ECON 2630Principles of Macroeconomics

Instructor: Dr. Ou Hu

Principles of Macroeconomics

• Macroeconomics studies the behaviors of overall economy.

• Goals of Macroeconomics– Sustainable economic growth– Full employment– Stable price

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Principles of Macroeconomics

Spending, Income, and GDP

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Gross Domestic Product, GDP: A Definition

– A nation’s gross domestic product (GDP)

• Total value of all final goods and services produced for the marketplace during a given period within the nation’s borders

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Gross Domestic Product, GDP: A Definition

• The total value– Approach of GDP is to add up dollar value of every good or service

—the number of dollars each product is sold for– GDP must be adjusted to take away the effects of inflation– Nominal GDP vs. Real GDP

• …of all final…– When measuring production, we do not count every good or

service produced in the economy• Only those that are sold to their final users

• Avoids over-counting intermediate products when measuring GDP– Value of all intermediate products is automatically included in value of final

products they are used to create

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Gross Domestic Product, GDP: A Definition

• …goods and services…– Goods: cars, furniture, computers, beer, etc.– Services: medical, financial, educational, etc.

• …produced…– In order to contribute to GDP, something must

be produced.

Q: should stocks or bonds be included in the calculation

of GDP?

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Gross Domestic Product, GDP: A Definition

• …for the marketplace…– GDP does not include all final goods and services

produced in the economy• Includes only the ones produced for the marketplace—that is,

with the intention of being sold

• …during a given period…– GDP measures production during some specific period

of time• Only goods produced during that period are counted how about used goods?• GDP is actually measured for each quarter, and then reported

as an annual rate for the quarter• Once fourth quarter figures are in, government also reports

official GDP figure for entire year

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Gross Domestic Product, GDP: A Definition

• …within the nation’s borders– U.S. GDP measures output produced

within U.S. borders• Regardless of whether it was produced by

Americans– Americans abroad are not counted– However, foreigners producing goods or services

within the country are included:

Chinese Acrobat Team, Honda, Rolling Stones

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The Expenditure Approach to GDP

• Expenditure approach divides output into four categories according to which group in the economy purchases it as final users– Consumption goods and services (C)—purchased by

households– Private investment goods and services (I)—purchased

by businesses– Government goods and services (G)—purchased by

government agencies– Net exports (NX)—purchased by foreigners

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The Expenditure Approach to GDP

• When we add up the purchases of all four groups we get GDP

GDP = C + I + G + NX

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Consumption Spending

• Consumption is the part of GDP purchased by households as final users– Almost everything households buy during the

year is included as part of consumption spending when we calculate GDP

– One exception is construction of new homes• Counted as private investment

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Private Investment

• Private investment has three components– Business Purchases of Plant, Equipment, and Software

• A firm’s plant, equipment, and software are intended to last for many years—only a small part of them is used up to make the current year’s output

• Are regarded as final goods, and firms that buy them as final users of those goods

– New Home Construction• Residential housing is an important part of nation’s capital stock• House will continue to provide services into the future

– Changes in Inventories• We count the change in firms’ inventories as part of investment in measuring

GDP• Why?

– When goods are produced but not sold during the year, they end up in some firm’s inventory stocks

– Part of the nation’s capital stock– Will provide services in the future, when they are finally sold and used

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Government Purchases

• Purchases by state, local governments and federal government are included

• Government purchases include – Goods

• Fighter jets, police cars, school buildings, spy satellites, etc.

– Services• Such as those performed by police, legislators, and military

personnel

• Government is considered to be a purchaser even if it actually produces the goods or services itself

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Government Purchases

• Exclude transfer payments– Transfer payments represent money

redistributed from one group of citizens (taxpayers) to another (poor, unemployed, elderly)

– While transfers are included in government budgets as outlays they are not purchases of currently produced goods and services

• Exclude interest paid on government debt

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Net Exports

• Once we recognize dealings with the rest of the world, we must correct an inaccuracy in our measure of GDP – Deduct all U.S. imports during the year, leaving

us with just output produced in United States

• To properly account for output sold to, and bought from, foreigners– We must include net exports—difference

between exports and imports—as part of expenditure in GDP

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Consumption $9,732.0

Durable Goods $1,079.6

Non-durable Goods 2,833.0

Services 5,819.4

Investment 2,132.3

Business Fixed Investment 1,483.2

Residential 641.5

Inventory 7.6

Government Purchases 2,691.4

Net Exports – 712.7

Exports 1,640.3

Imports 2,353.0

GDP $13,843.0

US GDP, 2007 (billions of dollars)

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Other Approaches to GDP: The Value-Added Approach

• Value added – Firm’s contribution to a product or– Revenue it receives for its output

• Minus cost of all the intermediate goods that it buys• GDP is sum of values added by all firms in economy

Company RevenuesCost of

Purchased InputsValue

Added

ABC Grain $0.50 $0.00 $0.50

General Flour

$1.20 $0.50 $0.70

Hot'n'Fresh $2.00 $1.20 $0.80

Total $2.00

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Other Approaches to GDP: The Factor Payments Approach

• In any year, value added by a firm is equal to total factor payments made by that firm

• Thus, GDP must equal total factor payments made by all firms in the economy

• All of these factor payments are received by households in the form of wages and salaries, rent, interest or profit

– GDP is measured by adding up all of the income—wages and salaries, rent, interest, royalties,and profit—earned by all households in the economy

• Gives us an important insight into the macroeconomy– Total output of economy (GDP) is equal to total income

earned in the economy

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Measuring GDP: A Summary

• Different ways to calculate GDP– Expenditure Approach

• GDP = C + I + G + NX

– Value-Added Approach• GDP = Sum of value added by all firms

– Factor Payments Approach• GDP = Wages and Salaries + interest + rent + profit

Therefore, Total output = Total household income

GDP Global Perspective

• http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28nominal%29

• http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28nominal%29_per_capita

• http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28PPP%29_per_capita

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Problems With GDP

• Quality Changes

• Underground Economy

• Non-market Production

• Not a perfect measure of economic well-being

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Quality Change

– While BEA includes impact of quality changes for many goods and services (such as automobiles and computers)

• Does not have the resources to estimate quality changes for millions of different goods and services

By ignoring these quality improvements, GDP probably understates true growth from year to year.

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The Underground Economy

• Some production is hidden from government authorities– Either because it is illegal or

• Drugs, prostitution, most gambling

– Because those engaged in it are avoiding taxes• Production in these hidden markets cannot be

measured accurately

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Non-Market Production

• GDP does not include non-market production– Goods and services that are produced, but not sold in the

marketplace

• Whenever a non-market transaction becomes a market transaction GDP will rise– Even though total production has remained the same

• Can exaggerate the growth in GDP over long periods of time

• What do these problems tell us about value of GDP?– For certain purposes—especially interpreting long-run changes in

GDP—we must exercise caution

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Not a perfect measure of economic well-being

• No value measured on leisure

• “Bad” things can raise GDP.

Disasters, wars, etc.

• Externality – ecological cost

The Business Cycle

• Alternating increases and decreases in economic activity over time

• Phases of the business cycle

• Peak

• Recession

• Trough

• Expansion

Figure 1: The Business CycleL

evel

of

real

ou

tpu

t

Time

Peak

Peak

Peak

Recession

Recession

Expansion Expansion

Trough

Trough

Growth

Trend

The Business Cycle

U.S. Recessions since 1950

PeriodDuration,Months

Depth(Decline in Real

Output)

1953-54 10 -2.6%

1957-58 8 -3.7

1960-61 10 -1.1

1969-70 11 -0.2

1973-75 16 -3.2

1980 6 -2.2

1981-82 16 -2.9

1990-91 8 -1.4

2001 8 -0.4

2007-09 18 -3.7

Source: National Bureau of Economic Research, http://www.nber.org and Minneapolis Federal Reserve Bank, http://www.minneapolisfed.org/ Output data are in 2000 dollars

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Types of Unemployment

• In United States, people are considered unemployed if they are not working AND actively seeking a job– Unemployment can arise for a variety of reasons, each

with its own policy implications– This is why economists have found it useful to classify

unemployment into four different categories– Frictional unemployment

– Seasonal unemployment

– Structural unemployment

– Cyclical unemployment

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Frictional Unemployment

• Short-term joblessness experienced by people who are between jobs or who are entering the labor market for first time or after an absence

• Because frictional unemployment is, by definition, short-term, it causes little hardship to those affected by it

• By spending time searching rather than jumping at the first opening that comes their way

– People find jobs for which they are better suited and in which they will ultimately be more productive

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Seasonal Unemployment

• Joblessness related to changes in weather, tourist patterns, or other seasonal factors

• Is rather benign– Short-term– predictable– Workers are often compensated in advance for unemployment

they experience in off-season

• To prevent any misunderstandings, government usually reports the seasonally-adjusted rate of unemployment

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Structural Unemployment

• Joblessness arising from mismatches between workers’ skills and employers’ requirements – Or between workers’ locations and employers’

locations

• Generally a stubborn, long-term problem– Often lasting several years or more

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Cyclical Unemployment

• When the economy goes into a recession and total output falls, the unemployment rate rises

• Since it arises from conditions in the overall economy, cyclical unemployment is a problem for macroeconomic policy

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Figure 2: U.S. Unemployment Rate, 1960–2007

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Figure 3: Unemployment in Western Europe, 1980 - 2007

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High Unemployment in Europe

• Unemployment rates have increased since 1980

– 2007 unemployment rates

Country Italy France Germany UK US

Unemployment Rate

6.0% 8.2% 8.0% 5.3% 5.5%

Structural rigidities explain persistently high rates– Regulated labor markets– High minimum wages– Generous unemployment benefits– Powerful labor unions

Definition of Full Employment

• Natural Rate of Unemployment (NRU)

• Full employment level of unemployment

• Can vary over time

•Demographic changes

•Changing job search methods

•Public policy changes

• Actual unemployment can be above or fall below the NRU

Economic Cost of Unemployment

• GDP Gap

• GDP gap = actual GDP – potential GDP

• Can be negative or positive

• Okun’s Law

• Every 1% of cyclical unemployment creates a 2% GDP gap

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How Unemployment is Measured

• The unemployed are those willing and able to work, and who are actively searching for jobs

• Others were able to work, but preferred not to– Including millions of college students, homemakers,

and retired people

• Still others not counted when calculating civilian employment statistics

In the military, in hospital, and in prison

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Figure 4: Employment Status of the U.S. Population – An Illustration

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Figure 5: How BLS Measures Employment Status

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US Employment Data, Jan 2008

Employed 146.2 million

Unemployed 7.6 million

Labor Force 153.8 million

Not in the Labor Force 78.8 million

Working-Age Population 232.6 million

Unemployment Rate 4.9%

Participation rate 66.1%

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Problems In Measuring Unemployment

– Treatment of involuntary part-time workers • Some economists have suggested that involuntary

part-time workers should be regarded as partially employed and partially unemployed

– Treatment of discouraged workers• Individuals who would like to work but, because they

feel little hope of finding a job, have given up searching

Some Data Sources

• Bureau of Economic Analysis– www.bea.gov

• Federal Reserve Bank of St. Louis – http://www.stlouisfed.org/