OVERVIEW OF MACROECONOMICS

Chapter 2 (Mankiw); Chapter 20 (Samuelson & Nordhaus); Chapter 21 (Case &Fair)

MACROECONOMICS

 Is the study of the behaviour of an economy as

a whole.
 It examines the forces that affect many firms,
consumers, and workers at the same time.
 It contrasts with Microeconomics, which
studies individual prices, quantities and
markets.
TWO CENTRAL THEMES

 The short-term fluctuations in output,

employment, and prices that we call the
business cycle and,

 The long-term trends in output and living

standards known as economic growth.
DEVELOPMENT OF MACROECONOMICS

The development of macroeconomics was one

of the major breakthroughs of 20th century
economics.
 Leads to a much better understanding of how
to combat periodic economic crises and how to
stimulate long term economic growth.
BIRTH OF MACROECONOMICS

 John Maynard Keynes

 In
1930s he tried to understand the economic
mechanism that produced the Great Depression.
 Employment Act of 1946
 US Congress proclaimed federal responsibility for
macroeconomic performance.
 For the first time, Congress affirmed the
government’s role in promoting output growth,
fostering employment and maintaining price
stability.
CENTRAL MACROECONOMIC QUESTIONS

 Why do output and employment fall and how

can unemployment be reduced?
 What are the sources of price inflation, and
how can it be kept under control?
 How can a nation increase its rate of economic
growth?
WHY DO OUTPUT AND EMPLOYMENT FALL AND
HOW CAN UNEMPLOYMENT BE REDUCED?

 All market economies show pattern of

expansion and contraction known as business
cycle.
 One key goal of macroeconomic policy has
been to use monetary and fiscal policy to
reduce the severity of business cycle
downturns and unemployment.
 Macroeconomics examines the source of
persistent unemployment and suggest possible
remedies.
WHAT ARE THE SOURCES OF PRICE INFLATION,
AND HOW CAN IT BE KEPT UNDER CONTROL?
 A market economy uses prices as a yardstick to
measure economic values and conduct business.
 During periods of rapidly rising prices or price inflation,
the price yardstick loses its value.
 People get confused on relative prices and make
mistakes in their spending.
 Macroeconomic policy emphasized price stability as a
key goal.
 Macroeconomics can suggests the proper role of
monetary and fiscal policy, of exchange rate systems,
and of an independent central bank in containing
inflation.
HOW CAN A NATION INCREASE ITS RATE OF
ECONOMIC GROWTH?

 Macroeconomics is concerned about economic

growth.
 Growth in the productive potential of an economy.
 A country’s productive potential determines the
growth in its real wages and living standards.
 Key factors in rapid economic growth are the
predominance of free market, high rates of
saving and investment, low trade barriers, and
an honest government wth strong property
rights.
 All economies face inevitable tradeoffs among
these goals.
 Increasing the rate of growth of output over the long
run may require greater investment in education
and capital; but higher investment requires lower
current consumption of items like food, clothing &
recreation.
 Policymakers are forced to rein in the economy
through macroeconomic policies when it grows too
fast, when unemployment falls too low, in order to
prevent rising inflation.
 There are no simple formulas in solving these
problems but sound macroeconomic policies
can help achieve country’s economic objectives
in the most effective manner.
OBJECTIVE & INSTRUMENTS

 Having surveyed the principal issues of

macroeconomics, let us now discuss the major
goals and instruments of macroeconomic
policies.
 How do economists evaluate the success of an
economy’s overall performance?
 What are the tools that governments can use to
pursue their economic goals?
GOALS & INSTRUMENTS OF MACROECONOMICS
POLICIES
 Objectives:
 Output – high level and rapid growth
 Employment – high level with low involuntary

unemployment.
 Price-level stability

 Instruments:
 Monetary Policy – controlling money supply to
determine interest rates
 Fiscal Policy – government expenditures; taxation
OBJECTIVES: OUTPUT

 Provide the goods and services that the

population desires.
 The most comprehensive measure of the total
output in an economy is the gross domestic
product (GDP).
 measure of the market value of all final goods &
services produced in a country during a year.
 There are two ways to calculate GDP
 RealGDP – constant prices; serves as carefully
monitored pulse of a nation’s economy.
 Nominal GDP – current market price

 Despite short-term fluctuations in the business

cycle, advance economies exhibit a steady
long-term growth in real GDP & an improvement
in the living standards, called economic growth.
OBJECTIVE: EMPLOYMENT

 Of all the macroeconomic indicators,

employment and unemployment are mostly
directly felt by individuals.
 People want to be able to get high-paying jobs
without searching or waiting too long; they want
to have job security and good benefits
 In macroeconomics terms, these are objectives of
high unemployment, which is the counterpart of low
unemployment.
 Unemployment rate reflects the state of the
business cycle: when output is falling, the
demand for labor falls and unemployment
rises.
OBJECTIVE: PRICE STABILITY

 Maintain price stability – this means that

overall price level is either unchanged or rising
very slowly.
 How?
 To track prices, government statisticians construct
price indexes, or measures of the overall price level.
 Example:
 (CPI) Consumer Price Index – the average price of goods
and services bought by consumers.
 Economists measure price stability by looking at the inflation
rate. The inflation rate is the percentage change in the overall
price level from one year to the next.
 Example:

CPI in 2001 – 177.1

2002 – 179.9
Thus, inflation rate as of 2002 is:
= {[P(2002)- P(2001)]/P(2001)} x 100%
= {[(179.9 -177.1)]/177.1} x 100%
= 1.6%
TOOLS: FISCAL POLICY

 Denotes the use of (1) government expenditure

and (2) taxes.
 (1)Government Expenditure
 Government Purchases – spending on goods & services
 Government Transfer Payments – boosts the incomes of
targeted groups such as elderly & unemployed
 Government expenditure determines the relative size of
the public and private sectors – how much GDP is
consumed collectively rather than privately.
  Government expenditure also affect the overall
spending in the economy and thereby influence the
level of GDP.
 (2) Taxation - affects the overall economy in
two ways.
 Taxes affect people’s income.
 Leaves household with lesser disposable income, affects
their spending and saving – which is important in
investment & output in the short & long run.
 Taxes affect the prices of goods & services and
factors of production.
TOOLS: MONETARY POLICY

 Government conducts through managing the

nation’s money, credit and banking system.
 They determine the money supply and financial
conditions
 Changes in money supply move interest rates
up and down, and affects spending in the
sectors such as business investing, housing
and foreign trade.
 It has an effect on both actual and potential
GDP.
INTERNATIONAL LINKAGES

 All nations participate in the world economy

and are linked together by trade and finance.
 E.g : Import and Export
Lending and Investment
 As economics become more closely linked,
policymakers devote increasing attention to
international economic policy.
 International trade is not the end of itsel.
 They are concerned with international trade
because trade serves the ultimate goal of
improving living standards.
 The major area of concern are:
 Trade policies
 Financial management.
 Trade policies
 Tariffs

 Quotas

 Other regulations that restrict or encourage imports

and exports
 International Financial Management
 Foreign exchange rate
 Managingexchange rate is the single most important
macroeconomic policy.
AGGREGATE SUPPLY & DEMAND

 Economist have developed aggregate supply

and demand analysis to help explain the major
trends in output and prices.

 We begin by explaining this important tool of

macroeconomics and then use it to understand
some important historical events.
INSIDE THE MACROECONOMY
Total amount which the
Monetary Output
different sectors in the
Policy Aggregate (Real GDP)
economy willingly spend
Demand
in a given period

Fiscal
Policy

Employment
Interaction of and
Aggregate Unemployment
Other
Supply &
Forces Demand

Price
Level & Prices and
Costs Aggregate inflation
Supply

Potential
Output
Total quantity of goods &
services that the nation’s Foreign
Capital, businesses willingly Trade...
Labor, produced and sell in a
Technology given period.
AGGREGATE DEMAND & SUPPLY CURVES

 Often used to analyze macroeconomic

conditions.
 This shows us how aggregate supply and
demand reacts with monetary and
technological change to determine national
output.
 AGGREGATE DEMAND & SUPPLY
The downward sloping
P curve is the Aggregate
Demand Curve which
represents what everyone
in the economy –
consumers, governments,
businesses and foreigners
AS – would buy at different
aggregate prices.

B C
200

150 The upward sloping curve is

AD
the Aggregate Supply Curve
which represents the
quantity of goods and
services that businesses
are willing to produce and
2300 3000 3300 Q sell at each price level
Macroeconomic equilibrium is
a combination of overall price
and quantity at which all
buyers and sellers are
satisfied with their purchases,
sales and prices
MACROECONOMIC HISTORY: 1900-2003

 Wartime Boom
 Tight Money, 1979-1982

 The Growth Century

THE ROLE OF ECONOMIC POLICY

 The striking change of the 20th Century is the

development of Macroeconomics.
 The application of fiscal and monetary policy
helped lower unemployment and provided
largely stable prices over time the last two
decades.
 Business fluctuations are not eliminated but
the fundamental knowledge is available to
reduce the risk of galloping inflation and deep
recession.
 THE DATA OF
MACROECONOMICS
Chapter 2 (Mankiw); Chapter 20 (Samuelson & Nordhaus); Chapter 21(Case &Fair)
GROSS DOMESTIC PRODUCT
Two definitions:
1. Total expenditure on
domestically-produced
final goods and services
2. Total income earned by
domestically-located
factors of production
WHY EXPENDITURE = INCOME

In every transaction,
the buyer’s expenditure
becomes the seller’s income.
Thus, the sum of all
expenditure equals
the sum of all income.
THE CIRCULAR FLOW
Income($)

Labor

Households Firms

Goods(bread)

Expenditure($)
CONSUMPTION (C)

def: the value of all goods • durable goods

and services bought by last a long time
households. Includes: ex: cars, home
appliances
• non-durable goods
last a short time
ex: food, clothing
• services
work done for
consumers
ex: dry cleaning,
air travel.
U.S. CONSUMPTION, 2001

% of
$ billions
GDP
Consumption $7,064.5 69.2%
Durables 858.3 8.4
Nondurables 2,055.1 20.1
Services 4,151.1 40.7
INVESTMENT (I)
def1: spending on [the factor of production] capital.
def2: spending on goods bought for future use.
Includes:
 business fixed investment
spending on plant and equipment that firms will use
to produce other goods & services
 residential fixed investment
spending on housing units by consumers and
landlords
 inventory investment
the change in the value of all firms’ inventories
U.S. INVESTMENT, 2001

% of
$ billions
GDP
Investment $1,633.9 16.0%
Business fixed 1,246.0 12.2
Residential fixed 446.3 4.4
Inventory -58.4 -0.6
INVESTMENT VS. CAPITAL

 Capital is one of the factors of production.

At any given moment, the economy has a
certain overall stock of capital.

 Investment is spending on new capital.

INVESTMENT VS. CAPITAL

Example (assumes no depreciation):

 1/1/2002:
economy has $500b worth of capital
 during 2002:
investment = $37b
 1/1/2003:
economy will have $537b worth of capital
STOCKS VS. FLOWS
Flow Stock

More examples:
stock flow
a person’s wealth a person’s saving
# of people with # of new college
college degrees graduates
the govt. debt the govt. budget deficit
GOVERNMENT SPENDING (G)
 G includes all government spending on goods
and services.
 G excludes transfer payments
(e.g. unemployment insurance payments),
because they do not represent spending on
goods and services.
GOVERNMENT SPENDING, 2001

% of
$ billions
GDP
Gov spending $1,839.5 18.0%
Federal 615.7 6.0
Non-defense 216.6 2.1
Defense 399.0 3.9
State & local 1,223.8 12.0
 NET EXPORTS (NX = EX - IM)
def: the value of total exports (EX)
minus the value of total imports (IM)
U.S. Net Exports, 1960-2000
50

-50

-100
$ billions

-150

-200

-250

-300

-350

-400
1960 1965 1970 1975 1980 1985 1990 1995 2000
AN IMPORTANT IDENTITY

Y = C + I + G + NX
where
Y = GDP = the value of total output
C + I + G + NX = aggregate expenditure
A QUESTION FOR YOU:
Suppose a firm
 produces $10 million worth of final
goods
 but only sells $9 million worth.

Does this violate the

expenditure = output identity?
WHY OUTPUT = EXPENDITURE
 Unsold output goes into inventory,
and is counted as “inventory investment”…
…whether the inventory buildup was
intentional or not.
 In effect, we are assuming that
firms purchase their unsold output.
GDP:
AN IMPORTANT AND VERSATILE CONCEPT
We have now seen that GDP measures
 total income
 total output
 total expenditure
 the sum of value-added at all stages
in the production of final goods
GNP VS. GDP
 Gross National Product (GNP):
total income earned by the nation’s factors of
production, regardless of where located

 Gross Domestic Product (GDP):

total income earned by domestically-located
factors of production, regardless of nationality.

(GNP – GDP) = (factor payments from abroad)

– (factor payments to abroad)
DISCUSSION QUESTION:

What explains why GNP differs

from GDP for some of the
following countries?
(GNP – GDP) AS A PERCENTAGE OF GDP
FOR SELECTED COUNTRIES, 1997.
U.S.A. 0.1%
Bangladesh 3.3
Brazil -2.0
Canada -3.2
Chile -8.8
Ireland -16.2
Kuwait 20.8
Mexico -3.2
Saudi Arabia 3.3
Singapore 4.2
REAL VS. NOMINAL GDP

 GDP is the value of all final goods and services

produced.
 Nominal GDP measures these values using
current prices.
 Real GDP measure these values using the
prices of a base year.
REAL GDP CONTROLS FOR INFLATION
Changes in nominal GDP can be due to:
 changes in prices

 changes in quantities of output produced

Changes in real GDP can only be due to

changes in quantities,
because real GDP is constructed using
constant base-year prices.
PRACTICE PROBLEM

2002 2003
P Q P Q
good A $1 10 $2 15

good B $10 3 $15 4

 Compute nominal GDP in 2002 and 2003

 Compute real GDP in each year using
2002 as the base year.
ANSWERS TO PRACTICE PROBLEM
 Nominal GDP multiply Ps & Qs from same year
2002: $1 x 10 + $10 x 3 = $40
2003: $2 x 15 + $15 x 4 = $90

 Real GDP multiply each year’s Qs by 2002 Ps

2002: as above: $40
2003: $1 x 15 + $10 x 4 = $55 (2002$)

 So in real terms, GDP did not rise as much as it

would seem from nominal terms.
U.S. REAL & NOMINAL GDP, 1967-2001
11,000
10,000
(billions of U.S. dollars)

9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1965 1970 1975 1980 1985 1990 1995 2000
NGDP (billions of $) RGDP (billions of 1996 $)
GDP DEFLATOR
 The inflation rate is the percentage
increase in the overall level of prices.
 One measure of the price level is
the GDP Deflator, defined as

Nominal GDP
GDP deflator = 100 
Real GDP
UNDERSTANDING THE GDP DEFLATOR
Example with 3 goods
For good i = 1, 2, 3
Pit = the market price of good i in month t
Qit = the quantity of good i produced in month t
NGDPt = Nominal GDP in month t
RGDPt = Real GDP in month t
UNDERSTANDING THE GDP DEFLATOR
NGDPt P1t Q1t  P2t Q2t  P3t Q3t
GDP deflator  100   100 
RGDPt RGDPt
  Q1t   Q2t   Q3t  
 100     P1t    P2t    P3t 
  RGDPt   RGDPt   RGDPt  

The GDP deflator is a weighted average of prices.

The weight on each price reflects
that good’s relative importance in GDP.
Note that the weights change over time.
WORKING WITH PERCENTAGE CHANGES
USEFUL TRICK #1 For any variables X and Y,
the percentage change in (X  Y )
 the percentage change in X
+ the percentage change in Y

EX: If your hourly wage rises 5%

and you work 7% more hours,
then your wage income rises approximately 12%.
WORKING WITH PERCENTAGE CHANGES
USEFUL TRICK #2
the percentage change in (X/Y )
 the percentage change in X
 the percentage change in Y

EX: GDP deflator = 100  NGDP/RGDP.

If NGDP rises 9% and RGDP rises 4%,
then the inflation rate is approximately 5%.
CONSUMER PRICE INDEX (CPI)
 A measure of the overall level of prices
 Published by the Bureau of Labor Statistics
(BLS)
 Used to
 track changes in the
typical household’s cost of living
 adjust many contracts for inflation
(i.e. “COLAs”)
 allow comparisons of dollar figures from
different years
HOW THE BLS CONSTRUCTS THE CPI
1. Survey consumers to determine composition
of the typical consumer’s “basket” of goods.
2. Every month, collect data on prices of all items
in the basket; compute cost of basket
3. CPI in any month equals
Cost of basket in that month
100 
Cost of basket in base period
THE COMPOSITION OF THE CPI’S “BASKET”
Food and bev.
5.8% 5.9%
Housing 17.6%
2.8%
Apparel 2.5%
4.5% 4.8%
Transportation

Medical care

Recreation
16.2%
Education

Communication
40.0%
Other goods and
services
UNDERSTANDING THE CPI
Example with 3 goods
For good i = 1, 2, 3
Ci = the amount of good i in the CPI’s basket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month t
Eb = cost of the basket in the base period
UNDERSTANDING THE CPI
Et P1t C1 + P2t C2 + P3t C3
CPI in month t  100   100 
Eb Eb
 C1   C2   C3  
 100    P1t    P2t    P3t 
 Eb   Eb   Eb  

The CPI is a weighted average of prices.

The weight on each price reflects
that good’s relative importance in the CPI’s basket.
Note that the weights remain fixed over time.
REASONS WHY
THE CPI MAY OVERSTATE INFLATION
 Substitution bias: The CPI uses fixed weights,
so it cannot reflect consumers’ ability to substitute
toward goods whose relative prices have fallen.
 Introduction of new goods: The introduction of new
goods makes consumers better off and, in effect,
increases the real value of the dollar. But it does not
reduce the CPI, because the CPI uses fixed weights.
 Unmeasured changes in quality:
Quality improvements increase the value of the dollar,
but are often not fully measured.
THE CPI’S BIAS
 The Boskin Panel’s “best estimate”:
The CPI overstates the true increase in the cost of
living by 1.1% per year.
 Result: the BLS has refined the way it calculates the
CPI to reduce the bias.
 It is now believed that the CPI’s bias is slightly less
than 1% per year.
CPI VS. GDP DEFLATOR
prices of capital goods
• included in GDP deflator (if produced domestically)
• excluded from CPI

prices of imported consumer goods

• included in CPI
• excluded from GDP deflator

the basket of goods

• CPI: fixed
• GDP deflator: changes every year
 TWO MEASURES OF INFLATION
Percentage
change 16

14 CPI
12

10

6
GDP deflator
4

-2
1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998
Year
MEASURING UNEMPLOYMENT:
CATEGORIES OF THE POPULATION
 employed
working at a paid job
 unemployed
not employed but looking for a job
 labor
force
the amount of labor available for producing
goods and services; all employed plus
unemployed persons
 notin the labor force
not employed, not looking for work.
TWO IMPORTANT LABOR FORCE CONCEPTS
 unemployment rate
percentage of the labor force that is
unemployed
 labor force participation rate
the fraction of the adult population
that ‘participates’ in the labor force
COMPUTE PERCENTAGE CHANGES IN LABOR
FORCE STATISTICS
Suppose
 the population increases by 1%
 the labor force increases by 3%
 the number of unemployed persons
increases by 2%

Compute the percentage changes in

the labor force participation rate: 2%
the unemployment rate: 1%
 Okun’s Law (Observation)
 Employed workers help produce GDP, while
unemployed workers do not.
So one would expect
a negative relationship between
unemployment and real GDP.
 This relationship is clear in the data…
OKUN’S LAW Okun’s Law states
that a one-percent
Percentage change decrease in
in real GDP
10 unemployment is
associated with two
8
1951 percentage points
6 1984 of additional growth
2000
4 in real GDP
1999

2 1993
1975
0

-2 1982

-3 -2 -1 0 1 2 3 4
Change in
unemployment rate
END.