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%

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.%

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.%

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.%