Chapter 1 Macro-Economics -
What is Macro-Economics?
The most important indicator of a nation’s economic well-being is a measure of its output
and income during a given year, which is called the gross domestic product (GDP). These
numbers are related to country size, so we often look at GDP per capita. GDPs can change
for two reasons:
(1) more is produced, and
(2) the prices of those goods change.
Most countries are characterized by a steady GDP growth over time. Still, there are also
significant and recurring fluctuations of GDP around its trend (long run) called business
cycles (short run, temporary output fluctuations around long-run growth).
The consumer price index measures the evolution of the cost of a basket of goods meant to
represent average spending by consumers. Its per cent increase is the rate of inflation.
In normal times, inflation is related to the business cycle. The inflation rate is generally
procyclical: it tends to rise when activity is high and declines in periods of slack. In contrast,
the unemployment rate is countercyclical: it moves against the cyclical behaviour of output,
falling when output grows rapidly and rising when output grows more slowly or falls.
The real economy refers to all real or non-financial elements of an economy. The real
economy is contrasted with the financial or monetary economy: this concerns the
production and consumption of goods and services and the incomes associated with
productive activities.
The variables to be explained using economic principles are called endogenous variables.
The other variables—those we do not try to explain—are called exogenous variables.
, Chapter 2 Macro-Economics -
Macroeconomic Accounts
GDP is a flow variable (measured per unit of time). Flow variables differ from stock
variables, which are always defined with reference to a particular point in time, such as the
quantity of water held back by a dam.
There are three ways to measure GDP:
1. GDP = the sum of final sales within a geographic location during a period of time.
Goods and services sold to the consumer or firm that will ultimately use them are final sales.
For example, the purchase of a loaf of bread is a final sale. In contrast, a loaf of bread
purchased by a grocery store which is later sold to a household is not a final but an
intermediate sale.
2. GDP = the sum of value added occurring within a given geographic location during a
period of time.
A firm creates value added by transforming purchased input goods and raw materials into
products it can sell in the marketplace.
3. GDP = the sum of incomes earned from economic activities within a geographic location
during a period of time.
GDP also measures all incomes earned within a country’s borders—by residents and
non-residents alike. Because one person’s final spending must be someone else’s income.
Suppose an economy produces only two goods (apples and oranges) and requires no
imports. The nominal GDP, or GDP at current prices:
𝑎 𝑎 𝑜 𝑜
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = 𝑃 𝑄 + 𝑃 𝑄
However, if the price of oranges increases from one year to the next, nominal GDP rises even
while the volume of final sales has not changed at all. Increases in real GDP correspond to
increases in physical output, the number of apples and oranges produced and sold.
𝑎 𝑎 𝑏 𝑏
𝑟𝑒𝑎𝑙 𝐺𝐷𝑃𝑡 = 𝑃0𝑄𝑡 + 𝑃0𝑄𝑡
The distinction between nominal and real GDP can be used as a measure of the general
price level. The GDP deflator, one way of measuring the price level, is the ratio of nominal
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
to real GDP: 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = 𝑃𝑡 = 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
The inflation rate can be measured by the rate of increase in the GDP deflator:
𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑔𝑟𝑜𝑤𝑡ℎ − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑔𝑟𝑜𝑤𝑡ℎ
For example, in 2015 the nominal GDP of the euro area rose by 2.8% while the real GDP
increased only by 1.6%. On average, therefore, prices rose by roughly 1.2%.
,Unreported income and output are frequently referred to as the underground economy. A
large number of transactions are not recorded. They belong to the informal economy.
The difference between taxes and transfers is called net taxes and is represented by T. What
is left of GDP after these taxes and transfers are subtracted is called private income, Y− T.
- Consumption spending (C)
- Investment spending (I)
- Government purchases (G)
- Exports (X)
- Imports (Z)
- Net taxes (T)
- Saved (S)
- Spent (consumption) (C)
The private sector invests in productive equipment (I), which it finances in part by savings
(S); the balance S−I is the private sector’s net saving behaviour. Similarly, the public sector’s
net saving behaviour is reflected in its budget surplus T−G.
, Total domestic spending (GDP) (Y), called absorption, is the sum (C + I + G) of private and
public spending on all goods and services. Part of absorption includes the purchase of
imported goods and services (Z). When the net exports (X− Z) are positive, net exports
increase demand for domestic production above that originating with domestic residents;
when negative, demand for domestic production is less than total domestic demand.
The GDP is broken down into four main categories: (1) final sales of consumption of goods
and services (C), (2) final sales of investment goods and changes in inventory stocks (I), (3)
final sales to the government (G), and (4) sales to the rest of the world (X). Since part of
domestic income leaks abroad to pay for imported goods, imports (Z) must be subtracted:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑍 or 𝑌 = 𝐶 + 𝑆 + 𝑇
These equalities show that:
(𝑆 − 𝐼) + (𝑇 − 𝐺) = (𝑋 − 𝑍)
If S > I, the private sector in the aggregate is a net saver. If S < I, the private sector is a net
borrower. Similarly if T > G, the government is saving, and if G > T it is borrowing.
An alternative to GDP is to define the economic activity
of a country by its residents, both people and the firms
they own, wherever they produce or earn income. This
is called gross national income (GNI). The GNI is
obtained by adding to GDP those incomes earned
abroad by resident entities and subtracting incomes
generated by non-resident entities within the country.
In the process of producing output, productive equipment is subjected to wear. Properly
measured, this depreciation should be subtracted to give a clearer picture of the output that
is really available as income. Subtracting depreciation from GDP gives us the net domestic
product (NDP), GNI becomes NNI.
The balance of payments accounts record all economic transactions between a country
and the rest of the world. Imports are entered with a minus sign (called debits), while
exports contribute positively to the balance (called credits). The net result is line IA, the
balance of goods and services. A second account to consider is the balance of
international income (line IB). This account summarizes the net income of a nation
which originates from abroad. Primary income consists of non-resident employee
incomes and interest earned abroad. Secondary income includes remittances of
employees who reside in a foreign country and send money home. For example, when
a Polish plumber living in London sends money to relatives living in Warsaw, this counts
as a credit to the Polish secondary income account and as a debit to the UK. The sum of
the balances of trade in goods, services, and international income is called the current
account balance (X-Z). The financial account is a country’s net lending/borrowing.
