MACROECONOMICS BY BLANCHARD
THE SHORT RUN: DEMAND DETERMINES OUTPUT
CHAPTER 2: A TOUR OF THE BOOK
Gross Domestic Product: The measure of aggregate output in the national income accounts.
Defining Gross Domestic Product: 3 methods
1. GDP is the value of the final goods and services produced during a period (production)
By doing it like this. We record and add up the production of all final goods, and this is indeed
roughly the way actual GDP numbers are put together.
2. GDP is the sum of value added in the economy during a given period (production side)
In this case we minus the intermediate goods from the revenues to obtain the value added.
3. GDP is the sum of incomes in the economy during a given period (income side)
We can also look at the income side of GDP (i.e. wages and profits). In this case we simply
add up all wages plus all profits for the firms to gain our value added and in turn the GDP.
Nominal GDP: The sum of quantities of the final goods produced times their current price.
It becomes apparent that for this definition, GDP increases over times for two reasons.
★ Production of most goods increases over time.
★ The price of most goods also increases over time.
However, it is our goal to measure production and its change over time, therefore, we need to
eliminate the effect of increasing prices on our measure of GDP. That why we use Real GDP.
Real GDP: Constructed as the sum of quantities of final goods times constant/common price.
The problem when constructing real GDP in practice is that there is obviously more than
one final good. Real GDP must be defined as a weighted average of the output of all final
goods, and this brings us to what the weights should be.
o We could opt for the relative prices of the goods, being natural rights. However, these
relative prices change over time which raises the question what we should do in that
case. We could choose to use relative prices in a particular year or we can change the
weights over time. In the U.S. they use weights that reflect relative prices and which
change over time, this is called the real GDP in chained dollars.
Nominal GDP = Dollar GDP = GDP in current dollars
Real GDP = GDP in terms of goods = GDP in constant dollars = GDP adjusted for inflation = GDP in
chained dollars = GDP in 2009 (or any year really) dollars.
In assessing the performance of the economy from year to year, economists focus on the rate of
growth of real GDP, also called GDP Growth.
- Expansions: Periods of positive GDP growth.
- Recessions: Periods of negative GDP growth.
,Unemployment: The number of people who do not have a job but are looking for one.
Labour force: Employment + Unemployment
Unemployment rate: The ratio of the number of people who are unemployed to the number of people
in the labour force.
Discouraged workers: When unemployment is high, some of the unemployed give up looking for a
job and therefore are no longer counted as unemployed. These are called discouraged workers.
Because the unemployment rate only counts the people looking for a job, it can be a poor
indicator of unemployment in the labour market.
Participation rate: The ratio of the labour force to the total population of working age.
Typically, a higher unemployment rate is associated with a lower participation rate. This is because
when lots of people are unemployed, people tend to stop searching and are thus not part of the labour
force anymore. Which, in turn, lower the participation rate.
Economists care about unemployment for two reasons…
1. They care about unemployment because of its direct effect on the welfare of the unemployed.
2. They also care about the unemployment rate because it provides a signal that the economy
may not be using some of its resources. However, also very low unemployment can be a
problem as the economy may be overusing its resources and run into labour shortages.
Inflation rate: The inflation rate is the rate at which the price level increases. Macroeconomists
typically look at two measures of the price level, at two price indexes: GDP deflator and the CPI.
→ GDP deflator: The ratio of nominal GDP to real GDP in year t. An advantage of defining the
price level as the GDP deflator is that it implies a simple relation between nominal GDP, real
GDP, and the GDP deflator. If we rewrite the formula, we know that the rate of growth of
nominal GDP is equal to the rate of inflation plus the rate of growth of real GDP (only
for large changes)
Nominal GDPt $ Yt
Pt = =
Real GDPt Yt
The GDP deflator gives the average price of output.
→ The Consumer Price Index: To measure the average price of consumption, or, equivalently,
the cost of living, macroeconomists look at the Consumer Price Index. To compute the index,
prices are collected to gain insights into the consumer costs for a typical consumption basket.
When the price of imported goods increases relative to the goods produced at home, the CPI increases
faster than the GDP deflator.
Pure inflation: Pure inflation is a case wherein all prices and all incomes would rise at the same level
and thus making inflation only a minor inconvenience. Pure inflation hardly exists.
- Not all prices and wages rise proportionately.
, - Inflation leads to other distortions, this variation in relative prices leads to more uncertainty,
making it harder for firms to make decisions about the future.
Okun’s Law: Okun’s Law suggests that if output growth is high, unemployment will decrease.
Furthermore, we see that the horizontal axis at the point where output growth is roughly equal to 3%
which means that it keeps 3% growth to keep unemployment constant. This is true for 2 reasons:
★ Population, i.e. labour force, increases over time, so employment must growth over time just
to keep the unemployment rate constant.
★ Output per worker also increases with time, which implies that output growth is higher than
employment growth.
The Phillipscurve
Phillips plotted the rate of inflation against the unemployment rate. It thus shows the relation between
the change in the rate of inflation and the unemployment rate. It is shown that on average, higher
unemployment leads to a decrease in inflation. In this case, 6% unemployment is the tipping point
from either inflation increase or decrease.
What determines the level of aggregate output in an economy?
Three possible answers
★ Short-run: Movement in output comes from movement in the demand for goods. Therefore,
consumer confidence in this case largely influences the level of aggregate output.
★ Medium-run: Movement in output is determined by the supply side. In turn, the amount
produced depends on how advanced the technology is, the amount of capital used, and the size
and skills of the labour force.
★ Long-run: The true determinants of output are factors like a country’s education system, its
saving rate, and the quality of its government.
Which of the three above is right? They all are!
→ In the short run, the first answer is the right one. Year-to-year movements in output are
primarily driven by movements in demand.
→ In the middle run, say a decade, the second answer is right. The economy tends to return to
the level of output determined by supply factors (capital, technology, labour force) in the
medium run. To add, over a decade, these factors move sufficiently slow that we can take
them as given.
→ In the long run, say a few decades, the third answer is right.
CHAPTER 3: THE GOODS MARKET
3.1 THE COMPOSITION OF GDP
GDP typically consists of five parts, namely: consumption, investment, government spending, net
exports, and inventory investment.
I. Consumption: The goods and services purchased by consumers.
II. (Fixed) Investment: Investments is the sum of non-residential investment, the purchase by
firms of new plants or machines, and residential investment, the purchase by people of new
houses or apartments.
, III. Government spending: Purchases of goods and services by the government. In effect, the
national income accounts treat the government as buying the services provided by their
employees and the providing these services to the public, free of charge.
Note: G does not include government transfers (social security) as these are not purchases of
goods and services.
IV. Exports: The purchase of U.S. goods and services by foreigners.
- Imports: The purchases of foreign goods and services by consumers, firms and
governments.
The difference between exports and imports is called net exports or the trade balance. If export
exceed imports, the country runs a trade surplus and vice versa a trade deficit.
V. Inventory investment: The difference between goods produced and goods sold in a given
year. If production exceeds sales and firms accumulate inventories as a result, then inventory
investment is said to be positive.
Inventory investment: production – sales
3.2 THE DEMAND FOR GOODS
The total demand for goods is given by the following identity. It defines Z as the sum of
consumption, investment, government spending, exports minus imports.
Total demand for goods ( Z ) ≡C + I + G+ X−ℑ
For now, we make a few simplifications for this model.
★ All firms produce the same goods which can be used by consumers, firms, or the
government. We thus, only look at one market.
★ Firms are willing to supply any amount of the good at a given price level, this assumption is
only valid in the short run.
★ The economy is closed, meaning that it does not trade with the rest of the world.
X = IM = 0 → Z ≡ C + I + G
Consumption: Consumption decisions depend on many factors, but the main one surely is disposable
income. This is the income that remains once consumers have received transfers from the government
and paid their taxes.
The C(Yd) function is called the consumption function. Furthermore, this function is a
behavioural function as it reflects some aspect of behaviour (consumer behaviour).
C(Yd) can also be described as C=C 0+ C1 Y D
→ The parameter C1 is called the propensity to consume or marginal propensity consume. C1
gives the effect that an additional dollar of disposable income has on consumption. Herein,
there are two natural restrictions, first, C1 has to be positive, second, it is lower than 1.
→ C0, the subsistence level of income, in this case has a literal interpretation as it shows what
people would consume if their disposable income were equal to zero. A natural restriction is
that C0 is always positive (people need to eat).
Disposable income Y D ≡ Y −T
In this formula, T is taxes paid minus government transfers received by consumers.
