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Summary European Economics: Part 2

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Universiteit Van Amsterdam (UvA)

A full summary of the most recent readings, lectures, tutorials including references to authors, graphs, periods, theories, institutions and articles week by week

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macroeconomics
european economics
business cycle
recession
expansion
inflation
deflation
gross domestic product
market basket
consumer price index
unemployment
shoe leather costs
longrun economic gro

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Macroeconomics
Essentials of Economics, Krugman & Wells 3rd Ed.

Chapter 10 Macroeconomics: The Big Picture
Macroeconomics examines the overall behaviour of the economy – how the actions of all the individuals and
firms in the economy interact to produce a particular economy-wide level of economic performance.

Macroeconomics is different from microeconomics in that many thousands or millions of individual actions
compound upon one another to produce an outcome that isn’t simply the sum of those individual actions.
Consider the paradox of thrift: seemingly virtuous behaviour – preparing for hard times by saving more – ends
up harming everyone. Seemingly profligate (= ‘’wasteful’’) behaviour leads to good times for all.

Macroeconomists are concerned with questions about policy, about what the government can do to make
macroeconomic performance better. This policy focus was strongly shaped by history, in particular by the Great
Depression of the 1930s. before the 1930s. economists tended to regard the economy as self-regulating. In a self-
regulating economy, problems such as unemployment are resolved without government intervention, through
the working of the invisible hand. The Great Depression changed all that and created a demand for action. In
1936 the British economist John Keynes published The General Theory OF Employment, Interest and Money.
According to Keynesian economics, economic slumps are caused by inadequate spending, and they can be
mitigated by government intervention through monetary and fiscal policy.

Monetary policy uses changes in the quantity of money to alter interest rates and affect overall spending. Fiscal
policy uses changes in government spending and taxes to affect overall spending.

The Business Cycle

The vertical axis shows either employment
as an indicator of how much the economy is
producing, or real GDP a measure of the
economy’s overall output.

Recessions, or contractions, are periods of
economic downturn when output and
employment are falling.

Expansions, or recoveries, are periods of
economic upturn when output and
employment are rising.

The business cycle is the short-run
alternation between recessions and
expansions. The point at which the economy turns from expansion to recession is a business-cycle peak. The
point at which the economy turns from recession to expansion is a business-cycle trough.

The most important effect of a recession is its effect on the ability of workers to find and hold jobs. The most
widely used indicator of conditions in the labour market is the unemployment rate. Recessions hurt the standard
of living of many families. Recessions are furthermore bad for firms: profits suffer during recessions, with many
small businesses failing, and do well during expansions.

Keynes suggested that monetary and fiscal policy could be used to mitigate the effects of recessions, while
another macroeconomist, Milton Friedman, established a consensus that it’s important to rein in booms as well
as to fight slumps. So modern policy makers try to ‘’smooth out’’ the business cycle.

Long-Run Economic Growth

1

,Long-run economic growth is the sustained upward trend in the economy’s output over time. Long-run
economic growth is fundamental to many of the most pressing economic questions today: responses to key
policy questions depend in part on how fast the economy grows over the next decades. The public’s sense that
the country is making progress depends crucially on success in achieving long-run growth. In particular, long-
run growth per capita – a sustained upward trend in output per person – is the key to higher wages and a rising
standard of living. It is especially crucial for poorer countries.

Inflation and Deflation

A rising overall level of prices is inflation. A falling overall level of prices is deflation. Supply and demand can
only explain why a particular good or service becomes more expensive relative to other goods and services, it
cannot explain why prices of a good have risen over time despite the fact that production of that good has
become more efficient and that the good has become substantially cheaper compared to other goods.

Movements in inflation are closely related to the business cycle. When the economy is depressed and jobs are
hard to find, inflation tends to fall; when the economy is booming, inflation tends to rise. In the long run. The
overall level of prices is mainly determined by changes in the money supply, the total quantity of assets that can
be readily used to make purchases.

Both inflation and deflation can pose problems for the economy: inflation discourages people from holding onto
cash, because it loses value over time if the price level is rising. Deflation can cause the reverse, if the price level
is falling, cash gains value over time and the amounts of goods that can be bought increases, so holding on to it
can become more attractive than investing in other productive assets.

The economy has price stability when the overall level of prices changes slowly or not at all, which is a
desirable goal in the economy.

International imbalances

An open economy is an economy that trades goods and services with other countries. A country runs a trade
deficit when the value of goods and services bought from foreigners is more than the value of goods and services
it sells to them. It runs a trade surplus when the value of goods and services bought from foreigners is less than
the value of the goods and services it sells to them. There is no simple relationship between the success of an
economy and whether it runs trade surpluses or deficits, however. The determinants of the overall balance
between exports and imports lie in decisions about savings and investment spending. Countries with high
investment spending relative to savings run trade deficits; countries with low investment spending relative to
savings run trade surpluses.

Chapter 11 GDP and CPI: Tracking the Macro-Economy

2

,Almost all countries calculate a set of numbers known as the national income and product accounts. The
accuracy of a country’s accounts is a reliable indicator of its state of economic development; the more reliable
the accounts, the more economically advanced the country.

The national income and product accounts, or national accounts, keep track of the flows of money between
different sectors of the economy. Economists use the national accounts to measure the overall market value of
the goods and services the economy produces (GDP).

Gross Domestic Product

Final goods and services are goods and services sold to the final, or end, user. Intermediate goods and
services are goods and services – bought from one firm by another firm – that are inputs for production of final
goods and services. In the case of intermediate goods and services, the purchaser – another firm – is not the final
user. Gross domestic product, or GDP, is the total value of all final goods and services produced in the
economy during a given year.

There are in fact three methods for calculating GDP:

1. Adding up total value of all final goods and services produced

This method adds up the value of all the final goods and services produced in the economy – a calculation that
excludes the value of intermediate goods and services. Why are intermediate goods excluded? Because counting
the full value of each producer’s sales would cause us to count the same items several times and artificially
inflate the calculation of GDP. The way to avoid this double counting is to count only each producer’s value-
added in the calculation of GDP. The value added of a producer is the value of its sales mines the value of its
purchases of intermediate goods and services.

2. Adding up spending on all domestically produced goods and services

This method adds up aggregate spending on domestically produced final goods and services; GDP can be
measured by the flow of funds into firms. This measurement must also be carried out in a way that avoids
double-counting; we omit sales of inputs from one business to another when estimating GDP using spending
data (counting only the value of sales to final buyers).

3. Adding the total factor income earned by households from firms in the economy

This method adds up all the income earned by factors of production from firms in the economy: the wages
earned by labour; the interest paid to those who lend their savings to firms and the government; the rent earned
by those who lease their land or structures to firms; and dividends, the profits paid to the shareholders, the
owners of the firms’ physical capital.

The most important use of GDP is as a measure of the size of the economy, providing us a scale against which to
measure the economic performance of other years or to compare the economic performance of other countries.
However, to measure actual changes in aggregate output, we need a modified version of GDP that is adjusted to
price changes, known as real GDP.

Real GDP: A Measure of Aggregate Output

GDP can grow because the economy grows, but it can also grow because of inflation. Even if an economy’s
output doesn’t change, GDP will go up if the prices of the goods and services the economy produces have
increased. Likewise, GDP can fall either because the economy is producing less or because prices have fallen. In
other to accurately measure the economy’s growth, we need a measure of aggregate output. Aggregate output is
the economy’s total quantity of output of final goods and services. The measure that is used for this purpose is
known as real GDP.

Real GDP is the total value of all final goods and services produced in the economy in a given year, calculated
using the prices of a selected base year. Nominal GDP is the value of all final goods and services produced in
the economy during a given year, calculated using the prices current in the year in which the output is produced.
Chained dollars is the method of calculating changes in real GDP using the average between the growth rate
calculated by using an early base year and the growth rate calculated using a late base year.

3

, GDP is a measure of a country’s aggregate output. A country with a larger population, other things equal, will
have higher GDP simply because there are more people working. So if we want to compare GDP across
countries but want to eliminate the effect of differences in population size, we use the measure GDP per capita.
GDP per capita is GDP divided by the size of the population; it is equivalent to the average GDP per person.

Real GDP per capita is thus a measure of an economy’s average aggregate output per person – and so of what it
can do. It is not a sufficient goal in itself because it doesn’t address how a country uses that output to affect
living standards. A country with a high GDP can afford to be healthy, to be well educated, and in general to have
a good quality of life. But there is not a one-to-one match between GDP and the quality of life.

Just as macroeconomists find it useful to have a single number representing the overall level of output, they also
find it useful to have a single number representing the overall level of prices: the aggregate price level. The
aggregate price level is a measure of the overall level of prices in the economy. We can summarize the prices of
all these goods and services with a price index.

To measure average price changes for consumer goods and services, economists track changes in the cost of a
typical consumer’s consumption bundle – the typical basket of goods and services purchased before the price
changes. A market basket is a hypothetical set of consumer purchases of goods and services. Economists use
the same method to measure changes in the overall price level: they track changes in the cost of buying a given
market basket. In addition, they normalize the measure of the aggregate price level, which means that they set
the cost of the market basket equal to 100 in the chosen base year. Working with a market basket and a base
year, and after performing normalization, we obtain a price index. A price index measures the cost of
purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the
selected base year. A price index can be calculated using the following formula:
Price index in a given year = cost of market basket in a given year / cost of market basket in base year x 100

This method of the price index is used to calculate a variety of price indexes to track average price changes
among a variety of different groups of goods and services, e.g. the consumer price index.

Price indexes are also the basis for measuring inflation. The inflation rate is the percent change per year in a
price index – typically the consumer price index.
Inflation rate = (price index in year 2 – price index in year 1) / price index in year 1 x 100

The consumer price index, or CPI, measures the cost
of the market basket of a typical urban family. It is
calculated by surveying market prices for a market
basket that is constructed to represent the
consumption of a typical family.

There are two other price measures that are also
widely used to track economy-wide changes. One is
the producer price index. The producer price index,
or PPI, measures changes in the prices of goods
purchased by producers. The PPI often responds to
inflationary or deflationary pressures more quickly
than the CPI. As a result, the PPI is often regarded as
an ‘’early warning signal’’ of changes in the inflation rate.

The other widely used price measure if the GDP deflator. The GDP deflator for a given year is 100 times the
ratio of nominal GDP to real GDP in that year. These three price measures usually move closely together.

4

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