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Ec210 Michaelmas Term Course Notes

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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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