Introduction. Prof. Eric Sims. Fall University of Notre Dame. Sims (ND) Introduction Fall / 26

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1 Introduction Prof. Eric Sims University of Notre Dame Fall 2010 Sims (ND) Introduction Fall / 26

2 Logistics Syllabus and related issues Sims (ND) Introduction Fall / 26

3 About Me Assistant Professor, Dept. of Economics B.A. Trinity University, 2003 Miracle in Mississippi October 27, 2007 Ph.D. University of Michigan, 2009 Don t get the wrong picture Wife proud ND graduate Lewis chicken Signed Charlie Weis picture in office (oops?) Michigan Sucks Sims (ND) Introduction Fall / 26

4 Out of Style? Sims (ND) Introduction Fall / 26

5 Introduction Macroeconomics: study of aggregate economy Key questions: Why does the economy grow over time? Why does economy experience periodic deviations from its growth path? What is the role of government? What the heck happened in ? Sims (ND) Introduction Fall / 26

6 Basic Approach of this Course Economists do it with models But the models are used to help understand the real world Micro-founded macroeconomics. Agents Optimize. This requires some math Equilibrium approach market-clearing as the relevant benchmark Fundamentally dynamic Sims (ND) Introduction Fall / 26

7 Introduction Topics Math Exponents and logs Solving systems of equations Basic derivative rules Data GDP and components, price indexes Real vs nominal variables Basic facts Growth, business cycles, co-movement, volatility Why do economists use models? Sims (ND) Introduction Fall / 26

8 Math Need to know Properties of exponents and natural logs Solving systems of equations by substitution Some basic calculus rules Sims (ND) Introduction Fall / 26

9 GDP GDP: dollar value of all goods and services produced in a country in a given period of time Nominal GDP: sum of prices times quantities of goods Problem: we get utility (i.e. happiness) from quantities, not prices Need a way to account for price movements Sims (ND) Introduction Fall / 26

10 Real vs Nominal Variables Nominal: measured in terms of the unit of account (i.e. dollars) Real: measured in terms of units of goods (i.e. quantities) In multi-good world, can t just sum up quantities though Sims (ND) Introduction Fall / 26

11 Real GDP Notation: real GDP = y t Pick some year as base year (b) Calculate real GDP in subsequent years as as quantities times base year prices This will take out common movements in prices This defines an implicit price index or deflator; ratio of nominal GDP in a given year to real GDP in that year Sims (ND) Introduction Fall / 26

12 Components of GDP Accounting identity y t = c t + I t + g t + nx t c: consumption (70%) I : investment (15%) g: government spending (20%) nx: exports minus imports (-5%) Sims (ND) Introduction Fall / 26

13 Log Scales Rule of thumb: work with most macro series in natural logs Why? First difference of log is approximately growth rate Induces approximate linear trends, allows unit-less interpretation of movements Sims (ND) Introduction Fall / 26

14 Post-War Quarterly Real GDP 16.8 Log Real GDP Sims (ND) Introduction Fall / 26

15 Components of GDP Consumption Investment Government Spending.02 Net Export Share Sims (ND) Introduction Fall / 26

16 Observations Dominant feature, by far, is the upward trend In comparison, recessions are minor even the most recent one This is important to keep in mind when thinking about active stabilization policies Consumption, investment, and government spending all trend up too Consumption is smoother than investment, but series tend to go up and down together (co-movement) Sims (ND) Introduction Fall / 26

17 Detrending Macro is traditionally divided into two time scales long run and short run Business cycles defined as movements about long run trend To see cycles more clearly, want to remove this trend Sims (ND) Introduction Fall / 26

18 HP Filtered GDP and Components.04 GDP.06 Consumption Investment.2 Government Spending Sims (ND) Introduction Fall / 26

19 Price Level GDP deflator: p t = nominal t /y t CPI is constructed differently; uses fixed weight baskets. See book Prices also trend up. Inflation defined as growth rate of price level Sims (ND) Introduction Fall / 26

20 Price Level and Inflation 5.0 Price Level.04 Inflation Sims (ND) Introduction Fall / 26

21 Time Series Facts Average annualized growth rate of real GDP: 3.25% Average growth rates of consumption, investment, and government spending similar This means that the ratios of components to GDP are roughly mean-reverting Average annual inflation: 3.0% What does this mean average growth of nominal GDP is? Sims (ND) Introduction Fall / 26

22 Interest Rates Quoted interest rates are nominal they are quoted in current dollar terms Economic actors should care about real interest rates Real interest rate is approximately nominal interest rate minus expected inflation Sims (ND) Introduction Fall / 26

23 Real and Nominal Interest Rates Federal Funds Rate Real Interest Rate Sims (ND) Introduction Fall / 26

24 Models We are interested in cause and effect relationships Unlike medicine or natural sciences, can t typically run experiments Hence, we create models to allow us to run experiments in our fictitious model economies This allows us to say something about cause and effect, and to make policy recommendations Without some kind of model, almost impossible to say anything sensible Sims (ND) Introduction Fall / 26

25 What is a Model? A model is a structured framework to help us understand the real world A good model should be: Built from first principles (i.e. reasonable) Transparent Right balance between realism and simplicity Exogenous variable: determined outside model Endogenous variable: determined by the model Sims (ND) Introduction Fall / 26

26 Our Plan of Action We are going to build up models Many of these (especially early) are painfully simple But they can give us insight into complex situations As we go along, we ll make models more realistic At each step, we stop to do a smell test Sims (ND) Introduction Fall / 26