Karthikn 202slides1

Econ 20210: Elements of Economic Analysis - 3, Honors
Karthik Nagarajan
University of Chicago
karthikn@uchicago.edu
January 3, 2017
Karthik Nagarajan (Univ. of Chicago) Econ 20210 Lectures 1 & 2 January 3, 2017 1 / 57
Outline
1 What is Macroeconomics?
2 Syllabus
3 Aggregates: Measuring the Economy
4 Gross Domestic Product

National Accounting
Growth
Business Cycles
GDP Components
5 Labor Aggregates
6 Price Indices and Inflation
What is Macroeconomics?
Macroeconomics is the study of the economy as a whole, or the study of

the aggregate economy.
Why do we care?
• The pieces of an economy - people, firms, markets - don’t exist in
isolation from on another. How do these pieces come together?
• We ultimately care about objects that are not tied to any specific part
of the economy - well-being, unemployment etc.
• Policy! How should the government think about the economy?
Fundamental Questions in Macroeconomics
Macroeconomists are primarily interested in answering the following

questions.
• Why do economies grow?
• What causes fluctuations in the economy (booms and recessions)?
• Why are people unemployed?
• What causes inflation and what are its effects?
Tentative Course Outline
Broadly, this course will cover the following material.

1. Measurement and aggregates (today)
2. Economic growth
3. Business cycles
4. Models of money and inflation
5. Special topics (time dependent - you get to choose!)
- Asset pricing
- Income inequality
- Endogenous growth
- Unemployment - labor matching
Course Objectives
• Provide you with a strong foundation in macroeconomic theory by

introducing the canonical models in the field
• Show you how the theory is motivated by and connected to real data
• Develop the mathematical and computational tools required to
analytically and numerically solve macroeconomic models
• Introduce you to more frontier topics in macroeconomics (depending
on time)
Logistics
Lecture: Tuesdays and Thursdays, 1:30-2:50 PM, HM 130

Discussion Session: Thursdays, 6:00-6:50 PM, RO 015
Instructor: Karthik Nagarajan

Email: karthikn@uchicago.edu
Office Hours: Mondays, 5:00-6:00 PM and by appointment.
TA: Lloyd Han

Email: lloydhan@uchicago.edu
Office Hours: Wednesdays, 5:00-6:00 PM in Saieh 230.
Requirements and Grades
• 6 or 7 problem sets (20%). Can be submitted in pairs (one

write-up for both students).
• Midterm and Final Exams.
- Worth 30% and 35% respectively, or 25% and 40%; whichever is
higher.
- Midterm tentatively scheduled for Feb. 7, in class.
• MATLAB project (10%). Assigned around midterm, due at the end
of the quarter.
• Class participation (5%).
Note on MATLAB
MATLAB is a powerful computational tool for numerical analyses. The

goal of the applied portions of this course is to provide you with some level
of familiarity and expertise with the software.
• No prior programming experience is required! Don’t stress.
• We’ll ease you into the software - Lloyd will offer a tutorial session
(probably next week) and problem sets will contain some short
MATLAB components for practice. We’re more than happy to answer
your questions.
• Practice is key. A MATLAB guide will be posted and you should work
through it as well as the practice problems on the homework.
Having experience with MATLAB is great if you want to RA for professors,
write an honors thesis, apply to grad school; you’ll also need it for Econ
203!
What are Aggregates?
Aggregates are variables that summarize some aspect of the economy by

using data from its various parts. They often involve adding or averaging
over individual agents (consumers, goods, firms, markets etc).
The most common and important aggregates in macro are

1. GDP (aggregate output)
2. Price indices (average prices)
3. Unemployment rate (percentage of total)
Why are aggregates useful?
Benefits:
• Vast amounts of information in economy; aggregates condense this
information into manageable numbers
• Allow us to make statements about the average behavior and
outcomes in the economy
• Can approach questions of overall well-being, growth, fiscal and
monetary policy - captures entire economy (including how all agents
interact with each other)
• Enable comparisons across countries and time.
Costs:
• Ignore and hide important differences between agents (income
inequality)
• Economic interpretation sometimes difficult
Gross Domestic Product (GDP)
The GDP of a country is the total value of final goods and services
produced within that country’s territory over a given period of time.
• Gross = does not include cost of capital depreciation
• Domestic = produced within the country’s territory
• Product = output
GDP - 2
Other important points:

• GDP only includes the value of final goods and services - goods and
services used to produce other goods are not included.
• GDP is a flow variable - it is defined over a period of time (GDP last
year) rather than at a point in time (stock variable).
Related aggregates:
1. Gross National Product: Total value of final goods and services
produced by the nationals of a country over a given period of time.
2. Net Domestic Product: GDP minus the cost of capital depreciation.
Nominal GDP
Computing GDP requires a notion of value. We need to convert apples,

laptops, doctors performing surgeries and all other goods into the same
units. Nominal GDP uses current prices to convert all goods into dollar
units.
X
Nominal GDPt = pit × yit (1)
i
Problem with nominal GDP - if all quantities are halved and prices are
doubled in the next year, then nominal GDP is unchanged!
Real GDP
We want GDP to measure output, so we need to get rid of the effects of

prices. Real GDP fixes prices to the levels in some base year b i.e.
X
Real GDPt = pib × yit (2)
i
Nominal GDPt
GDP Deflatort = × 100 (3)
Real GDPt
Adjusting for prices makes a big difference!
Figure: Log of Nominal and Real GDP/GNP in the U.S. from 1869 to 2015.
Real GDP - 2
Real GDP and its growth rate are the primary aggregates used by
macroeconomists to asses an economy’s performance.
• The higher the output in the economy, the more there is to eat -
people like to eat!
Also use real GDP per capita, which can be interpreted as the average
income of the country’s residents.
Real GDPt
Real GDP per capitat = (4)
Populationt
Shortcomings of real GDP
• Doesn’t account for distribution of wealth. One person could have an

amazing life, everyone else is dirt poor.
• Difficult to measure.
• Does not include the value of household production (e.g. parents
cooking meals for their families).
• Does not include the informal sector (black market goods like drugs).
• Doesn’t capture quality improvements (smartphones today are better
than the cellphones of the 1990s).
National Accounting
An example:
Consider the following example economy. In one year, a farmer produces
wheat using land he or she owns and sells it to a miller for $1. The miller
grinds the wheat into flour, which is then sold to a baker for $3. The
baker uses the wheat flour to make bread, and the bread is sold to a
grocery store for $8 that finally sells the bread at $15 to households. The
grocery store employs a cashier who is paid $3. No other goods or services
are sold in this economy.
What is the GDP of this economy?
National Accounting
Three ways of computing GDP:

1. Expenditure method: Yt = Ct + It + Gt + Xt
2. Income method: Yt = wt Nt + (rt + δ)Kt + Πt
3. Value-added method: Yt = f (Nt , Kt , At )
All equivalent! Equality of the three implies no waste - all expenditure is
on goods and services (produced output goes to someone), and someone is
earning what is spent.
Growth Rates
The growth rate of a variable X is defined as the percentage change in X

over time.
Xt+1 − Xt
gX ,t =
Xt
Taylor Approximation in One Variable
An nth order Taylor approximation of a function f (x) around a point x̄ is

given by
n
X f (i) (x̄)
f (x) ≈ (x − x̄)i + O(x n+1 ) (5)
i!
i=1
where O(x n+1 ) → 0 as x → x̄.
We’ll be using Taylor approximations a lot in this course.
Growth Rates
Growth rates can be approximated by

Xt+1 − Xt
gX ,t = ≈ log Xt+1 − log Xt (6)
Xt
Plotting variables on a log scale allows us to interpret the slope as a
percentage change!
U.S. Real GDP
Figure: Log of Real GDP/GNP from 1869 to 2015.
Growth Rates
Why do we care about growth?
What will your income be in 30 years? Today U.S. per capita GDP
≈ $53, 000.
Growth at 1% → $ 71,542
Growth at 2% → $ 96,572
Growth at 3% → $ 130,359!
Fundamental macro question: why do countries grow (or not)?
U.S. Real GDP growth rate
Figure: Growth rate of U.S. Real GDP
Recap
Last lecture:
• GDP definition - real and nominal
• National accounting
• U.S. GDP growth
Today:
• Business Cycles
• Labor aggregates
• Price Indices and inflation
I will teach during discussion section today
Recap
Figure: Log of Real GDP/GNP from 1869 to 2015 with a linear trend.
Trends
Linear trend on log-scale is a good fit for the U.S. GDP time series - tells
us that the growth rate of U.S. GDP has been approximately constant in
the long run!
A trend is a function of time that fits the given time series data (in this
case GDP). In general, the trend captures the long run average behavior
of a time series.
Linear Trends
A time series {Xt }T

t=1 with a linear trend looks like
Xt = β0 + β1 t + εt
| {z } |{z}
Trend Deviation
You fit a linear trend to a time series by solving the following optimization
problem.
T
X
min (Xt − β0 − β1 · t)2
β0 ,β1
t=1
This is a linear regression of Xt on time t!
Polynomial Trends
A general polynomial (of degree n) trend is
Xt = β0 + β1 t + · · · + βn t n + εt
| {z } |{z}
Trend Deviation
which can be fit to a time series by solving

T n
!2
X X
min Xt − βi t i
{βi }ni=0
t=1 i=1
This is a linear regression of Xt on time t, t 2 , . . ., t n
Exponential trends
An exponential trend looks like
Xt = e β0 +β1 t+εt
Therefore
log Xt = β0 + β1 t + εt
So fitting an exponential trend to the series {Xt }Tt=1 is the same as fitting
T
a linear trend to {log Xt }t=1 . β1 here is the percentage growth rate of Xt
over time.
GDP Trend
Previously, we fit a linear trend to the log GDP. The trend tells us about
the long run behavior of the U.S. economy!
We also care about the short run deviations, which economists refer to
as business cycles.
ˆ
εt = log GDPt − log GDP
|{z} | {z } | {z }t
Deviation Real data Trend value
Business Cycles
Using a fitted linear trend, deviations look like
Figure: Proportionate deviations of real GDP from linear trend.
Hodrick-Prescott Filter
H-P filter a more sophisticated way to detrend a series which shows long
run cyclical behavior.
Xt = τt + ct + εt
|{z} |{z} |{z}
Trend Cycle Deviation
Solve for trend component

T T −1
!
X X
min (Xt − τt )2 + λ [(τt+1 − τt ) − (τt − τt−1 )]2
τ
t=1 t=2
Suggested: λ = 1600 for quarterly data, 100 for annual.
H-P Fitted GDP
Figure: H-P trend fitted to real quarterly GDP.
Back to Business Cycles
Figure: Proportionate deviations from H-P trend.
Why do Business Cycles Matter?
Deviations look small, but we know recessions are bad for a lot of people.
According to the National Bureau of Economic Research, a recession is a

significant decline in economic activity.
Fundamental macro question: what drives business cycles?
Expenditure Components of GDP
Figure: Expenditure components of GDP over time.
Expenditure Components of GDP
Figure: GDP shares of expenditure components over time.
Labor Aggregates
• Real GDP tells us a lot, but not everything. Aggregates like

unemployment and the lack of jobs pretty important.
• However, terms like ”unemployment” are bandied about pretty

casually by the media and politicians. As economists, we need to be a
little more cautious and understand the subtleties associated with
these quantities.
Important Definitions
The population is divided into two groups: those in the labor force and
those that are not. To be in the labor force, a person must
1. Eligible to work. Usually an age requirement (like 15-65 years in most
countries).
2. Not institutionalized, full-time students or in the military.
3. Currently working or actively looking for work.
Within the labor force, those people that are currently working are
employed, while those that are not working but actively looking for work
are unemployed.
Important Aggregates
1. The unemployment rate.

unemployedt
Ut = × 100% (7)
labor forcet
2. The employment rate or employment-to-population ratio.
employedt
et = × 100% (8)
populationt
3. The labor force participation rate.

labor forcet
pt = × 100% (9)
populationt
Labor Force and Employment
Figure: Labor force participation and employment rates in the U.S. (monthly).
Unemployment Rate
Figure: U.S. Unemployment Rate
Unemployment Types
Not all unemployment is bad. Economists distinguish between various

types of unemployment.
• Frictional unemployment - people switching jobs. Usually healthy
because people reallocate to jobs they’re better at.
• Seasonal unemployment - farmers/fishermen don’t work during the
winter.
• Structural unemployment - people’s skills become obsolete, so they
lose their jobs. Long run unemployment.
• Cyclical unemployment - this is the one we care about. Due to
business cycle fluctuations and lack of demand for workers.
Labor Market Churning
• How do we distinguish between the types of unemployment?

• We need to look at both labor supply and labor demand.
• ... as well as how active the labor market is.
• Loosely speaking, churn is a measure of how active hiring and firing
are in the labor market. More churning usually means more
reallocation of labor to its efficient use, so it’s healthy!
Vacancies
Figure: U.S. Total Nonfarm Job Openings.
Hires and Separations
Figure: U.S. Total Nonfarm Hires and Separations.
Inflation
Inflation (deflation) is defined as a sustained increase (decrease) in the

general price level of an economy.
Why does it matter?

• Wages are usually slow to adjust to price changes - loss of real
income! Fixed income earners like pensioners are most affected.
• Affects saving and investment behavior - you get 1% interest from
your savings account, but it doesn’t account for inflation!
• Hyperinflation (extremely high inflation) = s**t hitting the fan.
Notable examples - Post-WWI in Germany leading to the rise of the
Nazi party. Zimbabwe in 1990s-2000s, monthly inflation peaked at
79600000000%!
• Deflation - Great Depression, Credit crunch in Japan since the 1990s.
Price Indices
To measure inflation, we first need to measure the general level of prices.

We use price indices to do so. The two important ones are
• Consumer Price Index (CPI): uses prices paid by consumers for a
representative basket of goods.
• Producer Price Index (PPI): uses prices received by sellers for a
representative basket of goods.
Why do they differ? Because of sales taxes, producer subsidies and trade.
Computing Price Indices
First, we need a base year 0. Price indices compare the level of prices in a
year t to those in the year 0.
• Laspeyres index.
N
X
pit yi0
i=1
PtLaspeyres = N
X
pi0 yi0
i=1
• Paasche index.
N
X
pit yit
i=1
PtPaasche = N
X
pi0 yit
i=1
Fischer Index
• Both Laspeyres and Paasche indices fail to account for consumers

adjusting to prices.
• Laspeyres index overstates inflation.
• Paasche index understates inflation.
Solution: use the geometric mean of both (Fischer Index)!
r
Fischer
PtLaspeyres PtPaasche

Pt =
Chained Indices
Another problem with price indices - representative baskets change a lot

over long spans of time! How do we compare prices today (which includes
those of goods like laptops, cellphones, Playstations) to prices in the
1960s?
Solution: Use chained indices. Example of a chained Laspeyres index:
N
X N
X N
X
pi1 yi0 pi2 yi1 pit yi,t−1
i=1 i=1 i=1
PtChained Laspeyres = N
× N
× ··· × N
X X X
pi0 yi0 pi1 yi1 pi,t−1 yi,t−1
i=1 i=1 i=1
Prices in the U.S.
Figure: U.S. CPI and PPI History
Inflation Rate
The inflation rate is defined as the percentage change in the price index P
over a given period of time.
Pt+1 − Pt
it =
Pt
Inflation in the U.S.
Figure: U.S. Inflation Rate

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Econ 20210: Elements of Economic Analysis - 3, Honors

3 Aggregates: Measuring the Economy

4 Gross Domestic Product

6 Price Indices and Inflation

Macroeconomics is the study of the economy as a whole, or the study of

Macroeconomists are primarily interested in answering the following

Broadly, this course will cover the following material.

• Provide you with a strong foundation in macroeconomic theory by

Lecture: Tuesdays and Thursdays, 1:30-2:50 PM, HM 130

Instructor: Karthik Nagarajan

TA: Lloyd Han

• 6 or 7 problem sets (20%). Can be submitted in pairs (one

MATLAB is a powerful computational tool for numerical analyses. The

Aggregates are variables that summarize some aspect of the economy by

The most common and important aggregates in macro are

Other important points:

Computing GDP requires a notion of value. We need to convert apples,

We want GDP to measure output, so we need to get rid of the effects of

• Doesn’t account for distribution of wealth. One person could have an

What is the GDP of this economy?

Three ways of computing GDP:

The growth rate of a variable X is defined as the percentage change in X

An nth order Taylor approximation of a function f (x) around a point x̄ is

where O(x n+1 ) → 0 as x → x̄.

We’ll be using Taylor approximations a lot in this course.

Growth rates can be approximated by

Figure: Log of Real GDP/GNP from 1869 to 2015.

Why do we care about growth?

Fundamental macro question: why do countries grow (or not)?

Figure: Growth rate of U.S. Real GDP

A time series {Xt }T

This is a linear regression of Xt on time t!

A general polynomial (of degree n) trend is

which can be fit to a time series by solving

This is a linear regression of Xt on time t, t 2 , . . ., t n

An exponential trend looks like

Figure: Proportionate deviations of real GDP from linear trend.

Solve for trend component

Suggested: λ = 1600 for quarterly data, 100 for annual.

Figure: H-P trend fitted to real quarterly GDP.

Figure: Proportionate deviations from H-P trend.

According to the National Bureau of Economic Research, a recession is a

Fundamental macro question: what drives business cycles?

Figure: Expenditure components of GDP over time.

Figure: GDP shares of expenditure components over time.

• Real GDP tells us a lot, but not everything. Aggregates like

• However, terms like ”unemployment” are bandied about pretty

1. The unemployment rate.

3. The labor force participation rate.

Figure: U.S. Unemployment Rate

Not all unemployment is bad. Economists distinguish between various

• How do we distinguish between the types of unemployment?

Figure: U.S. Total Nonfarm Job Openings.

Figure: U.S. Total Nonfarm Hires and Separations.

Inflation (deflation) is defined as a sustained increase (decrease) in the

Why does it matter?

To measure inflation, we first need to measure the general level of prices.

• Both Laspeyres and Paasche indices fail to account for consumers

Another problem with price indices - representative baskets change a lot

Solution: Use chained indices. Example of a chained Laspeyres index:

Figure: U.S. CPI and PPI History

Figure: U.S. Inflation Rate

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