Introduction to Macroeconomics
Introduction to Macroeconomics
What is Macroeconomics
Macroeconomics examines economies
at the aggregate (international, national,
Some aspects of macroeconomics are
about comparing two aggregate
economies at the same time.
Why study the economy at the
Much of macroeconomics is concerned with
policies such as money supply or tax policy
which is national in scope.
Equilibrium effects means that outcomes are
different when we consider the economy in
There are certain phenomenon like economic
growth and business cycles which affect the
aggregate economy equally.
We can consider interesting dynamic
Amateur History of
Around 1930, a major worldwide
contraction occurred in virtually every
developed economy. For example,
output in the USA fell by more than 20%
and unemployment rose to 25%.
Decline in output continued for the better
part of a decade.
US Great Depression
USA GDP (1992 Prices)
UK economist Lord Keynes developed a
theory in which prices failed to adjust quickly
so that a fall in corporate investment or a rise
in savings leads to a decline in output.
Hicks developed IS-LM model, a mathematical
version of Keynes thinking which is still the
baseline framework for thinking about
For 20-30 years, most macro was about
measuring the gap between demand and
potential output and stimulating demand
sufficiently to reach potential.
Much of Macroeconomics is about comparing
one economy at different points in time.
Two phenomenon can be observed in
single data series.
First, economy is growing with a secular
trend over time.
Second, economy is growing unevenly
Japan Post-war GDP
Trend and Cycle
During the 1950’s, macro conceptually
split changes in output into two parts:
Long-term growth which would be studied in
models in which prices adjust perfectly to
Business Cycles which would be studied in
models in which they would not. Advances
in computation and statistics meant that
large models could be constructed meant to
represent large economies.
Golden Era of Growth
Internationally, 1950’s and 1960’s were a
period when output growth was at a
faster pace than before the war.
Also a period in which there was
relatively little international trade in
goods and capital compared to pre-WWI
Fixed exchange rates under Bretton
Growing prominence of optimization
theory and marginal analysis in
microeconomics led to incorporation into
Optimal models of saving, investment
and demand for liquidity were used to
describe a medium term equilibrium
around which the economy would
fluctuate in the short-run.
Simple principal of optimization of
smooth functions is the first derivative of
function should equal zero at extremum.
Economists consider the costs C and
benefits B of some activity A. Net benefit
of activity is B(A)-C(A).
Optimal level of A is B’(A*) = C ’(A*) , i.e.
where the marginal benefit equals the
Models by “Term”
Long-term: Take prices as flexible and
solve for potential level of output.
Medium Term: Take output as given and
solve for optimal decisions of agents.
Short-term: Take dollar prices or wages
as given solve for output.
In 1960’s, monetarists led by Milton Friedman
began to emphasize the role of the money
supply (as opposed to real demand factors) as
determinants of fluctuations in output and
In particular, Friedman pointed out the way
that demand stimulus, once it becomes
expected may lose its effectiveness.
Inflation and Deflation in China
CN: Consumer Price Index: PY=100
PY = 100
During 1970’s, oil price shocks led to
rapid price rises and low production
levels called stagflation.
In many country’s, inflationary
expectations led to wage-price spirals
and historically high inflation rates.
Developed economies begin 20 year
slowdown in productivity growth rates.
In early 1970’s, US abandons Bretton Woods,
and exchange rates start to float. After a few
years of relative stability, exchange rates
become one of the most volatile variables.
International trade increases.
Oil price rises damaging to developing
countries, a problem partly solved when OPEC
oil revenues are recycled as loans to 3rd World.
Volatile Exchange Rate
JP: FOREX: Inter-Bank: Spot Rate
Lucas develops economic theories which
rigorously incorporate the formation of
expectations of future in economic models.
Rational expectations models offer theoretical
challenges but also explanations for rise of
inflationary spirals and seeming
ineffectiveness of monetary policy.
Expectations based models also offer
explanation for volatility of exchange rates.
Real Business Cycles
Kydland and Prescott develop real
business cycle models which unify longrun, medium run, and short-run into
single coherent model.
One shortcoming of these models is that
money plays no role in short-run.
RBC models are small and do not
capture short-run dynamics well.
U.S. central bank cuts the money supply to
counter-act inflation. Deep recession in USA
Latin American countries default on their debts
leading to persistent financial crisis.
Most developing economies begin long period
of stagnation and even shrinking income levels.
Only East Asia continues to grow. China
reforms agricultural system and India institutes
structural reforms that spark growth.
New Keynesian Models
Using rigorous models of monopoly, a number
of economists develop rigorous models in
which prices are sticky because of adjustment
Unlike RBC models, these models can explain
why monetary policy has significant effects on
These models are typically static and cannot
explain dynamics or long-run at all.
Productivity slowdown generates interest
in models which can explain which
policies are likely to lead to fastest or
most welfare enhancing growth levels.
Two competing schools. “Brains” school
emphasizes role of education and
human capital. “Ideas” school
emphasizes R & D and invention of new
goods and technologies.
Globalization: Big expansion in international
trade, internatioal lending and direct investment.
Productivity Takeoff: After 20 years of slow
growth, in 1995 productivity growth takes off
Financial crisis in a number of developing
economies in Latin American and East Asia.
Rise of Unemployment in Europe, Inequality in
USA, Economic Stagnation in Japan
Central Banks Choose Monetary Policies meant
to lead to steady inflation: Inflation Targeting.
Structural Unemployment in HK
HK: Unemployment Rate
New Neo-classical Synthesis
Economists begin to incorporate New
Keynesian models of price stickiness into
unified RBC framework.
These models explain which type of policies can
offset effects of price-stickiness which might lead to
underemployment without leading to wage-price
Economists also incorporate models of
financial market imperfections into unified
framework to explain financial crises in
Divide subjects into 3 categories: long,
medium and short-term.
Examine dynamics of productivity, inflation,
unemployment in the long-run.
Examine savings and investment decisions
using dynamic marginal analysis and
implications for fiscal policy and trade deficits
in medium run.
Examine business cycles in the short-run.
Develop rigorous models of macroeconomic
issues at each level of analysis (but not
necessarily develop unified models as we
would do at the Ph.D. level).
Emphasize some empirical uses that we can
put to these theories.
Most applications were developed to explain
economic phenomenon in USA and EU, but
we will have bias when possible to focus on
3 exams associated with theories of
various terms. Final may/may not be
3 problem sets for test preparation.
Some empirical exercises to be graded
What are the students expected to
Mathematically, students should be able
to understand first derivatives (partial
and time included).
Understand statistical concepts like
expected value, variance, covariance &
Very basic understanding of national
accounts (i.e. what is output,
consumption, investment etc.)