Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 1

Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz

Slides prepared by Ed Wilson

1

Chapter One

Introduction



2

Chapter Objectives Introduce three linked macroeconomy

models Explain the long run growth in

productive capacity Explain the medium-term

determination of inflation using aggregate demand and supply

Compare the short run fixed price changes in real output



3

1.1 Macroeconomics Encapsulated in Three Models

1.2 To Reiterate . . .

1.3 Schools of Thought

1.4 Outline and Preview of the Text

1.5 Prerequisites and Recipes

Chapter Organisation



4

1.1 Three Models Macroeconomics is organised around

three models Each model is concerned with

different time frames The long run The medium run The short run

Let’s consider each in more detail



5

Very Long Run Economic Growth Growth theory describes the long run

behaviour of the economy The time is usually measured in

multiples of decades (e.g. 20 years or more)

The focus is on the average growth in important macroeconomic variables

Short-run fluctuations in important variables like employment, investment and output are ignored



6

Very Long Run Economic Growth The long run level of output is

determined solely by supply-side considerations

That is, output is determined by the productive capacity of the economy

All factors of production are assumed to be fully employed

Economic growth is, therefore, a function of increases in productive capacity



7

Very Long Run Economic Growth Differences in average growth rates of

economies are important Chapters 3 and 4 examine the causes

of economic growth and the differences between countries growth rates

Major causes of economic growth are Development of new technology Accumulation of physical and human

capital Appropriate provision of infrastructure Higher rates of domestic saving



8

Very Long Run Economic Growth Economic growth determines the

changes in the standard of living A country growing at an average of 4%

per year instead of 2% will have a 50% higher standard of living over a generation of 20 years

This higher 4% average annual growth rate will lead to a seven fold increase in the standard of living over 100 years!

Let’s now introduce a model which will be useful for our analysis



9

Fixed Productive Capacity What determines the change in the

overall price level (the inflation rate)? The aggregate supply (AS)–aggregate

demand (AD) model explains short- to medium-run determination of inflation and real output

In the long run the productive capacity of the economy is assumed to be constant



10

Fixed Productive Capacity This is represented by a vertical AS

schedule at real output level Y0

P

Y0 Y

AS

Pri

ce

Level



11

Fixed Productive Capacity The AD schedule represents, for each

price level, the level of output where both the goods and money markets are in equilibrium

These schedules will be fully explained in Chapters 5 and 6

The intersection of the AS and AD schedules determines the price (P0) and real output (Y0)



12

Fixed Productive Capacity AD and AS in the long run

P

Y0 Y

AD

Pri

ce

Level

AS

P0 What happens when AS shifts

rightwards?

What happens when AD shifts

rightwards?Price increases

Price decreases



13

The Short Run Short-run fluctuations in real output

are important AD is the major determinant of these

variations In the short run the price level is

pegged at P0 making the short-run AS schedule horizontal



14

AS

The Short Run AD and AS in the short run

P

Y0 Y

AD

Pri

ce

Level

P0

What happens when AD shifts

rightwards?Price unchanged



15

The Medium Run How do we describe the transition

between the short run and long run? High AD pushes real output above Y0

(according to the long-run model) Over time, firms will increase prices

and the AS curve will move upwards The medium run will give an

upsloping AS curve



16

The Medium Run The relative steepness of the AS

curve is a major controversy in macroeconomics

P

Y0 Y

AD

Pri

ce

Level

AS

P0



17









18

1.2 To Reiterate … What follows fills in the details Growth theory, AS and AD form a very

important framework for the further analysis of Growth and GDP The business cycle

Let’s consider each in turn



19

Growth and GDP



20

Growth and GDP Table 1.1 compares the per capita real

income growth rates in various countries Note the very large differences ranging

from 0.1% for Ghana to 3.5% for Japan and China (3.0)

Brazil (2.4%), Ireland (2.3), France (2.1) and Spain (2.0) are the next band

Note the lower but similar growth rates for Australia and NZ



21

The Business Cycle and GDP The business cycle describes the

variation of economic activity around the path of trend growth

Inflation, growth and unemployment all demonstrate cyclical patterns

The output gap measures the difference between actual and potential output:

Output gap = potential output – actual output



22

The Business Cycle and Inflation Increases in inflation are inversely

related to the output gap Expansionary AD policies tend to

produce inflation when unemployment is relatively low

The cost of the cycle above trend is inflation and the cost below trend is unemployment



23

Business Cycle Features Business cycles have common

characteristics Procyclical variables rise with

expansionary business activity (e.g. output, employment, interest rates and money supply)

Countercyclical variables (like inventories and bankruptcies) move in the opposite direction to business activity



24

Business Cycle Features Some variables exhibit more variability

than others (e.g. inventories are volatile while consumption is smooth, especially relative to output)

The impulse-propagation model describes: how a shock (impulse) disturbs the

economy from a long-run trend which lasts (propagates) over time

Economists disagree over possible propagation mechanisms



25

Business Cycle Features There are three broad types of

shocks Policy shocks which affect fiscal

expenditure and interest rates (e.g. fiscal and monetary policies)

Supply shocks which affect production and price-setting (e.g. technology advances)

Private sector shocks which affect aggregate demand (e.g. changes in private investment)



26

Business Cycle Features There is debate about the actual timing of

Australian business cycles Which measure should be used?

Variables like unemployment lag changes in real GDP (called lagging indicators)

Leading indicators like firms’ profitability and building approvals precede changes in GDP

Aggregating variables into a composite index will give a coincident index to measure turning points in the business cycle



27

Business Cycle Features Another debate concerns separating

the cycle from trend The classical business cycle considers

actual levels so that a fall in GDP describes negative growth

Two consecutive quarters of negative growth in real GDP is called a (classical) recession

The growth cycle considers fluctuations in growth rates of the economy around the trend growth rate



28









29

1.3 Schools of Thought During the 1960s there were two main

views The monetarists believed the economy is

best left to itself The Keynesian’s argued that

government intervention could improve economic performance

Two schools have developed since then the new classical school in the 1970s the Keynesian school in the 1980–90s



30

New Classical School Consistent with the monetarist view

Economic agents optimise Decisions rationally use all available

information (rational expectations) Markets are assumed to clear

These assumptions ensure there is no involuntary unemployment

The real business cycle extension argues that real supply side shocks are the major causes of fluctuations in economic activity



31

New Keynesian School Extends the earlier Keynesian view

that markets will not always clear even if agents are maximising

Reasons are varied and include There is incomplete information Institutions affect the workings of

markets Costs of changing wages and prices

lead to price rigidities These reasons explain fluctuations in

output and employment



32

Economic Controversies The two main competing views of modern

macroeconomics are highlighted in real-world political and media discussions

Frequently these differences are exaggerated in debate

There are significant areas of agreement Debate and research continually evolve

new areas of consensus e.g. there is increasing agreement on information problems with wage-price setting



33









34

1.4 Text Outline and Preview

The key overall concepts of this book are growth, aggregate supply and demand Chapters 3 and 4 consider long-run

economic growth Chapters 5–7 explore the AS curve Chapters 8–10 explore the AD curve Chapters 11–12 explore international

adjustment in an integrating global economy

Chapters 13–17 examine individual sectors which make up an economy



35

1.4 Text Outline and Preview

The key overall concepts of this book are growth, aggregate supply and demand Chapters 18–19 consider Australian

macroeconomic policy applications Chapter 20 introduces briefly some

frontiers of macroeconomic research



36









37

1.5 Prerequisites & Recipes

The text requires no mathematical prerequisite beyond high school algebra

There are helpful websites www.mcgraw-hill.com.au/mhhe/econ/

dornbusch (for chapter summaries and problems)

www.rba.gov.auwww.treasury.gov.au

www.abs.gov.au www.asx.com.au www.ecosoc.org.au/

www.economist.com www.bloomberg.com/au/ rfe.wustl.edu

Documents

Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Slides prepared by Ed Wilson 1