AU 1 Introduction To Macroeconomics 6

Macroeconomics
1. Introduction to Macroeconomics
1.1. What is Macroeconomics?
1.2. The Basic Model: The Circular-Flow Model
1.3. The Basic Data: GDP and its Components
1.3.1. What Is GDP?
1.3.2. Three Ways of Computing GDP
1.3.3. Nominal vs. real GDP and the GDP-Deflator
1.3.4. From GDP to Disposable Income of Households
1.3.5. GDP and Welfare
1.4. Questions for Review
RAINER MAURER, Pforzheim
Lecture Notes: www.rainer-maurer.de

E-Mail:
rainer.maurer@hs-pforzheim.de
Colloquium:
Friday 17.15 - 18.45 (room W1.4.03)
Literature:1)
Chapter 22, Mankiw, N.G.: Principles of Economics, Harcourt College.
Chapter 2, Mankiw, N.G.: Macroeconomics, Worth Publishers.
1)
-1-
Prof. Dr. Rainer Maurer
The recommended literature typically includes more content than necessary for an understanding of this
chapter. Relevant for the examination is the content of this chapter as presented in the lectures.
-2-
Microeconomics studies the behavior of individual

households and firms.
Macroeconomics studies the economy as a whole that

is the sum of the individual behavior of households and
firms.
-3-
As we will see: The macroeconomic whole is more than

the sum of its microeconomic parts!
Microeconomics deals with disaggregated data, while

macroeconomics deals with aggregated data, like
the sum of the value of all goods and services produced
in an economy (GDP),
the sum of the common change of all prices of goods
and services (inflation),
For the economy as a whole it is (in the short run version of

the Keynesian theory) not possible to increase savings
by reducing expenditure since total income falls if all
households and companies reduce their expenditure:
Savings = Income - Expenditure
-5-
Famous example: The savings paradoxon:

For an individual household or company it is always
possible to increase savings by reducing expenditure
since individual income stays constant if the household
reduces expenditure:
Savings = Income - Expenditure
-4-
the share of all unemployed persons in the total labor

force (unemployment rate) and so on
-6-

Macroeconomics deals with three domains:
Macroeconomic
Theories

Macroeconomic
Theories:
Macroeconomic
Aims
Theories =
Explications
Explication of macroeconomic observations:

Why is per capita income in some countries higher as in others?
Neoclassical growth theory (chapter 4)
Why are there business cycle fluctuations?
Neoclassical & Keynesian macro model (chapters 2 & 3)
Why is there inflation?
Macreconomic
Strategies
Neoclassical and Keynesian macro model (chapter 2 )

Why is there unemployment?
A bunch of different theories (chapter 6)
-7-
Macroeconomic
Aims:
Choice of macroeconomic aims:
Shall the average income growth of a country equal -2%, 0%, 2% or 10%?
(Chapter 4)
Shall business cycle fluctuations be prevented? (Chapter 2 & 3)
Conflict of aims cannot be solved by objective science!

Political (normative) decisions are necessary!
see Digression!
Digression: The Choice of Macroeconomic Aims (1):

The choice of macroeconomic aims has to aspects:
1. What aims can be reached?
2. What aims are desirable?
Ad 1: The first question is a technical question: What aims are possible? As we
will see, the answer depends on the macroeconomic theory, which we assume
to be correct or good enough. Different theories may tell us different stories
about what aims are possible.
For example, Keynesian theory is much more optimistic about the effectiveness
of fiscal policy than neoclassical theory (We will analyze the reasons in chapter
3). Furthermore, under neoclassical theory demand-side caused business cycle
fluctuations are not possible. Hence according to Keynesian theory demandside caused business cycle fluctuations can be smoothed by fiscal theory, while
under neoclassical theory fiscal policy is not only ineffective but superfluous. So
if you think that neoclassical theory describes reality better than Keynesian
theory, the question, whether business cycle fluctuations should be a macroeconomic aim, does simply not emerge for you - whether you think that
smoothing business cycle fluctuations is desirable or not.
Another example are economic growth theories: You may find high per capita
income growth rates (say 10% or 20% per year) absolutely desirable if this
does not harm the environment or causes an consumption of exhaustible
resources. However most economic growth theories tell us that income growth
normally causes also a consumption of environmental goods or exhaustible
production factors. In this case economic theories tell us that a trade-off exists
between income growth and the protection of the environment.
- 10 RAINER MAURER, Pforzheim
Shall the inflation target equal -2%, 0%, 2% ? (Chapter 6)
-8-
-9-

(1) Infinite regress: You substantiate one reason with another and so on.
(2) Logical circle: substantiate an argument with an argument you have already
substantiated.
(3) Arbitrary stop: You end the process of substantiation with an argument you
hold subjectively to be sufficient and without need for a further
substantiation.
Many philosophers believe that state (3) is the only acceptable. If you agree
(of course by your subjective decision), you agree that ethical decisions are in
last instance of subjective nature and can therefore not be binding for others
who might have different subjective point of views.

This means that a choice has to be made: How much environment shall be
sacrificed in order to increase per capita income? The answer to such type of
questions depends on how desirable a aim like income growth is compared
to a aim like environmental protection. This leads to the second type of
questions What aims are desirable?
Ad 2: The selection of an economic aim has to rely always on subjective
preferences. Such choices can not be based on objective science. These
choices can only be based on subjective preferences and if the society as a
whole is affected the members of the society have to find a viable
compromise based on their individual preferences. This is certainly no easy
task. All that science can do in such decision forming processes, is to explain
what kind of trade-offs exist between desirable aims. The final choice must be
made by society. Such choices are therefore very often called political
choices.
It should be clear that the selection of an economic aim is always an ethical
decision. Ethical decisions determine aims of acting. They are expressed in
form of shall-sentences. To say You shall not lie. or You shall treat others in
the same way you want to be treated. is of the same methodological nature as
to say Economic growth shall not cause lasting damages to the environment.
or Business cycle fluctuations shall not be fought by the government, if this is
likely to cause an increase of government debt. Even though such decisions
are about things that shall be (aims of acting) are inevitable and important for
every human being, they cannot be based on objective science but are, in last
instance, always choices depending on subjective preferences. In ethics we talk
of the trilemma of substantiation of ethical rules, which many modern
philosophers hold to be inevitable, because if you try to substantiate an
ethical decision you always end up with one of three possible states:
- 11 -
- 12 -
Theory: Why is
per capita
income in some
countries higher
as in others?
Macroeconomic
Strategies:
Derivation of strategies to reach the selected aims :
How can income growth be influenced to reach a growth target if we
postulate the neoclassical growth theory? (Chapter 4)
Strategy: How can a selected growth

target be realized, if we assume a
certain theory to be correct?
How can business cycles be affected by macro policy if we postulate the

neoclassical or the Keynesian macro model? (Chapter 2 & 3)
How can the selected inflation rate be targeted under neoclassical or the
Keynesian macro theory? (Chapter 6)
Target selection:
What growth rate
shall a country
target?
-2%, 0%, 2%...?
- 13 Source: Penn World Tables, NBER
Theory: What
causes business
cycle
fluctuations?
Policy: If we want to fight business

cycle fluctuations and assume a
certain theory to be correct, how can
we reach this aim?
These small deviations of

actual GDP (=green line)
from its long-run trend
(=black line) are the
business cycle
fluctuations.
Target selection:
Shall we fight
business cycle
fluctuations?
Source: SVG, Jg. 2004/5
Source: SVG, Jg. 2004/5
1.2. The Circular-Flow Model

The Circular-Flow model is a basic concept that appears

in all macroeconomic models.
It is also the backbone of macroeconomic statistics
(National Accounting).
It is based on the idea that the economic exchange of
goods and production factors between households and
firms can be described as a circuit.
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Its inventor was the French medic

Franois Quesnay (1694 - 1774), who
took the idea from the discovery of the
blood circuit in those times.
- 18 -
The Circular Flow Model
The Circular Flow Model
- Neoclassical Version -
- Keynesian Version
Production
Factors
are Buyer of
Production Factors
Market Equilibrium Prices
Production
Factors
Goods
Firms
Prices are
flexibel and
adjust until
supply equals
demand!
are Suppliers of Goods

on Goods Markets
are Buyer of
Production Factors
Market Equilibrium Prices
Market Equilibrium Quantities
are Buyer of Goods on

Goods Markets
are Supplier of
Production Factors
are Supplier of
Production Factors
Goods
Production
Factors
Goods

As the circular flow model shows, households own all the
production factors of the economy:
Business relations between firms (selling and buying of intermediate

inputs) are set off and do therefore not appear.
Business relations between households (e.g. granting and taking of

credits) are set off and do therefore not appear.
In chapter 2 we will develop a more realistic version of the circularflow model.
- 21 -
Households own the labor force and supply their labor to firms
via the labor market.
Households own the capital (= wealth) and supply their capital to
firms over the various segments of the capital market, e.g.:
Households hold saving accounts at banks. Banks offer this
money to firms (=foreign capital).
Households buy shares of firms (=own capital)
Households buy corporate bonds (fixed rate securities) from
firms (=foreign capital).
In case of a private company, a household has invested its
money directly into a firm and owns this firm directly (=own
capital).
- 22 -
Households also own real estate, like production areas and

production facilities and rend these to firms and via real
estate markets.
Some firms do also own real estate. However, in this case
firms had to use capital to buy this real estate. This capital
belongs finally to households. Hence, in this case firms do
not have to pay rents to households but interest or
dividends.
are Buyer of Goods on

Goods Markets
Government and foreign countries are omitted.
Market Equilibrium Quantities
- 20 -
For the sake of clearness, this circular-flow model is a bold simplification:
are Suppliers of Goods

on Goods Markets
Digression: Comments to this Simple Circular-Flow Model:
Prices are
rigid,
therefore
supply
quantities
adjust to
demand
quantities
- 19 -
Goods
Firms
Households
Households
Production
Factors
- 23 -
Our circular-flow model is based on the simplifying

assumption that only households and firms exist.
If we add up the gross production value (=net
production value plus depreciation) over all firms, we
would receive the Gross Domestic Product (GDP) of
such a simplified economy.
However in reality not only households and firms but
also the government and foreign countries exist.
To make the calculation of GDP realistic, we have to
take care for them (and a couple of additional
subtleties).
This is done in the next section:
- 24 -
1.3.1. What Is GDP?
1.3.1. What Is GDP?

1.3.1. What Is GDP?
Official definition of Gross Domestic Product (GDP):
Market value of all final products produced

within a country in a given period of time.
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- 26 -
1.3.1. What Is GDP?
1.3.1. What Is GDP?
Some Comments on the Definition:

What means market value?
As is well known, you cant compare apples and oranges.

What means products?
GDP measures not only tangible products, but also intangible
- 27 -
products i.e. services.
Unofficial Definition: Services are all those products, which

cannot drop on your feet.
Examples for services: Hair cuts, management consultancy,

music concerts, foot care, medical treatment, insurance,
home help, bank transfer, building design, movies, hotel
accommodation, flights, bus rides, trade with goods (!),
granting of credits and so on
Consequently, what is needed is a kind of measure that

makes these different products comparable.
Therefore, the market price of each product is taken and
multiplied by the quantity of each product.
This makes sense, because the market price contains the
information, what value a product has in the eyes of the
producers and consumers.
Hence the market price can be taken to evaluate a product.
- 28 -
1.3.1. What Is GDP?
1.3.1. What Is GDP?
goods and services, a simple summation of the market value

of all goods and services sold by firms (i.e. their sales) would
lead to a mistake as the following example shows:
A car tire producer sells a tire to a car producer: 1st counting
The car producer attaches the tire to a car and sells this car
to a car dealer: 2nd counting
The car dealer sells the car to the final consumer: 3rd
counting
Consequently, this procedure would lead to a multiple
counting of the tire and hence an overestimation of actual

production.
- 29 -

What means all final products?
Solution: To determine the value added by the firm, take the
sales of the firm and subtract the payments for all intermediate
goods bought by the firm. The result is called gross value added
of the firm, because it is the market value the firm has added to
the market value of the intermediate inputs.
This leads to the formula:

Sales of
Firm

Even though GDP corresponds to the market value of all
minus
Intermediate Inputs
form other Firms
This is the standard procedure GDP ist measured.

Roughly 80% of German GDP measured this way.
However there are many economic activities, where
measurement of GDP is much more difficult. These are
discussed in the following.
= Gross Value
Added of the Firm
= Contribution of the
Firm to GDP
- 30 -
1.3.1. What Is GDP?
1.3.1. What Is GDP?
Housing stock:
Houses are machines, which produce the service
dwelling.
While the services of rental apartments are easily
measures by their rent payments, the services
provided by self-owned condominiums and houses
have to be estimated.
To do so, statistical offices use an estimated
market-equivalent rent for self-owned
condominiums and houses. Hence the assumption is
made that the owner pays a rent to himself.
- 31 -
Home production:
If you prepare a meal in your apartment the value added
created by your work does not enter GDP. If you buy the
meal in a restaurant, the value added created by the
cook of this restaurant enters GDP.
If a working women pays a professional cleaner to tidy
her apartment, these services are completely accounted
for in GDP. If the women and her cleaner marry however,
the cleaners services are no longer paid for and GDP
shrink.
=> Only production, that reaches the final consumer via a
market transaction, is accounted for in GDP.
=> Only home production undertaken by officially
registered employees is accounted for by GDP.

Really all? There are products, whose coverage is difficult:
- 32 -
1.3.1. What Is GDP?
Proposal in the latest

System of National
Accounts Revision
(SNA 2008) by the
UN Statistical
Commission for the
coverage of goods
and services not sold
over markets (nonmonetary sectors).
This includes i.a.
subsistence farming
and barter trade.
Problem: Many
developing countries
still have not the
financial means to
make the necessary
estimations...

Home production:
Subsistence farming: A large part of production in
developing countries is production of food by small farms
for their own consumption (subsistence farming). Since
this production is consumed without market transactions
it does not enter measured GDP.
Since in most developing countries no estimation of the
value added by subsistence farming is made by
statistical offices (for financial reasons...), an important
part of total GDP is not accounted for in these countries.
Consequently, actual GDP in developing countries is
typically significantly larger than GDP as measured by
statistical offices.
- 33 -
Really all? There are products, whose coverage is difficult:
1.3.1. What Is GDP?
1.3.1. What Is GDP?

The shadow economy is another area, where coverage by

Black market economy:
national accounting is difficult, because producers do not pay

taxes or provide production data to statistical offices.
Until recently, the Federal Statistical Office of Germany (FSO)
has estimated the level non-taxed value added creation in legal
sectors only.
Starting with September 2014, the FSO provides also estimates
of the value added of illegal activities.
o
- 34 -
Drugs
Smuggling
- 35 -
Drugs: Based on the Epidemiological Survey of Substance

Abuse by the Munich Institut fr Therapieforschung the
FSO calculates value added for 5 different drugs: Heroin,
Cocaine, Ecstasy, Amphetamine and Cannabis.
Since, with exception of Cannabis, production takes
typically not place in Germany, the value added created by
these sectors results mostly from the trade margin, i.e. the
difference between street prices and import prices. These
prices are regularly gathered and published by the German
Bundeskriminalamt.
- 36 -
1.3.1. What Is GDP?
1.3.1. What Is GDP?

Black market economy:

Another area, where the coverage of GDP is incomplete,
- 37 -
are the services provided by the government, parties, trade

unions, churches and other non-profit organizations.
These organizations provide the largest part of their
services for free to their clients, i.e. without measurable
payments. Hence no market prices exist to evaluate their
services.
Therefore, statistical offices estimate the production value
of non-profit organizations by (essentially) their payroll
costs. Thereby they assume that the value of goods and
services produced by the employees of these organizations
equals the value of their wages and salaries.
Smuggled goods: Here the FSO focuses on the estimation

of smuggled cigarettes. Information is provided by the
Waste Disposal Study of the German cigarette industry.
The cigarette industry draws a sample of the tax strips from
trashed cigarette packages found in the Yellow Bags.
Packages with tax strips from countries not known as
typical holiday countries and where cigarette prices are
significantly lower as in Germany, are regarded as
smuggled.
Here too, the value added mostly results from the trade
margin, i.e. the difference between street prices and
import prices
Digression: Internally-generated investment goods and R&D

Not all produced goods are sold by firms. Some goods are used within a firm as
investment goods.
1.3.1. What Is GDP?
Example: The engineering team of a carmaker constructs a production machine

used to produce cars within the firm
- 39 -
What means within a country?

GDP measures only goods and services produced
within a country regardless by whom:
If somebody from Strasbourg works in Freiburg, this is

accounted for as German GDP. If somebody from Freiburg
works in Strasbourg, this is accounted for as French GDP.
Therefore, the GDP-concept is also called inland

concept (contrary to the inhabitant concept on which
the calculation of Gross National Product (GNP) is based.
In this case, the estimated market value of the investment good is added to the
sales of the firm. However the market value of the intermediate inputs, used to
produce the investment good, is not subtracted, since an investment good
(typically a machine) is not completely worn off within one year. Instead only an
estimate of the yearly erosion of the machine, called physical depreciation is
subtracted.
According to the the latest Revision of the System of National Accounts (SNA
2008) research and development expenditures (R&D) are no longer part of
production costs but have to be treated like investment goods. As a result, all
R&D activities (whether they lead to product or process innovation or not !)
increase the value added produced by the firm. The argument of the FOS is a
bit philosophical: There is no unsuccessful R&D, because the company
increases its knowledge capital even if R&D does not lead to product or
process innovation. In other words, we even learn from out mistakes...
1.3.1. What Is GDP?
To sum up:
The measurement of GDP is internationally standardized

by the UN. Standardized numbers are available at the
Statistical Office of the UN:
Definition of GDP: Market value of all final goods and

services produced within a country in a given period of time
Market Value = Evaluation with Market Prices

Adjustment for intermediate inputs to prevent multiple
http://unstats.un.org/unsd/snaama/selectionbasicFast.asp
Within the EU more detailed subaggregates of GDP are

available (ESVG 1995) at the Statistical Office of the
European Commission:
Self Owned Condominiums and Houses,

Home Production,
Non-profit Organizations
Shadow Economy
http://ec.europa.eu/economy_finance/ameco/user/serie/Se
lectSerie.cfm
counting.
all Final Goods and Services => Accounting Problems:
- 40 -
1.3.1. What Is GDP?
- 38 -
Accounting for domestically produced goods and

services only.
- 41 -
and from the statistical office of the EU (EUROSTAT):
http://epp.eurostat.ec.europa.eu/portal/page/portal/statistic
s/search_database
- 42 -

GDP is defined according to the way it is produced (production
account). However, following the circular flow model, there are
three ways how GDP can be calculated:

1.3.1. What Is GDP?
1. Production Account: Making of the Cake

2. Distribution Account: Distribution of the Cake
3. Expenditure Account: Consumption of the Cake
The same cake is subdivided by three different kind of
criteria:
1. Production Account: What is the contribution of a certain

industry to GDP?
- 43 -
2. Distribution Account: What kind of economic units receive

how much of GDP?
3. Expenditure Account: For what kind of purposes is GDP

used?
- 44 -
1. GDP by Production Account:
Production Account
Making of the Cake
The production account of GDP follows directly the above

definition of GDP, i.e. the Market value of all final goods and
services produced within a country in a given period of time is
calculated.
In a world with firms only (and no government, non-profit
organizations, private households and black market activities),
GDP would equal the sum of gross value added of all firms:
Distribution
of the Cake
Consumption
of the Cake
Value Added of all Firms

= Sum of Market Sales of all Firms
./. Sum of Intermediate Inputs of all Firms
Expenditure
Account
Distribution
Account
- 46 -
Digression: Peculiarity of the official statistic definition
Following the official statistic definition, we have to take care for a

statistical convention, which disturbs this intuitively appealing relationship:
Following the official definition, the value added tax paid by firms does not
count as value added by firms, while the subsidies received by firms do
count as value added by firms. Given this convention, the formula for
calculating GDP equals then:
Gross Value Added of all Firms

= Sales of all Firms
./. Sum of Intermediate Inputs of Firms
./. Value Added Tax Paid by Firms
+ Subsidies received by Firms
In the following we will neglect this peculiarity for the sake of simplicity!
- 47 -
In a world with only firms, value added calculated by this

formula would actually equal GDP.
And in fact, value added by firms does count for about 80%
of all GDP in most countries.
However, as already mentioned in section 1.3.1., we have to
take care that beside firms there are governments, non-profit
organizations, private households and illegal production
activities, where value added is created.
Since these entities do not sell most of their production over
(legal) markets, their value added are estimated.
The resulting number is then added to the value added of
firms to finally yield GDP.
- 48 -
48 %
After taking care of all these details, the final formula

for GDP measured by production account equals:
71 %
48 %
28 %
GDP = Value Added of Firms

+ Value Added of illegal economic units
+ Value Added of Government and Non-profit
Organizations
+ Value Added of households
- 49 -
Source: SVG, Jg. 2004/5; 1) Without balance of value added tax and subsidies; 2) inclusive value added of
households and non-profit organizations, without value added by illegal economic units)
- 50 -
2. GDP by Distribution Account:
GDP by distribution account explains how GDP is

distributed between workers, capital owners and the
government. The standard definition is:
Production Account
Making of the Cake
GDP =
Distribution
of the Cake
Consumption
of the Cake
Expenditure
Account
Distribution
Account
Net Compensation of Domestic and Foreign

Employees (salaries and wages) and SelfEmployed Working within the Country
+ Net Income from Wealth held within the Country
(= Interest Payments, Dividends, Profits , Rents)
by Natives and Foreigners
Net Tax
+ Indirect Taxes1) ./. Subsidies2)
Burden
+ Direct Taxes3) ./. Social Transfers4)
+ Depreciation = Withdrawals for reinvestment made
necessary by the erosion of machines
Value Added Tax; 2) Subsidies to firms; 3) Taxes on Salaries- & Capital Income, Wealth, Car Tax, Social Security Contributions of
Employees and Employers, Direct Taxes of Incorporated Enterprises; 4) Social Aid, Housing Subsidies, Governmental Allowances to
- 52
Unemployment Compensation etc.
1)
2. GDP by Distribution Account:
according to currently available data:
Gross Compensation of Domestic and Foreign
Employees (salaries and wages) and SelfEmployed Working within the Country
+ Net Income from Wealth held within the Country
(= Interest Payments, Dividends, Profits , Rents)
by Natives and Foreigners
+ Indirect Taxes1) ./. Subsidies2)
+ Depreciation
1) Value Added Tax; 2) Subsidies to firms; 3) Taxes on Salaries- & Capital Income, Wealth, Car Tax, Social Security Contributions of
Employees and Employers, Direct Taxes of Incorporated Enterprises; 4) Social Aid, Housing Subsidies, Governmental Allowances to
- 53
Unemployment Compensation etc.
GDP =
- 54 -
3. GDP by Expenditure Account:

GDP by expenditure account explains how the GDP is used.
The standard definition is:
Production Account
Making of the Cake
Distribution
of the Cake
Consumption
of the Cake
GDP = Consumption of Households (= C)

+ Government Consumption (= G)
+ Depreciation (= *K)
Gross
Investment
+ Net Investment (= NI)
+ Exports (= X) ./. Imports (= M)
Expenditure
Account
Distribution
Account
- 56 -
GDP at Market Value by
within the Country by

Nationals & Foreigners
Expenditure
Consumption of
Households
Exports ./. Imports
Government
Consumption2)
T
DG
T Direct Taxes ./. Social

Transfers + Indirect Taxes
./. Subsidies
Net Investment
of Firms
Depreciation
Depreciation
Gross
Investment
Distribution
Net Compensation of
Domestic and
Gross Value
Foreign Employees
Added3) of Firms, and Self-Employed
Government1)
Working within the
Non-profit
Country
Organizations1)
and Private
Net Income from Wealth
Households
Gross Value Added
Production
1)
Estimated: Value Added of Government = Government Consumption ./. Purchase of Intermediate Goods by the Government.
Estimated: Government Consumption = Employment Compensation & Government Purchases of Goods and Services
3) According to the official definition (s. digression) value added tax ./. subsidies must still be added. This is neglected here for simplification,
- 58
2)
Source: SVG, Jg. 2004/5; 1) Including Change of Stocks
- 57 -

1.3.1. What Is GDP?
Once again the definition of GDP:

Market value of all final goods and services produced within
a country in a given period of time.
Market value means that the quantities of all goods and

services are multiplied with their market prices before they
are added up (apples and oranges problem).
This means however:
- 59 -
If the prices of all goods and services, grew with a rate of nearly
2% per year (= target inflation rate of the European Central Bank),
GDP as defined above would grow by 2% - even if the actual (real)
production of goods were constant!
In order to eliminate this effect of inflation on GDP statistical

offices calculate real GDP.
- 60 -
Produced Appels
Determination of real GDP:

Instead of evaluating apples and oranges with their
current prices ( = nominal GDP), they are evaluated with
their prices in an (arbitrarily) fixed year.
This year is called the base year.
Consequently, real GDP of the year 2008 at prices of
the year 1995, informs about the level of GDP in the year
2008, if prices since 1995 had stayed constant.
As a result, the yearly increase in all prices, which has
taken place form 1995 to 2008 ( = the rate of inflation) is
eliminated from real GDP!
The following simplified example illustrates this method.
Year
Produced Oranges
GDP
Quantity
kg
Price
Quantity
kg
Price
nominal
real
(Prices=2001)
2000
100
10
50
30
2500
4000
2001
150
20
100
40
7000
7000
2002
300
30
150
50
16500
12000
- 61 -
- 63 -
- 62 -
Determination of real GDP:
This calculation of real GDP shows:
If positive inflation was prevalent from the past to the

present,
real GDP before the base year is always larger than
nominal GDP,
while real GDP after the base year is always smaller
than nominal GDP.
A comparison of real and nominal GDP shows this:
- 64 -
Source: AMECO, EU-Commission
The elimination of inflation also implies that in times of

positive inflation the growth rate of nominal GDP is
always larger than the growth rate of real GDP.
GDP
Year
nominal
GDP-Growth
real
(Prices=2001)
Nominal
(= with
Inflation)
Real
(= without
Inflation)
This too follows from our numerical example:
- 65 -
2000
2500
4000
2001
7000
7000
(7000-2500)
/ 2500)
= 180 %
(7000-4000)
/ 4000)
= 75 %
2002
16500
12000
(16500-7000)
/ 7000 )
= 136 %
(12000-7000)
/ 7000)
= 71 %
- 66 -
A Useful Side-Effect:
Definition of GDP-Deflator:
The calculation of real GDP also delivers an indicator for

the rate of inflation.
To do so, first the value of nominal GDP of each year is
divided by the value of each years real GDP.
The result is a times series called GDP-Deflator
Then, the growth rate of this GDP-Deflator corresponds
to the rate of inflation of all goods and services since
GDP embraces the value of all goods and services.
Applied to our numerical example, the following results:
Memory hook:
- 67 -
Digression: From GDP-Deflator to GDP-Chain Price Index
nominal
real
GDP-Deflator
(=Price Level)
Inflation Rate
(=Change of
Price Level)
(Prices=2001)
2000
2500
4000
2500 / 4000
= 62,5 %
2001
7000
7000
7000 / 7000
= 100 %
(100 - 62,5)
/ 62,5
= 60%
2002
16500
12000
16500 / 12000
= 137,5 %
(137,5 - 100)
/ 100
= 37,5 %
GDP
Jahr
- 68 -
- 69 -
- 70 -
Digression: From GDP-Deflator to GDP-Chain Price Index
1%
yoy
- 71 -
This increase in the GDPDeflator corresponds to an

average yearly rate of inflation of
2,8 %
- 72 -

1.3.1. What Is GDP?
- 73 -
One more time the definition of GDP:
The purchasing power of the population of a country

depends of course primarily on the income of the
population. The income of the population differs in several
points from GDP:
Market value of all final goods and services produced within

a country in a given period of time.
Consequently, GDP reflects the production potential of a

country.
1. GDP does not include income of inhabitants earned abroad

and GDP does include income of foreigners earned within
the country.
2. GDP does include capital depreciation. Since depreciation
corresponds to capital goods that are consumed in
production of other goods, it cannot be part of household
income.
3. A part of GDP flows to the government in form of taxes.
Hence this part of GDP too cannot be part of household
income.
There are, however, problems e.g. market potential

analysis where not the production potential but the
purchasing power of the population of a country is in the
center of interest.
It is evident that there must be a link between production
potential of a country and the purchasing power of its
population, but it is also evident that there are differences.
Where exactly are those differences?
- 74 -
- 75 -
Therefore the following adjustment of GDP does make

sense:
As this decomposition shows,

disposable income of
households is the aggregate
that should be used for
market potential analysis.
It is therefore often simply
called purchasing power.
1) These interest payments are subtracted by the statistical offices, because they are in
the short term not available for purchases. This is a little bit arbitrary, since the same
- 77 holds for rents, insurance fees etc., which are not subtracted!
In many countries it is
available on the regional level.
In Germany for example on
the level of districts (Kreise).
Only if other numbers are not
available, GDP should be
used for such kind of analysis.
From GDP at market prices to national income:
Gross Domestic Product at Market Prices
./. Depreciation
= Net Domestic Product at Market Prices
./. indirect Taxes + Subsidies
= Net Domestic Product at Factor Prices
+ Income of Inhabitants Abroad
./. Income of Foreigners Within the Country
= Net National Income at Factor Prices
./. Direct Taxes (Taxes on Labor & Wealth Income etc.)
+ Social Transfers (=Social Benefits, Child Benefits etc.)
./. Interest on Consumer Credits1)
= Disposable Income of Households
- 76 -
Pforzheim
If, however, if possible one

should try to correct GDP
towards an aggregate that
comes closer to disposable
income.
- 78 -
Should GDP be used as an indicator of welfare?

1.3.1. What Is GDP?
Of course, welfare is a somewhat cloudy expression.

However, commonly welfare means the economic
well-being of people.
Certainly, economic well-being depends stronger on
disposable income but GDP.
Therefore, disposable income is a better indicator for
welfare.
There are, however, other objections against the
explanatory power of GDP and also disposable income
as an indicator of welfare!
- 79 -
- 80 -
Average Yearly Working Hours per Employee in the Year 2004
Leisure time: In a country where people have a strong

preference for consumption (and hence for a high income that
makes high consumption possible) GDP will be larger than
the GDP of a country where people have a strong preference
for leisure time. Nevertheless, people of both countries may
have the subjective impression that they share the same level
of welfare.
- 81 -
Non-market production: As already seen, GDP measures only

goods and services, which are traded over markets. Home
production (education of children, cooking, housekeeping,
subsistence agriculture) is not captured, even though it
does of course affect the welfare of people too.
Source: IAT Gelsenkirchen

Income distribution: A high GDP might come along with a very

uneven distribution of income. Therefore, an analysis of
economic welfare should not only reflect the level of GDP and
the like, but also take care about measures of income
distribution.
- 83 -
Environment: Environmental protection consumes intermediate products (air cleaner, clarification plants), which
can therefore not be used to produce final goods. The benefits
from environmental production are not sold over markets and
therefore not captured by GDP. If instead final products, which
are sold over markets, were produced, this would be captured
by GDP. Hence, environmental protection reduces measured
GDP, even though the positive effect of environmental
protection on welfare can be larger than the negative effect of
a lower GDP on welfare.
- 82 -

Capabilities: Disposable income measures only purchasing power
available to people. What people can do with this purchasing
power does also depend on other factors like:
personal health,
personal education,
access to information,
legal framework,
political freedom
and so on. Therefore, the same level of income can grant a
person more or less implementation options (or in the words of
Amartya Sen capabilities) depending on these factors. For
example: (1) A severely handicapped or sick person can enjoy a
high income level not in the same way as a healthy person. (2) A
person with a low education level or restricted access to
information will typically know less options, how to spend income,
than a well-educated person or a person with full access to all
relevant information.
- 84 -

Capabilities:
Consequently, the same income level can go along with quite
different levels of attainable capabilities.
Capabilities are however hard to measure, since they depend
on soft factors, which lack statistical coverage.
Nevertheless, some factors, which are likely to have a significant
impact on capabilities, are available, e.g.:
o life expectancy and
o average education level.
Therefore, the United Nations have started a project, where every
year since 1990 a so called Human Development Index (HDI) is
calculated for 169 member countries.
The HDI is calculated according to the following definition:
- 85 -
Should GDP be used as an indicator

of welfare?
Capabilities:
Definition of
Human Development
Index:
= GDP+ Income of inhabitants abroad

./. Income of foreigners within
GNP= Gross National Product

scaled between 1 and 100
LE= Live Expectancy scaled

between 1 and 100
HDI=
An index number
between 1 and 100
EDU= Education Index scaled

between 1 and 100
- 86 -
A ranking of countries
according to life expectancy
yields a difference of 15%
compared to a ranking based
on Per-Capita GNP
A ranking of countries
according to the HDI yields a
difference of only 5%
compared to a ranking based
on Per-Capita GNP
- 87 -
- 88 -
Capabilities:
As these diagrams show, GNP contains a lot of information
about life expectancy and the education level.
As we have already seen, it does also contain valuable
information about the relationship between the business cycle
and the labor market in each country.
Taken together, one can come to the conclusion that GNP
contains a lot of very different information which is quite useful
for the discussion of macroeconomics questions.
A ranking of countries according

to mean years of schooling
yields a difference of only 24%
compared to a ranking based on
Per-Capita GNP
- 89 -
- 90 -
You should be able to answer the following questions at

the end of this chapter. All of the questions can be
answered with the help of the lecture notes. If you have
difficulties in answering a question, discuss this question
with me at the end of the lecture, attend my colloquium or
send me an E-Mail.
- 91 -
1.
What is the difference between micro- and macroeconomics?
2.
What is the relation between macroeconomic theories, aims and

strategies?
3.
What kind of questions are typical for macroeconomic theory, what

for the discussion of macroeconomic aims?
4.
Explain the circular flow model of an economy.
5.
What kind of conclusions can be dawn from this model?
6.
Who owns the production factors of an economy?
7.
Explain the fundamental equation of the circular-flow model.
8.
Define GDP.
11. How does the calculation of GDP take care of the apples and
oranges problem?
19. A household aid marries his former employer. What effect has this
marriage on GDP?
12. What kind of information contains the market price of a good?
20. What difficulty emerges in interpreting the GDP of countries with a

large sector of agricultural subsistence?
13. What are services?
21. What are non-profit organizations?
14. Are services covered by the calculation of GDP?
16. You visit a music concert. Do you buy a service or a good?
22. How does the production of institutions, which grant their products
and services for free to their customers, enter the calculation of
GDP?
17. What kind of products are not correctly captured by GDP?
23. Why does adding up the sales of firms does not lead to GDP?
18. You decide to take your meals further on in restaurants only. What
is the effect of your decision on GDP?
24. Explain the problem of multiple count based on an example.

15. You buy a CD-player. Do you buy a service or a good?
- 93 -
25. What role play intermediary goods in the calculation of GDP?
- 94 -
26. Does a Swiss citizen working in the town of Konstanz affect the
German GDP?
32. How is value added of firms, of the government and private

Households computed?
27. Does a German citizen, who runs a firm in Austria, affect the
German GDP?
33. What kind of aggregate should be the base of an analysis of

market potential of a country or a region?
28. Does a German citizen, who works in a bank in Luxembourg, affect

the German national income?
34. What is the definition of depreciations as contained in GDP?

35. How is the aggregate called that results, if you subtract
depreciation form GDP?
29. You sell your two years old Maserati at eBay. How does this
transaction affect the current GDP?
36. Explain the derivation of disposable income starting with GDP.
30. What are the three ways of calculating GDP?
37. Specify four reasons that reduce the appropriateness of GDP as a

measure of wealth.
31. Specify the components of GDP following the three ways of

calculating GDP.
- 92 -
- 95 -
- 96 -
38. What factor has to be considered, if the GDP of 1994 has to be

compared with the GDP of 2002?
46. Use the number in the following table to determine real GDP at prices
of the year 2000 and at prices of the year 2002.
39. The nominal GDP of country A was 100 000 in the year 1950 and
130 000 000 in the year 2000. In the same span of time the BIPDeflator has grown with an annual rate of 5% per year. The nominal
GDP of country B was 250 000 in the year 1950 and 120 000 000
in the year 2000. In the same span of time the GDP-Deflator has
grown with an annual rate of 2%. Which country has experienced the
strongest growth of real GDP?
Apples
40. What is the difference between nominal and real GDP?
Oranges
Year
Quantity
kg
Price
Quantity
kg
Price
2000
100
10
50
30
2001
150
20
100
40
2002
300
30
150
50
GDP
real
(Prices =
2000)
real
(Prices =
2002)
42. How is the GDP-Deflator affected, if all prices stay constant compared
to the base year and only the real production quantities of goods
change?
43. What is the relationship between GDP-Deflator and the rate of
inflation?
- 97 -
41. What is the definition of the GDP-Deflator?

49. Find the value of Net Income from Wealth within the Country by
Nationals & Foreigners from the following numbers of the National
Accounts:
48. Calculate the missing numbers.

2000
2001
2002 2003 2004 2005 2006
Nominal GDP
2063
2113
2143 2162 2207 2241 2307
Real GDP (Base 2000)
2063
2088
2088 2084 2110 2129 2186
Year
Unity
Net Taxes (T) = Direct Taxes ./. Social Transfers + Indirect Taxes ./.
Subsidies = 250 ,
Consumption of Households = 500 ,
Net Investment of Firms = 100 ,
Exports = 300 ,
Gross Investment = 150 ,
New Indebtedness of Government (DG) = 100 ,
Imports = 200 ,
Bn. Euro
Nominal GDP Growth

Real GDP Growth
GDP-Deflator
Rate of Inflation
- 99 -
GDP at Market Value by
1)
2)
Distribution
Net Compensation of
Domestic and
Foreign Employees
and Self-Employed
Working within the
Country
Gross Value
Added of Firms,
Government1)
Non-profit
Organizations
and Private
Net Income from Wealth
Households
within the Country by
Nationals & Foreigners
Value Added Tax

./. Subsidies
Expenditure
Consumption of
Households
Exports ./. Imports
Government
Consumption2)
T
DG
T Direct Taxes ./. Social

Transfers + Indirect Taxes
./. Subsidies
Net Investment
of Firms
Depreciation
Depreciation
Gross
Investment
Gross Value Added
Production
Estimated: Value Added of Government = Government Consumption ./. Purchase of Intermediate Goods by the Government.
Estimated: Government Consumption = Employment Compensation & Government Purchases of Goods and Services
- 98 -
- 101 -
Net Compensation of Domestic and Foreign Employees and SelfEmployed Working within the Country = 600 .
- 100 -

AU 1 Introduction To Macroeconomics 6

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Macroeconomics

RAINER MAURER, Pforzheim

RAINER MAURER, Pforzheim

Lecture Notes: www.rainer-maurer.de

Prof. Dr. Rainer Maurer

Prof. Dr. Rainer Maurer

1.1. What is Macroeconomics?

1.1. What is Macroeconomics?

1.1. What is Macroeconomics?

Microeconomics studies the behavior of individual

RAINER MAURER, Pforzheim

RAINER MAURER, Pforzheim

Macroeconomics studies the economy as a whole that

Prof. Dr. Rainer Maurer

1.1. What is Macroeconomics?

1.1. What is Macroeconomics?

As we will see: The macroeconomic whole is more than

Microeconomics deals with disaggregated data, while

For the economy as a whole it is (in the short run version of

RAINER MAURER, Pforzheim

RAINER MAURER, Pforzheim

Famous example: The savings paradoxon:

Prof. Dr. Rainer Maurer

Prof. Dr. Rainer Maurer

Prof. Dr. Rainer Maurer

the share of all unemployed persons in the total labor

1.1. What is Macroeconomics?

1.1. What is Macroeconomics?

Explication of macroeconomic observations:

RAINER MAURER, Pforzheim

Neoclassical and Keynesian macro model (chapter 2 )

Conflict of aims cannot be solved by objective science!

Digression: The Choice of Macroeconomic Aims (1):

RAINER MAURER, Pforzheim

Shall the inflation target equal -2%, 0%, 2% ? (Chapter 6)

Prof. Dr. Rainer Maurer

Prof. Dr. Rainer Maurer

Digression: The Choice of Macroeconomic Aims (2):

RAINER MAURER, Pforzheim

RAINER MAURER, Pforzheim

Digression: The Choice of Macroeconomic Aims (2):

Prof. Dr. Rainer Maurer

Strategy: How can a selected growth

How can business cycles be affected by macro policy if we postulate the

RAINER MAURER, Pforzheim

RAINER MAURER, Pforzheim

- 13 Source: Penn World Tables, NBER

Policy: If we want to fight business

RAINER MAURER, Pforzheim

These small deviations of

Source: SVG, Jg. 2004/5

Source: SVG, Jg. 2004/5

1.1. What is Macroeconomics?

Prof. Dr. Rainer Maurer

RAINER MAURER, Pforzheim

RAINER MAURER, Pforzheim

The Circular-Flow model is a basic concept that appears

Its inventor was the French medic

The Circular Flow Model

The Circular Flow Model

are Suppliers of Goods

Market Equilibrium Prices

Market Equilibrium Quantities