Chapter 1

 This chapter introduces you to

1. the subject matter of macroeconomics
2. the tools macroeconomists use
3. some important concepts and measures in
macroeconomic analysis

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1.1 Macroeconomics is the study of economic
issues at the aggregate level, that is, aggregate
variables - variables that cover the economy as a
whole. It addresses many topical issues:

• Why does the cost of living keep rising?

• Why are millions of people unemployed, even when the
economy is booming?
• What causes recessions?
• Can the government do anything to combat recessions?
Should it?
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• What is the government budget deficit?
How does it affect the economy?
• Why do countries have such a huge trade deficit?
• Why are so many countries poor? What policies
might help them grow out of poverty?

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40,000 9/11/2001

First oil
30,000 price shock
long-run upward trend…
20,000 Great
Depression Second oil
price shock
10,000

World War II
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 10
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1) Macroeconomics for the long run (aka growth economics)
-Deals with the trends (persistent, long run movement) of main economic
variables such as GDP, consumption, investment, unemployment
-Seeks explanations for long-run income levels, economic growth and

structural unemployment etc

-Helps to design structural (long run) policies, policies which affect basic

structures of and incentives in the economy, (such as the degree of market

competition, propensities to save and invest, to engage in education and
R&D). These policies aim at promoting long-run growth and prosperity, and
improving the long-run (structural) unemployment.

2) Macroeconomics for the short run (aka business cycle economics)

-Deals with annual or quarterly fluctuations around trend in macroeconomic
variables (business cycles)
-Seeks explanations for these fluctuations
-Helps to design short-run policies, such as monetary or fiscal policies of

demand management, to mitigate business cycles.

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1.Trend:-the value which GDP would assume if the economy were always on its
long-term growth path
2.Business cycle:- short term fluctuations in economic activity 10
 1. The macroeconomy affects society’s well-being.
6000
10Social problems like homelessness,
property crime
domestic violence, crime,(right
andscale)
poverty5000

100,000 population
percent of labor force

crimes per
are linked to the economy.
6
4000

4
For example…
unemployment
(left scale) 3000
2

0 2000
1970 1980 1990 2000

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 2. The macroeconomy affects your well-being.
5
In most years, wage growth falls 5

percent change from 12 mos earlier

when unemployment is rising.
4
change from 12 mos earlier

3
3
1
2

1 -1

0
-3
-1
-5
-2

-3 -7
1965 1970 1975 1980 1985 1990 1995 2000 2005
unemployment rate inflation-adjusted mean wage (right scale)

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 3. The macroeconomy affects politics.
Unemployment & inflation in election years
year U rate inflation rate elec. outcome
1976 7.7% 5.8% Carter (D)
1980 7.1% 13.5% Reagan (R)
1984 7.5% 4.3% Reagan (R)
1988 5.5% 4.1% Bush I (R)
1992 7.5% 3.0% Clinton (D)
1996 5.4% 3.3% Clinton (D)
2000 4.0% 3.4% Bush II (R)
2004 5.5% 3.3% Bush II (R)
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 They use economic models and data
 Economic Models
• …are simplified versions of a more complex reality
 irrelevant details are stripped away
• …are used to
 show relationships between variables
 explain the economy’s behavior
 devise policies to improve economic performance

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 The values of endogenous variables
are determined in the model.
 The values of exogenous variables
are determined outside the model:
the model takes their values & behavior
as given.

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 No one model can address all the issues we care
about.
 So we will learn different models for studying
different issues (e.g., unemployment, inflation,
long-run growth).
 For each new model, you should keep track of:
• assumptions
• which variables are endogenous, and which are exogenous
• the questions it can help us understand, and those it
cannot

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1. Long run (Growth) models
Explain how the economy works in the long run
The standard of living and its growth rate over the very
long run.
 Study trends of economic variables
In the long run output determined by factors of production
& technology and unemployment equals its natural rate

Modelling assumptions
Prices are flexible and work to adjust SS and DD
The economic fundamentals (like preferences, technology)
evolve smoothly and predictably overtime (no exogenous
shocks)
No expectational errors

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2. Short run (Business cycle) models
Explains the economy’s short run behavior
Studies economic fluctuations around the normal state
output determined by AD and AS and
unemployment negatively related to output
Modelling assumptions
Exogenous shocks:-sudden supply-side or/and demand-side events
that cause a sudden change in the economy, such as Shifting weather
condition, sudden change in the moods of consumers and investors, change in
the fiscal and monetary policies
Prices are sticky in the short run & demand won’t always
equal supply. For example,
• many labor contracts fix the nominal wage
for a year or longer
• many magazine publishers change prices
only once every 3-4 years
Expectational errors (mismatch b/n actual events and
people’s expectations) 18
a) Static model:- a model in which all the variables
included in the model refer to the same time period
or more generally the model is conceptualized
without time as an entity (time does not play an
essential role
Example: Linear demand function Yt  aPt  bX t   d ,t
b) Dynamic model:- is made up of variables that
refer to different time periods (time plays an
essential role & describe the process of growth)
Yt  aPt  bX t  cYt 1   d ,t

K t  K t 1  K t  I t  K t Capital accumulation model

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 Microeconomics is the study of how individual
households and firms make decisions.
• Households maximize utility
• Firms maximize profit.
 Macroeconomic events and performance arise from
many microeconomic transactions, so
macroeconomics uses many of the tools of
microeconomics.
 Modern macroeconomic theory is typically based on
microfoundations of macroeconomic behavior.
• Sometimes these microfoundations are implicit,
other times they are explicit in the models used.
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1. Gross Domestic Product (GDP):- is a measure of a country’s
aggregate output produced during a given period

1.1 Nominal GDP

GDPmeasured in current prices

GDP=current production*current prices=P t*Qt

1.2 Real GDP

GDP measured in base-year price

GDP=current production*base-year price= P b*Qt
Real GDP=Nominal GDP/GDP price index

Where

2. Per capita GDP=GDP/Population 21

Assume there are two firms in the economy producing
steel (intermediate output) and car (final output)

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a. Expenditure approach
GDP is the value of final goods and services produced in
the economy during a given period.
Sum of all expenditures of economic agents (households,
firms, government, countries) on final goods and services
GDP= C+I+G+NX

C= Personal consumption expenditure=Durable consumer goods +

Nondurable consumer goods + Services
I=Gross private domestic investment=Business fixed assets +
Construction(residential & non residential) + Inventory investment
G=Government spending=Current govt expenditure + Capital govt
expenditure
NX= Export (X) – Import (M)

Example:
Value of final output (cars sold)= $200.
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b. Income approach
GDP is the sum of all incomes in the economy during a given
period.
GDP=Employee compensation + rents + interest + profit( proprietors’ income
& corporate profits) + taxes on production and imports + net foreign factor
income
 Sum of all incomes earned by all economic agents for supplying
factors of production

Example:
 incomes in the steel company: 80$ + 20$ = 100$
incomes in the car company: 70$ + 30$ = 100$
GDP=$80+$20+$70+$30=$200

c. Value-added approach
GDP is the sum of all value added in the economy during a given
period.
steelcompany: value added = 100$
car company: value added = 200$ - 100$ (steel bought) = 100$
GDP=$100+$100=$200 24
a. GDP growth
GDP growth  gY  YtYtY1t 1  YtY1t (Discrete time)
Y ( t ) dY ( t ) / d ( t ) d ln(Y ( t ))
GDP growth  gY  Y (t )  Y (t )  d (t )  ln Yt  ln Yt 1 (Continuous time)
 0, Economic expansion

gY  0, Economic recession (contraction)
 0, Stagnation


b. Per capita GDP growth

Y ( t ) P ( t )
Per capita growth  Y (t )  P (t )  GDP growth  Popn growth

c. Rule of 70
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3. Unemployment rate:-is the percentage of the labour
force unemployed.

Given: Labour force (L), #employed (E), #involuntary

unemployed (U) and working-age population (W)

L=E+U
Unemployment rate=(U/L)*100
Employment rate=(E/L)*100
Participation rate=(L/W)*100

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1. Frictional Unemployment
Workers who are either searching for jobs (mobility) or
waiting to take jobs in the near future.

2. Structural unemployment:- due to the mismatch

worker skills and job requirement

3. Cyclical Unemployment:- is caused by a decline in

total spending and typically begins in the recession
phase of the business cycle.

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 Because frictional and structural unemployment
is largely unavoidable in a dynamic economy, full
employment is something less than 100%
employment of the labor force.

 Economists say that the economy is “fully

employed” when it is experiencing only frictional
and structural unemployment.

 That is, full employment occurs when there is no

cyclical unemployment.

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5. Inflation
Refers to a sustained rise in the general level of prices
(average not individual prices)
Pt  Pt 1
t  Pt 1

Methods of measuring inflation

a) GDP deflator
NominalGDPt
Pt  Re alGDPt

b) Consumer Price Index (CPI)

The CPI reports the price of a “market basket” of consumer
goods and services that presumably are purchased by a typical
urban consumer.

Price of the most recentbasketin the particularyear

CPI t  Price estimateof the same market basketin base year 100
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Based on causes of inflation, there are two types
of inflation: demand-pull inflation and cost-push
inflation.
a) Demand-pull inflation
Caused by an excess of total spending beyond
the economy’s capacity to produce.
Too much spending chasing too few goods

b) Cost-push inflation
The theory of cost-push inflation explains rising
prices in terms of factors that raise per-unit
production costs at each level of spending.

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 Macroeconomics is the study of the economy
as a whole, including
• growth in incomes,
• changes in the overall level of prices,
• the unemployment rate.
 Macroeconomists attempt to explain the
economy and to devise policies to improve its
performance.

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 Economists use different models to examine
different issues.
 Models with flexible prices describe the
economy in the long run; models with sticky
prices describe the economy in the short run.
 Macroeconomic events and performance arise
from many microeconomic transactions, so
macroeconomics uses many of the tools of
microeconomics.
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