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CH 19: OVERVIEW OF MACROECONOMICS

Macroeconomics is the study of the behavior of the economy as a whole. It examines the forces
that affect firms, consumers, and workers in the aggregate.
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

Key Concepts of Macroeconomics


The three central questions of macroeconomics:
1. Why do output and employment sometimes fall, and how can unemployment be reduced?
(Business Cycles)
2. What are the sources of price inflation, and how can it be kept under control? (Inflation)
a. A chicken that cost 10 thousand Zimbabwean dollars at the beginning of the year
would cost 10 trillion Zimbabwean dollars at the end!
3. How can a nation increase its rate of economic growth?
Key factors in long-term economic growth according economic historians:
1.
2.
3.
4.
5.

Reliance on well-regulated private markets for most economic activity


Stable macroeconomic policy
High rates of saving and investment
Openness to international trade
Accountable and non-corrupt governing Institutions.

Objectives and Measurements of Macroeconomics


Objectives
Output: High level and rapid growth of output
Employment: High level of employment with low involuntary unemployment
Stable prices
Instruments
Monetary policy: Buying and selling bonds, regulating financial institutions
Fiscal policy: Government expenditures and Taxation

Measuring Economic Success

Gross Domestic Product (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

Real GDP % growth rate in year t:

GDP tGDPt 1
100
GDPt 1

Economic Growth is a process wherein an economy exhibits a steady long-term growth in real
GDP and an improvement in living standards.
Potential GDP represents the maximum sustainable level of output that the economy can
produce.
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When output rises above potential output, price inflation tends to rise
While a below-potential level of output leads to high unemployment.

Recession is a period of significant decline in total output, income, and employment, usually
lasting more than a few months and marked by widespread contractions in many sectors of the
economy.

Depression is a severe and protracted downturn.

Unemployment rate is the percentage of the labor force that is unemployed.


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 is defined as a low and stable inflation rate. It is important because a smoothly
functioning market system requires that prices accurately convey information about relative
scarcities. Most nations seek the golden mean of slowly rising prices as the best way of
encouraging the price system to function efficiently.
Price indexes, or measures of the overall price level are constructed by government
statisticians to track prices
Consumer price index (CPI), measures the trend in the average price of goods and services
bought by consumers
Inflation rate is the percentage change in the overall level of prices from one year to the next

Inflation Rate year t=

Pt Pt1
100
Pt 1

Deflation occurs when prices decline (which means that the rate of inflation is negative)
Hyperinflation is a rise in the price level of a thousand or a million percent a year

The Tools of Macroeconomic Policy


A policy instrument is an economic variable under the control of government that can affect
one or more of the macroeconomic goals.
Fiscal policy denotes the use of taxes and government expenditures.
Government expenditures come in two distinct forms.
1. Government purchases comprise spending on goods and servicespurchases of tanks,
construction of roads, salaries for judges, and so forth.
2. Government transfer payments increase the incomes of targeted groups such as the
elderly or the unemployed.
Taxation affects the overall economy in two ways.
1. Taxes leave households with more or less disposable or spendable income
2. Taxes affect the prices of goods and factors of production and thereby affect incentives
and behavior
Monetary policy manages the nations money, credit, and banking system.
The Central Bank sets short-run interest-rate targets and attains those targets through
buying and selling government securities
Exchange-rate system is also a central part of monetary policy in an open economy.
2

International Linkages
Globalization is a phenomenon where nations increasingly participate in the world economy
and are linked together through trade and finance.
International trade has replaced empire-building and military conquest as the surest road
to national wealth and influence.
Current account balance represents the numerical difference between the value of exports
and the value of imports, along with some other adjustments. It is closely related to net exports,
which is the difference between the value of exports and the value of imports of goods and
services.
Remember: international trade and finance are not ends in themselves. Rather, international
exchange serves the ultimate goal of improving living standards.
Trade policies consist of tariffs, quotas, and other regulations that restrict or encourage imports
and exports.
Foreign exchange rate represents the price of its own currency in terms of the currencies of
other nations.

Aggregate Supply and Demand


Aggregate supply refers to the total quantity of goods and services that the nations
businesses willingly produce and sell in a given period. It depends upon the (1) price level, (2)
the productive capacity of the economy, and (3) the level of costs.
Aggregate demand, which refers to the total amount that different sectors in the economy
willingly spend in a given period. It equals total spending on goods and services. It depends on
the (1) level of prices, (2) monetary policy, (3) fiscal policy, and (4) exogenous forces (e.g. wars,
weather, and other government policies)
AD = C + I + G + NX

Microeconomic Supply and Demand Curves versus Aggregate Supply and


Demand Curves
The microeconomic supply and demand curves show the quantities and prices of individual
commodities, with such things as national income and other goods prices held as given.
By contrast, aggregate supply and demand curves show the determination of total output
and the overall price level, with such things as the money supply, fiscal policy, and the capital
stock held constant.
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. At this position,
there will be neither excess supply nor excess demandand no pressure to change the overall
price level.

Macroeconomic History: 1900-2008


1930s: John Maynard Keynes founded macroeconomics as he tried to understand the economic
mechanism that produced the Great Depression.
1936: JMK wrote The General Theory of Employment, Interest, and Money. It has two
main arguments:
1. It is possible for high unemployment and underutilized capacity to persist in market
economies
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2. Government fiscal and monetary policies can affect output and thereby reduce
unemployment and shorten economic downturns
Employment Act of 1946 (JMK died this year): Responsibility of Federal Government to
promote maximum employment, production, and purchasing power.
1960s: Wartime Boom. President John Kennedy brought Keynesian economics to Washington.
His economic advisers recommended expansionary policies, and Congress enacted measures to
stimulate the economy
1963 to 1964: Cuts in personal and corporate taxes. GDP grew rapidly during this period,
unemployment declined, and inflation was contained.
1965: The US economy was at its potential output.
1965 to 1968: Buildup for the Vietnam War; defense spending grew by 55 %. President Johnson
postponed painful fiscal steps to slow the economy, thus overheating the economy
1968: Tax increases and civilian expenditure cuts was implemented but too late to prevent
inflationary pressures
1966 to 1981: The Great Inflation. Inflation began to rise under the pressure of low
unemployment and high factory utilization.
It was easier to stimulate the economy than to persuade policymakers to raise taxes to slow the
economy when inflation threatened. Economists during great inflation
1970s: Time of troubles: rising oil prices, grain shortages, a sharp increase in import prices, union
militancy, and accelerating wages.
1979 to 1982: Tight Money Policy. Paul Volcker, prescribed the strong medicine of tight
money to slow the inflation; interest rates rose sharply, stock market fell, and credit was hard to
find.
1979: Housing construction, automobile purchases, business investment, and net exports
declined sharply.
The effects of the tight money were twofold
1. Output moved below its potential and unemployment rose sharply
2. Tight money and high unemployment produced a dramatic decline in inflation, from an
average of 12% per year in the 19781980 period to an average of around 4% per year in
the subsequent period.
1900 to 2008: The Growth Century. Average earnings rose from $0.15 per hour in 1900 to
over $30 per hour in 2008.

The Role of Macroeconomic Policy


The Great Moderation: a period of reduced business-cycle volatility caused by the discovery
and application of macroeconomics, along with a good appreciation of the role and limitations of
monetary and fiscal policy.

CH 20: MACROECONOMIC DATA


Gross Domestic Product: The Yardstick of an Economys
Performance
Gross domestic product (GDP) measures the total value of goods and services produced in a
country during a year. Along with consumption goods and services, we must also include gross
investment.
The gross domestic product (GDP) 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.

Two Measures of National Product (which are exactly the same)


1. Flow-of-Product Approach or Expenditure Approach includes only final goods goods
ultimately bought and used by consumers. National income or product is the sum of the
annual flow of final goods and services
GDP = Consumption + Investment + Government Spending + Net Exports
2. Flow-of-Cost Approach or Income Approach includes all the costs of doing business; these
costs include the wages paid to labor, the rents paid to land, the profits paid to capital, and so
forth.
GDP = Labor Compensation + Profits + Other Property Income + Depreciation + Taxes

National Accounts Derived from Business Accounts


Business account for a firm or nation is a numerical record of all flows (outputs, costs, etc.)
during a given period.
The national accounts simply add together or aggregate the outputs and costs of all the firms in
the country.

The Problem of Double Counting


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

Details of the National Accounts


Real vs. Nominal GDP: Deflating GDP by a Price Index
Nominal GDP (or GDP at current prices) for a particular year is measured using the actual
market prices of that year.
Nominal GDP per capita = Nominal GDP / Population
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Real GDP is calculated by tracking the volume or quantity of production after removing the
influence of changing prices or inflation.
Real GDP per capita = Real GDP / Population
GDP deflator (or Price of GDP) is the difference between nominal GDP and real GDP
GDP Deflator = 100 x Nominal GDP / Real GDP
One common approach is to use the first year as the base year. The base year is the year in
which we measure prices. Consumer Price Index (CPI) can be substituted to GDP deflator.

Consumption
Consumption expenditures are divided into three categories:
1. Durable goods such as automobiles
2. Nondurable goods such as food, and
3. Services such as medical care

Investment and Capital Formation


Increasing capital requires the sacrifice of current consumption to increase future consumption.
Investment consists of the additions to the nations capital stock of buildings, equipment,
software, and inventories during a year. The national accounts include mainly tangible capital
(such as buildings and computers) and omit most intangible capital (such as research-anddevelopment or educational expenses).
Note: Real Investment is included in GDP, but NOT financial investment.
Net Investment = Gross Investment Depreciation

Government Purchases
Some government purchases are consumption-type goods (like food for the military), while
some are investment-type items (such as schools or roads).
Note: Transfer Payments are not included in GDP
Official Government Budget = Government Spending + Transfer Payments
Taxes are included in the Income Approach but not in the Expenditure Approach to GDP

Net Exports
Net exports is the difference between exports and imports of goods and services

Gross Domestic Product, Net Domestic Product, and Gross National


Product
By subtracting depreciation from GDP we obtain net domestic product (NDP)
NDP = GDP depreciation
GNP is the total output produced with labor or capital owned by U.S. residents, while GDP is the
output produced with labor and capital located inside the United States.

From GDP to Disposable Income


National Income (NI) represents the total incomes received by labor, capital, and land. It is
constructed by subtracting depreciation from GDP.
NI = GDP Depreciation
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Disposable income (DI) is what actually gets into the hands of consumers to dispose of as they
please
DI = NI + Transfer Payments Taxes Net Business Saving

Saving and Investment


Measured saving is exactly equal to measured investment. This equality is an identity, which
means that it must hold by definition.
I = product-approach GDP minus C
S = earnings-approach GDP minus C
National Investment = Private Investment + Net Exports
National Saving = Private Saving + Government Saving
National Investment = National Saving
It should be no surprise that national prosperity does not guarantee a happy society, any more
than personal prosperity ensures a happy family Arthur Okun