978-0133780581 Chapter 1 Lecture Note

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Chapter 1. A Tour of the World

I. MOTIVATING QUESTION

What is macroeconomics?

The chapter does not provide an explicit or formal answer. Instead, it takes you on an economic

tour of the world and then describes the 2008global macroeconomic crisis and other issues of

concern to macroeconomists who study the United States, the Euro area, and China. A working

definition of macroeconomics at this point is the study of output, unemployment, and inflation,

terms that will be defined precisely in Chapter 2.

II. WHY THE ANSWER MATTERS

This chapter attempts to provide students an incentive to master the theoretical material that

follows in the remainder of the text. The implicit promise is that the theoretical model developed

in the text will allow students to make sense of the various macroeconomic issuesthat continue to

impact countries around the world.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

Chapter 1 does not provide any analytical tools. However, it does force students to confront some

basic data and introduces data sources for various regions of the world. In addition, the chapter

introduces and defines the concepts of output, growth, the unemployment rate, and the

inflation rate. A more precise definition of these terms follows in Chapter 2.

Chapter 1 mentions in passing the terms standard of living, productivity and purchasing

power parity. All of these terms and concepts will be explored in later chapters in the text.

2. Assumptions

Implicit in the Tour of the World is the assumption that the same basic macroeconomic tools can

be used to analyze economies throughout the world. It might be worth making this point

explicitly. The macroeconomic framework developed in the text would be neither terribly useful,

nor compelling as a theory, if it applied only to the United States, and not to the other market

economies.

IV. SUMMARY OF THE MATERIAL

1. The Crisis

Included in the 7th edition of the textbook is a discussion around the major macroeconomic crisis

that occurred in 2008. Figure1-1 outlines the output growth rates for the world economy, the

advanced economics and for the other countries separately since 2000. From 2000 to 2007 the

world economy had a sustained expansion. Annual average world output growth was 4.5%, with

advanced economies growing at 2.7% per year, and emerging and developing economies

growing at an even faster 6.6% per year. By 2008, the world, advanced and emerging economy

output growth rate began to decline marking the beginning of the macroeconomic crisis.

Highlights of the Macroeconomic Crisis:

U.S. housing prices, which had doubled since 2000, started to decline in 2007.

A number of mortgage loans originated during the earlier expansion were to

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high-risk borrowers which were increasingly unable to make mortgage payments.

Declining housing prices caused the mortgages to exceed the market value of the

homes thus creating an incentive to default.

Banks that originated the loans often bundled, packaged and repackaged the loans

into new securities and then sold them to other banks and investors. The holdings of

securities, instead of mortgages by banks, added complexity that made it impossible

to appraise the value of these derivative financial obligations.

The complexity of the value of the securities and the quality of the assets made

banks reluctant to lend to each other.

September 15, 2008, a major bank, Lehman Brothers, went bankrupt creating

borrowing issues and asset valuation problems for other banks. Within weeks the

whole financial system was in jeopardy.

Figure 1-2 shows how the financial crisis became an economic crisis with the

collapse of stock prices indicated in the three stock price indexes (for the United

States, Euro area and emerging economies).By the end of 2008, stocks had lost half

or more of their value from the previous peak.

The decline in housing prices and the collapse in stock prices lead to a decline in

consumption of goods and services.

Businesses’ concerns over sales and continuous decline in housing prices caused a

sharp reduction in investment along with a decline in the building of new homes.

Despite strong actions by the Fed, including a cut in interest rates, and the U.S.

government which cut taxes and increased government spending, both demand and

output continued to decline in the U.S.

A decline in the U.S. imports along with U.S. banks needing to repatriate funds

from other countries moved a U.S. crisis into a world crisis.

By 2009, average growth in advanced economies was -3.4%, by far the lowest

annual growth rate since the Great Depression. Growth in emerging and developing

economies remained positive but was 3.5 percentage points lower than the

2000–2007 average.

Table 1-1, shows by 2010, economic growth in the U.S. was positive but still not at

pre-crisis levels.

Tables 1-1 and1-2 showconsistently high unemployment rates for the United States

and Euro area since the beginning of the crisis. However, U.S. unemployment rates

are beginning to improve and are down to 5.4% as of 2015.

2. The United States

In the United States, the 1990-2007 average rate of growth of the economy was 3.0%. In contrast

the rate of growth during the crisis (2008-2009) was -1.5%. However, by 2015 the U.S. economy

was growing at an annual rate of 2.5%. U.S. unemployment rates increased from a pre-crisis

average of 5.4% to an average of 8.0% over the period 2010-2014. However, by 2015 the U.S.

unemployment rate was down to 5.4% as firms began to add employees.

One of the primary economic issues facing the U.S. is the current Federal Reserve policy of

extremely low interest rates which have been necessary to propel growth. Figure 1-4 shows the

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federal funds rates from 2000-2015 which highlights this policy. At the current time the Fed is

near zero interest rate bound and cannot lower rates much to stimulate growth if deemed

necessary. The low rates also push investors to take excessive risks in search of higher returns.

Another macroeconomic issue is the low productivity in the U.S. Table 1-2 shows that

productivity growth is significantly lower in all sectors of the economy relative to the 1990s.

Slow productivity growth can decrease the real earnings power of workers and lead to an

increase in income inequality. Policy makers need to change this trend.

3. The Euro Area

Figure 1-5 displays a map the EU17 that uses the Euro as a common currency along with the

2014output of the Euro area’s output for the countries of France, Germany, Italy and Spain. Table

1-3 shows that over the 1990-2007 time period right before the crisis, the Euro Area together

experienced positive but relatively low growth The Euro Area also endured low inflation and

continued high unemployment. The crisis caused growth to decline to negative 2.0% over the

2008-2009 period while the unemployment rate averaged 11.1% over the 2010-2014 time period.

Some Euro Area countries, such as Greece and Spain, continue to struggle with unemployment

rates exceeding 23%, even in 2015.

The issues facing the Euro area are:

How to reduce unemployment.

How to function effectively as a common currency area.

How to reduce unemployment

The debate over remedies for high unemployment in Europe is characterized by two polar views.

According to the first view, high unemployment is the result of tight monetary policy by the

European Central Bank. The suggested remedy is lower interest rates. According to the second

view, high unemployment is a result of rigid labor market institutions, particularly with respect to

worker protection such as generous unemployment insurance policies that reduce the incentive to

find work. Thus, the suggested remedy is to restructure labor market institutions—in fact to

model them after the institutions in the United States. The United Kingdom has followed this

approach, evidently with some success in reducing the unemployment rate. Some economists,

however, remain skeptical that the U.K.’s approach is the right model for Europe. These

economists point out that Denmark and the Netherlands have low unemployment rates, despite

providing generous social insurance for workers. The way forward, the skeptics argue, is to study

the details of worker protection policies in places where such policies have been consistent with

low unemployment, and to apply the lessons to other European economies. However, skeptics

point out that other countries in the Euro Area have labor markets with similar worker

protections but yet have low unemployment rates. For example, Germany’s 2015 unemployment

rate is below 5%.

How to function effectively as a common currency area

The Euro offers political and economic benefits. Politically, the adoption of a single currency

provides a strong symbol of European unification after the wars of the 20th century and before.

Economically, the Euro has eliminated exchange rate uncertainty among participating countries,

and thus may facilitate trade and contribute to the economic development of Europe as, perhaps,

the largest economic power in the world. On the other hand, the adoption of a single currency has

eliminated the discretion of each country individually to use monetary policy to stimulate output

and reduce unemployment. Countries that participate in the Euro have a common monetary

policy, in the same way that states in the United States have a common monetary policy. This

situation creates the possibility of policy conflicts when some countries are in recession and

others are in an economic boom.

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The chapter points to the recent policy conflicts among Euro members. Highlighting the issue are

deep recessions of countries including Ireland, Portugal, and Greece, that are unable to

individually decreasetheir interest rates, or depreciate their currency. These problems have

prompted some economists argue that they should drop out of the Euro. Others argue that such

an exit would be both unwise, as it would give up on the other advantages of being in the Euro,

isextremely disruptive, and could lead to even deeper problems for the country that exits. Policy

issues associated with monetary union are discussed further in Chapter 20.

4. China

China’s economy commands the attention of macroeconomists because of its exceptional growth

over the last three decades. Since 1980, China’s output has grown at roughly 10% a year. Table

1-4 shows that the crisis has had little effect on the Chinese economy. While, Chinese exports

slowed down during the crisis it was nearly fully offset by a major fiscal expansion by the

Chinese government. The result was sustained growth of demand and, in turn, of output.

However, China’s economic growth rate is falling and was only 6.8% in 2015.

Although official Chinese statistics are not as accurate as in richer countries, research suggests

that there is no clear bias in the numbers. In other words, high growth in China is a fact, and not

an artifact of poor statistics. China has achieved high growth through rapid accumulation of

capital (investment rates exceeding of output) and fast technological progress. The latter

achievement is in part a result of the Chinese government’s strategy of encouraging foreign firms

—which are typically more productive than Chinese firms—to produce in China. The

government has also encouraged joint ventures between foreign and Chinese firms. Such joint

ventures allow Chinese firms to learn from more productive foreign firms.

Although China’s success seems to provide a model for other developing countries to follow,

questions remain about the operational lessons to draw from China’s experience. In most other

cases, the transition from central planning to a market economy has been accompanied by a large

decline in output. Some argue that the slow pace of China’s transition—thirty years and still

incomplete—was an important factor in China’s success. Others argue that the political control

of the Communist party during the transition has enabled better protection of property rights for

firms, thereby creating incentives for investment.

V. PEDAGOGY

1. Points of Clarification

Chapter 1 mentions in passing that an annual growth rate of 10% means output will double in

about 7 years. The “rule of 70” tells us how long it takes for an amount to double in value so

instructors may wish to mention it here. Also, the text does not use logarithms, although it does

use graphs on logarithmic scales. Instructors who wish to use logarithms in the course can use

the rule of 70 as a way to reacquaint students with the use of the natural logarithm.

2. Alternative Sequencing

i. The Global Crisis. Indeed, instructors could use the global crisis as the running example

to introduce most the material. The 7thEdition features a streamlined organization where

an early and continuous examination of the global crisis provides an integrated

framework to think about the short, medium run, and long run.

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ii. Output, the Unemployment Rate, and the Inflation Rate. Output, the unemployment rate,

and the inflation rate are not defined precisely until Chapter 2. Some instructors may

prefer to cover the definitions from Chapter 2, and possibly the discussion of why

macroeconomists care about these variables, before discussing the material in this

chapter.

3. Enlivening the Lecture

An alternative to posing the motivating question of this chapter is to ask students what they hope

to learn from the course. The answers can be used to construct a description of what the course

—and macroeconomics—is about. Another alternative is to begin a lecture on this chapter (and

the course) by asking what the Federal Reserve should do with regard to interest rates. Students

should develop alternative opinions based on illustrative newspaper quotes or student answers.

VI. EXTENSIONS

1. The Rest of the World

The Tour of the World presented in this chapter focuses attention on the United States, Europe,

and China. Economic events in other regions are discussed only briefly at the end of the chapter.

Current economic events in some of these regions are discussed at various places throughout the

text. However, instructors may wish to devote more time to these regions at the outset,

especially if the course will consider the open economy.

2. Positive and Normative Economics, Policy Disagreements, and Methodology

Instructors may wish to distinguish between positive and normative economics and to discuss

how normative perspectives can lead economists to different policy prescriptions even when they

agree on the facts. Instructors may also wish to remind students of the difficulties that

economists and other social scientists face because of the inability to conduct controlled

experiments. A discussion of this sort was presented in Chapter 1 of the first edition of the text.

3. Distribution of Economic Benefits

The second edition of the text included a discussion about income inequality in the section on the

U.S. economy. In subsequent editions, including the current edition, income inequality is

discussed in Chapter 13. Instructors may wish to raise this issue in the introductory discussion of

the U.S. economy.

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