Macroeconomics I

Chapter 1: The Science of

Macroeconomics
 Some issues in macroeconomics
Macroeconomics, i.e. the study of the economy as a
whole, addresses many issues, e.g.:

 Why are so many countries poor? What policies might help them
grow out of poverty?
 What causes recessions? What is
“government stimulus” and why might it help?
 Why does the cost of living keep rising?
 What is the government budget deficit?
How does it affect workers, consumers, businesses, and
taxpayers?
Lecture Notes 2
U.S. Real GDP per capita
(year 2000 prices/dollars)

9/11/2001
long-run upward trend…
First oil
price shock

Great
Depression Second oil
price shock

World War II
Turkish Real GDP per capita
(year 2005 prices/dollars)
$9,000 2008 US
Mortgage
$8,000 Crises
$7,000 1994 Turkish
Currency Crises
$6,000

$5,000

$4,000 2001 Turkish

Banking
$3,000 Crises

$2,000
1960

1970

1980

1990

2000

2010
U.S. Inflation Rate
(% per year)

Money
printing for
oil price
financing
shocks
WWI
Digression- The Great Moderation
Turkish Inflation Rate Great
unstability
(% per year)
in Turkish
120%
economy
100%
oil price
shocks
80%

60%

40%

20%

0%
1960

1970

1980

1990

2000

2010
U.S. Unemployment Rate
(% of labor force)
Turkish Unemployment Rate
(% of labor force)
15%

14%

13%

12%

11%

10%

9%

8%

7%

6%
1960

1970

1980

1990

2000

2010
 Why learn macroeconomics?
1. The macroeconomy affects society’s well-being.
U.S.
U.S. Unemployment
Unemployment and
and

crimes per 100,000 population

Property
Property Crime
Crime Rates
Rates
Property crimes
percent of labor force

(right scale)

Unemployment
(left scale)
 Why learn macroeconomics?
2. The macroeconomy affects your well-being.
5 In most years, wage growth falls 5
when unemployment is rising.

percent change from 12 mos earlier

4
3
change from 12 mos earlier

3
1
2

1 -1

0
-3
-1
-5
-2

-3 -7
1965 1970 1975 1980 1985 1990 1995 2000 2005
unemployment rate inflation-adjusted mean wage (right scale)
Why learn macroeconomics?
3. The macroeconomy affects political & demographical
outcomes outcomes.
Unemployment & Inflation in Election years in the US

Year Unemployment rate Inflation rate Election Outcome

1976 7.7% 5.8% Carter (D/Chal.)
1980 7.1% 13.5% Reagan (R/Chal.)
1984 7.5% 4.3% Reagan (R/Inc.)
1988 5.5% 4.1% Bush I (R/Inc.)
1992 7.5% 3.0% Clinton (D/Chal.)
1996 5.4% 3.3% Clinton (D/Inc.)
2000 4.0% 3.4% Bush II (R/Chal.)
2004 5.5% 3.3% Bush II (R/Inc.)
2008 7.2% 3.8% Obama (D/Chal.)
2012 7.7% 2.0% Obama (D/ Inc.)

Turkey more ‘crisis’-driven:

• 1994 Currency Crisis  Refah Partisi got the highest vote share in the 1995 elections
• 2001 Banking Crisis  AK Parti came in power in 2002
Correlation ≠ Causation
Corr(Drowning, Icecream Cons.)>0
Does drowning induce more ice cream consumption??
 Summer heat  More Swimming  More Drowning
 Summer heat  More Need to Cool Down  More Ice cream Cons.

Corr(Life Expectancy, Average Temperature)>0

Does increasing world temperature induce longer lives??
 Higher technology, income and better health resources Longer Life
Expectancy
 More Energy Consumption and CO2 emission Global Warming 
Increasing world temperatures
Do Not Assume Causation just by Correlation!
Lecture Notes 13
Correlation ≠ Causation

I repeat: Correlation≠ Causation!

Lecture Notes 14
Economic models
…are simplified versions of a more complex reality
 irrelevant details are stripped away
…are used to
 show relationships between variables
 explain the economy’s behavior
 devise policies to improve economic performance

Lecture Notes 15
How Economic Models Work

Assumptions

Lecture Notes 16
Example of a model:
Supply & demand for new cars
 shows how various events affect price and quantity of
cars
 assumes the market is competitive: each buyer and
seller is too small to affect the market price
Variables
Qd = quantity of cars that buyers demand
Qs = quantity that producers supply
P = price of new cars
Y = aggregate income
Ps = price of steel (an input)
Lecture Notes 17
The demand for cars
demand equation: Q d = D (P,Y )
 shows that the quantity of cars consumers demand is
related to the price of cars and aggregate income

Lecture Notes 18
Digression: functional notation

 General functional notation

shows only that the variables are related.
Q d = D (P,Y ) A list of the
variables
 A specific functional form shows
that affect Q d
the precise quantitative relationship.
 Example:
D (P,Y ) = 60 – 10P + 2Y

Lecture Notes 19
The market for cars: Demand

demand equation: P
Price
Q = D (P,Y )
d
of cars

The demand curve

shows the relationship
between quantity D
demanded and price, Q
other things equal. Quantity
of cars

Lecture Notes 20
The market for cars: Supply

supply equation: P
Price
Q = S (P,PS )
s
of cars S

The supply curve shows

the relationship between
quantity supplied and D
price, other things equal. Q
Quantity
of cars

Lecture Notes 21
The market for cars: Equilibrium

P
Price
of cars S

equilibrium
price
D
Q
Quantity
of cars
equilibrium
quantity
Lecture Notes 22
The effects of an increase in income
demand equation:
P
Q d = D (P,Y ) Price
of cars S

An increase in income
increases the quantity P2
of cars consumers demand P1
at each price… D2
D1
Q
…which increases the Q1 Q2
Quantity
equilibrium price and of cars
quantity.

Lecture Notes 23
The effects of a steel price increase
supply equation:
P S2
Q = S (P,PS )
s
Price
of cars S1

An increase in Ps reduces
the quantity of cars P2
producers supply at each P1
price…
D

…which increases the Q

Q2 Q1
market price and Quantity
of cars
reduces the quantity.

Lecture Notes 24
Endogenous vs. exogenous variables

 The values of endogenous variables

are determined in the model.
 The values of exogenous variables
are determined outside the model:
the model takes their values & behavior
as given.
 In the model of supply & demand for cars,
endogenous: P, Qd, Qs
exogenous: Y, Ps
Lecture Notes 25
The use of multiple models
 No single model can address all the issues we care
about.
 E.g., our supply-demand model of the car market…
 can tell us how a fall in aggregate income affects
price & quantity of cars.
 cannot tell us why aggregate income falls or steel
prices increase.

Lecture Notes 26
The use of multiple models
 So we will learn different models for studying
different issues (e.g., unemployment, inflation, long-
run growth).
 For each new model, you should keep track of
 its assumptions
 which variables are endogenous,
which are exogenous
 the questions it can help us understand,
those it cannot

Lecture Notes 27
Prices: flexible vs. sticky

 Market clearing: An assumption that prices are

flexible, adjust to equate supply and demand.
 In the short run, many prices are sticky –
adjust sluggishly in response to changes in supply or
demand. For example:
 many labor contracts fix the nominal wage
for a year or longer
 many magazine publishers change prices
only once every 3-4 years

Lecture Notes 28
Prices: flexible vs. sticky

 The economy’s behavior depends partly on whether

prices are sticky or flexible:
 If prices sticky (short run),
demand may not equal supply, which explains:
 unemployment (excess supply of labor)
 why firms cannot always sell all the goods
they produce
 If prices flexible (long run), markets clear and
economy behaves very differently

Lecture Notes 29
Outline
 Introductory material (Chaps. 1 & 2)
 Classical Theory (Chaps. 3-7)
How the economy works in the long run, when prices
are flexible
 Growth Theory (Chaps. 8-9)
The standard of living and its growth rate over the very
long run
 Business Cycle Theory (Chaps. 10-14)
How the economy works in the short run, when prices
are sticky
Lecture Notes 30