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II. Some useful macroeconomic
basic concepts
Remark
• What follows is an overview of some basic
concepts in macroeconomics that the
student is expected to understand when
studying this course
• These concepts will not be subject to
examination directly, but represent
preconditions for a good understanding of
material of the study
II.1 National Income Accounts
Public Finance
Gross Domestic Product
• GDP: a measure of all currently produced final goods
and services evaluated at market prices
– Currently produced: flow of output per time unit
– Final goods and services
• Intermediate goods excluded
• Only a portion of capital goods - called depreciation - is used up
in current production and is included in GDP
• Investment in inventories, i.e. net change in inventories of final
goods awaiting sale or of materials used in production process,
is included in GDP (they are currently produced output)
– Market prices evaluation: nominal GDP as a measure of value
of output at market prices at given time (for real GDP see
bellow)
• Goods and services, not sold in markets, excluded form GDP
• Different ways to GDP evaluation: production, income
and expenditure approaches
GDP, CZ, 1995 & 2009
current prices, mil. CZK, production approach
INDICATORS
Output
Intermediate consumption (-)
Gross value added
Taxes on products
Subsidies on products(-)
Gross domestic product
1995
3,500,407
2,174,181
1,326,226
166,962
26,666
1,466,522
Source: Czech Statistical Office
2009
8,781,438
5,523,486
3,257,952
409,976
42,063
3,625,865
GDP, CZ, 1995 & 2009
current prices, mil. CZK, income approach
INDICATORS
Compensation of employees
Wages and salaries
Social contributions of employers
Net Taxes on production and imports
Taxes on productions and imports
Subsidies
(-)
Gross
operating
surplus and mixed
income
Fixed capital consumption
Net operating surplus and mixed income
Gross domestic product
1995
630,430
483,434
146,996
137,808
179,731
41,923
698,284
296,410
401,874
1,466,522
Source: Czech Statistical Office
2009
1,607,525
1,244,175
363,350
322,327
423,855
101,528
1,696,013
654,553
1,041,460
3,625,865
GDP, CZ, 1995 & 2009
current prices, mil. CZK, expenditure approach
INDICATORS
Final consumption expenditure
Households
General Government
NPISHs
Gross capital formation
Gross fixed capital formation
Changes in inventories
Acquistion of valuables less disposals
National gross final expenditure
Exports of goods and services
Imports of goods and services
External balance of imports and exports
Gross domestic product
1995
2009
1,052,305 2,635,883
736,087 1,804,334
306,326 798,957
9,892
32,592
477,684 788,489
461,825 814,039
13,732
-29,207
2,127
3,657
1,529,989
744,094
807,561
-63,467
1,466,522
Source: Czech Statistical Office
3,424,372
2,506,983
2,305,490
201,493
3,625,865
From GDP to Disposable income
• From Gross Domestic Product to Gross National Product:
• Add foreign earnings of domestic residents and firms
• Subtract earnings by foreign residents and firms
• From Gross to Net: subtracting depreciation
• From Net National Product to National Income: subtract indirect taxes
• National Income as a sum of factor earnings from current production of
goods and services, i.e. incomes of factors of production (land, labor
and capital)
• Personal Income - slightly different from National Income - is income
received by all persons in a country, regardless of the source. It is
National Income minus
• Corporate tax and undistributed profits
• Social Security payments
Plus
• Transfer payments
• Personal interest
• Personal Disposable Income: Personal Income minus Personal Taxes
GDP, GNP, NNP, National Income,
Personal Income
US, current prices, bill.USD, 2010
Gross domestic product
Plus: Income receipts from the rest of the world
Less: Income payments to the rest of the world
Equals: Gross national product
Less: Consumption of fixed capital
Private
Domestic business
Capital consumption allowances
Less: Capital consumption adjustment
Households and institutions
Government
General government
Government enterprises
Equals: Net national product
Less: Statistical discrepancy
Equals: National income
Less: Corporate profits with inventory valuation and capital consumption adjustments
Taxes on production and imports less subsidies\1\
Contributions for government social insurance
Net interest and miscellaneous payments on assets
Business current transfer payments (net)
Current surplus of government enterprises\1\
Wage accruals less disbursements
Plus: Personal income receipts on assets
Personal current transfer receipts
Equals: Personal income
Less: Personal taxes
Equals: Personal disposable income
Source: Bureau of Economic Analysis, Department of Commerce
14,660.4
706.2
517.9
14,848.7
1,868.9
1,534.0
1,241.5
1,208.9
-32.6
292.5
334.9
280.8
54.1
12,979.8
151.6
12,828.2
1,624.8
999.5
1,004.4
738.1
132.1
-13.3
0.0
1,907.6
2,296.4
12,546.7
1,354.3
11,379.9
Nominal and Real Values
• Nominal GDP (and its components),
valued at current prices (see the slides
above)
• Real GDP, valued at constant prices of
certain period (usually year, i.e. base year
prices)
– Real GDP shows what would have happened to
output had not been for the change of prices
• GDP deflator = nominal GDP/real GDP
Consolidated Government Finances,
CZ, 2009, mil. CZK, current prices
State
Budget,
incl. SFA
Total Revenue and Grants
Expenditure and Lendings Minus Repaym.
Overall Deficit/Surplus
1
949,967
1,153,623
-203,656
Nonbudgetary
funds
2
122,649
131,731
-9,082
Social
Security
3
212,109
217,369
-5,260
Consolidati Consolidated
on
Central Gov.
4
1+2+3+4=5
-148,446
1,136,279
-148,446
1,354,277
0
-217,998
Local
Budgets
6
381,759
321,709
60,050
Consolidatio Consolidated
n
General Gov.
7
-162,782
-162,782
0
5+6+7=8
1,355,256
1,513,204
-157,948
Source: Czech Ministry of Finance
Remark: The numbers above are constructed according the IMF standard
methodology. You may encounter slightly different numbers in different
databases or different websites, especially as to state budget.
II.2 Basic identities
National Income identity and
CA
• Basic identity: Y = C + I + G + CA
CA = X - M, current account, i.e. exports
minus imports
Domestic absorption: C + I + G
• CA > 0 - surplus, country lends
abroad, “foreigners” borrow and will
have to repay
• CA < 0 - deficit, country borrows
abroad, will have to repay
• Other interpretation of CA: change of
Net Foreign Wealth of the country
Savings and current account
• National savings: S = Y - C - G, i.e.
income less everything we spend either
as private individuals or as government
– Closed economy: S = I
• Open economy: S = I + CA
– Country can build up savings by lending
abroad
– Another interpretation: I = S - CA, i.e. country
can finance investment without increasing
savings (i.e. lowering consumption) by
borrowing abroad
Private and Government Spending
• Private savings: disposable income (YD = Y - T)
minus personal consumption C: Sp = Y - T - C
• Government savings: revenues (T) minus
expenditures (G): Sg = T - G
• S = I + CA = (Y - T - C) + (T-G) = Sp + Sg
• Define budget deficit: BD = - Sg = G - T
• Private savings: Sp = I + BD + CA
• Crucial interpretation of private savings - it can
take three forms: a. investment in domestic
capital, b. purchase of wealth from foreigners,
c. purchase of the debt (newly issued) of the
Government
II.3 Aggregate supply
Basic cornerstones
II.3.1 Production function
Production function, marginal products for labor
(MPL)/capital (MPK) – primarily microeconomic concept
• two factors
• product Y, labor N, capital K
• F(.) – technology,
• Y = F(K,N) ,
F K  FK 0, F N  FN  0.
• FN = MPL – extra amount of output the firm gets from
one extra unit of labor
• diminishing MPL: holding K fixed, MPL decreases as N
increases
• The same: FK = MPK
Y
FK 2 , N
FK1 , N
K 2  K1
N
MPL
MPLK 2 , N
MPLK1 , N
N
Optimization behavior of the firm
– profit maximization (1)
• Firm sells production at the price P,
hires workers at wage W and finances
capital at interest R
• Profit:  = P.F(K,N) – W.N – R.K
• Profit maximization subject to N (K
fixed):
d
 0  P.FN K, N   W  0
dN
and
FN K, N   W P
Optimization behavior of the firm
– profit maximization (2)
• Same procedure when maximizing profit
subject to capital (labor fixed)
• First-order condition: FN=W/P, FK=R/P
• Interpretation: firms hires the factor up
the point when hiring the next unit ceases
to profitable
W.N
P.F
W.N
P.F
A
N

A
N
N
Profit max at point A:
marginal revenue (slope of WN)
equals marginal costs
(slope of P.F)
Aggregate supply – short term
• Most of the course – short term
analysis
– Capital K fixed, labor N as only variable
input into production function
• Aggregate supply equals production:
AS = Y = F(K,N)
II.3.2 Labor market
Demand (1)
• First order condition for profit
max.=>  implicit relation between
demand for labor and real wage
• Total derivative: dFN (N D , K)  dW P 
and
FNK
1
dN  dK 
d W P 
FNN
FNN
D
Demand (2)
• With higher real wage firm’s demand
for labor falls
• Partial derivative of labor demand with
respect to real wage is
1 FNN  0
and
W
N  N ( , K) , N DW P  1 FNN
P
D
D
is an explicit expression of the labor
demand  decreasing function of real
wage
Supply of labor
households’ optimization (1)
• Typical worker: maximizing his utility to
achieve a mix between consumption C
and leisure H, knows the price P
• Utility
UT  UT C, H - NS , UTC , UTH- NS  0


• Max UT subject to
PC  WN S  0
• Analytical solution not so easy, graphical
exposition:
C
NS W P 
W P 2  W P 1  N
W P2 H
S
2
N
B
W P 1 H
UT2
A
UT1
H  NS2
H  N1S
H
H  NS
S
1
Supply of labor (2)
• Labor supply – increasing function of
real wage
• Aggregation over the whole labor
market:
N  N W P, N
S
S
S
WP
0
Equilibrium on the labor
market
• Condition: N  N
• Employment N 0 , real wage
• Assumptions:
D
S
W P 0
– Real wage flexible
– Nominal wage adjusts
– Full information
• Important: the concept of labor demand
generally accepted by all, but
macroeconomists fundamentally differ about
supply of labor; the above formalization very
often refused
NS W P 
W
P
W
 
 P 1
E
W
 
 P 0
N D W P 
W
 
 P 2
N0
N
II.4 Elementary specification of
aggregate demand components
(for a closed economy, but see LIII)
Consumption and savings
Determinants of personal consumption
• Disposable income: YD  Y  T
– T=T(Y)
– the larger YD, the larger consumption and savings
• Real interest rate:
– “reward” for consumption postponement
– higher r → lower consumption, higher savings
(and vice versa)
• Consumption function:
C  CYD, r , CYD  0, Cr  0
• Savings function:
S  SYD, r , SYD  0, Sr  0
Remark on consumption and
savings
• There are many ways how even these
simple specifications of consumption and
savings functions are differently used in
different models
• In discussing different models, we will
interchangeably vary (simplify)
specification, e.g. consumption being the
function of YD only, or savings depending
only on r
• Also, later we will consider more elaborated
consumption (saving) functions, with
additional explanatory variables
Investment demand,
governmental expenditure
• Interest – measures the costs of
investment financing, return must be
higher than interest
• Higher interest  few projects with return
exceeding interest (and vice versa)
• Demand for investment: I  Ir , Ir  0
• Same remark as in case of consumption
function: this is an oversimplified version
of investment function, some more
sophisticated specifications again later
Aggregate demand
• Exogenous governmental
expenditure: G
• Aggregate demand
AD  CY - TY, r  Ir   G
II.5 Money, interest
Functions and forms of money
• Definition: stock of assets that can be readily
used to make transactions
– It is generally accepted in payment for goods and
services or in repayment of debts
• Functions:
– Medium of exchange
– Store of value
– Unit of account
• Types of money:
– Historically: commodity money, namely gold, till 1971
– Fiat money: currency (coins and paper), demand
deposits, near money
• Government declares it as legal tender
– Classification: M1, M2, M3, L
Czech monetary aggregates
levels, 30.9.2011, mil. CZK
Currency
in circ.
Overnight
deposits
363.663,6
1.712.583, 8 2.076.247,4 340.250,1
Repurchase
agreements
4.801,2
M1
Deposits
up to 2y
Deposit
redeem. 3m
291.685,4
M2
2.708.182,9
Money
markets
Debt
securities
M3
32.367,1
2.578,9
2.747.930,0
Source and for detailed explanation of terms: www.cnb.cz
M3, CZ, %yoy
20
15
10
5
0
-5
Jan/03
Jan/04
Jan/05
Jan/06
Jan/07
Jan/08
Jan/09
Jan/10
Jan/11
M3, Euro zone, %yoy
Demand for money
• Historically, two approaches that differ on
the role of interest on money demand
• Quantity theory of money, developed at
the beginning of 20th century, stipulates
that money demand is not influenced by
interest (or, only indirectly)
– Will be discussed in Lecture on Classical
Model
• Theory of liquidity preference, originated
by Keynes, where interest rate has an
essential role
– Will be introduced in Lecture on Keynesian
model
Supply of money (1)
• Under the control of the governments
(central banks)
– Policy tool
• Historically
– Gold and non-gold money co-existed
– Both gold and non-gold money freely
convertible
– „Full“ commodity money: money supply
determined by amount of gold in the
reserves
Supply of money
(2)
• In modern economies given by
– Direct decision of state (central bank) to increase/decrease the
money supply:
• Issuing currency (notes and coins)
• Requiring mandatory reserves of commercial banks
• Via open market operations (purchase/sale of governmental assets)
– Remark: today - a very exceptional period when Central Banks extensively
purchase other assets as well
– Behavior of households and commercial banks
• Households deposit money with commercial banks
– Households decide how much of money they have, they keep as
cash, and how much they deposit as demand deposit in banks:
currency-deposit ratio a=CR/DD, CR – currency, DD – demand
deposits, determined by households’ behavior
• Commercial banks create money
– Banks keep only fraction of deposits and the rest they loan to
households or firms: reserve-deposit ratio b=RS/DD, determined by
behavior of banks and by regulatory laws
Money multiplier
• Monetary base, directly controlled by central
bank: B = CR + RS
– CR directly issued by central bank (“coined and
printed money”)
– RS are existing reserves, as resulted from the past
• Money supply, overall money available (M1), i.e.
currency plus total demand deposits: MS =
CR+DD
• What is the relation between MS and B?
M S CR  DD

B
CR  RS
MS
CR D D  1

B CR D D  RS D D
MS a  1

B ab
a 1
ab
m – money multiplier, m > 1
 M S  mB , m 
Nominal and real interest rate
• Nominal: interest i, paid by the banks, i.e. a return
from the investment, expressed in money units (at
current price level), determined by
–
–
–
–
–
Strength of the economy and willingness to save
Rate of inflation
Risk
Tax treatment of the interest
Time period of the loan
• Many types of interest rates, determined on many
different money markets – see Literature (Mishkin)
• Real: The real return r (in units of goods and services),
i.e. nominal interest, adjusted for the change of
purchasing power of the money return, i.e. for inflation
– In consumption (saving) and investment functions above:
real interest
Literature to Lecture II
On national accounts, identities and aggregate demand:
• Any textbook on macroeconomics (see literature to
Lec. I)
On production function:
• Any textbook on microeconomics (see literature to
Lec. I)
Labor market:
• Heijdra, B.J.: Foundations of Modern Macroeconomics
(2nd ed.), Oxford University Press, 2000, Ch. 1
• Barro, R.J., Macroeconomics, MIT Press, Cambridge,
MA, 1998 (5th ed.), Ch. (supply of labor)
On money and interest:
• Mankiw, Ch. 7 and 18
• Mishkin, F.S., The Economics of Money, Banking and
Financial Markets, HarperCollinsPublishers, 1993 (8th
ed.), Ch. 14-16 (there is a Czech translation of 3rd ed.)