1. Introduction to MacroeconomicsCopyright 2004 South-Western

2. MEANING OF ECONOMICS The word Economics originates from the Greek work Oikonomikos which can be divided into two parts: (a) Oikos, which means Home, and (b) Nomos, which means Management.Thus, Economics means Home Management. The head of a family faces the problem of managing the unlimited wants of the family members within the limited income of the family.Copyright 2004 South-Western 3. MEANING OF ECONOMICS If we consider the whole society as a family then the society also faces the problem of tackling unlimited wants of the members of the society with the limited resources available in that society. Thus, Economics means the study of the way in which mankind organizes itself to tackle the basic problems of scarcity.Copyright 2004 South-Western 4. BROAD SCOPE OF ECONOMICS Economic Problems The main economic problems faced by every society are: 1.Unlimited human wants, 2.Limited availability of resources to satisfy those wants, and 3.Fulfillment of unlimited wants with limited resources.Copyright 2004 South-Western 5. BROAD SCOPE OF ECONOMICS Three Main Economic Questions In recent times, economists have analyzed economic systems from a broad perspective. These modern economists talk about three main economic questions: (1)What to produce, (2)How to produce and , (3)For whom to produce.Copyright 2004 South-Western 6. What Is Macroeconomics? What Is Microeconomics? Macroeconomics deals with questions about variables that describe the economy of an entire nation. Microeconomics deals with questions related to individual economic agents, such as households and firms. Micro-an individual tree Macro- the entire forestCopyright 2004 South-Western 7. The Scope of EconomicsMicroeconomicsandMacroeconomics TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns Divisions of Economics MicroeconomicsMacroeconomicsProductionPricesIncomeEmploymentProduction/output in individual industries and businesses Howmuchsteel Howmuchoffice space HowmanycarsPrice of individual goods and services Distribution of income and wealthEmployment by individual businesses and industriesPriceofmedicalcare Priceofgasoline Foodprices ApartmentrentsWagesintheauto industry Minimumwage Executivesalaries PovertyJobsinthesteel industry Numberofemployees inafirm Numberof accountantsNational production/output Aggregate price level National incomeEmployment and unemployment in the economyTotalindustrialoutput Grossdomestic product GrowthofoutputConsumerprices Producerprices RateofinflationTotalwagesand salaries Totalcorporate profitsTotalnumberofjobs UnemploymentrateCopyright 2004 South-Western 8. Macroeconomics Macroeconomics deals with the economy as a whole. It studies the behavior of economic aggregates such as aggregate income, consumption, investment, and the overall level of prices. Aggregate behavior refers to the behavior of all households and firms together. A macroeconomist would ponder questions such as, what would happen to Pakistans unemployment rate if China or EU suddenly stops trading with Pakistan and what policy should the government of Pakistan then follow? The focus would always be on Pakistan as a whole.Copyright 2004 South-Western 9. Areas of concern Unemployment Prices-inflation Interest rates-rental price of money Govt. budget- fiscal deficit How much government spends? How much revenue government earns through taxes? Productivity with the given amount of resources how much output do you get Value of currency- exchange rates Macroeconomic policy Fiscal Policy Monetary policy Copyright 2004 South-Western 10. Economic Theory in Practice Positive versus Normative Economics Positive Economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It explains what will happen under certain conditions. Normative Economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. It explains what should happenIntroductiontoMacroeconomicsCopyright 2004 South-Western 11. Positive vs Normative Economics For example, the statement, "government should provide basic healthcare to all citizens" is a normative economic statement. The statement, "government-provided healthcare increases public expenditures" is a positive economic statement.Copyright 2004 South-Western 12. PositiveorNormative? 1. The retirement age should be raised to 70 to combat the effects of our ageing population 2. A rise in average temperatures will increase the demand for sun screen products. 3. The government should increase the minimum wage to 6 per hour to reduce poverty. 4. Higher interest rates will reduce house pricesCopyright 2004 South-Western 13. Measuring a Nations IncomeCopyright 2004 South-Western 14. THE ECONOMYS INCOME AND EXPENDITURE When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Copyright 2004 South-Western 15. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT 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.Copyright 2004 South-Western 16. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT The equality of income and expenditure can be illustrated with the circular-flow diagram.Copyright 2004 South-Western 17. Figure 1 The Circular-Flow DiagramMARKETS FOR GOODS AND SERVICES Firms sell Goods Households buy and services sold RevenueWages, rent, and profitGoods and services boughtHOUSEHOLDS Buy and consume goods and services Own and sell factors of productionFIRMS Produce and sell goods and services Hire and use factors of productionFactors of productionSpendingLabor, land, MARKETS and capital FOR FACTORS OF PRODUCTION Households sell Firms buyIncome = Flow of inputs and outputs = Flow of dollarsCopyright 2004 South-Western 18. The Circular-Flow Diagram-with Saving & investment Revenue Goods and services soldMARKETS MARKETS FOR FOR GOODS AND SERVICES GOODS AND SERVICES Firms sell Firms sell Households buy Households buySpending Goods and services boughtSaving FIRMS Produce and sell goods and services Hire and use factors of productionHOUSEHOLDS Buy and consume goods and services Own and sell factors of productionFinancial Market InvestmentFactors of production Wages, rent, and profitLabour, land, MARKETS and capital FOR FACTORS OF PRODUCTION Households sell Firms buyIncome = Flow of inputs and outputs = Flow of dollarsCopyright 2004 South-Western Copyright 2004 South-Western 19. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT GDP is the market value of all final goods and services produced within a country in a given period of time.Copyright 2004 South-Western 20. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT GDP is the Market Value . . . Output is valued at market prices. Example: If the price of an apple is twice the price of an orange, then an apple contributes twice as much to GDP as does an orange. . . . Of All Final . . . It includes all items produced in the economy and sold legally in markets. Example: Vegetable you buy at the grocery store are part of GDP, vegetables you grow in your garden are not. It records only the value of final goods, not intermediate goods (the value is counted only once). Copyright 2004 South-Western 21. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT . . . Goods and Services . . . It includes both tangible goods (food, clothing, cars) and intangible services (housecleaning, doctor visits). Example: When you buy a CD, you are buying a good, and the purchase price is part of GDP. . . . Produced . . . It includes goods and services currently produced, not transactions involving goods produced in the past. Example: When Honda produces and sells a new car, the value of the car is included in GDP. But when a persons sells a used car to another, the value of the used car is not included in GDP. Copyright 2004 South-Western 22. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT . . . Within a Country . . . It measures the value of production within the geographic confines of a country. Example: When a U.S. citizen owns a factory in Pakistan, the production at his factory is not part of U.S. GDP (It is part of Pakistans GDP). . . . In a Given Period of Time. It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).Copyright 2004 South-Western 23. THE COMPONENTS OF GDP GDP includes all items produced in the economy and sold legally in markets.Copyright 2004 South-Western 24. THE COMPONENTS OF GDP What Is Not Counted in GDP? GDP excludes most items that are produced and consumed at home and that never enter the marketplace. It excludes items produced and sold illicitly, such as illegal drugs.Copyright 2004 South-Western 25. THE COMPONENTS OF GDP GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)Y = C + I + G + NX This equation is an identity.Copyright 2004 South-Western 26. THE COMPONENTS OF GDP Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing. Goods include household spending on durable (such as automobiles and appliances) and non-durable goods ( such as food and clothing). Investment (I): The spending on capital equipment, inventories, and structures, including new housing.Copyright 2004 South-Western 27. THE COMPONENTS OF GDP Government Purchases (G): The spending on goods and services by local, state, and federal governments. Does not include transfer payments ( Social Security benefit to a person or an unemployment insurance benefit) because they are not made in exchange for currently produced goods or services. Net Exports (NX): Exports minus imports.Copyright 2004 South-Western 28. Table 1 GDP and Its ComponentsCopyright2004 South-Western 29. ACTIVE LEARNING 1GDP and its components In each of the following cases, determine how much GDP and each of its components is affected (if at all). A. Debbie spends $200 to buy her husband a dinner at the finest restaurant in New York. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. C. Jane spends $1200 on a computer to use in her editing business. She got last years model on sale for a great price from a local manufacturer. D. General Motors builds $500 million worth of cars, 30. ACTIVE LEARNING 1Answers A. Debbie spends $200 to buy her husband a dinnerat the finest restaurant in New York. Consumption and GDP rise by $200. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China.Investment rises by $1800, net exports fall by $1800, GDP is unchanged. 30 31. ACTIVE LEARNING 1Answers C. Jane spends $1200 on a computer to use in her editing business. She got last years model on sale for a great price from a local manufacturer.Current GDP and investment do not change, because the computer was built last year. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million of them.Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million. 31 32. REAL VERSUS NOMINAL GDP Inflation can distort economic variables like GDP, so we have two versions of GDP: One is corrected for inflation, the other is not. Nominal GDP values production of goods and services at current prices. It is not corrected for inflation. Real GDP values the production of goods and services at constant prices (base year). Real GDP is corrected for inflation.Copyright 2004 South-Western 33. REAL VERSUS NOMINAL GDP The change in nominal GDP reflects both prices and quantities. The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.Copyright 2004 South-Western 34. Table 2 Real and Nominal GDPCopyright2004 South-Western 35. Table 2 Real and Nominal GDPCopyright2004 South-Western 36. Table 2 Real and Nominal GDPCopyright2004 South-Western 37. The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. The GDP deflator is a measure of the overall level of prices. One way to measure the economys inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. Copyright 2004 South-Western 38. The GDP Deflator The GDP deflator is calculated as follows:N o m in a l G D P G D P d e fla to r = 100 R eal G D PCopyright 2004 South-Western 39. The GDP Deflator Converting Nominal GDP to Real GDP Nominal GDP is converted to real GDP as follows:R e a l G D P20X XN o m in a l G D P 20X X = 100 G D P d e f la to r2 0 X XCopyright 2004 South-Western 40. Table 2 Real and Nominal GDPCopyright2004 South-Western 41. EXAMPLE: PizzaCoffeeyearPQPQ2005$10400$2.0010002006$11500$2.5011002007$12600$3.001200Compute nominal GDP in each year: 2005: $10 x 400 +$2 x 1000= $6,0002006: $11 x 500 + $2.50 x 1100 = $8,250 2007: $12 x 600 +$3 x 1200MEASURING A NATIONS INCOME= $10,800Increase: 37.5% 30.9% 41 42. EXAMPLE: PizzaCoffeeyearPQPQ2005400 500$2.00 $2.00 $2.5010002006$10 $10 $112007$12600$3.001200Compute real GDP in each year, using 2005 as the base year: 2005: $10 x 400 + $2 x 1000 = $6,000 2006: $10 x 500 + $2 x 1100 = $7,200 2007: $10 x 600 + $2 x 1200 = $8,400 MEASURING A NATIONS INCOME1100Increase: 20.0% 16.7% 42 43. EXAMPLE: year 2005Nominal GDP $6000Real GDP $60002006$8250$72002007$10,800$8400In each year, nominal GDP is measured using the (then) current prices. real GDP is measured using constant prices from the base year (2005 in this example). MEASURING A NATIONS INCOME43 44. EXAMPLE: year 2005Nominal GDP $60002006$82502007$10,80037.5% 30.9%Real GDP $6000 $7200 $840020.0% 16.7 % The change in nominal GDP reflects both prices and quantities. The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). Hence, real GDP is corrected for inflation. MEASURING A NATIONS INCOME44 45. EXAMPLE: yearNominal GDPReal GDPGDP Deflator2005$6000$6000100.02006$8250$7200114.62007$10,800$8400128.614.6% 12.2%Compute the GDP deflator in each year: 2005:100 x (6000/6000) =100.02006:100 x (8250/7200) =114.62007:100 x (10,800/8400) =128.6MEASURING A NATIONS INCOME45 46. ACTIVE LEARNING 2Computing GDP 2007 (base yr) P Good A Good B$30 $100Q2008 P2009 Q900 $31 1,000 192 $102 200PQ$36 $1001050 205Use the above data to solve these problems: A. Compute nominal GDP in 2007. B. Compute real GDP in 2008. C. Compute the GDP deflator in 2009. 46 47. ACTIVE LEARNING 2Answers 2007 (base yr) P Good A Good B$30 $100Q2008 P2009 Q900 $31 1,000 192 $102 200PQ$36 $1001050 205A. Compute nominal GDP in 2007.$30 x 900 + $100 x 192 = $46,200 B. Compute real GDP in 2008.$30 x 1000 + $100 x 200 = $50,000 47 48. ACTIVE LEARNING 2Answers 2007 (base yr) P Good A Good BQ$30 $1002008 P2009 Q900 $31 1,000 192 $102 200PQ$36 $1001050 205C. Compute the GDP deflator in 2009. Nom GDP = $36 x 1050 + $100 x 205 = $58,300 Real GDP = $30 x 1050 + $100 x 205 = $52,000 GDP deflator = 100 x (Nom GDP)/(Real GDP) = 100 x ($58,300)/($52,000) = 112.148 49. GDP AND ECONOMIC WELLBEING GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy.Copyright 2004 South-Western 50. GDP AND ECONOMIC WELLBEING Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life, however.Copyright 2004 South-Western 51. GDP AND ECONOMIC WELL-BEING Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.Copyright 2004 South-Western