ECN 100: PRINCIPLES OF MACROECONOMICS

SPRING 2023

Dr. Andrea TERZI

SLIDES SHARED IN CLASS

Application: A Production Possibility Table for
Grades in Economics and History

History Economics
Hrs of Study Grade Hrs of Study Grade
20 98 0 40
18 94 2 46
10 78 10 70
4 66 16 88
0 58 20 100
Application: A Production Possibility Curve
If the student is allocating 10
hrs for each subject and she
want to improve the grade in
Economics from 70 to 88
Econ Grade (marginal benefit), she must
10 give up 12 points in History
0 16 hrs for Econ and 4 (marginal cost).
hrs for History
If she judges that the marginal
88 benefit is greater than the
10 hrs for each
marginal cost, she will
History and Econ reallocate her time accordingly.
70
The opportunity cost of her
decision is 12 points in History.
PPC

40
58 66 78 10 History grade
0
Application: A Production Possibility Table for
Cotton and Wheat
The table shows the trade-off between production of cotton and wheat: As
the production of cotton (wheat) increases, the opportunity
cost of producing extra units of cotton (wheat) rises.

% of Units of % of Units of
Resources cotton Resources wheat
Devoted to Devoted to
cotton Production
of wheat
0 0 100 300
20 300 80 270
40 550 60 225
60 750 40 165
80 900 20 90
100 1000 0 0
Increasing Opportunity Costs of the Tradeoff
The principle of increasing marginal opportunity cost tells us that
opportunity costs increase the more you concentrate on the activity.
In order to get more of something, generally one must give up ever
increasing quantities of something else.

Cotton

A
Slope is flat at A. This means there is a low opportunity
cost to produce more guns.

B Slope is steep at B. This means there is a high

opportunity cost to produce more guns.

Wheat
Application: A Production Possibility Table for
Guns and Butter

The table shows the trade-off between

production of guns and butter.

% of Number % of Pounds Row

Resources of Guns Resources of Butter
Devoted to Devoted to
Guns Production
of Butter
0 0 100 15 A
20 4 80 14 B
40 7 60 12 C
60 9 40 9 D
80 11 20 5 E
100 12 0 0 F
Application: A Production Possibility Curve for Guns
and Butter
Opportunity cost of choosing
guns over butter increases as
you increase the production of
guns.
Production possibilities curves
typically bow outward because
some resources are better
suited for certain kinds of
goods than other kinds of
goods.
There is a limit to what you can
achieve, given existing
institutions, resources, and
technology.
 Comparative Advantage
The reason we must give up more and more butter as we produce
more guns is that some resources are relatively better suited to
producing guns, while others are relatively better suited to producing
butter.
A resource has a comparative advantage if it is better suited to the
production of one good than to the production of another good.
Under this assumption, the marginal opportunity cost of producing
one good by giving up a quantity of the other good, is increasing.
The shape of the PPC is bowed-out, i.e., concave to the origin,
reflecting the hypothesis.
Efficiency
Productive efficiency is achieving as
much output as possible from a given
amount of inputs or resources.
Inefficiency is getting less output from
Butter inputs that, if devoted to some other
activity, would produce more output.
Points A and C are points of efficiency.
A Point D is unattainable with given
amounts of inputs.
D Point B is a point of inefficiency.

B
Guns
 Efficiency and Technological Change
Biased technological increase.
Neutral technological increase or an
increase in resources.

A A

B B
Real and monetary flows between functional sectors

GOODS
MARKE
T
INTERNATIONA INTERNATIONA
L CONNECTION L CONNECTION

HOUSEHOLDS GOVERNMEN BUSINESS

T
(Consumption) (Production)

FACTOR
MARKE
T
U.S. economy: Connections between households, businesses and government.
 Two Roles of Government
The government plays two general roles in a well-managed
market economy:
1. An actor: The government acquires goods and services from
the private sector for its functioning in the pursuit of public
purpose and collects a proportion of its spending as taxes.
2. A referee: The government sets the rules that determine
relations between businesses and households (e.g., labor
standards laws, consumer protection, anti-trust laws, etc.)
 Ways to pursue the public purpose
In its role as both an actor and a referee, government pursues
policies in six major areas:
1.

1. Providing a stable set of institutions and rules

2. Promoting effective and workable competition
3. Correcting for externalities (effect of a decision on a third
party not taken into account by the decision maker)
4. Ensuring economic stability and growth
5. Providing public goods (e.g. education)
6. Adjusting for undesirable market results (e.g. income
redistribution, use of drugs, etc.)
Trade off between private and public goods (in the short run)
Measuring economic growth
Economic growth is primarily measured by the change in the
volume of overall output (called GDP) over time
Measure the volume of output in subsequent periods
Calculate the rate of change between the level of GDP of two
subsequent periods
Rate of change:

Year source
Useful GDP (at constant prices) data
U. S. economy Rate of change
2021 800 billion -
2022 818 billion [(818/800)-1]*100 =
2.25%
Switzerland, Gross Domestic Product, Level and rate of change, Constant Prices
CHF, billion Percent
190 7

6
180
5
170 4

160 3

2
150
1

140 0

-1
130
-2
120 -3

110 -4

-5
100
-6

90 -7
1980 1985 1990 1995 2000 2005 2010 2015 2020
Change P/P, rhs CHF, lhs
United States, SA, AR, USD
USD, trillion
25.0

22.5

20.0

17.5

15.0

12.5

10.0

7.5

5.0

2.5

0.0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
Gross Domestic Product, Total, Current Prices BEA, Personal Consumption Expenditures, Total Personal Consumption Expenditures (Pce)
Describing the Business Cycle
A standard pattern of four phases:
1. The top of a business cycle is called the peak
2. Eventually the economy faces a downturn (i.e., a
lower rate of growth) and may enter a recession (i.e.,
a decline in GDP and a negative rate of growth)
3. The bottom of a recession or depression is called the
trough
4. When it comes out of the trough, the economy faces
an upturn and enters an expansion as total output
begins to expand at a higher rate of growth
Business Cycle Phases

Total
Output

Peak
Do Secular
wnt
urn Upturn Growth
Trend

Trough

Expansion Recession Expansion

Quarters
1 2 3 4 1 2 3 4 1 2 3
 United States, Gross Domestic Product, Total, GDP Plus, Constant Prices, AR, Change P/P
15

10

Percent
0

-5

-10

-15
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
China vs United States – A GDP Comparison
Duration and Timing of Business Cycles Since 1854

Past cycle Duration (in months)

dating in the
Business Cycles Pre-World War II (1854 – Post-World War II
US: NBER 1945)
Forecasting (1945 – 2018)
cycles: Number 22 11
Economic indi
cators Average duration 50 66
(U.S.) Length of longest cycle 99 (1870-79) 128 (1991-2001)
Length of shortest cycle 28 (1919-21) 28 (1980-82)
Ave. length of expansions 29 59
Length of shortest expansion 10 (1919-20) 12 (1980-81)
Length of longest expansion 80 (1938-45) 120 (1991-2001)
Ave. length of recessions 21 11
Length of shortest recession 7 (1918-19) 6 (1980)
Length of longest recession 65 (1873-79) 18 (2007-2009)
 Real GDP, United States:
Trend growth versus real growth

Pre-crisis trend growth

Real GDP, Billions USD

Source: Dianova, V. (2018). Author's elaboration of Bureau of Economic Analysis data

 Unemployment and Jobs
Unemployment: People who are willing to work, have no job, and are
actively searching
The unemployment rate is determined by dividing the number of
people who are unemployed by the number of people in the labor
force.
Labor force: Employment + Unemployment

For example, if the total unemployed stands at 8 million and the labor
force stands at 160 million, the unemployment rate is:

8 million ÷ 160 million = 0.05 × 100 = 5%

 Unemployment and Jobs
Frictional unemployment is a result of individuals moving from
one job to another, students searching for their first job, etc.
Cyclical unemployment is that which results from fluctuations
in economic activity.
Structural unemployment is that caused by the institutional
structure of an economy or by economic restructuring making
some skills obsolete with technological progress.
Seasonal unemployment is related to seasonal changes in
economic activity.
 Target Rate of Unemployment
The target rate of unemployment is the lowest
sustainable rate of unemployment that policy makers
believe is achievable given existing conditions
(demographics, institutions).
The appropriate target rate of unemployment has been a
matter of debate.

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 Labor Force Participation Rate
The labor force participation rate is the proportion of
the working-age population that is either working or
actively looking for work.
It includes only the non-institutionalized, civil, working
age population.
https://fred.stlouisfed.org/series/CIVPART

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Click here for US unemployment in each State
U.S. unemployment

13.5

11.5

Percent
9.5

7.5

5.5

3.5
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

U-3
 Gross Domestic Output
Gross Domestic Product (GDP) is the value of all final goods
and services newly produced in an economy (i.e., within a
country’s borders) in a given time period (a flow concept).
GDP does not measure total transactions in the economy.
It only counts final output (and not also intermediate goods to
avoid double-counting).
.

Final output is goods and services purchased for final

use.
Intermediate products are used as an input in the
production of some other product.
 The expenditure components of GDP
GDP is divided into four expenditure categories:
1. Consumption (C) is spending by households on goods an services
2. Investment (Igross) is spending by business on means of production
(maintenance and repair, as well as additions to the stock of capital goods),
and also including the net change in inventories (unsold output)
3. Government spending (G) is goods and services that government buys.
Transfer payments are not included (social security payments,
unemployment benefits, business subsidies, etc.)
4. Exports (X), that is, foreigners’ spending on output produced
domestically
5. Must subtract: Imports (M), that is, output not produced domestically
 The Components of GDP
Since all production is categorized into one of these four
divisions, by adding up these four categories, we get total
production of U.S. goods and services
GDP = Consumption spending
+ Gross Investment spending
+ Government spending
+ Exports
− Imports
GDP = C + Ig + G + X – M
 GDP vs. NDP
The technical term “Gross” means unadjusted for Depreciation (aka Capital
Consumption Allowance)
Depreciation is the value of output produced to replace, repair, and maintain
investment assets that have been used up in producing that year’s GDP
Igross= Depreciation + Inet
Net domestic product (NDP) is GDP adjusted for depreciation
NDP = GDP – Depreciation = C + Inet + G + (X – M)
Igross= Ig = all business expenses on capital goods including expenses to maintain and
replace existing capital goods
Inet = In = all business expenses on capital goods NOT including expenses to maintain
and replace existing capital goods
 What Is Counted in GDP?

Not Counted Counted

Secondhand sales Value added by a used car dealer

Sales of stocks or bonds Commissions paid to stock brokers

Government transfer payments

Work of house-spouses
 Practice: Counted or not counted?
Should the value of the following trades be included in
the expenditure components of GDP?
purchase of sugar by a pastry shop
purchase of a computer by a business
purchase of a corporate share of Apple
purchase of a 20th century villa
value of helicopter produced in the year expected to
be sold next year
Value Added Approach Example: Ice Cream
Production
Participants Cost of Materials ($) Value of Sales ($) Value Added ($)
Farmer 0 100 100

Cone factory and 100 250 150

ice cream maker
Middleperson 250 400 150

Vendor 400 500 100

Totals 750 1,250 500

At each stage of the production process, the Value Added equals the value of incomes
that have been generated (wages, profits, rents, interest)
Value of final output = Value of incomes earned from productive services
 Two Ways of Measuring Total Output
The value of the output sold to ultimate users (including the change in inventories)
equals the value added at all stages of production

Add up sales to ultimate users

.

Consumers
Business firms
Government
Foreign sector
Plus: Change in inventories
Less: All imports
Add up each domestic producer’s value added, where value added for a single producer
is:
.

The difference between the value of the producer’s sales and the value of
intermediate products used up (= the cost of materials that a firm uses to
produce a good or service), that is, the increase in value that the producer
contributes to a product or service
Equal to all incomes generated by the production process (wages, profits,
rents, interest)
 GDP vs. GNP

Gross National Product (GNP) is the output produced by a

country’s citizens
.

GNP = GDP + (domestic factor income earned abroad −

foreign factor income earned in the country) = GDP +
Net foreign factor income
Net foreign factor income is the income from domestic factor
sources located abroad minus foreign factor income earned
domestically
 Practice: Can you measure GDP, NDP, and GNP?
1.

GDP= 884 NDP=825 GNP=886

2.

Government purchases 15
Consumption spending 30
GDP= 55
NetNDP=53
investmentGNP=52
spending 10
Depreciation 2
Imports 15
Net foreign factor income −3
Exports 13
 Nominal and Real GDP
GDP is estimated at current prices – Nominal GDP
Comparing GDP over time by ignoring the problem of changing
prices will result in overstating or understating growth in terms of
“volume” produced
A method to compare GDP over time is by recalculating the value
of GDP of each year at constant prices – Real GDP
Real GDP = GDP measured in terms of base year’s prices
Dividing nominal GDP by a number that reflects how much higher
(or lower) prices are on average when compared to the “base
year”
Let 2021 be the base year:
GDP of 2022 real (at 2021 prices) = GDP of 2022 nominal * (100 / Price Index 2022)
United States: Nominal and Real GDP
USD, trillion
25.0

22.5

20.0

17.5

15.0

12.5

10.0

7.5

5.0

2.5

0.0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020
BEA, Gross Domestic Product Gross Domestic Product, Constant Prices, Chained
Comparing GDP over time: Application
Data from 2020 to 2021
GDP at current prices (i.e., nominal GDP) rises 10%, from $382 billion to $440 billion.
This means 15% nominal growth
The GDP deflator rises 10%, from 100 to 110
Calculate real growth (output volume) between 2020 and 2021

GDP in 2021 at constant prices (recalculated at 2020 prices) = (Nominal GDP

in 2021 / Price index in 2021) X 100 = (440 / 110) X 100 = 400 billion
This means that GDP in 2021 was worth 400 billion at 2020 prices
What was the change from GDP of 2020 (at 2020 prices) and GDP of 2021 (at
2020 prices)?
Rate of change of real GDP = (400 / 382 – 1) X 100 = (1.047 – 1) X 100 = 4.7%
 Practice: Can you measure the rate of growth?
1. Year GDP at current GDP at constant prices (in Price Rate
market prices real terms)
Billion $ Billion $ at base year's Index of
prices growt
h
2020 4,000 4,000 100.   -
00
GDP= 884 NDP=825 GNP=886
2021 10,000 5,000  200.   +25%
2. 00
2022 12,750 5,100  250.   +2%
00
  2021 2022 perc. change
nominal gdp 6.4 8.0 +25%
GDP=price
55 index
NDP=53100
GNP=52 125 +25%
real gdp 6.4 6.4 +4.17%
(100/100)=6.4 (100/125)=6.4
 Comparing GDP across space

Comparing GDP across space entails to:

.

Use a common unit of account, i.e., converting

into a common currency (employing an exchange
rate based on “purchasing power parity”)
Relate GDP to the size of population (GDP per
capita)
Differences may be misused in comparing
various countries’ living standards when there
are wide differences in nonmarket activities
 Does GDP measure well-being?

GDP measures the value of market output

It contributes to living standards but it is not an
accurate measure of living standards, or
happiness, or economic welfare
Other indicators have been proposed to
measure well-being, such as the genuine
progress indicator (GPI)
 Growing GDP: Is it good or bad?

Income per capita and life expectancy

Income per capita and CO2 emissions

 Does GDP measure well-being?

The GPI makes a variety of adjustments to GDP

to better measure the progress of society rather
than just economic activity
It includes measures of the values of household
work and parenting, of higher education, of
volunteer work, of services of highways and
streets, the cost of crime, of commuting, of
automobile accidents, of ozone depletion, of
water and air and noise pollution, the loss of
wetlands, depletion of nonrenewable energy
resources, carbon dioxide emissions damage,
and an income distribution index
 The AD/AS Model
Short-run equilibrium output may differ from long-run
potential output
Equilibrium output is the level of output toward which the
economy gravitates in the short run when spending matches
expected business revenue
Potential output is the highest amount of output an economy
can sustainably produce using existing production processes
and resources

© 2020 McGraw-Hill Education

 The AD/AS Model Consists of Three Curves
1. Aggregate Demand (AD) Curve: a curve that shows how a
change in the price level will change aggregate expenditures on
domestic output

2. Short-Run Aggregate Supply (SAS) Curve: a curve that

shows how a change in the price level will change the
production of domestic output
3. Long-Run Aggregate Supply (LAS) Curve: a curve that
shows the productive potential of the economy

© 2020 McGraw-Hill Education

 The Long-Run Aggregate Supply Curve
The long-run aggregate supply (LAS) curve shows the long-run
relationship between output and the price level.
The LAS curve is vertical because potential output is unaffected
by the price level.
The position of the LAS curve depends on potential output
which is the amount of goods and services an economy can
produce when both capital and labor are fully employed.

© 2020 McGraw-Hill Education

The interactive AD/AS Model

L
A
S

Yf Y
Shifts in the LAS Curve
Increases in the LAS are
caused by increases in:
Price level .

LAS0 LAS1 LAS2

Growth-compatible
institutions
Capital
Entrepreneurship
Technology
Available resources

Real output

© 2020 McGraw-Hill Education

The interactive AD/AS Model

AD

Y
The Aggregate Demand Curve
Why the AD curve is downward sloping:
.

International effect - as the price level falls

(assuming the exchange rate does not change),
net exports will rise
Money wealth effect - a fall in the price level will
make the holders of money richer, so they buy
more
Multiplier effect - the amplification of initial
changes in expenditures (spending begets more
spending)

© 2020 McGraw-Hill Education

Shifts in the AD Curve
A shift in the AD curve means that at every price level,
total expenditures have changed. Five important shift
factors are:
.

Foreign income (foreigners will buy more/less)

Exchange rate fluctuations (domestic goods become more/less
expensive as domestic currency appreciates/depreciates)
Distribution of income (between profits/wages and amongst income
categories)
Expectations (positive expectations for future result in more consumption
and investment)
Asset prices and financial crises (affect perceived wealth and the
debt burden)
Government policies (government spending not compensated by tax
increases).
Shifts in the AD Curve
The AD curve shifts out
by more than the initial
change in
Price level expenditures:
Exports increase by
100
Initial Multiplie The multiplier
effect r effect
magnifies this shift
P0 AD curve shifts to the
right by a multiple of
Total effect
100, in this case by 300.

100 200
AD1
AD0
Real output
300

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The interactive AD/AS Model

P
LAS

SAS

Y
 The Short-run Aggregate Supply Curve
Firms tend to set price via cost-plus-markup pricing procedure
Most markets are posted-price markets, in which the price is set by producers and
changes infrequently and insignificantly. Producers typically respond to changes in demand
by changing production (instead of prices)
A smaller, yet significant, share of markets is made of auction markets, where prices are
set via interaction between buyers and sellers. The more demand, the higher the price
suppliers are able to set (these are mainly markets for resources, e.g. oil)
Why is the SAS curve described as upward sloping (but not very steep)?
In the short run (i.e., with a given productive capacity), an increase in output entails higher
unit costs of production (increasingly so as output nears its ‘potential’ level). Hence, for a
greater output to be profitable, business need to raise prices, i.e., the SAS slopes upwards

© 2020 McGraw-Hill Education

Shifts in the SAS Curve
Shifts in the SAS are caused by:
.

Changes in Input prices

Price level
Productivity
SAS1 Amongst others.
SAS0 When production costs increase,
the SAS curve shifts up. When
production costs decrease, the SAS
SAS2 curve shifts down.
In general:
%Δ in price level =
%Δ in wages – %Δ in productivity

Real output
© 2020 McGraw-Hill Education
The LAS Curve
Potential output is assumed
to be in the middle of a
Price level range bounded by high and
LAS low levels of potential
output.
When resources are over-
utilized (point C), factor
C SAS prices may be bid up and
B the SAS shifts up.
A
Overutilized
When resources are under-
resources utilized (point A), factor
Underutilized prices may decrease and
resources SAS shifts down.
Real
Low-level High-level output
potential potential
output output

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The interactive AD/AS Model

P
AD

SAS L
A
S

Y
Short-run and long-Run Equilibrium

The economy is in short-

run equilibrium when the
Price level
LAS AD and the SAS curves
intersect.
The economy is in long-
SAS run equilibrium when the
H intersection of the AD
P1
and the SAS curve also
intersects with the LAS
curve.
E
P0
AD1
AD0
YP Real output

© 2020 McGraw-Hill Education

An Inflationary Gap in the AD/AS Model
An inflationary gap is the
amount by which equilibrium
Price level output is above potential
LAS output.
At point B, resources are being
used beyond their potential and
the inflationary gap is Y2 – YP.
SAS0 Eventually wages and prices
E
increase and SAS shifts to return
P0 SAS2 the economy to a long and
B short-run equilibrium at E.
P2

Gap
AD0
YP Y2 Real output

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Recessionary gap and demand management
policy
If the economy is at point A,
Price level there is a negative output gap
LAS equal to Y0 – YP (<0), named
recessionary gap
The appropriate fiscal policy is to
increase government spending
SAS and/or decrease taxes
P E
A AD shifts to the right and output
P
1 0
returns to potential output YP
and prices increase to P1

Gap
AD1
AD0
Y0 YP Real output

© 2020 McGraw-Hill Education

 Aggregate Demand Policy
A primary reason for government policy makers’ interest in the
AS/AD model is that monetary or fiscal policy may shift the AD
curve.
.

Countercyclical fiscal policy is fiscal policy in which the

government offsets a change in AD that could create a
business cycle
Fiscal policy is the deliberate change in either government
spending or taxes to stimulate or slow down the economy.
Monetary policy involves the Federal Reserve Bank changing
the money supply and interest rates.
© 2020 McGraw-Hill Education
 Effectiveness and limitations of countercyclical fiscal policy

Effectiveness depends on the government’s ability to perceive

and to react appropriately to a problem
Implementing fiscal policy through changing taxes and
government spending can be a slow legislative process
There is no guarantee that government will do what
economists say is necessary
Potential output (the level of output that the economy is
capable of producing without generating inflation) is difficult
to estimate
There are other possible interrelationships in the economy
that the model does not take into account

© 2020 McGraw-Hill Education

 Practice exercise

Increased sales taxes

Employee wages increase
Oil prices increase
Consumer nominal wealth increases
Consumer expectations worsen
Business expectations worsen
Personal taxes increase
Government spending increases
A recession abroad
Appreciation of the foreign value of the currency
Technology and education increase
Increase in trade barriers

© 2020 McGraw-Hill Education

 Practice exercise

Increased sales taxes SRAS up

Employee wages increase AD up SRAS shift depends on productivity
Oil prices increase SRAS up
Consumer nominal wealth increases AD up
Consumer expectations worsen AD down
Business expectations worsen AD down
Personal taxes increase AD down
Government spending increases AD up
A recession abroad AD down
Appreciation of the foreign value of the currency AD down
Technology and education increase LRAS right and SRAS down
Increase in trade barriers SRAS up

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