Introduction to

Macroeconomics
Lecture 2

ECO 216
NBS
Spring 2023
Dr. Muhammad Fawad Khan
Macroeconomic data
• Three most used economic statistics are:

o Gross Domestic Product (GDP): measures the output of goods and

services

o The Consumer Price Index (CPI): measures the price level in an

economy

o The unemployment rate: measures the part of labor force who are
out of jobs
Lecture 2 2
Gross Domestic Product
 Total income earned by everyone (individuals and firms) in the economy
OR
 Total expenditure on the “domestically produced” final goods and
services
OR
 Total market value of final goods and services produced within a
nation’s borders in a given time period

Expenditure always equals income in an economy because every ruppee

spent by a buyer becomes income for the seller

Lecture 2 3
 Circular flow in the economy

To compute GDP, we can look at either the flow of dollars from firms
to households or the flow of dollars from households to firms. 4
 Rules of measuring GDP
• Use market prices to add the total value of different goods and
services
• Use only the currently produced new goods, ignore the used goods
• Treat inventories as investments. Because even though they will be
sold in later periods, they are produced in current period.
• Consider only the final goods. Leave out the intermediate goods, as
their value is included in the value of the final good.
• Impute the value of goods and services that are not transacted
through the market (e.g. rent of a house lived by owners, or market
value of domestic services)
Lecture 2 5
 Three approaches of measuring GDP
• The value-added approach
• Sum of the value-added at each stage of production.
• Value added –> the final sales value minus the value of intermediate
inputs used in the production process
• The expenditure approach
• Sum of expenditures made by the final buyers of final goods and
services in an economy
• e.g. the consumption of food, education and medicines by households,
machinery purchases by firms, and the purchase of goods and services
by the government, purchase of domestic items by foreigners
• GDP = C + I + G + NX
• The income approach
• measures GDP as the sum of incomes of factors of production (wages,
rent, interest and profit). Lecture 2 6
 Value-added approach
• Suppose that rice is the only final product of an economy: It goes
through several (3) stages of production.

Value of Value of Value-added

Stage of Production intermediate Sales
good
Farmer – raw rice 12,000 12,000
Rice Miller -Milled Rice 12,000 15,000 3,000
Retailers - Rice 15,000 20,000 5,000
GDP= Total Value Added 20,000

7
 Expenditure approach
• expenditures made by the final buyers of products and services

Value of Value of Value-added

Stage of Production intermediate Sales
good
Farmer – raw rice 12,000 12,000
Rice Miller -Milled Rice 12,000 15,000 3,000
Retailers - Rice 15,000 20,000 5,000
GDP= expenditure on 20,000
the final product
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 Income Approach
• sum of payments to the various factors of production
Sales 20,000
Expenses:
Wages 8000
Rent 4000
Interest 2000
Total 14,000
Profit 6,000
GDP=Sum of payments 20,000
to factors

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 Three approaches of measuring GDP Explained in
• The value-added approach detail in the
• Sum of the value-added at each stage of production. book and in
lecture
• Value added –> the final sales value minus the value of intermediate
inputs used in the production process
• The expenditure approach
• Sum of expenditures made by the final buyers of final goods and
services in an economy
• e.g. the consumption of food, education and medicines by households,
machinery purchases by firms, and the purchase of goods and services
by the government
• GDP = C + I + G + NX
• The income approach
• measures GDP as the sum of incomes of factors of production (wages,
rent, interest and profit). Lecture 2 10
 The distinction between GDP and GNP
• GNP = GDP + Net Factor Income from the Rest of the World (NFIRW)

• NFIRW - measures the difference between the earnings of Pakistani

residents in other countries and foreign residents in Pakistan
• Remittances add to the GNP of Pakistan (not to GDP)
• And income earned by MNCs in Pakistan is subtracted from GNP
(not from GDP)

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Components of GDP
There are four types of spending in an economy

• Consumption (C)

• Investment (I)

• Government purchases (G)

• Net exports (NX)

Lecture 2 12
Consumption (C)
Def: The value of all goods and services bought by households.
Including:
 Durable Goods
 Non durable goods
 Services

Lecture 2 13
Investment (I)
Def: Spending on items bought for future use
Three types:
• business fixed investment
purchase by firms of new plant, equipment, structure, patents,
that firms will use to produce other goods & services
• residential fixed investment
Spending on new housing units by households and landlords.
• inventory investment
The change in the value of all firms’ inventories.
Lecture 2 14
Government spending (G)
Def: Goods and services bought by federal, provincial and
local governments e.g.
• Roads
• Military
• Services of govt. workers (teachers, doctors, bureaucrats,
clerks, police)

Lecture 2 15
Net exports (NX = Ex - Im)
Def: The value of total exports (Ex) minus the value of total
imports (Im).

Net exports is the net expenditure from abroad on our

goods and services, which provides income for domestic
producers.

Lecture 2 16
Therefore,

Lecture 2 17
Real vs. Nominal GDP
Remember the definition?
GDP is the total market value of final goods and services produced within a
nation’s borders in a given time period

• nominal GDP measures the GDP using current prices

• real GDP measures it using the prices of a base year

Changes in nominal GDP can be due to price changes OR quantity changes

Changes in real GDP is only due to quantity changes

Lecture 2 18
 Example
Suppose an economy only produces Apples and Oranges

• nominal GDP in 2020 = (2020 Price of Apple X 2020 Quantity of Apple)

+ (2020 Price of Oranges X 2020 Quantity of Oranges)
• nominal GDP in 2021 = (2021 Price of Apple X 2021 Quantity of Apple)
+ (2021 Price of Oranges X 2021 Quantity of Oranges)

• real GDP in 2020 = (2020 Price of Apple X 2020 Quantity of Apple)

+ (2020 Price of Oranges X 2020 Quantity of Oranges)
• real GDP in 2021 = (2020 Price of Apple X 2021 Quantity of Apple)
+ (2020 Price of Oranges X 2021 Quantity of Oranges)
Lecture 2 19
US Real vs. Nominal GDP (1950-2007)

Real GDP
(in 2000 dollars)
Nominal GDP

Lecture 2 20
Measuring the GDP
• In US, GDP is computed quarterly, whereas, in Pakistan it is
computed on annual basis
• Two types of data are used:

Administrative data: Statistical data:

Such as taxes collected, Collected through
education and health surveys, such as
infrastructure, salaries of manufacturing units,
govt. staff retail units, agri. farms
Lecture 2 21
 Issues with Pakistan’s GDP calculations

• No quarterly estimates. Only annual.

• No calculations for regional economies, e.g., provincial

economies

• Too old base years, e.g., 2005 up till recently

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Next,
ways of measuring the price level

Lecture 2 23
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

• The GDP deflator measures the price of overall output

relative to its price in the base year.
Lecture 2 24
 The Consumer Price Index (CPI)
• GDP deflator depicts price changes in all the items produced in
the economy.
• Households care only about the prices of items they consume
• Before measuring the CPI, Pakistan Bureau of Statistics Survey
consumers to first determine composition of the typical
consumer’s “basket” of goods.
• The CPI is the price of this basket of goods and services relative
to the price of the same basket in some base month or year.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑚𝑜𝑛𝑡h 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑡h𝑎𝑡 𝑚𝑜𝑛𝑡h
𝐶𝑃 𝐼 𝑎𝑛𝑦 𝑚𝑜𝑛𝑡h=100 x
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑒 𝑚𝑜𝑛𝑡h 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛𝑏𝑎𝑠𝑒 𝑚𝑜𝑛𝑡h 25
Composition of CPI’s Basket (an example)

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 Other measures of inflation
• Core inflation
measures changes in price of a consumer basket that excludes food
and energy products
because food and energy prices exhibit substantial short-run volatility,
core inflation is sometimes considered a better measure of the actual
trend in inflation
• Producer price index
which measures the price of a typical basket of goods bought by firms
rather than consumers
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Example
2020 2021
P Q P Q
Wheat Rs. 20 600 Rs. 23 1,000
Cars Rs. 100 192 Rs. 110 200

Using 2020 as base year, compute nominal GDP, real GDP,

the GDP deflator, and CPI for each year
Lecture 2 28
Solution
Nominal GDP
2020 = 20 x 600 + 100 x 192 = 31,200
2021 = 23 x 1000 + 110 x 200 = 45,000

Real GDP
2020 = same as nominal GDP in 2020
2021 = 20 x 1,000 + 100 x 200 = 40,000

GDP deflator
2020: nominal and real GDP in 2020 are same so GDP deflator is 100
2021: 45,000/40,000 x 100 = 112.5

CPI
2020 = since 2020 is base year, simple to find that its CPI is 100
2021 = (23x600 + 110x192 / 20x600 + 100x192) x 100 = 111.92
Lecture 2 29
Measuring the unemployment rate

Lecture 2 30
 Categories of 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 i.e.
all employed + unemployed persons
• Not in the labor force
not employed and not looking for a job
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 Important labor force concepts
• Unemployment rate
percentage of the labor force that is unemployed
Mathematically:

• Labor force participation rate

the percentage of the adult population that is in the labor force or
participates in the labor force
Mathematically:

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 Computing labor force statistics

• E = 146.1, U = 6.9, POP = 231.7 • unemployment rate

U/L x 100% = (6.9/153) x 100% =
• labor force 4.5%
L = E +U = 146.1 + 6.9 = 153.0
• labor force participation rate
• not in labor force L/POP x 100% = (153/231.7) x
NILF = POP – L = 231.7 – 153 = 100% = 66.0%
78.7
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 Practice

What are the returns to scale of the following

production functions?

Lecture 3 34
 Practice

What are the returns to scale of the following

production functions?
(a) Constant Returns to Scale
(b) Constant Returns to Scale
(c) Decreasing Returns to Scale
(d) Increasing Returns to Scale

Lecture 3 35
Exercise

• Show that (a) has constant marginal returns of labor,

and (b) & (c) has decreasing marginal returns of labor

Lecture 3 36