ECOS2040 Intermediate
Financial Economics
Semester 1, 2023
School of Economics
Faculty of Arts and Social Sciences
University of Sydney
Olivier Blanchard and Jeffrey Sheen,
Macroeconomics, 4th Australasian Edition,
Pearson.
Textbook
+ additional materials
Chapter 2
Output, inflation and
unemployment
Key Macroeconomic Variables
Three key measures of macro analysis
• Output (GDP)
• Unemployment rate
• Inflation rate
Section 2.1: Aggregate Output
• National income and product accounts are an accounting
system used to measure of aggregate economic activity.
• The measure of aggregate output in the national income accounts
is gross domestic product, or GDP.
GDP: Production and Income
There are three ways of defining GDP:
1. GDP is the value of the final goods and services produced in
the economy during a given period.
• A final good is a good that is destined for final
consumption.
• An intermediate good is a good used in the production of
another good.
GDP: Production and Income
STEEL COMPANY (FIRM 1) CAR COMPANY (FIRM 2)
Revenues from sales $100 Revenues from sales $200
Expenses $80 Expenses $170
Wages $80 Wages $70
Steel purchases $100
Profits $20 Profits $30
GDP: Production and Income
There are three ways of defining GDP:
2. GDP is the sum of value added in the economy during a given
period.
▪ Value added equals the value of a firm’s production
minus the value of the intermediate goods it uses in
production.
GDP: Production and Income
There are three ways of defining GDP:
3. GDP is the sum of the incomes in the economy during a given
period.
THE COMPOSITION OF AUSTRALIAN GDP BY TYPE OF INCOME, 1960 AND 2011
SHARES 1960 2011
Labour income 70% 55%
Capital income 23% 35%
Indirect taxes and subsidies 7% 10%
Source: RBA G12; labour income includes mixed income
Nominal and Real GDP
• Nominal GDP is the sum of the quantities of final
goods produced times their current price.
• Nominal GDP increases over time because:
1. The production of most goods increases over time.
2. The prices of most goods also increase over time.
• Real GDP is constructed as the sum of the quantities of
final goods times constant (rather than current) prices.
Nominal and Real GDP
Using 2010 dollars to compute real GDP, then:
Year Quantity of Cars Price of cars Nominal GDP
2009 10 $20,000 $200,000
2010 12 $24,000 $288,000
2011 13 $26,000 $338,000
Year Quantity of Cars Price of cars Real GDP
2009 10 $24,000 $240,000
2010 12 $24,000 $288,000
2011 13 $24,000 $312,000
Nominal and Real GDP
• Nominal GDP is also called dollar GDP or GDP in current dollars.
• Real GDP is also called GDP in terms of goods, GDP in constant
dollars, GDP adjusted for inflation, or GDP in, say, 2010
dollars.
• Problem: Real GDP growth rate depends on the choice of the base
year when there is more than one final good.
• One solution: Construct real GDP by chaining the rate of changes.
Nominal and Real GDP
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Potato Chips (bags) Computers (unit)
Year Q P($) Q P($)
1998 10,000 2 1 10,000
1999 11,000 2.5 2 5,000
2000 12,000 3 4 2,500
Potato chip and Computer production and prices
Year 1998 prices 1999 prices 2000 prices
1998 30 30 32.5
1999 42 37.5 38
2000 64 50 46
Real GDP measured by the fixed-base-year method (in $1,000)
Numbers along the diagonal are nominal GDPs. Why?
Nominal and Real GDP
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With more than one good, the real GDP growth rates vary with the base year.
Year 1998 prices 1999 prices 2000 prices
1998 30 30 32.5
1999 42 37.5 38
2000 64 50 46
Real GDP measured by the fixed-base-year method (in $1,000)
Period 1998 prices 1999 prices 2000 prices Chained rate
1998-99 40 25 16.9 32.5
1999-00 52.4 33.3 21.1 27.2
Real GDP growth (% change)
The chained rates are simple averages of the two alternative growth rates
over the period.
Nominal and Real GDP
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How to compute the level of real GDP?
• First, pick an arbitrary year as the base year, say 1998.
• Using the chained rates and the nominal GDP in 1998 ($30,000), we can
then compute the real GDP in chained (1998) thousand dollars:
Year Chained rate real GDP (in chained (1998)
thousand dollars)
1998 100 30
1999 32.5 39.8
2000 27.2 50.6
1999 = 1998 × 1 +
ℎ 1998−99
100
= 30 × 1 +
32.5
100
= 39.75
2000 = 1999 × 1 +
ℎ 1999−00
100
= 39.75 × 1 +
27.2
100
= 50.56
Nominal and Real GDP
GDP growth equals:
1
1
−
−−
t
tt
Y
YY
• Periods of positive GDP growth are called
expansions.
• Periods of negative GDP growth are called
recessions.
Section 2.2: The Other Major Macroeconomic
Variables
GDP is obviously the most important macroeconomic variable. But
two other variables tell us about other important aspects of how an
economic is performing:
1. Unemployment
2. Inflation
The Unemployment Rate
labour force = employed + unemployed
L = N + U
unemployment rate:
Australia
June 2012
Employed
11.5 million
Unemployed
0.63 million
L
U
u =
12 =
0.63
0.63+11.5
=5.2%
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The Unemployment Rate
The crisis of 2008 had a small but visible effect.
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The Unemployment Rate
Latest data from ABS
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0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
08-1976 09-1979 09-1982 09-1985 09-1988 09-1991 09-1994 09-1997 10-2000 10-2003 10-2006 10-2009 10-2012 10-2015 10-2018 10-2021
Unemployment rate - original
The Unemployment Rate
▪ Only those looking for work are counted as
unemployed. Those not working and not looking
for work are not in the labour force.
▪ People without jobs who give up looking for work
are known as discouraged workers.
▪ Participation rate
ageworkingofpopulation
forcelabour
=
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The Inflation Rate
• Inflation is a sustained rise in the general level of prices—the price
level.
• The inflation rate is the rate at which the price level increases.
• Deflation is a sustained decline in the price level, or a negative
inflation rate.
The GDP Deflator
• The GDP deflator is what is called an index number—
set equal to 100 in the base year.
• The rate of change in the GDP deflator equals the rate
of Inflation:
P
Y
Yt
t
t
= =
nominal GDP
real GDP
t
t
$
( )P P
P
t t
t
− −
−
1
1
• Nominal GDP is equal to the GDP deflator times real GDP:
$Y PYt t t=
The Consumer Price Index
• The GDP deflator measures the average price of output,
while the consumer price index (CPI) measures the
average price of consumption, or equivalently, the cost
of living.
• The CPI and the GDP deflator move together most of
the time.
Inflation of the Consumer Price Index and
the GDP Deflator in Australia
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Inflation
Why do we hate inflation?
• Suppose the inflation rate is 5% per year. How long does it take to
double the price?
• What if the inflation rate is 10% per year instead?
Who loves inflation?
0
1
2
3
4
5
6
7
2000 2005 2010 2015
A
U
D
Big Mac Price in Australia
(source: The Economist)
Section 2.3: A Road Map
Output is determined by:
• demand in the short run, say, up to a few years;
• the level of technology, the capital stock, and the labour force in
the medium run, say, up to a decade or so;
• factors such as education, research, saving, and the quality of
government in the long run, say, a half century or more.
Chapter 3
The Goods Market
The Composition of
Australian GDP, 2011
3-1
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Section 3.1: The Composition of GDP
• Consumption (C) refers to the goods and services purchased by
consumers.
• Investment (I), sometimes called fixed investment, is the
purchase of capital goods. It is the sum of non-residential
investment and residential investment.
The Composition of GDP
• Government Spending (G) refers to the purchases of goods and
services by the federal, state, and local governments. It does not
include government transfers, nor interest payments on the
government debt.
• Imports (IM) are the purchases of foreign goods and services by
consumers, business firms, and the Australian government.
• Exports (X) are the purchases of Australian goods and services by
foreigners.
The Composition of GDP
▪ Net exports (X − IM) is the difference between
exports and imports, also called the trade balance.
Exports > imports trade surplus
Exports < imports trade deficit
Exports = imports trade balance
▪ Inventory investment is the difference between
production and sales.
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Z C I G X IM + + + −
Z C I G + +
Section 3.2: The Demand for Goods
• The total demand for goods is written as:
• The symbol “” means that this equation is an identity, or
definition.
• Under the assumption that the economy is closed, X = IM =
0, then:
• Consider the flow of money/value in an open economy
Interlude: injections and leakages
• Private Investment is an injection while Saving is a leakage.
• Government Sector: Government expenditure is an injection
and net taxes (T) a leakage (where T = Taxes - Transfer
Payments).
• Overseas Sector: Exports are an injection and Imports a
leakage.
Demand Income
Z = C + I + G + X – M Y = C + S + T
Equating them, Z = Y C + I + G + X – M = C + S + T
Rearrange I + G + X = S + T + M
Injections = Leakages
Interlude: injections and leakages
Consumption (C)
• The function C(YD) is called the consumption function. It
is a behavioural equation, that is, it captures the behavior
of consumers.
• Disposable income, (YD), is the income that remains once
consumers have paid income taxes and received transfers
from the government.
C C YD= ( )
( )+
Y Y TD  −
Consumption (C)
Consumption and
Disposable
Income
Consumption
increases with
disposable
income, but less
than one for one.
C C YD= ( )
Y Y TD  −
C c c Y T= + −0 1( )
Investment (I)
• Investment is taken as given (until later), or treated as an
exogenous variable:
• Consider what factors can affect investment levels?
I I=
Government Spending (G)
• Government spending, G, together with taxes, T, describes fiscal
policy—the choice of taxes and spending by the government.
• We shall assume that G and T are also exogenous.
Y c c Y T I G= + − + +0 1( )
Y Z=
Then:
• The equilibrium condition is that, production, Y, be equal to
demand. Demand, Z, in turn depends on income, Y, which itself
is equal to production.
Section 3.3: The Determination of Equilibrium
Output
• Equilibrium in the goods market requires that production, Y, be
equal to the demand for goods, Z:
Using Algebra
• The equilibrium equation can be manipulated to derive some
important terms:
• Autonomous spending and the multiplier:
Y c c Y T I G= + − + +0 1( )
1 0 1(1 )c Y c I G c T− = + + −
Y
c
c I G c T=
−
+ + −
1
1 1
0 1[ ]
multiplier autonomous spending
Using a Graph
The Effects of an
Increase in
Autonomous
Spending on Output
An increase in
autonomous
spending has a
more than one-for-
one effect on
equilibrium output.
How Long Does It Take for Output to Adjust?
• In response to an increase in consumer spending, output does not
jump to the new equilibrium immediately, but rather increases over
time. The adjustment depends on how and how often firms revise
their production schedule.
• Describing formally the adjustment of output over time is what
economists call the dynamics of adjustment.
S Y CD −
S Y T C − −
Y C I G= + +
Y T C I G T− − = + −
S I G T= + −
I S T G= + −( )
• If T > G, the
government is running a
budget surplus—public
saving is positive.
• If T < G, the
government is running a
budget deficit—public
saving is negative.
This equilibrium condition for the goods
market is called the IS relation.
Section 3.4: Investment = Saving: An Alternative
Approach to Goods-Market Equilibrium
• Saving is the sum of private plus public saving. Private
saving (S), is saving by consumers.