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Introduction to Macroeconomics
U6301 Macroeconomics for International and Public Affairs

Readings: ABC Chapters 1 and 2

Martsella Davitaya
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Outline

1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity using GDP

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But let’s start from the beginning…

• Economics studies how scarce economic resources are allocated and used to
maximize production for a society

Economics

Microeconomics Macroeconomics

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Macroeconomics vs. Microeconomics

Microeconomics Macroeconomics

Subject Economic behavior Economic behavior

Level of analysis Individual units Entire economy

Aggregate
Agents Individual
(sectors of economy)

Markets Particular goods and services Composite

Prices Relative Absolute
In the short run via changes in
Market Adjustment Only via changes in prices
quantities
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Using Microeconomics in Macroeconomics

• Macroeconomics is based on microeconomics – microfoundations

- macroeconomic events are the result of the decisions of millions of individual

agents, maximizing their own welfare and arise from the interaction of many
people

• But… not every statement that is true for an individual is always true for the
entire economy

⇒ Macro has specific subjects and specific methods of analysis

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Key Topics in Macroeconomics

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Source: Word count from United States Economic Forecast Report by Deloitte
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1. Long-run changes in output – why are some countries richer than others?

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Economic Growth

• Evaluation of country’s economic performance over time

- Relative change in output eliminates level and currency differences

- Annual growth rate 𝑔 of output in any year 𝑡 – annual percentage change in

output from year 𝑡 − 1

𝑌 −𝑌
𝑔 =
𝑌

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Ratio scales (log scales)

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https://www.youtube.com/watch?v=jbkSRLYSojo

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Natural log of series – log scale in base e

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Long-run Growth vs. Business Cycle

Aggregate
Output Economic Growth
(potential output)

Business Cycle
(actual output)

Time (years)

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2. Short run fluctuations/business cycles – why do recessions occur?

• Business cycle = Alternating periods of positive and negative growth rates

• Recession = period when output is declining (NBER) or below its potential level

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3. Unemployment – what causes unemployment?

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4. Inflation – why prices grow?

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Inflation

• Measure of how prices change over time

- Inflation rate 𝜋 in any year 𝑡 – annual percentage change in the level of

prices from year 𝑡 − 1

𝑃 −𝑃
𝜋 =
𝑃

- Deflation: when prices of most goods and services decline 𝜋 < 0

- Hyperinflation: an extremely high rate of inflation

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5. International Economy – how are these variables affected by links

between economies?

• Trade surplus:

exports exceed imports

• Trade deficit:

imports exceed exports

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6. Macroeconomic Policy – are structural/fiscal/monetary policies useful?

Macroeconomic Policy

Economic Growth Stabilization Policy

• aimed to stimulate economic • aimed to smooth out business
growth in the long run and to cycle in the short run and to
affect productive possibilities diminish the depth of recessions
of the economy and the height of booms

Fiscal Monetary Macroprudential

Policy Policy Policies
government money supply structural
spending, (LTV), cyclical
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taxation (CCyB)
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What Macroeconomics is About?

• Overall Output

- long-run changes – why are some countries richer than others?

- short run fluctuations – why do recessions occur?

• Unemployment – what causes high unemployment?

• Inflation – why prices grow and what is cost of inflation for society?

• International Economy – how are these variables affected by links between

economies?

• Macroeconomic Policy – are structural/fiscal/monetary policies useful?

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Outline

1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity using GDP

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What Macroeconomists Do?

• Controlled experiments not always possible ⇒ use models
- to simplify the analysis of complex economic reality
- to examine the relationship between economic phenomena and the regularity
of their development
- to understand what goes on in the economy and how the economy works
- to develop policies that might prevent, correct, or alleviate economic
problems and improve the situation in the economy
- to forecast future development of economic process

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Macroeconomic Models
assumptions predictions

Exogenous Endogenous
(independent) variable (dependent) variable
determined by forces MODEL determined within the
outside the model model.

• Models do not need to be «realistic», but should be consistent with the empirical facts

• Positive vs. normative analysis

- Positive analysis examines consequences of a policy

- Normative determines whether a policy should be used

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Outline
1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity

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Outline
1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity

• 3 Approaches of measuring GDP

• Structure of Economy and Circular Flows

• GNP

• GDP over time and across countries

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Using GDP
• National Accounts – system used to measure overall output and income in a country

• In the US, NIPA – National Income and Product Accounts

• Most common measure for aggregate output is Gross Domestic Product

• GDP measures the total market value of all the final goods and services produced within
the country (by domestic economy) during a one-year period
“adds up everything from nails to toothbrushes, tractors, shoes, haircuts,
management consultancy, street cleaning, yoga teaching, plates, bandages, books,
and the millions of other services and products in the economy”
Diane Coyle

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GDP measures the total market value of all the final goods and services produced within
the country (by domestic economy) during a one-year period

• total  measures aggregate output

• market  only official market transactions are included (self-made goods and shadow
economy are excluded)
• value  measured in money (blns of dollars, yens, etc.)
• all final goods and services  transfer payments (welfare benefits and subsidies) and
financial transactions (purchases of bonds and shares) are excluded (because income is not
created, but redistributed and nothing new is produced)

• final goods and services  in order to avoid double counting, intermediate goods (that form
inputs for final product such as steel in car production or flour in baking bread) are excluded

• produced  not redistributed or resold

• within the country  i.e., in the domestic economy, no matter by what factors of production,
either owned by the citizens of the country or by foreigners (goods and services produced by
national factors abroad are excluded)

• during a year  only newly (currently) produced goods 29

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Three Approaches to Calculating GDP

• Product Approach (Value Added)
market value of all goods and services produced in the economy
(excluding intermediates)

• Income Approach
income earned by each agent in the economy

• Expenditure Approach
all the purchases of final goods and services in the economy

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Approach 1. Value Added Approach: Receipts on Each Stage of Production

Receipts of farmer from miller $.18

Receipts of miller from baker $.18 $.24 = $.42

Receipts of baker from grocer $.18 $.24 $.38 = $.80

Total consumer
Receipts of grocer from consumer $.18 $.24 $.38 $.20 = $1.00 expenditure

Value added (= income created) at each stage of production

$.18 Value added by farmer

$.24 Value added by miller

$.38 Value added by baker

$.20 Value added by grocer

Total value added =Total income created =Total consumer expenditure 31

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Value Added Approach Summary

Firm’s value added = Revenue – Value of intermediate goods

purchased from the other firms

Total value added = Value of total output (total sales) –

– Value of total intermediate product

GDP =  values added

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Value Added Approach: Example

• Product Approach:
Revenue from Orange INC 35,000
Revenue from Juice INC 40,000
- Oranges purchased from OrangeINC -25,000
GDP 50,000

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Approach 2. Expenditure Approach

sums up spending of all macro agents on all macro markets

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A Simple Example

• Expenditure Approach:
Oranges sold to public 10,000
Juice sales 40,000
GDP 50,000
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Approach 3. Income Approach

sums up income of all macro agents

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A Simple Example

• Income Approach:
Wages paid to Orange INC employees 15,000
Profits of Orange INC (35000-15000) 20,000
Wages paid to Juice INC employees 10,000
Profits of Juice INC (40000-10000-25000) 5,000
GDP 50,000
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Recap three Approaches to Defining GDP

They all give the same answer!

• Expenditure Approach
Measures all the purchases of final goods and services in the economy

• Product Approach
Measures the market value of all goods and services produced in the
economy (excluding intermediates)

• Income Approach
Measures the income earned by each agent in the economy (+ adjustments)

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Fisheries m.kr.
Wages
Sales Income
-15.000
35.000
Simple example 2
Sales to individuals 10.000
Sales to Fish Packing 25.000 Product Approach
Income from Fisheries 35.000
Income from Fish Packing 40.000
Fish Packing - Inputs -25.000
Wages -10.000 GDP 50.000
Bought from Fisheries -25.000
Sales of packed fish 40.000

Expenditure approach Income Approach

Fish sold to indiv. 10.000 Wages from Fisheries 15.000
Sales of packed fish 40.000 Wages from Fish Packing 10.000
GDP 50.000 Profit of Fisheries 20.000
Profit from Fish Packing 5.000
GDP 50.000

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Outline
1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity

• 3 Approaches of measuring GDP

• Structure of Economy and Circular Flows

• GNP

• GDP over time and across countries

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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households

• the owners of economic resources

• the earners of national income;
• the main consumers of goods and services
• the main savers
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Structure of Economy
• We can represent economy by 4 macro agents on 4 macro markets

Consumption spending C includes expenditures made by

Households
households for:
• current consumption – purchases of non-durable goods
• consumption of durable goods
• payments for services
C
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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms

• the main producers of goods and services

• the main demanders for economic resources
• the consumers of the part of aggregate output
• the main borrowers
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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Investment spending I represent expenditures made

by private business firms and households to buy capital
Households Firms
goods. It is the sum of expenditures for:
• purchases of new equipment, machinery and tools
• new nonresidential construction
• new residential construction
I • inventory investment

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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms

Private Sector

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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms Government

• the producer of public goods

• the consumer of the part of aggregate output
• the redistributor of national income
• lender or borrower in the financial markets
• the regulator of economic activity
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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets
Government spending G consist of
the government sector’s purchase of
goods and services. They include
Households Firms Government expenditures on:
• goods purchased to run
government and the military
• payments to government
G employees and the military for their
personal services;
CG IG • 47
and exclude transfer payments
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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms Government

Closed Economy

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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms Government Foreign Sector

interacts with the national economy through two channels:

• international trade - exchange of goods and services

• capital flows - exchange of assets, primarily financial (bonds and shares)

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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms Government Foreign Sector

• The value of domestic production that is sold to other countries is
called exports X
• The value of foreign production that is purchased by the domestic
economy is the country’s imports M
NX = X- M
• The difference between gross exports and gross imports is called
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net exports NX
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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Households Firms Government Foreign Sector

Open Economy

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Another Look at Expenditure Approach

Expenditures by all macro agents on 4 macro markets give us GDP

Households Firms Government Foreign Sector

C + I + G + NX =Y
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Note on NX
• Goods and services produced abroad are bought by all domestic macroeconomic agents
(households, firms, and government). Thus they are parts of corresponding consumption
spending C, investment spending I, and government purchases of goods and services G.

• Because gross domestic product includes the value of only domestically produced goods
and services, then in order to calculate GDP, we must subtract the value of all imported
goods and services and add the value of all domestically produced production bought by
foreigners:

• Therefore, imported production is excluded from the value of GDP, but it is registered
twice in national accounts 53
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Structure of Economy
We can represent economy by 4 macro agents on 4 macro markets

Goods Resource Financial Foreign Exchange

Market Market Market Market

money bonds
market market

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Outline
1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity

• 3 Approaches of measuring GDP

• Structure of Economy and Circular Flows

• GNP

• GDP over time and across countries

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aggregate expenditures (AE) = aggregate income (Y) = aggregate product (Y)

Expenditures Revenues
Goods
Market
goods and goods and
services purchased services sold

Households Firms

land, L, K, inputs
entrepreneurship (factor services)
Resource
Market Factor Payments
Incomes
(w, rents, interest, profits) 56
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AE = C + I Y = C + Spvt
Consumption spending (C) Revenues
Goods
Market
Investment spending (I)

Households Firms

Financial
Saving (Spvt) Market Loanable Funds

Resource
Market Factor Payments
Incomes (Y)
(w, rents, interest, profits) 57
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AE = C + I + G Y = C + Spvt + T - TR - INT
Consumption spending (C) Revenues
Goods
Market
Investment spending (I)
Government
spending (G)
Taxes (T) Taxes (T)

Transfers (TR)
Government Subsidies

Households Firms
Loan to government Interest payments
if G+TR>T (INT)

Financial
Saving (Spvt) Market Loanable Funds

Resource
Market Factor Payments
Incomes (Y)
(w, rents, interest, profits) 58
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Private, Government, National Saving

• Private Disposable Income

YD = C + Spvt = Y – T + TR + INT

• Government budget (public saving)

SG = T – (G + TR + INT)

• National Saving

S = SG + Spvt 59
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Foreign Sector and Net Exports

payments for foreign goods and services (M)

foreign goods and services

Domestic Foreign
Economy Economy

domestic goods and services

payments for domestic goods and services (X)

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Exports (X)
Foreign Sector
Imports (M)
Revenues
Goods
Consumption spending (C)
Market
Investment spending (I)
Government
spending (G)
Taxes (T) Taxes (T)

Transfers (TR)
Government Subsidies

Households Firms
Loan to government Interest payments
if G+TR>T (INT)

Saving (Spvt) Financial

Market Loanable Funds
Capital inflow if M > X
Resource
Market Factor Payments
Incomes (Y)
(w, rents, interest, profits) 61
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Important Identities in Open Economy

AE = C + I + G + X - M and Y = C + Spvt + T - TR – INT - NFP

Since AE = Y, we get CAPITAL FORMATION EQUATION

I = Spvt + T - TR - INT – G + M - X

Private Government Foreign Sector

saving saving saving

National Saving 62
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Private, Government, National Saving

• Private Disposable Income

YD = Y – T + TR + INT + NFP

• Government budget (public saving)

SG = T – (G + TR + INT)

• National Saving

S = SG + Spvt = Y + NFP – C – G
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Outline
1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity

• 3 Approaches of measuring GDP

• Structure of Economy and Circular Flows

• GNP

• GDP over time and across countries

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GDP vs. GNP

• Gross National Product (GNP) is the total market value of all final goods and
services produced within a year by factors of production owned by the citizens of
that country

• It doesn't matter where the output is actually produced in the domestic economy
or abroad

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Italian worker works in Germany

• He adds to:
− Gross Domestic Product of Germany
− Gross National Product of Italy

Income of Italian in Income of foreigners received Net Factor

Germany – within Italy = Payments from
Abroad

GNP = GDP + NFP

• Hence, GNP can be greater or less than GDP, depending on whether the citizens of the country
(Italians) earn more or less abroad (in Germany) than foreigners earn in this country (Italy)

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Outline
1. What Macroeconomics is About?

2. What Macroeconomists Do?

3. Measuring Economic Activity

• 3 Approaches of measuring GDP

• GNP

• GDP over time and across countries

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Comparing income across time and countries

• Need to separate differences in amounts of goods and services from differences

in the prices of the goods and services

• Comparing output

- in one country at two points in time: take into account differences in prices
between the two points in time

- between two countries at a point in time: take into account differences in

prices between the two countries

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#1. Across time: Nominal GDP vs. Real GDP

• GDP is measured with market values/prices of goods and services
𝐺𝐷𝑃 = 𝑃 𝑄 + 𝑃 𝑄 + ⋯

• Nominal GDP is GDP measured at current prices ⇒ affected by

- Changes in the size of physical volume of production
- Changes in prices (level of inflation)

• Taking account of price changes over time: real GDP

• Real GDP is GDP measure with constant prices ⇒ measures true change in
output

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Banana Republic – Economy produces bananas

Quantity Price Nominal GDP Real GDP

(in tons) (in dollars) (in current prices) (in prices of 2023)

Year
100 150 150 × 100 = 15000 150 × 100 = 15000
2023
Year
80 200 200 × 80 = 16000 150 × 80 = 12000
2024

• In 2024 the real GDP decreased while the nominal GDP increased due to the
increase in prices

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• Nominal GDP = current year prices × current year quantities

𝒏

= 𝑷𝒊𝒕 𝑸𝒊𝒕
𝒊 𝟏

• Real GDP = base year prices × current year quantities =

𝒏

= 𝑷𝒊𝟎 𝑸𝒊𝒕
𝒊 𝟏

where
- 𝑃 and 𝑃 are the prices for good i correspondingly in the current (t)
year and in the base (0) year;
- 𝑄 is the quantities of good i produced in the current (t) year

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Nominal vs. Real GDP in US, 1947 – 2022

Nominal GDP tracks changes in price AND quantity

Real GDP holds prices constant at the base year

True, false or uncertain: If real GDP lies above nominal

GDP before the base year, prices are rising over time

Base year

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Price Indices

• Measures of general price level

1. Consumer Price Index (CPI)

2. Personal Consumption Expenditures (PCE)

3. GDP Deflator

• Price indices are used to measure inflation and adjust nominal values for inflation
to find real values

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CPI
• is based on the prices of items in a fixed representative "market basket" of hundreds
of final goods and services used by typical urban consumers in a base year

• is the government's gauge of inflation in the US

• is considered to be the best measure of the cost of living

• is used to adjust tax brackets and social security payments and wages for inflation

• is calculated as Laspeyres index, i.e., fixed basket (base year) quantities index:

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆𝒔 ×𝑩𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒊𝒆𝒔 ∑𝒏

𝒊 𝟏 𝑷𝒊𝒕 𝑸𝒊𝟎
CPI = 𝑩𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆𝒔 ×𝑩𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒊𝒆𝒔
= ∑𝒏
× 𝟏𝟎𝟎
𝒊 𝟏 𝑷𝒊𝟎 𝑸𝒊𝟎

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Real GDP, Price Indexes, and

Inflation (11 of 12)

• Application: The Fed’s preferred inflation measures

– The Federal Reserve focuses its attention on the
personal consumption expenditures (PCE) price index
 The Fed forecasts both the overall PCE price index
and the core PCE price index
– The PCE price index is superior to the CPI because it
avoids substitution bias and is revised when better
data are available
– Differences between the PCE price index and the CPI
include formulas used in their calculation, coverage of
different items, and weights given to different items
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 1/18/2024

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Real GDP, Price Indexes, and

Inflation (12 of 12)
• Application: The Fed’s preferred inflation measures
– The Fed uses the core PCE price index to measure
the underlying trend in inflation
– But the Fed forecasts both the core and overall PCE
price index because the Fed needs to keep its eye on
both underlying trends but also the actual inflation rate
faced by households
– The inflation rate in the overall PCE price index tends
to revert to the core measure after a period when the
two measures deviate (Figure 2.5)

Copyright © 2024 Pearson Education, Inc. All Rights Reserved

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Figure 2.5: Overall PCE Inflation Rate and Core PCE

Inflation Rate, January 1960 to December 2021

Copyright © 2024 Pearson Education, Inc. All Rights Reserved

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GDP deflator
• is an alternative general price index that reflects the importance of
products in current market baskets (current year quantities), rather than in
base year market baskets (base year quantities), which become less
relevant over time

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆𝒔 ×𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒊𝒆𝒔

GDP Deflator =
𝑩𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆𝒔 ×𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒊𝒆𝒔

∑𝒏
𝒊 𝟏 𝑷𝒊𝒕 𝑸𝒊𝒕
∑𝒏
𝒊 𝟏 𝑷𝒊𝟎 𝑸𝒊𝒕
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#2. Across countries: International prices and

purchasing power
• Need to choose a set of prices and apply it to both countries

• Ex: a regular cappuccino in Sweden vs. Indonesia

• Convert prices into US dollars using current exchange rates:

• $3.90 in Stockholm and $2.63 in Jakarta

• International current exchange rate is not a good measure of how much a

rupiah will buy in Jakarta and how much a krona will get you in Stockholm

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• When comparing living standards across countries, use estimates of GDP

per capita in a common set of prices known as purchasing power parity
(PPP)⁠ prices

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• Prices are typically higher in richer countries

- wages are higher
• Difference between GDP per capita in Sweden and Indonesia:
- at current exchange rates: GDP pc in Indonesia is only 6% of the level
of Sweden
- at PPP: GDP pc in Indonesia is 21% of the level of Sweden

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