Lecture Macroeconomics: Lecture 28 - Prof. Dr.Qaisar Abbas
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Review of the previous lecture
1.
The Fed can control the money supply with
§
open market operations
§
the reserve requirement
§
the discount rate
2.
Portfolio theories of money demand
§
stress the store of value function
§
posit that money demand depends on risk/return of money &
alternative assets
Review of the previous lecture
3.
The Baumol-Tobin model
§
is an example of the transactions theories of money demand,
stresses “medium of exchange” function
§
money demand depends positively on spending, negatively on
the interest rate, and positively on the cost of converting nonmonetary assets to money
Lecture 28
Review of the previous lectures
Instructor: Prof. Dr. Qaisar Abbas
The Science of Macroeconomics
•
•
Macroeconomics is the study of the economy as a whole, including
•
growth in incomes
•
changes in the overall level of prices
•
the unemployment rate
Macroeconomists attempt to explain the economy and to devise policies to
improve its performance.
The Science of Macroeconomics
•
Economists use different models to examine different issues.
•
Models with flexible prices describe the economy in the long run;
models with sticky prices describe economy in the short run.
•
Macroeconomic events and performance arise from many
microeconomic transactions, so macroeconomics uses many of the
tools of microeconomics.
The data of Macroeconomics- GDP, Unemployment &
inflation
•
Gross Domestic Product (GDP) measures both total income and
total expenditure on the economy’s output of goods & services.
•
Nominal GDP values output at current prices; real GDP values
output at constant prices. Changes in output affect both measures,
but changes in prices only affect nominal GDP.
•
GDP is the sum of consumption, investment, government
purchases, and net exports.
The data of Macroeconomics- GDP, Unemployment &
inflation
•
The overall level of prices can be measured by either
1. the Consumer Price Index (CPI), the price of a fixed basket of
goods purchased by the typical consumer
2. the GDP deflator, the ratio of nominal to real GDP
•
The unemployment rate is the fraction of the labor force that is not
employed.
•
When unemployment rises, the growth rate of real GDP falls.
National Income:
Where it Comes From and Where it Goes
•
Total output is determined by
• how much capital and labor the economy has
• the level of technology
•
Competitive firms hire each factor until its marginal product equals its
price.
•
If the production function has constant returns to scale, then labor
income plus capital income equals total income (output).
National Income:
Where it Comes From and Where it Goes
•
The economy’s output is used for
• consumption (which depends on disposable income)
• investment (depends on the real interest rate)
• government spending (exogenous)
•
The real interest rate adjusts to equate the demand for and supply of
• goods and services
• loanable funds
•
A decrease in national saving causes the interest rate to rise and
investment to fall.
Economic Growth
•
•
The Solow growth model shows that, in the long run, a country’s standard
of living depends
•
positively on its saving rate.
•
negatively on its population growth rate.
An increase in the saving rate leads to
§
higher output in the long run
§
faster growth temporarily
§
but not faster steady state growth.
Economic Growth
•
•
Key results from Solow model with tech progress
§
steady state growth rate of income per person depends solely on
the exogenous rate of tech progress
§
the U.S. has much less capital than the Golden Rule steady state
Ways to increase the saving rate
§
increase public saving (reduce budget deficit)
§
tax incentives for private saving
Economic Growth
•
•
Productivity slowdown & “new economy”
§
Early 1970s: productivity growth fell in the U.S. and other
countries.
§
Mid 1990s: productivity growth increased, probably because of
advances in I.T.
Empirical s run aggregate supply curve is horizontal, because
prices are sticky at predetermined levels.
Introduction to Economic Fluctuations
•
•
Shocks to aggregate demand and supply cause fluctuations in GDP
and employment in the short run.
The Fed can attempt to stabilize the economy with monetary policy.
Aggregate Demand
•
Keynesian Cross
§ basic model of income determination
§ takes fiscal policy & investment as exogenous
§ fiscal policy has a multiplied impact on income.
•
IS curve
§ comes from Keynesian Cross when planned investment depends
negatively on interest rate
§ shows all combinations of r and Y that equate planned
expenditure with actual expenditure on goods & services
Aggregate Demand
•
•
•
Theory of Liquidity Preference
§
basic model of interest rate determination
§
takes money supply & price level as exogenous
§
an increase in the money supply lowers the interest rate
LM curve
§
comes from Liquidity Preference Theory when money demand
depends positively on income
§
shows all combinations of r andY that equate demand for real
money balances with supply
IS-LM model
§
Intersection of IS and LM curves shows the unique point (Y, r ) that
Aggregate Demand
•. IS-LM model
§ a theory of aggregate demand
§ exogenous: M, G, T,
P exogenous in short run, Y in long run
§ endogenous: r,
Y endogenous in short run, P in long run
§ IS curve: goods market equilibrium
§ LM curve: money market equilibrium
Aggregate Demand
•
AD curve
§ shows relation between P and the IS-LM model’s equilibrium Y.
§ negative slope because
P
(M/P )
r
I
Y
§ expansionary fiscal policy shifts IS curve right, raises income, and
shifts AD curve right
§ expansionary monetary policy shifts LM curve right, raises income,
and shifts AD curve right
§ IS or LM shocks shift the AD curve
Aggregate Supply
•
Three models of aggregate supply in the short run:
§
sticky-wage model
§
imperfect-information model
§
sticky-price model
•
All three models imply that output rises above its natural rate when the
price level falls below the expected price level.
•
Phillips curve
§
derived from the SRAS curve
§
states that inflation depends on
§
expected inflation
§
cyclical unemployment
Aggregate Supply
3.
How people form expectations of inflation
§
§
adaptive expectations
§
based on recently observed inflation
§
implies “inertia”
rational expectations
§
based on all available information
§
implies that disinflation may be painless
Aggregate Supply
•
The natural rate hypothesis and hysteresis
§
the natural rate hypotheses
§
§
states that changes in aggregate demand can only
affect output and employment in the short run
hysteresis
§
states that agg. demand can have permanent effects on
output and employment
Five Debates Over Macroeconomic Policy
•
•
•
•
Advocates of active monetary and fiscal policy view the economy as
inherently unstable and believe policy can be used to offset this inherent
instability.
Critics of active policy emphasize that policy affects the economy with a lag
and our ability to forecast future economic conditions is poor, both of which
can lead to policy being destabilizing.
Advocates of rules for monetary policy argue that discretionary policy can
suffer from incompetence, abuse of power, and time inconsistency.
Critics of rules for monetary policy argue that discretionary policy is more
flexible in responding to economic circumstances.
Five Debates Over Macroeconomic Policy
•
•
•
•
Advocates of a zero-inflation target emphasize that inflation has many costs
and few if any benefits.
Critics of a zero-inflation target claim that moderate inflation imposes only
small costs on society, whereas the recession necessary to reduce inflation
is quite costly.
Advocates of reducing the government debt argue that the debt imposes a
burden on future generations by raising their taxes and lowering their
incomes.
Critics of reducing the government debt argue that the debt is only one
small piece of fiscal policy.
Five Debates Over Macroeconomic Policy
•
•
Advocates of tax incentives for saving point out that our society discourages
saving in many ways such as taxing income from capital and reducing
benefits for those who have accumulated wealth.
Critics of tax incentives argue that many proposed changes to stimulate
saving would primarily benefit the wealthy and also might have only a small
effect on private saving.
Advances in Business Cycle Theory
•
•
Real Business Cycle theory
§
assumes perfect flexibility of wages and prices
§
shows how fluctuations arise in response to productivity shocks
§
the fluctuations are optimal given the shocks
Points of controversy in RBC theory
§
intertemporal substitution of labor
§
the importance of technology shocks
§
the neutrality of money
§
the flexibility of prices and wages
Advances in Business Cycle Theory
•
New Keynesian economics
§ accepts the traditional model of aggregate demand and supply
§ attempts to explain the stickiness of wages and prices with
microeconomic analysis, including
§
menu costs
§
coordination failure
§
staggering of wages and prices
