Macroeconomics Review: Key Concepts from Micro to Aggregate Supply & Demand

From Microeconomics to Macroeconomics

Reconciling Micro and Macro

Economics studies the allocation of scarce resources. Microeconomics focuses on individual markets and choices, while macroeconomics examines the economy as a whole, including the connections between markets and aggregate outcomes.

• Microeconomics: Studies demand and supply in single markets, aiming for efficient allocation and market clearing.

• Macroeconomics: Studies aggregate outcomes such as real GDP, unemployment, and inflation, and considers economy-wide policies (fiscal, monetary, trade).

• Key Insight: Individual optimization does not always lead to desirable aggregate outcomes.

Hands-Off vs. Hands-On Approaches

The speed at which markets self-adjust determines whether economists advocate for government intervention (Hands-On) or not (Hands-Off).

• Hands-Off: Belief in quick self-adjustment, market failures are rare, associated with right-leaning politics.

• Hands-On: Belief in slow self-adjustment, market failures are common, associated with left-leaning politics.

• Fallacy of Composition: Micro outcomes do not always aggregate to macro outcomes.

GDP and Living Standards

Measuring GDP

Gross Domestic Product (GDP) is a key indicator of material living standards. To compare living standards over time, changes in price and population must be excluded.

• Nominal GDP: Value of all final goods/services produced in a country at current prices. $\text{Nominal GDP}_{t} = \sum P_{t} \times Q_{t}$

• Real GDP: Value of all final goods/services produced in a country at constant base-year prices. $\text{Real GDP}_{t} = \sum P_{\text{base year}} \times Q_{t}$

• Real GDP per Capita: Real GDP divided by population. $\text{Real GDP per Capita}_{t} = \frac{\text{Real GDP}_{t}}{\text{Population}_{t}}$

GDP Calculation Methods

• Expenditure Approach: $Y = C + I + G + (X - IM)$, where C = consumption, I = investment, G = government spending, X = exports, IM = imports.

• Income Approach: Sums all incomes earned in production (wages, rent, profit).

• Value Added Approach: Sums the value added at each stage of production.

Why subtract imports? Imports are subtracted because they are not produced domestically and should not be included in GDP.

The Circular Flow and Injections/Leakages

The circular flow model illustrates how money moves through the economy, identifying injections (additions to spending) and leakages (withdrawals from spending).

• Injections: Investment, government spending, exports.

• Leakages: Savings, taxes, imports.

Limitations of GDP as a Measure of Well-Being

• Omits non-market production (e.g., household work).

• Omits the underground economy.

• Ignores environmental sustainability.

• Ignores leisure and social factors.

• Ignores political freedoms and social injustice.

Potential GDP, Economic Growth, and Business Cycles

Potential GDP

Potential GDP is the level of real GDP when all resources are fully employed. Actual GDP can be above (unsustainable) or below (underutilization) potential GDP.

• Short-run goal: Achieve potential GDP per capita.

• Long-run goal: Increase potential GDP per capita (economic growth).

Economic Growth

Economic growth is the expansion of the economy's capacity to produce goods and services (increase in potential GDP).

• Occurs through increases in the quantity or quality of inputs (labour, capital, technology).

Business Cycles

Business cycles are fluctuations of real GDP around potential GDP, including periods of expansion, peak, contraction, and trough.

• Economic shocks: Unexpected events affecting macroeconomic performance.

• Internal shocks: Originate within the economy (e.g., changes in consumer confidence).

• External shocks: Originate outside the economy (e.g., oil price shocks).

• Positive shocks: Boost economic activity.

• Negative shocks: Reduce economic activity (often trigger recessions).

Unemployment and Inflation

Measuring Unemployment

• Employed: Working at a paid job (full- or part-time).

• Unemployed: Not working but actively searching, on temporary layoff, or about to start a new job.

• Labour Force: Employed + Unemployed.

• Unemployment Rate: $\text{Unemployment Rate} = \frac{\text{Number Unemployed}}{\text{Labour Force}} \times 100$

• Labour Force Participation Rate: $\text{Labour Force Participation Rate} = \frac{\text{Labour Force}}{\text{Working Age Population}} \times 100$

Types of Unemployment

Type	Cause	Healthy?	Needs Fixing?
Frictional	Normal job search and matching	Yes	No
Seasonal	Changes in demand by season	Yes	No
Structural	Mismatch of skills or location	No	Yes
Cyclical	Business cycle downturns	No	Yes

• Natural Rate of Unemployment: The rate associated with full employment (potential GDP).

Measuring Inflation

Inflation is a persistent rise in the average price level, measured by the Consumer Price Index (CPI).

• CPI uses a fixed basket of goods (about 700 items) reflecting typical spending proportions.

• CPI is set to 100 in the base year; a CPI of 151 means prices rose 51% since the base year.

• Inflation Rate: $\text{Inflation Rate} = \frac{\text{CPI}_{\text{this year}} - \text{CPI}_{\text{last year}}}{\text{CPI}_{\text{last year}}} \times 100$

Total vs. Core Inflation

Total inflation includes all items; core inflation excludes volatile items (e.g., food, energy) for a clearer trend.

Inflation and Interest Rates

• Nominal Interest Rate: The stated rate, not adjusted for inflation.

• Real Interest Rate: Adjusted for inflation; reflects purchasing power. $\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate}$

• Unexpected inflation benefits borrowers and hurts lenders.

Quantity Theory of Money (QTM)

QTM links the money supply to the price level:

• Assumes velocity (V) and output (Q) are fixed, so increases in money supply (M) raise prices (P).

$M \times V = P \times Q$

• In reality, velocity can change, affecting the relationship between money supply and inflation.

The Phillips Curve

The Phillips Curve illustrates the short-run trade-off between unemployment and inflation.

• Lower unemployment is associated with higher inflation, and vice versa (short run).

• Stagflation (high unemployment and high inflation) can occur due to supply shocks.

Types of Inflation

Type	Cause	Business Cycle Phase	Unemployment Impact	Inflation Impact	Phillips Curve
Demand-Pull	Increase in Aggregate Demand	Expansion	Decrease	Increase	Movement along curve
Cost-Push	Decrease in Aggregate Supply	Any phase (may cause contraction)	Increase	Increase	Curve shifts (stagflation)

Aggregate Supply and Aggregate Demand

Aggregate Supply (AS) and Aggregate Demand (AD)

Macroeconomics uses the AS/AD model to analyze the entire economy, focusing on the overall price level and real GDP.

• Aggregate Supply (AS): Total quantity of goods and services businesses plan to produce.

• Aggregate Demand (AD): Total quantity of goods and services demanded by all players.

Long-Run Aggregate Supply (LAS)

• LAS is vertical at potential GDP; in the long run, all prices and wages adjust.

Short-Run Aggregate Supply (SAS)

• SAS is upward sloping; as the price level rises, quantity supplied increases due to sticky input prices.

• Shifts in SAS are caused by changes in input prices, technology, or supply shocks.

Aggregate Demand (AD)

• AD is downward sloping; as the price level rises, quantity demanded decreases due to wealth, interest rate, and exchange rate effects.

• Shifts in AD are caused by changes in expectations, interest rates, government policy, foreign GDP, and exchange rates.

Macroeconomic Equilibrium and Shocks

• Long-run equilibrium occurs where LAS, SAS, and AD intersect.

• Shocks to AD or SAS can push the economy out of equilibrium, affecting price level and real GDP.

• Simultaneous shocks to AD and SAS make the impact on one variable ambiguous and the other certain.