Review Session: ECON220F/G Introductory Macroeconomics Yulei Luo SEF of HKU April 25, 2016 Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 1 / 13
The Structure of Macroeconomics Key Macroeconomic Variables: GDP (real and nominal), the unemployment rate (employment and unemployment), the price level, the inflation rate, the interest rate (nominal and real). Main topics: Economic Growth (increases in the average standard of living in the long-run). Business cycles (short-run fluctuations in employment, production, and income; expansions and recessions) The financial system (linking savings made by households to investment made by firms) The effects of monetary policy and fiscal policy (expansionary or contractionary; fight recessions or inflation) Major Macro Models: Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 2 / 13
Major Macro Models The economic growth model (the Solow model). The aggregate expenditure model (the Keynesian model) The AD-AS model The Phillips model Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 3 / 13
Saving, Investment, and the Financial System The total value of saving in the economy (the sum of private saving and public saving) must equal the total value of investment. Note that in an open economy it is the sum of domestic investment and foreign net investment. The market for loanable funds is a combination of many financial markets (the markets for CDs, bonds, stocks, mutual funds, etc.), in which the interactions of borrowers (firms) and lenders (households) can determine the real market interest rate and the quantity of loanable funds exchanged in equilibrium (the supply of funds=the demand for funds). The equilibrium quantity of loanable funds is equal to both saving and investment in equilibrium. Investment determines the process of capital accumulation and then affect economic growth. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 4 / 13
Economic Growth The economic growth model can be used to explain changes in real GDP per capita in the long-run. The production function can be written as Y t = A t F (K t, N t ) = A t K α t N 1 α t, (1) The per capita production function can be used to relate the level of technology and capital per capita to real GDP (i.e., real total income) per capita. A simple example of the p.c. production function at any period t is: y t = A t f (k t ) = A t k α t, (2) where α (0, 1), A t is the level of technology, and k t is the stock of capital p.c. Hence, given the level of A t, we can draw the relationship between y t and k t in the (k t, y t ) space. Note that here A t can summarize some important factors: the quality of physical capital (i.e., better physical capital), more human capital, and better management and organization in production. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 5 / 13
Saving-Investment Relationship Using the definitions of saving, public saving, and private saving as well as the GDP identity, we can write down the following equality in a closed-economy: S t = I t. The aggregate capital stock accumulation equation is: K t+1 = (1 δ) K t + I t. The next period s aggregate production can be written as Y t+1 = A t+1 K α t+1n 1 α t+1, (3) which can lead to higher real GDP p.c. in the next period if I t and K t+1 are higher. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 6 / 13
The Aggregate Expenditure Model The AE model assume that the PL is fixed and examines the relationship between AE (total spending) and real GDP (aggregate supply). If not considering economic growth, in the short-run, the equilibrium GDP will not change unless AE changes. Changes in inventories is the difference between planned investment and actual investment. The mechanism of adjustments to macro equilibrium: When AE is greater (less) than GDP, inventories will decline (increase), and total employment and production will increase (decrease). Hence, fluctuations in AE cause the year-to-year fluctuations in GDP. Understanding the consumption function, MPC (MPS), and the multiplier effect. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 7 / 13
Aggregate Demand There is an inverse relationship between changes in the PL and changes in consumption, investment, and net exports included in AE. With higher prices, AE decreases at every level of GDP, thereby causing higher level of equilibrium real GDP. Hence, the AD curve shows the relationship between the PL and the real GDP demanded by HHs, firms, and government. Changes in some factors would shift the AD curve: Changes in government policies (MP involves changes in IRs, and FP involves changes in government purchases and taxes) Changes in the expectations of households and firms (optimistic or pessimistic about their future income or profits) Changes in foreign variables (the nominal exchange rate;relative real GDP/income growth) Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 8 / 13
Aggregate Supply In the long-run, the level of real GDP (also called potential or full-employment GDP) is determined by the number of workers, the capital stock, and the level of technology, and is independent of the PL. Therefore, the LR AS is a vertical line. In the short-run, the AS curve is upward sloping, i.e., as the PL increases, the quantity of G&S firms are willing to supply will increase: As prices of final G&S (the PL) rise, prices of inputs (wages and prices of intermediate goods) rise more slowly, thereby increasing profits and then increasing the willingness of firms to supply more final G&S. As the PL changes, some firms are slow to adjust their prices, thereby increasing sales and production. A dominant explanation for the upward sloping SR-AS curve: Inaccurate predictions of firms and workers about future PLs plus sticky prices and wages due to contracts, menu costs, etc. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 9 / 13
The AD-AS Model Long-run macro equilibrium: The AD and SR-AS curves interact at a point on the LR-AS. Short-run macro equilibrium: The interactions of the AD and SR-AS curve formulate a testable hypothesis. such as the wages of workers. The SR and LR effects of recessions, expansions, and negative supply shocks can be examined in the AD-AS model. The effects are determined by the adjustments of the expectations of firms and workers about the PL. E.g., when a recession caused by a reduction in AD happens, workers and firms will gradually realize the actual PL is lower than their expected PL, and consequently workers are willing to accept lower wages and firms are willing to accept lower prices. Revise the model if it fails to explain well the economic data. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 10 / 13
Monetary Policy The two monetary policy targets are: (1) the money supply and (2) the interest rate The Fed typically uses the interest rate target. The Fed can increase or decrease bank reserves through open market operations and then increase or decrease the money supply through the banking system. The Fed funds rate (a SR nominal interest rate) is determined by the supply of reserves relative to the demand for them in the federal funds market. Changes in the FFR will result in changes in other short-term nominal interest rates (e.g., interest rates on T-bills) and long-term real interest rates (e.g., returns on corp. bonds). Therefore, the MP can affect the AD through the interest rate channel. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 11 / 13
Fiscal Policy Two types of FP: changes in government purchases and federal taxes. The effects of FP on AD: first, changes in GP affect AD directly because GP is a component of AD; second, changes in taxes affect consumption and investment by changing disposable income. FP could generate the multiplier effect through the consumption function that depends on disposable income. FP also has the crowding out effect by the interest rate channel in the money market. Tax policy could have long-run effects because it can expand the productive capacity by increasing the supply of savings, labor, etc. Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 12 / 13
Inflation, Unemployment, and the Phillips Curve Just like the LR-AS, the LR-PC is also vertical at the NRU. Every SR-PC corresponds to every expected inflation rate. Changes in expectations of the inflation rate will shift the SR PC. Understand two types of expectations: adaptive expectation (gradual adjustment to the new equilibrium) and; rational expectation (quick adjustment along the LR PC to the new equilibrium). Luo, Y. (SEF of HKU) ECON1220F/G April 25, 2016 13 / 13