Macroeconomics

Chapter-01
GDP: The measure of aggregate output in the national income accounts is
called the gross domestic product of GDP.
Measure of GDP—
 From the production side: GDP equals the value of the final goods and
services produced in the economy during a given period.
 Also from the production side: GDP is the sum of value added in the
economy during a given period.
 From the income side: GDP is the sum of incomes in the economy during a
given period.
Nominal and Real GDP:
Nominal GDP: Nominal GDP is the sum of the quantities of final goods
produced times their current price.
Nominal GDP increases overtime for two reasons:
 First, the production of most goods increases over time.
 Second, the price of most goods increases over time.
Real GDP: Real GDP is constructed as the sum of quantities of final goods
constant (rather than current) prices.
To construct real GDP, we need to multiply the numbers of unit production by
common or based price.
Synonyms of nominal and real GDP:
Nominal GDP is also called dollar GDP or GDP in current dollars.
Real GDP is also called, GDP in terms of goods, GDP in constant dollars, GDP
adjusted for inflation.
Indication of nominal and real GDP:
 Real GDP is denoted in Yt and t refers year.
 Nominal GDP is denoted in $Yt and t refers year.
GDP: Level versus Growth rate
A country with twice the GDP of another country is economically twice as big as
other country. The level of Real GDP per person, the ration of real GDP to the
population of the country. It gives us the average standard of living of the country.
GDP growth: The rate growth of real GDP, often called just GDP growth.
Expansions: Periods of positive GDP growth are called expansions.
Recessions: Periods of negative GDP growth are called recessions.
GDP growth in year t is constructed as (Yt – Yt-1)/ Yt-1 and expressed as a
percentage.
The Unemployment Rate:
GDP is obviously the most important macroeconomics variable. But two other
variables, unemployment and inflation, tell us about other important aspects of
how an economy is performing.
Employment: employment is the number of people who have a job.
Unemployment: unemployment is the number of people who do not have a job
but are looking for one.
The labor force: the labor force is the sum of employment and unemployment.
L= N+U
Labor force= employment + unemployment
The unemployment rate is the ratio of the number of people who are unemployed
to the number of people in the labor force:
u= U/L
Unemployment rate= unemployment/ labor force.
Participation rate, a higher unemployment rate is typically associated with a lower
participation rate.
Why do economists care about unemployment?
Economist care about unemployment for two reasons. First, they care about
unemployment because of its direct effect on the welfare of the unemployed.
Second, economists also care about the unemployment rate because it provides a
signal that the economy may not be using some of its resources.
  Can very low unemployment also be a problem? The answer is yes.
The Inflation: Inflation is a sustained rise in the general level of prices- the
price level.
The Inflation Rate: The inflation rate is the rate at which the price level
increases.
Deflation: Deflation is a sustained decline in the price level.
The practical issue is how to define the price level. Macroeconomists typically
look at two measures of the price level, at two price indexes: the GDP deflator
and the consumer price index (CPI).
The GDP deflator
The GDP deflator in year t, Pt, is defined as the ratio of nominal GDP to real GDP
in year t:

The GDP deflator is what is called an index number. The rate of change, (Pt −
Pt−1)/Pt−1, has a clear economic interpretation: It gives the rate at which the
general level of prices increases over time – the rate of inflation.
One advantage to defining the price level as the GDP deflator is that it implies a
simple relation between nominal GDP, real GDP and the GDP deflator. To see
this, reorganize the previous equation to get:

Nominal GDP is equal to the GDP deflator multiplied by real GDP. Or, putting it
in terms of rates of change, the rate of growth of nominal GDP is equal to the
rate of inflation plus the rate of growth of real GDP.
The consumer price index
To measure the average price of consumption or, equivalently, the cost of living,
macroeconomists look at another index, the consumer price index.
Why do economists care about inflation?
Pure Inflation: If a higher inflation rate meant just a faster but proportional
increase in all prices and wages– a case called pure inflation.
Why do economists care about inflation? Precisely because there is no such thing
as pure inflation:
 During periods of inflation, not all prices and wages rise proportionately.
Consequently, inflation affects income distribution, meaning for instance
that retirees in many countries receive payments that do not keep up with the
price level, so they lose in relation to other groups when inflation is high.
For example, during the very high inflation that took place in Russia in the
1990s, retirement pensions did not keep up with inflation, and many retirees
were pushed to near starvation.
 Inflation leads to other distortions. Variations in relative prices also lead to
more uncertainty, making it harder for firms to make decisions about the
future, such as investment decisions. Some prices, which are fixed by law or
by regulation, lag behind others, leading to changes in relative prices.
Taxation interacts with inflation to create more distortions. If tax brackets
are not adjusted for inflation, for example, people move into higher and
higher tax brackets as their nominal income increases, even if their real
income remains the same.
If inflation is so bad, does this imply that deflation (negative inflation) is good?
The answer is no. First, high deflation (a large negative rate of inflation) would
create many of the same problems as high inflation. Second, even a low rate of
deflation limits the ability of monetary policy to affect output.
Most macroeconomists believe that the best rate of inflation is a low and stable rate
of inflation, somewhere between 1and 4%.
Output, Unemployment, and the Inflation Rate: Okan’s Law and the Phillips
Curves
The three main dimensions of aggregate economic activity: output growth, the
unemployment rate, and the inflation rate. Those dimensions has relation among
them. The first relation is:
Okan’s Law
If output growth is high, unemployment will decrease. The relation was first
examined by U.S. economist Arthur Okan and for this reason has become known
as Okan’s Law.
 The change in the unemployment rate on
the vertical axis against the rate of
growth of output on the horizontal axis
for the figure.
Looking at the figure and the line
suggests two conclusions:

1. There is a tight relation between the

two variables: Higher output growth leads to a decrease in unemployment. The
slope of the line is -0.4. This implies that, on average, an increase in the growth
rate of 1% decreases the unemployment rate by roughly -0.4%. This is why
unemployment goes up in recessions and down in expansions
2. This line crosses the horizontal axis at the point where output growth is roughly
equal to 3%. In economic terms: It takes a growth rate of about 3% to keep
unemployment constant. This is for two reasons. The first is that population, and
thus the labor force, increases over time, so employment must grow over time just
to keep the unemployment rate constant. The second is that output per worker is
also increasing with time, which implies that output growth is higher than
employment growth. Suppose, for example, that the labor force grows at 1% and
that output per worker grows at 2%. Then output growth must be equal to 3 %( 1%
+ 2%) just to keep the unemployment rate constant.
The Phillips Curve
New Zealand economist, A. W. Phillips, and has become known as the Phillips
curve. Phillips plotted the rate of inflation against the unemployment rate. Since
then, the Phillips curve has been redefined as a relation between the change in the
rate of inflation and the unemployment rate.
The change in the inflation rate (measured using the CPI) on the vertical axis the
unemployment rate on the horizontal axis. Looking at the figure again suggests two
conclusions:
1. The line is downward sloping, although the fit is not as good as it was for
Okun's law: Higher unemployment leads, on average, to a decrease in
inflation; lower unemployment leads to an increase in inflation. But this is
only true on average. Sometimes, high unemployment is associated with an
increase in inflation.
2. The line crosses the horizontal axis at the point where the unemployment
rate is roughly equal to 6%. When unemployment has been below 6%,
inflation has typically increased, suggesting that the economy was
overheating, operating above its potential. When unemployment has been
above 6%, inflation has typically decreased, suggesting that the economy
was operating below potential. But, again here, the relation is not tight
enough that the unemployment rate at which the economy overheats can be
pinned down precisely. This explains why some economists believe that we
should try to maintain a lower unemployment rate, say 4 or 5%, and others
believe that it may be dangerous, leading to overheating and increasing
inflation.
 A successful economy is an economy that combines high output
growth, low unemployment, and low inflation.
THE SHORT RUN, THE MEDIUM RUN AND THE
LONG RUN
What determines the level of aggregate output in an economy?
 In the short run, say, a few years, the first answer is the right one. Year-to-
year movements in output are primarily driven by movements in demand.
Changes in demand, perhaps due to changes in consumer confidence or other
factors, can lead to a decrease in output (a recession) or an increase in output
(an expansion).
 In the medium run, say, a decade, the second answer is the right one. Over the
medium run, the economy tends to return to the level of output determined by
supply factors: the capital stock, the level of technology and the size of the
labor force. And, over a decade or so, these factors move sufficiently slowly
that we can take them as given.
 In the long run, say, a few decades or more, the third answer is the right one.
To understand why China has been able to achieve such a high growth rate
since 1980, we must understand why both capital and the level of technology
in China are increasing so fast. To do so, we must look at factors such as the
education system, the saving rate, and the role of the government.
SUMMARY
 We can think of GDP, the measure of aggregate output, in three equivalent
ways: (1) GDP is the value of the final goods and services produced in the
economy during a given period; (2) GDP is the sum of value added in the
economy during a given period; and (3) GDP is the sum of incomes in the
economy during a given period.
 Nominal GDP is the sum of the quantities of final goods produced multiplied
by their current prices. This implies that changes in nominal GDP reflect both
changes in quantities and changes in prices. Real GDP is a measure of output.
Changes in real GDP reflect changes in quantities only.
 A person is classified as unemployed if he or she does not have a job and is
looking for one. The unemployment rate is the ratio of the number of people
unemployed to the number of people in the labor force. The labor force is the
sum of those employed and those unemployed.
 Economists care about unemployment because of the human cost it represents.
They also look at unemployment because it sends a signal about how
efficiently the economy is using its resources. High unemployment indicates
that the economy is not utilizing its human resources efficiently.
 Inflation is a rise in the general level of prices – the price level. The inflation
rate is the rate at which the price level increases. Macroeconomists look at two
measures of the price level. The first is the GDP deflator, which is the average
price of the goods produced in the economy. The second is the CPI, which is
the average price of goods consumed in the economy.
 Inflation leads to changes in income distribution. It also leads to distortions
and increased uncertainty.
 There are two important relations among output, unemployment, and inflation.
The first, called Okan’s Law, is a relation between output growth and the
change in unemployment: High output growth typically leads to a decrease in
the unemployment rate. The second, called the Phillips curve, is a relation
between unemployment and inflation: A low unemployment rate typically
leads to an increase in the inflation rate.
 Macroeconomists distinguish between the short run (a few years), the medium
run (a decade) and the long run (a few decades or more). They think of output
as being determined by demand in the short run. They also think of output as
being determined by the level of technology, the capital stock and the labor
force in the medium run. Finally, they think of output as being determined by
factors such as education, research, saving and the quality of government in
the long run.
 Chapter- 03
The Goods Market
When economists think about year-to-year movements in economic activity, they
focus on the interactions between production, income and demand:
● Changes in the demand for goods lead to changes in production.
● Changes in production lead to changes in income.
● Changes in income lead to changes in the demand for goods.
 The composition of GDP
If we want to understand what determines the demand for goods, it makes sense to
decompose aggregate output (GDP) from the point of view of the different goods
being produced, and from the point of view of the different buyers for these goods.
The decomposition of GDP typically are consumption (C), investment (I),
government spending (G), inventory investment and net exports: exports (X),
imports (IM).
Few information:
Consumption is the largest part of composition of GDP.
Investment sometimes called fixed investment to distinguish it from
inventory investment (which we will discuss shortly). Investment is the sum
of nonresidential investment, the purchase by firms of new plants or new
machines (from turbines to computers), and residential investment, the
purchase by people of new houses or apartments.
Government spending (G) represents the purchases of goods and
services by the national, regional and local governments.
Note that G does not include government transfers (for instance,
unemployment benefits and pensions), or interest payments on the
government debt. Although these are clearly government expenditures, they
are not purchases of goods and services.
Imports (IM): The purchases of foreign goods and services by domestic
consumers, domestic firms, and the government.
Exports (X): The purchases of domestic goods and services by
foreigners.
 The difference between exports and imports (X – IM) is called net exports,
or the trade balance. If exports exceed imports, the country is said to run a
trade surplus. If exports are less than imports, the country is said to run a
trade deficit.
The difference between goods produced and goods sold in a given year – the
difference between production and sales, in other words – is called
inventory investment.
If production exceeds sales and firms accumulate inventories as a result,
then inventory investment is said to be positive. If production is less than
sales, and firms inventories fall, then inventory investment is said to be
negative.
 The Demand for Goods
Denote the total demand for goods by Z. Using the decomposition of GDP we saw
we can write Z as:
Z ≡ C + I + G + X – IM
This equation is an identity (which is why it is written using the symbol ≡ rather
than an equal’s sign). It defines Z as the sum of consumption, plus investment, plus
government spending, plus exports, minus imports.
Some simplifications of the identity:
1. Assume that all firms produce the same good, which can then be used by
consumers for consumption, by firms for investment or by the government.
With this (big) simplification, we need to look at only one market – the
market for ‘the’ good – and think about what determines supply and demand
in that market.
2. Assume that firms are willing to supply any amount of the good at a given
price, P. This assumption allows us to focus on the role demand plays in the
determination of output.
3. Assume that the economy is closed – that it does not trade with the rest of
the world: both exports and imports are zero. This assumption will also
simplify our discussion because we won’t have to think about what
determines exports and imports.
Under the assumption that the economy is closed, X = IM = 0, so the
demand for goods, Z, is simply the sum of consumption, investment, and
government spending:
Z=C+I+G
 Consumption (C)
Consumption decisions depend on many factors. The main one is surely income or,
more precisely, disposable income (YD).
Disposable income (YD): The income that remains after consumers have
received transfers from the government and paid their taxes.
Let C denote consumption and YD denote disposable income. We can then write:
C = C(YD) [3.1]
(+)
Consumption, C, is a function of disposable income, YD. The function C(YD) is
called the consumption function. The positive sign below YD reflects the fact that
when disposable income increases, so does consumption. Economists call such an
equation a behavioral equation to indicate that the equation captures some aspect
of behavior – in this case, the behavior of consumers.
The relation between consumption and disposable income is given by the simpler
relation:
C = c0 + c1(YD) [3.2]
In other words, it is reasonable to assume that the function is a linear relation. The
relation between consumption and disposable income is then characterized by two
parameters, c0 and c1:
 The parameter c1 is called the marginal propensity to consume. It gives
the effect an additional dollar of disposable income has on consumption.
If c1 is equal to 0.6, then an additional dollar of disposable income
increases consumption by $1 × 0.6 = 60 cents.
Marginal propensity to consume or Propensity to consume: In economics, the
marginal propensity to consume (MPC) is a metric that quantifies induced
consumption, the concept that the increase in personal consumer spending
(consumption) occurs with an increase in disposable income (income after
taxes and transfers).
A natural restriction on c1 is that it must be positive: an increase in disposable
income is likely to lead to an increase in consumption. Another natural restriction
 is that c1 must be less than 1: People are likely to consume only part of any
increase in disposable income and save the rest.
The parameter c0 has a simple interpretation. It is what people would consume if
their income in the current year were equal to zero: if YD equals zero in equation
(3.2), C = c0. A natural restriction is that, if current income were equal to zero,
consumption would still be positive: with or without income, people still need to
eat! This implies that c0 is positive. How can people have positive consumption if
their income is equal to zero? Answer: they dissave. They consume either by
selling some of their assets, or by borrowing.
The parameter c0 has a less literal and more frequently used interpretation. Changes
in c0 reflect changes in consumption for given level of disposable income.
Increases in c0 reflect an increase in consumption given income, decreases in c0 a
decrease. There are many reasons why people may decide to consume more or
less, given their disposable income. They may, for example, find it easier or more
difficult to borrow, or may become more or less optimistic about the future.
The relation between consumption and
disposable income shown in equation (3.2) is
drawn in Figure 3.1. Because it is a linear
relation, it is represented by a straight line. Its
intercept with the vertical axis is c0; its slope
is c1. Because c1 is less than 1, the slope of
the
line is less than 1: equivalently, the line is
flatter than a 45° line.
Next, we need to define disposable income, YD. Disposable income is given by
YD ≡ Y – T. where Y is income and T is taxes paid minus government transfers
received by consumers. For short, we will refer to T simply as taxes: but
remember that it is equal to taxes minus transfers. Note that the equation is an
identity, indicated by ≡.
Replacing YD in equation (3.2) gives
C = c0 + c1( Y − T ) [3.3]
Consumption, C, is a function of income, Y, and taxes, T. Higher income increases
consumption, but less than one for one. Higher taxes decrease consumption, also
less than one for one.
Investment (I)
Endogenous Variable: Some variables depend on other variables in the model
and are therefore explained within the model. Variables like these are called
endogenous variable.
Exogenous variable: Some variables are not explained within the model but
are instead taken as given. Variables like these are called exogenous variable.
In this equation investment (I) is an exogenous variable. And we write,
Government spending (G)
Fiscal policy: Fiscal policy is the means by which a government adjusts its
spending levels and tax rates to monitor and influence a nation's economy.
Assuming that exports and imports are both zero, the demand for goods is the sum
of consumption, investment and government spending:
Z=C+I+G
Replacing C and I from equations (3.3) and (3.4), we get

Z= [3.5]
The demand for goods, Z, depends on income, Y, taxes, T, investment, L, and
government spending, G.
In equilibrium condition, now exploring the relation between production and
demand. Assume that firms do not hold inventories. In this case, inventory
investment is always equal to zero, and equilibrium in the goods market requires
that production, Y, be equal to the demand for goods, Z:
Y=Z [3.6]
There are three types of equations:
I) Identities ii) Behavioral equations III) Equilibrium conditions.
This equation is called an equilibrium condition. Examples of each: the equation
defining disposable income is an identity, the consumption function is a behavioral
equation and the condition that production equals demand is an equilibrium
condition.
Replacing demand, Z, in equation (3.6) by its expression from equation (3.5) gives

[3.7]
  In equilibrium, production, Y (the left side of the equation), is equal to
demand (the right side). Demand in turn depends on income, Y, which is
itself equal to production.
We are using the same symbol Y for production and income. GDP either from the
production side or from the income side. Production and income are identically
equal.
Using Algebra
Rewrite the equilibrium equation (3.7):

Move c1Y to the left side and reorganize the right side:

Divide the sides by (1- c1):

[3.8]
Equation (3.8) characterizes equilibrium output, the level of output such that
production equals demand. Let’s look at both terms on the right, beginning with
the term in brackets:
 The term [c0 + L + G − c1T] is that part of the demand for goods that does
not depend on output. For this reason, it is called autonomous spending.
Autonomous means independent – in this case, independent of output.
Balanced budget: taxes equal government spending. If T = G, then
(G = c1T ) = (T - c1T ) = (1 - c1)T > 0
 Turn to the first term, 1/(1 − c1). Because the propensity to consume (c1) is
between 0 and 1, 1/(1 − c1) is a number greater than 1. For this reason, this
number, which multiplies autonomous spending, is called the multiplier.
The closer c1 is to 1, the larger the multiplier.
What does the multiplier imply? Suppose that, for a given level of income,
consumers decide to consume more. More precisely, assume that c0 in equation
(3.3) increases by $1 billion. Equation (3.8) tells us that output will increase by
more than $1 billion. For example, if c1 equals 0.6, the multiplier equals 1/(1 −
0.6) = 1/0.4 = 2.5, so output increases by 2.5 × $1 billion = $2.5 billion.
We have looked at an increase in consumption, but equation (3.8) makes it clear
that any change in autonomous spending – from a change in investment, to a
change in government spending, to a change in taxes – will have the same
qualitative effect: it will change output by more than its direct effect on
autonomous spending.
Where does the multiplier effect come from? Looking back at equation (3.7) gives
us a clue: an increase in c0 increases demand. The increase in demand then leads to
an increase in production. The increase in production leads to an equivalent
increase in income (remember that the two are identically equal). The increase in
income further increases consumption, which further increases demand, and so on.
Using a Graph