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Macroeconomics
Lecture 1
Selcuk Caner
Bilkent University
5/23/2017
1
Course Outline
Overview
 National Accounts
 The Open Economy
 Macroeconomic Policy
 Debt and Fiscal Policy
 Macroeconomic Policy Tools
 Financial Programming

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Some Rules
I expect participation in class
 You may not talk to each other in
class!
 You may be ejected out of class if
you do not comply with the above
rule

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More Rules

University rule: Attendance is mandatory!
 I enforce this rule!
 Random roll calls to verify the names in
the attendance list.
 If your name is on the list but you are not
present in the class, you will face
disciplinary action.

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More Rules (continued)

Bilkent University has no tolerance for
cheating.
– Any student involved in cheating in an exam is
expelled one semester from the university.

According to Public Law 4207, smoking is
banned in all closed public areas.
Smoking in all University buildings are
banned. I strongly enforce this Law.
Anybody smoking in a university building
will face disciplinary action.
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Exams and Grading
One mid-term exam with a weight of
30%.
 Final exam 50%.
 Quizzes 10%.
 Homework 10%

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Back to Macroeconomics:
Important issues in macroeconomics

Capital accumulation.

Unemployment, even when the
economy is booming?

Why are there recessions/crises?
Can the government do anything to
combat recessions/crises? Should it?

High inflation.
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Important issues in macroeconomics

What is the government budget
deficit? How does it affect the
economy?

Why does Turkey have such a huge
Current account deficit?

Why are so many countries poor?
What policies might help them grow
out of poverty?
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Why learn macroeconomics?
1. The macroeconomy affects society’s well-
being.
 example:
Unemployment and social problems
2. The macroeconomy affects your well-being.
 example 1:
Unemployment and earnings growth
 example 2:
Interest rates
3. The macroeconomy affects politics & current events.
 example:
Inflation and unemployment
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Economic models
…are simplied versions of a more complex
reality
• irrelevant details are stripped away
Used to
• show the relationships between
economic variables
• explain the economy’s behavior
• devise policies to improve economic
performance
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Example of a model:
The supply & demand for new cars
 explains
the factors that determine the
price of cars and the quantity sold.
 assumes the market is competitive: each
buyer and seller is too small to affect the
market price
 Variables:
Q d = quantity of cars that buyers demand
Q s = quantity that producers supply
P = price of new cars
Y = aggregate income
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Ps = price of steel (an input)
The demand for cars
demand equation:
d
Q  D (P ,Y )
shows that the quantity
of cars consumers demand
is related to the price of
cars
and aggregate income.
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Digression: Functional notation

General functional notation shows only
that the variables are related:
Q d  D (P ,Y )

A specific functional form shows the
precise quantitative relationship:
Examples:
1)
2)
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Q d  D (P ,Y )  60  10P  2Y
d
Q  D (P ,Y ) 
0.3Y
P
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The market for cars: demand
demand equation:
Q
d
 D (P ,Y )
The demand curve
shows the relationship
between quantity
demanded and price,
other things equal.
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P
Price
of cars
D
Q
Quantity
of cars
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The market for cars: supply
supply equation:
s
Q  S (P , Ps )
The supply curve
shows the relationship
between quantity
supplied and price,
other things equal.
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P
Price
of cars
S
D
Q
Quantity
of cars
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The market for cars: equilibrium
P
Price
of cars
S
equilibrium
price
D
Q
equilibrium
quantity
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Quantity
of cars
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The effects of an increase in income:
demand equation:
Q d  D (P ,Y )
An increase in income
increases the quantity
of cars consumers
demand at each price…
…which increases
the equilibrium price
and quantity.
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P
Price
of cars
S
P2
P1
D1
Q1 Q2
D2
Q
Quantity
of cars
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The effects of a steel price increase:
supply equation:
s
Q  S (P , Ps )
S2
Price
of cars
An increase in Ps
reduces the quantity of
cars producers supply
at each price…
…which increases the
market price and
reduces the quantity.
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P
S1
P2
P1
D
Q2 Q1
Q
Quantity
of cars
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Prices: Most Important Factors in Economic
Dynamics: Flexible Versus Sticky
 Market
clearing: an assumption that
prices are flexible and adjust to equate
supply and demand.
 In the short run, many prices are sticky--they adjust only sluggishly in response
to supply/demand imbalances.
For example,
– labor contracts that fix the nominal
wage for a year or longer
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Prices: Flexible Versus Sticky

The economy’s behavior depends partly on
whether prices are sticky or flexible:

If prices are sticky, then demand won’t always
equal supply. This helps explain
– unemployment (excess supply of labor)
– the occasional inability of firms to sell
what they produce

Long run: prices flexible, markets clear,
economy behaves very differently.
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National Accounts
Gross Domestic Product
Two definitions:
1. Total expenditure on
domestically-produced
final goods and services
2. Total income earned by
domestically-located
factors of production
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Why expenditure = income
In every transaction,
the buyer’s expenditure
becomes the seller’s income.
Thus, the sum of all
expenditure equals
the sum of all income.
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The Circular Flow
Income($)
Labor
Households
Firms
Goods(bread)
Expenditure($)
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Value added
definition:
A firm’s value added is
the value of its output
minus
the value of the intermediate goods
the firm used to produce that
output.
Q=F(K,L,M)
GDP = wL-rK = Q - M
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Final goods, value added, and GDP

GDP = value of final goods produced
= sum of value added at all stages
of production

The value of the final goods already
includes the value of the intermediate
goods,
so including intermediate goods in
GDP would be double-counting.
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The expenditure components of GDP
• consumption
• investment
• government spending
• net exports
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Consumption (C)
definition: the value of all • durable goods
last a long time
goods and services bought
ex: cars, home
by households. Includes:
appliances
• non-durable goods
last a short time
ex: food, clothing
• services
work done for
consumers
ex: dry cleaning,
air travel.
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Investment (I)
def1: spending on [the factor of production] capital.
def2: spending on goods bought for future use.
Includes:
 business fixed investment
spending on plant and equipment that firms
will use to produce other goods & services
 residential fixed investment
spending on housing units by consumers and
landlords
 inventory investment
the change in the value of all firms’ inventories
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Investment vs. Capital

Capital is one of the factors of
production.
At any given moment, the economy
has a certain overall stock of capital.

Investment is spending on new
capital.

DK= I
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Investment vs. Capital
Example (assumes no depreciation):
 1/1/2002:
economy has $500b worth of capital
 during 2002:
investment = $37b
 1/1/2003:
economy will have $537b worth of
capital
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Stocks vs. Flows
Flow
Stock
More examples:
stock
flow
a person’s wealth
a person’s saving
# of people with
college degrees
# of new college
graduates
the govt. debt
the govt. budget deficit
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Government spending (G)

G includes all government spending
on goods and services.
 G excludes transfer payments
(e.g. unemployment insurance
payments), because they do not
represent spending on goods and
services.
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An important identity
Net Exports=EX-IM
Y = C + I + G + NX
where
Y = GDP = the value of total output
C + I + G + NX = aggregate
expenditure
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GDP:
An important and versatile concept
GDP measures




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total income
total output
total expenditure
the sum of value-added at all stages
in the production of final goods
China
Russia
U.S.
Turkey
9.7%
-2.7%
3.3%
3.1%
Average Annual
GDP Growth
Rate 1990-2002
34
240
Economic Growth, GDP (1995=100)
220
200
180
160
140
120
100
80
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Russian Federation
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Turkey
China
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GNP vs. GDP

Gross National Product (GNP):
total income earned by the nation’s factors of
production, regardless of where located

Gross Domestic Product (GDP):
total income earned by domestically-located
factors of production, regardless of nationality.
(GNP – GDP) = (factor payments from abroad)
– (factor payments to abroad)
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Real vs. Nominal GDP
GDP is the value of all final goods
and services produced.
 Nominal GDP measures these
values using current prices.
 Real GDP measure these values
using the prices of a base year.

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Real GDP controls for inflation
Changes in nominal GDP can be due
to:
 changes in prices
 changes in quantities of output
produced
Changes in real GDP can only be due
to changes in quantities,
because real GDP is constructed
using constant base-year prices.
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problem, part 1
2001
good
A
good
B
2002
2003
P
Q
P
Q
P
Q
$30
900
$31
1,000
$36
1,050
$100
192
$102
200
$100
205

Compute nominal GDP in each year

Compute real GDP in each year
using 2001 as the base year.
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Answers to practice problem, part 1
 Nominal GDP multiply Ps & Qs from
same year
2001: $46,200 = $30  900 + $100  192
2002: $51,400
2003: $58,300
 Real GDP
2001 Ps
multiply each year’s Qs by
2001: $46,300
2002: $50,000
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2003: $52,000 = $30  1050 + $100  205
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GDP Deflator
The inflation rate is the percentage
increase in the overall level of
prices.
 One measure of the price level is
the GDP Deflator, defined as

Nominal GDP
GDP deflator = 100 
Real GDP
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problem, part 2
Nom.
GDP
Real
GDP
2001
$46,200
$46,200
2002
51,400
50,000
2003
58,300
52,000
GDP
deflator
inflation
rate
n.a.
 Use
your previous answers to compute
the GDP deflator in each year.
 Use
GDP deflator to compute the
inflation rate from 2001 to 2002, and
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from 2002 to 2003.
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2001
Nom.
GDP
$46,200
Real
GDP
$46,200
GDP
deflator
100.0
inflation
rate
n.a.
2002
51,400
50,000
102.8
2.8%
2003
58,300
52,000
112.1
9.1%
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Understanding the GDP deflator
Example with 3 goods
For good 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
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Understanding the GDP deflator
NGDPt
P1t Q1t  P2t Q2t  P3t Q3t
GDP deflator  100 
 100 
RGDPt
RGDPt
  Q1t
 100   
  RGDPt

 Q2t 
 Q3t  
 P1t  
 P2t  
 P3t 

 RGDPt 
 RGDPt  
The GDP deflator is a weighted average of
prices.
The weight on each price reflects
that good’s relative importance in GDP.
Note that the weights change over time.
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Working with percentage changes
USEFUL TRICK #1
For any variables X and Y,
the percentage change in (X  Y )
 the percentage change in X
+ the percentage change in Y
EX: If your hourly wage rises 5%
and you work 7% more hours,
then your wage income rises
approximately 12%.
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Working with percentage changes
USEFUL TRICK #2
the percentage change in (X/Y )
 the percentage change in X
 the percentage change in Y
EX:
GDP deflator = 100  NGDP/RGDP.
If NGDP rises 9% and RGDP rises 4%,
then the inflation rate is approximately
5%.
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Consumer Price Index (CPI)
A measure of the overall level of prices
Published by
In the US, the Bureau of Labor Statistics (BLS)
in the US.
In Turkey, State Statistics Institute
Used to
–track changes in the
typical household’s cost of living
–adjust many contracts for inflation
(i.e. “COLAs”)
allow comparisons of values from different years 49
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How is the CPI constructed?
1. Survey consumers to determine
composition of the typical consumer’s
“basket” of goods.
2. Every month, collect data on prices of
all items in the basket; compute cost
of basket
3. CPI in any month equals
Cost of basket in that month
100 
Cost of basket in base period
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Exercise: Compute the CPI
The basket contains 20 pizzas and
10 compact discs.
For each year, compute
prices:
2000
2001
2002
2003
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pizza
$10
$11
$12
$13
CDs
$15
$15
$16
$15
 the cost of the basket
 the CPI (use 2000 as
the base year)
 the inflation rate from
the preceding year
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answers:
2000
2001
2002
2003
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cost of
basket
$350
370
400
410
CPI
100.0
105.7
114.3
117.1
inflation
rate
n.a.
5.7%
8.1%
2.5%
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The composition of the CPI’s “basket”
Food and bev.
17,6%
Housing
5,9%
2,8%
Apparel
Transportation
5,8%
2,5%
4,5%
4,8%
Medical care
Recreation
16,2%
Education
Communication
40,0%
Other goods and
services
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Understanding the CPI
Example with 3 goods
For good i = 1, 2, 3
Ci = the amount of good i in the CPI’s
basket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month
t
Eb = cost of the basket in the base
period
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Understanding the CPI
Et
P1t C1 + P2t C2 + P3t C3
CPI in month t  100 
 100 
Eb
Eb
 C1 
 C2 
 C3  
 100    P1t    P2t    P3t 
 Eb 
 Eb 
 Eb  
The CPI is a weighted average of prices.
The weight on each price reflects
that good’s relative importance in the CPI’s
basket.
Note that the weights remain fixed over time.
55
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Reasons why
the CPI may overstate inflation
 Substitution
bias: The CPI uses fixed weights,
so it cannot reflect consumers’ ability to
substitute toward goods whose relative prices
have fallen.
 Introduction
of new goods: The introduction of
new goods makes consumers better off and, in
effect, increases the real value of the dollar.
But it does not reduce the CPI, because the
CPI uses fixed weights.
 Unmeasured
changes in quality:
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Quality
improvements increase the value of 56
CPI vs. GDP deflator
prices of capital goods
• included in GDP deflator (if produced
domestically)
• excluded from CPI
prices of imported consumer goods
• included in CPI
• excluded from GDP deflator
the basket of goods
• CPI: fixed
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• GDP deflator: changes every year
57
Two measures of inflation
Percentage
change 16
CPI
14
12
10
8
6
GDP deflator
4
2
0
-2
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
Year
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Okun’s Law

Employed workers help produce
GDP, while unemployed workers do
not.
So one would expect
a negative relationship between
unemployment and real GDP.

This relationship is clear in the
data…
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Okun’s Law
Okun’s Law states
that a one-percent
decrease in
unemployment is
associated with two
percentage points
of additional growth
in real GDP
Percentage change
10
in real GDP
8
6
1951
1984
2000
4
1999
1993
2
1975
0
-2
-3
1982
-2
-1
0
1
2
3
4
Change in
unemployment rate
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