Dorn Busch 11

CHAPTER 1  An introduction introduction to macroeconomics

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Objectives •

Introduce three linked macroeconomic models that explain the behaviour of the economy.

•

Explain the long-run growth in productive capacity.

•

Use the concepts of aggregate supply and aggregate demand to explain what determines the rate of inflation.

•

Introduce the concept of the business cycle to explain variations from the long-run growth path.

•

Outline the two main schools of thought that have influenced the economic policy debate in the past 50 years.

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Objectives •

Introduce three linked macroeconomic models that explain the behaviour of the economy.

•

Explain the long-run growth in productive capacity.

•

Use the concepts of aggregate supply and aggregate demand to explain what determines the rate of inflation.

•

Introduce the concept of the business cycle to explain variations from the long-run growth path.

•

Outline the two main schools of thought that have influenced the economic policy debate in the past 50 years.

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Chapter organisation 1.1

Macroeconomics Macroeconomics encapsulated encapsulated in three models

1.2

To reiterate...

1.3

Schools of thought

1.4

Outline and preview of the text

1.5

Prerequisites Prerequisit es and recipes

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1.1 Three models • Macroeconomics is organised around three models. • Each model is concerned with different time frames:  – The long run  – The medium run  – The short run.

• Let’s consider each in more detail.

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Very long-run economic growth • The long run is a period of decades or more over which potential output is expected to grow. • The time period is usually measured in multiples of decades (e.g. 20 years or more). • Growth theory explains the long-run behaviour of the economy. • Short-run fluctuations in important variables like employment, investment and output are ignored, on the assumption that changes in these variables average out over time. continued Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

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Very long-run economic growth • The long-run level of output is determined solely by supply-side considerations. • Output is determined by the productive capacity of the economy. •  All factors of production (land, labour, capital and technology) are assumed to be fully employed. • The economy is operating at its ‘potential output’.

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Very long-run economic growth • Economic growth is a function of increases in productive capacity. • Major causes of economic growth are:  – development of new technology  – accumulation of physical and human capital  – appropriate provision of infrastructure  – higher rates of domestic saving.

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Very long-run economic growth • Economic growth determines the changes in the standard of living. •  A country growing at an average of 4% per year instead of 2% will have a 50% higher standard of living over a generation of 20 years. • This higher 4% average annual growth rate will lead to a seven-fold increase in the standard of living over 100 years!

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Fixed productive capacity • In the long run, the productive capacity of the economy is assumed to be constant or fixed. • The productive capacity of the economy determines output.

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Fixed productive capacity • This is represented by a vertical aggregate supply schedule at real output level Y 0 (potential output). P

 AS

   l   e   v   e    l   e   c    i   r    P

Y 0

Y continued

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Fixed productive capacity • This level of output is associated with a certain rate of growth in prices. • What determines the change in the overall price level (the inflation rate)? • The aggregate supply (AS) –aggregate demand (AD) model explains short- to medium-run determination of inflation and real output.

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Fixed productive capacity • For each price level, the AD schedule represents the level of output where both the goods and money markets are in equilibrium. • The intersection of the AS and AD schedules determines the price (P 0) and real output (Y0).

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Fixed productive capacity •  AD and AS in the long run.

 AS

P

 AD    l   e   v   e    l   e   c    i   r    P

P 0

Y 0

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Y

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The short run • The short run is a period of time short enough that markets are unable to clear. • In the short run, actual output can deviate from potential output. • Short-run fluctuations in real output are important. •  AD is the major determinant of these variations. • In the short run, the price level is pegged, making the short-run AS schedule horizontal.

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The short run •  AD and AS in the short run.

P

   l   e   v   e    l   e   c    i   r    P

P 0

 AD

Y 0

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Y

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The medium run • How do we describe the transition between the short run and the long run? • High AD pushes real output above Y 0 (according to the long-run model). • Over time, firms will increase prices and the AS curve will move upwards. • The medium run will give an upward-sloping AS curve.

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The medium run • The relative steepness of the AS curve is a major controversy in macroeconomics. P

   l   e   v   e    L   e   c    i   r    P

P 0

 AS

 AD

Y 0

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Y

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1.2 To reiterate… • Growth theory and the AS – AD framework can be used to analyse many macroeconomic issues. • These two models provide a basis for the further analysis of:  – growth and GDP  – the business cycle.

• Let’s consider each in turn.

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Growth and GDP

Table 1.1 Per capita real income growth rates for various countries, 1913 –2010 and 1981 –2010 (average annual growth rate, per cent)

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Growth and GDP • Table 1.1 compares the per capita real income growth rates in various countries. • There are very large differences over the period 1913 –2010; ranging from 0.6% for Ghana to 3.6% for China. • Japan (2.9%), Brazil (2.3%) and Ireland (2.2%) are the next highest band. • Note the lower but similar growth rates for Australia (1.6%) and New Zealand (1.5%).

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The business cycle and the output gap • The business cycle describes the variation of economic activity around the path of trend growth. • Inflation, growth and unemployment all demonstrate cyclical patterns that contribute to this variation. • The output gap measures cyclical variations in output from the trend growth path. • It measures the difference between actual and potential output.

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The business cycle and the output gap • Output gap ≡ actual output – potential output. • During a recession, actual output falls below potential output. A negative gap is associated with unemployment. • During a boom, actual output rises above potential output. A positive gap is associated with over employment.

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The business cycle and inflation • The cost of the cycle above trend is inflation and the cost below trend is unemployment. • The costs of inflation are less obvious than those of unemployment. • Unemployment is associated with a loss in potential output. • Inflation upsets price relationships and reduces the efficiency of the price system.

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Business cycle features • Business cycles have common characteristics. • Business cycles are associated with a pattern of expansion (recovery) and contraction (recession). • Economic variables can indicate something of the nature of the business cycle. • Procyclical variables rise with expansionary business activity (e.g. output, employment, interest rates and money supply).

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Business cycle features • Countercyclical variables (like inventories and bankruptcies) move in the opposite direction to business activity. • Some variables exhibit more variability (volatility) than others. • For example, inventories are volatile while consumption is smooth, especially relative to output. • Business cycles do not occur as regular fluctuations in the level of economic activity.

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Business cycle features • The impulse-propagation model can be used to explain what causes actual output to deviate from the trend. • The impulse-propagation model explains:  – how shocks (impulses) disturb the economy from its longrun trend  – how this leads to effects that last (propagate) over time.

• Economists disagree over possible propagation mechanisms.

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Business cycle features • There are three broad types of shocks:  – policy shocks, which affect fiscal expenditure and interest rates (e.g. fiscal and monetary policies)  – supply shocks, which affect production and price-setting (e.g. technology advances)  – private sector shocks, which affect aggregate demand (e.g. changes in private investment).

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Business cycle features • There is debate about the several aspects of  Australian business cycles. • What is a business cycle? • How are variations in economic activity separated from the trend? • Which indicators should be used to measure the business cycle?

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Business cycle features • Various economic indicators can be used to measure the course of the business cycle:  – Leading indicators, like firms’ profitability and building approvals precede changes in GDP.

 – Lagging indicators, like unemployment lag changes in real GDP.  – Variables can be aggregated into a composite index that will give a coincident index to measure turning points in the business cycle.

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Business cycle features • Two types of business cycle can be identified:  – The classical business cycle considers actual levels so that a fall in GDP describes negative growth.  – Two consecutive quarters of negative growth in real GDP is called a (classical) recession.  – The growth cycle considers fluctuations in growth rates of the economy around the trend growth rate.

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1.3 Schools of thought • During the 1960s there were two main views:  – The monetarists believed the economy is best left to itself.  – The Keynesian’s argued that government intervention could improve economic performance.

• Two schools have developed since then:  – The New Classical school in the 1970s  – The New Keynesian school in the 1980 –90s.

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New Classical school • Three central assumptions of the New Classical school are:  – economic agents optimise  – decisions are made rationally using all available information (rational expectations)  – markets are assumed to clear.

• These assumptions ensure there is no involuntary unemployment. • They also lead to a further assumption that markets are continuously in equilibrium.

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New Keynesian school • Extends the earlier Keynesian view that markets will not always clear even if agents are maximising. • Reasons are varied and include:  – There is incomplete information.  – Institutions affect the workings of markets.  – Costs of changing wages and prices lead to price rigidities.

• These reasons explain fluctuations in output and employment.

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Economic controversies • The two main competing views of modern macroeconomics are highlighted in real-world political and media discussions. • These differences are frequently exaggerated in debate. • There are significant areas of agreement. • Debate and research continually evolve new areas of consensus, e.g. there is increasing agreement on information problems with wage-price setting.

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1.4 Text outline and preview • The key overall concepts of this book are growth, aggregate supply and demand.  – Chapter 2 examines national income accounting.  – Chapters 3 –5 explore the AD – AS model, wage/price adjustment and the basics of policy.  – Chapters 6 –7 consider long-run economic growth.  – Chapters 8 –10 explore the underpinnings of AD – the IS –LM model.

 – Chapters 11 extends AD model to an open economy.  – Chapters 12 –16 examine individual sectors that make up an economy.  – Chapters 17 –18 consider the issues of inflation and unemployment. continued Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

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1.4 Text outline and preview  – Chapter 19 examines the theory of policy in an uncertain world.  – Chapter 20 considers big macro-economic events.  – Chapter 21 extends the analysis to international adjustments and interdependence.  – Chapter 22 presents an introduction to some of the frontiers of economic research.

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