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Chapter 1

Macroeconomics I

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1.1. Concepts

Macroeconomics:

General concepts

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Introduction

Definition: Macroeconomics is the branch of economics devoted to the study of the economy as a whole.

Importance: It´s important for:• Consumers:

• Exchange rates• Interest rates• Inflation

• Businesses• Citizens / voters

It´s often in the news

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Some important issues for macroeconomists

Income

Why are there recessions? Can the government do anything to combat recessions? Should it?

¿Why are there so many poor countries? What policies might help them grow out of poverty?

Prices

Why does the cost of living keep rising?

Unemployment

Why are millions of people unemployed, even when the economy is booming?

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Microeconomics vs Macroeconomics

Complements, not substitutes Micro: studies individual agents and markets

(remember def of macro)

Macro Micro

Eco as a whole Agents´ decisions

Specific markets

Imp: total income and its changes

Keep income constant

Imp: expectations Not very important

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Microeconomics vs Macroeconomics

Macro deals with economy-wide events, but these arise from the interactions of individual agents.

This is known as “microeconomic fundaments of macroeconomics”

The integration between the two branches is incomplete

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1.2 Models

Economics as a science of models

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Economic models

Def: economic models are simplified versions of a more complex reality. They show the relationships between the most important economic variables, ignoring irrelevant details.

We use them to explain the economy’s behavior and to devise policies.

The relationships between economic variables are often shown using equations.

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Assumptions and plurality of models

Models are based on assumptions. We often ignore them, but they are the base of our models. If the assumptions are wrong, the model won´t work properly. x

Through assumptions, we manage to represent a simplification of reality (less complex, more manageable) If one model could explain everything, that would be enough. However,

we use different models to deal with different things. For example,

If we want to know how a fall in aggregate income affects new car prices, we can use the S/D model for new cars.

But if we want to know why aggregate income falls, we need a different model.

There is no one “correct” model, only models that are appropriate for different things.

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Assumptions and plurality of models x

For each new model, you should keep track of its assumptions, which of its variables are endogenous and which are exogenous, the questions it answers , the questions it cannot answer, and what are the conclusions, and how do they compare to the real world

3 groups of models, according to their temporal horizon

Long run (classical model): flexible prices

Very long run (growth models): flexible prices, emphasis on growth

Short run: sticky prices

What does “sticky prices” mean?

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Types of variables

Endogenous vs exogenous Endogenous: determined within the model Exogenous: determined outside the model

Examples:

Flow vs stock Flow: a quantity measured per unit of time Stock: a quantity measured at a certain point in time

Examples:

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1.3 Data of macroeconomics

Macroeconomics as a “science of data”

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The “science” of economics

Economists often think of their discipline as the most “scientific” among the social sciences. x

This is partly due to the great emphasis economics puts on gathering and analyzing data, and on its subsequent analysis.We will focus on data to measure:

Production Prices Unemployment

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(1)Production

National income and product accounts are an accounting system used to measure of aggregate economic activity.

The measure of aggregate output in the national income accounts is gross domestic product, or GDP.

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GDP

There are three possible ways to define GDP (GDP= Gross Domestic Product):

1. Definition based on expenditure

2. Definition based on value added

3. Definition based on income

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GDP – 1st definition

1. GDP is the value of the final goods and services produced in the economy during a given period of time.

That is, it´s the total expenditure on final goods and services produced in the economy during a given period of time.

A final good is a good that is intended for final consumption (those that are not intermediate goods).

An intermediate good is a good used in the production of another good (that is, it gets consumed in the process).

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Intermediate or final goods and services Special cases

Capital goods: a produced good (no natural resources) used to produce other g&s but that is not consumed in the process. They are final goods.

Used goods: not included in GDP (they were accounted for in the year they were produced)

Inventories: unsold final goods, final goods in production, inputs held by firms.

“Investment in inventories” (amount by which inventories increase that year) is considered “final goods”.

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Components of aggregate expenditure

Consumption (C) Non durable goods Durable goods Services

Investment (I) Businesses´fixed I Residencial I I in inventories

Government spending (G) It doesn´t include transfer payments (they´re just reallocation of

income) G&S purchased by all levels of government

Net exports (X-M), NX

Note: capital (K) is a factor of production. I is spending on new capital

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GDP – 2nd definition

2. GDP is the sum of value added in the economy during a given period.

Value added equals the value of a firm’s production minus the value of the intermediate goods it uses in production.

By using the concept of value added, we avoid the problem of “double counting”.

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GDP – 3rd definition

3. GDP is the sum of the incomes in the economy during a given period.

That is, it´s total income earned by the factors of production of an economy in a certain period of time.

Example The Composition of GDP by Type of Income,1960 and 2003

1960 2003

Labor income 66% 64%

Capital income 26% 28%

Indirect taxes 8% 8%

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GDP and the circular flow

The expenditure and income definition are equivalent, and this can be seen in the circular flow:

The circular flow is very useful to represent a simple economy, but GDP allows us to aggregate many different goods and services.

How? Through prices Example: add apples and pears.

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GDP is an imperfect measure

It does not include… valuable things, such as leisure, domestic production,

The informal or underground economy, which can be specially problematic if using GDP to compare countries

Deterioration of the environment

It has some difficulties in measuring the value of g&s that are not traded in the market (there are no prices), they go into GDP with an imputed value (example: g&s produced by the government)

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GNP = Gross National Product

GNP: total income earned by national factors of production, independently of where they are located

GDP = rents “at home” of national factors+ rents “at home” of foreign factors

GNP = rents “at home” of national factors+ rents “abroad” of national factors

GNP-GDP= rents “abroad” of national factors – rents “at home” of foreign factors.

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Nominal and real GDP

Nominal GDP is the sum of the quantities of final goods produced times their current price.

Real GDP is the sum of the quantities of final goods produced times constant prices.

We know what happens with the value of g&s when quantities change, but prices don´t.

It´s important to know the base year

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Nominal and real GDP

Nominal GDP is also called dollar GDP or GDP in current dollars.

Real GDP is also called GDP in terms of goods, GDP in constant dollars, GDP adjusted for inflation, or GDP in “base year” dollars.

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Nominal and real GDP

From 1960 to 2003, nominal GDP increased by a factor of 21. Real GDP increased by a factor of 4.

Nominal and Real GDP U.S. GDP Since 1960

What does this imply about prices and quantities?

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Nominal and real GDP

Real GDP per capita is the ratio of real GDP to the population of the country.

GDP growth equals: 1

1)(

t

tt

Y

YY

Periods of positive GDP growth are called expansions. Periods of negative GDP growth are called recessions.

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Other related measures

NDP = net domestic product

NDP = GDP– depreciation

Potential GDP: value of all final g&s produced in the economy in a certain period of time when all the available resources are in use. Its graphical representation is a line with positive slope.

GDP deflator = (nominal GDP/ real GDP) (x100)

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GDP deflator

Example with 3 goods (i = 1, 2, 3)

Pit = the market price of good i in month t

Qit = the quantity of good i produced in month t

NGDPt = Nominal GDP in month t

RGDPt = Real GDP in month t

RPIB

NPIBdeflatorGDP 100_ 1t 1t 2t 2t 3t 3t

t

P Q P Q P QRGDP

100 1t 2t 3t

1t 2t 3tt t t

Q Q QP P P

RGDP RGDP RGDP

100

The GDP deflator is a weighted average of prices, where the weight on each price reflects that good’s relative importance in GDP.

Note that the weights change over time

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(2)Prices

Inflation is a sustained rise in the general level of prices (referred to as “the price level”)

Conversely, deflation is a sustained decline in the price level. It corresponds to a negative inflation rate

The inflation rate is the rate at which the price level increases, calculated as the percentage increase in the overall level of prices

1rateinflation 11

1

t

t

t

tt

P

P

P

PP

We care about inflation because: During periods of inflation, not all prices and wages rise

proportionately, inflation affects income distribution. Inflation leads to other distortions

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Prices

The GDP deflator is sometimes used as a measure of inflation. But other measures exist: Consumer price index (most often used) Producer price index

…

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CPI

CPI = consumer price index It measures the cost of a basket of consumption

goods. It´s widely used to estimate “the cost of living”

Note: it´s not based on all g&s, only on those included in the

basket. And , even then, not all g&s in the basket have the

same importance

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Calculating the CPI

INE calculates the CPI in the following way: Survey consumers to determine the composition of the typical

consumer’s “basket” of goods. Every month, collect data on prices of all items in the basket;

compute cost of basket CPI in any month equals

Cost of basket in that month100

Cost of basket in base period

J

jjTjT

J

jjTjt

QP

QP

1

1100

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CPI

Example with 3 goods (i = 1, 2, 3)Ci = the amount of good i in the CPI’s basketPit = the price of good i in month tEt = the cost of the CPI basket in month tEb = cost of the basket in the base period

t

b

ECPI in month

E 100t

1t 1 2t 2 3t 3

b

P C +P C +P CE

100

31 21t 2t 3t

b b b

CC CP P P

E E E

100

The CPI is a weighted average of prices, where the weight on each price reflects that good’s relative importance in the CPI’s basket.

Note that the weights remain fixed over time.

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Differences between GDP deflator and CPI

In what they take into account: GDP defl. measures the prices of all g&s

produced in the economy, CPI only those purchased by consumers

GDP only includes g&s produced domestically (in the economy)

In how they are constructed: CPI is based on a pre-determined basket, with

chosen and fixed weights, while in the GDP defl. the weights change as the composition of GDP changes.

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Some other problems with CPI

CPI doesn't take into account the fact that consumers can substitute between goods (substitution bias).

CPI doesn't deal well with the introduction of new g&s in the market.

CPI has difficulties taking into account changes in quality.

These are some of the reasons why some argue that CPI may overstate inflation

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CPI

Inflation Rate, Using the CPI and the GDP Deflator since 1960

The inflation rates, computed using either the CPI or the GDP deflator, are largely similar.

CPI and GDP deflator tend to move together, although there are some exceptions.

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(3)Employment

According to their employment status we talk about: Employed pop: working at a paid job. Unemployed pop: not working, but actively looking for

a job. Labor force: employed + unemployed Not in the labor force: not employed, and not looking

for a job (inactive) Also:

Discouraged worker: someone who wants a job, but is no longer looking

Underemployed workers: workers who work part time, but would like to work full time

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Types of unemployment

Seasonal unemployment: when the job is only available part of the year

Frictional unemployment: short-run, occasional unemployment, caused by normal imperfections in labor markets

Structural unemployment: chronic, long-term unemployment Two main causes: low skill levels and displacement of economic activity. Are people who are structurally unemployed out of a job the whole year?

Cyclical unemployment: due to a slow down of the economy

We care about the type and size of unemployment : Because of its direct effects on the welfare of the

unemployed. Because it signals that the economy may not be using some

of its resources efficiently.

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Unemployment

labor force = employment + unemployment

L = N + U

Unemployment rate:

(x100) L

Uu

Natural rate of unemployment (un) is the “healthy” unemployment rate that will always occur in an economy,

Cyclical unemployment = u – un

u

Participation rate =labor force

popu la tion o f w orkin g age

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Unemployment

U.S. Unemployment Rate Since 1960.

Since 1960, the U.S. unemployment rate has fluctuated between 3 and 10%, going down during expansions, and going up during recessions.

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Okun´s law (or Okun´s “rule of thumb”)

There is an intuitive relationship between unemployment and GDP

Employed workers produce g&s, increasing GDP

This relationship was formalized by Arthur Okun in 1962.

It says that a 1% increase in the unemployment rate corresponds to, approximately, a 2-2.5% decrease in output.

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Okun´s law

* Graph taken from Wikipedia.

Some commonly used formulations of Okun´s law:% change in real GDP = 3%- 2 (change in unemployment rate)

Because Okun´s law is based on the observation of actual data, the exact magnitudes depend on the country and time.

)u-(u 5.2Y

YY

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End of chapter 1

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Assumptions…

An economist, a physicist, and a chemist are stuck on a desert island with a can of beans and no can opener.

The physicist suggests a lever made from driftwood and a rock that when jumped upon will exert enough force to crack the can.

The chemist suggests a solution of salt water and minerals to weaken the lid.

The economist suggests they all just assume they have a can opener.

back

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So many different models…

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