Macroeconomic Principles

MACROECONOMIC PRINCIPLES INTRODUCTION AND REVIEW ECONOMICS is a social science that examines how a society uses its limited resources to satisfy unlimited wants. RESOURCES – land (natural resources), labor (human), and capital (man made durable inputs). SCARCITY – wants > resources (or ability to satisfy wants at zero price) scarcity => choice => trade-offs and competition OPPORTUNITY COSTS – giving up something of value. The benefits of the highest valued alternative. The opportunity cost of holding cash is the interest rate. PRIVATE PROPERTY RIGHTS – are needed for markets to work. These ownership rights allows individuals to control how resources are used. They can modify, trade, and exclude people from using the resource. The owner captures are gain or loss in resource value. This influences the incentives owners face. MARKETS – institutional arrangement that enables buyers and sellers to get together in order to exchange goods and services. Prices are determined in markets. Prices provide information and incentives that influence behavior. Markets help move resources to their highest valued use. Markets result in decentralized decisions rather than a central plan. There is a better use of distributed information and knowledge. MICROECONOMICS – the study of how household and firms make decisions and how they interact in markets. MACROECONOMICS – the study of economy-wide phenomena, including inflation, unemployment, and economic growth. Economic growth and fluctuations. What caused the current recession? What are monetary and fiscal policies? How do they work? The last 2 recessions occurred 7 / 90 (peak) 3 / 01 (trough) and 3 / 01 (peak) 12 / 01 (trough). The most recent economic peak was 12/07. That 1 is when the current recession began. The economy appears to have reached a trough during the 3rd quarter of 2009 where real GDP increased 2.8 percent. The average growth in the first quarter of a recovery during the post WW II period is 3.5 percent. Notice it trends upward over time (long-run economic growth), but it is not a smooth process (short-run economic fluctuations or business cycle) Sources of growth include technological change, capital accumulation, human capital, private property rights, and trade. Sources of business cycles include monetary policy, energy price changes, financial panics, and events like 9/11. These are all called shocks to the economy causing the economy to move away from its long-run trend. Example of a SHOCK - Energy Prices 2 Oil prices often increase before a recession. SUPPLY AND DEMAND (chapter 4) Competitive short-run market DEMAND – shows the various amounts of a good or service an individual is willing to purchase at all possible prices. Holding other things constant. Held constant are: 1. Buyers income – an increase (decrease) in income that increases (decreases) demand is a normal good. It’s the reverse for an inferior (low quality) good. 2. Prices of related goods. Substitute goods – two goods that satisfy the same purpose. When the price of chicken goes up (reducing the quantity demanded of chicken), the demand for beef increases. Complementary goods – two goods that are consumed jointly. When the price of peanut butter goes up (reducing the quantity demanded of peanut butter), the demand for jelly decreases. 3 3. Tastes – if you like something more, demand increases. An apple a day keeps the doctor away, increases the demand for apples. 4. Expected prices – if you think the price of a TV will be lower next week, you will wait until next week to buy a new TV. Today’s demand for TVs decreases. Other examples are coffee and crude oil. 5. Other – weather, number of buyers, usefulness, etc. Price per unit = P, Qd = quantity demanded per unit of time, Qs = quantity supplied per unit of time, D = demand, and S = supply Demand and Supply Table: P $5 $4 $3 $2 $1 Qd 2 mil. 3 4 5 6 Qd2 3 4 5 6 7 Qs 6 mil. 5 4 3 2 Plot P and Qd Law of demand – there is an inverse relationship between price and quantity demanded. Why? 1. Diminishing subjective marginal valuation results in a decrease in willingness to pay. 2. Substitution effect – as the relative price increases (Px/Py, wheat/corn = $4/$2 = 2 so wheat is twice as valuable as corn or 2 corn trades for 1 wheat, $6/$2 = 3 now wheat is three times as valuable as corn or 3C = 1W), you buy less of the relatively more expensive good. Income effect – as the price increases, your real income (income/price, $100/$2 = 50 units, $100/$4 = 25 units) falls, reducing purchasing power and quantity demanded. 4 CHANGES IN DEMAND vs. CHANGES IN QUANTITY DEMANDED MARKET DEMAND CURVE – is the horizontal sum of the individual demand curves. SUPPLY – shows the various amounts of a good or service individuals are willing to sell at all possible prices. Holding other things constant. Held constant are: 1. Input prices – higher input prices increase the cost of production, decreasing supply (shifts left). 2. Technology – an improvement in technology results in producing the same output at a lower cost or more output at the same price increase supply (shifts right). 3. Number of sellers – an increase in the number of sellers increases supply. 4. Expected prices – higher prices in the future reduces supply today. 5. Other – taxes and subsidies. The supply curve shows the profit-maximizing behavior of sellers. It reflects the increasing marginal cost of production. 5 CHANGES IN SUPPLY vs. CHANGES IN QUANTITY SUPPLIED Market supply curve is the horizontal sum of individual supply curves. Comparative statics – start in equilibrium, change one factor at a time (shock the system), find new equilibrium, and compare equilibriums. Most of the models we will look at (in this class) are comparative static models. Market equilibrium – price where Qs = Qd, the market clears, balance between buyers (who want a good deal, a low price) sellers (who want a good deal, a high price), market tends to adjust to the equilibrium. Efficient allocation of resources that maximizes buyers and sellers gains from trade. Prices provide information and incentives that influence behavior. EQUILIBRIUM excess demand: P<P* Qd>Qs P rises excess supply: P>P* Qd<Qs P falls Examples: 1. Increase buyer’s income with a normal good. 2. Technological change. 3. 1 and 2 at the same time. 4. The impact of higher crude oil prices on gasoline and natural gas. MACROECONOMIC MEASUREMENT (Chapters 10 and 11) NOMINAL GROSS DOMESTIC PRODUCT = GDP = Y = the market value of all final goods and services produced within a country in a given period of time. Quarterly statistic. 1. Dollar market value 2. Final not intermediate goods to avoid double counting (computer chips and computers) 6 3. Flow or per year 4. All goods and services, excludes illegal transactions and home production (Jiffy Lube vs. doing it yourself) 4. GNP measures the output of a country’s factors of production independent of location. NDP = GDP – Depreciation Personal income = income of households and noncorporate businesses Personal disposable income = personal income - taxes TOTAL INCOME = TOTAL EXPENDITURES = GDP = Y Circular Flow Diagram: G&S FIRMS HOUSEHOLDS FACTOR MKT. Somebody’s expenditure is somebody’s income. Total Expenditures = C + I + G + NX = Y C = Consumption expenditures by households (2/3s of total) I = investment spending on capital equipment, inventories, and structures (including household purchases of new housing) (16%). Most variable. G = Government spending on all goods and services by state, local, and federal governments. (18%) NX = Net exports = Exports – Imports Per Capita GDP = GDP / POPULATION NOMINAL (Y) vs. REAL (y) GDP 7 Y 02 = P apples 02 * Q apples 02 + P oranges 02 * Q oranges 02 y 02 = P apples 01 * Q apples 02 + P oranges 01 * Q oranges 02 Base year is 2001 so we use 2001 prices and 2002 quantities. By holding prices constant we measure the actual or real change in total output. P apples Q apples P oranges Q oranges 2001 $1 100 $2 150 2002 $2 150 $3 200 Y 01 = ($1 * 100) + ($2 * 150) = $100 + $300 = $400 Y 02 = ($2 * 150) + ($3 * 200) = $300 + $600 = $900 The total value has increased but some of the increase in nominal GDP is due to higher prices. Alternatively we calculate real GDP and hold prices constant equaling their value in some base year. y 01 = $400 = Y01 Do you see why? y 02 (base 01) = ($1 * 150) + ($2 * 200) = $150 + $400 = $550 % change Y = (Y 02 – Y 01) / Y 01 = ($900 - $400) / $400 = 500/400 = 5/4 = 1.25 or 1.25 * 100 = 125% % change y = (y 02 – y 01) / y 01 = ($550 - $400) / $400 = 150/400 =15/40 = 3/8 = .375 or .375 *100 = 37.5% GDP Deflator = measure (index) of the overall price level in the economy. Y = y * P solve for P, so P = Y/y P 01 = Y 01 / y 01 = $400 / $400 = 1 or 1 *100 = 100 index = 100 in base year P 02 = Y 02 / y 02 = $900 / $550 = 1.64 or 1.64 * 100 = 164 8 % change P = (P 02 – P 01) / P 01 = (164 – 100) / 100 = .64 or .64 * 100 = 64% Some actual numbers for the U.S. in billions of dollars. Recall that 1,000 billion equals a trillion (1,000,000,000,000), ( x.x% = percentage change from a year ago) How big is a trillion? Start counting 1, 2, 3 at a rate of one number per second. It would take you 32,000 years to reach a trillion. Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Nominal GDP 9,951.5 10,286.2 10,642.3 11,142.1 11,867.8 12,638.4 13,398.9 14,077.6 14,441.4 14,256.3 Real GDP 11,226.0 11,347.2 11,553.0 11,840.7 12,263.8 12,638.4 12,976.2 13,254.1 13,312.2 12,987.4 The above numbers are in billions of dollars. So, 1,000 billion equals 1 trillion. GDP Percentage Change 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 6.4 3.4 3.5 4.7 6.5 6.5 6.0 5.1 2.6 -1.3 4.1 1.1 1.8 2.5 3.6 3.1 2.7 2.1 0.4 -2.4 9 Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 GDP Deflator 88.647 90.65 92.118 94.10 96.77 100.00 103.257 106.214 108.483 109.77 %∆ GDP Deflator 2.3 1.6 2.2 2.8 3.3 3.3 2.9 2.1 1.2 Real GDP or real GDP per capita is a good but imperfect measure of welfare. Generally high and growing GDP per capital results in better health (longer life expectancy) and more education (higher adult literacy). Overall quality of life is better in richer countries. See Table 3 page 107. It doesn’t measure all aspect by any means. Ignors pollution and leisure lowers GDP but not welfare. Good but imperfect. COST OF LIVING (CONSUMER PRICE INDEX) Chapter 11 Consumer Price Index = CPI – measures the overall cost of goods and services bought by a typical consumer. Calculated at the Dept. of Labor Bureau of Labor Statistics. Monthly statistic. CALCULATION: 1. Consumer survey to determine what goods and services are being purchased by consumers. Now this is updated every two years. It’s a FIXED basket of goods and services. 2. Find prices. 3. Compute costs of purchasing the fixed basket of goods and services. 4. Compute costs of purchasing the fixed basket of goods and services in a base year. 5. Divide step 3 by step 4 and multiple by 100. CPI = (cost of the basket in current year / cost of the basket in base year) * 100 10 P apples Q apples P oranges Q oranges 2001 $1 100 $2 150 2002 $2 150 $3 200 The Qs now represent the quantity consumed by individuals. They are our weights. Assume 2001 is a base year. CPI 01 = [(P apples 01 * Q apples 01 + P oranges 01 * Q oranges 01) / (P apples 01 * Q apples 01 + P oranges 01 * Q oranges 01)] * 100 = [($1 * 100 + $2 * 150) / ($1 * 100 + $2 * 150)] * 100 = [$400 / $ 400] * 100 = 1 * 100 = 100 CPI 02 = [(P apples 02 * Q apples 01 + P oranges 02 * Q oranges 01) / (P apples 01 * Q apples 01 + P oranges 01 * Q oranges 01)] * 100 = [($2 * 100 + $3 * 150) / $400] * 100 = [($200 + $450) / $400] * 100 = ($650 / $400) * 100 = 1.63 * 100 = 163 % Change in the CPI between 2002 and 2001 = [(CPI 02 – CPI 01) / CPI 01] = (163 – 100 / 100) * 100 = (63/100) * 100 = .63 * 100 = 63% When you compare the CPI in any given year with the base year of 100, the difference equals the percentage change over the period. If its more than one year, divide by the number of years to get the average annual percentage increase. What is included in the basket? Figure 1 page 117 Housing = 43%, Food & Beverages = 15%, Transportation = 17%, Education & Communication = 6%, Medical care = 6%, Recreation = 6%, Apparel = 4%, and other = 3% This is the expenditure breakdown for a typical household or individual. 11 Consumer Price Index Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 CPI 172.2 177.1 179.9 184.0 188.9 195.3 201.6 207.3 215.3 214.5 %∆ CPI 3.0 2.8 1.6 2.3 2.7 3.4 3.2 2.8 3.8 -0.4 Figure 2 page 233 compares the CPI to the GDP deflator. MEASUREMENT ISSUES: 1. Substitution Bias – the CPI uses fixed weights or quantities. However, when the relative price of apples increases, people consume less apples (Q apples falls) and more oranges (Q oranges rises). The true weights have changed but the index weights remain the same. The weight on the more expensive apples is too large (overstating the cost) and the weight on the cheaper oranges is too small (again overstating the cost). To get around this problem we now update the weights every two years, reducing the bias. 2. New Goods – excluding new goods gives a misleading picture of the cost over time. Often, the price of new goods falls over time. Need to capture this. 3. Quality Change – only partial adjustment for quality change. You get more for your money. The introduction of air bags in cars raised the cost, but also in quality (safety). Misleading to treat the increase in car prices like any other price increase. The CPI is measuring the cost increase of the same good or service. Or, a TV lasts longer without needing repairs. This lowers the effective cost of living. 4. Outlet Effects – places like Costco lowers the cost of living, needs to be taken into account. The Boskin Commission estimated that because of these problems, the CPI over stated the increase in the cost of living by about 1.1% per year. 12 Lebow and Rudd at the Fed now estimate the CPI overstates the increase in the cost of living by .6%. The BLS has improved the index. About 1/3 of expenditures (and income tax brackets) are indexed to the CPI. The Boskin estimate implies we would spend an extra $1 trillion on Social Security over the next ten years (using 1.1% bias). Understates real wages and real growth. The CPI and GDP Price Deflator follow each other closely. Biggest differences occur during energy price spikes. The CPI gives energy a bigger weight. See page 231 figure 2. Producer price index measures the cost of a basket of goods and services purchased by firms. ADJUSTING NUMBERS FOR INFLATION: I can remember when a gallon of gasoline cost … Price in today’s dollars = Price in the past * CPI today / CPI past Babe Ruth’s Salary Salary 2001 dollars = Salary in 1931 dollars * CPI 2007 / CPI 1931 = $80,000 * (207/15.2) = $80,000 * 13.62 = $1,089,474 Movies page 123 Table 2 Gone with the Wind is number 1. REAL vs. NOMINAL INTEREST RATES i = nominal interest rate (% reported in the press) r = real interest rate = i – inflation rate Should use expected inflation. See Fig. 3 page 234. Assume zero inflation: 13 You loan $100 for 1 year at 10% interest. After 1 year you are paid back in full $110. You have an extra $10 or 10% to spend. In this case i = r. Now assume you make the same deal but inflation is unexpectedly 5%. You are repaid $110, but your real increase in buying power is only $5 or 5%. While i = 10%, after the fact r = 5% r = i – expected inflation = 10% - 5% = 5% You are paid back in dollars that buy 5% less. So lenders take this into account when they make loans. i = r + expected inflation If lender wants a 10% real return and expects 5% inflation over the life of the loan, then they make the loan at 15%. r = 15% - 5% = 10% Borrowers gain from unexpected inflation. What about deflation? Falling prices. Japan? Lend 100 yen at 5% but prices fall (unexpectedly) by 3%. The yen’s buying power will increase 3% over the life of the loan. What is the real interest rate on this loan? r = i – inflation = 5% - (-3%) = 5% + 3% = 8% Real cost of borrowing has increased. Lenders gain from unexpected deflation. Even if i = 0, if prices fall the real interest rate is positive. Assume deflation equals 5% and i = 0. r = 0 – (-5%) = 5% ! 14 LABOR MARKETS AND UNEMPLOYMENT (chapter 15) REVIEW LABOR SUPPLY AND DEMAND Labor demand: Firms hire workers up to the point where the marginal cost (nominal wage = W) equals the marginal benefit (value of the marginal product of labor = VMPL = MPL * Price) Recall that the MPL equals the change in a firm’s output divided by a unit change in labor. Assume diminishing marginal returns so the MPL falls as L increases (other things constant). So the VMPL also falls as L increases holding price and technology constant. VMPL = W or P * MPL = W or MPL = W / P = w = the real wage w = the purchasing power of W. Labor demand curve = DL Nominal terms and real terms An increase in the MPL due to improved technology or an increase in W shifts labor demand to the right. There are other factors that can cause it to shift, we will talk about them later in the class. Labor Supply: As the wage (real or nominal) increases, so does the quantity of labor supplied. Labor supply is a work-leisure choice. Changes in the wage cause income and substitution effects. Substitution effect: increase W or w makes leisure more expensive (higher opportunity cost of leisure, so we reduce leisure and work more hours). Income effect: leisure is a normal good. As wages (and income) rises, we take more leisure and work less. 15