Introduction to

Macroeconomics
Lecture 8
Introduction to Macroeconomics

 Microeconomics examines the behavior of

individual decision-making units—business
firms and households.
 Macroeconomics deals with the economy
as a whole; it examines the behavior of
economic aggregates such as aggregate
income, consumption, investment, and
the overall level of prices.
 Aggregate behavior refers to the behavior of
all households and firms together.
The Roots of Macroeconomics

 The Great Depression was a period of

severe economic contraction and high
unemployment that began in 1929 and
continued throughout the 1930s.
The Roots of Macroeconomics

 Classical economists applied

microeconomic models, or “market
clearing” models, to economy-wide
problems.
 However, simple classical models failed to
explain the prolonged existence of high
unemployment during the Great
Depression. This provided the impetus for
the development of macroeconomics.

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The Roots of Macroeconomics

 In 1936, John Maynard Keynes published The General

Theory of Employment, Interest, and Money.
 Keynes believed governments could intervene in the
economy and affect the level of output and employment.
 During periods of low private demand, the government
can stimulate aggregate demand to lift the economy out
of recession.
BIGGEST ECONOMIES
COUNTRY 2006(BİLLION $)
1 USA 13.262,1
2 JAPAN 4.463,6
3 GERMANY 2.890,1
4 CHINA 2.554,2
5 ENGLAND 2.357,6
6 FRANCE 2.227,3
7 ITALY 1.841,0
8 CANADA 1.273,1
9 SPAIN 1.216,7
10 RUSSIA 975,3
11 BRASIL 966,8
12 KOREA 877,2
13 INDIA 854,5
14 MEXICO 811,3
15 AUSTRALIA 743,7
16 HOLLAND 662,8
17 BELGIUM 387,0
18 SWITZERLAND 382,4
19 SWEDEN 380,8
20 TURKEY 378,4
RICHEST AND POOREST COUNTRIES
RANK COUNTRY GDP $PER CAPITA
1 LUXEMBOURG 69.800
2 NORWAY 42.364
3 USA 41.399
4 IRELAND 40.610
5 ICELAND 35.115
6 DENMARK 34.740
28 ISRAEL 23.474
30 GREECE 22.392
50 ARGENTINA 14.109
62 RUSSIA 11.041
66 BULGARIA 9.223
74 IRAN 7.980
75 TURKEY 7.950
87 CHINA 7.198
122 INDIA 3.320
150 SENEGAL 1.759
169 LIBERIA 1.033
175 ETHIOPIA 823
178 BURUNDI 739
Macroeconomic Concerns

 Three
of the major concerns of
macroeconomics are:
 Inflation
 Output growth
 Unemployment
Inflation and Deflation

 Inflation is an increase in the overall

price level.
 Hyperinflation is a period of very rapid
increases in the overall price level.
Hyperinflations are rare, but have been
used to study the costs and consequences
of even moderate inflation.
 Deflation is a decrease in the overall
price level. Prolonged periods of deflation
can be just as damaging for the economy
as sustained inflation.
Inflation and Deflation

ANNUAL INFLATION RATES IN TURKEY (CPI), 1983-

2006

120
100
Inflation rate (%)

80
60
40
20
0
83

85

87

89

91

93

95

97

99

01

03

05
19

19

19

19

19

19

19

19

19

20

20

20
Years
Output Growth:
Short Run and Long Run
 The business cycle is the cycle of short-term ups and
downs in the economy.
 The main measure of how an economy is doing is
aggregate output:
 Aggregate output is the total quantity of goods and
services produced in an economy in a given period.
Output Growth:
Short Run and Long Run
TURKİSH REAL GDP, 1987-2006

Real GDP in thousands of

180.000
160.000
140.000
120.000
1987 TL 100.000
80.000
60.000
40.000
20.000
0
87

89

91

93

95

97

99

01

03

05
19

19

19

19

19

19

19

20

20

20
Years
Output Growth:
Short Run and Long Run
 A recession is a period during which
aggregate output declines. Two
consecutive quarters of decrease in
output signal a recession.
 A prolonged and deep recession becomes a
depression.
 Policy makers attempt not only to smooth
fluctuations in output during a business
cycle but also to increase the growth rate
of output in the long-run.
Unemployment

 The unemployment rate is the percentage of the labor force that is

unemployed.
 The unemployment rate is a key indicator of the economy’s health.
 The existence of unemployment seems to imply that the aggregate labor
market is not in equilibrium.
Government in the Macroeconomy

 There are three kinds of policy

that the government has used
to influence the
macroeconomy:
1. Fiscal policy
2. Monetary policy
3. Growth or supply-side policies
Government in the Macroeconomy

 Fiscal policy refers to government

policies concerning taxes and spending.
 Monetary policy consists of tools used by
the Central Bank to control the quantity
of money in the economy.
 Growth policies are government policies
that focus on stimulating aggregate supply
instead of aggregate demand.
The Components of
the Macroeconomy
 Macroeconomics focuses on four groups
1) Households and
2) Firms (the private Sector)
3) The government (the public sector)
4) Rest of the world (the international sector)
The Components of
the Macroeconomy
 Thecircular flow
diagram shows the
income received and
payments made by
each sector of the
economy.
The Components of
the Macroeconomy
 Everyone’s
expenditure is
someone else’s
receipt. Every
transaction must
have two sides.

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The Three Market Arenas

 Households, firms, the government, and the rest of

the world all interact in three different market
arenas:
1. Goods-and-services market
2. Labor market
3. Money (financial) market
The Three Market Arenas

 Households and the government purchase goods and services (demand) from
firms in the goods-and services market, and firms supply to the goods and
services market.
 In the labor market, firms and government purchase (demand) labor from
households (supply).
The Three Market Arenas

 In the money market—sometimes called the financial

market—households purchase stocks and bonds from firms.
 Households supply funds to this market in the expectation of
earning income, and also demand (borrow) funds from this market.
 Firms, government, and the rest of the world also engage in
borrowing and lending, coordinated by financial institutions.
Financial Instruments

 Treasury bonds, notes, and bills are promissory notes

issued by the government when it borrows money.
 Corporate bonds are promissory notes issued by
corporations when they borrow money.
Financial Instruments

 Shares of stock are financial instruments that give to

the holder a share in the firm’s ownership and therefore
the right to share in the firm’s profits.
 Dividends are the portion of a corporation’s profits that
the firm pays out each period to its shareholders.
Examining Output: Gross Domestic
Product
 Gross domestic product (GDP) is the total market value
of all final goods and services produced within a given
period by factors of production located within a country.
Final Goods and Services

 The term final goods and services refers to goods and services produced for
final use.
 Intermediate goods are goods produced by one firm for use in further
processing by another firm.
Value Added
 Value added is the difference between the value of goods
as they leave a stage of production and the cost of the
goods as they entered that stage.
 In calculating GDP, we can either sum up the value added at
each stage of production, or we can take the value of final
sales. We do not use the value of total sales in an economy
to measure how much output has been produced.
Value Added

Value Added in the Production of a Gallon of Gasoline

(Hypothetical Numbers)
STAGE OF PRODUCTION VALUE OF SALES VALUE ADDED
(1) Oil drilling $ .50 $ .50
(2) Refining .65 .15
(3) Shipping .80 .15
(4) Retail sale 1.00 .20
Total value added $1.00
Exclusions from GDP

 GDP ignores all transactions in which money or goods change hands but in
which no new goods and services are produced.
GDP Versus GNP

 GDP is the value of output produced by factors of production

located within a country. Output produced by a country’s
citizens, regardless of where the output is produced, is
measured by gross national product (GNP).
Calculating GDP

GDP can be computed in two ways:

 The expenditure approach: A method of computing GDP
that measures the amount spent on all final goods during a
given period.
 The income approach: A method of computing GDP that
measures the income—wages, rents, interest, and profits—
received by all factors of production in producing final
goods.
The Expenditure Approach

Expenditure categories:
 Personal consumption expenditures (C)—household
spending on consumer goods.

• Gross private domestic investment

(I)—spending by firms and households
on new capital: plant, equipment,
inventory, and new residential structures.
The Expenditure Approach

Expenditure categories:
 Government consumption and gross investment (G)

• Net exports (EX – IM)—net

spending by the rest of the world, or
exports (EX) minus imports (IM)
The Expenditure Approach

 The expenditure approach calculates GDP by adding together

these four components of spending. In equation form:

GDP  C  I  G  ( X  M )
Personal Consumption Expenditures
 Personal consumption expenditures (C) are expenditures by
consumers on the following:
 Durable goods: Goods that last a relatively long time, such as cars
and household appliances.
 Nondurable goods: Goods that are used up fairly quickly, such as
food and clothing.
 Services: The things that we buy that do not involve the production
of physical things, such as legal and medical services and education.
Components of GDP, 1999:
The Expenditure
Components of GDP, Approach
1999: The Expenditure Approach
BILLIONS OF PERCENTAGE
DOLLARS OF GDP
Total gross domestic product 9,299.2 100.0
Personal consumption expenditures (C) 6,268.7 67.4
Durable goods 761.3 8.2
Nondurable goods 1,845.5 19.8
Services 3,661.9 39.4
Gross private domestic investment (l) 1,650.1 17.7
Nonresidential 1,203.1 12.9
Residential 403.8 4.3
Change in business inventories 43.3 0.5
Government consumption and gross investment (G) 1,634.4 17.6
Federal 568.6 6.1
State and local 1,065.8 11.5
Net exports (EX – IM)  254.0  2.7
Exports (EX) 990.2 10.6
Imports (IM) 1,244.2 13.4
Note: Numbers may not add exactly because of rounding.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Gross Private Domestic Investment

 Investment refers to the purchase of new capital.

 Total investment by the private sector is called gross private domestic
investment. It includes the purchase of new housing, plants, equipment, and
inventory by the private (or non-government) sector.
Gross Private Domestic Investment

 Nonresidential investment includes

expenditures by firms for machines, tools,
plants, and so on.
 Residential investment includes
expenditures by households and firms on
new houses and apartment buildings.
 Change in inventories computes the
amount by which firms’ inventories change
during a given period. Inventories are the
goods that firms produce now but intend to
sell later.
Gross Investment versus
Net Investment
 Gross investment is the total value of all newly produced
capital goods (plant, equipment, housing, and inventory)
produced in a given period.
 Depreciation is the amount by which an asset’s value falls
in a given period.
 Net investment equals gross investment minus
depreciation.

capitalend of period = capitalbeginning of period + net investment

Government Consumption and
Gross Investment
 Government consumption and gross investment
(G) counts expenditures by federal, state, and
local governments for final goods and services.
Net Exports

 Net exports (EX – IM) is the difference between exports (sales

to foreigners of U.S.-produced goods and services) and imports
(U.S. purchases of goods and services from abroad). The figure
can be positive or negative.
The Income Approach

 National income is the total income earned by the factors of

production owned by a country’s citizens.
 The income approach to GDP breaks down GDP into four
components:

GDP = national income + depreciation + (indirect taxes – subsidies) + net

factor payments to the rest of the world + other
The Income Approach
Components of GDP, 1999: The Income Approach
BILLIONS OF PERCENTAGE
DOLLARS OF GDP
Gross domestic product 9,299.2 100.0
National income 7,469.7 80.3
Compensation of employees 5,299.8 57.0
Proprietors’ income 663.5 7.1
Corporate profits 856.0 9.2
Net interest 507.1 5.5
Rental income 143.4 1.5
Depreciation 1,161.0 12.5
Indirect taxes minus subsidies 689.7 7.4
Net factor payments to the rest of the world 11.0 0.1
Other  32.2  0.3
Source: See Table 17.2.
From GDP to Disposable Income
GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income,
1999
DOLLARS
(BILLIONS)
GDP 9,299.2
Plus: receipts of factor income from the rest of the world + 305.9
Less: payments of factor income to the rest of the world  316.9
Equals: GNP 9,288.2
Less: depreciation  1,161.0
Equals: net national product (NNP) 8,127.1
Less: indirect taxes minus subsidies plus other  675.5
Equals: national income 7,469.7
Less: corporate profits minus dividends  485.7
Less: social insurance payments  662.1
Plus: personal interest income received from the government and consumers + 456.6
Plus: transfer payments to persons +1,011.0
Equals: personal income 7,789.6
Less: personal taxes  1,152.0
Equals: disposable personal income 6,637.7
Source: See Table 17.2.
From GDP to Disposable Income

 Net national product equals gross national product

minus depreciation; a nation’s total product minus what
is required to maintain the value of its capital stock.
From GDP to Disposable Income
 Personal income is the total income of households.
Equals (national income) minus (corporate profits minus
dividends) minus (social insurance payments) plus
(interest income received from the government and
households).
 Personal income is the income received by households
after paying social insurance taxes but before paying
personal income taxes.
Disposable Personal Income and Personal
Saving
Disposable Personal Income and Personal Saving, 1999
DOLLARS
(BILLIONS)
Disposable personal income 6,637.7
Less:
Personal consumption expenditures  6,268.7
Interest paid by consumers to business  194.8
Personal transfer payments to foreigners  26.6
Equals: personal saving 147.6
Personal savings as a percentage of disposable personal income: 2.2%
Source: See Table 17.2.
Disposable Personal Income and Personal
Saving
 The personal saving rate is the percentage of
disposable personal income that is saved. If the
personal saving rate is low, households are spending a
large amount relative to their incomes; if it is high,
households are spending cautiously.
Nominal versus Real GDP

 Nominal GDP is GDP measured in current dollars, or the current prices we

pay for things. Nominal GDP includes all the components of GDP valued at
their current prices.
 When a variable is measured in current dollars, it is described in nominal
terms.
Calculating Real GDP

 A weight is the importance attached to an item within a group of items.

 A base year is the year chosen for the weights in a fixed-weight procedure.
 A fixed-weight procedure uses weights from a given base year.
Calculating Real GDP
A Three-Good Economy
(1) (2) (3) (4) (5) (6) (7) (8)
GDP IN GDP IN GDP IN GDP IN
YEAR 1 YEAR 2 YEAR 1 YEAR 2
IN IN IN IN
PRODUCTION PRICE PER UNIT YEAR 1 YEAR 1 YEAR 2 YEAR 2
YEAR 1 YEAR 2 YEAR 1 YEAR 2 PRICES PRICES PRICES PRICES
Q1 Q2 P1 P2 P 1 x Q1 P 1 x Q2 P 2 x Q1 P 2 X Q2
Good A 6 11 $.50 $ .40 $3.00 $5.50 $2.40 $4.40
Good B 7 4 .30 1.00 2.10 1.20 7.00 4.00
Good C 10 12 .70 .90 7.00 8.40 9.00 10.80
Total $12.10 $15.10 $18.40 $19.20
Nominal GDP Nominal GDP
in year 1 in year 2
Calculating the GDP Price Index

 The GDP price index is one measure of the overall price

level.
 The old procedure used by the Bureau of Economic
Analysis (BEA) to estimate changes in the overall price
level used the quantities produced in a chosen year (the
base year) as weights. But overall price increases are
sensitive to the choice of the base year. The new
procedure, known as the chained price index, avoids the
problems associated with the use of fixed weights.
The Problems of Fixed Weights

The use of fixed price weights to

estimate real GDP leads to problems
because it ignores:
1. Structural changes in the economy.
2. Supply shifts, which cause large
decreases in price and large increases in
quantity supplied.
3. The substitution effect of price
increases.
Limitations of the GDP Concept

 Society is better off when crime decreases, but a decrease in crime is not
reflected in GDP.
 An increase in leisure is an increase in social welfare, not counted in GDP.
 Nonmarket and domestic activities are not counted even though they amount
to real production.
Limitations of the GDP Concept

 GDP accounting rules do not adjust for production that pollutes the
environment.
 GDP has nothing to say about the distribution of output. Redistributive
income policies have no direct impact on GDP.
 GDP is neutral to the kinds of goods an economy produces.
The Underground Economy

 The underground economy is the part of an economy in which transactions

take place and in which income is generated that is unreported and therefore
not counted in GDP.
Per Capita GDP/GNP

 Per capita GDP or GNP measures a country’s GDP or GNP divided by its
population.
 Per capita GDP is a better measure of well-being for the average person that
its total GDP or GNP.