STUDY GUIDE
MACROECONOMICS
ERASMUS UNIVERSITY COLLEGE
2020
,PBL 1
Chapter 2; A tour of the book
2.1 Aggregate (total) output
Like any accounting system, the national income accounts first define concepts and then
construct measures corresponding to these concepts.
GDP: Production and income
The measure of aggregate output in the national income accounts is called the gross
domestic product (GDP).
Aggregate output The total amount of output produced in the economy
Gross domestic product A measure of aggregate output in the national income accounts. (The
(GDP) market value of the goods and services produced by labour and property
located in the country.)
Intermediate good A good used in the production of a final good.
There are 3 definitions for GDP
Total domestic production aggregate production
1. GDP is the value of the final goods and services
produced in the economy during a given period.
2. GDP is the sum of value added in the economy during a
given period
Total Domestic income aggregate income
3. GDP is the sum of incomes in the economy during a
given period
Total spending on domestic products
- By HHS, firms, the government and the RoW
Aggregate production and aggregate income are ALWAYS equal.
Final A good which is used directly for consumption or investment (as opposed to
goods intermediate goods which are used in the process of production).
Value The value a firm adds in the production process, equal to the value of its production
added minus the value of the intermediate inputs it uses in production
Nominal and real GDP
Nomin The sum of the quantities of final goods produced in an economy times their current price.
al GDP Also known as GDP in current euros. €Yt = nominal GDP in year t
Real A measure of aggregate output. The sum of quantities produced in an economy times their
GDP price in a base year. Also known as GDP in terms of goods, GDP in constant euros, or GDP
adjusted for inflation. GDP will always refer to real GDP and Yt = real GDP in year t
Nominal GDP increases over time for two reasons
1. The production of most goods increases over time
2. The prices of most goods increases over time
The Real GDP ( in reference year euros) is constructed to eliminate the effect of increasing
prices on our measure of GPD. Problem constructing real GDP more than one final good
thus is the weighted average of the output of all final goods.
GDP: Level versus growth rate
Real GDP per Ratio of real GDP to population average standard of living
person
GDP growth The growth rate of real GDP in year t; equal to (Yt - Yt - 1)/Yt - 1.
Expansion A period of positive GDP growth.
Recession A period of negative GDP growth. Usually refers to min 2 consecutive quarters of
negative GDP growth.
2.2 The unemployment rate
GDP is important as a measure of aggregate activity, but unemployment and inflation is also
important.
Employment The number of people who have a job N
Unemployment The number of people who do (1) not have a job but (2) are looking for one U
Labour force Sum of employment and unemployment; L=N+U
unemployment Ratio of the number of people who are unemployed to the number of people in the
rate labour force u=U/L
Participation Ratio of the labour force to the total population of working age
rate
,Measuring the unemployment rate can be done through counting the people who are
registered at unemployment offices. Moreover, surveys can be held to compute the
unemployment rate through (two surveys)
Labour Force Survey Statistical survey conducted in EU member countries annually designed to capture
(LFS) data about the labour market.
Current Population A large monthly survey of US households used, in particular, to compute the
Survey (CPS) unemployment rate.
There are two categories of people that do not count as unemployed
Not in the labour force The number of people who are neither employed nor looking for
employment.
Discouraged workers A person who has given up looking for employment.
Why do economists care about unemployment?
1. Direct effect on the welfare of the unemployed
financial and psychological suffering and it
becomes widespread through the world.
2. Provides a signal that the economy may not be
using some of its resources, low unemployment rate can also be bad because it can
overuse its resources and run into labour shortages.
Out of labour force discouraged workers, students
2.3 The inflation rate
Inflation A sustained rise in the general level of prices
Price level The general level of prices in an economy
Inflation rate The rate at which the price level increases over time
Deflation Negative inflation
Two measures of the price level/price indexes; (1) the GDP deflator and (2) consumer price
index.
The GDP deflator
GDP deflator The ratio of nominal GDP to real GDP; a measure of the overall price level. Gives the
average price of the final goods produced in the economy. Pt=Nominal GDPt/real GDPt
= €Yt/Yt
Index A number, such as the GDP deflator, that has no natural level and is thus set to equal
number some value (typically 1 or 100) in a given period. (new-old)/old πt
In the year where real GDP is equal to nominal GDP, the index number is 1. Nominal GDP is
equal to the GDP deflator times real GDP. In terms of rates of change, the rate of growth of
nominal GDP is equal to the rate of inflation plus the rate of growth of real GDP.
The consumer price index
The GDP deflator gives the average price of output – the final goods produced in the
economy. But consumers care about the average price of consumption – the goods they
consume. The two prices need not be the same. The set of goods produced in the economy is
not the same as the set of goods purchased by consumers, for two reasons:
1. Some of the goods in GDP are sold not to consumers but to firms (machine tools, for
example), to the government or to foreigners.
2. Some of the goods bought by consumers are not produced domestically but are imported
from abroad.
Cost of living The average price of a consumption bundle (basket of consumer goods
and services).
Consumer price index The cost of a given list of goods and services consumed by a typical urban
(CPI) dweller
CPI is also index number, so it has a base year.
Two notable things about the GDP deflator (price of goods produced) and HICP (price of goods
consumed)
1. They move together most of the time
2. If they do not This means that when the price of imported goods decreases or
increases less relative to the price of goods produced in Europe, the HICP increases less
than the GDP deflator
However, we use them interchangeably thus price level Pt can mean both measures.
Why do economists care about inflation?
, 1. During periods of inflation, not all prices and wage rise proportionally (affecting income
distribution)
2. Inflation leads to other distortions, also more uncertainty (delaying investments)
Reasons why deflation is also bad
1. Distortion and uncertainty (same as inflation)
2. Limits the ability of monetary policy to affect output
Therefore, we need a stable, small increase of inflation.
2.4 Output, unemployment and the inflation rate: Okun’s law and the Phillips curve
Okun’s law
Okun’s The negative relation between GDP growth (horizontal) and the change in the
law unemployment rate (vertical).
Two conclusions:
1. Line is downward sloping, higher output growth leads to a decrease in unemployment
key to decreasing unemployment is a high enough rate of growth.
2. Line crosses horizontal axis at output growth of 1.5% needed to keep unemployment
constant
a. Population, and thus the labour force, increases over time, so employment must grow over time
just to keep the unemployment rate constant
b. Output per worker is also increasing with time, which implies that output growth is higher than
employment growth.
The Philips curve
Whereas Okun’s law implies that GDP growth can decrease the rate of unemployment, Philips
curve says that when unemployment becomes very low, the inflation will increase.
Philips curve The curve that plots the relation between movements in inflation and
unemployment.
Original Philips captured the relation between the inflation rate and the unemployment rate.
curve
Modified Philips captures the negative relation between the change in the inflation rate
curve (vertical) and the unemployment rate (horizontal).
Two conclusions:
1. Line is downward sloping (but smaller fit than Okun’s law). Higher unemployment,
decrease in inflation vice versa. (ONLY true on average)
2. Line crosses horizontal axis at unemployment rate of 8%. below 8%, inflation
increases, economy overheating, operating above its potential.
2.5 The short run, the medium run and the long run
What determines the level of aggregate output in an economy?
1. Movements in output come from movements in the demand for goods correct
answer for short run
2. What matters is the supply side, how much can be produced (depending on technology,
capital and size and skill of its labour force) correct answer for medium run
3. The true determinants of output are factors like a country’s education system, the
saving rate and the quality of the government. correct answer for long run
Short run A period of time extending over a few years at most. year-to-year movements in
output are primarly driven by movements in demand. Prices are fixed
Medium A period of time between the short run and the long run (a decade) the economy
run tends to return to the level of output determined by supply factors (capital stock, level of
technology, size of labour force). Prices are flexible
Long run A period of time extending over decades. (few decades or more) The economy
depends on its ability to innovate and introduce new technologies, and how much people
save, the quality of the county’s education system, the quality of the government etc.
Labour force, capital stock are no longer constant, technology can also change.
Chapter 3
When looking at the short-run, we focus on the interactions among production, income and
demand
1. Changes in the demand for goods
lead to changes in production
2. Changes in production lead to
changes in income
