Introduction
Chapter #1
Micro vs Macro Economics
• Micro: behavior of individual economic units (households, firms)
– Issues include product and input price determination
– Market supply and demand (for specific product) vs AS and AD (GDP)
– Downward slopping DC (wealth and substitution) and IDC (Law of DMU)
• Macro: aggregates individual markets, looks at economy as a whole
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–
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Issues include economic growth, inflation, unemployment, BOP and ForEx
Long-run econ growth and short-run fluctuations constituting business cycle
Interaction between 3 main markets and nation vs rest of the world
Understand how econ works to make it perform better (government policies)
AS (output firms willing to supply at different price levels) vs
AD (level of output at which goods and financial markets are simultaneously in
equilibrium for any price level, position determined by monetary and fiscal
policy together with consumers’ confidence)
– AD in RGDP downward slopping (assuming fixed money supply) due to effects:
wealth ↑ prices ↓ purchasing power of money, poorer consumers buy less
interest rate - ↑ prices ↑ prices of money or interest rate (mortgages, car loans)
net exports - foreign/domestic goods cost less/more at home/abroad,
NX ↓ and hence RGDP = Y = C + I + G + NX
Macroeconomics In Three Models
• Study of macroeconomics is grounded in three models, appropriate for
a particular time period (described by AS)
1. Very Long Run Model: growth theory  focuses on production capacity
(potential output - when resources are fully employed) vertical AS
accumulation of capital and improvements in technology
2. Long Run Model: a snapshot of the very long run model, in which capital and
technology are largely fixed, but allow for temporary shocks
• Level of capital & technology are fixed and determine potential output level
• Output is fixed, but prices (inflation) determined by changes in AD
3. Short Run Model: business cycle theories with flat AS
• Changes in AD determine how much of the productive capacity is used and
the level of output and unemployment
• Prices are fixed in this period, but output is variable
4. Long Run Model: a snapshot of the very long run model, in which capital and
technology are largely fixed
Very Long Run Growth
• Figure 1-1a illustrates growth of income per person in the U.S. over last century
 smooth growth of 2-3% per year on average smoothing short run changes
• Growth theory examines how the accumulation of inputs and improvements in
technology lead to increased standards of living (ignore short run fluctuations –
tend to average over the years)
• Average rate of growth is important (2% vs 4% over 20 or 100 years - TVM)
• Rate of saving (vs consumption) is a significant determinant of future well
being and economic growth
The Long Run Model
• Long run AS is vertical, at the potential level
of output (slow growth, 2-3% annually)
– Output is determined by the supply side of
the economy and its productive capacity
– Price is determined by the demand relative
to the productive capacity of the economy
• Conclusion: high rates of inflation always
due to changes in AD (can be substantial)
Zimbabwean inflation rates since independence
Date
Rate
Date
Rate
Date
Rate
Date
Rate
Date
Rate
1980
7%
1986
15%
1992
40%
1998
48%
2004
133%
1981
14%
1987
10%
1993
20%
1999
57%
2005
586%
1982
15%
1988
7%
1994
25%
2000
55%
2006
1.2K%
1983
19%
1989
14%
1995
28%
2001
112%
2007
66.2K%
1984
10%
1990
17%
1996
16%
2002
199%
07/08
231M%
1985
10%
1991
48%
1997
20%
2003
599%
11/08
79.6B%
The Short Run Model
• Short run fluctuations in output are
largely due to changes in AD
– The AS curve is flat in the short run
due to fixed/rigid prices, so changes
in output are due to changes in AD
• Changes in AD in the short run
constitute phases of the business cycle
– In the short run, AD determines output
and thus unemployment, leaving prices
unaffected
The Medium Run
• How do we get from the horizontal
short run AS curve to the vertical long
run AS curve?
• The medium run AS curve is tilting
upwards towards the long run AS curve
position
– When AD pushes output above the
sustainable level, firms increase prices
– As prices increase, the AS curve is no
longer pegged at a particular price level
– Firms start to rise price and AS begins to
move upward
– How steep is AS is the main controversy
in macroeconomics
The Phillips Curve
• The speed of price adjustment to increase in AD is critical for understanding economy
• Prices tend to adjust slowly  AD drives the economy in the meantime
• The speed of price adjustment is illustrated by the Phillips curve, which plots the inflation
rate against the unemployment rate
• Unemployment decrease from 6 to 4% will increase inflation by only 1% over one year
• In the short run, AS curve is relatively flat, and movements in AD drive changes in prices,
output, and unemployment
Growth and GDP
• The growth rate of the economy is the rate at which GDP is increasing
– Most developed economies grow at a few percentages per year
• Growth in GDP is caused by:
1.
2.
Increases in available resources (labor and capital)
Increases in the productivity of those resources
The Business Cycle and the Output Gap
•
Business cycle: somewhat regular pattern of expansion and contraction in economic
activity about the path of trend growth
– Trend GDP is potential GDP realized if factors of production were fully utilized
Econ not physical concept - physical labor full employment when everyone works 16 hours
- econ when everyone who want to work has a job (unprecise)
Defined by convention, e.g. labor fully employed when unemployment is 5%
•
Deviation of output from the trend
is referred to as the output gap
– Output gap = actual output
– potential output or trend
– Measures the magnitude of cyclical
deviations of output from the potential
level
•
Commonly recession refers to economy
in bad shape
•
Econ definition measures recession from
peak to through.
•
So when recession is over it does not imply end of tough times but that economy is turning
Inflation and the Business Cycle
• Inflation of 1960s and 1970s
• Prices > septupled 1960-09
(on average $1 in 1960 worth
$7.76 by 2012), most of the
price increase during 1970s
• The inflation rate estimated
as percentage change in CPI
(cost of a basket of goods
bought by average household)
• If AD is driving the econ,
periods of growth cause
inflation, while periods of
contraction reduced prices
and produce inflation < 0.