Macroeconomics Midterm Study Guide: GDP, CPI, Inflation, and Core Models

PART 1 — GDP, CPI, AND INFLATION

Nominal vs Real GDP

• Nominal GDP: Measures the value of all final goods and services produced within a country in a given period using current year prices.

• Formula: $\text{Nominal GDP} = \sum (P_{current} \times Q_{current})$

• Real GDP: Measures the value of all final goods and services using base-year prices, allowing for comparison across years by removing the effects of price changes (inflation).

• Formula: $\text{Real GDP} = \sum (P_{base} \times Q_{current})$

Value-Added Method of GDP

• Definition: GDP is calculated as the sum of value added at each stage of production, preventing double counting.

• Value Added Formula: $\text{Value Added} = \text{Sales} - \text{Cost of intermediate goods}$

GDP as a Measure of Standard of Living

• Measures total production in the economy.

• Reflects average income per person.

• Indicates economic growth capacity over time.

Limitations of GDP

• Does not include household work (e.g., unpaid domestic labor).

• Excludes the underground economy (unreported transactions).

• Ignores environmental damage, leisure, and income inequality.

Consumer Price Index (CPI)

• Steps to Calculate CPI:

  1. Choose a base year basket of goods and services.

  2. Calculate the cost of the basket each year.

  3. Compute CPI:

  $CPI = \frac{\text{Cost of basket this year}}{\text{Cost of basket base year}} \times 100$

Inflation Rate

• Formula: $\text{Inflation} = \frac{CPI_{new} - CPI_{old}}{CPI_{old}} \times 100$

Purchasing Power

• As prices rise, the purchasing power of money falls.

• Example: $30,000 in 1993 could buy more goods than $30,000 today due to inflation.

PART 2 — EXPENDITURE APPROACH TO GDP

• GDP Formula: $GDP = C + I + G + NX$

• Components:

  • C: Consumption (household spending)

  • I: Investment (business spending on capital, inventories)

  • G: Government spending

  • NX: Net exports (Exports - Imports)

• Examples:

  • Purchase of Nestle equipment → Investment (I)

  • Inventory increase → Investment (I)

  • Government exhibit → Government spending (G)

  • Restaurant purchase → Consumption (C)

  • American hotel stay by a foreigner → Export (X)

PART 3 — AGGREGATE EXPENDITURE (AE MODEL)

• AE Equation: $AE = C + I + G + (X - IM)$

• Graph Axes: Vertical axis = AE; Horizontal axis = National income (Y)

• Slope of AE: Marginal propensity to spend (z): $z = MPC(1 - t) - m$

• Intercept of AE: Autonomous spending (consumption, investment, government spending, exports)

• Inventory Adjustment:

  • If AE > Y: Inventories fall, production rises.

  • If AE < Y: Inventories rise, production falls.

PART 4 — CONSUMPTION & INVESTMENT

• Largest Component of Spending: Consumption

• Marginal Propensity to Consume (MPC): $MPC = \frac{\Delta C}{\Delta Y}$

• If income is not consumed, it is saved.

• Determinants of Investment:

  • Expected return

  • Technology

  • Business expectations

  • Costs

  • Existing capital stock

• Investment is volatile due to large purchases and irregular timing.

PART 5 — IMPORTS AND NET EXPORTS

• Import Function: $IM = mY$

• Net Exports: $NX = X - mY$

• Exports (X) are exogenous (determined outside the model); Imports (IM) are endogenous (depend on income).

• If the domestic currency appreciates:

  • Imports increase

  • Exports decrease

PART 6 — MULTIPLIER

• Multiplier Formula: $\text{Multiplier} = \frac{1}{1 - z}$

• Change in Income: $\Delta Y = \text{Multiplier} \times \Delta I$

• If saving rises, AE falls, increasing the risk of recession.

PART 7 — FISCAL POLICY

• Balanced Budget: $T = G$

• Deficit: $G > T$

• Surplus: $T > G$

• Recessionary Gap: Actual GDP < potential GDP

  • Solutions: Increase G, decrease taxes, increase exports, increase investment

• Inflationary Gap: Actual GDP > potential GDP

  • Solutions: Decrease G, increase taxes, reduce investment, reduce exports

PART 8 — AD/AS MODEL

• Aggregate Demand (AD) Components: $C + I + G + NX$

• Why AD Slopes Downward:

  1. Wealth effect

  2. Interest-rate effect

  3. International-trade effect

• AD Shifts When: Spending changes due to optimism, taxes, government spending, or foreign income.

PART 9 — SHORT-RUN AGGREGATE SUPPLY (SRAS)

• SRAS is upward sloping due to sticky wages/factor prices (wages adjust slowly downward).

• SRAS Shifts When:

  • Wages change

  • Productivity changes

  • Input prices change

  • Inflation expectations change

• Supply Shock: Sudden change in production costs (e.g., drought shifts SRAS left).

PART 10 — AUTOMATIC STABILIZERS

• During Recession:

  • Tax revenue decreases

  • Employment Insurance (EI) payments increase

  • Welfare payments increase

  • Government deficit increases

• During Expansion:

  • Tax revenue increases

  • Transfer payments decrease

• Examples: Progressive taxes, EI, welfare

• Automatic stabilizers reduce the size of the multiplier, dampening economic fluctuations.

PART 11 — LONG-RUN GROWTH

• LRAS (Long-Run Aggregate Supply) is determined by:

  • Labour

  • Capital

  • Technology

  • Education

  • Institutions

• Growth shifts LRAS to the right.

• Productivity Graph:

  • Vertical axis: Productivity

  • Horizontal axis: Capital per worker

  • Movement along curve: More capital

  • Shift of curve: Technology improvement

PART 12 — LOANABLE FUNDS

• National Saving: $NS = Y - C - G$

• Public Saving: $T - G$

• Private Saving: $NS - (T-G)$

• If $I > NS$, interest rates rise; if $I < NS$, interest rates fall.

PART 13 — PHILLIPS CURVE

• Phillips Curve: Shows the relationship between unemployment and the rate of change of wages (wage inflation).

• As unemployment falls, wage inflation tends to rise, and vice versa.