SSRIC Teaching Resources Depository
Macroeconomics
James Gerber, San Diego State University

Macroeconomics Chapter 1: An Overview of the Macroeconomy

© The Author, 1998; Last Modified 14 August 1998
Macroeconomics and microeconomics are the two main branches of economics. It is probably obvious, but still worth stating, that macro examines the "big" issues and micro looks at the "small" issues. In terms of the economy, this means that macro is concerned with the overall economy and its major components, while micro focuses on individual units, such as firms and consumers. Neither branch is more important than the other, although individual macroeconomists and microeconomists might disagree about this.

The core of macroeconomics can be reduced to a few very simple themes. Generally, these themes revolve around the topics of income and economic growth, jobs, and prices:

These three questions span the vast majority of macroeconomic analysis. Most of the research done by macroeconomists is related to one of these questions, although it may not be evident from the research itself.

Note that in posing these questions we have already introduced some macroeconomic terms, either directly (income) or indirectly (unemployment, inflation). Macroeconomics uses a large number of specialized terms and it is important to become familiar with their basic definitions. Therefore, before we turn to quantitative macroeconomic analysis, it is useful to go over some of the basic economic concepts and definitions that are used to measure the economy.

Economic systems are ones "in which goods and services are produced with the ultimate object of satisfying human wants (Stone, 1984)." Production, as Stone points out, is divided into intermediate goods and services, and final goods and services. Intermediate goods and services are absorbed back into the production process, while final goods and services, are divided into consumption and accumulation (investment). When goods are accumulated, or invested, they are saved and used to make more goods and services in the future.

Figure 1 is a crude schematic of a complete system of production; several points need to be made before it is a serviceable set of concepts.

Figure 1

First, it is helpful if we specify the actors in our economic system. For most purposes, it is sufficient to include four kinds of economic actors. These are households, businesses, government, and the foreign sector. As we move through an exploration of the macroeconomy, we will also mention financial institutions (banks, insurance companies, financial consultants, stock brokers, and so forth) but in fact, these are a special type of business firm. Each of the four has a special role in the macroeconomy.

Second, we must note that some of our production is supplemented by foreign production ( imports), and conversely, some of our output is sent abroad ( exports). Exports are goods that we produce but do not consume or invest. Similarly, imports are goods we do not produce, but that are available for consumption or investment. Clearly, we have to take into account imports and exports.

Third, it is helpful to clarify the meaning of the term "production." Specifically, we must have a definition that is concrete enough to allow for measurement. This is not as simple as it may seem since production takes place in a very wide variety of circumstances. I am not referring here to the differences between firms, but to the differences between production in households, governments, and firms. All three of these domestic economic actors produce goods and services, but with some significant differences. In the case of firms, goods and services are produced with the intention of selling them in a formal market. There are records of the quantity produced, and since the production is sold, it has a known value. Therefore, the output of firms is included in the definition of production, and it is valued at its market price.

Households also engage in production. They produce meals, laundry services, housecleaning services, childcare services, and so on. Unlike firms, these are rarely produced with the intention of selling them in a formal market. I cook for my wife and kids but our dining room is not a restaurant. There is no record of the production that goes on in most households, and since the consumers are the same as the producers, the output never passes through a formal market where it would have a price. By convention, household production for consumption inside the household is not included in the formal measurement of production. This is solely for convenience (i.e., ease of measurement) and by historical convention; in theory, production inside a household is no different from production in a firm. A loaf of bread tastes the same no matter whose oven it is baked in.

Governments pose another set of questions about production. Governments in most countries do not engage directly in production for the market, but they do produce large quantities of goods and services. For example, governments usually provide highways and roads, education services, national defense, clean water, irrigation systems, criminal justice services, fire protection, and sewage treatment, to name just a few. The problem is how to value production when it does not pass through a market where a price is set. Taking national defense as an example, how do we measure its value? There is no market price, yet we all value our security. Production by governments is included in measurements of production and, by convention, we value their output at its cost of production since there is no measure equivalent to a market price.

A fourth clarification is the distinction between consumption and accumulation. Originally, the only goods or services placed into the accumulation category were those that earned income for someone. This includes the construction of places of work (factories, office buildings, and other structures that house businesses) and the equipment and machines that business people use (business computers, copy machines, assembly lines, business owned vehicles, and so forth). In the United States, we also add houses to the investment (accumulation) category. This is done because houses are long lived, unlike most other consumption goods. However, one might argue that cars and refrigerators bought by households are long lived as well, and should be included as investments by the same criteria. This makes logical sense, but in our system of measuring national production, they are counted as consumption, not investment.

Finally, a fifth issue: How do we measure all this. No doubt this is an enormous task. (If you are interested, some of the details can be gleaned from the government's monthly publication Survey of Current Business which is available for free over the internet; your library undoubtedly subscribes. The March, 1998, has a lengthy description of the methodology and data sources.) The key point is that production is measured by adding up the total expenditure on output. This raises the issue of production that is not sold--is it counted? The answer is "Yes." Unsold production shows up as a change in business inventories, and this is counted as a form of investment. Some of this investment is intentional, but much of it may be unintentional.

Figure 2 puts all of these issues and concepts together in a diagram called the circular flow of income and expenditure.
Figure 2

The main actors in the economic system are enclosed in boxes: Households, businesses, government, and foreigners. Across the top, the arrows point in the direction of the expenditures on goods and services. For example, households buy consumption goods, so there is a C coming out of the household's box. Households also devote some of their income to savings, which flows into financial institutions (specialized types of businesses) that in turn make loans to businesses that wish to invest (I). Investment, or accumulation, is shown as a flow of expenditures by businesses. The two remaining actors in an economy, government and foreigners, each add to the flow of expenditures on consumption goods and investment goods, but rather than breaking up their expenditures into C and I, we treat them as separate expenditure flows.

One idiosyncrasy of economic accounting should be apparent by now. Namely, in the economic view, only businesses invest. This follows from the definition of investment, or accumulation, as output which is not consumed, but that is set aside to assist in next period's production. Note that this rules out many types of activities that are common to households. For example, if you buy a share of stock, it is savings (the S arrow in Figure 2) but not investment. Again, economic investment includes only those things that add to the productive capacity of an economy. What households call investment (savings accounts, purchases on the stock market, mutual funds, rare antiques or artwork, real estate, and so forth) economists call personal investment, or personal financial investment. These things are not included in the definition of investment when they measure I. The connection of households to investment flows is through financial institutions, where specialized firms take household savings and lend it to businesses so they can purchase factories, office buildings, and new equipment.

The circular flow also records the flow of income payments across the bottom of Figure 2.

Conceptually, Figure 2 is constructed so that all income flows are generated by production in businesses, and are paid to households. This follows from the facts that households supply land, labor, and capital to businesses, in return for which they receive rent, wages, and interest payments. In effect, this is simply a way to say that households own the economy, including all businesses. Therefore, when businesses make payments for the inputs they buy, the money ends up in households; when businesses earn profits, again the money is paid to households ( dividends) since businesses are owned by households. (You may wonder what happens to profits earned which are not paid out. You can think of these " retained profits" as payments to households which are re-lent to businesses.)

One of the most important concepts in the national accounts is the equivalence between income and output. That is, the expenditure on production by households (C), businesses (I), government (G) and foreigners (X-M) equals the total value of production. In turn, the activity of production must generate income payments which are equivalent to the value of the goods produced. Consequently, the top arrows are equal in value to the arrows across the bottom. In order to see this more clearly, think of a specific example such as a car. If a household buys a car for $20,000, the firm selling the car and receiving the $20,000 takes the money and uses it to pay its workers (wages and salaries), its stockholders (dividends), its landlord (rents), its banker (interest) and its suppliers of glass, steel, car parts, and so forth. In turn, those suppliers, pay their workers, stockholders, and so on. Ultimately, the entire $20,000 is distributed as income.

Before households receive their incomes, however, taxes are taken out. Taxes are, in a sense, the income of government. That is, they form the revenue that governments need in order to make transfer payments, and to buy goods and services. Note the distinction between these two arrows coming out of the government category. Governments buy things, but they also spend their tax revenues on direct payments to individuals though social security, unemployment insurance, veteran's pensions, and income maintenance programs such as welfare. As far as households are concerned, transfer payments are another form of income. From the viewpoint of the economy, however, transfer payments are different because they are not created by production, representing instead a redistribution of the income that is generated in production. Transfers are put back into the income flow after taxes are removed and, along with the remaining after-tax income flow, they make up disposable income. Note that the taxes in Figure 2 include all types: income, sales, motor vehicle taxes, and so forth. And finally, note also that government includes all levels, not solely the federal level.

Many students are confused by the jargon of economics and its specialized use of everyday words such as income and money. Its worth taking a minute to clarify a few common errors which, unfortunately, if left un-corrected will cloud our thinking about the economy. For example, if you ask someone why the economy suffered the terrible depression of the 1930s, many people ultimately blame it on a "lack of money." Or, during the last economic slowdown (1990-91) it was common to hear that new car sales were sluggish because consumers did not have the money to buy cars. We all know what people mean when they say this, but in fact, these statements confuse money with income. Fewer cars were sold by the automakers because people's incomes fell, not because they lacked money. Money is different from income; it is the most easily spendable ( liquid) type of asset in our economy, while income is a measurement of earnings over some period of time. Money is the physical amount of currency, coins, checking accounts, and traveler's checks (M1). In some definitions it also includes household savings accounts and money market funds (M2).

Another misused term is wealth. Wealth is the total of all past savings. Wealth can be stored in many different forms, from stocks to bank accounts, to money stuffed under your mattress, to rare postage stamps, or whatever. Recall that savings is the part of household disposable income that is not consumed. The cumulation of all past savings is a household's wealth.

One of the key differences between wealth and money, on the one hand, and income and savings on the other, is that the former are stock variables while the latter are flow variables. Stocks are things that can be measured at a point in time, while flows are variables that can only be measured over some period of time. Money and wealth are stocks, savings and income are flows. For example, it is sensible to state how much money or wealth someone has at any moment of time. I could add up the money in my wallet, the coins in my pocket and the value of my checking account to arrive at my total holdings of money. My income, however, can only be measured over a week, or a month, or a year. Some unit of time must be attached to it because it is a flow variable and not a stock. (Stating how much income you have at a moment in time is meaningless in the same way it is to ask how much water a river holds. If you ask a hydrologist, they will undoubtedly give you a measure of "gallons per minute"--a variable with a time dimension.)

The main components of any national economy are captured in a set of accounts called the national income and product accounts (NIPA). The NIPA are a systematic set of measurements of a nation's output and income over a period of time, usually one year or one quarter (3 months). The NIPA presented in the accompanying file are yearly data for the United States, 1929 to 1996.

The national income and product accounts date from the 1930s for most industrial economies, and the 1950s or 1960s for most developing ones. Although the general idea of trying to measure the entire output and income of a nation dates back to the works of two 17th century Englishmen, William Petty and Gregory King, the concepts necessary to construct a fully developed set of national accounts were developed in the 1930s and the 1940s. Leading contributors to the development of our modern set of national accounts were Richard Stone and James Meade in the UK and Simon Kuznets in the US, among others. Each of these three later earned Nobel Prizes for this and other work.

A brief overview of the concepts behind the NIPA is a useful starting point. Table1 is a list of the main components of our economy. Table 1 begins with the most common measure of overall output, gross domestic product (GDP). For the United States in 1997, GDP was over 8 trillion dollars ($8,018.0 billion). GDP is defined as the market value of all final goods and services produced during the year by residents of a country. Note the following components of the definition:

The main sub-components of GDP are the same items as in the circular flow of Figure 2. These consist of personal consumption expenditures (C) of households, private domestic investment (I) of businesses, government expenditures (G), and net exports (NX) to foreigners. NX is defined as total exports minus imports and can be (and is) negative.
Table 1
Gross Domestic Product
Gross domestic product (GDP):
  • The market value of all final goods and services produced during the year by residents of a country. 
  • $7,636.0 billion in 1996 
Personal consumption (C):
  • Purchases of new goods and services by households. 
  • $5,207.6 billion in 1996 
Private domestic investment (I):
  • Purchases of assets that will be used in production for more than one year. 
  • Includes new residential construction. 
  • $1,116.5 billion in 1996. 
Government (G):
  • Purchases of final goods and services and investment by all levels of government. 
  • $1,406.7 billion in 1996. 
Net exports (NX):
  • Exports of goods and services minus imports of same. 
  • $-94.8 billion in 1996. 
Table 2 breaks each of component of GDP into the sub-component included in the data file. After each item in Table 2, the variable name from the data set is given in parentheses.
Table 2
The Main Subcomponents of GDP
Personal consumptionexpenditures (C): 
  • Durable goods (C1A) 
  • Nondurable goods (C1B) 
  • Services (C2)
  • Gross private domestic investment (I):
    • Total fixed investment (I1) 
      • Nonresidential fixed investment (I1A) 
        • Nonresidential structures investment (I1AA) 
        • Nonresidential equipment investment (I1AB) 
      • Residential investment (I1B) 
    • Inventory investment (I2) 
    Government expenditures (G):
    • Federal (G1) 
    • State and local (G2) 
    Net Exports (NX):
    • Gross exports (EX) 
    • Imports (IM) 
    Since output equals income, adding up the output of C + I + G + NX should also equal total income. Therefore, if we add up everyone's income, we should get the same number as C + I + G + NX. Total income is called national income (NI) in the NIPA and Table 3 breaks it up into its five main components.
    Table 3
    National Income and ItsComponents
    National income (NI):
    • The sum of all factor incomes. 
    • $6,254.5 billion in 1996. 
    Wages, salaries, and benefits (NI1):
    • Payments to individuals in return for their work. 
    • $4,426.9 billion in 1996. 
    Corporate profits (NI4A):
    • Net income based on current production. 
    • $735.9 billion in 1996 
    Proprietor's income (NI2A and NI2B):
    • Net income of sole proprietorships and partnerships. 
    • $520.3 billion in 1996 
    Rental income (NI3):
    • Income from rental property. 
    • Includes imputed income from owner-occupied dwellings. 
    • Includes royalties, patents, copyrights. 
    • $146.3 billion in 1996. 
    Interest income (NI5):
    • Net interest received by businesses. 
    • Includes interest paid by households on their home loans. 
    • $425.1 billion in 1996. 
    People also receive transfer payments as a part of their income. These are not included because transfer payments are not the result of income that is created in production; they are a redistribution of existing or newly earned income that is accounted for elsewhere.

    The astute student will have noticed that GDP in Table 1 is $7,636.0 billion, while national income is "only" $6,254.5. There are three reasons why they are different. First, some of what we pay for a good is no one's income, for example sales taxes or tariffs on the goods we import. Therefore we must subtract indirect business taxes from GDP. Second, some of what is produced goes to replace the machines that wore out in production. This is called depreciation, and it too must be subtracted from GDP since it is output used to replace worn out equipment. Third, some of our income is paid to foreigners for the use of their capital and labor. An example is a Toyota factory in Ohio that earns profit income for its Japanese owners. When we adjust for these items the part of GDP that remains is national income. This relationship is summarized in Equations 1 and 2.

    Equation 1:

    and Equation 2: 1-6 The labor force and unemployment

    The national income and product accounts are measures of production and income; they omit measures of jobs and unemployment. We turn now to a consideration of the basic concepts and definitions relevant to a discussion of employment and unemployment.

    The first important concept is the labor force. The labor force is a measure of the size of the available pool of workers. It is comprised of both the employed and the unemployed. This may seem straightforward, but the key is in the definitions of employed and unemployed. These are not exhaustive categories and many adults are neither. In order to be unemployed, a person must be 16 years of age or older, not working, and making an effort to find a job. If a person does not want a job, or if they want one but are not looking, then they are not counted as unemployed but are considered to be out of labor force.

    The definition of employment includes any work for pay even if you only worked one hour. That means that people who want to work full time but are only working part time are counted as employed. In addition, if you work for 15 hours or more per week in a family owned business, you are counted as employed even if you received no pay.

    The labor force, employment, and unemployment are measured by the Bureau of Labor Statistics (BLS). The BLS conducts a monthly telephone survey of approximately 60,000 households across the nation. The survey is carefully designed to provide proportional representation of every region, ethnicity, family arrangement, occupational category, age,education level, and so on. This is to ensure a representative sample so that statistical inferences may be extrapolated to the whole US population. The telephone interviewers ask the respondents a series of questions such as

    This is not the precise wording, but you get the idea: the interviewer has to determine if the person is employed, unemployed, or out of the labor force.

    Since a different government agency measures unemployment (the Bureau of Labor Statistics in the Department of Labor) than the one that measures production and income (the Bureau of Economic Analysis in the Department of Commerce), the availability of data is not the same. Data for unemployment rates is readily available back to 1929 (the same as GDP and its components), but most other measures of the labor force begin in the 1940s, 1950s, and even later. In particular, the decomposition of data by race, an item of great interest since the 1960s, began in 1972. Similar decompositions by gender began in the 1950s.

    Macroeconomics is also concerned with the overall level of prices and the rate at which they are rising or falling. A general rise in the price level is defined as inflation, while a fall in prices is called deflation. Inflation and deflation are usually expressed in percentage terms.

    In order to measure inflation, economists add up all prices into just one number. If you stop and think for a moment, you will realize that it does not make sense to treat equally all the prices of things in the economy. For example, we buy a lot of bread but only a few tulips, so changes in the price of bread should count for more than changes in the price of tulips. Economists handle this problem by constructing an index number for prices. An index number is an average in which some goods (bread) are given relatively more weight than other goods (tulips). The weights that are used are equivalent to the relative importance of each good in a typical consumer basket of goods and services. In other words, if the typical consumer spends 0.1% (0.001) of their income on bread, then before the price of bread is added to the other prices, it is multiplied by 0.001. (The sum of weights must equal 1.000.)

    Another issue concerns the differences between firms and households. The goods and services that you and I buy are different from what General Motors buys. They buy steel, pumps, generators, electrical wiring harnesses, and other intermediate goods, whereas you and I buy oranges, shirts, haircuts, education, pizzas, and other final goods. Consequently, it does not make sense to measure the change in prices for households in the same way that one would measure the change in prices for firms. The way around this problem is to construct two price indexes, one for households called the consumer price index (CPI), and one for businesses called the producer price index (PPI).

    The differences between these two indexes is in the composition of goods that go into each one. The consumer price index is based on the price of a basket of goods and services that a typical household buys; the producer price index is based on the price of a basket of goods and services that a typical firm buys. In both cases, the measurement of prices is a weighted average where the weights reflect purchasing patterns of typical households and businesses. Needless to say, if you are not typical, it may not be a good measure of prices for the things you buy.

    The indexes are re-calculated monthly so changes can be compared on a month to month basis. When the number are published, they are always presented in reference to a base year which serves as a standard of comparison. The level of prices in the base year is always set equal to 100. An example will illustrate this point. Suppose that in 1992 the researchers for the Bureau of Labor Statistics bought their typical consumer basket of goods and services for $2,000. If 1992 was the base year, they would set the $2,000 equal to 100. If the same basket cost $2,100 a year later in 1993, then the price index for 1993 would be as follows:

    1993 CPI = 100 [(2,100)/(2,000)] = 100 (1.05) = 105.

    This implies the following:

    Current year price index =
    100 [(price of a consumer basket in current year)/(price of a consumer basket in base year)].

    The rate of inflation can easily be calculated as the percentage change in the price indexes, expressed in percents:

    Inflation = [(1993 CPI - 1992 CPI)/(1992 CPI)] 100 =
    [(105-100)/100] 100 = 5%.

    Inflation between any two years, whether consecutive or not, and whether one is a base year or not, can be calculated in exactly the same way: as the percentage change in the price index.

    For the CPI in the data set, the base year is an average of prices in 1982, 1983, 1984. The PPI uses 1982 as its base year.

    There is a third price index in the data set, called the GDP deflator. It would make more sense to have called this the GDP price index, because the word "deflator" is confusing to novice macroeconomists. Nevertheless, you should not be confused by this; just remember it is a price index for all the goods that enter into the calculation of GDP (see Tables 1 and 2). The base year for the GDP deflator is 1992.

    The accompanying data file has the NIPA for the US (annual data, 1929-1996), as well as price indexes, labor force measures, productivity measures, federal finances, the money supply and interest rates, and comparative stock market and production indexes for the US, Japan, UK, and Canada. (See the codebook for a complete list.)

    Some adventurous types may want to gather their own data. Or, better yet, you may want specific measures for a term paper or a research report that are not in the accompanying data file. All the data series presented here, and a vast quantity of additional historical data are available in (usually) two formats: hardcopy in federal government publications and electronically from federal government web servers.

    Two hardcopy sources of data are The Survey of Current Business and The Economic Report of the President. The former is a monthly publication from the Department of Commerce, containing the latest releases of GDP and price data as well as specialized articles on a variety of topics such as US international transactions, and regional indicators of income and production. The Economic Report is an annual series which comes out in February of most years. It contains several chapters of text which give the current presidential administration's view of the economy and its definition of the main issues. It also has a lengthy set of historical tables with macroeconomic data.

    Both the Survey of Current Business and The Economic Report of the President are available on-line from federal government web sites. They require an Adobe Acrobat Reader, which you can download for free if you need to. The addresses are http://www.bea.doc.gov/bea/pubs.htmfor the Survey, and http://www.whitehouse.gov/WH/EOP/CEA/html/publications.html for the Economic Report. The Bureau of Economic Analysis (publishers of the Survey) also have a wealth of additional data at http://www.bea.doc.gov/.

    In addition to these sites, the latest-latest macro data can be found on the Whitehouse's website in an area called the Economic Statistics Briefing Room. This data is also linked to the agency that provides it so, for example, you can go straight from the latest CPI release to the Bureau of Labor Statistics where the CPI is calculated and where you can find a vast amount of current and historical data (as well as detailed information on methodology). The address for the Economic Statistics Briefing Room at the Whitehouse is http://www.whitehouse.gov/fsbr/esbr.html.

    Another interesting site used to develop the accompanying data file is the Department of Commerce. There you can find the entire federal budget, as well as a complete set of historical measures such as federal expenditure and revenues, going back to the founding of the Republic: http://cher.eda.doc.gov/BudgetFY97/histtoc.html

    If you cannot find what you are looking for at any of these sites, try looking at the main gateway to federal statistics, FEDSTATS: http://www.fedstats.gov/


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