Transcript Chapter 1 PPT

Chapter One
Introduction
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 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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
Chapter Organisation
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
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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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
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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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
6
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
7
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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
8
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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
9
Fixed Productive Capacity

This is represented by a vertical AS
schedule at real output level Y0
AS
Price Level
P
Y0
Y
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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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)

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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Fixed Productive Capacity

AD and AS in the long run
Price Level
P
AD
AS
P0
What happens when
AD shifts rightwards?
Price increases
What happens when
AS shifts rightwards?
Price decreases
Y0
Y
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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The Short Run

AD and AS in the short run
What happens when
AD shifts rightwards?
Price Level
P
Price unchanged
P0
AS
AD
Y0
Y
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
4
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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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The Medium Run

The relative steepness of the AS curve is a
major controversy in macroeconomics
Price Level
P
P0
AS
AD
Y0
Y
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
6
Chapter Organisation
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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Growth and GDP
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
1
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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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
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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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
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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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
2
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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
3
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
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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)
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
5
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
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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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
7
Chapter Organisation
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
8
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
2
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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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
0
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
1
Economic Controversies
The two main competing views of modern
macroeconomics are highlighted in realworld 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

Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
2
Chapter Organisation
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
3
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
4
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
5
Chapter Organisation
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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
6
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.au
www.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
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
Slides prepared by Ed Wilson
3
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