ECONOMICS

Chapter 1
MACROECONOMICS: THE BASICS



Table of contents

1. Macroeconomics: The basics
1.1 Major macroeconomic concepts and variables................................................................................ 1

1.1.1 National income accounting: GDP and GNP .................................................................................... 1

1.1.2 Inflation............................................................................................................................................ 8

1.1.3 Interest rates................................................................................................................................... 11

Appendix: Some US macroeconomic series ................................................................................................. 13

1.2 The basic model of the real market in a closed economy .............................................................. 16

1.2.1 The determination of demand ......................................................................................................... 16

1.2.1.1 Consumption and saving ........................................................................................................... 17

1.2.1.2 Investment ................................................................................................................................ 19

1.2.1.3 Government expenditure ........................................................................................................... 20

1.2.2 Equilibrium in the real market: The IS relation............................................................................... 21

1.2.2.1 The determination of equilibrium output................................................................................... 21

1.2.2.2 The derivation of the IS curve................................................................................................... 23

1.2.2.3 Investment equals saving........................................................................................................... 25

1.3 The basic model of the financial market in a closed economy ...................................................... 27

1.3.1 The demand for money ................................................................................................................... 27

1.3.2 Equilibrium in the money market: The LM relation........................................................................ 29

1.3.2.1 Money demand, money supply and the equilibrium interest rate .............................................. 29

1.3.2.2 The derivation of the LM curve................................................................................................. 29

1.4 The IS-LM model ............................................................................................................................. 31

1.4.1 Equilibrium in the real and financial markets ................................................................................. 31

1.4.2 The effects of fiscal policy in a closed economy and crowding out................................................ 32

1.4.3 The effects of monetary policy in a closed economy ...................................................................... 33

1.4.4 Expected inflation and the IS-LM model ........................................................................................ 35

1.5 The labour market........................................................................................................................... 36

1.5.1 Wage determination ........................................................................................................................ 36

1.5.2 Price determination ......................................................................................................................... 37

1.5.3 Equilibrium in the labour market and natural unemployment ......................................................... 38

1.6 General equilibrium in the real, financial and labour markets.................................................... 41

1.6.1 Aggregate supply ............................................................................................................................ 41

1.6.2 Aggregate demand .......................................................................................................................... 43

1.6.3 Equilibrium output in the short and the medium run....................................................................... 46

1.6.4 The dynamic effects of fiscal policy ............................................................................................... 49

1.6.5 The dynamic effects of monetary policy ......................................................................................... 51



1. Macroeconomics: The basics
This chapter is an introduction to some of the fundamental concepts of macroeconomics. We
begin by defining the concepts that are used in macroeconomics to quantify the economy.
These concepts are called macroeconomic because they describe the behaviour of large
economic aggregates such as production or consumption by the sum of all economic agents of
a country. Subsequently, this chapter will introduce the principal models that are used by
economists to study the interaction of the main macroeconomic variables. Since one of the
major purposes of macroeconomics is to guide economic policy, we will use those models for
an examination of the effects of various macroeconomic policy interventions. The concepts
studied in this chapter will be crucial to the understanding of the subsequent chapters.
1.1 Major macroeconomic concepts and variables
1.1.1 National income accounting: GDP and GNP
Gross domestic product (GDP) is the concept that quantifies aggregate economic activity in a
certain geographical area, mostly defined as a country. It is a measure of the total value of
final goods and services produced by an economy during a particular period. Suppose that we
have two firms, one producing chocolates (firm A) and another selling insurance (firm B). The
annual production of these firms is sold for CHF 40’000 and CHF 60’000, respectively. If
these were the only firms in the Swiss economy, Swiss GDP for the year would be
GDP = Sales A + Sales B ,
GDP = (40'000 + 60'000) =100'000 CHF .
If we have more firms, we have to add up their sales in order to obtain the value of all the
goods and services produced. However, GDP measures the value only of final goods and
services. This means that from the value of all goods and services produced one has to
subtract the value of intermediate goods and services, which are those used up in the
production of other goods and services. GDP is thus defined as the market value of final
goods and services newly produced on the territory of a certain economic unit (usually a
country) over a certain period of time (usually a year).
GDP is a concept that can be described and decomposed in several different ways. We can
outline the three main decompositions.
1.
One possibility is to decompose GDP by factor incomes. The proceeds from sales of
output go to the selling firms, which, in turn, must pay the different factors of
production they employ. Economic theory generally identifies labour and capital as the
main factors of production. Workers (i.e. the factor “labour”) receive wages, whereas
the owners of capital receive rents, interest or dividends. The factor-incomes version
of GDP simply corresponds to the sum of all these incomes in an economy, measured
over a particular time period.
2.
A second decomposition of GDP is the expenditure decomposition. Once the various
owners of production factors have received their income, they will use this income in
chapter 1 / page 1

some way. Thus, overall production is equal to the sum of factor payments, which are,
in turn, equal to the sum of expenditure by the different factor owners, such as
households (i.e. workers), firms, the government and foreign residents.