Macroeconomics: The Big Picture

"If you can not measure it, you can not improve it.“

-Sir WilliamThomson

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Some key concepts follow here

In this module, we will learn some key concepts. We’ll answer questions such as:

How do I measure the size of a macroeconomy?

What measures do I use to determine whether that

economy is ‘healthy’ or not?

Sometimes an economy seems good…other times bad. What are

these differences?

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For Milestone #2, you’ll use these tools in assessing the health of the nation you are studying for your research paper!

Let’s start with the broadest measure of an economy: Gross Domestic Product

What is GDP?

(In general) It is a measure of economic activity. It tells you the

total size of an economy as measured by economic output

and income.

(Specifically) GDP is the total value (measured in dollars) of all final goods and services produced

during a particular year within the borders of an economy.

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What do we mean by “Final Goods and Services”

What IS included in GDP?The value of final goods and

services- things that are newly produced goods and will not be resold (in other words,

they have reached their final customer).

What is NOT included in GDP?Nonproductive transactions such as:

Secondhand salesExpenditures for stocks and bonds

Transfer payments

Sales of used items don’t represent “new” production…so

they are not counted in GDP!Slide 4 of 46

There are two ways to measure GDP

• Expenditure Approach

• Income Approach

The expenditure approach is the more

easily understood approach. We’ll pay

more attention to this one!

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The Expenditure Approach

The expenditure approach measures economic

activity here

It measures the total value

of all goods and services produced in a

given area.

Think of it as the sum of all spending (i.e. “expenditures”) that

occur in a country in one year.Slide 6 of 46

The Income Approach (also called the Earnings or Allocations Approach)

GDP = Wages + Rents + Interest + Profits (+ an adjustment)

The expenditure approach determines the size of an economy (i.e. GDP) by measuring all spending

on final goods and services.

Keep in mind that all that spending eventually turns into someone’s income.

Therefore, in theory, you should be able to add everyone’s income and arrive at the same number.

That approach to determining GDP is called the Income Approach.

This approach also requires that you make several complicated adjustments for taxes and other

factors.

I encourage you to understand the Income Approach and other measures of income.

However, in this class we’ll primarily focus on GDP as it is measured using the Expenditure Approach.

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The Income ApproachThis income

approach measures economic

activity here

It measures the total value

of income earned in a given area.

In theory, the two numbers should be the

same…

…someone earns income from all things

produced!

This is an important point: Regardless of which method you use, you will (in theory

arrive at the same number for GDP.

Everything produced in an economy eventually becomes someone’s income.

Therefore, GDP equals income.

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So how big IS our economy?

Source: Worldbank Data.org

In 2011, the U.S. GDP was about $15 trillion. That is the value of all things produced here in that year.

Yes…that is trillion with a “t”!

That was (and still is) the largest economy in the

world.

Today, we are on pace to produce about $16 trillion

in goods and services.

China has recently

overtaken Japan for the second

ranking.

Many economists expect they will overtake the US

by 2030.

This chart gives us a comparison for one point in time. What about looking at an economy OVER time?

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Looking at historic GDP data

Analysis of historic GDP data (or any dollar based economic data) requires an inflation adjustment.

Why? Because prices have changed. See below!

Because of these changes in prices, it simply isn’t fair to compare older data with

newer data.

Similarly, it isn’t fair to compare your income with your great grandfather’s

income.

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He may have only made $5,000 per year…but that could have been a lot of

money in his time!

We have to correct for price changes if we want to see if a country’s economy is really growing.

No! Prices are getting higher, but they are producing

fewer items.

Look at this simple example. In 1920, this

country produced 100 units of a good that cost $1,000 per unit. If that is all they

produced, then GDP would be $100,000.

In 2000, they produced 82 units of that good at a price of $2,144. Therefore, GDP

was $175,774.

But…is this country’s economy bigger?

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x =

So how do we control for those changes in prices to see if a country is really growing?

We use a price index such as the Consumer Price Index (CPI)

Price Index – a measure of the price of a specified collection of goods and services called a market basket in a

given year as compared to the price of an identical collection of goods or services in a reference year.

If you took a basket of goods we all commonly buy – like gas, milk, TVs, electricity, and bread -

you could add the prices together.

Think of it this way:

Perhaps it is $800 today.

TODAY

You could examine what that same basket of goods cost in a different period…let’s use 1980

as an example.

Perhaps it was $600 in 1980.

1980

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Calculating a price index

We could then use our formula to determine a price index. Let’s call today the base year and 1980 the specific year.

In this case, we’d have (600/800)*100That equals 75!

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Using a price index

We could then use the price index to adjust GDP data.

Let’s say that GDP in this country was $10 million in 1980 and $100 million

now.

These are nominal figures. In order to compare them, we need to adjust for

inflation.

In other words, we need to adjust from Nominal GDP to Real GDP

Real GDP is calculated by dividing “nominal” GDP (which means GDP

that is not adjusted for price changes) by the price index.

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Using a price index

Let’s try it using the formula below:

For 1980, Real GDP = $10 million / (75 / 100)

That equals $13.3 million…

…In today’s dollars!

Now we can fairly compare GDP from 1980 to today….because they are in REAL TERMS

Changes in Real GDP are commonly observed as “ups and downs” in economic activity…that up and down movement is called the “business cycle” and

understanding that is a Key Learning Outcome! Slide 15 of 46

Let’s try a simple example

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Imagine we have a hypothetical economy that produces only one

good…maybe that good is umbrellas.

In 1950, they produced 10 umbrellas and each one sold for one dollar in that

year.

In 2000, they produced 30 umbrellas and each one sold for three dollars in

that year.

With that information, we can calculate nominal GDP. That is the value of all output in the prices that were charged

in that year.

For 1950, that number is 10 times $1 or $10.

For 2000, it is 30 times $3 or $90.

Here is where this concept gets important:

It would not be fair to say that this economy has grown from $10 to $90.

Here is where this concept gets important:

If it did, that would mean it is nine times larger!

Here is where this concept gets important:

But it is only producing 3 times as many umbrellas, each costing more.

We need to control for changes in price!

To do that, we need to develop a price index. And for that, we must pick a

base year.

You can pick any year but I recommend using the most recent. Here we will

use the year 2000.

So the price index in 1950 will be the price in that year (the specific year) divided by the price in the base year

(2000)…times 100.

That is ($1 / $3) times 100.That equals 33.33.

For 1975, it is $2/$3 times 100 or 66.67.

For 2000, it is $3/$3 times 100 or 100. The price index is always 100 in the

base year.

Now we are ready to calculate Real GDP.

To calculate Real GDP, we take nominal GDP and divide it by:

(the price index/100)

For the year 1950, that number is:$10 / (33.33/100).

That is the same as:$10/0.3333

Which is $30.

For 1975, it is $40 / (66.67/100)That equals $60.

For 2000, it is $90 / (100/100)That equals $90.

Now we can compare Output in 1950 to Output in 2000. We have controlled for

price changes!

And we can conclude that Real GDP has increased in this nation from $30 to

$90.The economy is three times larger (in

real terms).

Let’s do some more complicated practice……

Try to follow this example Nominal GDP is output times current prices at

the time that output was sold

A price index shows us how prices have changed over time. In 1995, prices were $1 versus $6 in 2000. Therefore the 1995 price index is 1/6*100 or 16.67 Note that the

selection of 2000 for a base year is arbitrary.

Real GDP is Nominal GDP * (price index/100).

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Try this one on your own. You’ll see questions like this on the test!

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Here is another example.

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Nominal GDP Versus Real GDP

The U.S. has experienced real economic growth!

Nominally (the blue line), we have experienced a lot of growth.

Total nominal GDP increased from about $500 billion in 1950 to

$11trillion in 2003.

But much of that growth is due to increases in prices.

The pink line controls for price changes and shows us if we have

had “real growth”.

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Most economies wobble between period of rapid growth and periods of slow growth or

even decline.

It might look like this:

Now the we understand the REAL GDP, we can analyze changes in an economy

Growth begins…Then accelerates…And eventually tops out.

Every so often, the economy even

retracts.

This up and down pattern of economic growth is referred to as the BUSINESS

CYCLE…a Key Learning Outcome.

Source: Pretend, made up data by Sean Slide 21 of 46

The business cycle has four phases

• Peak– The high point, a temporary maximum

• Trough– Output has “bottomed out”

• Recession– Real GDP, income and employment is declining

• Expansion (also called a recovery)– Real GDP, income, and employment are risingHere we see U.S. Real

GDP from 1990 to 2003.

Note how it has grown from 1990 to 2003 but

not steadily.

In fact, it declined in both 1990 ad 2001…each of which were

recessions.

That is the core of this chapter. Over the long

term, we expect the economy to grow…

In the short run, we see these minor

fluctuations. This chapter studies their

causes and their impacts.

These are actual historical phases of the U.S. business cycle. You’ll see them numerous times in your life. They are a Key Learning Outcome…

But even more, knowing them is an important skill for any business person!

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One cause is “momentous innovation”.

Why isn’t growth more regular?…In other words, What are some of the causes the business cycle?

New developments such as the railroad, the microchip, and cell phones have all ushered in an

era of new growth.

Another cause is productivity.A good example of this is the feminization of the workforce.

Prior to the 1960s, many women did not work.

As they entered the workforce in large numbers in the 1960s, the amount we produced increased.

In economic terms, the use of this resource caused Real GDP

to increase more rapidly…leading to an expansion!

There are other factors that cause the business cycle such as

political events, war, terrorism and many more

Each either adds to or takes away from growth causing that

irregular pattern.

In other words, our economy is CYCLICAL!

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Dates of last 10 business cycles in the U.S.

Here are the dates for the peak and trough in each of

the last 10 business cycles. These are estimated by

NBER, the National Bureau of Economic Research.

Look at it this way: In October 1949, an expansion

started. It lasted 45 months.

When it ended, we went through a recession that

lasted 10 months.

You do NOT need to memorize any of these

numbers.

But study the pattern – which is longer recessions

or expansions?

How long can you expect an expansion or recession to

last…in general?

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An Irregular Pattern Indeed!

What we observe is that even this pattern is irregular.Sometimes, expansions last

120 months…that is ten years!

Other times they can be much shorter. In the early 1980s we suffered through back to back recessions in

what is called a “Double Dip”.

Some recessions can be short…like this 8 month

recession.

Others, like our most recent can be much longer. The

recession resulting from the financial crisis lasted 18

months!

Here is what you need to know:

The average expansion lasts about 60 months. The average

recession lasts about 10 months.

Knowing these numbers can help you plan. Being aware of where you are in the

business cycle can help with decisions like:

“Should I open a business?”

“Should I get a graduate degree?”

“Is this a good time to quit my job and change careers?”

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Let’s turn our attention to the byproducts of the business cycle

When an economy is growing to slowly, unemployment

usually occurs. Think of this as an economy that is to

COOL! Business is slow and people are being laid off.

When an economy is growing to quickly, inflation usually occurs. Think of this as an economy that is to HOT! Supply can’t keep up with a rapidly growing demand and prices start getting bid up.

This irregular pattern of growth has consequences.

We’ll study two of them.

The first is UNEMPLOYMENT

The second is INFLATION

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These byproducts or ‘problems’ (inflation and unemployment)

associated with the business cycle are a key learning outcome!

We will focus a lot of out attention on these two important variables!

Let’s turn our attention to unemployment

Unemployment is the failure of the economy to fully use its

labor force

Let’s assume we live in an economy that has 100

people in it.

It includes:

10 children

It measures the fraction of people that would like to work,

are able to work, and are willing to work…but can not

find work.

15 retired people

75 working aged people

And 60 of them are working

The unemployment rate = the number of people

unemployed divided by the labor force.

Meaning there are 15 people that want to work but are not.

In this scenario, the labor force is 75…

And unemployment is 15…

So the unemployment rate is 15/75, which is 20%

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Individual exercise

Try to determine the unemployment rate for these two economies

? ?

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What has been the U.S.experience with unemployment?

Like many economic indicators, it is volatile.

One thing you might note: it has taken longer for the unemployment rate to start falling after the last several recessions have ended. This

is due to a reluctance on the part of business to hire until they are sure we are recovering and is called a “jobless recovery”.

You might also note the recent spike…the last recession was

certainly painful.

Periods in the grey bars are recessions. Periods in the white

sections are expansions (recoveries). As we would expect,

unemployment goes up in recession and falls afterwards.

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In our nation’s worst recession, unemployment hit 25%

In the Great Depression, one in four men were unemployed.

There were no social programs like unemployment

insurance.

If you were out of work, you were on your own. Many

people lost everything.

In some cases, private citizens or businesses gave

bread to unemployed men.

This man might have been on a

“bread line”.

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Unemployment rates in the U.S. are relatively low

Once again, proof that we are fortunate to live in a big stable economy.

We are lucky. Imagine trying to get a job in Zimbabwe with 90%

unemployment.

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Unemployment can be classified into three types

• Frictional – voluntary movement from one job to another. “Between jobs”.

• Structural – unemployment due to changes in industrial composition or geographical distribution of business

• Cyclical – unemployment due to the cycle of the economy

This type isn't bad. Typically, this means an

employee is leaving voluntarily because they

have a better job coming.

Example: the recent Ford plant shutdown.

While painful for employees it is usually

beneficial for the company.

This is the one that really hurts. There just

aren’t enough jobs to go around.

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No, some unemployment is expected

Specifically, we want:

Frictional

Structural

This is a sign of improvement!

Full employment rate of unemployment (natural rate of unemployment or NRU)

Is an unemployment rate of zero a reasonable goal?

The natural rate of unemployment (which means we are at Full Employment) is

between 4% and 6%

It includes frictional and structural unemployment but

does not include cyclical unemployment. XWe’ll discuss full

employment and the natural rate of unemployment

(NRU) a lot this semester. Make sure you understand

it!Slide 33 of 46

How does the current unemployment rate compare to this standard?

At around 7.6%, we are out of the normal range!

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Let’s look at Inflation - the second byproduct of economic instability

The technical definition of inflation: a persistent, substantial rise in the

general level of prices

I am sure you have noticed increased prices in the grocery store.Slide 35 of 46

How is inflation measured?

Most commonly measured using the Consumer Price

Index (CPI) published by the Bureau of Labor Statistics

(BLS).

The Federal Government's Bureau of Labor Statistics

collects data on hundreds of goods that we all routinely

buy.

These things include gas, milk, bread, TVs, cars, and many

other things.

They then use this data to develop a “Price Index”.

Think of it this way: If that “Basket of goods” cost $2000

in 1990 and cost $2500 today, they could assume prices have

gone up by 25% (which is $500/$2000).

This is the same price index we used earlier to adjust

nominal GDP data.

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Calculating a Price Index

To develop the “Price Index, you first select a year…any

year.

Then you compare the price of that basket of goods in that

year to all other years.

Year

Let’s try an example. Say we pick the year 2000 for

our base year…

Price of the basket of goods Price Index

2000 $10,000 100

2001 $11,000 110

That’s $10,000 divided by $10,000 times 100.

That’s $11,000 divided by $10,000 times 100.

2002 $13,000 130That’s $13,000 divided by

$10,000 times 100.

2003 $17,000 170That’s $17,000 divided by

$10,000 times 100.

Now that we understand the CPI, we can look at its history to see how prices have changed in the

U.S. Slide 37 of 46

The Consumer Price Index (CPI)

Here are the actual data.For this graph, the government has used 1983 as its base

year.

The index will always equal 100 in the base year.

In 1975, it equaled 50, meaning things cost half as

much then as they did in 1983.

That suggests a rapid increases in prices between 1976 and 1983. If you were

alive (as an adult) then…I bet you remember that.

Move forward to 2007, where the CPI was 200. That means prices doubled between 1983

and 2007…a much more modest period of price

increases.

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Inflation is relatively low in the U.S. (and most all other developed countries)

However price increases are modest in the U.S.

Inflation in Zimbabwe is has reached more than

1 million percent!

That means prices double everyday!

Can you even imagine living in an environment

like that?!?!

Once again, proof that we are fortunate to live in a big stable economy.

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The opposite side of the coin: Deflation

During the great depression, the U.S. experienced a relatively long

period of price decline or stagnation.

For example, something that cost $1.00 in 1920… …Cost $0.68 by 1933

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What is the problem with deflation?

The #1 problem: It reduces demand. No one buys anything because

everyone thinks it will be cheaper tomorrow.

Shop keepers get desperate and lower prices. This becomes a self fulfilling

prophecy!

That is called a “Deflationary spiral”

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Sometimes inflation can get out of control

As people start expecting inflation to occur, they build it into contracts

and regularly add it to prices.

Eventually, this can become a self fulfilling prophecy.

People expect higher prices, so they charge more… which leads to

higher prices.

If that happens long enough, price increases can get out of control-

that is called hyperinflation.

For sale:

$1 milli

on

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Examples of bad hyperinflation: Germany

Germany went through its worst inflation in 1923-24.

After losing World War I, winning countries demanded

payment for damages.

The German government decided to simply print the

money.

That meant that more money was chasing the same amount

of goods and services, so prices started to rise.

Prices got so high, they had to print a bill with the number

100,000,000,000,000 on it to accommodate high prices!

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When prices start to spiral upward, governments print

bigger bills to accommodate high prices.

Here are some examples of large bills printed in the past:

With bad inflation, bills get big

Italy: 10,000 LiraCroatia: 100,000 DinaraYugoslavia: 10 billion DinaraZimbabwe: 100 Trillion Zim Dollars

Can you imagine carrying around bills of that size?

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Inflation overview

We have learned that hyperinflation is bad.

We have learned that deflation is bad.

Developed economies try to walk a fine line…

Keep a little bit of inflation around to avoid deflation- but don’t let it get out of control!

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What does a healthy economy look like?

A government’s goal is to promote economic growth without igniting inflation.

Strong economic growth drives down unemployment.

The best recent U.S. example of this type of growth was the 1990s “Tech Boom”.

Growth was strong, unemployment was low and inflation was low but above zero.

That is why some called the 1990s expansion (which had a lot of growth with little inflation)

“The Goldilocks Economy”!)

It wasn’t too cool and it wasn’t too

hot!

Just right!

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In summary

A nation’s total output can be measured by adding the value of all products produced or all income

earned. That will equal Gross Domestic Product.

Unfortunately, GDP wobbles from rapid growth to decline. That wobbling is a pattern that repeats over

time and is called the business cycle.

Over time, prices change so when comparing GDP from one year to another, we must adjust for inflation.

When GDP is adjusted for inflation, it is called Real GDP or RGDP.

Economists, politicians and others use RGDP to measure the health of our economy!

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