macroeconomics. macroeconomics vs. microeconomics major issues: –determination of aggregate...

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

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

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

GDP 10,480

C 7,385 70%

Durable 911 12%

Non-Dur 2,086 29%

Services 4,388 58%

I 1,589 15%

Non-Res 1,080 68%

Res 504 32%

Chg Inv 5 0%

G 1,932 18%

F 679 35%

S&L 1,253 65%

NX -426 -4%

X 1,006 10%

I 1,433 14%

BEA2002

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

• InflationInflation refers to a situation in which the economy’s overall price level is rising.

• The inflation rateinflation 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:

G D P d efla to r =N o m in a l G D P

R eal G D P 1 0 0

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:

R eal G D PN o m in a l G D P

G D P d efla to r2 0 X X2 0 X X

2 0 X X

1 0 0

Real and Nominal GDP

Copyright©2004 South-Western

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

Real and Nominal GDP1947-2004

Real GDP with Pct. Changes1947-2004

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 Choose a Base Year and Compute the Index: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 andbeverages

17%Transportation

Medical care

6%

Recreation

6%

Apparel

4%

Other goodsand services

4%

41%Housing

6%Education and communication

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

1965

Percentper Year

15

CPI

GDP deflator

10

5

01970 1975 1980 1985 1990 20001995

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:

S ala ry S a la ryP rice lev e l in 2 0 0 1

P rice lev e l in 1 9 3 12 0 0 1 1 9 3 1

$ 8 0 ,.

$ 9 3 1,

0 0 01 7 7

1 5 2

5 7 9

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

1965

Interest Rates(percentper year)

15

Real interest rate

10

5

0

–51970 1975 1980 1985 1990 1995 2000

Nominal interest rate

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

Copyright©2003 Southwestern/Thomson Learning

AdultPopulation

(211.9 million)

Labor Force(141.8 million)

Employed(135.1 million)

Not in labor force(70.1 million)

Unemployed (6.7 million)

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

Copyright©2003 Southwestern/Thomson Learning

10

8

6

4

2

01970 19751960 1965 1980 1985 1990 2005

Percent ofLabor Force

1995 2000

Natural rate ofunemployment

Unemployment rate

Figure 3 Labor Force Participation Rates for Men and Women Since 1950

Copyright©2003 Southwestern/Thomson Learning

100

80

60

40

20

01950 1955 1960 1965 1970 1975 1980 1985 1990 2000

Labor-ForceParticipation

Rate (in percent)

Women

Men

1995

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

Copyright©2003 Southwestern/Thomson Learning

Quantity ofLabor

0

Surplus of labor =Unemployment

Laborsupply

Labordemand

Wage

Minimumwage

LD LS

WE

LE

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

Billions of1996 Dollars

Real GDP

(a) Real GDP

$10,000

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,0001965 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

Billions of1996 Dollars

(b) Investment Spending

$1,800

1,600

1,400

1,200

1,000

800

600

400

2001965 1970 1975 1980 1985 1990 1995 2000

Investment spending

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