MACRO ECONOMICS

Gross Domestic Product (GDP) – measure of how well an economy is performing.

 Administrative data – byproduct of government functions (tax collections, education programs, defense, and
regulations
 Statistical data – retail establishment, manufacturing firms, and farms

GDP summarize all these data with a single number representing the dollar value of economic activity in a given
period of time.

Ways to view GDP: INCOME = EXPENDITURE

1. Total income of everyone in the economy

2. Total expenditure of on economy’s output of goods and services

National Income Accounting - the system used to measure GDP and related statistics

The Circular Flow

 Inner loop (flow of goods and labor)

1. households sell their labor to the firms.
2. The firms use the labor to product goods.
3. The firms sell the goods to the household.
 Outer loop (Flow of money)
1. The household buy goods from the firm.
2. The firms use the revenue to pay wages, remainder is profit
(to the owners of the firm, who are part of the household)
 GDP Computation (both must be equal)
1. Total income from the production of goods = wages + profit (flow of goods and labor)
2. Total expenditure on purchases of goods (flow of money)

Stocks and Flow

 Stock – quantity measured at a given point in time.

o Accumulation of flow
 Flow – quantity measured per unit of time.
o GDP is the most important flow variable in economics.
 Ex:
o Wealth = stock; income and Expenditure = flow
o Unemployed people = stock; people losing jobs = flow
o Amount of capital in the economy = stock; amount of investment = flow
o Government debt = stock; government budget = flow

Rules for Computing GDP

 GDP is the market value of all FINAL goods/services produced within the economy in a given period of time.
 GDP = (Price x Qty)x + (Price x Qty)y + … where Price = Market Value
 Used/resold goods are NOT accounted in the current GDP as it is just a transfer of asset.
 Paid wages, unsold product, no revenue – DO NOT affect GDP as total expenditure in the economy did not
change. Total income did not change either – though more is distributed as waged and less profit.
o Due to Spoilage: If transactions affect NEITHER expenditure NOR income, GDP DOES NOT change.
o Put to inventory: The firms are assumed to buy the goods for inventory. Profit is not reduced by the
additional wages. As higher wages paid raised income, spending is increased for inventory, GDP rises.
  If the goods inventoried are sold. Spending increased by customers, but inventory expense
decreased by firm, so the sales DOES NOT affect GDP.
 Intermediate goods and value added
o any PROCESSED goods/raw materials are NOT accounted, as only FINAL goods are valued in the GDP.
The intermediate goods will be accounted as part of the market price of the final goods.
o Another way to compute value of final goods: The value added = Output – Intermediate goods.
 Imputed Value - Estimated value of goods/services not sold in the marketplace.
o Ex. Rent is accounted in the GDP. Expenditure of the renter and income of the landlord.
 For homeowners: GDP includes “rent” that homeowners “pay” themselves – reflected in their
expenditure and income.
o Valuing government services – services to the public. GDP value them at wages of public servants.
o No imputation (not accounted in the GDP) is made for the value of goods/services sold in the
underground economy, activities not in the marketplace – home cooking, rent on cars, lawn mowers,
jewelry, other goods OWNED by households.
o This makes GDP an imperfect measure of economic activity.

REAL GDP VS. NOMINAL GDP

 Nominal GDP – Value of goods/services at CURRENT prices

o Measures the current dollar value of the output of the economy
o can increase either because prices rise or if quantity rise
o Not a good gauge of economic wellbeing. Inaccurately reflects how the economy satisfies the demands
of household, firms, and government.
 Real GDP – Economy’s output of goods/services WITHOUT being influenced by changes in prices.
o Value of goods/services at a constant set of prices (base-year prices)
o Change in quantity without change in price.
o RGDP = (‘14P x ‘14Q)x + (‘14P x ‘14Q)y VS. (‘14P x ‘15Q)x + (‘14P x ‘15)y VS. (‘14P x ‘16Q)x + (‘14P x ’16Q)y
 2014 Price = base-year price = Pbase
o Better measure of economic wellbeing.

GDP deflator – takes away inflation from nominal GDP to yield real GDP

 Measures the price of output relative to base year price

 Also known as the implicit price deflator for GDP is the ratio of nominal and real GDP.
 Reflects the status of the overall level of prices in the economy
 GDP deflator is the price of goods in the current year relative to the price of the base year, P/ P base
 Allows economist to separate Nominal GDP into two parts: Quantity Measure (RGDP) and Price Measure (GDPD)

Chain-Weighted Measures of Real GDP

 Every 5 years a new base year is chosen. (1)

 Average price in Year X and Year Y are used to measure REAL growth from X to Y. (2)
 Y/Y growth rates are put together to form a “chain” (2)
 (1) and (2) have no significant differences.

The Components of Expenditure

1. Consumption (C)
2. Investment (I)
3. Government Purchases (G)
4. Net exports (NX)
 National Income Accounts identity: If Y = GDP, then Y = C + I + G + NX
 1. Consumption
o Tangible (goods)
 Durable – long term use
 Non-Durable – short term use
o Intangible (services)
2. Investment – to be counted in the GDP, it should NOT just be reallocated, it should add/create value.
o Business fixed investment – AKA nonresidential fixed investment,
o Residential fixed investment
o Inventory investment
3. Government Purchases
o Does not include transfer payment to individuals: Social security and welfare – since it’s just reallocation
4. Net Export – trade with other countries.
o NX = Sold (export) – Bought (import)

Other Measure of Income

1. Gross National Income (GNP) = GDP + Factors payments FROM abroad – Factors payments TO abroad.
o GDP measures total income produced domestically
o GNP measures total income earned by nationals/residents
2. Net National Product (NNP) = GNP – Depreciation (economy’s stock PPE depreciation)
o Depreciation is called consumption of fixed capital
o NNP is approximately = National Income (NI) = NNP – Statistical Discrepancy
 NI measures how much everyone in the economy has earned. It has 6 components:
1. Compensation of Employees – wages and fringe benefits of workers
2. Proprietors’ Income – income of noncorporate businesses
3. Rental Income – income from landlords incl. imputed rent from owners – depreciation
4. Corporate Profits – income from corporations after payments to workers/creditors
5. Net Interest – int domestic businesses pay – int they receive + int earned from foreigners
6. Taxes on Production and Import – Sales Tax – subsidy
3. Disposable Income = Personal Income – Personal Taxes

Seasonal Adjustment

 Economist are interested with quarter-to-quarter fluctuations

 Income exhibit a regular seasonal pattern: Y increases during the year, peaking in the 4 th qtr. and declining in the
1st qtr. of the next year.
o Changes of ability to produce
o People have seasonal taste
o Preferred times for activities: Vacations and Christmas shopping
 Economic statistics as seasonally adjusted, hence GDP changes as it follows through.

CASE STUDY GDP

 Films, books, and arts expenditures in production WERE considered intermediate costs. Only ticket sales were
considered as the final good.
 In 2013, actual films, books, and arts were considered capital investment because it has long term benefits – like
factories, house etc. Hence, aside from tickets sales, expenditures in production are added to the GDP.
 Expenditures to produce short-lived entertainments likes newspaper and radio show are NOT capital
investments.

Measuring the Cost of Living: Consumer Price Index

  Inflation – percentage change in price level from one period to the next
 Consumer Price Index - measures of the level of price.
 Producer Price Index – measures the price of goods purchased by firms.
 Core Inflation – measures the increase in price of goods that excludes food and energy products.
o F&E products exhibit substantial short-run volatility
o Better gauge of ongoing inflation trends

CPI vs. GDP and PCE Deflators

1. GDP deflators measures the price of ALL goods and services produced
o CPI only measures the prices of goods and services bought
o Increase in price of goods bought only by firms/government will show up in the GDP deflator, not in CPI

2. GDP deflators includes only those goods produced domestically

o Increase in price of imports and sold locally affects the CPI

3. GDP deflators assigns changing weights

o CPI assigns fixed weights on the prices of different goods
o CPI is computed using a fixed basket of goods, whereas GDP deflators allows the basket of goods to
change over time as the composition of GDP changes

 (CPI) Price index with a fixed basket of goods is Laspeyres index

o When prices of goods are changing, this index tends to overstate the increase as it does not account that
customers can substitute less expensive goods
 (GDP deflator) Price index with a changing basket of goods is Paasche index.
o When prices of goods are changing, this index tends to understate the increase as it does not reflect the
reduction of consumers’ welfare that may result from substitution
 Neither is superior in measuring cost of living
 PCE Deflator – implicit price deflator for personal consumption expenditures.
o Calculated like the GDP deflator, but only based consumption component of the GDP
o Ratio of nominal consumer spending to real consumer spending
o Like CPI, it only includes prices of goods and services that consumer buys. It excludes part of investment
and government purchase. It also includes imported goods.
o Like GDP deflator, it allows the basket of goods to change over time as the composition of the consumer
spending changes.
o Preferred gauge of how quickly prices are rising

CPI and Overstating Inflation

 Cost-of-Living Allowances (COLAs) – uses CPI to adjust for changes in the price levels.
o Ex. Social Security allowances are adjusted/annum automatically so inflation will not erode living
standards of elderly.
 CPI PROBLEMS:
1. It tends to overstate inflation. Hence, when prices change, the TRUE cost of living rises less rapidly.
2. Introduction of new goods increases the REAL value of the currency. YET the increase in purchasing power is
not reflected in a lower CPI.
3. It does not measure changes in quality. The quality-adjusted price of the goods will not rise as fast the
unadjusted price.

Measuring Joblessness: The Unemployed Rate

  Economy’s workers are the chief resource, keeping workers employed is a paramount.

 The household survey:

o Employed – paid employees, business owners, unpaid worker in the family business, workers on leave
o Unemployed – not employed, unavailable to work, waiting to be recalled
o Not in the labor force – full time student, homemaker, retiree, discouraged workers

Labor force = employed + unemployed workers

 The Establishment Survey

o The person must show in the payroll to confirm one is an employed person
o If a person works 2 jobs, it is only counted as one in the household survey and twice in the
establishment survey
o Business owners are unemployed in the establishment survey as they are not in the payroll\

CONCLUSION

 GDP, CPI and unemployment rate QUANTIFY the performance of the economy
EXTERNALITIES
 The uncompensated impact of one person’s action on the well-being of a bystander – can be positive or negative
 Market equilibrium is not efficient when there are externalities

Externality and Market Inefficiency

 Welfare Economics
 In the absence of government intervention, the price adjusts to balance the supply and demand.
 The market allocates resources to maximize the total value to the consumers who buy and use
the goods minus the total costs to the producers who make and sell.
 Negative Externalities
 Ex. The factories emit pollution: For each unit of goods produced, a certain amount of pollution
enters the atmosphere. It creates a health risk; hence it is a negative externality.
 Due to this externality, the cost of producing the goods to the society is > cost incurred
by the producers.
 Social cost = private cost of producer + cost bystander hurt
 Pollution emitted = Social cost curve – production cost curve

 Q optimum = target production (intersection of demand and social cost)

o Optimal amount of goods produced from the standpoint of the society
 Q market = market equilibrium. Reflects only the private cost of production. Marginal
customers values steel < social cost of producing it.
 Taxation will alter the supply – internalizing the externality
 Incentivize buyers/sellers to lessen goods consumption that will harm the environment. People
respond to incentives.

 Positive Externalities
 o Technological spillover – the impact of one’s firm research and production efforts on other firms’ access
to technological advance
 Industrial Policy – government intervention that aims to promote technology-enhancing
industries.

SUMMARY

 Negative externalities lead markets to produce larger quantity than is socially desirable.
 Positive externalities lead markets to produce a smaller quantity that is socially desirable
 The government can internalize the externality by taxing goods with negative externalities and subsidizing goods
with positive externalities

Public Policies Toward Externalities

1. Command-and-control policies
o Requiring/forbidding certain behaviors
o It is impossible to prohibit all polluting activity
o Can require the firms to adopt a technology to reduce emissions
2. Market-based policies
o Align private incentives with social efficiency
o Internalize the externality, subsidize
o Corrective Taxes (Pigovian Taxes) – deal with negative effects of negative externalities

3. Tradable Pollution Permits – if one firm wants to increase it emission cap, it must be offset by another firm who
willingly wants to decrease its emission cap. They must pay either ways.
o Supply curve for pollution is perfectly elastic

4. Objection to the Economic Analysis of Pollution

o Economists have little sympathy for this. People face trade-offs. Value must be compared with
opportunity cost. A clean environment can be viewed as simply another “good.”

Private Solutions to Externalities

 Moral Codes and Social Sanctions

 Charities
  Coase Theorem – If private parties can bargain over the allocation of resources at no cost, the private market
will always solve the problem of externalities and allocate resources efficiently.
o the interested parties can reach a bargain in which everyone is better off, and the outcome is efficient

Private Solutions Do Not Always work

 Transaction Cost – The costs the parties incur in the process of agreeing to and following through on a bargain.
o Sometimes parties fail to solve an externality problem because of this
o Bargaining does not always work even when a mutually beneficial agreement is possible
o Often, each party tries to hold out for a better deal

CONCLUSION

 Market equilibrium maximizes the sum of producer and consumer surplus.

 When the buyers and sellers in the market are the only interested parties, the outcome is efficient from the
standpoint of society as a whole
 If activity yields positive externalities, the socially optimal quality is greater than the equilibrium (+, S>E)
 If activity yields negative externalities, the socially optimal quality is less than the equilibrium (-, S<E)

NATIONAL INCOME
The Circular Flow of Money($) Through the Economy

 Household receive income and use it to

o Pay taxes
o Consume goods and services
o Save through the financial markets
 Firms
o Receive revenue from sale of goods and services
o Use the revenue to pay for the factors of production
 Household and firms borrow in the financial markets to
o Buy investment goods – houses, factories
 Government
o Receives revenues from taxes
o Use it to pay for government purchases
o Excess tax revenue is called public saving – can be surplus or budget deficit

What Determines the Total Production of Goods and Services

 GDP – economy’s output of goods and services depends on

1. Factors of production – quantity of inputs to produce goods/services
 2 most important factors of production:
 Capital (K) – set of tools the workers use. Ex. Crane, calculator, PC
 Labor (L) – time spent by workers working
2. Production function (Y) – how much output is produced from given amounts of capital and labor.
 Y=F(K,L) output is equal to the amount of capital and labor
 Y reflects the available technology for turning capital and labor into output
 Constant return of scale (z) – Y has a z if an increase in output is equal to the increase of Y and L:
zY=F(zK,zL)

National Income Distribution to the Factors of Production

 Factors of production and production function determine total output, it also determines national income.
  Neoclassical theory of distribution – how income is distributed from firms to household
1. Prices adjust to balance supply and demand – applied to the markets for factors of production. Demand
for each factor of production depends on the marginal productivity of the factor
 Factor prices – determinant of the distribution of national income. It is the amounts paid to each unit of the
factors of production. Ex. Wage of workers, rent collected

Factor demand arises from the thousands of firms that use Capital and Labor

The Decisions Facing a Competitive Firm

 Competitive firm – small relative to the market which it trades, it has little influence on market prices.
o Competitive firms take the prices of its outputs and its inputs as given by the market condition.
o The firm sells at price (P), hires workers at a wage (W), and rents capital at a rate (R).
o Profit = Revenue (PY) – Labor Costs (WL) – Capital Cost (RK)
o Profit = PF(K,L) – WL – RK
o Profit depends on the factors of production.

The Firm’s Demand for Factors

 Profit-maximizing quantities
 The Marginal Product of Labor (MPL) – The extra amount of output the firm gets from one extra unit of
labor, holding the amount capital fixed.
o MPL = F(K,L+1) – F(K,L)

 Diminishing Marginal Product – Holding the amount of capital fixed, the marginal product of labor
decreases as the amount of labor increases.
o Δ profit = Δ Revenue – Δ cost
o Δ profit = (P x MPL) – W
o If the extra revenue exceeds the wage, hiring increases profit
o MPL = Wage/Selling Price
o W/P = real wage
o The firms hire up to the point MPL = real wage
o Real wage = firm’s labor demand curve
Ex. If Price of bread (P) = $2/loaf

Workers wage (W) = $20/hour

Real wage = 10 Loaves/hour

When MPL falls below 10 Loaves/hour

Hiring more workers will become unprofitable

 Marginal Product of Capital (MPK) – the amount of extra output the firm gets from and extra unit of capital,
while holding the labor constant.
o MPK = F(K+1,L) – F(K,L)
o Δ profit = Δ revenue – Δ cost
o Δ profit = (P x MPK) – R
o MPK = R/P
o R/P = real rental price of capital (measured in unit of goods)

 The firm demands each factor of production until the factor’s marginal product falls to equal its real factor
price.

The Division of National Income

 If all firms are competitive, profit maximizing, then each factor of production is paid its marginal contribution
to the production process.
 Total real wages paid = MPL x L
 Total real rental return paid to owners = MPK x K
 Economic profit – the income that remains after the firms have paid the factors of production
 Economic Profit = Y – MPL(L) – MPK(K)
 Total income is divided among the return to labor, return to capital, and economic profit
 Euler’s Theorem: IF the production function has the property of constant return of scale, then economic
profit is zero.
 3 types of agents: Workers, Owners of Capital, and Owners of Firm.
 Total Income is Divided: Wages, Return of Capital, and Economic Profit.
 Most firms own rather than rent the capital; often firm owners and capital owners are the same people.
Economic Profit and Return of Capital are lumped together.
 Accounting profit = Economic Profit + MPK(K)
 If economic profit is 0 under constant return of scale, profit maximization and competition:
Profit = Return of Capital in the national income

Cobb-Douglas Production Function

 Describes how economies turn capital and labor into GDP

 As economy grew, total income of workers and capital owners increase at the same rate.
 Cobb-Douglas function has constant returns to scale
  Marginal productivity of a factor is proportional to its average productivity

The Growing Gap Between Rich and Poor

 A fall in labor share and rise in capital share tends to increase inequality
 The sharp rise in inequality was largely due to an educational slowdown
 Technology demands more skilled workers relative to unskilled workers
 Education development paced faster than tech development so the gap between skilled workers and
unskilled workers grew more slowly. As skilled workers wage growth slowed down
 Reversing the rise in income inequality will likely require putting more of society’s resources to education
– human capital.

Determinants of the Demand for Goods and Services

 Assume closed economy

 Y=C+I+G
 Consumption
o All forms of consumption make up about 2/3 of GDP
o Output of economy (Y) = Income
o Disposable income = Y-T (income after tax)
o Consumption Function: C = C(Y-T)
 Divided by consumers between consumption and savings.
o Marginal Propensity to consume (MPC) – amount by which consumption changes when disposable
income increases by a dollar. (MPC is between 0 and 1)
 Ex. If MPC = 0.7, thus 70 cents is spent, and 30 cents is saved.
 C = MPC(Y-T) + c ̅
 Investment
o the quantity of investment goods demanded depends on the interest rate. Returns must exceed the
cost to be profitable. If interest rate increases, fewer investments projects are profitable, and the
quantity of investment goods demanded falls
 Nominal interest rate – rate of interest that investors pay to borrow money
 Real interest rate – the nominal interest rate corrected for the effects of inflation
 Ex. If nominal rate is 8%, and inflation is 3%, the real rate is 5%
 Interest rata on a loan depends on its term
 The higher the probability of default, the higher the interest rate
 Holders of government issue bonds do not pay taxes on the interest, hence lower interest
 Government Purchases
o A type of government spending is transfer payments to household
o Transfer payments are NOT made in exchange for the economy’s output. Hence, they are not
included in the variable G.
o Transfer payments affect the demand for goods/services indirectly as it increases the households’
disposable income, as oppose to taxes.
o Increase in transfer payments financed by an increase in taxes leaves disposable income unchanged
o If T = taxes – transfer payments, then disposable income = Y-T includes positive and negative impact
of transfer payments
o G =T, the government has a balanced budget
o If G > T, budget deficit – government must borrow from financial markets
o If G < T, budget surplus – government can use to pay its debt

Supply and Demand for Goods and Services in Equilibrium

  Interest rate is the price that has the crucial role of equilibrating supply and demand
 Equilibrium in the Market for Goods/Services: The S/D for Economy’s Output
o The demand for the economy output comes from C,I,G
o Consumption depends on Disposable income
o Investment depends on real interest rate
o Government purchases and taxes are exogenous variables set by fiscal policy makers
o The supply output is equal to demand, which is the sum of consumption, investment, and
government purchases
o At the equilibrium interest rate, the demand for goods/services equals the supply.
 Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds
o National Savings/Savings = The output that remains after the demands of the consumers and
government have been satisfied
o Savings = Investment
 Private Savings = Y – T – C
 Public Savings = T – G
o Savings and Investment can be supply and demand
o Goods = Loanable Funds
o Price = Interest Rates
o Household lend their savings to investors or deposit their savings in a bank which then loans the
funds out.
o At Equilibrium Interest rate, households’ desire to save balances the firms’ desire to invest, and the
quantity of loanable funds supplied equals the quantity demanded.

Changes in saving: Effects of Fiscal Policy

 When the government changes its spending or level of taxes, it affects demand for economic output, and
alters national savings, investments, and the equilibrium interest rate.
 Increase in Government spending, is met by equal decrease in investment
 To induce investment to fall, interest rate must rise
 Government purchases crowd out investment
 If Increase in Government spending is not accompanied of an increase in tax, the government must loan,
reducing public savings
 Reduction of national savings reduces the supply of loanable funds available for investment
 Reduction of national savings increases interest rate

 Reduction of taxes, increases disposable income, increases MPC, increases consumption

 Output is fixed, Factors of production is fixed, government spending is fixed, increase in consumption will
mean decrease in investment
 For investment to decrease, interest rate must increase
  Decrease in taxes, like increase in government spending, crowds out investment and increase interest rate

Changes in Investment Demand

 Increase in technological innovation, increase demand for investment

 Increase personal tax, to cut tax for those who invest in new capital, it increases demand for investment
 At any given interest rate, the demand for investment goods and loanable funds is higher

CONCLUSION

 Prices adjust to equilibrate supply and demand

 Factor prices equilibrate factor markets
 Interest rates equilibrate the supply and demand for goods/services
o Supply and demand for loanable funds
 Factors of Production and Production technology determines the economy output of goods/services
o Increase in one of the factors of production or technological advances raises output.
 Competitive, profit-maximizing firms hire labor until marginal product labor = real wage
o Firms rent capital until marginal product of capital = real rental price
o Each factor is paid its marginal product
o If production factor has constant return to scale, all output is used to compensate the inputs
 Y=C+I+G
o Consumption depends positively on disposable income
o Investment depends negatively on the real interest rate
o Government purchases and taxes changes originate externally from fiscal policy
 The real interest rate adjusts to equilibrate the supply and demand for the economy’s output –
equivalently, the supply of loanable funds (from savings) and the demand for loanable funds (investments)
 Decrease in national savings, with increase in government spending/decrease in tax, decreases the supply of
loanable funds, which in turn reduces the equilibrium amount of investment, and increases interest rate.
 Increase in tech innovation/tax incentives for investment can increase demand for loanable funds, and raise
interest rates
 Increase in investment demand, increases quantity of investment ONLY if higher interest rate stimulates
additional savings.