Preparation course MSc Business & Econonomics- Macroeconomics: Introduction & Concepts

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1 Preparation course MSc Business & Econonomics- Macroeconomics: Introduction & Concepts Tom-Reiel Heggedal Economics Department 2014 TRH (Institute) Intro&Concepts / 20

2 General Information Me: Tom-Reiel Heggedal, Associate Professor, Goal: Cover some basic macro topics (not cover all macro 101) 1: good to know basic macro 2: training in economic modelling and analysis 3: its a prep for Business Cycle course Lit: Gartner, Macroeconomics, ch Or Burda and Wyplosz: Macroeconomics. On growth: better with Jones, Introduction to Economic Growth, or Aghion and Howitt: The Economics of Growth. Timing: Monday & Tuesday, Wednesday Slides: TRH (Institute) Intro&Concepts / 20

3 Outline Part 1: Long run macro (Economic Growth) Introduction Long vs short run macro Basic macro concepts: modelling, GDP, National accounting Production function (marginals, derivation, differentiation) Growth facts Growth accounting (logarithms) Solow model and capital accumulation (continuous time vs discrete time) The savings decision (intertemporal consumption choice (Lagrange)) Permanent income & Ricardian equivalence The Ramsey Cass Koopmans model. Technological change and productivity (TFP) Solow model with technical change Endogenous technical change TRH (Institute) Intro&Concepts / 20

4 Outline cont. Part 2: Short run macro (Business Cycles) The RBC model and fluctuations New Keynesian models and frictions (price & wage rigidity) Keynes model: short run goods demand IS-TR model: short run demand with central bank (AS-AD: short/medium run with supply) (Phillips curve (and expectations)) Part 3: Open economy macro Basic concepts: exchange rates, PPP, trade balance (The Mundell-Fleming model) TRH (Institute) Intro&Concepts / 20

5 Macroeconomics Introduction to macro Microeconomics examines the behavior of individual decision-making units business firms and households Macroeconomics deals with the economy as a whole; it examines the behavior of economic aggregates such as aggregate income, consumption, investment, and the overall level of prices. Aggregate behavior refers to the behavior of all households and firms together. Three major concerns in macro: Inflation, unemployment, output growth Three types of policy that governments use to influence the macroeconomy: Fiscal policy; policies concerning taxes and spending (redistribution) Monetary policy: tools used by the Federal Reserve to control the quantity of money (interest rate) in the economy Growth or supply-side policies: focus on stimulating aggregate supply instead of aggregate demand (education, infrastructure, R&D) TRH (Institute) Intro&Concepts / 20

6 Macroeconomics Short run vs long run Long run focus on trends and long run output: growth models, long term effects of fiscal policies Solow model with capital accumulation Ramsey model with endogenous savings and capital accumulation Short run focus on fluctuations: Business cycle Monetary and fiscal policies to compensate: Keynes model, IS-LM model (Mundell Fleming in open economy) Monetary policy and the active, independent central bank: interest rates and exchange rates IS-TR Medium run: inflation and expectations drive the economy to the natural rate of unemployment: AS-AD model and the Phillips curve. Real Business Cycle models New Keynesian model (DSGE models) TRH (Institute) Intro&Concepts / 20

7 Macroeconomics Short run vs long run Relationship between actual and potential production (trend) and the output gap (business cycle) TRH (Institute) Intro&Concepts / 20

8 Macroeconomics Introduction to macro TRH (Institute) Intro&Concepts / 20

9 Gross Domestic Product GDP (usually nominal (with prices)): evaluates all final goods and services produced in a country at current prices Produced cars 1000 at price USD : GDP $Y of 50 mil USD Real GDP (only with units of production): 50mil = 1000 = Y For real values divide by a basket of goods with weighted price P; Consumer Price Index Only count current production; not resale GDP as value of sales of final goods and services GDP as sum of value added of goods and services GDP as sum of incomes: tax on sales + labor income + capital income Gross National Product/Income: income generated by those living in a country. GDP + net transfers TRH (Institute) Intro&Concepts / 20

10 National income Gross National Income: income generated by those living in a country: Gross National Income= GDP + net income from abroad + net transfers from abroad Gross means without taking into account capital depreciation. Net national income= GDP - capital depreciation + net income from abroad + net transfers from abroad. In the following we ll ignore capital depreciation, net income from abroad and net transfers from abroad Depreciation is reintroduced when we set up the Solow model. TRH (Institute) Intro&Concepts / 20

11 Notional Accounting Notation Y - GDP, the output of the economy C - Private consumption S - Private saving; consume less than income/production I - Investments: Firms and people s purchases of durable goods. G - Government spending: Purchases of goods and services by the government. T - The level of taxation. X - Exports IM - Imports TRH (Institute) Intro&Concepts / 20

12 National Accounting GDP (measured as production), Y Produced, is sold to consumption, investment, gov. spending or exports: Y Produced = C + I + G + X IM. (1) If we assume no income (or transfers) from abroad, the output (production) of the economy is the income of the economy. Y Prod is the income to firms. This income is distributed to owners (as rents, profits, dividends etc.) or workers (wages, bonuses etc) so that Y Produced = Y Income Y Inc again is used on consumption, saving and taxes: Y Inc = C + S + T. (2) TRH (Institute) Intro&Concepts / 20

13 National Accounting The circular flow identity Combining 1 and 2 (setting Y Prod = Y Inc ) gives C + I + G + X IM = C + S + T (S I ) + (T G ) + (IM X ) = 0, which is called the circular flow identity. This is a key accounting identity; all saving arrives somewhere as spending. What must be the case if the government runs a deficit and trade is balanced? What is cause and what is effect: T increases implies what? Accounting and modelling S = (T G ) + (IM X ) + I IM = (S I ) + (T G ) + X TRH (Institute) Intro&Concepts / 20

14 National Accounting Current account and foreign assets Net exports: NX = X IM, approximates current account. Countries may borrow or save abroad change net foreign assets. US current account deficit; NX is negative. If government budget balances, then I > S and there is borrowing from abroad (china). Germany; NX > 0 & G = T S > I and foreign assets increases. Financial transactions: [Wiki] The current account is one of the two primary components of the balance of payments,... It is the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers.... A current account surplus increases a country s net foreign assets by the corresponding amount, and a current account deficit does the reverse. Both government and private payments are included in the calculation. It is called the current account because goods and services are generally consumed in the current period Norway saves more than it invests at home; what are the implications for the current account and the net foreign assets? TRH (Institute) Intro&Concepts / 20

15 The long run production function Y (real) GDP, K (real) capital, L labor Y = F (K, L) or written as Y = F (A, K, L) where we treat total factor productivity A as an input. A is a measure of the productivity of the input factors K and L. The function F is assumed to satisfy a set of conditions: Positive marginal products: Marginal product of labor (MPL): Y L > 0, (MPK) Y K > 0, Y Y Diminishing marginal products: L < 0, K < 0 Constant returns to scale: F (sk, sl) = sf (K, L). Draw F and K F in K TRH (Institute) Intro&Concepts / 20

16 Piketty: introduction Capital in the Twenty-First Century by Thomas Piketty. A top 10 best selling book on amazon this year. Focuses on wealth and income inequality, and the natural tendency for capitalism to induce a concentration of wealth. The main (economic) contribution of the book is the historical estimates of the wealth (capital) distribution, how large wealth was relative to national income, and the income distribution. These facts are used to establish that the rate of return on capital has been larger than output growth (r > g) for most of history (except for )...and that this will be the case in the years to come. The main thesis of the book is that is follows from r > g that wealth will be more and more unequally distributed. The main policy prescription is a global wealth tax and highly progressive income taxes. TRH (Institute) Intro&Concepts / 20

17 Piketty: the first fundamental law of capitalism Denote the rate of return on capital r, then the income from capital in the economy is rk. The income share of capital in the economy is then rk Y. Denote α the income share and β the capital-income ratio. Then the first law is α = r β. This is an identity that follows from the definitions of the variable. Piketty equates wealth with capital (really: wealth=housing(land)+natural resources+capital) The identity is used to back out e.g. r: In 2010 in wealthy countries income from capital is typically 30% while the capital income ratio is 600%. This gives a rate of return on capital... TRH (Institute) Intro&Concepts / 20

18 Piketty: Major contribution: capital-income ratio High ratio means that wealth is important relative to output Why decline of ratio? Major shocks. Why rise of ratio? Need model. TRH (Institute) Intro&Concepts / 20

19 Piketty: capital-income ratio: US Lower ratio : 3-4 in US compared to 6 in Europa Decomposition of capital (wealth): Land and Housing. TRH (Institute) Intro&Concepts / 20

20 Piketty: private vs public capital Net public capital varies around zero TRH (Institute) Intro&Concepts / 20

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