Note. Growth rate: the percentage rate of change in a variable X from period t to period

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1 Intermediate Macroeconomics Economics 4353/7353 Spring 2012 Handout 1 Chapter 1: Introduction to Macroeconomics I. The issues central to the field of macroeconomics A. Long-term economic growth 1. The rate of growth over time determines standard of living. Example. (a) U.S. Almost a 100-fold increase in aggregate level of real output, (Fig. 1.1 in the text). U.S. aggregate GDP in 2010 in (chained) 2005 dollars was $13, billion and in nominal (2010) dollars was $14,526.5 billion. (b) U.S. almost a 15-fold increase in real output per capita, ; this represents about a 2% average annual growth rate. In 2007, real output for the U.S. was about $45,000 per capita in 2005 dollars. Note. Growth rate: the percentage rate of change in a variable X from period t to period t + 1. The formula is: [( X t+ 1 X t ) / X t ] 100% = [( X t+ 1 / X t ) 1] 100%. Example U.S. real GDP = 13, billion in 2005 $ 2006 U.S. real GDP = 12, billion in 2005 $ Growth rate = [(13, , )/12, ](100%) = 1.77%. 2. Average Labor Productivity: the amount of output produced per unit of labor input. (a) Labor input is typically measured in terms of workers or hours. (b) A very simple growth equation can be based on: Y = ( Y / N)( N). (c) Average labor productivity (measured per worker) increase in the U.S.: more than 6-fold, , despite fewer hours per year. One perspective: labor productivity as the source of growth. Example. Suppose that for a fictional country, one has the following data. Year Output Employment ,000,000 1, ,300,000 1,100 Step 1. Output growth from 2001 to 2002 = Step 2. Employment growth = Step 3. Average labor productivity in 2001 = Average labor productivity in 2002 = Step 4. Growth in average labor productivity = Step 5. Use the simple equation: Y = (Y/N)(N) to derive an approximation for your answer in Step 1 above. 1

2 Note. Let W = XZ. Then: ( Δ W ) / W ( ΔX / X ) + ( ΔZ / Z). Let W = X / Z. Then: ( Δ W / W ) ( ΔX / X ) ( ΔZ / Z). 3. Note: estimates for the particular items in the first example in I.A.1. differ somewhat (indeed sometimes a great deal), from source to source at any given point in time; and, as more sample information becomes available and as a consequence of conceptual considerations, are revised over time. This represents a good example of where data development (that is, further data development), is required see below. 4.Questions and further points (a) There has been an extraordinary increase in standard of living, that is, extraordinary growth, in the U.S. and some other countries. However, this growth is uneven, in any one country, over time. (i) See the accompanying graph showing output per capita, and Fig. 1.2 in the text for average labor productivity. (ii) Some of this is due to business cycle fluctuations. (iii) However, also, e.g.: (Y/N) growth for the U.S.: % % %. (b) Across countries and time, stretches of fast and slow productivity growth can last for long periods, with consequences such as the following: 1870: income per capita in Norway < income per capita in Argentina. 2005: income per capita in Norway was about three times that in Argentina. (c) The general question is: what determines a nation s long-run economic growth? Why do some countries grow faster than others? An example of a more narrow question regarding growth: why do some countries poor in raw resources, (Japan, South Korea primarily harbors, soil), grow faster than others rich in raw resources even with some infrastructure already in place, (some in Latin America transport links, plus metals, oil and natural gas)? (d) What roles do, or might, each of the following play in determining economic growth: the degree of openness, the nature and policies of government, the degree of development of financial institutions, the degree of income or wealth inequality? B. Business cycles: causes and characteristics 1. The data in the accompanying graphs and several of the graphs in Chapter 1 suggest the existence of irregular cyclical fluctuations around a growth trend. 2. Business cycles: this term refers to short-run, (more or less), contractions and expansions in economic activity. The definition will be made more precise in Chapter 8. (a) Contractions are often referred to as recessions. (b) There have been 11 complete cycles since the end of World War II, embedded in which have been 11 recessions including the most recent (December 2007-June 2009). (c) None of the post-wwii fluctuations, (neither contractions nor expansions), have been as great in amplitude as those in the period (d) During the most recent recession, growth rate in U.S. real GDP hit bottom in (- 8.9%) and (-6.7%). Growth rates for the following three quarters of 2009 were: -0.7%, 1.7%, 3.8%. Then it fell steadily downward over the period from 3.9% to 0.4%. Perhaps the 2

3 economy is now moving into a steadier recovery mode: the growth rates for and were 1.3% and 1.8%, respectively. (e) Note: The phrase economic activity in item B.2 just above is intended to indicate that one s focus should encompass a whole set of macroeconomic variables when studying business cycles, not merely fluctuations in real GDP. 3. There are many interrelated questions regarding business cycles that have (at best) incomplete answers. (a) Why are some contractions more severe than others, some expansions more robust than others? For example, the contraction in (severe) or the most recent contraction (severe) compared to that in 2001 (mild)? More generally, what determines the amplitude and duration of contractions or expansions? (b) The frequency of cycles was somewhat greater during the period , (also somewhat greater [15 versus 11] during the shorter period that excludes the Great Depression and World Wars, ), than during the period since Moreover, the average length of contractions has been considerably less since 1945 (although the duration of the most recent contraction was the longest since the Great Depression). Why? (c) Additionally, the volatility of output and a number of other important macro variables has been significantly less during the period from about 1985 to date (or at least until 2008) than during the period before that. (See the accompanying growth rate graph, for example.) An explanation for this has been elusive. (d) Why do so many aggregate variables move together over time? For example, real GDP, investment, and the nominal interest rate generally move upward (downward) together in an expansion (contraction). Another (not surprising) example is the inverse relationship between output movements and unemployment. (e) What role do bubbles in asset markets play in business cycles? Do financial crises constitute a (the?) key source of the severity of recessions? (f) What possibilities might there be for government policy, ( traditional macro fiscal policy and monetary policy; regulatory architecture for the financial sector), to influence business cycles, and in particular, to moderate recessions? 4. It is important to remember that even during mild recessions, many people lose jobs and savings, and many people suffer. C. What causes unemployment? 1. Unemployment rate: The fraction of the labor force who do not currently have jobs and who are actively seeking jobs. The (average) unemployment rate for the U.S. for 2008 was 5.8%, for %, and for 2010, 9.6%, and in one month hit double digits (10.1% in October 2009). It remained high (the 8.9% - 9.1% range) during most of 2011, although recently has fallen a bit (8.5% in December). 2. It may be that some other variable, perhaps the non-employment rate, is a more useful measure here, at least during some periods. (The non-employment rate takes into account discouraged workers, who want jobs but due to lack of success in finding jobs have given up actively searching.) 3. Until about 1940, the unemployment rate being 10% or more often occurred during recessions. The worst episode was during the Great Depression, when the unemployment rate reached 24.9% -- a quarter of the labor force. In the post-world War II period, the unemployment rate was above 10% 3

4 during the 4 th quarter of 1981 and in the first two quarters of Aside from these three quarters, in the U.S. it has been in single digits in the post-wwii period until October The unemployment rate is never zero. Even with the very strong expansion in the U.S. from March 1991 to March 2001, the lowest rate reached was 4% (in the year 2000). We shall want to ask why the unemployment rate in the U.S. rarely gets closer to zero, (it did fall below 4% during part of the 1960 s, and at its lowest was 1.2% in 1944). 5. For reasons that are not altogether clear, the unemployment rates in some of the richer countries in Europe have remained high for much of the period since the early 1980 s, (7 to 8% or even higher during expansions), relative to levels earlier in the post-wwii period. 6. Note: To develop a proper perspective on labor markets in relation to business cycles, it is very important to focus on movements in employment, as well as the unemployment rate. D. What causes inflation? 1. Inflation rate: The percentage rate of increase (corresponds to a decrease when negative) in the level of prices. The formula for it is: π t+ 1 = [( Pt + 1 Pt ) / Pt ] 100% = [( Pt + 1 / Pt ) 1] 100%, where P denotes the general price level. Using the broadest measure, the inflation rate for the U.S. for 2010 was 1.2%, and 2.5% (at a yearly rate) during the first three quarters of Using a measure specific to consumption goods, the Consumer Price Index (CPI), the rate for 2010 was 1.6% (1.0% with food and energy stripped out). In November 2011, the CPI was (at a yearly rate) 3.4% (2.2% with food and energy stripped out). 2. The term deflation refers to the case where the price level is falling. The inflation rate is negative in this case, as for the CPI in June 2011, (-2.5%). 3. Prior to WWII, periods of inflation (price level increasing), often corresponding to periods of war, were offset by periods of deflation, so that the price level remained more or less constant (see Fig.1.4 in the text, for the CPI). Since WWII, the price level has risen steadily on a quarterly basis in the U.S. and in most of the other rich countries, (Japan during parts of the period being an exception), until recently, and even recently the inflation rate has been positive when food and energy are excluded. However, while generally positive, the rate of inflation varies widely across time in any given country and across countries. Example. In the U.S., using the broadest measure of inflation, the inflation rate was below 2% during the period and below or very close to 2% during the recent period However, it was much higher at other times, peaking at over 10% during part of 1975 and again in Inflation erodes the purchasing power of money, and thereby undermines its function as a medium of exchange. This is most clearly seen when the inflation rate in an economy is extremely high, that is, when there is hyperinflation. For example, during most of the year 1985, the price level in Bolivia rose at an annual rate of 11,750%. By some estimates, the annual inflation rate for Zimbabwe was running at over 11 million per cent during parts of At such rates, prices increase constantly, people receive wages and salaries on a daily or even hourly basis, and rush to spend it as quickly as possible. The monetary system breaks down. 5. However, even at much lower (positive) inflation rates, money functions as the medium of exchange in a much less efficient fashion. Hence, we want to know what causes inflation. 6. Returning to the economic situation in the recent period 2008-date in the U.S., there has been an ongoing concern that the U.S. might experience deflation, at least according to some measures of 4

5 the price level. (In fact, the inflation rate as measured by the CPI has been negative during a number of months in , though to reiterate, always positive with food and energy stripped out.) Socalled debt-deflation in the midst of a contraction can make things considerably worse. We will come back to this issue later in the course. 7. We will also consider briefly the important role of inflation-rate expectations in determining the actual rate of inflation, and the relevance of this for the months (perhaps several years) ahead. E. What are the consequences, for individual nations economies, of being situated within the global economic system? 1. A country has an open economy if it trades and has financial interactions with other countries. This is as opposed to a country with a closed economy. There has been an ongoing trend of most economies becoming more open so-called globalization. 2. One key question that arises here: to what extent are business-cycle expansions or contractions transmitted from one country or group of countries to other countries? More generally, to what extent are cycles synchronous across countries or groups of countries? Example. The financial crisis in the U.S., given that capital markets are to a significant extent global. Example. Business-cycle transmission from richer economies to the emerging economies of Eastern Europe. 3. U.S. Imports: produced abroad and purchased by individuals in the U.S. U.S. Exports: produced in the U.S. and sold to individuals in other countries. U.S. Trade Deficit = U.S. Imports U.S. Exports. There is a trade surplus if exports are greater than imports. During recent years, both U.S. imports and U.S. exports have been very significant when measured, for example, as a percentage of total real output, (Fig.1.5 in the text). Neither has been below 10% measured as a fraction of real output during the last 25 years or so. (The net, that is, the trade deficit or trade surplus, has of course been (generally) much smaller in comparison to real output.) The U.S. economy is much more open than in the period, for example, of (However, as the book points out [p.8], international trade was already very important for the U.S. before WWI. Why might this make sense in the context of American history?) 4. In recent years, the U.S. has been running large trade deficits. To the extent that these deficits represent trade imbalances (or to the extent that they correspond to asset-market imbalances), are they bad for the U.S. economy or for the economies of U.S. trading partners? What causes them? Are they related to the large Federal budget deficits that the U.S. has been running for most of the last 25 years? F. Can government policies enhance a nation s economic performance? 1. Fiscal policy: determines government spending and taxation. Monetary policy: related to the determination of growth in the money supply and the determination of short-term interest rates. Monetary policy is set by the central bank. In the U.S., the central bank is the Federal Reserve System (the Fed). 2. Government Budget Deficit = Government Spending Government Revenue. When this is negative, it corresponds to a surplus. 3. Historically, the U.S. has run large Federal deficits during times of war or depression, and then paid them off, so that overall, over time, there was budget balance. 4. More recently, there have been large deficits during peacetime and in the absence of depression, (Fig.1.6 in the text). Large deficits: early 1980 s

6 Surpluses: Large deficits: 2002 date (and beyond) For 2010, the Federal deficit as a percentage of GDP was about 8.8% and was probably something not far from that for Note also that both U.S. Federal government spending and U.S. Federal tax collections have remained high, relative to total real output, since WWII. 5. Are large government deficits bad for the U.S. economy? Also, to repeat the question above: is there a relationship between these large Federal deficits and the large trade deficits, (often referred to as the twin deficits )? 6. There is currently (and has been in the past) an ongoing debate regarding the use of various sorts of tax cuts and/or various sorts of government spending to stimulate economic activity. (a) The debate in part concerns the efficacy of such policies in the short run. For example, such policies can result in increases in government deficits, possibly for a significant number of years into the future. One s general, perhaps somewhat-fuzzy notion of fiscal probity aside, there is the specific concern that anticipations of policy actions (e.g. tax increases) in the future in relation to (potentially enormous) federal deficits may in fact undermine efficacy of fiscal policy in the present. (b) Not unrelated to (a), participants in the debate stress the need to evaluate fiscal policy actions making use of cost/benefit analysis that takes into account both short-run impact and longerrun impacts. (c) The debate also concerns possible resulting expansion of the public sector (in the context of economic activity and perhaps from other perspectives as well). 7. Turning to the Fed and monetary policy: (a) One of the important policy tools that the Fed has used, in much of the post-wwii period, is that of targeting the Fed funds rate, the short-term interest rate at which banks borrow reserves from each other. Traditionally, the idea has been that, by means of this target rate, when the economy shows weakness, the Fed would seek to put downward pressure on interest rates, whereas when the economy appears to be overheating, (that is, a significant increase in the inflation rate threatens), the Fed would seek to raise interest rates. Example. May 2000 mid 2003, the Fed funds rate target fell from 6.5% to 1%. Mid 2004 mid 2006, this rate rose from 1.25% to 5.25%, and remained there until September Since September 2007, this target rate has fallen, with the current target rate being 0.25%, and actual values of the Fed funds rate and other key short-term rates being somewhere close to zero. (b) The implications of such an interest rate policy for the economy has been a matter of ongoing debate. We will consider the question: have Fed actions, rather than helping, actually increased the severity of some (not all) recessions, beginning with the Great Depression? (c) However, whatever the case in the past, it seems clear that during the period from late 2007 into early 2009 and beyond, the policy of targeting the Fed funds rate has been (at least in and of itself) ineffective. Given this, but perhaps more significantly, given the (belatedly but mostly accurately(?)) perceived nature of the ongoing difficulties in the financial sector, the Fed has engaged in a variety of alternative policy actions, many of which can be broadly viewed as lender of last resort policies. Some actions have been pursued in conjunction with the Treasury. Some one might characterize as ad hoc, (including a key case of withholding of action, namely, allowing Lehman Brothers to fail in September 2008). Others one can fairly characterize as reflecting a more systematic strategic viewpoint. 6

7 (d) There is also the question, one that differs somewhat from most of the cases that would fall under item (b) just above, as to whether the relatively low level of the Fed funds target rate from late 2001 into mid 2005 helped to set the stage for the subsequent financial crisis beginning in 2007 (hitting its worst point in the last months of 2008), and thence the recent contraction. 8. Most of our focus on policy will be on fiscal policy and monetary policy of the traditional macroeconomics sort. However, we shall also consider now and then the possibility that government actions at the microeconomic level might be helpful in moderating recessions, (while also perhaps fostering greater productivity and thereby increasing the average growth rate of the economy). Example. The cost of severance packages in the German labor market. Example. The nature of government regulatory oversight in the financial sector. II. What Macroeconomists Do To Address These Issues A. Macroeconomic forecasting 1. As discussed in the text, macroeconomic forecasting is very difficult, due to the complexity of the economic system, and relatively few economists engage in forecasting as their primary activity. 2. This is not, of course, to say that forecasting is unimportant. Example. During the first half of 2007, the Fed, in deciding upon interest-rate policy, was uncertain as to which loomed as the greater threat on the horizon: a significant upward movement in the inflation rate; or increasing weakness in the economy, perhaps leading into a recession. Reflecting this uncertainty, the Fed funds rate target remained at 5.25% until September Arguably, better forecasting would have led to earlier cuts in the target rate (which is not to say that the policy would necessarily have prevented a contraction). B. Macroeconomic analysis: private sector and public sector economists monitor and analyze current economic conditions. 1. As discussed in the text, politicians, rather than economists, are often the ones actually setting policy. And politicians are often more interested in re-election than in economic analysis relevant to a particular policy. 2. That said, economic analysis and economic theory have had increasing influence in recent years. For example, this is clearly visible in the macroeconomic policymaking in some emerging economies, (Chile, for example, and some of the Eastern European countries that were formerly under the control of the Soviet Union). C. Data development: an ongoing process for making data more useful for forecasting, analysis of current conditions, and evaluation of economic theories and models 1. One example, implicit in the comments in I.A.3 above, is that involving revisions in aggregate output data for the U.S., which is relevant to evaluation of the growth path in the U.S. over the past century or more. Such revisions are also relevant to conclusions regarding the volatility of business cycle fluctuations before the Great Depression in comparison to the period after WWII. 2. Another example can be found in Box on pp in the text: Does the CPI continue to be a misleading measure of inflation, implying that further changes in the construction of this data series are needed? D. Macroeconomic research 1. The overall goal is to make general statements about how the economy works. 7

8 2. Theoretical and empirical research are necessary as a basis for forecasting and economic analysis. 3. Economic theory: a set of ideas about the economy, organized in a logical framework. 4. Economic model: a simplified representation of some aspect of the economy, (usually in mathematical form). A good economic model is based on reasonable assumptions; can be used to study real-world problems and provide insight into those problems; and generates testable implications, that is, implications that can be compared to real-world data to determine to what extent the model is consistent with the data. Example. Work through the Box on p.13 of the text. Although the title is: Developing and Testing an Economic Theory, what is actually being developed is a model of commuting, that reflects and implements the theory. Example. The importance of research is illustrated in a simple fashion by means of the example in the second paragraph on p.12 of the text. In the example, the International Monetary Fund (IMF) is assisting a small developing country in bringing down its high inflation rate. Read through the entire paragraph. Note well the crucial role of economic research, in that it provides both casespecific material relevant to fighting inflation, and general theoretical principles regarding the causes and cures of inflation. III. Why macroeconomists disagree A. Disagreement in the realm of normative analysis stems from differences in personal value judgments. B. Disagreement in the realm of positive analysis 1. There is disagreement as to focus (and accompanying expenditure of resources): which among competing economic theories or models are more promising? 2. Implications in the realm of positive analysis can be tested. However, there are data limitations, partly because economists can rely on controlled experiments only to a very limited extent (in contrast to the natural sciences). As a result, economists must rely primarily on statistical analysis of data that is available, (sometimes in conjunction with computer simulations). Not surprisingly, disagreement arises regarding which data are relevant, and regarding the sort(s) of statistical analysis to be used, in evaluating any particular economic model. Note: As a consequence, disagreement in the realm of positive analysis can appear to be disagreement in the realm of normative analysis, when the latter does not in fact exist. IV. Two major schools of thought in macroeconomics A. The Classical Approach 1. The market economy works well on its own; the invisible hand leads people, acting in their own best interests, to maximize the general welfare (subject to a more or less limited [depending on the economist] set of qualifications). 2. Wages and prices adjust rapidly enough so that equilibrium prevails. 3. Government should have only a limited role in the economy. 8

9 B. The Keynesian Approach 1. Wages and prices often adjust slowly, so that markets can be out of equilibrium for extended periods of time. In particular, relatively high rates of unemployment may persist because wages and prices do not adjust quickly enough to maintain equilibrium in labor markets. 2. Government should intervene so as to enhance the performance of the economy. This characterization is imprecise and over-simplified but reflects a distinction that does exist (albeit with many shades of gray). Read through the discussion on pp in the text. 9

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