Fundamentals of Macroeconomics

Macroeconomics is the study of the behavior of the economy as a whole. It examines the forces
that affect firms, consumers, and workers in the aggregate. There are various tools that government
can use to pursue their economic goals. Following table lists the major objectives and instruments
of macroeconomic policy.

Objectives: Instruments:

Output: Monetary policy:

High level and rapid growth of output Buying and selling bonds, regulating financial
institutions
Employment: Fiscal policy:
High level of employment with low Government expenditures
involuntary unemployment Taxation

Stable prices:
Maintaining stable price level

Output:
The ultimate objective of macroeconomic activity is to provide the goods and services that the
population desires. What could be more important for an economy than to produce shelter, food,
education, and recreation for its people?

High Employment:
Of all the macroeconomic indicators, employment and unemployment are most directly felt by
individuals. People want to be able to get high-paying jobs without searching or waiting too long,
and they want to have job security and good benefits.

Price Stability:
The third macroeconomic objective is price stability. This is defined as a low and stable inflation
rate. Price stability is important because a smoothly functioning market system requires that prices
accurately convey information about relative scarcities.

Fiscal Policy:
Fiscal policy denotes the use of taxes and government expenditures. Government expenditure comprise
spending on goods and services. Taxations affects people’s income and also taxes affect the prices
of goods and factors of production and thereby affect incentives and behavior.

Monetary Policy:
The second major instrument of macroeconomic policy is monetary policy, which the government
conducts through managing the nation’s money, credit, and banking system. Through its
operations, the central bank influences many financial and economic variables, such as interest
rates.
Measuring the Value of Economic Activity:

Gross Domestic Product: Gross domestic product (GDP) is the total market value of all final
goods and services produced annually within a country’s borders. Thus, if apples cost $0.50 each
and oranges cost $1.00 each. If economy had produced 4 apples and 3 Oranges then GDP would
be equals $5.00.

GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges)

= ($0.50 × 4) + ($1.00 × 3)
= $5.00.
There are two ways to measure GDP. Nominal GDP is measured in current market prices. Real
GDP is calculated in base year prices.

In Simply GDP = C + I + G
Here C= Consumption Expenditure
I = Investment Expenditure
G= Government Expenditure

Nominal GDP = (Price of Apples in 2023 × Quantity of Apples in 2023) + (Price of Oranges in
2023 × Quantity of Oranges in 2023)

Real GDP = (Price of Apples in 2011 × Quantity of Apples in 2023) + (Price of Oranges in 2011×
Quantity of Oranges in 2023). Let Base Year = 2011

Potential GDP represents the maximum sustainable level of output that the economy can produce.
When an economy is operating at its potential, there are high levels of utilization of the labor force
and the capital stock.

GNP Gap = Difference between potential GNP and actual GNP.

Net Domestic Product: Net domestic product (NDP) equals the total market value of all final
goods and services produced annually within a nation during a year less depreciation:

NDP = GDP – Depreciation

Gross National Product: Gross national product (GNP) is the total market value of all final goods
and services produced annually owned by the residents of a country. Gross National Product
(GNP) is Gross Domestic Product (GDP) plus net factor income from abroad.

GNP = GDP + (X-M)

= C + I + G + (X-M)
Here C= Consumption Expenditure
I = Investment Expenditure
G= Government Expenditure
X-M= Net Export
Net National Product: Gross national product (GNP) is the total market value of all final goods
and services produced annually owned by the residents of a country less depreciation.

NNP = GNP – Depreciation

Computing National Income:

Economists use three approaches to compute GDP: the expenditure approach, the income
approach, and the value-added approach.

The Expenditure Approach:

The national income accounts divide GDP into four broad categories of spending:
■ Consumption (C)
■ Investment (I )
■ Government purchases (G)
■ Net exports (NX).

Thus, letting Y stand for GDP, Y = C + I + G + NX.

GDP is the sum of consumption, investment, government purchases, and net exports.

Consumption consists of the goods and services bought by households. It is divided into three
subcategories: nondurable goods, durable goods, and services. Nondurable goods are goods that
last only a short time, such as food and clothing. Durable goods are goods that last a long time,
such as cars and TVs. Services include the work done for consumers by individuals and firms,
such as haircuts and doctor visits.

Investment consists of goods bought for future use. Investment is also divided into three
subcategories: business fixed investment, residential fixed investment, and inventory investment.
Business fixed investment is the purchase of new plant and equipment by firms. Residential
investment is the purchase of new housing by households and landlords. Inventory investment is
the increase in firms’ inventories of goods.

Government purchases are the goods and services bought by federal, state, and local
governments. This category includes such items as military equipment, highways, and the services
provided by government workers. It does not include transfer payments to individuals, such as
Social Security and welfare.

Net exports are the value of goods and services sold to other countries (exports) minus the value
of goods and services that foreigners sell us (imports). Net exports are positive when the value of
our exports is greater than the value of our imports and negative when the value of our imports is
greater than the value of our exports. Net exports represent the net expenditure from abroad on our
goods and services, which provides income for domestic producers.

Thus, we can compute GDP by summing the purchases made by the four sectors of the economy.
GDP equals consumption (C) plus investment (I) plus government purchases (G) plus net exports
(EX – IM).
The Income Approach:

There are two steps involved in computing GDP using the income approach. First, we must
compute national income. Second, we must adjust national income for certain things. The end
result is GDP.

National income is the sum of five components: (1) compensation of employees, (2) proprietors’
income, (3) corporate profits, (4) rental income of persons, and (5) net interest. We discuss the
details of each in the following paragraphs.

COMPENSATION OF EMPLOYEES: The wages and benefits earned by workers.

PROPRIETORS’ INCOME: The income of non-corporate businesses, such as small farms,

mom-and-pop stores, and law partnerships.

CORPORATE PROFITS: The income of corporations after payments to their workers and
creditors.

RENTAL INCOME: The income that landlords receive, including the imputed rent that
homeowners “pay” to themselves, less expenses, such as depreciation.

NET INTEREST: The interest domestic businesses pay minus the interest they receive, plus
interest earned from foreigners.

The income approach to computing GDP requires us to add certain things to national income and
to subtract certain things from national income.

GDP = National income

- Income earned from the rest of the world
+ Income earned by the rest of the world
+ Indirect business taxes
+ Capital consumption allowance
+ Statistical discrepancy
To compute GDP subtracting from national income the income earned from the rest of the world
and adding to national income the income earned by the rest of the world.

Indirect business taxes are excise taxes, sales taxes, and property taxes which need to add. These
taxes are not part of national income because they are not considered a payment to any resource
(land, labor, etc.).

The estimated amount of capital goods used up in production through natural wear, obsolescence,
and accidental destruction which also need to add.

GDP and national income are computed using different sets of data. Hence, statistical
discrepancies or pure computational errors often occur and must be accounted for in the national
income accounts.
Example: Let a country’s consumption expenditure is $850, Investment expenditure $300,
Government expenditure $200. If country’s Gross National Product $1550 and Capital
Consumption Allowance $30. Now find out i) GDP ii) NNP iii) X-M

Answer:

i) Gross Domestic Product (GDP) = C + I + G

= 850 + 300 +200
= $ 1350

ii) Net National Product (NNP) = GNP – CCA

= 1550- 30
= $ 1520

iii) Net Export (X-M) = GNP – GDP

= 1550 – 1350
= $ 200