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Ec210 Michaelmas Term Notes

Economics Notes > EC210 - Macroeconomic Principles Notes

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EC210: Macroeconomic Principles

Lecture 1: Introduction Macroeconomic is the study of the economy as a whole using models to explain macroeconomic phenomena Model: Takes exogenous (e.g. technological availability, consumer preferences) variables and determines endogenous (e.g. real GDP, inflation) ones
- Macroeconomic models captures essential features of the world needed to analyse a particular macroeconomic problem
- Basic structure consists of:
Decision makers (consumers, firms)
Objectives (consumers' utility, firms' profits)
Constraints (consumers's budget, firms' production technologies)
- Difficulty in aggregating from an individual household/firm to the whole economy (representative agent assumption: not a lot of differences between individuals so economy as a whole is a scaled up version of one individuals however makes it hard to understand debt; differences between borrowers/savers etc.)
- Aim to find an equilibrium where behaviour is consistent
- Macroeconomic models have changed from using past data (i.e. previous correlations) to trying to incorporate predictions for the futures/circumstances which would result in change (i.e. correlation between unemployment and inflation found pre 1970s subsequently exploited by government but in the 1970s ended up with high inflation and high unemployment indicating model was not accurate)
- Used to understand the world and make predictions about the future Growth and Business Cycles
- GDP: The values of goods and services produced within a country's border over a particular period of time --> time series of GDP can be separated into trend and business cycle components
- Can plot growth graphs using natural logarithms to interpret gradient of a time series as a growth rate
- Standard way to separate time series into business cycle and trend components is by applying a filter - trend (line of best fit) is economic growth, deviation is business cycle Recent Macroeconomic Events
- Government Spending and Taxes: Rise in size of government --> upward trend in taxes and spending (effect on private investments? crowding out of private economic activity?)
- Inflation Targeting: Use monetary policy (controlling of interest rates) to reach inflation targets however in the past nominal interest rates were kept low and stable as it was not used to target inflation but just to hold down borrowing costs for the US government (led to high inflation volatility); changed in the 1950s when FED gained independence but broke down in the 60s/70s resulting in regime shift (Paul Volcker); recently reached new problem of too low interest rates (ECB -ve rates)
- Volatility of GDP and Inflation Rate: High volatility in 1970/80s however after this variability of both variables dropped dramatically (the Great Moderation) ---> policy makers attributed it to good policy (learnt from mistakes of the past), while it also has been attributed to luck and sectoral shifts
- Imports and Exports: Assumptions of closed economy becoming less realistic, upward trends in both imports and exports; net exports primarily negative ---> current account deficit/capital account surplus (accumulating debt to rest of world/selling assets) whether it is good or bad depends on what the debt is being accumulated for

EC210: Macroeconomic Principles

- Credit Markets and Financial Crisis: High interest rate spread - gap between interest rates on AAA-rates and BBA-rate corporate disk (asymmetric information); Limited commitment - role of collateral (housing crisis)
- Unemployment: Affected by many factor - aggregate economic activity (business cycle), demographics, government policies (unemployment insurance), rise of service economy
- Labour Productivity: Key in understanding long-term growth --> average labour productivity growth from late 1960s to early 1980s

EC210: Macroeconomic Principles

Lecture 2: Measuring GDP 3 Approaches to Measure GDP (theoretically all approach should agree) - refer to island example if needed: 1) The Product Approach (Value Added Approach):
- Sum of value-added across all productive units in the economy - how much is produced by each firm net any immediate approach 2) The Expenditure Approach
- Total spending on all final goods and services produced in the economy
- C + I + G + NX 3) The Income Approach
- Sum of all income received by economic agents contributing to production: include compensation of employees, proprietors' income, rental income, corporate profits, net interest, indirect business taxes and depreciation Problems with GDP
- In the real world there is often inaccuracy between GDP figures due to trade-off between accuracy and promptness of GDP estimate e.g. unreliable data in UK (claimed double dip recession which was later revised to not have occurred)
- Timeline: Published quarterly in most countries; series of estimates released - one month after advanced quarterly figures released (first snapshot), two months after preliminary figures released, three month after 'final' data released, annually more comprehensive data is released, every five years even more comprehensive data is released
- GDP intended as measure of output however (1) Government sector is priced at input cost (2) Shadow/Informal economy is not counted in GDP (e.g. illegal transactions: drugs/stolen goods/gambling; legal activities to evade tax: unreported income from selfunemployment etc.) ---> changed in the US/UK this year so GDP figures include shadow economy estimates

GDP as Measure of Welfare
- GDP often used as measure of welfare however does not consider: (1) Inequality - income distribution across individuals; economists have found there is no correlation between Gini Coefficient and GDP (as it is a statement of averages) (2) Non-market activities - Does not consider hope production and externalities/
market failure

EC210: Macroeconomic Principles

Lecture 3: Comparing GDP Comparing real GDP across time (i.e. removing effects of inflation) and countries (i.e. removing effect of differences in relative prices) Price Indices

* Price Index: Weighted average to set of observed prices that gives a measure of the price level (e.g. Implicit GDP price deflator; CPI)

* Allows us to measuring inflation rate (the rate of change in the price level) to distinguish between changes in nominal GDP and real GDP Implicit GDP price deflator:

* Use prices to weight the change in quantity for each good

* Compute 2 ratios (1) g1 using year 1's prices as weight (2) g2 using year 2's prices

* Prices between years are different if relatives prices changes between Y1 and Y2

* Chain-weighted ratio of real GDP is [?] g1 g2 (i.e. Y2 real GDP = Y1 nominal GDP x gc)
Implicit GDP price deflator is measured as ratio of nominal GDP to real GDP in Y2
Considers substitution away from goods with increasing prices to cheaper ones Consumer Price Index

* Includes only goods and services purchased by consumers

* Takes quantities in base year as typical basked of goods bought by the average consumer

* Ratio of the cost of basket in current year divided by cost in base year

* However does not consider: (1) Changes in quality of goods (2) Basket changes over years (3) Does not consider substitution to cheaper goods Comparing Real GDP across countries

* Prices of identical goods sold in different countries vary significantly even if prices converted to same currency

* If P denotes prices of US G&S in USD, eP* indicates cost of Chinese G&S in USD:
- Law of once price (PP) satisfied is P=eP*
- However usually P > eP* due to Penn-Balassa-Samuelson Effect (positive relationship between prices and real GDP across countries)
- Can result real GDP comparisons exaggerating differences in income between rich and poor countries

EC210: Macroeconomic Principles

Lecture 4: One-Period Macroeconomic Model Emphasise "micro-foundations" (i.e. derive optimal choices of firms and consumers given market prices --> derive market prices using market clearing conditions) Representative Consumer: Owns equal shares of firms in the economy Consumer Optimisation

* Indifference curves represent the consumer's preferences over consumption good and leisure (slope = MRS between consumption and leisure)

* Subject to constraints
- Time Constraint: l + Ns = h
- Budge Constraint: C = wNs + p - T
Together: C = w(h-l) + p - T = -wl + wh + p - T (only can control C and l)

* Consumer's optimisation problem: moving to the highest indifference curve subject to budget constraint

* If indifference curve cuts budge line there is incentive to change behaviour to increase utility (therefore choose when indifference curve is tangent to budge constraint), 2 types of solutions: (1) Interior Solutions (2) Corner Solutions

* Increase in real wages:
- To trace out labour supply curve consider effects of real wage (income and substitution effects)
- Substitution Effect: The price of leisure rises so consumer substitutes from leisure to consumption
- Income Effect: Higher income implies consumption and leisure increases (as they are normal goods)
Consumptions must rise but leisure can rise or fall
- If Substitution Effect > Income Effect then labour supply is upward sloping ---> in course assume substitution effect is greater (primarily in short term, income effect significant in long term) The Representative Firm

* Neoclassical Production Function: Y = zF(K, Nd)
- Z = Total factor productivity
- K = Quantity of capital input
- Nd = Quantity of labour input

* Assumptions
- Constant returns to scale lY = zF(lK, lN) for any positive constant l
- Positive but diminishing product of capital and labour first partial derivatives > 0, second partial derivatives < 00 (zFKK, zFNN)
- Inada conditions (technical conditions) (1) MPK/MPN goes to infinity when K goes to 0 (2) MPK/MPN goes to 0 when K goes to infinity

* Cobb-Douglas Production Function
- Y = zKaN1-a
- MPK = zaKa-1N1-a
- MPN = z(1-a)KaN-a
- z(lK)a (lN)1-a = lY
- Profit Maximisation: p = zF(K,Nd) - wNd; First Order Condition: [?]F/[?]Nd - w = 0
When firm maximises profits MPN (Labour Demand Curve) = w

EC210: Macroeconomic Principles

Competitive Equilibrium

* Representative consumer optimises given market prices

* Representative firm optimises given market prices

* Labour market clears

* Government budge constraint satisfied (G=T no debt in one-period model)

* MRSl,C = MRTl,C = MPN

* Competitive Equilibrium = Pareto Optimum
- First Welfare Theorem: Under certain conditions, a competitive equilibrium is Pareto optimal (i.e. maximises total surplus --> the only way to make one individual better off it to make another worse off)
- Second Welfare Theorem: Under certain conditions, a Pareto optimum can be implemented as a competitive equilibrium Two Approaches to Solve Models: Social Planner Maximise household's utility subject to resource constraints ---> always pareto optimal (no prices)

Competitive Equilibrium Maximise household's utility subject to budget constrains - solve every economic agents problems individually (households, firms) ---> take prices as given, find prices through market clearing conditions in closed economy (not always pareto optimal, only under certain conditions i.e. no market power)

EC210: Macroeconomic Principles

Lecture 5: Growth Facts Measuring Growth (1) Output per head: yt = GDP/Population (indicates standard of living)
- To compare yt across countries adjust for PP
- Growth rate: gt = (yt - yt-1)/yt-1 ---> small changes in g lead to big changes in y
- RULE OF 70: Given sustained growth rate how long it takes to double living standards (70/growth rate) G ~2% implies doubling of y in 35 years (Asian Tigers) (2) Output per worker (indicates productivity ---> labour force participation rate varies between countries due to demographics/female participation etc.) (3) Life Expectancy (4) Infant Mortality However will focus on (1) & (2) as more data available/easier to link to economic theory

* Initially there had been stagnation for many years (GDP increased in proportion to population ---> constant living standards) however growth in most countries from the late 1800's

* Large cross-country difference in GDP per capital and GDP per worker (35x higher US output per worker then Niger)

* Bimodal world distribution - high & low % of world GDP per worker/GDP per capital related to US but smaller percentages in the middle
Convergence: whether poor countries can catch up to richer ones ---> absence of countries in middle suggests its not easy to go from one end to the other however countries with lower level of output per capital in 1950 have typically grown faster
- Mediterranean countries caught up to European however fewer success stories in Africa
- Conditional convergence (among 'similar countries' poorer grow faster than richer but not absolute convergence (poor countries grow fast than the rich)

* Growth models aim to address: (1) Why is there growth?
(2) Why are some countries poorer than others?
(3) Why do some countries grow fast than others (4) Is there convergence over time across countries?
- Growth through physical capital accumulation (from saving & investment) however limits to this type of growth
- Growth through human capital (limited by diminishing returns)
- Black box (Total factor productivity) ---> technology

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