Unit 1

Unit 1:
 concepts and variables of macroeconomics

 income, expenditure and the circular flow,
components of expenditure.
 Static macroeconomic analysis short and the long
run

determination of supply, determination of demand,
and conditions of equilibrium
slide 1
Gross Domestic Product:
Expenditure and Income
GDP is the sum of values of final goods and services produced within the geographical boundary of
an economy in a year.
Two definitions:
 Total expenditure on domestically-produced
final goods and services.
 Total income earned by domestically-located
factors of production.
Expenditure equals income because

every dollar spent by a buyer
becomes income to the seller.
National income Accouting: reference Mankiw slide 2

The Circular Flow
Income ($)
Labor
Households Firms
Goods
Expenditure
($)
Saving Investment Identity
In a 2 sector economy, Saving is a leakage from

the circular flow of income whereas investment
is like an injection to it.
To keep the circular flow of income balanced,
Leakage must be equal to injection.
Thus, Saving= investment

Methods of computing GDP
 Total product method or value added method

 Expenditure method
 Income method

Value added
definition:
A firm’s value added is the value of its output
minus the value of the intermediate goods
the firm used to produce that output.

Intermediate input
 An intermediate input is the one which is produced and exhausted in

production of another good in the same year.
 Example: Suppose a bakery buys flour worth Rs. 200 to produce
cake and uses it entirely in the same year . Then it becomes
intermediate input.
 : Suppose a bakery buys flour worth Rs. 200 to produce cake but
uses only 3/4th of it by 31st March, then flour worth Rs. 150 becomes
intermediate input and the rest is treated as the baker’s inventory or
final good.

Final goods, value added, and GDP
 GDP = value of final goods produced
= sum of value added at all stages
of production.
 The value of the final goods already includes the
value of the intermediate goods,
so including intermediate and final goods in GDP
would be double-counting.
 Final goods are the goods directly used for consumption.

The Value added method
explained
Commodity Intermediate Value of Value of Value added
input output intermediate
input
Milk - 500 - 500
Cottage Milk 1000 500 500
Cheese
Sweet Cottage 1600 1000 600
cheese
GDP 1600

Treatment of inventories
 Inventories are unsold goods

 If a firm is unable to sell some of his output, it is
considered to be a part of the firm’s investment, called
inventory investment
 Inventories are included in the GDP of the year in which
they are produced, not that of the year they are
ultimately sold
 If some intermediate goods remains unused at the end
of the year, it is also treated as inventory.

Review questions
 A restaurant owner buys bread worth $50 to make sandwiches.

Price of sandwich is $5 per piece. He manages to sell 30
sandwiches using bread worth $40. He eats the rest of the bread
himself.
 Calculate the gross value added by the restaurant owner

GDP doesn’t include
 Transfer payments: payments made without any

productive activities( pension, pocket money)
 Unpaid service of homemakers
 Payment made in course of second hand sale
 Share prices
 Non marketed transaction
 Any illegal or black market transaction
Point to be noted
 Any brokerage in case of second hand sale or

share market related activities are part of GDP
as it is the value of the broker’s service
 Similarly, contribution of the service sector is
estimated to be same as the salaries or wages
paid to the service sector employees like
firefighters, doctors, and so on

Which of the following are
included in GDP?
 Your pocket money
 Your maid servant’s income
 Expenditure on smuggled cosmetics
 Your grandparent’s pension
 Salary of a firefighter
 You buy a second hand house
 Share broker’s income
The components of Expenditure
 consumption
 investment
 government spending
 net exports

Consumption (C)
definition: The value of all  durable goods
goods and services bought last a long time
by households. Includes: ex: cars, home
appliances
 nondurable goods
last a short time
ex: food, clothing
 services
work done for
consumers
ex: dry cleaning,
air travel.
Investment (I)
Definition 1: Spending on [the factor of production]
capital.
Definition 2: 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.
Investment vs. Capital
Note: Investment is spending on new capital.
Example (assumes no depreciation):
 1/1/2006:
economy has $500b worth of capital
 during 2006:
investment = $60b
 1/1/2007:
economy will have $560b worth of capital

Stocks vs. Flows
Flow Stock
A stock is a
quantity measured
at a point in time.
E.g.,
“The U.S. capital stock
was $26 trillion on
January 1, 2006.”
A flow is a quantity measured per unit of time.
E.g., “U.S. investment was $2.5 trillion during 2006.”

Stocks vs. Flows - examples
flow
stock
a person’s
a person’s wealth
annual saving
# of people with # of new college

college degrees graduates this year
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.

Net exports: NX = EX – IM
def: The value of total exports (EX)
minus the value of total imports (IM).
National income Accouting: reference Mankiw

An important identity
Y = C + I + G + NX
aggregate
value of expenditure
total output
Or GDP
using
expenditure
method

 Saving investment identity using
expenditure method
 for an open economy with govt.
 Y=C+I+G+NX-T
 C=(Y-T)
 Y-C+T-G-NX=I
 (Y-C)+(T-G)+(M-X)=I
 Personal Saving+Govt SAving+World
Saving=I
 S=I
Review questions
 Identify the following as consumption,

investment or government purchase
 a) Maruti Suzuki’s stock of unsold cars
 b) you buy a pair of jeans
 c) A landlord spends $100 on repairing the
house
 d) Government buys fighter planes to use in
border
Review Questions: Classify the
following variables into stock and
flow variables
 your saving
 No. of fresh graduates in the year 2019
 Public debt
 No. of unsold cars produced by Maruti Suzuki in
the year 2019
 A person’s wealth

Review Questions
 Mobin and Mona just bought their new

house. In the national income accounting,
this transaction is considered as
a)consumption on durable goods.
b) fixed investment.
c)consumption on semi-durable goods.
d) inventory investment.

 Which of the following statements is true?
a) Intermediate goods are type of capital goods.
b) Final goods are produced in the same year as the
related final good, whereas capital goods are produced
in different years.
c) Capital goods are produced in one year and final goods
are produced over a period of more than one year.
d) Capital goods are not final goods, because they are
used up in the same period in which they are produced.

In using the expenditure approach to GDP,
consumption
a) includes consumer durables, semidurables, nondurable
goods, but excludes services.
b) includes houses and all purchases by business firms.
c) includes consumers spending on durable goods, and
nondurable goods, and services.
d) includes houses and services

Income approach
 GDP= wages and salaries (also called

compensation of employees)+interest +rental
income + profit or business cash flow
 if a person lives in his own house, we assume
that he is paying the rent to himself so we add
and deduct the market rate of rent from his own
income. This is called housing service
imputation

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)

GDP vs GNP continued
 GNP= GDP+ net factor earning from abroad

 Net national product at market price
(NNPmp) =GNP-depreciation
Net national product at factor cost
(NNPfc)= NNPmp-indirect business tax +subsidy
NNPfc=National income

Nominal GDP
 Is the market value of all final g & s produced in a
year.
 Calculated using current prices when the output
was produced
 Includes inflation
 It is hard to compare market values from year to
year when the value of the $ itself changes
(inflation or deflation)
 To measure changes in the quantity of output, we
need a “yardstick” that stays the same size.
slide 34
Real GDP
 The value of the final g & s produced

in a given year expressed in the
prices of a base year
 2000
Nominal Vs Real
slide 35
Traditional Method of Calculating
Real GDP
 This economy produces apples &

oranges
 The base year is 2000. Since 2000 is
the base year, real and nominal GDP
are the same.
slide 36
 To find the real GDP in 2000, + the value of
apples & oranges produced in 2000 using the
table:
GDP Data For 2000
Item Q P
Apples 60 $.50
Oranges 80 $.25
Value of apples = 60 apples X $.50 = $30

Value of oranges = 80 oranges X $.25 = $20
 Real GDP in 2000 = $30 + $20 = $50
slide 37
 To calculate real GDP in 2006, + the value of apples and
oranges using the prices of 2000
GDP Data For 2006

Item Q P
Apples 160 $1.00
Oranges 220 $2.00
 Value of apples = 160 apples X $.50 = $80

 Value of oranges = 220 oranges X $.25 = $55
 Real GDP in 2006 = $80 + $55 = $135
 Real GDP is “constant dollars” or “2000 dollars” measure
(taken inflation out) slide 38
2 purposes of estimating Real
GDP
 To compare the standard of living over time
(based on quantity, not price)
 To compare the standard of living among
countries
slide 39
Price Index
 A measure of the price of a specified collection of g
& s (market basket) in a given year as compared to
the price of an identical collection of g & s in a
reference year.
 PI = price of market basket for a specific year X 100
price of same market basket in the base year
 Find Real GDP = Nominal GDP X 100

PI
slide 40
GDP Deflator
 An average of current prices expressed as a

percentage of base year prices.
 Measures the price level
 The average level of prices
 GDP deflator = (NGDP / RGDP) X 100
 ($135 / $50) X 100 = GDP deflator
 2.7 X100 = 270
If NGDP rises but RGDP remains unchanged,
prices have risen.
slide 41
Real GDP and the Price Level
Deflating the GDP Balloon
Nominal GDP increases because production—real GDP–
increases.
slide 42

Nominal GDP also increases because prices rise.
slide 43
We use the GDP deflator to let the air out of the nominal
GDP balloon and reveal real GDP.
slide 44
The Consumer Price Index
(CPI)
 Index the gov’t uses to measure

inflation
 Gov’t uses it to adjust SS benefits
and income tax brackets
 Reports 300 items in a market basket
slide 45
Inflation
 A rise in the general level of prices

 Inflation rate = current CPI-Index CPI = rate (X 100)= %
index CPI
or Year2 – Year1 = rate (X 100) = %

Year1
slide 46
Practice problems
 Identify each of the following transactions as

consumption, investment, government purchase and net
export
a. Purchase of an airplane by the Air force
b. Purchase of an airplane by Air India
c. Purchase of 20 Air-India tickets by Srilankan cricket team
d. Purchase of 20 air-india tickets by Indian cricket team
e. Purchase of an Air ticket by Prime minister’s Office

 Which of the following is NOT an example of a
transfer payment in the sense of the national
income accounts?
 a) Government family allowances
 b) Public unemployment insurance benefits
 c) Dividends paid by corporations to stockholders
 d) Disability pensions paid from the social
insurance system

 What of the following does NOT enter GDP?
 a) ...public service
 b) ...public education
 c) ...life expectancy
 d) ...national defense

Chapter Summary
1. Gross Domestic Product (GDP) measures both

total income and total expenditure on the
economy’s output of goods & services.
2. GDP is the sum of consumption, investment,

government purchases, and net exports.
National
CHAPTER income
2 TheAccouting:
Data ofreference Mankiw
Macroeconomics slide 50
The Neoclassical model: Static
Macroeconomics Analysis
Is a general equilibrium model:

 Involves multiple markets
 each with own supply and demand
 Price in each market adjusts to make quantity
demanded equal quantity supplied.
slide 51 slide 51
Neoclassical model
The macroeconomy involves three types of markets:
1. Goods (and services) Market : Where finishined
products are bought and sold
2. Factors Market or Labor market , needed to produce
goods and services
3. Financial market or loanable funds market
Are also three types of agents in an economy:

1. Households
2. Firms
3. Government
slide 52 slide 52
Neoclassical model
Agents interact in markets, where they may be
demander in one market and supplier in another
1) Goods market:
Supply: firms produce the goods
Demand: by households for consumption,
government spending, and other firms demand
them for investment
slide 53 slide 53
Neoclassical model
2) Labor market (factors of production)
Supply: Households sell their labor services.
Demand: Firms need to hire labor to produce the
goods.
3) Financial market
Supply: households supply private savings:
Savings = income -consumption
Demand: firms borrow funds for investment;
government borrows funds to finance
expenditures.
slide 54 slide 54
Neoclassical model
 We will develop a set of equations to charac-

terize supply and demand in these markets
 Start with production…
slide 55 slide 55
Part 1: Supply in goods market:
Production
Supply in the goods market depends on a
production function:
denoted Y = F (K, L)
Where
K = capital: tools, machines, and structures
used in production
L = labor: the physical and mental efforts of

workers
slide 56 slide 56
The production function
 shows how much output (Y ) the economy can
produce from
K units of capital and L units of labor.
 reflects the economy’s level of technology.
 Generally, we will assume it exhibits constant
returns to scale but there is diminishing
marginal product of labour
 In short run, capital stock is fixed, but in long run,
it is variable.
slide 57 slide 57
Part 2: Equilibrium in the factors
market
 Equilibrium is where factor supply equals

factor demand.
 Recall: Supply of factors is fixed.
 Demand for factors comes from firms.
 Demand for factors of production is
dependent on the demand for the goods
that they produce. This type of demand is
called derived demand.
slide 58 slide 58
Demand in factors market
Analyze the decision of a typical firm.
• It buys labor in the labor market, where price is
wage, W.
• It rents capital in the factors market, at rate R.
• It uses labor and capital to produce the good, which
it sells in the goods market, at price P.
• In perfectly competitive commodity and factor
market, W,R, and P are constants.
slide 59 slide 59
Assume the market is competitive:

Each firm is small relative to the market, so its
actions do not affect the market prices.
It takes prices in markets as given - W,R, P.
slide 60 slide 60
It then chooses the optimal quantity of Labor and capital

to maximize its profit.
How write profit:

Profit = revenue -labor costs -capital costs [Revenue=
Price(P)*output (Y)]
= PY - WL - RK
= P F(K,L) - WL - RK (Replacing Y by F(K,L), i.e
the production function. )
slide 61 slide 61
Demand in the factors market
 Increasing hiring of L will have two effects:
1) Benefit: raise output by some amount( by the
marginal product of labour)
2) Cost: raise labor costs at rate W
 To see how much output rises, we need the

marginal product of labor (MPL)
slide 62 slide 62
Marginal product of labor (MPL)
An approximate definition (used in text) :

The extra output the firm can produce using one
additional labor (holding other inputs fixed)
MPl=change in output/change in labour
slide 63 slide 63
The MPL and the production function : production function is
concave because of diminishing MPl, i.e, output is increasing,
but at a diminishing rate
Y
output
F (K , L )
MPL
1 As more labor is
MPL added, MPL 
Slope of the production

MPL
function equals MPL: rise
over run
1
L
labor
slide 64 slide 64
Diminishing marginal returns
 As a factor input is increased, its marginal

product falls (other things equal).
 Intuition:
L while holding K fixed
 fewer machines per worker
 lower productivity
slide 65 slide 65
Firm problem continued
So the firm’s demand for labor is determined by the

condition:
P*MPl is the value of marginal product of labour the
equilibrium condition for the firm is :P *MPL = W
Hires more and more L, until MPL falls enough to satisfy
the condition.
Also may be written:

MPL = W/P, where W/P is the ‘real wage’
slide 66 slide 66
MPL and the demand for labor
labor supply
Units of
output Each firm hires labor
up to the point where

MPL = W/P
Real
wage

MPL, Labor
demand
L Units of labor, L
slide 67 slide 67
Determining the rental rate
We have just seen that MPL = W/P
The same logic shows that MPK = R/P : real

rental rate =R/P
 diminishing returns to capital: MPK  as K 
 The MPK curve is the firm’s demand curve
for renting capital.
 Firms maximize profits by choosing K
such that MPK = R/P .
slide 68 slide 68
Demand for goods & services
Components of aggregate demand:
C = consumer demand for g & s
I = demand for investment goods
G = government demand for g & s
(closed economy: no NX )
slide 69 slide 69
Consumption, C
 def: disposable income is total income minus total taxes:
Y–T
 Consumption function: C = C (Y – T )
Shows that (Y – T )  C
 def: The marginal propensity to consume (MPC) is the
increase in C caused by an increase in disposable income.
 So MPC = derivative of the consumption function with
respect to disposable income.
 MPC must be between 0 and 1.
 If an individual’s income is 0, his consumption is positive but
constant. This is called autonomous consumption.
slide 70 slide 70
The consumption function
C (Y –T )
The slope of the

rise
consumption function
is the MPC.
Y–T
slide 71 slide 71
Consumption function cont.
Suppose consumption function:

C=10 + 0.75Y
MPC = 0.75
For extra dollar of income, spend 0.75 dollars
consumption
Marginal propensity to save = 1-MPC
def: The marginal propensity to save(MPS) is the
increase in S caused by an increase in disposable
income.
slide 72 slide 72
Investment, I
 The investment function is I = I (r ), I’<0
where r denotes the real interest rate, the
nominal interest rate corrected for inflation.
 The real interest rate is
the cost of borrowing
 the opportunity cost of using one’s
own funds to finance investment

spending.
So, r  I
slide 73 slide 73
The investment function
r
Spending on
investment goods
is a downward-
sloping function of
the real interest rate
I (r )
slide 74 slide 74
Government spending, G
 G includes government spending on
goods and services.
 G excludes transfer payments
 Assume government spending and total
taxes are exogenous:
G G and T T
slide 75 slide 75
The market for goods & services
 Agg. demand: C (Y  T )  I (r )  G
 Agg. supply: Y  F (K , L )
 Equilibrium: Y = C (Y  T )  I (r )  G
The real interest rate adjusts
to equate demand with supply.
We can get more intuition for how this works

by looking at the loanable funds market
slide 76 slide 76
The Loanable Fund Market
 A simple supply-demand model

of the financial system.
 One asset: “loanable funds”
demand for funds: investment
supply of funds: saving
“price” of funds: real interest
rate

Loanable funds demand curve
 Demand for funds:

Investment
 The demand for loanable funds…
 comes from investment:
 Firms borrow to finance spending
on plant & equipment, new office
buildings, etc.
 Consumers borrow to buy new
houses.
 depends negatively on r, the
“price” of loanable funds (cost of
borrowing).

Supply of funds: Saving
 The supply of loanable funds  Types of saving
comes from saving:  private saving = (Y – T ) – C
Households use their saving to  public saving = T–G

make bank deposits,
 national saving, S= private saving + public
purchase bonds and other
saving
assets. These funds become  = (Y –T ) – C + T–G
available to firms to borrow to  = Y–C–G
finance investment spending.  As Y, G, and T are fixed, Saving will be fixed
irrespective of the rate of interest.
The government may also
contribute to saving if it does
not spend all the tax revenue it
receives.

Savings and Loanable fund
market equilibrium in Long run
 In long run, the economy is at
full employment, i.e, all the
factors of production are fully
employed and output is fixed.
 So, saving is also fixed
 At equilibrium,
 S=I(r) holds true.

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Unit 1:

 concepts and variables of macroeconomics

Expenditure equals income because

National income Accouting: reference Mankiw slide 2

In a 2 sector economy, Saving is a leakage from

National income Accouting: reference Mankiw slide 4

 Total product method or value added method

National income Accouting: reference Mankiw slide 5

National income Accouting: reference Mankiw slide 6

 An intermediate input is the one which is produced and exhausted in

National income Accouting: reference Mankiw slide 7

National income Accouting: reference Mankiw slide 8

National income Accouting: reference Mankiw slide 9

 Inventories are unsold goods

National income Accouting: reference Mankiw slide 10

 A restaurant owner buys bread worth $50 to make sandwiches.

National income Accouting: reference Mankiw slide 11

 Transfer payments: payments made without any

 Any brokerage in case of second hand sale or

National income Accouting: reference Mankiw slide 13

National income Accouting: reference Mankiw slide 15

National income Accouting: reference Mankiw slide 18

National income Accouting: reference Mankiw slide 19

# of people with # of new college

the govt debt the govt budget deficit

National income Accouting: reference Mankiw slide 20

National income Accouting: reference Mankiw slide 21

National income Accouting: reference Mankiw

National income Accouting: reference Mankiw slide 23

 Identify the following as consumption,

National income Accouting: reference Mankiw slide 26

 Mobin and Mona just bought their new

National income Accouting: reference Mankiw slide 27

National income Accouting: reference Mankiw slide 28

National income Accouting: reference Mankiw slide 29

 GDP= wages and salaries (also called

National income Accouting: reference Mankiw slide 31

 Gross Domestic Product (GDP):

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

National income Accouting: reference Mankiw slide 32

 GNP= GDP+ net factor earning from abroad

National income Accouting: reference Mankiw slide 33

 The value of the final g & s produced

 This economy produces apples &

Value of apples = 60 apples X $.50 = $30

GDP Data For 2006

 Value of apples = 160 apples X $.50 = $80

 Find Real GDP = Nominal GDP X 100

 An average of current prices expressed as a

Deflating the GDP Balloon

 Index the gov’t uses to measure

 A rise in the general level of prices

or Year2 – Year1 = rate (X 100) = %

 Identify each of the following transactions as

National income Accouting: reference Mankiw slide 47

National income Accouting: reference Mankiw slide 48

National income Accouting: reference Mankiw slide 49

1. Gross Domestic Product (GDP) measures both

2. GDP is the sum of consumption, investment,