What is macroeconomics?

What is macroeconomics?
• Studies interaction between main aggregate economic
variables:
1. Output
2. Employment
3. Inflation
• Studies impact of main government policies:
1. Fiscal policy
2. Monetary policy
• Simplifies and summarizes these interactions with
models of the economy
Macro/ch2
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Difference with microeconomics
• Micro studies supply and demand relations
in a specific market, production at the level
of the firm, consumption at the level of the
consumer etc…
• Micro make use of relative prices and not
price levels
• Micro is based on premises which are
generally accepted while macro evolves
overtime and its premises depend on schools
of thought (e.g. Keynesian versus classical
assumptions)
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The 3 main measures of macro performance
• Aggregate output
measures total production in the economy
– Total Gross Domestic Product - GDP
– GDP per capita (GDP/number of inhabitants)
– Rate of growth of GDP or (GDP1 -GDP0)/GDP0
• Unemployment rate
measures proportion of people without jobs
• Inflation rate
measures the overall increase in prices
Macro/ch2
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Aggregate output: GDP
• GDP is the value of the final goods and
services produced in the economy during
a given period
• GDP is the sum of the value added in the
economy during a given period
• GDP is the sum of income earned in the
economy during a given period
GDP is a flow (not a stock)
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Calculating GDP
Example:
• Mine extracts iron ore.
• Steel mill buys - $10 worth - of iron ore that it
used to produce steel. It then sell the steel for
$25 to a cutlery factory.
• Cutlery manufacturer transforms the steel - $25
worth - into a cutlery set sold directly to the
consumer (at a factory store) for $35.
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5
Value of final goods: to avoid double
counting
Value of final good = $35
Including the value of the iron ore or of
the steel produced would be double
counting.
Why? Because the iron ore is included
in the value of the steel and the steel is
included in the value of the cutlery set
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6
Value added approach
Definition: Value added = value of sale
minus value of purchased inputs (the
intermediate goods used in production)
• Mine: (no purchased input) VA = $10
• Steel mill:
VA = $25 - $10 = $15
• Cutlery factory: VA = $35 - $25 = $10
• Total value added
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= $35
7
Income approach
Another interpretation of the value added:
The value added is equal to all the production costs
incurred by the firm - other than the purchase of
material.
so what is left?
the payments to owners of the factors of production.
to the owners of land
to the owners of capital
to the workers
and to the proprietors/entrepreneurs
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i.e.
i.e.
i.e.
i.e.
the rent
the interest
their wages
their profit
8
The value added corresponds to the income
of these 4 groups (if a tax is paid to the
government, it should also be taken into
account).
Let’s now set up a table showing the rent, the
interest, the wages and the profit in each of
the 3 firms and illustrating how the sum of
these costs in equals the value added by
each firm.
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Income approach
Mine
Steel mill Cutlery
factory
$3
$1
Total
Rent
$1
Interest
$2
$8
$2
$12
Wages
$5
$3
$4
$12
Profit
$2
$1
$3
$6
VA
$10
$15
$10
$35
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$5
10
Nominal and real GDP
• Some data on nominal GDP
Nominal
GDP in $ billion
Growth
of nominal GDP
since 1960
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1960
1994
2000
526
6,736
9,872
x13
x16
11
Nominal GDP is GDP measured in $ in the specific year
quoted.
Do these huge increases represent real growth (or growth
in the quantity of goods produced)?
Remember that GDP is calculated as the sum of the value
of the various goods.
Value = quantity * price
so these large rates of growth include
as well as
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growth in quantity ( or real growth )
growth in price ( or inflation )
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Nominal GDP
• Definition: sum of value of goods and services
produced during the year at current prices
• Nominal GDP increases overtime because
1. quantity of goods and services produced increases
2. their price also increases (inflation)
• The 2nd cause does not correspond to real
growth but to a change in the measuring
yardstick, the dollar (the $ looses its value - it
depreciates - it shrinks ).
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13
The $ looses its value - it
depreciates - it shrinks
GDP in 2000
1950 $
2000 $
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GDP = 5
GDP = 10
14
How to calculate real GDP?
• Nominal GDP is calculated every year.
• But these yearly data do not allow us to judge
by how much the economy has actually grown,
in terms of quantity of goods and services
produced.
• So we need to calculate real GDP to appraise
the real growth of the economy over the years.
• Unfortunately there are more than one way to
do it!
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• How do we neutralize the effect of the changes
in price in order to only retain the effect of the
changes in quantity?
• The solution is to measure GDP in 2 different
years with the same set of prices. Then the
difference in the two measures of GDP will only
include the change in quantity.
• Which set of prices should we use?
• Depending of the set of prices chosen we will get
slightly different results.
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Calculation of real GDP: the index problem
• As price increases are not homogeneous*,
the conversion from nominal to real GDP
will yield different results according to the
base year used
– First year - Laspeyres Index
– Last year - Paasche Index
• This problem can be circumvented by using
a chained index
* i.e. not the same for every good
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Nominal GDP Growth
P0
Books
TV
Nominal
GDP
Q0
P0Q0
P1
Q1
P1Q1
$1
1000 $1000
$1.1
1050 $1155
$500
10 $5000
$600
11 $6600
$6000
$7755
Rate of growth of nominal GDP: 7755  6000 *100  29.25%
6000
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Real growth versus inflation
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Real growth
%∆Q
Inflation
%∆P
BOOKS
5%
10%
TV
10%
20%
For the
economy
?
?
19
Base: earlier year - Laspeyres
P0
Books
TV
Real
GDP
Q0
P0Q0
Q1
P0Q1
$1
1000 $1000
$1
1050 $1050
$500
10 $5000
$500
11 $5500
$6000
Rate of growth of real GDP:
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P0
$6550
6550  6000
*100  9.17%
6000
20
Base: latter year - Paasche
P1
Q0
Books
$1.1
TV
$600
Real
GDP
P1Q0
P1
Q1
1000 $1100
$1.1
1050 $1155
10 $6000
$600
11 $6600
$7100
Rate of growth of real GDP:
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P1Q1
$7755
7755  7100
*100  9.23%
7100
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Chained index*: average price
Paver
Q0
Books
$1.05
1000
TV
$550
10
Real
GDP
PaverQ0
Paver
Q1
$1050
$1.05
1050 $1102.5
$5500
$550
$6550
Rate of growth of real GDP:
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11
PaverQ1
$6050
$7152.5
7152.2  6550
*100  9.20%
6550
*Approximation for actual method
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Terminology
• Nominal GDP or $Y
– $GDP
– GDP in current dollars
• Real GDP or Y
–
–
–
–
GDP in terms of goods
GDP in constant dollars
GDP adjusted for inflation
GDP in 1995 dollar (if base=1995)
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Unemployment rate u
• L=N+U
– L is labor force
– N is number of employed
– U is number of unemployed
• u = U/L
– u is rate of unemployment
• Data gathered by Bureau of Labor Statistics (BLS)
• Current Population Survey
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Additional employment statistics
• A = L + NL
– A is adult population
– NL is not in the labor force
• Discouraged workers (not looking for job anymore)
• Retirees, home makers etc.
• Participation rate = L/A
• When u is high, people stop looking for jobs
and # of discouraged workers (in NL)
increases, hence the participation rate drops
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Labor statistics problem
In a given month in the US,
100 million people are working: N = 100
10 million are not working but are looking for work: U = 10
and 20 million are not working and have given up looking for work: DW = 20.
Calculate the labor force: L = N + U = 100 + 10 = 110
Calculate the official unemployment rate: u = U/L = 10/110 = 9.1%
If an additional 40 million adults are not working for various other reasons beside
being discouraged (retired, homemaker etc.)
Calculate the adult population: A = L + DW + 40 = 170
Calculate the participation rate: PR = L/A = 110/170 = 65%
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Unemployment & output: Okun’s law
∆ in u
2
*
1
0
%∆ in GDP = 3% - 2* ∆ in u
*
* *
-2
-1
-2
-1
0 *
1
*
2
*
*
*
3
GDP growth
*
This is a purely empirical relation showing that high increases in
unemployment correspond to low output growth
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The inflation rate
• Definition: rate at which the price level
increases
• Measured
– By GDP deflator = nominal GDP / real GDP
– By CPI or Consumer Price Index
GDP deflator can be calculated by methods
similar to those developed for the
calculation of real GDP
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Calculation of GDP deflator
Using data from previous example
Year 0 (as base)
Year 1
Nominal
$6000
$7755
Real
$6000
$6550
GDP Deflator
1
1.18
That is: the rate of inflation is 18%
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CPI or Consumer Price Index
• Based on cost in $ of a fixed basket of goods and
services consumed by an average urban
consumer
• Monthly indicator existing since 1917 (BLS)
• Data gathered in 85 cities and 22,000 retail stores
• Revised every 10 years as consumption changes
Value of basket at current prices
CPI =
*100
Value of basket at base prices
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Difference between GDP deflator and CPI
• Deflator based on all the goods and services
produced in the economy so it includes
government, investment and exports.
• CPI is based on a fixed subset of consumption
goods and services so it includes imports.
• The set of goods and services on which the
deflator is based changes from year to year
while the set included in the CPI is adjusted
every 10 years.
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Inflation and unemployment:
the Phillips curve
∆ in π
4
3
2
1
0
-1
-2
-3
-4
4
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It shows a negative relation
*
*
*
*
*
*
*
*
*
*
6
8
10
u
32