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Unit 4
MACROECONOMICS
Measuring a Nation’s Income
Microeconomics is the study of how individual
households and firms make decisions and how
they interact with one another in markets.
Macroeconomics is the study of the economy as
a whole. Its goal is to explain the economic
changes that affect many households, firms,
and markets at once.
Measuring a Nation’s Income
Macroeconomics answers questions like the
following:
 Why is average income high in some countries and
low in others?
 Why do prices rise rapidly in some time periods
while they are more stable in others?
 Why do production and employment expand in
some years and contract in others?
THE ECONOMY’S INCOME AND
EXPENDITURE
• When judging whether the economy is doing
well or poorly, it is natural to look at the total
income that everyone in the economy is
earning.
THE ECONOMY’S INCOME AND
EXPENDITURE
• For an economy as a whole, income must
equal expenditure because:
– Every transaction has a buyer and a seller.
– Every dollar of spending by some buyer is a dollar
of income for some seller.
Figure 1 The Circular-Flow Diagram
Revenue
Goods
and services
sold
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
•Households buy
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
Warm up question…
What’s the difference between
Microeconomics and
Macroeconomics?
THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• Gross domestic product (GDP) is a measure of
the income and expenditures of an economy.
• GDP is the total market value of all final goods
and services produced within a country in a
given period of time.
THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• “GDP is the Market Value . . .”
– Output is valued at market prices.
• “. . . Of All. . .”
– Includes all items produced in the economy and
legally sold in markets
• “. . . Final . . .”
– It records only the value of final goods, not
intermediate goods (the value is counted only once).
• “. . . Goods and Services . . .”
– It includes both tangible goods (food, clothing, cars)
and intangible services (haircuts, housecleaning,
doctor visits).
THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• “. . . Produced . . .”
– It includes goods and services currently produced, not
transactions involving goods produced in the past.
• “ . . . Within a Country . . .”
– It measures the value of production within the
geographic confines of a country.
• “. . . In a Given Period of Time.”
– It measures the value of production that takes place
within a specific interval of time, usually a year or a
quarter (three months).
THE COMPONENTS OF GDP
• GDP includes all items produced in the
economy and sold legally in markets.
• What Is Not Counted in GDP?
– GDP excludes most items that are produced and
consumed at home and that never enter the
marketplace.
– It excludes items produced and sold illicitly, such
as illegal drugs.
THE COMPONENTS OF GDP
GDP (Y) is the sum of the following:




Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)
Y = C + I + G + NX
THE COMPONENTS OF GDP
• Consumption (C):
• The spending by households on goods and
services, with the exception of purchases of new
housing.
• Investment (I):
• The spending on capital equipment, inventories,
and structures, including new housing.
THE COMPONENTS OF GDP
• Government Purchases (G):
– The spending on goods and services by local,
state, and federal governments.
– Does not include transfer payments because they
are not made in exchange for currently produced
goods or services.
• Net Exports (NX):
– Exports minus imports.
GDP Review! Is it counted? Where?
• A painter purchases new paintbrushes for his
business.
• The services of an accountant.
• A purchase of a used automobile.
• A Social Security check paid to a retired worker.
• The sale of a new home.
• An increase in business inventories.
• The government’s purchase of a new fighter plane.
• Unemployment paid to a laid-off worker.
Gross National Product (GNP)
• An economic statistic that includes GDP, plus
any income earned by residents from overseas
investments, minus income earned within the
domestic economy by overseas residents.
REAL VERSUS NOMINAL GDP
• Nominal GDP values the production of goods
and services at current prices.
• Real GDP values the production of goods and
services at constant prices.
Table 2 Real and Nominal GDP
Table 2 Real and Nominal GDP
Table 2 Real and Nominal GDP
REAL VERSUS NOMINAL GDP
• An accurate view of the economy requires adjusting
nominal to real GDP by using the GDP deflator.
The GDP Deflator
• The GDP deflator is a measure of the price level
calculated as the ratio of nominal GDP to real GDP
times 100.
• It tells us what portion of the rise in nominal GDP
that is attributable to a rise in prices rather than a
rise in the quantities produced.
The GDP Deflator
• The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator =
 100
Real GDP
The GDP Deflator
• Nominal GDP is converted to real GDP as
follows:
Real GDP20XX
Nominal GDP20XX

 100
GDP deflator20XX
Table 2 Real and Nominal GDP
Figure 2 Real GDP in the United States
Billions of
2000 Dollars
$10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1970
1975
1980
1985
1990
1995
2000
2005
IS GDP A GOOD MEASURE OF
ECONOMIC WELL-BEING?
• GDP is the best single measure of the economic wellbeing of a society.
• GDP per person tells us the income and expenditure
of the average person in the economy.
• Higher GDP per person indicates a higher standard of
living.
• GDP is not a perfect measure of the happiness or
quality of life, however.
GDP AND ECONOMIC
WELL-BEING
• Some things that contribute to well-being are not
included in GDP.
– The value of leisure.
– The value of a clean environment.
– The value of almost all activity that takes place outside of
markets, such as the value of the time parents spend with
their children and the value of volunteer work.
Table 3 GDP and the Quality of Life
Unemployment
How many of you are unemployed?
Identifying Unemployment
• How Is Unemployment Measured?
– Categories of Unemployment
• The problem of unemployment is usually
divided into two categories.
• The natural rate of unemployment
• The cyclical rate of unemployment
How is Unemployment Measured?
• Natural Rate of Unemployment
– The natural rate of unemployment that does not go away
on its own even in the long run.
– It is the amount of unemployment that the economy
normally experiences.
How is Unemployment Measured?
• Cyclical Unemployment
– Cyclical unemployment refers to the year-to-year
fluctuations in unemployment around its natural rate.
– It is associated with short-term ups and downs of the
business cycle.
Why Are There Always Some People
Unemployed?
• Frictional unemployment refers to the
unemployment that results from the time that it
takes to match workers with jobs.
– In other words, it takes time for workers to search for the
jobs that best suit their tastes and skills.
• Structural Unemployment is the unemployment that
results because the number of jobs available in some
labor markets is insufficient to provide a job for
everyone who wants one.
How is Unemployment Measured?
• Describing Unemployment: Three Basic Questions:
– How does government measure the economy's rate of
unemployment?
– What problems arise in interpreting the unemployment
data?
– How long are the unemployed typically without work?
Aggregate Supply and Demand
Practice
Aggregate Demand
• The Aggregate Demand
Curve shows the total
amount of goods and
services that consumers,
businesses, governments
and people in other
countries will purchase at
each and every price
level.
• Represents all the
demand in the economy.
Aggregate Demand
• Why downward
sloping?
– The wealth effect
– The income effect
– The foreign purchases
effect
Aggregate Demand
• Factors causing a shift in the
Aggregate Demand Curve
are changes in…
1.
2.
3.
4.
Consumer spending
Investment spending
Government spending
Net export spending
• Increases in AD increase
real GDP and the price level.
• Decreases in AD decrease
real GDP and the price level.
Aggregate Supply
• The Aggregate Supply
Curve shows the total
amounts of goods and
services that suppliers will
produce at each and
every price level.
• A higher price level
increases the quantity of
goods and services
supplied
• A decrease in the price
level decreases the
quantity supplied
Aggregate Supply
• Anything that changes
production costs shifts AS.
–
–
–
–
Price of inputs
Productivity
Technology
Government taxes, subsidies,
and regulations
• Increases in AS increase real
GDP and lower price level
• Decreases in AS decreases
real GDP and raise the price
level
Inflation
What is inflation?
• Inflation refers to a situation in which the
economy’s overall price level is rising.
– Money supply grows faster than the supply of
goods and services.
• The inflation rate is the percentage change in
the price level from the previous period.
Cost Push inflation
• Increased production costs for a large section of the
market create an increase in prices
Demand Pull inflation
• Demand exceeds production capacity thus creating
an increase in prices
The inflation rate is calculated as follows:
Inflation Rate in Year 2=
CPI in Year 2  CPI in Year 1
100
CPI in Year 1
Understanding Inflation and the CPI –
Research Activity
• Your job is to figure out what the CPI is, how
it’s calculated, and ultimately how it is used.
THE CONSUMER PRICE INDEX
• The consumer price index (CPI) is a measure of
the overall cost of the goods and services
bought by a typical consumer.
– It is used to monitor changes in the cost of living
over time.
– When the CPI rises, the typical family has to spend more dollars to
maintain the same standard of living.
How the Consumer Price Index Is
Calculated
Price of basket of goods and services
Consumer price index 
 100
Price of basket in base year
How the Consumer Price Index Is
Calculated
• Calculating the Consumer
Price Index and the
Inflation Rate: Another
Example
– Base Year is 2002.
– Basket of goods in 2002
costs $1,200.
– The same basket in 2004
costs $1,236.
– CPI = ($1,236/$1,200) 
100 = 103.
• What is the inflation rate?
– Prices increased 3 percent
between 2002 and 2004.
Unanticipated Inflation: Helped or
Hurt?
• Remember: Unexpected inflation hurts savers
and people on fixed incomes, or being paid
fixed amount; it helps people who have
borrowed money at a fixed rate of interest.
Aggregate Supply & Demand cont.…
Aggregate Demand
• Why downward sloping?
– The wealth effect
• When prices fall, people can
buy more with the money
they currently have.
– The Interest Rate Effect
• As price levels rise, demand
for money rises and
investment spending reduces.
– The foreign purchases effect
• When price level rises for a
good it becomes more
expensive in comparison.
• Decrease in Net Exports
Aggregate Supply
• Long run curve is vertical
– Nation is producing as
efficiently as possible.
• Short run curve has upward
slope
– Mixture of wages and prices
Fiscal Policy
• Use of the federal government’s power to tax
and spend to regulate economic activity.
Who’s to blame for lack of growth?
• The People?
• The Government?
• Businesses?
• The Government is often blamed when the
economy experiences UNEMPLOYMENT,
DECREASE IN GROSS DOMESTIC PRODUCT OR
INFLATION.
– Why? Can the government do anything about it?
ECONOMIST POINT OF VIEW
• Many economist believe that the federal
government can, and should, help alleviate
these problems at times by using traditional
discretionary fiscal policy.
– “Expansion”
Traditional Expansionary Fiscal
Policy…
• The increase spending on goods and services
and/or reduce taxes to increase aggregate
demand
• Multiplier Effect: the additional shifts in
aggregate demand that result when expansionary
fiscal policy increases income and thereby
increases consumer spending.
– Applies to anything that alters GDP
– Used during recessions or times of high
unemployment
Does Traditional Fiscal Policy Work?
• It has critics for several reasons.
• Why….?
• Economist do not know with certainty how large
the multiplier effects are or how long it takes
fiscal policy to work. Therefore by the time
expansionary policy takes effect, the economy
may no longer be in a recession and the policy
may lead to inflation.
Hard Times…?
• Contractionary Fiscal Policy calls for reduced
governmental spending and/or increases in
taxes to decrease aggregate demand.
– Reductions in aggregate demand should then lead
to decreased prices.
– Used during times of high inflation
The Crowding Out Effect
• Stimulating aggregate demand can cause interest
rates to rise, which lowers investment spending
(too expensive for consumers/businesses).
– When more money is demanded, it increases interest
rates and shifts AD curve to the right to maintain
balance between supply and demand.
– Eventually shifts AD curve to the left when demand
drops.
– Amount of increase in aggregate demand depends on
whether multiplier or crowding out effect is larger.
Taxes
• When government cuts taxes, it shifts
aggregate demand to the right
– Consumers will usually save more and spend
more
– Influenced by multiplier and crowding out effects
Fiscal Policy: Two Act Play
• Demand-Side Fiscal Policy
– Traditional “Expansionary Fiscal Policy”
• Supply-Side Fiscal Policy
– Tax cuts for businesses to give them more income
to spend as they choose
– Increase production, investment, and supply of
goods
– Attempt to lower unemployment and inflation
Money Supply is Key
• There is a direct relationship between the
money supply and the level of business
activity.
• More Money = More Activity
• Less Money = Less Activity
Monetary Policy
• Use of the Federal Reserve’s power to control
the money supply in an effort to limit inflation
and/or stimulate economic growth.
– “The Fed”
– Nation’s Bank
– Lends to member banks
Automatic Stabilizers
• Changes in fiscal policy that stimulate
aggregate demand when the economy goes
into a recession without policymakers having
to take any deliberate action.
– Tax System (automatic reduction in taxes from
decreased income)
– Government spending
• Increase in unemployment spending & other aide
services