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PART 1 Introduction

Macroeconomics:
Branch of economics that studies the economy as a whole, especially the overall levels of production, employment, consumption, investment and prices.
Microeconomics:
Branch of economics that studies the individual behavior of firms and consumers and how they interact on a particular market.

Macroeconomics focuses on the following issues:
- Where does economic growth come from?
- Could economic growth continue indefinitely, or is there some limit to growth?
- Is there anything that governments can do to alter economic growth? - What are the origins of business cycles?
- Should governments act to smooth business cycles ?
- What does cause high rates of inflation?
- How does the central bank affect prices and interest rates?
- What are the root causes of a high unemployment rate?
- Should countries adopt fixed or flexible exchange rates against the U.S. dollar?

To answer previous questions, Macroeconomists use theories and models.
- In economics, as in other sciences, explanations and predictions are based on theories and models.
- A theory is a set of rules and assumptions used to explain observed phenomena. - A model is a simplified representation of the reality based on theories. - In economics, a model usually consists of a system of equations.

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- The relationship between facts, theories, model, and predictions:

Predictions

Model

Theories

Data

“If I couldn’t formulate a problem in economic theory mathematically, I didn’t know what I was doing. I came to the position that mathematical analysis is not one of many ways of doing economic theory: it is the only way. Economic theory is mathematical analysis. Everything else is just pictures and talk.”
Robert E. Lucas

1995 Nobel Price in Economics

Chapter 1

The Long Run

- Can you identify the country in which:
i) Life expectancy at birth < 50 years. ii) One in every ten infants dies before reaching their first birthday. iii) More than 90% of households have no electricity, refrigerator, telephone, or car. iv) Fewer than 10% of young adults have graduated from high school.

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- U.S. real GDP has increased by a factor of 43 since 1890:

- GDP per capita is usually used as a measure of the standard of living. GDP per Capita



GDP
Population

Remarks:
- Differences among countries in GDP per capita pose more of a mystery than differences in GDP.
- GDP per capita growth figures tell whether a country moves or not to higher living standards.

- U.S. real GDP per capita has risen by a factor of 9 since 1890:

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- In Canada, the real GDP has increased by a factor of 20 since 1926 and the GDP per capita by a factor of 5.6:

- From 1870 to 2009, the U.S. per capita real GDP grew at a
“roughly” constant rate of about 1.8% per year.
- From 1870 to 2009, the average American became about 12.3 times richer.

- Various economic growth scenarios for the U.S.:
Growth Rate of per Capita Real Real per Capita GDP in 2009 (in
GDP from 1870 to 2009
2005 dollars)
1% per year

13,955

2% per year

54,890

3% per year

213,031

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The rule of 72:
Amount of time it takes for something growing at a constant rate of g% to double:
Doubling time ≈ 72/g

- The evolution of output per capita in four rich countries since
1950:

- Growth rate of GDP per person since 1960 versus GDP per person in 1960 among OECD countries:

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- Growth rate of GDP per person since 1950, versus GDP per person in 1950 (2005 dollars) among 76 Countries:

- The distribution of income per capita growth rates from 1975–
2009:

- The distribution of income per capita growth rates from 1975–
2009:
Growth
Miracles

3% Average

Growth
Disasters

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- The pace of growth worldwide has accelerated and the income gaps between poor and rich countries has increased:

0.5% per year 1.1% per year

2.2% per year

- Most of the richest countries in the world today were the ones which started growing the earliest (for more than a century).
- The countries which started growing late experienced bursts of rapid growth.
- The last century has seen an unprecedented rise in standard of living. - Some countries have grown on parallel tracks.
- Some countries have failed to keep up with others.
- Some countries have experienced miraculous growth.
- Some countries have experienced disastrous growth.

Source: Heston, Summers, and Aten (2011).

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Source: Heston, Summers, and Aten (2011).
20% of the world’s population receives 60% of the world income.

- Why are differences in standards of living among countries so large? - Why some countries are so rich and others so poor?
- Why some countries grow quickly and others slowly?
- Will the poor countries continue to trail behind the rich ones?
- Will our grandchildren be as rich compared to us as we are compared to our grandparents?
- Does a higher standard of living lead to greater happiness?

- Before 1800:
i) Differences in income per capita across countries were relatively small. ii) No significant growth in standards of living.
- After 1800:
i) Large differences in income per capita across countries. ii) Large differences in economic growth across countries.

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- From the end of the Roman Empire to 1500, there was no output per capita growth in Europe.
- From about 1500 to 1700, the growth rate of output per person turned out to be about 0.04% per year in the world 0.1% per year in
Europe.
- From 1700 to 1820, the growth rate of output per person increased to 0.07% in the world and 0.2% per year in Europe.

- For most of recorded human history, there was essentially no sustained growth in standards of living in the world:

Source: Jones (2011)

“If the 130,000‐year period since modern humans made their first appearance were compressed into a single day, the era of modern growth would have begun only in the last 3 minutes.”
Macroeconomics 2e (2011)
C.I. Jones

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Why countries were unable to increase their output per person prior
1800?

“This slow rate of progress, or lack of progress, was due to two reasons‐to the remarkable absence of important technical improvements and to the failure of capital to accumulate.”
Economic Possibilities for our Grandchildren (1930)
J.M. Keynes

- The world population grew slowly from the Neolithic Revolution until the second half of the 20th century:
0.09% per year
From 1 A.D. to
1800

0.04% per year from
10,000 B.C. to 1 A.D.

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- The world before 1800 was characterized by:
i) Agrarian Economies.

ii) Family based production. iii) Little technological progress.
- Technological innovations outside agriculture contributed little to overall production.

- Technological innovations in agriculture only generated temporary gains in standard of living.

Why were economic growth and population growth so low for so long? How do economic growth and demographic growth interact?
- Thomas Malthus (1766-1834) was a British scholar influential in political economy and demography.
- His theory about population was first published in 1798 and titled:
“An Essay on the Principle of Population.”

- A Malthusian Model of Economic Growth:

Land X
Labour L

Productivity Z

Inputs
Production
Function

Aggregate
Output Y

Output per
Capita y

Population
Size

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- The Malthusian Model relies on two main assumptions:
i) A larger population L brings the standard of living y down:

ii) A higher income per capita y raises the population growth
L
rate L :
L
L

Prediction 1: Productivity improvement keeps the standard of living constant:

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Results:
- A higher productivity increases the standard of living and population growth immediately.
- A larger population lowers the land per capita and the standard of living in the short-run.
- The standard of living equals the subsistence level in the longrun.
- The population size is higher in the long-run.
- More productive economies will not have higher living standards but higher population.

Prediction 2: “Family planning” increases the standard of living:

Results:
- A population control policy lowers population growth.
- A lower population raises the land per capita and the standard of living in the short-run.
- The standard of living is higher in the long-run.
- The population size is lower in the long-run.

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- The predictions of the Malthusian Model are accurate to describe:
i) The world before 1800. ii) In 1000 A.D. technologically advanced China had the same low living standard as technologically backward Europe. iii) The introduction of the potato in Ireland in the 18th century.

- The Malthusian Model does no longer apply to the last two centuries: i) Higher income per capita lowers the growth rate of population. ii) A larger population did not bring the standard of living down: - Over the last 200 years both population and living standards increased significantly in western Europe:

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Was Mathus wrong?
- Did not take into account capital accumulation.
- Did not predict that economic growth also lowers population growth. - Agricultural land as a fraction of total wealth in the United
Kingdom:

Does economic growth make us happy?
- In 1930, Keynes predicted that generations in 2030 will enjoy significantly higher standards of living and abundant free time.

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- Relationship between income and happiness in the U.S. on a scale from 1 to 3 (1 is “not too happy”, 2 is “pretty happy”, and 3 is “very happy”): - In the U.S., rich people are likely to report themselves as happier than poor people:
Table 1

Income Level

Distribution of Happiness in the
United States Across Income
Groups (Percent)
Top Quarter

Bottom Quarter

Very happy

37

16

Pretty happy

57

53

Not too happy

6

31

C2011 Prentice Hall. Macroeconomics Updated Plus MyEconLab Student Access Kit, 5/E. All rights reserved.

- In the U.S. over the last 21 years, a higher standard of living was not associated with an increase in self reported happiness:
Table 2

Distribution of Happiness in the
United States Over Time
(Percent)
1975

1996

Very happy

32

31

Pretty happy

55

58

Not too happy

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C2011 Prentice Hall. Macroeconomics Updated Plus MyEconLab Student Access Kit, 5/E. All rights reserved.

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Easterlin’s Paradox:
According to Richard Easterlin (1974, 1995) economic growth in developed countries only marginally contributes, if at all, to quality of life and that average happiness in developed countries has remained relatively static during the last half of the 20th century.

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- Relationship between income and happiness in a cross-section of countries: Remarks:
- People in poor countries generally report themselves to be less happy than people in wealthy countries.
- Average happiness is not always higher in rich countries:
i) Among countries with income per capita below $20,000, there is a positive relationship between income and happiness. ii) Among countries with income per capita above $20,000, there is no relationship between income and happiness.
- Average happiness does not seem to rise within a country as it gets richer. - People’s happiness may not only depend on what they consume but also on how their consumption relates to some benchmark that they use for comparison:
i) Consumption of other people around them. ii) Own past consumption.

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Remarks:
- Growth changes people’s consumption benchmarks.
- Growth allows people to stay ahead of their consumption benchmarks. - Relative income rather than absolute income tends to affect happiness the most.

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