SENIOR FRESHMAN INTERMEDIATE ECONOMICS (MACRO)

Welcome to my home page!

Every week we will include a brief resume of the lectures, reading and problems.

The secret of success is to keep up with the material covered in the lectures. If you have problems, you should call around to our teaching assistants, Paolo Figini and Suzanne O'Neill. I also have office hours every week and you are welcome to see me then. Or else feel free to talk after the lectures.

AGENDA WEEK-BY-WEEK

L1 : Welcome to Intermediate Econ Analysis macro. Review of Course. Introduction to TAs: Paolo Figini and Suzanne O'Neill.

L2. Seven stylised facts about economic growth. How to explain this diverse experience? We start with Harrod-Domar model, g = s/v, where s is the savings/investment ratio and v is the capital output ratio. Reading DMcA chs 1 and 2. Problems p.35, exercises 6 and 3.

Answers to Problem sets:

Q6. India's 1993 per capita income was $1220 measured in purchasing power parity (Table 2.1) and its growth rate was 3 per cent during the period 1980-93. Assuming his growth rate is sustained, how long will it take India to reach the present per capita GDP level in developed countries of about $22,000? Suppose developed countries continue to grow at 2 per cent per year, how long before convergence is achieved? How plausible are these projections in your view?

· 1220 (1.03)n = 22,000 log 1220 + n log 1.03 = 22,000 n log 1.03 = log 22,000 - log 1220 n = log 22,000 - log 1220 log 1.03 n = 4.342 - 3.086 0.0128 n = 98 years

· 1220 (1.03)n = 22,000 (1.02)n log 1220 + n log 1.03 = 22,000 + n log 1.02 n (log 1.03 - log 1.02) = log 22,000 - log 1220 n (0.0128 - 0.0034) = 1.256 n = 1.256 0.0042 n = 299 years The implications of the above figures is that firstly, catching up will be a very long process and secondly, if India wants to catch up with the industrial countries at a faster rate, growth must be in excess of 3 per cent per annum.

Q3. Between 1960 and 1990, Korea and Zambia had the same ratio of investment to GNP. Yet Korea's GNP grew by 9 per cent per year while Zambia's grew by just 1 per cent. What factors would you consider in trying to explain this difference in performance?

Each country had an investment ratio of 23% during this period, just about the same as the US (24%). Zambia made all the mistakes which results in lower productivity of investment: too much protection of domestic industry from foreign competition, excessive government intervention in the economy, macroeconomic imbalances as represented by the government's weak fiscal position and depreciating exchange rate. Also Zambia was unfortunate to have specialised and invested heavily in the copper industry, where the terms of trade were unsatisfactory and which had an inflexible production structure. Korea, by contrast, used its investment well. A further reference point to note: while Zambia has to cope with a drastic population growth of 3% per annum since 1980, Korea's population growth has slowed to below 1% per annum.

L 3 Population grow affects a country's capacity to save (s) and also the productivity of capital (v). The Solow model takes both labour force growth and investment into account. Empirical studies show that only a part of total economic growth can be explained by 'standard' factors such as investment (changes in capital stock) and additions to the labour force. Hence the importance of the SOLOW RESIDUAL. For more details on this see handout from Burda and Wyplotz.

L 4 Solow residual also called Total Factor Productivity (TFP). TFP very important for successful developing countries. Recent World Bank study estimates annual TFP increaseof 3.9% for China. This gives a huge boost to living standards, and when added to China's prodigious 40% investment rate explains its extraordinary growth performance in recent years (8% p.a.in GNP per person). Six reasons explaining TFP. Importance of economic policies. THE NEW ECONOMIC POLICY CONSENSUS. Lastly we introduced the idea of potential GNP growth - easy, now that we've mastered the Solow residual!

Reading: McAleese ch 11 (sections 1 to 3 incl) and ch 14.

Problems: p. 291 no 2; p.292 exercise 3

Answers to Problems

Q2. What is the difference between actual and potential GNP? How is potential GNP calculated? Of what practical use are potential GNP estimates?

Actual GNP is the value of current output produced by productive factors owned by permanent residents of a country. Potential GNP is defined as the maximum output attainable with full utilisation of productive factors and consistent over the medium term with low inflation. Two observation are worthwhile:

i). Potential output is different from maximum output in an engineering sense (and the first will be lower). ii). The concepts of low inflation and medium term are open to different interpretations.

There are two ways of estimating potential GNP: through the analysis of the past trend of the growth rate or through the production function approach. This second estimate, regularly produced (for example by OECD), is computed as follows:

i) Separate private from public sector (due to the difficulty of measuring output in the latter, actual government output is assumed to be equal to its potential). ii) Estimate the growth of productive inputs. iii) Estimate the utilisation levels consistent with low inflation. iv) Assess the impact of new technologies and changes in economic policy on economic activity. v) Derive the total factor productivity growth. vi) Combine the previous statistics together in order to obtain an estimate of potential growth for private sector and then re-aggregate the public sector to obtain potential GNP.

Since deviations from potential GNP in either direction can cause problems (inflation if actual exceeds potential GNP and unemployment if the former is far less than the latter), its estimate gives a guidance to economic authorities in the management of monetary, fiscal and industrial policies. Besides, business economists use estimates of potential GNP to estimate future economic growth from which sales forecasts are derived. Q3. Consider an economy with only three goods. Their market prices are P1 = 5, P2 = 10 and P3 = 15. The production (and consumption) of each good during 1995 was Q1 = 20, Q2 = 25 and Q3- = 10. (a) What is the value of nominal GNP? (b) Assume that in 1996 prices rise to P1 = 6, P2 = 12 and P3 = 17, and quantities produced (and consumed) go to Q1 = 21, Q2 = 27 and Q3 = 11. Calculate the value of nominal GNP. Compute real GNP, using 1995 prices as the base year. What is the rate of inflation? What is the real rate of growth of the economy?

GNP95 = P1Q1 + P2Q2 + P3Q3 = (5 x 20) + (10 x 25) + (15 x 10) = 100 + 250 + 150 = 500

GNP96 = P1Q1 + P2Q2 + P3Q3 = (6 x 21) + (12 x 27) + (17 x 11) = 126 + 324 + 187 = 637

real GNP96 is calculated using 1995 prices and 1996 quantities.

real GNP96 = (5 x 21) + (10 x 27) + (15 x 11) = 105 + 270 + 165 = 540

real GNP index: GNP95 = 100 GNP96 = (540 / 500) x 100 = 108

real growth rate = (real GNP96 - real GNP95) / real GNP95 = (540 - 500) / 500 = 40 / 500 = 0.08 = 8%

GNP price deflator = (nominal GNP / real GNP) x 100 = (637 / 540) x 100 = 118

inflation rate = (nominal GNP - real GNP) / real GNP = (637 - 540) / 540 = 18%

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L 5 : Some final words on potential GNP. Difficult to estimate but still very important from long run and short run policy. Now to the analytics of the Aggregate Supply (AS) curve. To derive it we need: a) production funtion b) labour supply curve - labour force assumed to be rational (no money illusion) and utility maximising c) labour demand curve (determined by profit maximising employers). This yields equilibrium (= potential!) level of income at a given time. What happens if there is a rise in prices? Nothing except inflation. THERE IS NO TRADE OFF. NO PHILLIPS CURVE. THIS LEADS TO THE VERTICAL AGGREGATE SUPPLY (AS) CURVE.

L 6: If all markets were flexible there should in theory be no unemployment. Yet unemployment of 11% prevails in Europe today. Why? In this lecture we analyse the 'classical reasons for unemployment. Some have to do with whether it is rational for a redundant employee to seek employment - here we discuss search unemployment, the replacement ratio. Second, one must ask if it will be possible for the employee to offer their services at a lower pay level - here we encounter problems causes by minimum pay legislation, trade union restrictions, employer resistance (due to 'efficiency wages' or 'market for lemons' factors). Third the problem may go deeper: the longer people remain unemployed the harder it is for them to find work. This is the problem of HYSTERESIS. (See McAleese ch 14 for formal definition. See also O'Hagan Economy of Ireland for a critical application of these ideas to the Irish situation.)

Exercise: Q4 on list of sample questions and Discussion Question Q 3 McAleese p. 292.

Q3. Discuss reasons why the aggregate supply curve might be vertical. Do you find them convincing?

In the classical model the aggregate supply (AS) curve can be considered a proxy for potential output and represents the possible combinations of real output (y) and the price level (p) consistent with equilibrium in the economy. Under certain assumptions AS is vertical:

i) Individuals are utility maximising. ii) Firms are profit maximising. iii) Markets for factors of production and goods are perfectly competitive (full flexibility of prices and wages). iv) Existence of rational expectations (absence of money illusion).

The AS curve can be derived as in figure 11.3. The starting point is the equilibrium in the labour market in which demand and supply are functions of the real wage. At equilibrium, L* is the employment level and (w/p)* the real wage. Corresponding to L* is an equilibrium level of real output as you can see in the bottom half of figure 11.3. Call that level of output Y*. According to the classical school this level of output will not be changed by either a fall or a rise in price. If prices rise by 10%, employees will demand full and instantaneous compensation. If prices fall by 10%, they will accept a 10% fall in wages. All this follows because employees are assumed to be 'rational' and free from money illusion.

Figure 11.4 shows that a rise in the price level from P0 to P1 implies a decrease in the real wage. Because the cost of labour has now fallen, employers demand more labour for the same nominal wage, hence the shift of demand of labour to the right to D(P1). However, supply of labour decreases because workers are free from money illusion and perceive the reduced purchasing power of their wages, hence the shift of supply of labour to the left to S(P1).

The equilibrium is restored in point E1 with a higher nominal wage which increase cancels out the increase in the price level, thus maintaining the same real wage. This implies the same quantity of labour (L*) employed in the economy and, through the production function, the same total output Y0. Hence, a vertical AS curve.

Now check pp 275-277 to see what happens if money illusion happens to be present and/or if nominal wages happen to be rigid or 'sticky'.

The slope of the AS curve is an important issue in the macroeconomic debate. This is not only a theoretical exercise because the slope of AS determines the effectiveness of economic policies. In this regard, it is useful to distinguish between the long run and the short run (that is defined as the period of time in which, because of imperfections, the price mechanism cannot adjust to the new conditions in the markets).

At least two models are relevant in the short run, both dealing with imperfections in the labour market. They are explained as follows, complementing the information given in the text.

i) The first one is called the sticky-wage model. After the increase in the general price level from P0 to P1, profit maximising firms shift their demand of labour from D(P0) to D(P1); due to rigidities (i.e., minimum wage or contracts signed before the increase in inflation), in the short run workers have to accept to work for a lower real wage and cannot shift their supply of labour which is still S(P0). The new wage is Wt. There is room for employers to increase employment (and output) because the marginal cost of labour has decreased. Hence, because of an increase in the price level from P0 to P1, output increases and the AS curve is positively sloping.

ii). The second alternative model is called the worker-misperception model. After the increase in prices, workers are offered a higher nominal wage. Because of money illusion, they perceive this increase as an increase in their purchasing power. Their supply curve shifts to the right and the equilibrium real wage falls. Again, the decrease in the cost of labour allows firms to produce a higher level of output: AS is positively sloping.

While these imperfections can affect the slope of the AS curve in the short run, this irrational behaviour is unlikely to persist for a long time; eventually workers will respond in the classical manner and the AS curve will be vertical. There is disagreement, however, on the length (and therefore the political relevance) of the short term: it is assumed to be 1-2 years but new-classical economists argue that is much shorter than that.

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L 7: From classical analysis of the unemployment problem to classical solutions. Make the labour market more flexible; avoid downturns; special assistance the the long-term unemployed - 'active' labour market policies in order to deal with hysteresis. The Bundesbank's view of unemployment and the OECD package.But is something missing? Introduction to Keynes and the General Theory (1936), one of the greatest masterpieces ever written in economics.

L8 Public holiday

Exercises: nos 5 and 6 in hand-out - model answers will be released after reading week.

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L9 Keynes' two objections to the classical model. First, his fundamental objection was that if labour markets were flexible and reductions in nominal wages followed an increase in unemployment, aggregate demand might fall. Business expectations would become even more pessimistic and investment would fall. This in turn would lead to a fall in the general price level. There might in Keynes' words be no way by which employees could actually bring about the decline in real wages needed to restore full employment.

Second, nominal wages might be rigid downwards. For various reasons, workers might be prepared to accept a fall in real wages if that happened as a result of price increases while the same fall in real wages would be resisted fiercely if it were proposed to bring it into effect via a nominal wage cut.

Nominal wage rigidity leads to an upward sloping AS curve, as described in McAleese pp 273-279. Once we have an upward sloping AS curve, then changes in AD affect real output as well as prices. Hence AD becomes important for living standards and the level of employment. To Keynes, this meant that we have to try to understand the composition and determinants of AD. To this subject we turn next.

L10 Determinants of Consumption; Keynesian function has income. Consumption depends on real disposable income. But the response to changes in 'income' which are expected tends to differ from the response to income which is unexpected. Likewise, the consumer will distinguish between permanent and transitory income (as the lottery vs salary income example showed). Account must also be taken of wealth, age-distribution of population (% of old and young), liquidity constraints (your bank manager may not provide a loan, even if you, as a forward-looking rational consumer, are quite confident that your future income will be such as to permit high borrowing today) and interest rates.

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PLEASE NOTE REVISED SAMPLE QUESTIONS --- REVISED PAGE ONE AS FOLLOWS:

DEPARTMENT OF ECONOMICS

Senior Freshman Professor Dermot McAleese Michaelmas Term 1997

Intermediate Economics (Macro) Sample Questions (Revised version)

1. Outline the three main pillars of the new policy consensus. (McAleese ch 1)

2. Between 1960 and 1990, Korea and Zambia had the same ratio of investment to GNP. Yet Korea's GNP grew by 9 per cent per year while Zambia's grew by just 1 per cent. What factors would you consider in trying to explain this difference in performance? (McAleese ch 2)

3. India's 1993 per capita income was $1220 measured in purchasing power parity (DMcA, Table 2.1) and its growth rate was 3 per cent during the period 1980-93. Assuming his growth rate is sustained, how long will it take India to reach the present per capita GDP level in developed countries of about $20,000? Suppose developed countries continue to grow at 2 per cent per year, how long before convergence is achieved? How plausible are these projections in your view? (McAleese ch 2)

4. What is the aggregate supply (AS) curve? Explain how it is derived in the classical model. What assumptions are needed to make it vertical? What factors cause the AS curve to shift outwards? (McAleese ch 11)

5. Give four reasons explaining the existence of unemployment in the classical model. (McA ch 14)

6. What is meant by hysteresis in the context of unemployment? What explanations are given to account for the growth in the numbers of long-term unemployed in Europe over the last decade? Does hysteresis affect the costs of recessions? (McA ch 14)

7. Discuss how market imperfections can lead to a positively-sloped AS curve in the short run.

8. Use diagrams to explain the following statement: Outward shifts in the aggregate demand curve affect output only temporarily, whereas outward shifts in the aggregate supply curve affect output permanently. And, whereas a positive demand shock raises prices, a positive supply shock reduces them.

9. The Central Bank in a closed economy announces that inflation is 'public enemy number one' and engages in restrictive monetary policy to reduce it from 6% to 3%. What would be the likely effects, if any, on output and unemployment? Would your answer be different in the long-run and the short-run? Can disinflation be costless?

---oOo---

10. Outline the main determinants of aggregate consumption. In considering the effects of a change in income show how consumption responds according to whether the change in income is (a) permanent or transitory (b) expected or unexpected.

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L 11 Definition of investment. Three types of investment: residential, business and inventory. Investment depends on expected future profits (sales minus costs) compared with cost of capital. Both of these concepts need careful definition (see McAleese chapter 10 pp 250-257). Keynes emphasised the 'extreme precariousness of estimates of prospective yield' on investment projects. This explains why investment is so volatile - and why we get recessions and booms - and why a market economy can sometimes get stuck in a long-drawn out recession. The same herd instinct is at work in explaining why stock market collapse in one country can often lead to similar collapses in neighbouring countries even those with very different economic characteristics.

Now we are ready to derive the IS curve

L12 Derivation of IS and LM curves. Each curve is an equilibrium locus showing combinations of interest rate (i) and real income (y) consistent with equilibrium in goods and money market respectively. We analysed the factors which can cause these curves to shift position. Equilibrium i, y position may not coincide with full employment y. What then? Wait for classical adjustment mechanisms to work, say the classical economists (of 1990s as well as 1930s). Keynes argued that this process takes too long (in the long run, we are all dead). Instead we need to take control of ISLM curves and shift them outwards through policy up to the point of full employment GNP (i.e. y). Our next step is to analyse fiscal policy (McAleese ch 14) and then onto monetary policy.

L13 Fiscal Policy: how it works in theory. What is fiscal policy? An expansionary fiscal policy refers to a net increase in government spending or a net reduction in taxation. Combined with the multiplier it results in a shift outwards of the IS curve. The new equilibrium levle of income will be to the right of the original level of income, and employment will be higher. General rule fo Keynesian model: fiscal policy should be expansionary in times of recession and contractionary in times of economic boom. The objective is to keep the economy on its potential growth path.

L14 Fiscal Policy: how it works in practice. The limitations of fiscal policy were assessed, drawing on ch 15 of McAleese. Brief analysis of fiscal vs monetary policy. If the IS curve is steep or vertical, monetary policy (represented by shifts in the LM curve) will be ineffective. Students can work out for themselves what happens if the LM curve is steep. If both curves are steep,then a combination of fiscal and monetary policy may be required to move the economy to the required position.

L 15 Business Fluctuations I. Definition of business fluctuations. Why they matter: they are associated with unemployment, with haphazard and often destructive shifts in wealth, and with slower growth. British economic policy has been set a target of breaking out of the stop-go cycle and aligning actual growth with potential growth. Brief discussion of what causes cycles and

L 16 Business Fluctuations 2. Summary of lecture below:

WHAT CAN BE DONE ABOUT BUSINESS FLUCTUATIONS?

1. STUDY AND UNDERSTAND THEIR CAUSES:

· Not one but many theories of business fluctuations 'Business cycle theory reminds us that we do not understand economic fluctuations as well as we would like. Fundamental questions about the economy remain open to dispute. Is the stickiness of wages and prices a key to understanding economic fluctuations? Does monetary policy have real effects?' Mankiw p. 388

· The problem is that fluctuations are often caused by random shocks. There are many and diverse types of shock and, by definition, all are unpredictable.

· Effects of these shocks magnified by propagation mechanisms such as the multiplier and accelerator. · Nominal rigidities in wages and prices explain why these real fluctuations are not instantaneously counteracted and may be prolonged. 2. ESTABLISH BEST POSSIBLE ESTIMATES OF POTENTIAL GNP AND DERIVE RELIABLE, TIMELY ESTIMATES OF CURRENT GNP.

· To derive potential GNP estimates, we require careful modelling of the economy. This is an on-going exercise.

3. IMPLEMENT COUNTER-CYCLICAL FISCAL POLICIES

· dismal record of many governments' fiscal policy - Irish fiscal policy has on average been pro-cyclical rather than counter-cyclical!

· solution may be to implement coarse-tuning rather than fine-tuning policies · adhere to strict overall guidelines (Maastricht)

3. MANAGE MONETARY POLICY SO THAT PRICE STABILITY IS THE CENTRAL OBJECTIVE.

· Bad monetary policy, and inflation, can be sources, not cures, of business fluctuations because of 'long and variable' lags between monetary policy action and its effects on the real economy. · Hence only limited scope for counter-cylical intervention. 4. GOVERNMENT CAN ALSO HELP BY 'TALKING DOWN' BOOMS AND 'TALKING UP' RECESSIONS

· ..... but such verbal or symbolic interventions are of limited value in practice.

CONCLUSION

GOVERNMENT ACTION HAS DIMINISHED THE OVERALL AMPLITUDE OF FLUCTUATIONS.

Policy activism means that the danger of collapse and major boom is diminished. There has been a permanent raising of the 'floor' of the business cycle and a lowering of the 'ceiling'. Policy is difficult because nobody is quite sure when these ceilings and floors are near to being reached.

BUT .... Bad policies have created fluctuations: Lawson boom in the UK post-1988; Reagan tax cuts in early 1980s in the US; German unification 1990.

ECONOMISTS AND POLICY-MAKERS MUST TRY HARDER!

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