Lecture 1

Introduction to Macroeconomics
And Measurement

Macroeconomics, 6th edition

© 2024 by W. W. Norton & Company
What is Macroeconomics?

Macroeconomics Microeconomics
• The study of how the • The study of individual people,
interactions of people and firms firms, or market behavior
through markets affect overall
economic activity
Important Macroeconomic Questions to Consider
1. Why is today’s average American
• more than 10 times richer than 100 years ago?
• 25 times richer than the average Ethiopian?
2. How do we understand the causes of the 2008–2009 global
financial crisis and the macroeconomic disruption associated
with the Covid-19 pandemic?
3. What determines the rate of inflation?
4. Why has the unemployment rate in Europe been twice as high as
it is in the United States the past 20 years?
5. What role does the stock market play in an economy?
Per Capita GDP in Six Countries
The U.S. Employment-Population Ratio
Inflation Rate in Certain Rich Countries
Inflation

It is obvious that (most) unemployment is bad.

But what are the costs of inflation to society?
• Unexpected and symmetric inflation
• Unexpected and asymmetric inflation
• Deflation
• Sticky prices
The Unemployment Rate in the United States, Europe, and Japan
1.2 How Macroeconomics Studies Key Questions

Macroeconomists have a general approach to study questions of

interest:
• Document the facts.
• Develop a model.
• Compare predictions of the model with original facts.
• Use the model to make other predictions that will eventually be tested.
Models

Models simplify the complicated real world into its most relevant
elements.
A model is useful if it has good predictive power.
Economic models often involve systems of multiple equations.
Parts of an Economic Model (1 of 2)

Parameter
• An input that is fixed over time, except when the model builder
changes it for an experiment
Exogenous variable = “outside of the model”
• An input that can change over time, but determined ahead of time by
the model builder
Endogenous variable = “within the model”
• An outcome of the model; something that is explained by the model
Parts of an Economic Model (2 of 2)
Suppose We Have a Working Model…

How can we use it?

• Change parameters and exogenous variables to see how they affect
endogenous variables.
• Predict costs and benefits of new government policies.
Model Example—1

Labor supply and demand

Variables:
• 𝐿𝑠 = number of hours laborers want to work
• 𝐿𝑑 = number of labor hours firms want to hire
• 𝑤 = wage
Parameters: f̅ , l̅, and a̅
Model Example—2

Supply function
• Ls = f(w)
• Ls = a̅w + l̅
• Ls = 2w + 30
Demand function
• Ld = f(w)
• Ld = f̅ - w
• Ld = 60 - w
Model Example—3

• Supply function
• Ls = 2w + 30
• Demand function
• Ld = 60 - w
• Equilibrium
• Ld = L s
Model Example—4

• Increase in income taxes • Increase in an input price

An Overview

More divisions
• Theoretical
o Mathematical models
• Empirical
o Data
• Theoretical and empirical methods are not independent.
The Long Run

Income per person in the United States:

• $4,200 in 1870
• $76,000 in 2022
• Many countries have not experienced similar increases in living
standards.
The analysis of economic growth helps explain the long run.
Per Capita GDP in the United States, 1870–2022
The Short Run

Potential output
• Measure of how per capita GDP would evolve with completely flexible
prices and fully employed resources
• In 2008–2009, actual output was 6 percent less than potential output.
• Deviations in actual and potential output usually last only a short time.
Long-term growth dominates short-run fluctuations.
Issues for the Future

Will we see another 10-fold increase in per capita GDP in the next
100 years?
What determines how much the economy consumes or saves in any
given year?
How do firms make investment decisions?
What are the implications of the current deficit and debt?
How will the rise of globalization affect the economy in the future?
Why do we trade and what are the consequences of long-term trade
deficits?
Welfare

Welfare: Variable used to determine preferable policies and rank

outcomes
Measuring welfare is highly subjective.
• More GDP (consumption) increases welfare.
Are there variables other than GDP that we should consider?
Pareto Efficiency and Free Markets (1 of 2)

Complete and competitive markets

Deviations:
• Market power
• Externalities
• Public goods
• Asymmetric (imperfect) information
Pareto Efficiency and Free Markets (2 of 2)

Why do economists disagree?

• Nature of market failures (magnitude)
• Theory of complete and competitive markets breaks down.
• Which Pareto efficient outcome is best?
Chapter 2

National income accounting:

• Method of aggregating the production of diverse goods
into a single measure of overall economic activity
National accounting:
• State of an economy at a given time
• Changes to an economy over time
• Differences across countries
2.2 Measuring the State of the Economy

Gross domestic product (GDP):

• The market value of the final goods and services
produced in an economy over a certain period
• http://www.bea.gov/
United States GDP:
• $25.5 trillion in 2022 ($76,000 per person)
Measuring the State of the Economy

Production measure of GDP: The number of goods produced in the

economy
Expenditure measure of GDP: The total purchases in the economy
Income measure of GDP: All the income earned in the economy
All three approaches give identical measures of GDP:

Production Expenditures Income

The Expenditure Approach to GDP

The national income accounting identity states:

Y = C + I + G + NX
where:
• 𝑌 = GDP (in dollars)
• 𝐶 = Consumption
• 𝐼 = Investment
• 𝐺 = Government purchases
• 𝑁𝑋 = X − M = Exports − Imports
Consumption

Consumption expenditures
• Spending by households on motor vehicles, food, housing
services, and medical care
• Consumption expenditures account for roughly 68
percent of GDP.
Investment

Business fixed investment (nonresidential)

• Spending by firms on plants, machinery, and equipment
• Spending by firms on intellectual property products
(IPP)
Residential investment
• Construction of new houses and apartment buildings
Inventory investment
• Changes in inventories (of final or intermediate goods)
Government Purchases

Includes:
• National, State, and Local government purchases
• Examples of government purchases are public schools,
highways, government-funded research, and national
defense
Excludes:
• Transfer payments such as Social Security, Medicare or
payments on government debt.
Net Exports

Net Exports (NX):

• NX = X − M
• Net Exports = Exports − Imports
• Net Exports is the Trade Balance
Exports:
• Goods and services produced by U.S. businesses shipped
abroad and sold to foreigners
Imports:
• Foreign produced goods and services sold to U.S.
consumers and businesses
The Expenditure Approach to U.S. GDP
Expenditure Shares of U.S. GDP
The Income Approach to GDP

The income approach

• Measures the sum of all income earned in the economy
Capital
• Inputs into production other than labor that are not used up in the
production process
• Increased by firms through investment
Depreciation
• The deterioration of the capital stock due to wear and tear
• GDP − Depreciation = Net Domestic Product
The Income Approach to U.S. GDP in 2022
Total Share of GDP to Inputs

Share of GDP to labor

• Two-thirds (approx.)
• Labor’s share of GDP has remained approximately
constant over time.
Share of GDP to capital
• One-third (approx.)
Labor’s Share of GDP
The Production Approach to GDP

No “double counting” in GDP

• Only the final sale of goods and services count.
Value added:
• The amount each producer contributes to GDP
• The revenue generated by each producer minus the
value of intermediate products
Only new production of goods and services counts
toward GDP.
What Is Included in GDP and What Is Not? (1 of 2)

GDP considers only final goods and services.

Intermediate goods are not included in GDP
calculations.
• For example, if Alcoa sells aluminum to Ford to make a
Focus ST, the sale of the car is included in GDP, but not
the sale of the aluminum.
What Is Included in GDP and What Is Not? (2 of 2)

Included: Not included:

• Government spending on • Government transfer payments
goods/services • Environmental conditions
• Factory production • A measure of a nation’s health
• Healthcare expenditures • Time spent cooking at home
• Ingredients and food purchased • Babysitter
• Kids in day care
Measures of Well-Being

GDP is used by economists as a proxy for standards of

living.
2.3 Measuring Changes Over Time (1 of 2)

When examining GDP over time, we need to take into account

changes in prices.
Nominal GDP:
• A measure of GDP when prices and quantities have not been separated,
using current year prices
• nominal GDP = price level × real GDP
Real GDP:
• Actual quantity of goods and services, using base year prices
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
• real GDP = 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
2.3 Measuring Changes Over Time (2 of 2)
To compute GDP across time, we must use a certain year’s
prices.
• Real GDP will be measured in a certain year’s dollars.
• Nominal GDP is measured in current dollars.
Nominal GDP: Yt = P1tQ1t + P2tQ2t + … + PNtQNt
• where N is the total number of goods and services in the economy,
and P1t … PNt are prices in year t.
Real GDP: Yt = P1,t−1Q1t + P2,t−1Q2t + … + PN,t−1QNt
• where N is the total number of goods and services in the economy
and P1,t−1 ... PN,t−1 are prices in year t−1.
A Simple Example: Where Real GDP Doesn’t Change (1 of 2)

Consider an economy that produces two goods:

• apples
• computers
nominal GDP = (price of apples × quantity of apples)
+ (price of computers × quantity of computers)
If the quantity of goods and services produced does not change, but
prices do change:
• Nominal GDP will change.
• Real GDP will not change.
A Simple Example: Where Real GDP Doesn’t Change (2 of 2)

Suppose: Year Price of Quantity Price of Quantity of

Apples of Apples Computers Computers
2025 $1 500 $900 5
2026 $2 500 $1000 5

Nominal GDP in 2025:

$1 $900
Nominal GDP2025 =( × 500 apples) + ( × 5 computers) = $5,000
𝑎𝑝𝑝𝑙𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑟

Nominal GDP in 2026:

$2 $1000
Nominal GDP2026 =( × 500 apples) + ( × 5 computers) = $6,000
𝑎𝑝𝑝𝑙𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑟
Real and Nominal GDP in a Simple Economy, 2025-2027
A Second Example: Where Real GDP Changes

Suppose: Year Price of Quantity Price of Quantity of

Apples of Apples Computers Computers
2026 $2 500 $1000 5
2027 $3 550 $1000 6

Real GDP in 2027 using 2027 prices, so Real GDP = nominal GDP
$3 $1000
Real GDP2027 =( × 550 apples) + ( × 6 computers) = $7,650
𝑎𝑝𝑝𝑙𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑟

Real GDP in 2027 using 2026 prices:

$2 $1000
Real GDP2027 =( × 550 apples) + ( × 6 computers) = $7,100
𝑎𝑝𝑝𝑙𝑒 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑟
Quantity Indexes (1 of 3)

Calculating real GDP changes over time:

• The Laspeyres index
o Calculates changes in real GDP using the initial prices
• The Paasche index
o Calculates changes in real GDP using the final year prices
Over long time intervals, the two indexes can result in
substantial differences.
Quantity Indexes (2 of 3)

The Fisher index (chain weighting) is the preferred

approach to calculating real GDP.
• Average of the Laspeyres and Paasche index
• Can be applied on a year-by-year basis if we compute
real GDP each year
Recall: nominal GDP = real GDP × price level
• which is the GDP deflator rearranged:
𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
• Price level (GDP Deflator) = 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
Quantity Indexes (3 of 3)
We can make the following transformation:
%∆ 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑌 ≈ %∆ 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 + %∆ 𝑟𝑒𝑎𝑙 𝑌
where %∆ 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 = 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝜋
Using Chain-Weighted Data

Main reason for using chain-weighted data:

• Prices of computers rapidly changed in the 1990s
Main disadvantage:
• The sum of real C, I, G, NX will not equal real chain-weighted GDP
because the prices used in constructing the components are different.
General rule to follow:
• For particular components of GDP, we look at the ratio of nominal
variables.
• When you want real rates of economic growth, use the chain-weighted
real measures.
2.4 Comparing Economic Performance across Countries

The exchange rate:

• Price at which different currencies are traded
To make comparisons of GDP across countries:
• GDP must be expressed in a common currency by first
adjusting it by the exchange rate.
• This value of nominal GDP must be multiplied by the
ratio of prices in the countries.
An Example of Comparisons of Economies

Suppose we are trying to compare GDP in China and the United States
for 2019. In 2019, U.S. GDP was $20.6 trillion.
• Use the 2019 exchange rate to turn Chinese yuan into USD:
$1
China’s real GDP in USD= 95.1 trillion yuan × = $13.8 trillion
6.91 𝑦𝑢𝑎𝑛

• Adjust for relative price level of goods:

𝐶ℎ𝑖𝑛a′𝑠 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑖𝑛 USD
China’s real GDP in USD = U.S. price level ×
𝐶ℎ𝑖𝑛a′𝑠 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
𝑈.𝑆.𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
= × China’s nominal GDP in USD
𝐶ℎ𝑖𝑛a′𝑠 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
1
= × $13.8 trillion = $20.1 trillion
0.684
Comparison of Countries
• In general, rich countries tend to have higher price levels
than poor countries.
• This is mainly because poor countries have lower wages.