Macroeconomic Analysis I

Topic 1
Introduction

( Abel, Bernanke & Croushore: Chapter 1

&
Williamson: Chapter 1 )

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 Learning Objectives
• Summarize the main issues addressed in macroeconomics

• Understand basic structure of macroeconomic model

• Differentiate between the classical and Keynesian

approaches to macroeconomics

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 What Macroeconomics Is About
Macroeconomics: the study of structure and performance of
national economies and government policies that affect
economic performance

Issues addressed by macroeconomists:

– Long-run economic growth
– The international economy
– Business cycles or short run fluctuations
– Unemployment
– Inflation
– Macroeconomic policy

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 What Macroeconomics Is About
Long-run economic growth
– Figure 1.1: Output of United States since 1869
– Note decline in output in recessions; increase in output
in some wars
– Two main sources of growth
• Population growth
• Increases in average labor productivity

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Figure 1.1 Output of the U.S. economy, 1869-2014
Sources: Federal spending
and receipts for 1869–1929
from Historical Statistics of the
United States, Colonial Times
to 1970, p. 1104; GNP 1869–
1928 from Christina D. Romer,
“The Prewar Business Cycle
Reconsidered: New Estimates
of Gross National Product,
1869–1908,” Journal of
Political Economy, 97, 1
(February 1989), pp. 22–23;
GNP for 1929 from FRED
database, Federal Reserve
Bank of St. Louis,
Research.stlouisfed.org/fred2/
series/GDPA; Federal
spending and receipts as
percentage of output, 1930–
2011 from Historical Tables,
Budget of the U.S.
Government, Table 1.2

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 What Macroeconomics Is About
Average labor productivity
– Output produced per unit of labor input

– Figure 1.2 shows average labor productivity for United

States since 1900

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 Figure 1.2 Average labor productivity in the
United States, 1900-2014

Sources: Employment in
thousands of workers 14 and
older for 1900–1947 from
Historical Statistics of the
United States, Colonial Times
to 1970, pp. 126–127;
workers 16 and older for
1948 onward from FRED
database, Federal Reserve
Bank of St. Louis,
research.stlouisfed.org/fred2
/series/ CE16OV. Average
labor productivity is output
divided by employment,
where output is from Fig.
1.1.

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 What Macroeconomics Is About
Average labor productivity growth:
 About 2.5% per year from 1949 to 1973

 1.1% per year from 1973 to 1995

 1.9% per year from 1995 to 2007

 1.1% per year from 2007 to 2014

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 What Macroeconomics Is About
Business cycles
– Business cycle: Short-run contractions and
expansions in economic activity

– Downward phase is called a recession

– Macroeconomists put a lot of effort to find out what

are the causes of business cycles, decide what can
be done and evaluate the policy options available for
influencing the course of the business cycle

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 What Macroeconomics Is About
Unemployment
– Unemployment: the number of people who are
available for work and actively seeking work but
cannot find jobs

– U.S. experience shown in Fig. 1.3

– Recessions cause unemployment rate to rise

– Even when the economy is doing well and growing

steadily, there is still some unemployment in the
economy

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Figure 1.3 The U.S. unemployment rate, 1890-2014

Sources: Civilian
unemployment rate (people
aged 14 and older until 1947,
aged 16 and older after 1947)
for 1890–1947 from Historical
Statistics of the United States,
Colonial Times to 1970,
p.135; for 1948 onward from
FRED database Federal
Reserve Bank of St. Louis,
research.stlouisfed.org/fred2/
series/UNRATE.

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 What Macroeconomics Is About
Inflation
– U.S. experience shown in Fig. 1.4

Inflation vs Deflation
– Inflation rate: the percentage increase in the level of
prices
– Deflation: when prices of most goods and services
decline
– Hyperinflation: an extremely high rate of inflation
(prices rise by more than 50% per month)

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 Figure 1.4 Consumer prices in the United States,
1800-2014

Sources: Consumer price index, 1800–1946 (1967 = 100) from Historical Statistics of
the United States, Colonial Times to 1970, pp. 210–211; 1947 onward (1982–1984 =
100) from FRED database, Federal Reserve Bank of St. Louis,
research.stlouisfed.org/fred2/series/CPIAUCSL.
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Data prior to 1971 were rescaled to a base with 1982–1984 = 100.
 What Macroeconomics Is About
Macroeconomic Policy
– Fiscal policy: government spending and taxation
• Effects of changes in federal budget
• U.S. experience in Fig. 1.6
• Large fiscal deficit during the Great Depression in
the 1930s (due to government-financed jobs
programs) and during World War II (due to
military spending)

– Monetary policy: growth of money supply;

determined by central bank; the Fed in U.S.

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Figure 1.6 U.S. Federal government spending and tax collections,
1869-2014

Sources: Federal spending and

receipts for 1869–1929 from
Historical Statistics of the
United States, Colonial Times to
1970, p. 1104; GNP 1869–1928
from Christina D. Romer, “The
Prewar Business Cycle
Reconsidered: New Estimates of
Gross National Product, 1869–
1908,” Journal of Political
Economy, 97, 1 (February
1989), pp. 22–23; GNP for
1929 from FRED database,
Federal Reserve Bank of St.
Louis,
Research.stlouisfed.org/fred2/s
eries/GDPA; Federal spending
and receipts as percentage of
output, 1930–2011 from
Historical Tables, Budget of the
U.S. Government, Table 1.2.

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 The Production Function
The production function
Y = AF(K, N)

Y is the output
K is the amount of capital
N is the amount of labour
A is the “total factor productivity” – which measures the
effectiveness with which capital and labor are used

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 The Production Function
Application: Cobb-Douglas production function works well
for European Union (EU) economy:
Y = A K0.3 N0.7

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The production function relating output and capital
Marginal product of capital
𝜕Y
MPK =
𝜕K

• MPK is the slope of

production function
(Y v.s. K)

• MPK > 0 implies that

more capital input
leads to more output

𝜕(MPK) 𝜕2 Y
• = <0
𝜕K 𝜕K2
implies diminishing
marginal productivity
of capital

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The production function relating output and labour
Marginal product of labour
𝜕Y
MPN =
𝜕N

• MPN is the slope of

production function
(Y v.s. N)

• MPN > 0 implies that

more labour input
leads to more output

𝜕(MPN) 𝜕2 Y
• = <0
𝜕N 𝜕N2
implies diminishing
marginal productivity
of labour

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 Macroeconomic Model
• Models are built to explain macroeconomic
phenomena

• Macroeconomists use models which are organized

structures to explain long-run economic growth,
why there are business cycles and the role of
economic policy in the macro-economy

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 Macroeconomic Model
• A macroeconomic model captures the essential
features of the world needed to analyze a particular
macroeconomic problem

• Macroeconomic models should be simple, but

simplicity could mean that we leave out some
“realistic” features of the actual economy

• Example: Electronic road map is a model of a part of

the earth’s surface to guide motorists through the
road system but does not provide a realistic depiction
of the earth’s surface, climate, vegetation, etc.
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 Microeconomic Principles in Macro Model
• Build macroeconomic models on sound
microeconomic principles

• As the macro-economy consists of many consumers

and firms, each making decisions at the micro level,
macroeconomic behaviour is the sum of many
microeconomic decisions

• Example: Changes in government policy affect the

decisions of consumers and firms - hence we need to
use microeconomic principles to analyse how policy
changes affect the behaviour of consumers and firms
and aggregate these decisions across the economy
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 Why Macroeconomists Disagree
Classicals vs. Keynesians
– The classical approach
• The economy works well on its own
• The “invisible hand”: the idea that if there are free
markets and individuals conduct their economic
affairs in their own best interests, the overall
economy will work well
• Wages and prices adjust rapidly to get to
equilibrium
– Equilibrium: a situation in which the quantities
demanded and supplied are equal
– Changes in wages and prices are signals that
coordinate people’s actions
Conculsion: Government should have only a limited
role in the economy
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 Why Macroeconomists Disagree
Classicals vs. Keynesians
– The Keynesian approach
• The Great Depression: Classical theory failed
because high unemployment was persistent
• Keynes: Persistent unemployment occurs
because wages and prices adjust slowly, so
markets remain out of equilibrium for long periods
Conclusion: Government should intervene to
restore full employment

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 Why Macroeconomists Disagree
Classicals vs. Keynesians
– The evolution of the classical-Keynesian debate
• Keynesians dominated from WWII to 1970

• Stagflation led to a classical comeback in the

1970s

• Last 30 years: excellent research with both

approaches

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 Roadmap

Consumer Business Cycles Business Explanation of short-

and Firm (Characteristics Cycle run fluctuation,
Optimization & Behaviour) Theories inflation and
and the Topic 7 Topics 8 & 9 unemployment
Goods Topic 10
Market
Topics 2, 3

IS
Curve

AD-AS
Money IS-LM model
model
demand and Topic 5
Topic 6
Supply and LM
the Asset Curve
Market
Topic 4

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