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ECON 203
Introduction to Macroeconomics
Lecture Notes
Second Edition
HANY FAHMY E. [email protected]
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Part 1
Lecture Notes on the Circular
Flow and the Basic Keynesian Model
Second Edition
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ECON 203, Winter 2010 Hany Fahmy1
Lecture Notes onThe Circular Flow of Income and the National Accounts
In this note I introduce brie�y the main indicators of macroeconomic performance. Inparticular I focus on output, general price level and employment. The handout starts withan introduction and a review of the basic macroeconomic concepts. After that, the circular�ow of income and the national accounts are discussed in detail.
1E-mail address: [email protected]
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Introduction and BasicMacroeconomic Concepts
A. Nominal and Real Gross Domestic Product (GDP)
Nominal GDP, GDPN ; is the value of all �nal goods and services produced in an economyin a speci�c period of time, usually one year.
GDPN = P � Y; (1)
where P is the general price level and Y is the quantity of �nal goods and services produced.Real GDP, GDPR, is the quantity of �nal goods and services produced in an economy in
a speci�c period of time measured in the market price of the base year.
GDPR =GDPN
GDP deflator(2)
and
GDP deflator =GDPNGDPR
� 100: (3)
Consider an economy producing two goods, x and y, such that in 2006, the base year,20 units of x are sold at $5 each, and 8 units of y are sold at $50 each. In 2007, 25 units ofx were produced at a price of $20 per unit, and 10 units of y were produced at a price of$100 per unit. Given the previous information, we can calculate the real and nominal GDPin both years as:
GDPN(2006) = (20� 5) + (8� 50) = $500;and
GDPR(2006) = (20� 5) + (8� 50) = $500:Observe that both the real and nominal GDP values are exactly the same in the base year.It follows then, the GDP de�ator in the base year is always 100. This can be seen fromequation (3) above, where
GDP Deflator(2006) =GDPNGDPR
� 100 = 500
500� 100 = 100:
As for 2007, we have:
GDPN(2007) = (25� 20) + (10� 100) = $1500;
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andGDPR(2007) = (25� 5) + (10� 50) = $625:
Using equation (3) above, we can �nd the GDP de�ator in 2007 as
GDP Deflator(2007) =GDPNGDPR
� 100 = 1500
625� 100 = 240:
B. The Rate of Growth
The rate of growth in real GDP is the annual percentage change in real GDP de�ned as
rate of growth in real GDP =GDPR(year 2)�GDPR(year 1)
GDPR(year 1)� 100%:
Following our previous example, the growth rate of real GDP from 2006 to 2007 is calculatedas
Rate of growth in real GDP =GDPR(2007)�GDPR(2006)
GDPR(2006)� 100%
=625� 500500
� 100% = 25%:
C. The Real GDP Percapita
The real GDP percapita is simply de�ned as
Real GDP percapita =GDPR
Population:
It is simply the share of each individual of the real GDP of the economy. It is a measure ofwelfare; the higher the real percapita real GDP, the higher the share of each individual ofthe real GDP of the economy. One disadvantage of real percapita GDP is that it does notre�ect the income distribution in the economy.
D. The Price Level and the In�ation Rate
The general price level is a measure of the average prices of all goods and services producedin an economy. There are many price indexes used; for instance, the Consumer PriceIndex, CPI, is a weighted average of the prices of a basket of goods and services producedin an economy over a period of time and is calculated as
CPIcurrent year =Cost of base year quantities at current pricesCost of base year quantities at base year prices
� 100:
The In�ation rate, �, is the percentage change in the price level from one period to anotherand is calculates as
�t =CPIt � CPIt�1
CPIt�1� 100%:
The following is an illustration of how to compute the CPI.
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Example 1 Assume for simplicity that our basket consists of only two goods: wheat andcloth, were 2003 and 2004 prices are reported in the following table
P (2003) P (2004)Wheat 4 5Cloth 12 16
Assume further that the representative consumer in the Canada buys 5 units of each consumergood. Compute the 2004 CPI using 2003 as the base year. Based on the previous information,we can compute the following.
The value of the bundle (basket) at the base year is
(5 wheat� 4) + (5 cloth� 12) = 80:
The value of the bundle in 2004 is
(5 wheat� 5) + (5 cloth� 16) = 105:
The CPI in 2003 isIndex2003 =
80
80� 100 = 100:
and the CPI in 2004 isIndex2004 =
105
80� 100 = 131:25:
E. Employment and the Labor Force
The employed, E;are those who worked part-time or full-time during the past week; theunemployed, UN;are those who were not employed during the past week but activelysearched for work at some time during the last four weeks. The labor force, L; is
L = E + UN:
The total population consists of those who are in the labor force and those who are not inthe labor force. People in the labor force are either employed or unemployed. Those whoare outside the labor force are the children, retirees, and those who decided not to be in thelabor force. Therefore, the unemployment rate is calculated as
Unemployment rate =Labor Force� Employed
Labor Force� 100%;
and the participation rate is the labor force divided by the working age population.
Problem 2 In an economy, 100,000 people are in the labor force and the unemploymentrate is 25%. As this economy moves out of a recession and jobs increase, 10,000 discouragedworkers become encouraged to search for jobs. What is the new unemployment rate?
Solution 3 See solution in class.
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F. The Business Cycle and the Trade o¤Between In�a-tion and Unemployment
The business cycle shows how the economic activity, i.e., the GDP, changes over time. Acycle starts from a trough (minimum point) and ends at a trough. The economy is said tobe in an expansion phase if it is moving from a trough to a peak along the business cycle.The economy is said to be in a recession if it is moving from a peak towards a trough. Adepression is a severe recession.According to the Keynesian school, there is always a trade-o¤ between in�ation and
unemployment; if the economy is featuring a recession, for instance, in�ation will decreasebut unemployment will increase and vice-versa in expansion.Although, the trade-o¤ between in�ation and unemployment can be observed along the
business cycle, yet this is not always the case; an economy might feature high in�ation andhigh unemployment at the same time. This phenomenon is known as stag�ation.
G. The Full Employment Level of Output, Yp, and theNatural Rate of Unemployment UNwhen all resources in the economy are fully utilized, the economy is said to be at the potential(full employment) level of output, denoted Yp: This is the optimal level of output that welike to have. If this level is achieve, unemployment should be zero, however, this is notcompletely true. The idea is that there exist a level of unemployment even if all resourcesare fully utilized. This unemployment rate that exists at the potential level of output iscalled �the natural rate of unemployment� and denoted UN : UN exists because of frictional,structural, and seasonal unemployments.
Frictional, Structural, and Seasonal Unemployment
Frictional Unemployment is a type of unemployment that exists when individuals leave jobsfor other jobs (between jobs). Structural Unemployment is another type of unemploymentthat exists due to a change in the structure of the economy. For instance, A computerspecialist located in a small town, where people hardly use computers, is unemployed becausethe structure of the economy does not provide a suitable job in his �eld. A third type ofunemployment occurs when the individual is specialized in a seasonal job.Natural unemployment can be justi�ed on the basis of any of the three previously men-
tioned types of unemployment.
Cyclical Unemployment
A fourth type of unemployment is resulting from �uctuations on the business cycle; it iscalled cyclical unemployment. For instance, laying o¤ worker in a recession is classi�edunder cyclical unemployment.
Remark 4 The equilibrium level of unemployment (the level of unemployment that exists
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at Yf) is never zero. This is mainly because of the frictional, seasonal, and structural unem-ployment.
Remark 5 The equilibrium level of unemployment in Canada is about 6%.
Example 6 Say, for instance, that the current unemployment rate is 11%. Assume furtherthat you learned that 2% is due to frictional unemployment, 4% is due to structural unem-ployment, and 5% is due to cyclical unemployment. Then, you can deduce that the naturalrate of unemployment, UN , is 6%.
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The Circular Flow and NationalAccounts
The circular �ow of income is a diagram that shows how real resources and money paymentsare channeled between households and the business sector. The diagram is omitted here.
A. Three Approaches to Measuring GDP
A.1. The Output Approach to GDP
GDP is measured as the value of all �nal goods and services in an economy in a speci�cperiod of time, usually one year. Therefore, according to this approach
GDP = P � Y:
A.2. The Expenditure Approach to GDP
1. The GDP is measured as the aggregate expenditures in an economy as
GDP = C + I +G+X �M;
where:
C � Consumption expenditures is spending by households on currently produced goodsand services.
I � Investment expenditures is expenditure by business on currently produced �nalgoods and services, e.g., I includes the value of machines, buildings, equipment, andinventories used by business. Note that I here is gross investment, i.e., it does notconsider depreciation.
Net Investment = Gross Investment� depreciation:
G � Government expenditures is the purchase of currently produced �nal goods andservices by the government.
X � Exports are expenditures by foreigners on our domestic goods and services.M � Imports are expenditures by domestic residents on foreign products.
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A.3. The Income Approach to GDP
We know that at equilibriumY = GDP;
where Y is the income earned by all factors of production. Therefore, we can measure theGDP from the income side. To this end, we de�ne the following
Net domestic income = employment income + pro�ts and business income
+ interest and investment income
orNDI = W +BI;
where:
1. W � Employment Income is the sum of all wages, salaries, and bene�ts paid to labor.BI � Business Income is the sum of pro�t, interest, investment and business income.
Once we know the NDI; the GDP at basic price and at market price can be obtainedas
GDP at basic price = NDI + CCA;
andGDP at market price(GDPN) = NDI + CCA+Net TIN ;
where CCA denotes the capital consumption allowance which measures the deprecia-tion in capital stock and Net TIN denotes net indirect taxes which are the sales andexcise taxes minus subsidies as
Net TIN = Sales and Excise Taxes� Subsidies:
B. GDP versus GNP
GDP is the income or output produced inside the country boarders regardless of citizenshipor borders. Gross National Product (GNP) and Gross National Income (GNI) are equal andrepresent the GDP plus the net foreign property income as
GNP = GDP + (Inflow � outflow) of foreign properties:
Remark 7 Caution when calculating the GDP. The following points should be taken intoaccount when calculating the GDP using any of the previously mentioned approaches:
1. Final goods and services only should be included in the calculations of GDP. Inter-mediate goods should not be included in the calculations of GDP. The value addedapproach is used to avoid double counting problems. The value added, V A; is thesum of the di¤erences between the market value of output, O; and the cost of inputspurchased from other businesses, I; at each stage of production.
V A =X(O � I):
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2. Goods that are resold do not enter the GDP calculations because they have alreadybeen recorded
3. Many goods and services are excluded from the GDP calculations since they are notmarketed and thus hard to measure. These include home cleaning, unreported jobs,maintenance, and other households activities.
4. Transfers of ownership are not included in GDP calculations. Purchase of shares is anexample
Remark 8 Nominal GDP can be expressed, using the previously mentioned three approaches,as
GDPN = NDI + CCA+Net TIN ;
orGDPN = P � Y;
orGDPN = P � [C + I +G+NX]:
HenceGDPR = Y = C + I +G+NX:
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ECON 203, Winter 2010 Hany Fahmy1
Lecture Notes onThe Analysis of AD and the AD-AS Model
In this note I give three versions of Aggregate Expenditure (AE) model. In each version,I consider (1) the AE function, (2) the equilibrium level of output, and (3) the Multiplier.The analysis is then followed by a detailed discussion of the AD-AS model. The aggregatedemand (AD) and the aggregate supply (AS) model is a framework used to explain thebehavior of real output and prices in an economy. The interaction between AD and ASyields the actual equilibrium level of output and prices.
1E-mail address: [email protected]
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The Keynesian AD Analysis
Version 1: No Government and No Foreign Sector
The Model
AD � GDP � AE = C + I;C = c0 + cY;
I = I0;
where:c0 is the autonomous consumption, which is the level of consumption that does not
depend on income;c = 4C
4Y � MPC is the marginal propensity to consumer (MPC). It explains the changein consumption caused by a change in income. In other words, it shows how much out ofeach additional increase in income by one dollar is devoted to consumption. MPC is alwaysa fraction, i.e.,
0 < MPC < 1:
Example 1 If MPC = 0:8, this means that an increase in aggregate income by one dollarwill cause an 80% increase in aggregate consumption, that is, 80 cents out of the dollarincrease in income will be allocated for consumption. This, of course, leaves 20 cents allocatedfor savings.
Remark 2 Note that the marginal propensity to save, MPS, and the MPC should add toone.
MPS +MPC = 1:
Remark 3 Also note that cY is called the induced consumption, which is the part of theconsumption function that depends on income.
(1) The AE Function of Version 1
We can derive the AE function by simply substituting the consumption function, C = c0+cY ,and the investment, I0, into the AE identity. This yields
AE = A0 + cY;
whereA0 = c0 + I0
is the autonomous expenditure.
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(2) The Equilibrium Level of Output in Two Di¤erent Ways
We are after the aggregate equilibrium level of output, i.e., the output level at which theaggregate demand, AD; is equal to the aggregate supply, AS:In general, the AD and AS equations are expressed as follows:
AD � AE � GDP = C|{z}Cons: Expenditure
+ I +G
andAS � Y = C|{z}
Planned Cons:
+ S + T:
So, at equilibrium we have
G+ I + C = AE = Y = C + S + T:
Now, back to our model, the equilibrium condition is then
AE = Y
Using the AE = A0 + cY , we can solve for the equilibrium level of output, Y �:An alternative way to express the equilibrium level of output can be obtained by noting
that also at equilibriumI = S:
Investment is constant (autonomous), but saving is not; it depends on income. Consequently,we need to derive the saving function. Since saving appears only in the AS equation, AS �Y = C + S, then we can use the de�nition of the consumption function and express thesaving function as
S = Y � C = Y � [c0 + cY ]:Rearranging yields
S = �c0 + (1� c)Y;where
(1� c) = 4S4Y �MPS:
Figure 1 illustrates the realization of general equilibrium using the two previously mentionedways.
Problem 4 Suppose that consumption is $20,000 when income is $31,000, and consumptionincreases to $20,800 when income increases to $32,000, what is the marginal propensity tosave?
Solution 5 See solution in class.
Problem 6 Suppose that T = 0 and Z = 0. If MPC = 0:6, then we can say that asaggregate income increases by one unit, aggregate consumption will increase by 60%:
Solution 7 See solution in class.
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(3) The Multiplier
The multiplier, ( 4Y4A0 ); is the ratio of the change in equilibrium income Y due to the changein any of the components of the autonomous expenditure A0:
Claim 9 The multiplier in version is 11�MPC
:
Proof. 3 To see this, impose the general equilibrium condition and solve for the equilibriumlevel of income as follows.At equilibrium
Y = AE = C + I; (1)
whereC = c0 + cY (2)
andI = I0: (3)
(2) and (3) in (1) yieldsY = (c0 + I0) + cY:
solving for Y yields
Y =1
1� c(c0 + I0)or
Y = (1
1� c)A0;
and thus4Y4A0
=1
1� c:
In general the multiplier can be obtained from the following general form.
Multiplier =1
1� slope of AE
Version 2: Introducing the government
The Model
AD � GDP � AE = C + I +G;C = c0 + cY d;
Yd = Y � T;T = tY;
I = I0;
G = G0;
where:Yd is the disposable income (income after tax);t is the tax rate.3The proof is not required.
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(1) The AE Function of Version 2
We can derive the AE function by simply substituting the consumption function, the invest-ment, and the government expenditure into the AE identity. This yields
AE = A0 + c(1� t)Y;
whereA0 = c0 + I0 +G0
is the autonomous expenditure.
(2) The Equilibrium Level of Output
At equilibrium we haveAE = Y:
Using the AE function derived in (1) above, we can solve for the equilibrium level of output,Y �:
(3) The Multiplier
Using our general formula, the multiplier in version 2 is obtained as
Multiplier =1
1� slope of AE =1
1� [MPC(1� t)] :
Remark 10 Notice that the multiplier in version 1 is higher than the multiplier in version2.
Version 3: An Open Economy
The Model
AD � GDP � AE = C + I +G+X � Z;C = c0 + cY d;
Yd = Y � T;T = tY;
I = I0;
G = G0;
X = X0;
Z = zY;
where z = 4Z4Y �MPZ is the marginal propensity to import (MPZ). It explains the change
in expenditure on imports caused by a change in national income.
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Tax Multiplier
We have seen the expenditure multipliers associated with the above three models. The taxmultiplier is di¤erent than the expenditure multipliers that we have seen. The tax multipliersimply shows the e¤ect of changing taxes on real GDP. Since taxes a¤ect output negatively,the tax multiplier has a negative sign and is obtained as
Tax Multiplier =�MPC1�MPC
Remark 14 It is easy to see that if the government changed both the government spendingand taxes by the same amount and in the same direction, then output will change by thesame value, that is,
4Y = 4T = 4G
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The AD-AS Model
A. The Short-Run AD-AS Model
In the short-run, factor prices, supplies of factors of production, and technology are �xed byassumption.
De�nition 15 The AD is the planned aggregate expenditures; that is what we plan to spendon Canadian goods and services at di¤erent price levels.
AD = Y = C + I +G+NX:
The AD curve slopes downward with a negative slope indicating the negative relation betweenthe general price level and the planned aggregate expenditures; a higher price level reducesthe expenditures panned by households, business, residents of other countries and vice-versa.
A.1. Three Explanations for the Negative Slope of the AD Curve
1. The Wealth E¤ect
An increase in the general price level reduces the purchasing power of the householdsand business sectors, i.e., they can buy less in real terms, and thus reduces the plannedaggregate expenditures.
2. The Substitution E¤ect
A rise in the domestic price level increases the price of domestic goods relative toforeign goods. This may cause some households and businesses to substitute foreigngoods for domestic goods, which, in turn, reduces the aggregate planned expenditures.
3. The Interest rate e¤ect
An increase in the general price level, P; will cause households and businesses to de-mand more money in order to undertake transactions (the demand on money balances,Md; increases), which, in turn, pushes the interest rate, i, to increase. As the interestrate increase, consumption and investment expenditures decrease and thus aggregateplanned expenditure goes down.
P ")Md ") i ") C # and I #) AE #) AD # :
De�nition 16 The AS is the output of �nal goods and services businesses would produce atdi¤erent price levels given that wage rates, net indirect taxes are constant. The AS curveslopes upward with a positive slope because the higher the general price level the more theproducers are willing to increase output of real goods and services.
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