Macroeconomics Lecture 1: Introduction and Measuring the Economy

Introduction to Macroeconomics and Economic Modeling

  • Macroeconomics is defined as the study of how the interactions of people and firms through markets affect overall economic activity.

  • In contrast, Microeconomics is the study of individual people, firms, or market behavior.

  • Key macroeconomic questions include:

    • Why is the average American today more than 1010 times richer than an American 100100 years ago?

    • Why is the average American 2525 times richer than the average Ethiopian?

    • What were the causes of the 2008–20092008\text{--}2009 global financial crisis?

    • What determines the rate of inflation?

    • Why has the unemployment rate in Europe been twice as high as in the United States over the last 2020 years?

    • Does the COVID-19 pandemic have long-run economic effects?

Historical Economic Trends and Data

  • Per Capita GDP (measured in ratio scale, 20222022 dollars) from 18801880 to 20202020 shows significant growth in countries like the United States, Japan, and the U.K., while countries like Argentina, South Africa, and China show varying trajectories.

  • Inflation rates in rich countries (U.S., U.K., Japan, and the Euro area) peaked in the 1970s1970\text{s} and 1980s1980\text{s} before stabilizing in the 1990s1990\text{s} and 2000s2000\text{s}.

  • Costs of inflation to society can stem from:

    • Unexpected and symmetric inflation.

    • Unexpected and asymmetric inflation.

    • Deflation.

    • Sticky prices.

  • Unemployment rates vary by region:

    • Europe has generally seen higher unemployment rates compared to the United States and Japan since the 1980s1980\text{s}.

    • Japan typically maintains a significantly lower and more stable unemployment rate.

Macroeconomic Effects of COVID-19

  • The pandemic had a strong negative effect on GDP due to lockdowns and voluntary social distancing.

  • The resulting recession was much deeper than the one caused by the Global Financial Crisis of 20082008.

  • Characteristics of the COVID-19 economic impact:

    • Disruption of education.

    • Extraordinary government measures that are beneficial in the short run but potentially costly in the long run.

    • Both the U.S. and U.K. economies displayed "V-shaped" recoveries in quarterly real GDP.

The Methodology and Structure of Economic Models

  • Macroeconomists use a four-step approach to study questions:

    1. Document the facts.

    2. Develop a model.

    3. Compare model predictions with the original facts.

    4. Use the model to make other predictions for future testing.

  • Models simplify the real world into relevant elements; a model is deemed useful if it has strong predictive power.

  • Components of an Economic Model:

    • Parameters: Inputs that are fixed over time unless changed by the model builder for an experiment.

    • Exogenous Variables: Inputs that can change over time but are determined ahead of time by the model builder ("outside the model").

    • Endogenous Variables: Outcomes or results explained by the model ("within the model").

  • Model application involves changing parameters and exogenous variables to observe effects on endogenous variables and predicting the costs/benefits of government policies.

Labor Market Model Example

  • Variables:

    • LsL_s: Number of hours laborers want to work (Supply).

    • LdL_d: Number of labor hours firms want to hire (Demand).

    • ww: Wage.

  • Parameters:

    • fˉ,lˉ,aˉ\bar{f}, \bar{l}, \bar{a}.

  • Equations:

    • Supply function: Ls=aˉw+lˉL_s = \bar{a}w + \bar{l}.

    • Linear example: Ls=2w+30L_s = 2w + 30.

    • Demand function: Ld=f(w)L_d = f(w).

    • Linear example: Ld=60−wL_d = 60 - w.

  • Equilibrium:

    • Defined where Ld=LsL_d = L_s.

    • Shifts in the model include:

      • A decrease in job satisfaction (denoted by lˉ↓\bar{l} \downarrow) shifts the supply curve.

      • An increase in an input price (denoted by fˉ↓\bar{f} \downarrow) affects the equilibrium employment (L∗L^*) and wage (w∗w^*).

Time Horizons and Economic Well-being

  • The Long Run: Focuses on economic growth and standards of living. Income per person in the U.S. rose from $4,200\$4,200 in 18701870 to $76,000\$76,000 in 20222022, representing an average annual growth rate of 2%2\%.

  • The Short Run: Focuses on business cycles, inflation, unemployment, and monetary/fiscal policy.

  • International Macroeconomics: Covers open economies, currency crises, and exchange rates.

  • Welfare: A variable used to rank outcomes and determine preferable policies.

    • While GDP/consumption increases welfare, other subjective factors include:

      • Leisure.

      • Equality.

      • Life expectancy.

      • Environmental quality.

      • Individual freedom.

Measuring Gross Domestic Product (GDP)

  • Gross Domestic Product is the market value of final goods and services produced in an economy over a specific period.

  • National Income Accounting: The method of aggregating production into a single measure where:

    • Total Production=Total Income=Total Spending\text{Total Production} = \text{Total Income} = \text{Total Spending}.

  • U.S. GDP Statistics:

    • 20052005: $12.5 trillion\$12.5 \text{ trillion}.

    • 20082008: $14.4 trillion\$14.4 \text{ trillion} ($47,000\$47,000 per person).

    • 20222022: $25.5 trillion\$25.5 \text{ trillion} ($76,300\$76,300 per person).

Approaches to Measuring GDP

  • Production Measure: The number of goods produced in the economy.

  • Expenditure Measure: The total purchases in the economy.

  • Income Measure: All the income earned in the economy.

  • The Expenditure Approach Identity:     Y=C+I+G+NXY = C + I + G + NX

    • YY: GDP.

    • CC: Personal consumption expenditures (largest share, approx. 68.2%68.2\% in 20222022).

    • II: Gross private domestic investment (approx. 18.0%18.0\% in 20222022). Includes:

      • Business fixed investment (plants, machinery, equipment, IPP).

      • Residential investment (new houses/apartments).

      • Inventory investment.

    • GG: Government purchases (approx. 17.3%17.3\% in 20222022).

    • NXNX: Net exports (X−MX - M; exports minus imports). In 20222022, this was −3.9%-3.9\% for the U.S.

Detailed Expenditure Shares (2022 U.S. Data)

  • Total GDP: $25.5 trillion\$25.5 \text{ trillion} ($76,300\$76,300 per person).

  • Consumption Categories:

    • Motor vehicles and parts: $0.7 trillion\$0.7 \text{ trillion} (2.7%2.7\% share).

    • Food: $1.3 trillion\$1.3 \text{ trillion} (5.1%5.1\% share).

    • Housing: $3.0 trillion\$3.0 \text{ trillion} (11.8%11.8\% share).

    • Medical care: $2.7 trillion\$2.7 \text{ trillion} (10.6%10.6\% share).

  • Investment Categories:

    • Nonresidential structures: $0.6 trillion\$0.6 \text{ trillion}.

    • Equipment: $1.3 trillion\$1.3 \text{ trillion}.

    • Intellectual property products (IPP): $1.4 trillion\$1.4 \text{ trillion}.

    • Residential: $1.1 trillion\$1.1 \text{ trillion}.

  • Net Exports:

    • Exports: $3.0 trillion\$3.0 \text{ trillion}.

    • Imports: $4.0 trillion\$4.0 \text{ trillion}.

The Income and Production Approaches

  • Income Approach Components (2022):

    • Compensation of employees: $13.5 trillion\$13.5 \text{ trillion} (53.2%53.2\% of GDP).

    • Wages and salaries: $11.2 trillion\$11.2 \text{ trillion}.

    • Benefits: $2.4 trillion\$2.4 \text{ trillion}.

    • Taxes less subsidies: $1.6 trillion\$1.6 \text{ trillion}.

    • Net operating surplus of businesses: $6.0 trillion\$6.0 \text{ trillion}.

    • Depreciation (deterioration of capital): $4.3 trillion\$4.3 \text{ trillion} (16.8%16.8\% of GDP).

  • Key Formula:     GDP−depreciation=net domestic product\text{GDP} - \text{depreciation} = \text{net domestic product}

  • Factor Shares:

    • Labor Share: Approximately 2/32/3 of GDP (historically constant).

    • Capital Share: Approximately 1/31/3 of GDP.

  • Production Approach & Value Added:

    • GDP counts only the final sale of goods (no "double counting").

    • Value Added: Revenue generated minus the value of intermediate products.

    • Included in GDP: Government spending on goods/services, factory production, healthcare expenditures, food purchased, daycare.

    • Excluded from GDP: Government transfer payments, environmental conditions, nation's health, home cooking, unpaid babysitting.

Real vs. Nominal GDP

  • Nominal GDP: Measures GDP using current year prices; prices and quantities are not separated.

    • Yt=P1tQ1t+P2tQ2t+...+PNtQNtY_t = P_{1t}Q_{1t} + P_{2t}Q_{2t} + ... + P_{Nt}Q_{Nt}

  • Real GDP: Actual quantity of goods using base year prices to remove the effect of inflation.

    • Yt=P1,t−1Q1t+P2,t−1Q2t+...+PN,t−1QNtY_t = P_{1,t-1}Q_{1t} + P_{2,t-1}Q_{2t} + ... + P_{N,t-1}Q_{Nt}

  • Conversion Formulas:     nominal GDP=price level×real GDP\text{nominal GDP} = \text{price level} \times \text{real GDP}     real GDP=nominal GDPprice level\text{real GDP} = \frac{\text{nominal GDP}}{\text{price level}}

Comparing GDP Across Countries

  • Exchange Rate: The price at which different currencies are traded.

  • Price Level Adjustments (PPP): Rich countries tend to have higher price levels than poor countries, primarily because poor countries have lower wages.

  • Example Comparison (U.S. vs. China 2019):

    • Chinese GDP: 95.1 trillion yuan95.1 \text{ trillion yuan}.

    • Exchange rate: $1=6.91 yuan\$1 = 6.91 \text{ yuan}.

    • Unadjusted calculation: 95.1×1012 yuan×$16.91 yuan=$13.8 trillion95.1 \times 10^{12} \text{ yuan} \times \frac{\$1}{6.91 \text{ yuan}} = \$13.8 \text{ trillion}.

    • Ratio to U.S. GDP ($20.6 trillion\$20.6 \text{ trillion}): 13.820.6=67%\frac{13.8}{20.6} = 67\%.

    • Adjusted for relative prices (China's prices are 68.4%68.4\% of U.S. prices):         real GDPChina adjusted=10.684×$13.8=$20.1 trillion\text{real GDP}_{\text{China adjusted}} = \frac{1}{0.684} \times \$13.8 = \$20.1 \text{ trillion}.

    • Conclusion: At common prices, China's economy is only 2%2\% smaller than the U.S. economy, not 33%33\% smaller.