Session 1

Introduction to Macroeconomics

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 Learning Objectives
• To differentiate between the microeconomics and macroeconomics.
• To know certain key concepts in macroeconomics including real,
nominal, actual, and potential GDP.
• To know some other key concepts in macroeconomics such as
business cycle, expansion, recession, peak, trough, and output gap.
• To differentiate between the long run and the short run.
• To understand the use of the AD-AS diagram as an important tool in
macroeconomic analysis (i.e., in understanding fluctuations of real
GDP, price level and unemployment rate).
• To differentiate between the effects of changes in demand in the
long run and the short run.

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 Micro and Macroeconomics
• Microeconomics: examines
behavior of individual
economic units (households,
firms)
– Issues include determination of
price, output, employment of
individual units such as firms
– How does a firm decide its
profit maximizing output(q), or
price(p), or amount of labour
(l)?
– Average price level, aggregate
output, unemployment rate are
given
• Macroeconomics: examines
the behavior of the economy
as a whole.
-Issues include determination of
aggregate output, average price level,
unemployment rate .
- What causes economic slowdown?
-What causes an increase in
unemployment rate?
- What causes an increase in price
level?
-price, output, unemployment of any
individual units are given
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 Macroeconomics
• Macroeconomics deals with big issues of
economic life such as aggregate output,
price level, unemployment rate.
• It is useful in explaining the fluctuations of
these macro aggregates over time.
• It also explains the role of macroeconomic
policies (i.e. monetary policy and fiscal
policy) to improve the performance of the
economy.

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 Economic Growth, Actual
and Potential Real GDP
• Nominal GDP= market value of all final goods are services
produced within a country in a given time period. It is
measured in terms of prevailing (current) prices.
• Real GDP=market value of all final goods are services
produced within a country in a given time period. It is
measured in terms of base year(constant) prices.
• Economic growth is measured by the percentage increase in
physical quantities of aggregate output (Real GDP or Gross
Domestic Product at constant prices).
• Potential real GDP= the level of output that could be
produced when all resources (land, labour, capital etc) were
fully utilized is called potential GDP.
• Potential output is also known as full employment level
output/capacity output/maximum possible output/trend
output.
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 Economic Growth, Actual and
Potential Real GDP(contd..)
• Potential output grows slowly and steadily
over time(will have smooth and sustained
upward trend) as resources grow slowly.
• Actual real GDP deviates from potential
level in the short run as it is determined by
consumer and business optimism, global
demand, government spending, oil price
shocks etc
• Real GDP fluctuates around potential GDP
in a business cycle in short run.
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Business Cycle

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 Business Cycle (contd..)
• Business Cycle: A business cycle is a
periodic but irregular up and down
movement in actual production.
• It is not a regular, predictable, repeating
cycle like the phases of the moon.
• The timing and intensity of the business
cycle varies a lot.

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Phases and Turning Points of
Business Cycle
• It has two phases: (a) an Expansion and (b)
a Recession.
• It has two turning points: (a) a Peak and (b)
a Trough
• Expansion: a period in which real GDP
increases
• Recession: a period during which real GDP
decreases for at least two successive
quarters.

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Phases and Turning Points of
Business Cycle (contd..)
• A peak: the highest level of real GDP
in a business cycle at which expansion
ends and recession begins.
• A trough: the lowest point in a
business cycle at which recession ends
and expansion begins

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 Business Cycle and Output
Gap
• Deviation of actual output from the
trend/potential output is referred to as the
output gap
– Output gap = actual output – potential
output
– Output gap measures the magnitude of
cyclical deviations of output from the
potential level
– It tells us whether the resources are
overutilized or underutilized.

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 Measuring Potential Output
• It is hard to measure potential output.
• It is not easy to decide when resources have been
fully utilized.
• Actual output oscillates around the potential GDP.
• Methods:
• 1. By estimating the average of actual real GDP
over a period of time.
• 1. By fitting a trend line to the actual GDP over
time.
• 3. By applying a filtering technique such as Hodrik
Precott Filter Method
• Estimates of potential output may be in accurate.
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Actual and Potential Output,
1960-2012

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The Price Level and Inflation
• The Labour Bureau measures the price level by
calculating the consumer price index(CPI).
• The CPI is a measure of the average of prices paid
by consumers for a fixed basket of consumer goods
and services.
• A major purpose of the CPI is to measure changes
in cost of living and the value of money.
• Inflation rate=((CPI this year-CPI last year)/CPI
last year)*100

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 The Unemployment Rate
• The amount of unemployment is an indicator of
the extent to which people who want jobs can’t
find them.
• The unemployment rate is the percentage of the
people in the labor force who are unemployed.
• That is, Unemployment rate = (Number of people
unemployed/ Labor force)*100
• Labor force = Number of people employed +
Number of people unemployed, but seeking for
work.

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Co-movement and timing of
economic variables
• A procyclical variable: moves up
during expansions and down during
contractions (e.g. inflation)
• A countercyclical variable: moves
down during expansions and up
during expansions (e.g.
unemployment rate).

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 Inflation and the Business
Cycle
• The inflation rate can be estimated by the percentage change in the consumer
price index (CPI)
– CPI is a price index that measures the cost of a given basket of goods bought by the
average household
• If AD is driving the economy, periods of growth are accompanied by
increases in prices and inflation, while periods of contraction associated with
reduced prices and negative inflation rates

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 Unemployment and the
Business Cycle
• The unemployment rate measures the fraction of the workforce that
is out of work and looking for a job or expecting a recall from a
layoff
– Important indicator of well-being of an economy/households
– Optimal unemployment rates differ from country to country
– Optimal unemployment rate linked to the potential level of output for a
given economy (see Figure 2-8)

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 Macro Performance and
AD/AS model
• The performance of an economy is generally judged by
three broad measures: the growth rate of output, the
unemployment rate, and the inflation rate.
• The behavior of the economy can be analyzed using the
AD-AS model. The AD curve is downward slopping.
The slope of AS curve depends on the time frame.
• In the short-run, the AS-curve is horizontal (or relatively
flatter).
• In the long run, the AS curve is vertical (or relatively
steeper).

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Macroeconomics In Three
Models
1. Short Run Model:
• Time: A few years –from now to next 2/3 years
• Price and wages: They are relatively fixed (stable) in
this period
• Productive capacity: it is fixed as size of labour force,
stock of capital, level of technology are fixed.
• Actual real GDP= or> or < potential GDP

Prices are relatively fixed, but output is determined by

changes in AD.

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 The Short Run Model
• Short run fluctuations in output are largely due to changes in
AD
– The AS curve is flat in the short run due to fixed/rigid prices,
so changes in output are due to changes in AD

• Changes in AD in the
short run constitute
phases of the business
cycle
– In the short run, AD
determines output, and
thus unemployment

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 The Long Run Model
2. Long Run Model (DFS)/Medium run (Blanchard):
• Time: say a decade –from now to next 9/10 years
• Price and wages: They are flexible in this period.
• Productive capacity: it is relatively fixed as the size of
labour, stock of capital, level of technology are
growing but their growth is insignificant as compared
to existing total stock of capital, size of labour force,
and level of technology.
• Actual GDP=potential GDP

Output is relatively fixed (determined by productive

capacity or supply), but prices are determined by changes
in AD.

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 The Long Run Model
• In the long run, the AS curve is
vertical and pegged at the
potential level of output
– Output is determined by the
supply side of the economy
and its productive capacity
– The price level is determined
by the level of demand
relative to the productive
capacity of the economy

• Conclusion: high rates of

inflation are always due to
changes in AD in the long run

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 GDP per capita, PPP (constant
2011 international $)
14500
12500
10500
8500
6500
4500
2500
500
-1500

China India

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 GDP per capita, PPP (constant 2011
international $)

1990 2016 Annual average Growth

Rate 1990-2016

China 1527 14400 (9 times) 9.03

India 1755 6092 (3 times 4.92

Niger 894 906 0.12

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 Very Long Run Model
• Figure a illustrates growth of income per person in
China, India, and Niger during 1990-2016
– Why do countries like Niger grow very slowly?
– Why do countries like China grow very quickly?
– What policies can raise average growth rates over long periods
of time?
• Very long run model examines how the
accumulation of inputs and improvements in
technology lead to increased standards of living

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 Very Long Run Model
• 3. Very Long Run Model (DFS)/Long-run(Blanchard):
• Time: say a few decades –from now to next 30/35
years
• Productive capacity: It is fully flexible as the size and
skills of labour, stock of capital, level of technology
can grow substantially.
• The skills of workers depends on the quality of the
country’s education system.
• The size of the stock of capital depends on how much
people save.
• The level of technology depends on ability of an
economy to innovate and introduce new technologies.
• Actual GDP=potential GDP

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 Very Long Run Model
• Other factors include:
• 1. Clear system of laws
• 2. Honest government to enforce these laws

• Output is determined by education system, saving rate,

ability of an economy to introduce new technologies, the
quality of its government, efficient legal system etc.
• Prices are determined by both demand and supply.

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 Summary
• Nominal GDP is the market value of all final goods and services produced
in a country in a given time period.
• Real GDP is the market value of all final goods and services produced in a
country in a given time period measured at some base year prices.
• The trend path of output is the path that real GDP would take if all factors
of production were fully employed (also known as potential GDP).
• Actual real GDP tends to fluctuate around potential real GDP.
• The output gap measures the size of these cyclical deviations and is defined
as the gap between actual real GDP and potential GDP.
• Inflation, growth, and unemployment are related through economic cycles.
• The performance of an economy is generally judged by three broad
measures: the growth rate of output, the unemployment rate, and the
inflation rate.
• The behavior of the economy can be analyzed using the AD-AS
model. The AD curve is downward slopping. The slope of AS curve
depends on the time frame. In the short-run, the AS-curve is
horizontal. In the long run, the AS curve is vertical. 29
 Summary
• In the short run, the level of output is determined by aggregate
demand alone, while prices are not affected by changes in aggregate
demand (i.e., fixed or stable). The short-run models explain
recession and expansions.
• In the long run, productive capacity can be taken as given. Output
depends on aggregate supply or productive capacity. Prices depend
on both demand and supply.
• In the very long-run, productive capacity changes and it becomes
variable. The very long-run model explains why some countries
have higher average growth rates (and thus higher living standards)
than others.
• The AD-AS framework is a very simplified representation of the real
world that cannot describe the behavior of all people and
enterprises in an economy.
• However, it serves very well to explain how economic disturbances
affect output, employment, and prices.

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 Mid-Term 2017-18
• Why is real GDP of a Nation relatively
fixed in the long-run (or long-run
aggregate supply curve is vertical)? (5
marks)

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 Question 1, Textbook Conceptual
(page no.21)
1. Using the aggregate supply and
demand model, explain how output and
prices are determined. Will output vary
or stay fixed in the long-run? Suppose
the aggregate demand curve were to
remain fixed: what can we infer about
the behavior of prices over time (very
long-run).

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 Question 2 Textbook
Technical (page no.21)

• 1. Suppose that actual output is $120

billion and potential (full-
employment) output is $156 billion.
What is the output gap in this
hypothetical economy? Would you
expect unemployment level to be
higher or lower than usual?

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 Application: Home Work
• During 2008-10, increases in the
unemployment rate were associated
with decreases in the inflation rate in
the US. However, in the 1974-75
unemployment and inflation moved
in the same direction. How can you
explain this?

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Empirical Question: Textbook page
no.21 (Home work)
• Calculate by how much India’s per capital real
GDP has increased between the year you were
born (assume 1999-00) and today (2018-19).
(Go to Reserve Bank of India website.
https://www.rbi.org.in/Scripts/AnnualPublications.
aspx?head=Handbook%20of%20Statistics%20on%20I
ndian%20Economy. Refer to Tables 1 and 2 of the
Handbook of Statistics on Indian Economy in 2019
and 1999)

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