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Macroeconomics
The study of the structure and performance of the aggregate economy
Economics
How to evaluate things in economics mainly based on limited or scarce resources, consider what is best, efficient, fair, and rare.
Scarcity
we don’t have unlimited supply
Choice
we decide how to allocate scare resources
Opportunity Cost
of the next best alternative (if OP cost of A if high, we may want to choose B)
Policies
Aim to incentivize “optimal” behaviour/choice for “best” outcomes
Capitalism
The ownership is in the hands of the private individuals or entities, who control the means of production, distribution, and exchange of goods and services
Command
Government owns the capital (natural resources)
Positive Analysis
What are the effects of the policy (doesn’t have to be factually accurate)
Making predictions
Normative Analysis
Should a policy be implemented? -> “TO”
Value judgements
Theoretical Models
Use equations to represent production, behavior, accounting rules, and constraints.
Graphs to visualize economic relationships (e.g., supply and demand).
Formalize processes like how resources are allocated or how markets function.
Empirical Tools
Use data to build models and estimate effects in the real economy.
Measure magnitudes, such as the impact of policies on output or employment.
Calibration: Borrow estimates (e.g., labor supply elasticity) from other studies and plug them into models to make predictions.
System of National Accounts (SNA)
Used to compile accurate and systematic measures of aggregate economic activity of nation or jurisdictional area
Sets up standardized measurement of macroeconomic variables based on a set of accounting principals.
One of the common macroeconomic measures generated using the System of National Accounts is GDP.
GDP (Gross Domestic Product)
The market values of all final goods and services produced in an economy during a fixed period of time
GDP measures "value"
Market Value
The value of good(s) at market prices
Price that you see in stores
Measure GDP #1: The Product Approach
Sum all final goods and services produced in the economy at their market value.
Note: final output excludes intermediate production to avoid double counting
Intermediate goods and services
Those used up in the production of final goods and services within a fixed period of time
E.x, flour, steel, gold
Value added (of a producer)
The value of it's output minus the value of it's inputs purchased from other producers
E.x, Raw products,
Measure GDP #2: The Expenditure Approach
Sum all final goods and services purchased in the economy
Pizza example:
GDP=total spending=1pizza=$25
Income Expenditure Identity
GDP = C + I + G + NX
C= Consumption
I= Investment
G= Government Expenditures
NX= Net Exports
Measure GDP #3: Income Expenditure Identity
Sum all income received by workers, the government and
firms (wages, taxes, and profits)
Fundamental Identity of National Income Accounting
Total Production = Total Expenditure = Total Income
No matter which approach we use, product, income or expenditure, we have the same GDP.
Issues of Measurement: GDP
Questions you might ask:
is GDP comparable across countries?
does it measure progress accurately?
what about costs of resources?
what about costs of pollution (dirty air, water, etc.)?
do these GDP measures adequately capture quality or value?
what about happiness?
should GDP include home production?
what about unpaid child care?
GNP (Gross National Product)
The total market value of production by all of the national factors of production
GNP: All national (Canadian) workers that are working in other countries
GDP: Production that occurs only in Canada (includes by non-Canadian labour)
What’s produced in Canada vs. what Canadians produce outside
NFP (Net Factor Payments)
Income earned abroad by Canadian factors minus income earned in Canada by foreign factors
GNP = GDP + NFP
Savings Identities & Formulas
Saving = current income - current spending
Change over a period of time
Yd = private disposable income
= the income that households have to spend
= income received from all sources, less taxes
= GDP + NFP + TR + INT – T
where INT is interest on government debt, TR is net transfers, and T is Tax
y = GDP
Yd = Y + NFP + TR + INT – T
Private Saving
Spvt = private disposable income – consumption
Spvt = Yd – C
= (Y + NFP + TR + INT – T) – C
Government Saving
Sgovt = net gov't income – gov't purchases
Sgovt = (T – TR – INT) – G
if Sgovt<0 then gov't has a budget deficit
National Saving
S = Spvt + Sgovt
= (Y + NFP – T + TR + INT – C) + (T – TR – INT – G)
S = Y + NFP – C – G
National Saving = total income – total spending of economy
Recall that Y = GDP = C + I + G + NX, so...
S = Y + NFP – C – G
S = (C + I + G + NX) + NFP – C – G
S = I + NX + NFP
International Components in Savings
CA (Current Account): payments received from abroad less payments made to foreign countries by the domestic economy
CA = NX + NFP
so
S = I + CA
Private Saving Formula
Spvt = I + (- Sgovt) + CA
Saving Vs Wealth (Measurement Type)
Stock Variable: calculated at point in time
Flow Variable: calculated over (within) a period of time
Wealth
The difference between an agent's assets & liabilities
National Wealth
= total wealth of all residents of a country
= domestic physical assets + net foreign assets
net foreign assets
= foreign financial & physical assets – foreign liabilities
Nominal Variable
A variable measured in terms of current market values
Real Variable
A variable measured in terms of a base unit
Accounting for Inflation
Inflation rate: percentage increase in the price level over a specific period of time
π is the inflation rate
Pt+1 is the price level in period t+1 and
Pt is the price level in period t
How is inflation measured?
Price index: measure of the average level of prices for some specified set of goods and services relative to the prices in a specified base year
How prices change over time in a spefic region
Three Commonly Used Indices:
1. GDP deflator: price index that measures the overall level of prices of goods & services included in GDP.
GDP deflator = nominal GDP/ real GDP
Three Commonly Used Indices:
2. CPI (Consumer Price Index): measures changes in prices of subset of consumer goods, a fixed "basket" of goods, relative to a base reference period
Three Commonly Used Indices:
3. Chain Fisher Volume Index: a combination index which changes the base price and chains across time.
The chained fisher volume index (for a difference of more than1 year) is determined
by multiplying subsequent indexes.
Ex/ for year 3 it is: (year 1 to 2)×(year 2 to 3).
These indexes give the real growth of GDP between the periods indicated, and as
such Real GDP in subsequent periods should be calculated by multiplying the chain
Fisher index by the initial (base) year GDP (previous periods are the product of the
base year GDP and the inverse of the chain fisher index).
Issues with Consumer Price Indexes & “real” GDP
1. Basket becomes outdated
2. Goods may have not existed then & do now
3. Historical measures of real GDP often have to be
recalculated for any comparison
Interest Rates
Interest rate: rate of return promised by a borrower to a lender
Nominal interest rate (i): the rate which is agreed upon between the borrower & lender
Real interest rate (r): the rate at which the real value of the asset (loan value) increases over time
Nominal and Real interest rates Formula
When nominal interest rates and inflation are typically low,
real interest rates can be approximated by
r ≈ i – π
If we are in a period of high inflation and low constant interest rates, is it better to borrow or to lend?
Since we typically don’t know what inflation will be until the next period is realized, we need to use expected values
The expected real interest rate is approximated by the nominal interest rate minus expected rate of inflation
i – π^e
Graphing
Carrot Demand: Demand decreases as price rises; downward-sloping line.
Pets & Income (Linear): Pets increase steadily with income; more kids raise the intercept.
Pets & Income (Non-linear): Pets rise with income but slow at higher incomes.
Graphing Pet example
Pets = a + b*Kids + c*ln(Income)
Data Types
Cross Section: multiple entities at one point in time
Time Series: one entity across multiple periods of time
Panel: multiple entities across multiple points of time
Pooled Cross Section: (multiple entities at one point in time, pooled with another set of entities at a different point in time
Theoretical vs Empirical
Theoretical Analysis (Theory)
Formalizes economic theories with mathematical expressions.
Focuses on behavior, constraints, and institutional rules.
Produces testable predictions through solutions to equations.
Goal: Use logic to predict how the economy should behave.
Empirical Analysis (Data)
Uses data, statistics, and mathematics to test hypotheses.
Estimates the magnitude of relationships suggested by theory.
Focuses on observing real-world patterns and verifying predictions.
Model Classifications
Treatment of Information
e.g. full information vs missing or asymmetric information
Time Dimension
e.g. static vs dynamic
Treatment of State Dependency
e.g. deterministic vs stochastic
Type of Agent(s)
e.g. representative agent vs more than one type of agent
Scope
e.g. Partial vs General Equilibrium
Market Functionality
e.g. Market clearing vs non-clearing models
Which class of models would be more appropriate to study business cycle or recession duration, Static or Dynamic?
Modern macroeconomic models are often dynamic, incorporating stochastic and general equilibrium frameworks, while some non-equilibrium models like search & matching are also widely used.
The IS-LM model, though previously popular for teaching, is criticized for lacking dynamic features and realistic market treatments
Model Elements
Variable (take on different values and they vary)
refers to an item (e.g. price, interest rates,
consumption, investment, GDP) that can take on different
possible values
Variables represent both the inputs to models, and the outputs
from models
Error terms (u)
Endogenous: determined within the model (most variables)
Exogenous: determined outside of the model (right-hand side)
e.x, Wheat→ the output is exogenous
What goes into the making of wheat (labour, sun, soil, etc.) → endogenous
Parameters: Lower Case
characterize the strength and direction of relationships between variables. (the a, b, g’s and α, β, ɣ’s)
In theoretical analysis, parameters are sometimes calibrated, but they can also be estimated, as they are in empirical analysis
Estimation is conducted by applying the model to data, to determine (and test) the predicted relationship between variables
Building Macroeconomic models
Incorporating several components of the economy (relationship between variables of interest)
Components of economic models are often framed in relation to markets (e.g., labour, goods, financial, etc.), market participants (e.g., buyers, sellers, regulators), & or outcomes (e.g., prices, quantities, aggregates, and distributions)
Production
processes or production functions are a key component that helps us understand firms’ supply decision (how much they wish to sell in the goods market), but also firms’ demand for inputs (e.g. labour and capital) in their respective markets
Factors of production: inputs such as capital, labour, raw materials, land and energy utilized by the producers in the economy
Aggregate Production Function (Basic Example)
Y = A x F(K,N)
Y=real output produced
A=a multiplicative productivity effect
K=quantity of capital used
N=the number of workers employed
F=a function specifying how much output is
derived from given quantities of input K & N
Non-linear due to dimishing returns (more production results in smaller increases in outputs)
Never slope down
Firms objective: Profit Maximization
Major factor in firm decsians making to determine quanities of input and output
Profit maxing quantities of N & K determined by:
*Marginal Product of Labour (MPN)
= the increase in output resulting from a one unit increase in labour
= ∆Y/∆N
*Marginal Product of Capital (MPK)
= the increase in output resulting from a one unit increase in capital
= ∆Y/∆K
*Relative Prices
TFP – Total Factor Productivity
A = Measuring Productitivty
A is generally calculated using the “known” factors of Y and F(K,N)
if Y=A×F(K,N) then A = Y / F ( K , N )
The level of A is important in firms’ decision making, and factor markets, because it influences MPK and MPN
Labour Demand
* To determine how many workers to hire, firms need to compare the costs and benefits of hiring an additional worker
What are the benefits of hiring on more worker?
MPN x P = MRPN
MRPN is Marginal Revenue Product of Labour
What is the cost of hiring an added worker?
nominal wage: the wage that is paid to worker
Hiring Rule (Profit Maximizing Decision)
firm will continue to hire so long as MRPN ≥ W Firms maximize profits by hiring until
MRPN = W
How do we know this maximizes profits?
Profits = revenue – costs = P x Q – N x W
Q is quantity produced by the production process, e.g., A*F(K,N)
W=Marginal Cost
MRPN is Marginal Benefit
Profit maximization occurs where MB=MC
Hiring rule in real terms
MPN = w
w = W/P = real wage
real wage: nominal wage divided by price level
Economic models often discuss outcomes in real terms
Labour demand can be written as function of real wages in a
complex or simple way, e.g.
N^D=f(w) where f'(w)<0
Labour Demand Curve
Labour demand curve: the amount of workers a firm will wish to hire at given wages
Factors that Shift Labour Demand Curve
1. Beneficial productivity shock
2. Higher capital stock
Aggregate Labour Demand: the sum of all labour demands of all firms in the economy
e.g. 100 firms like Sonny’s would mean an aggregate labour demand of ND=500-20w
(or as we graph it w=25-ND/20). Of course, a more complex function would
incorporate more depending on the research question e.g. ND=f(A,K,w
Labour Supply
Labour Supply: labour the worker is willing to supply
Labour Supply Curve
Labour Supply Curve: the labour the worker is willing to supply at given wages
Aggregate Labour Supply: sum of all individual labour supply
Aggregate Labour Supply curve: sum of all labour that workers are willing to supply given at wages
Factors that Shift Labour Supply Curve
1.Wealth: increase in wealth will decrease the labour supply
2.Expected future real wage: increase in E[wf] will decrease the labour supply
3.Population: increase in population will increase labour supply
4.Participation rate: Increase in LFP will boost labour supply
Labour Market Equilibrium
In this simple, market clearing, labour market example, equilibrium occurs when ND=NS
Potential Output
Labour Market Equilibrium and Potential Output What the economy actually produces is typically called output (or national output or national income or actual output), and is denoted by Y
Full Employment Output (or Potential Output): is a measure of what the economy would produce if all resources were fully employed, sometimes denoted by Y* or FE
Full-Employment level of employment: the equilibrium level of employment, N (or N*, or N)
Sticky wage models
Can be graphed similar to our market clearing model, but wages “stick” and do not adjust quickly to clear the market
Institutional Factors: Wage floors and/or negotiated contracts might keep wages above market clearing levels
Search & Matching Framework
Job search: Workers and firms take time to find suitable matches.
Match dynamics: Jobs are temporary; workers or firms may part ways.
Unemployment: Constant due to search time and job turnover.
flows in = flows out
flows in: # of matches M(U,V)
U is the number of unemployed and V is number of vacancies (job postings)
flows out: δE → matches destroyed
E is # employed
M(U,V) = δE
Key Labour Market Terms/Measures
Employed: worked full-time or part-time during past week
Unemployed: without work during past week and actively looked for work during past 4 weeks. Excludes full-time students
Not in the Labour Force: not working during past week, and not looking for work in past 4 weeks
Labour Force (LF) = Employed + Unemployed
Participation Rate = Labour Force/working age population
Unemployment Rate (R4) = Unemployed/Labour Force
Employment Ratio (Rate) = Employed/working age population
Types of Unemployment
1. Frictional: Workers are unemployed briefly when changing jobs
2. Structural: Longer term unemployment which may result from poor
capabilities, or from changes in economy that shift demand from one industry/skill/area to another
3. Cyclical: Occurs as the economy fluctuates around full- employment level
Natural Rate of Unemployment: unemployment due to frictional and structural causes
Issues in Measuring Unemployment
Discouraged workers: people become discouraged by not finding a job and stop searching
Underemployment: people may be able to find part time, but wish to work full time
Long-Term Unemployment: people unable to find jobs for longer periods of time
Measures of Unemployment
R1: Proportion of LF out of work for 1 year or more
R2: Proportion of LF out of work for 3 months or more
R3: Unemployment Rate per U.S. definition
R4: Official Unemployment Rate
R5: Includes discouraged workers
R7: Includes involuntary part-time workers
Factors that can influence changes in unemployment
1. Participation rate changes
2. Structural changes in the economy
3. Policy Changes that influence incentives
4. Hysteresis
*skills and mis-match
*insider/outsider theory