Macroeconomics

Macroeconomics vs.
Microeconomics
Major issues:
Determination of aggregate production, income, prices,
and employment
Improving the performance of the macroeconomy
Long-run: Economic growth and price stability
Short-run: Reducing fluctuations in output, production and
employment/unemployment

Stylized Graph of the Business Cycle

Circular Flow: A model that demonstrates the
relationships in the macroeconomy.

Figure 1 The Circular Flow

MARKETS
FOR
GOODS AND SERVICES
Firms sell
Goods
Households buy
and services
sold
Revenue

Wages, rent,
and profit

Goods and
services
bought

HOUSEHOLDS
Buy and consume
goods and services
Own and sell factors
of production

FIRMS
Produce and sell
goods and services
Hire and use factors
of production

Factors of
production

Spending

MARKETS
FOR
FACTORS OF PRODUCTION
Households sell
Firms buy

Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars

Copyright 2004 South-Western

Macroeconomic Variables
The circular flow diagram demonstrates that
the important variables are
Output and income: real and nominal gross
domestic product (GDP)
Important implication from the circular flow
diagram: Value of output=Aggregate expenditures or
demand=Aggregate Income

Aggregate Prices Inflation

Employment/Unemployment

The Measurement of Aggregate

Output and Income
By definition, aggregate output is equal to
aggregate income. The value of output is
equal to the income (wages, interest, rents
and profits) received by the factors.
There are Various measures of aggregate
output but we will use the concept of:
Gross domestic product (GDP)

Gross Domestic Product

GDP is the market value of all final goods and
services produced within a country in a given period
of time.
Market value prices, illegal, household
All imputed values for rent
Final goods and services intermediate goods are not
double counted
Produced (newly) - products resold, inventory
Within the country Excludes US production abroad
includes ROW production with the US
Given period of time (generally yearly or quarterly)

Components of GDP
Since aggregate production equals aggregate income,
lets call GDP = Y
Y can be broken up into the following parts
Consumption HH spending on G&S (except new housing)
Investment Business spending on K but includes HH of new
housing
Government Purchases of G&S
Net Exports (= Exports Imports) Net addition (subtraction)
attributable to purchases by ROW.

Y = C + I + G + NX

BEA
2002

GDP

10,480

7,385

Durable

911

12%

Non-Dur

2,086

29%

Services

4,388

58%

1,589

Non-Res

1,080

68%

Res

504

32%

Chg Inv

0%

1,932

679

35%

S&L

1,253

65%

NX

-426

-4%

1,006

10%

1,433

14%

70%

15%

18%

GDP Data
The US Department of Commerces Bureau
of Economic Analysis has data on line:
http://www.bea.doc.gov/

Economic Report of the President

http://w3.access.gpo.gov/eop/

Graphs and Data

http://www.econmagic.com

Real GDP

Table 3 GDP, Life Expectancy, and Literacy

Copyright2004 South-Western

Economic Growth
Economic growth is something that is very important in improving
the standard of living of a population.
The Rule of 70 illustrates how small changes in growth rates can
affect the standard of living.
Doubling Time = 70/(% growth rate)
Examples: Growth Rate Doubling time

2%
35 years

4%
15 years

6%
11.5 years

10%
7 years

Now, China has been growing pretty close to 10% for the last 20 or
so years so the GDP has doubled once, doubled again, and doubled a
third time, so it is 2x2x2=8 times larger than it was 20 years ago!

Figure 2 The Growth in Real

GDP per Person

Determinants of Economic Growth

Remember our production possibilities curve and the first week!
Increased number of resources: L, K, NR, E
Investment
Growth in Labor Force

Increased productivity of resources:

Work Ethic
Technology
Education
Risk-taking and innovation

Social system that allows the efficient use of resources and promotes
productivity
Market system and self-interest
Laws, property rights, and public order
Political and economic freedom

Table 1 The Variety of Growth Experiences

Copyright2004 South-Western

Measuring the Cost of Living

Inflation refers to a situation in which the
economys overall price level is rising.
The inflation rate is the percentage change
in the price level from the previous period.

THE CONSUMER PRICE

INDEX
The consumer price index (CPI) is a measure of the
overall cost of the goods and services bought by a
typical consumer.
The Bureau of Labor Statistics reports the CPI each
month.
It is used to monitor changes in the cost of living
over time.
When the CPI rises, the typical family has to spend
more dollars to maintain the same standard of living

Calculating the Consumer Price Index

Fix the Basket: Determine what prices are most
important to the typical consumer.
The Bureau of Labor Statistics (BLS) identifies a market
basket of goods and services the typical consumer buys.
The BLS conducts monthly consumer surveys to set the
weights for the prices of those goods and services.

Find the Prices: Find the prices of each of the goods

and services in the basket for each point in time.
Compute the Baskets Cost: Use the data on prices to
calculate the cost of the basket of goods and services at
different times.

 Choose a Base Year and Compute the

Index:
Designate one year as the base year, making it
the benchmark against which other years are
compared.
Compute the index by dividing the price of the
basket in one year by the price in the base year
and multiplying by 100.

 Compute the inflation rate: The inflation

rate is the percentage change in the price
index from the preceding period
The Inflation Rate
The inflation rate is calculated as follows:

 Calculating the Consumer Price Index and

the Inflation Rate: Another Example

Base Year is 2002.

Basket of goods in 2002 costs $1,200.
The same basket in 2004 costs $1,236.
CPI = ($1,236/$1,200) 100 = 103.
Prices increased 3 percent between 2002 and
2004.

FYI: Whats in the CPIs Basket?

16%
Food and
beverages
17%
Transportation

Education and
communication

6%

41%
Housing

6%
6% 4% 4%

Medical care
Recreation

Apparel

Other goods
and services
Copyright2004 South-Western

Problems in Measuring the Cost of

Living
The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure of the
cost of living.

Problems in Measuring the Cost of

Living
Substitution bias
Introduction of new goods
Unmeasured quality changes

The GDP Deflator versus the Consumer

Price Index
The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
the consumer price index reflects the
prices of all goods and services bought by
consumers.

Figure 2 Two Measures of Inflation

Percent
per Year
15
CPI

10

GDP deflator

1965

1970

1975

1980

1985

1990

1995

2000
Copyright2004 South-Western

CORRECTING ECONOMIC
VARIABLES FOR THE EFFECTS OF
INFLATION
Price indexes are used to correct for the
effects of inflation when comparing dollar
figures from different times.

Dollar Figures from Different Times

Do the following to convert (inflate) Babe

Ruths wages in 1931 to dollars in 2001:
S a la ry

2001

S a la ry 1931

P ric e le v e l in 2 0 0 1

P ric e le v e l in 1 9 3 1

177
$ 8 0 ,0 0 0
1 5 .2
$ 9 3 1 ,5 7 9

Table 2 The Most Popular Movies of All Times,

Inflation Adjusted

Copyright2004 South-Western

Real and Nominal Interest Rates

Interest represents a payment in the future for a
transfer of money in the past.
The nominal interest rate is the interest rate
usually reported and not corrected for inflation.
It is the interest rate that a bank pays.

The real interest rate is the nominal interest rate

that is corrected for the effects of inflation.

 If you borrow $1,000 for one year, and

Nominal interest rate was 15%.
During the year inflation was 10%.

Then, Real interest rate = Nominal interest

rate Inflation
= 15% - 10% = 5%

Figure 3 Real and Nominal Interest Rates

Interest Rates
(percent
per year)
15

10

Nominal interest rate

0
Real interest rate
5

1965

1970

1975

1980

1985

1990

1995

2000

Copyright2004 South-Western

Inflation Summary
The consumer price index shows the cost of
a basket of goods and services relative to
the cost of the same basket in the base year.
The index is used to measure the overall
level of prices in the economy.
The percentage change in the CPI measures
the inflation rate.

Inflation Summary
The consumer price index is an imperfect
measure of the cost of living for the
following three reasons: substitution bias,
the introduction of new goods, and
unmeasured changes in quality.
Because of measurement problems, the CPI
overstates annual inflation by about 1
percentage point.

Inflation Summary
The GDP deflator differs from the CPI because it
includes goods and services produced rather than
goods and services consumed.
In addition, the CPI uses a fixed basket of goods,
while the GDP deflator automatically changes the
group of goods and services over time as the
composition of GDP changes.

Inflation Summary
Dollar figures from different points in time
do not represent a valid comparison of
purchasing power.
Various laws and private contracts use price
indexes to correct for the effects of
inflation.
The real interest rate equals the nominal
interest rate minus the rate of inflation.

Business Cycle
Economic fluctuations are irregular and
unpredictable.
Fluctuations in the economy are often called the
business cycle.

Most macroeconomic variables fluctuate

together.
As output falls, unemployment rises.

Figure 1 A Look At Short-Run Economic

Fluctuations
(a) Real GDP
Billions of
1996 Dollars
$10,000
9,000

Real GDP

8,000
7,000
6,000
5,000
4,000
3,000
2,000
1965

1970

1975

1980

1985

1990

1995

2000

Copyright 2004 South-Western

THREE KEY FACTS ABOUT

ECONOMIC FLUCTUATIONS
Most macroeconomic variables fluctuate
together.
Most macroeconomic variables that measure
some type of income or production fluctuate
closely together.
Although many macroeconomic variables
fluctuate together, they fluctuate by different
amounts.

Figure 1 A Look At Short-Run Economic

Fluctuations
(b) Investment Spending
Billions of
1996 Dollars
$1,800
1,600
1,400

Investment spending

1,200
1,000
800
600
400
200
1965

1970

1975

1980

1985

1990

1995

2000

Copyright 2004 South-Western

THREE KEY FACTS ABOUT

ECONOMIC FLUCTUATIONS
As output falls, unemployment rises.
Changes in real GDP are inversely related to
changes in the unemployment rate.
During times of recession, unemployment rises
substantially.

EXPLAINING SHORT-RUN ECONOMIC

FLUCTUATIONS
Short Run Differs from the Long Run
Long-run Growth
Short-run fluctuations

Stylized Business Cycle

Recessions
Depressions
Expansions

Unemployment and Its Natural

Rate
Long-run versus Short-run Unemployment:
Long-run: The natural rate of unemployment
Short-run: The cyclical rate of unemployment

Natural Rate of Unemployment

The amount of unemployment that the economy normally
experiences and does not go away on its own even in the long
run. (sum of frictional, structural and seasonal unemployment)

Cyclical Unemployment
Associated with with short-term ups and downs of the
business cycle and refers to the year-to-year fluctuations in
unemployment around its natural rate.

 Describing Unemployment
Three Basic Questions:
How does government measure the economys rate
of unemployment?
What problems arise in interpreting the
unemployment data?
How long are the unemployed typically without
work?

How Is Unemployment Measured?

Unemployment is measured by the Bureau of
Labor Statistics (BLS).
It surveys 60,000 randomly selected households every
month.

Based on the answers to the survey questions, the

BLS places each adult (over 16) years old into one
of three categories:
Employed
Unemployed
Not in the labor force

Employed, Unemployed, Not in

the Labor Force, Labor Force
Employed: A person is considered employed if he or she has
spent most of the previous week working at a paid job.
Unemployed: A person is unemployed if he or she is on
temporary layoff, is looking for a job, or is waiting for the start
date of a new job.
Not in the Labor Force: A person who fits neither of these
categories, such as a full-time student, homemaker, or retiree, is
not in the labor force.

Labor Force
The labor force is the total number of workers and the BLS
defines the it as the sum of the employed and the unemployed .

Figure 1 The Breakdown of the Population in

2001

Employed
(135.1 million)

Labor Force
(141.8 million)

Adult
Population
(211.9 million)
Unemployed (6.7 million)

Not in labor force

(70.1 million)

Copyright2003 Southwestern/Thomson Learning

How Is Unemployment Measured?

The unemployment rate is calculated as the
percentage of the labor force that is unemployed.
Unemployment Rate= (Unemployed/Labor Force)*100

The labor-force participation rate is the

percentage of the adult population that is in the
labor force.
Labor-force Participation Rate=
(Labor Force/Adult Population)*100

Table 1 The Labor-Market Experiences of

Various Demographic Groups

Copyright2004 South-Western

Figure 2 Unemployment Rate Since 1960

Percent of
Labor Force
10

Unemployment rate

6
Natural rate of
unemployment

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Copyright2003 Southwestern/Thomson Learning

Figure 3 Labor Force Participation Rates for

Men and Women Since 1950
Labor-Force
Participation
Rate (in percent)
100

80

Men

60

40

Women

20

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright2003 Southwestern/Thomson Learning

Issues in Measuring
Unemployment

It is difficult to distinguish between a person who is

unemployed and a person who is not in the labor force.
Discouraged workers, people who would like to work but have
given up looking for jobs after an unsuccessful search, dont
show up in unemployment statistics.
Other people may claim to be unemployed in order to receive
financial assistance, even though they arent looking for
workLength of Unemployment

Duration of Unemployment
Most spells of unemployment are short.
Most of the economys unemployment problem is attributable to
relatively few workers who are jobless for long periods of time.

Why does unemployment occur?

In an ideal labor market, wages would adjust to balance the
supply and demand for labor, ensuring that all workers
would be fully employed.
Frictional unemployment refers to the unemployment that
results from the time that it takes to match workers with
jobs. In other words, it takes time for workers to search for
the jobs that are best suit their tastes and skills.
Structural unemployment is the unemployment that results
because the number of jobs available in some labor
markets is insufficient to provide a job for everyone who
wants one.

Frictional Unemployment and

Job Search
Job search
the process by which workers find appropriate
jobs given their tastes and skills.
results from the fact that it takes time for
qualified individuals to be matched with
appropriate jobs.

Public Policy and Job Search

Government programs can affect the time it takes
unemployed workers to find new jobs.
Government-run employment agencies
Public training programs
Unemployment insurance

Effects of Unemployment
Insurance
Unemployment insurance increases the
amount of search unemployment.
It reduces the search efforts of the
unemployed.
It may improve the chances of workers
being matched with the right jobs.

Structural Unemployment
Structural unemployment occurs when the
quantity of labor supplied exceeds the
quantity demanded.
Structural unemployment is often thought to
explain longer spells of unemployment.

Public Policy and Job Search

Why is there Structural Unemployment?
Minimum-wage laws
Unions
Efficiency wages

Figure 4 Unemployment from a Wage Above the

Equilibrium Level
Wage
Labor
supply

Surplus of labor =
Unemployment
Minimum
wage
WE

Labor
demand

LD

LE

LS

Quantity of
Labor
Copyright2003 Southwestern/Thomson Learning

Unemployment Summary
The unemployment rate is the percentage of those who
would like to work but dont have jobs.
The Bureau of Labor Statistics calculates this statistic
monthly.
The unemployment rate is an imperfect measure of
joblessness.
In the U.S. economy, most people who become
unemployed find work within a short period of time.
Most unemployment observed at any given time is
attributable to a few people who are unemployed for long
periods of time.

Unemployment Summary
One reason for unemployment is the time it takes for workers to
search for jobs that best suit their tastes and skills.
A second reason why our economy always has some
unemployment is minimum-wage laws.
Minimum-wage laws raise the quantity of labor supplied and
reduce the quantity demanded.
A third reason for unemployment is the market power of unions.
A fourth reason for unemployment is suggested by the theory of
efficiency wages.
High wages can improve worker health, lower worker turnover,
increase worker effort, and raise worker quality.