Introduction to

Macroeconomics
Economics 514
Macroeconomic Analysis

What is Macroeconomics
Macroeconomics

examines economies
at the aggregate (international, national,
regional) level.
Some aspects of macroeconomics are
about comparing two aggregate
economies at the same time.

Why study the economy at the

aggregate level?
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
aggregate.
There are certain phenomenon like economic
growth and business cycles which affect the
aggregate economy equally.
We can consider interesting dynamic
questions.

Amateur History of
Macroeconomics/Macroeconomic History
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

Macro theory
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 business
cycles.
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
across time.

Japan Post-war GDP

600000
500000
400000
300000
200000
100000
0
55

60

65

70

75

80

85

JAPAN_GDP

90

95

00

Trend and Cycle

(Hodrick-Prescott Detrending)
600000
500000
400000
300000

20000

200000
10000

100000
0

0
-10000
-20000
55

60

65

70

75

JAPAN_GDP

80

85
Trend

90

95
Cycle

00

Macro Progresses
During

the 1950s, macro conceptually

split changes in output into two parts:
Long-term

growth which would be studied in

models in which prices adjust perfectly to
economic conditions.
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,

1950s and 1960s 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
period.
Fixed exchange rates under Bretton
Woods agreement.

Neo-classical synthesis
Growing

prominence of optimization
theory and marginal analysis in
microeconomics led to incorporation into
macroeconomic models.
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.

Marginal Analysis
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
marginal cost.

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.

Monetarism
In

1960s, 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
especially inflation.
In particular, Friedman pointed out the way
that demand stimulus, once it becomes
expected may lose its effectiveness.

Inflation and Deflation in China

CN: Consum er Price Index: PY=100
PY = 100
125

120

115

110

105

100

95
1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Stagflation 70s
During

1970s, oil price shocks led to

rapid price rises and low production
levels called stagflation.
In many countrys, inflationary
expectations led to wage-price spirals
and historically high inflation rates.
Developed economies begin 20 year
slowdown in productivity growth rates.

International Economics
In

early 1970s, 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
JPY/USD
320
300
280
260
240
220
200
180
160
140
120
100
80
Jun-1976

Jun-1980

Jun-1984

Jun-1988

Jun-1992

Jun-1996

Jun-2000

Jun-2004

Rational Expectations
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.

Eighties
U.S.

central bank cuts the money supply to

counter-act inflation. Deep recession in USA
and elsewhere.
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
costs.
Unlike RBC models, these models can explain
why monetary policy has significant effects on
output.
These models are typically static and cannot
explain dynamics or long-run at all.

Endogenous Growth
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.

1990s
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
again.
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: Unem ploym ent Rate
%
9

2
Jun-1996

Jun-1997

Jun-1998

Jun-1999

Jun-2000

Jun-2001

Jun-2002

Jun-2003

Jun-2004

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
spirals.

Economists

also incorporate models of

financial market imperfections into unified
framework to explain financial crises in
emerging markets.

This course
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.

Focus
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
Asian issues.

Requirements
3

exams associated with theories of

various terms. Final may/may not be
cumulative.
3 problem sets for test preparation.
Some empirical exercises to be graded
for credit.

What are the students expected to

know?
Mathematically,

students should be able

to understand first derivatives (partial
and time included).
Understand statistical concepts like
expected value, variance, covariance &
correlation.
Very basic understanding of national
accounts (i.e. what is output,
consumption, investment etc.)