Lecture 3. Aggregate Demand and The Surplus Approach to Economics.

Reading: Bowles et al Chapter 16 pp 403---444

Watch the slideshow:

Download the Handout: MDU_macro_lecture3_handout.pdf

Today:

1                  Why are there unemployed resources in the economy?

2                  Introduction to business cycles

3                  Aggregate Supply and Demand

4                  Unemployment

5                  Income, Consumption, and Saving

6                  Unemployment and Government Fiscal Policy

7                  The Multiplier

8                  Yet another set of Stylised Facts

1.                Why are there unemployed resources in the economy?

The Great Depression really is the starting point for our analysis of aggregate demand and the stimulation of economic activity through fiscal policy. Read about it here. http://econ161.berkeley.edu/TCEH/Slouch_Crash14.html.

The resources used in production are Land, Labour, Capital and Enterprise. At any moment, some of these resources are either not being used in their most efficient way (Ph.Ds sweeping streets) or not being used at all (Ph.Ds on the dole). Why, in an era of very tightly integrated capital markets globally and quite tightly integrated labour markets at least in some parts of the world, do unemployed resources exist? This is the subject of this lecture.

In the output lost in 2001 in the US economy, Bowles et al (pg 403) suggest that had the manufacturing resources of the US economy been fully utilised, an extra $1.2 trillion worth of good would have been produced. The output gap for Ireland from 1970--2005 is shown below

The figure below shows Ireland's percentage deviation from it's potential GDP from 1970 to 2005 compared with the USA (data for this figure came from http://www.imf.org/external/pubs/ft/weo/2000/02/data/ngap.csv).



What we see is striking. First, there is no discernible pattern to the individual fluctuations, though Ireland and the USA do track one another's highs and lows, albeit in a lagged way. Second, the magnitude of each change is different for each country. This means each country experiences macroeconomic shocks differently. The canonical example is the http://en.wikipedia.org/wiki/1973_oil_crisis of the early 1970's. Look at the graph for this period. What do we see? The countries experience an overall steep drop in deviations from potential, with Ireland experiencing a worse decrease than the USA. Third, in terms of the future from 2005, if you were to put a bet on, where would you say that line will go? Would you be confident about that assertion?

2. Introduction to Business Cycles.

Let's look again at the Great Depression's effect on output in the G7 (i.e. the richest) countries.

Here we can see a massive drop in output caused by a series of macro shocks.

First, let's dispel a common misunderstanding. There are no such thing as business cycles. The word 'cycle' implies if you take a point on the graph of GDP against time, this point will reappear with the same frequency and amplitude a bit down the time line. This is of course not the case. If it were, and the economy did move in waves, then counteracting the effects of these waves would be simple: we would simply adjust our expectations, and hence our spending and saving patterns, to match the ebb and flow of that wave, were it so regular. No, there is no 'cycle' here, only fluctuations in output plus noise.

Actual vs. potential GDP here. This has implications for policy, depending on where we are in the business cycle.

Where do you think we are now?

3                  Aggregate Supply and Demand

Aggregate Demand is defined as the total demand for goods and services in the economy during a specific time period. It is often called effective demand. Find out more about the definition here.

Aggregate Supply is defined as the total supply of goods and services by a national economy during a specific time period. Find out more about the definition here.

4                  Unemployment

Unemployment refers to the numbers of workers actively seeking work but who cannot find work. The actual number of unemployed workers in Ireland is given by the Central Statistics Office, available here. Ireland hasn't had a serious short term or long term (+12 months) unemployment problem in a long time, as we can see from the graphs below.

8    Growth Stylised Facts

From Kaldor, Kuznets, Romer, Lucas, Barro, Mankiw-Romer-Weil, and others.

1. In the short run, important fluctuations: output, employment, investment, and consumption vary across booms and recessions.

2. In the long run, so goes the story, we should see balanced growth: output per worker (Y/N) and capital per worker (K/L) grow at roughly constant rates (there is considerable disagreement about this statement, however). The return to capital (r), is roughly constant, though the real wage rate (w) can grow at the same rates as output. And the income shares of labour and capital (wL/Y and rK/Y) stay roughly constant.

3. Substantial cross-country differences in both income levels and growth rates.

4. Persistent differences versus conditional convergence.

5. Formal education. Highly correlated with high levels of income (obviously two-directional causality here); together with differences in saving rates can "explain" a fraction of the cross-country differences in output; this is an important predictor of high growth performance.

6. R&D and IT: These are the most powerful engines of growth (but obviously we'll require more basic skills and education to take advantage of these first);

7. Government Policies: Taxation, infrastructure, inflation, law enforcement, property rights and corruption and important determinants of growth performance.

8. Democracy. An inverted U-shaped relation.

9. Openness. International trade and financial integration can promote growth.

10. Inequality. The Kuznet's curve, an inverted U-shaped relation between income inequality and GDP per capita

11. Financial Markets and Risk Sharing.

12. Fertility. Higher fertility rates are correlated with lower levels of income and lower levels of economic growth. The Malthus curve, the Lewis model.

13. Structural transformation really mattes. This is the Theory of Transformational Growth.

14. Urbanisation over the long stretch of history really matters.

15. Institutional and social factors, e.g. Ireland's history as a colony, existing social norms, etc.