DISCLAIMER: If you do not attend lectures,

you are duly warned that these notes do not

contain all of the material presented in class.
You do not attend lectures at your own peril!
Also note that not all material in these notes
may be covered in class.
CHAPTER ONE
I. INTRODUCTION AND
MEASUREMENT

1. What Is Macroeconomics?
Macroeconomics: is the study of relationships
between aggregate economic variables, such
as between output, unemployment, and the
rate of inflation. Macroeconomics was born
out of the Great Depression in the 1930s due
to the work of John Maynard Keynes, a British
economist. It was the result of people
desperately wanting to know what caused the
Depression and how it could be ended. People
study macroeconomics for the following
reasons:

A. Curiosity — people want to figure out how

what we observe happens and there are two
major questions people seek answers for:

1
i) What causes the economy to grow over
time? (As we want to know what factors will
make people permanently better off).
ii) What causes the economy to experience
fluctuations? (as we want to understand why
there are fluctuations in output produced, the
number of people unemployed, and the rate of
inflation).
In addressing these two fundamental questions
we need to answer questions such as:
What causes inflation?
What causes unemployment?
What affect does inflation have on economic
activity?
What affect does a government budget deficit
have on economic activity?
How do a country’s international links affect
economic activity? And there are so many of
such questions that need to be answered in
order to answer the two major questions raised
above.

B. To Become Educated — the Oxford

Concise English Dictionary defines this as
“the development of character or mental
powers” which is very different from being
trained which is “to teach a person a specified

2
skill by practice”. Universities teach academic
subjects (“abstract, theoretical, not of practical
relevance”) and concentrate on educating
students whereas polytechnics teach
vocational subjects (“directed at a particular
occupation and its skills”) and concentrate on
training students. Economics is first and
foremost an academic subject although
studying it also happens to teach good
quantitative (working with numerical
information) and analytical (examining and
understanding structures or systems) skills
which are valuable in many areas of
employment.

C. Employment. — Employment can be

gained directly through the education and
knowledge received at university eg. if we
understand how economies work we can do
better in life than if we don’t understand how
they work. If employers think this subject, and
the skills taught, are useful for the jobs they
want to be filled they in their organizations or
enterprises it will increase our chances of
gaining employment. The completion of
university study and relatively good
performance are also used by employers as

3
signals of a student’s capabilities regardless of
what the students studied.

2. How Do We Study Macroeconomics?

Economics is a social science which means it
involves studying society to understand why
people do what they do, but it tries to approach
it ”scientifically”. Note that this approach is
not the myth of the neutral uninvolved
scientist in a white lab coat seeking the greater
absolute truth. Instead, it is prejudiced,
emotive, involved people seeking to make
some sense of what we observe and
experience.

2.1 Economic Models

A fundamental tool used by economists to
understand the economy, and one which we
will use repeatedly through this course, is an
economic “model” where:
Economic Model: is a theory that summarises,
often in mathematical terms, relationships
among economic variables.
And from Concise Oxford Dictionary,

4
Theory: is a system of ideas explaining
something, especially one based on general
principles independent of the particular things
to be explained. Or, an economic theory is a
generalisation based on a few principles that
enables us to understand and predict the
economic choices made by people. You should
note, however, that any model is a simplified
description of a system to assist calculations
and predictions. A model takes the general
theoretical view of the world and applies it to a
specific setting. In formulating a model we
attempt to approximate the normally very
complex and messy reality using a few factors
which believe are the most important ones.
Why simplify and approximate? Because if we
didn’t we would have no hope of
understanding anything as the complexity of
the literal real world would overwhelm us.
Some models use plain old English. Some
models use mathematics. The language of
mathematics can be useful because it makes
clear what is going on, and helps us to
dispense with less important or irrelevant
things. In developing a model we use two
types of variables: exogenous variables and
endogenous variables:

5
Exogenous Variables: are determined outside
of the model. So that they do not capture the
decisions made by people in which we are
primarily interested in learning about.
Assuming that some variables are exogenous
helps to simplify matters by not having
everything being decided at once.

Endogenous Variables: are determined within

the model. And do capture the decisions made
by people in which we are primarily interested
in learning about.

So a model is a set of very general

“assumptions” plus some more specific
assumptions. Using deductive logic we can
then deduce what we expect to happen given
certain circumstances. Then we can compare
our deductions with what actually happens
using inductive logic when interpreting data.
That is, we can “test” the model using real
world data. If we got it right, great, then
maybe we know something about what is
going on. If we got it wrong, then try and think
of anew economic model learning from our
failure. This is the scientific part (based on

6
falsification of models and theories — if this
interests you then you should study the
philosophy of science), although in economics
it is really only “pseudo-scientific” as the data
tends to be non-replicable in many cases
(unlike the natural sciences where experiments
can be held under tightly controlled conditions
and repeated) and many theories are not
rejected and abandoned even when the data
does not support them.

In building economic models economists tend

to assume two general principles about how
people and the societies in which they exist
behave in trying to understand the decisions
made by people:
1. Optimisation Principle — people are
motivated by self-interest, or equivalently, that
people try and do the best they can. Note that
this can be doing the best you can to act
charitably; it doesn’t mean that people are
selfish or greedy as is a common
misperception! It also does not rule out
making mistakes or having regrets afterwards
as people may not be all informed or all wise;
it simply means people do the best they can
with what they have available to them,

7
including their own decision making
capabilities.
2. Equilibrium Principle — that people’s
actions tend to become consistent with each
other. In the limit the economic forces are so
balanced that there is no tendency for people’s
behaviour to change. Note that this doesn’t
mean that the world is static or unchanging, or
that it ever reaches such a state, and it doesn’t
tell us how long it takes to reach an
equilibrium even if one was ever reached, it
simply says that if people’s actions are
inconsistent with each other that there are
economic forces that try and make them
consistent. In many cases, we look at what
happens when these forces have worked
through and people’s actions are actually
consistent and misses out how this state of
affairs came to be (and some economists are
critical of this approach saying the path we go
down influences where we end up.)

Example of the Process of Building an

Economic Model:
Say we want to understand what will happen
to a firm’s output if the price of the good it
produces increases. To get anywhere we have

8
to set some structure; that is we have to make
some assumptions. So assume that:
- The markets for inputs and outputs are
perfectly competitive (=> the prices of the
inputs and outputs are exogenous variables
in this problem).
- The technology available is given, that
is it is exogenous, and we will also have to
assume what particular type of technology
the firm is using i.e. what characteristics it
embodies.
- The level of output is endogenous; it is
the variable that is being determined by
the firm, given the other variables.
- We will also have to assume what sort
of behaviour we think firms follow i.e.
profit max., output max., wage bill
maximiser! (This is where the
optimisation principle is used)
- We will have to assume something
about how demand plans and supply plans
are co-ordinated. (This is where the
equilibrium principle is used).
All of these things together form a theory of
how the firm works, i.e. it is an economic
model. Then we see what behaviour we would

9
expect to be followed by a firm that
experiences a price rise given the model.
Going through this exercise can help us
understand what factors influence the
behaviour of firms in what ways i.e. we are
better able to understand how firms work. We
can also test these models using real world
data. For example, say output of the firm falls
if the price of its good increases, then we may
reject our model and have to think some more
about how firms work. This may mean making
big changes to the model or small changes,
depending on the circumstances.

Once we have developed a model how do we

tell if we have a good one? A good model is
one that:
1. Helps us to understand better what we
observe.
2. Can be used to predict the macro variables
of interest in the future.
Some models are designed to aid our
understanding, for other models their
predictive power is the key thing. The key is to
test our theories and models against the real
world (and to be honest some economists are
not good at this). If the model is shown to be

10
poor then we learn from it and change it, and if
enough different models are shown to be poor
then we take a hard look at the general
principles on which they are built and possibly
change them as well.
The method goes something like:
1. Why do people do what they do?
2. Hypothesise general principles (make a
testable proposition/tentative theory) to
understand and make sense of people’s
behaviour.
3. Focus on specific behaviour of people that
looks interesting and requires understanding.
– 4. Develop a model to try and understand
and make sense of it; i.e. using general
principles + specific assumptions + logical
reasoning => deductions.
– 5. Observe and measure relevant people’s
behaviour. (That is, collect data on the relevant
variables).
– 6. If observations are inconsistent with
deductions then reject model and back to 4.,
learning from the failure.
– 7. If observations are consistent with
deductions then do not reject model and go
back to 3., learning from the non-failure.

11
– 8. If there are lots of rejections of models
using the same general principles then go back
to 2., learning from failures. And of course
life, being messy and complex, does not tend
to work as smoothly as this makes it out to be.
Some people start at 5. and go to 3. and then to
1. Some people get failures and hide them
because there are no rewards for failures!
There are fads and the like which skew what is
looked at and what isn’t. Some people forget
entirely about 5! Such is the messy and
difficult path to understanding!

3. Why Macroeconomics Is Different From

Microeconomics: The Issue of Aggregation
Since the previously described approach to
developing an economic understanding of
society is generic in nature, an obvious
question to ask is what makes
macroeconomics any different from
microeconomics since they both just involve
studying economic behaviour of people?
Recall that microeconomics is the study of the
decisions made by firms and households, and
how these decision makers interact in the
marketplace. Macroeconomics is the study of
the decision made by all firms and households,

12
and the interactions of these decision makers
in all markets. Furthermore, when studying a
single market we invoke the ceteris paribus
assumption but in macroeconomics this is no
longer true since we are studying all markets
at the same time. So macroeconomics is
different because of the sheer scale, all
markets are aggregated together, and because
the general effects of any changes in behaviour
have to be taken into account, rather than just
analysing economic decisions in isolation from
each other.

3.1 Techniques for Developing Aggregate

Models in Macroeconomics
Studying the aggregation of all markets at the
same time creates a major problem — how do
we model aggregate economic behaviour? In
microeconomics this was easy, just model a
household or a firm, but how do we model a
whole economy? We could try and model each
firm, household, each type of good, at each
point in time in a year, but this is far too
complex a task, even if we did have the
computing power to do it (there are other
problems with this approach which I will leave
alone). So how do we cope with the issue of

13
aggregation in developing macroeconomic
models? There are four basic methods used to
develop macroeconomic models allowing for
the fact that we are dealing with whole
economics instead of individual markets:

1) The “Macro Relationship” Paradigm

This just looks at the relationships between
macro variables and examines if there is are
systematic relationships and patterns between
them, and use our micro economic theory to
guide us in exploring and modelling such
relationships and patterns. Our hope is that
distributional stuff averages out, is of
secondary importance, or has a systematic bias
which does not change too often over time.

2) The “Representative Agent” Paradigm

Everyone is the same so we can model the
economy as though it behaves like one person,
or firm. This is really just a special case of 1),
where the guidance of micro theory is made
explicit.

3) The “Small Number of Differences”

Paradigm

14
Allow people and firms to be different, but
only have a very small number of different
agents i.e. two types such as young and old, or
rich and poor. This is an extension of 1), and
the hope is that it allows for the major
distributional influences.
4) The “Large Number of Differences”
Paradigm
Allow lots of differences, but only in very
special ways. Typically this means that no
agent can have any measurable effect on
economic activity by themselves. That is, there
are few individuals that are so rich (like Bill
Gates) that can significantly influence the
economy. This is an extension of 3) with some
restrictive assumptions imposed to make it
workable.

Which way is best should be determined by

how well the resultant theories and models
help us understand economic behaviour and
predict into the future i.e. it is an empirical
matter. In each case we have to compare or
test the results of our predictions based on
such modelling with what actually happens. If
in using an approach we don’t do a good job
of predicting the future then it could be

15
because this is a bad assumption and we
should reject it. Similar things can be done to
handle differences in goods and services,
financial assets, time, geographic space. There
is no ultimate solution to the issue of
aggregating over all markets, and whichever
way we deal with it involves some problems
we just have to learn to live with. Finally,
notice that with each technique we use our
microeconomic ideas and theories to help
guide our creation of macroeconomic models.
This is why for the first half of the course we
be learning about specific microeconomic
theories and models, so we can use them later
on in the second half of the course to guide us
in developing our macroeconomic models.

3.2 The Aggregation Problem

While these basic techniques for aggregating
over all markets makes it appear as though we
have figured out how to deal with the issue of
aggregation in developing macroeconomic
models, the act of aggregating over all markets
creates a problem when we come to empirical
studies of an economy. This is called the
aggregation problem: we can’t distinguish
empirically between changes in people’s

16
underlying behaviour and changes in the
distribution of economic activity.
Example of the Aggregation Problem and its
Consequences:
Consider a simple economy with two types of
people, called Bekele and Abebech, to see an
example of the aggregation problem and its
consequences:

Example of the Aggregation Problem

Description of Economy:
– YB = the income of Bekele,
– YA = the income of Abebech,
– CB = the consumption of Bekele,
– CA = the consumption of Abebe,
– CB = 0.6YB
– CA = 0.4YA
– Y = YB + YA is aggregate income.
– C = CB + CA is aggregate consumption.
– Tax rate = 12.5% of C.
Year 1:
– YB = $100 => CB = $60.
– YA = $100 => CA = $40.
– Y = YB + YA = $200
– C = CB + CA = $100
– C = 0.5Y. (Where 0.5 is the aggregate
marginal propensity to consume)

17
– Tax receipts = 0.125 × $100 = $12.50.
Year 2:
– Suppose Y (the aggregate income) doubles
and everyone knows that it is going to happen.
– Scenario 1: YB = $200 and YA = $200 (that
is the increased income is equally distributed
among all households/citizens).
CB = $120 and CA = $80.
Y = $400 and C = $200 => C = 0.5Y
Tax receipts = 0.125 × $200 = $25.00.
– Scenario 2: YB = $100 and YA = $300 (the
increased income is earned only to one group
of households/one group of citizens).
CB = $60 and CA = $120
Y = $400 and C = $180 => C = 0.45Y
Tax receipts = 0.125 × $180 = $22.50

It looks as though people in the economy are

spending less on consumption goods than they
used to. In fact Bekele and Abebech are
behaving exactly the same as they were
before. What has changed is the relative
distribution of income (and therefore the
amount of consumption). Normally we don’t
know what each Bekele and Abebech in the
world get and spend, and all we see is C and
Y. So we can never be sure with the data we

18
have got whether or not it indicates that people
have changed their behaviour or if people are
behaving the same but a different distribution
of economic activity has arisen. Why do
changes in the distribution of economic
activity matter?

1. Changes in the Distribution of Economic

Activity Makes it Difficult to Understand the
Aggregate Economy. We need stable
systematic relationships to exist between
aggregate economic variables to say anything
sensible about the aggregate economy. For
example, in scenario 1 and scenario 2 the
aggregate MPC is 0.5 while in scenario 3 the
aggregate MPC is 0.45. For macroeconomic
policy we want to know what the aggregate
MPC is in order to understand how people
behave regarding saving and consumption as
certain changes happen in the economy (for
example as income, tax rate, transfer, etc
change). But how can we do this if our
measured MPC keeps changing!

2. Changes in the Distribution of Economic

Activity Make Planning, Predicting, and

19
Forecasting an Aggregate Economy a
Nightmare!
- If tax was 12.5% then in scenario 2 the
tax take would be $25 while that in
scenario 3 it would be $22.5, or 11%
lower. So if the government knew
people’s incomes were about to increase
and used C = 0.5Y to work out its tax
receipt, but instead income increased
according to scenario 3 then the tax receipt
of the government would be 11% below
what they expected, which would affect,
among other things, their budget balance,
interest rates, exchange rates, investment,
etc etc!
- If Banks were using forecasts of
scenario 1 to determine interests rates they
should charge for and lending they make,
if scenario 2 eventuated they would
underestimate the amount of savings of
people and charge too high an interest rate.
- People’s plans can be out of kilter with
what actually happens even if people do
not change how they actually behave when
the distribution of activity matters.
Governments, businesses, etc can not
make accurate forecasts if they depend on

20
 the distribution of economic activity, as
well as the level of economic activity,
when we cannot observe the former
variable!
What we have seen is that the distribution of
economic activity among different people (and
we can do the same thing in terms of types of
goods, time, and geographic location) can
have a fundamental influence on what happens
overall and can undermine our attempt to
understand the behaviour aggregate economy,
thus also hurting our attempts to forecast and
plan for the future, and to conduct government
policies. In the end we do the best we can with
what we have got.

4. Output
We now know that macroeconomics is the
study of people’s behaviour in the aggregate
and that often we try and think about people’s
behaviour in the aggregate by developing
macroeconomic theories and expressing the
theories as models. We also know that to help
develop our macroeconomic theories and
models we need to know something about
what people actually choose to do, and that to
gauge how well we do understand people’s

21
behaviour we need to test our models with
what we observe really happens. To do these
we need to make operational the
macroeconomic variables in which we are
interested, that is define them, and then discuss
how data on them is collected in practice,
including highlighting deficiencies in the
measures. While data collection may seem
humdrum it is an extremely important part of
being a social scientist as the data are required
to help formulate macroeconomic theories and
models and also to test them as just mentioned.
These matters, relating to the macroeconomic
data used by economists, are the subject of the
following sections, staring with output.

4.1 Gross Domestic Product

A very common measure of the aggregate
output of an economy is GDP, or the market
value of all final goods and services produced
in the economy for a given period (usually a
year). Note that final goods and services do
not include inputs that are used up in the
production process. e.g. the petrol used by a
taxi operator is not included in GDP, but petrol
bought by a family is included.

22
Why not include the petrol used by the taxi
operator? Because we already include the
contribution of the petrol to output in the price
of the taxi fare which is included in measuring
GDP. To add the petrol sold to the taxi
operator, as well as the taxi fare, would double
count the contribution of the petrol to output.
Finally, note that we do count the petrol sold
to the family because that is its final
consumptive destination, or the final market
transaction. In the case of the taxi operator it is
the taxi services provided which are the final
market transaction and consumed by the
household sector, and are included in GDP.

There are two types of GDP:

– Nominal GDP: measures the market value
of final goods and services produced using
current prices.
– Real GDP: measures the market value of the
output of final goods and services produced
using prices of some base period; and an
increase in real GDP results only from an
increase in output produced.

4.2 Measurement of Gross Domestic

Product

23
The concept we use to derive a measure of
GDP is the circular flow of expenditure and
income. We will start with a simple example
and then move onto the more realistic, and
hence more complicated, example.
GDP in a Closed Economy without the
Government
– Consider an economy which has two types
of institutions: households and firms.
Households do three things:
1) Supply factors of production to firms (e.g.
labour services) and receive income for these
factors.
2) Purchase and consume goods and services
from the firms.
3) Save some of their income.
Firms do five things:
1) Purchase factors of production from
households and pay the households for these
factors.
2) Sell goods and services to households.
3) Purchase goods and services from other
firms.
4) Purchase investment goods, or expand their
inventories.
5) Borrow to finance their investment
expenditures (from loans or retained earnings).

24
This simple economy has three types of
markets:
1) Goods and services markets.
2) Factor markets.
3) Financial markets.
In this simple economy we can see that all of
the income that firms receive is paid back to
households in the form of:
1. Wages for labour services.
2. Profits to the owners of the firms.
3. Interest payments to the households who
lend money to the firms, usually through
banks.
4. Rents for other factors such as land supplied
by households to firms.
Thus the following relationship holds:
Aggregate income = Aggregate expenditure
or,
Y = C + I.
The left hand side (LHS) are the factor
payments paid by firms to owners of factors of
production (the households) and the RHS are
the expenditures on the production of firms by
households and firms. Since GDP equals total
expenditure on final goods and services, we
have

25
GDP = C + I in this economy.

GDP in an Open Economy with the

Government
In reality, an economy not only includes
households, firms, and financial firms, but also
the government and interactions with other
countries.
The government does three things:
1) It purchases goods and services from firms.
2) It levies taxes on households, and it makes
transfer payments to households (e.g.
unemployment benefit, or superannuation).
3) Borrows to finance the difference between
its revenue and spending if it is running a
deficit, or lends if it is running a surplus.
The rest of the world does two things:
1) Buys goods and services from domestic
firms, and sells goods and services to domestic
firms.
2) Lends to, or borrows from, domestic
households and firms.
Thus the following relationship holds:
Aggregate income = Aggregate expenditure
or,
Y = C + I + G +NX.

26
And hence now we have GDP = C +I +G+NX.
Note that this measure of GDP equals
aggregate expenditure, or aggregate income.
This equality occurs since the value of output
can be measured either as:
1. The sum of incomes paid to the factors of
production.
2. As expenditure on that output.
– Two particular types of flows are sometimes
of interest to economists:
Injections are expenditures into the circular
flow of income that do not originate with
households.
Leakages are income receipts that are not
spent on domestically produced goods and
services, and hence move out of the circular
flow of income.
We know that for firms Y = C + I + G + EX −
IM and for households that Y = C + S + T.
Since Y must be the same in both cases, we
get that,
I + G + EX = S + T + IM
or,
Injections = Leakages
We now have a conceptual framework within
which to measure GDP. Government
statisticians in the Department of Statistics,

27
use this framework to measure GDP in three
ways.

Measuring GDP Method 1 — The

Expenditure Approach
This approach is based on the assumption that
whatever is produced in a given economy will
be purchased by households for consumption (
C), or purchased by business firms for
investment ( I), or purchased by government
(G), or exported to the rest of the world (i.e.
consumed by foreigners). Since we are
interested in the market value of domestically
produced final goods and services, we deduct
whatever is imported from abroad for
consumption, or investment.
Investment includes:
- Purchases of capital equipment by firms.
- Expenditures on new residential houses by
households.
- Changes in inventories (stocks of raw
materials, unfinished goods, or unsold goods)
by firms.
Government purchases do not include transfer
payments.

28
Measuring GDP Method 2 — The Factor
Incomes Approach
This approach is based on the assumption that
whatever is produced in a given economy will
be distributed to the factors of production
employed for the production process. This
approach measures GDP using the following
approach:
1. Add together all incomes paid by firms to
households.
That is we add wages, salaries, other labour
income, corporate profits, interest, other
investment income, farmer’s income and the
income of non-farm unincorporated
businesses. This gives us domestic income at
factor cost.
2. Adjust factor costs to get to market prices.
i.e. subsidies to firms, and indirect taxes paid
by consumers create a wedge between factor
incomes and market prices.
We have to add indirect taxes to, and subtract
subsidies from, domestic income at factor cost.
This gives us Net Domestic Product at market
prices.
3. Account for depreciation: Depreciation: is
the decrease in the value of the capital stock
from wear and tear and the passage of time.

29
Gross Investment: is the amount spent on
replacing worn out (or depreciated) capital, as
well as making net additions to the capital
stock.
Net Investment: is gross investment less
depreciation; and by adding the amount that
the capital stock depreciated to net domestic
product at market prices gives us Gross
Domestic Product.

Measuring GDP Method 3 — The Output

Or Value Added Approach
This approach measures GDP by summing the
value of output in each sector of the economy.
GDP is broken down into broad product
categories e.g. construction, agriculture. GDP
then equals the value added in each sector.
Value Added: is the value of a firm’s output
minus the value of intermediate goods bought
from other firms. Final Goods: are goods
consumed by the final user (either consumed
all at once or over time if investment goods).
Intermediate Goods: are goods which firms
use in the production of other goods and
services (note they are not “consumed”, but
“used”). The value added also equals the sum
of incomes paid to the factors of production

30
used by a firm to produce its output. We use
value added to avoid double counting
expenditure on both intermediate and final
goods.
– The following example about a loaf of bread
illustrates how value added works:
1. The farmer grows wheat by hiring labour,
capital equipment, and land, and paying
wages, interest, and rent, and receiving a
profit.
2. The entire value of the wheat produced is
the farmer’s value added.
3. The miller buys the wheat from the farmer
and turns it into flour.
4. The miller hires labour and capital
equipment to do so, and pays them wages,
interest, and retains a profit.
5. The value added by the miller is the
difference between the price of the flour paid
by the baker, and the price the miller paid for
the wheat.
6. Finally, the consumer buys a loaf of bread
from the grocer and the purchase price is the
some of the value added of the farmer, the
miller, the baker, and the grocer. Where in
practice, the value added of all final goods and

31
services is added together, which gives us the
output measure of GDP.

Weaknesses of GDP as A Measure of

Welfare
Some weaknesses of the current measure of
GDP (either the expenditure or factor incomes
approaches) as a welfare measure include the
following:
1) Measures only output that is traded in
markets; e.g. restaurant meals and day-care
services are included in GDP, but meals made
at home and home-care of children are not
included in GDP. Statistics of certain countries
estimated that household production of final
goods and services equalled 40% of measured
national GDPs.
2) Does not include illegal activities; e.g.
smuggling rare objects, some forms of
gambling, prostitution, and drugs. These are
final goods and services consumed by people,
even if they are illegal.
3) Does not include pollution, or other
externalities; e.g. effects of acid rain, water
pollution, or smog. Each of these factors either

32
directly lowers our welfare now, or is
“negative production” in the sense that part of
our environment has been destroyed.
4) Does not include the value of leisure to
people; e.g. if a person works, this contributes
to GDP, but if the person decides to choose
leisure, then it is not counted in GDP even
though increased leisure does make us better
off!
5) GDP misses out or mislabels some forms of
investment; e.g. human capital is an important
part of our capital stock, but investments in it
(education, training) are not necessarily
included, or may not be included in the
appropriate category. Example, some
consumption items, such as government
spending, may be capital items. These items
directly add to our productive capacity and
potential for increases in welfare in the future,
but are not accounted for by GDP as it is
measured.
6) It is a flow measure, so it is not an accurate
indicator of our productive capacity; e.g. if an
earthquake wiped out certain city (town) in
Ethiopia; we would lose a large part of our
capital stock, and therefore be less productive
in the future even though Ethiopia’s GDP

33
would likely increase as people and firms
rebuilt what had previously existed, and we
would definitely not be better off than before
the earthquake.

4.3 The Business Cycle

Economists use real GDP to measure the state
of the economy as it passes through the
business cycle:
– Business Cycles: are the periodic but
irregular up-and-down changes in output,
inflation rates, interest rates etc. Business
cycles are measured as the difference of actual
real GDP from trend real GDP where trend
real GDP is the long-term, or average, growth
rate of real GDP. Other terms that you may
come across and should know relating to the
economy’s movement through the business
cycle are:
– Contractionary Phase: occurs when the
output growth rate is falling.
– Expansionary Phase: occurs when the output
growth rate is increasing.
– Trough: is the point at which output growth
is at its lowest during a business cycle. This is
the turning point between the contractionary
and expansionary phases.

34
– Peak: is the point at which output growth is
at its highest during a business cycle. The
turning point between the expansionary and
contractionary phases.
– Recessions: occur when real output, as
measured by GDP, falls for two consecutive
quarters.
– Depression: is a severe trough; and we can
see how the relate to each other with the
following graph:

4.4 Application: Housework And GDP

• Source: Baumol and Blinder,
Macroeconomics, (6th ed.), p. 111.
The Issue:
GDP does not measure all of the final goods
and services produced in an economy, only
goods and services traded in markets. We
would like the total value of goods and
services produced in an economy, not just the
amount traded in markets. Some problems
with using only traded goods and services as a
measure of output are:
– 1) Inaccurately Measuring the Effects of
Economic Fluctuations — if measured GDP
decreases during a recession, maybe non-

35
market production increases (=> recession is
not so bad from a welfare perspective).
– 2) Inaccurately Measuring the Rate and
Benefits of Economic Growth — measured
GDP may increase a lot over time, but maybe
non-market production has steadily decreased
over time (⇒ the rate of economic growth is
not growing nearly as fast as is thought).
– 3) Inaccurately Comparing the Welfare of
People in Different Countries — much
economic activity in developing countries is
not traded on markets cf. developed countries
(=> GDP overstates welfare gap between
people in the two groups of countries).

The Analysis:
The major problem is how to measure the
value of output produced in the non-traded
sector, because prices are not available. The
article mentions two methods:
1) The opportunity cost of the resources
involved (using the foregone earnings given
up by the affected resources). If you spend an
hour cooking, you could have spent that hour
in employment in the market sector and so the
value to you of the hour of cooking must then

36
be at least as much as the wages foregone.
This can result in an inaccurate measure
of non-traded output because an hour of
cooking by an accountant would be valued
considerably more highly than an hour of
cooking by a general labourer (or university
lecturer!) even though in the market sector the
value of output is price times quantity, and the
above is assuming different prices for the same
good! The problem is that the opportunity cost
measure is not a true measure of “the next best
foregone alternative” or equally it is not
measuring total surplus as we use with demand
curves in microeconomics. Why? Consider
why an accountant would cook a meal. It is
probably better for them to work an extra hour,
get the hour’s pay, and then use some of it to
hire a maid to cook a meal, or buy one at a
restaurant. Say the accountant works forty
hours a week. It seems unlikely that their
employer will let them work 47 hours to take
advantage of the above situation (jobs are
typically lumpy in the hours we can work so
that we cannot just say what hours we will
work). The best foregone alternative is not the
wage paid to an accountant, it is the part-time

37
job they can find, and the wage for this may be
a lot lower than their normal wage.
2) Use market prices of the resources which
have uses in the market sector that are similar
to those uses in the non-market sector. An
hour of cooking at home could be measured
using the hourly wage paid to a junior cook in
a restaurant. Each unit of output, say an hour
of cooking, is measured the same as any other
unit of output, as in the market sector. This
may understate the value of the hour of
cooking at home compared to a restaurant
because the price of a restaurant meal equals
the marginal and fixed costs of making the
meal (labour, management, capital). The meal
at home costs more than just the labour
involved, it also should include the cost of the
capital involved, the electricity (or gas) used
etc.

Summary:
1) Household production in developed
countries type countries ranges from 1/3 to a
1/2 of market output as measured by GDP.
2) The value of household production seems to
be increasing at the same rate as market based

38
production, because they both enjoy the same
benefits of technological advances.
3) There is some evidence that the growth rate
of household production increases when the
growth rate of market based production
decreases.
4) The key issue is whether or not there is a
serious mis-measurement problem; it turns out
that the answer is yes.

4.5 Application: GDP As A Measure Of

Welfare
Source: The Press, 11 February, 1997, p. 4;
and Australian Financial Review, 2
July, 1997.
The Issue:
People are interested in comparing the welfare
of people across countries and over time and
tend to use real GDP (a measure of output
produced in the current period) to do this
because it is one the few standardised
international measures relating to output and
we tend to assume that output is related to
welfare. For example, in the articles in
question we could use GDP per capita (or per
capita income) of residents of Christchurch or
Australia. There are some, though, who think

39
that GDP is not a good measure of people’s
welfare. The Christchurch City Council
believes that there are no informative
measures of the quality of life. People in
Australia believe that using GDP gives a
distorted view of what has happened to
people’s welfare. So what is the answer to this
question? Is GDP a good measure of people’s
welfare? And, if not, what can we do about it?

The Analysis:
There are reasons to think that GDP may not
give an accurate measure of the welfare of
people (this is the “quality of life” or “national
well-being” mentioned in the articles):
– 1) Externalities — GDP per capita may miss
out externalities such as pollution or
congestion.
– 2) Non-Trade Goods and Services — per
capita income may miss out goods and
services produced in non-market activities
such as crime (a bad) or volunteer work.
– 3) Flows Versus Stocks — repairing
environmental damage will add to GDP (a
flow), but it is cancelled out by the damage
originally done, so the state of the
environment (a stock) reverts back to its

40
original level and net welfare has not changed
even though GDP has increased.
– 4) Distribution of Income — it may be that
we care about additions to poorer people’s
income more than we care about additions to
richer people’s income which then raises the
issue of how to aggregate peoples welfare into
social welfare. So why not simply account for
these factors just mentioned? It turns out that
there are several fundamental difficulties in
actually measuring people’s welfare, some of
which we will now explore.
1) How do we measure the environment stock?
– We can measure pollution by say particles of
contaminants per cubic cm and compare it to
the world health standard then there is the
difficulty of converting differences between
the level of pollution here and the WHO
standard into dollar terms measuring it as a
“bad”. One way may be to work out the value
of a human life (how?) and determine how
much the pollution reduced this value, times
the number of people affected. Another way is
to look at associated health problems (asthma,
lung cancer etc), the medical costs involved
and use this as the measure of the bad but then
this would not include things like the potential

41
shortening of people’s lifespans. There is no
easy solution to this question.

2) How do we measure externalities?

– Road Congestion: could be measured by the
number of people delayed, times the amount
of time people are delayed due to the
congestion, times the wage rate they earn, or
maybe the per capita wage, to avoid the
measuring of the same “bad” with different
“prices”. This would be a costly thing to do
(maybe sampling techniques should be used)
and then there is the issue of whether this truly
measures the (negative) value of the “bad”?
– Privacy: we would expect that if a city has a
higher population maybe people have less
privacy (smaller properties) overall and this
should be reflected in the prices of houses vis-
a-vis other centres, although it probably only
makes up a small bit of the overall price of a
house. The issue then is how do you separate
out the bit of the house price change due to
increase/decrease of privacy and that due to
other factors?!
3) How do we measure social welfare?

42
– We may care about the distribution of
income, but then how do we weight the
incomes of rich and poor, especially since
different people may differ on the weights!
4) How do we measure non-market activity?
– We have already seen from the first article
that this is difficult to do. There are lots of
other things can thought about too, including
measuring traded goods and services that are
presently not measured such human capital.
Using GDP as a measure of welfare when it is
severely flawed for this purpose may cause:
– Incorrect evaluations of the effects of
government policies.
– A bias towards policies that increase GDP
even though they in fact reduce people’s
welfare.

Summary:
1) Measuring welfare of people is a hard thing
to do and the simple truth is that we do not
have a good way of measuring welfare.
2) There is some evidence that welfare has not
gone up by nearly as much as is indicated by
GDP because of factors such as:
– Pollution (a bad).
– Crime (a bad).

43
– Unemployment (a bad).
– Increased life expectancy (a good — but is
this a measure of the quality of life?).
3) GDP is not a measure of people’s welfare
and so we should be careful of people using it
like this.

5. The Labour Market

The quantity of labour employed is an
important macroeconomic input, and the state
of the labour market directly affects us and can
have serious political consequences, especially
given the costs of unemployment which are:
1. Loss of output
What relationship should we expect to find
between unemployment and real GDP?
Because employed workers help to produce
goods and services and unemployed workers
do not, increases in the unemployment rate
should be associated with decreases in real
GDP. This negative relationship between
unemployment and GDP is called Okun’s
law, after Arthur Okun, the economist who
first studied it. According to Okun’s Law,
unemployment falls (rises) when real GDP
grows faster (slower) than potential output. Or
Okun’s law states that the deviation of output

44
from its natural rate is inversely related to the
deviation of unemployment from its natural
rate; that is, when output is higher than the
natural rate of output, unemployment is lower
than the natural rate of unemployment. From
any one year to the next, the very simple
equation
Percentage change in real GDP=
percentage growth in potential output – (2.5 x
percentage point change in unemployment
rate)

fits the data very well. Okun’s Law shows that

specifically in the United States a 1-
percentage-point fall in unemployment is
associated with an extra 2.5 percentage points
of growth in real GDP. For example, in a year
in which potential output grew 2.5 percent and
unemployment fell by 1 percentage point, real
GDP would grow by full 5 percent. Because of
Okun’s Law, if you know what is happening to
real GDP relative to potential output, you have
a good idea of what is happening to the
unemployment rate, and vice versa. Okun’s
Law can be represented by the following
equation:

45
2. Loss of income.
3. Loss of human capital.
4. Increase in crime.
5. Loss of human dignity.
As a result, we want to know something about
the labour market.
5.1 Employment and Unemployment
First we need to know the following
definitions:
– Working Age Population: equals the number
of civilians who are fifteen years or older.
– Unemployment: consists of the number of
working age people who are available for
work at the going wage rate, but who do not
have jobs.
– Labour Force: is the number of working age
people unemployed plus the number of people
employed; and we calculate the unemployment
rate as follows:
Unemployment rate = (no. unemployed/no. in
the labour force)× 100.

Example: Suppose at the end of September

2003 for Ethiopia in 000s
– working age population = 3,044
– Unemployed = 88
– employed = 1,939

46
– labour force = unemployed + employed =
2,027
– Number not in the labour force = (working
age population - labour force) = 1,017
Unemployment rate = (88/2027)× 100
= 4.4%
We can classify unemployment by the three
ways in which someone can become
unemployed:
– Frictional Unemployment: occurs from
normal market activity such as the closing of
existing firms and starting of new firms, and
people entering and leaving the labour force.
Students who have finished their studies and
are looking for a job are frictionally
unemployed.
– Structural Unemployment: arises when there
is a long-term decline in the number of jobs in
a particular region or industry or when there is
a mismatch between the skill of a given group
of labour and the technology. (Hence, there is
a structural problem)
– Cyclical Unemployment: occurs due to the
effects of the changing growth rates of output
e.g. high unemployment usually occurs when
output is growing slowly.

47
5.2 Measuring Unemployment
Unemployment is officially measured using
the Household Labour Force Survey (HLFS);
in Ethiopia conducted by Central Statistical
Authority (CSA). An individual is said to be
unemployed if the answer to either 1) and 2) or
1) and 3) is yes:
1) If they would like a job but do not have one.
2) If they have actively sought work in the last
four weeks.
3) If they have a job to start within four weeks.
If a person does not have a job and has not
actively sought work in the last four weeks,
then they are considered to be out of the labour
force (e.g. stay-at-home parents and university
students).
Weaknesses of HLFS as A Measure of
Unemployment
1) Does not measure under-employment.
A part-time worker may wish to work more
hours at the going wage rate, but be unable to
do so. This person will be measured as
employed, although there is an unemployment
element present as well.
2) Includes people with unrealistic wage
expectations.

48
A person who has no educational qualification
may be seeking employment, not have a job,
but expect to be paid $50 an hour. They are
measured as unemployed, but it does not make
sense to count this person as unemployed as
they are not willing to work given the current
conditions.
3) Does not include discouraged workers.
Some people spend a great deal of effort
looking for work but eventually give up,
believing that there is no work available for
them. These people are called discouraged
workers and are not measured as unemployed.
The official measure of unemployment may
thus understate the actual level of
unemployment.

6. The Price Level

An economic variable that has been found to
be important in understanding the behaviour of
aggregate economies is the average level of
prices, or price level. Price Level: is a
weighted average of all of the prices of all of
the goods and services produced in an
economy. Unlike microeconomics it is not a
relative price of a single good or service and is
a nominal variable, unlike the relative prices

49
you use in microeconomics which are real
variables.
6.1 Measuring the Price Level
The average level of prices, or price level, is
measured by a price index. We will look at
two commonly used price indices.
Price Level Measure 1 — Consumer Price
Index
One commonly used price index is the
Consumer Price Index. This index measures
the average level of prices of goods and
services typically consumed by an Ethiopian
family. It is based on the spending patterns of
households. Note that rural and urban
consumer price indices might be calculated
separately and since the consumption pattern
of households in rural and urban areas are
different the calculated indices could be
different. The following table presents a
simple example of calculating such an index,
the inflation rate in this economy is 14 percent.

50
Weaknesses of the CPI as a Measure of the
Average Level of Prices
1) It does not capture substitution effects.
The CPI is based on a fixed basket of goods
and services, but the actual basket changes
over time (eg. if the price of chicken increases
compared to beef, then people substitute beef
for chicken). The effects of the price increase
are mitigated to some degree but this is not
picked up in the CPI.
2) It can miss changes in the basket of goods.
Some goods disappear, while others appear.
The CPI misses these changes (e.g. CDs would
not have been included in the CPI for many
years after they became available and I wonder
if DVDs are included at all.
3) It does not incorporate the effects of quality
improvements.
The quality of many goods increases over time
which affects their prices (e.g. moving from
black and white to colour TV). This would not
be picked up in the CPI, overstating increases
in the average level of prices. It is also worth
pointing out that the CPI measures the average
level of prices, not changes in the relative
prices of goods and services. It can be the case
that even if all prices increase, there are no

51
changes in the relative prices of the goods. It
can also be the case that the relative prices of
goods change without there being any inflation
or deflation.
Price Level Measure 2 — GDP Deflator
Another measure of the average price level is
the GDP deflator. This index measures the
average level of prices of all goods and
services that make up GDP (including
investment and consumption goods not in the
CPI). A simple example showing how the
GDP deflator is calculated is presented in
Table 2. The inflation rate for this economy is
2.4 percent.

Thus nominal GDP for this period is $13,420

and real GDP for this period is $13,110. If we
had the quantities for the base period we
would work out real GDP for the base period
and see how the economy has grown or shrunk
over the time period in question.

52
Weaknesses of the GDP Deflator as a
Measure of the Average Level of Prices
1) It understates increases in the cost of living.
The GDP Deflator is based on the current
basket of goods and services, with the basket
changing over time (e.g. it does record that
people substitute between goods and services
when their prices change). What it does not
capture is that in substituting from a more
expensive good to others, that welfare may be
lost because of an overall increase in the cost
of living.

6.2 Inflation
Of particular importance to economists is
studying the rate of change of the price level,
which can take one of three forms:
– Inflation: is the upward movement in the
average level of prices.
– Deflation: is the downward movement in the
average level of prices.
– Price Stability occurs when the average level
of prices is moving neither up nor down; and
we calculate the inflation rate in the following
way:

53
One reason alone for trying to understand what
can happen to the price level and why is that
inflation affects the value of money, where the
value of money is the amount of goods and
services that can be purchased by a given
dollar (or nominal) amount of money. If
inflation exists, then money is losing value
(i.e. it is worth less in real terms) which is
actually another form of government tax –
here it is the inflation tax, or a tax on people’s
money holdings.

6.3 Application: Statistical Guessing Games

• Source: The Economist, 7 December, 1996,
pp. 37-38.
The Issue:

54
• The CPI as measured overstates the true cost
of living and the issues are:
– Why does the CPI overstate the true cost of
living?
– What are the implications from the CPI
overstating the true cost of living?
– What can be done about this matter?
The Analysis:
• Why does the CPI overstate the “true” cost-
of-living? There are several possible reasons:
1. The CPI does not take into account
substitution effects arising from price
increases. Say the price of beef goes up, then
people switch to buying more lamb or chicken,
so the cost of living does not increase by as
much as the initial price increase.
2. The CPI does not measure all prices in all
shops and is only calculated using samples of
prices from various locations from various
shops. In the US, at least, the samples do not
include prices of goods sold in discount shops,
which causes the CPI to overstate increases in
the cost of living.
3. The CPI does no take into account quality
improvements. Say firms add more features to
a good and charge the old price. In fact the
price per feature has fallen, but this is not

55
reflected in the CPI. The CPI doesn’t
distinguish between a price increase caused by
the same good being sold at a higher price, or
a good with more features sold at a higher
price to reflect the cost of the new features.

What are the implications of using a measure

that overstates the true cost-of-living? For the
US (and thus the same types of problems will
occur with other countries) the implications
are as follows:
1. The CPI overstating the cost of living could
lead to the possible understatement of the rate
of growth of output Recall that essentially
GDP = P × Q, where P is price and Q is
quantity. People have a measure of GDP and
try and estimate P and then “back-out” a
measure of Q. If P is overstated then for a
given level of GDP Q will be understated and
thus it will be though that people are not as
well off as they actually are. Say nominal GDP
grew by 5%. Say scenario 1 has P increase by
4% and Q increase by 1% (these are
approximate figures, but will do here) and
scenario 2 has P increase by 1% and Q
increase by 4%. They both add up to 5%, but
people are much better off under scenario 2

56
than scenario 1, as they have more goods and
services to consume. It also affects
measurements of labour productivity
measured, which, in simple terms, equals Q/L,
where L is labour input. Under scenario 2,
growth in labour productivity is much higher
than in scenario 1. This has implications for
the macroeconomic policies related to growth
and industrial R&D policies that are put in
place and how they are evaluated in terms of
their effectiveness.
2. Inaccurate measurement of the cost of living
affects government expenditures because of
indexation of social welfare benefits with the
cost of living. Such payments make up 1/3 of
US Federal Government budget so they are
significant. If the measure of the cost of living
overstates actual increases, then the
government will increase the benefits more
than necessary and so there will be an
unintended transfer of income from taxpayers
to beneficiaries.
3) Inaccurate measurement of the cost of
living may affect government revenue because
of indexation of tax rates with cost of living
(so that bracket creep does not occur). If tax
rates are increased by more than the increase

57
in actual cost of living, then taxpayers will pay
less tax than intended as they will be kept in
lower tax brackets because the marginal tax
rate brackets are inflated more than the actual
cost of living.
4) Incorrect monetary policies. Since the
Reserve Bank uses a measure of the CPI to
judge the performance of its policies which
then affects its monetary policy actions it
could be misled as to the true state of the
economy and undertake the wrong policies.

What can be done about the matter?

Unfortunately there is no easy answer as there
is no one right way to calculate a price index.
Adjustments for some of the factors mentioned
above could be attempted; more resources
could be devoted to collecting information for
the price index, etc.

Summary:
1) The CPI is believed to overstate increases in
the cost-of-living in the US by 0.8% to 1.6%.
For example, say the CPI measured a 4%
increase in the cost of living, then the actual
cost of living would have increased by only
2.4% to 3.2%.

58
2) Inaccurately calculating cost-of-living
indices can have important consequences.
Inaccurately calculating the true cost-of-living
could cost the US Treasury over US$630
billion over the next decade more than they
anticipated because of indexation of benefits
and tax rates to cost of living! In NZ,
inaccurately calculating the cost-of-living
could cause “incorrect” levels of benefits,
student allowance levels, income tax ranges,
etc set by the government and “incorrect”
monetary policy by the RBNZ.
3) Calculating price indices is not easy as there
is no one correct way to weight the prices of
the different items to make an index.

7. International Relations
People in countries exchange goods and
services and assets with people in other
countries and the Balance of Payments
measures a country’s transactions with the rest
of the world. There are two parts to the BOP:
1). Current Account: which measures all goods
and services transacted between a country’s
residents and residents from the rest of the
world including: Exports of goods and
services to foreign countries, imports of goods

59
and services from foreign countries, and
interest payments on overseas debt.
2). Capital Account: which measures all asset
transactions between a country’s residents and
residents from the rest of the world including:
Foreigners buying the shares of Ethiopian
companies, Changes on overseas debt of
Ethiopia.
Ex-ante, the capital account balance is exactly
equal to the current account balance, but with
the opposite sign, when the domestic economy
is in equilibrium with foreign economies. Ex-
post, the capital account balance is always
equal to the current account balance, but with
the opposite sign, even if the domestic and
foreign economies are not in equilibrium. This
is because the recording of the changes in
flows must equal the recording of the changes
in stocks because of the existence of
accounting identities. In practice, it is very
difficult to measure all capital flows
accurately.
Other terms used in the area of international
relations which you should know are:
– Visibles: are exports or imports of goods in
the current account.

60
– Invisibles: are transfers, exports and imports
of services, as well as payments and receipts
of international investment income (e.g.
dividends, and interest); and note that transfers
are also included in the current account (e.g.
foreign aid payments, gifts etc.)
– Terms of Trade: equals the ratio of the index
of export prices to the index of import prices.

8. The Public Sector

Whether a person agrees with it or not, modern
governments intervene a great deal in national
economies and thus we need to know
something about them.
8.1 Government Revenue and Spending
An important economic variable relating to
government activity is the Government Budget
Balance:
Government Budget Balance: equals total
government revenue less total government
spending.
Government Budget Deficit: occurs when the
government spends more than it receives in
revenue.
Government Budget Surplus: occurs when
government revenue exceeds what it spends;
where revenue and spending are calculated

61
using standard accounting practices instead of
the cash flow basis that was used for many
years in the past.
Government Revenue
Government revenue comes mainly from:
Income taxes, Indirect taxes (e.g. sales tax,
excise taxes on petrol, cigarettes, or alcohol),
State owned enterprises (SOE) income (e.g.
Airways Corporation) and income on other
investments, taxes on companies, etc.
Government Spending
Government expenditure is mainly in the form
of:
Purchases of goods and services (e.g.
education or health), transfer payments or
social welfare (e.g. unemployment, sickness,
and family benefit), interest payments on
government issued debt, etc.

8.2 Government Assets and Liabilities

When a government runs a deficit it usually
causes an increase in government issued debt
and when it runs a budget surplus it usually
causes government issued debt to fall. A
budget deficit or surplus may not affect
government issued debt if the government
sells or buys assets. The full range of assets

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and liabilities the government has at its
disposal are detailed below.
Government Assets
The sorts of assets held by the government are:
Physical assets include government owned
land, building, and equipment, military
equipment, national parks, the electricity
network, forests, state highways etc;
Ownership of Commercial Organisations (the
SOEs and the like); financial assets from
monies the government has saved in various
funds relating to future liabilities, etc; and
other investments such as student loans.

Government Liabilities
The sorts of liabilities facing the government
are: Debt from past borrowings, Pension, and
other liabilities. And note that there is a lot of
uncertainty with respect to the liabilities, (e.g.
pensions involve demographic and interest rate
assumptions in which small changes can have
big effects).
9. Conclusion
1. Macroeconomics is the study of two key
issues and everything in macroeconomics
centres around these two issues: what causes

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the aggregate economy to grow over time and
what causes the aggregate economy to
experience fluctuations?
2. Trying to understand the aggregate
economy is hard because we are talking about
studying the whole economy, which is very
complex. We try and simplify matters to make
sense of the aggregate economy, but this can
lead to the aggregation problem. The “trick” is
to find a good balance between simplifying
and missing out too much. Our success or
failure at understanding the aggregate
economy is usually determined empirically.
– Are the assumptions used “sensible”?
– Testing theories against data to see if the
theories are consistent with what we observe
people actually do.
– How well can we accurately forecast the
future?
3. Measuring the aggregate economy is hard
since while we have clear definitions about
what we want to measure to see if we
understand the world, our ability to actually
measure people’s economic behaviour is
severely limited. We muddle along doing the
best we can!

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4. We are making progress and for a young
discipline we have learnt a lot in a short space
of time, but there is still a lot we do not know.
This course is designed to show you with
regards to macroeconomics:
– What we know.
– What we don’t know.
– How we go about gaining understanding and
knowledge.

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