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1-1 Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e CHAPTER 1 An introduction to macroeconomics

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Page 1: Dorn Busch 11

1-1Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

CHAPTER 1An introduction to macroeconomics

Page 2: Dorn Busch 11

1-2Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Objectives• Introduce three linked macroeconomic models that explain

the behaviour of the economy.

• Explain the long-run growth in productive capacity.

• Use the concepts of aggregate supply and aggregate demand to explain what determines the rate of inflation.

• Introduce the concept of the business cycle to explain variations from the long-run growth path.

• Outline the two main schools of thought that have influenced the economic policy debate in the past 50 years.

Page 3: Dorn Busch 11

1-3Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Chapter organisation1.1 Macroeconomics encapsulated in three models

1.2 To reiterate...

1.3 Schools of thought

1.4 Outline and preview of the text

1.5 Prerequisites and recipes

Page 4: Dorn Busch 11

1-4Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

1.1 Three models• Macroeconomics is organised around three models.

• Each model is concerned with different time frames:

– The long run– The medium run– The short run.

• Let’s consider each in more detail.

Page 5: Dorn Busch 11

1-5Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Very long-run economic growth

• The long run is a period of decades or more over which potential output is expected to grow.

• The time period is usually measured in multiples of decades (e.g. 20 years or more).

• Growth theory explains the long-run behaviour of the economy.

• Short-run fluctuations in important variables like employment, investment and output are ignored, on the assumption that changes in these variables average out over time.

continued

Page 6: Dorn Busch 11

1-6Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Very long-run economic growth

• The long-run level of output is determined solely by supply-side considerations.

• Output is determined by the productive capacity of the economy.

• All factors of production (land, labour, capital and technology) are assumed to be fully employed.

• The economy is operating at its ‘potential output’.

continued

Page 7: Dorn Busch 11

1-7Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Very long-run economic growth

• Economic growth is a function of increases in productive capacity.

• Major causes of economic growth are:

– development of new technology– accumulation of physical and human capital– appropriate provision of infrastructure– higher rates of domestic saving.

continued

Page 8: Dorn Busch 11

1-8Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Very long-run economic growth

• Economic growth determines the changes in the standard of living.

• A country growing at an average of 4% per year instead of 2% will have a 50% higher standard of living over a generation of 20 years.

• This higher 4% average annual growth rate will lead to a seven-fold increase in the standard of living over 100 years!

Page 9: Dorn Busch 11

1-9Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Fixed productive capacity• In the long run, the productive capacity of the

economy is assumed to be constant or fixed.

• The productive capacity of the economy determines output.

continued

Page 10: Dorn Busch 11

1-10Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Fixed productive capacity

• This is represented by a vertical aggregate supply schedule at real output level Y0 (potential output).

P

Y0 Y

AS

Pri

ce level

continued

Page 11: Dorn Busch 11

1-11Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Fixed productive capacity

• This level of output is associated with a certain rate of growth in prices.

• What determines the change in the overall price level (the inflation rate)?

• The aggregate supply (AS)–aggregate demand (AD) model explains short- to medium-run determination of inflation and real output.

continued

Page 12: Dorn Busch 11

1-12Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Fixed productive capacity

• For each price level, the AD schedule represents the level of output where both the goods and money markets are in equilibrium.

• The intersection of the AS and AD schedules determines the price (P0) and real output (Y0).

continued

Page 13: Dorn Busch 11

1-13Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Fixed productive capacity

• AD and AS in the long run.

P

Y0 Y

AD

Pri

ce level

AS

P0

Page 14: Dorn Busch 11

1-14Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The short run• The short run is a period of time short enough that

markets are unable to clear.

• In the short run, actual output can deviate from potential output.

• Short-run fluctuations in real output are important.

• AD is the major determinant of these variations.

• In the short run, the price level is pegged, making the short-run AS schedule horizontal.

continued

Page 15: Dorn Busch 11

1-15Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The short run

• AD and AS in the short run.

P

Y0 Y

AD

Pri

ce level

P0

Page 16: Dorn Busch 11

1-16Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The medium run• How do we describe the transition between the short

run and the long run?

• High AD pushes real output above Y0 (according to the long-run model).

• Over time, firms will increase prices and the AS curve will move upwards.

• The medium run will give an upward-sloping AS curve.

continued

Page 17: Dorn Busch 11

1-17Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The medium run

• The relative steepness of the AS curve is a major controversy in macroeconomics.

P

Y0 Y

AD

Pri

ce L

evel

AS

P0

Page 18: Dorn Busch 11

1-18Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

1.2 To reiterate…• Growth theory and the AS–AD framework can be

used to analyse many macroeconomic issues.

• These two models provide a basis for the further analysis of:

– growth and GDP– the business cycle.

• Let’s consider each in turn.

Page 19: Dorn Busch 11

1-19Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Growth and GDP

Table 1.1 Per capita real income growth rates for various countries, 1913–2010 and 1981–2010 (average annual growth rate, per cent)

continued

Page 20: Dorn Busch 11

1-20Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Growth and GDP

• Table 1.1 compares the per capita real income growth rates in various countries.

• There are very large differences over the period 1913–2010; ranging from 0.6% for Ghana to 3.6% for China.

• Japan (2.9%), Brazil (2.3%) and Ireland (2.2%) are the next highest band.

• Note the lower but similar growth rates for Australia (1.6%) and New Zealand (1.5%).

Page 21: Dorn Busch 11

1-21Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The business cycle and the output gap

• The business cycle describes the variation of economic activity around the path of trend growth.

• Inflation, growth and unemployment all demonstrate cyclical patterns that contribute to this variation.

• The output gap measures cyclical variations in output from the trend growth path.

• It measures the difference between actual and potential output.

continued

Page 22: Dorn Busch 11

1-22Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The business cycle and the output gap

• Output gap ≡ actual output – potential output.

• During a recession, actual output falls below potential output. A negative gap is associated with unemployment.

• During a boom, actual output rises above potential output. A positive gap is associated with over employment.

Page 23: Dorn Busch 11

1-23Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

The business cycle and inflation• The cost of the cycle above trend is inflation and the

cost below trend is unemployment.

• The costs of inflation are less obvious than those of unemployment.

• Unemployment is associated with a loss in potential output.

• Inflation upsets price relationships and reduces the efficiency of the price system.

Page 24: Dorn Busch 11

1-24Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• Business cycles have common characteristics.

• Business cycles are associated with a pattern of expansion (recovery) and contraction (recession).

• Economic variables can indicate something of the nature of the business cycle.

• Procyclical variables rise with expansionary business activity (e.g. output, employment, interest rates and money supply).

continued

Page 25: Dorn Busch 11

1-25Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• Countercyclical variables (like inventories and bankruptcies) move in the opposite direction to business activity.

• Some variables exhibit more variability (volatility) than others.

• For example, inventories are volatile while consumption is smooth, especially relative to output.

• Business cycles do not occur as regular fluctuations in the level of economic activity.

continued

Page 26: Dorn Busch 11

1-26Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• The impulse-propagation model can be used to explain what causes actual output to deviate from the trend.

• The impulse-propagation model explains:

– how shocks (impulses) disturb the economy from its long-run trend

– how this leads to effects that last (propagate) over time.

• Economists disagree over possible propagation mechanisms.

continued

Page 27: Dorn Busch 11

1-27Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• There are three broad types of shocks:

– policy shocks, which affect fiscal expenditure and interest rates (e.g. fiscal and monetary policies)

– supply shocks, which affect production and price-setting (e.g. technology advances)

– private sector shocks, which affect aggregate demand (e.g. changes in private investment).

continued

Page 28: Dorn Busch 11

1-28Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• There is debate about the several aspects of Australian business cycles.

• What is a business cycle?

• How are variations in economic activity separated from the trend?

• Which indicators should be used to measure the business cycle?

continued

Page 29: Dorn Busch 11

1-29Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• Various economic indicators can be used to measure the course of the business cycle:

– Leading indicators, like firms’ profitability and building approvals precede changes in GDP.

– Lagging indicators, like unemployment lag changes in real GDP.

– Variables can be aggregated into a composite index that will give a coincident index to measure turning points in the business cycle.

continued

Page 30: Dorn Busch 11

1-30Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Business cycle features

• Two types of business cycle can be identified:

– The classical business cycle considers actual levels so that a fall in GDP describes negative growth.

– Two consecutive quarters of negative growth in real GDP is called a (classical) recession.

– The growth cycle considers fluctuations in growth rates of the economy around the trend growth rate.

Page 31: Dorn Busch 11

1-31Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

1.3 Schools of thought

• During the 1960s there were two main views:

– The monetarists believed the economy is best left to itself.

– The Keynesian’s argued that government intervention could improve economic performance.

• Two schools have developed since then:

– The New Classical school in the 1970s– The New Keynesian school in the 1980–90s.

Page 32: Dorn Busch 11

1-32Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

New Classical school

• Three central assumptions of the New Classical school are:

– economic agents optimise– decisions are made rationally using all available information

(rational expectations)– markets are assumed to clear.

• These assumptions ensure there is no involuntary unemployment.

• They also lead to a further assumption that markets are continuously in equilibrium.

Page 33: Dorn Busch 11

1-33Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

New Keynesian school

• Extends the earlier Keynesian view that markets will not always clear even if agents are maximising.

• Reasons are varied and include:

– There is incomplete information.– Institutions affect the workings of markets.– Costs of changing wages and prices lead to price rigidities.

• These reasons explain fluctuations in output and employment.

Page 34: Dorn Busch 11

1-34Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

Economic controversies

• The two main competing views of modern macroeconomics are highlighted in real-world political and media discussions.

• These differences are frequently exaggerated in debate.

• There are significant areas of agreement.

• Debate and research continually evolve new areas of consensus, e.g. there is increasing agreement on information problems with wage-price setting.

Page 35: Dorn Busch 11

1-35Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

1.4 Text outline and preview

• The key overall concepts of this book are growth, aggregate supply and demand.

– Chapter 2 examines national income accounting. – Chapters 3–5 explore the AD–AS model, wage/price

adjustment and the basics of policy.– Chapters 6–7 consider long-run economic growth.– Chapters 8–10 explore the underpinnings of AD – the

IS–LM model. – Chapters 11 extends AD model to an open economy. – Chapters 12–16 examine individual sectors that make up an

economy.– Chapters 17–18 consider the issues of inflation and

unemployment.continued

Page 36: Dorn Busch 11

1-36Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

1.4 Text outline and preview

– Chapter 19 examines the theory of policy in an uncertain world.

– Chapter 20 considers big macro-economic events. – Chapter 21 extends the analysis to international

adjustments and interdependence. – Chapter 22 presents an introduction to some of the frontiers

of economic research.

Page 37: Dorn Busch 11

1-37Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd Dornbusch, Bodman, Fischer, Startz, Macroeconomics, 3e

1.5 Prerequisites and recipes• The text requires no mathematical prerequisite

beyond high school algebra.

• There are a number of helpful websites, including:

– www.mhhe.com/au/dornbusch (for chapter summaries and problems)

– www.rba.gov.au – www.treasury.gov.au– www.abs.gov.au – www.asx.com.au – www.ecosoc.org.au– www.economist.com – www.voxeu.org – www.aeaweb.org/rfe.