Macroeconomics 1 - Week 1
Introduction to Macroeconomics
The data of Macroeconomics
17.02.2015
Miroslava Federičová
What is Economics about?
 The study of how best to allocate scarce resources among
competing uses (trade-offs -> choices)
Core issues
 WHAT to produce with limited resources
 HOW to produce the goods and services we select
 FOR WHOM goods and services are produced
How to answer these questions?
What are the resources and uses?
Factors of production Production Possibilities
• Land
• Labor
• Capital
• Entrepreneurship
Market
mechanism
Market mechanism:
The use of market prices to
signal desired resource
allocation
The Invisible Hand (Adam
Smith)
Positive vs. Normative analysis
 Positive statements
 Attempts to describe and analyze the reality
 „minimum-wage laws cause unemployment“
 Normative statements
 Based on subjective value system attempts to
prescribe how the world should look like
 „government should raise the minimum wage“
 Modern economics – positive science
 Have to get rid of subjective value system
Macroeconomics and Microeconomics
Microeconomics
 Studies the behavior of individual consumers, firms,
government agencies that compose the larger economy
 The study of how households and firms make decisions and
how they interact in the markets
Macroeconomics
 Studies the behavior of the entire economy as a whole,
economy-wide phenomena (inflation, unemployment,
economic growth)
 Goal: understand and improve the performance of the
economy as a whole
 Closely linked: the economy as a whole is just a collection of
many household and many firms interacting in many markets
Macroeconomists address diverse questions
 Why is average income high in some countries while it is
low in others?
 Why do prices rise rapidly in some periods of time while
they are more stable in other periods?
 Why do production and employment expand in some
years and contract in others?
The data of Macroeconomics
 Many types of data to measure the performance
of economy
 Three macroeconomic variables are especially
important:
 Real GDP – total income of everyone in economy
 Inflation rate – how fast prices are rising
 Unemployment rate – the fraction of the labor
force out of work
 How are they determined? Why do they change
over time? How do they interact?
National Accounting
National Accounting
 When judging whether the economy is doing well or
poorly, it is natural to look at the total income that
everyone in the economy is earning.
 Why? – necessary for designing succesfull
macroeconomic policies
 National Accounting: The measurement of aggregate
economic activity usign complete and consistent
accounting techniques
Measures of Output
Gross Domestic Product (GDP)
 Measures two things at once: the total income of
everyone in the economy and the total expenditure on
the economy’s output of goods and services (income
must equal expenditure)
 Most frequently used measure of aggregate output
Macroeconomic Circular Flow
Product
markets
Factor
markets
Households Government Firms
Rest of the
World
Rest of the
World
Supply of factors of production
Demand for goods and services Supply of goods and services
Demand for factors of production
Taxes
Transfers and services
Transfers and services
Taxes
Imports and
Exports
Measures of Output
 Total market value of all final goods and services produced within
a nation’s borders in a given time period
 Market value
 How to sum apples, cars, theatre performaces, teaching at school?
 Throught Prices (each good and service produced and brought to a market has a
price)
 Final goods
 It records only the value of final goods, not intermediate goods (the value is
counted only once – as the value of intermediate good is included in the value of
final good)
 Exception – intermediate good is not used but it is added to the firm’s inventory
 Produced - Currently produced – used car
 Within a nation’s boarders
 Given time – year or a quarter (seasonally adjusted)
GDP
 Why we count only final goods and services and omit
intermediate?
 GDP is increased by 100 000 USD
 GDP = sum of final goods = sum of value added
Measures of Output
 What Is Not Counted in GDP?
 GDP excludes most items that are produced and consumed at
home and that never enter the marketplace.
 It excludes items produced and sold illicitly, such as illegal drugs.
 Domestic – refers to production within borders - alternative
accounting for ownership of factors of production is Gross National
Income (Product)
 Gross – depreciation of fixed capital (wearing out of plant and
equipment) not deducted yet, after deduction -> Net Domestic
product
 GDP (Y) is the sum of the following:
Y = C + I + G + NX
 Consumption (C)
 The spending by households on goods and services,
with the exception of purchases of new housing.
 Investment (I)
 The spending on capital equipment, inventories, and
structures, including new housing.
 Government Purchases (G)
 The spending on goods and services by local, state, and
federal governments.
 Does not include transfer payments because they are
not made in exchange for currently produced goods or
services (social security benefits).
 Net Exports (NX) – exports minus imports
U.S. GDP and Its Components (2009)
Consumption
71%
Government Purchases
21%
Net Exports
-3 %
Investment
11%
Real vs. Nominal GDP
 Nominal GDP values the production of goods and
services at current prices.
 Real GDP values the production of goods and services at
constant prices (i.e. reflect only changes in the amounts
being produced).
 Adjustment using constant prices of a base period
 Chain-weighted price adjustment
 GDP deflator = (Nominal GDP / Real GDP)*100
 Reflects only the prices of goods and services
 Take inflation out of nominal GDP
Constant Prices (of a base period)

Real vs. Nominal GDP
US Real and Nominal GDP
0
2000
4000
6000
8000
10000
12000
14000
16000
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
GDP in bill. of current USD GDP bill of chained 2005 USD
Advanced: Problem with constant prices

Advanced: Problem with constant prices
Advanced:Chain-Weighted Price Adjustment
 Chain-weighted indices use moving average of price
levels in consecutive years as an inflation adjustment
 One method is e.g. to use price levels and structure of
previous period to find the volume index then chain
those to a reference year
 Most real national accounts are obtained using this
method nowadays
Three approaches to measuring GDP
1. Output approach: GDP= sum of gross value
added
2. Expenditure approach: GDP=sum of final
demand aggregates ~ demand side
3. Income approach:
GDP=wages+profits+interest+rent (distributed
to owners of factors of production) ~ supply
side
Three approaches to measuring GDP
Different measures of income

Different measures of income
Gross national Income as % of GDP (2009)
65
70
75
80
85
90
95
100
105
Source: Eurostat
Limitations of GDP
Example: US between 1990 and 2009
 GDP growth of 58.2%
 GDP per capita grew by 28.2%
 Mean household income grew by 14.2%1
 Median household income grew by 4.5%
1) It might be correctly striking to you that the mean (average) household income grew slower than (average)
GDP per capita since you know that all income in the economy should be equal to GDP. Here the difference is
due to statistical imprecisions - the mean household income comes from Census data where e.g. the highest
category of incomes is reported as e.g. 250 000 plus, so it is less precise…so census data capture only a part of
the increase in the income inequality…see http://krugman.blogs.nytimes.com/2011/02/03/economic-growth-andhousehold-income/
.. So economically more important is the comparison between mean and median income and
between GDP and GDP per capita…
GDP and economic well-being
 GDP is the best single measure of the economic well-being of a
society.
 GDP per person tells us the income and expenditure of the
average person in the economy.
 Higher GDP per person indicates a higher standard of living.
 GDP is not a perfect measure of the happiness or quality of life,
however.
 Some things that contribute to well-being are not included in GDP.
 The value of leisure.
 The value of a clean environment.
 The value of almost all activity that takes place outside of markets,
such as the value of the time parents spend with their children and
the value of volunteer work.
Alternative measures
 UN Human Development Index
 comparative measure of life expectancy, literacy,
education and standards of living
 http://hdr.undp.org/en/statistics/
 OECD Better Life Index
 http://www.oecdbetterlifeindex.org/
 Can construct your own index
GDP, Life Expectancy, and Literacy
Human Development Index
GDP and Happiness
 Is it GDP we should try to maximize?
 Can we measure happiness? Yes
 Standard thinking:
↑ GDP → ↑ Income → ↑ Consumption → ↑ Happiness
 Easterlin Paradox:
 In international comparisons average reported happiness does
not vary much with income per person especially when income is
sufficient to cover basic needs
 In U.S. between 1946-70 great growth in GDP but no trend in
reported happiness
 Does income after some level influence the level of happiness
Summary
 Because every transaction has a buyer and a
seller, the total expenditure in the economy
must equal the total income in the economy.
 Gross Domestic Product (GDP) measures an
economy’s total expenditure on newly
produced goods and services and the total
income earned from the production of these
goods and services.
Summary
 GDP is the market value of all final goods
and services produced within a country in a
given period of time.
 GDP is divided among four components of
expenditure: consumption, investment,
government purchases, and net exports.
Summary
 Nominal GDP uses current prices to value
the economy’s production. Real GDP uses
constant base-year prices to value the
economy’s production of goods and services.
 The GDP deflator—calculated from the ratio
of nominal to real GDP—measures the level
of prices in the economy.
Summary
 GDP is a good measure of economic wellbeing
because people prefer higher to lower
incomes.
 It is not a perfect measure of well-being
because some things, such as leisure time
and a clean environment, aren’t measured by
GDP.
The measurement of CPI
The consumer price index (CPI)
 The consumer price index (CPI) is a measure of
the overall cost of the goods and services
bought by a typical consumer
 The Bureau of Labor Statistics reports the CPI
each month.
 It is used to monitor changes in the cost of living
over time.
 When the CPI rises, the typical family has to
spend more dollars to maintain the same
standard of living.
How the CPI is calculated
 Fix the Basket: Determine what prices are most
important to the typical consumer.
 The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
 The BLS conducts monthly consumer surveys to set
the weights for the prices of those goods and services.
 Find the Prices: Find the prices of each of the goods
and services in the basket for each point in time.
 Compute the Basket’s Cost: Use the data on prices to
calculate the cost of the basket of goods and services at
different times.
How the CPI is calculated
 Choose a Base Year and Compute the Index:
 Designate one year as the base year, making it the
benchmark against which other years are compared.
 Compute the index by dividing the price of the basket
in one year by the price in the base year and
multiplying by 100.
CPI= (Price of basketx / Price of basketbase )*100
 Compute the inflation rate
Inflation
 Inflation refers to a situation in which the
economy’s overall price level is rising.
 The inflation rate is the percentage change in
the price level from the previous period.
 The Inflation Rate
 The inflation rate is calculated as follows:
Inflation Rate in Year 2 =
CPI in Year 2-CPI in Year 1
CPI in Year 1
100
What’s in the CPI’s Basket?
16%
Food and
beverages
17%
Transportation
Medical care
6%
Recreation
6%
Apparel
4%
Other goods
and services
4%
41%
Housing
6%
Education and
communication
Problems in Measuring the Cost of Living
 The substitution bias, introduction of new
goods, and unmeasured quality changes
cause the CPI to overstate the true cost of
living.
 The issue is important because many government
programs use the CPI to adjust for changes in the
overall level of prices.
 The CPI overstates inflation by about 1
percentage point per year.
The GDP Deflator versus the Consumer
Price Index
 The GDP deflator is calculated as follows:
GDP deflator =
Nominal GDP
Real GDP
100
The GDP Deflator versus the Consumer
Price Index
 Economists and policymakers monitor both the
GDP deflator and the consumer price index to
measure how quickly prices are rising.
 There are two important differences between the
indexes that can cause them to diverge.
The GDP Deflator versus the Consumer
Price Index
 The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
 …the consumer price index reflects the
prices of all goods and services bought by
consumers.
The GDP Deflator versus the Consumer
Price Index
 The consumer price index compares the
price of a fixed basket of goods and services
to the price of the basket in the base year
(only occasionally does the BLS change the
basket)...
 …whereas the GDP deflator compares the
price of currently produced goods and
services to the price of the same goods and
services in the base year.
Two Measures of Inflation
1965
Percent
per Year
15
CPI
GDP deflator
10
5
0
1970 1975 1980 1985 1990 20001995
Copyright©2004 South-Western
Summary
 The consumer price index shows the cost of
a basket of goods and services relative to the
cost of the same basket in the base year.
 The index is used to measure the overall
level of prices in the economy.
 The percentage change in the CPI measures
the inflation rate.
Summary
 The consumer price index is an imperfect
measure of the cost of living for the following
three reasons: substitution bias, the
introduction of new goods, and unmeasured
changes in quality.
 Because of measurement problems, the CPI
overstates annual inflation by about 1
percentage point.
Summary
 The GDP deflator differs from the CPI
because it includes goods and services
produced rather than goods and services
consumed.
 In addition, the CPI uses a fixed basket of
goods, while the GDP deflator automatically
changes the group of goods and services
over time as the composition of GDP
changes.