Everyone is concerned about macroeconomics lately. Why? Because the state of the macroeconomy affects everyone in many ways. Recently, there is much discussion of recessions-- periods in which real GDP falls mildly-- and depressions, when GDP falls more severely. Macroeconomists are also concerned with issues such as inflation, unemployment, monetary and fiscal policy. Welcome to Macroeconomics!

What should we know? The Data for Macroeconomic Income and expense The Real Economy in the Long Run Growth, saving and investment, financial system and unemployment Money and Prices in the Long Run Monetary system Macroeconomics of Open Economies Short-run economics Fluctuations

Part I. Data for Macroeconomics Income & Expense (Chapter 23 & 24) There are 2 ways of viewing GDP Total income of everyone in the economy Total expenditure on the economy’s output of goods and services Income, Expenditure And the Circular Flow

Data for Macroeconomics For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES

GDP Gross domestic product (GDP) is a measure of the income and expenditures of an economy. It is the total market value of all final goods and services produced within a country in a given period of time. GDP is the most widely reported measure of a nation’s economic performance

Government purchases of goods and services Government purchases of goods and services Y = C + I + G + NX Total demand for domestic output (GDP) Total demand for domestic output (GDP) is composed of is composed of Consumption spending by households Consumption spending by households Investment spending by businesses and households Investment spending by businesses and households Net exports or net foreign demand Net exports or net foreign demand This is the called the national income accounts identity.

To compute the total value of different goods and services, the national income accounts use market prices. Thus, if $0.50 $1.00 GDP = (Price of apples  Quantity of apples) + (Price of oranges  Quantity of oranges) = ($0.50  4) + ($1.00  3) GDP = $5.00 $0.50 $1.00

The value of final goods and services measured at current prices is called nominal GDP. It can change over time either because there is a change in the quantity of goods and services or a change in the prices of those goods and services. Hence, nominal GDP Y = P  Q, where P is the price level and Q is real output Real GDP is the value of goods and services measured using a constant set of prices.

Let’s see how real GDP is computed in our apple and orange economy. For example, if we wanted to compare output in 2002 and output in 2003, we would obtain base-year prices, such as 2002 prices. Real GDP in 2002 would be: (2002 Price of Apples  2002 Quantity of Apples) + (2002 Price of Oranges  2002 Quantity of Oranges). Real GDP in 2003 would be: (2002 Price of Apples  2003 Quantity of Apples) + (2002 Price of Oranges  2003 Quantity of Oranges). Real GDP in 2004 would be: (2002 Price of Apples  2004 Quantity of Apples) + (2002 Price of Oranges  2004 Quantity of Oranges).

Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices. measures the price of output relative to its price in the base year The GDP deflator measures the price of output relative to its price in the base year. It reflects what’s happening to the overall level of prices in the economy. GDP Deflator = Nominal GDP Real GDP

Summary of GDP GDP is a good measure of economic well- being 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.

Measuring cost of living Turning dollar figures into meaningful measures of purchasing power Consumer Price Index (CPI) can be used CPI is used to monitor changes in the cost of living over time CPI rises  typical family has to spend more money to maintain same standard of living CPI has strong relationship with inflation

The Consumer Price Index (CPI) turns the prices of many goods and services into a single index measuring the overall level of prices.

Let’s see how the CPI would be computed in our apple and orange economy. typical consumer For example, suppose that the typical consumer buys 5 apples and 2 oranges every month. Then the basket of goods consists of 5 apples and 2 oranges, and the CPI is: CPI= ( 5  Current Price of Apples) + (2  Current Price of Oranges) ( 5  2002 Price of Apples) + (2  2002 Price of Oranges) In this CPI calculation, 2002 is the base year. The index tells how much it costs to buy 5 apples and 2 oranges in the current year relative to how much it cost to buy the same basket of fruit in 2002.

The Inflation Rate The inflation rate is calculated as follows:

GDP Deflator VS Consumer Price Index produced domestically The GDP deflator reflects the prices of all goods and services produced domestically, whereas... bought by consumers …the consumer price index reflects the prices of all goods and services bought by consumers.

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. GDP Deflator VS Consumer Price Index

CPI The consumer price index is imperfect: substitution bias the introduction of new goods unmeasured changes in quality. Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.

Correcting Economic Variables for the Effects of Inflation Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. Carabao “Made in Thailand” sold about 1.5 million cassettes in How much did the band earn if we convert into 2003? : Suppose each cassette the band received 20 baht, thus, 1.5 times 20 = 30 million baht. This can convert to value in 2003 by = 30,000,000 * (Price level 2003/Price level 1985) = 30,000,000 * (106.1/54.1) = 58,835,489 baht

Correcting Economic Variables for the Effects of Inflation Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. Interest rate The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays. The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

Part II. Real Economy in the Long Run Production and Growth Saving, Investment, and Financial System Unemployment and its Natural Rate

Production and Growth Economic growth is determined by productivity Productivity refers to the amount of goods and services that a worker can produce from each hour of work. The inputs used to produce goods and services are called the factors of production. The factors of production directly determine productivity.

How Productivity Is Determined Physical Capital Human Capital Natural Resource Technological Knowledge

ECONOMIC GROWTH AND PUBLIC POLICY Government Policies That Raise Productivity and Living Standards Encourage saving and investment. Encourage investment from abroad Encourage education and training. Establish secure property rights and maintain political stability. Promote free trade. Promote research and development.

The Importance of Saving and Investment One way to raise future productivity is to invest more current resources in the production of capital.

Diminishing Returns and the Catch-Up Effect As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns. Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while.

Diminishing Returns and the Catch-Up Effect The catch-up effect refers to the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich.

ECONOMIC GROWTH AND PUBLIC POLICY Government Policies That Raise Productivity and Living Standards Encourage saving and investment. Encourage investment from abroad Encourage education and training. Establish secure property rights and maintain political stability. Promote free trade. Promote research and development.

Saving and investment are key ingredients to long-run economic growth Save large portion of GDP  more resources are available for investment in capital  higher capital raises a country’s productivity and living standard

The Financial System financial system The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment.

FINANCIAL INSTITUTIONS The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

FINANCIAL INSTITUTIONS Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds

Financial Markets The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempted. IOU

Financial Markets The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes.

Bond & Stock Bond Bond holder is a creditor of the corporation Bondholders get only the interest on their bonds. Stock Owner of share = part owner If company is very profitable  stockholders enjoy benefits of these profits Compared to bonds, stocks offer both higher risk and potentially higher returns.

Financial Intermediaries Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.

Financial Intermediaries Mutual Funds A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. They allow people with small amounts of money to easily diversify.

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX

Some Important Identities closed economy Assume a closed economy – one that does not engage in international trade: Y = C + I + G + NX Y = C + I + G GDP is the sum of consumption, investment, and government purchases

Some Important Identities To find out national saving, subtract C and G from both sides of the equation: Y- C - G = C + I + G – C – G Y – C – G =I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Some Important Identities Substituting S for Y - C - G, the equation can be written as: S = I

Some Important Identities National saving, or saving, is equal to: S = I S = Y – C – G T denote the amount of taxes minus the amount it pays back to households in form of Social security or welfare S = (Y – T – C) + (T – G)

Some Important Identities S = (Y – T – C) + (T – G) The two T’s in this equation cancel each other National saving are separated into two parts Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)

The Meaning of Saving and Investment Surplus and Deficit If T > G, the government runs a budget surplus The surplus of T - G represents public saving. If G > T, the government runs a budget deficit

THE MARKET FOR LOANABLE FUNDS Loanable funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

Supply and Demand for Loanable Funds The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Supply and Demand for Loanable Funds The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The interest rate in the market for loanable funds is the real interest rate.

Supply and Demand for Loanable Funds Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200 Copyright©2004 South-Western

Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits

Policy 1: Saving Incentives Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Policy 1: Saving Incentives A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.

Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600 Copyright©2004 South-Western

Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved.

Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

Figure 3 An Increase in the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Supply Demand,D1D1 D2D2 5% $1,200 6% $1,400 Copyright©2004 South-Western

Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.

Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments.

Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.

Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate and reduces the equilibrium quantity of loanable funds. S2S which raises the equilibrium interest rate... Supply,S1S1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable funds... Copyright©2004 South-Western

Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

IDENTIFYING UNEMPLOYMENT Categories of Unemployment The problem of unemployment is usually divided into two categories. The long-run problem and the short-run problem: The natural rate of unemployment unemployment that does not go away on its own even in the long run. It is the amount of unemployment that the economy normally experiences. The cyclical rate of unemployment year-to-year fluctuations in unemployment around its natural rate. It is associated with short-term ups and downs of the business cycle.

Figure 2 Unemployment Rate Since 1960 Copyright©2003 Southwestern/Thomson Learning Percent of Labor Force Natural rate of unemployment Unemployment rate

IDENTIFYING UNEMPLOYMENT Describing Unemployment Three Basic Questions: How does government measure the economy’s rate of unemployment? What problems arise in interpreting the unemployment data? How long are the unemployed typically without work?

How Is Unemployment Measured? Based on the answers to the survey questions, the BLS places each adult into one of three categories: Employed Unemployed Not in the labor force

How Is Unemployment Measured? Labor Force The labor force is the total number of workers, including both the employed and the unemployed.

Figure 1 The Breakdown of the Population in 2001 Copyright©2003 Southwestern/Thomson Learning Adult Population (211.9 million) Labor Force (141.8 million) Employed (135.1 million) Not in labor force (70.1 million) Unemployed (6.7 million)

How Is Unemployment Measured? The unemployment rate is calculated as the percentage of the labor force that is unemployed.

The labor-force participation rate is the percentage of the adult population that is in the labor force. How Is Unemployment Measured?

Why Are There Always Some People Unemployed? In an ideal labor market, wages would adjust to balance the supply and demand for labor, ensuring that all workers would be fully employed. In reality there are always some workers without jobs, even when the whole economy is doing well. Why???

Why Are There Always Some People Unemployed? Frictional unemployment  unemployment that results from the time that it takes to match workers with jobs. Job search Structural unemployment  unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. Minimum-Wage laws, Unions, Theory of efficiency wages

1.) JOB SEARCH Job search the process by which workers find appropriate jobs given their tastes and skills. results from the fact that it takes time for qualified individuals to be matched with appropriate jobs.

Public Policy and Job Search Government programs can affect the time it takes unemployed workers to find new jobs. These programs include the following: Government-run employment agencies Public training programs Unemployment insurance

2.) MINIMUM-WAGE LAWS When the minimum wage is set above the level that balances supply and demand, it creates unemployment.

Figure 4 Unemployment from a Wage Above the Equilibrium Level Copyright©2003 Southwestern/Thomson Learning Quantity of Labor 0 Surplus of labor = Unemployment Labor supply Labor demand Wage Minimum wage LDLD LSLS WEWE LELE

3. ) UNIONS AND COLLECTIVE BARGAINING A union is a worker association that bargains with employers over wages and working conditions. The process by which unions and firms agree on the terms of employment is called collective bargaining.

4.) THE THEORY OF EFFICIENCY WAGES Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity. The theory of efficiency wages states that firms operate more efficiently if wages are above the equilibrium level.

Wages above the equilibrium Minimum-wage laws and unions Prevent firms from lowering wages in the presence of a surplus of workers Efficiency-wage theory Firms prefer to keep wages above the equilibrium level Unemployment is the result of wages above the level that balances the quantity of labor supplied and the quantity of labor demanded.