LECTURE NOTES

What is Macroeconomics?

Macroeconomics (Greek makro = ‘‘big’’) describes and explains economic

processes that concern aggregates. An aggregate is a multitude of economic
subjects that share some common features. By contrast, microeconomics treats
economic processes that concern individuals. Macroeconomics studies the structure
of aggregate economies and the impact of policies on their performance.
Example: The decision of a firm to purchase a new computer from company A is
not a macroeconomic problem. The reaction of Turkish households consumption to
an increased rate of income taxation is a macroeconomic problem.
Macroeconomic questions we will address this term:
What determines economic fluctuations? (business cycle)
Why some countries grow faster than others? (economic growth)
What causes unemployment?
What drives prices changes? (inflation)
What is the role of economic policies and the government? (monetary and fiscal
policies)
How being part of a global economic system affects the economy of a country?
National Accounts:
Gross Domestic Product (GDP) is a measure of output. We care about GDP
because output is highly correlated (at certain times) with things we care about
(standard of living, wages, unemployment, inflation, budget and trade deficits,
value of currency, etc...)
Definition: GDP is the Market Value of all Final Goods and Services Newly
Produced on Domestic Soil During a Given Time Period.
Three ways of measuring GDP:

Production Method: Measure the Value Added summed across all firms (value
added = sale price less cost of raw materials)

Income Method: Labor Income (wages/salary) + Capital Income (rent, interest,

dividends, profits)+ Government Income (taxes)

Expenditure Method: Spending by consumers (C) + Spending by businesses (I) +

Spending by government (G) + Net Spending by foreign sector (NX)

Fundamental identity of national income account:

total production = total income = total expenditure

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A simple example of how GDP is measured:

Orange Inc. Transactions

Wages Paid to Employees $15000
Taxes paid to government $ 5000
Revenue received from sale of oranges $ 35000

- Oranges sold to public $ 10000

- Oranges sold to Juice lnc $ 25000
Juice Inc. Transactions
Wages paid to Juice lnc employees $ 10000
Taxes paid to government $ 2000
Oranges purchased from Orange lnc $ 25000
Revenue received from sale of orange juice $ 40000

What is the total value (in dollars) of the economic activity generated by these 2
firms?

Production Method (value added: sales – intermediate good): 35 + (40– 25) = 50

Income Method (Wages + Profits + Taxes) = 15 + 10 + 15 + 3 + 5 + 2 = 50
Expenditure approach (expenditure by final users): 10 + 40 = 50

GDP (Y) is a measure of Market Production! Market value = how much you have
to spend to buy

What is produced in the market has to show up as being purchased or held by some
economic agent;

Who are the economic agents we will consider on the expenditure side?

Consumers (refer to expenditure of consumers as “consumption”)

Businesses (refer to expenditure of firms as “investment”)
Governments (refer to expenditures of governments as “government spending”)
Foreign Sector (refer to expenditures of foreign sector as “net exports”)

We will predominantly spend our time working with the Expenditure Approach:

Y = C + I + G + NX

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We produce oranges and I can potentially:

Sell them to some domestic customer (Consumption), Sell them to some business
(Investment), Keep them in my stock room as inventory (Investment)
, Sell them to the city of Istanbul for the shelters (Government spending), Sell them
to some foreign customer (Net Export).

Components of Expenditure:
• Consumption (C):

The Sum of Durables, Non-Durables and Services Purchased Domestically by Non-

Businesses and Non-Governments (i.e., individual consumers).
Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables).
Does Not Include Purchases of New Housing.

• Investment (I):

The Sum of Durables, Non-Durables and Services Purchased Domestically by

Businesses

Includes Business and Residential Structures, Equipment and Inventory Investment

Land purchases are not counted as part of GDP (land is not produced)

Stock purchases are not counted as part of GDP (stock transactions do not represent
production – they are saving)

There is a difference between financial and economic investment.

Government Spending (G):

Goods and services purchased by domestic government. For the U.S., 2/3 of this is
at the state level (police and fire protection, school teachers, snow plowing) and 1/3
is at the federal level (President, Post Office, Missiles).
Note: Welfare and Social Security are not government Spending. These are transfer
payments. Nothing is produced in this case.

Net Exports (NX): Exports (X) - Imports (M)

Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil

Imports: The Amount of Goods Produced on Foreign Soil Purchased

Domestically.

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Only include expenditures for goods that are “produced”.

If I give $10 to a movie theater to watch a movie, it is counted as expenditure.

If I give $10 to my friend for a birthday present, it is not counted as expenditure.
If I give $10 to the ATM machine to put in my savings account, it is not counted as
expenditure.

The second example would be considered a “transfer” (once I give $10 to my

friend, he can go to the movies if he wants to – once that $10 is spent, it will show
up in GDP). – “Transfers” are defined as the exchange of economic resources
from one economic agent to another when no goods or services are exchanged.

The third example is considered “saving” (I am delaying expenditure until the

future). Once I spend the $10 in the future, it will show up in GDP.

How would these transactions be counted as part of 2008 U.S. GDP Calculation?

• I purchase a $500 Swiss watch.

• I receive $200 unemployment check from the state government.
• The city of Chicago spends $1 million this year repairing its streets.
• US steel purchases a new $10 million steel rolling machine for its factory.
• Ford Motor Company purchases $10 worth of steel for building fenders.
• I buy a 1998 Ford Escort from a Dealer.
• I buy a plot of land for $100,000.
• I pay a local accountant $175 for her help in filling in my taxes.
• A U.S. travel agent is paid $1000 for services rendered to U.S. customers
while in Tokyo for a year.

What GDP is not?

GDP is not an absolute measure of well being .

Size effects: GDP per capita is not a perfect measure of welfare

GDP Does Not Measure:

• Non-Market Activity (home production, leisure, black market activity)

• Environmental Quality/Natural Resource Depletion
• Life Expectancy and Health

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 • Income Distribution
• Crime/Safety

Defining Savings:

Yd = Disposable Income = Y - T + Tr
Y: Income

T = Taxes Tr = Transfers (ie, Welfare, Unemployment Benefits)

Yd = C + S

Sp = Personal (Household or Private) Saving

Sp = Y - T + Tr–C

Government savings (Public savings) = T - G – Tr = Sgov

Total savings are given by S = Sp + Sgov

So, S = Y - G – C and S = I + NX

In a closed economy without a government:

Y : GDP
C: households spending on consumption
S: saving
S ≡ Y - C or Y ≡ C + S
Y or GDP by expenditure
Y ≡ C +I or
Y≡C+I=C+S
thus S ≡ I

Note: Gross domestic product (GDP) measures the output produced by factors of
production located in the domestic economy
Gross national product (GNP) measures the total income earned by domestic
citizens
GNP = GDP + net income from abroad.

Inflation:
Using current market values allows summing different types of goods and services,

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but how to compare variables over time?
Production today Production tomorrow
20 computers 20 computers
20 bicycles 20 bicycles

• If prices of computers and bicycles double between today and tomorrow, the
current market value of GDP (i.e., nominal GDP) also doubles. However, the
amount of physical production remains unchanged.

• What is wrong? Nominal GDP today is expressed in terms of dollars of today and
nominal GDP tomorrow is expressed in terms of dollars of tomorrow. If there is
inflation, the purchasing power of the dollar has changed over time.

• By looking at the current market value of goods changes over time, you can’t tell
whether this change reflects changes in the goods produced or in their prices. That
is why we need to look at the “real” GDP or at constant prices.

To compare the market value of output over time, we need to know how does the
purchasing power of 1$ change over time. For that we need a price index.

How Are Prices Measured? Price Indexes measure the cost of a fixed ‘basket’ of N
goods over time
P(t) = ∑Ni=1 wi . pi (t)

(weights (w’s) are usually fixed or slowly moving)

Inflation rate = % change in P, where P is the general price level

Inflation = [P(t+1) - P(t)] / P(t)

A commonly used price index is the CPI (consumer price index) – measures price
changes of consumer goods. In US, BLS surveys over 80,000 goods per month in
different locations around the country.

GDP Deflator (one prominent price index): Value of Current Output at Current
Prices / Value of Current Output at Base Year Prices

An Example:
2000 2008
Q P Y Q P Y
A 10 1 10 20 2 40
B 15 3 45 20 4 80
C 50 0.5 25 40 1 40

Y (2000) = 80 = (10 + 45 + 25)

Y (2008) = 160 = (40 + 80 + 40)

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Nominal GDP went up by 100%

Current Output at Current Prices: 160

Current Output at Base Year Prices: 100 (1*20 + 3*20 + 0.50*40)

Inflation Rate Between 2000 and 2008 = 60%

What is real GDP growth between 2000 and 2008? 25%

Notes on Price Indexes:

Need to Pick a Basket of Goods (cannot measure all prices)

‘Ideal/Representative’ Basket of Goods Change Over Time

Invention (Computers, Cell Phones, VCRs, DVDs).

Quality Improvements (Anti-Lock Brakes)

Criticisms of Price Indices: –Part of the Change in Prices Represents a Change in

Quality - Actually, not measuring the same goods in your basket over time.

Technology advances drive down the price of ‘same’ goods over time

Determination of National Income:

Prices and wages are fixed.

The actual quantity of total output is demand-determined ---“Keynesian” model.
For now, also assume: no government no foreign trade.
Given no government and no international trade, aggregate demand has two
components:
• Investment
Firms’ desired or planned additions to capital and inventories for now, we assume
investment is autonomous that is, independent of current income or output
• Consumption
Household demand for goods and services
So, AD = C + I

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1930s). See Sloman and W ride C hapter 17. Note at the outset two important
assumptions:

Prices are assumed fixed; so we can think of changes in expenditures as changes

in quantities.
T here allocate
Households is spare their
productive
income capacity in the economy
between consumption andsosaving:
that increases in output are
possible.
Disposable Income
W e focus on the short run changes: quarter-to-quarter or year-to- year.
• Income that households have for spending or saving
The Consumption F unction no taxes (T) no transfer (Tr)
• Yd = Y no government
AsConsumption Function:
we have seen, households can allocate their disposable income to two things:
consumption of goods and services or saving. W e assume that, in aggregate,
consumption, C , will be related to disposable income, Y d, as in the diagram:

Slope = b = MPC

Yd
!"
"

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Consumption function is given by: C = a + b* Y where “a” is autonomous
spending and “b” is the marginal propensity to consume which is the slope of the
function) is “b” – i.e. for each additional $1 of income, $ “b” is consumed.
For c = 0.7 and a=8, savings function is given by:

The marginal propensity to save –MPS- (the slope of the function) is 0.3 – i.e. for
each additional $1 of income, 30 cents is saved. Since all income is either saved or
spent on consumption, MPS+MPC=1. In this example, 0.3 + 0.7 = 1.
Note that this is a simple consumption function because:
Consumption depends not only on current income by on what households expect
their future (sometimes called permanent) income to be. Thus if income were to
drop temporarily households reduce their consumption by less than if they thought
the fall was permanent. Over the long run, a is smaller and b is larger.
Consumption may depend on wealth (which is a stock) as well as current income
(which is a flow). E.g. owner occupiers seem to spend more when the value of their
house goes up.
Uncertainty may matter. If people are particularly uncertain about the future, they
may save more and consume less now.

Equilibrium:
• Aggregate demand (AD)
Consumption + investment equals to the output supplied by firms
• AD = Y or C + I = Y
Firms supply all the output demanded by households and firms.
In this simple model price level is fixed, supply decisions do not depend on price

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 , and rear ranging:

• Firms are ready to produce and actually produce what ever demanded at the
7KH³PXOWLSOLHU´ is the factor by which autonomous spending is multiplied to get
same price level.
national income.YIn= the
In equilibrium, C + simplest
I. model it is one minus the M PC .
45ȗ line
Z (Z = Y)

Z = a + bY + I

a+I

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" From the national accounts we know that AD = Y; Expenditure equals Output , so:

Y = a + b*Y + I and rearranging:

Y = [1 / (1-b)] ( a + I)

The multiplier, 1/ (1 – b), is the factor by which autonomous spending is multiplied

to get national income. In the simplest model it is one minus the MPC.

An Example:
Suppose that consumption is C = 100 + 0.75*Y and I = 100. We have
Y = 100 + 0.75*Y +100 or Y* (1 - 0.75) = 200
Y = 200/0.25 = 800

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Suppose now that firms become more optimistic about the future. They decide to
invest more, and so investment spending rises to I = 200.
Then, Y = 300/0.25 = 1200 and aggregate income goes up by:
ΔY = 400 = [1/(1 – b)] * ΔI = 4*100

Next:
Paradox of Thrift, Introducing Government and Foreign Sector, Money Market…..

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