Macroeconomics Lecture 1

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MacroeconomicsLecture 1

• Selcuk Caner
• Bilkent University

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Course Outline

• Overview
• National Accounts
• The Open Economy
• Macroeconomic Policy
• Debt and Fiscal Policy
• Macroeconomic Policy Tools
• Financial Programming

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Some Rules

• I expect participation in class
• You may not talk to each other in class!
• You may be ejected out of class if you do not
  comply with the above rule

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More Rules

• University rule Attendance is mandatory!
• I enforce this rule!
• Random roll calls to verify the names in the
  attendance list.
• If your name is on the list but you are not
  present in the class, you will face disciplinary
  action.

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More Rules (continued)

• Bilkent University has no tolerance for cheating.
  
• Any student involved in cheating in an exam is
  expelled one semester from the university.
• According to Public Law 4207, smoking is banned
  in all closed public areas. Smoking in all
  University buildings are banned. I strongly
  enforce this Law. Anybody smoking in a
  university building will face disciplinary
  action.

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Exams and Grading

• One mid-term exam with a weight of 30.
• Final exam 50.
• Quizzes 10.
• Homework 10

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Back to Macroeconomics Important issues in
macroeconomics

• Capital accumulation.
• Unemployment, even when the economy is booming?
• Why are there recessions/crises? Can the
  government do anything to combat
  recessions/crises? Should it?
• High inflation.

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Important issues in macroeconomics

• What is the government budget deficit? How does
  it affect the economy?
• Why does Turkey have such a huge Current account
  deficit?
• Why are so many countries poor? What policies
  might help them grow out of poverty?

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Why learn macroeconomics?

• The macroeconomy affects societys well-being.
• example Unemployment and social problems

• The macroeconomy affects your well-being.
• example 1 Unemployment and earnings growth
• example 2Interest rates

• The macroeconomy affects politics current
  events.
• example Inflation and unemployment

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Economic models

• are simplied versions of a more complex reality
• irrelevant details are stripped away
• Used to
• show the relationships between economic variables
• explain the economys behavior
• devise policies to improve economic performance

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Example of a model The supply demand for new
cars

• explains the factors that determine the price of
  cars and the quantity sold.
• assumes the market is competitive each buyer and
  seller is too small to affect the market price
• Variables
• Q d quantity of cars that buyers demand
• Q s quantity that producers supply
• P price of new cars
• Y aggregate income
• Ps price of steel (an input)

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The demand for cars
shows that the quantity of cars consumers demand
is related to the price of cars and aggregate
income.
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Digression Functional notation

• General functional notation shows only that the
  variables are related

• A specific functional form shows the precise
  quantitative relationship

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The market for cars demand
P Price of cars
The demand curve shows the relationship between
quantity demanded and price, other things equal.
Q Quantity of cars
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The market for cars supply
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The market for cars equilibrium
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The effects of an increase in income
An increase in income increases the quantity of
cars consumers demand at each price
which increases the equilibrium price and
quantity.
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The effects of a steel price increase
An increase in Ps reduces the quantity of cars
producers supply at each price
which increases the market price and reduces the
quantity.
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Prices Most Important Factors in Economic
Dynamics Flexible Versus Sticky

• Market clearing an assumption that prices are
  flexible and adjust to equate supply and demand.
  
• In the short run, many prices are sticky---they
  adjust only sluggishly in response to
  supply/demand imbalances. For example,
• labor contracts that fix the nominal wage for a
  year or longer

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Prices Flexible Versus Sticky

• The economys behavior depends partly on whether
  prices are sticky or flexible
• If prices are sticky, then demand wont always
  equal supply. This helps explain
• unemployment (excess supply of labor)
• the occasional inability of firms to sell what
  they produce
• Long run prices flexible, markets clear,
  economy behaves very differently.

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National Accounts
Gross Domestic Product

• Two definitions
• Total expenditure on domestically-produced
  final goods and services
• Total income earned by domestically-located
  factors of production

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Why expenditure income
In every transaction, the buyers expenditure
becomes the sellers income. Thus, the sum of all
expenditure equals the sum of all income.
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The Circular Flow
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Value added
definition A firms value added is the value
of its output minus the value of the
intermediate goods the firm used to produce that
output.
QF(K,L,M) GDP wL-rK Q - M
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Final goods, value added, and GDP

• GDP value of final goods produced
• sum of value added at all stages of
  production
• The value of the final goods already includes the
  value of the intermediate goods, so including
  intermediate goods in GDP would be
  double-counting.

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The expenditure components of GDP

• consumption
• investment
• government spending
• net exports

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Consumption (C)

• durable goods last a long time ex cars, home
  appliances
• non-durable goodslast a short time ex food,
  clothing
• serviceswork done for consumers ex dry
  cleaning, air travel.

definition the value of all goods and services
bought by households. Includes
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Investment (I)

• def1 spending on the factor of production
  capital.
• def2 spending on goods bought for future use.
• Includes
• business fixed investmentspending on plant and
  equipment that firms will use to produce other
  goods services
• residential fixed investmentspending on housing
  units by consumers and landlords
• inventory investmentthe change in the value of
  all firms inventories

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Investment vs. Capital

• Capital is one of the factors of production. At
  any given moment, the economy has a certain
  overall stock of capital.
• Investment is spending on new capital.
• DK I

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Investment vs. Capital

• Example (assumes no depreciation)
• 1/1/2002 economy has 500b worth of capital
• during 2002investment 37b
• 1/1/2003 economy will have 537b worth of
  capital

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Stocks vs. Flows
More examples
stock flow a persons wealth a persons
saving of people with of new
college college degrees graduates the govt.
debt the govt. budget deficit
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Government spending (G)

• G includes all government spending on goods and
  services.
• G excludes transfer payments (e.g. unemployment
  insurance payments), because they do not
  represent spending on goods and services.

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An important identity
Net ExportsEX-IM
Y C I G NX where Y GDP the
value of total output C I G NX
aggregate expenditure
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GDP An important and versatile concept

• GDP measures
• total income
• total output
• total expenditure
• the sum of value-added at all stages in the
  production of final goods

China 9.7
Russia -2.7
U.S. 3.3
Turkey 3.1
Average Annual GDP Growth Rate 1990-2002
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GNP vs. GDP

• Gross National Product (GNP) total income
  earned by the nations factors of production,
  regardless of where located
• Gross Domestic Product (GDP)total income earned
  by domestically-located factors of production,
  regardless of nationality.
• (GNP GDP) (factor payments from abroad)
  (factor payments to abroad)

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Real vs. Nominal GDP

• GDP is the value of all final goods and services
  produced.
• Nominal GDP measures these values using current
  prices.
• Real GDP measure these values using the prices of
  a base year.

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Real GDP controls for inflation

• Changes in nominal GDP can be due to
• changes in prices
• changes in quantities of output produced
• Changes in real GDP can only be due to changes in
  quantities,
• because real GDP is constructed using constant
  base-year prices.

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problem, part 1
2001 2001 2002 2002 2003 2003
P Q P Q P Q
good A 30 900 31 1,000 36 1,050
good B 100 192 102 200 100 205

• Compute nominal GDP in each year
• Compute real GDP in each year using 2001 as the
  base year.

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Answers to practice problem, part 1

• Nominal GDP multiply Ps Qs from same
  year2001 46,200 30 ? 900 100 ? 192
  2002 51,400 2003 58,300
• Real GDP multiply each years Qs by 2001
  Ps2001 46,3002002 50,000 2003 52,000
  30 ? 1050 100 ? 205

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GDP Deflator

• The inflation rate is the percentage increase in
  the overall level of prices.
• One measure of the price level is the GDP
  Deflator, defined as

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problem, part 2
Nom. GDP Real GDP GDP deflator inflationrate
2001 46,200 46,200 n.a.
2002 51,400 50,000
2003 58,300 52,000

• Use your previous answers to compute the GDP
  deflator in each year.
• Use GDP deflator to compute the inflation rate
  from 2001 to 2002, and from 2002 to 2003.

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Nom. GDP Real GDP GDP deflator inflationrate
2001 46,200 46,200 100.0 n.a.
2002 51,400 50,000 102.8 2.8
2003 58,300 52,000 112.1 9.1
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Understanding the GDP deflator
Example with 3 goods For good i 1, 2, 3 Pit
the market price of good i in month t Qit
the quantity of good i produced in month t NGDPt
Nominal GDP in month t RGDPt Real GDP in
month t
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Understanding the GDP deflator
The GDP deflator is a weighted average of prices.
The weight on each price reflects that goods
relative importance in GDP. Note that the
weights change over time.
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Working with percentage changes
USEFUL TRICK 1 For any variables X and Y,
the percentage change in (X ? Y ) ? the
percentage change in X the percentage
change in Y
EX If your hourly wage rises 5 and you work
7 more hours, then your wage income rises
approximately 12.
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Working with percentage changes
USEFUL TRICK 2 the percentage change in (X/Y
) ? the percentage change in X ? the
percentage change in Y
EX GDP deflator 100 ? NGDP/RGDP. If NGDP
rises 9 and RGDP rises 4, then the inflation
rate is approximately 5.
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Consumer Price Index (CPI)

• A measure of the overall level of prices
• Published by
• In the US, the Bureau of Labor Statistics (BLS)
  in the US.
• In Turkey, State Statistics Institute
• Used to
• track changes in the typical households cost of
  living
• adjust many contracts for inflation (i.e.
  COLAs)
• allow comparisons of values from different years

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How is the CPI constructed?

1. Survey consumers to determine composition of the
   typical consumers basket of goods.
2. Every month, collect data on prices of all items
   in the basket compute cost of basket
3. CPI in any month equals

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Exercise Compute the CPI
The basket contains 20 pizzas and 10 compact
discs.
prices pizza CDs 2000 10 15 2001 11 15 2002
12 16 2003 13 15

• For each year, compute
• the cost of the basket
• the CPI (use 2000 as the base year)
• the inflation rate from the preceding year

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answers
cost of inflation basket CPI
rate 2000 350 100.0 n.a. 2001
370 105.7 5.7 2002 400 114.3 8.1 2003
410 117.1 2.5
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The composition of the CPIs basket
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Understanding the CPI
Example with 3 goods For good i 1, 2, 3 Ci
the amount of good i in the CPIs basket Pit
the price of good i in month t Et the cost of
the CPI basket in month t Eb cost of the
basket in the base period
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Understanding the CPI
The CPI is a weighted average of prices. The
weight on each price reflects that goods
relative importance in the CPIs basket. Note
that the weights remain fixed over time.
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Reasons why the CPI may overstate inflation

• Substitution bias The CPI uses fixed weights,
  so it cannot reflect consumers ability to
  substitute toward goods whose relative prices
  have fallen.
• Introduction of new goods The introduction of
  new goods makes consumers better off and, in
  effect, increases the real value of the dollar.
  But it does not reduce the CPI, because the CPI
  uses fixed weights.
• Unmeasured changes in quality Quality
  improvements increase the value of the dollar,
  but are often not fully measured.

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CPI vs. GDP deflator

• prices of capital goods
• included in GDP deflator (if produced
  domestically)
• excluded from CPI
• prices of imported consumer goods
• included in CPI
• excluded from GDP deflator
• the basket of goods
• CPI fixed
• GDP deflator changes every year

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Two measures of inflation
Percentage
change
16

14

12

10

8

6

4

2

0

2
-
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
Year
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Okuns Law

• Employed workers help produce GDP, while
  unemployed workers do not. So one would expect
  a negative relationship between unemployment and
  real GDP.
• This relationship is clear in the data

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Okuns Law
Okuns Law states that a one-percent decrease in
unemployment is associated with two percentage
points of additional growth in real GDP
Percentage change in real GDP
10
1951
1984
2000
1999
1993
1975
1982
Change in unemployment rate
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