Macroeconomics In The Global Economy

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Macroeconomics In The Global Economy

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Title: Macroeconomics In The Global Economy

1
Macroeconomics In The Global Economy

Wei wei
Shool of Economics and Finance
Jiaotong University

2
Chapter 1 Introduction

The approach of Macroeconomics
Some of the key questions addressed by
macroeconomics
Macroeconomics in historical perspective
Providing a broader framework for macroeconomic
analysis

3
The approach of Macroeconomics

What is macroeconomics ?
Macroeconomics is the study of aggregate
behavior in an economy. While the economic life
of a country depends on millions of individual
actions taken by business firms, consumers,
workers, and government officials, macroeconomics
focuses on the overall consequences of these
individual actions. For example, prices---- price
index.

The approach of Macroeconomics
The basic approach of Macroeconomics is to look
at the overall trends in the economy.
Special summary measures of economic activity
---GNP, the saving rate, or the consumer price
index--- give the big picture of changes and
trends.
These overall macroeconomic measures provide the
basic equipment that allows macroeconomists to
focus on the dominant changes in the economy.

How do economists do their job?
First, try to understand on a theoretical level
the decision processes of individual firms and
households.
Second, try to explain the overall behavior of
the economy by aggregating, or adding up, all the
decisions of the individual households and firms
in the economy.
Third, giving empirical content to theory by
collecting and analyzing actual macroeconomic
data.

6
Some of the key questions addressed by
macroeconomics

The most important single measure of production
in the economy is the GNP.
Economic growth and business cycles
Unemployment is a second key variable that
macroeconomics investigates.
A third key variable that interests
macroeconomists is the inflation rate.
The fourth major variable that macroeconomists
look at is the trade balance.

7
Macroeconomics in historical perspective

The creation of macroeconomics
Economic statisticians began to collect
and systematize aggregate data which provided the
scientific basis for macroeconomic
investigations.
The careful identification of business
cycle as a recurrent economic phenomenon.
The Great Depression
A new theoretical framework to explain
the Great Depression proposed by Keynes.

The development of macroeconomics
Keynesian and neo-Keynesian
Main idea
Keyness policy recommendation is the major
tool of promoting economic growth.
Non- Keynesian
In fact, to many economists, it began to
appear that stabilization policies were actually
a major source of renewed instability.
A counterrevolution began.
Monetarism and its central idea.
New classical macroeconomics Lucas and
Barro.
Advocates of the real business-cycle theory.

9
Providing a broader framework for macroeconomic
analysis

The general theory is limited to short-term
economic fluctuations and stabilization policies.
Our analysis is pushed further by providing an
especially broad view of macroeconomics.
Beside the attention on short-term economic
fluctuations and stabilization policies, we focus
more attention on other central concerns of
macroeconomics,such as the determination of
economic growth rate, or balance of payment, etc.
Considerable attention has been given to
the differences in economic institutions in
different countries in order that we discover a
more general macroeconomic theory.

10
Chapter 2 Basic Concepts in Macroeconomics

Looking at different measures of aggregate income
and outcome and their interrelationship.
The process of aggregating across many different
goods and services requires some common unit of
measure the role of price and price indexes.
A subject that permeates much of discussion in
macroeconomicsFlows and Stocks
Two factors that influence the Intertemporal
decisions of economic agentsInterest Rates and
Present Value.
Another factor that is vital in understanding
decision making across time periods expectations

11
GDP and GNP

What are GDP and GNP?
How to calculate them?
interrelationship of them
GNP GDPNFP
GNP per capita and economic well-being

12
Real Versus Nominal Variables

The construction of price indexes
Consumer price index or consumer price
deflator
Pct w1(P1t/P10) w2(P2t / P20) WN(PNt /
PN0)
Ct nominal consumption expenditure / Pct
Pct Ct / Pct
Deflator for investment spending
(PI), government spending (PG), exports (PX), and
imports (Pm)

Real GDP
To calculate real production, we think of the GDP
of the economy as equal to the product of
average price level in the economy, multiplied
by the level of real production in the economy.
GDP PQ
How to calculate Q ?
We start with the definition of Nominal GDP as
the sum of final expenditures throughout the
economy.
Then, we use the price indexes for consumption,
investment, government spending, exports and
imports to calculate a time series of real
expenditures for each of these categories.
Finally, we can get Q by adding up the sum of
final expenditures of these categories.

How can we get P ?
Once getting real GDP, Q, then we can compute
the GDP price deflator P using the formula as
follow
P GDP/Q
Generally, we get Real GDP by using the formula
as follow
Q GDP /P

15
Flows and Stocks in Macroeconomy

A flow is an economic magnitude measured as a
rate per unit of time.
A stock is an economic magnitude measured at a
point of time.
Investment and the capital stock
Saving and wealth
The current account and net international
investment position
Deficit and the stock of public debt

16
Some Intertemporal Aspects of Macroeconomics
Interest Rates and Present Values

Many key macroeconomics issues involve choices
that not only take place in time but that involve
decisions about timing. We call the choices
involve later as intertemporal choice.
Two crucial elements in the analysis of
intertemporal decisions
Interest rates and net present values
Using interest rates, we can translate a given
time path of money in the future into a present
value today. an economic magnitude measured

17
The Role of Expectation

At the time that economic agents make
intertemporal choices, they are generally
uncertain about the future, so they have to
formulate some expectations about the future.
How do economic agents actually formulate their
expectations ?
Static expectations
Next year is going to be like this year.
Adaptive expectations
Individuals update their expectations about
future depending on the extent to which their
expectations about present period turned out to
be wrong.
Rational expectation
Individuals make efficient use of all
available information.
What economic model the individuals is using
and just what economic information he or she has
at hand.

18
Chapter 3 Output Determination Introducing
Aggregate Supply and Aggregate Demand

Macroeconomics as the study of economic
fluctuations
The Determination of aggregate supply
The classical approach to aggregate supply
The Keynesian approach to aggregate supply
The determination of aggregate demand
Equilibrium of aggregate supply and aggregate
demand
Aggregate supply and demand in the short run and
the long run

19
Macroeconomics as the study of economic
fluctuations

Economic fluctuations have been a central concern
of macroeconomics
Economic fluctuations output and employment
fluctuations
Unemployment rate
Potential output, current output and output gap
When employment fluctuates, so does output,
since output is produced using labor inputs. Just
as we measure the extent to which employment
falls short of the full-employment level, we also
can measure the extent to which output falls
short of the level that would be produced if all
labor were fully employed.

Economic performance is not only measured in
terms of the general trend of output, but also in
terms of whether the output gap is increasing or
decreasing.
Okuns law
There is a great regularity that a reduction
of unemployment of 1 percent of labor force in
the US was associated with a rise in GNP and fall
in the output gap of 3 percent.
Business cycle
Unlike periods of sustained unemployment,
business cycles represent shorter-term
fluctuations of output and employment, typically
lasting 3-4 years.
A key feature of business cycles is that
important macroeconomic variables-output, prices,
investment, business profits, and various
monetary variables-tend to move together in a
systematic fashion.

21
The Determination of aggregate supply

Aggregate supply
Definition
Aggregate supply is the total amount of
output that firms and households choose to
provide, given the pattern of wages and prices in
the economy.
Optimal supply decision
In fact, supply decision bases not only on
current wages and prices, but also on
expectations about future wages and prices.

Formulation of aggregate supply
The Formulation of aggregate supply is
complicated by the fact that there are many kinds
of goods in the economy, produced by a very large
number of firms and households.
Our theoretical framework ignores these
complications and assumes that the economy
produces a single output.
The production Function
QQ (K, L, t)
In the equation, output is a function of the
capital and labor used in production and of the
state of technology.

The production function has two characteristics
An increase in the amount of any input will
make output go up.
We assume that the marginal productivity of
each factor declines as more of that factor is
used with a fixed amount of the other factor.

Q
B
Q(K0,L)
L
24
Q
MPL
Q(K1gtK0)
MPL(K1gt K0)
Q(K1)
MPL(K0)
L
L
(b) Marginal productivity of labor
(a) Production function
25

The demand for labor and the output supply
function
The firm should hire labor until the marginal
product of labor input equals the real wage.

w/p, MPL
(w/p)a
(w/p)b
L
La
Lb
26

We can summarize these findings by writing the
demand for labor as a function of real wage and
the levels of capital and technology
LD LD(w/P, K, t )
Using the labor-demand schedule. We can now
derive an output supply schedule which shows the
amount of output the profit-maximizing firm will
supply at each level of w/p, K, and t.
QS QS LD(w/P, K, t ) , K, t
Note that QS is a negative function of w/p for
an indirect reason.

Note also that QS is a positive function of K
and t,for direct and indirect reasons.
More simply, output supply is a negative
function of w/p and a positive function of K and
t
QS QS (w/P, K, t )
The Supply of Labor
The supply schedule for labor, LS
Labor-supply decision Household must choose
between supplying labor and enjoying leisure, the
so-called Labor-leisure decision.

Assumptions
A worker must choose only between labor and
leisure and in which he consumes all his wage
earnings,which are his only source of income.
The worker can choose to work any number of
hours per day.
UL UL(C, L)

29
C
UL2
UL1
UL0
?C1
gt ?C0
B
?L
?C0
A
?L
L
30

How much labor and consumption workers actually
choose depends both on the utility function and
on the real wage level.

C
Z1(w/p) 1gt (w/p) 0
Z0 (w/p) 0
C1 3 (w/p) 0
C0 (w/p) 0
L
1
2
3
31
UL2
C
Z2(w/p) 2
UL1
C2
Z1(w/p) 1
C1
L
(w/p)
(w/p) 2
(w/p) 1
L
L 1
L 2
32

Substitution effect and Income effect
Substitution effect means that each hour of
leisure represents a greater amount of forgone
consumption of goods when the real wage goes up.
With leisure more expensive, households
substitute away from it and choose longer
working hours.
Income effect works to reduce labor supply when
wages increase.
The effect of a rise in wages on the supply of
labor is theoretically ambiguous the
substitution effect tends to increase L, the
income effect tends to decrease L. The relative
influence of these two effects depends on
household preferences.

33
The Classical Approach to Aggregate Supply

We already derived the Aggregate supply function,
the demand for labor, and the supply of labor.
Now we combine these and summarize the results in
an aggregate supply curve.
The Main idea of classical approach
For any price level, the nominal wage is fully
flexible and adjusts to keep the supply of labor
and the demand for labor equilibrated. Thus, the
real wage is determined so as to clear the labor
market.

34
P
Q
QS
Q(K0, L)
Qf
Q
L
(w/p)
LS
LD
L
Lf
35

Deriving the aggregate supply curve
How does the supply of aggregate output
respond when the price level increase?

(w/p)

Unemployment in the classical approach
Amendments to the basic model
One amendment allows for the fact that
some people may choose voluntarily to be
unemployed, at least for short periods of time.
A second amendment emphasizes that
various forces in the labor market-- laws,
institutions, traditions-- may prevent the real
wage from moving to its full-employment level. If
the real wage is stuck above the full-employment
level, the unemployment results.

The Keynesian approach to aggregate supply
Assumption Nominal wages and prices do not
adjust quickly to maintain labor-market
equilibrium.
Sticky wages
Long-term labor contracts
As the price level(P) rises, the real wage
falls, the desired level of labor input goes up,
the desired level of output supply also rises. As
a result, the aggregate supply curve is upward
sloping.

Involuntary unemployment
Involuntary unemployment is that some people
who are willing to work at the wage received by
other workers of comparable ability cannot do so.
Why does involuntary unemployment arise?
Nominal wage rigidity(Keynesian)
Real wage rigidity(classical theory)
Aggregate Supply a summary
classical aggregate supply
Keynesian aggregate supply
extreme Keynesian aggregate supply

The determination of aggregate demand
The equilibrium level of output and the price
level over an entire economy is determined by the
interaction of aggregate supply and aggregate
demand.
The structure of aggregate demand with a
closed economy
QD C I G
Aggregate demand curve
Real Balance Effect
One immediate effect of a price increase
is to reduce the real value of money held by the
public.

If people hold a given amount of currency and
bank balances and the price level rises,they will
be able to buy fewer goods with their money.

In an open economy, aggregate demand is the total
amount of domestic goods demanded at the given
level of prices by both domestic and foreign
purchasers.
The aggregate demand schedule in the open
economy is still down-word-slope.
In the open economy, as in the closed economy, a
rise in the price level tends to cause a fall in
aggregate demand.
A rise in domestic prices compared with
foreign prices makes it more expensive to buy
domestic goods and relatively less expensive to
buy foreign goods.

The Equilibrium of Aggregate Supply And Aggregate
Demand
The aggregate supply-aggregate demand framework
is useful apparatus for determining the
equilibrium of output and the price level. We can
use this framework to study the effects of
specific economic policies as well as of external
shocks on the equilibrium levels of Q and P.
Output market equilibrium is given by the
intersection of the aggregate demand curve and
aggregate supply schedule. This equilibrium will
also determine the level of employment in the
economy.

Equilibrated level of output does not signify the
optimal level of output. There might by output
gap.
Change on equilibrium Demand side
Aggregate demand expansion
Changes in monetary, fiscal, and
exchange-rate policies shift the position of
aggregate demand schedule.
Expansionary monetary, and fiscal policies and
devaluated exchange-rate policy can result in
aggregate demand expansion

A demand expansion in the classical case

A demand expansion in the Keynesian case

48
A demand expansion in the Keynesian extreme case

Under classical conditions, a rise in
aggregate demand leads only to a rise in prices,
with no effect on output.
In the keynesian case, an aggregate demand
expansion raises output (and employment) as well
as the price level. It leads to the important
conclusion that policy changes can, in the
keynesian case, affect output.
Change on equilibrium supply side
A supply shock once-and-for-all
technological improvement

A technological improvement in the Classical case

A technological improvement in the basic
Classical case

A technological improvement in the extreme
Classical case

P0w/a0

P1w/a1

Source of economic fluctuation
Macroeconomists differ about the shape of the
aggregate supply schedule.
Macroeconomists differ about the relative
importance of the different kinds of shocks that
hit an economy.
Aggregate Supply And Demand In The Short Run And
The Long Run
Keynes stressed nominal wages do not
necessarily adjust instantly to maintain full
employment. But Keynes himself, and later
economists working in his tradition, recognized
nominal wages are not truly fixed they simply
adjust slowly to imbalances of aggregate demand.

Dynamic equation for wages
W1 (W1 W)/ W
W1 a(Q Qf )
Short- and long-term Effects of an aggregate
demand Contraction

55
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56

Short-term Effects of an aggregate demand
Contraction
Aggregate demand declines, the immediate
result is to shift output from Qf at point E down
to Q1 at point A.
long-term Effects of an aggregate demand
Contraction
With the reduction of output, nominal wages tend
to fall. And as nominal wages fall, the aggregate
supply curve shift to the right

After the full adjustment of nominal wages,output
is back to the full-employment level, and the
full effect of the shock to aggregate demand
appears as lower prices rather than lower output.
Economy shows Keynesian properties in the short
run and classical properties in the long run. In
this sense, the debate between modern Keynesian
and modern classical economists is mainly about
timing.

59
Chapter 4 Consumption and Saving

Central issue How households divide their income
between consumption and saving.
Major topics
National Consumption and Saving
The Basic Unit The Household
The Intertemporal Budget Constrain
Household Decision Making
The permanent-Income Theory of Consumption

The Life-Cycle Model of Consumption and Saving
Household Liquidity Constrains and Consumption
Theory
Aggregate Consumption and National Saving Rates
Consumption, Saving and the Interest Rate
Business Saving and Household Saving Theory
and Evidence

The Framework of analysis
The Cumulative effect of the consumption and
saving decisions of households helps to determine
the rate of growth of the economy, the trade
balance, and the level of output and employment.
The analysis of consumption and saving decision
relies heavily on a life-cycle theory of
consumption and saving
Keynes consumption theory
Our strategy in understanding total saving in the
economy is to start with the household, then add
firm behavior, and finally add government saving
behavior

62
National Consumption and Saving

As we construct the theory of household saving
and consumption, we focus on the choice of
consuming or saving out of disposable personal
income.
How to calculate the disposable personal income?
Personal saving, gross business saving, and
government saving
The compare of gross saving rate among different
countries

63
The Basic Unit The household

Much data are collected on level of household,
rather than on the level of the individuals that
compose the family.
Assumption
Nonmonetary economy and numeraire goods
A given household produces a stream of
output Q1, Q2, ...Qt over T periods and consumes
an amount C1, C2, Ct .

If the household lives in isolation, and if the
output is not storable, then the household has to
consume each period exactly what it produces or
let some of its output go to waste.
if the output is storable, the household might be
able to store some of the output in some periods
and the consume out of this accumulated savings
in other periods.
Even if the output is not storable, the household
still can save if the household is linked to
other households through a market for financial
assets.
The existence of financial assets greatly
enhances the possibilities open to households to
adjust their profiles of consumption over time
for any given time path of output.

Income and output
Y Q r B-1
Stock of bonds
B B-1 ( Y - C) B-1 (Q r B-1 - C)
Saving in the period
B - B-1 S

66
The Intertemporal Budget Constraint

The budget constraint in the two-period model
Assumptions
Households inherit no assets from the past
and finish their life with no assets ether.
B0 0 B2 0
B1 - B0 B1 S1
B2 - B1 S2
- B1 S2

Conclusion
The decision for households is not whether to
save or whether to borrow, but rather when to
save and when to borrow.
S1 Y1 - C1 Q1 - C1 B1
S2 Y2 - C2 Q2 r B1 - C1
C1 C2/(1 r) Q1 Q2 /(1 r) W1
Receive an inheritance
C1 C2/(1 r) (1 r) B0 Q1 Q2 /(1 r)

Period 2

Period 1

69
Household Decision Making

The intertemporal utility function
UL(C1, C2)
The budget constraint of household

Period 2

Period 1

For a given level of current income, consumption
depends not only on current income but also on
future income. It also depends on interest rate
and tastes of households

71
The Permanent-Income Theory of Consumption

Friedman This year's consumption should depend
on an average level of income expected this year
and in future years.
Households tend to smooth consumption over time.
Because income is bound to fluctuate year to
year, households use capital markets to maintain
fairly steady consumption against a backdrop of
fluctuating income.
Permanent-income is defined as a kind of average
of present and future incomes.

YP YP/(1 r) Q1 Q2 /(1 r)
YP (1 r)/(2 r)Q1 Q2 /(1 r)
S1 Q1 - C1 Q1 - YP

The special case of equal consumption each period
holds only for particular kinds utility
functions, but nonetheless, the ideas behind this
case have more general validity. Households
decide their consumption levels on the basis of
their permanent income.
Three prototypical kinds of shocks to income
Temporal current shocks
Permanent shocks
Anticipated future shocks
The estimation of future income
Adapted expectations
YP aYP-1 (1 - a)Y

Rational expectation
Empirical evidence on the permanent-income model
Durables and nondurables
The permanent-income hypothesis applies to
consumption, and consumption is not exactly the
same thing as the expenditure on consumer goods.
Consumption is properly measured as the sum
of expenditures on nondurables plus the flow of
services rendered by the existing stock of
consumer durables.
Consumption and taxes

75
The Life-Cycle Model of Consumption AND Saving

The life-cycle model builds on the theory that
consumption in a particular period depends on
expectations about life-time income and not on
the income of current period.
The distinctive contribution of the life-cycle
hypothesis is its observation that income tends
to fluctuate systematically over the course of
persons life and that personal saving behavior
is therefore crucially determined by ones stage
in the life cycle.

-S

Time

Retirement
Years

Working
Years

Consumption during retirement is financed both
from savings accumulated during the working years
and from transfers that old people receive from
the government and from their children.
Social security taxes and social security system.
Some other implications of the life-cycle theory
YP (1 r)/(2 r)Q1 Q2 /(1 r)
k(r)W1
Consumption is a fraction of wealth, with the
factor of proportionality (k), or the marginal
propensity to consume out of wealth,depending on
the interest rate, time preference and the ages
of individuals in the household.
Evidence on the life-cycle model
The role of bequests What motivates bequests?

79
Household Liquidity Constraints and Consumption
theory

Households that cannot borrow and that lack a
stock of financial wealth are said to be
liquidity constrained, in that the most they
can spend is the income that they earn in the
current period.
Intertemporal theories of consumption are
explicitly based on the assumption that agents
can freely borrow and lend within the limits of
their lifetime budget constraint.
Financial markets normally lend against
collateral, not just the promise of future
earnings from labor.
The proportion of liquidity constrained
households is higher among young households than
old ones.

80
Aggregate Consumption and National Saving Rates

Macroeconomics foundations for macroeconomic
variables.
Aggregating from the individual household to the
whole economy
Simple case
Complicated case
The aggregate saving in the economy is
determined by the balance of saving and
dissaving, averaged over the entire population.
Model with overlapping generations

81
Consumption, Saving and Interest Rate

It is often supposed, somewhat naively, that as
interest rates rise, and thus, as the rate of
return to saving increases, it must be the case
that saving will also increase.
It is useful to divide the effect of the
interest-rate increase into two parts a
substitution effect, which always tends to
raise saving, and an income effect, which may
raise or lower saving.

84
Business Saving and Household Saving Theory and
Evidence

Business firms are ultimately owned by
households, and therefore the overall level of
private saving is still basically determined by
household behavior, and the division of saving
between households and firms is somewhat
arbitrary.

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