CHAPTER 1.

MACROECONOMIC
FOUNDATIONS

1.1 Introduction to macroeconomics

1.2 Other macroeconomic indicators
1.3 National accounts
1.4 GDP components
1.5 Labour market indicators
1.6 Inequality and climate issues in macroeconomics
 Chapter 1.4 -
GDP Components

❖ Introduction
❖ Consumption
❖ Investment
❖ Public Expenditure
❖ International trade
 Introduction – GDP Components

• One of the potential estimations of the GDP takes the following

expression (Expenditure approach):

GDP = Y = Aggregate Demand = C + I + G + (X – M)

• This definition gives rise to multiple analysis related to the

patterns of each of these subcomponents.

• Studying all of these patterns is extremely helpful for us to

anticipate different responses from economic agents to each
policy.
 Introduction – GDP
Components (II)
In this course, we mainly
focus on two of the most
crucial GDP’s components:

➢ Consumption

➢ Investment

Why are they so different

across countries?
What is their dynamics?

Source: CORE-ECON
 Consumption (I)
• Consumption is the backbone of the economy and the largest
part of GDP.

• When consumption falls dramatically, we might expect a

recession (e.g., post 2008, 2020 lockdowns).

• Firms sell products or services to consumers. Consumers pay

for these things with their incomes.

• Which is the main factor explaining consumption?

 Consumption (II)

• Income (rent) is the main explanatory variable of consumption patterns.

➢ From now onwards, we will refer to income as Y (remember, Y =
income = production in a closed economy)

• But only income? No! it is disposable income – Income after taxes (T)
and transfers (TR) from the governments (subsidies, scholarships…)

𝑌 𝐷 = 𝑌 − 𝑇𝑎𝑥𝑒𝑠 𝑇 + 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠 (𝑇𝑅)

𝐶 = 𝑓 𝑌𝐷

• In next chapter, we will take a deep to this consumption function.

 Consumption (III)

• Also, individuals not only consume but save (S) part of their
incomes.

𝑌𝐷 = 𝐶 + 𝑆

• In societies where individuals save relatively more, will have

less income to consume, but more savings to invest.

• Consumption and Saving can be aggregated to National

Account measures. This is known as the National Income (NI).
 Investment (I)

• Firms have to invest in things in order to produce the products or

services they sell to consumers.

➢Starbucks has to invest in shops in order to sell its product - coffee.

➢Ryanair has to invest in planes in order to sell its service – cheap

flights.

• Investment is highly dependent on the level of production (Y)

and interest rates (i) but, for the moment, we will consider
ҧ meaning that investment is
Investment (I) as exogenous ( 𝐼),
given in our models, but we know this is not the case in reality…
 Investment (II)

Investment can be divided into:

❑ Investment in Physical Capital – Gross Capital Formation

(Formación Bruta de Capital):

➢ Fixed Gross Capital Formation (Formación bruta de capital fijo). If you

take out depreciation, you get the fixed net capital formation (formación
neta de capital fijo).

➢ Changes in inventories

❑ Residential Investment.
 Investment (III)

• Indeed, investment is the most volatile component of the GDP, why is it?

Source: CORE-ECON
 Investment (IV)
• Investment is drastically driven by the current situation of the national
economy but, even more, by expectations on future economic growth

Negative Positive
Expectations Expectations

Source: CORE-ECON
 Investment (V)

• Nowadays, worldwide
investment is below its trend
before the 2008 Financial
Crisis.

• It shows that firms are having

negative expectations for the
economic future, pushing
down the (expected) levels of
investment.

Source: IMF (June 2019)

 Public Expenditure (I)
• Governments buy goods and services but also, they provide public
goods and services. We know it as government (or public)
expenditure (G) - sometimes referred as government/public
spending.

• Public spending enables governments to produce and purchase

goods and services, in order to fulfil their objectives – such as the
provision of public goods or the redistribution of resources.

• Transfer payments (TR) are those already explained in the

consumption section and are included in the Consumption through
the disposable income. They do not buy goods and services for the
government and so are not accounted in the government spending,
however these Transfers are part of all Total Expenses by a
government.
 Public Expenditure (II)
• Government
spending can be
represented as
a ratio over
GDP.

• This way, we
can compare
across
countries.
 Public Expenditure (III)
• Governments are highly dependent on what they get as fiscal
revenues through Taxes (T).

…In order for them to expend (G).

• The balance between fiscal revenues and fiscal expenditures is

named as (Public) Fiscal Balance (FB) (saldo fiscal o saldo público).
𝐹𝐵 = 𝑇 − (𝐺 + 𝑇𝑅)

• If FB < 0 – The government is running into a (Primary) Fiscal Deficit.

• If FB > 0 – The government is having a (Primary) Fiscal Surplus.
The fiscal balances is a flow variable (it is calculated for each year).
 Public Expenditure (IV)
• A government is able to manage either its expenditures (G), or its
fiscal revenues (T) and/or its transfers (TR).

• This ability is known as the fiscal policy, and it affects to the

overall GDP and the consumption through the disposable income
(𝑌 𝐷 )
𝑌 𝐷 = 𝑌 − 𝑇𝑎𝑥𝑒𝑠 𝑇 + 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠 (𝑇𝑅)

• If they increase G, ∆G > 0 or ∆TR > 0 (expend more) it is known

as expansive fiscal policy.

• If they reduce G, ∆G < 0 or ∆TR < 0 (expend less) it is known as

contractive fiscal policy.
 Public Expenditure (V)
• A government can also affect the GDP and the consumption through
Taxes

• If they increase taxes T, ∆T > 0, individuals will have less disposable

income (𝑌 𝐷 ) to expend and consume affecting GDP. It is known as
contractive fiscal policy.

• If they reduce taxes T, ∆T < 0, individuals will have more disposable

income (𝑌 𝐷 ) to expend and consume, affecting GDP. It is known as
expansive fiscal policy.
 Further topics on the
Government (I)
• When the government is having a fiscal deficit (fiscal revenues lower
than government expenses), it has to sell bonds (in the money
market) to get resources from the private sector. This way it can
cover its public deficit and continue with its usual activity.

• These bonds represent a liability for a government as it will have to

pay them back to lenders at some point in the future plus an
(nominal) interest rate. These interest rates are extra-costs for any
government (they are higher the higher the interest rates of bonds).

• To pay these bonds, the government will take use of its future fiscal
revenues (coming from taxes).
 Further topics on the
Government (II)
• The stock of these public bonds plus their interests is known as
Public Debt. This a stock variable (it is calculated in a given
moment).

• Public debt can be represented as ratio over the GDP.

• When this public debt ratio reaches high values, governments

might be seen as non-trusty, therefore, private investors and
lenders (using their savings) will ask for higher interest rates to
buy those government bonds.

• If this situation deteriorates in time (for many years), government

will have to dedicate more and more fiscal resources to pay its
debts plus interests, leading the national government to
unsustainability problems.
Further topics on the
Government (III)
 Further topics on the
Government (IV)
• Finally, if we consider all these interest rates as fiscal expenses
for a government, we will be talking about the Total Fiscal
Balance:
𝐹𝐵 = 𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐹𝑖𝑠𝑐𝑎𝑙 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠

• The Primary Fiscal Balance (T-G) is the Fiscal Balance after

having into account all the fiscal revenues and expenses of a
government (the one we explained before).

• But if we take into account the interest rates paid for the bonds it
sells, we will be talking about the total fiscal balance, which can
show a deficit or a surplus too. Indeed, a country might have a
surplus or a deficit in the primary balance while having positive
interest rates.
 International Trade
• The difference between Exports (part of the national production
going abroad) and Imports (part of international production
coming to the national economy) is known as Trade Balance
(TB) - Saldo comercial.

• If TB > 0, exports are higher than imports, so there is a Trade

Surplus. It means income (rent) from the rest of the world is
coming into the national economy.

• If TB < 0, exports are smaller than imports, so there is a Trade

Deficit. Income (rent) from the national economy is coming out
to the rest of the world.

• All these flows are registered in the Balance of Payments.

 Everything together (I)
• Let’s take all these accounting expressions

𝐺𝐷𝑃 = 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

𝑌 𝐷 = 𝑌 − 𝑇 + 𝑇𝑅

𝑌𝐷 = 𝐶 + 𝑆
• From the last two, we get:

𝐶 + 𝑆 = 𝑌 − 𝑇 + 𝑇𝑅
• Let’s assume TR=0 (transfer usually are very small on aggregate)

𝑌 =𝐶+𝑆+𝑇
 Everything together (II)
• Taking back the GDP expression:

𝐶+𝑆+𝑇 ≡𝑌 ≡𝐶+𝐼+𝐺+𝑋 −𝑀

(𝑆 − 𝐼) ≡ (𝐺 − 𝑇) + (𝑋 − 𝑀)
This is called balance of payments equilibrium.

• We get three balances:

➢ (𝑆 − 𝐼) --- Private Sector Balance.

➢ (𝐺 − 𝑇) --- Public Fiscal Balance related to the government.
➢ (𝑋 − 𝑀) --- Trade balance, only in an open economy.
 Everything together (III)
• In a closed economy:
(𝑆 − 𝐼) ≡ (𝐺 − 𝑇)

• There should be an accounting balance between savings from

private sector (S-I) and savings from the Public Sector (G-T).

• If this equilibrium does not exist, governments and private

sector will have problems to finance their activities, thus, they
will need to open the economy such as:
(𝑆 + 𝑇 − 𝐺) − 𝐼 ≡ (𝑋 − 𝑀)

• Where now, 𝑆 + 𝑇 − 𝐺 is refereed as Total Savings in an

economy.
 Everything together (IV)
Some clarifications, what does it mean that in this closed economy…?

• S > I → S – I > 0; it says that all the savings in an economy are enough to
finance the Investment but also that the excess could finance the Public
Sector. The private sector has financing capacity.

➢ For instance, through Loans – “households save in bank accounts

(deposits) and then Banks finance firms”.
➢ Private savings could also Finance the Public Sector by buying
Public debt bonds. It would allow the Public Sector to get resources
for G.
• S < I → S – I <0; it says that all the savings are not enough to finance the
Investment, therefore, private sector would need savings from the
external sector (through foreign Banks moving foreign savings through
loans) or from the Public Sector (Transfers). The private sector has
financing needs.