Macroeconomics is divided into two parts

• Theory of economic growth– focuses on long run trend of real GDP

• the source of improved living standards

– the long-run trend is called potential GDP– potential GDP depends on the available supply of

labor (L), capital (K), and technology (T)

• Theory of economic fluctuations– focuses on short-run ups and downs in the

economy (recessions, Asian financial crisis

Real GDP, Potential GDP, Unemployment Rate, and the Natural Unemployment Rate

21_01

1990

BILLIONS OF 1992 DOLLARS

6,500

7,000

6,000

5,500

5,000

4,5001980 19841982 19881986 1992 1994

Real GDP

Potential GDP

Unemployment rate

6 percent

PERCENT

12.5

10.0

7.5

5.0

2.5

0.01980 19841982 19881986 1992 19941990

Real GDP is below potentialGDP and unemploymentrate is above natural rate of unemployment.

Real GDP is nearpotential GDP and unemployment rateis near natural rate of unemployment.

Real GDP is abovepotential GDP and unemployment rate is below natural rate of unemployment.

Aggregate production function

• Real GDP = F(labor, capital, technology)

• Y = F(L,K,T)

• Thus to explain the long term growth of real GDP we need to look at L, K, and T

• Today we discuss L briefly and focus mainly on K

• Will come back to T later

Labor (L): Factors determining growth of aggregate hours

• Aggregate hours =

• (hours per employee) (employment to population ration)

• (working age population)

• L = (L/E) (E/P) (P)

• Consider an example: the forecast of aggregate hours by the Council of Economic Advisers

Example: CEA Forecast of L (aggregate hours)

1973-1990

1990-1997

1997-2005

Growthrate ofaggregatehours (L)

1.7 1.5 1.1

Growthrate ofworkingagepopulation(P)

1.5 1.0 1.0

Two explanations of unemployment

• Job rationing explanation– Uses supply and demand model (see diagram)– real wage higher than market equilibrium

• minimum wage• insider-outsider theory• efficiency wages

• Job search explanation– job destruction and job creation creates flux– role of unemployment benefits

–

Job rationing: real wage is higher than market

equilibrium, hence unemployment 21_8

QUANTITY OF LABOR

REAL WAGE3. and there is this much unemployment, or excess supply.

2. firms hire this many workers...

1.

Equilibrium wage

Labor supply

A

Labor demand

When the realwage is abovethe intersec-tion of supplyand demand...

Job search: “flows” in and out of unemployment

21_9

Lo

se job o

r q

uit

Employed Not in labor force

Enter or re-enter labor forceFind job

Unem-

ployed

Find job Drop out of labor

forc

e

Mo

ve to n

ew

job

directly

Becom

e u

nem

plo

yed

Lo

ok for

work

Le

ave lab

or

forc

e

Now let’s move on to capital

• First, note that investment increases the amount of capital (see next graph). – Hence, we will focus on what determines

investment.

• Second, put on your big picture glasses

22_01

Capitalat end oflast year

($10 trillion)

Capitalat end ofthis year

($10.5 trillion)

Gross investmentduring this year($1.5 trillion)

Depreciation($1 trillion)

Net investment($.5 trillion)

Look again at basic spending equation Y = C + I + G+ X

• Divide by Y to convert to shares of GDP:

• 1 = (C/Y) + (I/Y) + (G/Y) + (X/Y)

• for example, – if G/Y goes down, – then (C/Y + I/Y + X/Y) must go up

• But how? What is the incentive? What transmits the information? In other words what is the price? Answer: the interest rate.

Shares in recent U.S. history22_02

PERCENT

1990198019701960195019401930–10

0

10

20

30

40

50

60

70

80

90

CY

XY

GY

IY

People tend to lower consumption when the interest rate rises

22_03 INTEREST RATE (R) (PERCENT)

2.5

5.0

7.5

0.0

A higher interest rate...

...lowers the amount of consumption.

65.0 70.062.5 67.5

C

Y

CONSUMPTION AS A SHARE OF GDP (PERCENT)

Firms tend to lower investment when the interest rate rises

22_04 INTEREST RATE (R) (PERCENT)

2.5

5.0

7.5

0.0

A higher interest rate...

15.0 20.012.5 17.5

I

Y

INVESTMENT AS A SHARE OF GDP (PERCENT)

...lowers the amount of investment.

Three episodes in this part of the story: (1) interest rate exchange rate(2) exchange rate (exports-imports = net exports)(3) combine: interest rate net exports

22_05 INTEREST RATE (R) (PERCENT)

2.5

5.0

7.5

0.0

A higher interest rate...

...lowers the amount of net exports.

0.0 5.0 - 4.0 - 2.5 2.5

X

Y

NET EXPORTS AS A SHARE OF GDP (PERCENT)

Sum up: “non-government” share

22_06

2.5

5.0

7.5

0.0

R

2.5

5.0

7.5

0.08075 85

NG

Y

(d) Nongovernment Share

R

0.0 2.5

X Y

(c) Net Exports Share

-2.5PERCENTPERCENT

R

2.5

5.0

7.5

0.065.062.5 67.5

C Y

(a) Consumption Share

R

2.5

5.0

7.5

0.015.012.5 17.5

I Y

(b) Investment SharePERCENT PERCENT

Finding the equilibrium interest rate

22_07

2.5

5.0

7.5

0.0

R

65.062.5 67.5

C

Y

(a) Consumption Share

R

2.5

5.0

7.5

0.015.012.5 17.5

I

Y

(b) Investment Share

R

2.5

5.0

7.5

0.08075 85

NG

Y

(d)

R

2.5

5.0

7.5

0.00.0 2.5

X

Y

(c) Net Exports Share

-2.5

PERCENT PERCENT PERCENT PERCENT

3. Investment andthe remainingshares are thendetermined fromthe interest rate.

First mark the shareof spending availablefor nongovernmentaluses; in this case 78because thegovernmentpurchases share isassumed to be 22percent.

1.

2.The intersection ofthese two linesdetermines theequilibrium interestrate, which can thenbe shown in all thediagrams.

NongovernmentShare

End of Lecture