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Part I
Introduction
Tendai Makova
Room 234 Comm. Bldng
to
tmakova@sociol.uz.ac.zw Macroeconomics
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What is Macroeconomics? Macroeconomic Questions

• Macroeconomics: study of behavior of economy at
aggregate level (BIG picture).
• Focuses on the relationships among major
economic aggregates: national output/income
(GDP), consumption, investment, general price
level, the unemployment rate, trade balance etc.
• Aggregates result from behaviour of different
economic agents: households, firms, govt &
foreign sector.
• In contrast, microeconomics deals with market
behaviour of individual firms & consumers. 3
i. Why does output fluctuate?
ii. What determines economic growth?
iii. Why do we have unemployment & how
can it be reduced?
iv. What are the sources of price inflation
& how can it be kept under control?
v. How does domestic activity affect other
countries & our trade balance?
These questions generally translate into macroeconomics
objectives
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Objectives of Macroeconomics
1. Economic Growth
1. Economic growth i. High level & rapid growth of
2. Full employment output
3. Price stability • Output: goods & services
4. Balance of Payments Stability produced in the economy.
• Comprehensive measure: Gross
5. Equitable distribution of Domestic Product (GDP).
income • Steady long-term growth in GDP
is called economic growth.
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Actual & Potential Output 2. Full Employment

• All eligible people who want to work
• Actual output (GDP): what is actually
have a job at prevailing wage rates.
produced (Y).
• Employment: number of adult
• Potential Output: what can be
produced if all factors are utilized at
workers who hold a job.
their normal levels [FE income (Y*)]. • An unemployed person is one who is
• Y* grows steadily as its determinants not currently employed & is actively
change but Y is subject to large seeking a job, waiting to begin a job,
business cycle swings. on layoff, waiting to return to a
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previous job. 8

2. Full Employment 3. Price Stability

• Labour force: total number of adult • General price level should either be constant
workers (employed or unemployed). or rise very slowly.
• Govt uses price indices such as the consumer
• Unemployment rate = price index to track price movements.
[Unemployed/Labour force] x 100. • Price stability is measured by the inflation
• Unemployment rate when the rate which is the % change in overall prices
economy is at full employment is called from one year to another.
the natural rate of unemployment or • A decline in prices is termed deflation &
NAIRU (Non-Accelerating Inflation Rate extremely high inflation is called
of Unemployment). hyperinflation & this results in the breakdown
9 of the price system. 10

Business Cycle Business Cycle Cont’d

Economic Growth, Unemployment & Inflation can • Business cycle: recurring & fluctuating levels
all be explained using the Business Cycle Concept. of economic activity over a long period of
Real GDP
Actual GDP
time.
(Y)
Inflationary Gap
Y > Y*
Potential GDP
• Trough: unused productive capacity, profits
Peak (Y*)
are low (negative), economic prospects
Recession/
Contraction bleak, new investment low.
Recovery/
Expansion Recessionary Gap
Y* > Y • Expansion/Recovery: rundown equipment
Trough replaced; prospects improve; output, income
& consumer spending increase, new
Time 11 investment picks up. 12

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Business Cycle Cont’d
• Peak: existing capacity used to a high
degree; resource shortages; excess demand
exists in markets; costs & prices rise
(inflation).
• Contraction/Recession: fall in GDP for two
successive quarters; demand falls hence
output falls & unemployment rises; profits
drop; unused capacity increases, investment
falls. NB: a sustained recession is called a
depression 13
4. BOP/External Stability
Balance of Payments
• BOP shows a record of imports (M) &
exports (X) of a country (trade
balance or net exports).
• Balance needed between X & M.
• Exports > Imports – trade surplus
• Exports < Imports – trade deficit
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5. Equitable Distribution of Income
• Involves sharing of the ‘national cake’,
a highly subjective issue.
• Highly unequal distribution of income
may lead to social & political conflict.
• Also has effects on the structure &
development of the economy.
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Business Cycle Cont’d
• If (Y > Y*): inflationary gap,
upward pressure on prices due
increase in resource prices.
• If (Y < Y*): recessionary gap,
economy is operating below its
potential. Unemployment is
increasing.
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BOP Cont’d
Exchange rate
• Amount of local currency required to purchase a
unit of foreign currency.
• An important aggregate in stabilising the BOP.
• Measures the external power of the local currency.
• A rise reflects a depreciation (decrease in external
value) whilst a fall reflects an appreciation (increase
in external value).
Homework
• Which of the two (depreciation & appreciation) is
good for a country?
• What is devaluation & revaluation?
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Other Aggregates
Interest rate
• Cost of borrowing/ price of money.
• Determines the level of investment in
the economy.
• High interest rates → high cost of
borrowing → low investment → low
productive capacity → low output &
high unemployment.
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Tools of Macroeconomics Fiscal Policy

• Govts influence macroeconomic
activity through policy.
• Policy instrument: economic variable
under the control of govt that affects
one or more of the macroeconomic
goals.
• Main instruments: fiscal policy &
monetary policy.
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• Use of tax (T) & govt expenditure (G).
• Govt expenditure: spending on goods &
services & transfer payments (elderly,
unemployed, etc).
• Tax affects (i) disposable income hence
private consumption & savings and (ii)
prices of goods & factors of production
hence investment incentives.
• Who is responsible for the fiscal policy?
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Monetary Policy Circular Flow of Income (CFI)

• Central bank regulation of the money
• Used to illustrate macro-economic inter-
supply & interest rates.
relationships among households, firms,
• Interest rate sensitive areas such as govt & the foreign sector as they interact in
housing/property market, business the four key markets namely:
investment & net exports (exchange rate)
• Goods & Services market.
are affected.
• Resource market.
• For example: ↓ money supply → ↑ interest
• Loanable Funds/Financial market.
rates → ↓investment → ↓GDP vice versa.
• Foreign Exchange market.
• Who is responsible for the monetary
policy? 21 22

The Circular Flow Diagram

• Four key markets coordinate the
circular flow of income.
• The resource market coordinates
the actions of businesses
demanding resources
households supplying them in
exchange for income.
• The goods & services market
&
Part II
National Income
coordinates the demand for and
supply of domestic production
(GDP).
• The foreign exchange market
brings the purchases (imports)
from foreigners into balance with
the sales (exports plus net inflow
of capital) to them.
• The loanable funds market
Accounting
brings net household saving &
the net inflow of foreign capital
into balance with the borrowing
of businesses & govts.
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National Income Accounting Gross Domestic Product (GDP)

• Used to measure overall performance of the • Primary & most widely used measure of
economy using a body of statistics that records an economy’s performance .
economic activity. • GDP measures total market value of
• It enables economists & policymakers to: final goods & services produced within
a) Assess the health of the economy by comparing a country during a specific time period,
levels of production at regular intervals; usually a year.
b) Track the long run course of the economy to see • Prior to it, the Gross National Product
whether it has grown, has been constant, or (GNP),which measures the value of
declined; goods & services produced by
c) Formulate policies that will safeguard & improve domestically owned resources
the economy. regardless of where they are used.
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What counts towards GDP? What counts towards GDP? Cont’d

• Only final goods & services count, i.e. goods used by the final
consumer, not for resale, processing or manufacturing .
• Sales at intermediate stages of production are not counted
as their value is embodied within the final-user good.
• Including goods at intermediate stages of production
results in double counting.
Source: Gwartney et al (2009)
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• Only transactions involving production
•Financial transactions & income transfers
are excluded because they do not reflect
actual production.
• Only production within the boundary of a
country.
• Only goods produced during the current period
(year)
•Thus, the purchase & sale of goods
produced during earlier years are not
counted in this year’s GDP. Second-hand
goods sales are not considered as well.
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Two Ways of Measuring GDP Two Ways of Measuring GDP

• Thus GDP can be derived by:
What is spent on a product is received
as income by those who helped i. totaling the expenditures on final-user
produce it. goods & services produced during the
year. Expenditure Approach; or
Amount spent to Money income ii. summing the income payments to the
purchase this year’s
total output = derived from producing
this year’s total output
resource suppliers & the indirect cost
of producing the goods & services.
Income Approach.
Dollar flow of Dollar flow of
expenditures = GDP = income (and indirect • In essence, buying (spending $) & selling
on final goods cost) of final goods (receiving $) are two aspects of the same
transaction.
Thus GDP is both a measure of INCOME & OUTPUT 29 30

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The Expenditure Approach The Expenditure Approach

• GDP is the sum of expenditures on final-user
goods & services purchased by households,
business, govts, & foreigners.
• When calculated by this method, there are
four components of GDP:
1. Personal Consumption Purchases (C) [Household
expenditures on durable & non durable goods & services]
2. Gross Private Investment (I) [purchases of
machinery, equipment & tools by business enterprises, all
construction (residential & industrial), changes in inventory
(unconsumed output)]
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3. Govt Purchases (G)
[consumption expenditure on goods & services
used in providing public services (including
labour) & investment spending on social capital
such as schools, highways, dams, bridges, which
have long life spans]
4. Net Exports (X – M)
[expenditure on domestic goods & services by
foreigners (exports) less spending on foreign
goods by domestic economic agents (imports)]
GDP = C + I + G + ( X – M) 32

Income Approach Income Approach Cont’d

• GDP is the sum of costs incurred & income
(including profits) generated by the production of
goods & services during the period.
• The income components of GDP:
1. Employee compensation (including self-
employment) [salaries, wages, payments to
social insurance & private pensions, health &
welfare funds]
2. Rents [income received by households & firms
that supply property resources – figure included
is net rent which is gross rental income minus
3. Interest: money paid by firms to suppliers of capital &
interest received by households on savings deposits,
certificates of deposit (CDs) & corporate bonds
4. Profits
a) proprietor's income which flows to owners of sole
trading firms & partnerships,
b) income to corporations/public companies which
are divided into
i. Corporate income tax: levied on earnings & flow
to govt
ii. Dividends: paid to shareholders & ultimately
flow to households
iii. Undistributed profits: money saved for capital
reinvestment (retained earnings)
Thus,

depreciation of rental property] Employee Compensation + Rents + Interest + Profits = National Income

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Income Approach Cont’d Income Approach Cont’d

• Not all income components of GDP result in an • Thus when derived by the Income Approach,
income payment to a resource supplier. To get
GDP, we need to account for 3 other factors: GDP is equal to the sum of
• Indirect business taxes: Taxes that increase the
firm’s production costs & therefore final prices but do • National income,
not accrue to the resource suppliers. (employee compensation, rents, interest, profits)
• Depreciation: Cost of wear & tear on machines & • Indirect business taxes,
other capital assets used to produce goods & services.
• Net Income of Foreigners: Income that foreigners • Depreciation, &,
earn producing goods within the country’s borders • Net income of foreigners.
minus the income the country’s citizens earn abroad.
Sum of the above = GDP
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A Summary Real & Nominal GDP

• GDP measured in current money value is
The two methods of calculating GDP are summarized called nominal GDP whilst GDP measured
below:
using constant money value is called Real GDP
• Since GDP is a money or nominal value of
goods & services, year to year market values
are affected by inflation/deflation thus
making direct comparison ‘tricky/misleading’
• The way around this problem is to deflate the
GDP when prices rise or inflate it when prices
fall to transform it from a nominal to a real
value.
Source: Gwartney et al (2009) 37 38

Real & Nominal GDP Two Key Price Indices

• “Real GDP" means adjusted for inflation,
hence Nominal GDP tells us of money value
while RGDP focuses on physical quantities.
• Price indices are used to adjust income &
output data for the effects of inflation.
• A price index is a measure of the price of a
specified collection of goods & services
(market basket) in a given year as
compared to the price of an identical (or
highly similar) basket in an earlier
reference (or base) year.
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• Consumer Price Index (CPI): measures changes in
the prices of a fixed market basket of goods &
services purchased by a typical urban household.
• GDP Deflator or GDP Price Index: compares the
market value of all the goods & services included in
the GDP in a given year to the same market basket
in a reference year.
• The GDP deflator is therefore a broader & more
comprehensive price index than the CPI.
• For the GDP Deflator, relative weights of goods &
services are annually adjusted whilst for the CPI,
the weights are fixed (though reviewed
periodically) to reflect a constant market basket.
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Converting Nominal GDP to

Price Index Formula
Real GDP
• The price index (PI) for a given • The formula for converting year t
year is given by: nominal GDP into real GDP (in base year
prices) is:
Price Price of a market basket in a
Index in specific year
a given = x 100 Nominal GDP
year
Price of same market
basket in a base year
Real = X 100
GDP Price Index

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Converting Earlier Figures into Current
• Sometimes we will want to make real data (e.g.
income) comparisons in terms of the purchasing
power of the dollar during the current year.
• This can be done by “inflating” the data for
earlier years for increases in the price level.
• The formula for converting the figures for an
earlier year into current dollars is:
price indexcurrent year
x 100%
Figurecurrent $ = Figureearlier $
price indexearlier year
If prices have risen, this will “inflate” the data for
earlier years & bring them into line with the current
purchasing power. 43
Shortcomings of GDP
1. Does not count non-market production (services of
homemakers or DIY).
2. Does not count underground economy (SMEs &
backyard industry) – non-income economy (barter).
3. Does not include illegal activities (prostitutes, drug
dealers, etc).
4. Makes no adjustment for leisure (increase in leisure
has a positive effect on well-being).
5. Does not include satisfaction or self actualization that
people derive from work.
6. Ignores improvements in the quality of products
(increase in quality has great effect on well-being as
does quantity).
7. Disasters can raise GDP (war, oil spills, tsunamis)??
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Alternatives to GDP
1. Human Development Index (HDI) - uses GDP as a part
of its calculation & then factors in indicators of life
expectancy & education levels.
2. Genuine Progress Indicator (GPI) or Index of
Sustainable Economic Welfare (ISEW) – takes the same
raw information supplied for GDP & then adjusts for
income distribution, add the value of household &
volunteer work, & subtract crime & pollution.
3. Gini Coefficient - measures the disparity of income
within a nation.
4. Wealth Estimates - a system for combining monetary
wealth with intangible wealth (institutions & human
capital) & environmental capital. 47
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What is Inflation?
• Inflation is an increase in the general level
of prices. It is typically calculated annually but
can also be calculated on a month-on-month
basis.
• Inflation can be calculated using either the CPI or
the GDP deflator.
• The Rate of Inflation is calculated as:
This year’s Last year’s
Inflation = price index - price index x
rate Last year’s
price index
Even though the CPI & the GDP deflator are based on
different market baskets & procedures, they yield relatively
similar estimates of the rate of inflation. 44
Shortcomings of GDP Cont’d
8. Does not adjust for harmful side effects (social costs of
pollution not deducted from overall GDP).
9. Ignores the issue of composition (does mix of goods enrich
or compromise well-being) – a grenade & mealie-meal may
be assigned same weight.
10.Reveals nothing about the distribution of the output (does
90% output go to 10% population – fairness/equity).
11.Per capita output measures only the magnitude of total
output per person but conceals changes in the standard of
living of individuals or households.
12.Ignores non-economic sources of well-being such as
reduction in crime & drug abuse, tranquility in the
household, good international relations, etc.
Homework: What are the strengths of GDP? 46
Alternatives to GDP Cont’d
5. Gross National Happiness – uses indicators such as living
standards, health, education, eco-system diversity &
resilience, cultural vitality & diversity, time use & balance,
good governance, community vitality & psychological well-
being to assess progress towards gross national happiness
(Bhutan).
6. Happy Planet Index - measures the environmental efficiency
with which human well-being is achieved within a given
country or group. Human well-being is defined in terms of
subjective life satisfaction & life expectancy while
environmental impact is defined by the Ecological Footprint
[a measure of human demand on the earth’s ecosystems]
(New Economics Foundation (NEF) – 2006).
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NATIONAL INCOME
DETERMINATION
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Aggregate Expenditure Model
• Put forward by John Maynard Keynes who
developed the idea that “total production
/output (Y) is determined by total spending
(AE) in the economy.
• 3 possible relationships between Y & AE:
1. AE=Y – equilibrium level of output & income.
2. AE>Y – output increases to match spending.
3. AE<Y – output falls to match spending.
• This brings us to the concept of desired
aggregate expenditure. 51
The Two Sector Model
(Simple Keynesian Model)
• Our analysis begins with a very simplified model with
only two of the four components mentioned above –
consumption & investment i.e.
AE = C + I
• These two determine the level of equilibrium output.
• We assume a closed economy (no international trade),
no govt, & a constant price level.
• Wage rate & interest rate are given (exogenous).
• Saving becomes the only withdrawal & investment the
only injection into the circular flow of income.
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National Income Determination
• Looks at how the level of real GDP is
determined & how it fluctuates around
the level of potential GDP.
• We consider two models of income
determination:
1. The Aggregate expenditure Model
(Keynesian Model).
2. The Aggregate Demand-Aggregate
Supply (AD-AS) Model.
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Desired Aggregate Expenditure (AE)
• Refers to the sum of desired or planned spending on domestic
output by the four economic agents.
• AE is made up of the expenditure components: consumption (C),
investment (I), govt expenditure (G), & net exports (X – M).
AE = C + I + G + (X – M)
• NB: National Income Accounts measure actual expenditures in
the above four categories whilst National Income Theory deals
with desired expenditures.
• AE is divided into two components:
– autonomous (does not change systematically with or depend
on national income); &
– induced (systematically related/respond to changes in
national income).
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Consumption, Saving & Investment
• Consumption spending (C) is household
expenditure on durable & non-durable
goods & services while saving (S) is that
part of disposable income not consumed.
• Saved income is the one that is borrowed
for investment spending (I).
• Consumption, Saving & Investment play
central roles in an economy.
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Consumption, Saving & Investment
• Economies that save & invest more tend to
experience higher growth than those that
consume more.
• Where consumption & investment spending
are high, aggregate demand increases raising
output & employment in the short run.
• A drop in consumption leads to a drop in
aggregate expenditure leading to a recession
as investment falls.
The Consumption Function
• Relates total desired consumption
expenditures of all households to factors that
determine it, i.e., disposable income, wealth,
interest rates, & expectations about the
future.
• In the simple case (this case) the consumption
function relates desired consumption
expenditure to disposable income.
• The concept is based on the hypothesis that
there is a stable empirical relationship
between consumption & income (Keynes).
C-function Cont’d
• Consumption can be broken down into:
1. Autonomous consumption is the minimal amount
consumed by an individual at zero income (through
borrowing or dissaving).
2. Induced consumption is the one that varies with
disposable income (the higher the income, the higher
the amount consumed).
• The consumption function can be represented by
the following equation:
C = a + bYD
• a represents autonomous & bYD represents
induced consumption expenditure
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Income (Y), Consumption (C) & Saving (S)
• Personal income (Y) less taxes (T) gives
disposable income (Yd) that is (Y - T = YD).
• But in our Two Sector Model, (Y = YD) since we
assume no govt hence no income tax.
• Disposable income is either consumed or saved.
(YD = C + S).
• Studies show that income is the primary
determinant of C & S.
• C & S rise with disposable income hence there is
a positive relationship.
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Consumption Function Characteristics
1. Consumption increases as income increases.
2. Consumption is positive even if income is
zero.
3. When income increases, consumption
increases but by a lesser percentage.
Y  C
• Since the two are positively related, the c-
function is upward sloping on a graph.
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