What Macroeconomics Is All About

Chapter 19
What
Macroeconomics
Is All About
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to
1. Describe the meaning and importance of the key

macroeconomic variables, including national income,
unemployment, inflation, interest rates, exchange rates,
and trade flows.
2. Explain that most macroeconomic issues are about long-

run trends or short-run fluctuations, and that government
policy is relevant for both.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-2

Key Macroeconomic Variables
Output and Income

The production of output generates income.
To measure total output in dollars, we add up the values of the

many different goods produced.
This gives nominal national income (in current dollars).
Using base-period prices, we get real national income (in

constant dollars).
Figure 19.1 Growth and Fluctuations
in Real GDP, 1962–2005

Movements in Real GDP
Real GDP fluctuates around a rising trend:

- the trend shows long-run economic growth
- the short-run fluctuations show the business cycle
APPLYING ECONOMIC CONCEPTS 19.1

The Terminology of Business Cycles

Potential Output and the Output
Gap
Potential output is what the economy could produce if all

resources were employed at their normal levels of utilization
- often called full-employment output
The output gap measures the difference between potential

output and actual output.
Output Gap = Y-Y*

When Y < Y* , there is a recessionary gap.
When Y > Y*, there is an inflationary gap.
Figure 19.2 Potential GDP and
the Output Gap, 1971–2005

Employment, Unemployment, and
the Labor Force
Employment: the number of workers (16+) who hold jobs.
Unemployment: the number who are not employed but are

actively looking for a job.
Labor force: the total number of employed + unemployed.
The unemployment rate is the number of unemployed

expressed as a percentage of the labour force.

Unemployment Rate
Number of people unemployed

Unemployment = X 100
Rate Number of people in the labor
force
Even when Y = Y*, some unemployment exists:
• frictional unemployment
• structural unemployment

Full and Cyclical Unemployment
The unemployment rate when Y=Y* is called full employment.
Cyclical unemployment is neither structural or frictional

- changes with the ebb and flow of the business cycle
Why Does Unemployment Matter?
Some unemployment is desirable, as it reflects the time required for

workers and firms to “find” each other so that good matches are made.
But some unemployment is associated with human hardship, especially
for those individuals with skills that are not in high demand by firms.

Figure 19.3 Labor Force, Employment,
and Unemployment, 1960–2006

Productivity
Productivity: a measure of output per unit of input

- often measured as GDP per worker (labor
productivity)
- or GDP per hour of work
Increases in productivity are probably the single largest
determinant of long-run increases in material living standards.

Figure 19.4 Labor
Productivity, 1960–2006

Inflation and the Price Level
The price level: the average level of all prices in the economy.
Inflation: the rate at which the price level is changing.
The CPI is based on the price of a typical “consumption

basket,” relative to the price in some base year:
∑PQ t 0
CPI t = ×100
∑P Q 0 0

Inflation Matters
APPLYING ECONOMIC CONCEPTS 19.2

How the CPI Is Constructed
Why Inflation Matters
The purchasing power of money is negatively related to the

price level.
Also, because it is hard to forecast accurately, inflation adds
to the uncertainties of economic life.

Table 19.1 Expenditure
Behavior in 1997

Table 19.2 1997 Expenditure
Behavior at 2007 Prices

Figure 19.5 The Price Level and the
Inflation Rate,1960–2006

Interest Rates
The interest rate is the price of borrowing funds — the

percentage amount per period.
Nominal interest rate: the rate expressed in money terms.
Real interest rate: the rate expressed in terms of purchasing

power.
The burden of borrowing depends on the real interest rate.

Figure 19.6 Real and Nominal
Interest Rates, 1960–2006

The International Economy
Foreign exchange: foreign currencies or claims on foreign

currencies.
Exchange rate: the number of U.S. dollars required to
purchase one unit of foreign currency.
An appreciation of the U.S. dollar means that a U.S. dollar buys
more foreign currency
- a rise in the exchange rate
A depreciation of the U.S. dollar means that a U.S. dollar buys less
foreign currency
- a fall in the exchange rate
Figure 19.7 U.S. Dollars Needed
to Purchase A Euro, 1999–2007

Exports and Imports
The balance of payments accounts record all payments

made in international transactions — goods, services, and
assets:
- trade balance (exports – imports)
- current account balance
- capital account balance
For the U.S., the increasing role of international trade is an

important aspect of globalization.

Figure 19.8 Imports, Exports,
and Net Exports, 1960–2006

Growth Versus Fluctuations
Long-Term Economic Growth
Long-term growth is considerably more important for a

society’s living standards from decade to decade than short-
term fluctuations.
There is considerable debate regarding the ability of

government to influence the economy’s long-run growth rate.

Short-Term Fluctuations
Short-term fluctuations are often called business cycles.
Economists debate the effectiveness of monetary and fiscal

policy in influencing these fluctuations.
Some economists argue that despite the power of policy to

affect the economy, governments should not attempt “fine-
tuning.”

What Lies Ahead?
To organize our thinking about macroeconomics, we must

develop some tools. These will include:
• discussing the measurement of national income
• building a simple model of the economy
• modifying the model to make it more realistic
• using our model to analyze some pertinent economic
issues

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Chapter 19

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1. Describe the meaning and importance of the key

2. Explain that most macroeconomic issues are about long-

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-2

Output and Income

To measure total output in dollars, we add up the values of the

This gives nominal national income (in current dollars).

Using base-period prices, we get real national income (in

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-4

Real GDP fluctuates around a rising trend:

APPLYING ECONOMIC CONCEPTS 19.1

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-5

Potential output is what the economy could produce if all

The output gap measures the difference between potential

Output Gap = Y-Y*

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-7

Employment: the number of workers (16+) who hold jobs.

Unemployment: the number who are not employed but are

Labor force: the total number of employed + unemployed.

The unemployment rate is the number of unemployed

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-8

Number of people unemployed

Even when Y = Y*, some unemployment exists:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-9

The unemployment rate when Y=Y* is called full employment.

Cyclical unemployment is neither structural or frictional

Why Does Unemployment Matter?

Some unemployment is desirable, as it reflects the time required for

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-10

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-11

Productivity: a measure of output per unit of input

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-12

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-13

Inflation: the rate at which the price level is changing.

The CPI is based on the price of a typical “consumption

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-14

APPLYING ECONOMIC CONCEPTS 19.2

Why Inflation Matters

The purchasing power of money is negatively related to the

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-15

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-16

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-17

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-18

The interest rate is the price of borrowing funds — the

Nominal interest rate: the rate expressed in money terms.

Real interest rate: the rate expressed in terms of purchasing

The burden of borrowing depends on the real interest rate.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-19

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-20

Foreign exchange: foreign currencies or claims on foreign

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-22

The balance of payments accounts record all payments

For the U.S., the increasing role of international trade is an

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-23

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 19-24

Long-Term Economic Growth

Long-term growth is considerably more important for a

There is considerable debate regarding the ability of