A Brief Intro To Macro S

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A Brief Introduction to Macroeconomics
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What determines gross domestic product (GDP), unemployment, exchange rates, interest rates, and
inflation? Why do some countries grow quickly while others stagnate? These are the types of questions that the
study of macroeconomics addresses. The answers to these questions are important to policymakers, firms, and
households. For example:
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 Policymakers attempt to understand the forces causing recessions and booms so they can steer the
economy away from prolonged episodes of high unemployment or excess inflation.
 Firm managers want to understand how demand for their product evolves with the macroeconomy, as
well as how changes in interest rates, inflation, and exchange rates affect their costs and revenues.
 Pension plan managers need reliable estimates of future economic growth and returns on different
assets to ensure that their pension funds can pay their beneficiaries in the future.
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 Households are better able to plan for retirement, and perhaps even choose which sector in which to
seek employment, when they understand key economic concepts and important forces in the
macroeconomy.
This note sets the groundwork for a module on macroeconomics by introducing concepts and definitions
that will be revisited in subsequent technical notes. For a more in-depth treatment of some of the material in
this note, including the nature of money and inflation, students should consult a standard macroeconomics
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textbook. This note guides students through the building blocks of an approach that provides insight into the
determinants of GDP and interest rates. It begins by introducing national income accounting and the
components of GDP and by discussing why economists care about GDP. This motivates developing a model—
a logical framework—for predicting GDP. It then introduces two different approaches to predicting GDP: one
in which GDP is determined by the factors of production and one in which GDP is determined by total
spending. Building on the spending approach, the note introduces the determinants of the components of GDP
(consumption, investment, and government spending). It then walks students through examples of how to
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determine endogenous variables from systems of equations and exogenous variables.1 It concludes by discussing the
role of assumptions in macroeconomics and by listing some of the assumptions we will maintain in subsequent
technical notes.
1 Endogenous variables are those whose values are determined within the model. Exogenous variables are those whose values are assumed to be
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determined outside the model. The typical exercise goes like this: “Assume that a certain exogenous variable increases. How does that affect the model’s
endogenous variables?”
This technical note was prepared by Daniel Murphy, Assistant Professor of Business Administration. Copyright © 2014 by the University of Virginia
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This document is authorized for educator review use only by RAMANNA SHETTY, Alliance Business School Bangalore until Jan 2024. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
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National Income Accounting
GDP is defined as the market value of final goods and services produced in a country during a period of
time. GDP is a flow in the sense that it represents an amount per unit of time. There are three equivalent ways
of thinking about and measuring GDP.
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1. The output approach: GDP is the market value of everything that is produced. To measure the market
value of output, we can either examine the value of final goods and services or examine the value added
at each stage in the production of final goods and services.
2. The expenditure approach: GDP is total spending on final goods and services because anything that
has a market value was either bought or sold by someone.
3. The income approach: GDP is income received by producers (including wages received by workers
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and profits received by owners of firms).
An Illustration of the Approaches to Computing GDP
To help illustrate the equality between the income, expenditure, and production approaches to measuring
GDP, consider a simple economy in which an apple juice firm buys apples to produce apple juice. The juice
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is the only final good in the economy.
During a period of time, the firm sells 10 bottles of juice for $1 each. Workers’ wages total $5, and the cost
of apples used to make the juice is $3.
Now let’s compute GDP based on the three different approaches to measuring GDP:
 Output. The value of final goods produced is $10, so the output approach to measuring GDP yields a
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nominal GDP of $10.

 Expenditure. Total expenditure on final goods (the apple juice) is $10, so nominal GDP based on the
expenditure approach is $10.
 Income. Here we add up the income of workers, intermediate-goods producers, and final-goods
producers. Workers receive $5, apple growers receive $3, and the juice firm makes a profit of $2. Total
income is $5 + $3 + $2 = $10.
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Appendix A illustrates the equivalence among these approaches to measuring GDP in what is known as
the circular flow diagram.
Using the expenditure approach, macroeconomists decompose GDP into four broad categories of
spending:
 �(personal consumption expenditure): spending by households on final goods and services
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 �(gross private domestic investment): spending by firms on goods and services

 �(government spending): spending by the government on goods and services
 ��(net exports): exports minus imports, or net cross-border spending on goods and services
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The symbol �typically refers to GDP (income or output), so the national income identity can be expressed as:
� � � � ��. (1)
GDP and its components in Equation 1 are expressed in real (rather than nominal) terms. Equation 1 is
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an identity; the equality between �and � � � ��always holds because we classify all final output as
being purchased by households, firms, government, or foreigners, and because spending also equals total
income (Y). We will focus on the expenditure approach to measuring GDP, but keep in mind the equivalence
among the three approaches.
Consumption (�) includes purchases of new goods such as cars, food, and clothing. It also consists of
purchases of services such as health care and transportation. In the United States, consumption accounts for
more than 70% of GDP. Is that high? Other advanced economies have lower consumption shares (e.g.,
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Germany 57%, Japan 60%, United Kingdom 66%), as do emerging-market economies (e.g., China 34%,
Brazil 63%).2
Investment (� ) consists primarily of spending by firms on new capital goods (e.g., structures, equipment,
software). Construction of new homes is also classified as investment, as is spending on items that are held as
inventories (rather than used for final consumption or production). The investment share of GDP in the United
States is 20%. In Greece, the share is 13%, and in China, it is nearly 50%. (Note that �does not include selling
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and buying of stocks and bonds. Can you explain the distinction?)
Government spending (�) includes civil services provided by the government and goods purchased by the
government. A question is how to classify government investment, such as spending on the construction of
new roads and other new capital formation. The World Bank classifies such expenditures as � , but the US
Bureau of Economic Analysis (BEA) classifies all government spending as � (and then separately lists
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government consumption and government investment). Following the World Bank classifications, the US-
government-purchases share of GDP is 16% (France’s is 25%, Peru’s 11%); BEA data, which include
government investment in G, puts the number at 20%.
A fourth category, net exports (�� ), consists of net sales of goods and services to foreigners (exports
minus imports). Table 1 lists the components of GDP for the United States.
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2 The World Bank provides data on country-level components of GDP. See World Bank, “World Development Indicators,”
http://wdi.worldbank.org/table/4.8 (accessed Jul. 15, 2014).
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Table 1. US GDP and its components, 2017.
Billions of Percentage
dollars of GDP
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GDP 19,485 100
Personal consumption expenditures (C ) 13,321 68.4
Durable goods 1,407 7.2
Nondurable goods 2,750 14.1
Services 9,165 47
Gross private domestic investment (I ) 3,368 17.3
Fixed investment 3,343 17.2
Nonresidential structures 585 3
Equipment 1,150 5.9
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Intellectual property products 852 4.4
Residential investment 755 3.9
Change in private inventories 26 0.1
Government consumption expenditures and gross investment (G ) 3,374 17.3
Federal 1,265 6.5
National defense 744 3.8
Nondefense 521 2.7
State and local 2,109 10.8
Net exports of goods and services (NX ) -578 -3.0
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Exports 2,350 12.1
Imports 2,929 15
Source: Created by author.
Initially, we will assume net exports are zero—for most countries, net exports, whether positive or negative,
are less than 5% of GDP—and focus on the other components of GDP. Later we will reintroduce net exports.
Thus for now we can rewrite the closed-economy national income accounting identity as (Equation 2):
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� � � �. (2)
Why Do Economists Care about GDP?
GDP is one way to summarize a country’s ability to produce goods and services that meet the needs of its
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citizens. Economists assume that people are better off when they consume more goods and services and when
the government provides more services to its citizens. Therefore, in a closed economy, �and �capture the
extent to which a country’s citizens benefit from the country’s productive resources. Investment (� ) measures
the extent to which an economy is adding to its ability to produce goods and services in the future and thus to
its ability to provide �and �in the future.
GDP is of course an incomplete measure of a country’s well-being. It is an aggregate measure that does
not offer any information on how the different components are distributed among a country’s citizens. For
example, if �is high but only a handful of residents enjoy the consumption, then the aggregate measure does
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not represent the consumption of the average citizen.3 GDP also omits activities such as home production (e.g.,
child-rearing) that are not exchanged on the market but nonetheless contribute to citizens’ well-being. It
includes some activities that generate harmful externalities (such as pollution) without accounting for their
3 The median income, for example, might be very low in a country, while the average income is high. In this sense, inequality can distort the relevance
of aggregate measures such as GDP for understanding social well-being.
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costs. Despite these caveats, by capturing the value of goods and services that are exchanged on the market,
GDP offers a comprehensive measure of at least one factor that determines citizens’ well-being.
What Determines GDP and Its Components?
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Below we explore two different approaches to determining �� , one in which �is determined by productive
capacity and a second approach in which �is determined by desired spending. Under the first approach, output
depends entirely on how much the economy can produce based on its factors of production (e.g., technology,
capital, and labor). An implicit assumption of this approach is that there are no wasted resources—firms and
households purchase everything that is produced in the economy. This approach is helpful for understanding
differences in GDP across countries. For example, why is output higher in Japan and the United States than in
Spain and much higher than in Mexico (Figure 1)? It is also useful for understanding within-country differences
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in GDP over long periods of time (e.g., why is GDP in the United States much higher in 2017 than in 1917?).
We will use the first approach when we explore growth rates across countries in subsequent technical notes.4
Figure 1. Real GDP per capita in Japan, the United States, Spain, and Mexico.
GDP per capita (2010 US dollars)

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60000
50000
40000
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30000
20000
10000
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
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United States Japan Spain Mexico
Source: Created by author based on data from the Federal Reserve Bank of St. Louis FRED Economic Data site,
https://fred.stlouisfed.org/ (accessed Aug. 11, 2017).
Changes in the economy over short-term frequencies are more relevant for workers trying to find jobs and
firms trying to forecast revenues. To help us understand changes in output at business cycle frequencies (one
to two years), we take an alternative approach that permits �to depend on desired spending. This approach is
useful for understanding cyclical fluctuations in GDP, unemployment, and inflation (Figure 2).
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4 Economic growth is discussed in a technical note: Kieran Walsh, “Growth Theory,” UVA-GEM-0168 (Charlottesville, VA: Darden Business
Publishing, 2018).
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Figure 2. Unemployment, inflation, and recessions in the United States.
Civilian Unemployment Rate: 16 yr +

SA, %
Inflation (CPI-U: All Items)
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Y/Y %Change
18 18
16 16
14 14
12 12
10 10
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8 8
6 6
4 4
2 2
0 0
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-2 -2
-4 -4
65 70 75 80 85 90 95 00 05 10 15
Source: Bureau of Labor Statistics/Haver Analytics
Approach 1 to determining GDP: Y is determined by productive capacity

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Here we briefly assume that �is determined by the factors of production, including labor �, capital �, and
technology �. Labor �includes the time that workers spend producing goods and services. Capital �includes
machines, buildings, and other items that are used to produce goods and services (e.g., an x-ray machine at a
hospital). Technology �represents the efficiency with which capital and labor are combined to produce output.
We can write the aggregate production function as (Equation 3):
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� ��, �, �. (3)
If �, �, and �are fixed by the amount of technology, capital, and labor in an economy (i.e., if they are
exogenous to our model), then �is given by Equation 3. Therefore, changes in output track exogenous
changes in the factors of production. Equation 3 represents the level of output that the economy is capable of
producing when workers are working at their desired levels (e.g., everyone in the labor force works around 40
hours a week). Going forward, we will refer to this as the full-employment level of output � (also known as potential
GDP). A simple but powerful implication of Equation 3 is that large differences in GDP across countries or
over long periods of time are driven by differences in technology, capital, and labor.
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While this approach to studying GDP has its advantages, there are also some obvious limitations. One of
the limitations of this approach is that it assumes that all labor and other factors of production (e.g., capital) are
fully employed. Cyclical unemployment (to be defined in a future technical note) is a prominent feature of the
business cycle (Figure 2), however, and there is strong empirical evidence that in the short-term (approximately
one year) output is determined not just by factor inputs but also by desired spending.
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Approach 2 to determining GDP: Y is determined by desired spending
The remainder of this technical note focuses on an alternative approach that allows for slack in the
economy—machines that aren’t being used or workers who are unemployed. This model extension helps us
understand cycles in output and how fiscal and monetary policy can affect the level of output and employment.
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In “Aggregate Demand and Aggregate Supply” (UVA-GEM-0127), we formalize how the two approaches are
linked.5
Here we assume that output depends on desired spending. Capital and labor may be necessary to support
a certain level of output, but if desired spending is less than what the production factors can support, then the
factors are left idle. For example, a barber may sit at his shop, but output only occurs if customers actually
purchase a haircut. Otherwise, the barber’s labor is a resource that is not fully utilized.
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To determine total spending, let’s begin by examining the determinants of the different components of
GDP. We will start with the most basic determinants of spending, and will add other factors as the course
proceeds.
Consumption. What determines how much households want to consume? One important factor is their
disposable income (i.e., income net of taxes). When households have higher after-tax income, they will consume
more. Recall that total income is equal to total expenditure, so we can write the consumption function as
(Equation 4):
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�� , (4)
where �is net taxes paid to the government and � �is disposable income.6 Equation 4 states that a higher
level of total output (income) is associated with higher desired consumption, all else equal. Consumption is also
often considered to depend negatively on the interest rate �because a higher interest rate is associated with a
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higher cost of consumption today relative to consumption in the future.7 In developing our model, we make
the simplifying assumption that �is independent of � , reflecting the fact that the majority of households’
consumption (e.g., grocery purchases) is relatively independent of interest rates.
Government spending. We assume that government spending is determined outside our model by the political
system. Therefore, government spending �is exogenous to the model. The government pays for its spending
through taxes, �, and by issuing bonds (i.e., borrowing in the financial markets). If � � , then the government
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borrows and runs a deficit. We will permit government deficits in our model and thus assume that taxes can be
higher or lower than government spending. Taxes are also exogenous in our analysis. We will use boldface to
indicate exogenous variables.
Investment. When firms want to buy capital and households want to buy new homes, they typically borrow
.8 When �is high, households and firms must
money to do so. The cost of borrowing is the real interest rate �
pay more in the future to borrow money today. In other words, the opportunity cost of installing new capital
is high when �is high. Therefore, we assume that investment is falling in the interest rate (Equation 5):
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5 Daniel Murphy, “Aggregate Demand and Aggregate Supply,” UVA-GEM-0127 (Charlottesville, VA: Darden Business Publishing, 2014).
6 An example of a specific functional for Equation 4 is � � � 0.2 � �, which states that households spend 20 cents of each additional
dollar of after-tax income.
7 For example, the cost of purchasing a car can depend on the interest rate charged on the loan associated with financing the purchase.
8 Investment depends on the real interest rate � , which is equal to the nominal interest rate �net of expected inflation. Appendix B discusses how
the interest rate in our model relates to various interest rate measures in the data. Appendix C discusses why investment depends on the real, rather
than the nominal, interest rate.
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��. (5)
Now we can rewrite the closed-economy national income identity as (Equation 6)
� � � �� ⏟
�� , (6)
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where the and signs indicate that �is increasing in � �and �is decreasing in � . We will typically omit
the plus and minus subscripts, but readers should be aware of the direction of relationships implicit in each
function they encounter.
We want to know what determines output and its components. Let’s go through the components on the
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right side of Equation 6 one by one. �is easy; we take �as given (e.g., we assume it is set exogenously by
politicians). �is straightforward as well; Equation 5 states that if you know � , you also know �
. �is not difficult
either; Equation 4 states that knowing �is sufficient for knowing �(since we take �as given). Considering
both sides of Equation 6, there are two unknowns (�and � ). We can’t solve for two unknowns in one equation,
so we need to incorporate additional information that will help us understand what determines �and �.
The money market. The additional information that is necessary to complete our model of �and � is
contained in the money market—the supply-and-demand forces that determine the cost of borrowing money
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(the interest rate). Before outlining the money market, let’s first review the role of money in the economy.
Money is the medium of exchange for goods and services and a unit of account. For example, prices of
goods and services are given in units of money (e.g., $5 for a loaf of bread). We use money to buy services, and
we are given money in exchange for services we provide.
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The amount of goods and services we can buy with money depends on the price of those goods and
services. We refer to the price of a bundle of goods (e.g., the price to buy goods and services for an average
household) as the price level P. The level of real money balances (�/�) is equal to the amount of money in the
economy � relative to the price level �. As we will discuss below, higher levels of real balances facilitate higher
levels of output.
Money can be loaned and borrowed. If one wants to buy services but doesn’t own enough money for the
transaction, one can borrow money from a lender. The rate at which a person borrows is called the nominal
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interest rate, �
. The real (inflation-adjusted) interest rate, �
, is the yield on a loan, adjusting for expected changes in
the prices of goods and services: � � � � , where �� is expected inflation. If the price level �remains
constant (� 0), then �= � .
Money supply and demand. Now that we have outlined the basic function of money, we are ready to analyze
the money market. The supply of money is related to the amount of dollars (in paper and electronic form)
circulating in the economy. We assume for now that the supply of nominal money balances � is fixed by a
country’s central bank and is exogenous to the model. For now, we will also assume that the price level is fixed.
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Therefore, the supply of real money balances �/�is controlled by the central bank.
What about demand for money? Think about what determines how much cash you want to hold. The more
you want to spend, the more money you need (relative to prices), so aggregate real money demand is increasing
in aggregate spending �.9 Money demand also depends on the nominal interest rate � , which is the amount of
9 Remember that �is aggregate spending, aggregate income, and aggregate output. They are all the same! Why?
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money that must be paid in the future to borrow a dollar today. If �is high, then it’s more costly to hold on to
cash today (the opportunity cost of holding your cash is high, as is the cost of borrowing from someone else).
Therefore, money demand is decreasing in � . Under the assumption that the price level is expected to remain
constant, we can express the dependence of real money demand on aggregate spending �and the real interest
rate �as (Equation 7):
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ℒ ⏟
�, ⏟
�, (7)
where ℒ stands for liquidity demand (specifically, money is a liquid asset because it can be exchanged for goods
and services). Equilibrium holds in the money market when money supply equals money demand:
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�
ℒ �,� . (8)
�
Figure 3 shows the interest rate that prevails in equilibrium when the real money supply is �/�and output is
�.
Figure 3. The money market.

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�
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ℒ �
,�
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�/� �/�
Source: Created by author.
Of course, Equation 8 (the money market) alone cannot tell us the actual level of output in the economy.
It can only tell us what the interest rate will be if output is at some specified level. The actual level of output in
equilibrium depends on both the money market (Equation 8) and desired spending (Equation 6).
Mechanically, we can use these two equations to solve for �and �, given a set of exogenous variables (e.g.,
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�, �,�/�). We can then explore the effects of changing these exogenous variables. In particular, with these
equations, we can determine what happens to equilibrium output, savings, investment, and interest rates in
response to exogenous changes in the macroeconomy. For example, how do changes in the money supply
affect output? What is the effect of government spending and taxes on output and investment? In a subsequent
technical note, we will introduce a simple but powerful graphical analysis (the IS/LM model) of equilibrium in
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the market for goods (Equation 6) and the money market (Equation 8).10 We will also add to the list of factors
that determine the components of GDP, permitting a richer mapping between real-world phenomena and our
model.
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A Preview of the IS/LM Model: Some Intuition
The IS/LM model, which we develop in detail in a subsequent technical note, allows us to formalize and
make explicit the macroeconomic relationships of interest. But in working through a model, it is easy to get
caught up in the technical details (and curve shifting) and to lose sight of the basic intuition. Here we introduce
some intuition that we can retain as we formalize our model of the macroeconomy.
Consider for a moment an increase in real balances �/�. What effect might this have on the economy?
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You likely have some intuition for how an increase in the money supply affects interest rates, investment,
consumption, and output. Here is the intuition embedded in the IS/LM model, which you can check against
your own intuition: when the real money supply increases, price of money today (the interest rate) falls. The
lower interest rate causes investment to increase along the investment demand function. Higher spending on
investment causes output to increase. The increase in output is also an increase in income (e.g., more workers
are employed), which causes an increase in desired consumption. Therefore, all else equal, a higher money
supply causes a decrease in interest rates and in increase in consumption and investment (and hence output).
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You can return to this intuition as you work through the IS/LM model. It may also be helpful to write
down your intuition about the effects of other changes in the economy (such as an increase in government
spending).
What Is the Use of Models and Assumptions?

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In this note, we have laid out some fundamental building blocks that will help us create a workhorse model
of international macroeconomics. Models are very important in economics because they provide a framework
through which we can coherently map assumptions into outcomes. Models use a set of behaviors (e.g., the
consumption function, investment function, and money demand function introduced in this note) and
constraints to predict outcomes.
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Models are necessarily simplifications of the real-world settings they mimic. Their assumptions, at best
approximations to reality, are often invalid in reality. Does a model with false assumptions invalidate its use as
an analytic tool? Not necessarily. It depends on whether the assumptions are crucial for the model’s predictions
or if they are simplifications made for tractability. For example, we assume that government spending is
exogenous (i.e., it does not respond to income), but in reality, government spending may be endogenous (i.e.,
legislators respond to economic conditions). Despite the fact that government spending may be endogenous in
reality, the assumption of exogenous government spending is a useful benchmark from which to build our
model. Indeed, many key insights of the model we are building carry through to more complicated settings with
assumptions that more closely approximate reality.
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Because models are simplifications, it is important to keep track of—even if just in the back of your mind—
the assumptions we have made so far. These include:
10 Daniel Murphy, “The IS/LM Model,” UVA-GEM-0126 (Charlottesville, VA: Darden Business Publishing, 2014).
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 Inflation expectations are zero (and hence the real interest rate equals the nominal interest rate).
 The aggregate price level �is exogenous. We will relax this assumption in a subsequent technical note.11
 Government spending and monetary policy are exogenous.
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 Consumption depends on current income but not on the interest rate.
The criteria for a useful model are whether it captures the key mechanisms that operate in reality and
whether it is a tractable tool for understanding changes in policy and other conditions in the macroeconomy.
The assumptions in our model permit a tractable understanding of the key forces in the macroeconomy. We
will maintain most of these assumptions in subsequent technical notes,12 although the interested student is
encouraged to consider how the model’s predictions might change under alternative assumptions. Once you
have a complete understanding of how the model works under a strong set of assumptions, it becomes easier
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to see how the model’s predictions differ under alternative and perhaps more realistic conditions.
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11 In GEM-0127, we permit �to vary with macroeconomic conditions (and we therefore do not write it in boldface). In the meantime, we can treat
�as exogenous.
12 We permit prices to change endogenously in Murphy, “Aggregate Demand and Aggregate Supply” (UVA-GEM-0127).
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Appendix A (Optional)
The Circular Flow Diagram
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As discussed in the main body of this technical note, gross domestic product (GDP) has only one definition,
but there are three approaches (the output approach, the expenditure approach, and the income approach) that we
can use to calculate its value.
GDP is the market value of all final goods and services produced within a country in a given period of time.
Figure A1 shows how the three approaches to measurement are connected using a circular flow diagram,
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first proposed in the 18th century by Richard Cantillon.
Figure A1. The circular flow diagram.

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Note: The figure and this appendix were created by Felipe Saffie, Assistant Professor of Business Administration, University of Virginia
Darden School of Business.
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Appendix A (continued)
Every transaction involves two elements: (1) a real side (a good or a service), and (2) a monetary side (a
payment). The agent that delivers a good receives money and the agent that receives a good delivers money.
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Thus, apples and money flow in opposite sense in the economy. There are two agents denoted by yellow
rectangles: (1) the firm, and (2) the household. These agents interact in two markets denoted by red ellipses:
(1) the market for goods, and (2) the market for factors. In the market for goods, the firm delivers goods and
receives money from the household; in the market for factors, the household delivers services and receives
money from the firm. Note that the direction of the money flow (denoted by the outer green circle) is opposite
to the direction of the goods flow (denoted by the inner blue circle). This simple diagram, like an electric circuit,
has the same flow at every point, and nothing is lost. This is the main reason why we can measure GDP using
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different approaches.
First, if we start with the goods market, the firm supplies all the apple juice produced at the equilibrium
market price. This coincides with the definition of GDP and the output approach to measuring GDP, since
apples are the only final good in the economy. Second, the household buys all these apples for final consumption
at the equilibrium price. Because this is the only use for the unique final good, aggregate consumption
corresponds to the expenditure approach. Note that, in terms of value, both agents receive exactly the same
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amount; this is the nature of an economic exchange: the value of an apple is one dollar. Third, the household
uses its income to buy these goods. The household collects income in the market for factors, where labor, land,
and knowledge are rewarded with wages, rent, and profits. Because the household spends all its income on the
final good and the firm distributes all its revenue, the total income is exactly enough to buy 100 apples in the
economy. This constitutes the income approach to measuring GDP.
This flow diagram is extremely simple, as it abstracts from the government, exports and imports, and
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savings and investment. It is simple to extend the diagram to include these other actors and markets, but the
main intuition survives: The economy is a closed system and economic activity can be measured at any node
of the circuit.
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Appendix B
Interest Rates in the Model and in the Data
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An interest rate is the rate of return that a borrower pays a lender. There are many interest rates in the
economy, reflecting the variety of loans given to different types of borrowers. For example, homebuyers borrow
in the form of mortgages, the government borrows by issuing government bonds (called Treasury bonds in the
United States), and large firms finance their capital expenditures by issuing corporate debt. The interest rate on
these loans is typically quoted in nominal terms—the amount of money that a borrower must pay in the future
to obtain a unit of money today. These interest rates tend to move up and down together (Figure B1), and
therefore for simplicity we will refer to these interest rates collectively as the nominal interest rate �
. From a
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modeling perspective, referring to a single nominal interest rate is equivalent to assuming that there are two
assets in the economy: monetary assets and nonmonetary assets (e.g., bonds, which yield a nominal interest
rate �).1
The interest rate typically targeted by the central bank is the federal funds rate. This is the interest rate on
short-term loans between banks. Since firms do not typically borrow at the federal funds rate, we will not
include the federal funds rate as part of � . The federal funds rate is nonetheless important, as it responds to
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similar supply-and-demand forces in the money market as other interest rates that are more directly related to
investment.
The real interest rate, �

, is the nominal rate adjusted for expected inflation � �: � � � � . We model
investment as depending on the real, rather than nominal, interest rate (��). This is because firms’ future
revenues from new capital expenditure are expected to increase with future inflation. Therefore, for any given
nominal rate, the profitability of a new investment project is higher (and net real borrowing costs lower) when
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the expected inflation is higher. We could instead write � ⏟�, � � , but for theoretical reasons that are
discussed in Appendix C, we assume specifically that the investment function is ��.
In practice, there has been little difference over the past couple of decades between changes in �and
changes in � , at least in high-income economies, since inflation expectations have remained relatively stable
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(Figure B2). Therefore, when you observe movements in the nominal interest rate, you can usually assume
that these translate into movements in the interest rate that is relevant for investment decisions.
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1 Assuming that there is a single interest rate on a nonmonetary asset has the additional benefit that equilibrium in asset markets is identical to
equilibrium in the money market. This implies that modeling the money market is sufficient for determining the returns on nonmonetary assets (e.g.,
loans) in the economy. For details, see Section 7.4 of Andrew B. Abel, Ben S. Bernanke, and Dean Croushore, Macroeconomics, 9th ed. (Boston: Pearson
Education, 2016).
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Appendix B (continued)
Figure B1. Various interest rate measures, July 1968–May 2022.
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Figure B2. Inflation expectations, January 1978–March 2022.
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Note: Figure shows the median expected price change over the next 12 months from the University of
Michigan Survey of Consumers.
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Appendix C
An Alternative Take on the Relationship between Investment and the Real Interest Rate
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To understand why investment depends on the real (rather than only the nominal) interest rate, it first helps
to distinguish between the two rates. The nominal interest rate �is the amount of currency a borrower must pay
in the future to obtain a unit of currency today. For example, a nominal one-year interest rate of 10% implies
that to borrow $100 today, you will have to pay $10 next year (plus the $100 principal). The real interest rate �is
the bundle of goods that a borrower has to pay in the future to obtain a bundle of goods today. For example,
a real interest rate of 10% implies that to obtain 100 apples today, you will have to pay 10 apples next year (plus
the 100 apples of principal).
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The nominal and real interest rates are equal when the price level remains constant. For example, if the
price of apples remains at $1 per apple, then a nominal interest rate of 10% implies a real interest rate of 10%
(borrowing $100 and paying back $110 is the same as borrowing 100 apples and paying back 110 apples).
However, if the price of apples increases the subsequent year, then the real interest rate will be lower than the
nominal rate. Why is this? Consider borrowing $100 at a nominal interest rate of 10%. If the price of apples
increases by 10% next year (to $1.10/apple), then a payment of $110 (interest plus principal) will allow the
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lender to purchase 100 apples—hence the lender receives a real yield of zero apples. Equivalently, borrowing
100 apples requires the borrower to pay back 100 apples in the following year for a real interest rate of zero.
Therefore, when inflation is 10%, a nominal interest rate of 10% implies a real interest rate of 0%.
Having outlined the differences between the real and nominal interest rates, we now address why
investment depends on the real interest rate. Consider a company that wants to borrow apples today to plant
in the ground to grow apple trees. The firm’s profits depend on how many apples it can sell next year net of its
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interest payments. The nominal interest rate describes how many dollars a firm must pay back in the future,
but ultimately its profits depend on how much it pays on the loan in terms of apples. More concretely, if the
price of apples increases 10% (from $1 to $1.10), a 10% nominal interest rate implies that a firm can borrow
100 apples to plant and pay back $110, which equals 100 apples in the following year. If inflation is only 0%,
then the same nominal interest rate of 10% implies that the firm must pay back 110 apples the following year.
Therefore, for a given nominal interest rate, the firm is better off with a higher inflation rate.
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A Brief Intro To Macro S

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An Illustration of the Approaches to Computing GDP

nominal GDP of $10.

 �(gross private domestic investment): spending by firms on goods and services

http://wdi.worldbank.org/table/4.8 (accessed Jul. 15, 2014).

Why Do Economists Care about GDP?

of aggregate measures such as GDP for understanding social well-being.

What Determines GDP and Its Components?

GDP per capita (2010 US dollars)

United States Japan Spain Mexico

Civilian Unemployment Rate: 16 yr +

Source: Bureau of Labor Statistics/Haver Analytics

Approach 1 to determining GDP: Y is determined by productive capacity

Now we can rewrite the closed-economy national income identity as (Equation 6)

Figure 3. The money market.

Source: Created by author.

What Is the Use of Models and Assumptions?

Figure A1. The circular flow diagram.

The real interest rate, �

discussed in Appendix C, we assume specifically that the investment function is ��.

Figure B1. Various interest rate measures, July 1968–May 2022.

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