What Macroeconomics Tries to Explain

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What Macroeconomics Tries to Explain

• Microeconomic deals with behavior of individual
  decision makers and individual markets
• Macroeconomic deals with broad outlines of the
  economy
• Which view is better?
• Depends on what were trying to do

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Macroeconomic Goals

• Economistsand society at largeagree on three
  important macroeconomic goals
• Economic growth
• Full employment
• Stable prices
• Why is there such universal agreement on these
  three goals?
• Because achieving them gives us opportunity to
  make all of our citizens better off

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Economic Growth

• Economists monitor economic growth
• By keeping track of real gross domestic product
  (real GDP)
• Total quantity of goods and services produced in
  a country over a year
• Real GDP has actually increased faster than the
  population
• During this period (1929 to 2002), while U.S.
  population did not quite triple. Quantity of
  goods and services produced each year has
  increased more than tenfold

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Figure 1 U.S. Real Gross Domestic Product,
1929-2002
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High Employment (or Low Unemployment)

• Unemployment affects distribution of economic
  well being among our citizens
• People who cannot find jobs suffer a loss of
  income
• Joblessness affects all of useven those who have
  jobs
• A high unemployment rate means economy is not
  achieving its full economic potential

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High Employment (or Low Unemployment)

• Unemployment rate
• Percentage of the workforce that would like to
  work, but cannot find jobs
• Used to keep track of employment
• The nations commitment to high employment has
  twice been written into law
• With memory of Great Depression still fresh,
  Congress passed Employment Act of 1946
• Required federal government to promote maximum
  employment, production, and purchasing power
• A numerical target was added in 1978, when
  Congress passed Full Employment and Balanced
  Growth Act
• Called for an unemployment rate of 4
• In the 1990s, we came closer and closer and
  finallyin December 1999we reached the target
  again for the first time since the 1960s
• In 2001 unemployment rate began to creep up
  again, and continued rising through the first
  half of 2003, when it averaged 6

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Figure 3 U.S. Quarterly Unemployment Rate,
19602003
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Employment and the Business Cycle

• When firms produce more output, they hire more
  workerswhen they produce less output, they tend
  to lay off workers
• We would thus expect real GDP and employment to
  be closely related, and indeed they are
• Business cycles
• Fluctuations in real GDP around its long-term
  growth trend
• Expansion
• A period of increasing real GDP
• Contraction
• A period of declining real GDP

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Employment and the Business Cycle

• Recession
• A contraction of significant depth and duration
• Depression
• An unusually severe recession
• In the twentieth century, United States
  experienced one decline in output serious enough
  to be considered a depressionthe worldwide Great
  Depression of the 1930s
• From 1929 to 1933, the first four years of Great
  Depression, U.S. output dropped by more than 25

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Figure 3 The Business Cycle
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Stable Prices

• With very few exceptions, inflation rate has been
  positive
• During 1990s, inflation rate averaged less than
  3 per year
• Other countries have not been so lucky
• An extreme case was the new nation of
  Serbiaprices rose by 1,880 in August 1993
• Why are stable pricesa low inflation ratean
  important macroeconomic goal?
• Because inflation is costly to society
• With annual inflation rates in the thousands of
  percent, the costs are easy to see
• Purchasing power of currency declines so rapidly
  that people are no longer willing to hold it
• Economists regard some inflation as good
• Price stabilization requires not only preventing
  inflation rate from rising too high. But also
  preventing it from falling too low, where it
  would be dangerously close to turning negative

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Figure 4 U.S. Annual Inflation Rate, 1922-2003
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• GDP Production and Income

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Production and Gross Domestic Product, GDP A
Definition

• The nations gross domestic product (GDP)
• Total value of all final goods and services
  produced for the marketplace during a given
  period within the nations borders

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Production and Gross Domestic Product, GDP A
Definition

• The total value
• Approach of GDP is to add up dollar value of
  every good or servicethe number of dollars each
  product is sold for
• However, using the dollar prices at which goods
  and services actually sell also creates a problem
• If prices rise, then GDP will rise, even if we
  are not actually producing more
• GDP must be adjusted to take away the effects of
  inflation
• of all final
• When measuring production, we do not count every
  good or service produced in the economy
• Only those that are sold to their final users
• Avoids over-counting intermediate products when
  measuring GDP
• Value of all intermediate products is
  automatically included in value of final products
  they are used to create

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Figure 1 Stages of Production
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Production and Gross Domestic Product, GDP A
Definition

• goods and services
• We all know a good when we see one
• Final services count in GDP in the same way as
  final goods
• produced
• In order to contribute to GDP, something must be
  produced
• During the period being considered
• E.g. buying land, stocks and bonds

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Production and Gross Domestic Product, GDP A
Definition

• for the marketplace
• GDP does not include all final goods and services
  produced in the economy
• Includes only the ones produced for the
  marketplacethat is, with the intention of being
  sold
• E.g. child, wash car, mowing, walk dog
• during a given period
• GDP measures production during some specific
  period of time
• Only goods produced during that period are
  counted
• GDP is actually measured for each quarter, and
  then reported as an annual rate for the quarter
• E.g. homes, old furnitures, old signed photoes

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Production and Gross Domestic Product, GDP A
Definition

• within the nations borders
• GDP measures output produced within U.S. borders
• Regardless of whether it was produced by
  Americans
• Americans abroad are not counted
• However, foreigners producing goods or services
  within the country are

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Is GDP a good indicator?

• Going Beyond GDP
• http//www.youtube.com/watch?vEp4DWx1--sY
• Consumption
• http//www.youtube.com/watch?v8YioR2ULrrQ

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The Expenditure Approach to GDP

• The Commerce Departments Bureau of Economic
  Analysis (BEA) http//www.bea.gov/newsreleases/ind
  ustry/gdpindustry/gdpindnewsrelease.htm
• Agency responsible for gathering, reporting, and
  analyzing movements in the nations output
• Calculates GDP in several different ways
• Expenditure approach divides output into four
  categories according to which group in the
  economy purchases it as final users
• Consumption goods and services (C)purchased by
  households
• Private investment goods and services
  (I)purchased by businesses
• Government goods and services (G)purchased by
  government agencies
• Net exports (NX)purchased by foreigners

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The Expenditure Approach to GDP

• When we add up the purchases of all four groups
  we get GDP
• GDP C I G NX

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Consumption Spending

• Consumption is the part of GDP purchased by
  households as final users
• Almost everything households buy during the year
  is included as part of consumption spending when
  we calculate GDP
• One exception is construction of new homes
• Counted as private investment
• Some quirky exceptions to the definition of
  consumption
• Total value of all food products that farm
  families produce and consume themselves
• Total value of the housing services provided by
  owner-occupied homes

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Private Investment (Capital formation)

• Private investment has three components
• Business Purchases of Plant, Equipment, and
  Software
• A firms plant, equipment, and software are
  intended to last for many yearsonly a small part
  of them is used up to make the current years
  output
• Software are regarded as final goods, and firms
  that buy them as final users of those goods
• New Home Construction
• Residential housing is an important part of
  nations capital stock
• House will continue to provide services into the
  future
• Changes in Inventories
• We count the charge in firms inventories as part
  of investment in measuring GDP
• Why?
• When goods are produced but not sold during the
  year, they end up in some firms inventory stocks
• Part of the nations capital stock
• Will provide services in the future, when they
  are finally sold and used

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Case 1 When inventories are unchanged over the
course of a year

• Inventory on January 1 500
• Total production for the year 1000
• Total sales for the year 1000
• Inventory on December 31 500
• Change in inventory 0

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Case 2 When inventories increase over the course
of a year

• Inventory on January 1 500
• Total production for the year 1000
• Total sales for the year 800
• Inventory on December 31 700
• Change in inventory 200

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Case 3 When inventories fall over the course of
a year

• Inventory on January 1 500
• Total production for the year 1000
• Total sales for the year 1450
• Inventory on December 31 50
• Change in inventory 450

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Private Investment and the Capital Stock Some
Provisos

• Specifically, private investment does not include
• Government Investment
• An important part of the nations capital stock
  is owned and operated not by business, but by
  governmentfederal, state, and local
• Consumer durables
• Goods such as furniture, automobiles, washing
  machines, and personal computers for home use can
  be considered capital goods
• Will continue to provide services for many years
• Human capital
• To measure the increase in capital stock most
  broadly we include the additional skills and
  training acquired by workforce during the year

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Government Purchases

• Purchases by state, local governments and federal
  government are included
• Government purchases include
• Goods
• Fighter jets, police cars, school buildings, spy
  satellites, etc.
• Services
• Such as those performed by police, legislators,
  and military personnel
• Government is considered to be a purchaser even
  if it actually produces the goods or services
  itself

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Government Purchases

• Transfer payments represent money redistributed
  from one group of citizens (taxpayers) to another
  (poor, unemployed, elderly)
• While transfers are included in government
  budgets as outlays they are not purchases of
  currently produced goods and services
• Not included in government purchases or in GDP

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Net Exports

• Once we recognize dealings with the rest of the
  world, we must correct an inaccuracy in our
  measure of GDP
• Deduct all U.S. imports during the year, leaving
  us with just output produced in United States
• To properly account for output sold to, and
  bought from, foreigners
• Must include net exportsdifference between
  exports and importsas part of expenditure in GDP

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Other Approaches to GDP The Value-Added Approach

• Value added
• Firms contribution to a product or
• Revenue it receives for its output
• Minus cost of all the intermediate goods that it
  buys
• GDP is sum of values added by all firms in economy

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Figure 1 Stages of Production
1.50
1 0.50 0.75 1.25 1.5 5
1.25
0.75
0.50
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Other Approaches to GDP The Factor Payments
Approach

• In any year, value added by a firm is equal to
  total factor payments made by that firm
• GDP equals sum of all firms value added
• Each firms value added is equal to its factor
  payments
• Thus, GDP must equal total factor payments made
  by all firms in the economy
• All of these factor payments are received by
  households in the form of wages and salaries,
  rent, interest or profit
• GDP is measured by adding up all of the
  incomewages and salaries, rent, interest, and
  profitearned by all households in the economy
• Gives us an important insight into the
  macroeconomy
• Total output of economy (GDP) is equal to total
  income earned in the economy

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Measuring GDP A Summary

• Different ways to calculate GDP
• Expenditure Approach
• GDP C I G NX
• Value-Added Approach
• GDP Sum of value added by all firms
• Factor Payments Approach
• GDP Sum of factor payments made by all firms
• GDP Wages and Salaries interest rent
  profit
• GDP Total household income

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Real Versus Nominal GDP

• Since GDP is measured in dollars, a serious
  problem exists when tracking change in output
  over time
• Value of the dollarits purchasing poweris
  changing
• Usually need to adjust our measurements to
  reflect changes in the value of the dollar
• Nominalwhen a variable is measured over time
  with no adjustment for the dollars changing
  value
• Realwhen a variable is adjusted for the dollars
  changing value
• Most government statistics are reported in both
  nominal and real terms
• Economists focus almost exclusively on real
  variables

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How GDP Is Used

• Governments reports on GDP are used to steer the
  economy over both short-run and long-run
• In short-run, to alert us to recessions and give
  us a chance to stabilize the economy
• In long-run, to tell us whether our economy is
  growing fast enough to raise output per capita
  and our standard of living, and fast enough to
  generate sufficient jobs for a growing population
• Many (but not all) economists believe that, if
  alerted in time
• Government can design policies to help keep the
  economy on a more balanced course

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Figure 2 Real GDP Growth Rate,19602003
Actual GDP growth rate
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Problems With GDP

• Quality changes
• While BEA includes impact of quality changes for
  many goods and services (such as automobiles and
  computers)
• Does not have the resources to estimate quality
  changes for millions of different goods and
  services
• By ignoring these quality improvements, GDP
  probably understates true growth from year to year

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The Underground Economy

• Some production is hidden from government
  authorities
• Either because it is illegal or
• Drugs, prostitution, most gambling
• Because those engaged in it are avoiding taxes
• Production in these hidden markets cannot be
  measured accurately
• BEA must estimate it
• Many economists believe that BEAs estimates are
  too low
• As a result, GDP may understate total output

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Non-Market Production

• GDP does not include non-market production
• Goods and services that are produced, but not
  sold in the marketplace
• Whenever a non-market transaction becomes a
  market transaction GDP will rise
• Even though total production has remained the
  same
• Can exaggerate the growth in GDP over long
  periods of time
• What do these problems tell us about value of
  GDP?
• For certain purposesespecially interpreting
  long-run changes in GDPwe must exercise caution
• GDP works much better as a guide to short-run
  performance of economy
• Short-term changes in real GDP are fairly
  accurate reflections of the state of the economy
• A significant quarter-to-quarter change in real
  GDP virtually always indicates a change in actual
  production rather than a measurement problem
• This is why policy makers, business people, and
  the media pay such close attention to GDP as a
  guide to the economy from quarter to quarter