WEEK 1

What are we doing this semester?

Plan for the semester

Plan for the semester

Introduction Facts and measurement of macroeconomics Aggregate supply and aggregate demand model Short-run and long-run models Fiscal policy Monetary policy Inflation Business cycles and economic policy International finance

MACROECONOMICS
It is a controversial subject that is interlaced with political ideological disputes It looks at the big picture where everything is connected What happens in macroeconomics must be the result of all the individual decisions analyzed in macroeconomics
Microfoundations of macroeconomics: representative agent model Ad hoc relationships

J.M, Keynes

Origins and Issues of Macroeconomics

Economists began to study economic growth, inflation, and international payments during the 1750s. Modern macroeconomics dates from the Great Depression, a decade (1929-1939) of high unemployment and stagnant production throughout the world economy. John Maynard Keynes book, The General Theory of Employment, Interest, and Money, began the subject.

Origins and Issues of Macroeconomics

Short-term versus Long-term Goals
Keynes focused on the short-term on unemployment and lost production. In the long run, said Keynes, were all dead. During the 1970s and 1980s, macroeconomists became more concerned about the long-term inflation and economic growth.

Example From The News (3 years ago)

Nothing to smile about, The Economist, Jan 24th 2008 Past success Inflation down, maintaining growth, stability Warning signs Above target-inflation, growth slowing down American business cycle, consumer slowdown, investment mood, export markets What to do Interest cuts (but risk of inflation, fall in exchange rate) Government spending (but budget deficit)

Example From The News (2 years ago)

UK to fare worst in recession, Financial Times Jan 29th 2009
IMF: Britain is facing the deepest recession of any big industrialised economy IOL: the global recession would certainly cost at least 18m-30m jobs worldwide, and could claim more than 50m World output, measured at market exchange rates, would fall in 2009 for the first time since the second world war Risk of deflation Stories: credit crunch; international imbalances Fiscal stimulus; near zero interest rates; public debt Non-orthodox policies: quantitative easing

Example from the news (last year)

The Great Stabilization The Economist December 29th 2009
It has become known as the ``Great RecessionBut an equally apt name would be the ``Great Stabilization
Global economic activity was falling faster than in the early 1930s. This time though the decline was stemmed within months

It was the result of the biggest, broadest and fastest government response in history
Fiscal stimulus with gusto Central Banks slashed the interest rate

Is it all over?

Examples from the news: Jan 2011

With inflation surging to 3.7% in December, the Bank of England is under even greater pressure to raise UK interest rates (Guardian, 18 Jan 2011) Britains inflationary relapse: A test for nerves.
The scare of deflation was short lived and only a year since the recovery began, prices are surging rather than falling Several economists, believe the Central Bank should stay firm! The surge in prices should eventually be tamed by spare capacity in the economy

Examples from the news right now

The Economist Jan 2012: Europes deepening crisis
Above anything else, Europes troubled economies need growth;
Fixed currency and lost of competitiveness respect to Germany: lower real wages or input prices, increase productivity + work off public debts (taxes increase, public spending decreases or economic growth) The best recipe for growth is to raise productivity: structural reform
Nobody said that was easy!
WE HAVE TO MAKE MASSIVE CUTS SO WE CAN REDUCE DEBT..WHICH

WILL CUT INTO GROWTH WHICH IS NEEDED SO WE CAN MAKE MASSIVE CUTS

Economic Growth

Public Debt

Budget balance

CHAPTER

20

Measuring GDP and Economic Growth

The recent recession in the UK has been described as the worst since the 1930s. To assess the state of the economy, economists, commentators and politicians turn to the measure of GDP and the growth of GDP. What exactly is GDP? What does it tell us about the state of the economy? How do we compare economic well-being between one country and another? Indeed, how can we compare economic growth in the 2000s with that in the 1930s?
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Gross Domestic Product

GDP Defined
GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period. This definition has four parts: Market value Final goods and services Produced within a country In a given time period

Gross Domestic Product

Market Value GDP is a market value goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in pounds.

Gross Domestic Product

Final Goods and Services GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. Excluding intermediate goods and services avoids double counting.

Gross Domestic Product

Produced Within a Country GDP measures production within a country domestic production. In a Given Time Period GDP measures production during a specific time period, normally a year or a quarter of a year.

Gross Domestic Product

GDP and the Circular Flow of Expenditure and Income
GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and output shows the direct link between productivity and living standards. The circular flow diagram in Figure 20.1 (fig 21.1 in the previous edition) illustrates the equality of income, expenditure and the value of production.

 Focal point of macroeconomics is the level of income paid out to factors of production employed by firms to produce output which is then put on the market for people to buy What can go wrong:
Firms do not use all available factors of production Demand fall short of output

How do economists measure income? We start by using a visual model.

Gross Domestic Product

Gross Domestic Product

Households and Firms Households sell and firms buy the services of labour, capital and land in factor markets. For these factor services, firms pay income to households: wages for labour services, interest for the use of capital, and rent for the use of land. A fourth factor of production, entrepreneurship, receives profit. In the figure, the blue flow, Y, shows total income paid by firms to households.

Gross Domestic Product

Gross Domestic Product

Gross Domestic Product

Governments Governments buy goods and services from firms and their expenditure on goods and services is called government expenditure. Government expenditure is shown as the red flow G. Governments finance their expenditure with taxes and pay financial transfers to households, such as unemployment benefits, and pay subsidies to firms. These financial transfers are not part of the circular flow of expenditure and income.

Gross Domestic Product

Rest of the World Firms in the UK sell goods and services to the rest of the world exports and buy goods and services from the rest of the world imports. The value of exports (X ) minus the value of imports (M) is called net exports, the red flow X M. If net exports are positive, the net flow of goods and services is from UK firms to the rest of the world. If net exports are negative, the net flow of goods and services is from the rest of the world to UK firms.

Gross Domestic Product

The blue and red flows are the circular flow of expenditure and income.

The sum of the red flows equals the blue flow.

Gross Domestic Product

The circular flow demonstrates how GDP can be measured in two ways. Aggregate expenditure Total expenditure on final goods and services, equals the value of output of final goods and services, which is GDP: GDP = C + I + G + (X M) Aggregate income Aggregate income equals the total amount paid for the use of factors of production: wages, interest, rent and profit. Firms pay out all their receipts from the sale of final goods, so income equals output of final goods: GDP = Y

Why is Domestic Product Gross

Gross and Net Domestic Product
Gross means before deducting the depreciation of capital. The opposite of gross is net. Depreciation is the decrease in the capital stock that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Net investment is the change in the capital stock. Net investment = Gross investment Depreciation.

Measuring UK GDP
The Office for National Statistics uses two approaches to measure GDP: The expenditure approach The income approach

Measuring UK GDP
The Expenditure Approach
The expenditure approach measures GDP as the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. GDP = C + I + G + (X M)

Measuring UK GDP
Table 20.1 shows the expenditure approach with data (in billions) for 2010. GDP = 948 + 208 + 338 46 = 1,448

Measuring UK GDP
The Income Approach
The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire.

Measuring UK GDP
The United Kingdom National Accounts divide incomes into three categories: 1 Compensation of employees 2 Gross operating surplus 3 Mixed incomes These three components sum to Gross domestic income at factor cost.

Measuring UK GDP
Nominal GDP and Real GDP Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Currently, the reference base year is 2006 and we describe real GDP as measured in 2006 pounds. Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. Nominal GDP is just a more precise name for GDP.

Measuring UK GDP
In Table 20.3(c), we calculate real GDP in 2010. The quantities are those of 2010, as in part (b). The prices are those in the base year (2006) as in part (a). The sum of these expenditures is real GDP in 2010, which is 160 million.

Chain Volume Measure of Real GDP

Value Production in Prices of Adjacent Years
Part (a) shows the quantities and prices in 2009. Part (b) shows the quantities and prices in 2010. Part (c) the quantities of 2010 valued at 2009 prices. Part (d) the quantities of 2009 valued at prices of 2010.

Mathematical Note: Chain Volume Measure of Real GDP

Find the Average of Two Percentage Changes
Part (a) shows production valued at 2009 prices, increased by 10.3 per cent. Part (b) shows production valued at 2010 prices increased by 9.1 per cent. The average increase in production is 9.7 per cent.

Mathematical Note: Chain Volume Measure of Real GDP

Link (Chain) Back to the Base Year
To find real GDP in 2010 in base-year prices (2006), we need to know the 1 Real GDP in 2006 2 Average growth rate each year from 2006 to 2010. Table 3 assumes some average growth rates.
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Mathematical Note: Chain Volume Measure of Real GDP

Starting with real GDP in 2006 of 135 million and the growth rates in Table 3, real GDP in each year since 2006 is calculated as follows: Real GDP in 2007 is 6 per cent higher than the 135 million in 2006, which is 143 million. The figure illustrates the linking back to the base year.
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The Uses and Limitations of Real GDP

The Standard of Living Over Time
Real GDP per person is real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy.
Long-term Trend
A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year. For example, in 1960, real GDP per person was 8,070 and in 2010, it was 21,216. So real GDP per person in 2010 was 2.6 mes its 1960 level that is, 21,216 8,070 = 2.6.

The Uses and Limitations of Real GDP

Two features of our expanding living standard are: The growth of potential GDP per person Fluctuations of real GDP around potential GDP The value of production when all the economys labour, capital, land and entrepreneurial ability are fully employed is called potential GDP (smooth black line in Fig 20.4).

The Uses and Limitations of Real GDP

Real GDP per person in the UK:
Doubled between 1960 and 1994. Was 2.6 times its 1960 level in 2010.

Productivity Growth Slowdown

The growth rate of real GDP per person slowed after 1970. How costly was that slowdown?

The Uses and Limitations of Real GDP

Figure 20.5 illustrates the Lucas wedge. The red line is actual real GDP per person. The thin black line is the trend that real GDP per person would have followed if the 1960s growth rate of potential GDP had persisted. The shaded area is the Lucas wedge.

The Uses and Limitations of Real GDP

Real GDP Fluctuaons The Business Cycle A business cycle is a periodic but irregular upand-down movement of total production and other measures of economic activity. Every cycle has two phases: 1 Expansion 2 Recession and two turning points: 1 Peak 2 Trough
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The Uses and Limitations of Real GDP

Real GDP Fluctuaons The Business Cycle

A business cycle is a periodic but irregular upand-down movement of economic activity.

Figure 20.6 illustrates the business cycle.

An expansion is a period during which real GDP increases. Recession is a period during which real GDP decreases its growth rate is negative for at least two successive quarters.

The Uses and Limitations of Real GDP

The Standard of Living Across Countries
Two problems arise in using real GDP to compare living standards across countries: 1 The real GDP of one country must be converted into the same currency units as the real GDP of the other country. 2 The goods and services in both countries must be valued at the same prices.

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The Uses and Limitations of Real GDP

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The Uses and Limitations of Real GDP

Limitations of Real GDP
Real GDP measures the value of goods and services that are bought in markets. Some of the factors that influence the standard of living and that are not part of GDP are Household production Underground economic activity Health and life expectancy Leisure time Environmental quality Political freedom and social justice

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CHAPTER

22

Economic Growth

Economic Growth: The Production Possibilities Frontier

Economic growth is a sustained expansion of the economys production possibilities outward shifting PPF. We measure economic growth by the increase in real GDP over a given period. The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.
We focus on a model economy in which everything remains the

same (ceteris paribus) except the two goods were considering. Trade-off that the society faces in terms of opportunity costs.

Production Possibilities and Opportunity Cost

Production Possibilities Frontier
Figure 2.1 shows the PPF for two goods: CDs and pizza. Any point on the frontier such as E and any point inside the PPF such as Z are attainable. Points outside the PPF are unattainable.
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Production Possibilities and Opportunity Cost

In moving from E to F, the quantity of pizzas produced increases by 1 million. The quantity of CDs produced decreases by 5 million. The opportunity cost of producing the fifth 1 million pizzas is 5 million CDs. One of these pizzas costs 5 CDs.
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Economic Growth
Figure 2.5 illustrates the tradeoff we face. We can produce pizzas or pizza ovens along PPF0. By using some resources to produce pizza ovens today, the PPF shifts outward in the future.
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Economic Growth
The economic growth rate is the annual percentage change of Y real GDP Y
g 2011 =
2011 2010

Y2010

100

This measure does not tell us about changes in the standard of leaving (see previous slides) Economic growth is like compound interest: the Rule of 70!
The Rule of 70 states that the number of years it takes for the level of a variable to double is approximately 70 divided by the annual percentage growth rate of the variable.

Economic Growth Trends: UK

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Economic Growth Trends

Figure 22.3(a) shows the growth in the rich countries. Japan grew rapidly in the 1960s, slower in the 1980s, and even slower in the 1990s. Growth in Canada and the US have been similar to that in Europe Big 4.
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Economic Growth Trends

Figure 22.3(b) shows the growth of real GDP per person in group of poor countries. The gaps between real GDP per person in the US and in these countries have widened.
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Stylized facts of income and growth

Stylized facts of income and growth

How Potential GDP Grows

Economic growth occurs when real GDP increases. But a one-shot increase in real GDP or a recovery from recession is not economic growth. Economic growth is the sustained, year-on-year increase in potential GDP.
What Determines Potential GDP?
Potential GDP is the quantity of real GDP produced when the quantity of labour employed is the full-employment quantity. To determine potential GDP we use a model with two components: an aggregate production function PF and an aggregate labour market LM

Conclusions
Definition of GDP and economic growth How to measure GDP
The circular flow diagram Real and nominal GDP Potential and real GDP

Next time: the classical economy and theories of economic growth