Foundations of Macroeconomics Explained

Welcome to this introduction to chapter 1 in the book Macroeconomics. I am Nils Gartfrids and I am the author of the book. And this first chapter is the introduction to the book and it is about models and data. So we first introduce our macroeconomic model that we will use throughout the book. And then we... discuss briefly why there will be two versions of the model for the one for the short run and one for the long run and Then we look at the national accounts which give us the basic Macroeconomic data the national account tell us how much is produced and in which sectors how income is distributed how goods and services are used and how much is saved and invested So our macroeconomic model will contain three markets. There's the goods market, and implicitly we also have services there. We are not going to make any distinction between goods and services. From an economic point of view they are similar, so we just say the goods market. And then the second market is the labor market, where workers sell their labor. and the price is the wage. And then we have the financial markets where you can borrow and lend and in the basic model the firms are borrowing from the households in order to finance investment. And then there are three types of decision makers. So there is the typical firm. So the way we think about the economy we think that all firms are alike and they maximize profits and all households are also alike so we just need to think about one typical household that is maximizing utility and then we have the policymakers we have the government that sets decides about taxes and government expenditure and the central bank that decides about the interest rates and in the basic model the policy is taken as exogenous. So we focus really on the decisions of the firm and the household. And a model is a simplified description of the world. We assume that consumers and firms are all alike. And this brings a tremendous simplification because we just need to look at the typical consumer and the typical firm. And furthermore, we assume that consumers consumers and firms are rational and they have very simple objective functions so the consumers are maximizing a simple utility functions and the firms are maximizing profits and finally we use simple mathematics to describe the economic relations especially the utility function to describe the preferences of their typical household and the production function to describe the technology that is available to the typical firm. And why do we make this simplification? Well, macroeconomists are not stupid. It's not that we think that all consumers are alike or all firms are alike. I mean, we know that people are different. We know it's hard to predict what an individual person will do. I mean, when will... Niels Gottfried's buy new shoes. It's very hard to predict. I mean, I don't know myself. And on the micro level, there are, of course, a lot of specific things that affect the behavior of individual consumers and firms. But we are not interested in the specific things. We are interested in the overall picture. And we want to describe how firms and households behave on average. And then we hope, we cross our fingers, and we hope that by writing down very simple objective functions and assuming people are rational, we can, at least in rough terms, describe the average behavior of firms and households. And we need to simplify because macro is really complicated. There are so many interactions, even in a small macroeconomic model, as you will see, there are lots of interactions between different variables. And we really need to simplify drastically in order to understand anything in macroeconomics. Another thing, a trick that we use is that, well, we limit the analysis. We do not try to explain everything. There are some things we try to explain, and those are the endogenous variables. They are the variables that are determined within the model. But we also leave things outside the model, and they are called exogenous variables. And they are not... explained within the model. We say, well, they happen to be what they are. For example, we look at the decisions of firms and households, but we may take government expenditures, give and say, well, the government does this, we don't know exactly why, but let's now focus on the firms and households. And the point of the exogenous variables is not that they are actually constant in the real world. Of course they are not. Nothing is constant in the real world. They may vary too. The point is that we are not trying to explain them. So when there's a change in an exogenous variable, we call that a shock, just because it's something we don't understand. For some reason, the government increased its expenditure. Or for some reason, the central bank raised its interest rates. And now we see what happens in the economy. So those are the shocks, kind of shocks, that we will use our model to analyze. But... But this again is something we do in order to limit the analysis and make it manageable. And in our baseline model we will have, in the closed economy, we have four endogenous decisions. And three of them are made by the firm. So the firm decides about production, about prices. The firm sets the wages and the firm decides how much to invest, how much capital to acquire. And the consumer is just deciding how much to consume and how much to save of his income. So that is the closed economy model. Then we have the policy decisions, the interest rate or money supply determined by the central bank and the taxes and government expenditure determined by the government. But they are exogenous. in the basic model so that we really only have four endogenous decisions. Then when we open up the economy to the rest of the world we allow trade. So we have imports and exports and we also allow international borrowing and this is now the consumers who can now choose between consuming domestically produced goods and goods produced abroad and similarly the foreign consumers can choose between consuming goods produced in the small open economy that we analyze or goods produced in the rest of the world and that gives us then import and export functions and Also, the consumers can choose between lending in different currencies they can lend in the home currency or the foreign currency and That will lead us to the interest parity condition So in the open economy we have six endogenous decisions that we need to analyze and then we have a macroeconomic model that we can use for everything. So yeah, this picture here gives an overview of the model, the markets, the flows of goods and labor and loans and payments. So you can stop the tape and look at that. to get an overview of the model. Well, a brief comment about the short and the long run. So basically we have the same model throughout the book, but we have two different analysis, the short run and the long run. And why? Well, there are two key differences between the short run analysis and the long run analysis. One concerns... the weight setting we assume that in the short run the wages are sticky that means that they adjust slowly to shocks so remember a shock is a change in an exogenous variable so suppose we have an equilibrium then there's a shock in the and that is a change in an exogenous variable what about the weight well in the short run it doesn't adjust or it adjusts slowly In the long run, we assume that wages completely adjust to the shock, so we go to a long-run equilibrium. So that's one key difference between the short-run analysis and the long-run. The other key difference is concerned with expectations. So when we look at the long-run equilibrium, the natural assumption is that expectations are correct. People know what is going on. Otherwise, it wouldn't really be a long-run equilibrium. So a long-run equilibrium, we may have a constant level of production. Everyone knows that this is the level of production and income. We may have a constant inflation rate, so people know that inflation is 2%. Or maybe we have a steady growth rate, so everyone knows that production is growing 2% per year. That is a natural idea about long-run equilibrium, that people know what is happening. When we do the short-run analysis, then we take expectations as given. We say, okay, right now we're here, it is 2015. people have some expectations about what will happen in 2016, but they're not sure. They happen to be optimistic or they happen to be pessimistic. Whatever, they have their expectations. And as we will see, expectations play a very important role in economics. So it influences the equilibrium, what kind of expectations people have. But in the short-run analysis, we just... take the expectations as given. And because of this difference in weight setting and expectations, then the effect of a shock may be different in the long and the short run. If we say, suppose that we raise government expenditure, this may, for example, increase production in the short run, but not in the long run, for example. So that's a key thing to keep in mind. also something that makes an additional complication in macroeconomics that we have to have different analysis of the short and the long run. So that much about the model So now let's consider the data. The basic data for macroeconomics is the national accounts Because they can answer a number of questions, key questions about the economy And in the national accounts, we talk about the production side, the income side, and the user side. And the production side of the national accounts can answer the question, what is the value of all goods and services produced in the country? And how much do different production sectors contribute to the total production in the economy? The income side. We look at the incomes. We can see what is the total income in a country and how is that income distributed between capital income and labor income. And then we can look at the user side and say, okay, we produce this much goods and services. How are they used? How much is used for consumption? How much is used for investment? How much is used by the government and the private sector? And finally, we can also in the national accounts see savings and investment. So what does the country do with its income? How much is consumed, saved, invested? And how much is used to buy financial assets or to lend? So just like an individual, if you have an income, you can consume, you can make real investment. Maybe you buy a house. And what do you do with the rest? well, you can buy financial assets. You put it in the bank. Well, the same applies to a country. If you consume and make real investment that are lower than your income, then the rest of the money is used to lend to the rest of the world. So the national accounts give us an overview of the economy. So let us first look at the production side. How much is produced? and where? Well GDP gross domestic product is the sum of value added in all the production sectors in the economy and the value added that is the value of production or the value of the output from all the producers minus the inputs that they use so we deduct the input because other ways we would double count the input calculate the value added for each firm and then you add them up so Here we have from the OECD data on production divided into six different production sectors. Where the first three are agriculture, industry and construction. And then we have three service sectors, which are trade and hotels and restaurants and financial and consulting businesses and other services like education, healthcare. And if we look at the rough numbers here, you can see that Well, agriculture and fishing and forestry are very small sectors today. In developed economies, they constitute only, production there is only 1 or 2% of the total production or value added in the economy. Industry and construction together make up about 23, 24, 25% of production. So if we take all those three together, agriculture, industry and construction, we have roughly a quarter of production is in those sectors. So that means that pretty much three quarters of production is nowadays in the service sectors. So we do, in that sense, we do have a service economy. And roughly speaking, you could say that about 20 percent is in trade and hotels and restaurants and transports. About 30% is in financial intermediation and consulting and real estate and those kind of services. And then about 20-25% is in other service activities. This includes then education, healthcare, which is partly done by the government. So, We see the service sectors are very important. At the same time, we shouldn't neglect industry. We should remember that many of these services are related to goods. For example, in the shops, we are buying the goods that are produced in industry. Many of the financial and the consulting businesses are actually delivering services to the industry. So, so. We should not conclude that industry is unimportant, but as a matter of fact, if we look at where people are employed and where most of the production is, it's actually in the service industries. So, that tells us about the production side. The next question is who gets the income? So now we turn to the income side and ask how is income distributed between labor income and capital income? So capital income is for example interest payments and dividend payments. So GDP at market price, that is valued at the price that you sell in the market. And that includes value added tax and sales taxes, the so-called indirect taxes. and those taxes do not go to labor or capital. For this reason we need to deduct the indirect tax from the GDP at market price in order to get the income that is actually distributed between labor and capital. So we deduct the indirect taxes and add the subsidies that government pays to the firms and then we get gross value added at basic prices and that is then distributed between labor and capital and in the OECD we have something called compensation of employees which is then wages and also social insurance contributions and stuff like that all that is included in compensation of employees so if we take the compensation of employees as a fraction of the gross value added at basic prices then we get the share of income being compensation of employees and you see here it's somewhere around 60% so that would suggest that 60% of the income goes to labor now You should remember one thing here is that there are quite a lot of people who are self-employed. And do they have capital income or labor income? Well, presumably it's kind of a mix of labor income and capital income. To get a more correct measure of how much income goes to labor, one can make some kind of allocation of the income of the self-employed between labor and capital income. And if you do that, then you get a somewhat higher share for the labor income. So normally we say that the labor income share is around two-thirds, around 66% of total income. So let's remember that as a baseline, that two-thirds of the income goes to the workers, or to labor. And... The rest then, roughly one third goes to capital and we should remember that part of that income is used to pay for depreciation of capital. Capital depreciates and you have to cover depreciation which is around 15% of GDP. So that it's only part of this that is actually dividends and interest payments. Okay, so we have learned that. Labour income is roughly two-thirds of income. So now we come to the user side of the national accounts, and we ask the question, where do the goods and services come from, and how are they used? And this table here shows sources and uses of goods and services for the USA in 2008. So when looking at big numbers like this, it's very hard to understand numbers in billions. And therefore we will express things as percent of GDP, because then the numbers become much more meaningful. And also these fractions are fairly stable over time, so they are worth learning what they are, because most of them will not change. dramatically from one year to another so you get the sense of how important are different variables that we talk about when we come to the theory. So we set GDB to 100 it's typically 100% of itself and then of course we also use goods and services that are imported and imports in this year 2008 corresponded to 18% of GDP in the US. And how were those goods and services used? Well, a large share was used for private consumption. So private consumption in the US corresponded to 70% of GDP. A smaller share, 17% of GDP, was used for government consumption. And a similar share, 15% of GDP, was used for private investment, which is investments in machines and factory buildings and the like. And we also have government investment, and that was a small fraction, about 3% of GDP. That is building of roads and schools and such things. And finally we have exports, which constituted... 13% of GDP. So obviously these numbers differ between countries and here we have some numbers for other countries. You see that private consumption is somewhere between 50 and 70 percent of GDP. Government consumption is somewhere around 20-25% 30 almost 30 percent of GDP private investment 15 20 25 percent of GDP government in investment two or three percent of GDP exports varies a lot from the United States has 13 percent to very large shares 77 percent in the Netherlands imports similarly depends very much on the size of the country, it's very large shares in small countries and the small share in large countries. And net exports, that is exports minus imports, that varies quite a lot. You have a big surplus in Norway, almost a fifth of GDP, 19%, and you had, for example, in this period, a deficit in the United States of 5% of GDP. So the national accounts can give us an idea of how large different components are of aggregate demand. and the use of goods and services, and also how countries differ. For example, if we look at the government use as a share of GDP, that is, government consumption and government investment, in the US, Australia and Korea, that share is about 20% of GDP. That is, one-fifth of GDP is used by... the government. In the Scandinavian countries, Denmark, Iceland, and Sweden, and Netherlands, it's kind of Scandinavian, the share is about 29% of GDP. So it's much higher. So put differently, you could say that the government sector in the US is about two-thirds of what it is in Sweden, if you look at it as a fraction of GDP. So the Scandinavian countries have bigger government, mainly because education and health care is financed by taxes in the Scandinavian countries. But in the US, a larger share of education and health care is privately financed and therefore counts as private consumption. Similarly, you can see that the... openness of the economy, the export share is very different. The US is a big economy so a lot of the goods and services that you use are actually produced in the country and exports and imports are smaller shares of GDP in the US. Exports are 13 percent of GDP while in Denmark, Sweden, Netherlands, which are smaller countries, the exports are more than 50 percent of GDP. So clearly these small countries are much more dependent on what happens in the world outside. If something happens abroad it's not that important for the US. So that tells you how you can learn things from the national accounts. Finally we come to the fourth step which is to look at production, income, saving, investments and net lending. So as an individual, I have some income, hopefully. And what can I do with that income? Well, I can consume goods. I can go to a restaurant and spend the money. I can also make investments. I can buy a summer house, for example. So I use my income for consumption and investment. But then the money that remains after I've made consumption and investment, What do I do with that? Well, I put it in the bank. I lend it to the bank. Or I maybe buy government bonds, or I put it in some fund, or I buy shares. So I buy financial assets. And that is called, in the national account, net lending. So I buy financial assets. So I have my income, I consume, I make real investments. and the rest goes to buy financial assets. Well, the same is true about the country. The country has some income. Some of that income, most of it is used for consumption and real investment, and the rest, what you do with it, well, you buy financial assets abroad. You can lend to other countries. You can buy stocks in other countries. So if we let Y be GDP, and then YF the incomes from other countries so this is like wage payments and interest payments from abroad net and then we have also transfers from abroad these are things like government aid or remittances that people send so the income of the country is what you produce in the in the country plus the primary income from abroad plus net transfers from abroad. That is the income of the country. Then what you use it for, well you can consume private consumption C and you can use it for government consumption CG. You can use it for private investment I and government investment IG. So if you deduct the consumption and investment, then you have what the country's net lending. But that is equal to the current account. If you look at... carefully at the identities you find that that is equal to net exports plus net primary income from abroad plus the transfers from abroad which is the current account well some of the F's and G's should have been superscripts here okay so we learned that the income that you don't consume and invest is lending to other countries and that is equal to the current account. And here we look at some statistics for some countries. Again, we measure everything in terms of GDP, so we set GDP to 100. If you look at the bottom line here, we have the U.S. GDP is 100. Then you have net primary income from the rest of the world, that is wages and interest payments from the rest of the world. That's 1%. 1% of GDP and then if you add that you get gross national income at market prices. Now there's rounding error so it's still 100. Let's look at the UK instead. You have GDP is 100, net primary income from the rest of the world is 2% of GDP and then you have gross national income at market prices is 102. But then you do... transfers to the rest of the world like government aid to developing countries and other things you deduct one and then you have gross national disposable income which is 101 percent of GDP and then you have final consumption expenditures this is now both private and government consumption is 86 percent of GDP that means that the savings is then 15 percent of GDP and then you make investments, 17% of GDP, and then you end up with a current account deficit, because investment is bigger than savings, and you have a deficit. And now there's again a rounding error, so it's minus 1, but it looks like it should be minus 2. So the point is that the current account is the net lending of the country, which is the income. minus consumption and investment. And by looking at this, you see that there is actually substantial international borrowing and lending. We have a lot of financial integration in the world today. So if you look at the current account as a share of GDP in 2008, you had a surplus of 18% of GDP in Norway. This is because Norway has a lot of income from oil and gas. Most of that income goes to the government, and the government is saving much of that oil income in a fund, so they are investing in shares and lending abroad. So that's why Norway has such a big surplus in the current account. In this year, 2008, the U.S. instead had a deficit. So the U.S. was borrowing from other countries, and... Greece had a very large deficit of 15% of GDP in this year. Of course, these numbers are different today. They vary from year to year, but the point is that the financial markets are highly integrated today, and you have a lot of financial borrowing and lending across countries and in different currencies. So, this is something we have to look at later. Okay, so there are some key definitions that you should really learn because whenever you want to look up a number you will come across these definitions the concept of production versus value-added market price and base price or factor price a gross product net product production income income and disposable income and and depending on how you Combine those concepts you can get a lot of different measures of income and production, but the key is to understand those definitions and these distinctions. in order to understand the data that you find in the international accounts. Finally, let me introduce a very useful rule of thumb, which we will use for derivations in several places. So suppose you have a variable z, which is equal to x times y divided by q. Then the rule of thumb says that the percentage change in z is roughly the percentage change in x plus the percentage change in y minus the percentage change in q. The intuition behind this rule is, well, if you look at this formula here, z equals x times y over q. Imagine that x increases 5%. Well, then the whole thing will increase 5%. x times y over q will also increase 5%. because you multiply the whole thing by 1.05, right? Suppose now that y increases 5%. Again, that will increase the whole thing by 5%. But then if q increases 5%, then the whole thing will decline by roughly 5%, not exactly 5%, but because you divide... the whole thing by 1.05. So if you add up those things you find that the change in z is 5 plus 5 minus 5 percent. That is the total increase in z will then be about five percent. This is an approximation. One way of proving this is to take the logs and then noting that the change in the log is approximately the relative change. That is, if something increases by 5% the change in the log is roughly 0.05. Well there are other things in this chapter. There is a review of indexes that used to measure real growth and inflation. There is an explanation of how we compare real incomes between countries. And in the appendix there is a repetition of basic mathematical concepts such as functions, derivatives, logs, exponents, and we do use basic math in this book, so please remind yourself of those basic concepts. You have learned them before but you have forgotten them and you need to repeat this. So good luck with your studies. of chapter one.

So we first introduce our macroeconomic model that we will use throughout the book. And then we... discuss briefly why there will be two versions of the model for the one for the short run and one for the long run and Then we look at the national accounts which give us the basic Macroeconomic data the national account tell us how much is produced and in which sectors how income is distributed how goods and services are used and how much is saved and invested So our macroeconomic model will contain three markets. There's the goods market, and implicitly we also have services there. We are not going to make any distinction between goods and services.

From an economic point of view they are similar, so we just say the goods market. And then the second market is the labor market, where workers sell their labor. and the price is the wage. And then we have the financial markets where you can borrow and lend and in the basic model the firms are borrowing from the households in order to finance investment. And then there are three types of decision makers.

So there is the typical firm. So the way we think about the economy we think that all firms are alike and they maximize profits and all households are also alike so we just need to think about one typical household that is maximizing utility and then we have the policymakers we have the government that sets decides about taxes and government expenditure and the central bank that decides about the interest rates and in the basic model the policy is taken as exogenous. So we focus really on the decisions of the firm and the household. And a model is a simplified description of the world. We assume that consumers and firms are all alike.

And this brings a tremendous simplification because we just need to look at the typical consumer and the typical firm. And furthermore, we assume that consumers consumers and firms are rational and they have very simple objective functions so the consumers are maximizing a simple utility functions and the firms are maximizing profits and finally we use simple mathematics to describe the economic relations especially the utility function to describe the preferences of their typical household and the production function to describe the technology that is available to the typical firm. And why do we make this simplification? Well, macroeconomists are not stupid.

It's not that we think that all consumers are alike or all firms are alike. I mean, we know that people are different. We know it's hard to predict what an individual person will do. I mean, when will...

Niels Gottfried's buy new shoes. It's very hard to predict. I mean, I don't know myself.

And on the micro level, there are, of course, a lot of specific things that affect the behavior of individual consumers and firms. But we are not interested in the specific things. We are interested in the overall picture. And we want to describe how firms and households behave on average. And then we hope, we cross our fingers, and we hope that by writing down very simple objective functions and assuming people are rational, we can, at least in rough terms, describe the average behavior of firms and households.

And we need to simplify because macro is really complicated. There are so many interactions, even in a small macroeconomic model, as you will see, there are lots of interactions between different variables. And we really need to simplify drastically in order to understand anything in macroeconomics.

Another thing, a trick that we use is that, well, we limit the analysis. We do not try to explain everything. There are some things we try to explain, and those are the endogenous variables.

They are the variables that are determined within the model. But we also leave things outside the model, and they are called exogenous variables. And they are not...

explained within the model. We say, well, they happen to be what they are. For example, we look at the decisions of firms and households, but we may take government expenditures, give and say, well, the government does this, we don't know exactly why, but let's now focus on the firms and households.

And the point of the exogenous variables is not that they are actually constant in the real world. Of course they are not. Nothing is constant in the real world.

They may vary too. The point is that we are not trying to explain them. So when there's a change in an exogenous variable, we call that a shock, just because it's something we don't understand. For some reason, the government increased its expenditure.

Or for some reason, the central bank raised its interest rates. And now we see what happens in the economy. So those are the shocks, kind of shocks, that we will use our model to analyze.

But... But this again is something we do in order to limit the analysis and make it manageable. And in our baseline model we will have, in the closed economy, we have four endogenous decisions.

And three of them are made by the firm. So the firm decides about production, about prices. The firm sets the wages and the firm decides how much to invest, how much capital to acquire.

And the consumer is just deciding how much to consume and how much to save of his income. So that is the closed economy model. Then we have the policy decisions, the interest rate or money supply determined by the central bank and the taxes and government expenditure determined by the government. But they are exogenous. in the basic model so that we really only have four endogenous decisions.

Then when we open up the economy to the rest of the world we allow trade. So we have imports and exports and we also allow international borrowing and this is now the consumers who can now choose between consuming domestically produced goods and goods produced abroad and similarly the foreign consumers can choose between consuming goods produced in the small open economy that we analyze or goods produced in the rest of the world and that gives us then import and export functions and Also, the consumers can choose between lending in different currencies they can lend in the home currency or the foreign currency and That will lead us to the interest parity condition So in the open economy we have six endogenous decisions that we need to analyze and then we have a macroeconomic model that we can use for everything. So yeah, this picture here gives an overview of the model, the markets, the flows of goods and labor and loans and payments. So you can stop the tape and look at that.

to get an overview of the model. Well, a brief comment about the short and the long run. So basically we have the same model throughout the book, but we have two different analysis, the short run and the long run. And why?

Well, there are two key differences between the short run analysis and the long run analysis. One concerns... the weight setting we assume that in the short run the wages are sticky that means that they adjust slowly to shocks so remember a shock is a change in an exogenous variable so suppose we have an equilibrium then there's a shock in the and that is a change in an exogenous variable what about the weight well in the short run it doesn't adjust or it adjusts slowly In the long run, we assume that wages completely adjust to the shock, so we go to a long-run equilibrium.

So that's one key difference between the short-run analysis and the long-run. The other key difference is concerned with expectations. So when we look at the long-run equilibrium, the natural assumption is that expectations are correct.

People know what is going on. Otherwise, it wouldn't really be a long-run equilibrium. So a long-run equilibrium, we may have a constant level of production.

Everyone knows that this is the level of production and income. We may have a constant inflation rate, so people know that inflation is 2%. Or maybe we have a steady growth rate, so everyone knows that production is growing 2% per year.

That is a natural idea about long-run equilibrium, that people know what is happening. When we do the short-run analysis, then we take expectations as given. We say, okay, right now we're here, it is 2015. people have some expectations about what will happen in 2016, but they're not sure.

They happen to be optimistic or they happen to be pessimistic. Whatever, they have their expectations. And as we will see, expectations play a very important role in economics. So it influences the equilibrium, what kind of expectations people have.

But in the short-run analysis, we just... take the expectations as given. And because of this difference in weight setting and expectations, then the effect of a shock may be different in the long and the short run. If we say, suppose that we raise government expenditure, this may, for example, increase production in the short run, but not in the long run, for example.

So that's a key thing to keep in mind. also something that makes an additional complication in macroeconomics that we have to have different analysis of the short and the long run. So that much about the model So now let's consider the data.

The basic data for macroeconomics is the national accounts Because they can answer a number of questions, key questions about the economy And in the national accounts, we talk about the production side, the income side, and the user side. And the production side of the national accounts can answer the question, what is the value of all goods and services produced in the country? And how much do different production sectors contribute to the total production in the economy?

The income side. We look at the incomes. We can see what is the total income in a country and how is that income distributed between capital income and labor income. And then we can look at the user side and say, okay, we produce this much goods and services.

How are they used? How much is used for consumption? How much is used for investment?

How much is used by the government and the private sector? And finally, we can also in the national accounts see savings and investment. So what does the country do with its income?

How much is consumed, saved, invested? And how much is used to buy financial assets or to lend? So just like an individual, if you have an income, you can consume, you can make real investment. Maybe you buy a house.

And what do you do with the rest? well, you can buy financial assets. You put it in the bank.

Well, the same applies to a country. If you consume and make real investment that are lower than your income, then the rest of the money is used to lend to the rest of the world. So the national accounts give us an overview of the economy.

So let us first look at the production side. How much is produced? and where? Well GDP gross domestic product is the sum of value added in all the production sectors in the economy and the value added that is the value of production or the value of the output from all the producers minus the inputs that they use so we deduct the input because other ways we would double count the input calculate the value added for each firm and then you add them up so Here we have from the OECD data on production divided into six different production sectors.

Where the first three are agriculture, industry and construction. And then we have three service sectors, which are trade and hotels and restaurants and financial and consulting businesses and other services like education, healthcare. And if we look at the rough numbers here, you can see that Well, agriculture and fishing and forestry are very small sectors today.

In developed economies, they constitute only, production there is only 1 or 2% of the total production or value added in the economy. Industry and construction together make up about 23, 24, 25% of production. So if we take all those three together, agriculture, industry and construction, we have roughly a quarter of production is in those sectors.

So that means that pretty much three quarters of production is nowadays in the service sectors. So we do, in that sense, we do have a service economy. And roughly speaking, you could say that about 20 percent is in trade and hotels and restaurants and transports. About 30% is in financial intermediation and consulting and real estate and those kind of services.

And then about 20-25% is in other service activities. This includes then education, healthcare, which is partly done by the government. So, We see the service sectors are very important. At the same time, we shouldn't neglect industry. We should remember that many of these services are related to goods.

For example, in the shops, we are buying the goods that are produced in industry. Many of the financial and the consulting businesses are actually delivering services to the industry. So, so. We should not conclude that industry is unimportant, but as a matter of fact, if we look at where people are employed and where most of the production is, it's actually in the service industries.

So, that tells us about the production side. The next question is who gets the income? So now we turn to the income side and ask how is income distributed between labor income and capital income?

So capital income is for example interest payments and dividend payments. So GDP at market price, that is valued at the price that you sell in the market. And that includes value added tax and sales taxes, the so-called indirect taxes.

and those taxes do not go to labor or capital. For this reason we need to deduct the indirect tax from the GDP at market price in order to get the income that is actually distributed between labor and capital. So we deduct the indirect taxes and add the subsidies that government pays to the firms and then we get gross value added at basic prices and that is then distributed between labor and capital and in the OECD we have something called compensation of employees which is then wages and also social insurance contributions and stuff like that all that is included in compensation of employees so if we take the compensation of employees as a fraction of the gross value added at basic prices then we get the share of income being compensation of employees and you see here it's somewhere around 60% so that would suggest that 60% of the income goes to labor now You should remember one thing here is that there are quite a lot of people who are self-employed.

And do they have capital income or labor income? Well, presumably it's kind of a mix of labor income and capital income. To get a more correct measure of how much income goes to labor, one can make some kind of allocation of the income of the self-employed between labor and capital income.

And if you do that, then you get a somewhat higher share for the labor income. So normally we say that the labor income share is around two-thirds, around 66% of total income. So let's remember that as a baseline, that two-thirds of the income goes to the workers, or to labor. And...

The rest then, roughly one third goes to capital and we should remember that part of that income is used to pay for depreciation of capital. Capital depreciates and you have to cover depreciation which is around 15% of GDP. So that it's only part of this that is actually dividends and interest payments.

Okay, so we have learned that. Labour income is roughly two-thirds of income. So now we come to the user side of the national accounts, and we ask the question, where do the goods and services come from, and how are they used? And this table here shows sources and uses of goods and services for the USA in 2008. So when looking at big numbers like this, it's very hard to understand numbers in billions.

And therefore we will express things as percent of GDP, because then the numbers become much more meaningful. And also these fractions are fairly stable over time, so they are worth learning what they are, because most of them will not change. dramatically from one year to another so you get the sense of how important are different variables that we talk about when we come to the theory.

So we set GDB to 100 it's typically 100% of itself and then of course we also use goods and services that are imported and imports in this year 2008 corresponded to 18% of GDP in the US. And how were those goods and services used? Well, a large share was used for private consumption.

So private consumption in the US corresponded to 70% of GDP. A smaller share, 17% of GDP, was used for government consumption. And a similar share, 15% of GDP, was used for private investment, which is investments in machines and factory buildings and the like.

And we also have government investment, and that was a small fraction, about 3% of GDP. That is building of roads and schools and such things. And finally we have exports, which constituted...

13% of GDP. So obviously these numbers differ between countries and here we have some numbers for other countries. You see that private consumption is somewhere between 50 and 70 percent of GDP.

Government consumption is somewhere around 20-25% 30 almost 30 percent of GDP private investment 15 20 25 percent of GDP government in investment two or three percent of GDP exports varies a lot from the United States has 13 percent to very large shares 77 percent in the Netherlands imports similarly depends very much on the size of the country, it's very large shares in small countries and the small share in large countries. And net exports, that is exports minus imports, that varies quite a lot. You have a big surplus in Norway, almost a fifth of GDP, 19%, and you had, for example, in this period, a deficit in the United States of 5% of GDP. So the national accounts can give us an idea of how large different components are of aggregate demand.

and the use of goods and services, and also how countries differ. For example, if we look at the government use as a share of GDP, that is, government consumption and government investment, in the US, Australia and Korea, that share is about 20% of GDP. That is, one-fifth of GDP is used by...

the government. In the Scandinavian countries, Denmark, Iceland, and Sweden, and Netherlands, it's kind of Scandinavian, the share is about 29% of GDP. So it's much higher. So put differently, you could say that the government sector in the US is about two-thirds of what it is in Sweden, if you look at it as a fraction of GDP. So the Scandinavian countries have bigger government, mainly because education and health care is financed by taxes in the Scandinavian countries.

But in the US, a larger share of education and health care is privately financed and therefore counts as private consumption. Similarly, you can see that the... openness of the economy, the export share is very different.

The US is a big economy so a lot of the goods and services that you use are actually produced in the country and exports and imports are smaller shares of GDP in the US. Exports are 13 percent of GDP while in Denmark, Sweden, Netherlands, which are smaller countries, the exports are more than 50 percent of GDP. So clearly these small countries are much more dependent on what happens in the world outside.

If something happens abroad it's not that important for the US. So that tells you how you can learn things from the national accounts. Finally we come to the fourth step which is to look at production, income, saving, investments and net lending.

So as an individual, I have some income, hopefully. And what can I do with that income? Well, I can consume goods. I can go to a restaurant and spend the money. I can also make investments.

I can buy a summer house, for example. So I use my income for consumption and investment. But then the money that remains after I've made consumption and investment, What do I do with that?

Well, I put it in the bank. I lend it to the bank. Or I maybe buy government bonds, or I put it in some fund, or I buy shares.

So I buy financial assets. And that is called, in the national account, net lending. So I buy financial assets.

So I have my income, I consume, I make real investments. and the rest goes to buy financial assets. Well, the same is true about the country.

The country has some income. Some of that income, most of it is used for consumption and real investment, and the rest, what you do with it, well, you buy financial assets abroad. You can lend to other countries. You can buy stocks in other countries. So if we let Y be GDP, and then YF the incomes from other countries so this is like wage payments and interest payments from abroad net and then we have also transfers from abroad these are things like government aid or remittances that people send so the income of the country is what you produce in the in the country plus the primary income from abroad plus net transfers from abroad.

That is the income of the country. Then what you use it for, well you can consume private consumption C and you can use it for government consumption CG. You can use it for private investment I and government investment IG. So if you deduct the consumption and investment, then you have what the country's net lending. But that is equal to the current account.

If you look at... carefully at the identities you find that that is equal to net exports plus net primary income from abroad plus the transfers from abroad which is the current account well some of the F's and G's should have been superscripts here okay so we learned that the income that you don't consume and invest is lending to other countries and that is equal to the current account. And here we look at some statistics for some countries. Again, we measure everything in terms of GDP, so we set GDP to 100. If you look at the bottom line here, we have the U.S. GDP is 100. Then you have net primary income from the rest of the world, that is wages and interest payments from the rest of the world.

That's 1%. 1% of GDP and then if you add that you get gross national income at market prices. Now there's rounding error so it's still 100. Let's look at the UK instead.

You have GDP is 100, net primary income from the rest of the world is 2% of GDP and then you have gross national income at market prices is 102. But then you do... transfers to the rest of the world like government aid to developing countries and other things you deduct one and then you have gross national disposable income which is 101 percent of GDP and then you have final consumption expenditures this is now both private and government consumption is 86 percent of GDP that means that the savings is then 15 percent of GDP and then you make investments, 17% of GDP, and then you end up with a current account deficit, because investment is bigger than savings, and you have a deficit. And now there's again a rounding error, so it's minus 1, but it looks like it should be minus 2. So the point is that the current account is the net lending of the country, which is the income.

minus consumption and investment. And by looking at this, you see that there is actually substantial international borrowing and lending. We have a lot of financial integration in the world today.

So if you look at the current account as a share of GDP in 2008, you had a surplus of 18% of GDP in Norway. This is because Norway has a lot of income from oil and gas. Most of that income goes to the government, and the government is saving much of that oil income in a fund, so they are investing in shares and lending abroad.

So that's why Norway has such a big surplus in the current account. In this year, 2008, the U.S. instead had a deficit. So the U.S. was borrowing from other countries, and...

Greece had a very large deficit of 15% of GDP in this year. Of course, these numbers are different today. They vary from year to year, but the point is that the financial markets are highly integrated today, and you have a lot of financial borrowing and lending across countries and in different currencies. So, this is something we have to look at later. Okay, so there are some key definitions that you should really learn because whenever you want to look up a number you will come across these definitions the concept of production versus value-added market price and base price or factor price a gross product net product production income income and disposable income and and depending on how you Combine those concepts you can get a lot of different measures of income and production, but the key is to understand those definitions and these distinctions.

in order to understand the data that you find in the international accounts. Finally, let me introduce a very useful rule of thumb, which we will use for derivations in several places. So suppose you have a variable z, which is equal to x times y divided by q.

Then the rule of thumb says that the percentage change in z is roughly the percentage change in x plus the percentage change in y minus the percentage change in q. The intuition behind this rule is, well, if you look at this formula here, z equals x times y over q. Imagine that x increases 5%.

Well, then the whole thing will increase 5%. x times y over q will also increase 5%. because you multiply the whole thing by 1.05, right?

Suppose now that y increases 5%. Again, that will increase the whole thing by 5%. But then if q increases 5%, then the whole thing will decline by roughly 5%, not exactly 5%, but because you divide...

the whole thing by 1.05. So if you add up those things you find that the change in z is 5 plus 5 minus 5 percent. That is the total increase in z will then be about five percent.

This is an approximation. One way of proving this is to take the logs and then noting that the change in the log is approximately the relative change. That is, if something increases by 5% the change in the log is roughly 0.05.

Well there are other things in this chapter. There is a review of indexes that used to measure real growth and inflation. There is an explanation of how we compare real incomes between countries. And in the appendix there is a repetition of basic mathematical concepts such as functions, derivatives, logs, exponents, and we do use basic math in this book, so please remind yourself of those basic concepts. You have learned them before but you have forgotten them and you need to repeat this.

So good luck with your studies. of chapter one.

Transcript for:Foundations of Macroeconomics Explained

Transcript for:
Foundations of Macroeconomics Explained