Macroeconomics

Continuation of the Assignment 1

• After find a correlation between 2 variables X and Y, now identify two
other variables what might have an impact on Y.
• Download and include its data into the excel sheet previously made.
• Go to youtube and watch the following 2 minutes video
• https://www.youtube.com/watch?v=vctRl8yFd54
• Using this knowledge run a regression analysis for your variables
• CGPAs are correlated with Hours of Study (This you have done)
• Next – You think IQ and Brain size also impact CGPAs ( Download this)
• CGPAt = 𝛂 + 𝛃1(Hours of Study) + 𝛃2 (IQ) + 𝛃3 (Brainsizet) + 𝛍t
• Run the Regression and interpret values of Betas and the R-squared.
The Focus of this section

• GDP growth
• Unemployment
• Inflation
• Interest Rates
• Trade – Exchange Rates
• Monetary and Fiscal Policy implications
Gross Domestic Product

• Sum of all final goods and services produced in a year within a

particular boundary.

• Gross vs Net
• Gross National Product
• Gross National income = GDP + Interests + Dividends
Gross Domestic Product Definition

Two definitions:
1. Total expenditure on
domestically-produced
final goods and services
2. Total income earned by
domestically-located
factors of production
Final goods, value added, and GDP

 GDP = value of final goods produced

= sum of value added at all stages
of production
 The value of the final goods already includes the
value of the intermediate goods,
so including intermediate goods in GDP would be
double-counting.
Why expenditure = income
In every transaction,
the buyer’s expenditure
becomes the seller’s income.
Thus, the sum of all
expenditure equals
the sum of all income.
Value added
definition:
A firm’s value added is
the value of its output
minus
the value of the intermediate goods
the firm used to produce that output.
Income Approach to GDP
• Total Net Income = wages + rents + interest + profits + indirect
business tax- Net factor income from abroad - Depreciation
The expenditure components of GDP

•consumption
•investment
•government spending
•net exports
Consumption (C)
def: the value of all goods • durable goods
last a long time
and services bought by
ex: cars, home
households. Includes: appliances
• non-durable goods
last a short time
ex: food, clothing
• services
work done for
consumers
ex: dry cleaning,
air travel
Investment (I)
def. 1: spending on [the factor of production]
capital
Def. 2: spending on goods bought for future use
Includes:
 business fixed investment
spending on plant and equipment that firms will use to
produce other goods & services
 residential fixed investment
spending on housing units by consumers and landlords
 inventory investment
the change in the value of all firms’ inventories
Investment vs. Capital
 Capital is one of the factors of production.
At any given moment, the economy has a certain
overall stock of capital.
 Investment is spending on new capital.
Government spending (G)
• G includes all government spending on
goods and services.
• G excludes transfer payments
(e.g, unemployment insurance payments),
because they do not represent spending on
goods and services.
Net exports (NX = EX - IM)
def: the value of total exports (EX)
minus the value of total imports (IM)
An important identity
Y = C + I + G + NX
where
Y = GDP = the value of total output
C + I + G + NX = aggregate expenditure
Pakistan’s Real GDP and its components as a
percentage for 2015
Percentage of
GDP GDP 2015
Consumption 77% From Table 9 - PBS
Government
Spending 11%
Investment 16%
NX -3%

11140138 100%
A question for you:
Suppose a firm
• produces $10 million worth of final goods
• but only sells $9 million worth.

Does this violate the

expenditure = output identity?
Why output = expenditure
• Unsold output goes into inventory,
and is counted as “inventory investment”…
whether the inventory buildup was
intentional or not.
• In effect, we are assuming that
firms purchase their unsold output.
GDP:
An important and versatile concept
We have now seen that GDP measures
 total income
 total output
 total expenditure
 the sum of value-added at all stages
in the production of final goods.
IF EXPENDITURE INCREASES??

PRODUCTION INCREASE OR

SOLD AT HIGHER PRICE

REAL VERSUS NOMINAL GDP
• Nominal GDP values the production of goods and services at current
prices.
• Real GDP values the production of goods and services at constant
prices.
Table 2 Real and Nominal GDP

Copyright©2004 South-Western
Table 2 Real and Nominal GDP

Copyright©2004 South-Western
Table 2 Real and Nominal GDP

Copyright©2004 South-Western
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

• The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
The GDP Deflator

• Converting Nominal GDP to Real GDP

• Nominal GDP is converted to real GDP as follows:

Nominal GDP20XX
Real GDP20XX   100
GDP deflator20XX
Table 2 Real and Nominal GDP

Copyright©2004 South-Western
GNP vs. GDP
• Gross National Product (GNP):
total income earned by the nation’s factors of
production, regardless of where located

• Gross Domestic Product (GDP):

total income earned by domestically-located
factors of production, regardless of nationality
Real vs. Nominal GDP
 GDP is the value of all final goods and services produced.
 Nominal GDP measures these values using current prices.
 Real GDP measure these values using the prices of a base year.
Real GDP controls for inflation
Changes in nominal GDP can be due to:
 changes in prices
 changes in quantities of output produced
Changes in real GDP can only be due to changes
in quantities,
because real GDP is constructed using
constant base-year prices.
Practice problem, part 1
2002 2003 2004
P Q P Q P Q
good A $30 900 $31 1,000 $36 1,050

good B $100 192 $102 200 $100 205

 Compute nominal GDP in each year

 Compute real GDP in each year using 2002 as
the base year.
Answers to practice problem, part 1
Nominal GDP multiply Ps & Qs from same year
2002: $46, 200 = $30  900 + $100  192
2003: $51, 400
2004: $58, 300

Real GDP multiply each year’s Qs by 2002 Ps

2002: $46, 200
2003: $50, 000
2004: $52, 000 = $30  1050 + $100  205
U.S. Real & Nominal GDP, 1967-2003
GDP Deflator
 The inflation rate is the percentage increase in
the overall level of prices.
 One measure of the price level is
the GDP Deflator, defined as
Nominal GDP
GDP deflator = 100 ´
Real GDP
Practice problem, part 2
GDP inflation
Nom. GDP Real GDP
deflator rate
2002 $46,200 $46,200 n.a.
2003 51,400 50,000

2004 58,300 52,000

 Use your previous answers to compute
the GDP deflator in each year.
 Use GDP deflator to compute the inflation rate
from 2002 to 2003, and from 2003 to 2004.
Answers to practice problem, part 2
GDP Inflation
Nom. GDP Real GDP
deflator rate
2002 $46,200 $46,200 100.0 n.a.
2003 51,400 50,000 102.8 2.8%

2004 58,300 52,000 112.1 9.1%

 Inflation and
Unemployment
Slides from “Macroeconomics” by G.
Mankiw
In 2009, $1 was worth Z$2,621,984,228,
675,650,147,435,579,309,984,228
Types of Inflation
Why do I Need to
Consider CPI?
THE CONSUMER PRICE INDEX
• When the CPI rises, the typical family has to spend more dollars to
maintain the same standard of living.
How the Consumer Price Index Is Calculated

• 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.
How the Consumer Price Index Is Calculated

• Find the Prices: Find the prices of each of the goods and services in
the basket for each point in time.
How the Consumer Price Index Is Calculated

• Compute the Basket’s Cost: Use the data on prices to calculate the
cost of the basket of goods and services at different times.
 How the Consumer Price Index Is
Calculated
• Choose a Base Year and Compute the 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.
How the Consumer Price Index Is Calculated

• Compute the inflation rate: The inflation rate is the percentage

change in the price index from the preceding period.
How the Consumer Price Index Is Calculated

• The Inflation Rate

• The inflation rate is calculated as follows:

CPI in Year 2 - CPI in Year 1

Inflation Rate in Year 2 =  100
CPI in Year 1
Table 1 Calculating the Consumer Price Index and the Inflation
Rate: An Example

Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the Inflation
Rate: An Example

Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the Inflation
Rate: An Example

Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the Inflation
Rate: An Example

Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the Inflation
Rate: An Example

Copyright©2004 South-Western
 In Pakistan
• The Pakistan Bureau of Statistics reports the CPI each month.
• Prevailing base year 2007-2008
• 40 Cities of Pakistan (1 to 13 markets chosen) total of 76
• Monthly
The Basket Used
Formula Used
 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.
Exercise: Compute the CPI

The basket contains 20 pizzas and

10 compact discs.

prices: For each year, compute

pizza CDs  the cost of the basket
2002 $10 $15  the CPI (use 2002 as
2003 $11 $15 the base year)
2004 $12 $16  the inflation rate from
the preceding year
2005 $13 $15
 answers:

cost of inflation
basket CPI rate
2002 $350 100.0 n.a.
2003 370 105.7 5.7%
2004 400 114.3 8.1%
2005 410 117.1 2.5%
The composition of the CPI’s “basket”

Food and bev.

5.8%
Housing 17.6% 5.9%
2.8%
Apparel 2.5%
4.5% 4.8%
Transportation

Medical care

Recreation
16.2%
Education

Communication
40.0%
Other goods and
services
 Reasons why
the CPI may overstate inflation

• Substitution bias: The CPI uses fixed weights,

so it cannot reflect consumers’ ability to substitute
toward goods whose relative prices have fallen.
• Introduction of new goods: The introduction of
new goods makes consumers better off and, in effect,
increases the real value of the dollar. But it does not
reduce the CPI, because the CPI uses fixed weights.
• Unmeasured changes in quality:
Quality improvements increase the value of the dollar,
but are often not fully measured.
CPI vs. GDP deflator
prices of capital goods
• included in GDP deflator (if produced domestically)
• excluded from CPI

prices of imported consumer goods

• included in CPI
• excluded from GDP deflator
the basket of goods
• CPI: fixed
• GDP deflator: changes every year
 Two measures of inflation
Percentage
change 16

14 CPI
12

10

6
GDP deflator
4

-2
1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998
Year
Core inflation
• Core inflation is the change in the costs of goods and services but does not
include those from the food and energy sectors.
Unemployment
Categories of the population

 employed
working at a paid job
 unemployed
not employed but looking for a job
 labor force
the amount of labor available for producing
goods and services; all employed plus
unemployed persons
 not in the labor force
not employed, not looking for work.
Two important labor force concepts

• unemployment rate
percentage of the labor force that is
unemployed
• labor force participation rate
the fraction of the adult population
that ‘participates’ in the labor force
Exercise: Compute labor force statistics

U.S. adult population by group, May 2003

Number employed = 137.5 million
Number unemployed = 9.0 million
Adult population = 220.8 million

Use the above data to calculate

• the labor force
• the number of people not in the labor force
• the labor force participation rate
• the unemployment rate
 Answers:

• data: E = 137.5, U = 9.0, POP = 220.8

• labor force
L = E +U = 137.5 + 9.0 = 146.5
• not in labor force
NILF = POP – L = 220.8 – 146.5 = 74.3
• unemployment rate
U/L = 9/146.5 = 0.061 or 6.1%
• labor force participation rate
L/POP = 146.5/220.8 = 0.664 or 66.4%
 Okun’s Law
• Employed workers help produce GDP, while
unemployed workers do not.
So one would expect
a negative relationship between
unemployment and real GDP.
• This relationship is clear in the data…
Okun’s Law Okun’s Law states
that a one-percent
Percentage change decrease in
in real GDP
10 unemployment is
associated with two
8
1951 percentage points
6 1984 of additional growth
2000
4 in real GDP
1999

2 1993
1975
0

-2 1982

-3 -2 -1 0 1 2 3 4
Change in
unemployment rate
Long vs Short Term Unemployment
• The problem of unemployment is usually divided into two categories.
• The long-run problem and the short-run problem:
• The natural rate of unemployment
• The cyclical rate of unemployment
Unemployment
• Domino Effect
• Loss of income -> Loss of Production -> Loss of Consumption -> Loss
of investment -> Lower standard of living
Frictional Unemployment
• Unemployment from normal labor turnover
• Entering / leaving Labor Force
• In between jobs
Structural unemployment
• Change in technology
• Change in skills needed to perform
• Changes in location of jobs
• Sunset industries “VHS tapes” demand has decreased. Industry is
diminishing
Cyclical unemployment

• Higher or lower than normal unemployment due to

the business cycle
• Higher than normal unemployment at a biz cycle
trough
• Lower than normal unemployment at business cycle
in a peak. Increase in gdp
Natural unemployment
• Natural unemployment = Structural + Fictional
IDENTIFYING UNEMPLOYMENT
• Natural Rate of Unemployment
• The natural rate of unemployment is unemployment that does not go away
on its own even in the long run.
• It is the amount of unemployment that the economy normally experiences.
IDENTIFYING UNEMPLOYMENT
• Cyclical Unemployment
• Cyclical unemployment refers to the year-to-year fluctuations in
unemployment around its natural rate.
• It is associated with with short-term ups and downs of the business cycle.
 Figure 2 Unemployment Rate Since 1960

Percent of
Labor Force

10 Unemployment rate

Natural rate of
4
unemployment

0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Copyright©2003 Southwestern/Thomson Learning

 Figure 3 Labor Force Participation Rates for Men and Women
Since 1950

Labor-Force
Participation
Rate (in percent)
100

Men
80

60

40 Women

20

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Copyright©2003 Southwestern/Thomson Learning

 Interpret this !

Labor Force Participation

Demographic Group Unemployment Rate Rate
Adults of Prime Working Age (ages 25 to 54) empty cell empty cell
White, male 4.4% 89.40%
White, female 4.6 74.3
Black, male 10.1 80.7
Black, female 9.1 75.8
Teenagers (ages 16 to 19) empty cell empty cell
White, male 19.2 35.6
White, female 15.5 36.8
Black, male 36.5 25.9
Black, female 29.7 28.4
Does the Unemployment Rate Measure What We Want It To?

• 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 work.
Why Are There Always Some People Unemployed?

• In an ideal labor market, wages would adjust to balance the supply

and demand for labor, ensuring that all workers would be fully
employed.
Why Are There Always Some People Unemployed?

• 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.
Why Are There Always Some People Unemployed?

• 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.
JOB SEARCH
• This unemployment is different from the other types of
unemployment.
• It is not caused by a wage rate higher than equilibrium.
• It is caused by the time spent searching for the “right” job.
Why Some Frictional Unemployment is Inevitable

• Search unemployment is inevitable because the economy is always

changing.
• Changes in the composition of demand among industries or regions
are called sectoral shifts.
• It takes time for workers to search for and find jobs in new sectors.
Public Policy and Job Search

• 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.
Public Policy and Job Search

• Structural unemployment occurs when the quantity of labor supplied

exceeds the quantity demanded.
• Structural unemployment is often thought to explain longer spells of
unemployment.
• Why is there Structural Unemployment?
• Minimum-wage laws
• Unions
• Efficiency wages
MINIMUM-WAGE LAWS
• When the minimum wage is set above the level that balances supply
and demand, it creates unemployment.
 Figure 4 Unemployment from a Wage Above the Equilibrium
Level

Wage

Labor
Surplus of labor =
supply
Unemployment
Minimum
wage

WE

Labor
demand

0 LD LE LS Quantity of
Labor

Copyright©2003 Southwestern/Thomson Learning

UNIONS AND COLLECTIVE BARGAINING
• A union is a worker association that bargains with employers over
wages and working conditions.
• In the 1940s and 1950s, when unions were at their peak, about a
third of the U.S. labor force was unionized.
• A union is a type of cartel attempting to exert its market power.
UNIONS AND COLLECTIVE BARGAINING
• The process by which unions and firms agree on the terms of
employment is called collective bargaining.
THE THEORY OF EFFICIENCY WAGES
• Efficiency wages are above-equilibrium wages paid by firms in order
to increase worker productivity.
• The theory of efficiency wages states that firms operate more
efficiently if wages are above the equilibrium level.