Macroeconomic Theory and Policy: Lecture 1 (Ch.

1)

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Course Organization

In the Fall term, lecture will be held on Tuesday and tutorial will be held every Monday

In the Winter term, the lecture will be on Monday and the tutorial will be held every
Tuesday

Office hour:
▶ My office hour: Right after lecture

▶ TA’s office hour: see announcement

▶ Additional office hour will be available before the mid-term and exam

Email: eco202y1y.c@course.utoronto.ca

Piazza: TA and I will answer questions on Piazza

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Grade Structure

Group assignment
▶ Four take home group assignments, each worth 2.5% (total 10%)

▶ They will be post and be submitted on Crowdmark

▶ Once started, you have 3 hours to submit

▶ Up to four students a group

Weekly Quizzes
▶ Post and be submitted on Quercus after each lecture

▶ Best 20 quizzes, each worth 0.5% (total 10%)

▶ Due every Thursday after each lecture

Writing Assignment
▶ Two writing assignments , each worth 5% (total 10%)

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Grade Structure

Test: worth 15% each

▶ Mid-term 1: Oct 23 (Monday)

▶ Mid-term 2: Fall term exam period, schedule by the university

▶ Mid-term 3: Feb 26 (Monday)

Exam: worth 25%

▶ It will be comprehensive

▶ Winter term exam period, schedule by the university

Please check the outline for more information

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Textbook
We are going to follow the textbook for the majority of the course

Textbook: Macroeconomics, by Charles I. Jones, 5th edition

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What are You Going to Learn (ch. 1)

What are the important macroeconomics questions to be considered

foundations of macroeconomic models and modeling

the three-part structure of the text:

▶ The long run

▶ The short run

▶ Issues for the future

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Important Macroeconomic Questions to Consider

Why is today’s average North American

▶ more than 10 times richer than 100 years ago?

▶ 50 times richer than the average Ethiopian?

What could be the cause of high income inequality across the world and even within
a single country?
▶ Is it equitable that such a small percentage of people control such a large percent of the
world’s wealth?

Why has the unemployment rate in Europe been almost twice as high as it has been
in the United States?

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Important Macroeconomic Questions to Consider

Do we understand and know the causes of the global financial crisis in 2007-2008
▶ Was it greedy banks lending money, irresponsible homeowners living beyond their
means, or government institutions such as Freddie Mac and Fannie Mae?

What are the causes of the recent rise in prices?

What role do stock markets play in the economy?

How did the 2008 Affordable Care Act impact the price of healthcare, economic
growth, and government expenditures?

some of these “macroeconomic” questions may overlap with research in other

disciplines

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GDP Per Capita
GDP Per Capita represents the average income per individual in a country

GDP per Capita is much higher in developed countries (Western Europe and
Western Offshoots - North America + Australia, New Zealand) compared to the rest

Meanwhile, Asia, Eastern Europe and Middle East experience an uptick in recent
years

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Economic Growth

Economists develop mathematical models to study these phenomena

▶ For example, why do some countries grow faster than others?

▶ To answer this question, we will use the Solow growth model and a model of
endogenous growth

▶ We are going explore these in the first half of the course

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Inflation Rate in Certain Developed Countries

The inflation rate is the percentage change in the price level – often measured using
CPI

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News on Inflation

News on Inflation appear almost every weeks

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What are the costs of inflation to society?

Unexpected and symmetric inflation

▶ Wages are simply the price of labor

▶ Therefore, purchasing power of workers is unaffected, in this case, no one is worse off

Unexpected and asymmetric inflation

▶ Suppose wages increase less than the prices for goods and services

▶ In this case, workers are worse off and relative price distortions emerge

▶ Unexpected and uneven inflation is generally costly to society

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What are the costs of inflation to society?

Deflation
▶ Deflation increases the real value of outstanding debt, this is harmful to borrowers and
restricts access to credit
⋆ Firm also earn less in dollar term but might hold same amount of debt

▶ Consumer form an expectation that the price would keep falling

Sticky prices
▶ Sticky prices are related to the asymmetric (uneven) inflation

▶ If some prices do not adjust as quickly as others, there are resulting distortions and
inefficiencies

▶ Distortions are bad—see end of the lecture—Pareto efficiency and free markets

▶ Sticky prices cause inflation to be costly

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The Unemployment Rate in the United States, Europe, and Japan
Unemployment rate are highly correlated with the business cycle

Before 1980, unemployment rates in Europe were actually lower than in the United
States, while Japan has remained low over this time frame

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How Macroeconomics Studies Key Questions

Macroeconomists have a general approach to study questions of interest:

Document the facts
▶ In recent years, more macroeconomists rely more and more on micro-data

Develop a model
▶ Models simplify the complicated real world into its most relevant elements
⋆ The goal of a model is not to perfectly replicate every single detail/feature of markets or
behavior

▶ A model is useful if it has good predictive power

▶ Economic models often involve systems of multiple equations

Compare predictions of the model with original facts

Use the model to make other predictions that will eventually be tested

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Parts of an Economic Model

Parameter: An input that is fixed over time, except when the model builder changes it
for an experiment
▶ Minimum we assume not to change; can be changed by the model builder as an
experiment.

Exogenous variable: An input that can change over time, but determined ahead of
time by the model builder
▶ Exogenous = “outside of the model”

▶ Can change over time but determined outside of the model.

Endogenous variable: An outcome of the model—something that is explained by the

model
▶ Endogenous = “within the model”

▶ Determined by factors plugged into our model.

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Parts of an Economic Model

For example, a linear model

Y = β0 + β1 X1 + β2 X2

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Suppose We Have a Working Model. . .

How can we use it?

▶ Models are built using existing data, but can be used to predict events and outcomes for
which we do not have data yet – set up a counterfactual “what if” situation

▶ Change parameters and exogenous variables to see how they affect endogenous
variables

▶ Predict costs and benefits of new government policies – a change in parameter that
mimic the policy

▶ All models can make inaccurate predictions, so we should always interpret the results
with caution

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Model Example: Labor supply and demand

Variables:
▶ Ls = number of hours laborers want to work

▶ LD = number of labor hours firms want to hire

▶ w = wage

no exogenous variables

Parameter: f̄ , l̄, ā

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Model Example: Labor supply and demand

Supply Function:

Ls = f (w) = āw + l̄ = 2w + 30

Demand Function:

Ld = g(w) = f̄ − w = 60 − w

Equilibrium:

Ld = Ls

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Model Example: Labor supply and demand
Consider a case of an increase in income taxes

Firm would still pays a wage of w, but worker receives only a wage of (1 − t)w

For any given wage, the worker gets to keep less of his wage so he supplies less
′ ′
labor. In equilibrium, we move from (w ∗ , L∗ ) to (w ∗ , L∗ )

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Model Example: Labor supply and demand
Consider a case of an increase in an input price

As production costs increase for firms, their demand for labor decreases. It lead to a
leftward shift in Ld
′ ′
The equilibrium move from (w ∗ , L∗ ) to (w ∗ , L∗ )

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Theoretical and Empirical Approach
They rely on each other to solidify the validity of analyses

Most mainstream theoretical methods are motivated by empirical work, theoretical

models typically try to explain some important feature of the data

Empirical macroeconomics needs theoretical macroeconomics to establish causation

▶ Suppose the data show that when interest rates decrease, taxes usually go down

▶ It might be tempting to conclude that reduced interest rates lead to decreased taxes.
However, this can go the other way around

▶ Or, there is likely omitted variable bias here, which implies that a third variable is causing
the changes in both interest rates and taxes

▶ For instance, poor macroeconomic conditions probably result in the central bank
decreasing interest rates and the government cutting taxes

Empirical work can never establish causality with 100 percent probability. But, when
it is supported by theory, a causal relationship is more convincing
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An Overview of the Course
Microeconomics also has many subfields and a lot of them are overlapped with
macroeconomics

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The Long Run

Income per person in the United States:

▶ $2,800 in 1870

▶ $44,000 in 2008

As seen earlier, many countries have not experienced similar increases in living
standards

The analysis of economic growth helps explain the long run

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Per Capita GDP in the United States, 1870–2015
Overall growth is upward

Short-run fluctuations can cause peaks and troughs

It encourages us to ask, Will there ever be a long-run peak? Can we grow forever?
What does the future hold?

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The Short Run

Potential output (Yp ): Measure of how per capita GDP would evolve with completely
flexible prices and fully employed resources

Short-run fluctuations are often defined as deviations of actual output (Y) from its
potential level
▶ When Y > Yp , this is an expansion

▶ When Y < Yp , this is a recession

In 1982, actual output was 5 percent less than potential output, which is economically
important
▶ In today’s prices, the gap was roughly $1,500 per person ($6,000 for a typical family of 4)

▶ This recession represented a large cost in terms of lost income

Recessions are costly and cause devastation in the short run but are overcome by
long-run trends

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Welfare

Welfare: Variable used to determine preferable policies and rank outcomes

Measuring welfare is highly subjective

▶ More GDP (consumption) increases welfare

Are there variables other than GDP that we should consider?

▶ Leisure

▶ Equality

▶ Life expectancy

▶ Environmental quality

▶ Individual freedom

Often, policymakers use increasing GDP as a benchmark for standards of living and
welfare

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Pareto Efficiency and Free Markets
How do efficiency can be measure in term of welfare?

Pareto efficiency is reached when you cannot make someone else better off without
making another worse off

The fundamental theorem of welfare economics (a version of Adam Smith’s invisible

hand) states if there is a competitive market for everything, then equilibrium will be
Pareto efficient

However, if complete and competitive markets do not exist there is no reason to

believe that equilibrium will be Pareto efficient

Deviations:
▶ Market power

▶ Externalities

▶ Public goods

▶ Asymmetric (imperfect) information

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Why do economists disagree?

Nature of market failures (magnitude)

Theory of complete and competitive markets breaks down

Which Pareto efficient outcome is best?

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Next Lecture

Next lecture will cover Ch.2

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