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Introduction to Macroeconomics

Chapter No.1
What is Macroeconomics?
• Macroeconomics is the study of the structure
and performance of national economies and
of the policies that governments use to try to
affect economic performance of a country.
Issues in Macroeconomics
• What determines a nation's long-run
economic growth?
• What causes a nation's economic activity to
• What causes unemployment?
• What causes prices to rise?
• How does being part of a global economic
system affect nations' economies ?
• Can government policies be used to improve a
nation's economic performance?
Some Important Concepts
Long - Run Economic Growth
• Difference in standard of living in different
• Some economies experienced sustainable
economic growth.
• Some nations have never experienced sustained
growth or have had periods of growth offset by
periods of economic decline.
“ Hence the period of rapid economic growth which
is offset period of economic decline is known as long
run growth.”
Output of the U.S. economy
• The long-run growth in USA is a result of
increase in population and average
productivity of labour Force.
Business Cycle
• Macroeconomists use the term business cycle
to describe short-run, but sometimes sharp,
contractions and expansions in economic
• The downward phase of a business cycle,
during which national output may be falling or
perhaps growing only very slowly, is called a
• Unemployment is the number of people who
are available for work and are actively seeking
work but cannot find jobs.
• It is measured by unemployment rate.
Ur = Number of unemployed/Total labour force
• Recessions have led to significant increases in
Analytical Question
Can average labour productivity fall even though
total output is rising? Can the unemployment
rate rise even though total output is rising?
• When the prices of most goods and services
are rising over time, the economy is said to be
experiencing inflation.
• The percentage increase in the average level
of prices over a year is called the inflation rate.
• High inflation also means that the purchasing
power of money erodes quickly.
Problem No.1
• Here are some macroeconomic data for the
country of O for the years 2008 and 2009.
2008 2009
Output 12000 14300
Employed 1000 1100
Unemployed 100 50
Total labour force 1100 1150
Prices 2 2.5
a. Average labour productivity in 2008 and 2009.
b. The growth rate of average labour
between 2008 and 2009.
c. The unemployment rate in 2008 and 2009.
d. The inflation rate between 2008 and 2009.
What Macroeconomists Do?
• Macroeconomic Forecasting
• Macroeconomic Analysis
Monitoring of the economy and think about
the implications of current economic events.
• Macroeconomic Research
Economic Theory
• An economic theory is a set of ideas about the
economy that has been organized in a logical
framework. Most economic theories are
developed in terms of an economic model.
• Economic model is a simplified description of
some aspect of the economy, usually
expressed in mathematical form.
Economic Policy
• Set of instruction to control the performance
of the economy.
• There are two types of macro economic
1. Fiscal Policy
2. Monetary Policy
Economic Analysis
• Positive Analysis
• Normative Analysis
Positive Analysis
• A positive analysis of an economic policy
examines the economic consequences of a
policy but doesn't address the question of
whether those consequences are desirable.
• e.g. if a tax is imposed on a good its price will
tend to rise.
Normative Analysis
• A normative analysis of policy tries to
determine whether a certain policy should be
• e.g. a tax should be imposed on tobacco to
discourage smoking
Analytical Question 2
Which of the following statements are positive in nature
and which are normative?
a. A tax cut will raise interest rates.
b. A reduction in the payroll tax would primarily benefit
poor and middle-class workers.
c. Payroll taxes are too high.
d. A cut in the payroll tax would improve the President's
popularity ratings.
e. Payroll taxes should not be cut unless capital gains
taxes are cut also.
Classical Versus Keynesians
Classical Approach
• Adam Smith (1776)
• Published book Wealth of Nation.
• Concept of invisible hand
Keynesian Approach
• Great Depression (1936)
• John Maynard Keynes
• General theory of Employment, Interest and
The Classical Approach

• The invisible hand of Economics: General

welfare will be maximized (not the
distribution of wealth) if:
– there are free markets;
– individuals act in their own best interest.
The Classical Approach (continued)
• To maintain markets’ equilibrium – the
quantities demanded and supplied are equal:
– Markets must function without impediments.
– Wages and prices should be flexible.
The Classical Approach (continued)
• Thus, according to the classical approach, the
government should have a limited role in the
The Keynesian Approach

• Keynes (1936) assumed that wages and

prices adjust slowly.
• Thus, markets could be out of equilibrium
for long periods of time and
unemployment can persist.
The Keynesian Approach
• Therefore, according to the Keynesian
approach, governments can take actions to
alleviate unemployment.
The Keynesian Approach
• The government can purchase goods and
services, thus increasing the demand for
output and reducing unemployment.
• Newly generated incomes would be spent and
would raise employment even further.
Evolution of the Classical-
Keynesian Debate
• After stagflation – high unemployment
and high inflation – of the 1970s, a
modernized classical approach
• Substantial communication and cross-
pollination is taking place between the
classical and the Keynesian approaches.
Unified Approach to
• Individuals, firms and the government interact
in goods, asset and labour markets.
• The macroeconomic analysis is based on the
analysis of individual behaviour.
The Unified Approach (continued)

• Keynesian and classical economists agree

that in the long run prices and wages
adjust to equilibrium levels.
• The basic model will be used either with
classical or Keynesian assumptions about
flexibility of wages and prices in the short
The Measurement and Structure
of the National Economy
Chapter No.2
National Income Accounts
• The national income accounts are an
accounting framework used in measuring
current economic activity.
Approaches of Measurement
• Product Approach (excluding output used in
intermediate stage of production).
• Income Approach (income received by the
producer of output)
• Expenditure Approach (amount of spending
by the ultimate purchaser of the output).
Product Approach
• The product approach measures economic
activity by adding the market values of goods
and services produced, excluding any goods
and services used up in intermediate stages of
• Concept of value added (value of output
minus value of input)
Income Approach
• The income approach measures economic
activity by adding all income received by
producers of output
• Rent, are the income from from property received by house
• Interest, Private business pay to house hold
• Wages, received by workers.It is largest component of
National Income
• Profit, received by owners of firm
Expenditure Approach
• The expenditure approach measures activity
by adding the amount spent by all ultimate
users of output.
The Expenditure Approach to
Measuring GDP
• The expenditure approach measures GDP as total
spending on final goods and services produced
within a nation during a specified period of time.
• Total spending on goods and services includes:
1. Consumption (C)
2. Investment (I)
3. Government Expenditure (G)
4. Net Export (NX)
• Consumption is spending by domestic
households on final goods and services,
including those produced abroad.
• Consumption expenditures are grouped into
three categories:
1. Consumer durables (car, television, mobile)
2. Nondurable goods (food, cloth, fuel)
3. Services (Education, Health care, Financial
• Investment includes both spending for new
capital goods, called fixed investment, and
increases in firms' inventory holdings, called
inventory investment.
• Fixed investment in turn has two major
1. Business Investment
2. Residential Investment
Government Expenditure
• Government expenditure include any
spending by the government for a currently
produced good or service.
• It also include the transfer payment (benefit)
to the individuals of the country.
Net Export
• Net exports are exports minus imports.
• If exports are greater than imports NX >0.
• If exports are less than imports NX<0.
Income-Expenditure Identity
• Y = GDP = total production (or output)
= total income
= total expenditure;
Y = C + I + G + NX.
Fundamental Identity of National
Income Accounting

total production=total income=total expenditure

Gross Domestic Product
• Gross domestic product used to measure the
over all economic activity of a country.
• GDP is calculate by using the following
1. Product approach
2. Expenditure approach
3. Income approach
Product Approach
• A nation's gross domestic product (GDP) as
the market value of final goods and services
newly produced within a nation during a fixed
period of time.
Market Value
• Goods and services are counted in GDP at their
market values that is, at the prices at which they
are sold.
• It allows adding the production of different goods
and services.
• Some useful goods and services are not sold in
formal markets.
Market Value (Cont……)
• Some nonmarket goods and services are
partially incorporated in official GDP
measures. An example is activities in the so-
called underground economy.
• The underground economy includes both legal
activities (hidden from government record
keepers to avoid payment of taxes) and illegal
activities (drug dealing and gambling).
Newly Produced Goods and Services
• As a measure of current economic activity,
GDP includes only goods or services that are
newly produced within the current period.
Final Goods and Services
• Only the value of final goods and services
include in the measurement of GDP.
• Final goods also include capital goods and
inventory investment.
GDP Versus GNP
• Gross National Product is the market value of
final goods and services newly produced by
domestic factors of production during the
current period, whereas GDP is production
taking place within a country.


Net Factor of Payment
• NFP is the income earned by the domestic
factor of production from the rest of the
• From the above definition,
• In developed economies GNP = GDP.
• In Underdeveloped economies GNP > GDP.
Measures of National Income
• Net National Product
– Less: Capital Consumption Allownce
– Add: Subsidy
• National Income at market price
• National Income at factor cost
• Personal Income
• Personal Disposable Income
Private Disposable Income (PDI)
• Private disposable income, measures the amount
of income the private sector has available to
• Mathematically,
PDI = Y + NFP + TR + INT - T
Y = gross domestic product (GDP);
NFP = net factor payments from abroad;
TR = transfers received from the government;
INT = interest payments on the government's debt;
T = taxes.
Net Government Income (NGI)
• Net government income equals taxes paid by
the private sector, T, minus payments from the
government to the private sector (transfers
and interest payments on the government
• Mathematically,
• Private Saving: private saving is equal to
private disposable income minus
Spvt = (Y+NFP+TR+INT-T)-C
• Government Saving: It is defined as net
government income less government
purchases of goods and services.
Sgov = (T - TR - INT) - G.
National Saving
• S = Spvt + Sgov
• = (Y+NFP+TR+INT-T)-C + (T - TR - INT) - G.
• S= I + CA
• Uses of Spvt
1, Spvt is used to fund new capital (Investment)
2, Provide the resource to Govt needs to finance
its budget deficit (-Sgov)
2, Foreign lending
Current Account (CA)
• The current account balance equals payments
received from abroad in exchange for currently
produced goods and services (including factor
services), minus the analogous payments made
to foreigners by the domestic economy.
• CA = NX + NFP
• NX = X – M
• NFP = Income from abroad – Payment made to
National Wealth
• The value of all assets own by a person or country.
• Current assets – Current Liabilities
• It is total wealth of the residents of a country, it
consist two parts
1, Domestic physical assets (Stock of capital, goods,
2,Net foreign assets= Countries foreign assets(foreign
stock, bonds and factories own by domestic resident)
minus its foreign liabilities (domestic physical and
financial assets own by foreigners)
Note: Domestic financial assets held by domestic
residents are not part of National wealth.
National wealth can change in two ways.
1, Value of existing assets or liabilities that make
up national wealth
* Stock Prices
• The wearing out or depreciation of physical assets
which corresponded to a drop in the value of asset
2, National Saving
• Increase in domestic stock of capital
• Increase in stock of net foreign assets
Nominal and Real GDP
• Nominal GDP measure the current dollar value
of the output of the country
• Total output at current prices
• Y= Pn X Qn
Pn= new price, Qn= new Quantity
• Real GDP measure output at base year or
constant prices
• Y = Pb X Qn Pb = Base year price
GDP deflator
• The GDP deflator is a measure of the level of
prices of all new, domestically produced, final
goods and services in an economy
• GDP deflator = nominal GDP / Real GDP
• = Pn X Qn / Po X Qn

• Real GDP = nominal GDP / GDP deflator

• nominal GDP=Real GDP X GDP deflator
Consumer Price Index ( CPI)
• Consumer Price Index
• measures changes in the price level of a market
basket of consumer goods and services purchased by
households. The CPI in the Pakistan is defined by the
ministry of finance as "a measure of the average
change over time in the prices paid by urban
consumers for a market basket of consumer goods
and services.
Calculation of Growth rate

• Growth Rate =
• (Current – Previous/ Previous) X100
Difference b/w CPI and GDP price Index

• Three main differences are

1, GDP deflator measure prices of all goods & services
produced where as CPI measure the prices of only
goods & services bought by consumer.
2, GDP deflator shows the prices of all goods & services
produced domestically, imported goods are not
included in GDP deflator. CPI consider imported
3, CPI is computed using fixed basket of goods. GDP
deflator allows the basket of goods to change
overtime as the composition of GDP deflator.
Cost of Living
• The dollar does not buy as much as it did ten year
ago the cost of every thing almost gone up.
• Which price index better explain increase in cost of
• GDP deflator ( understate increase in cost of living)
• Base year price

• CPI ( overstate cost of living)

• substitute goods
Interest rate
• Rate of return promised by a borrower to a lender is
called nominal interest rate.
• Real Interest rate ( r)
• An interest rate that has been adjusted to remove the effects of inflation
to reflect the real cost of funds to the borrower, and the real yield to the
Real Interest Rate = Nominal Interest Rate - Inflation (Actual)
• The real interest rate of an investment is calculated as the amount by
which the nominal interest rate is higher than the inflation rate.
Expected Real Interest Rate = Nominal Interest Rate - Inflation
• Stock variables
• measure at a point of time like money supply

• Flow Variables
• Variables that can measure per unit of time
Circular Flow of Income In Closed