Principles of Economics
Overview of Macroeconomics
20.Overview of Macroeconomics
• MACROEOCONOMICS is the study of the behaviour of
the economy as a whole.
• Short term fluctuations in Y, u, and P:
Business
cycle
• Long term trends in Y and living standards: Economic
growth
• Started in 1930s by John Maynard Keynes whose
theory helped fighting Great depression
• 1936: The General Theory of Employment, Interest and
Money: high and production below PPF can persist,
hence government has to use fiscal and monetary
policy to shorten downturns.
Macroeconomic objectives and
instruments
OBJECTIVES:
1. Low unemployment
2. Inflation control
3. High growth rate of the economy
These goals are often confronted, for example too
low unemployment increases inflation, or too
low inflation causes GDP to stagnate
INSTRUMENTS:
1. Monetary policy: control M to affect i
2. Fiscal policy: G, T
1. High and growing level of output (Y)
• Gross domestic product (GDP) is the most
comprehensive measure of the total output in an
economy (Y)
• NOMINAL GDP is measured in actual market prices.
• REAL GDP is measured in constant prices (taking
certain year’s price level as a base)
• GDP GROWTH RATE, gY, is a percentage increase in GDP
in a time period (mostly year)
• POTENTIAL OUTPUT is the maximum sustainable
output that the economy can produce
• When Y is above potential Y inflation appears, when it
is below u rises.
2. Low unemployment
• Unemployment rate (u) is the share of people
who do not work but seek job in the labour
force (employed + unemployed):
unemployed seeking job
u=
labour force
• Employment rate the share of people who
work in the labour force (employed +
unemployed)
3. Stable price level
• Price stability is the situation in which the overall
level of prices either remains unchanged or rises
very slowly.
• Inflation (π) is the percentage change in the
overall level of prices in a year.
• Price level is measured using price indices, mostly
CPI (consumer price index):
Pt  Pt 1
t 
Pt 1
100%
• Price index is a measure of the average level of
prices
• Where P stands for the level of prices, t for the
current year and t – 1 for the previous year.
Undesired price levels
• DEFLATION is the fall in price level
• HYPERINFLATION is is the inflation of 1000%
or more (e.g. Croatia in the war year 1992)
• High inflation erodes pensions, taxes become
variable, the currency sis no longer a value of
worth.
• Deflation causes stagnation
Fiscal policy
• POLICY INSTRUMENT is a government controled variable
which affect at least one macroeconomic goal.
• FISCAL POLICY denotes use of taxes (T) and government
spending (G) and is conducted by Ministry of finance
• G consists of:
1. Public goods (infrastructure, defence, salaries for
public services)
2. Transfer payments (aid for unemployed and elderly)
• G is part of Y (income) and therefore affects GDP.
• T affect i) incomes and ii) prices of goods and factors
IS curve
• IS curve shows the
relation between output
and interest rate when
goods markets are at its
equilbria.
• Expansive f.p. shifts IS
rightwards, and
restrictive leftwards.
i
IS
Y
Monetary policy
• MONETARY POLICY is an activity of affecting
money supply (M)
• It is conducted by the central bank (HNB in
Croatia)
• Money consists of the means of exhange
(cash, deposit money)
• Money supply affects interest rates, stock
prices, investments, etc., which affects output.
LM curve
• LM curve shows
relationship between
output and interest rate
when financial markets
are at their equilibria.
• Expansive M.P. shifts LM
rightwards, restrictive
M.P. shifts it leftwards.
i
LM
Y
IS-LM model
• IS-LM shows relation
between i and Y when
goods and services
markets and financial
markets are at its
equilbrium.
i
LM
i*
IS
Y*
Y
Restrictive fiscal policy
• Fall in interest rate
• Fall in the output
Expansive fiscal policy
• i rises
• Y rises
Restrictive monetary policy
• i rises
• Y falls
Expansive monetary policy
• i falls
• Y rises
Aggregate supply and aggregate
demand
• Aggregate supply (AS) is total amount of goods
and services that a country produces and sells in
certain period at all possible price levels.
• AS depends on the productive capacity and level
of costs
• Aggregate demand (AD) is total amount of goods
and services that consumers, government and
companies spend in a certain period of time at all
possible price levels. It is deducted from IS-LM
model (equilibrium on the goods and financial
markets)
Deduction of aggregate demand from
IS-LM model
Macroeconomic equilibrium
Price level P
AS
P*
AD
0
Y*
Output Y
•AD& AS: fiscal policy, money supply and capital stock is constant
•D&S: other goods’ prices, tastes, income, technology and costs held
constant
•Macroeconomic equilibrium is a combination of the overall price level
and output level at which all sellers and buyers are satisfied with their
purchases, sales and prices.
International economy
• International economy is the system of trading
and finance connections among countries.
• International trade: borderless microeconomics
• Trade policies affect international trade (tariffs,
quotas, subsidies)
• International finance: borderless
macroeconomics
• International financial management deals with
exchange rates in different exhange rate systems
Macroeconomic history
•
•
•
•
Great depression (1930’s)
Wartime boom (1960’s)
Tight money (1979 – 1982)
Expansion decade (1990’s)
21. Measuring economic activity
• GDP is the most common measure of national output
• GNP contains total output of the companies produced
by the observed country domestically or abroad,
without domestic output of the foreign companies
• GDP includes all production in a country without
output of domestic companies abroad and includes
output of foreign companies in the observed country
• Up to 1992 GNP was more common, later it was GDP
• Two ways to measure national product:
1. CONSUMPTION APPROACH: Sum of all
expenditures on goods and services:
Y = C + I + G + NX
2. INCOME APPROACH: Sum of all incomes in an
economy:
Y = w + i + r + Π + Dp + T
• They both have to give the same GDP
• In order to exclude double counting
intermediate products are excluded
Gross domestic product (GDP), National
income (NI) and Disposable personal
income (DI)
GDP
X
Dp
Taxes
G
I
C
NDP =
NI
Net business saving
NI
Transfer payments
DI
Nominal and real GDP
• NOMINAL GDP is expressed in current prices
• REAL GDP excludes the effect of price changes
• Real GDP can be obtained from the nominal GDP by
DEFLATIONING (dividing with the price index)
GDPreal = GDPnom/P
• Price indices: CPI (consumer price index) and PPI (producer
price index)
• CPI: measure of the average change over time of the urban
consumers’ basket of goods (364 classes of goods)
•PPI: measure of the price level of goods at th wholesale or
producer level, where weights are share of the commoditie’s
net sales in total sales.
Investment and saving
Y=C+S
(income can be either saved or consumed)
Investment is made from savings: I = S
Accumulation of investment creates capital: K = ΣI
In detail:
IT = I + NX = SP + SG = ST
IT (national investment), SP (private saving), SG
(government saving), ST (total saving)
Example 1
GDP = 1000, where expats produce 200.
Residents of the country produce abroad 100.
Find GNP
• GNP = 1000 – 200 + 100 = 900
Exercise 2
• Let rent be 100, profit 500, investments 600,
depreciation 400, wages 5500, interests 500,
consumption 6700and taxes 300. Find GDP
and NDP using both approaches.
• Consumption approach
– GDP = C + I + G + NX
– GDP = 6700 + 600 = 7300
• Income approach
– GDP = w + i + R + Pf + Dp + T
– GDP = 5500 + 500 + 100 + 500 + 400 + 300 = 7300
• NDP = BDP – Dp = 7300 – 400 = 6900
Exercise 3
• Find nominal and real GNP
Year
Nominal GNP
Real GNP
1942
1952
1962
1972
1982
1988
160
350
1080
1210
3170
1800
2610
4000
GNP deflator
(1982=100)
25,5
31,9
100
121,7
• GNP deflator = nominal GNP / real GNP * 100
Year
Nominal GNP
Real GNP
GNP deflator
(1982=100)
1942
1952
1962
1972
1982
1988
160
350
570
1210
3170
4860
1080
1370
1800
2610
3170
4000
14,8
25,5
31,9
46,3
100
121,7
Exercise 4
• If GDP is 3000, depreciation 600, taxes 300,
net business savings 100 and trasfer payments
50, find national income and disposable
personal income. Find GNP if country has no
international relations.
• NI = GDP – Dp
• NI = 3000 – 600 = 2400
• DI = NI – T – Net business savings + TR
• NI = 2400 – 300 – 100 + 50
• If a country has no international relations then
GDP = GNP = 3000
Zadatak 1:
• Table below shows GDP of Croatia in prices from 1990
for 1990 – 1997. Find chain and base indices (1990 =
100)
year
1990
1991
1992
1993
1994
1995
1996
1997
GDP in
000 kn
280 544
231 381
195 450
179 764
190 317
203 323
215 522
229 531
base index
chain index
• Base index (1990=100) = BDPt / BDP90. * 100
– 231 381 / 280 544 * 100 = 82,48
– 195 450 / 280 544 * 100 = 69,67
• Chain index = BDPt / BDPt-1 * 100
– 231 381 / 280 544 * 100 = 82,48
– 195 450 / 231 381 * 100 = 84,47
year
1990
1991
1992
1993
1994
1995
1996
1997
GDP in
000 kn
280 544
231 381
195 450
179 764
190 317
203 323
215 522
229 531
Base index
1990=100
100
82,4
69,6
64
67,8
72,4
76,8
81,8
Chain indeks
82,4
84,4
91,9
105,8
106,8
105,9
106,5