Chapter 1: Introduction

1. Chapter 1:Introduction Macroeconomics:Theory and policy

2. Chapter 1. Outline • 1.1 Concepts • Definition • Micro vs macro • 1.2 A science of models • Definition • Types of variables • 1.3 Data of macroeconomics • Production (GDP) • Prices (CPI) • Unemployment (definitions, Okun´s law)

3. 1.1. Concepts Macroeconomics: General concepts

4. Introduction Definition: Macroeconomics is the branch of economics devoted to the study of the economy as a whole.

5. Microeconomics vs Macroeconomics • Complements, not substitutes • Micro: studies individual agents and markets (remember def of macro)

6. Microeconomics vs Macroeconomics • Macro deals with economy-wide events, but these arise from the interactions of individual agents. This is known as “microeconomic fundaments of macroeconomics” • The integration between the two branches is incomplete

7. 1.2 Models Economics as a science of models

8. Economic models • Def: economic models are simplified versions of a more complex reality. They show the relationships between the most important economic variables, ignoring irrelevant details. • We use them to explain the economy’s behavior and to devise policies. • The relationships between economic variables are often shown using equations.

9. Assumptions and plurality of models • Models are based on assumptions. We often ignore them, but they are the base of our models. If the assumptions are wrong, the model won´t work properly. • Through assumptions, we manage to represent a simplification of reality (less complex, more manageable) • If one model could explain everything, that would be enough. However, we use different models to deal with different things. For example, • If we want to know how a fall in aggregate income affects new car prices, we can use the S/D model for new cars. • But if we want to know why aggregate income falls, we need a different model. • There is no one “correct” model, only models that are appropriate for different things.

10. Assumptions and plurality of models x • For each new model, you should keep track of • its assumptions, • which of its variables are endogenous and which are exogenous, • the questions it answers , • the questions it cannot answer, and • what are the conclusions, and how do they compare to the real world • 3 groups of models, according to their temporal horizon • Long run (classical model): flexible prices • Very long run (growth models): flexible prices, emphasis on growth • Short run: sticky prices • What does “sticky prices” mean?

11. Types of variables • Endogenous vs exogenous • Endogenous: determined within the model • Exogenous: determined outside the model • Examples: • Flow vs stock • Flow: a quantity measured per unit of time • Stock: a quantity measured at a certain point in time • Examples:

12. 1.3 Data of macroeconomics Macroeconomics as a “science of data” Production Prices Unemployment

13. (1)Production • National income and product accounts are an accounting system used to measure of aggregate economic activity. • The measure of aggregate output in the national income accounts is gross domestic product, or GDP.

14. GDP • There are three possible ways to define GDP (GDP= Gross Domestic Product): • Definition based on expenditure • Definition based on value added • Definition based on income

15. GDP – 1st definition • GDP is the value of the final goods and services produced in the economy during a given period of time. That is, it´s the total expenditure on final goods and services produced in the economy during a given period of time. • A final good is a good that is intended for final consumption (those that are not intermediate goods). • An intermediate good is a good used in the production of another good (that is, it gets consumed in the process).

16. Intermediate or final goods and services Special cases • Capital goods: a produced good (no natural resources) used to produce other g&s but that is not consumed in the process. They are final goods. • Used goods: not included in GDP (they were accounted for in the year they were produced) • Inventories: unsold final goods, final goods in production, inputs held by firms. “Investment in inventories” (amount by which inventories increase that year) is considered “final goods”.

17. Components of aggregate expenditure • Consumption (C) • Non durable goods • Durable goods • Services • Investment (I) • Businesses´fixed I • Residencial I • I in inventories • Government spending (G) • It doesn´t include transfer payments (they´re just reallocation of income) • G&S purchased by all levels of government • Net exports (X-M), NX Note: capital (K) is a factor of production. I is spending on new capital

18. GDP – 2nd definition • GDP is the sum of value added in the economy during a given period. • Value added equals the value of a firm’s production minus the value of the intermediate goods it uses in production. • By using the concept of value added, we avoid the problem of “double counting”.

19. GDP – 3rd definition • GDP is the sum of the incomes in the economy during a given period. • That is, it´s total income earned by the factors of production of an economy in a certain period of time.

20. GDP and the circular flow • The expenditure and income definition are equivalent, as can be seen in the circular flow. • The circular flow is very useful to represent a simple economy, but GDP allows us to aggregate many different goods and services. • How? Through prices • Example: add apples and pears.

21. GDP is an imperfect measure • It does not include… • valuable things, such as leisure, domestic production, • The informal or underground economy, which can be specially problematic if using GDP to compare countries • Deterioration of the environment • It has some difficulties in measuring the value of g&s that are not traded in the market (there are no prices), they go into GDP with an imputed value (example: g&s produced by the government)

22. GNP = Gross National Product • GNP: total income earned by national factors of production, independently of where they are located • GDP = rents “at home” of national factors+ rents “at home” of foreign factors • GNP = rents “at home” of national factors+ rents “abroad” of national factors • GNP-GDP= rents “abroad” of national factors – rents “at home” of foreign factors.

23. Nominal and real GDP • Nominal GDP is the sum of the quantities of final goods produced times their current price. • Real GDP is the sum of the quantities of final goods produced times constant prices. • We know what happens with the value of g&s when quantities change, but prices don´t. • It´s important to know the base year

24. Nominal and real GDP • Nominal GDP is also called dollar GDP or GDP in current dollars. • Real GDP is also called GDP in terms of goods, GDP in constant dollars, GDP adjusted for inflation, or GDP in “base year” dollars.

25. Nominal and real GDP • From 1960 to 2003, nominal GDP increased by a factor of 21. Real GDP increased by a factor of 4. Nominal and Real GDP U.S. GDP Since 1960 • What does this imply about prices and quantities?

26. Other related measures • NDP = net domestic product NDP = GDP– depreciation • Potential GDP: value of all final g&s produced in the economy in a certain period of time when all the available resources are in use. • GDP deflator = (nominal GDP/ real GDP) (x100)

27. GDP deflator Example with 3 goods (i = 1, 2, 3) Pit = the market price of good i in month t Qit = the quantity of good i produced in month t NGDPt = Nominal GDP in month t RGDPt = Real GDP in month t • The GDP deflator is a weighted average of prices, where the weight on each price reflects that good’s relative importance in GDP. • Note that the weights change over time

28. (2)Prices • Inflation is a sustained rise in the general level of prices (referred to as “the price level”) • Conversely, deflation is a sustained decline in the price level. It corresponds to a negative inflation rate • The inflation rate is the rate at which the price level increases, calculated as the percentage increase in the overall level of prices • We care about inflation because: • During periods of inflation, not all prices and wages rise proportionately, inflation affects income distribution. • Inflation leads to other distortions

29. Prices • The GDP deflator is sometimes used as a measure of inflation. But other measures exist: • Consumer price index (most often used) • Producer price index • …

30. CPI • CPI = consumer price index • It measures the cost of a basket of consumption goods. It´s widely used to estimate “the cost of living” • Note: it´s not based on all g&s, only on those included in the basket. • And , even then, not all g&s in the basket have the same importance • To calculate the CPI for a certain month:

31. CPI Example with 3 goods (i = 1, 2, 3) Ci = the amount of good i in the CPI’s basket Pit = the price of good i in month t Et = the cost of the CPI basket in month t Eb = cost of the basket in the base period • The CPI is a weighted average of prices, where the weight on each price reflects that good’s relative importance in the CPI’s basket. • Note that the weights remain fixed over time.

32. Differences between GDP deflator and CPI • In what they take into account: • GDP defl. measures the prices of all g&s produced in the economy, CPI only those purchased by consumers • GDP only includes g&s produced domestically (in the economy) • In how they are constructed: • CPI is based on a pre-determined basket, with chosen and fixed weights, while in the GDP defl. the weights change as the composition of GDP changes.

33. Some other problems with CPI • CPI doesn't take into account the fact that consumers can substitute between goods (substitution bias). • CPI doesn't deal well with the introduction of new g&s in the market. • CPI has difficulties taking into account changes in quality. • These are some of the reasons why some argue that CPI may overstate inflation

34. CPI Inflation Rate, Using the CPI and the GDP Deflator since 1960 The inflation rates, computed using either the CPI or the GDP deflator, are largely similar. • CPI and GDP deflator tend to move together, although there are some exceptions.

35. (3)Employment • According to their employment status we talk about: • Employed pop: working at a paid job. • Unemployed pop: not working, but actively looking for a job. • Labor force: employed + unemployed • Not in the labor force: not employed, and not looking for a job (inactive) • Also: • Discouraged worker: someone who wants a job, but is no longer looking • Underemployed workers: workers who work part time, but would like to work full time

36. Types of unemployment • Seasonal unemployment: when the job is only available part of the year • Frictional unemployment: short-run, occasional unemployment, caused by normal imperfections in labor markets • Structural unemployment: chronic, long-term unemployment • Two main causes: low skill levels and displacement of economic activity. • Are people who are structurally unemployed out of a job the whole year? • Cyclical unemployment: due to a slow down of the economy • We care about the type and size of unemployment : • Because of its direct effects on the welfare of the unemployed. • Because it signals that the economy may not be using some of its resources efficiently.

37. Unemployment • labor force = employment + unemploymentL = N + U • Unemployment rate: • Natural rate of unemployment (un) is the “healthy” unemployment rate that will always occur in an economy, • Cyclical unemployment = u – un • Participation rate

38. Okun´s law (or Okun´s “rule of thumb”) • There is an intuitive relationship between unemployment and GDP • Employed workers produce g&s, increasing GDP • This relationship was formalized by Arthur Okun in 1962. • It says that a 1% increase in the unemployment rate corresponds to, approximately, a 2-2.5% decrease in output.

39. Okun´s law Because Okun´s law is based on the observation of actual data, the exact magnitudes depend on the country and time. • * Graph taken from Wikipedia. Some commonly used formulations of Okun´s law:% change in real GDP = 3%- 2 (change in unemployment rate)