Introductory Macroeconomics Lecture 5 PDF

Introductory Macroeconomics Lecture 5: Introduction to Short-Run Macroeconomics Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Beginning of Short-run macroeconomics Introd...

Introductory Macroeconomics Lecture 5: Introduction to Short-Run Macroeconomics Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Beginning of Short-run macroeconomics Introduction to short-run macroeconomics – trends vs. cycles – potential output and output gaps – Okun’s law: unemployment and output gaps – overview of business cycle theory BOFAH chapter 6 2 Trend vs. Cycles 3  Trends vs. Cycles Economic variables fluctuate at different frequencies – trends (long-run, fluctuate over multiple decades) – business cycles (short-run, fluctuate over periods of 4-5 years) – seasonal cycles (very short-run, fluctuate at regular/predictable time periods within a year) We usually remove the effects of predictable seasonal cycles and focus on ‘seasonally-adjusted ’ data 4 Trend vs. Cycle in Employment 5 In Raw Data 6 In Seasonally-Adjusted Data 7 The Impact of Covid 8 The Impact of Covid 9  Trends vs. Cycles Terminology Peak : high-point of economic activity prior to downturn, marks end of expansion trough : low-point of economic activity prior to upturn, marks end of contraction recession : often defined two consecutive quarters of negative real GDP growth, but this is just a ’rule of thumb’ 10 Trend vs. Cycle in GDP 11 Big Changes Move the Trend 12 Potential Output and Output Gaps 13  Potential Output Yt∗ Potential output or natural output : amount of output produced when using resources at ‘normal rate’. – This can be thought of as the natural productive capacity of an economy at a given point in time. Reflects underlying supply-side factors: – labour, physical capital, technology, etc We will denote potential output by Yt∗ Actual output Yt can be above or below Yt∗ 14  Output Gap Output gap is the deviation between actual output Yt and potential output Yt∗ , that is Yt − Yt∗ Output Gapt = × 100 or Yt − Yt∗ Yt∗ (in percentages) (in levels) The output gap is – positive when Yt > Yt∗ – negative when Yt < Yt∗ Unintuitive observation – Contraction from peak is when output is shrinking but Yt > Yt∗ – Expansion from trough is when output is growing but Yt < Yt∗ 15 Okun’s Law 16  Unemployment Similarly let u∗t denote the natural rate of unemployment Rate of unemployment we would expect when the economy is operating at Yt∗ Gap between actual unemployment ut and natural unemployment u∗t is a measure of cyclical unemployment (unemployment gap) Policymakers want to try to keep the unemployment rate as close to u∗t as possible Estimating u∗t one of the most controversial topics in macro – RBA estimates the Non-Accelerating Interest Rate of Unemployment (NAIRU) 17  Okun’s Law Cyclical unemployment is negatively associated with output gap – Unemployment higher than normal when output less than normal Y −Y ∗   – Example ut − u∗t = −β tY ∗ t × 100 or − β (Yt − Yt∗ ) t (in percentages) (in levels) 18 Okun’s Law in Changes 19  Discussion Some important theoretical questions to address – what causes fluctuations in output over time? – what causes fluctuations in potential output? – what causes fluctuations in output gap? Related important measurement issues – natural output Yt∗ , natural unemployment u∗t not directly observed – need some method to estimate them 20 Overview of Business Cycle Theory 21  Business Cycle Theory What do we want from a theory of business cycles? A conceptual framework that identifies key (i) shocks hitting the economy (global supply shocks, terms of trade shocks, productivity shocks, confidence shocks, unexpected changes in policy,... ) and (ii) propagation mechanisms that transmit shocks to the rest of the economy Such a framework then provides a way to evaluate the pros and cons of various kinds of policy (e.g., monetary policy, fiscal policy) 22  Two Main Theoretical Approaches Classical (pre-1930s) business cycle theory – key idea: Say’s Law: ‘supply creates its own demand ’ * not possible to have economy-wide lack of demand * business cycles driven by fluctuations in aggregate supply (e.g., lack of agricultural production) – key policy conclusion: markets operate well, demand-side policies such as government interventions are counter-productive Keynesian business cycle theory (since 1930s) – key idea: Say’s Law need not hold at macro level * can have economy-wide market failure due to lack of demand * business cycles driven by fluctuations in aggregate demand (e.g., confidence, ‘animal spirits ’ of investors) – key policy conclusion: government interventions can stabilise business cycle fluctuations by stabilising aggregate demand 23  Keynes’s General Theory (1936) Written against background of the Great Depression (1929–1939) Unemployment over 20% in many countries. Widespread deflation Classical theory did not provide useful policy recommendations Macroeconomics as a distinct field emerges from this set of debates Almost immediately economists began working out attempts at synthesising Keynesian and classical ideas – Hicks (1937) ‘Mr. Keynes and the Classics’ – waves of ‘Neoclassical economics’ (1950s-1960s), ‘New Classical economics’ (1970s-1980s) , ‘New Keynesian economics’ (1990s- ) etc 24 Covid vs. Great Depression 25  Two Approaches to Teaching This Debate (1) Start with supply-oriented classical approach, long-run macro. Then turn to demand-oriented short-run (more Keynesian) macro or (2) Start with demand-oriented Keynesian approach, short-run macro. Then turn to supply-oriented long-run (more Classical) macro We will follow approach (2) We will also consider an intermediate approach that puts equal emphasis on demand and supply (AD-AS model lectures 11-12) 26  Learning Outcomes 1 Understand the difference between trend and cycle in the data. 2 Understand the different kinds of fluctuations and terminology in relation to the business cycle. 3 Understand the difference between output, potential output, and the output gap; and the parallels with unemployment, natural unemployment and the unemployment gap. 4 Understand how the output gap and unemployment gap relate to each other through Okun’s Law. 5 Explain the two main theoretical approaches to business cycles and distinguish the time horizons for which they are most applicable. 27  New Formula(s) and Notation Okun’s Law Yt − Yt∗   ut − u∗t = −β × 100 or − β (Yt − Yt∗ ) Yt∗ (in percentages) (in levels) u∗ natural unemployment ∗ Y potential output β sensitivity of output to changes in unemployment 28  Next Lecture Keynesian Macroeconomics, Part One – determinants of aggregate expenditure – Keynesian equilibrium (Keynesian cross) – role of government expenditure BOFAH chapter 7 29