Review of macro-economicsjuliohuato@gmail.com

Introductory macroeconomicsFocuses on:1. The structure or composition of a

modern economy2. the behavior of the economy in the

short run (business cycles) and long run (growth), and

3. the principles of fiscal and (to a lesser extent) monetary policy.

Structure of the economyStudy of the national accounts: how output (Y), price level (P), and employment or -- more commonly – unemployment(u) are measured. Y is measured using GDP: the value of the final goods newly

produced in a year in the economy and traded in organized markets.

P is measured by an index (CPI, PPI, PCEPI, GDP deflator, where GDP deflator = Nominal GDP/Real GDP, where -- in turn -- real GDP is GDP calculated at constant prices, i.e. the prices of a base year). π= (P1-P0)/P0 is the inflation rate.

u is measured as members of the labor force (L) unemployed as a fraction of L. L is defined as those legally and physically able to work, employed or unemployed but actively engaged in job searching.

To study business cyclesWe use a simple macroeconomic model based on Keynes’ work. In all economies, the output produced in a period of time (CG

and MP) has to go to individual consumption (“consumption” proper, of CG) or to productive consumption (of MP).

In a monetary economy, the output produced in a period of time is sold in markets and, before the sectors can use or consume CG or MP, they have to buy the goods in markets.

It is helpful to assume that, to consume CG, individuals are organized as “households.” To produce CG + MP, individuals (the same individuals, in fact) are organized as “businesses” or “firms.” Also, people are organized as a “government” to produce and consume certain goods (CG and MP). Finally, since this is a national economy inserted in a global economy, there is another sector called the “rest of the world” (ROW).

To study business cycles For simplicity, markets will be classified in three types:

Goods markets (markets where people trade the flow of CG and the MP produced in that period),

Factor markets (markets where businesses hire or rent LP, MP produced in previous periods, and natural resources for use in the period), and

Financial markets (markets where people trade the ownership of businesses and natural resources, bonds, at each point in time)

In a monetary economy, the output produced will be valued in the markets and, when sold, that value will be realized and appear to the producers (and sellers) as income. Thus, total income = the value of output.

At first, the total income is the total revenues of businesses, but the businesses belong to households (the owners of LP, previously produced MP, and natural resources); hence, the total income will be split into income from labor (wages, salaries, benefits) and income from property (rents, interests, profits). In turn, the profits of legally incorporated businesses may be split into dividends (distributed to individual stockholders) and retained profits (kept by the corporation to enhance its operations)

To study business cycles In a monetary economy, the output purchased for individual

or productive consumption, again, as valued in the markets, will appear to the buyers (all the sectors) as expenditure. C: consumption expenditure, the spending by households in the

purchase of CG I: investment spending, the spending of businesses in the

purchase of MP G: government spending, both for consumption or investment X: exports or the spending by the ROW in the purchase of goods

(CG and MP) produced by domestic businesses M: imports or the spending by domestic households, business,

and government in the purchase of foreign goods (CG and MP)

Business cycles

Simple macro modelThe pieces of the model are:

1. A consumption function and2. Macroeconomic equilibrium

The result is a model of total output or income determination as driven by fiscal policy (government spending and taxes)

Consumption function

Macro equilibrium

Solution of the model

Solution of the model

Solution of the model

Fiscal policyFiscal policy: taxation/spending. The economy can be more directly affected via:delta_Y* = [1/(1-mpc)] delta_Gdelta_Y* = - [mpc/(1-mpc)] delta_T

Monetary policySaving = Y - T - CInvestment depends on Y, Wealth, i, and expected return on investment projects.

How is i determined? A big chunk of the course is devoted to this very topic. Monetary policy can affect it. We will discuss this later in the course.