Chapter 11 – Introduction to
Macroeconomics
This chapter starts our coverage
of Macroeconomics, the study of
how the economy works as a
whole.
The chapter defines the key
variables to measure the “health”
of an economy, and briefly
discusses how the variables are
measured and interpreted.
Microeconomics Versus
Macroeconomics
Microeconomics -- the “web of
connections” of all the individual
interdependent markets that make
up an economy.
Macroeconomics – putting the
microscope away and looking at
the overall economy as its own
entity, imperfections and all.
The Macro Goal Variables
Measures of Economy’s “Health”
Definitions and Realistic Goals
(US, for the most part).
Goal #1 – Sufficient
Production or Output
Measured by Real Gross Domestic
Product (Real GDP).
Real GDP (Y) -- The total production or
output of final goods and services over
a period of time, expressed in constant
prices of a base year.
Real Versus Nominal GDP
Nominal GDP (unadjusted GDP) -Total production at current prices.
Real GDP (GDP adjusted for
changes in prices) -- Total
production at constant prices of a
base year.
Why is Production or
Output Important?
Real GDP – the sum total of
production of final goods and
services across all markets of the
economy, it measures total
production or output.
By definition, Real GDP identically
measures total income to all the
factors derived from production
and sales.
Real GDP -- Realistic Goal
Realistic Goal for Real GDP -- to
be as high as possible without
accelerating inflation
(overstimulated economy).
The Full Sustainable Level
of Real GDP (Potential GDP)
The Full Sustainable Level
of Real GDP (YF) – the maximum
level of Real GDP the economy can
produce without bringing on
accelerating inflation or
overstimulation.
Characterizing the
Economy: Y versus YF
Y < YF -- sluggish economy
Y > YF -- economy with
accelerating inflation
Y = YF -- economy with constant
inflation rate (desired
state)
Characteristics of YF
Unobservable.
Has grown at 2.5% per year for the
US historically since World War II.
Maybe for the US, it has grown 3%
per year in most recent decade.
Growth rate is not the same for all
countries (Europe, Canada is less).
Recession -- A Special Case
Recession -- The situation where
the level of real GDP decreases, or
exhibits negative growth, for at
least two consecutive quarters.
Clearly, in a recession, Y < YF.
Goal Variable #2 -- Inflation
Measured by the Inflation Rate -the growth or percentage change
in the overall price level.
First, measure the price level (P):
Consumer Price Index (CPI).
Inflation Rate = Percentage
Change in P.
Why is Inflation a Problem?
Inflation erodes the purchasing power
of money, causes distortions in
decisions.
-- Why hold money?
-- Why lend money?
Inflation can erode people’s standard
of living, put pressure on labor
markets.
-- Fixed incomes.
-- Workers with insufficient raises.
Realistic Goal -- Inflation
Ideal Goal: Inflation Rate = 0%.
Realistic Goal (US):
|Inflation Rate| < 3%.
The Consumer
Price Index (CPI)
Key measure of the price level (P).
Computed based upon a Market
Basket: comprehensive set of
goods and services purchased by
consumers.
Fixed Weight Index
Computing a CPI
Example -- Compute the CPI for 2008
with 1992 as the base year.
CPI2008 =
(Cost of 1992 Market Basket
Purchased in 2008)
(Cost of Actual Consumer
Purchases in 1992)
Computing The Inflation
Rate (Given the CPI)
Example -- Compute the Inflation Rate
for 2008, given that the CPI for 2007
and 2008 have been calculated.
Inflation =
Rate2008
CPI2008 – CPI2007 x 100%
CPI2007
Biases in the CPI
(as a Fixed Weight Index)
Entry Bias -- goods leaving and
entering the market basket.
Quality Bias -- different quality of the
same goods over time.
Outlet Bias -- retail vs outlet prices?
Commodity Substitution Bias -changing quantities over time due to
demand response to goods that have
become relatively expensive.
The GDP Deflator
An alternative measure of the price
level (P).
Market Basket: comprehensive set of
goods and services purchased by all
spenders in the economy (consumers,
businesses, government, and
foreigners on US exports and imports).
Chain Weighted Index – alleviates
some of the biases of the CPI due to
being a fixed weight index.
Converting
Nominal GDP to Real GDP
Example -- find Real GDP2008
Real GDP2008 = Nominal GDP2008
P2008
Real GDP for other years is computed the
same way.
Real GDP Growth = Percentage Change in
Real GDP.
Goal Variable #3 -Unemployment
Measured by the Unemployment Rate (u).
u = (# of people unemployed) x 100%
(labor force)
Unemployed -- those people out of work
and seeking work.
Labor Force -- people employed +
people unemployed
What the Unemployment
Rate Does Not Measure
discouraged workers, those who
drop out of the labor force
part-time versus full-time
employment
compensation of those working
people with multiple jobs
Realistic Goal -Unemployment Rate
Realistic Goal -- as low as possible
without inflation accelerating
(overstimulated economy).
Natural Rate of Unemployment (uN) -The lowest unemployment rate the
economy can achieve without
accelerating inflation.
Realistic Goal: u = uN
Interpretation: u versus uN
u = uN  Desired State of
Economy
u > uN  Sluggish Economy
u < uN  Accelerating Inflation
(Overstimulated Economy)
Types of Unemployment
Total Unemployment = Frictional +
Structural + Demand-Deficient
Frictional Unemployment -Unemployment due to time
involved to matching unemployed
and appropriate jobs.
Structural and DemandDeficient Unemployment
Structural Unemployment -Unemployment due to a mismatch
of available workers and jobs.
Demand-Deficient Unemployment
-- Unemployment due to a
generally sluggish economy.
There are not enough jobs for
everyone who wants one.
The Natural Rate of
Unemployment Revisited
Natural Rate of Unemployment (uN) -The unemployment rate in which
inflation has no tendency to accelerate
or decelerate.
Another Interpretation -- uN is the
unemployment rate with zero demanddeficient unemployment.
Economy at uN: “full employment”.
Where is uN for the US?
Historically, uN = 5.5%
Is uN now maybe 5%?
Most other countries: uN is higher
than US measure.
Real GDP and the
Unemployment Rate
u = uN  Y = YF,
(Desired State of Economy)
u > uN  Y < YF,
(Sluggish Economy)
u < uN  Y > YF,
(Accelerating Inflation)
Unemployment -- Not an
Independent Problem
Real GDP Growth 
Employment Growth  u
Real GDP and unemployment -not independent problems.
Focus on getting one of them to
the desired goal, and the other one
will automatically follow (although
not a perfect correlation).