1. Why do Macroeconomics?

1. 1. Why do Macroeconomics?

2. Course Learning Objectives • To understand the workings of the modern macroeconomy in the short run • We will place emphasis on how a government can deal with economic shocks especially those that effect a small open economy • We will also emphasize the role of expectations, flexibility & the time frame in macroeconomics • I will provided empirical evidence to back up (or refute) the conclusions of the models

3. The Point of Macro • See MankiwChpt 1 • Macroeconomics is about understanding the behaviour of economic aggregates: total (national) output, employment, the general price level, etc • Macro was invented by John Maynard Keynes • Before Keynes people tried to understand the economy by doing micro • Micro is about understanding the behaviour of individual entities • From the bottom up • Keynes pointed out that you could get insight from looking at the economy as a whole

4. The Point of Macro • The two are related (or ought to be) but the process of aggregating all the individual markets has the potential to make things very complicated • E.g. USSR • Macro is basically a series of short cuts that allow us cut through the complication of aggregation

5. The Point of Macro • This is one reason why macro can be controversial • Plenty of room to disagree on the appropriateness of short cuts in any model • There should not be disagreement because any Model should be • “As simple as it needs to be – but no simpler” • Empirically validated i.e. it really does explain the world (the scientific method) • This is relevant to the recent crisis

6. Implication for the Course • We will start with simple models and add to them as we need to understand more phenomena • I will present empirical justification of each model i.e. show that it works under what circumstances (Learning Objective 4)

7. Ideology and Macro • Macro much more than macro is influenced by ideology • This is even true in the profession • This should not happen if the scientific method is applied • Although more difficult in economics than natural science • Ambiguity facilities polemics • See the current crisis • It is important to separate out technical economics issues from your (and my) political biases • I will point out ideological issues as we go

8. The Big Questions • Three important Questions in Macro: • How do we ensure High Employment / Low Unemployment ? • How do we generate Price Stability / Low Inflation? • How do we Growth the economy? • Our concern is with the first two (Learning Objectives 1 & 2) • Often referred to as “Stabilization policy” • The third is more a long-run matter and is left to Macro II

9. A Word on Growth • Really Important question • Why and how are some countries richer than others? • Example of Zambia vsKorea • Ireland vs Everybody pre Celtic Tiger • A side note: look at the dip in korea around 1997 • Asian banking crisis • In the long run even extreme crises look trivial

12. Our Focus: Economic Cycles • Fluctuations in economic activity: GDP in Booms and Recessions • Why do they occur? (LO 1) & What do we do about them? (LO2) Actual Boom Real GDP Trend Recession 0 Time

13. Why Care? • Economic Cycles may seem trivial in comparison to growth so why bother with them? • Two reasons: • Recessions may be short run phenomena but can cause a lot of pain if you are in them • Misunderstanding cycles could lead to wrong policies that undermine long term growth

14. Cyclical Misery • Over the cycle unemployment and inflation can cause plenty of human misery • Misery index is the sum of the two • Aside: later we will look at whether moderate unemployment and inflation are really costly • As you know from first year • A recession will tend to increase U and lower  • A boom will tend to decrease U and raise  • There would seem to be a trade-off between U and  • While this may be true in the short-run, it may not be so in the long-run • Investigating the nature of this trade-off an whether we can take advantage of it is a huge question we will spend a lot of time on it • This is all related to LO 3

15. CYCLES AND UNEMPLOYMENT Unemployment tends to fall in booms and rise in recessions Real GDP Actual Trend 0 Time U % Unemployment Rate (U%) Time 0

16. CYCLES AND INFLATION Inflation often falls in recessions and accelerates in booms Real GDP Actual Trend 0 Time + Inflation Rate (%)  0 Time _

17. STABILISATION – “NATURAL” GDP, etc. • If cycle causes problems then we should stabilise the economy to be close to Trend GDP • Broadly this corresponds to a level of GDP where output and employment are such that inflation is stable. • The corresponding “natural” rate of Unemployment is a concept we shall meet later. • It depends on structural features of the labour market: labour mobility, wage flexibility, levels of unemployment benefits, etc. • The Natural Unemployment rate is not fixed: it can be influenced by policy (and history).

18. STABILIZATION: TARGETS AND INSTRUMENTS • A useful framework is to think in terms of • (a) policy targets or objectives • (b) policy instruments. • A coherent policy must have at least as many targets as instruments. • Think of dart boards and darts • Our targets in the short/medium term are • (i) Full-employment GDP (“natural” GDP) • (ii) price stability, or low inflation • Our instruments are • Fiscal Policy • Monetary Policy • There will be trade-offs between the targets • There will also be important questions about which policy one assigns to which target.

19. Example: The Current Crisis • Talk of targets and instruments may sound abstract but is relevant to current situation and not understood by many authorities • Four targets: • Control deficits • Re-capitalise banks • Provide Liquidity to markets • Boost employment • One Instrument allowed: Fiscal policy • Others not allowed: Monetary policy