Chapter 11 – Introduction to Macroeconomics

This chapter starts our coverage of Macroeconomics, the study of how the economy works as a whole.

The chapter defines the key variables to measure the “health” of an economy, and briefly discusses how the variables are measured and interpreted.

Microeconomics Versus Macroeconomics

Microeconomics -- the “web of connections” of all the individual interdependent markets that make up an economy.

Macroeconomics – putting the microscope away and looking at the overall economy as its own entity, imperfections and all.

The Macro Goal Variables

Measures of Economy’s “Health”Definitions and Realistic Goals

(US, for the most part).

Goal #1 – Sufficient Production or Output

Measured by Real Gross Domestic Product (Real GDP).

Real GDP (Y) -- The total production or output of final goods and services over a period of time, expressed in constant prices of a base year.

Real Versus Nominal GDP

Nominal GDP (unadjusted GDP) -- Total production at current prices.

Real GDP (GDP adjusted for changes in prices) -- Total production at constant prices of a base year.

Why is Production or Output Important?

Real GDP – the sum total of production of final goods and services across all markets of the economy, it measures total production or output.

By definition, Real GDP identically measures total income to all the factors derived from production and sales.

Real GDP -- Realistic Goal

Realistic Goal for Real GDP -- to be as high as possible without accelerating inflation (overstimulated economy).

The Full Sustainable Level of Real GDP (Potential GDP)

The Full Sustainable Level of Real GDP (YF) – the maximum level of Real GDP the economy can produce without bringing on accelerating inflation or overstimulation.

Characterizing the Economy: Y versus YF

Y < YF -- sluggish economy

Y > YF -- economy with

accelerating inflation

Y = YF -- economy with constant

inflation rate (desired

state)

Characteristics of YF

Unobservable.Has grown at 2.5% per year for the

US historically since World War II.Maybe for the US, it has grown 3%

per year in most recent decade.Growth rate is not the same for all

countries (Europe, Canada is less).

Recession -- A Special Case

Recession -- The situation where the level of real GDP decreases, or exhibits negative growth, for at least two consecutive quarters.

Clearly, in a recession, Y < YF.

Goal Variable #2 -- Inflation

Measured by the Inflation Rate -- the growth or percentage change in the overall price level.

First, measure the price level (P):

Consumer Price Index (CPI).Inflation Rate = Percentage

Change in P.

Why is Inflation a Problem?

Inflation erodes the purchasing power of money, causes distortions in decisions.

-- Why hold money? -- Why lend money?Inflation can erode people’s standard of

living, put pressure on labor markets. -- Fixed incomes. -- Workers with insufficient raises.

Realistic Goal -- Inflation

Ideal Goal: Inflation Rate = 0%.

Realistic Goal (US):

|Inflation Rate| < 3%.

The Consumer Price Index (CPI)

Key measure of the price level (P).

Computed based upon a Market Basket: comprehensive set of goods and services purchased by consumers.

Fixed Weight Index

Computing a CPI

Example -- Compute the CPI for 2008 with 1992 as the base year.

CPI2008 = (Cost of 1992 Market Basket Purchased in 2008) (Cost of Actual Consumer Purchases in 1992)

Computing The Inflation Rate (Given the CPI)

Example -- Compute the Inflation Rate for 2008, given that the CPI for 2007 and 2008 have been calculated.

Inflation = CPI2008 – CPI2007 x 100%

Rate2008 CPI2007

Biases in the CPI (as a Fixed Weight Index)

Entry Bias -- goods leaving and entering the market basket.

Quality Bias -- different quality of the same goods over time.

Outlet Bias -- retail vs outlet prices?Commodity Substitution Bias -- changing

quantities over time due to demand response to goods that have become relatively expensive.

The GDP Deflator

An alternative measure of the price level (P).

Market Basket: comprehensive set of goods and services purchased by all spenders in the economy (consumers, businesses, government, and foreigners on US exports and imports).

Chain Weighted Index – alleviates some of the biases of the CPI due to being a fixed weight index.

Converting Nominal GDP to Real GDP

Example -- find Real GDP2008

Real GDP2008 = Nominal GDP2008

P2008

Real GDP for other years is computed the same way.

Real GDP Growth = Percentage Change in Real GDP.

Goal Variable #3 -- Unemployment

Measured by the Unemployment Rate (u).

u = (# of people unemployed) x 100% (labor force)

Unemployed -- those people out of work and seeking work.

Labor Force -- people employed + people unemployed

What the Unemployment Rate Does Not Measure

discouraged workers, those who drop out of the labor force

part-time versus full-time employment

compensation of those workingpeople with multiple jobs

Realistic Goal -- Unemployment Rate

Realistic Goal -- as low as possible without inflation accelerating (overstimulated economy).

Natural Rate of Unemployment (uN) -- The lowest unemployment rate the economy can achieve without accelerating inflation.

Realistic Goal: u = uN

Interpretation: u versus uN

u = uN Desired State of

Economyu > uN Sluggish Economy

u < uN Accelerating Inflation

(Overstimulated Economy)

Types of Unemployment

Total Unemployment = Frictional + Structural + Demand-Deficient

Frictional Unemployment -- Unemployment due to time involved to matching unemployed and appropriate jobs.

Structural and Demand-Deficient Unemployment

Structural Unemployment -- Unemployment due to a mismatch of available workers and jobs.

Demand-Deficient Unemployment -- Unemployment due to a generally sluggish economy. There are not enough jobs for everyone who wants one.

The Natural Rate of Unemployment Revisited

Natural Rate of Unemployment (uN) -- The unemployment rate in which inflation has no tendency to accelerate or decelerate.

Another Interpretation -- uN is the unemployment rate with zero demand-deficient unemployment.

Economy at uN: “full employment”.

Where is uN for the US?

Historically, uN = 5.5%

Is uN now maybe 5%?

Most other countries: uN is higher than US measure.

Real GDP and the Unemployment Rate

u = uN Y = YF,

(Desired State of Economy)u > uN Y < YF,

(Sluggish Economy)u < uN Y > YF,

(Accelerating Inflation)

Unemployment -- Not an Independent Problem

Real GDP Growth Employment Growth u

Real GDP and unemployment -- not independent problems.

Focus on getting one of them to the desired goal, and the other one will automatically follow (although not a perfect correlation).