Introduction

1. Introduction Chapter #1

2. Micro vs Macro Economics • Micro: behavior of individual economic units (households, firms) • Issues include product and input price determination • Market supply and demand (for specific product) vs AS and AD (GDP) • Downward slopping DC (wealth and substitution) and IDC (Law of DMU) • Macro: aggregates individual markets, looks at economy as a whole • Issues include economic growth, inflation, unemployment, BOP and ForEx • Long-run econ growth and short-run fluctuations constituting business cycle • Interaction between 3 main markets and nation vs rest of the world • Understand how econ works to make it perform better (government policies) • AS (output firms willing to supply at different price levels) vs AD (level of output at which goods and financial markets are simultaneously in equilibrium for any price level, position determined by monetary and fiscal policy together with consumers’ confidence) • AD in RGDP downward slopping (assuming fixed money supply) due to effects:wealth - ↑ prices ↓ purchasing power of money, poorer consumers buy lessinterest rate - ↑ prices ↑ prices of money or interest rate (mortgages, car loans)net exports - foreign/domestic goods cost less/more at home/abroad, NX ↓ and hence RGDP = Y = C + I + G + NX

3. Macroeconomics In Three Models • Study of macroeconomics is grounded in three models, appropriate for a particular time period (described by AS) • Very Long Run Model: growth theory  focuses on production capacity (potential output - when resources are fully employed) vertical ASaccumulation of capital and improvements in technology • Long Run Model: a snapshot of the very long run model, in which capital and technology are largely fixed, but allow for temporary shocks • Level of capital & technology are fixed and determine potential output level • Output is fixed, but prices (inflation) determined by changes in AD • Short Run Model: business cycle theories with flat AS • Changes in AD determine how much of the productive capacity is used and the level of output and unemployment • Prices are fixed in this period, but output is variable • Long Run Model: a snapshot of the very long run model, in which capital and technology are largely fixed • Level of capital & technology determine level of potential output • Output is fixed, but prices determined by changes in AD • Short Run Model: business cycle theories • Changes in AD determine how much of the productive capacity is used and the level of output and unemployment • Prices are fixed in this period, but output is variable

4. Very Long Run Growth • Figure 1-1a illustrates growth of income per person in the U.S. over last century  smooth growth of 2-3% per year on average smoothing short run changes • Growth theory examines how the accumulation of inputs and improvements in technology lead to increased standards of living (ignore short run fluctuations – tend to average over the years) • Average rate of growth is important (2% vs 4% over 20 or 100 years - TVM) • Rate of saving (vs consumption) is a significant determinant of future well being and economic growth

5. The Long Run Model • Long run AS is vertical, at the potential level of output (slow growth, 2-3% annually) • Output is determined by the supply side of the economy and its productive capacity • Price is determined by the demand relative to the productive capacity of the economy • Conclusion: high rates of inflation always due to changes in AD (can be substantial)

6. The Short Run Model • Short run fluctuations in output are largely due to changes in AD • The AS curve is flat in the short run due to fixed/rigid prices, so changes in output are due to changes in AD • Changes in AD in the short run constitute phases of the business cycle • In the short run, AD determines output and thus unemployment, leaving prices unaffected

7. The Medium Run • How do we get from the horizontal short run AS curve to the vertical long run AS curve? • The medium run AS curve is tilting upwards towards the long run AS curve position • When AD pushes output above the sustainable level, firms increase prices • As prices increase, the AS curve is no longer pegged at a particular price level • Firms start to rise price and AS begins to move upward • How steep is AS is the main controversy in macroeconomics

8. The Phillips Curve • The speed of price adjustment to increase in AD is critical for understanding economy • Prices tend to adjust slowly  AD drives the economy in the meantime • The speed of price adjustment is illustrated by the Phillips curve, which plots the inflation rate against the unemployment rate • Unemployment decrease from 6 to 4% will increase inflation by only 1% over one year • In the short run, AS curve is relatively flat, and movements in AD drive changes in prices, output, and unemployment

9. Growth and GDP • The growth rate of the economy is the rate at which GDP is increasing • Most developed economies grow at a few percentages per year • Growth in GDP is caused by: • Increases in available resources (labor and capital) • Increases in the productivity of those resources

10. The Business Cycle and the Output Gap • Business cycle: somewhat regular pattern of expansion and contraction in economic activity about the path of trend growth • Trend GDP is potential GDP realized if factors of production were fully utilizedEcon not physical concept - physical labor full employment when everyone works 16 hours - econ when everyone who want to work has a job (unprecise) Defined by convention, e.g. labor fully employed when unemployment is 5% • Deviation of output from the trend is referred to as the output gap • Output gap = actual output – potential output or trend • Measures the magnitude of cyclical deviations of output from the potential level • Commonly recession refers to economyin bad shape • Econ definition measures recession from peak to through. • So when recession is over it does not imply end of tough times but that economy is turning

11. Inflation and the Business Cycle • Inflation of 1960s and 1970s • Prices > septupled 1960-09 (on average $1 in 1960 worth $7.76 by 2012), most of the price increase during 1970s • The inflation rate estimated as percentage change in CPI (cost of a basket of goodsbought by average household) • If AD is driving the econ, periods of growth causeinflation, while periods of contraction reduced prices and produce inflation < 0.