MACRO ECONOMICS
TABLE OF CONTENTS
Part 1 Introduction ........................................................................................................................................... 2
1. WHAT IS (MACRO) ECONOMICS?........................................................................................... 2
2. THINKING LIKE A (MACRO) ECONOMIST ................................................................................ 3
Part 2 The Data of Macroeconomics................................................................................................................. 4
4. MEASURING A NATION’S WELL-BEING AND THE PRICE LEVEL ................................................. 4
Part 3 The Real Economy in the Long Run....................................................................................................... 12
5. PRODUCTION AND GROWTH .............................................................................................. 12
6. UNEMPLOYMENT AND THE LABOR MARKET ........................................................................ 18
Part 4 Interest rates, money and prices in the long run .................................................................................. 24
7. SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM ........................................................... 24
8. THE MONETARY SYSTEM..................................................................................................... 26
9. OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS ..................................................... 39
Part 5 The short-run economic fluctuations .................................................................................................... 46
10. BUSINESS CYCLES .............................................................................................................. 46
11. KEYNESIAN ECONOMICS AND IS-LM ANALYSIS................................................................... 49
12. AGGREGATE DEMAND AND AGGREGATE SUPPLY............................................................... 63
13. THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND .................. 72
14. THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT......................... 77
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,PART 1 INTRODUCTION
1. WHAT IS (MACRO) ECONOMICS?
1.1. MICROECONOMICS AND MACROECONOMICS
Microeconomics →focuses on the individual parts of the economy
→How households and firms make decisions and how they interact in specific
markets
Macroeconomics →looks at the economy as a whole
→Economy-wide phenomena, including inflation, unemployment, and economic
growth
1.2. THREE PRINCIPLES OF MACROECONOMICS
1. The standard of living depends on a country’s ability to produce goods and services
2. Prices rise when the government prints too much money
3. Society faces a short-run trade-off between inflation and unemployment
Principle 1: An Economy’s Standard of Living is Related to its Ability to Produce Goods and Services
Standard of living : A measure of welfare based on the amount of goods and services a person’s
income can buy.
→Almost all variations in living standards are explained by differences in countries’
productivities.
Productivity : is the amount of goods and services produced from each hour of a worker’s time.
Principles 2: Prices Rise When the Government Prints Too Much Money
Inflation : is an increase in the overall level of prices in the economy
→One cause of inflation is the growth in the quantity of money
→When the government creates large quantities of money, the value of money falls
Principles 3: Society Faces a Short-run trade-off Between Inflation and Unemployment
Philipps Curve : illustrates the trade-off between inflation and unemployment
→Inflation increases ➔ unemployment decreases
→It’s a short-run trade-off!
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,2. THINKING LIKE A (MACRO) ECONOMIST
2.1. MACROECONOMIC MODELS
Economists use models to simplify reality in order to improve our understanding of the world.
→A model will contain variables
o Endogenous variables : values are determined within the model
o Exogenous variables : values are determined outside the model
Ceteris paribus = meaning ‘other things equal’
→is used to note when other factors that might affect outcomes are assumed to be constant.
2.2. THE ROLE OF ASSUMPTIONS
Sometimes it is useful simplifying the real world
o Example: to understand international trade, it may be helpful to start out assuming that there are only two countries in the
world producing only two goods
o Economists need to think about which assumptions are most helpful to make
o Once we understand the model, we can begin to relax some assumptions
The art in scientific thinking is deciding which assumptions to make
o Economists use different assumptions to answer different questions
2.3. THE (MACRO)ECONOMIST AS POLICY ADVISOR
Scientists versus policy advisors
o When economists are trying to explain the world, they are scientists
o When economists are trying to change the world, they are policy advisors
Positive statements are statements that attempt to describe the world as it is
o E.g. higher federal budget deficits will cause interest rates to increase
Normative statements are statements about how the world should be
o E.g. The income gains from a higher minimum wage are worth more than any slight reductions in employment
2.4. WHY MACRO-ECONOMIST DISAGREE
o They may disagree about the validity of alternative positive theories about how the world works
o They may have different values and, therefore, different normative views about what policy should try
to accomplish
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,PART 2 THE DATA OF MACROECONOMICS
4. MEASURING A NATION’S WELL-BEING AND THE PRICE LEVEL
4.1. THE ECONOMY’S INCOME AND EXPENDITURE
• When judging whether the economy is doing well or poorly, it is natural to look at the total income
that everyone in the economy is earning
• For an economy as a whole, income must equal expenditure because:
o Every transaction has a buyer and a seller
o Every dollar of spending by some buyer is a dollar of income for some seller
The Circular Flow (simplified) The Circular Flow (extended)
4.2. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT
Gross domestic product = GDP
= is a measure of the income and expenditures of an economy
= The market value of all final goods and services produced within a country in a
given period of time
- “GDP is the Market Value . . .” → Output is valued at market prices.
- “. . . Of All . . .” → Not fully correct: excludes informal production, household production
- “. . . Final . . .” → It records only the value of final goods, not intermediate goods (the value is counted only
once).
- “. . . Goods and Services . . . “ → It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, house
cleaning, doctor visits).
- “. . . Produced . . .” → It includes goods and services produced in the period we’re considering, not transactions
involving goods produced in the past.
- “ . . . Within a Country . . .” → It measures the value of production within the geographic confines of a country.
- “. . . In a Given Period of Time.” → It measures the value of production that takes place within specific interval of time, usually
a year or a quarter (three months).
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,4.3. THE COMPONENTS OF GDP
GDP (Y) is the sum of the following:
- Consumption (C)
- Investment (I)
- Government purchases (G)
- Net exports (NX)
Y = C + I + G + NX
• Consumption (C):
o The spending by households on goods and services, with the exception of purchases of new
housing
• Investment (I):
o Spending on goods that will be used in the future to produce other goods and services
= capital equipment + inventories + structures (including new housing)
• Government Purchases (G):
o The spending on goods and services by local and central governments
o Does not include transfer payments because they are not made in exchange for currently
produced goods or services
• Net Exports (NX):
o = export – import
o Import is already included in C, I and G
4.4. OTHER MEASURES OF INCOME
Gross National Product = GNP
= the total market value of all final goods and services produced by the residents of a
country in a given period of time
Net National Product = NNP
=GNP minus depreciations
4.5. REAL GDP VERSUS NOMINAL GDP
• Nominal GDP : values the production of goods and services at current prices
• Real GDP : value the production of goods and services at constant prices
• An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator
(We look more at real GDP than at nominal GDP)
4.5. THE GDP DEFLATOR
• The GDP deflator is a measure of the price level calculated as follows:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator = x 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
→It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the
quantities produced
• Nominal GDP = real GDP * GDP deflator / 100
• Alternative indicator : CPI (chapter 5)
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,4.6. LIMITATIONS OF GDP AS A MEASURE OF WELL -BEING
• Most economists consider GDP to be the most appropriate measure of the economic well-being of a
society
• GDP per person tells us the mean income and expenditure of the people in the economy
• Higher GDP per person indicates a higher standard of living
• GDP is not a perfect measure of the happiness or quality of life, however
4.7. GDP AND ECONOMIC WELL-BEING
Some things that contribute to well-being are not included in GDP
• The value of leisure
• The value of a clean environment
• The value of almost all activity that takes place outside of markets, such as the value of the time
parents spend with their children and the value of volunteer work
! GDP has nothing to say about the distribution of income
4.8. MEASURING THE COST OF LIVING
Inflation = the term used to describe a situation in which the economy’s overall price
level is rising
The inflation rate = the percentage change in the price level from the previous period
4.9. THE CONSUMER PRICE INDEX
Consumer price index = CPI
= a measure of the overall cost of the goods and services bought by a typical
consumer
→Statistical offices report 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 money to maintain the
same standard of living
4.10. HOW THE CONSUMER PRICE INDEX IS CALCULATED
1. Fix the Basket:
o Determine what prices are most important to the typical consumer
(which goods and services, for which quantities you want to measure the overall prices?)
o On the basis of consumer surveys
2. Find the Prices:
o Find the prices of each of the goods and services in the basket for each point in time
3. Compute the Basket’s Cost:
o Use the data on prices to calculate the cost of the basket of goods and services at different
times
4. Choose a Base Year and Compute the Index:
o Designate one year as the base year, making it the benchmark against which other years are
compared
o CPI year x = (Price basket in x / Price basket in base year) * 100
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, 5. Compute the inflation rate:
o The inflation rate is the percentage change in the price index from the preceding period
𝐶𝑃𝐼 𝑖𝑛 𝑌𝑒𝑎𝑟 2−𝐶𝑃𝐼 𝑖𝑛 𝑌𝑒𝑎𝑟 1
o Inflation Rate in Year 2 = x 100
𝐶𝑃𝐼 𝑖𝑛 𝑌𝑒𝑎𝑟 1
4.11. PROBLEMS IN MEASURING THE COST IN LIVING
• Substitution Bias
o The basket does not change to reflect consumer reaction to changes in relative prices
▪ Substitution toward relatively less expensive goods
▪ The index overstates the increase in cost of living
• Introducing of New Goods
o The basket does not reflect change in purchasing power brought on by introduction of new
products
o New products result in greater variety, which in turn makes each euro more valuable
o Need less money to maintain standard of living
• Unmeasured Quality Changes
o If the quality of a good rises (falls) from one year to the next, the value of a euro rises (falls),
even if the price of the good stays the same
o Statistical offices try to adjust prices for constant quality, but such differences are hard to
measure
• Implication:
o CPI overstates true cost of living
o Important because many government programs use the CPI to adjust for changes in overall
price level
• Relevance of the CPI
o Only indicates cost of living for average consumer
4.12. THE GDP DEFLATOR VERSUS THE CONSUMER PRICE INDEX
• The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator = x 100
Real GDP
• Economists and policymakers monitor both the GDP deflator and the CPI index to gauge how quickly
price are rising
• There are two important differences between the indexes that can cause them to diverge:
1. Goods and services produced domestically versus goods and services bought by consumers
2. Price of a fixed basket of goods and services over the years (CPI) versus price of produced goods
and services in the respective years (Deflator)
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,4.13. CORRECTING ECONOMIC VARIABLES OF THE EFFECTS OF INFLATION
Price indexes are used to correct for the effects of inflation when comparing money figures from different
times
• Example: comparison MPs’ salary in Britain:
𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 2015
• Salary2015 = Salary1947 *
𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 1947
1018.6
= 1000 * = 35,230
28.9
• Salary of MP’s in 2015: £74,000
Indexation : When some money amount is automatically corrected for inflation by law or contract
4.14. REAL AND NOMINAL INTEREST RATES
Interest →represents a payment in the future for a transfer of money in the past
Nominal interest rate = the interest rate usually reported and not corrected for inflation
Real interest rate = the nominal interest rate that is corrected for the effects of inflation
= Nominal interest rate – inflation rate
• Example: Deposit of €1,000 for one year, nominal interest rate = 15% and inflation rate = 10%
• Real interest rate = 15% - 10% = 5%
4.15. STATEMENTS
→Are the following statements true or false?
Statement 1: Suppose that an IT company that is owned entirely by US residents opens a new data center in
Belgium. Services produced within this center will contribute more to Belgian GDP than to Belgian GNP.
True but value created in profit income will be added to US GNP.
Statement 2: The value of the consumption component (C) of the GDP of the Eurozone increases when an
Italian resident buys a Korean Smartphone.
True, consumption goes up and net exports goes down. Change in GDP is zero.
Statement 3: The GDP deflator is less prone to substitution bias than the CPI.
True, CPI has a fixed basket. GDP not, it changes.
Statement 4: When the CPI increases from 110 in year t to 121 in year t+1, the CPI inflation rate of year t for
sure equals 10%.
False, we need to know the CPI inflation rate for t-1 to calculate this, we don’t know the base year so we can’t
know for sure.
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,4.16. CLASS EXERCISES
1.What components of GDP (if any) would each of the following transactions affect? Explain.
a. A family buys a new refrigerator – consumption (spending by households)
b. Aunt Jane buys a new house – investment
c. Aston Martin sells a DB7 from its inventory – (UK perspective) consumption up & investment
down, GDP unaffected because no production.
Changes in inventory is included in Investments
d. You buy a pizza – consumption
e. The government builds a new motorway – government spending. Investment category only refers
to private investments. Motorways are a public investment.
f. You buy a bottle of Californian wine – (perspective of EU) consumption goes up & net imports goes
up so net exports goes down, GDP unaffected
g. Honda expands its factory in Derby, England – (perspective of UK) investment
3.Below are some data from the land of milk and honey
Year Price of milk (€) Quantity of milk Price of honey (€) Quantity of honey
(liters) (jars)
2019 1 100 2 50
2020 1 200 2 100
2021 2 200 4 100
a. Compute nominal GDP, real GDP and the GDP deflator for each year, using 2019 as the base
year.
b. Compute the percentage change in nominal GDP, real GDP and the GDP deflator in 2020 and
2021 from the preceding year. For each year, identify the variable that does not change. Explain
in words why your answer makes sense. Real GDP
Nominal GDP Real GDP GDP deflator % change % change % change
nominal real deflator
2019 200 200 100 -
-
2020 400 400 100 100% 100% 0%
2021 800 400 200 100% 0% 100%
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, c. Did economic well-being rise more in 2020 or 2021? Explain
In 2020 because quantity increased whilst prices remained the same → real GDP increased
7.Suppose that people consume only three goods, as shown in this table:
Tennis balls Tennis racquets Cola
2019 price (€) 2 40 1
2019 quantity 100 10 200
2020 price (€) 2 60 2
2020 quantity 100 10 200
a. What is the percentage change in the price of each of the three goods? What is the percentage
change in the overall price level?
- 0% for tennis balls, 50% for racquets and 100% for cola
- Overall change:
Cost basket CPI Inflation
€800 100 (=800/800)x100 -
2019
2020 €1200 150 (=1200/800)x100 50%
b. Have tennis racquets become more or less expensive relative to cola? Does the well-being of some
people change relative to that of others? Explain
Increase in cola prices leads to more wellbeing, and the other way around for tennis.
Extra: One day Boris the barber collects €400 for haircuts. Over this day, his equipment depreciates in value
by €50. Of the remaining €350, Boris sends €30 to the government in sales taxes, takes home €220 in wages,
and retains €100 in his business to add new equipment in the future. From the €220 that Boris takes home,
he pays €70 in income taxes. Based on this information, compute Boris’ contribution to GDP and Net
National Product.
GDP: 400
GNP: 400, assuming Boris is located where he practices his business
Net National Product: 350 (400 – 50, GDP minus depreciation amount)
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