Macroeconomics1 Chapter I. Introduction
Macroeconomics Lecture Note
J.D. Han*
King’s College
I wish to acknowledge that this lecture note owes greatly to the macroeconomics I have learned from Professor Jack Carr, who has inspired me to take macroeconomics as my profession. Copyright reserved. No part of this material shall be reproduced without the author’s consent.
"Of course, no reasonable man ought to insist that the facts are exactly as I have described them. But that either this or something like it is a true account ...... This, I think, is both a reasonable contention and a belief worth risking, for risk is a noble one...... " (Plato, Phaedo, II4 d.)
ChapterI. Introduction
1. Key Issues in Macroeconomics: What are our interests and goals in Macroeconomics?
Economics is devoted to the betterment of human material welfare. The material welfare is measured best, at the practical level, by the per capita national income, which is equal to the GDP divided by the size of population.
In terms of per capita national income, the optimal situations can be described as follows: (1) The per capita national income should be high at the maximum potential level at any point in time; (2) the per capita national income should grow rapidly with minimum inflation, and (3) the national income should be stable over time.
We may also want a lowest possible rate of inflation and a stable price level as well.
(1) Maximum Potential Income: Full Employment - Short-term Goal
It is ideal if the actual national income approaches its maximum potential. How would we know whether or not the maximum potential is being realized now? One obvious indicator is the rate of unemployment. There is a one-to-one relationship between the unemployment rate and the level of national income: The higher the rate of unemployment, the lower the level of the national income.
The maximum potential national income can be called the ‘Full Employment National Income’ (Yf for its notation). The full employment national income or Yf does not correspond to the zero rate of unemployment, but to a certain positive figure of unemployment rates. That positive figure of unemployment rate is only ‘Natural’ and the best that we can achieve in terms of employment. Thus it is also called ‘Natural Rate of Unemployment’. In other words, the Full Employment means a positive figure of the Natural Rate of Unemployment or NRU in a short form (its notation is UN).
How do we know when the actual national income is below the maximum potential level? One sign is the existence of unemployment of production factors above and beyond the ‘natural level’. When capital and labour available are `under-employed', the aggregate income created from the employment of the factor does fall short of the maximum potential income, that is, the Full Employment (National) Income or the Natural Rate (of Unemployment National) Income.
Under-employment indicates the situation where the actual rate of unemployment (U) exceeds the natural rate of unemployment (UN): U>UN. The difference between the two unemployment rates is called `Cyclical Unemployment', which points to under-employment. The natural rate of unemployment is some positive rate of unemployment perfectly compatible with full employment, and consists of frictional and structural employment.
Questions arise as to a) the cause of, b) the duration of and c) the remedy for the under-employment situation where the actual national income is smaller than the full employment income: What prevents an economy from enjoying the maximum potential income? How long would the undesirable situation of the under-employment last? In other words, is the under-employment transient meaning `will be gone', or of equilibrium, meaning `being stuck'? What can be done about the under-employment?
(2) Strong Economic Growth with Minimum Inflation - Long-term Ideal
The performance of per capita national income over time determines the future path of an economy in the long-run. In Canada, the national income evaluated at the current market prices or the market prices of each year grew at an average 10% annum during the ten year period of 1976-1986, 7% of which could be attributed to the simple increases in the prices and the rest to the actual growth of the amount of goods and services. In other words, the rate of the growth of national income in real terms is 3% per annum. This is a strong growth in the light of the size of the Canadian economy and its advanced stage of economic growth.
(3) Stabilization of National Income - Medium-term Ideal
We would like to have a stable national income over time, having the least fluctuations and deviations from the Long-run Growth Trend. These ups and downs of the national income over time are called, in their entirety, ‘business cycles’. Minimizing business cycles, if possible, is welfare-increasing.
When the government is trying to stabilize the national income, it may use fiscal and monetary policies. The policies are called ‘income stabilization policies’ or ‘activist policies’. Whether the government can eliminate/reduce the amplitude and the duration of business cycles or not is an open question. Keynesians do believe that it is possible, and Classical economists think otherwise.
(4) Stable Price Level: A Low Inflation
Inflation is not just a nuisance. It leads to misallocation of resources, diverting valuable resources from their best uses. This may not decrease the accounting value of national income. However, it certainly decreases economic welfares.
The costs of inflation are represented with Menu Cost, and Shoe-Leather Cost, for instance. However, innocuous they may sound, they may seriously harm efficient allocation of resources.
Surprice inflation has an additional cost for the society: it helps employers at the expense of
employees, and debtors at the expense of creditors.
(5) Trade Off Between Two Goals: Income versus Inflation.
Some economists argue that the above the goal of high income cannot be obtained by a low inflation: The two goals cannot be achieved at the same time, and there is an inevitable trade-off between the two.
The level of national income is inversely related to unemployment rates. Therefore, the above argument means that a low unemployment rate (meaning a high level of national income) can only be achieved with a relatively high rate of inflation. As we will see later, this is the idea behind Phillips Curve.
Other economists do not agree with this. They argue that depending on the inflation expectations, a low rate of inflation and a low rate of unemployment can be achieved at the same time. This will be reviewed in terms of “Expectations Augmented Phillips Curve”.
2. Divided House of Macroeconomics Thoughts
In contrast to microeconomics (Price Theory) where there is a general consensus, the macroeconomics has many irreconcilable divisions within its house: There are multiple schools of macroeconomic thoughts, which have quite different, and competing frames of references. Sometimes they are completely opposite. They tend to disagree on what the most important issues are, let alone what the solutions should be. We are going to review the KeynesianSchool, the ClassicalSchool, the Neo-Classical Synthesis, the NewClassicalSchool or the Rational Expectations Theory Model, and the NewKeynesianSchool.
For instance, as to the key issues raised above, each school of macroeconomics thought has different views. Suppose that an economy is not achieving its maximum potential national income, or that the actual rate of unemployment is higher than the natural rate of unemployment.
(1) The KeynesianSchool of Macroeconomics Thoughts
The Keynesian school of macroeconomics was initiated by John Maynard Keynes through his publication of The General Theory of Employment, Interest, and Money in 1936.According to the Keynesian school, it is the lack of the economy’s aggregate demand that prevents the economy from achieving the maximum potential national income. The ‘cyclical’ component of unemployment rates will not easily go away: Some equilibrating or ‘anchoring’ forces hold the economy down at a level of under-employment. The remedy should be an injection of demand.
Given the bleak prospect of business, which presumably has caused the current recession, it is unlikely that any private economic agents, such as households or firms, will bring an additional demand for the economy: They are all concerned with, and thus constrained by the financial bottom line.
It should be the government that has to bring more demand to the economy. In fact, according to the Keynesian view, the government is able to do so, as it is not constrained by the budget constraint: The government is the only economic agent that can spend more than earn for a prolonged period of times due to its prerogative or sovereign privileges of printing paper monies and issuing bonds.
How about an increase in the aggregate supply? It would not resolve the recession: The recession was caused by ‘too little demand amid too much supply’. An increase in supply will be just added to inventories, which will put more downward pressures on production processes at the corporate level.
Can we reduce the unemployment with wage cuts? In fact, all the economists in the 1930swere believed that wage cuts were classical. They believed that workers could not get a job or were unemployed when they demanded too high wages. Thus, they thought that the only solution to the Great Depression was a wage cut: If wages are cut, and thus the cost of hiring workers is reduced, in the very short run there occur incentives for employers to hire more workers.
However, Keynes disagreed. The above solution is unsustainable. If wage rates are cut, some may get new jobs. More outputs may be produced. However, there will be a reduction in the wages of the previously employed labor forces. The total aggregate wage bills may decrease. If so, there will be less consumption, and thus the newly produced outputs will not be sold. The production should scale down, and the national income falls.
(2) The Classical School of Macroeconomic Thoughts
On the other hand, according to the economists of the Classical school, as long as there is a well-functioning labor market system without undesirable impediments, a prolonged recession is impossible while certain degrees of short-run fluctuations might be inevitable.
Under-employment of a production factor (such as labor) situation comes from the temporary failure of the alignment of supply and demand of the factor (labor) market. Most commonly, unemployment occurs when some workers are demanding too high a wage rate and thus are not hired by any willing employers. In the absence of any stubborn stupidity of individuals (such as money illusion) and any structural rigidity of the economic system (such as unions), in the long-run as the workers `come to their senses' out of hardship and lower their wage rate to a reasonable level, the unemployment will vanish. Therefore, as long as the functioningof market forces is not hindered, eventually (in the long-run) the national income gravitates to the level corresponding to the full level of employment. The full employment (national) income is the very equilibrium income at least in the long-run.
Student Notes:
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The short-run fluctuations or business cycles are inevitable. In fact, recessions give a good lesson to undisciplined workers and correct them. They are the periods of consolidation and adjustment for the better. What we can do best to the economy in the short-run is to inform the worker correct and to remove any structural rigidity because both hinder the smooth functioning of the market forces.
Is there any way of increasing the full employment income in the classical model? Yes, in the long-run, there is. The level of full employment income is constrained by the amount of production factors. Even the national income might be at the full employment level, but the actual value is small because the level of the full employment income is low. For instance, suppose that there is a large population yet a small amount of capital in an economy. The scarcity of capital imposes a bottleneck in the production: The low capital-labor ratio means a scarcely equipped worker having a low productivity of labor. The national income is stuck low at the `low' full employment of the existing capital and labor. It is not too difficult to imagine an economy where workers are fully employed, tinkering all day long with poor equipment, for a pittance. The situation is a kind of `low level equilibrium.'
According to the classical school of macroeconomics, the level of the full employment income can be raised with a breakthrough in the availability of production factors. If the amount of capital increases or there occurs an innovation of capital-saving technology, the workers' productivity will rise to bring larger wages. The level of the full employment national income will rise.
3) Differences between Classical and Keynesian Schools
This disagreement between the two schools is highly politicized in the realm of policy issues. They do have fundamentally different views on the role of government in the economy: Except for some monetarists (to whom the author belong), it is generally accepted that a government's expansionary monetary or fiscal policy will increase aggregate demand. However, the rightward shift of the aggregate demand curve may bring different impacts on the price level and the national income depending on the shape and configuration of the aggregate supply curve.
In other words, Keynesian and Classical schools do operate on different assumptions of the aggregate supply conditions. In the KeynesianSchool, there is a positive economic role for government: Expansionary fiscal and monetary policies which shift the aggregate demand to the right will bring about and increase in real national income without any increase in the price level. In the Classical school in its alliance with fiscal and monetary conservatives, it is argued that the lasting impact of the increased AD due to an expansionary monetary or fiscal policy is only inflationary.
This difference in political implications comes from the different assumptions of the supply conditions. Keynesians assume that the Aggregate Supply curve is horizontal or relatively flat. What does the horizontal supply curve mean? It means that the (aggregate) supply (of all the goods and services) increases greatly in response to a very small stimulus of an increase in the price level. In other words, the aggregate supply is infinitely elastic with respect to the change in the price level.
Recall that in microeconomics the price elasticity of supply measures the increase of supply in response to a unit price rise.
For a given increase in price, the responsive increase in supply is relatively small in Case I: the supply is inelastic with respect to price. For the same increase in price, the resultant increase in supply is relatively large in Case II: the supply is elastic with respect to price. The first case is close to the assumption of the Classical school and, the latter to the Keynesian aggregate supply curve.
Why is the aggregate supply assumed to be elastic in the case of the Keynesian school?The Keynesian economics came out during the Great Depression when there was a lot of unemployed workers and idle capacities. In the face of a rising price of output, entrepreneurs could easily increase production and supply of output without substantially raising the costs of hiring production factors. This means that the supply could be so easily expanded, and was very responsive and elastic with respect to a rise in output prices: the supply curve was in fact almost horizontal.
With this configuration of the supply and demand curves, only the shift of the aggregate Demand curve will bring about an increase in the equilibrium national income. Put differently, when a government is engaged in expansionary monetary policy (by increasing money supply [MS]) or/and fiscal policy (by increasing government expenditures [G] or cutting taxes [T]), the resultant increase in the aggregate demand shifts the aggregate demand curve. It will bring about only benevolent impacts on the economy: the national income rises while the price level remains unchanged. The rigidity of the general price level is the cornerstone of the Keynesian theory.
The Classical school consists of many branches, but they all basically assume a vertical aggregate supply curve for the economy. For instance, the Monetarists belong to a branch of classical school largely attributed to Milton Friedman. They argue that there are two kinds of the aggregate supply curve. The long-run Aggregate Supply curve is vertical while the short-run Aggregate Supply curve may be positively sloped. In the long-run, as all production factors are more or less fully utilized in the economy in its own way. An increase in the price of outputs does not lead to any increase in production. The aggregate supply curve is vertical at the full employment level. The vertical AS curve implies that it is impossible to increase the equilibrium national income only by increasing the AD.