Ec210 Michaelmas Term Course Notes

Overview 04 October 2010 Topics * Macroeconomic models * Economic growth and business cycles * Recent macroeconomic events Reading * Williamson (Chapter 1) Key Points * Long-run growth (trend) * Business cycles * Exogenous vs. endogenous * Decision makers, objectives and constraints Macroeconomic Models * Macroeconomics = the study of the economy as a whole * Models are built to explain macroeconomic phenomena * Two important phenomena: i. Long-run growth ii. Business cycles * A model takes exogenous variables and determines endogenous variables * A macroeconomic model captures the essential features of the world needed to analyse a particular macroeconomic problem Basic structure of a model: * Decision makers: ? Consumers and firms * Objectives: ? Consumers' utility, firms' profits * Constraints: ? Consumers' budget constraints, firms' production technologies Microeconomics in Macroeconomics * Now accepted that we must use microeconomic principles to determine macroeconomic effects * Ration expectations revolution in the 1970s introduced more microeconomics into macroeconomics * Lucas Critique = Article written by Robert E. Lucas in 1976 argued macroeconomic analysis was only sensible if microeconomic behaviour was taken seriously Economics Growth and Business Cycles GDP * We are most interested in Gross Domestic Product (GDP): * GDP = The value of goods and services produced within a country's borders over a particular period of time * The time series of GDP can be separated into trend and business cycle components * US per capita real GDP growth roughly constant at 2.1% per year * Log Transformation * Graph of transformation * A useful transformation of a series is to take the natural logarithm of the raw data * The slope of the graph is a good approximation to its growth rate: # Trends and Business Cycles * Another useful transformation is to separate the time series into business cycle and trend components * Carried out by applying a filter * i.e. Hodrick-Prescott filter (HP filter) * Trend = The economic growth ? Tells us how GDP is moving on average ? Graph demonstrating trend * Business Cycle = Deviation from the trend# Greater than zero - Boom # Less than zero - Recession ? Graph demonstrating business cycles * The two most remarkable business cycles in the US were: * The Great Depression (| real GDP 29%) * WW2 (| real GDP 158%) Understanding Recent and Current Macroeconomic Events * Aggregate productivity * * Economic growth theory tells us that growth in aggregate productivity is what determines growth in living standards in the long run * Average labour productivity growth slowed down from late 1960s to early 1980s. Why? * Teaching and development of technology during this time ? Graph demonstrating productivity slowdown A larger government - taxes and spending, government deficits * An | size of government - An | trend in taxes and spending. * Government spending may crowd out private economic activity * ? Graph of US government spending and taxation * The government deficit - An | in government debt * What are the macro effects of a government deficit? * Ricardian Equivalence = An economic theorem that proposes that whether a government finances its spending with debt or tax increases, does not affect aggregate demand in the economy Monetary policy, inflation, nominal and real interest rates * Interest rates affect economic decisions * How can monetary policy affect nominal and real interest rates? * Graph of US nominal interest rate versus inflation rate * Graph of US real interest rate versus inflation rate * Fisher Relation* Good estimate if the expected inflation rate is close to the actual inflation rate Course Notes Page 1 * Microeconomics in Macroeconomics (Lucas Critique) * GDP * Log transformation of time series * Aggregate productivity | living standards | * Government size * Great Moderation * Oil prices * Current account surplus/deficit * Interest rate spread * House prices * Factors of unemployment (4) Definitions * Business Cycle = Deviation from the trend * GDP = The value of goods and services produced within a country's borders over a particular period of time * Great Moderation = The period after the 1981-82 recession * Interest Rate Spread = Interest rate difference between safe and risky assets * Lucas Critique = Article written by Robert E. Lucas in 1976 argued macroeconomic analysis was only sensible if microeconomic behaviour was taken seriously * Macroeconomics = the study of the economy as a whole * Ricardian Equivalence = An economic theorem that proposes that whether a government finances its spending with debt or tax increases, does not affect aggregate demand in the economy * Trend = The economic growth * Unemployment Rate = How many won't find work immediately Formulae * * * * * * Inflation rate tracks the nominal interest rate reasonably closely * Because economic decisions are based on real interest rates, market forces tend to determine the real interest rate * GDP and inflation is more stable since the early 1990s ? Graph demonstrating GDP and inflation stability since early 1990s * Great Moderation = The period after the 1981-82 recession * Western economies are moving to the service sector A more open economy - imports and exports, current account deficits Oil Prices ? Graph showing oil prices * Oil prices increased dramatically in the 1970s. Why? * OPEC reduced output of crude oil in 1973 and 1979 Current Account Surplus/Deficit * The current account surplus is net export plus net factor payments * A deficit implies borrowing from abroad * Also linked to the government deficit i.e. the twin deficits * More trade has a positive effect on general economic welfare, as it allows countries to specialize in production and exploit their comparative advantages * Running a current account deficit is not necessarily a bad thing in the shortterm as it allows consumers to smooth aggregate consumption over time ? Graph showing US current account and government surplus Credit markets and the financial crisis Interest Rate Spread * Interest Rate Spread = Interest rate difference between safe and risky assets # Asymmetric information - the gap between interest rates of AAA and BAA rated corporate debt # Graph showing interest rate spread of US ? Time series of interest rate spread indicates the recession is related to the financial crisis House Prices * House prices are important indicators because they are the biggest part of a persons wealth * We use property as collateral to borrow for the mortgage # Can further use as collateral by refinancing ? Graph showing US house prices Unemployment * Small increases in unemployment have big GDP effects ? Graph showing relationship between unemployment and GDP * Average unemployment approximately 5% in US * Unemployment Rate = How many won't find work immediately * Graph showing unemployment rate in US * Factors Affecting Unemployment * Aggregate economic activity * Demographics * Government policies * The rise of the service economy Course Notes Page 2 

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