Lecture Notes

Potential GDP and Output Gaps

  • Potential GDP, viewed as the trend rate of growth, affects policy decisions. Growth above potential indicates a positive output gap, while growth below indicates a negative output gap. Post-COVID, potential GDP growth seems slower due to hysteresis.

Impact on Policy

  • A negative output gap suggests room for economic expansion, while being at potential implies that expansion could be inflationary.

Growth Calculations and Cross-Country Comparisons

  • Growth rates are reflected in slopes on a log real GDP per capita scale; doubling of the economy can be observed when moving from eight to ten.

Business Cycle Data

  • US growth data shows collapses and output gaps. The economy has faced crises like the global financial crisis, sovereign debt crisis, and the COVID-19 pandemic.

Output Around the Peak

  • Output declines post-peak for about four to five quarters, with roughly a 2% GDP decline, and recovers in eight to nine quarters.

Unemployment and Price Inflation

  • Unemployment increases sharply after the peak and remains high.

Importance of Data

  • Models must align with recession data, reflecting variable behaviors and relationships over time.

Financial Cycle

  • Financial cycles involve asset prices and credit, with larger swings than GDP. Expectations of higher asset prices lead to more borrowing.

Okun's Law

  • Okun's Law: Output above trend means unemployment is below trend, described by the equation: Unemployment Gap=α−β(Output Gap)\text{Unemployment Gap} = \alpha - \beta(\text{Output Gap})

Global Financial Crisis

  • The perception of output gaps is impacted by how potential is specified. COVID-19 created an even bigger output gap affecting policy decisions.

Cyclical Variables

  • Procyclical variables rise with high growth (e.g., consumption), countercyclical variables decline (e.g., government spending), and acyclical variables show no strong relationship with output.

Consumption and Real GDP

  • Real GDP and real personal consumption expenditure are closely aligned, with consumption being slightly less volatile than output.

Government Spending

  • An increase in real GDP leads to a fall in government consumption expenditures due to automatic stabilizers.

Causality

  • Timing (leading, lagging, coincident variables) can indicate causality. Leading variables move before GDP, while lagging variables peak after output peaks.

Consumption and Investment

  • Investment is highly procyclical and more volatile than output and consumption.

XY Scatter Graphs

  • XY scatter graphs show the marginally negative relationship between government spending and output and a strong positive relationship between investment and output.

Data Figures

  • Data supports observations: a 1% change in output leads to predictable changes in consumption, investment and government spending, based on the equation: σ<em>y=βσ</em>x\sigma<em>y = \beta \sigma</em>x

Macroeconomic Models

  • Exogenous variables are fed into models, and endogenous variables are explained. Dynamic models, featuring time, are more useful.

Real Exchange Rate

  • The real exchange rate is the ratio of domestic to foreign goods prices in the same currency, affecting purchasing power.

Exchange Rate Basics

  • An appreciation means £1 buys more dollars, dollars are most commonly used to price currencies.

Real Exchange Rate

  • The real exchange rate (sigma) is the ratio of domestic to foreign goods prices in the same currency, described as: sigma=SPP<em>\text{sigma} = \frac{SP}{P<em>}, where S=Nominal Exchange RateS = \text{Nominal Exchange Rate}, P=Price levels of Domestic GoodsP = \text{Price levels of Domestic Goods}, and P</em>=Price levels of Foreign GoodsP</em> = \text{Price levels of Foreign Goods}.

  • Sigma varies if P or S varies. Short-run data shows a relationship between nominal and real exchange rates.

Conventions of the External and Internal Terms Of Trade

  • External terms: P is the price of export goods, and P star is the price of import goods. Internal terms: P is the price of non-traded goods, and P star is the price of traded goods.

Effects of Exchange Rate Changes

  • An appreciation increases the price of domestic goods relative to foreign goods, decreasing net exports. A depreciation increases net exports.

Balance of Payments

  • When the real exchange rate falls, net exports improve, and vice versa. The UK has a service-heavy economy and structural deficits.

Two-Period Model

  • Any deficit in period one must be offset by a surplus in period two.

US Deficits

  • The US has large persistent deficits, with foreign holdings of US assets greater than US holdings of foreign assets.

Purchasing Power Parity (PPP)

  • Absolute PPP: domestic and foreign goods prices equalize in the long run. Relative PPP: Changes in exchange rates reflect changes in domestic and foreign prices. The solvency condition dictates that a country must regain its competitiveness over its lifespan, described by: ΔS=ΔP∗−ΔP\Delta S = \Delta P* - \Delta P. If prices in the domestic economy are increasing, then everything else being equal, we must see a decline in the nominal exchange rate domestically to keep us competitive.