Macroeconomics

1. Discuss in detail the three different approaches to measuring the GDP: production, expenditure, and income.
While all three methods of calculating the Gross Domestic Product (GDP) will provide for, theoretically, identical
results, the approaches differ.
Final goods and services are the end result of production and manufacturing and are what a consumer will see on
the store shelf,
1
and examples below show nominal GDP, or the prevailing, unadjusted market price at the time
the good or service was produced, rather than the real GDP, a price adjusted measure, expressed in the price of a
base year, which accounts for changes in the overall price level.
A. Production Approach
Calculates the GDP by summing up the total market value of all final goods and services in the economy.
BEWARE OF DOUBLE COUNTING!
o Use value-added calculation to remove the cost of intermediate inputs (or goods) used in production
o HOWEVER do not remove labor costs or capital costs because they are not intermediate inputs in
production

Ioluc -AJJcJ = Rc:cnuc - (Cost o IntcrmcJiotc Inputs ot Eocb ProJuction Stogc)
To better illustrate this point we will use a bakery, MacroBakery, as an example and show how the value-added
approach avoids double-counting.
Input/Good
Produced
Value Added
Bakery Bread (Revenue) (Cost of Flour) (Cost of Yeast)
(Cost of Eggs)
Miller Premium Flour (Revenue from MacroBakery) (Cost of
Wheat)
Farmer Harvested Wheat (Revenue from Flour Miller)

Input/Good
Produced
Revenue
Generated
Value Added
Bakery Bread $600 Total of
Final Goods
$200
Miller Premium Flour $400 $200
Farmer Harvested Wheat $200 $200
Total $1,200 $600 Total of
Value-Added

Because the GDP only the dollar value of the final goods, only $600 would be counted in the GDP not $1,200.

B. Expenditure Approach
Calculates the GDP by aggregating (summing) total expenditures, domestically produced, on final goods and
services.
Total expenditure subdivides consumption, investment, government expenditures/purchases, and net exports
0P = C +I + 0 + NX
Consumption is domestic household spending on final durable goods, such as automobiles and furniture,
nondurable goods, such as fuel, clothing, and food, and services, such as doctors, mechanics, and lawyers.
Durable goods are calculated based on the utility received from the good over a one year time horizon. For
example, the calculation consumption for a new car would be the leasing rate or a new home would be the
mortgage rate.

1
"Consumer Goods Definition." Investopedia The Webs Largest Investing Resource. Investopedia. Web. 31 Jan. 2012.
<http://www.investopedia.com/terms/c/consumer-goods.asp>.
Investment expenditures can be further divided into fixed investments and inventory investment. Fixed
investments are business expenditures on plant or structure (warehouse, factory, and office space) and equipment
(machinery, technology, and vehicles). Depreciation is included by adjusting out depreciation expense to only
account for capital consumption. Inventory investments are the final goods still in inventory at the end of the
year. (Think end of year clearance sales at your favorite clothing store.)
Government purchases include goods, such as military equipment, and services, such as medical and housing
allowances of civil servants, purchased domestically or abroad by the federal, state, or local government,
however; it does not include transfer payments or interest payments. Transfer payments, such as social security,
Medicare benefits, welfare benefits, and unemployment insurance, are not included because they are not provided
in exchange for new goods and or services.
Net exports is the difference between domestic exports and domestic imports. Exports are goods and services
produced domestically and sold to foreign entities (think Made in America and sold to Mexico). Imports are
goods and services produced by a foreign entity and purchased by domestic residents (think Made in China
purchased by Americans).
C. Income Approach
Calculates the GDP by summing up the total income of households, firms, proprietors, and the government.
This approach is the exact OPPOSITE of the expenditure approach expenditures or spending of one person,
theoretically, equals the income of another person
Income approach is subcategorized into: labor income, capital income, government income, depreciation, and net
income of foreign entities.
Labor income includes the salaries, wages, and fringe benefits (401K matching or health subsidies for example)
paid to workers, in addition to self-employed income.
Capital income includes corporate profits, rental income, and interest income (interest paid by bank on savings
account for example).
Government income includes sales tax as well as indirect business tax or taxes which increase cost of production
and therefore the cost of the final good.
Depreciation is the cost of utility on new and current use capital assets used to product goods and services (this
does not include machines, warehouses, or factories with a utility equal to zero). Because firms subtract
depreciation as an expense on the firms income statement, it must be added into income in order to parallel what
the GDP measures.
Net income of foreign entities is income foreigners receive by working domestically that is not included within
labor and capital income, subtracted from the income earned by domestic workers in foreign countries.

2. Discuss the cyclical behavior of the major components of the GDP (consumption, investment, different
components of investment) and of labor market variables (wage rate, employment).

Business Cycles
Long-term fluctuations in economic activity, measured against (real) GDP which include rapid deviations from
high growth during a boom, shown by a peak, and deviations of stagnation or waning, termed recessions and
depicted by troughs.
Business cycle measurements account for three core components: cyclicality, economic indicators, and variability
relative to GDP.

Cyclicality
Macroeconomic variables (the components within the question) may be correlated to changes in GDP:
o If the variable is positively correlated (have the same comovement) with deviations in GDP procyclical
o If the variable is negatively correlated (meaning that it moves in the complete opposite direction) with
deviations in GDP countercyclical
o If the variable is neither acyclical

The degree of correlation between any two variables, x and y, is measured by , the correlation coefficient, where:
p =
Co:(x, y)
:or(x) :or(y)


p: |-1, 1]
p: |pcrcctly ncgoti:cly corrclotcJ, pcrcctly positi:cly corrclotcJ]

Economic Indicators
An economic indicator is just an economic statistic (think unemployment rate) which is used to provide insight
about the health of the overall economy.
Indicators are associated with time and are categorized as: leading, lagging, coincident or unclear.
o Leading indicators will change before the change in the overall economy.
Used to predict or signal the future economic state.
o Lagging indicators change after the overall economy.
Used to confirm an economic shift or pattern (think Monday morning quarterback).
o Coincident indicators occur at approximately the same time as the economic condition with which they
are aligned.
Have neither predictive nor confirmation properties (think retail sales go up during holiday time
we expect retail sales to increase when people buy presents).
o Unclear indicators are those which do not fall into any of the three prior categories.

Variability Relative to GDP
Variability relative to GDP of a macroeconomic variable is a statistical analysis, measured by the number of
standard deviations, (illustrated by the amount of dispersion or variation,) from the GDP trend.
Using the amount of dispersion or variation (standard deviation) the variable is determined to be more volatile or
less volatile than GDP.
Cyclicality Economic Indicator Variability (Relative) to GDP
Consumption procyclical coincident less volatile
Investment procyclical coincident more volatile
Price Level countercyclical coincident less volatile
Money Supply procyclical leading less volatile
Wage Rate procyclical unclear unclear
Employment procyclical lagging less volatile

SEE ATTACHED WSJ ARTICLE FOR WAGE RATE

3. Derive the budget constraint of the representative household and display it graphically in the Consumption
Leisure space.
BELOW IS AN EXPLANATION OF THE PROCESS. For more detail www.skchugh.com/images/Chapter2.pdf.
The solutions are at https://webspace.utexas.edu/hamermes/www/Chap002Solutions.pdf.

To get a grasp on what is going on, lets forget about representative household and focus on an individual, Bob. (The
idea is the same and you may have a household with one income, it makes the most sense.)

Bobs goal is to maximize his utility because in economics utility = happiness
Bob goes to work and gets paid for working
o Bob works for a certain number of hours n
o Bobs pre-tax paycheck can be viewed as (this part depends on the question and how you have learned it):
Aggregate labor income (think weekly/annual salary) I
Gross wage rate (think hourly wage) w
Wage rates are most often used to show an hourly wage
o Bob paycheck shows his net income and reflects the tax rate or t withdrawn (think FICA).
o Bobs paycheck reflects his after-tax wage or net income:
After-tax/net labor income (1-t)I
After-tax/net wage rate (1-t)w
Bob can buy goods with his after-tax/net pay to increase his utility/happiness
o All of the goods that Bob can buy (cars, furniture, etc.) are aggregated under the umbrella consumption c
BUT BOB HAS ANOTHER OPTION.
THINK OF IT THIS WAY:
PEOPLE USUALLY DONT LIKE WORKING (BECAUSE IT REDUCES THEIR TIME FOR ALL THE OTHER
THINGS THEY WANT TO DO LEISURE) BUT NEED TO WORK IN ORDER TO GET PAID AND BUY STUFF
THAT MAKES THEM HAPPY. HOWEVER, WE CAN TAKE THE TOTAL NUMBER OF HOURS IN ONE WEEK
AND SUBTRACT THE HOURS BOB WORKS, n, TO SHOW THE NUMBER OF HOURS HE HAS FOR LEISURE l.
(Think work bad, leisure good!)
**********Note that leisure hours arent always having a party BUT are those hours where Bob is NOT WORKING.
**********Note ONE WEEK MODEL

THEREFORE:
Bobs weekly leisure equals the Total Available Hours (in a week) minus his hours worked
o l = 168 - n
Bobs gains utility from consumption AND from leisure which DERIVES his utility function u(c, l)
BUT:
Bob is constrained by the amount of money he can spend on consumption because the amount of consumption
depends on how much he works!

Budget Constraint Model
o Here we work with a ONE WEEK MODEL
Total Available Hours = 168 hours
(24 hours)*(7 days)
o NOTE Bob can work as many hours in the week as he wants.
1. Bobs weekly disposable income:
I = (1 - t) w n

2. Because we already found that the number of Bobs leisure hours equals total available hours minus the hours he
works, we can substitute in for n in the above equation:
I = (1 - t) w (168 - l)

3. Assuming that Bob does NOT save ANY of his weekly pay and spends it all, THEN every unit of c
(consumption) can be purchased at the current market price, P. Bobs weekly consumption is:
Pc = I

4. Combine the equations from #2 and #3 to show the BUDGET CONSTRAINT. Note that Bob CHOOSES the
amount of consumption and leisure all of the other variables are out of Bobs control. (Remember, this is a
take it or leave it market.)
Pc = (1 - t) w (168 - l)

5. To GRAPH this, we must solve for consumption, find the y-intercept, and find the slope.

Solve for consumption: c = _[
168 (1-t)w
P
- [
(1-t)w
P
] l

y-intercept: [
168 (1-t)w
P


slope: [
(t-1)w
P


x-intercept set c = 0 l = 168
This means that if Bob wants ZERO consumption, all of his hours can be used for leisure



m
p
t
i
o
n

(
c
)

















Budget Constraint Consumption-Leisure Model


With Optimality (Maximum Utility at the Point Where the Indifference Curve is
Tangential with the Budget Constraint

4. Discuss graphically the effects of an increase in the wage rate. Under what conditions is the labor supply
upward sloping?

Think of this question somewhat the same as #3. Lets go back to Bob.
http://site.xavier.edu/turnerc1/lecture10.pdf

Bob only has two ways to use his time either leisure or labor.
Bobs goal is to maximize his utility/happiness!!
o But there are OPPORTUNITY COSTS Remember ALL of Bobs time is leisure or labor!
Bobs opportunity cost (or cost of next best alternative) of ONE extra hour of Leisure is
EQUAL to Bobs wage rate.
Bob may chose to LOWER his Labor Hours if the VALUE of ONE HOUR of Leisure
Bobs wage rate.

WAGE RATES CHANGE!!!!!!!!!!!!!!

A change in wage rates generate:
1. Substitution Effect
2. Income Effect

Substitution Effect
A result of INCREASE IN WAGES
The idea that as the cost/value of one unit of Leisure INCREASES Bob will choose to LOWER leisure time
and INCREASE labor time (his time working)
Think about it this way:


Income Effect
A result of INCREASE IN WAGES
When Bobs wage rate INCREASES his REAL INCOME INCREASES leading to INCREASED
CONSUMPTION of ALL normal goods
Think about it this way:
Bobgetsa100%
RAISE(from
$100/hrto$200/hr)
Thenextdayhis
wifeaskshimto
leaveworkONE
HOURearly
Bobnowweighsthe
costoftheone
additionalhourof
leisurewithhiswife,
withlossofthe$200
laborhour
(opportunitycost)
Theref
subst
laborf
results
HIGH


What is the NET EFFECT?!
When looking at LABOR SUPPLY AND WAGE RATE and LEISURE is a NORMAL GOOD, INCREASING the
WAGE RATE will:
1. INCREASE IF SUBSTITUTION EFFECT is GREATER than the INCOME EFFECT
2. DECREASE IF INCOME EFFECT is GREATER than the SUBSTITUTION EFFECT

SUBSTITUTION EFFECT

Bobgetsa100%
RAISE(from
$100,000/yearto
$200,000/year)
Thenextdayhis
wifeaskshimto
leaveworkONE
HOURearly
Bobleavethe
officeand
increaseshis
LEISURE
consumption
therebyREDUCING
Laborhours
BecauseBob's
raiseINCREASED
hisREALINCOME
hewillconsume
MORELeisure
hours(workless)

INCOME EFFECT



As the wage increases LEISURE rises therefore INCOME EFFECT > SUBSTITUTION EFFECT













LABOR SUPPLY UPWARD SLOPING

Labor Supply
W
a
g
e

(
w
)

w
0

S
Substitution Effect > Income Effect
Income Effect > Substitution Effect