Principles of Macroeconomics

Eco-104

Dr. Adnan Haider

Professor of Business Economics and Analytics
ahaider@iba.edu.pk

Week-01: Spring 2024

 Economists use models to understand what goes on in the economy.
Here are two important points about models: endogenous variables
and exogenous variables. Endogenous variables are those which the
model tries to explain. Exogenous variables are those variables that a
model takes as given. In short, endogenous are variables within a
model, and exogenous are the variables outside the model.

Price Supply
This is the most famous economic model.
It describes the ubiquitous relationship
P* between buyers and sellers in the market.
The point of intersection is called an
equilibrium.
Demand
Q
*
Quantity
 Market clearing is an alignment process whereby decisions between
suppliers and demanders reach an equilibrium. Here’s how it works.
Let’s say you begin with a demand and supply curve for some item.
Remember that the demand curve slopes downward meaning that
as you increase the price (by moving along the demand curve), the quantity
demanded decreases. Conversely, the supply curve slopes upward implying that as
the price increases (by moving along the
supply curve), the amount supplied will increase.

The center point A is where market decisions reach an

P D D´ S
equilibrium.
B
P´ Now, suppose that there is a sudden
A increase in the demand for that items.
P*
Demand will shift from D to D´.

r t ag e The increase in demand places upward pressure on

Sh o
the price to point B since the original price, P* no
longer clears the market. Notice the “shortage.”
Q* Q´
Q
P S SHIFTS IN DEMAND: Suppose your income
rises? Your demand for a given product, for
example, pizza, will also increase.

This translates into a rightward shift in the

demand curve from D to D'. Result:
D' both price and quantity are higher.
D
Q P S S'
SHIFTS IN SUPPLY: A fall in the price
of materials increases the supply of pizza; at any given
price, pizzerias find that the sale of pizza is more
profitable, and thus the supply of pizza rises.

This translates into a rightward shift in supply D

from S to S'. Result: price falls, quantity rises. Q
Economists typically assume that the market will go into an equilibrium of
supply and demand, which is called the market clearing process. This
assumption is central to the pizza example on the previous slide. But,
assuming that markets clear continuously, is unrealistic. For markets to clear
continuously, prices would have to adjust instantly to changes in supply and
demand. But, evidence suggests that prices and wages often adjust slowly.
So, remember that although market-clearing models assume that wages and
prices are flexible, in actuality, some wages and prices are sticky. Market-
clearing models may not describe every instant in an economy, but they do
depict the equilibrium toward which the economy gravitates.
 Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
broader marketplace. In microeconomics, an individual chooses to
maximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many

individuals trying to maximize their own welfare. Because
aggregate variables are the sum of the variables describing
individuals’ decisions, the study of macroeconomics
is based on microeconomic foundations.
Gross Domestic Product (GDP) is the dollar value of all
final goods and services produced within an economy in a
given period of time.

The consumer price index (CPI) measures the level of

prices.

The unemployment rate tells us the fraction of workers

who are unemployed.

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Gross Domestic Product is the best measure of how
well the economy is performing. The Bureau of
Economic Analysis (part of the U.S. Dept. of
Commerce) calculates GDP via administrative data,
which are byproducts of government functions such
as tax collection, education programs, defense, and
regulation, and statistical data, which come from
government surveys of, for example, retail
establishments manufacturing firms and farm activity.

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Figure: Per Capita Real GDP (in 2017 dollars) for the
United States, 1948–2023
Figure: Natural Logarithm of Per Capita
Real GDP
Figure: Percentage Deviations from Trend in Per
Capita Real GDP
GDP in Pakistan
 Income, Expenditure,
And the Circular Flow
Two ways Total income of everyone in the economy
of viewing GDP
Total expenditure on the economy’s
output of goods and services

Income $

Labor

Households Firms

Goods

Expenditure $

For the economy as a whole, income must equal expenditure.

GDP measures the flow of dollars in the economy.
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1) To compute the total value of different goods and services, the national income accounts
use market prices.
Thus, if:

$0.50 $1.00

GDP = (Price of apples  Quantity of apples)

+ (Price of oranges  Quantity of oranges)
= ($0.50  4) + ($1.00  3)
GDP = $5.00

2) Used goods are not included in the calculation of GDP.

3) The treatment of inventories depends on if the goods are stored or
if they spoil. If the goods are stored, their value is included in GDP.
If they spoil, GDP remains unchanged. When the goods are finally sold
out of inventory, they are considered used goods (and are not counted).

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4) Intermediate goods are not counted in GDP– only the value of
final goods. Reason: the value of intermediate goods is already
included in the market price. Value added of a firm equals the
value of the firm’s output less the value of the intermediate goods
the firm purchases.

5) Some goods are not sold in the marketplace and therefore don’t
have market prices. We must use their imputed value as an estimate
of their value. For example, home ownership and government services.

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The value of final goods and services measured at current prices is called nominal GDP. It can
change over time, either because there is a change in the amount (real value) of goods and
services or a change in the prices of those goods and services.
Hence, nominal GDP Y = P  y, where P is the price level and y is real output—and remember
we use output and GDP interchangeably.
Real GDP or, y = YP is the value of goods and services measured using a constant set of prices.

This distinction between real and nominal can also be applied to other monetary values, like
wages. Nominal (or money) wages can be denoted by W and decomposed into a real value (w)
and a price variable (P). Hence, W = nominal wage = P • w
w = real wage = w/P

This conversion from nominal to real units allows us to eliminate the problems created by having
a measuring stick (dollar value) that essentially changes length over time, as the price level
changes.

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 Let’s see how real GDP is computed in our apple and orange economy.

For example, if we wanted to compare output in 2009 and output in 2010, we would
obtain base-year prices, such as 2009 prices.
Real GDP in 2009 would be:
(2009 Price of Apples  2009 Quantity of Apples) +
(2009 Price of Oranges  2009 Quantity of Oranges).
Real GDP in 2010 would be:
(2009 Price of Apples  2010 Quantity of Apples) +
(2009 Price of Oranges  2010 Quantity of Oranges).
Real GDP in 2011 would be:
(2009 Price of Apples  2011 Quantity of Apples) +
(2009 Price of Oranges  2011 Quantity of Oranges).
Note that 2009 prices are used to compute real GDP for all three years. Because prices
are held constant from year to year,
real GDP varies only when the quantities produced vary.

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 THE IMPLICIT PRICE DEFLATOR FOR GDP

GDP Deflator = Nominal GDP

Real GDP

Nominal GDP measures the current dollar value of the output of

the economy.

Real GDP measures output valued at constant prices.

The GDP deflator, also called the implicit price deflator for GDP,
measures the price of output relative to its price in the base year. It
reflects what’s happening to the overall level of prices in the economy.

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 In some cases, it is misleading to use base-year prices that
prevailed 10 or 20 years ago (i.e., computers and
college). In 1995, the Bureau of Economic Analysis
decided to use chain-weighted measures of
real GDP. The base year changes continuously
over time. This new chain-weighted
measure is better than the more
traditional measure because it
Average pricesensures
in 2009that prices will not be too out
and 2010 are of date.
used to measure
real growth from 2009 to 2010.
Average prices in 2010 and 2011
are used to measure real growth from
2010 to 2011, and so on. These growth
rates are united to form a “chain” that is
used to compare output between any two
dates.

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 YY =
= CC +
+ II +
+GG+
+ NX
NX
Totaldemand
Total demand Investment
Investment
fordomestic
for domestic isiscomposed
composed spendingby
spending by
output(GDP)
output (GDP) of
of businessesand
businesses and
households
households Netexports
Net exports
ornet
or netforeign
foreign
Consumption Government demand
demand
Consumption Government
spendingby
spending by purchasesof
purchases ofgoods
goods
households
households andservices
and services

This is the called the national income accounts identity.

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 AAMankiw
Mankiw
Macroeconomics
Macroeconomics
Case
CaseStudy
Study
GDP and Its
Components
In 2007, U.S. GDP totaled about 13.8 trillion.
This number is incomprehensible. So, if we
divide this number by the total population of
$302 million, we get GDP per person—the
amount of expenditure for the average
American– which equaled $45,707 in 2007.
Let’s break it down visually on the next slide.

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 GDP (Y) was $45, 707 per person
Here are the Components of Y in 2007:
Remember that these
calculations are performed per
Consumption = $32,144 person just for
Investment = $7,052
comprehension
purposes.
Government Purchases =
$8,854
Net Exports = $2,343

YY =
= CC +
+ II +
+GG+
+ NX
NX

$45,707
$45,707 =
= $32,144
$32,144 +
+ $7,052
$7,052 +
+ $8,854
$8,854 +
+ $2,343
$2,343
Note: The numbers above must be multiplied by the U.S. Population
302 million to obtain the totals for the above national income
accounts identity Y = C + I + G + NX.
GDP and Its components
Pakistan Case
GDP and Its components
Pakistan Case
To see how the alternative measures of income relate to one
another, we start with GDP and add or subtract various quantities.
To obtain gross national product (GNP), we add receipts of factor
income (wages, profit, and rent) from the rest of the world and
subtract payments of factor income to the rest of the world.
GNP = GDP + Factor Payments from Abroad - Factor Payments to Abroad
Whereas GDP measures the total income produced domestically, GNP
measures the total income earned by nationals (residents of a nation).
To obtain net national product (NNP), we subtract the depreciation of
capital—the amount of the economy’s stock of plants, equipment, and
residential structures that wears out during the year:
NNP = GNP – Depreciation
In the national income accounts, depreciation is called the consumption
of fixed capital. It equals about 10% of GNP. Because depreciation of
capital is a cost of producing the output of the economy, subtracting depreciation
shows the net result of economic activity.

26
 Net
NetNational
Nationalisisapproximately
approximatelyequal
equaltotoanother
another
measure
measurecalled
callednational
nationalincome.
income.TheThetwo
twodiffer
differby
by
aasmall
smallcorrection
correctioncalled
calledthe
thestatistical
statistical
discrepancy,
discrepancy,which
whicharises
arisesbecause
becausedifferent
differentdata
data
sources
sourcesmay
maynot
notbe
becompletely
completelyconsistent.
consistent.

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The
The Consumer
Consumer PricePrice Index
Index (CPI)
(CPI) turns
turns the
the prices
prices of
of many
many goods
goods
and
and services
services into
into aa single
single index
index measuring
measuring thethe overall
overall level
level of
of
prices.
prices. The
The Bureau
Bureau ofof Labor
Labor Statistics
Statistics weighs
weighs different
different items
items byby
computing
computing the the price
price of
of aa basket
basket of
of goods
goods and
and services
services produced
produced by by
aa typical
typical customer.
customer. TheThe CPI
CPI is
is the
the price
price of
of this
this basket
basket of
of goods
goods
relative
relative to
to the
the price
price ofof the
the same
same basket
basket inin some
some base
base year.
year.

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 Let’s see how the CPI would be computed in our
apple and orange economy.

For example, suppose that the typical consumer buys 5 apples and 2 oranges every month.
Then the basket of goods consists of 5 apples and 2 oranges, and the CPI is:

CPI = ( 5  Current Price of Apples) + (2  Current Price of Oranges)

( 5  2009 Price of Apples) + (2  2009 Price of Oranges)

In this CPI calculation, 2009 is the base year. The index tells how much it costs to buy 5
apples and 2 oranges in the current year relative to how much it cost to buy the same basket of
fruit in 2009.

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This statistic measures the increase in the price of a consumer basket that
excludes food and energy products. Because food and energy prices exhibit
substantial short-run volatility, core inflation is sometimes viewed as a better
gauge of ongoing inflation trends.

30
The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices
of only the goods and services bought by consumers. Thus, an increase in the price of goods
bought only by firms or the government will show up in the GDP deflator, but not in the CPI.

Also, another difference is that the GDP deflator includes only those goods and services
produced domestically. Imported goods are not a part of GDP and therefore don’t show up in
the GDP deflator.

The final difference is the way the two aggregate the prices in the economy. The CPI assigns
fixed weights to the prices of different goods, whereas the GDP deflator assigns changing
weights.

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1-32
The labor force is defined as the sum of the employed and unemployed, and the
unemployment rate is defined as the percentage of the labor force that is unemployed.
The labor-force participation rate is the percentage of the adult population who are in
the labor force.

Unemployment Rate = Number of Unemployed

 100
Labor Force

Labor-Force Participation Rate = Labor Force

 100
Adult Population

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 The Bureau
Labor
Statistics
Labor Force = 147.4 mill
ion
Unemployment rate =
5.5%
Labor Force Participatio
n Rate = 66.0%

The Bureau of Labor Statistics (BLS) computes these statistics for the
overall population and for groups within the population: men
and women, whites and blacks, teenagers and prime-age workers. In
2008, the statistics broke down as follows:
Labor Force = 145.0 + 10.1 = 155.1 million

Unemployment rate = (10.1/155.1) x 100 = 6.5%

Labor-Force Participation Rate = (155.1/234.6) x 100 = 66.1%

Hence, about two-thirds of the adult population was in the labor force,
and about 6.5 percent of those in the labor force did not have a job.

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Figure: The Unemployment Rate in the United
States, 1948–2023