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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
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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Figure 2 Unemployment Rate Since 1960
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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
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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
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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
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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
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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