Core Macroeconomic Concepts: GDP, Inflation, Unemployment

Posted on Mar 31, 2025 in Economy

1. GDP and National Income Measurement

Limitations of GDP in Terms of Production

  • The informal economy
  • Illegal activities
  • Domestic work

Other National Income Measures

  • Gross National Income (GNI) = GDP + income that domestic citizens earn abroad – income that foreigners earn in the domestic country
  • Net National Product (NNP) = GNI – depreciation of capital

Challenges in GDP Comparison

  • Different population sizes: Addressed by GDP per capita
  • Different currencies: Addressed by converting GDP to U.S. dollars
  • Different price levels: Addressed by calculating GDP at purchasing power parity (PPP)

Measuring the Price Level and Inflation

The price level is a snapshot of the prices of goods and services in an economy at a particular period.

Issues with Inflation Metrics

Problems with measures of the price level (Inflation):

  • Fixed weights or chain-linked index? – Addresses substitution bias
  • New goods? – How to incorporate them
  • Quality changes? – Adjusting for improvements
  • Relevance for individual consumer? – CPI represents an average

Types of Inflation

  • Headline inflation: Inflation based on the Consumer Price Index (CPI)
  • Core inflation: Inflation based on CPI excluding food and energy (other variants exist)

Real vs. Nominal Values

  • Real interest rate = nominal interest rate – inflation (r = i – π)
  • Real wage = Nominal wage / Price level

2. Understanding Unemployment

Measuring Unemployment

Claimant Count

  • Number of people claiming unemployment benefits
  • Sensitive to changes in rules for eligibility

Labour Force Surveys

  • Based on survey responses
  • Sensitive to changes in definitions/question formulation

Challenges in Unemployment Measurement

  • Discouraged workers: Not actively seeking work, thus not counted
  • Underemployed: Employed individuals who want to work more hours
  • Labour market programs: Participants may not be counted as unemployed
  • Average measure: Does not capture duration of unemployment or differences between groups

Cyclical Unemployment

The deviation of unemployment from its natural rate, varying with the business cycle.

Theories of Unemployment

Keynesian View

  • Unemployment due to insufficient aggregate demand and flaws in the market mechanism.
  • Effective demand: Not only what people are willing to buy, but what they can and do buy.

Neo-classical Synthesis

  • Sticky prices and wages cause the labour market to adjust slowly, but it will adjust in the long run.

Marxist View

  • Unemployment is a necessary condition for capitalism to survive (reserve army of labour).

Structural Unemployment

Arises from mismatches between job seekers and available jobs.

  • Occupational and geographical immobility
  • Technical change

3. The Financial System and Savings

Role of the Financial System

A group of institutions that matches one person’s saving with another person’s investment.

Transfer Mechanisms

  • Direct transfer through financial markets: e.g., bond and stock markets
  • Indirect transfer through financial intermediaries: e.g., banks, investment funds
  • Transforms short-term liabilities (like deposits) into long-term investments (like loans)

National Saving and Government Budgets

National Saving = Private Saving + Public Saving

National Saving = (Y – C – T) + (T – G)

  • If T – G > 0 → Budget surplus
  • If T – G < 0 → Budget deficit → Government debt increases
  • In a closed economy where S = I → a budget deficit implies that the government borrows from the private sector.

4. Money, Banking, and Inflation

Functions of Money

  • Medium of Exchange: Facilitates transactions by being accepted as payment.
  • Unit of Account: Standardized measure to set prices and record debts.
  • Store of Value: Maintains purchasing power over time; depends on economic stability.

Measuring the Money Stock

Narrow Money (M1)

  • Currency in circulation
  • Overnight deposits

Role of Central Banks

Responsible for the money supply and financial stability.

  • Clearing bank payments
  • Acting as a lender of last resort

Risks in Banking

  • Credit risk: Risk of default on loans
  • Liquidity risk: Risk of not being able to fund withdrawals
  • Systemic risk: Risk of failure across the whole financial sector

Mitigating Banking Risks

  • Macroprudential policy (e.g., reserve requirements)
  • Deposit insurance

Tools of Monetary Control

Open Market Operations

  • Outright purchase/sale of short-term government securities in the open market.

Quantity Theory of Money

Relates the quantity of money to the price level. The value of money (1/P) is inversely related to the price level (P).

Velocity of Money

The equation of exchange: M * V = P * Y

  • M = Money Supply
  • V = Velocity of Money (average number of times a unit of money is spent)
  • P = Price Level
  • Y = Real Output (Real GDP)

Costs of Inflation

  • Shoe leather costs: Resources wasted when inflation encourages people to reduce their money holdings.
  • Menu costs: Costs of changing prices.
  • Price signals and misallocation of resources: Inflation distorts relative prices.
  • Tax distortions: Inflation can increase tax burdens (e.g., bracket creep).

Costs of Deflation

  • Impact on aggregate demand: Consumers may wait to consume, expecting prices to fall further.
  • Burden of debt increases in real terms, potentially leading to less investment and consumption.

5. International Trade and Finance

Determinants of International Trade

  • Preferences for domestic vs. foreign goods
  • Prices of goods at home and abroad
  • Exchange rates
  • Need for raw materials
  • Income levels at home and abroad
  • Cost of transportation
  • Trade policy (tariffs, quotas, etc.)

Net Capital Outflow (NCO)

NCO = Purchase of foreign assets by domestic residents – Purchase of domestic assets by foreigners

An identity holds: Net Exports (NX) = Net Capital Outflow (NCO)

Therefore, National Saving (S) = Domestic Investment (I) + Net Capital Outflow (NCO)

S = I + NCO

Substituting the components of national saving:

(Y – T – C) + (T – G) = I + NCO

Where (Y – T – C) is private saving and (T – G) is public saving.

Rearranging for private saving:

Private Savings = I + NCO + (G – T) (where G-T is the budget deficit)

The Current Account

Records flows of goods, services, income, and transfers.

Components

  • Trade balance on goods and services: Exports minus imports
  • Net primary income: Net factor payments from abroad (e.g., wages, interest, profits)
  • Net secondary income: Net transfer payments from abroad (e.g., foreign aid)

Interpreting the Current Account

  • Surplus: The country earns more from its international transactions than it spends; it uses fewer resources than it produces (lending to/investing abroad).
  • Deficit: The country spends more than it earns internationally (borrowing from/selling assets to abroad).

The Capital Account

Records purchases and sales of non-financial assets (e.g., land, natural resources ownership) and capital transfers.

Balance of Payments

A record of all economic transactions between residents of a country and the rest of the world. In theory, the current account and the capital/financial account balance (sum to zero), but statistical discrepancies arise because data is recorded separately.

Exchange Rates

Types of Exchange Rates

  • Nominal Exchange Rate (e): The rate at which one currency trades for another.
  • Real Exchange Rate: The rate at which goods/services of one country trade for those of another. Real Exchange Rate = (Nominal Exchange Rate * Domestic Price Level) / Foreign Price Level
  • Absolute Purchasing Power Parity (PPP) Exchange Rate: A theoretical exchange rate used for comparing income levels, based on the law of one price.

Purchasing Power Parity (PPP)

  • Absolute PPP: In competitive markets free of transport costs and trade barriers, the same good should have the same price (in a common currency) everywhere. Arbitrage possibilities exist otherwise. It often doesn’t hold perfectly due to transport costs, trade barriers, non-tradable goods, and different consumption baskets.
  • Relative PPP: Predicts that the change in the nominal exchange rate between two currencies will reflect the difference in their inflation rates. % Change in Exchange Rate ≈ Foreign Inflation (π*) – Domestic Inflation (π). This suggests a currency will depreciate against another if its inflation rate is higher.

Net International Investment Position (NIIP)

NIIP = Total value of foreign assets owned by domestic residents – Total value of domestic assets owned by foreigners

  • Positive NIIP: The country is a net creditor (owns more foreign assets than foreigners own of its assets).
  • Negative NIIP: The country is a net debtor (owes more to foreigners than it owns abroad).

6. Understanding Business Cycles

Fluctuations in economic activity (e.g., GDP, employment) around its long-term growth trend.

Causes of Business Cycle Fluctuations

  • Household spending decisions: Influenced by interest rates, house prices, taxes, confidence.
  • Firms’ decision-making: Based on expected demand, real wages, productivity, inventory levels.
  • External forces: Exchange rates, global crises, natural disasters, wars.
  • Government and central bank policy: Changes in tax rates, government spending, interest rates.
  • Confidence and expectations: Self-fulfilling prophecies can influence spending and investment.

Note: Rigid (sticky) prices and wages can amplify the effect of economic shocks.

Business Cycle Models

The New Classical Model

  • Deviations from the long-run trend are primarily due to imperfect information (e.g., misperceiving price level changes) and real supply shocks. Assumes rational expectations and flexible prices/wages.

The New Keynesian Model

  • Deviations from the trend are largely due to sticky prices and wages, preventing markets from clearing quickly in response to demand shocks. Allows a role for stabilization policy.

Real Business Cycles (RBC) Model

  • Short-run fluctuations are primarily driven by real shocks, particularly technology shocks affecting productivity. Downplays the role of monetary factors and demand shocks.

7. Keynesian Economic Models

Keynesian Model Assumptions (Simple Model)

  • Prices are fixed in the short run → Nominal GDP = Real GDP.
  • The interest rate is fixed (or determined outside the model initially).
  • There are available, unemployed production resources.

Deflationary Gap (Recessionary Gap)

A situation where the economy is operating below its full employment level of output. Aggregate demand is insufficient to employ all available resources. The economy is operating inside its Production Possibilities Frontier (PPF).

Policy Recommendation: Government should stimulate aggregate demand through:

  • Increased government spending (G)
  • Tax cuts (to boost C or I)
  • Increased transfer payments (to boost C)

Inflationary Gap

A situation where the economy’s actual output exceeds its full employment level of output. Aggregate demand is higher than the economy’s capacity to produce sustainably.

Mechanism: Firms are already operating at full capacity. To increase output further (or meet high demand), they must bid for scarce resources, including labour, leading to higher wages and costs. These increased costs are passed on to consumers as higher prices (inflation).

Policy Recommendation: Government should reduce aggregate demand (contractionary fiscal policy).

The Multiplier Effect

The concept that an initial change in autonomous spending (e.g., government spending, investment) leads to a larger final change in aggregate demand and national income. This occurs because the initial spending becomes income for others, who then spend a portion of it, creating further income, and so on.

Example: Expansionary fiscal policy (like increased G) increases income, which in turn increases consumer spending (C), further boosting aggregate demand.

Size of the Multiplier (k)

The size of the multiplier depends on the proportion of extra income that leaks out of the circular flow of income at each stage.

k = 1 / Marginal Propensity to Withdraw (MPW)

Withdrawals (leakages) are portions of income not passed on in domestic consumption:

MPW = Marginal Propensity to Save (MPS) + Marginal Propensity to Tax (MPT) + Marginal Propensity to Import (MPM)

Where the Marginal Propensity to Save (MPS) is related to the Marginal Propensity to Consume (MPC):

MPS = 1 – MPC

A smaller MPW (meaning smaller leakages) leads to a larger multiplier.