside the model);

– what questions can the model address and what what questions can the model address and what questions it cannot.questions it cannot.

Different models can give different and even opposite Different models can give different and even opposite answers.answers.

Models need to be tested empirically, i.e. it needs to Models need to be tested empirically, i.e. it needs to be checked whether actual data patterns coincide with be checked whether actual data patterns coincide with predictions of the model.predictions of the model.


OutputOutput Nominal GDP – Nominal GDP – money valuemoney value of of finalfinal output output of of allall

goods and services produced goods and services produced during a period of during a period of timetime within the borders of a country.within the borders of a country.

Value added=value of the output minus value of Value added=value of the output minus value of inputs. Instead of adding up value of final goods, inputs. Instead of adding up value of final goods, GDP can be obtained as a sum of economy wide GDP can be obtained as a sum of economy wide value added.value added.

GDP measures total output, total income, total GDP measures total output, total income, total expenditure.expenditure.

Other concepts – GNP, NNP, National Income (net Other concepts – GNP, NNP, National Income (net of indirect business taxes).of indirect business taxes).

More appropriate to look at GDP per capita.More appropriate to look at GDP per capita.


Problems with the concept of GDPProblems with the concept of GDP

Ignores …Ignores …– … … distribution;distribution;– … … household work;household work;– … … underground economy;underground economy;– … … leisure;leisure;– … … ecological costs;ecological costs;– … … quality of life;quality of life;– … … technological improvements.technological improvements.


Real GDPReal GDP

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Rt

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YpYpYpYpGDP

YpYpYpYpGDP

1,0,,0,,20,2,10,1

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Roughly speaking measures today’s production at Roughly speaking measures today’s production at yesterday’s prices.yesterday’s prices.

U.S. nominal GDP in 1996 was about 14 times higher than U.S. nominal GDP in 1996 was about 14 times higher than in 1959. But prices have increased 5 times. Hence, real in 1959. But prices have increased 5 times. Hence, real GDP grew only about 3 times.GDP grew only about 3 times.

Population grew by about 50 percent. Hence, real GDP per Population grew by about 50 percent. Hence, real GDP per capita increased only twice.capita increased only twice.


InflationInflation GDP deflator (implicit price deflator) GDP deflator (implicit price deflator)

= Nominal GDP / Real GDP.= Nominal GDP / Real GDP. It includes all the goods produced in the It includes all the goods produced in the

economy.economy. It includes only domestically produced goods.It includes only domestically produced goods. It is a weighted average of changes in prices.It is a weighted average of changes in prices.

1...

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21

0,

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0,2

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0,1

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Consumer Price IndexConsumer Price Index Includes domestic and imported goods.Includes domestic and imported goods. Is based on an average basket of goods.Is based on an average basket of goods. Is an average but with fixed weightsIs an average but with fixed weights

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Problems with CPIProblems with CPI

It overstates inflation because it is based It overstates inflation because it is based on a fixed basket; does not reflect properly on a fixed basket; does not reflect properly introduction of new goods; does not reflect introduction of new goods; does not reflect properly changes in quality of goods.properly changes in quality of goods.

One more problem from policymakers’ One more problem from policymakers’ point of view is that it includes very point of view is that it includes very volatile components that are beyond their volatile components that are beyond their control. Hence, core CPI, e.g. CPI less food control. Hence, core CPI, e.g. CPI less food and energy.and energy.


UnemploymentUnemployment

Unemployment is a fraction of those Unemployment is a fraction of those who would like to work but cannot who would like to work but cannot find job.find job.

Labor force participation is a fraction Labor force participation is a fraction of those who work or want to work.of those who work or want to work.

What is optimal level of What is optimal level of unemployment?unemployment?


Types of unemploymentTypes of unemployment FrictionalFrictional unemployment –due to normal turnover unemployment –due to normal turnover

in the labor market. It includes people who are in the labor market. It includes people who are temporarily between the jobs, because they are temporarily between the jobs, because they are moving or changing occupations for similar moving or changing occupations for similar reasons. It is reasons. It is voluntaryvoluntary..

StructuralStructural unemployment refers to workers who unemployment refers to workers who have lost their jobs because they have been have lost their jobs because they have been displaced by automation, because their skills are displaced by automation, because their skills are no longer in demand, or for other similar reasons.no longer in demand, or for other similar reasons.

CyclicalCyclical unemployment is attributable to a decline unemployment is attributable to a decline in the economy’s total production. It is positive in the economy’s total production. It is positive during recessions and negative during booms.during recessions and negative during booms.


Basic Demand-Supply ModelBasic Demand-Supply Model

A snapshot of the economy. I.e. levels of A snapshot of the economy. I.e. levels of inputs are fixed and fully utilized.inputs are fixed and fully utilized.Y=F(K,L)Y=F(K,L)

F exhibits constant returns to scale: F exhibits constant returns to scale: F(zK, zL)=z F(K,L)F(zK, zL)=z F(K,L)

F exhibits decreasing marginal product of F exhibits decreasing marginal product of labor and capital.labor and capital.

MPL = F (K, L +1) – F (K, L)MPL = F (K, L +1) – F (K, L)For a given K, MPL decreases as L For a given K, MPL decreases as L increasesincreases


Youtput

MPL and the production function

Llabor

F K L( , )

1

MPL

1

MPL

1MPL As more labor

is added, MPL

Slope of the production function equals MPL


Determining SupplyDetermining Supply

Profit = Revenue – Labor Cost – Profit = Revenue – Labor Cost – Capital Cost = PY – WL – RKCapital Cost = PY – WL – RK

ΔΔProfit = Profit = = = ΔΔRevenue – Revenue – ΔΔCost =Cost == MPL P – W= MPL P – W

If MPL > W/P hire moreIf MPL > W/P hire more MPL = W/P (MPL=real wage)MPL = W/P (MPL=real wage) MPK = R/P (MPK = real capital rent)MPK = R/P (MPK = real capital rent)


MPL and the demand for labor

Each firm hires labor

up to the point where MPL = W/P.

Each firm hires labor

up to the point where MPL = W/P.

Units of output

Units of labor, L

MPL, Labor demand

Real wage

Quantity of labor demanded


The equilibrium real wageThe real wage

adjusts to equate

labor demand with supply.

The real wage adjusts to

equate labor demand with supply.

Units of output

Units of labor, L

MPL, Labor demand

equilibrium real wage

Labor supply

L


The equilibrium real rental rateThe real rental rate adjusts to

equate demand for capital

with supply.

The real rental rate adjusts to

equate demand for capital

with supply.

Units of output

Units of capital, K

MPK, demand for capital

equilibrium R/P

Supply of capital

K


Determining DemandDetermining Demand Y = C + I + G + NXY = C + I + G + NX This is an This is an identityidentity. It always holds.. It always holds. C – private consumption. Depends on disposable C – private consumption. Depends on disposable

income Y – T. C=C(Y – T)income Y – T. C=C(Y – T) G – government consumption. Assume to be G – government consumption. Assume to be

fixed. Assume taxes T are fixed too.fixed. Assume taxes T are fixed too. Investment is Investment is notnot a purchase of financial a purchase of financial

instruments. It is construction of new plants, instruments. It is construction of new plants, purchases of new equipment, new housing, etc. purchases of new equipment, new housing, etc. Investment depends inversely on Investment depends inversely on realreal interest interest rate. I = I(r).rate. I = I(r).

Assume a closed economy, where NX=0.Assume a closed economy, where NX=0.


EquilibriumEquilibrium Y=F(K,L)Y=F(K,L) NX = 0NX = 0 C = C(Y – T)C = C(Y – T) I = I(r)I = I(r) K, L, G, T are fixed. Hence, Y is fixed. K, L, G, T are fixed. Hence, Y is fixed.

Hence, C is fixed.Hence, C is fixed. Y – C – G = I(r)Y – C – G = I(r) (Y – C – T) + (T – G) = I(r)(Y – C – T) + (T – G) = I(r) Private Saving + Public Saving = Private Saving + Public Saving =

InvestmentInvestment


Loanable funds market equilibriumr

S, I

I (r )

( )S Y C Y T G

Equilibrium real interest rate

Equilibrium level of investment


Government spending increases…Government spending increases…

Logically:Logically: As supply of loans decreases, their As supply of loans decreases, their

price (real interest rate) increases. price (real interest rate) increases. Crowding outCrowding out..

Mathematically:Mathematically: Y – C – G = I(r)Y – C – G = I(r) As G increased, Y – C – G decreasesAs G increased, Y – C – G decreases In order for I(r) to decrease, r should In order for I(r) to decrease, r should

rise.rise.


Government spending increases…Government spending increases…


Homework:Homework:

Chapter 2, problem 7 (a, b, c, d)Chapter 2, problem 7 (a, b, c, d) Chapter 3, problem 1Chapter 3, problem 1 Chapter 3, problem 9Chapter 3, problem 9

Due next Tuesday at 9 a.m. in classDue next Tuesday at 9 a.m. in class

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Macroeconomics I Lecture 1. September 4, 2007 Robert TCHAIDZE