Ch.6 Summary
Fundamental Concepts of Macroeconomics
Definition
Major Goals of Macroeconomics
- High Economic Growth: Increase in total output over time.
- Full Employment: Reducing unemployment to the natural rate.
- Price Stability: Keeping inflation low and stable.
- External Balance: Reducing budget and balance of payments (BoP) deficits.
- Fair Income Distribution: Reducing inequality among citizens.
National Income Accounting
Tools to measure the aggregate economic activity.
GDP (Gross Domestic Product)
Total market value of final goods and services produced within a country's boundary during a given period (usually 1 year).
\( GDP = \sum P_i Q_i \)
Sum of (Price × Quantity) for all final goods.
GNP (Gross National Product)
Total value produced by nationals (citizens) regardless of location.
\( GNP = GDP + NFI \)
NFI (Net Factor Income) = Income from abroad - Income paid to abroad.
- If NFI > 0, then GNP > GDP
- If NFI < 0, then GNP < GDP
Three Approaches to Measure GDP
GDP is calculated by adding the market value of goods/services produced by each sector.
To avoid Double Counting: Take only final goods OR sum the Value Added (Output Value - Intermediate Cost) at each stage.
Sum of all spending on final goods.
\( GDP = C + I + G + NX \)
- C: Personal Consumption (Durable + Non-durable + Services).
- I: Gross Private Investment (Business fixed + Residential + Inventory).
- G: Govt Purchases (Excludes transfer payments).
- NX: Net Exports (Exports - Imports).
Sum of incomes generated by factors of production.
GDP = Wages + Rent + Interest + Profits + (Indirect Business Taxes + Depreciation - Subsidies)
Other Income Accounts Relationships
\( NNP = GNP - \text{Depreciation} \)
\( NI = NNP - \text{Indirect Business Tax} \)
\( PI = NI - (\text{Retained Earnings} + \text{Corp Tax} + \text{Soc. Sec.}) + \text{Transfer Payments} \)
\( PDI = PI - \text{Personal Taxes} \)
\( PDI = C + S \) (Consumption + Saving)
Nominal vs Real GDP & Indices
Adjusting for Price Changes.
Nominal GDP
Valued at current year prices.
\( \text{Nominal} = \sum P_{current} \times Q_{current} \)
Can rise just because prices rose, even if output didn't.
Real GDP
Valued at base year prices.
\( \text{Real} = \sum P_{base} \times Q_{current} \)
Reflects actual change in output volume.
Price Indices
\( \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100 \)
- Measures prices of all domestically produced goods.
- Allows basket to change (Variable weights).
\( \frac{\text{Cost of Basket}_{current}}{\text{Cost of Basket}_{base}} \times 100 \)
- Measures prices of goods bought by consumers.
- Uses a Fixed Basket of goods.
- Includes imported consumer goods.
The Business Cycle
Recurrent ups and downs in economic activity.
Max output. Economy grows faster than trend. Low unemployment. Inflationary pressure.
Economic activity declines. Output falls. Unemployment rises.
Lowest point. High unemployment. Idle capacity. "Depression" if severe.
Expansion. Output and employment rise towards full employment.
Macroeconomic Problems
1. Unemployment
Labor Force: People (14-60) employed + those without jobs actively seeking.
Not in Labor Force: Students, Retired, Disabled, Discouraged workers.
Unemployment Rate = (Unemployed / Labor Force) × 100
Brief periods between jobs (e.g., graduates, switching jobs). Unavoidable.
Mismatch of skills or location (e.g., technology replaces workers). Unavoidable.
Caused by deficiency in demand (Recession). This is the problematic one.
Natural Rate of Unemployment = Frictional + Structural (Full Employment ≠ 0 unemployment).
2. Inflation
Sustained increase in general price level.
"Too much money chasing too few goods." AD exceeds AS.
Supply shock. Rise in input costs (wages, raw materials).
Economic Effects:
- Reduces purchasing power (Real income falls).
- Fisher Effect: \( i = r + \pi \) (Nominal Interest = Real + Inflation). Higher inflation raises nominal rates.
- Shoe-leather cost: Cost of frequent trips to bank.
- Menu cost: Cost of changing prices.
- Redistribution: Debtors win (pay back cheaper money), Creditors lose.
Trade & Budget Deficits
Budget Deficit
When Govt Spending (G) > Tax Revenue (T).
Financed by borrowing (internal/external) → Public Debt.
Ethiopian Context: Financed by external concessional loans for projects.
Trade Deficit
When Imports > Exports (NX < 0).
Identity: \( S - I = NX \)
- \( S - I > 0 \): Trade Surplus (Net Lender).
- \( S - I < 0 \): Trade Deficit (Net Borrower).
Macroeconomic Policies
Tools to stabilize the economy.
Fiscal Policy
Use of Taxation (T) and Government Spending (G).
Functions:
- Allocation: Providing public goods.
- Distribution: Taxes/Subsidies to reduce inequality.
- Stabilization: Managing demand (e.g., spending more during recession).
- Development: Financing infrastructure for growth.
Monetary Policy
Control of Money Supply and Interest Rates.
Mechanisms:
- Recession: Increase Money Supply → Lower Interest Rates → Increase Investment (I).
- Boom/Inflation: Decrease Money Supply → Raise Interest Rates → Reduce Demand.