Transcript Chapter 1 Motivation for Macroeconomic models? Macroeconomic Theory

Macroeconomic Theory
Chapter 1
Motivation for Macroeconomic
models?
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University






Macroeconomic models help us in framing key questions
that face macroeconomists:
How are the levels of output and employment are
determined and why they fluctuate?
Why does inflation occur and when should we worry about
it?
How does government policy affect inflation and
unemployment?
Why unemployment is high for lengthy periods in some
countries than others?
How do trade, international financial markets and exchange
rates affect employment and inflation?
Why are some countries rich and others are poor?
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Output, unemployment and inflation
The 3 equation model
 IS curve “aggregate demand”
 PC curve “supply side of the economy”
 MR “the behavior of inflation targeting central bank
What do we mean by impact on the economy?
 We mean impact on output, unemployment and inflation.
The basic model must answer the following questions:
 how actual output and employment is determined
 What determines employment at which inflation is stable
(medium run eq. level of employment
 How the economy adjusts from current position to medium
run eq. and what factors influence the speed and
smoothens of adjustment.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Assumptions and terminology
 A special feature of macroeconomics is that the behavior
of different agents has to be taken into account
simultaneously:
 Actions of households (to enter the labor force, to spend,
to save ..etc)
 Actions of firms (set wages, invest .. etc)
 Actions will be sensitive to government actions (T, G,
interest policy), current economic variables and
expectations of these variables such as tax, wages…etc.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Aggregate supply side:
refers to the supply of goods and services. The supply side
consists of:
 Factors of production
 Technology
 The way which incomes (workers and firms) are
determined
 Aggregate demand side
Refers to aggregate demand for goods and services and
consists of:
 C, I, and G
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 C is the expenditure of individuals on goods and services
(durable or non-durables)
 I expenditures of capital goods mostly by firms. New
housing and spending by the government on machinery
are also I.
 G on salaries, purchase of goods and services.
 Short run (months)
 A period during which aggregate demand, output and
employment can change but before prices and wages
respond to the change in output and employment
(assuming they are given), i.e., they are fixed or sticky or
rigid.
 Assuming that wages and prices are given can also refer to
the case when they change by a constant amount.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Therefore in the short run, wages and prices or their rate of
change do not respond to changes in the level of output, it
also means that it is aggregate demand that determines the
level of output and employment.
 Medium run
 The period during which wages and prices can respond to
changes in output and employment. The supply side of the
economy adjusts to establish a medium run equilibrium in
which inflation is constant.
 Capital stock (and technology) and the labor force
(population and migration, i.e., the supply side of the labor
market) are also constant.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The attention is focused on the behavior of wages and
price setters. No upward or downward pressure on wages
or prices.
 Long run: investigates the consequences of changes in
technology such as productivity growth. The growth
theory. Here we allow for population, physical capital and
technology to change.
 Market imperfections (market power, lack of complete
information.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fluctuations in output and employment
 See fig. 1.1. (compare between US and France) swings
from peak to trough is called business cycle.
 In the short run, the level of output depends on aggregate
demand.
 Fig. 1.2 shows unemployment in US and Europe
 The IS/LM model will help us to understand the factors that
influence AD.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 1.1
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 1.2
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Unemployment: International Comparisons
 Fig. 1.3 shows trends of unemployment in 7 countries.
 There is a rising rate in Europe between 1970s-1990s.
 There is a striking difference between US and European





economies
The idea of a roughly constant equilibrium unemployment
rate is plausible for US (6%) and Japan.
Till 1980s the European unemployment was lower than US.
There is a significant variability in unemp. rates.
Swedish unemployment rate is different.
Japan’s rate was very low till early 1990s.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 1.3
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Unemployment and recessions (June)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
US Unemployment rate Aug 2101
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
US Unemployment rate Aug 2101
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
US Unemployment rate Aug 2101
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Unemployment in Europe
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Unemployment in Europe
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Modeling medium run unemployment
 In the competitive model, labor market clears, i.e. real wage




adjusts so that the demand for labor equals its supply, and
firms are in equilibrium.
On the demand side, it is not profitable to employ more or
less labor.
On the supply side there will be no more supply of labor or
less supply.
The only kind of unemp in the competitive market is
voluntary unemp workers choose not to work because they
derive more utility from being unemployed, i.e., they prefer
leisure.
The rate of unemp that corresponds to the market clearing
level is the competitive equilibrium rate of unemp.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Imperfect Competition Model
 In an imperfect competition model the equilibrium labor market





does not necessarily coincide with market clearance. There can
be involuntary unemployment even at equilibrium.
In an imperfect competition model we can talk of wage setters
(employees or unions) and price setters (firms).
Firms can earn supernormal profit. The price set by the firm is
above MC and the difference is the profit the firm makes.
With imperfect competition money wages will be set by
employers or unions or by both
The real wage will depend both on the outcome of wage setting
and the price setting across the country, and will be higher than
perfect competition level. One explanation is the collective
bargaining power of employees will result in a wage that is
higher than the minimum an employee would work for.
The imperfectly competitive eq unemp rate is the level at which
both wage and price setters accept the prevailing real wage.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Inflation
 In an economy with constant inflation, it will be in a medium run





equilibrium, eq rate of unemployment “ERU”.
If AD rises output and employment will rise, unemp will be below
ERU.
Workers will be in a stronger bargaining position and real wages
have to rise. Current real wage is lower than what wage setters
will be satisfied with. Wage setters raise money wages
Price setters will not be satisfied as this will raise their costs. To
maintain their profits they will have to raise their prices.
AD that raises output and employment above eq leads to a rise
in inflation.
Can lower unemp and higher inflation be sustained by the
government setting its policy to achieve this. This will depend
on whether the labor market is competitive. In a competitive
labor market if employment is higher than the level at which
labor supply and demand are equal, the wage rate will either be
too low from the labor supply side or too high for firms.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 When unemp. is below ERU and inflation is up. Wage and
price setters are not in eq, wage setters would raise wages
as their living standards reduced. Raising money wages
will raise inflation even further.
 Look at fig. 1.4. In USA inflation is smooth in the post
1950s.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Inflation and Monetary Policy
 Monetary policy in some countries was directed at
reducing unemp, in other countries to an inflation target.
 Suppose that the CB policy is to set interest rates so as to
steer the economy to a low target rate of inflation. In
response to inflation it would put up interest rate, which ↓
AD as I(investment) ↓ due to higher interest rate, this in
turn ↓ emp and inflationary pressures.
 Fig 1.5 provides a schematic overview of the short and
medium run macro model.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 1.5
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Economic Growth
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Growth and diminishing returns to factor accumulation
 What determines the output per worker. In the short and
medium run it is assumed that the amount of capital
available to worker is fixed. In the long run the level of
output per worker depends on capital available. Human
capital should also be included (through education,
training ..etc.). Technology and efficiency matter as well.
 The neoclassical theory of economic growth was
developed by Solow and Swan, it focused on systematizing
the role of factor accumulation in growth. The essence of
the Solow/Swan model is that the level of output per head
would be higher if there was a higher level of capital per
worker.
 The model predicts that more investment would only raise
the growth rate of living standards temporarily, because it
assumes that there are diminishing returns to physical
investment.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 With more investments capital intensive techniques will be
adopted, output per worker ↑ but with each increase in
capital intensity, the bonus in terms of higher output per
worker diminishes, because part of the capital stock
disappears through depreciation and feeble improvements
in output will not generate sufficient extra savings to raise
capital intensity.
 Note the following:
 The model can be amended by including a particular kind
of technical progress: if technology is improving year on
year without using up any resources, we can say that there
is exogenous technical progress. In this case output per
head rises at this constant exogenous rate.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 When investment ↑ there is a period during which output





per head rises faster than the rate of exogenous technical
progress because of increases in capital intensity.
Eventually the economy will return to the original rate of
growth, with a higher living standards than what would
have been the case in the absence of the shift in higher
investment.
The model helps explain why should be a positive
relationship between output per head and capital per head.
But it does not predict correctly by how much a rise in
capital per head will raise output per head.
This question focuses attention on
The need to include human as physical capital as a factor
of production in the growth model.
Whether all countries have access to the same technology
Whether even if they do, the technology can be used
efficiently
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Growth and constant returns to factor accumulation
 Dissatisfaction with the role of exogenous technical
progress in the Solow/Swan model motivated the
endogenous growth theory.
 Drop the assumption of diminishing returns to the
accumulation of capital and replace it with an assumption
of constant returns.
 If the economy devotes higher investment this raises the
growth rate of the output per head permanently. This
transforms the process of growth into endogenous growth.
 Why returns to factor accumulation may not diminish? One
idea focuses on human capital, spending more time in
education can raise the growth rate permanently, as well as
higher investment in innovative activities.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Innovation and incentives: Schumpeterian growth
 Schumpeter argued that innovations could sustain long-
run growth and that institutions are important for creating
the appropriate incentives for firms to engage in innovative
activities.
 Ideas are a different form fixed capital: once an idea has
been developed, use of it by one does not prevent others
from using it too, as ideas are “not rival”. In the
Schumpeterian model, countries can be trapped with low
levels of GDP per capita because the institutional
structures are not conductive to taking advantage of
spillovers in innovation from rich countries.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 1.4
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University