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Intermediate Macroeconomics Chapter 1: The Science of Macroeconomics What Macroeconomists Study State of economy affects everyone, macroeconomic issues play a central role in national political debates. Macroeconomic issues are central to world politics. Macroeconomists make use of the data that history has given them. Macroeconomists observe that economies differ across countries and that they change over time. These observations provide both the motivation for developing macroeconomic theories and the data for testing them. Knowledge of economy is important for explaining economic events and for formulating economic policy. Three important variables used to measure economy performance are: o Real GDP@ total income of everyone in the economy. o Inflation rate@ measures how fast prices are rising. o Unemployment rate@ the fraction of the labour force that is out of work. Macroeconomists study: o How these variables are determined o Why they change over time. o How they interact with each other. Real GDP Grows over time. When GDP falls recessions occur. When GDP falls severely then a depression occurs. Recessions and depressions are associated with high unemployment. Inflation rate Periods of falling prices is called deflation. Inflation is around 2@3% each year. How economists think Economists often study politically charged views. Theory as model building Model represents the essence of the real object it is designed to resemble. Economists use models to explain economic variables. Models have to kinds of variables: o Endogenous variables< Variables that a model tries to explain. o Exogenous variables< variables that a model takes as given. (x and y). Purpose of model is to show how the exogenous variables affect the endogenous variables. Exogenous variables come from outside the model. Endogenous variables are determined within the model and are the models output. Exogenous Variables Model Endogenous Variables

Intermediate*Macroeconomics - Amazon Web Services · Intermediate*Macroeconomics! Chapter!1:!The!Science!of!Macroeconomics! What!Macroeconomists!Study!

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Page 1: Intermediate*Macroeconomics - Amazon Web Services · Intermediate*Macroeconomics! Chapter!1:!The!Science!of!Macroeconomics! What!Macroeconomists!Study!

Intermediate*Macroeconomics!Chapter!1:!The!Science!of!Macroeconomics!What!Macroeconomists!Study!

• State%of%economy%affects%everyone,%macroeconomic%issues%play%a%central%role%in%national%political%debates.%

• Macroeconomic%issues%are%central%to%world%politics.%• Macroeconomists%make%use%of%the%data%that%history%has%given%them.%• Macroeconomists%observe%that%economies%differ%across%countries%and%that%they%change%over%

time.%These%observations%provide%both%the%motivation%for%developing%macroeconomic%theories%and%the%data%for%testing%them.%

• Knowledge%of%economy%is%important%for%explaining%economic%events%and%for%formulating%economic%policy.%

• Three%important%variables%used%to%measure%economy%performance%are:%o Real%GDP@%total%income%of%everyone%in%the%economy.%%o Inflation%rate@%measures%how%fast%prices%are%rising.%o Unemployment%rate@%the%fraction%of%the%labour%force%that%is%out%of%work.%

• Macroeconomists%study:%o How%these%variables%are%determined%o Why%they%change%over%time.%o How%they%interact%with%each%other.%

Real!GDP!• Grows%over%time.%• When%GDP%falls%recessions%occur.%• When%GDP%falls%severely%then%a%depression%occurs.%• Recessions%and%depressions%are%associated%with%high%unemployment.%

Inflation!rate!• Periods%of%falling%prices%is%called%deflation.%• Inflation%is%around%2@3%%each%year.%

How!economists!think!• Economists%often%study%politically%charged%views.%

Theory!as!model!building!• Model%represents%the%essence%of%the%real%object%it%is%designed%to%resemble.%• Economists%use%models%to%explain%economic%variables.%• Models%have%to%kinds%of%variables:%

o Endogenous%variables<%Variables%that%a%model%tries%to%explain.%o Exogenous%variables<%variables%that%a%model%takes%as%given.%(x%and%y).%

• Purpose%of%model%is%to%show%how%the%exogenous%variables%affect%the%endogenous%variables.%• Exogenous%variables%come%from%outside%the%model.%• Endogenous%variables%are%determined%within%the%model%and%are%the%models%output.%

%Exogenous%Variables% Model% Endogenous%Variables%

Page 2: Intermediate*Macroeconomics - Amazon Web Services · Intermediate*Macroeconomics! Chapter!1:!The!Science!of!Macroeconomics! What!Macroeconomists!Study!

o !"#$!!"# =!"#$!1!!"#$%!!"!!""#$!!!!"#$!2!!"#$%&%'!!"!!""#$ +!"#$!2!!"#$%!!"!!""#$!!!!"#$!1!!"#$%&%'!!"!!""#$ .%

GDP!Deflator!• GDP%Deflator<%the%ratio%of%nominal%GDP%and%Real%GDP.%

• !"#!!"#$%&'( = !"#$%&'!!"#!"#$!!"# %

• Reflects%what’s%happening%to%the%overall%level%of%prices%in%the%economy.%• Nominal%GDP%measures%quantities%and%prices.%

Chain!Weighted!Measures!of!Real!GDP!• Ensures%prices%used%are%not%too%far%out%of%date%as%bureau%picks%base%years.%

The!components!of!Expenditure!• National ! Income!Accounts! IdentityN !! = ! + ! + ! + !"!• GDP%is%the%sum%of%consumption,%investment,%government%purchases%and%net%exports.%• Consumption<%the%goods%and%services%bought%by%households.%Involves%three%categories:%

o Nondurable%goods@%goods%that%last%a%short%time.%o Durable%goods@%goods%that%last%a%long%time.%o Services@%intangible%items%purchased.%

• Investment<%Goods%for%future%use.%Involves%three%categories:%o Business%fixed%investment@%purchase%of%new%plant%and%equipment%by%firms.%o Residential%fixed%investment@%purchase%of%new%housing%by%households%and%landlords.%o Inventory%investment@%increase%in%firms’%inventories%and%goods.%

• Government%Purchases@%goods%and%services%bought%by%the%government.%• Net%Exports@%accounts%for%trade%with%other%countries.%

o Exports%–%Imports.%

Measuring!the!Cost!of!Living:!The!Consumer!Price!Index!The!Price!of!a!Basket!of!Goods!

• Consumer%Price%Index<%Measure%of%level%of%prices.%• Turns%the%prices%of%many%goods%and%services%into%a%single%index%measuring%overall%prices.%

• !"# = ! (!"#$%&%'!!"!!""#$!!!!"##$%&!!"#$%)(!"#$%&%'!!"!!""#$!!!!"#$!!"#$!!"#$%)%

CPI!vs.!GDP!Deflator!• There%are%three%differences%between%the%two%measures:%

1. GDP%deflator%measures%the%prices%of%all%goods%and%services%produced%whereas%the%CPI%measures%the%prices%of%only%the%goods%and%services%bought%by%consumers.%Increase%in%price%of%goods%shows%up%in%GDP%deflator%but%not%CPI.%

2. GDP%deflator%includes%only%goods%produced%domestically.%Domestic%and%International%are%included%in%CPI.%

3. Different%results%from%the%two%measures%of%the%prices%in%the%economy.%• Laspeyres%index@%a%price%index%with%a%fixed%basket%of%goods.%• Paasche%Index@%price%index%with%changing%baskets.%• When%prices%of%goods%change%by%different%amounts%a%fixed%basket%tends%to%overstate%the%

increase%in%cost%of%living%as%consumers%have%the%opportunity%to%substitute%less%expensive%goods%for%expensive%ones.%

• CPI%is%a%fixed%basket%of%goods.%

Page 3: Intermediate*Macroeconomics - Amazon Web Services · Intermediate*Macroeconomics! Chapter!1:!The!Science!of!Macroeconomics! What!Macroeconomists!Study!

Chapter!3:!National!Income!Most%important%macroeconomic%variable%is%GDP.%Measures%both%the%total%output%of%goods%and%services%and%its%total%income.%

What!Determines!the!Total!Production!of!Goods!and!Services?!• The%GDP%depends%on:%

o Its%quantity%of%inputs,%called%the%factors%of%production%o Ability%to%turn%inputs%into%output%as%represented%by%the%production%function.%

The!Factors!of!Production!• Factors%of%Production<%the%inputs%used%to%produce%goods%and%services.%• Two%most%important%factors%are%capital%and%labour.%

o Capital%(K)%is%the%set%of%tools%that%workers%use.%o Labour%(L)%is%the%time%people%spend%working.%o Both%factors%are%fixed.%o ! = !%o Assumption%that%capital%and%labour%are%fully%utilised.%

The!Production!Function!• The%available%production%technology%determines%how%much%output%is%produced%from%given%

amounts%of%capital%and%labour.%• Y=%output.%• ! = !(!, !)%• The%production%function%reflects%the%available%technology%for%turning%capital%and%labour%into%

output.%• Constant%returns%to%scale<%a%property%where%an%increase%in%of%an%equal%percentage%in%all%

factors%of%production%causes%an%increase%in%output%of%the%same%percentage.%o Doubling%K%and%L%will%give%double%Y.%

How!is!National!Income!Distributed!to!the!Factors!of!Production?!• Total%Output=%Total%Income%• Neoclassical%theory%of%distribution@%demand%for%each%factor%of%production%depends%on%the%

marginal%productivity%of%that%factor.%

Factor!Prices!• Distribution%of%National%Income%is%determined%by%factor%prices.%• Factor%Prices<%the%amounts%paid%to%the%factors%of%production.%

o Wages%workers%earn.%o Rent%the%owners%of%capital%collect.%

• Equilibrium%factor%price%is%determined%by%the%intersection%of%the%downward%sloping%factor%demand%curve%and%the%vertical%supply%curve.%

Decisions!Facing!a!Competitive!Firm!• Competitive%Firm<%small%relative%to%markets%so%it%has%little%influence%on%market%prices.%• Cannot%influence%wages%of%workers%it%employs%because%other%firms%employ%workers.%• Competitive%firms%gain%a%higher%production%function%by%using%more%capital%or%having%more%

labour.%• Goal%of%firm%is%to%maximise%profit.%• Profit<%(Price%x%Output)%–%Costs%of%Production.%

Page 4: Intermediate*Macroeconomics - Amazon Web Services · Intermediate*Macroeconomics! Chapter!1:!The!Science!of!Macroeconomics! What!Macroeconomists!Study!

The!Firms!Demand!for!Factors!• More%the%firm%employs%the%more%output%it%produces.%• Marginal%product%of%labour%(MPL)%<%the%extra%amount%of%output%a%firm%gets%from%employing%

one%extra%unit%of%labour%holding%capital%fixed.%L+1.%• Diminishing%Marginal%Product<%the%marginal%product%of%labour%decreases%as%amount%of%

labour%increases.%

MPL$to$Labour$Demand$• Increase%in%revenue%from%an%additional%unit%of%labour%depends%on:%

o Marginal%product%of%labour.%o Price%of%the%output.%

• The%change%in%profit%from%hiring%an%additional%unit%of%labour%is:%o !"#$%& = !!!!!"# −!.%o If%change%is%positive%then%hire%additional%worker.%

• Real%Wage%(W/P)%<%the%payment%to%labour%measured%in%units%of%output%rather%than%dollars.%• Efficiency%is%when%Real%Wage%=%MPL.%

MPC$and$Capital$Demand$• Marginal%product%of%capital%(MPK)%–%the%amount%of%extra%output%the%firm%gets%from%an%extra%

unit%of%capital.%• Real%rental%price%of%capital<%The%rental%price%measured%in%units%of%goods%rather%than%dollars.%

Division!of!National!Income!• Economic%Profit<%! − !"#!!!! − (!"#!!!!)%• Accounting%Profit@%!"#$#%&"!!"#$%& + (!"#!!!!)%

CobbNDouglas!Production!Function!• The%division%of%national%income%between%capital%and%labour%has%been%roughly%constant%over%

a%long%period.%• As%economies%grew%more%prosperous%over%time,%total%income%of%workers%and%total%income%of%

capital%owners%grew%at%the%same%time.%• Capital%Income%=%MPK%x%K%=%αY%• Labour%Income%=%MPL%x%L%=%(1%–%α)%Y.%

o α%is%a%constant%between%zero%and%one%that%measures%capital’s%share%of%income.%• ! !, ! = !!!!!!!!%

o A%is%the%parameter%greater%than%zero%and%measures%productivity%of%available%technology.%o α%is%the%share%of%output.%

• Cobb@Douglas%production%function%has%constant%returns%to%scale.%• Increase%in%capital%rises%MPK%and%lowers%MPL.%

What!Determines!the!Demand!for!Goods!and!Services!• Circular%flow%diagram%contains%only%C,%I%and%G.%• Closed%economy@%No%NX%as%no%trade%occurs.%

o ! = !!! + !!! + !!."

Consumption!• Makes%up%2/3%of%GDP.%• Disposable%Income<%Income%after%tax.%Y@T.%• A%higher%level%of%disposable%income%leads%to%a%greater%consumption.%