Principles of Macroeconomics
Econ 202
D.W. Hedrick
Housekeeping
• Syllabus
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Textbook
Course outcomes and outline
Evaluations: quizzes,Aplia, midterms and final
Grades
Positive and civil learning environment
Recommended study habits
• Web page http://www.cwu.edu/~dhedrick
• Supplemental Instruction
Overview of the Course
• Macroeconomics vs. Microeconomics
– The big picture
– Circular Flow
– Determination of aggregate production, income, prices,
and employment
• Setting the stage with a Brief Review of
Microeconomics
– Demand and supply in product and resource markets
– Determinants of demand and supply: Micro vs. Macro
and the fallacy of composition
– Market equilibrium in product and resource markets
• Macroeconomic Variables
– Output and income: real and nominal gross domestic product
(GDP)
– Aggregate Prices
• Cost of living
• Inflation
– Employment and Unemployment
– Interest Rates and Exchange rates
• Determination of Macroeconomic Performance in the
Long-run
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Economic growth
Saving, Investment and the Financial System
Employment, unemployment
Monetary System
Money and Inflation
The Macroeconomics of Open-economies
• Determination of Macroeconomic Performance in
the Short-run
– Aggregate demand and supply
– Effects of fiscal and monetary policy
– Short-run tradeoffs between inflation and
unemployment
• Major Issues in Macroeconomics
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Stabilization policy
Rules vs. Discretionary monetary policy
Optimal inflation
Budget deficits vs. surpluses
Tax laws and savings and investment
The Measurement of Aggregate
Output and Income
• By definition, aggregate output is equal to
aggregate income. The value of output is
equal to the income (wages, interest, rents
and profits) received by the factors.
• Various measures of aggregate output:
– Gross domestic product (GDP)
– Gross national product (GNP)
Gross Domestic Product
• GDP is the market value of all final goods and
services produced within a country in a given
period of time.
– Market value – prices, illegal, household
– All – imputed values for rent
– Final goods and services– intermediate goods are not
double counted
– Produced (newly) - products resold, inventory
– Within the country – Excludes US production abroad
includes ROW production within the US
– Given period of time (generally yearly or quarterly)
Gross National Product and
Other Measures of Income
• GNP is the total income earned by a nation’s
permanent residents, includes US earning in ROW
and excludes ROW’s earnings in US
• Net National Product (NNP) = GNP-Depreciation
• National Income (NI) = NNP – indirect business
taxes + subsidies to businesses
• Personal Income (PI) = NI – corporate profits
taxes – retained earnings – social security taxes +
interest from government debt + transfer payments
• Disposable Income = PI – personal taxes – nontax
payments
Which Measure Should be Used?
• It depends, we are interested in understanding the
total domestic production of goods and services,
so we will use GDP.
• If you are interested in incomes earned by
permanent residents and citizens, GNP is the one
to use. NNP gives net production. NI the income
earned by residents by producing goods and
services. PI is the income by resident households
and noncorporate businesses. DI is the income
household and noncorporate businesses have after
taxes.
Components of GDP
• Since aggregate production equals aggregate income, let’s
call GDP = Y
• Y can be broken up into the following parts
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Consumption – HH spending on G&S (except housing)
Investment – HH spending on K including HH of new housing
Government Purchases of G&S
Net Exports (= Exports – Imports) Net addition (subtraction)
attributable to purchases by ROW.
• Y = C + I + G + NX
• Economic theory will be used to explain the determination
of the above components of aggregate demand=aggregate
output=aggregate income.
GDP Data
• The US Department of Commerce’s Bureau
of Economic Analysis has data on line:
– http://bea.gov/
• Economic Report of the President
– http://www.gpoaccess.gov/eop/index.html
• Graphs and Data
– http://www.economagic.com/
– FRED
Real Versus Nominal GDP
• Remember from micro:
– Expenditures or Revenue = PxQ
– Total Expenditures or Revenue = Σ PxQ
• Total can increase either because prices go up or
quantities increase
• Nominal GDP is measured in current dollars
• Real GDP corrects for increases in prices and tries
to measure the total quantity of goods
• Nominal GDP= Σ PCY x QCY
• Real GDP= Σ PBY x QCY
• GDP Deflator =
(Nominal GDP/Real GDP) X 100
Real and Nominal GDP
1947-2004
Real GDP with Pct. Changes
1947-2004
Table 2 Real and Nominal GDP
Copyright©2004 South-Western
The GDP Deflator
• The GDP deflator is a measure of the price
level calculated as the ratio of nominal GDP
to real GDP times 100.
• It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than a
rise in the quantities produced.
The GDP Deflator
• Remember The GDP deflator is calculated
as follows:
Nominal GDP
GDP deflator =
 100
Real GDP
The GDP Deflator
• Converting Nominal GDP to Real GDP
– Nominal GDP is converted to real GDP as
follows:
Real GDP20XX
Nominal GDP20XX

 100
GDP deflator20XX
Real and Nominal GDP
Year
Nominal GDP
GDP Deflator
Real GDP
2001
200
100
(200/100)X100=200
2002
600
171
(600/171)X100=351 (350)*
2003
1,200
241
(1,200/241)X100=498 (500)*
*errors due to rounding deflator
Copyright©2004 South-Western
Macro
Variable
GDP
2006
II
III
13197.3
%chg
RGP
11388.1
%chg
C
3.798%
11443.5
0.486%
115.886759
Sum
13322.6
0.949%
%chg
GDP Def
Annualized
1.946%
116.4206755
0.461%
1.843%
3.789%
9346.7
70.2%
I
2235.5
16.8%
G
2542.1
19.1%
X
-801.7
-6.0%
100.0%
Percentage Changes and GDP
• GDP is most often reported as the percentage
change in real GDP on annual basis.
• For example, from the BEA website Latest news
release -- 8/30/07 Real GDP increased at an
annual rate of 4.0 percent in Q2 2007, according
to final estimates.
• Nominal GDP = GDP Deflator x Real GDP
Y
=
P
x
Q
• When multiplying amounts one adds growth rates:
%ΔY approx. = %ΔP
+ %ΔQ
7.8% approx = 3.8%
+ 4.0%
Percentage Changes in Nominal GDP,
Real GDP and the GDP Deflator
Nominal GDP
Pct.Chg
RGDP
Pct. Chg
8703.50
GDP
Deflator
Inflation
1997
8304.3
95.4
1998
8747.0
5.3%
9066.90
4.2%
96.5
1.1%
1999
9268.4
6.0%
9470.30
4.4%
97.9
1.4%
2000
9817.0
5.9%
9817.00
3.7%
100.0
2.2%
2001
10100.8
2.9%
10083.00
2.7%
100.2
0.2%
2002
10469.6
3.7%
10048.8
-0.3%
104.2
4.0%
2003
10971.2
4.8%
10320.6
2.7%
106.3
2.0%
2004
11734.3
7.0%
10755.7
4.2%
109.1
2.6%
2005
12394.17
5.6%
11096.93
3.2%
111.7
2.4%
Quarterly Percent Change
in Real GDP
2000.1-2004.3
GDP AND ECONOMIC WELLBEING
• GDP is probably a good measure of the
economic well-being of a society.
• GDP per capita (or person) tells us the
income and expenditure of the average
person in the economy.
GDP AND ECONOMIC WELLBEING
• Higher GDP per person indicates a higher
standard of living.
• GDP is not a perfect measure of the happiness or
quality of life, however.
• Some things that contribute to well-being are not
included in GDP.
– The value of leisure.
– The value of a clean environment.
– The value of almost all activity that takes place outside
of markets, such as the value of the time parents spend
with their children and the value of volunteer work.
Table 3 GDP, Life Expectancy, and Literacy
Copyright©2004 South-Western
Summary
• Because every transaction has a buyer and a seller,
the total expenditure in the economy must equal
the total income in the economy.
• Gross Domestic Product (GDP) measures an
economy’s total expenditure on newly produced
goods and services and the total income earned
from the production of these goods and services.
• Changes in the overall level of prices from year to
year can be corrected using the GDP Deflator.
Measuring the Cost of
Living
• Inflation refers to a situation in which the
economy’s overall price level is rising.
• The inflation rate is the percentage change
in the price level from the previous period.
THE CONSUMER PRICE
INDEX
• The consumer price index (CPI) is a measure of
the overall cost of the goods and services bought
by a typical consumer.
• The Bureau of Labor Statistics reports the CPI
each month.
• It is used to monitor changes in the cost of living
over time.
• When the CPI rises, the typical family has to
spend more dollars to maintain the same standard
of living
Calculating the Consumer Price Index
• Fix the Basket: Determine what prices are most
important to the typical consumer.
– The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
– The BLS conducts monthly consumer surveys to set the
weights for the prices of those goods and services.
• Find the Prices: Find the prices of each of the
goods and services in the basket for each point in
time.
• Compute the Basket’s Cost: Use the data on
prices to calculate the cost of the basket of goods
and services at different times.
• Choose a Base Year and Compute the
Index:
– Designate one year as the base year, making it
the benchmark against which other years are
compared.
– Compute the index by dividing the price of the
basket in one year by the price in the base year
and multiplying by 100.
• Compute the inflation rate: The inflation
rate is the percentage change in the price
index from the preceding period
• The Inflation Rate
– The inflation rate is calculated as follows:
Table 1 Calculating the Consumer Price Index and the
Inflation Rate: An Example
Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the
Inflation Rate: An Example
Copyright©2004 South-Western
• Calculating the Consumer Price Index and
the Inflation Rate: Another Example
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Base Year is 2002.
Basket of goods in 2002 costs $1,200.
The same basket in 2004 costs $1,236.
CPI = ($1,236/$1,200)  100 = 103.
Prices increased 3 percent between 2002 and
2004.
FYI: What’s in the CPI’s Basket?
16%
Food and
beverages
17%
Transportation
Education and
communication
41%
Housing
6%
6%
6% 4% 4%
Medical care
Recreation
Apparel
Other goods
and services
Copyright©2004 South-Western
Consumer Price Index Data
• U.S. Department of Labor’s Bureau of Labor
Statistics (BLS)
– www.bls.gov
• Commercial website to compare cost of living
geographically
– http://www.homefair.com/homefair/calc/salcalc.html
– http://www.bestplaces.net/html/cost_of_living.html
Problems in Measuring the Cost of
Living
• The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure of the
cost of living.
Problems in Measuring the Cost of
Living
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
Problems in Measuring the Cost of
Living
• Substitution Bias
– The basket does not change to reflect consumer
reaction to changes in relative prices.
• Consumers substitute toward goods that have
become relatively less expensive.
• The index overstates the increase in cost of living by
not considering consumer substitution.
Problems in Measuring the Cost of
Living
• Introduction of New Goods
– The basket does not reflect the change in
purchasing power brought on by the
introduction of new products.
• New products result in greater variety, which in turn
makes each dollar more valuable.
• Consumers need fewer dollars to maintain any given
standard of living.
Problems in Measuring the Cost of
Living
• Unmeasured Quality Changes
– If the quality of a good rises from one year to the next,
the value of a dollar rises, even if the price of the good
stays the same.
– If the quality of a good falls from one year to the next,
the value of a dollar falls, even if the price of the good
stays the same.
– The BLS tries to adjust the price for constant quality,
but such differences are hard to measure.
Problems in Measuring the Cost of
Living
• The substitution bias, introduction of new
goods, and unmeasured quality changes
cause the CPI to overstate the true cost of
living.
– The issue is important because many
government programs use the CPI to adjust for
changes in the overall level of prices.
– The CPI overstates inflation by about 1
percentage point per year.
The GDP Deflator versus the Consumer
Price Index
• The BLS calculates other prices indexes:
– The index for different regions within the
country.
– The producer price index, which measures the
cost of a basket of goods and services bought
by firms rather than consumers.
The GDP Deflator versus the Consumer
Price Index
• Economists and policymakers monitor both
the GDP deflator and the consumer price
index to gauge how quickly prices are
rising.
• There are two important differences
between the indexes that can cause them to
diverge.
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
• …the consumer price index reflects the
prices of all goods and services bought by
consumers.
The GDP Deflator versus the Consumer
Price Index
• The consumer price index compares the price of a
fixed basket of goods and services to the price of
the basket in the base year (only occasionally does
the BLS change the basket)...
• …whereas the GDP deflator compares the price of
currently produced goods and services to the price
of the same goods and services in the base year.
Figure 2 Two Measures of Inflation
Percent
per Year
15
CPI
10
5
0
GDP deflator
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
CORRECTING ECONOMIC
VARIABLES FOR THE EFFECTS OF
INFLATION
• Price indexes are used to correct for the
effects of inflation when comparing dollar
figures from different times.
Dollar Figures from Different Times
• Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2001:
Salary2001
Price level in 2001
 Salary1931 
Price level in 1931
177
 $80,000 
15.2
 $931,579
Table 2 The Most Popular Movies of All Times,
Inflation Adjusted
http://www.movieweb.com/movies/boxoffice/alltime.php
http://www.filmsite.org/boxoffice.html
Copyright©2004 South-Western
Indexation
• When some dollar amount is automatically
corrected for inflation by law or contract,
the amount is said to be indexed for
inflation.
Real and Nominal Interest Rates
• Interest represents a payment in the future for a
transfer of money in the past.
• The nominal interest rate is the interest rate
usually reported and not corrected for inflation.
– It is the interest rate that a bank pays.
• The real interest rate is the nominal interest rate
that is corrected for the effects of inflation.
• If you borrow $1,000 for one year, and
– Nominal interest rate was 15%.
– During the year inflation was 10%.
• Then, Real interest rate = Nominal interest
rate – Inflation
= 15% - 10% = 5%
Compound Interest
• Simple formula:
– Pt=P0 (1 + i)t
• Complex Formula:
– Pnt=P0 (1 + i/n)nt
Figure 3 Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15
10
Nominal interest rate
5
0
Real interest rate
–5
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
Summary
• The consumer price index shows the cost of
a basket of goods and services relative to
the cost of the same basket in the base year.
• The index is used to measure the overall
level of prices in the economy.
• The percentage change in the CPI measures
the inflation rate.
Summary
• The consumer price index is an imperfect
measure of the cost of living for the
following three reasons: substitution bias,
the introduction of new goods, and
unmeasured changes in quality.
• Because of measurement problems, the CPI
overstates annual inflation by about 1
percentage point.
Summary
• The GDP deflator differs from the CPI because it
includes goods and services produced rather than
goods and services consumed.
• In addition, the CPI uses a fixed basket of goods,
while the GDP deflator automatically changes the
group of goods and services over time as the
composition of GDP changes.
Summary
• Dollar figures from different points in time
do not represent a valid comparison of
purchasing power.
• Various laws and private contracts use price
indexes to correct for the effects of
inflation.
• The real interest rate equals the nominal
interest rate minus the rate of inflation.