Chapter 1. Macroeconomic for
the long run and the short run
ECON320
Prof Mike Kennedy
What is macroeconomics?
• A definition by subject
– Macroeconomics is the study if economic growth
and business cycles
• A definition by method
– Macroeconomics is concerned with explaining
observed time series like GDP, prices,
unemployment, etc
Aggregation
• The concept of the output and the capital stock
– We treat the economy as producing one good (GDP) using the
capital stock and labour, both one-dimensional variables
– The capital stock includes both structures and machinery and
equipment.
– The aggregate is measured by multiplying the quantities by the
prices in some base year – need relative prices to not change
– All in all a lot of simplifying assumptions are involved.
• Robert Solow
“All theory depends on assumption that are not quite true. That
is what makes it theory. The art of successful theorising is to
make the inevitable simplifying assumptions in such a way that
the final results are not very sensitive.”
Canadian GDP in a historical context
10
ln(GDP)
9
Trend GDP
Logs of real GDP
8
7
6
5
4
Trend estimated using Hodrick-Prescott filter
US GDP in a historical context
17
16
ln(GDP)
Trend GDP
Logs of real GDP
15
14
13
12
11
Trend estimated using Hodrick-Prescott filter
The Canadian business cycles over
time have become more muted
30
25
20
Log differences
15
10
5
0
-5
-10
-15
-20
Business cycle
Straight lines = +/- 2 standard deviations
The US business cycles over time have
become more muted as well
30
25
Business cycle
20
Straight lines = +/- 2 standard deviations
Log differences
15
10
5
0
-5
-10
-15
-20
A look at the Canadian business since 1961
14.3
14.1
13.9
Log of rreal GDP
13.7
13.5
Recessions
13.3
ln(GDP)
ln(GDP trend)
13.1
12.9
12.7
12.5
12.3
Trend estimated using a Hodrick-Prescott filter
Aggregate supply and demand
• We want to develop a framework for analysing shortterm fluctuations in the economy
• To do this we will develop supply and demand curves
as in microeconomics but there the similarity ends
• You are no doubt familiar with the aggregate demand
curve from ECON222
• The aggregate supply curve is both more challenging
and more controversial
• In both cases, the underlying determinants of the
curves are quite complicated – there is a lot going on
under the surface
A closer look at changes in Canadian GDP and
the unemployment rate
10
10
∆GDP
8
6
6
4
4
2
2
0
0
-2
-2
-4
-4
-6
-6
Percentage points
Per cent change
∆Unemployment rate (right scale)
8
Canadian GDP and the unemployment rate at
an annual frequency
6
3
%∆ GDP
∆ Unemployment rate (right scale)
2.5
4
2
3
1.5
2
1
1
0.5
0
0
-1
-0.5
-2
-1
-3
-1.5
-4
-2
Percentage points
Percentage change
5
Business cycles
• The message from the previous few slides is
that there are virtually no periods when the
economy is operating at full employment
(proxied by the trend)
• We want to explain why this happens
• We start by looking at the period highlighted
by the box in the previous two figures
We will be for the most part interested in explaining
short-run fluctuations in key aggregates
• In studying economic fluctuations, we want to examine
the role of:
– Exogenous shocks
• These could arise from the supply and the demand side of the
economy – not a complete explanation, especially for the reaction
of the economy
– Short-run nominal rigidities
• After the occurrence of the shock, there is a period during which
some prices and wages are sticky
• Need imperfect competition and/or menu costs to explain this
– Errors in expectations
• Prices/wages are different from what was expected or negotiated
which can cause prices and wages to not adjust
The source of real rigidities and the
natural rate
• Consider the following price setting equation:
P  mPW , mP 1
• Suppose that a monopolizing union sets wages by maximizing:


W

   i  v Li
 P

The term within the brackets is the rent earned by workers
• The demand for labour in sector i is where we used the price
setting equation to eliminate W:


L W i 
L mPW i 
Li     
 ,   1
n W 
n  P 
where σ is the elasticity of labour demand wrt wages

• The wage setting equation for the union is:
d ln 
1 1
1


0
Wi
dW i
P
Wi
v
P
Wi

 m W v, m W 
1
P
 1




• Introducing unemployment we can arrive at the economy’s wage
setting curve. We start by defining the outside option:
v  (1  u)
W
 ub
P
• Which we can substitute this into the wage setting equation to get:
wi  mW [(1  u)w  ub)], wi 
Wi
W
, w
P
P
• If the union mark-up is the same across all sectors then wages will
be the same in all sectors
mWu
w
b
1 m W (1 u)
1
b
m W 1 1 
1  W  
 m u 
The natural rate of unemployment and
the importance of the supply side
• The natural rate of unemployment is, even without nominal rigidities:
mW 1
W
W
m
1
m
u
 W
P
1  m b m (1  m P b)

• We see that the natural rate of unemployment is rooted in market
imperfections – that is an excess supply of labour does not put
downward pressure on wages
• If mW =1 the ū = 0, there would be no unemployment!
• Note that a higher value of mP, a measure of imperfect competition,
and b will also raises the natural rate
• Note as well that the amount of employment (1 – ū) is given by the
supply side of the economy – the parameters mW, mP and b
characterise the supply structure
Explaining how nominal short-run rigidities can arise
from optimizing behaviour: The role of menu costs
• We assume that unemployment benefits are related to the
real wage as b = cw.
• The outside option now becomes
v  v(u)  [1 (1  c)u]w
• The optimal wage that the union will choose is:
wi  mW v(u)  mW [1  (1  c)u]w
• Normalising the labour force on unity we get L  1 u
• Labour demand in each sector will then be
Li  [(1 u) / n](m P wi )



Menu costs con’t
• Substituting the above into the union’s objective function we
get
6 4 4 7L 4 4 8
i
1  u  P 
(wi , u)  (wi  v(u))
( m wi )
 n 
• The utility loss from not adjusting wages is
UL  (wi , u)  ( w˜ i , u) where w
˜ is the initial wage rate set
by the union
• The utility loss in equilibrium is equal to the cost of not
adjusting – the menu cost, call it C

 0 in
optimum
6 4 7 48
(wi , u)
1  2 (wi , u)
2
˜
( w˜ i , u)  (wi , u) 
( w˜ i  wi ) 
(
w

w
)
i
i
wi
2 (wi )2

• Determining
1  2 (wi , u)
2
˜
UL  
(
w

w
)
i
i
2 (wi )2
2




˜
UL
 1 wi  wi
 


wi Li    wi 
w˜ i  wi (1 c)(u  u )

wi
1 (1 c)u
mW 1
1
u W

m (1  c) (1  c)
Shocks, expectation errors and nominal rigidities
• How u deviates from ū


Wi
We
B u  W i P
We W P
B u 
W
W
 m (1  u) e  u e  
 m (1  u)
 u e  
e
e
e
P
P
P  P P
W P P
P 




Wi
We W
W
 m (1  u)
 ub 
P
W
P




We
1  m (1  u)
 uc 
W


W



1  mW (1  u  u c)
1 u W e W 
u  u  


1 c  W 