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Principles of Macroeconomics
Lecture 1
INTRODUCTION TO MACROECONOMICS
&
MEASURING ECONOMIC ACTIVITY
PART 1: INTRODUCTION
MACROECONOMICS
TO
An Overview of Macroeconomics
1. What is Macroeconomics
2. Macroeconomic Goals
3. Key Macroeconomic Principles
What is Macroeconomics?
- Microeconomics study of behaviour of individuals
households and firms.
- Macroeconomics study the aggregate measures of the
economy
Macroeconomic aims
- Low Unemployment
- Price Stability (Low Inflation or Deflation)
- Economic Growth and Development
Low Unemployment
Unemployment rate, %
25%
Great Depression
(1929 - 1933)
20%
World War II
(1941 - 1945)
1973 - 1975 1981 - 1982
recession recession
15%
1990 - 1991
recession
10%
5%
0%
1930
1940
1950
1960
1970
1980
1990
2000
Source: Bureau of Labour Statistics
www.bls.gov
Price Stability
Long Run Economic Growth
PART 2: MEASURING
ECONOMIC
ACTIVITY
Learning outcome
Define GDP and the four expenditure
components of aggregate output.
 Calculate GDP in a simple example, avoiding
double counting.
 Distinguish between “net” and “gross” and
between “national” and “domestic.”
 List the four components of aggregate income.

Aims


Discuss the shortcomings of using GDP
Distinguish between real GDP and nominal
GDP
How an economy works
National Income Accounting



National income accounting – a set of rules and
definitions for measuring economic activity in the
aggregate economy – that is, in the economy as a
whole.
National income accounting is a way of measuring
total, or aggregate production.
Gross Domestic Product (GDP) is the total value of
all final goods and services produced in an
economy in a one-year period.
Calculating GDP



Calculating GDP requires adding together millions of
goods and services
All of the quantities of goods and services produced
are multiplied by their market price per unit to
determine a value measure of the good or service
The sum of all of these values is GDP
The Expenditure Approach

GDP is equal to the sum of the four categories of
expenditures.
GDP = C + I + G + (X – M)




C for Consumption
I for Investment
G for Government Spending
X for Exports, M for Imports and (X-M) for Net Exports
GDP is a Flow Concept

GDP is a flow concept, the amount of total final output a
country produces per year

A flow concept has a time period associated with it;
GDP is reported on an annual basis

Wealth accounts – a balance sheet of an economy’s
assets and liabilities – is a stock concept

A stock is the amount of something at a given point in
time; no time interval is associated with it
GDP Measures Final Output

GDP does not measure total transactions in the economy

It counts final output, but not intermediate goods.
Final output – goods and services purchased for final use.
 Intermediate products are used as an input in the production of
some other product


Counting the sale of both final and intermediate goods
would result in double counting.
Two Ways of Dealing with the problem
of Double Counting

Calculate only final output.


A firm would report how much it sold to consumers and how
much it sold to producers (intermediate goods)
Follow the value added approach
Value added is the increase in value that a firm contributes to a
product or service.
 It is calculated by subtracting intermediate goods (the cost of
materials that a firm uses to produce a good or service) from
the value of its sales.

Value Added Approach
Participants
Farmer
Dairy factory
and cheese
maker
Middleperson
Vendor
Totals
Cost of
Materials
€0
Value of
Sales
€100
Value Added
€100
100
250
150
250
400
€750
400
500
€1,250
150
100
€500
What is Counted in GDP

Not counted
 Value
of resale goods
 Government transfer payments
 Sales of stocks or bonds
 Work of housespouses

Counted
 Value
added by a used car dealer
 Commissions of stock brokers
GDP and NDP

Net Domestic Product is GDP adjusted for
depreciation – the amount of capital used up in
producing that year’s GDP
NDP = C + I + G + (X-M) – depreciation

NDP measures output available for purchase
National and Domestic Concepts

Gross Domestic Product (GDP) is the total value of all final
goods and services produced in an economy in a one-year
period

Gross National Product (GNP) is the aggregate final output
of citizens and businesses of an economy in one year

GDP is output produced within a country’s borders

GNP is output produced by a country’s citizens (both inside
and outside the country)

GNP = GDP + Net foreign factor income
The Income Approach


Aggregate income is the total income earned by
individuals and firms in a country on an annual basis.
Aggregate income consists of:
employee salary
 profits
 rents
 interests

Equality of Income
and Expenditure



Whenever a good or service is produced (output),
somebody receives income for producing it
Aggregate Income = Aggregate Production
Profit is a residual that causes income and
expenditures to become equal
Comparison of output among countries



Per capita GDP can be used to compare relative
standards of living among various countries
Because of differences in non-market activities and
difference in product prices, per capita GDP may be a
misleading measure of living standards.
Purchasing power parity adjusts for relative price
differences before making comparisons.
Economic Welfare Over Time


If increases in GDP are due to increases in prices, then
welfare does not increase
Changes in welfare over time are best represented by
changes in real GDP, that is nominal GDP adjusted for
inflation
Nominal GDP
Real GDP 
 100
GDP deflator
Consumer Price Index



The most widely used measure of inflation
Measures the cost of a standard basket of goods at
specific points of time
Items in the basket are assigned a relative weight
according to their relative importance
Consumer Price Index



The most widely used measure of inflation
Measures the cost of a standard basket of goods at
specific points of time
Items in the basket are assigned a relative weight
according to their relative importance
Some Limitations of National Income
Accounting

GDP measures economic activity, not welfare.


Subcategories are often interdependent.


GDP does not measure happiness, nor does it measure
economic welfare
For example, the line between consumption and investment
may be unclear
Measurement problems are in existence
Summary



Aggregate accounting is a set of rules and definitions
for measuring economic activity in the aggregate
economy
GDP is the total market value of all final goods and
services produced in an economy in one year
GDP is the sum of four expenditures:
GDP = C + I + G + (X – M)
Summary



Intermediate goods can be eliminated from GDP by:
 Measuring only final sales.
 Measuring only value added
Net domestic product is GDP less depreciation. NDP
represents output available for purchase because production
used to replace worn out plant and equipment (depreciation)
has been subtracted
GDP measures output produced within the borders of a
country; GNP measures the economic output produced by the
citizens of a country.
Summary



Aggregate income = Compensation of employees +
Rent + Interest + Profit
Aggregate income equals aggregate production
because whenever a food is produced somebody
receives income for producing it. Profit is crucial to
maintain that equality
Because GDP measures only market activities, GDP can
be a poor measure of relative living standards among
countries.
Summary


To compare income over time, we must adjust for pricelevel changes. After adjusting for inflation, nominal
measures are changed to “real” measures
% change in real GDP = % change in nominal
GDP - inflation
Nominal GDP
Real GDP 
 100
GDP deflator
Summary

GDP presents the following shortcomings:
 does
not measure economic welfare
 does
not incorporate transactions taking place within
the underground economy
 the
price index used to calculate real GDP is
problematic
 subcategories
of GDP are often interdependent
Exercises
1. Let us assume that GDP equals €10000.
Investment is €2000 and Government Purchases
are €2500. Exports are €500 and Imports are €750.
How much is Consumption?
Solution: As GDP = C + I + G + (X – M) by substitution,
10000 = C + 2000 + 2500 + (500-750)
10000 = C + 4250
C = €5750
2. Let us assume that the Consumer Price Index
(CPI) consists of a list of goods and services as in
the Table below:
CPI COMPONENT
WEIGHT
Milk
0.20
Bread
0.20
Education
0.10
Heating
0.15
Bus Transportation
0.15
Medical services and medicines
0.20
Let 2000 be the base year and suppose that in 2010, bread’s price has
doubled, milk has become more expensive by 20%, education has become
40% cheaper whereas the price for Medical Services and Medicines has
increased by 10% and decreased 20% for heating. The ticket for Bus
Transportation has retained the same price. What is the Consumer Price
Index (CPI) for 2010?
2. Solution: The year 2000 is set as the base year and the CPI equals the base,
that is 100%. Therefore, the sum of the CPI components multiplied by the
coefficients of their importance should equal 100:
CPI2000 = 0,2 X 100 + 0,2 X 100 + 0,1 X 100 + 0,15 X 100 + 0,15 X 100 + 0,2 X 100
= 100
Hence, in 2010 and taking into account the changes in the prices of goods and
services, the CPI can be computed as follows:
CPI2010 = 0,2 X 120 + 0,2 X 200 + 0,1 X 60 + 0,15 X 80 + 0,15 X 100 + 0,2 X 110
= 24 + 40 + 6 + 12 + 15 + 22 = 119
Therefore the level of prices has risen by 19% in 2010 in comparison with the
respective level of 2000.
In year 2009 the nominal GDP amounted to $20000 whereas in
year 2010, $22000. The GDP deflator is 120 and 125,
respectively. What is the change in the nominal GDP? How
much of the change is attributed to a real increase in production
and how much stems from changes in the price level?
Solution:
22000 - 20000
%nominal GDP 
100  10%
20000
125 - 120
%price 
100  4.17%
120
%nominal GDP  %real GDP  Inflation
10%  %real GDP  4.17%
%real GDP  5.83%
Helpful reading
Economics. Samuelson, & Nordhaus (2005) Ch. 20-21
Macroeconomics. Mankiw, (2007) Ch. 1-2