Part III: Macroeconomics, output, inflation, and unemployment

Basic Macro Ideas: 3 Units

Unit 11A: Output and Income Unit 11B: The Price Level Unit 12: The Labour Market and the Unemployment RateBasic Macro Ideas We now start considering macroeconomics: how the economy as a whole behaves.

We start by considering three basic terms:

• Aggregate output
• Inflation
• Unemployment

Aggregate Output, Inflation, and Unemployment

What do we mean by these and how do we measure them?Unit 11A Output and Income (Mankiw & Taylor, Ch 20)Preview of Unit 11A

Overall Output Measurement

1. We need to identify a measure of the overall ouput of the economy: this is the Gross Domestic Product (GDP).

GDP and Circular Flow

2. The GDP is best seen as resulting from a circular flow of resources.

GDP Measurement and Patterns

3.We can measure the GDP in various ways, and can observe empirical patterns, like cycles and growth.

GDP and Aggregate Income

GDP ("Gross Domestic Product") is a measure of the overall flow of commodities and services produced by an economy over a time interval usually one year).

The gist of macroeconomic theory is to come up with a theory of gdp determination: why is average income high in some countries and low in others? Why do production and employment expand in some years and contract in others?

Let us first have a look at some data.

GDP Per Capita: Some Data (1)

IMF DataMapper 50 thousand GDP per capita, current prices (U.S. dollars per capita) 40 thousand 30 thousand 20 thousand 10 thousand 0 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Italy European Union Sub-Saharan Africa CIMF, 2021, Source: World Economic Outlook (April 2021)

GDP Growth: Some Data (2)

IMF DataMapper Real GDP growth (Annual percent change) 5 O -5 -10 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 . Italy European Union @IMF, 2021, Source: World Economic Outlook (April 2021)

Unemployment: Some Data (3)

IMF DataMapper Unemployment rate (Percent) 15 10 5 O 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 . Italy Euro area Other advanced economies @IMF, 2021, Source: World Economic Outlook (April 2021)

GDP and Aggregate Income: Income and Expenditure Equality

The starting point is that the total value of what is produced amounts to total expenditure, and total income must equal expenditure:

1. Every transaction has a buyer and a seller.
2. Every euro of spending by some buyer is a euro of income for some seller.
3. The equality of income and expenditure can be illustrated with the circular-flow diagram.

The Circular Flow of Production and Income

Revenue Product market Purchases Goods sold Goods bought Demand for factors Supply for factors Firms Households Factor market Income paid to factors Income paid to factors

Simplified Picture of Circular Flow

1. This is a simplified picture, where we do not have government and the foreign sector.

Income Flow via Financial Sector

2. Also, income usually flows from households to firm via the financial sector.

Adding Government and Foreign Sector to Circular Flow

Rest of world Exports Imports Product market Supplies goods and services Taxes Taxes - Government Households Firms - Purchases factors of production Factor market

Adding the Financial Sector to Circular Flow

.... and adding also the financial sector Revenue (= GDP) Spending (= GDP) MARKETS FOR GOODS AND SERVICES Foreign Exchange Market 7G Imports Goods and services sold Investment Government Goods and services bought Taxes Taxes FIRMS Government Borrowing HOUSEHOLDS Borrowing Savings Income (= GDP) Wages, rent and profit (= GDP) Financial Institutions Net Capital Outflow MARKETS FOR FACTORS OF PRODUCTION Factors of production Labour, land and capital FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017 Exports

Gross Domestic Product (GDP) Definition

Gross domestic product (GDP) is a measure of the income and expenditures of an economy.

It is the total market value of all final goods and services produced within a country in a given period of time.

GDP Characteristics

GDP is the market value of all final goods and services produced within a country in a given period of time:

• Output is valued at market prices.
• It records only the value of final goods (not intermediate goods (the value is counted only once).
• It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, house cleaning).

GDP Production Period and Geographic Confines

It includes goods and services produced in the said period, not transactions involving goods produced in the past.

It measures the value of production within the geographic confines of a country.

It measures the value of production taking place within a specific interval of time, usually a year or a quarter.

Complementary Notions for Aggregate Production and Income

Complementary notions for aggregate production and income are as follows:

Gross National Product (GNP)

Gross national product (GNP): Total income earned by a nation's permanent residents. While GDP is based on location (it includes production by foreign residents), GNP is based on factor ownership (it includes production by nationals abroad): the two are likely to differ in developing countries, on account of substantial income flows (remittances) from migrants residing abroad. Sometimes it is also labeled GNI (Gross National Income)

Net National Product (NNP)

Net national product (NNP) GNP minus losses from depreciation, i.e. the wear and tear on the economy's stock of equipment.

Personal Income

Personal income The income received by households and non-corporate businesses.

Disposable Personal Income

Disposable personal income Personal income minus taxes and all obligations to the government.

GDP Inclusions and Exclusions

GDP includes all items produced in the economy and sold legally in markets (broadly defined: government services are valued at their cost).

GDP does not register most items that are produced and consumed at home and that never enter the marketplace.

GDP does not register items produced and sold illicitly, such as illegal drugs.

Hence, GDP estimates are less reliable, the wider the extent of the informal economy.

GDP Components (Income Y)

GDP (income Y) is the sum of:

1. Consumption: expenditure by households;
2. Investment: expenditure by firms;
3. Government Purchases: expenditure by the government;
4. Net Exports: (net) expenditure by the foreign sector:

Y = C + I + G + NX which is an identity, as we have income on the LHS and expenditure on the RHS

Consumption (C)

Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing.

Investment (I)

Investment (I): The spending on capital equipment, inventories, and structures, including new housing.

Government Purchases (G)

Government Purchases (G): The spending on goods and services by local and central governments, (not)including transfer payments (e.g., subsidies) because they are not made in exchange for currently produced goods or services.

Net Exports (NX)

Net Exports (NX): Exports minus Imports

Measuring GDP

GDP per capita is gross domestic product divided by the population of a country, giving a measure of national income per head.

As we shall see, it is a widely used measure of the average standard of living.

Nominal vs. Real GDP

Nominal GDP values the production of goods and services at current prices.

Real GDP values the production of goods and services at constant prices.

GDP as a Money Aggregate

GDP is by nature a money aggregate (you cannot add apples and potatoes, but you can add their money value

Suppose physical output (apples and potatoes) does not change, while the prices go up: nominal GDP grows, but actual production does not.

One way to see whether actual production changes is,

1. choose a base year and take its nominal GDP as a reference;
2. take the production level of any other year;
3. assess the value of that production level at base year prices!

Example: Apples and Potatoes Production

Assume an economy produces only two goods - apples and potatoes. Prices and quantities

Year	Price of apples per kg (€)	Quantity of apples (kg)	Price of potatoes per kg (€)	Quantity of potatoes (kg)
2016	1	100	2	50
2017	2	150	3	100
2018	3	200	4	150

FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017

Calculating Nominal GDP

Year	Calculating nominal GDP
2016	(€1 per kg apples × 100 kg) + (€2 per kg potatoes × 50 kg)= €200
2017	(€2 per kg apples × 150 kg) + (€3 per kg potatoes × 100 kg)= €600
2018	(€3 per kg apples × 200 kg) + (€4 per kg potatoes × 150 kg) = €1200

Part of the rise is attributable to the increase in the quantities of apples and potatoes and part to the increase in the prices of apples and potatoes. To take out the effect of changes in prices we use real GDP

Calculating Real GDP (Base Year 2016)

Year	Calculating real GDP (base year 2016)
2016	(€1 per kg apples × 100 kg) + (€2 per kg potatoes × 50 kg) = €200
2017	(€1 per kg apples × 150 kg) + (€2 per kg potatoes × 100 kg) = €350
2018	(€1 per kg apples × 200 kg) + (€2 per kg potatoes × 150 kg) = €500

FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017