Introduction to Macroeconomics PDF

INTRODUCTION. The economic behavior of individuals, or of organized groups like a family or a firm, and how they interact through markets, is traditionally dubbed "Microeconomics". The study of the system as a whole is commonly the realm of "Macroeconomics". the distinction, and sometime the discont...

INTRODUCTION. The economic behavior of individuals, or of organized groups like a family or a firm, and how they interact through markets, is traditionally dubbed "Microeconomics". The study of the system as a whole is commonly the realm of "Macroeconomics". the distinction, and sometime the discontinuity, between micro and macro phenomena is not only an oddity of economists, It also happens in other social sciences as well as in natural sciences. FOUR KEYWORD. 1→ economic growth measure how much production productivity → 1 of the keys (industrial revolution) boom of mast consumption- prosperity of families, supermarkets 2→ business cycle irregularities of the speed of growth that isn’t constant decelerate of accelerate the growth and sth can slow down or step back 3→ inflation free market the larger and larger social part go through the exchange of goods where the prices weren’t supposed by the governments are independent. 1st great thinker was Smith 17th understand what really matter if we want to associate the notion of well being people we should look to what the system offers to the society → ability to produce more and the changes of prices price change a long side quantity → rate of changing prices Inflation all the periods were the prices increases prices tend to increase and decrease all together not only in one market that is typically when the market is well spread → Germany after 2WW 4→ Unemployment diffusion of the goods but not to the all “level”of the society -unpleasant consequences the labor market- all people can enjoy the creation of wellbeing Relocation = moving people from non-profitable sectors to better performing ones. From agriculture to manufacturing What makes these phenomena "macro", and why do they need a "special" discipline? Economy-wide (socially relevant) phenomena Every day we observe businesses that are booming and others that are going bust, prices that go up or down, workers who are fired or get a job, people becoming worse off or better off. Yet quite often these "micro" phenomena scale up to such an extent that makes them of general (social, political) relevance.--> when this phenomenon aggregate themselves Aggregation We need data and techniques that capture phenomena that are relevant at the aggregate level across the whole economy. → finding, managing data Interaction A key feature of the "micro" phenomena that reach "macro" relevance is the activation of interactions across markets and sectors, normally through the basic market mechanism of prices (if most industries cut wages, workers are likely to cut consumption), but also through non-price mechanisms (firms in the consumption sector facing a fall in demand may decide to fire workers). Is the economy able to reach and maintain "general equilibrium" across markets, with full employment of available capital and labor, and stable prices? A controversial discipline Macroeconomics has been controversial ever since its foundation with The General Theory of Employment, Interest and Money by John M. Keynes in 1936. There are two orders of reasons: (macro phenomenon and micro specialized disciplines) How to move from "micro" to "macro". − Build macro on perfect competitive markets (flexible prices, equilibrium…) and perfectly rational optimizers (homo economicus) − Build macro on markets that may be dysfunctional (monopolies, oligopolies, rigid prices, disequilibrium…) and possibly limitedly rational individuals great depression → market doesn't go well so what can we do? do sth that get the system closer to competitive market or interact with the market people are not rational → what to do? economic policies Views of society and its values. Contiguity with economic policy, and politics, which involve different views of the "common good", of the goals of the economic system, the role of State, etc. There are as many "macroeconomics" as answers to the previous questions. high inflection after the covid was worried for the high employments → BCE interventions decided to fight inflation before the unemployment problem bc inflation is worse central banks give u the idea that inflation has to be fight first in spite of unemployment problem → set priorities bc the importance is to have a big cake and then distribute the slice of the cake to the society. NATIONAL ACCOUNTS. The national accounts are statistics published by national statistical offices that use information about individual behavior to construct a quantitative picture of the economy as a whole ISTAT-EUROSTAT The institutional sectors The economic authorities Economic activities are subject to general as well as specific laws enacted by legitimate authorities. From the point of view of the "macro-regulation" of the economic system, the so-called economic authorities are essentially two: 1.​ the central government 2.the central bank The central government The central government, upon parliamentary mandate and approval  ​ is responsible for the execution of a wide range of economic policy decisions (excluding those delegated to the central bank) ​ the most important decisions from the macroeconomic point of view are enacted through modifications in items that form the budget of public sector, i.e. revenues (all various forms of taxation) against expenditures (all various forms of disbursements towards the rest of the economy) → When the public budget is in deficit, the excess of expenditures not covered by revenues should be covered by borrowing from lenders. This is ordinarily done by issuing public obligations (bonds) bearing an interest to be paid to lenders. New issuances add to the stock of public debt, i.e. the total amount of loans to be repaid over time. The central bank In modern economies, the central bank is an independent public agency to which the State delegates the responsibility of management and control of the monetary system. The monetary system includes the central bank together with the other subjects that are involved, upon authorisation of the central bank, in the management of money, typically commercial banks. This task includes: the control and management of the amount of legal monetary instruments available in the economy in a given moment, which is called money supply, or more precisely money stock the control and management of the foreign exchange market, i.e. the market where the national currency can be exchanged with foreign ones oversight and regulation of the banking system and overall stability of the financial system The special status of the members of the European Economic and Monetary Union The 20 European countries belonging to the European Economic and Monetary Union (EMU) or Euro Zone (EZ), who have adopted the euro as their common currency, differ from other stand-alone sovereign countries with regard to their economic policy authorities The Maastricht Treaty (1991) is the founding treaty of the European Union (EU). It also defines the ground lines of the "economic constitution" of the members of the EMU. Limited fiscal sovereignty  The EMU member States retain formal fiscal sovereignty (there is no common fiscal authority), but they are subject to the limitations subscribed to in the Maastricht Treaty and subsequently specified by the Stability and Growth Pact (1997): it has transformed the criteria established by the Maastricht Treaty for admission to the EMU into permanent rules of fiscal policy of member States: − year public deficit < 3% of GDP − stock of public debt < 60% of GDP (or on a sustained reduction path) it introduces a set of regulations for application, verification and sanctions it has been reformed in 2006, 2009, 2012, 2024 A single currency and a single central bank The direct consequence of sharing a single currency is the devolution of monetary sovereignty (i.e. a national independent central bank) to the single common European Central Bank (ECB). → The ECB was instituted in 1999 and the euro entered circulation on 1-1- 2001. National central banks still exist but operate as branches of the ESCB (they cannot take independent decisions) but can exert some residual control on national banks The flow chart of the economy → The essential characteristic of a market economy is that (most of) economic transactions take place in markets The flow chart (here only the (non-financial) private sectors) stylises the fundamental two-way relationship between households and firms that generates economic activity It provides the basic accounting framework for the national accounts, first of all the Gross Domestic Product (GDP) GROSS DOMESTIC PRODUCT The GDP measures the amount of goods and services produced and exchanged through markets in a given period of time (including inventories and replacement of existing equipment) Method 1: GDP = Total value added of the CS = Total receipts − Intermediate goods Method 2: GDP = Total factor incomes of the HS (housesector) = Labour incomes (wages) + Capital incomes (profits) Method 3: GDP = Total final expenditures = Consumption goods + capital goods (investments) → Distinguish the new purchases and the amortization purchases the sum gives me the gross purchase National accounts are often presented in algebraic form, as we shall do subsequently, using a widely used conventional notation system. It is also conventional to adopt the expenditure definition of GDP. The conventional notation is Y for GDP, E for total expenditure. Therefore, Y=E In the case examined so far expenditure only consists of consumption goods, denoted by C, so that Y=C In this expression, GDP is a.k.a. "aggregate supply" (AS) (the total production of goods and services supplied by firms) vis-à-vis "aggregate demand" (AD) (the total purchases of goods and services). Let us now move on to gradually include some other important aspects of economic activity and its accounting. Adding investment and saving We begin with one of the key production factors in modern economies (after, at least, the Industrial Revolution of the XIX century), namely the set of physical means of production called capital (machineries, plants, factories, real estate). In the national accounts, the two operations of replacement of the existing stock of capital and the purchases of new equipment are reflected in the aggregate of gross investment, or fixed capital formation The standard algebraic notation for investment is I. So the value of GDP by the expenditure method is now Y=C+I National accounts are engineered in such a way that whenever €1 is spent on capital goods, €1 results as private savings in the HS account (or vice versa). This is indeed a necessary condition for the circular flow of income to be closed without "leakages". Let us use the income definition of GDP, denoting total factor incomes as YF Y = YF Households will either employ YF to buy consumption goods or save part of it: YF = C + S Substituting S=I Ex: Consider that now the firms of Mock Land decide to buy new capital goods of value 50. Hence Y = C + I = 180 + 50 = 230. The new value of total production is distributed to households as factor incomes YF = 230. For the household accounts to be consistent with the new production planned by firms, 50 of their factor income should be set aside (not consumed). Suppose that S ≠ I, then two possible cases arise, each of which implies an imbalance in the accounts: S > I: the share of YF not spent by households is greater than the share of Y created by firms' investments, hence Y cannot be entirely sold out, or there is excess supply (consider the previous example, suppose that saving is 60 and consumption 170: hence 10 of produced consumption goods would remain unsold) → Produces more than it is demanded. S < I: : the share of YF not spent by households is smaller than the share of Y created by firms' investments, hence Y cannot satisfy the whole demand for goods, or there is excess demand (consider the previous example, suppose that saving is 40 and consumption 190: hence 10 of demanded consumption goods would remain unsatisfied. → Produces less than it is demanded. Note that the necessary accounting identity S = I is not yet an explanation of how the mechanisms of the economic system operate in order to obtain this result. How does it happen that the independent decisions to save by a multitude of households add up exactly to the independent decisions to invest by a multitude of firms? As we shall see, this, known as the saving-investment coordination problem, is a key macroeconomic issue. Adding the public sector → the public sector is important because it accounts for a large part of the GDP, starting from the economic account/public budget used for revenues and expenses. The public sector gains revenues from taxes not because it sells goods. -​ revenues are collected through various forms of taxation: direct (income taxes), indirect (transaction taxes, e.g. value added tax) -​ expenditures include various disbursements towards the other sectors, i.e. current expenditures (for the supply of public goods and services like statal universities) investment expenditures (disbursements for acquisition of new public capital and infrastructures) and transfers (direct payments against citizens' entitlements such as pensions, unemployment benefits, interests on public debt, etc. it doesn’t concern the transfer of goods) The PS contributes to the formation of GDP by the amount of its current and investment expenditures. GDP = Consumption (private) + Gross investment (private) + Public expenditure (current goods and services + gross investment) The standard notation for public expenditure is G. So the value of GDP by the expenditure method is now Y = C+1+G The PS is no longer an entertainer, it is an important pilaster because people are aging and the pensions are raising so the PS has to pay them. The public budget is: -​ balanced when total revenues = total expenditures -​ in deficit when revenues < expenditures -​ in surplus when revenues > expenditures When the public budget is in deficit, the excess of expenditures not covered by revenues should be covered by borrowing from lenders. This is ordinarily done by issuing public obligations (bonds) bearing an interest to be paid to lenders. New issuances add to the stock of public debt, i.e. the total amount of loans to be repaid over time. The PS contributes to the formation of GDP by the value of its supply of goods and services, a.k.a current public expenditure. Since the PS is not-for-profit, these are imputed at the production cost, i.e. the total disbursements for wages and consumables (stationary for clerks, gasoline for police cars, drugs for hospitals, etc.). The standard notation for public expenditure is G. So the value of GDP by the expenditure method is now Y=C+I+G Note. The PS, like the private CS, has its endowment of physical capital, called public capital: buildings and real estate, infrastructures (roads, railroads, ports, etc.). Therefore the public sector can also contribute to the aggregate investment in the economy whenever it maintains or increases its own capital stock. Adding the foreign sector The FS is a virtual sector whose sole purpose is to account for all economic transactions between subjects resident in a given country and subjects resident in the rest of the world. There are two relevant economic transactions in this context: those for goods and services and those for the payments of factor incomes (wages, rent, interest, and profit). Exchanges of goods and services among residents and non-residents entail that: resident firms can sell products to foreign buyers (exports), resident buyers can buy products from foreign firms (imports) The balance between exports and imports is called trade balance (difference between exports and imports). (7) TB = EX − IM Payments of factor incomes arise as a consequence of free international movements of workers and capitals, and give rise to the foreign income account revenues: remittances from national emigrated workers, profits and interests paid back by national companies operating abroad payments: remittances abroad by immigrated foreign workers, profits and interests paid abroad by foreign companies The sum of the trade balance and net foreign incomes is called foreign current account. Using the previous standard notation and NFI = net foreign incomes: (8) CA = TB + NFI The FS contributes to GDP through the trade balance. Exports add up to, while imports subtract from, expenditure of residents as determination of resident firms' sales. Therefore, Y = C + I + G + EX − IM (9) Y = C + I + G + TB A surplus (positive) trade balance increases GDP while a negative (deficit) trade balance decreases it, with respect to residents' expenditure. Exports → goods produced that are a part of work in the internal country sos they are important Domestic consumers can buy goods from foreign so that diminishes the advantage of the exports because they don’t buy the same product produced in the internal country/domestic producers. The actual magnitude of the items adding up to GDP in the case of Italy in year 2023 are the following: Every year the Country decides the inventories → a negative inventories means that it has been decided to reduce. What does the composition of GDP look like in advanced economies? For each country the data are averages over time, but it is a well established regularity that the composition is rather stable over time.. NATIONAL INCOME. It measures the effectively that the households gain, it is concerned more in the wealthbeing, otherwise GDP is concerned more in efficiency not in wealthbeing. In addition to GDP, the other fundamental item in the national accounts is National Income (NI). Its aim is to measure the amount of resources made available by the economy to people who participate in the economy itself by means of labour and capital. NI is also the basis for welfare measurement and analysis. NI is given by amount of all factor incomes accruing to the HS: NI= Total factor incomes In an open economy, factor incomes are generated by the national sectors as well as through the foreign sector. The former coincide with GDP, the latter with net foreign incomes: NI = Y + NFI Using expression (9) for GDP: NI = C + I + G + TB + NFI But TB + NFI = CA, therefore (10) NI = C + I + G + CA A surplus (positive) foreign current account increases NI, while a negative (deficit) one decreases it, with respect to incomes generated domestically. Disposable National Income (DNI) Taxes and transfers modify the DNI. DNI takes into account that NI is reduced by taxation, which by convention is entirely imputed to the HS Using expression (10) for NI: DNI = C + I + G + CA − T Hence the PS plays a twofold role: it contributes to DNI by the amount of public expenditure G, but is also reduces DNI by means of the amount of taxation T. Recall that T and G make up the public budget B public budget B=T−G so that (11) DNI = C + I − B + CA [C = private consumption I = private investment] -​ if B = 0 (balanced budget) the PS is neutral on DNI (it concerns the hole ‘??’ of the PS), which is only determined by the incomes generated by the other sectors -​ if B < 0 (budget deficit) the PS increases DNI -​ if B > 0 (budget surplus) the PS decreases DNI. National income and the foreign sector Recall the account of the FS (expression (7)) given by the trade balance (TB) and the net foreign incomes (NFD): CA = TB + NFI Therefore the FS affects the incomes earned by the HS, and hence DNI, in two ways: it contributes to GDP via the TB (Y = C+ I + G + TB) and to the incomes received from and paid to the rest of world via NFI: DNI = C + I -B + TB + NEI But TB + NEI is the expression of CA, and hence we end up with final complete expression of DNI: (11) DNI = C + 1 - B + CA The economic relationships with the rest of the world add resources to DNI if CA > 0 (surplus), (higher than it is produced by households??) subtract resources if CA < 0 (deficit). In 2009 in IT there was a deficit In economies with nonzero budget balance and foreign current account (i.e. almost ever) GDP and DNI differ.  Differences are generally small, but sometimes they may be non negligible. Between 2007 and 2015, DNI remained below GDP. The main reason, in accordance with expression (11) was a sequence of pretty large current account deficits. A further refinement, mostly used for welfare analysis, is the per capita DNI, i.e. as a ratio to the resident population. With this graph we can compare the DNI per capita of Italy and other countries. We grow with a slower step than the other countries in the EU, a 15% gap that IT wasn’t capable to fill this gap. In the early few years of the 2000s, Italy's p.c. DNI grew in line with the rest of the EMU. Subsequently, it flattened through almost a decade, opening a wide gap with the rest of the EMU reaching 5000 euros (14%) in 2023. The comparative p.c. data clearly convey an important information that raises important questions for both scholars and policymakers: what happened to Italy that did not happen to the other members of the EMU? Limits and critiques to GDP As said, the GDP is the most common and widely used measure of the "dimension" of the economy. It also plays a key role for economic policymaking, welfare analysis, and international comparisons. However it is necessary to be aware of its intrinsic limits and avoid misuses. Recall the definition [slide 6]: the GDP measures the amount of goods and services produced and exchanged through markets. Hence, it does not account for a number of economic activities and transactions that do not go through regular markets: Intermediate goods and similar inputs "disappear" and have too narrow a definition being limited to regular market transactions. The most important case is that of depletion of environmental resources (especially non-reproducible), many of which do not have a market, are seemingly free and unlimited, and are not paid (accounted) for. What is the relationship between the amount of goods that are produced/the level of GDP and wellbeing? The relationship concerns how the growths produced are distributed because the better it is distributed the higher the wealthbeing will be. Higher GDP/production can indicate higher potential for wellbeing (more resources available), but doesn't guarantee it. Wellbeing depends on distribution, resource use, and non-monetary factors: GDP measures the total value of goods and services produced → a larger GDP means more "stuff" is available, potentially leading to a higher standard of living (better healthcare, education, infrastructure, etc.). However, if that wealth isn't distributed evenly (uniformemente), or if it's generated through unsustainable practices that harm the environment or exploit workers, overall wellbeing might not improve, or could even decline. Furthermore, wellbeing also depends on factors GDP doesn't capture, like social connections, personal freedom, and mental health. Ever since The Wealth of Nations by A. Smith, we believe that well-being depends on the amount of available goods and services (the original idea behind GDP). Yet the psychological school of "Happiness" argues that it may not be the case, and shows evidence of a poor (sometimes negative) relationship between the level (or growth) of GDP and reported indicators of well-being (Easterlin 1974, 2003).  GDP is an aggregate measure that fails to account for two major facts that may affect human well-being. First, income distribution. A country with high or growing GDP, even per capita GDP, may leave large fractions of population in poverty (Atkinson 2015). Second, access to material and immaterial capabilities (Sen 1985), such as health, safety, education, dignity, identity, that may be limited not only by low income. A path-breaking critique to the pitfalls of GDP, is the denouncement of dramatic living conditions behind the world highest GDP in the famous speech by Robert Kennedy at Kansas University in March 1968. Several studies have been put forward in order to elaborate better indicators of well-being and living standards than GDP. The most recent one has been prepared under the former French President Sarkozy's Commission a.k.a. Stiglitz Report (2009).. READING MACROECONOMIC DATA. Basic macroeconomic data to be familiar with include GDP over time, its typical fluctuating growth path, its main components such as aggregate consumption and investment, labour market responses in employment and unemployment, and the inflation rate (changes in prices). These data present a lot of similarities across countries and over time, a.k.a. "stylised facts". Hence they also represent the phenomena that macroeconomists are engaged to explain and the ground on which possibly different explanations are tested. We shall see mostly Italian data, but they are representative of regular macroeconomic phenomena, unless otherwise stated. Nominal GDP → measured in market place (in monetary value) GDP statistics are first presented as time series, i.e. point observations on a year or quarter basis reported as monetary values. These are also called nominal values or, more precisely, at current market prices. Basically, the nominal GDP in year t is the collection of goods and services produced in quantities q1t, q2t, …, qnt, … measured at the respective market price p1t, p2t, …, pnt, … Nominal GDP(t) = q1t×p1t + q2t×p2t + … + qnt×pnt + … It's the total value of everything produced, calculated using current prices. Each item's contribution is its quantity multiplied by its price, then everything is added together. GDP deflator Look at the formula of nominal GDP. Since the aim of the calculation of GDP is to measure the capacity of the economy to produce goods and services, the only relevant information is the former type. Indeed, as we have learned since Adam Smith's Wealth of Nations (1774), we do not believe that society is better off if GDP is higher because prices are higher. To this end statisticians have elaborated sophisticated techniques to separate changes in prices from changes in quantities. The basic idea is simple and it applies whenever we want to measure the real value, or purchasing power, of any sum of money, that is how much of "real things" we can buy with that sum of money: Real value of a sum of money = €M/P Of course citizens, economists and policy makers are interested in the real value of the euro in terms of broader categories of goods and services. To this end, price indexes are available, where P is not the price of a single good but something like a sophisticated weighted average of the prices of the "basket" of goods of interest. Two are the most relevant indexes: the consumer price index, the "basket" contains the most widely used consumption goods and services (that’s not a monetary value) → the price index tracks how the cost of a set of goods and services changes over time. It's a way to measure inflation by comparing the current cost of the "basket" to its cost in a base year. the GDP deflator, the "basket" contains all the available goods and services forming the GDP. The time series of all price indexes are presented as a list of pure numbers on the scale of hundreds. (is an estimation assuming that the prices didn’t change ) The GDP deflator is a price index that measures the changes in prices for all of the goods and services produced in an economy → GDP deflator is a measure of inflation, it tells how much prices have changed for *everything* produced domestically, unlike other indexes like the CPI which track a fixed basket of consumer goods. It's calculated by comparing nominal GDP (current prices) to real GDP (constant base-year prices). The picture below exemplifies this procedure for the value of the same shopping cart measured in 2015 and 2016 (the figures are imaginary) One year later the value of the same shopping cart has increased. Look at the year 2015, where the index is equal to 100. This is called the base year of the index. It means that Eurostat has taken the prices of goods and services in 2015 as the reference value, has set their value equal to 100, and then has scaled the prices of the same goods before and after 2015 in relation to 100. Depurated from the mere increase of prices, the path of real GDP is flatter than that of the nominal one. Going backward from 2015, prices are lower so the real value of GDP is higher than the nominal. Going forward is the opposite. Compare the total growth 2023/2000 of GDP in nominal terms (€ bln. 2005.9/1239.3) and in real terms (€ bln. 1780.2/1660.3). What explains the difference? Growth and growth rate GDP typically follows an irregular path of fluctuating growth The quantitative production of goods and services, as measured statistically by the GDP at constant prices, generally grows over time. Next step is to measure the pace at which GDP grows. This is given by the rate of growth over a given period of time (one year). − (very) long-run growth rate ( average > 10 years) − growth phases (average, several years) − medium short term fluctuations (business cycles) − recessions (spot the years, the GDP is as a negative growth than the level of the precious year, maybe for a crisis…) Mostly Italy's data will be used for expository purposes. Yet the chosen data can be regarded as representative of the empirical regularities of other advanced countries, unless otherwise specified and explained. The study of time series data starts from the choice of the time period to cover. This choice should be consistent with the aim of analysis. Our main reference period will be from 1970 up to the latest available data (generally 2023). 1970-today → the long term of analysis that we mean with the long run. The end in 1945 of II WWW, created a lot of economic movements to reconstruct buildings, produce food ecc… This graph represents real value: the value of real goods produced every year y-axis → euros of the goods Trial average is the way that the changes in the GDP are measured. Growth grows irregular phenomena but we can group many part of those changes as the graph represented: 1° phase→ 1970-80 high growth 2° phases→ 1980-90 medium growth 3° phase → were there is a break that causes a low growth 4° phenomena → recession, which are not very frequent, from 2008 to 2009 called the great recession due to the financial breakdown of the banks and households where the credits collapsed. There was a crisis not only for the developed country but in general for the western countries. There was a small recovery in 2010 but after there was this great recession. The problem was in European dimensions. In 2020 there was a recession due to COVID, it wasn’t due to an economic crisis. Measuring growth in the long run The key statistics characterising GDP growth in the long run are summarised in Table 3. The average rate over the whole period (column 2) is split in different phases denoted by decreasing average growth. The level of GDP every year slowed down, this is common for every country (IT has a most significant impact, but also the other countries slowed down) all across the western part. What determines the long-run growth rate? From a macroeconomic perspective, the long-run growth rate is determined by: 1. **Total Factor Productivity (TFP)**: Improvements in efficiency and technology that allow for more output from the same amount of inputs. 2. **Labor Supply**: Growth in the labour force due to population increases or immigration affects overall economic capacity. 3. **Capital Accumulation**: Investment levels influence how much physical capital is available for production processes. 4. **Human Capital Development**: Education and skill enhancement improve worker productivity over time. 5. **Economic Policies**: Fiscal policies, monetary stability, trade openness, and regulatory frameworks can either promote or hinder growth. These elements collectively shape an economy's potential output over the long term through their impact on productivity and resource allocation. Why is it different across countries? 1970-80 → highest average level of growth, Italy was in the best situation than the other countries. After the great recession IT had a level of GDP in 2023 was less than in 2009 before the crisis, other countries had a less impact than IT. Why, in the same country, are there phases of high growth and low growth? The level of GDP every year slowed down, this is common for every country (IT has a most significant impact, but also the other countries slowed down) all across the western part. Trend and cycle The fact that the annual rates of change of GDP are irregular entails the irregular path of the level of GDP itself. If the growth rate were constant, the level of GDP would increase uniformly, i.e. it would follow what statisticians call a linear trend. Before proceeding it is useful to introduce a largely used technique to deal with time series of macroeconomic data, namely their logarithmic transformation. This is done for various reasons, one being to exploit the property of logarithms to transform non-linear operations and relationships (multiplications, divisions, powers) into linear ones, a.k.a. log-linearization. The non-linear relationship between GDP and time is just an example. [See the Appendix of Ch.01 of Lecture Texts for a quick refresh on logarithms]. To begin with, let us take the logarithm of the value of GDP in each year t, i.e. logYt ≡ yt, then the year rate of change of GDP (2) can be approximated as follows: gt = 100×[Yt−Yt−1]÷Yt−1 ≈ 100×(yt − yt−1) ← "log-difference" The linear trend of GDP generally consists of a log-linear equation like (3) y*t = a + b×t, t = 0, 1, 2… that expresses the "virtual" value of (the log of) GDP y* in year t if GDP would have grown at the constant rate b, which approximates the year average growth rate GDP over the period of time considered Y →GDP in real value The equation represents the growth rate of output (GDP) over time, expressed in percentage terms. Here’s a breakdown: ​ gt: This is the growth rate at time. ​ Yt and Yt−1: These represent GDP or total output at times t and t-1, respectively. ​ The formula calculates the percentage change from one period to another. The linear trend represents how the GDP wool have grown if the percentage was always the same every year (1.6%) Each difference from the point and the line The path of actual GDP (gray dots) is the same as in Figure 2. Hence in the equation of the linear trend, the number of years t ranges from 1970 (t=0) to 2023 (t=54). Note that the coefficient of time (0.015) approximates the average growth over the whole time series (1.6%) 16 Not all points below the trend are recessions (recessions are red dots: see Figure 3). The recession expresses the lower growth compared to the previous year, that’s a different thing. Measuring deviations from trend In any year t we can measure the % difference between the actual level of GDP Yt and its corresponding value on the linear trend Y*t. This is also called the cyclical component of GDP. Using logarithms, (4) cyclical component 100×[Yt−Y*t]÷Y* ≈ 100×(yt − y*t) Consequently, actual GDP can also be measured as (5) Yt = Y*t + cyclical component This measurement of the business cycles adopts a specific terminology. A cycle consists of: an upward phase or expansion, i.e. a movement of GDP from a minimum below the trend (trough) to a maximum above the trend (peak) (e.g. 1975-80, 1983-1990)  a downward phase or contraction, i.e. a movement of GDP in the opposite direction (e.g. 1980-83, 2001-20) turning points, the high point (where the economy goes from expansion to contraction), the low point (where the economy goes from contraction to expansion). In addition, the cycles are characterised by: amplitude of phases, the percentage distance between a minimum and a maximum or vice versa; for instance, the 1975 "trough" is − 10%, the 1980 "peak" is +2.1%; thus the amplitude of the 1975-80 expansion is 12.1%; the amplitude of the 1980-83 contraction is from +2.1% to −0.8%, i.e. 2.9%, etc duration, the period of time between two points on the trend; the duration of cycles is also irregular, but is generally in the order of some years (from 6 to 8 in advanced countries). Fluctuations in the short run Figure 3 highlights that GDP grows irregularly (sometimes it decreases) even on a short-term horizon of a year (or a quarter!). An important aspect is that, beyond a certain extent, short-run fluctuations may be viewed as a symptom of instability of the economic system. How can we gauge these fluctuations, in the first place? Statistics offers a tool that is easily and largely used for the purpose of measuring the variability of a series of values, i.e. their standard deviation. Let us consider the time series of the year changes of GDP, g1. …. gt. … gT, and their average gM. Their standard deviation (conventionally denoted with σ) is For Italy 1970-2023 the result is σg = 2.75. The s.d. is a pure number. Is 2.75 large or small? How can we assess it? One simple rule of thumb is to compare the s.d. with the average. If it is greater, then we may say that growth is pretty variable. Variability can also be assessed in comparison with other countries. In the considered period Italy registered lower average growth and higher variability than the other advanced countries (if you wonder whether this may be a problem you are right).. THE COMPONENTS OF GDP: CONSUMPTION AND INVESTMENT. All main components of GDP display the same feature of fluctuating growth. Indeed, it is the fluctuating growth of the components that is transmitted to the aggregate of GDP. For each component we can measure: − its long-run growth trend − its variability both absolute and with respect to GDP − its correlation with GDP Let us focus on the two main components (private sector only): consumption and investment → they present robust empirical regularities in all advanced countries. In particular, investment is the most variable component, consumption the least variable, both in absolute and with respect to GDP. Consumption tends to grow a little bit more than GDP, and investment is the most volatile variable than GDP and consumption (consumption is less volatile than investment and GDP, investment is more volatile than consumption and GDP). Every component of GDp has its own growth and variability (??). Correlation with GDP As we shall see, it is important for macroeconomic analysis to establish whether and how the components of GDP change as GDP itself changes. This information can be obtained by means of correlation analysis, a statistical method that indicates the sign and strength of the comovement between two variables. Accordingly, macroeconomists classify variables in three categories: − procyclical variables: the correlation with GDP is positive − countercyclical variables: the correlation with GDP is negative − acyclical variables: the correlation with GDP is null Consumption and GDP The first step is a graphical analysis. Instead of a time series graph, we can ask our data processing programme to return a scatter plot, which allows precisely a first analysis of the correlation between variables. Let us begin with consumption using the same data as those in Figure 6 truncated at 2019, i.e. excluding the observations of 2020-23 that display anomalous volatility. Correlation analysis offers two more rigorous tools. ​ Interpolation line Let us consider the time series t = 1, …,T of two variables xt and yt. The interpolation line yields the linear equation which best fits the data (minimises the measurement errors between the fitted – hypothetical − value y*t and the observed value ). The sign of the coefficient b, the "slope" of the line, indicates the sign of the correlation: − a positive coefficient (positive correlation) indicates that the two variables are pro cyclical − a negative coefficient (negative correlation) indicates that the two variables are counter cyclical − zero coefficient (zero correlation) indicates that the two variables are a-cyclical It is used to mInimize the difference to have a more precise relation of the variable The value b = 0.77 of the interpolation equation confirms that consumption and GDP are procyclical. Recall that, according to the mathematical property of the equation of a line, b = ∆y/∆x. Therefore, b = 0.77 means that, in this given set of observations, 1% increase (or decrease) of GDP growth is associated on average with 0.77% increase (or decrease) of consumption growth. ​ Goodness of fit The dispersion of the cloud around the interpolation is a first visual indicator. More precisely, the indicator called R2, which lies between 0 and 1, measures how large (close to 0) or small (close to 1) are the measurement errors that we make by using the interpolation line.  The value 0.68 can be regarded as a fairly close correlation, and can be read as saying that 68% of changes in the value of consumption are "explained" by changes in the value of GDP. It is important to stress that "correlation is not causation", i.e. it does not allow us to say what is the cause of what is the effect, which is a further explanatory task. The closeness of the value in the line and the actual values, the phenomenon are not all aliens in the line, what will be the level of consumption if the GDP grows of 1% for example- EMPLOYMENT AND UNEMPLOYMENT - In Part 1 you have learned that "market" is an elusive word that may cover a variety of relationships among actors in the economic system. This is particularly true for the labour market, a catch-all word that encompasses a complex tangle of relationships between households who have or are willing to find a job and firms (and other organisations of various kinds) that need workforce for their purposes. The essence of the labour market is not about quantities bought and sold and their price like apples, but about which kinds of contracts, and consequent relationships, are established between employers and employees (Solow, 1990). For the reason just said, labour market data are particularly complex, in the first place because they are highly dependent on national legislations and regulations. We shall see the "minimum common denominator" in order to understand the notions and variables most relevant from the macroeconomic point of view. It’s the law who established the legal age to work – the key age for the labour is between 16 to 65 ( "able for work"). Active people are the part of the population who is legally considered able to work but don’t work and aren't even searching for a job. Labour force is a subset of the active population. The labour force also contained people who were searching for work – unemployed – green area). How much time is needed to not be considered unemployed? Each State decides it. The most important labour market indicators (Italian data 2023) Rate of activity → Active population ÷ Total population (63.4%) The potential labour endowment and capacity of the country. Rate of employment → Employed ÷ Total population (43.8%) → more general Employed ÷ Active population (69.0%) → The country's capacity to channel active population into the labour market and find a job. The rate of employment is used to find the efficiency of the economy and labor force in a country  Rate of unemployment → Unemployed ÷ Labour force (4.7%) → not working for personal choices, and tells how good/capable is the country to put those people into a job. A measure of efficiency of the labour market, and of the economic system as a whole, in the activation of available labour force. Note. Rate of employment and rate of unemployment have different denominators. It shows that Italy was capable more or less to increase the labour force Tendentially, labour force and employed grow (demographic effect). A net decrease of employed is uncommon (in case of major recessions, 1992, 2009-12) 7 Unemployment can increase as employment also grow, but less than the labour force. The problem is due to the speed of the labour force with respect to the creation of new jobs, many people took the new jobs and the old workers lost their job because they weren’t capable of achieving this development. An important feature in understanding labour market data correctly is that they give us, at a given moment, a static picture of the contents of the various "boxes", whereas in reality there are continuous flows between one "box" and another. The number of individuals we find in a given "box" at a given time is usually the difference between a certain number of incoming and outgoing individuals. Thus the unemployed are the difference between the number of people entering the labour force and the number of those who find a job. The employed and the unemployed both grow when the inflows into the labour market are greater than the flows into new jobs. So the dynamic of the labour force is a very important element of the labour market. In the 70’s there was a demographic change → more babies and an other phenomena was the entering of the woman in the labour always more → The State wasn’t able to create new jobs for everyone. Employment, unemployment and business cycle Developments in employment and unemployment are obviously important not only economically, but also socially. In this perspective, two are the relevant information: the total amount of employed and unemployed, and their fluctuations. These data display remarkable differences across countries. The USa has more fluctuations than Italy , the system of labour organization is more efficient. The sign of correlation has a negative sign OKUN’S LAW Okun's Law describes an inverse relationship between unemployment and GDP growth: Higher unemployment typically coincides with slower (or negative) GDP growth, and vice-versa. It's an empirical observation, not a strict economic law. It is quite common to think that unemployment is related to the business cycle. Do data confirm the intuition that unemployment increases when the economy slows down and vice versa, i.e. that unemployment is countercyclical? Given the obvious relevance of the question, it is a matter of ongoing investigations. A milestone was provided by the US economist Arthur M. Okun (1928-1980) who, in a study of 1962, confirmed the hypothesis that unemployment is countercyclical, which since then has been known as Okun's Law. As in our previous cases with consumption and investment, Okun's Law establishes a correlation between the rate of change in unemployment vis-à-vis the rate of change of GDP Correlation analysis confirms that in the US data unemployment is countercyclical. 1% increase, or decrease, of growth lowers, or raises, the unemployment rate by 0.4% "on average". R^2 is relatively high and indicates that correlation is good. The two intercepts of the line are important. What happens to the unemployment rate if the growth rate is 0? What growth rate keeps the unemployment rate constant? It should grow 3% per year This is a stable theory. The countercyclical measures the fluctuation and not the level: countercyclical measures address the *fluctuations* of the business cycle. They aim to smooth out peaks and troughs, not necessarily change the overall level of economic activity over the long run. Okun's Law in Italy seems to be confirmed by the sign of the interpolation line, but almost zero R2 warns that it is very poor statistically, i.e. the variations of the two variables are mostly unrelated. This finding is consistent with Figure 3, i.e. that Italy's unemployment rate displays sustained long term trends unrelated to short-run fluctuations of real GDP. The rate of inflation is the rate of increase of a price index over a given period of time (month, quarter, year) The inflation rate in the time series of a price index Pt , t = 1, …, T, is computed as (2) Knowing the inflation rate, and the previous observed price level, the current price level is (3) Pt = (1 + πt)× Pt−1 We can more easily calculate the inflation rate from the log-difference of the CPI, i.e. (4) πt ≈ (pt − pt−1)x100 We already met the GDP deflator, whose "basket" contains all goods and services in the economy. The other most common index is the consumer price index (CPI), whose "basket" is made of "representative" consumption goods, which is more relevant to household purchasing power. CPI Inflation is a major concern for policy authorities (esp. central banks). One main reason is that high inflation has several negative effects on households, such as loss of purchasing power and other welfare losses (we shall see other reasons in future lectures). The products’ prices from the 70’s have increased 25 times as they were. Like GDP, the CPI grows irregularly, i.e. the inflation rate fluctuates around its upward trend. Deflation: very rare to happen, even if it is close to 0 isn’t a good thing bc \\ || short term variability low and stable variability Inflation and business cycles As with other macro-variables, great attention is devoted to the correlation of inflation with GDP. As said, policy authorities (generally) wish to keep inflation under control; at the same time, they also like a vibrant economy with the lowest unemployment. Does data show this ideal situation, or instead that an expansion cycle also comes with higher inflation? Note. As a first attempt, put at work your microeconomics, and think of the market of a single good, say fish, with regular demand and supply, and an equilibrium price. When do you expect to see larger sales of fish together with rising prices and when with falling prices? We shall employ our familiar correlation analysis between inflation rate (i.e. rate of change in the CPI) and the rate of change of real GDP, yielding as usual the interpolation line. Correlation is positive, hence inflation seems procyclical, but the statistical significance is rather weak (a "cloud" of observations mostly unrelated to GDP is clearly visible) 17 Both are phenomena rather common in advanced countries. Both GDP and Inflation have phases, each point have a period: 70’s high inflation and high GDP → they had the tendency to move together (Positive correlation) 80-90 the economy and inflation slowed down a little bit (negative correlationship bc ) from the 90’s tìinflation is stable bc [There isn’t a apparently relationship between long period but we can see the relationship between inflation and GDP which can be of three kind (cyclical, procyclical and acyclical)] Let us take stock of the empirical relationships we have found so far. Both inflation and unemployment are correlated with GDP. Hence it is reasonable to expect that they show some statistical correlation (though indirect) between themselves. Suppose GDP rises and inflation is procyclical (+ πy) while unemployment is countercyclical (−uy) as in the above relationships. Then we can say that inflation will rise while unemployment will fall. The opposite occurs if GDP falls. Therefore this is a case which, we expect, originates from a negative correlation between inflation and unemployment. This kind of correlation, if confirmed by the data, would be no good news, especially for policy-makers. In fact, it would imply a so-called inflation-unemployment trade-off. Less unemployment (a "good thing") comes with more inflation (a "bad thing"), and less inflation (a "good thing") comes with more unemployment (a "bad thing"). What is the verdict of correlation analysis? Phillips Curve The study of the relationship between unemployment and inflation goes far back in time. A path-breaking study was presented in 1958 by the New Zealand economist A. W. Phillips (1914-1975). Phillips's original study concerned the rate of change in nominal wages vis-à-vis unemployment in Great Britain from 1861 to 1914, i.e. it was focused on the labour market, with two key findings. Corresponding to 0 increasing wages: when wages are stable and eventually also the prices, also the employment has a good situation. If you want to reduce unemployment it is needed to reduce inflation. [To have inflation stable it is needed to have a 45% of unemployment, a huge number] Italian data seem to support the negative correlation between inflation and unemployment. The slope indicates that across the data 1% of reduction of the unemployment rate "costs" 1.5% more inflation. The NAIRU seems very high, about 13% (no inflation "costs" high unemployment). However, the statistical significance of the correlation is rather poor. Yet, as in the case of the inflation-GDP relationship (not by chance), there are three different analogous phases. In the 1970s observations seem aligned almost vertically (same unemployment, rising inflation). In 2000-07 the cloud looked horizontal (large swings in unemployment, inflation almost stable (around the ECB 2% target). Only the years after the Great Recession 2008-19 do the display a significant negative correlation, with rising unemployment and falling inflation.. HISTORY. Genealogical tree The Great Depression from 1929 Imperfect Markets Classical Liberals(half 19th beginning 20th century). to 1939 led to → Recessions were not unfamiliar but in the -​ Ricardo roaring years had a great development and -​ Marshal the crisis extended quickly in the US and -​ Wickness also across the world far from being a They studied the basic notions in relation to the normal cyclical downturn. achievements of free competitive markets. consumption and investment showed a The basics are: prolonged parallel fall -​ focus on growth and fluctuations there was a general fall of prices and wages -​ self-regulation of market (and full employment of but demand for goods and employment did available resources) not recover. -​ distinction between fluctuations due to "real" The crisis drove the world into an obdurate factors (endowment of resources, accumulation of stagnation for almost a decade. capital, technological innovations), with effect on production and employment, and "monetary" factors (changes in the quantity of money and interest rates) with exclusive effect on the price level. -​ refrain of governments from interfering with market forces; in particular, "real" business cycles are not a pathological phenomenon, but the manifestation of a system that grows through waves of innovations and "creative destruction" of products and industries. The Great Depression did not coincide with old ideologies → was launched the Keynesian Revolution: one key issue for Keynes’s research program was to understand why and how market economics may fall, from psychological business cycle, into a prolonged state of depression with mass unemployment and with no self-corrective tendency. The theoretical turn was based on four attack points: uncertainty and the psychological conditioning of human decisions the influence of money on interest rates and investment, and the lack of coordination with savings (in embryo, the "discovery" of finance, not only as a handmaiden of economic development, but also as a source of instability and crisis) incoordination of prices and wages prominent role of aggregate demand (investment)as a curse of fluctuations and slumps in output and unemployment The 2nd great innovation of the Keynesian Revolution was the changes from a neutral to an active role of economic policy authorities in order to stabilise economic fluctuations and prevent depressions and mass unemployment → an entirely new view of fiscal and monetary policy was elaborated by the work of young scholars who will give life to a new theoretical paradigm, the Keynesian Macroeconomics. These innovative ideas for defeating depression and mass unemployment with public intervention to support spending on consumption and investment, both through expansionary monetary policy (strong creation of liquidity in the economic system) and through public spending, were followed particularly in the United States by the Roosevelt administration after 1933 with success (a little later in Great Britain). John Hicks gave a mathematical representation → The IS-LM model shows the relationship between interest rates (I) and real output (Y) where the goods market (IS) and the money market (LM) are simultaneously in equilibrium. IS represents all combinations of interest rates and output where planned investment equals planned saving. LM represents all combinations of interest rates and output where money demand equals money supply. The intersection of the two curves determines the equilibrium interest rate and output level. HIcks picked up two points: the role of money and finance in the transmission of investment shocks to the whole aggregate demand (which was indeed central in the General Theory) the failure of the price mechanism to work properly (the transmission from aggregate demand to output and unemployment due to the hypothesis of "rigid" or "sticky" prices and wages, which was not so central in the General Theory). Neoclassical synthesis combines Keynesian macroeconomics with neoclassical microeconomics. It argues that Keynesian analysis holds in the short run when prices are sticky, but in the long run, neoclassical principles prevail as prices adjust, leading the economy towards full employment. It uses the IS-LM model along with the Phillips curve to explain economic fluctuations. In the early 1970s, the Great Inflation ignited, triggered by a surge in the price of oil and raw materials, while the economies were already operating at levels close to full employment and therefore with internal pushes for rising prices and wages. The annual inflation on average increased 2 to 3 times with respect to the previous decade. It was also accompanied by a sharp setback in growth and employment: the combination of stagnation and inflation came to be called stagflation (countercyclical inflation). It was a new phenomenon because until then the "regular" relationship Okun's Law + Phillips Curve had prevailed: i.e. procyclical inflation in the presence of an increase in GDP and employment. The new world scenario appeared out of control and unmanageable for the traditional Keynesian tools as they presupposed stable or pro-cyclical prices and wages. In the stagflationary context, policies to support demand to reduce unemployment further pushed inflation, while restrictive policies to bring down inflation led to increases in unemployment. The imperative of fighting inflation also led to a change of macroeconomic paradigm, bringing to the fore alternative visions to the Keynesian one, first of all the Monetarism of the Chicago school of Milton Friedman, which essentially proposed a "return to the Classics". Their strong point was seen in a theory capable of providing a coherent explanation of the current phenomena, and above all that inflation would have been tamed with a shock of restrictive, strong and rapid monetary policy, without taking into account the negative effects on production and employment, which would have been small and transient in any case active spend-and-tax policies, and more generally State intervention in the economy, were also to be limited in order to keep inflation at bay and unleash free market forces for growth. The New Classical Macroeconomics, elaborated mostly at Chicago by Friedman's followers, completed the "return to the Classics" with a strong theoretical impulse to the study of perfect competitive markets and rational optimising economic agents (and the conviction that Keynesian Macroeconomics was messy and faulty). The intellectual and political climate established by this school, also called Neo-liberalism, received a boost from the bridling of inflation, and intertwined with the profound economic changes of the twenty years of the end of the 20th century. In particular the so-called Globalization, i.e.: the great return of faith in Liberalism and in the action of the spontaneous forces of the markets, the strong international expansion of private economic activity (especially through huge flows of direct investments and movements of financial capital), in conjunction with the dissolution of the Soviet Union (1990), the peaceful end of the Cold War, and the affirmation of the market economic system in a growing number of parts of the world. [Efficiency and growth → macroeconomics priorities] Leading NCM scholars on themselves Robert Lucas, founder and leader of the New Classical school, in his famous Nobel Prize Lecture of 2003 wrote that the problem of macroeconomic stabilisation was definitely resolved and was no longer a macroeconomic priority. - Have the New Classical contributions resulted in a revolution in macroeconomics? "Yes, I think it completely changes the way people who use that framework look at macro determinants of policy. Firstly, it's a positive story about what happens when there is some disturbance to the economy. Secondly, it's a completely different way of looking at policy evaluation". (R. Barro, interview in Snowdon et al, 1994, p. 277) - How do you view stabilisation policies in practice? "Our model is characterised by perfect competition and complete markets. Consequently [...] there is no scope for welfare-increasing stabilisation policies [.] In practice I view stabilisation policies as largely for the usual reason that have been offered by everyone from Milton Friedman to Edward Prescott and Robert Lucas" (Interview with C. Plosser, in Snowdon et al. 1994, p.282) ←The pupils of the Keynesian model, due to Globalisation, had to revise his model "The world is Keynesian not Classic" (Greenwald and Stiglitz 1987) However, the first phase of Globalization, beside a generalised economic expansion, was also marked by emergent problematic aspects: global markets brought also global instability: the promise that the rapid disinflation of the early 1980s would not damage employment was not kept; unemployment grew over the decade and in the main industrialised countries it settled at an average between 6% and 7% two or three points above the initial values the two American recessions of 1981-82 and 1991-92, the severe global financial crises of 1987-88, several episodes of financial instability in developing countries These phenomena showed the limits of an integral Neo-liberal approach, and that the Keynesian interpretation was still useful, empirically if not theoretically. Thus the conditions were created for the research, and the affirmation, of a conceptual framework capable of : integrating the liberation of market forces preached by the Neo-liberals with the need to keep these forces within the context of macroeconomic stability through appropriate actions of economic policy reformulating these ideas immune from the methodological criticisms of the New Classic school This task was carried out by a new group of Keynesian-inspired scholars who gave birth to the New Keynesian Macroeconomics. For a couple of decades across 20th and 21st century, a stable global macroeconomic framework was established (later called the "Great Moderation), favourable to sustained growth with low inflation, and for the first time also including new "emerging countries" which had remained long-delayed economically, in Latin America (Brazil, Chile), Eastern Europe, Asia (India, China). Rightly or wrongly, credit was also ascribed to the conceptual framework provided by the neo-Keynesians, in particular as a guide to the action of economic policy authorities, governments and international institutions. The most important and effective tool for stabilising economic activity was indicated in monetary (rather than fiscal) policy aimed at correcting fluctuations in GDP to an extent compatible with a low and stable rate of inflation, seen as a prerequisite for market forces to develop orderly and sustain growth. The Great Recession, the Covid-19 pandemic, and beyond The Great Recession → was less bad than the great depression, it lasted 4 years. Covid 19 → which wasn’t an economic phenomena, but social (??) Like the other "major events" of the past, the Great Recession was the stumbling block of the macroeconomic, New Keynesian, orthodoxy of the time on two grounds: the inability to foresee and prevent the crisis (too much faith in self-regulating financial markets), the ineffectiveness of conventional recipes.. PRODUCTION AND EMPLOYMENT. Our approach to the study of macroeconomic phenomena starts from the modern prototype of the Macroeconomics of the perfect economy, i.e. the kernel of the New (Neo-) Classical Macroeconomics (NCM). NCM was elaborate on the following principles: Macroeconomics should be built upon "microfoundations", i.e. rigorous and meaningful connections with individuals' economic behaviour. We have a rigorous and fully developed theory of how free markets, populated by fully rational agents, work and how they can achieve socially desirable goals. How does the macro-level of this economy work? Do macroeconomic phenomena show anything "special" that recommends public policies aimed at limiting or substituting free market forces? Maybe economic reality is not so clean and is affected by various imperfections, either in the structure of markets or in individuals' behaviour, however: - are these imperfections sufficiently large and relevant at the aggregate level? - let us bring the theory to the data: how good is it in explaining, replicating, predicting? NMC has been (still is) highly influential as normative benchmark or policies aimed at correcting the failures of the economy to perform as predicted by the macroeconomics of perfect markets. In simple words, if the theory is far from reality, bring reality closer to the theory. [New Neoclassical Synthesis models, often incorporating elements of Real Business Cycle (RBC) and New Keynesian economics, are used for: -​ Economic forecasting: Predicting future economic activity, like GDP growth, inflation, and unemployment. -​ Policy analysis: Evaluating the potential impact of monetary and fiscal policies, such as interest rate changes or government spending. -​ Understanding business cycles: Analysing the causes of economic fluctuations and exploring potential stabilisation mechanisms. -​ Academic research: Investigating macroeconomic phenomena and testing economic theories.] Uses of the model: explain, predict and replicate. The second use of the model is Remove the obstacle into economy and let the competitive market Any representation, or "model", of the economic system as a whole should be consistent with the circular income flow chart of the economy [MAC01]. The first task is "filling the boxes". To "fill the boxes" we have to state how we characterise the economic system. Except minor refinements, what follows draws on the microeconomics of firms and households in Part 1. STRUCTURE OF THE ECONOMY The economy is characterised by a given endowment of production factors, labour and capital. Production consists of a single good which measures the GDP of the economy. We shall not consider intermediate goods. MARKETS -​ no dominant positions: all agents are price takers -​ free entry and exit − all prices are fully flexible. i.e. free from restraints and only responsive to demand and supply -​ all agents are freely and completely informed about existing market conditions Agents' behaviour -​ Agents are fully (unboundedly) rational, i.e. elaborate and execute optimal plans responding to subjective goals (profit maximisation for firms, utility maximisation for households) Aggregate variables are derived as optimal decisions of a "representative" household or firm. MACROECONOMIC EQUILIBRIUM -​ Equilibrium in all markets presupposes the accounting closure of the circular income flow which in turn implies [MAC01] (1) Firms (2) Households Value of production (=GDP) = Factor incomes (National income) National income = Final expenditure The two national accounts also operate as the respective "budget constraint" of the two sectors. -​ Recall [MAC01, MAC02]. Rational people are free from money illusion, they (we) do not relate well being to sums of money for their own sake but to the "real" quantities of goods and services they (we) can obtain. The real purchasing power of a monetary sum is obtained by "deflating" (dividing) with an appropriate price index. Given the general price index (GPI) P (i.e. euros per one physical unit of GDP), Since all the monetary values in the two national accounts are divided by the same index P, they should close equivalently whether expressed in monetary values or in real values. Hitherto we shall proceed directly with real values only. Planning production. Inputs, output, technology Firms are production units which, adopting the best available technology, employ production factors with commitment to maximising the owner's income (capital income or profit) under the constraint (1) of paying providers of other production factors. We consider a single production period t (say the current year). Production planning is drawn on the technological relationship between inputs of capital equipment with labour, and output. There is one best technology available in the economy; this is freely known to the engineering department of each and all firms, and it is encapsulated into the so-called production function: (3) where Kt = capital equipment available in t, Nt = labour employed in t (number of hours worked), Yt is the resulting output, which aggregating across firms yields the economy's GDP. The signs in brackets are the signs of the relationship (first derivative) between Y and each input. The characterisation of production technology is extremely important, as it conditions how the whole system works. NCM complies with a long tradition in which technology is characterised by three key properties [see also Part 1 of the course] (a) Output increases as a factor is increased (b) Decreasing marginal productivity [The increasing production is positive but with a decreasing (smaller and smaller)] Said that each additional unit of a factor (given the other) increases output, decreasing marginal productivity means that output increases at a decreasing rate: for each additional increment ∆N, or ∆K, the productivity ratios ∆Y/∆N, or ∆Y/∆K are lower (lose efficiency). This technical characteristic is often referred to as the engineering notion of "congestion effect". Machineries and plants are usually characterised by standard of utilisations beyond which they lose efficiency. (c) Constant returns to scale Now let us consider the case that the firm increases both factors by the same scale, i.e. Z times. Returns to scale are constant if also output is multiplied by the same scale Z: It means that something changes between outputs and inputs in relation to technology. [Scale = instant which the elements are increasing simultaneously Marginal means the increasing of one factor keeping the other constant] Constant return to scale have been playing an ever greater role because they seem to capture easily some important industrial features, e.g.: − if a firm builds an exact replica of its existing plant (Z = 2), output doubles (and so on…) − if a firm introduces some technical innovation in the existing plant that raises the productivity of both factors by the same scale, output increases by the same scale. Since both factors are involved, the result is called total factor productivity (TFP), and is also regarded as "the third factor of production" (the problem is that it is generally immaterial and cannot easily be observed and quantified) Ex. The accounting department of a business is endowed with 50 accountants each with a mechanical computing machine. Now the 50 machines are replaced by 50 personal computers, which speed up the accounting operations and reduce mistakes. The department has the same number of workers and capital units as before, but the new technology embodied in the capital units has raised the total factor productivity. [The machinery increase the productivity of the two factors (50 accountants and 50 machines)] Cobb-Douglas production function In Part 1 you were presented, as an example of this kind of neoclassical production functions, This is a case in the class of power functions, i.e. made popular among economists by Charles Cobb and Paul Douglas (in an article published in 1928), hence the name of Cobb-Douglas production function. It’s sufficient that the sum of a and b is equal to 1 [“a” is around 0.4 and “b” is around 0.6] All in all, the now standard specification of Cobb-Douglas production functions is where Z > 1 is meant to capture technical innovations that raise TFP The increase of outpost is concave Black line: previous situation Blu line : same technology but more capital Red line: developed technology and more capital For any given value of K and Z, an increase in N increases Y (along the curve) at a diminishing rate (the curve is concave) Higher K (for give Z) or higher Z (for given K), allow production to escape from the law of diminishing returns: Y increases even for the same N Higher TFP as the greatest effect, since it captures innovations that raise productivity of both factors Planning production → Input costs The next step in planning production requires a decision about how much labour and capital to employ, and to this end firms consider each factor's cost in the respective market. The notion of market price is crucial, because under the assumption of free competitive markets, each firm takes those prices as given and has no power to change them. Labour The market price of labour is the wage rate per unit of work, say euros per hour worked W€t. Given the GPI Pt, each firm considers the real wage rate If firms hires Nt units (number of workers per standard working hours), then real labour income as a share of real GDP amounts to: (5) Capital The market price of capital is a.k.a. "user cost", since the firm is the "user" of capital on behalf of the owners. It consists of the sum R€t, due to capital owners per unit of capital employed. Given the GPI Pt, each firm considers the real user cost of capital. If firms are endowed with Kt units of physical capital, then capital income as a share of real GDP amounts to: → (real value of the capital) The two formulas should include the loss of the simple using of the machinery (the amortisation). The amortisation rate should be 100% The sum Rt should include the allowance for the fact that physical capital wears out, so that an amortisation fund At should be set aside (returned to the owners) in order to restore physical capital in its full capacity. The ratio At/Kt is the amortisation rate. For simplicity, we assume that physical capital wears out in 1 year, so that At/Kt = 1 (or 100%). Rt should also include the net return to capital that goes to owners in addition to amortisation. The ratio of the net return to capital w.r.t. to capital is the real interest rate, which is regarded as the kernel of the market cost of capital. Taking into account both the amortisation rate and the interest rate, the user cost of capital is So if capital is worth 1000, the amortisation rate is 100% and the interest rate 10%, the user cost is 1.1, capital income is 1100, of which 1000 amortisation and 100 net return. Profit maximisation and the demand for labour → Profit maximisation For the current year the stock of capital provided by owners is given and not modifiable. Hence the only variable factor is labour (no intermediate goods are necessary). Each firm chooses the labour input Nt in order to maximise the (real) profit to be distributed as capital income after paying labour income How much should the firm produce? We have to find the marginal result where In Part 1 you learned that a profit-maximising firm in a competitive market produces up to the point where the marginal cost of production matches the sale market price. Now the question is: what is the correspondent labour input? To answer, recall that the marginal cost of production is the cost of the additional input of labour that is necessary to produce one additional unit of output. Therefore, given the nominal wage rate W€t, the profit-maximising rule is Following this rule, how much real wage Wt is the firm willing to pay? [∆Y/∆N is the productivity of labour] Since ∆Y/∆N measures the increment of output of an additional unit of labour, i.e. the marginal product of labour (MPL), we can say that: Profit is maximal when the marginal product of labour covers exactly its unit real cost. The optimal employment of labour is the value of N that satisfies the rule W = MPL →The labour demand function The optimal employment of labour that satisfies the rule (8), is determined by the real wage rate Wt, given the capital equipment and its technology. Clearly, when Wt changes also Nt should change. The relationship between the optimal employment and the real wage rate yields the labour demand function (Nd) of the firm. The general formulation is the following: (9) labour demand function − decreasing in the real wage rate − increasing with capital and TFP Why is the demand for labour decreasing w.r.t. the real wage rate? For given capital equipment and technology, labour demand is subject to the law of decreasing productivity of labour. Additional inputs of labour, with a constant input of capital, have lower productivity, and hence should be paid a lower real wage rate. → Cobb-Douglas labour demand function  The Nd function is given by the MPL. Higher employment can only come with lower wages, and a higher wage can only come with lower employment. An increase in the firm's capital (with same technology) or in TFP (with same capital) allow the firm to expand labour demand at the same wage rate. A higher capital endowment increases productivity, the firm can pay more and have more workers. In this kind of economy there is a conflict between employment and wages. There can be a way out to the conflict between employment and wages: Invest in capital or way better invest in technology The demand for capital By demand for capital we mean the firm's decision about the optimal stock of capital to employ, i.e. consistent with profit maximisation. We are analysing a situation in which firms have a fixed endowment of capital, so, strictly speaking, it is not a decision variable like labour. But we can ask another interesting question: given that endowment of capital, what is the user cost of capital (amortisation + interest rate) that firms can pay to capital owners? It can be shown (not here) that the remuneration treatment of capital is symmetric to that of labour: The profit-maximising firm is willing to pay capital owners a real user cost of capital equal to its marginal productivity (MPK). In other words, as the firm pays workers a real wage rate equal to the MPL, it also pays capital owners a real user cost of capital equal to its marginal product (MPK = ∆Y/∆K): [The capital demand function is perfectly symmetric to the function of labour] (10) capital demand function: → The Cobb-Douglas capital demand function As a matter fact, a Cobb-Douglas type of production function yields for capital a similar demand curve as that for labour. The demand curve coincides with the MPK, which is decreasing owing to the law of decreasing productivity. If, as in the present case, firms should hold the capital Kt they have been endowed with, the demand curve indicates the real user cost Rt they are willing to pay as a result of profit maximisation. Note that, as with labour demand, capital demand may be higher, or the real user cost may be higher, if firms have greater labour force or a technology with higher TFP. The households' plan: optimal consumption and working time Households own production factors and can employ them in firms going through the factor markets. To the extent that their factors are employed, they earn the respective incomes that are the means for the households to satisfy their consumption needs. Key to the NCM is that households are rational in the strong sense that consumption and factor supply are a joint decision in a single plan aimed at maximising utility. ​ Utility of consumption, disutility of working time In our economy with capital endowed to firms in fixed amounts, households can increase their current year income only by offering labour to firms. This enlarges their feasible consumption but also entails a personal cost in terms of loss of alternative non-market activities ("leisure") or direct work effort. Both ways the number of hours worked N entails a utility loss. (11) Utility function − increasing in consumption at decreasing intensity − decreasing in hours worked at increasing intensity Working that’s not a bad thing (it takes laisure from us, as Mittone said to us). ​ The optimal plan The NCM assumption that households make optimal choices is translated into the mathematical formulation that they choose the plan (Ct, Nt) such that [It is called Gross domestic product bc there is a demand also for the new and for the previous..] In any kind of decision, the optimality principle states that the marginal benefit to be gained should (at least) compensate for the marginal cost to be borne. In this case, one additional hour of work reduces utility by ∆Ut/∆Nt < 0 but at the same time additional utility ∆Ut/∆Ct > 0 can be gained for each unit of consumption bought by the real wage rate Wt. Hence The optimal working time is up to the point where the utility gain of consuming the hourly wage compensates the utility loss of working one more hour. Working more hours increases our income, so we have more income to use The real wage rate is seen as the incentive that regulates the exchange of more effort for more