Macroeconomics: Policy and Data
Week 1
1
Topics for this week
 What is macroeconomics concerned with?
 How to measure aggregate output?
 How to correct for inflation?
 How to describe the labor market situation?
2
What is MACROeconomics about?
 Macroeconomics is the study of economic activity and prices in the overall economy of a nation or a
region
 Macroeconomic research draws heavily on microeconomics, which looks at the behavior of individual
firms, households, or markets
 Macroeconomists explain how the overall economy works by using an economic theory – a logical
framework to explain a particular economic phenomenon
 Economic theory involves developing an economic model – a simplified representation of the
economic phenomenon that takes a mathematical or graphical form
3
Building Models, Step-by-Step
 The development of an economic theory or model typically involves five steps:
1)Identify an interesting economic question
2)Specify the variables to be explained by the model (endogenous variables) and the variables that
explain them (exogenous variables)
3)Posit a set of equations or graphical analysis to connect movements in the exogenous variables to
the endogenous variables
4)Compare the conclusions of the model with what actually happens
5)Use the model to make further predictions
4
Models and Variables
5
Building Models, Step-by-Step
 The development of an economic theory or model typically involves five steps:
1)Identify an interesting economic question
2)Specify the variables to be explained by the model (endogenous variables) and the variables that
explain them (exogenous variables)
3)Posit a set of equations or graphical analysis to connect movements in the exogenous variables to
the endogenous variables
4)Compare the conclusions of the model with what actually happens
5)Use the model to make further predictions
6
Interpreting Macroeconomic Data: The GDP
 Real Gross Domestic Product (GDP): measures the output of actual goods and services produced
in an economy over a fixed period, usually a year
7
Business Cycles
 Business cycles are recurrent up and down movements in economic activity that differ in how regular
they are
 A recession occurs when economic activity declines and real GDP per person falls
 A depression occurs when the decline in real GDP is severe
8
The Unemployment Rate
 The unemployment rate measures the percentage of workers looking for work, but who do not have
jobs, at a particular point in time
9
The Inflation Rate
 The inflation rate tells us how rapidly the overall level of prices is rising
 Deflation occurs when the inflation rate is negative
 Hyperinflation refers to the situation of super high inflation
10
Macroeconomic Policy
 Fiscal policy deals with government spending and taxation

Government budget deficit is the excess of government spending over tax revenues for a
particular year
 Monetary policy is the management of the money supply and interest rates

Conducted by central banks, e.g., the Federal Reserve of the U.S. A recession occurs when
economic activity declines and real GDP per person falls
 Stabilization policy is macroeconomic policy that aims at minimizing business cycle fluctuations and
stabilizing economic activity


Activists advocate the use of policies to eliminate excessive unemployment whenever it develops
Nonactivists argue against the use of stabilization policies because the economy has a selfcorrecting mechanism
11
Financial Crises
 A financial crisis is a large-scale disruption in financial markets characterized by sharp declines in the
prices of assets (property that includes bonds, stocks, art, land) and business failures
 The United States and many other countries throughout the world experienced a major financial crisis
starting in 2007
12
Measuring Economic Activity
 Gross domestic product (GDP) is the total value of goods and services produced in an economy. It
is the broadest measure of economic activity.
 National income accounting is an accounting system that measures economic activity and its
components
 Fundamental identity of national income accounting: Total Production = Total Expenditure = Total
Income
 GDP is the current market value of all final goods and services newly produced in the economy
during a fixed period of time
 intermediate goods and services are used up entirely in the stages of production, whereas final
goods and services are the end goods in the production process.
13
Measurement Problems and Caveats
 GDP includes only goods and services that are newly produced in the current period
E.g., if you buy a 3-year-old car from a car dealership
 The cost of the used car is not included in GDP
 The value of the services provided by the car dealership is included in GDP
 Not all goods and services are counted in GDP because they are:
 Nonmarket goods and services, which do not have a market price (e.g., household services
produced within a family), or
 Produced in the underground economy
 Many nonmarket goods and services are counted in GDP by their imputed values

14
Measurement Problems and Caveats
 Value-added approach: By adding up the value added from each firm, we get the final value of the
goods and services produced
 Value added is the value of a firm’s output minus the cost of the intermediate goods purchased by
the firm
 A capital good (e.g., a robot) is used in the production of other goods that is not used up in the stages
of production
 New capital goods are classified as final goods because they are not included in spending on other
final goods and yet their production is part of economic activity
 Inventory investment is the change in inventories (firms’ holdings of raw materials, unfinished goods
and unsold finished goods) over a given period of time
 Inventory investment is included in GDP for the same reason that we include capital goods
15
A Detour: Stock and Flow Variables
 A flow variable is an amount per a given unit of time
 By contrast, a stock variable is a quantity at a given point in time. A stock is often an accumulation of
flows over time.
16
Measuring GDP: Different Approaches
 Production approach: GDP is the total value of goods and services produced in an economy.
 Expenditure approach: GDP is the total spending on currently produced final goods and services in
the economy within a given time period.
 Income approach: GDP is the sum of all incomes in the economy.
17
Real Versus Nominal GDP
 A nominal variable is a measure at current market (nominal) prices (e.g., nominal GDP)
 A real variable is a measure in terms of quantities of actual goods and services (e.g., real GDP)
 When we calculate nominal GDP, it is the sum of the quantities of the final goods produced times their
current price.It can increase for two reasons:
 either there is more output or the prices are higher
 If we want to measure changes in production, we have to eliminate the effect of increasing prices in
our measurement. Therefore, we calculate real GDP as the sum of the quantities of the final goods
produced times constant prices.
 If prices of some important goods changed dramatically relative to other goods, using a fixed baseyear for prices when calculating real GDP can produce misleading results
 Chain-weighted measures of GDP allow the base year to change continuously
18
The significance of the GDP
 Real GDP shows the economic size of a country.
 Real GDP per capita (real GDP divided by the population) gives the average standard of living.
 When assessing the performance of an economy, we focus on GDP growth
 GDP growth: 𝑌𝑡 − 𝑌𝑡−1
𝑌𝑡−1
19
Quality and GDP
 How can we compare the computers sold in 1981 with the computers sold in 2010? They are not the
same good! Should we look at the clock speed, the RAM, the hard drive, the network capabilities?
 We should look at how much more the customers are willing to pay for it. That approach is called
hedonic pricing.
 Using this method, DoC evaluated that the quality of computers increased by 18% per year. Thus, a
typical personal computer in 2010 delivers 1.1829 = 121 times the computing services a typical
personal computer delivered in 1981.
 Furthermore, the dollar price of computers declined by 10% per year. That means that their quality
adjusted price has fallen at the rate of 18%+10%=28%.
 Hence, we can conclude that a dollar spent on computers bought 1.2829 = 1,285 times more
computing services in 2010 than in 1981.
20
Seasonally-adjusted GDP
 Raw data on GDP tends to fall in cold and snowy months
 Therefore, economic statistics like GDP data are seasonally adjusted to account for regular seasonal
fluctuations within a year
21
Measuring Inflation
 Price indices are measures of the price level
 Examples:
GDP deflator (or implicit price deflator)
 Personal consumption expenditure deflator
 Consumer price index

22
Measuring Inflation: Deflators
GDP Deflator for Year y
= 100 x
Nominal GDP in Year y
Real GDP in Year y
PCE Deflator for Year y
= 100 x
Nominal PCE in Year y
Real PCE in Year y
23
Measuring Inflation: Consumer Price Index
 A measure of the average prices of consumer goods and services, i.e., a cost of living index
 Calculated monthly by the Bureau of Labor Statistics using a basket of thousands of consumer goods
and services
 If the basket consists of 10 gallons of gas and 2 apples, then the CPI for 2014 with a base year of
2005 is:
 The CPI is used in determining labor contracts and government payments such as Social Security
benefits, however a study led by Michael Boskin of Stanford University found that increases in the CPI
overstate increases in the cost of living by 1% point
24
The Inflation Rate
 The inflation rate is the % rate of change of the price level over a particular period:

 where
Pt - Pt 1
Pt
t =
=
Pt 1
Pt 1
t = inflation rate in period t
Pt = period level at time t
25
Different Measures of Inflation
26
Real GDP, Nominal GDP and the GDP Deflator
 Since:
 we know:
% Change in (x X y ) = (% Change in x)
+ (% Change in y )
% Change in No min al GDP =
(% Change in the Price Level)
+ (% Change in Real GDP)
 Because the % change in the price level is the inflation rate, while the % changes in nominal and real
GDP are the growth rate:
Inflation Rate = (Growth Rate of Nominal GDP)
- (Growth Rate of Real GDP)
27
Why Do Economists Care About Inflation?
 Pure inflation, ie. when all prices and wages rise proportionally, inflation would be a minor
inconvenience, since the relative prices would not be affected. However, in inflationary periods, not all
prices and wages rise proportionally. Thus inflation can affect the income distribution (example: Russia
in the 90s).
 There are other distortions as well, like the bracket creep, uncertainty in decision-making (e.g. in the
case of investments), the case of fixed prices, etc.
 So, if inflation is bad, then deflation is good? The answer is no. It also causes the same problems and
distortions, furthermore (as you will see later on) it limits the ability of monetary policy to act.
 Most macroeconomists believe that low and stable inflation is the best, somewhere between 0 and
3%.
28
Unemployment
29
Measuring Unemployment
 The employed are people who have a job.
 The unemployed are people (1) who do not have a job (2) but they are looking for a job.
 Labor force is the sum of the employed and the unemployed: Labor Force =
Number of Employed + Number of Unemployed
 Unemployment rate is the ratio of the the number of people who are unemployed to the number of
people in the labor force:
 People who are unemployed (according to the definition) might not register themselves as
unemployed at the unemployment offices. Because of that, statisticians now rather assess the number
of unemployed by using household surveys. Still, the unemployment rate does not tell the whole story
about the labor market.
30
Measuring Unemployment
 The unemployment rate does not anything about those people who do not have a job and are not
looking for one, ie. about those not in the labor force. Sometimes people give up looking up for a job –
they are called discouraged workers.
 Participation rate measures the ratio of the labor force to the total population of the working age:
Labor-Force Participation Rate =
Labor Force
Adult Population
 When the economy slows down, there is usually both an increase in unemployment and a decrease in
the participation rate. Example: Poland in the early 90s.
 Another measure is the employment ratio: Employment Ratio =
Employed
Adult Population
31
Why Do Economist Care About Unemployment?
 It has direct effect on the welfare of the unemployed, it can bring about financial and psychological
suffering. But keep in mind, some of the the unemployed are finding a new job very quickly, others
remain chronically unemployed.
 A high unemployment rate can also show that the economy is not using its resources efficiently.
However, sometimes economists are also worried about too low unemployment rates as well, since it
can point out labor shortages.
32
Measuring Interest Rates
 An interest rate is the cost of borrowing, or the price paid for the rental of funds
 Interest rates are returns for holding debt securities, such as bonds
 A nominal interest rate makes no allowance for inflation
 The real interest rate is the amount of extra purchasing power a lender must be paid for the rental of
his/her money
 The ex ante real interest rate is adjusted for expected changes in the price level
 The ex post real interest rate is adjusted for actual changes in the price level
33
Real vs Nominal Interest Rates
 The Fisher equation:
 where i = nominal interest rate
= nominal interest rate
r
p = expected inflation
e
 Credit markets are where households and businesses get funds (credit) from each other
 Because the real interest rate reflects the real cost of borrowing, it is likely to be a better indicator of
the incentives to borrow, invest, and lend in credit markets than nominal interest rates.
34
Thank you
for your attention!