Understanding Macroeconomics: Implications for Standard of Living

1. KYIV SCHOOL OF ECONOMICS APPLIED MACROECONOMICS I Instructor: Maksym Obrizan Lecture notes I # 2. CHAPTER 1 The Science of Macroeconomics Macroeconomics studies the state of the economy that has important implications for the standard of living of most people Recall the pre-2008 boom when the credit was rising and most Ukrainians showed great appetite for housing, vehicles and even phones that they bought with borrowed money… # 3. …and then the 2008 crisis came… Ukrainian bad credit experience was not unique as most other countries (including US and EU) suffered the same economic shock Things like real GDP, inflation and unemployment affect virtually any person in the country # 4. Moreover, with the current state of the global economy economic slowdown in USA will decrease Chinese demand for Ukrainian steel which may lead to budget deficit in Ukraine that will have to borrow from the IMF and so on… Thus, crises are no longer confined to the country borders

2. # 5. Quotes from Mankiw: “Although the job of making economic policy falls to world leaders, the job of explaining how the economy as a whole works falls to macroeconomists” “The macroeconomist’s ability to predict the future course of economic events is no better than the meteorologist’s ability to predict next month’s weather.” # 6. The difficulty here comes from the fact that economy is constantly hit by various shocks that are hard to predict How many people could predict: • the recent natural disaster in Japan? • the rise of Apple Inc? • the economic future of Greece? • A 30% drop of the UX index in August of 2011? # 7. Each of these events affects millions of people in one way or another Plus, there are always politicians who promise things that can delivered only at a very high costs… # 8. NOTES

3. Data Sources: National Bank of Ukraine website

4. # 13. Economists work with models Quote from Mankiw: “Models are simplified theories that show the key relationships among economic variables. The exogenous variables are those that come from outside the model. The endogenous variables are those that the model explains. The model shows how changes in the exogenous variables affect the endogenous variables.” # 14. The model of supply an demand for pizza # 15. Quantity demanded of pizza may depend on Quantity supplied of pizza may be affected by In equilibrium: Question: What will happen if Qs > Qd? # 16. Suppose that Ministry of Health warned that eating pizza increases the chances of a heart attack by 24%...

5. # 17. Quotes from famous economists: “All models are wrong but some are useful”. Remember: any model is wrong because it is a simplification of reality “The quality of economic model should be judged not by realism of its assumptions but by the quality of its predictions” Remember: A more “realistic” model may perform worse than a simpler one # 18. Modern macroeconomics is based on microfoundations following the Lucas critique of mid-1970s Prior to Lucas economists build large scale macroeconometric models that linked policy instruments (i.e. FED interest rate) to targets (i.e. inflation) Lucas argued that such models do not properly treat expectations and as a result the coefficients in the models are unstable # 19. CHAPTER 2 The Data of Macroeconomics Quote from Mankiw: “This chapter focuses on the three statistics that economists and policymakers use most often. Gross domestic product, or GDP, tells us the nation’s total income and the total expenditure on its output of goods and services. The consumer price index, or CPI, measures the level of prices. The unemployment rate tells us the fraction of workers who are unemployed.” # 20. Quote from Mankiw: “Economists distinguish between two types of quantity variables: stocks and flows. A stock is a quantity measured at a given point in time, whereas a flow is a quantity measured per unit of time.” For example, wealth is a stock while income (and expenditure) is a flow

6. # 21. Definition from Mankiw: “Gross domestic product (GDP) is the market value of all final goods and services produced within an economy in a given period of time.” Market value - # 22. Final goods – Increase in inventory typically counts as increase in GDP # 23. Imputations in GDP # 24. Real vs Nominal GDP When comparing GDP between two years one must use the same set of prices. For example, an economist can select 2000 as the base year and re-compute GDP of 2012 in prices of 2000

7. # 25. Quote from Mankiw: “Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices. The GDP deflator measures the price of output relative to its price in the base year” # 26. The National Income Accounts divide GDP into 4 broad categories: If Y denotes GDP then # 27. Consumption includes goods and services bought by households and is divided into three subcategories: nondurable goods (i.e. food), durable goods (TVs etc), and services (doctor visits and so on). Investment is also divided into three subcategories: business fixed investment, residential fixed investment (purchase of new residential housing), and inventory investment. # 28. Quote from Mankiw: “Government purchases are the goods and services bought by federal, state, and local governments. This category includes such items as military equipment, highways, and the services that government workers provide. It does not include transfer payments to individuals, such as Social Security and welfare.”

8. # 29. Quote from Mankiw: “Net exports are the value of goods and services exported to other countries minus the value of goods and services that foreigners provide us. Net exports represent the net expenditure from abroad on our goods and services, which provides income for domestic producers.” # 30. Gross and Net National Product # 31. National Income = NNP − Indirect Business Taxes. Five components of national income in the USA: ➤ Compensation of employees (70%) ➤ Proprietors’ income (9%) ➤ Rental income (2%) ➤ Corporate profits (12%) ➤ Net interest (7%) # 32. Personal Income = National Income - − Corporate Profits − Social Insurance Contributions − Net Interest + Dividends + Government Transfers to Individuals + Personal Interest Income Disposable Personal Income = Personal Income − Personal Tax and Nontax Payments

9. # 33. How Consumer Price Index and GDP deflator differ? # 34. The unemployment rate # 35. Quote from Mankiw: “The negative relationship between unemployment and GDP is called Okun’s law, after Arthur Okun, the economist who first studied it.” For the US it has been estimated by ordinary least squares as: Percentage Change in Real GDP = 3% − 2 × Change in the Unemployment Rate # 36. What will GDP growth be equal to • if unemployment does not change? • if unemployment changes from 8% to 3% • If unemployment increases by 4 percentage points?

10. # 37. CHAPTER 3National Income: Where It Comes From and Where It Goes Quote from Mankiw: “Factors of production are the inputs used to produce goods and services. The two most important factors of production are capital and labor.” # 38. Economists use production function to express the current state of technology # 39. Properties of the production function # 40.

11. # 41. The Cobb-Douglas production function # 42. # 43. Quote from Mankiw “The distribution of national income is determined by factor prices. Factor prices are the amounts paid to the factors of production—the wage workers earn and the rent the owners of capital collect.” Factor prices are determined in markets for factors # 44. Consider the problem of a competitive firm (i.e. a company that is so small that it cannot affect neither factor nor final good prices)

12. # 45. Figure 3-3 # 46. # 47. Figure 3-4 # 48.

13. # 49. The division of national income Quote from Mankiw: “The income that remains after the firms have paid the factors of production is the economic profit of the owners of the firms.” # 50. The difference between economic and accounting profit # 51. For now let’s consider a closed economy –a country that does not trade with other countries Then Y = C + I + G Define income after the payment of all taxes, Y − T, as disposable income Assume further that consumption is a function of disposable income # 52. Quote from Mankiw: “The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income increases by one dollar. The MPC is between zero and one: an extra dollar of income increases consumption, but by less than one dollar.”

14. # 53. Figure 3-6 # 54. The nominal interest rate is the interest rate that is usually reported The real interest rate, on the contrary, adjusts for inflation The quantity of investment goods demanded negatively depends on the real interest rate # 55. Figure 3-7 # 56. Quote from Mankiw:“If government purchases equal taxes minus transfers, then G = T, and the government has a balanced budget.” Typically, G>T and government runs a budget deficit (a flow) which adds to the government debt (a stock) We treat G and T as exogenous

15. # 57. Equilibrium in the market for goods and services # 58. The interest rate is the only variable not already determined in the last equation This is not a coincidence – the interest rate must adjust to equate the demand and supply of goods. Thus, at the equilibrium interest rate, the demand for goods and services equals the supply. # 59. Equilibrium in the financial markets # 60. Figure 3-8

16. # 61. A reduction in saving – Figure 3-9 # 62. # 63. Changes in investment demand – Figure 3-10 # 64. Figure 3-11