Quote of the Day

Like it or not we live in interesting

times. They are times of danger and
uncertainty; but they are also more
open to the creative energy of men
than any other time in history. And
everyone here will ultimately be
judged - will ultimately judge himself
- on the effort he has contributed to
building a new world society and the
extent to which his ideals and goals
have shaped that effort.
Robert F. Kennedy, 1925-68

Welcome to Macro: Big

Truth
Our twin objectives:

Pleasure: Macroeconomic forces underlay many of the

great events of world history (e.g., whats the link between
macro and the rise of Hitler and onset of WWII?), and
understanding the tides of history will make you a wiser,
happier person. Ditto understanding contemporary events
and (oft-angry) policy debates
Profit: Understanding the business cycle especially the
current recession can be a source of personal wealth

Investment returns correlate highly with the macroeconomy

Proper business planning requires awareness of cycles

Assignment 1: Read and retain

the
Syllabus

Make sure you understand:

Objectives/nature of this course

Your reading schedule
The components of your grade

Especially attendance/participation and policy on your

single quiz drop

Proper time allocation

How to find stuff on Moodle
The risks of unethical behavior, the importance of
observing classroom etiquette
3

The Walters Grade Scale

A = 90+
A- = 85 90
B+ = 82.5 85
B = 77.5 82.5
B- = 75 77.5

C+ = 72.5 - 75
C = 67.5 72.5
C- = 65 67.5
D = 55 - 65
F = < 55

Before you begin Macro...

If necessary, review basic Micro tools (i.e.,

chapters 2, 3, 4 in H&O), especially:

Opportunity cost
Comparative advantage and trade
The laws of supply and demand

Note: Well build macro models here, but some of this

will rely on your recall of how micro markets work

Efficiency and market equilibrium

The price system (i.e., the rationing and signaling
functions of prices)
5

Some Day 1 review:

The supply of and demand
for credit

The First Law of Demand says the demand

for credit (or loanable funds, in H&O) is
negatively related to its price which is the
interest rate borrowers pay to borrow
Similarly, lenders will offer more credit at a
higher price (interest rate) than a low one
So well have an equilibrium price but what
happens if demand shifts for some reason?
6

Using Micro in Macro: Initial

equilibrium in the loanable
funds market

What happens if Uncle Sam

borrows addl $100 billion?
Does Qe rise to $600 billion?

One price rises, whats the

net effect on private
borrowers?

In sum

The extra $100b of govt borrowing increases

the amount of loanable funds exchanged to
$550b and bumps the interest rate up to
5.5% in this hypothetical
Since the govt doesnt care what price it
pays for credit, its $100b of borrowing
crowds out about $50b of private borrowing,
and the higher price (5.5% > 5%) encourages
$50b more in lending (from whom or where?)
10

And note how the price system

worked
here

This demand
for borrowing probably originated in the
governments desire to stimulate aggregate demand
(about which much more later this semester!)
But it will also...

1.
2.

increase its share of present consumption of resources and

shift some private consumption or investment from the present
to the future;

And govts willingness to pay higher r does both:

Govt carves out a larger share of societys current

saving (rationing function of price)

And total saving increases because we get the

message from the higher r (signaling function of
price) to defer some of our plans.
11

Some questions to ponder,

though

In US, our huge borrowing has not apparently

pushed r up significantly. Why not?

If the govts extra borrowing does crowd out

some private borrowing, is this actually good
or bad for the macro-economy?

What is the elasticity of supply of loanable funds,

and why does this matter?

What, exactly, might be crowded out?

What else might affect r?

12

On to Macro...
Job 1: Gauges of economic performance

We need to know how were doing

The most commonly used output gauge:
Gross Domestic Product (GDP) = The market

value of final goods and services produced within a

country during a specific time period, usually a year.

Note that GDP is measured in dollars; each good produced

increases output by the amount the purchaser pays for the
good.

Which raises a question: What about goods produced but not yet
sold? Who attaches prices to these and might they be unrealistic?

Calculating GDP

What counts toward GDP?

Only final goods and services count

Sales at intermediate stages of production are not counted

since their value is embodied in the price the final user
pays. This way we avoid double (triple?) counting.
Stage of production

Sales Receipts

(at each stage of production)

Value added to the product

(equals income created)

Stage 1: farmers wheat

by farmer
$.30

$.30

Stage 2: millers flour

by miller
$.65

$.35

Stage 3: bakers bread

(wholesale)

by baker
$.90

$.25

Stage 4: grocers bread

(retail)

by grocer
$1

Total consumer expenditure = $1

$.10
Total value added = $1

What counts toward GDP? (cont.)

Financial transactions and

income transfers are
excluded as they dont reflect
production.
Only production within the
geographic borders of the
country is counted.
Only those goods produced
during the current period
are counted.
Where is this made?

Examples: What counts, what

doesnt
NOT included in GDP
Used cars
Grannys Soc. Sec.
check
Your purchase of
Amazon.com stock
Value of doing your
own laundry
Property damage in a
storm

Included in GDP
New cars
Grannys purchases of
Fixodent
Amazons purchase of
corporate jet
Your expenditures at a
dry cleaner
Expenses to repair
storm damage
16

Solved Problem 8.1

Calculating GDP
Suppose that a very simple economy
produces only four goods and services:
eye examinations, pizzas, textbooks,
and paper.
Assume that all the paper in this economy
is used in the production of textbooks.
Use the information in the following table
to compute GDP for the year 2013:

Production and Price Statistics for 2013

(1)
Product

(2)
Quantity

(3)
Price per
Unit

Eye examinations

100

$50.00

Pizzas

80

10.00

Textbooks

20

100.00

2,000

0.10

Paper

Solving the Problem

Step 1: Review the chapter material.
Step 2: Determine which goods and services listed in the table should be included in the
calculation of GDP.
GDP is the value of all final goods and services.
Therefore, we need to calculate the value of the final goods and services listed in the table.
Eye examinations, pizzas, and textbooks are final goods.
Paper would also be a final good if, for instance, a consumer bought it to use in a printer.
However, here we are assuming that publishers purchase all the paper to use in
manufacturing textbooks, so the paper is an intermediate good, and its value is not included
in GDP.

Solved Problem 8.1

Calculating GDP

Production and Price Statistics for 2013

Step 3: Calculate the value of

the three final goods and services
listed in the table.
Value is equal to the quantity produced
multiplied by the price per unit,
so we multiply the numbers in column (1)
by the numbers in column (2).

(1)
Product

(2)
Quantity

(3)
Price per
Unit

Eye examinations

100

$50.00

Pizzas

80

10.00

Textbooks

20

100.00

2,000

0.10

Paper

Product
Eye examinations

(1)
Quantity

(2)
Price per Unit

(3)
Value

100

$50

$5,000

Pizzas

80

10

800

Textbooks

20

100

2,000

Step 4: Add the value for each of the three final goods and services to find GDP.

GDP = Value of eye examinations produced + Value of pizzas produced +

Value of textbooks produced = $5,000 + $800 + $2,000 = $7,800.

Shortcomings of GDP

Shortcomings that
measurement error:

It doesnt count non-market

or household production
So if I pay you $10 to do
my laundry and you pay
me $10 to do yours,
GDP rises $20
It doesnt count the
underground economy
So beware international
comparisons (next slide)

Making
the

Connection

Why Do Many Developing Countries Have Such Large

Underground Economies?

In developing countries,
the underground economy is often
referred to as the informal sector,
as opposed to the formal sector,
in which output of goods and
services is measured.
Although it might not seem to matter
whether production of goods and
services is measured and included
in GDP or unmeasured, a large
informal sector can be a sign of
government policies that are
retarding economic growth.

In some developing
countries, more than half the
workers may be in the
underground economy.
The informal sector is large in some developing economies because taxes
are high and government regulations are extensive.
MyEconLab Your Turn:

Test your understanding by doing related problem 2.8 at the end of this chapter.

Shortcomings (cont)

Issues that misleading info

about wellbeing

No adjustment for leisure.

Not adjusted for externalities or
for (unmeasurable?) social
problems
Doesnt consider income
distribution
May understate gains in living
standards because of the
problem of estimating
improvements in the quality of
products

All that said, its a pretty good

way to take the economys
temperature
21

The Circular Flow:

Why GDP = C + I + G + NX
Figure 8.1
The Circular Flow and the Measurement of GDP

The diagram also shows that households

use their income to purchase goods and
services, pay taxes, and save.
Firms and the government borrow the
funds that flow from households into
the financial system, which
consists of banks and stock and
bond markets.
Expenditures by foreign firms and
households on domestically
produced goods and services are
called exports, and
spending on foreign-produced goods
and services is known as imports.
We can measure GDP either by calculating
the total value of expenditures on final
goods and services, or
by calculating the value of total income.

Transfer payments Payments by the government to households for which the

government does not receive a new good or service in return.

Figure 8.2

Components of GDP in
2010

Consumption accounts for 70.5 percent of GDP, far more than any of the other components.
In recent years, net exports typically have been negative, which reduces GDP.
Note that the subtotals may not sum to the totals for each category because of rounding.

A key issue: Real vs. Nominal GDP

(and other stuff measured in dollars)

Real values are adjusted for the changing

value or purchasing power of the dollar (i.e.,
inflation or deflation);
Nominal values arent adjusted for inflation.
Economists invented price indexes to make
these adjustments

A price index measures the cost of purchasing a

market basket (or bundle) of goods at a point in time
relative to the cost of purchasing the identical market
basket during an earlier reference (or base) period.

Two key price indexes

Consumer Price Index (CPI):

measures the impact of price
changes on the cost of a typical
bundle of goods and services
purchased by households.
GDP Deflator:
designed to measure the
change in the average price of
all the goods included in GDP
(which makes it a broader
index than the CPI).

Some detailed price inflation

data...

You can find current and historical CPI data at:

BLS Databases, Tables & Calculators by Subject

E.g., Since January 2000, the CPI has risen

from 169.3 to 233.887 by Nov. 13

Whats that mean? That by Nov. 13 it cost

38% more dollars than it did in Jan. 00 to buy
the same bundle of goods:

Percent change: (233.887 169.3)/169.3 = 38%.

So the dollar depreciated relative to goods by

38%

26

Working with price indexes

Well work a lot more with the CPI and GDP

deflator in Chapter 9, but for now note:

You can correct for inflation and calculate a real

value (relative to a base year) from any nominal
one by simply dividing by the price index (PI) for
that year, and then multiplying by 100 to move the
decimal place over
I.e.: Real = (Nominal/PI)*100
E.g., if gas costs $3.50 today, with CPI = 233.887
relative to the 1982-4 base, the real cost is
($3.50/233.887)*100 = $1.50 (in 82-4 dollars)
27

Some details on the GDP

deflator
H&O show how Real GDP is calculated by using the new

amounts of output produced each year, and multiplying

by the prices that prevailed earlier, in some arbitrarily
selected base year (as in Problem 8.3)
Note that this a distorted measure, since relative
prices change over time; chain weighting is sposed to
minimize distortions
You dont have to master what that means, exactly, but if
you want to see an example of how its done, see:
A chain-weighting example

28

Solved Problem 8.3

Calculating Real GDP
Suppose that a very simple economy produces only the following three final goods and
services: eye examinations, pizzas, and textbooks.
Use the information in the table below to compute real GDP for the year 2013.
Assume that the base year is 2005.
2005
Product

Quantity

2013
Price

Quantity

Price

Eye
examinations

80

$40

100

$50

Pizzas

90

11

80

10

Textbooks

15

90

20

100

Solving the Problem

Step 1: Review the chapter material.
Step 2: Calculate the value of the three goods and services listed in the table, using the
quantities for 2013 and the prices for 2005.
Remember that real GDP is the value of all final goods and services, evaluated at baseyear prices.
In this case, the base year is 2005, and we are given information on the price of each
product in that year.

Solved Problem 8.3

Calculating Real GDP
2013
Quantity

Product

2005 Price

Value

100

$40

$4,000

Pizzas

80

11

880

Textbooks

20

90

1,800

Eye examinations

Step 3: Add up the values for the three products to find real GDP.
Real GDP for 2013 equals the sum of:

Quantity of eye examinations in 2013 Price of eye examinations in 2005 = $4,000

Quantity of pizzas produced in 2013 Price of pizzas in 2005 = $880
Quantity of textbooks produced in 2013 Price of textbooks in 2005 = $1,800
or, $6,680
The quantities of each good produced in 2005 were irrelevant for calculating real GDP
in 2013, the value of which youll notice is $1,120 lower than the value for nominal GDP
that we calculated for the same year in Solved Problem 8.1.
MyEconLab Your Turn:

For more practice, do related problem 3.4 at the end of this chapter.

Comparing Real GDP and Nominal GDP

Figure 8.3
Nominal GDP
and Real GDP,
19902010

Currently, the
base year for
calculating GDP
is 2005.
In the years before
2005, prices were,
on average, lower
than in 2005, so
nominal GDP was
lower than real GDP.
In 2005, nominal and
real GDP were equal.
Since 2005, prices
have been, on
average, higher than
in 2005, so nominal
GDP is higher than
real GDP.

Remember to count your

blessings

See
Time Cost of Goods: Yesterday vs. Today
Compare the amount of hours the average
worker had to sacrifice to buy stuff over time
E.g., contacts cost 95 hours of labor (at aveg.
wage) in 1971, only 4 hours in 97 (i.e., 4% of
its former price); how much today?
Quit complaining about how your parents
had it better than you will!
32