ECON224 Macroeconomics II
Chapter 1: Introduction
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Roadmap
1 What is Macroeconomics
2 Macroeconomic Models
3 Microeconomic Principles
4 GDP and Natural Log of GDP
5 Decomposition of GDP – Trend component and Business Cycle component
6 How to Detrend Macroeconomic Data
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What is Macroeconomics
What is Macroeconomics
Macroeconomics is the study of aggregate economic activity (the
behavior of large collections of economic agents – consumers, firms and
government), and is motivated by large issues that affect many people
and many nations of the world.
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What is Macroeconomics
Figure 1.1: Per Capita Real GDP for the US, 1900-2014
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What is Macroeconomics
Figure 1.2: Natural Logarithm of Per capita Real GDP for the US, 1900-2014
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What is Macroeconomics
Figure 1.4: Percentage Deviation from Trend in Real GDP Per capita for the
US, 1900-2014
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What is Macroeconomics
Figure 1.6: Unemployment Rate for the US, 1940-2014
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What is Macroeconomics
Figure 1.8: Total taxes and total government spending
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What is Macroeconomics
Figure 1.14: Interest rate spread
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What is Macroeconomics
Figure 1.15: Relative Price of Housing
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What is Macroeconomics
Figure 1.16: Exports and imports of goods and services as pencentage of GDP
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What is Macroeconomics
Macroeconomics is distinct from microeconomics
Microeconomics deals with the choices of individual consumers or firms
Macroeconomics deals with the overall effects on economies of the
choices that all economic agents make
However, the tools used by macroeconomists and microeconomists have
been converging since 1970s
They consist of descriptions of consumers and firms (governments and
etc.), their objectives and constraints, and how they interact
Macroeconomic models are built up from microeconomic principles
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Macroeconomic Models
Macroeconomic models
Macroeconomists use models that can capture economic mechanisms to
explain how economies work and how they can be improved
The purpose of an economic model is to capture the essential features of
the world needed for analyzing a particular economic problem. To be
useful then, a model must be simple, and simplicity requires that we
leave out some ’realistic’ features of actual economies
Macroeconomists do not stick to a single all-purpose model. Instead, we
use an array of different models for different purposes
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Microeconomic Principles
Micro-founded Macroeconomics
Methodology:
The approach we adopt is to build macroeconomic model with
microeconomic principles as a foundation or micro-founded
macroeconomics.
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Microeconomic Principles
Why microeconomic principles
Macroeconomic behavior is the sum of many microeconomic decisions
Changes in government policy generally alter the behavior of consumers
and firms in ways that significantly affect the behavior of the economy as
a whole
To confidently predict the effects of a policy change on aggregate
behavior, we must analyze how the change in policy affects individual
consumers and firms. Then we can aggregate these decisions to look at
the behavior of the economy as a whole
The argument that macroeconomic policy analysis can be done in a
sensible way only if microeconomic behavior is taken seriously was
persuasively expressed by Robert E. Lucas in 1976. It is often referred to
as the Lucas critique
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Microeconomic Principles
Structure of a macroeconomic model
The basic structure of a macroeconomic model
The consumers and the firms
The set of goods
Consumers’ preference over goods
The technology available
to firms
The resources available
There are two important features of the model
consumers and firms optimize
the economy must be in equilibrium
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Microeconomic Principles
MCQ
Macroeconomic models are
A) never wrong.
B) accurate descriptions of the economy.
C) simple abstractions of reality.
D) consistent with all economic data.
Answer: C
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Microeconomic Principles
MCQ
What do we assume about households and firms
A) They act irrationally.
B) They do what the government tells them to do.
C) They look after each other.
D) They optimize
Answer: D
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GDP and Natural Log of GDP
Gross Domestic Product
Gross Domestic Product (GDP)
It is one measure of aggregate economic activity in a country
It is the quantity of goods and services produced within a country’s
borders during some specified period of time
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GDP and Natural Log of GDP
Figure 1.1: Per Capita Real GDP for the US, 1900-2014
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GDP and Natural Log of GDP
Why take the natural logarithm of the time series
Figure 1.2: Natural logarithm of Per Capita Real GDP
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GDP and Natural Log of GDP
Let Yt be per capita real GDP in year t, and Yt 1 be per capita real GDP
in year t 1
The growth rate from period t 1 to t:
gt =
Yt Yt 1
Yt 1
=
Yt
Yt 1
1
[Math] If x is a small number, then ln(1+ x)≈ x
Therefore, if gt is small,
ln(1+gt)≈ gt
that is,
gt = lnYt lnYt 1
Growth rate gt is approximated by the slope of the natural logarithm
of per capita GDP Yt.
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Decomposition of GDP – Trend component and Business Cycle
component
Decomposition of per capita GDP
Separate per capita GDP time series into two components: the growth
(trend) component and the business cycle component (percentage
deviation from trend)
log of per capita real GDP = trend component (log of trend GDP) +
business cycle component
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Decomposition of GDP – Trend component and Business Cycle
component
The growth (trend) component:
Figure 1.3: Natural logarithm of Per Capita Real GDP and Trend
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Decomposition of GDP – Trend component and Business Cycle
component
The business cycle component:
Figure 1.4: Percentage Deviation from Trend in Per Capita Real GDP
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How to Detrend Macroeconomic Data
How to detrend macroeconomic data
Take Yt – real GDP Per capita for example,
lnYt = lnY
g
t + lnY
c
t
yt = gt+ ct
How we can estimate the trend component gt and the cyclical component ct
separately, given that we only have observations of yt
Two approaches:
Assuming linear growth trend
Hodrick-Prescott filter (HP filter)
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How to Detrend Macroeconomic Data
Linear Trend
Assume the trend is linear – straight line
gt = β0+β1t
We choose β0 and β1 to minimize:
min
β0,β1
T
∑
t=1
[yt gt]2 =
T
∑
t=1
[yt (β0+β1t)]2
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How to Detrend Macroeconomic Data
The Evolution of log GDP and the growth trend
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How to Detrend Macroeconomic Data
HP Filter
HP filter allows for variations over time in the underlying growth trend.
We choose {gt}Tt=1 to minimize:
min
{gt}Tt=1
[
T
∑
t=1
(yt gt)2+λ
T
∑
t=1
[(gt+1 gt) (gt gt 1)]2
]
In general, for quarterly data, we choose λ = 1600
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How to Detrend Macroeconomic Data
The Evolution of log GDP and the growth trend
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How to Detrend Macroeconomic Data
The Cyclical Component of log GDP
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How to Detrend Macroeconomic Data
MCQ
The business cycle component of the log of real per-capita GDP is equal to
A) log of actual real GDP – log of trend GDP.
B) log of trend GDP / log of actual real GDP.
C) log of trend GDP – log of actual real GDP.
D) log of actual real GDP / log of trend GDP.
Answer: A
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