CHAPTER 1.

MACROECONOMIC
FOUNDATIONS

1.1 Introduction to macroeconomics

1.2 Other macroeconomic indicators
1.3 National accounting
1.4 GDP components
1.5 Labour market indicators
1.6 Inequality and climate issues in macroeconomics
 Chapter 1.2. -
Other macroeconomic
indicators

❖ Nominal Vs Real GDP

❖ Inflation
❖ Further topics on inflation
❖ Inflation nowadays
 Measuring GDP changes over
time: Nominal Vs Real GDP (I)
• What if in this definition of GDP, there is a permanent increase in
Prices? Or a decrease in X? How can we asses GDP changes over
time?

𝐼
𝐺𝐷𝑃𝑡 = ෍ 𝑃𝑖2020 𝑋𝑖2020
𝑖=1

• GDP could be higher as a result of price changes even when no

more goods nor services are produced!!

• This definition of the GDP is the Nominal GDP or GDP at current

prices.
 Measuring GDP changes over
time: Nominal Vs Real GDP (II)
2010 2016 2022
Production 1,000*10= 1,200*13= 1,500*15=
Good X 10,000 15,600 22,500

Production 1,000*2= 1,050*2= 900 *3=

Good Y 2,000 2,100 2,700
Nominal GDP 10,000+2,000 15,600+2,100 22,500+2,700
=12,000 =17,700 =25,200

• Note that price levels are going up or down while quantities are
not drastically moving.
• The continuous increase (changes) in prices is called inflation.
 Measuring GDP changes over
time: Nominal Vs Real GDP (III)
• Price effects could create illusory effects by which GDP is growing
(or decreasing) while it could be stagnated (or even decreasing).

• We need to account for these price effects to make comparable GDP

comparisons in time.

• To do this, we fix a base year (2010) for prices and allow quantities
(X) to change.
𝐼
𝐺𝐷𝑃𝑡 = ෍ 𝑃𝑖2010 𝑋𝑖2020
𝑖=1

• This definition of the GDP is the Real GDP or GDP at constant

prices (This is the one you should be looking at over time).
 Measuring GDP changes over
time: Nominal Vs Real GDP (IV)
2010 2016 2022
(Base year)
Production 1,000*10= 1,200*10= 1,500*10=
Good X 10,000 12,000 15,000

Production 1,000*2= 1,050*2= 900*2=

Good Y 2,000 2,100 1,800
Real GDP 10,000+2,000 15,600+2,100 15,000+1,800
(at constant =12,000 =14,100 =16,800
prices 2010)

• Now, all the years are comparable across them.

 Measuring GDP changes over
time: Nominal Vs Real GDP (V)

2010 2016 2022

Nominal 12,000 17,700 (∆= 25,200
GDP 5,700) (∆=7,500)
47,5% 42,4%
Real GDP 12,000 14,100 16,800
(∆=2,100) (∆=2,700)
17,5% 19,1%

• The “real” changes in production are now much lower, but actually,
they give us information on the capacity for a country to produce.
 Measuring GDP changes over
time: Nominal Vs Real GDP (VI)

• We can define this Real GDP as the actual quantity of goods and
services produced (using base year prices).

• We can, therefore, set a direct relationship between nominal GDP

and real GDP through the price levels, such as:

• Nominal GDP = Price level x Real GDP

• Alternatively, where now GDP is indicated as Y

Source: Jones (2017)

 Measuring GDP changes over
time: Nominal Vs Real GDP (VII)

• What if in this definition of GDP, there is a permanent increase in P?

Nominal GDP at
current prices

Price effect

Real GDP at
constant prices
 Measuring GDP changes over
time: Nominal Vs Real GDP (VIII)
• Thanks to the use of real GDP measures, we can analyze longer
time-series using the growth rates (we just saw)
• Spain in the long run, now we can (correctly) compare the economic
episodes or even the whole world.
Real GDP growth rates - Spain

Source: El Pais
 Measuring GDP changes over
time: Nominal Vs Real GDP (IX)
• One important remark is that real GDP might be calculated fixing
prices at the beginning of my period and allow quantities to
change – Laspeyres Index.

• But we can, alternatively, fix prices at the end of my period of

analysis whereas quantities evolve in the usual way - Paasche
Index.

• Depending on which prices we are fixing, real GDP changes would

be different, specially in longer time series.

• This is crucial because, in long time series, goods and services might
reduce their prices as a result of technological improvements
(example: laptops). If we use (old) prices at the beginning of my
period, we will not be capturing these improvements (productivity) in
our final GDP estimate.
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 Measuring GDP changes over
time: Nominal Vs Real GDP (X)
• Nominal and real GDPs can also be calculated in growth rates:

➢Growth rate (%) of Nominal GDP ≈ Growth rate (%) of production

+ Growth rate (%) of prices

➢Growth rate (%) of Real GDP ≈ Growth rate (%) of production

➢Growth rate (%) of Nominal GDP- Growth rate (%) of Real

GDP ≈ Growth rate (%) of prices.

• Note that if the growth rate of prices is higher than 0, Nominal GDP
will be higher than Real GDP.

• The Growth rate (%) of prices is known as inflation rate.

 Measuring GDP changes over
time: Nominal Vs Real GDP (XI)
• This is the growth rate of prices (inflation) for the US Economy:

Source: FRED.
 Inflation (I)
• The price level is the average level of prices of an economy.

• The average level of prices might be rising, falling, or remaining

stable.

• Inflation occurs when the price level persistently rises. The

inflation rate is the percentage change in the price level.

• Deflation occurs when the price level persistently falls.

• Disinflation refers to a (marginal) slowing process of the

inflation rate.

• Inflation is not the price level. Inflation equals change rate not
(level) prices!
 Inflation (II)

• Inflation refers to price (in)stability – it directly affects to the

(purchasing) value of money.

• Inflation reduces the (purchasing) value of money.

• Inflation could be anticipated (expectations) or unexpected.

 Inflation (III)
• There are three channels through which price changes might lead
to inflationary processes in a closed economy (We will analyse
them in due time):

➢Goods and services markets (demand inflation).

➢The markets of (inputs) production factors (supply inflation

of inputs’ costs).

➢The money market (monetary inflation related to the

monetary supply, explained later in the course)
 Inflation (IV)

• A common misperception is that inflation is bad for everyone

(who likes more expensive stuff?).

• A very common misperception is that inflation should always be

avoided.

• But this is not always and in any circumstance the case.

• As said, inflation reduces the value of money, so those winners

and losers from inflationary changes will depend on the situation
we are having

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 Inflation (V)

• Inflation has different impacts on employers and workers.

• Employers benefit from increases in prices of selling goods

(higher mark-ups) while they are hurt by increases in input prices
(higher costs).

• Workers lose from a fall in their real wage but they benefit from
lower real debts.

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 Inflation (VI)
• Inflation has different impacts on lenders and borrowers.
❖ Lenders are hurt by unanticipated inflation because the money
they get paid back has less purchasing power than the money
they loaned out.

❖ Borrowers benefit from unanticipated inflation because the

money they pay back is worth less than the money they
borrowed.

• Because of that, people who have borrowed money benefit from a

higher inflation rate when they pay the money back.

• The interest rate that a borrower pays is effectively lower thanks to

inflation – this is called the real interest rate.

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 Inflation (VII)

But…what is a real interest rate?

• Imagine you have 100€ and have to decide whether to put them
on a bank account or to buy something today.
• In the case you put the 100€ in the bank account, you will be
rewarded with a 2% of nominal interest (a year), getting 102€
at the end of the year.
• Imagine now that inflation rate increased by 5%, it means your
original 100€ would reduce in real terms to 95€ by the end of the
year.
• However, if you decide to go to the bank account, your original
100€ will increase 2% and then diminished 5%, giving you a total
reduction of 3%, which equals 97€, somehow the nominal
interest rate reduces the negative impact of inflation.

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 Inflation (VIII)

• The difference between nominal and real interest rates is the inflation
rate

Source: Jones (2017)

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 Inflation (IX)
• Nominal interest rate in period t: 𝑖𝑡. If the nominal interest rate for period t is
𝑖𝑡. , borrowing 1 dollar this year requires you to pay 1 + 𝑖𝑡. dollars next period.
• Real interest rate in
period t: 𝑟𝑡 . If we denote
the real interest rate for
year t by 𝑟𝑡 , then, by
definition, borrowing the
equivalent of one basket
of goods this period
requires you to pay the
equivalent of 1 + 𝑟𝑡
baskets of goods next
period.

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 Inflation (X)
𝑒
𝑒 𝑝𝑡+1
• Expected inflation in period t+1: π𝑡+1 = −1
𝑝𝑡
1+𝑖𝑡
• Hence: 1 + 𝑟𝑡 = ; Fisher equation: 𝒓𝒕 ≈ 𝒊𝒕 − π𝒆𝒕+𝟏
1+ π𝑒𝑡+1

Source: Blanchard (2020)

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 Inflation (XI)
• To sum up, is inflation bad? It depends.

• In general, it’s bad if you CANNOT accurately forecast it (and

protect against it), as some people will lose out whilst some will
win.

• Unexpected and unstable inflation IS a problem for society

because they redistribute income and wealth.

• Unexpected and unstable inflation provokes people to divert

resources from producing goods and services to forecasting and
protecting themselves from the inflation or deflation.

➢ Extreme case – Hyperinflation

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 Inflation (XII)

• Another common misperception is that disinflation and deflation are

good for everyone (who does not enjoy cheaper stuff?).

• Deflation increases the purchasing power of money. People who

have borrowed money are paying back that loan with money that is
effectively worth more than the money they borrowed. Deflation
effectively increases the interest rate that a borrower pays.

• Also deflation delays purchases (consumers) and reduces mark-

ups (firms)

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 Inflation (XIII)
• Indeed, deflation has such a destructive impact on an economy
that most policymakers agree that avoiding deflation is a far more
important objective.

• Question: Would you buy a new mobile phone today if you knew
that in a month it would be 10% cheaper?
• If the whole economy is doing the same, the economy would go into
recession very quickly.
• As consumption falls massively which puts further downward
pressure on prices so deflation falls further so people further delay
purchases.
• Unexpected deflation hurts businesses and households that are in
debt (borrowers) who in turn cut their spending. A fall in total
spending brings a recession and rising unemployment.

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 Inflation (XIV)

• As a result, the goal of policymakers is not zero inflation, but

small and predictable inflation rates.

“The ECB’s primary objective is to maintain price stability, that is, to preserve
the purchasing power of the euro. We do this by making sure that inflation –
the rate at which the overall prices for goods and services change over time
– remains low, stable and predictable.[…] The ECB’s Governing Council […]
considers that price stability is best maintained by aiming for 2% inflation
over the medium term.”

• The Federal Reserve and other major central banks have similar
targets, although not identical (Fed dual approach).

• Sometimes, central bank allow the inflation rate to go a bit above

2%, delaying their interventions.

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 Calculating inflation (I)
• To assess the level of prices plus their evolution, we have some price
indicators.

• The Consumer Price Index (CPI) is a measure of the average level

of the prices paid by a representative household for a representative
“basket” of consumer goods and services.
• The CPI is calculated monthly by the INE (data obtained from surveys).
The CPI is defined to equal 100 for a period called the reference base
period – That is, it is transposed into an index number.
• Then, the inflation rate is measured as the change in the CPI between
the reference period and the actual period.
 Calculating inflation (II)
• Suppose the initial survey shows
that the CPI basket is 2 books and
20 coffees (initial base period). In
this base period, say 2005, the
cost of the CPI basket is $100.

• Suppose that the survey taken one

month in 2015 reveals that the
price of a book is $35 and the price
of a coffee is $3.

• The CPI equals ($130  $100) 

100, or 130. So between the base
period and the current period, the
CPI has risen by 30 percent.

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 Calculating inflation (III)

• Representative basket from INE (actual base year 2016)

30
 Calculating inflation (IV)
• The CPI does not include the price of housing (and housing rents)

Source: INE
31
 Calculating inflation (V)

• The Spanish CPI does includes the (alquileres) housing rents

(subgroup within the housing group).

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 Calculating inflation (VI)

• It is highly important to measure correctly the CPI.

• It directly affects Wages, Pensions, Unemployment benefits, Bonds…

• Any bias in the CPI matters because many contracts and payments
are indexed to the CPI, including Social Security.

• So if you estimate inflation is 0.1% higher than it actually is could end

up paying millions more in wages and benefits the next month.

• Paying people more than they needs (wages) might even trigger
further increases in prices.

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 Calculating inflation (VII)
• The CPI might present a series of problems. One of them relates
with its compositional bias such that:

• New Goods Bias: New goods are often more expensive than the
goods they replace. Iphones!

• Quality Change Bias: Sometimes price increases reflect quality

improvements (safer cars, improved health care) and should not be
counted as part of inflation. Housing!

• Commodity Substitution Bias: Consumers substitute away from

goods and services with large relative price increases. Nutella.

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 Calculating inflation (VIII)
• Because of its internal composition the CPI is disaggregated.
• Core (subyacente) inflation vs General inflation
• The core inflation rate is the CPI inflation rate excluding the
volatile elements (of food and fuel).
• The core inflation rate attempts to reveal the underlying
inflation trend.
6.0

5.0

• In the Spanish 4.0

3.0
case:
2.0

1.0

0.0

-1.0

-2.0

General Subyacente Source: INE

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 Calculating inflation (IX)
• Even if the CPI is showing a certain aggregated pattern, goods
incorporated in the same basket could show different trends.
• It leads consumers and households to perceive prices of goods
and services to behave quite differently among them.

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 Calculating inflation (X)
• Finally, another alternative indicator is the GDP deflator:

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃𝑡
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟𝑡 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃𝑡
• The GDP deflator gives a value higher than 1 if Nominal GDP>Real
GDP. It can also be normalized to 100.
• The difference between the GDP deflator and regular CPI is small,
but the deflator entails all the services and goods in the economy.
• Problem: the GDP deflator comes with year-lags.
• With the GDP deflator we can get data for every year for the whole
set of goods and services.

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 Calculating inflation (XI)

• The difference between the GDP deflator (price levels) and

inflation rates obtained from the GDP deflator.

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 Further topics on inflation (I)
• Post-covid era: The inflation revival. “Inflation largely reflected strong
aggregate demand, the product of easy fiscal and monetary policies, excess
savings accumulated during the pandemic, and the reopening of locked-down
economies” (Bernanke & Blanchard, 2023) + supply chain disruptions
(including war).

Source: World Bank

 Further topics on inflation (II)

• Inflationary is also an indicator of future long-term demand.

• It helps anticipating the evolution of the economy.

• As it incorporates (households and firms) expectations.

• If inflation remains low for many years, it could be a sign of

economic stagnation due to the lack of demand.
 Further topics on inflation (III)

• Low inflation was a phenomenon in advanced and emerging

economies.

• It was a signal that world

demand is weak but also
That expectations were
also going down.
• There is supply inflation
effect by which prices of
many goods are decreasing
as a result of new
technologies and the increasing world competition.
 Further topics on inflation (IV)

• In commodity-oriented
economies, prices are key in
determining future economic
performance.

• These economies could suffer

from rapid falls in prices.

• And they can also experience

economic booms related to
these prices.

Source: IMF( October 2020)

 For a decade, inflation

Video

Let’s see the inflation patterns before the energy crisis…(this video
is from The Economist).
 Inflation nowadays (I)
• There has been a sudden
and an unexpected increase
in prices, leading a quick
inflation process.

• The hard task is how to

handle with this increase in
inflation.

• It has affected advances

economies, specially to the
USA, and it was pointing out
to a (mild) global
recession… after a recovery
from the Covid-shock.

Source: IMF(July 2022)

 Inflation nowadays (II)

Source: IMF( January 2022)

• The main increase in inflation is coming from goods instead of

services.
• It is because of the global production chains – Intermediate inputs
coming from emerging economies are becoming more expensive.
• Also there are mismatches between demand and supply worldwide.
 Inflation nowadays (III)

• In the case of the US, inflation is also being driven by an increase in

demand because of the strong recovery from the Covid shock.
• Therefore, the US inflation is a bit “easier” to handle than in Europe.

Source: IMF
 Inflation nowadays (IV)
• But in any case, the main
increase in inflation was led by
energy prices & supply chain
disruptions - supply shock.
• It affects firms’ production costs
which increase prices
subsequently.
• To the extent war is not over –
energy prices will continue
increasing…
• …And in the case of food prices
it is now creating scarcity and
famine worldwide (!).
Source: IMF(July 2022)
Inflation nowadays (V) in Europe

Source: Gonçalves and Koester (2022, ECB).

 Inflation nowadays (VI) in USA
Supply-driven and demand-driven contributions to year-over-year PCE inflation

Source: Shapiro (2022, Fed).

 To recap: Key concepts

❑ Nominal vs Real GDP.

❑ Inflation vs deflation vs disinflation.

❑ Inflation vs core inflation.

❑ Supply-driven vs demand-driven vs monetary driven inflation.

❑ CPI vs GDP deflator.

❑ Low inflation era vs post-Covid inflation.