Handout 1

4
We dont explain exogenous variable
We do explain endogenous variables
We want to see how endo. Vars change when we tweak exo vars.
5
Start with individual decision makers (consumers and firms)
Choose our objective
And consider our constraints
This is very much like micro
But then aggregate from individuals to the whole economy (this is the more
difficult part of macro)
We want to understand how we reach a general equilibrium under different
markets where everything is consistent with assumptions, and how things change
with changing exo variables.
Macroeconomics gives a crucial role to what happens over time, peoples
expectations play a crucial role, (the lack of acknowledgement of this was an
empirical downfall of early macroeconomic theory)
Whats the point of having a model? Well in one sense its scientific, we want to
explain phenomena; we might also want to make predictions about the future or
to inform policy, we need a model to understand the counterfactual.
6
The 2 big overarching issues are long run growth and business cycles (economic
fluctuations), both of these are references to GDP.
7
This is a time-series of US real GDP.
Here we see the 2 significant fluctuations, the great depression, and the bounceback in reaction to the war.
8
Its helpful to think of the series in slide 7 with a logarithmic scale, as we see an
exponential pattern to the raw data, so by taking logs we see a more or less
straight plot, with our 2 important deviations.
Taking logs is useful as then we can interpret the gradient of the graph as the
growth rate (you cant do that with raw numbers).
So we see that most of the 20th century US expansion is growing at a fairly
constant rate
9
A mathematical justification for the above, underlined claim in slide 8.
In addition we may want to explicitly take out the trend, that is to show a version
of this graph that includes just the business cycle, so remove anything that we
think of as the trend. Its helpful to keep those long-run and shirt-run issues
separate when thinking about the data.
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In this case you take the difference between the log of the difference of the
actual GDP series and your trend line, this is called the residual. Because it is
the residual of a variable you have taken logs of, it can be interpreted as the
percentage deviation from the trend. That residual we call the business cycle.
12
So you see the order of magnitude of business cycle fluctuations.
A typical business cycle is +/- 5% above and below trend
A big debate in macroeconomics is whether we could od better by having
monetary policy try to smooth out the business cycle.
13
So that was the data on the 2 big issues, growth and business cycles.
Some other key macroeconomic debates we will talk about are illustrated by the
following data.
14
Surprising post-war growth of the state.
What are the consequences of this? In particular to what extent does that extra
govt spending come at the cost of less private spending on consumption and
investment. To what extent is there crowding out? (by saving as a reaction to
anticipated tax rises, and increased govt. borrowing raising the interest rate, on
the other hand will the increasing govt. spending pay for itself by raising
productivity?)
Should the govt. use fiscal policy to try to smooth out the business cycle,
Keynesian vs. Monetarism.
15
US govt. debt is special because historically a lot of US debt is held by US citizens,
so as a country it is not necessarily that the US is indebted, we only have a
liability for the govt. and an asset for the citizens (it is internal). In recent years
more creditors come from outside the US, and this debt starts to become a
liability for the US as a whole.
16
In recent decades inflation targeting is the paradigm monetary policy which
central banks have wanted to adopt.
Throughout WW2, the start of the cold war and the Korean war, the policy of the
fed was explicitly to hold down borrowing costs for the US govt.
As you see, inflation at that time was very volatile.
He continues on with a history of 20th century monetary policy
17
What people were getting on their money in real terms, the nominal interest rate
cannot go ve, though the real one spends about as much time ve as they do
+ve.
Why is this possible, is this a good or bad thing? What are the consequences of a
ve real interest rate? Is the central bank even responsible for this?
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This graph shows us the volatility of growth and interest rates (not their nominal
levels).
19
There has been huge growth in international trade in recent decades, which is
reflected by this graph.
We see that he US current account deficit has been increasing significantly.
20
We see that there are fluctuations in interest rates faced by real-world borrowers,
as well as those set by central banks.
22
The labour market is special in the sense that it is predicated on a long-term
relationship between consumer and producer of labour.
Handout 2
3
If you were able to implement the 3 approaches perfectly, they should all agree.
5
There is no long-term investment, and the economy is closed (there is no trade
with other islands)
8
Some firms pay wages, 5 million from the farm, and 4 million from the
government, but we must also consider the government.
So far we have 4.5 million in taxes from firm, and a further 1 million levied directly
on households (maybe a labour income tax or something), so total 5.5 million in
taxes
Supposing the govt balances its budget, then it spends its 5.5 million on hiring
employees (maybe soldiers or whatever).
So from the consumers perspective we have a total of 5+4+5.5 = 14.5 million
income from wages.
Someone on the island must have made the loan to the farmer, so at some point
someone has to get the 0.5 million interest the farmer pays in the form of income.
Similarly someone somewhere on the island receives the 24 million in profits in
the form of income.
9
The restaurant gets 30 million revenue (so produces 30 million in value), but 12
million was spent on intermediate goods of coconuts. (If they were just a middle
man breaking even they would sell all the coconuts to someone else for 12
million, the same price they bought them for from the farmer, they have done
something to the coconuts to get 30 million in revenue, so have added a value of
18 million through their labour).
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Govt. services are counted as a cost for accounting consistency, but doing this we
have no measure of how much the services which the govt. provides are valued
by the society (they do not enter the market or the GDP figures)
Shadow economy is not included in GDP statistics.
Handout 3
5
Looking at the difference in the nominal rise in GDP across 2 years in the same
economy, how much of the change is due to the natural rise in the real quantity of
goods produced and how much of it is simply inflation.
10
GDP Price Deflator by definition includes all the goods and services that go into
measuring GDP, including I, G and X. CPI takes into account only C and M. That is
the substantive difference of what it measures.
The method of calculating it is also different.
CPI uses less information, it uses the quantities from year 1, and prices from both
years. The Deflator uses quantities and prices from both years.
The CPI will systematically turn out to be a little bit higher on average than the
GDP deflator, because the deflator (by taking the quantities from year 2) is taking
account of the fact that when the prices of goods go up, people typically
substitute away, they will buy less of what gets expensive, more of what gets
relatively cheaper, meaning that the cost of living doesnt go up by as much as if
the consumers simply stuck to the spending patterns from the previous year (they
are smart).
By accumulating these small differences in estimations over many decades you
can create a significant discrepancy, which can matter if youre pension is tied to
the inflation rate or whatever.
11
If youre an energy importer, then energy prices are going to be in the CPI but not
in the GDP deflator.
13
In theory there is an assumption that there is no difference between what we
classify as a mobile phone, or an apple in year 1, and what we classify as a mobile
phone or an apple in year 2. However this assumption is not true so we cannot
compare like-for-like, e.g. the cost of a mobile phone increasing over 10 years is
not just inflation, it may also be the perceived (perceived by the market) quality of
the good increasing.
What happens when a new product enters the market all together? E.g. go back
long enough and there are no mobile phones at all, so no price to use when
comparing with previous year. You can think of this as an extreme case of product
improvement. The consensus view is that most measures of inflation are
overstating inflation by 1 or 2 percent.
14
The problem here is that simply using the exchange rate can distort the picture.
P is price index of goods in the US; P* is the price index of goods in China; e is the
price of 1 Yuan in dollars, the exchange rate.
Suppose, for the sake of argument, that people in China and the US are

consuming the same basket of goods, and that those goods can be traded.
As the goods can be traded, we expect P and eP* to be very close, otherwise firms
would just buy goods in one country and ship them to the other to make a profit,
this in turn would equalise the market by increasing the supply of the good in the
country with the higher sale price.
In practice we dont see this relationship P=eP*.
It holds fairly well for goods which can be traded very easily, but goods which
cannot be (like haircuts) do not follow this rule.
So if its not equal, what do we expect? We tend to observe that prices tend to be
higher in ricer countries.
A country is richer because in some section of the economy (where goods are
traded, not home production) it is very very productive, but of course because
workers can choose which occupation they take, you can expect the wages
between the traded-goods and non-traded-goods sectors not to be completely
unrelated.