Macroeconomics In The Global Economy

1. Macroeconomics In The Global Economy Wei wei Shool of Economics and Finance Jiaotong University

2. Chapter 1 Introduction • The approach of Macroeconomics • Some of the key questions addressed by macroeconomics • Macroeconomics in historical perspective • Providing a broader framework for macroeconomic analysis

3. The approach of Macroeconomics • What is macroeconomics ? Macroeconomics is the study of aggregate behavior in an economy. While the economic life of a country depends on millions of individual actions taken by business firms, consumers, workers, and government officials, macroeconomics focuses on the overall consequences of these individual actions. For example, prices---- price index.

4. The approach of Macroeconomics • The basic approach of Macroeconomics is to look at the overall trends in the economy. • Special summary measures of economic activity ---GNP, the saving rate, or the consumer price index--- give the “big picture” of changes and trends. • These overall macroeconomic measures provide the basic equipment that allows macroeconomists to focus on the dominant changes in the economy.

5. How do economists do their job? • First, try to understand on a theoretical level the decision processes of individual firms and households. • Second, try to explain the overall behavior of the economy by aggregating, or adding up, all the decisions of the individual households and firms in the economy. • Third, giving empirical content to theory by collecting and analyzing actual macroeconomic data.

6. Some of the key questions addressed by macroeconomics • The most important single measure of production in the economy is the GNP. • Economic growth and business cycles • Unemployment is a second key variable that macroeconomics investigates. • A third key variable that interests macroeconomists is the inflation rate. • The fourth major variable that macroeconomists look at is the trade balance.

7. Macroeconomics in historical perspective • The creation of macroeconomics Economic statisticians began to collect and systematize aggregate data which provided the scientific basis for macroeconomic investigations. The careful identification of business cycle as a recurrent economic phenomenon. The Great Depression A new theoretical framework to explain the Great Depression proposed by Keynes.

8. The development of macroeconomics • Keynesian and neo-Keynesian • Main idea • Keynes’s policy recommendation is the major tool of promoting economic growth. • Non- Keynesian • In fact, to many economists, it began to appear that stabilization policies were actually a major source of renewed instability. • A “counterrevolution” began. • Monetarism and it’s central idea. • New classical macroeconomics: Lucas and Barro. • Advocates of the real business-cycle theory.

9. Providing a broader framework for macroeconomic analysis • The general theory is limited to short-term economic fluctuations and stabilization policies. • Our analysis is pushed further by providing an especially broad view of macroeconomics. • Beside the attention on short-term economic fluctuations and stabilization policies, we focus more attention on other central concerns of macroeconomics,such as the determination of economic growth rate, or balance of payment, etc. • Considerable attention has been given to the differences in economic institutions in different countries in order that we discover a more general macroeconomic theory.

10. Chapter 2 Basic Concepts in Macroeconomics • Looking at different measures of aggregate income and outcome and their interrelationship. • The process of aggregating across many different goods and services requires some common unit of measure: the role of price and price indexes. • A subject that permeates much of discussion in macroeconomics:Flows and Stocks • Two factors that influence the Intertemporal decisions of economic agents:Interest Rates and Present Value. • Another factor that is vital in understanding decision making across time periods: expectations

11. GDP and GNP • What are GDP and GNP? • How to calculate them? • interrelationship of them • GNP = GDP＋NFP • GNP per capita and economic well-being

12. Real Versus Nominal Variables • The construction of price indexes • Consumer price index or consumer price deflator • Pct = w1(P1t／P10) + w2(P2t ／ P20) + …+ WN(PNt ／ PN0) • Ct= nominal consumption expenditure ／ Pct • =PctCt ／ Pct • Deflator for investment spending (PI), government spending (PG), exports (PX), and imports (Pm)

13. Real GDP • To calculate real production, we think of the GDP of the economy as equal to the product of “average” price level in the economy, multiplied by the level of real production in the economy. • GDP = PQ • How to calculate Q ? • We start with the definition of Nominal GDP as the sum of final expenditures throughout the economy. • Then, we use the price indexes for consumption, investment, government spending, exports and imports to calculate a time series of real expenditures for each of these categories. • Finally, we can get Q by adding up the sum of final expenditures of these categories.

14. How can we get P ? • Once getting real GDP, Q, then we can compute the GDP price deflator P using the formula as follow: • P = GDP／Q • Generally, we get Real GDP by using the formula as follow: • Q = GDP ／P

15. Flows and Stocks in Macroeconomy • A flow is an economic magnitude measured as a rate per unit of time. • A stock is an economic magnitude measuredat a point of time. • Investment and the capital stock • Saving and wealth • The current account and net international investment position • Deficit and the stock of public debt

16. Some Intertemporal Aspects of Macroeconomics: Interest Rates and Present Values • Many key macroeconomics issues involve choices that not only take place in time but that involve decisions about timing. We call the choices involve later as intertemporal choice. • Two crucial elements in the analysis of intertemporal decisions • Interest rates and net present values • Using interest rates, we can translate a given time path of money in the future into a present value today. an economic magnitude measured

17. The Role of Expectation • At the time that economic agents make intertemporal choices, they are generally uncertain about the future, so they have to formulate some expectations about the future. • How do economic agents actually formulate their expectations ? • Static expectations • Next year is going to be like this year. • Adaptive expectations • Individuals update their expectations about future depending on the extent to which their expectations about present period turned out to be wrong. • Rational expectation • Individuals make efficient use of all available information. • What economic model the individuals is using and just what economic information he or she has at hand.

18. Chapter 3 Output Determination: Introducing Aggregate Supply and Aggregate Demand • Macroeconomics as the study of economic fluctuations • The Determination of aggregate supply • The classical approach to aggregate supply • The Keynesian approach to aggregate supply • The determination of aggregate demand • Equilibrium of aggregate supply and aggregate demand • Aggregate supply and demand in the short run and the long run

19. Macroeconomics as the study of economic fluctuations • Economic fluctuations have been a central concern of macroeconomics • Economic fluctuations: output and employment fluctuations • Unemployment rate • Potential output, current output and output gap • When employment fluctuates, so does output, since output is produced using labor inputs. Just as we measure the extent to which employment falls short of the full-employment level, we also can measure the extent to which output falls short of the level that would be produced if all labor were fully employed.

20. Economic performance is not only measured in terms of the general trend of output, but also in terms of whether the output gap is increasing or decreasing. • Okun’s law • There is a great regularity that a reduction of unemployment of 1 percent of labor force in the US was associated with a rise in GNP and fall in the output gap of 3 percent. • Business cycle • Unlike periods of sustained unemployment, business cycles represent shorter-term fluctuations of output and employment, typically lasting 3-4 years. • A key feature of business cycles is that important macroeconomic variables-output, prices, investment, business profits, and various monetary variables-tend to move together in a systematic fashion.

21. The Determination of aggregate supply • Aggregate supply • Definition • Aggregate supply is the total amount of output that firms and households choose to provide, given the pattern of wages and prices in the economy. • Optimal supply decision • In fact, supply decision bases not only on current wages and prices, but also on expectations about future wages and prices.

22. Formulation of aggregate supply • The Formulation of aggregate supply is complicated by the fact that there are many kinds of goods in the economy, produced by a very large number of firms and households. • Our theoretical framework ignores these complications and assumes that the economy produces a single output. • The production Function • Q＝Q (K, L, τ) • In the equation, output is a function of the capital and labor used in production and of the state of technology.

23. The production function has two characteristics: • An increase in the amount of any input will make output go up. • We assume that the marginal productivity of each factor declines as more of that factor is used with a fixed amount of the other factor. Q B Q=(K0,L) L

24. Q MPL Q(K1＞K0) MPL(K1＞ K0) Q(K1) MPL(K0) L L (b) Marginal productivity of labor (a) Production function

25. The demand for labor and the output supply function • The firm should hire labor until the marginal product of labor input equals the real wage. w/p, MPL (w/p)a (w/p)b L La Lb

26. We can summarize these findings by writing the demand for labor as a function of real wage and the levels of capital and technology: • LD = LD(w/P, K, τ ) • Using the labor-demand schedule. We can now derive an output supply schedule which shows the amount of output the profit-maximizing firm will supply at each level of w/p, K, and τ. • QS = QS［ LD(w/P, K, τ ) ， K, τ］ • Note that QS is a negative function of w/p for an “indirect” reason.

27. Note also that QS is a positive function of K and τ,for direct and indirect reasons. • More simply, output supply is a negative function of w/p and a positive function of K and τ: • QS = QS (w/P, K, τ ) • The Supply of Labor • The supply schedule for labor, LS • Labor-supply decision: Household must choose between supplying labor and enjoying leisure, the so-called Labor-leisure decision.

28. Assumptions • A worker must choose only between labor and leisure and in which he consumes all his wage earnings,which are his only source of income. • The worker can choose to work any number of hours per day. • UL = UL(C, L)

29. C UL2 UL1 UL0 △C1 > △C0 B △L △C0 A △L L

30. C • How much labor and consumption workers actually choose depends both on the utility function and on the real wage level. Z1[(w/p) 1> (w/p) 0 ] Z0[ (w/p) 0 ] C1 =3 (w/p) 0 C0 = (w/p) 0 L 1 2 3

31. UL2 C Z2[(w/p) 2 ] UL1 C2 Z1[(w/p) 1 ] C1 L (w/p) (w/p) 2 (w/p) 1 L L 1 L 2

32. Substitution effect and Income effect • Substitution effect means that each hour of leisure represents a greater amount of forgone consumption of goods when the real wage goes up. With leisure more expensive, households “substitute” away from it and choose longer working hours. • Income effect works to reduce labor supply when wages increase. • The effect of a rise in wages on the supply of labor is theoretically ambiguous: the substitution effect tends to increase L, the income effect tends to decrease L. The relative influence of these two effects depends on household preferences.

33. The Classical Approach to Aggregate Supply • We already derived the Aggregate supply function, the demand for labor, and the supply of labor. Now we combine these and summarize the results in an aggregate supply curve. • The Main idea of classical approach • For any price level, the nominal wage is fully flexible and adjusts to keep the supply of labor and the demand for labor equilibrated. Thus, the real wage is determined so as to clear the labor market.

34. P Q QS Q(K0, L) Qf Q L (w/p) LS LD L Lf

35. Deriving the aggregate supply curve • How does the supply of aggregate output respond when the price level increase?

36. P Q Q L (w/p) L

37. Unemployment in the classical approach • Amendments to the basic model • One amendment allows for the fact that some people may choose voluntarily to be unemployed, at least for short periods of time. • A second amendment emphasizes that various forces in the labor market-- laws, institutions, traditions-- may prevent the real wage from moving to its full-employment level. If the real wage is stuck above the full-employment level, the unemployment results.

38. The Keynesian approach to aggregate supply • Assumption: Nominal wages and prices do not adjust quickly to maintain labor-market equilibrium. • Sticky wages • Long-term labor contracts • As the price level(P) rises, the real wage falls, the desired level of labor input goes up, the desired level of output supply also rises. As a result, the aggregate supply curve is upward sloping.

39. Involuntary unemployment • Involuntary unemployment is that some people who are willing to work at the wage received by other workers of comparable ability cannot do so. • Why does involuntary unemployment arise? • Nominal wage rigidity(Keynesian) • Real wage rigidity(classical theory) • Aggregate Supply: a summary • classical aggregate supply • Keynesian aggregate supply • extreme Keynesian aggregate supply

40. P Qs Qs Qs Q Q Q

41. The determination of aggregate demand • The equilibrium level of output and the price level over an entire economy is determined by the interaction of aggregate supply and aggregate demand. • The structure of aggregate demand with a closed economy • QD = C + I + G • Aggregate demand curve • Real Balance Effect • One immediate effect of a price increase is to reduce the real value of money held by the public.

42. If people hold a given amount of currency and bank balances and the price level rises,they will be able to buy fewer goods with their money. P P1 B A P0 Q QD1 QD0

43. In an open economy, aggregate demand is the total amount of domestic goods demanded at the given level of prices by both domestic and foreign purchasers. • The aggregate demand schedule in the open economy is still down-word-slope. • In the open economy, as in the closed economy, a rise in the price level tends to cause a fall in aggregate demand. • A rise in domestic prices compared with foreign prices makes it more expensive to buy domestic goods and relatively less expensive to buy foreign goods.

44. The Equilibrium of Aggregate Supply And Aggregate Demand • The aggregate supply-aggregate demand framework is useful apparatus for determining the equilibrium of output and the price level. We can use this framework to study the effects of specific economic policies as well as of external shocks on the equilibrium levels of Q and P. • Output market equilibrium is given by the intersection of the aggregate demand curve and aggregate supply schedule. This equilibrium will also determine the level of employment in the economy.

45. Equilibrated level of output does not signify the optimal level of output. There might by output gap. • Change on equilibrium: Demand side • Aggregate demand expansion • Changes in monetary, fiscal, and exchange-rate policies shift the position of aggregate demand schedule. • Expansionary monetary, and fiscal policies and devaluated exchange-rate policy can result in aggregate demand expansion

46. QS P • A demand expansion in the classical case P1 QD’ P0 QD Q Qo

47. QS P • A demand expansion in the Keynesian case P1 P0 QD’ QD Q Qo Q1

48. A demand expansion in the Keynesian extreme case P - QS P QD’ QD Q Qo Q1

49. Under classical conditions, a rise in aggregate demand leads only to a rise in prices, with no effect on output. • In the keynesian case, an aggregate demand expansion raises output (and employment) as well as the price level. It leads to the important conclusion that policy changes can, in the keynesian case, affect output. • Change on equilibrium: supply side • A supply shock: once-and-for-all technological improvement

50. QS1 QS0 P • A technological improvement in the Classical case P0 P1 QD Q Qo Q1