Macroeconomics Based on the textbook by Karlin and Soskice: Macroeconomics: Institutions, Instability, and the Financial System Robert M. Kunst [email protected] University of Vienna and Institute for Advanced Studies Vienna October 1, 2017 . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 1/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna What is it all about? Macroeconomics mainly focuses on two issues: I Business cycles. Where do short-run fluctuations come from? If decision makers want to influence the fluctuations, are their main tools fiscal policy and monetary policy effective? This is about the short run, with a typical business cycle lasting around 4 years. I Economic growth. What determines the wealth of nations? Is it possible to influence aggregate production functions that determine output from production factors (labor, capital)? This is about the long run, so tools may need time to work, such as improving education and skill levels. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 2/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Keynesian models Models of aggregate demand are sometimes called Keynesian. In a narrower sense, Keynesian models are those models of aggregate demand that use the assumption of short-run constancy (stickiness) of prices. If prices do not move following unexpected exogenous impulses (`shocks'), economic policy will have a strong effect. A small demand impulse from the government will cause a larger effect on the total economy. The proportionality factor between input and output is called the fiscal multiplier or in short multiplier. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 3/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Components of aggregate demand Technically, aggregate demand is measured by gross domestic product (GDP) in constant prices, in economic terms `real output'. In the `account-zero' identity of aggregate demand, it holds that y D = C + I + G + (X − M); where y D denotes real expenditure, C stands for private consumption by households, I for gross fixed investment (in the language of national accounts, gross fixed capital formation), G for government spending on goods and services (that is, not on transfers or debt service), X for exports, and M for imports. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 4/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Three definitions of the GDP According to many macroeconomics textbooks, there are three definitions of the GDP (all are specified for a given time unit, usually a year or quarter): I The total of all expenditures by households, the government, and the firms of a country on final market products (= goods and services); I The total of all values added in the production process by households, firms, and the government of an economy; I The salaries and profits earned from all production units. Many textbooks and (historically) British national accounts use all three definitions and call them the expenditure method, the value added method, and the income method. Current national accounts (SNA, OECD) accept the second definition only. The other two . are approximately identical (inventories, unfinished.. .. .. .. .. .. .. .. goods.. .. .. .. .. .. etc.)... .. .. .. .. .. 5/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Is GDP and GNP the same? Gross national product (GNP) was used before a major reform of national accounting by OECD instead of GDP and GNI. GNP, the production by residents of an economy, is difficult to measure. US researchers continued using GNP instead of GDP for some time. GNI (gross national income) is the income (wages, profits, etc.) earned by residents of a country. It differs from GDP mainly by profits of foreign-owned firms. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 6/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Is purchasing a car investment? In macroeconomics, investment is the production of new production facilities (buildings, machines, farm animals etc.), not the purchase of existing assets. Building a house is investment, buying a house does not add to the aggregate capital stock, is just a transfer of ownership. The word is usually used in its singular form (French investment has increased). An investor is a firm or household that produces capital goods (production facilities), not a person who buys assets (houses or securities). In national accounts, investment is called fixed capital formation. Purchasing a car can be investment for a firm that uses the car as a means of production (transport). For a household, buying a new car is not investment. It is consumption of durables. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 7/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues The value added The main concept for calculating the GDP is the value added defined as value added = value of output sold minus costs of input, i.e. raw materials and intermediate goods Note that workers are not materials used up in the production process, such that their wages are not subtracted. Input may be imported, for example. The value added tax is a tax proportional to the value added. It is paid by the producer to the government, but the purchaser must pay an increased price to the producer (seller). .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 8/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Growth and cycles % −6 −2 2 4 2000 2005 2010 2015 The graph shows the annual growth rate of Austrian real GDP (seasonally adjusted). Most of the time, this growth rate is positive, but many researchers see cyclical fluctuations of variable . length with peaks and troughs: business. cycles. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 9/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues Historical and global events in GDP I Some researchers call the time from a peak to a trough a recession, others see a recession only if several consecutive growth rates are negative. The time from a trough to a peak is often called the recovery. I The particularly pronounced and lengthy global recession before World War II is called the Great Depression. I After the 1960s, longer-run averages of real growth rates have decreased in most OECD countries, even in the US. I From 1985 to 2006, business cycles were of a lower amplitude than before, volatility of GDP growth was smaller, particularly in the US. This episode is called the Great Moderation. I The pronounced recession of 2007{09 that hit upon most OECD and developing countries is called the global financial crisis, as it emanated from the US financial. sector.. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 10/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues GDP and the main demand components I % −15 −5 0 5 10 15 2000 2005 2010 2015 Growth rates in Austrian data. Investment (green) is more volatile than consumption (red) or total GDP (black). .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 11/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna General issues GDP and the main demand components II % 0 10 20 30 40 50 60 2000 2005 2010 2015 Shares in GDP for Austrian data. Investment (green) has a much lower share in output than consumption (red). Nonetheless, its movements determine the business cycle. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 12/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna The IS curve How does private demand react? For an adequate evaluation of potential fiscal policy by the government, for example to counteract an imminent or observed recession, it is important to know how the private sector will react: I If households receive an additional income, how much will they spend on purchasing consumer goods and services, how much will they save? I If households suddenly increase their confidence in their future income, will they immediately spend more? I If in this process the interest rate rises, will this discourage investment by firms because of their increased costs of raising funds? A great pioneer of the academic theory of aggregate demand management was the British economist John Maynard . Keynes. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 13/1 Macroeconomics University of Vienna and Institute for Advanced Studies Vienna The IS curve What affects aggregate demand? Three main channels for modeling aggregate demand: 1. Expectations are in the focus of theories that emphasize rational agents. If the government increases transfers to households but runs large deficits, households expect higher taxes in the future and will not increase spending. Rising unemployment decreases consumption, as households use precautionary saving to insure against unemployment risk; 2. Households do not want to run too much debt, and they may not even be able to do so, as banks will not lend. Also firms face such credit constraints; 3. Rising interest rates discourage investment and consumption, as they make credits more expensive. They increase the rent and profit income, which should encourage spending, but this effect is typically smaller. .