Microeconomics and Macroeconomics

Microeconomics – Examines the functioning of individual industries and the behavior of

individual decision-making units – firms and households.

Macroeconomics – Deals with the economy as a whole. Macroeconomics focuses on the

determinants of total national income, deals with aggregates such as aggregate consumption and
investment, and looks at the overall level of prices instead of individual prices.

Aggregate behavior – The behavior of all households and firms together.

Important Issues in Macroeconomics

Macroeconomics – The study of the economy as a whole, addresses many topical issues:
o What is the government budget deficit?
o How does it affect the economy?
o Why does the Philippines have such a huge trade deficit?
o Why are so many countries poor?
o What policies might help them grow out of poverty?

Why learn Macroeconomics?

1. The macroeconomy affects society’s well-being
➢ Increase in the unemployment rate is associated with:
o Suicides
o Homicides
o Increases in the population of state mental institutions
o More people sent to state prisons
o More deaths
o Increases in domestic violence and homelessness
2. The macroeconomy affects your well-being
 3. The macroeconomy affects politics.

Unemployment & inflation in election years

Year U rate Inflation rate Elec outcome
1976 7.7 5.8 High Carter (D) Ford loses
1980 7.1 13.5 High Reagan (R) Carter loses
1984 7.5 4.3 Low Reagan (R) wins
1988 5.5 4.1 Bush I (R) wins
1992 7.5 High 3.0 Clinton (D) loses
1996 5.4 3.3 Clinton (D) wins
2000 4.0 3.4 Bush II (R) wins
2004 5.5 3.3 Bush II (R) wins

Understanding Macroeconomics
We will use the circular flow of output and income between the business and household
sectors to illustrate macro-economic inter-relationships.

The Circular Flow Diagram

➢ Four key markets coordinate the circular flow of income
o Resource market:
coordinates actions of
businesses demanding
resources and households
supplying them in exchange
for income.
o Goods & services market:
coordinates the demand for
and supply of domestic
production (GDP).
o Foreign exchange market:
brings the purchases
(imports) from foreigners
into balance with the sales
(exports plus net inflow of
capital) to them.
o Loanable funds market:
brings net household saving
& net inflow of foreign
capital into balance with
borrowing of businesses and
governments.

Macroeconomic Concerns
Macroeconomics considers the performance of the economy as a whole.
We try to understand changes in
o The rate of economic growth (Output growth)
 o The rate of inflation or deflation
o Unemployment
o Our trade performance with other countries
Macroeconomics also includes an evaluation of the relative success or failure of government
economic policies.

Macroeconomic Concerns: Output Growth

o Business Cycle – The cycle of short-term ups and downs in the economy.
o Aggregate Output – The total quantity of goods and services produced in an economy in
a given period.
o Recession – A period during which aggregate output declines. Conventionally, a period in
which aggregate output declines for two consecutive quarters.
o Depression – A prolonged and deep recession.

Expansion and Contraction : The Business Cycle

➢ An Expansion or boom is the

period in the business cycle from
a trough up to a peak during
which output and employment
grow.
➢ A Contraction, recession, or
slump is the period in the
business cycle from a peak down
to a trough during which output
and employment fall.
Macroeconomic Concerns: Output Growth

Economic Growth
Unemployment
➢ The unemployment rate is the percentage of the labor force that is unemployed.
➢ The unemployment rate is a key indicator of economy’s health.
➢ The existence of unemployment seems to imply that the aggregate labor market is not in
equilibrium. Why do labor markets not clear when other markets do?

Macroeconomic Concerns: Inflation and Deflation

o Inflation: is an increase in the overall price level.
o Hyperinflation: is a period of very rapid increases in the overall price level.
o Deflation: is a decrease in the overall price level. Prolonged periods of deflation can be
just as damaging for the economy as sustained inflation.
o Stagflation: occurs when the overall price level rises rapidly (inflation) during periods of
recession or high and persistent unemployment (stagnation).

A Brief History of Macroeconomics

o Great Depression – The period of severe economic contraction and high unemployment
that begun in 1929 and continued throughout the 1930s.
o Fine-tuning – The phrase used by Walter Heller to refer to the government’s role in
regulating inflation and unemployment.
o Stagflation – A situation of both high inflation and high unemployment.

The Roots of Macroeconomics

The Great Depression was a period of severe economic contraction and high
unemployment that begun in 1929 and continued throughout the 1930s.

In 1936, John Maynard Keynes published The General Theory of Employment,

Interest, and Money.

Keynes arguments:
o The level of output and employment in an economy is determined by the aggregate
demand (AD)
o Governments could intervene in the economy and affect the level of output and
employment.
Two important objectives of macroeconomics policies:
o Sustained growth in GDP
o Price Stability
The U.S. Economy Since 1970

John Maynard Keynes

Much of the framework of modern macroeconomics comes from the works of John
Maynard Keynes, whose General Theory of Employment, Interest and Money was published in
1936.

Inflation
We measure the inflation rate as the percentage change in the average level of prices or
the price level.
The Consumer Price Index (CPI) – is a common measure of the price level used to
calculate inflation.
An alternative measure of inflation, called “core inflation” uses the CPI in its construction,
except the price index used to construct core inflation does not include any food or energy prices
(which tend to be fairly volatile).
 Inflation in the United
States
o Inflation rate in the
United States since 1961.
o Inflation was low
during the 1960s.
o Inflation increased
during the 1970s.
o Inflation was lowered
in two waves during the
1980s and 1990s.

Inflation Around the World

o Inflation rate in the
United States compared
with other countries.
o U.S. inflation has
been similar to that in other
industrial countries

Jobs and Unemployment

Why Unemployment is a Problem?

➢ Unemployment is a serious economic, social, and personal problem for two main reasons:
o Lost production and incomes
o Lost human capital
➢ The loss of a job brings an immediate loss of income and production – a temporary
problem.
➢ A high unemployment rate means economy is not achieving its full economic potential.
➢ A prolonged spell of unemployment can bring permanent damage through the loss of
human capital.
Macroeconomic Goals: Low Unemployment

Unemployment Around the World

o Unemployment rate in the United

states with those in Western
Europe, Japan, Canada and the
United Kingdom.
o In the 1960’s – 1970’s, U.S.
unemployment, on the average,
was higher than the other
countries shown.
o More recently, US
unemployment has declined
relative to the other countries.
Employment and the Business Cycle
When firms produce more output, they hire more workers – when they produce less output,
they tend to lay off workers.
o We would thus expect real GDP and employment to be closely related, and indeed they
are
Business Cycles
o Fluctuations in real GDP around its long-term growth trend
Expansion
o A period of increasing real GDP
Contraction
o A period of declining real GDP

Unemployment
o Unemployment is a state in which a person does not have a job but is available for work,
willing to work, and has made some effort to find work within the previous four weeks.
o The labor force is the total number of people who are employed and unemployed.
o The unemployment rate is the percentage of the people in the labor force who are
unemployed, key indicator of economy’s health.
o A discourage worker is a person who is available for work, willing to work, but who has
given up the effort to find work.

Economic Growth
➢ Economists monitor economic growth
o By keeping track of real gross domestic product (real GDP)
o Total quantity of goods and services produced in a country over a year.
➢ Although output has grown, rate of growth has varied over the decades
➢ Over long periods of time small differences in growth rates can cause huge difference in
living standards
➢ Economists and government officials are very concerned when economic growth slows
down
➢ Macroeconomics helps us understand a number of issues surrounding economic growth
➢ Countries with the highest overall economic standard of living have the freest markets
(more elements of capitalism).
o Examples: Hong Kong, the United States, Japan, Taiwan, Great Britain, Canada,
Sweden, South Korea, and Singapore.
o
Economic Growth and Fluctuations
➢ Potential GDP is the value of real GDP when all the economy’s labour, capital, land, and
entrepreneurial ability are fully employed.
➢ During the 1970s and early 1980s, real GDP growth slowed – a productivity growth
slowdown.

Government in the Macroeconomy

➢ There are three kinds of policy that the government has used to influence the
macroeconomy:
o Fiscal Policy – refers to government policies concerning taxes and expenditures.
 o Monetary Policy – consists of tools used by the Federal Reserve to control the
money supply.
o Growth or Supply-Side Policies – are government policies that focus on
stimulating aggregate supply instead of aggregate demand.

Functions of an Economy
An economy is a complex arrangements of many different buyers and sellers – households,
businesses, government, and the rest of the world – and of their interactions with each other.
An economy employs various resources to produce a variety of goods and services for
domestic and world consumption, and provides income for the resources.

The Components of the Macroeconomy

➢ The circular flow diagram shows the income received and payments made by each sector
of the economy
➢ Everyone’s expenditure go somewhere. Every transaction must have two sides.

➢ The Circular Flow of Payments

o Households receive income from
firms and the government,
purchase goods and services
from firms, and pay taxes to the
government.
o They also purchase foreign-made
goods and services (imports).
o Firms receive payments from
households and the government
for goods and services; they pay
wages, dividends, interest, and
rents to households and taxes to
the government.
o The government receives taxes
from firms and households, pays
firms and households for goods
and services—including wages to
government workers—and pays
interest and transfers to
households.
o Finally, people in other countries
purchase goods and services
produced domestically (exports).
o Note: Although not shown in this
diagram, firms and governments
also purchase imports.
The Three Market Arenas
➢ Households, firms, the government, and the rest of the world all interact in the goods-
and-services, labor, and money markets.

➢ Households and the government purchase goods and services (demand) from firms in the
goods-and-services market, and firms supply to the goods and services market.
➢ In the labor market, firms and government purchase (demand) labor from households
(supply).
o The total supply of labor in the economy depends on the sum of decisions made by
households.
o In the money market—sometimes called the financial market—households purchase
stocks and bonds from firms.
Households supply funds to this market in the expectation of earning income, and also
demand (borrow) funds from this market.
Firms, government, and the rest of the world also engage in borrowing and lending,
coordinated by financial institutions.

Financial Instruments
o Treasury bonds, notes, and bills are promissory notes issued by the federal government
when it borrows money.
o Corporate Bonds are promissory notes issued by corporations when they borrow money.
o Shares of stock are financial instruments that give to the holder a share in the firm’s
ownership and therefore the right to share in the firm’s profits.
o Dividends are the portion of a firm’s profits that the firm pays out each period to its
shareholders.
Aggregate Supply and Aggregate Demand
o Aggregate demand is the total demand for goods and services in an economy.
o Aggregate supply is the total supply of goods and services in an economy.
o Aggregate supply and demand curves are more complex than simple market supply and
demand curves.
What are the Government’s Main Economic Objectives?
o Low inflation
o Steady and sustained growth
o High levels of employment
o Improvements in living standards
Main Objectives of Government Economic Policy
o The key elements of the Government strategy are:
o Delivering macroeconomic stability (a very broad macroeconomic aim)
o Meeting the productivity challenge ( an important supply-side target)
o Increasing employment opportunity fo all (a labour market objective)
o Ensuring fairness for families and communities (commitment to equity)
o Protecting the environment ( green economics has a macroeconomic dimension)

CHAPTER 21: Measuring National Output and National Income

Gross Domestic Product

Gross Domestic Product (GDP) is the total market value of all final goods and services
produced within a given period by factors of production located within a country.

Final Goods and Services

o The term final goods and services in GDP refers to goods and services produced for final
use.
o Intermediate Goods are goods that are produced by one firm for use in further processing
by another firm.
Value Added
Value Added is the difference between the value of goods as they leave a stage of
production and the cost of the goods as they entered that stage.
o In calculating GDP, we can either sum up the value added at each stage of
production or we can take the value of final sales.

Exclusions of Used Goods and Paper Transactions

GDP ignores all transactions in which money or goods changes hands but in which no
new goods and services are produced.

Exclusion of Output Produced Abroad by Domestically Owned Factors of Production

GDP is the value of output produced by factors of production located within a country.
Output produced by a country’s citizens regardless of where the output is produced is measured
by gross national product (GNP).
Calculating GDP
o The expenditure approach: A method of computing GDP that measures the total amount
spent on all final goods during a given period.

o The income approach: A method of computing GDP that measures the income—wages,
rents, interest, and profits – received by all factors of production in producing final goods.

The Expenditure Approach

➢ Expenditure Categories:
o Personal consumption expenditures (C): household spending on consumer goods
o Gross private domestic investment (I): spending by firms and households on new
capital, that is, plant, equipment, inventory, and new residential structures
o Government consumption and gross investment (G)
o Net exports (EX - IM): net spending by the rest of the world, or exports (EX) minus
imports (IM)
o The expenditure approach calculates GDP by adding together the four components
of spending. In equation form:
▪ GDP = C + I + G + (EX - IM)

Personal Consumption Expenditures

➢ Personal consumption expenditures (C) are expenditures by consumers on the following:
o Durable goods: Goods that last a relatively long time, such as cars and appliances.
o Nondurable goods: Goods that are used up fairly quickly, such as food and
clothing.
o Services: Things that do not involve the production of physical things, such as legal
services, medical services, and education.
Gross Private Domestic Investment
➢ Investment refers to the purchase of new capital.
➢ Total investment by the private sector is called gross private domestic investment. It
includes the purchase of new housing, plants, equipment, and inventory by the private
sector.
➢ Nonresidential investment includes expenditures by firms for machines, tools, plants, and
so on.
➢ Residential investment includes expenditures by households and firms on new houses and
apartment buildings.
➢ Change in inventories computes the amount by which firms’ inventories change during a
given period. Inventories are the goods that firms produce now but intend to sell later.
➢ Remember that GDP is not the market value of total sales during a period – it is the market
value of total production.
o The relationship between total production and total sales is:
▪ GDP = final sales + change in business inventories

Gross Investment versus Net Investment

➢ Gross investment is the total value of all newly produced capital goods (plant, equipment,
housing, and inventory) produced in a given period.
➢ Depreciation is the amount by which an asset’s value falls in a given period.
➢ Net investment equals gross investment minus depreciation.
▪ Capital end of period = Capital beginning of period + net investment

Government Consumption and Gross Investment

➢ Government consumption and gross investment (G) counts expenditures by federal, state,
and local governments for final goods and services.

Net Exports
➢ Net exports (EX – IM) is the difference between exports and imports. The figure can be
positive or negative.
o Exports (EX) are sales to foreigners of domestic goods and services.
o Imports (IM) are purchases of goods and services from abroad.

The Income Approach

➢ National income is the total income earned by the factors of production owned by a
country’s citizens.
➢ The income approach to GDP breaks down GDP into four components:
o GDP = national income + depreciation + (indirect taxes – subsidies) + net factor
payments to the rest of the world + other
From GDP to Disposable Personal Income
➢ Net national product equals gross national product minus depreciation; a nation’s total
product minus what is required to maintain the value of its capital stock.
➢ Personal income is the income received by households after paying social insurance
taxes but before paying personal income taxes.
Nominal Versus Real GDP
➢ Nominal GDP is GDP measured in current dollars, or the current prices we pay for things.
Nominal GDP includes all the components of GDP valued at their current prices.
➢ When a variable is measured in current dollars, it is described in nominal terms.

Calculating Real GDP

➢ A weight is the importance attached to an item within a group of items.
➢ A base year is the year chosen for the weights in a fixed-weight procedure.
➢ A fixed-weight procedure uses weights from a given base year.

Using the base year to compute real GDP is called “fixed weight procedure” because the weights
are the prices
❖ Example: real GDP in year 1 is $12.10 (column 5) and real GDP in year 2 is $15.10 (column
6).
❖ Recall, that both columns use year 1 prices and that nominal and real GDP are the same in
year 1 because year 1 is the base year.
❖ GDP has increased from $12.10 to $15.10, an increase of 24.8 percent [15.1 – 12.1 / 12.1]
x 100.

Using the fixed-weight procedure and year 2 as the base year, i.e., using year 2 prices as the weights
❖ Real GDP in year 1 is $18.40 (column 7) and real GDP in year 2 is $19.20 (column 8).
Note that both columns use year 2 prices and that nominal and real GDP are the same in
year 2 because year 2 is the base year. Real GDP has increased from $18.40 to $19.20, an
increase of 4.3 percent.
❖ Shows that growth rates can be sensitive to the choice of the base year – 24.8 percent using
year 1 prices as weights and 4.3 percent using year 2 prices as weights.
❖ BEA procedure simply picked one year as the base year and did all the calculations using
the prices in that year as weights.
The new BEA procedure makes two changes:
❖ take the average of the two years’ price changes, between 24.8 percent and 4.3 percent
which is 14.55 percent [24.8 + 4.3 / 2]
❖ The second BEA change is to use years 1 and 2 as the base years when computing the
percentage change between years 1 and 2, then use years 2 and 3 as the base years when
computing the percentage change between years 2 and 3, and so on.

GDP Deflator
➢ The GDP deflator is one measure of the overall price level.
➢ Overall price increases can be sensitive to the choice of the base year. For this reason, using
fixed-price weights to compute real GDP has some problems.

If we are interested in how the overall price level changes, we need to weight the individual prices
in some way

❖ The “bundle” price in year 1 is $12.10 (column 5) and the bundle price in year 2 is $18.40
(column 7). Both columns use year 1 quantities. The bundle price has increased from
$12.10 to $18.40, an increase of 52.1 percent.
❖ Use the year 2 as the base year, which means using year 2 quantities as the weights. Then
the bundle price in year 1 is $15.10 (column 6), and the bundle price in year 2 is $19.20
(column 8). Both columns use year 2 quantities. The bundle price has increased from
$15.10 to $19.20, an increase of 27.2 percent.
❖ Take the average and you get 39.65%.
❖ The series of percentage changes computed this way is taken to be the series of percentage
changes in the GDP deflator, that is, a series of inflation rates.

The Problem of Fixed Weights

➢ The use of fixed-price weights to estimate real GDP leads to problems because it ignores:
o Structural changes in the economy.
o Supply shifts, which cause large decreases in price and large increases in quantity
supplied.
o The substitution effect of price increases.

GDP and Social Welfare

➢ Society is better off when crime decreases, however, a decrease in crime is not reflected in
GDP.
➢ An increase in leisure is an increase in social welfare, but not counted in GDP.
➢ Nonmarket and household activities are not counted in GDP even though they amount to
real production.
➢ GDP accounting rules do not adjust for production that pollutes the environment.
➢ GDP has nothing to say about the distribution of output. Redistributive income policies
have no direct impact on GDP.
➢ GDP is neutral to the kinds of goods an economy produces.
The Underground Economy
➢ The underground economy is the part of an economy in which transactions take place and
in which income is generated that is unreported and therefore not counted in GDP.

Gross National Income per Capita

➢ To make comparisons of GNP between countries, currency exchange rates must be taken
into account.
➢ Gross National Income (GNI) is a measure used to make international comparisons of
output. GNI is GNP converted into dollars using an average of currency exchange rates
over several years adjusted for rates of inflation.
➢ GNI divided by population equals gross national income per capita.

UNEMPLOYMENT, INFLATION, AND LONG-RUN GROWTH

Unemployment : Measuring Unemployment

➢ Employed – Any person 16 years old or older
1) who works for pay, either for someone else or in his or her own business for 1 or
more hours per week
2) who works without pay for 15 or more hours per week in a family enterprise, or
3) who has a job but has been temporarily absent with or without pay.
➢ Unemployed – A person 16 years old or older who is not working, is available for work,
and has made specific efforts to find work during the previous 4 weeks.
➢ Not in the labor force – A person who is not looking for work because he or she does not
want a job or has given up looking.
➢ Labor force – The number of people employed plus the number of unemployed.
o labor force = employed + unemployed
o population = labor force + not in labor force
➢ Unemployment rate – The ratio of the number of people unemployed to the total number
of people in the labor force.
𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
o 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 =
𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑+ 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
➢ Labor force participation rate – The ratio of the labor force to the total population 16 years
old or older.
𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
o 𝐿𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒 𝑝𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

Unemployment : Components of Unemployment Rate

Unemployment Rates for Different Demographic Groups

 ➢ Discouraged-worker effect – The decline in the measured unemployment rate that results
when people who want to work but cannot find jobs grow discouraged and stop looking,
thus dropping out of the ranks of the unemployed and the labor force.

Unemployment : The Costs of Unemployment

Some Unemployment is Inevitable
➢ When we consider the various costs of unemployment, it is useful to categorize
unemployment into three types:
o Frictional unemployment
o Structural unemployment
o Cyclical unemployment

Frictional, Structural, and Cyclical Unemployment

➢ Frictional unemployment – The portion of unemployment that is due to the normal
turnover in the labor market; used to denote short-run job/skill matching problems.
➢ Structural unemployment – The portion of unemployment that is due to changes in the
structure of the economy that result in a significant loss of jobs in certain industries.
➢ Natural rate of unemployment – The unemployment rate that occurs as a normal part of
the functioning of the economy. Sometimes taken as the sum of frictional unemployment
rate and structural unemployment rate.
➢ Cyclical unemployment – Unemployment that is above frictional plus structural
unemployment.

Social Consequences
➢ The costs of unemployment are neither evenly distributed across the population nor easily
quantified.
➢ The social consequences of the Depression of the 1930s are perhaps the hardest to
comprehend. Few emerged from this period unscathed.
➢ At the bottom were the poor and the fully unemployed, about 25 percent of the labor force.
Even those who kept their jobs found themselves working part-time.
➢ Many people lost all or part of their savings as the stock market crashed and thousands of
banks failed.

Inflation : The Consumer Price Index

➢ Consumer Price Index (CPI) – A price index computed each month by the Bureau of
Labor Statistics using a bundle that is meant to represent the “market basket” purchased
monthly by the typical urban consumer.

➢ The CPI Market Basket (Figure 22.1)

o The CPI market basket shows how a typical consumer divides his or her money
among various goods and services.
o Most of a consumer’s money goes toward housing, transportation, and food and
beverages.
 Figure 22.1 : The CPI Market Basket

➢ Producer Price Indexes (PPIs) – Measures of prices that producers receive for products
at all stages in the production process.
o The indexes are calculated separately for various stages in the production process.
o The three main categories are finished goods, intermediate materials, and crude
materials, although there are subcategories within each of these categories.

Inflation : The Costs of Inflation

➢ During inflations, most prices—including input prices like wages—tend to rise together,
and input prices determine both the incomes of workers and the incomes of owners of
capital and land.
➢ So inflation by itself does not necessarily reduce ones purchasing power.

Inflation May Change the Distribution of Income

➢ Real interest rate – The difference between the interest rate on a loan and the inflation rate.

Administrative Costs and Inefficiencies

➢ There may be costs associated even with anticipated inflation. One is the administrative
cost associated with simply keeping up.
 Public Enemy Number One?
➢ Economists have debated the seriousness of the costs of inflation for decades.

Long-Run Growth
➢ Output growth – The growth rate of the output of the entire economy.
➢ Per-capita output growth – The growth rate of output per person in the economy.
➢ Productivity growth – The growth rate of output per worker.

Output and Productivity Growth