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Macroeconomics
Macroeconomics vs.
Microeconomics
• Major issues:
– Determination of aggregate production, income, prices,
and employment
– Improving the performance of the macroeconomy
• Long-run: Economic growth and price stability
• Short-run: Reducing fluctuations in output, production and
employment/unemployment
• Stylized Graph of the Business Cycle
• Circular Flow: A model that demonstrates the
relationships in the macroeconomy.
Figure 1 The Circular Flow
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
Goods
•Households buy
and services
sold
Revenue
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
Copyright © 2004 South-Western
Macroeconomic Variables
• The circular flow diagram demonstrates that
the important variables are
– Output and income: real and nominal gross
domestic product (GDP)
• Important implication from the circular flow
diagram: Value of output=Aggregate expenditures or
demand=Aggregate Income
– Aggregate Prices – Inflation
– Employment/Unemployment
The Measurement of Aggregate
Output and Income
• By definition, aggregate output is equal to
aggregate income. The value of output is
equal to the income (wages, interest, rents
and profits) received by the factors.
• There are Various measures of aggregate
output but we will use the concept of:
– Gross domestic product (GDP)
Gross Domestic Product
• GDP is the market value of all final goods and
services produced within a country in a given
period of time.
– Market value – prices, illegal, household
– All – imputed values for rent
– Final goods and services– intermediate goods are not
double counted
– Produced (newly) - products resold, inventory
– Within the country – Excludes US production abroad
includes ROW production with the US
– Given period of time (generally yearly or quarterly)
Components of GDP
• Since aggregate production equals aggregate
income, let’s call GDP = Y
• Y can be broken up into the following parts
– Consumption – HH spending on G&S (except new
housing)
– Investment – Business spending on K but includes HH
of new housing
– Government Purchases of G&S
– Net Exports (= Exports – Imports) Net addition
(subtraction) attributable to purchases by ROW.
Y = C + I + G + NX
BEA
2002
GDP
10,480
C
7,385
Durable
911
12%
Non-Dur
2,086
29%
Services
4,388
58%
I
1,589
Non-Res
1,080
68%
Res
504
32%
Chg Inv
5
0%
G
1,932
F
679
35%
S&L
1,253
65%
NX
-426
-4%
X
1,006
10%
I
1,433
14%
70%
15%
18%
GDP Data
• The US Department of Commerce’s Bureau
of Economic Analysis has data on line:
– http://www.bea.doc.gov/
• Economic Report of the President
– http://w3.access.gpo.gov/eop/
• Graphs and Data
– http://www.econmagic.com
Real GDP
Table 3 GDP, Life Expectancy, and Literacy
Copyright©2004 South-Western
Economic Growth
• Economic growth is something that is very important in
improving the standard of living of a population.
• The Rule of 70 illustrates how small changes in growth
rates can affect the standard of living.
• Doubling Time = 70/(% growth rate)
– Examples: Growth Rate → Doubling time
–
2%
→ 35 years
–
4%
→ 15 years
–
6%
→ 11.5 years
–
10%
→ 7 years
• Now, China has been growing pretty close to 10% for the
last 20 or so years so the GDP has doubled once, doubled
again, and doubled a third time, so it is 2x2x2=8 times
larger than it was 20 years ago!
Figure 2 The Growth in Real
GDP per Person
Determinants of Economic Growth
• Remember our production possibilities curve and the first week!
• Increased number of resources: L, K, NR, E
– Investment
– Growth in Labor Force
• Increased productivity of resources:
–
–
–
–
Work Ethic
Technology
Education
Risk-taking and innovation
• Social system that allows the efficient use of resources and promotes
productivity
– Market system and self-interest
– Laws, property rights, and public order
– Political and economic freedom
Table 1 The Variety of Growth Experiences
Copyright©2004 South-Western
Measuring Inflation
• Inflation refers to a situation in which the
economy’s overall price level is rising.
• The inflation rate is the percentage change
in the price level from the previous period.
Real Versus Nominal GDP
• Remember from micro:
– Expenditures or Revenue = PxQ
– Total Expenditures or Revenue = Σ PxQ
• Total can increase either because prices go up or
quantities increase
• Nominal GDP is measured in current dollars
• Real GDP corrects for increases in prices and tries
to measure the total quantity of goods
• Nominal GDP= Σ PCurrent year x QCY
• Real GDP= Σ PBase year x QCY
• GDP Deflator =
(Nominal GDP/Real GDP) X 100
Table 2 Real and Nominal GDP
Copyright©2004 South-Western
The GDP Deflator
• Remember The GDP deflator is calculated
as follows:
Nominal GDP
GDP deflator =
 100
Real GDP
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 the rise in nominal GDP that is
attributable to a rise in prices rather than a
rise in the quantities produced.
The GDP Deflator
• Converting any nominal figure to a real one
is easy (such as nominal GDP is converted
to real GDP):
• Real = (Nominal/Deflator)*100, or in the
case of GDP:
Real GDP20XX
Nominal GDP20XX

 100
GDP deflator20XX
Real and Nominal GDP
Year
Nominal GDP
GDP Deflator
Real GDP
2001
200
100
(200/100)X100=200
2002
600
171
(600/171)X100=351 (350)*
2003
1,200
241
(1,200/241)X100=498 (500)*
*errors due to rounding deflator
Copyright©2004 South-Western
Real and Nominal GDP
1947-2004
Real GDP with Pct. Changes
1947-2004
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.
• The Bureau of Labor Statistics reports the CPI
each month.
• 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
Calculating the Consumer Price Index
• Fix the Basket: Determine what prices are most
important to the typical consumer.
– The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
– The BLS conducts monthly consumer surveys to set the
weights for the prices of those goods and services.
• Find the Prices: Find the prices of each of the
goods and services in the basket for each point in
time.
• Compute the Basket’s Cost: Use the data on
prices to calculate the cost of the basket of goods
and services at different times.
• Choose a Base Year and Compute the
Index:
– Designate one year as the base year, making it
the benchmark against which other years are
compared.
– Compute the index by dividing the price of the
basket in one year by the price in the base year
and multiplying by 100.
• Compute the inflation rate: The inflation
rate is the percentage change in the price
index from the preceding period
• The Inflation Rate
– The inflation rate is calculated as follows:
• 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.
Prices increased 3 percent between 2002 and
2004.
FYI: What’s in the CPI’s Basket?
16%
Food and
beverages
17%
Transportation
Education and
communication
41%
Housing
6%
6%
6% 4% 4%
Medical care
Recreation
Apparel
Other goods
and services
Copyright©2004 South-Western
Problems in Measuring the Cost of
Living
• The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure of the
cost of living.
Problems in Measuring the Cost of
Living
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
• …the consumer price index reflects the
prices of all goods and services bought by
consumers.
Figure 2 Two Measures of Inflation
Percent
per Year
15
CPI
10
5
0
GDP deflator
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
CORRECTING ECONOMIC
VARIABLES FOR THE EFFECTS OF
INFLATION
• Price indexes are used to correct for the
effects of inflation when comparing dollar
figures from different times.
Dollar Figures from Different Times
• Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2001:
Salary2001
Price level in 2001
 Salary1931 
Price level in 1931
177
 $80,000 
15.2
 $931,579
Table 2 The Most Popular Movies of All Times,
Inflation Adjusted
Copyright©2004 South-Western
Real and Nominal Interest Rates
• Interest represents a payment in the future for a
transfer of money in the past.
• The nominal interest rate is the interest rate
usually reported and not corrected for inflation.
– It is the interest rate that a bank pays.
• The real interest rate is the nominal interest rate
that is corrected for the effects of inflation.
• If you borrow $1,000 for one year, and
– Nominal interest rate was 15%.
– During the year inflation was 10%.
• Then, Real interest rate = Nominal interest
rate – Inflation
= 15% - 10% = 5%
Figure 3 Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15
10
Nominal interest rate
5
0
Real interest rate
–5
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
Inflation Summary
• The consumer price index shows the cost of
a basket of goods and services relative to
the cost of the same basket in the base year.
• The index is used to measure the overall
level of prices in the economy.
• The percentage change in the CPI measures
the inflation rate.
Inflation Summary
• The consumer price index is an imperfect
measure of the cost of living for the
following three reasons: substitution bias,
the introduction of new goods, and
unmeasured changes in quality.
• Because of measurement problems, the CPI
overstates annual inflation by about 1
percentage point.
Inflation Summary
• The GDP deflator differs from the CPI because it
includes goods and services produced rather than
goods and services consumed.
• In addition, the CPI uses a fixed basket of goods,
while the GDP deflator automatically changes the
group of goods and services over time as the
composition of GDP changes.
Inflation Summary
• Dollar figures from different points in time
do not represent a valid comparison of
purchasing power.
• Various laws and private contracts use price
indexes to correct for the effects of
inflation.
• The real interest rate equals the nominal
interest rate minus the rate of inflation.
Unemployment and Its Natural
Rate
• Long-run versus Short-run Unemployment:
– Long-run: The natural rate of unemployment
– Short-run: The cyclical rate of unemployment
• Natural Rate of Unemployment
– The amount of unemployment that the economy
normally experiences and does not go away on its own
even in the long run. (sum of frictional, structural and
seasonal unemployment)
• Cyclical Unemployment
– Associated with with short-term ups and downs of the
business cycle and refers to the year-to-year
fluctuations in unemployment around its natural rate.
• 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?
How Is Unemployment Measured?
• Unemployment is measured by the Bureau of
Labor Statistics (BLS).
– It surveys 60,000 randomly selected households every
month.
• Based on the answers to the survey questions, the
BLS places each adult (over 16) years old into one
of three categories:
– Employed
– Unemployed
– Not in the labor force
Employed, Unemployed, Not in the
Labor Force, Labor Force
• Employed: A person is considered employed if he or she
has spent most of the previous week working at a paid job.
• Unemployed: A person is unemployed if he or she is on
temporary layoff, is looking for a job, or is waiting for the
start date of a new job.
• Not in the Labor Force: A person who fits neither of these
categories, such as a full-time student, homemaker, or
retiree, is not in the labor force.
• Labor Force
– The labor force is the total number of workers and the
BLS defines the it as the sum of the employed and the
unemployed.
Figure 1 The Breakdown of the Population in
2001
Employed
(135.1 million)
Labor Force
(141.8 million)
Adult
Population
(211.9 million)
Unemployed (6.7 million)
Not in labor force
(70.1 million)
Copyright©2003 Southwestern/Thomson Learning
How Is Unemployment Measured?
• The unemployment rate is calculated as the
percentage of the labor force that is unemployed.
– Unemployment Rate= (Unemployed/Labor Force)*100
• The labor-force participation rate is the
percentage of the adult population that is in the
labor force.
– Labor-force Participation Rate=
(Labor Force/Adult Population)*100
Table 1 The Labor-Market Experiences of
Various Demographic Groups
Copyright©2004 South-Western
Figure 2 Unemployment Rate Since 1960
Percent of
Labor Force
10
Unemployment rate
8
6
Natural rate of
unemployment
4
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Copyright©2003 Southwestern/Thomson Learning
Figure 3 Labor Force Participation Rates for
Men and Women Since 1950
Labor-Force
Participation
Rate (in percent)
100
80
Men
60
40
Women
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Copyright©2003 Southwestern/Thomson Learning
Issues in Measuring Unemployment
• It is difficult to distinguish between a person who
is unemployed and a person who is not in the labor
force.
– Discouraged workers, people who would like to work
but have given up looking for jobs after an unsuccessful
search, don’t show up in unemployment statistics.
– Other people may claim to be unemployed in order to
receive financial assistance, even though they aren’t
looking for workLength of Unemployment
• Duration of Unemployment
– Most spells of unemployment are short.
– Most of the economy’s unemployment problem is
attributable to relatively few workers who are jobless
for long periods of time.
Why does unemployment occur?
• In an ideal labor market, wages would adjust to balance the
supply and demand for labor, ensuring that all workers
would be fully employed.
• 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 are 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.
Frictional Unemployment and
Job Search
• Job search
– the process by which workers find appropriate
jobs given their tastes and skills.
– results from the fact that it takes time for
qualified individuals to be matched with
appropriate jobs.
Public Policy and Job Search
• Government programs can affect the time it takes
unemployed workers to find new jobs.
– Government-run employment agencies
– Public training programs
– Unemployment insurance
Effects of Unemployment Insurance
• Unemployment insurance increases the
amount of search unemployment.
• It reduces the search efforts of the
unemployed.
• It may improve the chances of workers
being matched with the right jobs.
Structural Unemployment
• Structural unemployment occurs when the
quantity of labor supplied exceeds the
quantity demanded.
• Structural unemployment is often thought to
explain longer spells of unemployment.
Public Policy and Job Search
• Why is there Structural Unemployment?
– Minimum-wage laws
– Unions
– Efficiency wages
Figure 4 Unemployment from a Wage Above the
Equilibrium Level
Wage
Labor
supply
Surplus of labor =
Unemployment
Minimum
wage
WE
Labor
demand
0
LD
LE
LS
Quantity of
Labor
Copyright©2003 Southwestern/Thomson Learning
Unemployment Summary
• The unemployment rate is the percentage of those who
would like to work but don’t have jobs.
• The Bureau of Labor Statistics calculates this statistic
monthly.
• The unemployment rate is an imperfect measure of
joblessness.
• In the U.S. economy, most people who become
unemployed find work within a short period of time.
• Most unemployment observed at any given time is
attributable to a few people who are unemployed for long
periods of time.
Unemployment Summary
• One reason for unemployment is the time it takes for
workers to search for jobs that best suit their tastes and
skills.
• A second reason why our economy always has some
unemployment is minimum-wage laws.
• Minimum-wage laws raise the quantity of labor supplied
and reduce the quantity demanded.
• A third reason for unemployment is the market power of
unions.
• A fourth reason for unemployment is suggested by the
theory of efficiency wages.
• High wages can improve worker health, lower worker
turnover, increase worker effort, and raise worker quality.
Business Cycle
• Economic fluctuations are irregular and
unpredictable.
– Fluctuations in the economy are often called the
business cycle.
• Most macroeconomic variables fluctuate
together.
• As output falls, unemployment rises.
Figure 1 A Look At Short-Run Economic
Fluctuations
(a) Real GDP
Billions of
1996 Dollars
$10,000
9,000
Real GDP
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• Most macroeconomic variables fluctuate
together.
– Most macroeconomic variables that measure
some type of income or production fluctuate
closely together.
– Although many macroeconomic variables
fluctuate together, they fluctuate by different
amounts.
Figure 1 A Look At Short-Run Economic
Fluctuations
(b) Investment Spending
Billions of
1996 Dollars
$1,800
1,600
1,400
Investment spending
1,200
1,000
800
600
400
200
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• As output falls, unemployment rises.
– Changes in real GDP are inversely related to
changes in the unemployment rate.
– During times of recession, unemployment rises
substantially.
EXPLAINING SHORT-RUN ECONOMIC
FLUCTUATIONS
• Short Run Differs from the Long Run
– Long-run Growth
– Short-run fluctuations
• Stylized Business Cycle
– Recessions
– Depressions
– Expansions