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Linda Kamas June 21, 2011Santa Clara University

ECONOMICS 405MACROECONOMICS – THEORY AND POLICY

This course provides a comprehensive understanding of how the economy functions – the determinants of GDP, economic growth and business cycles, employment and unemployment, inflation/deflation, balance of payments and exchange rates, the role of government macroeconomic policy.

Necessary for managers to have an understanding of the economic environment in which businesses operate (firms are “fish” surviving in the “sea” of the economy – a healthy sea is crucial for the well-being of the fish).

Examples: need to understand GDP (important for sales growth), inflation (costs and pricing), interest rates (cost of capital and effects on demand), exchange rates (competitiveness overseas and at home with imports), etc.

Also important as informed citizen, voting, decisions on mortgages and other financial decisions, reading business

periodicals, etc.

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Microeconomics (Econ 401) Macroeconomics (Econ 405)Individual units: Aggregate Economy: Households buy goods/demand Add together all goods & service Firms produce/ supply Total quantity is Gross Domestic Product (GDP)Markets for goods, labor, money Economic Growth - percentage change in GDP and bonds Productivity is output per workerMarkets: determine price of good Prices – Consumer Price Index, Producer Price determine quantity produced Index, and GDP deflator Market structure: competitive, Inflation is percentage change in price index oligopolistic, monopolistic Inflation, Deflation, StagflationLabor markets – Labor – employment & unemployment rates individual workers Business cycles: Recession, Depression, wages and employment Recovery/Expansion

Government Policy: Government Policy: Antitrust/procompetiton Fiscal – government spending & taxes Taxes/subsidies to farms, industries Monetary – money supply & interest rates Price ceilings, floors

International Trade International Macroeconomics Comparative Advantage Balance of Payments – Current & Capital Accounts Tariffs & Subsidies Exchange Rates

GDP

Time

Y P Potential GDP

Y Actual GDP

recession

expansion orrecovery

long-run growth

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Potential GDP or Full Employment GDP (YP) is the level of output if all resources (labor, capital, & land) are fully employed. Actual GDP is usually below potential GDP. The output gap is the amount by which Actual GDP is less than potential GDP. The output ratio is: Actual GDP/Potential GDP.

Recessions are identified by the National Bureau of Economic Research (NBER): “A recession is a period between a peak and a trough, and an expansion is a period between a trough and a peak. During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year. . . The Committee does not have a fixed definition of economic activity. It examines and compares the behavior of various measures of broad activity: real GDP measured on the product and income sides, economy-wide employment, and real income.”

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Questions we will address:What determines potential GDP and its growth rate?What determines actual GDP and employment; why are we often producing less than our potential GDP?What causes business cycles and unemployment?What causes inflation, deflation, and stagflation?Why do we have large fiscal budget deficits and high federal debt?What makes interest rates rise and fall? What is the role of the Federal Reserve Bank (the Fed)?How can the government influence the macro economy through fiscal and monetary policies?What is the appropriate role of the government? Should the government try to affect macroeconomic variables or let markets determine outcomes?Why do some countries have trade surpluses and other trade deficits?What determines the value of the exchange rate and why does it rise/fall?

What caused the current economic crisis and what can/should the government do?

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Structure of the course

Macroeconomic Current Events

& History

Economic Theory Ideology: & Models Free Markets or

Role for the Government

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A BRIEF HISTORY OF MACROECONOMIC EVENTS AND THEORIES

18TH/19TH CENTURY: INDUSTRIAL REVOLUTION AND TRANSITION FROM FEUDALISM TO CAPITALISM

CLASSICAL ECONOMISTS (Smith, Ricardo, Marshall, Mill) – supported new economic institutions to promote capitalist development

Key ideas: invisible hand, laissez-faire, free trade, flexible wages and prices,

Say's Law (supply creates its own demand), stability of capitalism, self-correcting economy, no role for government policy

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MID-19TH CENTURY: ECONOMIC FLUCTUATIONS UNDER CAPITALISM AND UNEQUAL INCOME DISTRIBUTION

SOCIALISTS (Marx, Engels) – Internal contradictions of capitalism and its predicted demise Key ideas: declining profit rates, underconsumption, exploitation and immizeration of the working class, imperialism, predicted collapse of capitalism and formation of socialist economies.

1929-1930s: THE GREAT DEPRESSION

KEYNESIANS (Keynes, Heller, Samuelson, Solow, Tobin, and others) – theory on causes of recessions and unemployment and the importance of government macroeconomic policy Key ideas: insufficient aggregate demand, sticky or rigid wages and prices, unemployment equilibrium, inherent instability of capitalism, Phillips curve (inflation-unemployment tradeoff), fiscal and monetary policy to reduce unemployment and stabilize the economy (demand management policies), depression-era Keynesians favored fiscal policy over monetary policy.

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1950s to 60s: POST-WAR ECONOMIC BOOM TIMES

Keynesians in Charge - fiscal and monetary policy used to stabilize the economy to fight recession, unemployment and inflation.

LATE 60s: DEMAND-PULL INFLATION (EXCESS AGGREGATE DEMAND) Expansionary macroeconomic policy and Vietnam War - government spending led to “overheating” economy and inflation.

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1970s: STAGFLATION – UNEMPLOYMENT & INFLATION Oil price increases in 1973 & 1979 (supply shocks) cause inflation and unemployment - Keynesian economics comes under attack by conservatives

CONSERVATIVE ECONOMICS I: MONETARISM (Friedman, Schwartz, Brunner, University of Chicago economists and others) Key ideas: Classical (see above), quantity theory of money - inflation is due to excess supply of money, natural rate of unemployment (no Phillips curve trade-off between inflation and unemployment – unemployment below the natural rate causes accelerating inflation), no discretionary macroeconomic policy: monetary rule for money growth and no fiscal policy.

CONSERVATIVE ECONOMICS II: RATIONAL EXPECTATIONS/ NEWCLASSICAL SCHOOL (Lucas, Sargent, Barro and others) Key ideas: People use all the available information so they do not make systematic errors, Classical models, changes in output and unemployment occur only with unanticipated events and are therefore transitory, markets clear (are in equilibrium), all macro policy is ineffective.

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1980s: CONSERVATIVE ECONOMICS III: SUPPLY-SIDE/REAGANOMICS (Reagan, Laffer, Roberts, Kemp and others)

Key ideas: Tax cuts and deregulation can raise saving, investment, and work effort so much that inflation declines without a recession while fiscal deficits decrease.

1990s: THE “ROARING 90s” – ECONOMIC GROWTH RESURGENCE OF KEYNESIAN IDEAS – Clinton elected (Akerlof, Mankiw, Romer, Yellen and others)

Key ideas: markets do not clear (disequlibrium), deviations from full employment can be large and lasting even with rational expectations, provide rigorous explanations for wage and price stickiness, incorporate supply shocks into models.

1995-2000: THE “NEW ECONOMY” - IT REVOLUTION: Rapid economic growth with low inflation, low unemployment, rapid productivity growth, and federal fiscal budget surpluses.

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2001-2008: BUSH ADMIN. – RETURN TO CONSERVATIVE ECONOMICS

2001 recession, large tax cuts, terrorist attacks, war, increased government spending, federal budget deficits and rising government debt, economic recovery, oil prices soar, current account deficits, and growing foreign debt. Large & rising consumer debt. Soaring house prices and stock market.

2007 - PRESENT – HOUSING & STOCK MARKET BUBBLES BURST - FINANCIAL CRISIS; GREAT RECESSION

Subprime mortgage crisis, foreclosures, housing prices plummet, stock market crashes, financial market crisis, failure of financial institutions, credit crunch, large layoffs and unemployment rises.

Government response: massive government intervention: fiscal stimulus (government spending & tax cuts, loans and capital to companies & banks) and Federal Reserve Bank monetary actions (reduce interest rates, loans & credit to private sector, “printing money”) to prevent a severe recession or even depression. Recession “over” in June 2009 but unemployment remains high and growth slow.