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Four propositions of macro economics:In most economies, real output(GDP) follows a rising trend determined by the supply side of the economy1.In the short-run, fluctuations around the trend growth rate of GDP are dominated by demand side forces2.Fluctuations around trend growth may be substantial(and costly) because economies, by themselves, don't return to full speed quickly. This is because wages and prices are "sticky".3.Fiscal and monetary policy can, in theory, be used as discretionary instruments to adjust and stabilize fluctuations so the economy returns to its trend growth path.4.
SRASLRAS
Real OutputPrice Level
Y
NRU
[3][2][1]
SRAS
[1]-Increase in production without increase in prices[2]-increase in production needs significant increase in prices[3]-No matter what the price increase is, production cannot be improved
GDP
Development comes from productivity or labor force. For Vietnam it came from productivity. Vietnam is more of capitalist typeof politics. More open door. Growth becomes more easier. Nonew invention required when compared to Canada. And not the labor force either.
GDP
Time/Year
VietnamCanada
SRAS is a snapshot of the following:
GDPTime/Year
ActualTrendCyclicalUnemploymentSnapshot of this is SRAS
General Model
Fundamentals
Friday, October 16, 20099:18 AM
Macro Economics Page 1
ADSRASLRAS
Real OutputPrice Level
Y
NRU
AD’SRAS’ABCLRAS’
P
A
P
B
Y
A
Y
B
= Zero + Frictional unemployment (i.e., between employees) + structural unemployment (i.e., changing economy) + Institutionalunemployment
○
We do not account for cyclical unemployment
○
YNRU is 5.6% approx. for Canada
○
YNRU is the natural rate of unemployment•Is a function of labour force(L) and productivity(P)
○
Is the potential output or capacity
○
In China, productivity is the key
In India, labor force is the key(more people into labor force)
Labor force is the number of people that are currently working(excluding students and home makers)
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In Canada it is about 2.3%
When all the resources are employed, it is the GDP
○
LF: Labor force, health and life expectancy have improved over the years
○
Dollar value of things produced per hour
Education, quality of work for over time
Capital employed is directly proportional to productivity
Productivity:
○
Brain drain can cause LF to diminish and decrease productivity
○
LRAS may move bothways. Can move to left despite the fact that GDP is always growing, because of short term growth-falls.
○
LRAS•Is a function of wages(w), materials(m) and capital(k)
○
Firms costs
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But this quite doesn't happen because, wages are sticky in the short run; having said that they are flexible in the long run
Wages are slow to move down, but are quick to rise
Employers have relationships with employees
Employers sometime have contracts with employees
Unions have significant say, sometimes
SRAS moves down(right) because of low bargaining power of employees because of unemployment(competition for jobs) and employers have more options. So firms costsgo down
□
Adjustment in SRAS happens via labor market, most of the time
□
Demand uncertain and lack of comparability
□
Non-trivial: sociological factors come into play because people don't like wage cuts
□
During recession
Adjusts automatically
○
SRAS•Is a function of consumption(C), Investments (I), Government spending(G), Net exports minus imports(X-M)
○
Aggregate demand•causes inflation
○
x is the inflationary gap
○
GDP
U
P
Adjustment via labor market
Firms costs move up
SRAS goes up(left)
○
Boom•
ADSRASLRAS
Real OutputPrice Level
Y
NRU
AD’AB
Y
B
xC
○
Recession•World, Europe, Canada, Ontario, London, N.London, etc
○
The general model can be used to define any economy•
GDP
U
P
In general define the economy using GDP, unemployment and change in prices. For example, duringrecession, GDP decreases, unemployment increases, prices decrease•
Macro Economics Page 2
ADSRASLRAS
Real OutputPrice Level
Y
NRU
AD’AB
Y
B
xC
○
x is the output gap
Recession causes unemployment.
○
SRAS moves down because of adjustment in labor market
○
At B, nothing happened to nominal wages. But real wages have gone up(because goods are cheaper to buy)
○
GDP
U
P
During recessions, Government spending goes up to shift AD up(fiscal policy to be covered later)
○
SRAS labor force
Use, decay, obsolecence
□
Prices and x-m
□
AD
Auto recovery
○
G spending
Taxes
bonds
Fiscal policy
○
Interest rates
Currencies
Monetary policy
○
Primarily recovery is done by three mechanisms•Economy adjusts on its own through labor market forces, Refer SRAS
SRAS Shift
○
Obsolescence(things get obsolete and demand for them decreases)
Fleet turnover, inventory depletion(production, stop production)
Demand may go down
○
Policy response by other countries(x-m effects)
Not all players at point B, causing other forces to recover AD
People optimistic(least probable)
Other reasons
○
Use, decay and obsolescence cause AD to go down
○
Price drop may imply (x-m) and this causes AD to change
○
Auto Recovery•This boosts or busts the economy by altering the AD curve
Governments increases spending during recession and decreases during booms(G)
○
This should also increase the yield(or higher rate of return) because of the risk premium.
Also, sovereign default risks are high
This could cause inflation
◊
Print money
Sell bonds(essentially borrowing)
□
Increase taxes now or later
□
Where does the money for G come from?
Can G Get a dollar amount right or will it spike inflation bubble?
Implications of deficit
Significant questions
○
Italy and France had traditionally spent during all the times
EU has enforced a fiscal cap because they don't trust Governments
India has a very high deficit
Eg of surplus in boom => Norway investment outside of Norway
Government have trouble cutting on spending
□
Long Government periods
□
Problems
Governments run deficits during recessions and surpluses during booms
○
Can G do it all alone, given its proportion in economy?
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We might reach an inflationary state if G over spends during recession
Level and timing are two major considerations
○
Increase in G, say investment in roads and universities
More capacity and more productivity
LRAS might shift right
Increase in G Spending and its implications
○
No one knows where finally one ends up. Mechanism is important as opposed to magnitude. E.g. crowding effect of G spending
○
Structural deficit
Cyclical deficit
Deficits
○
Crowding effect
Bonds are more attractive because of high interest rates => high yielding => bond chasers => big scale borrowing
Problems with fiscal policies
○
Sovereign defaults
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Timing issue(overshoot)
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Fiscal Policy•Increase in interest rates
○
I
G
i
C
Firms costs go up(capital budgeting) - NPV -Firms' costs now low => SRAS down
Lowering interest rates = loosening money supply
○
Increasing interest rates = tightening money supply
○
High interest rates => Higher cost of capital for companies => low equity valuations and earnings per share => companies lessvaluable => stock market crash
There is also an opportunity cost of holding capital
Unexpected increase in Interest rates may lead to stock market crash
○
Monetary policy•
Macro Economics Page 3
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