Assume that expected inflation is based on the following: πet = θπt-1. if θ = 0, we know that

Introduction to Macroeconomics

Lecture Notes

Robert M. Kunst

March 2006

1 Macroeconomics

Macroeconomics (Greek makro = ‘big’) describes and explains economic

processes that concern aggregates. An aggregate is a multitude of economic

subjects that share some common features. By contrast, microeconomics

treats economic processes that concern individuals.

Example: The decision of a firm to purchase a new office chair from com-

pany X is not a macroeconomic problem. The reaction of Austrian house-

holds to an increased rate of capital taxation is a macroeconomic problem.

Why macroeconomics and not only microeconomics? The whole

is more complex than the sum of independent parts. It is not possible to de-

scribe an economy by forming models for all firms and persons and all their

cross-effects. Macroeconomics investigates aggregate behavior by imposing

simplifying assumptions (“assume there are many identical firms that pro-

duce the same good”) but without abstracting from the essential features.

These assumptions are used in order to build macroeconomic models. Typi-

cally, such models have three aspects: the ‘story’, the mathematical model,

and a graphical representation.

Macroeconomics is ‘non-experimental’: like, e.g., history, macro-

economics cannot conduct controlled scientific experiments (people would

complain about such experiments, and with a good reason) and focuses on

pure observation. Because historical episodes allow diverse interpretations,

many conclusions of macroeconomics are not coercive.

Classical motivation of macroeconomics: politicians should be ad-

vised how to control the economy, such that specified targets can be met

optimally.

policy targets: traditionally, the ‘magical pentagon’ of good economic

growth, stable prices, full employment, external equilibrium, just distribution

1

of income; according to the EMU criteria, focus on inflation (around 2%),

public debt, and a balanced budget; according to Blanchard, focus on low

unemployment (around 5%), good economic growth, and inflation (0—3%).

In all specifications, aim is meeting several conflicting targets simultaneously.

Examples for further typical questions to macroeconomics: what

causes business cycles (episodes of stronger and weaker economic growth)?

can an increase in the monetary supply by the central bank cause real effects?

what is responsible for long-run economic growth? should the exchange rate

of a currency be kept at a fixed level? can one decrease unemployment, if

one accepts an increase in inflation?

A survey of world economics: three large economic blocks (Eu-

rope, USA+Canada, Japan+Far East) with different problems, the remain-

der mostly developing countries.

1. USA: good growth, low inflation, tolerable unemployment rate, per-

sistent external deficit, increasing income inequality.

2. EU: moderate growth, low inflation, in some countries high unem-

ployment, inconspicuous external balance (total EU active, in Austria

recently turned active), for some countries large public debt, currently

important unification process, convergence and heterogeneity of indi-

vidual countries. ‘Richest’ EU countries Luxembourg, Denmark, then

‘mid-field’ with Austria, IRL, B, NL, UK, D, F, FIN, I, S; slightly be-

low E, GR, SLO, P. Last come most ‘new’ (2004 accession) countries

(from Malta down to Latvia). Very ‘rich’ non-EU countries Norway,

Iceland, and Switzerland.

3. Japan: recently weak growth, large external surplus, deflationary ten-

dencies.

2

2 System of National Accounts

Basic idea (not the definition): Summary of all economic activities within

a country’s territory and within a given time range (e.g., a year or quarter)

yields the gross domestic product (GDP). The value of all goods and ser-

vices is determined at market prices (final prices, purchasers’ prices). System

for compilation of data and bookkeeping of all positions is called the System

of National Accounts (SNA). In Europe, compilation of the SNA conforms

to the ESA (European System of Accounts) standard.

Economic activity is mainly measured by transactions. Phrases from

text books: diversification of labor (not complete self-subsistence) causes

transactions, exchange of money for goods or services, exchange of an asset

or liability for a different asset or liability, etc. The transactions take place on

markets. Money makes transactions easier than direct exchange of goods for

goods, which may require ‘double coincidence’ (hungry tailor meets freezing

baker).

Purpose of money: apart from payment and storage of value primarily

unit of measurement (numeraire). In economic text books, usually dollar

($), monetary unit (MU), or euro.

gross: many activities serve to repair or replace worn or damaged ma-

chines and objects (‘depreciation’), therefore it is not the total GDP that

contributes to the accumulation of aggregate wealth. In the SNA, ‘gross’

usually means ‘inclusive of depreciation’, ‘net’ often contains taxes, though

no depreciation.

Consumption of fixed capital (in economics, depreciation) of SNA is the

estimated wear and tear of produced means of production (this ‘depreciation’

should not be confused with positions in tax declarations or with changes in

the currency exchange rate).

3

Capital stock is the stock of fixed capital (machines, buildings, ...) in

enterprises and in the general government sector. This must be distinguished

carefully from the informal usage of the word ‘capital’ as ‘money, liquid

wealth’. By definition, capital contains all produced means of production.

The separation of capital such as machinery from intermediate consumption

such as raw materials can be difficult.

economic activities: only market activities can be fully accounted for.

Therefore, private exchange and domestic services pass by unnoticed. By de-

finition, however, legitimacy of a transaction should not play a role. There-

fore, the shadow economy (moonlighting) and illegal drug production are

part of the GDP, but such activities are difficult to measure. A consequence

of this measurement problem is an exaggerated wedge between developing

countries and OECD countries (with the per capita GDP of Angola you can-

not survive in Austria). Interest focuses on transactions–bilateral (requited)

transactions (purchase etc.) and unilateral (unrequited) transactions (trans-

fers)–while value changes of existing objects are not accounted fully.

value added : definition of GDP as the sum of values added in the produc-

tion process (ore → metal → screw → motor part → video recorder) avoids multiple counts. Problems in the valuation of public services.

market prices: in principle, all goods and services are valued at market

prices, that is, inclusive of all taxes. If data is collected at the net value

(without taxes), taxes must be added.

economic agents: Resident ‘institutional units’ are classified with regard

to their distinctive characteristics. Types of institutional units are: pri-

vate households, general government, financial and non-financial corpora-

tions (comprises most so called firms or enterprises), non-profit institutions

serving households. Foreign (non-resident) units are summarized as the ‘rest

4

of the world’, provided there are transactions with resident units. The same

person can be part of a private household and of an enterprise (rents out an

apartment, or even only uses his/her own condo but is assumed to rent it

out to him/herself).

resident is an institutional unit that is situated on a country’s territory.

Citizenship is not the criterion for residence. However, foreign students or

short-term foreign workers are not viewed as resident.

private households: produce and invest relatively little, consume, obtain

wage and profit income from corporations and from the government. As

self-employed persons, they obtain ‘mixed income’, though the separation of

households from corporations is occasionally difficult. Small (non-corporate)

firms and farms are counted as private households.

general government (‘public sector’): receives taxes from enterprises and

from private households, provides public goods (‘consumes them by itself’

according to SNA), no intention of profit.

corporations: produce and invest, do not consume, intention of profit.

Corporations, not the government sector, comprise also firms in public prop-

erty, if they cover 50% of their costs from sales. Because depreciation is now

called ‘consumption of fixed capital’, it represents a kind of consumption of

corporations. Corporations are either financial (banks etc.) or non-financial.

non-profit institutions serving households (NPIsH): institutions (such as

schools, churches) that cover less than 50% of their production costs from

sales; idea: no intention of profit. A small sector, for simplification often

added to households.

rest of the world : consumes goods and services produced by residents

(exports) and produces goods and services consumed by residents (imports).

imports of services: includes travels abroad by residents

5

exports of services: includes consumption of foreign tourists on the terri-

tory of the economy (imputed based on valuta purchases etc.)

sectors: the activities of individuals of a similar kind are added up (ag-

gregated). The aggregate of all households forms the household sector etc.,

whereby transactions within the sector disappear. This ‘consolidation’ elim-

inates the exchange between households, as it does not increase collective

wealth. Recorded are the production of capital within the firms, the pro-

duction by private households, public consumption, which by definition is

produced and consumed by the general government itself.

ex post : SNA records only after the economic processes have already

occurred, therefore only limited validity for the assessment of future reactions

in the economy. ex ante would be a task for economic theory.

flows and stocks: SNAmainly records flows of goods and services within a

time period (for example, the consumption of Austrian households in the first

half-year of 1996). Sometimes, also stocks are of interest (wealth, number

of unemployed persons, central bank money, capital stock on July 31, 1996)

at a fixed time point. Changes of stocks are flows (bath tub: water level at

time point 1 = water level at time point 0 + inflow — outflow; inflow and

outflow are flows; water level is a stock)

stocks: also short for ‘common stocks’ (shares) and occasionally for ‘in-

ventories’ (beware of the possibility of confusion)

2.1 Matrix of transactions between sectors

The new SNA convention affects this traditional presentation (followingHas-

linger), though it remains instructive and valid in principle. The NPIsH

sector is omitted here, an artificial sector ‘value changes’ completes the trans-

action matrix.

6

Diagram of monetary flows (payments) from the row sectors to the column

sectors, grossly simplified, goods flows partly in the opposite direction:

→ firms government households non- residents

value

changes

firms Tdir,F + Tind WF +Πd Im Πund,net

government subv + IP CP WP + trH SP

households C Tdir,H SH

non-residents X Im−X value changes IF,net IP,net names (notation as used in economics, not necessarily in SNA):

C . . . (private) consumption of households

CP . . .public consumption

IF . . . investment of corporations (enterprises, firms)

IP . . . investment of general government (public investment)

(‘investment’ always concerns means of production, not purchases of as-

sets)

Inet . . . investment without depreciation (wear and tear of the capital

stock)

WF . . .wage payments of firms to households

WP . . .wage payments in the public sector

trH . . . transfers to households (pensions, benefits, superscript indicates

direction ‘to households’; ‘transfers’=unilateral transactions without coun-

terpart)

SH , SP . . . saving (public sector often negative)

subv. . . . subsidies to enterprises

T . . . taxes etc.

Tind . . . indirect taxes are deductions before the calculation of income

7

(mainly value added tax) including customs, officially production taxes.

Tdir . . .direct taxes are deductions from earned income (wage tax, income

tax etc.), including contributions to social security

Πund . . .undistributed profits

Πd . . .distributed profits (dividends etc.)

X . . . exports

Im . . . imports

Economic circuit: row sums = column sums (inflow=outflow), nothing

is lost, often graphical presentation with arrows. (metaphorical analogy wa-

ter: sector Atmosphere with input evaporation and output rain, sector Conti-

nents with input rain and output evaporation from inland water and outflow

at estuaries, sector Oceans with input at estuaries and output evaporation

from seas; earth is a closed circuit, amount of water is globally preserved)

open and closed circuit: without value changes, the economic circuit

is open, for example at X > Im more payments would flow to Austria than

from Austria to non-residents. The hypothetical value changes sector (global

bank?) loses X − Im and closes the circuit.

2.2 Accounts of the SNA

The new SNA consists of a sequence of several accounts, in which many

single positions are recorded, while others result as balancing items (bold

type in the accounts). These accounts are calculated for all sectors (financial

and non-financial corporations, public households, private households and

NPIsH, rest of the world) and for the total economy.

8

2.2.1 Sectorial accounting

The accounts that are decomposed according to sectors (financial and non-

financial corporations, public households, private households and NPIsH) are

primarily income accounts, which focus on the contributions of individual

sectors to national income. Point of departure is the production account.

Gross output (all production at basic prices, i.e. without value added tax and

customs) is booked on the credit side of this account. To this correspond,

as uses, the intermediate consumption and the depreciation (consumption of

fixed capital). The balancing item is net value added. The columns ‘resources’

and ‘uses’ correspond to the bookkeeping terms ‘credit’ and ‘debit’.

Uses Resources

intermediate consumption gross output

depreciation

net value added

In the generation of income account, the balancing item of the production

account is transferred to the Resources. From the net value added, salaries

and wages (workers’ compensation) and some (so called ‘other’) production

taxes (e.g. payroll tax) are paid. The position ‘other subsidies received’

represents negative taxes, only the difference is of concern. The balancing

item of this account is called ‘operating surplus and mixed income’, where the

households and NPIsH earn mixed income, while the firms and government

9

receive an operating surplus:

Uses Resources

wages paid net value added

other taxes on production paid

— other subsidies received

operating surplus, net

mixed income, net

In the account of primary income allocation, the generation of income is

turned on its head. It yields, as a balancing item, the income of the sector.

For the total economy, the net value is slightly modified relative to the sum

of single sectors, as primary income may also cross borders and also because

of the hypothetical position ‘financial services indirectly measured’ (FISIM).

The relative contributions by the positions differ widely across sectors. Thus,

only the general government receives production taxes, while only households

receive wages. The meaning of a primary income is that it is generated

completely in the production process. By contrast, the secondary income is

income after its redistribution through unilateral transfers. Correspondingly,

production taxes (indirect taxes) show up in the primary account, but not

the ‘direct’ taxes.

Uses Resources

property income paid operating surplus, net

mixed income, net

wages received

production taxes received

— subsidies paid

property income received

primary income, net FISIM

10

In the account of secondary income distribution, fiscal authorities show their

power. Neither corporations nor private households receive direct taxes,

while other transfers re-distribute income flows among all sectors. As a bal-

ancing item, this account yields the so called disposable income, i.e. the

amount of income that is actually disposable for the sector’s expenditures

(or to the economy’s expenditures for the aggregate account)

Uses Resources

current taxes on income and wealth

paid primary income, net

social contributions paid current taxes on income and wealth

received

monetary social benefits paid social contributions received

other current transfers paid monetary social benefits received

disposable income, net other current transfers received

In the use of income account, all sectors except the corporations consume

out of their disposable income. The balancing item is the saving of the

sector, with a small correction because of contributions to pension funds,

which we would like to ignore. The quotient of saving and disposable income

in the household sector is called the household saving rate and represents an

important economic quantity. In Austria, this saving rate has dropped in

recent years from double-digit percentages to around 8%. Occasionally, also

the total saving rate is reported, which rather is a balancing item against the

non-resident sector.

Uses Resources

consumer expenditures disposable income, net

saving, net

11

In the capital account, saving serves as a resource for investment. After

deduction of a few lesser items, the net position of lending and borrowing

evolves as a balancing item. Gross fixed investment is called ‘gross’, as it

comprises depreciation. It is called fixed investment to distinguish it from

inventory investment, which is also seen as an investment. Fixed investment

can be broken up into residential construction, other construction investment

(buildings and structures, i.e. factories, streets, tunnels, ...), and equipment

investment (machines, vehicles, ...). Gross fixed investment minus deprecia-

tion is called net fixed investment.

Uses Resources

gross fixed investment net saving

— depreciation capital transfers received, net

changes in inventories

net acquisition of valuables

net acquisition of non-produced

assets

net position of lending and borrowing

2.2.2 SNA for the total economy

Parallel to sectorial SNA, there is an accounting for the total economy, in

which the main emphasis is on production accounts rather than on income.

In these total accounts, we find the primary target variable of SNA, the

gross domestic product (GDP). The GDP is distinct from the income items,

as it relates to the production by resident units rather than to the income

of residents. For production, all activities count that are performed on the

territory of an economy. For income, we are rather interested in activities

that are exercised by residents with permanent residence on this territory,

12

whether these activities take place at home or abroad. For disposable income,

one is more interested in the persons who earn the income. For the GDP,

it is more important, where production occurs. Even for disposable income,

however, residents are not defined by their citizenship. Longer-term guest

workers in Austria are counted as Austrians, while some border workers,

foreign students etc. are not counted as residents.

Again there is a production account, which departs from gross output,

which is recorded without goods taxes. Goods taxes are those indirect taxes

that depend on the quantity of production, i.e. primarily value added tax

(VAT) and customs. GDP should however also include these, thus they are

added, before intermediate consumption is subtracted. The balancing item is

GDP. Net of depreciation, this variable is called net domestic product (NDP).

GDP and NDP should correspond to the row sums across the values added

of all sectors.

Uses Resources

intermediate consumption gross output

gross domestic product goods taxes — goods subsidies

depreciation

net domestic product

In the sequence of accounts, the balancing item of exports and imports ac-

cording to SNA is recorded in a separate account as external balance of goods

and services. Otherwise, the generation of income account follows, whose

balancing item is again the operating surplus and mixed income. Note that

the previously added goods taxes are subtracted here just like other taxes,

such that the sectorial income accounts are comparable to the total. All

subsidies are minus positions (minus items), what really matters is the net

13

position of taxes minus subsidies.

Uses Resources

wages paid net domestic product

goods taxes paid

other production taxes paid

goods subsidies received

other subsidies received

operating surplus and

mixed income, net

In analogy to the sectorial account, an account of primary income alloca-

tion follows here, which yields the so-called net national income (NNI) as

a balancing item. The NNI should correspond to the sum of primary in-

comes net across all resident sectors. In the sequence of corrections in the

last two accounts (generation of income and primary distribution), the differ-

ence between resident production and resident income disappears, such that

the resulting NNI again expresses the income of residents, which is indicated

by the word ‘national’. Before all, the net position of border-crossing prop-

erty income can be sizeable, while the net position of border-crossing wages

and subsidies is comparatively small. In order to calculate ‘gross national

income’ (GNI), one must add depreciation to net national income. GNI ap-

proximately corresponds to the historical ‘gross national product’ (GNP).

The name ‘income’ for this item is better than ‘product’, as it describes the

income of residential population and not their production.

14

Uses Resources

property income paid operating surplus and

mixed income, net

wages received

production taxes received

— subsidies paid

net national income property income received

By way of the account of secondary income distribution, we obtain the dispos-

able income of the total economy. The positions in this account are relatively

small, as only few direct taxes and social contributions cross borders and their

net position is even smaller:

Uses Resources

income and property taxes paid net national income

social contributions paid income and property taxes received

monetary social benefits paid social contributions received

other current transfers paid monetary social benefits received

disposable income net other current transfers received

Like households, also the total economy consumes out of its disposable in-

come. Mainly, the household and the government sectors contribute to this

consumption. After an above mentioned small correction due to the change

in pension funds, the saving of the economy results as a balancing item. In a

parallel account for the non-resident sector, this use of income account also

shows the external position ‘external balance of current transactions’. This

is important insofar, as this ‘SNA current balance’ is available to an open

15

economy to finance its investment, apart from its saving.

Uses Resources

consumption expenditure disposable income net

saving net

The capital account has again the form that was described above. Finally,

the net position of lending and borrowing should correspond to the current

external balance. Due to measurement errors, there is no exact correspon-

dence. Therefore, there is the possibility of a ‘statistical difference’ on the

debit side. In total, however, the net position of lending and borrowing for

the total economy should be the negative value of the external balance.

Uses Resources

gross fixed investment net saving

— depreciation capital transfers net

inventory changes

net acquisition of valuables

net acquisition of non-produced assets

net lending/borrowing

2.3 Variants of GDP

Once more the most important current and historical (partly still used) def-

initions

• Gross national income (GNI, formerly ‘gross national product’): GDP plus primary income of residents from the rest of the world minus

primary income of non-residents from the economy; a GDP according

to the concept of residency of income earners instead of residency of

production units. International mobility (work abroad) confuses the

16