Overview of Macroeconomics

Microeconomics
● Decisions of individual units
● No matter how large
● Example: Large Firm pricing policy

Macroeconomics
● Behavior of entire economies
● No matter how small
● Example: inflation in Monaco
● Economic aggregates: aggregate output, inflation, unemployment, …

Two central themes

1. The short-term fluctuations in output, employment, financial conditions, and prices that
we call the business cycle
2. The longer-term trends in output and living standards known as economic growth.

Roots of Macroeconomics

★ Before the publication of Keynes “General Theory of Employment, Interest and Money”, the
distinction between Micro & Macro economic issues did not arise at all. The need for
separate study of macroeconomics was felt by Keynes while understanding and analyzing
the Great Depression of 1929. The Great Depression was a period of severe economic
contraction and high unemployment that began in 1929 and continued throughout the 1930s.
The accepted economic theory of the pre – Keynesian era, believed that the economy usually
remains at full employment level (full utilization of resources). If there are any departures
from this situation, these are purely temporary and for a short period of time. However, these
classical models failed to explain the prolonged existence of high unemployment during the
Great Depression. This provided the impetus for the development of macroeconomics.In
1936, John Maynard Keynes published The General Theory of Employment, Interest, and
Money. Keynes believed governments could intervene in the economy and affect the level of
output and employment.During periods of low private demand, the government can stimulate
aggregate demand to lift the economy out of recession.

Importance of Macroeconomics

Why do output and employment sometimes fall, and how can unemployment be reduced?

Macroeconomics studies the sources of persistent unemployment and high inflation. Having
considered the symptoms, macroeconomists suggest possible remedies, such as using
monetary policy to alter interest rates and credit conditions or using fiscal instruments such as
taxes and government spending.
What are the sources of price inflation, and how can it be kept under control?

Macroeconomics can suggest the proper role of monetary and fiscal policies, of exchange rate
systems, and of an independent central bank in containing inflation.

How can a nation increase its rate of economic growth?

Nations want to know the ingredients in a successful growth recipe. Economic historians have
found that the key factors in long-term economic growth include reliance on well-regulated
private markets for most economic activity, stable macroeconomic policy, high rates of saving
and investment, openness to international trade, and accountable and non corrupt governing
institutions.

Output - GDP is the measure of the market value of all final goods and services produced in a
country during a year.

● Nominal GDP is measured in actual market prices.

● Real GDP is calculated in constant or invariant prices.

Despite the short-term fluctuations seen in business cycles, advanced economies generally
exhibit a steady long-term growth in real GDP and an improvement in living standards; this
process is known as economic growth .

Potential GDP represents the maximum sustainable level of output that the economy can
produce.

High Employment, Low Unemployment. Of all the macroeconomic indicators, employment

and unemployment are most directly felt by individuals. In macroeconomic terms, these are the
objectives of high employment, which is the counterpart of low unemployment .
The labor force includes all employed persons and those unemployed individuals who are
seeking jobs. It excludes those without work who are not looking for jobs.

Price Stability. The third macroeconomic objective is price stability. This is defined as a low
and stable inflation rate.
Price indexes - consumer price index (CPI), which measures the trend in the average price of
goods and services bought by consumers.
The inflation rate is the percentage change in the overall level of prices from one year to the
next.

Fiscal Policy
Fiscal policy consists of government expenditure and taxation. Government expenditure
influences the relative size of collective spending and private consumption. Taxation
subtracts from incomes, reduces private spending, and affects private saving.
In addition, it affects investment and potential output. Fiscal policy is primarily used to affect
long-term economic growth through its impact on national saving and investment; it is also used
to stimulate spending in deep or sharp recessions.

Monetary Policy
Monetary policy, conducted by the central bank, determines short-run interest rates. It thereby
affects credit conditions, including asset prices such as stock and bond prices and exchange
rates.
Changes in interest rates, along with other financial conditions, affect spending in sectors such
as business investment, housing, and foreign trade.
Monetary policy has an important effect on both actual GDP and potential GDP.

Aggregate Supply And Demand

Aggregate supply refers to the total quantity of goods and services that the nation’s businesses
willingly produce and sell in a given period. (AS)
Aggregate demand, which refers to the total amount that different sectors in the economy
willingly spend in a given period. Aggregate demand (often written AD ) equals total spending
on goods and services.
The components of aggregate demand include consumption; investment; government
purchases; and net exports.

Macroeconomic Equilibrium.
A macroeconomic equilibrium is a combination of overall price and quantity at which all buyers
and sellers are satisfied with their overall purchases, sales, and prices.

Exercise
In 1981–1983, the Reagan administration implemented a fiscal policy that reduced taxes and
increased government spending.
a. Explain why this policy would tend to increase aggregate demand. Show the impact on output
and prices assuming only an AD shift.

Measuring Economic Activity

Gross Domestic Product: The yardstick of an economy’s performance

GDP : Is the total market value of the final goods and services produced within a nation during a
given period of time. Is used to measure the overall performance of an economy.

Is the most comprehensive measure of a nation’s total output of goods and services. It is the
sum of the dollar values of consumption ( C ), gross investment ( I ), government purchases of
goods and services ( G ), and net exports ( X ) produced within a nation during a given year.

GDP= C + I + G+ NX
Two Measures of National Product
1. Flow-of-Product Approach
GDP is defined as the total money value of the flow of products produced by the nation.
● Product Approach
● Consumption (C )
● Gross private domestic investment (I)
● Government purchase (G)
● Net exports (X)
● Earnings Approach

2. Earnings or Income Approach

GDP is calculated as the total cost of doing business or income accounts from the factors of
production.
● Compensation of labor (wages, salaries and supplements)
● Corporate profits
● Other property income ( rent, interest)
● Depreciation
● Net production tax
Both approaches yield exactly the same measure of GDP.

Circular flow of Macroeconomic Activity

National accounts are derived from Business Accounts.

An account for a firm or a nation is a numerical record of all flows during a given period.

The Problem of “Double Counting”

A final product is one that is produced and sold for consumption or investment.
GDP excludes intermediate goods —goods that are used up to produce other goods.
Value added is the difference between a firm’s sales and its purchases of materials and
services from other firms.

Consumption

Consumption is by far the largest component of GDP.

Consumption expenditures are divided into three categories:
durable goods such as automobiles,
 nondurable goods such as food,
services such as medical care.

The most rapidly growing sector is services.

Investment and Capital Flow

Investment consists of the additions to the nation’s capital stock of buildings, equipment,
software, and inventories during a year. Along with consumption goods and services, we must
also include gross investment in GDP. Gross investment is not adjusted for depreciation, which
measures the amount of capital that has been used up in a year. Net investment is always births
of capital (gross investment) less deaths of capital (capital depreciation).

Net investment = Gross investment - Depreciation.

Government Purchases
Some of our national output is purchased by federal, state, and local governments.
Some government purchases are consumption-type goods (like food for the military),
while some are investment-type items (such as schools or roads).
GDP includes only government purchases; it excludes spending on transfer payments.
Government transfer payments are payments to individuals that are not made in exchange for
goods or services supplied. (unemployment insurance, veterans’ benefits, and old-age or
disability payments)

Net Exports
Net exports is the difference between exports and imports of goods and services.
Exports some of local production bought by foreigners and shipped abroad.
Imports The products that we consume at home that is produced abroad.

Nominal GDP, Real GDP and GDP Deflator

Nominal GDP (P*Q) represents the total money value of final goods and services produced in a
given year, where the values are expressed in terms of the market prices of each year.
Real GDP ( Q ) removes price changes from nominal GDP and calculates GDP in terms of the
quantities of goods and services.
The difference between nominal GDP and real GDP is the price of GDP, sometimes called the
GDP deflator.

The link between nominal GDP, real GDP, and the GDP price index:

real GDP = ( nominal GDP /GDP price index )

Q =( PQ / P )
Growth of Real GDP = (GDP t – GDP t-1) / GDP t-1 x 100

GDP, NDP & GNP

Net domestic product (NDP) equals the total final output produced within a nation during
a year, where output includes net investment, or gross investment less depreciation:
NDP = GDP - depreciation
Gross national product (GNP) is the total final output produced with inputs owned by the
residents of a country during a year.

GDP = total gross income

National Income = sum of factor income – depreciation
Disposal Income = total incomes + transfer payments - taxes

Saving and Investment

Output can be either consumed or invested. Measured saving is exactly equal to measured
investment.
Product -approach: I = GDP - C
Earnings – approach: S = GDP - C
National saving equals national investment.

The components of investment are private domestic investment and foreign investment (or net
exports). The sources of saving are private saving (by households and businesses) and
government saving (the government budget surplus).

Private investment plus net exports equals private saving plus the budget surplus.These
identities must hold always, whatever the state of the business cycle.

National investment = private investment + net exports

National saving = private saving + government saving
National investment= National savings

Price Index and Inflation

Inflation (π ) denotes a rise in the general level of prices. A price index (P) is a measure of the
average level of prices. The rate of inflation is defined as the rate of change of the general price
level. Π = (Pt – Pt-1) / Pt -1 x 100
The opposite of inflation is deflation, which occurs when the general price level is falling.

Consumer Price Index

CPI is a measure of the average price paid by urban consumers for a market basket of
consumer goods and services. CPI=cost of basket t1/ cost of basket t-1

GDP Price Index

The GDP price index is the price of all goods and services produced in the country
(consumption, investment, government purchases, and net exports) rather than of a single
component (such as consumption).

Producer Price Index

PPI measures the level of prices at the wholesale or producer stage.

Consumption and Investment

The major components of national output are consumption and investment. High consumption
relative to income spells low investment and slow growth; high saving leads to high investment
and rapid growth.

Consumption And Saving

Consumption is expenditures by households on final goods and services. (durable and

nondurable goods, services) Saving is that part of personal disposable income that is not
consumed. Saving rises rapidly as income increases. Saving is the greatest luxury of all.

Personal saving is that part of disposable income that is not consumed; saving equals income
minus consumption. The break-even point —where the representative household neither saves
nor dis saves but consumes all its income.

The Consumption Function

The consumption function shows the relationship between the level of consumption
expenditures and the level of disposable personal income.

At any point on the 45° line, consumption exactly equals income and the household has zero
saving. When the consumption function lies above the 45° line, the household is dissaving.
When the consumption function lies below the 45° line, the household has positive savings. The
amount of dissaving or saving is always measured by the vertical distance between the
consumption function and the 45° line.

The marginal propensity to consume is the extra amount that people consume when they
receive an extra dollar of disposable income.
MPC = change in C / change in DI
The marginal propensity to save is defined as the fraction of an extra dollar of
disposable income that goes to extra saving. At any income level, MPC and MPS must always
add up to exactly 1, no more and no less.

MPS + MPC = 1

National Consumption Behavior

Consumption and saving behavior are key to understanding economic growth and business
cycles. Y (GDP) = C+I+G+NX

Determinants of Consumption:
1. Disposable Income C= C(Y-T)
2. Permanent Income and the Life-Cycle Model of Consumption.
 3. Wealth and Other Influences.

Investment often leads to changes in aggregate demand and affects the business cycle.

In addition, investment leads to capital accumulation. Adding to the stock of buildings and
equipment increases the nation’s potential output and promotes economic growth in the long
run.

Businesses invest to earn profits. Because capital goods last many years, investment decisions
depend on:
1. the level of output produced by the new investments,
2. the interest rates and taxes that influence the costs of the investment, I=I (r )
3. business expectations about the state of the economy.

Exercise
I consume all my income at every level of income. Draw my consumption function. What are my
MPC and MPS?
Solution MPC = 1 MPS = 0

Business cycles are economy-wide fluctuations in total national output, income, and
employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or
contraction in most sectors of the economy. Economists typically divide business cycles into two
main phases: recession and expansion . Peaks and troughs mark the turning points of the cycle.

In the short run, the nature of the inflationary process and the effectiveness of government
countercyclical policies depend on aggregate demand.
In the long run of a decade or more, economic growth and rising living standards are closely
linked with increases in aggregate supply.

Unemployment and Inflation

Employed. These are people who perform any paid work, as well as those who have jobs but
are absent from work because of illness, strikes, or vacations.
Unemployed. Persons are classified as unemployed if they do not have a job, have actively
looked for work in the prior 4 weeks, and are currently available for work.
Not in the labor force. This includes the percent of the adult population that is keeping house,
retired, too ill to work, or simply not looking for work.
Labor force. This includes all those who are either employed or unemployed.

Unemployment is an economic problem because it represents waste of a

valuable resource.Unemployment is a major social problem because it causes enormous
suffering as unemployed workers struggle with reduced incomes. During periods of high
unemployment, economic distress spills over to affect people’s emotions and family lives.
OKUN’S LAW
The unemployment rate usually moves inversely with output over the business cycle. This co-
movement is known as Okun’s Law. Okun’s Law states that for every 2 percent that GDP falls
relative to potential GDP, the unemployment rate rises about 1 percentage point.
This means that if GDP begins at 100 percent of its potential and falls to 98 percent of potential,
the unemployment rate rises by 1 percentage point, say, from 6 to 7 percent.

Equilibrium unemployment arises when people become unemployed voluntarily as they move
from job to job or into and out of the labor force. This is also sometimes called frictional
unemployment because people cannot move instantaneously between jobs.

Disequilibrium Unemployment occurs when the labor market or the macroeconomy is not
functioning properly and some qualified people who are willing to work at the going wage cannot
find jobs. Two examples of disequilibrium are structural and cyclical unemployment.
● Structural unemployment signifies a mismatch between the supply of and the demand
for workers. Mismatches can occur because the demand for one kind of labor is rising
while the demand for another kind is falling and markets do not quickly adjust.
● Cyclical unemployment exists when the overall demand for labor declines in business-
cycle downturns.

Inflation
Inflation occurs when the general level of prices is rising. Today, we calculate inflation by using
price indexes—weighted averages of the prices of thousands of individual products.

The consumer price index (CPI) measures the cost of a market basket of consumer goods and
services relative to the cost of that bundle during a base year. The GDP deflator is the price of
all the different components of GDP.

Three Strains of Inflation

1. Low Inflation. Low inflation is characterized by prices that rise slowly
and predictably. We might define this as single-digit annual inflation rates.
2. Galloping Inflation. Inflation in the double-digit or triple-digit range of 20, 100, or 200
percent per year is called galloping inflation or “very high inflation.” Galloping inflation is
relatively common, particularly in countries suffering from weak governments, war, or
revolution.
3. Hyperinflation. While economies seem to survive under galloping inflation, a third and
deadly strain takes hold when hyperinflation strikes. Nothing good can be said about an
economy in which prices are rising a million or even a trillion percent per year.

The Economic Impacts of Inflation

A redistribution of income and wealth among different groups The major redistributive impact of
inflation comes through its effect on the real value of people’s wealth. In general, unanticipated
inflation redistributes wealth from creditors to debtors, helping borrowers and hurting lenders.
An unanticipated deflation has the opposite effect. Distortions in the relative prices and outputs
of different goods, or sometimes in output and employment for the economy.
Inflation impairs economic efficiency because it distorts prices and price signals, distorts the
use of money, taxes etc.

Most economists agree that a predictable and gently rising price level provides the best climate
for healthy economic growth. A careful analysis of the evidence suggests that low inflation has
little impact on productivity or real output. By contrast, galloping inflation or hyperinflation can
harm productivity and redistribute income and wealth in an arbitrary fashion. A gradual rise in
prices will help avoid the deadly liquidity trap.

Modern Inflation Theory

1. Expected Inflation
Inflation has a high degree of inertia in a modern economy. People form an expected rate of
inflation, and that rate is built into labor contracts and other agreements. The expected rate of
inflation tends to persist until a shock causes it to move up or down.
2. Demand-Pull Inflation
Demand-pull inflation occurs when aggregate demand rises more rapidly than the economy’s
productive potential, pulling prices up to equilibrate aggregate supply and demand.
3. Cost-Push Inflation and “Stagflation”
Inflation sometimes increases because of increases in costs rather than because of increases in
demand. (Cost-push inflation) Inflation resulting from rising costs
during periods of high unemployment and slack resource utilization is called supply-shock
inflation. It can lead to the policy dilemma of stagflation when output declines at
the same time as inflation is rising.