What is macroeconomics?

Macro/ch2

1

What is macroeconomics?

•
Studies interaction between main aggregate economic
variables:


1.

Output


2.

Employment


3.

Inflation

•
Studies impact of main government policies:

1.

Fiscal policy

2.

Monetary policy

•
Simplifies and summarizes these interactions with
models

of the economy


Macro/ch2

2

Difference with microeconomics


•
Micro studies
supply and demand

relations
in a specific market,
production
at the level
of the firm,
consumption

at the level of the
consumer etc…

•
Micro make use of
relative

prices and not
price
levels

•
Micro is based on premises which are
generally accepted while macro evolves
overtime and its premises depend on schools
of thought (e.g. Keynesian versus classical
assumptions)

Macro/ch2

3

The 3 main measures of macro performance

•
Aggregate output

measures total production in the economy

–
Total Gross Domestic Product
-

GDP

–
GDP per capita (GDP/number of inhabitants)

–
Rate of growth of GDP or (GDP
1

-
GDP
0
)/GDP
0

•
Unemployment rate

measures proportion of people without jobs

•
Inflation rate

measures the overall increase in prices

Macro/ch2

4

Aggregate output: GDP

•
GDP is the
value of the final goods and
services

produced in the economy
during
a given period

•
GDP is the
sum of the value added

in the
economy
during a given period

•
GDP is the
sum of income earned
in the
economy
during a given period

GDP is a
flow

(not a
stock
)

Macro/ch2

5

Calculating GDP

Example:

•
Mine extracts iron ore.

•
Steel mill buys
-

$10 worth
-

of iron ore that it
used to produce steel. It then sell the steel for
$25 to a cutlery factory.

•
Cutlery manufacturer transforms the steel
-

$25
worth
-

into a cutlery set sold directly to the
consumer (at a factory store) for $35.


Macro/ch2

6

Value of final goods:
to avoid double
counting

Value of final good =
$35

Including the value of the iron ore or of
the steel produced would be double
counting.

Why?
Because the iron ore is included
in the value of the steel and the steel is
included in the value of the cutlery set


Macro/ch2

7

Value added approach

Definition: Value added = value of sale
minus value of purchased inputs (the
intermediate goods used in production)

•
Mine: (no purchased input) VA

= $10


•
Steel mill: VA = $25
-

$10 = $15


•
Cutlery factory: VA = $35
-

$25

= $10

•
Total value added

=

$35

Macro/ch2

8

Income approach

Another interpretation of the value added
:

The value added is equal to all the production costs
incurred by the firm
-

other than the purchase of
material.

so what is left?


the payments to

owners of the factors of production.


to the owners of
land




i.e. the
rent

to the owners of

capital




i.e. the
interest

to the
workers






i.e. their wages

and to the
proprietors/entrepreneurs


i.e.

their profit


Macro/ch2

9

The value added corresponds to the income
of these 4 groups (if a tax is paid to the
government, it should also be taken into
account).


Let’s now set up a table showing the rent, the
interest, the wages and the profit in each of
the 3 firms and illustrating how the sum of
these costs in equals the value added by
each firm.

Macro/ch2

10

Income approach

Mine

Steel mill

Cutlery

factory

Total

Rent

$1

$3

$1

$5

Interest

$2

$8

$2

$12

Wages

$5

$3

$4

$12

Profit

$2

$1

$3

$6

VA

$10

$15

$10

$35

Macro/ch2

11

Nominal and real GDP

•
Some data on nominal GDP


1960

1994

2000

Nominal

GDP in $ billion


526


6,736


9,872

Growth

of nominal GDP

since 1960


x13


x16



Macro/ch2

12

Nominal GDP is GDP measured in
$

in the specific year
quoted.


Do these huge increases represent
real

growth (or growth
in the quantity of goods produced)?


Remember that GDP is calculated as the sum of the
value

of the various goods.

Value =
quantity * price



so these large rates of growth include




growth in
quantity

( or
real growth

)

as well as




growth in
price

( or
inflation

)

Macro/ch2

13

Nominal GDP

•
Definition: sum of
value
of goods and services
produced during the year
at current prices

•
Nominal GDP increases overtime because

1.
quantity

of goods and services produced increases

2. their
price
also increases (inflation)

•
The 2nd cause does not correspond to
real

growth but to a change in the
measuring
yardstick, the dollar
(the $ looses its value
-

it
depreciates
-

it shrinks ).

Macro/ch2

14

The $ looses its value
-

it
depreciates
-

it shrinks

GDP in 2000

1950 $

2000 $

GDP = 5

GDP = 10

Macro/ch2

15

How to calculate real GDP?

•
Nominal GDP is calculated every year.

•
But these yearly data do not allow us to judge
by how much the economy has actually grown,
in terms of
quantity
of goods and services
produced.

•
So we need to calculate
real

GDP to appraise
the real growth of the economy over the years.

•
Unfortunately there are more than one way to
do it!

Macro/ch2

16



•
How do we
neutralize

the effect of the changes
in price in order to
only retain

the effect of the
changes in quantity?

•
The solution is to measure GDP in 2 different
years with the same set of prices. Then the
difference in the two measures of GDP will only
include the change in quantity.

•
Which set of prices should we use?

•
Depending of the set of prices chosen we will get
slightly different results.

Macro/ch2

17

Calculation of real GDP: the index problem

•
As price increases are not homogeneous*,
the conversion from nominal to real GDP
will yield different results according to the
base year used

–
First year
-

Laspeyres Index

–
Last year
-

Paasche Index

•
This problem can be circumvented by using
a
chained
index

* i.e.
not the same for every good

Macro/ch2

18

Nominal GDP Growth

P
0

Q
0

P
0
Q
0

P
1

Q
1

P
1
Q
1

Books

$1

1000

$1000

$1.1

1050

$1155

TV

$500

10

$5000

$600

11

$6600

Nominal

GDP

$6000

$7755

Rate of growth of nominal GDP:

Macro/ch2

19

Real growth versus inflation

Real growth

%∆Q

Inflation

%∆P

BOOKS

5%

10%

TV

10%

20%

For the
economy

?

?

Macro/ch2

20

Base: earlier year
-

Laspeyres

P
0

Q
0

P
0
Q
0

P
0

Q
1

P
0
Q
1

Books

$1

1000

$1000

$1

1050

$1050

TV

$500

10

$5000

$500

11

$5500

Real

GDP

$6000

$6550

Rate of growth of real GDP:

Macro/ch2

21

Base: latter year
-

Paasche

P
1

Q
0

P
1
Q
0

P
1

Q
1

P
1
Q
1

Books

$1.1

1000

$1100

$1.1

1050

$1155

TV

$600

10

$6000

$600

11

$6600

Real

GDP

$7100

$7755

Rate of growth of real GDP:

Macro/ch2

22

Chained index*: average price

P
aver

Q
0

P
aver
Q
0

P
aver

Q
1

P
aver
Q
1

Books

$1.05

1000

$1050

$1.05

1050

$1102.5

TV

$550

10

$5500

$550

11

$6050

Real

GDP

$6550

$7152.5

Rate of growth of real GDP:

*Approximation for actual method

Macro/ch2

23

Terminology

•
Nominal GDP or $Y


–
$GDP

–
GDP in current dollars

•
Real GDP or Y

–
GDP in terms of goods

–
GDP in constant dollars

–
GDP adjusted for inflation

–
GDP in 1995 dollar (if base=1995)

Macro/ch2

24

Unemployment rate u

•
L = N + U

–
L is labor force

–
N is number of employed

–
U is number of unemployed

•
u = U/L

–
u is rate of unemployment

•
Data gathered by Bureau of Labor Statistics (BLS)

•
Current Population Survey

Macro/ch2

25

Additional employment statistics

•
A = L + NL

–
A is adult population

–
NL is not in the labor force

•
Discouraged workers (not looking for job anymore)

•
Retirees, home makers etc.

•
Participation rate = L/A

•

When u is high, people stop looking for jobs
and # of discouraged workers (in NL)
increases, hence the participation rate drops

Macro/ch2

26

Labor statistics problem

In a given month in the US,


100 million people are working: N = 100


10 million are not working but are looking for work: U = 10



and 20 million are not working and have given up looking for work: DW = 20.


Calculate the labor force: L = N + U = 100 + 10 = 110




Calculate the official unemployment rate: u = U/L = 10/110 = 9.1%





If an additional 40 million adults are not working for various other reasons beside
being discouraged (retired, homemaker etc.)


Calculate the adult population: A = L + DW + 40 = 170




Calculate the participation rate: PR = L/A = 110/170 = 65%







Macro/ch2

27

Unemployment & output: Okun’s law

-
2

-
1

0

1

2

3

0

1

2

-
1

-
2

∆ in u

GDP growth

*

*

*

*

*

*

*

*

*

*

This is a purely empirical relation showing that high increases in
unemployment correspond to low output growth

%∆ in GDP = 3%
-

2* ∆ in u

Macro/ch2

28

The inflation rate

•
Definition: rate at which the price level
increases

•
Measured

–
By GDP deflator = nominal GDP / real GDP

–
By CPI or Consumer Price Index

GDP deflator can be calculated by methods
similar to those developed for the
calculation of real GDP

Macro/ch2

29

Calculation of GDP deflator


Using data from previous example


Year 0 (as base)

Year 1

Nominal

$6000

$7755

Real

$6000

$6550

GDP Deflator

1

1.18

That is: the rate of inflation is 18%

Macro/ch2

30

CPI or Consumer Price Index

•
Based on cost in $ of a fixed basket of goods and
services consumed by an average urban
consumer

•
Monthly indicator existing since 1917 (BLS)

•
Data gathered in 85 cities and 22,000 retail stores

•
Revised every 10 years as consumption changes


Macro/ch2

31

Difference between GDP deflator and CPI

•
Deflator based on all the goods and services
produced in the economy so it includes
government, investment and exports.

•
CPI is based on a fixed subset of consumption
goods and services so it includes imports.

•
The set of goods and services on which the
deflator is based changes from year to year
while the set included in the CPI is adjusted
every 10 years.

Macro/ch2

32

Inflation and unemployment:


the Phillips curve

∆ in π

u

4


6


8


10


0

-
1

-
2

-
3

-
4

4

3

2

1

*

*

*

*

*

*

*

*

*

*

It shows a negative relation