Course: ECO 2013, Principles of Macroeconomics | Textbook: Macroeconomics by Michael Parkin
Difficulty: Intermediate | Prerequisites: Module 1 (demand and supply, opportunity cost, equilibrium). You need to be comfortable shifting curves and reading equilibrium before starting here.
Module 2 moves from individual markets to the economy as a whole. You will learn how economists measure the size of the economy (GDP), track its health (unemployment, inflation), and explain why some countries grow rich while others stagnate. The module then introduces the expenditure multiplier and the aggregate supply and aggregate demand (AS-AD) model, which is the central framework for the rest of the course. If Module 1 gave you the tools, Module 2 shows you the machine those tools are used on.
GDP measures the total value of final goods and services produced in a country. Unemployment and inflation are the two headline indicators of macroeconomic health. Long-run growth depends on capital accumulation, technological progress, and institutions. In the short run, spending changes are amplified by the expenditure multiplier, and the AS-AD model explains how the price level and real GDP are determined together.
Gross Domestic Product (GDP)
The market value of all final goods and services produced within a country in a given time period. "Final" means the good is sold to its end user, not used as an input to further production. Think of it as: the total price tag on everything a country produced this year, counting each item only once.
Nominal GDP
GDP measured using current-year prices. It changes when either quantities or prices change, so it can be misleading as a measure of real output.
Real GDP
GDP adjusted for price changes by using the prices of a base year. It isolates changes in the quantity of goods and services produced. This is the version economists use to track economic growth.
GDP deflator
A price index that measures the average level of prices of all goods and services included in GDP. Calculated as (Nominal GDP / Real GDP) x 100. Useful for converting nominal GDP to real GDP.
Gross National Product (GNP)
The market value of all final goods and services produced by a country's residents, regardless of where production takes place. GDP counts production within borders; GNP counts production by citizens.
Expenditure approach to GDP
GDP = C + I + G + (X - M). Consumption (C) + Investment (I) + Government spending (G) + Net exports (Exports minus Imports).
Income approach to GDP
Measures GDP by summing all incomes earned in production: wages, rent, interest, and profit. In principle, the expenditure and income approaches yield the same number because every dollar spent is a dollar of income to someone.
Value added
The value of a firm's output minus the value of the intermediate goods it purchased. Summing value added across all firms avoids double counting and gives GDP.
Unemployment rate
The percentage of the labour force that is unemployed. Unemployment rate = (Number unemployed / Labour force) x 100. In simple terms: the fraction of people who want a job and are looking for one but cannot find one.
Labour force
The sum of employed and unemployed people. It does not include discouraged workers, retirees, students, or others not looking for work.
Labour force participation rate
The percentage of the working-age population that is in the labour force. Participation rate = (Labour force / Working-age population) x 100.
Frictional unemployment
Unemployment that arises from normal labour turnover, such as people entering the workforce or switching jobs. It exists even in a healthy economy.
Structural unemployment
Unemployment that arises when there is a mismatch between the skills workers have and the skills employers need, or when jobs are in one region and workers are in another.
Cyclical unemployment
Unemployment that rises above the natural rate during recessions and falls below it during expansions. It is the component of unemployment directly tied to the business cycle.
Natural rate of unemployment
The unemployment rate when there is no cyclical unemployment, i.e. the economy is at full employment. It includes frictional and structural unemployment. Think of it as: the "normal" level of unemployment that exists even when the economy is doing well.
Full employment
The state of the economy when the unemployment rate equals the natural rate. Real GDP at full employment is called potential GDP.
Consumer Price Index (CPI)
A measure of the average prices paid by urban consumers for a fixed basket of goods and services. The most widely reported measure of inflation.
Core inflation rate
The CPI inflation rate excluding food and energy prices, which are volatile. It gives a clearer signal of the underlying trend in inflation.
Inflation rate
The percentage change in the price level from one period to the next. Inflation rate = [(CPI this year - CPI last year) / CPI last year] x 100.
Real vs. nominal interest rate
The nominal interest rate is the rate you see quoted (e.g. 5%). The real interest rate is the nominal rate minus the inflation rate. The real rate reflects the true cost of borrowing and the true return on saving.
Economic growth
A sustained increase in real GDP per person over time. It is the main source of rising living standards.
Rule of 70
A quick way to estimate how long it takes for a variable to double. Doubling time ≈ 70 / growth rate (in percent). If real GDP grows at 2% per year, it doubles in roughly 35 years.
Labour productivity
Output per hour of labour. Growth in labour productivity is the main driver of growth in real GDP per person.
Human capital
The knowledge and skills workers acquire through education, training, and experience. It increases labour productivity.
Physical capital
The tools, machinery, buildings, and equipment used in production. More capital per worker generally means higher productivity.
Technological change
The development of new goods and better ways of producing existing goods. It is the most important source of sustained long-run growth.
Loanable funds market
The market in which savers supply funds and borrowers demand funds. The real interest rate adjusts to bring saving and investment into balance.
Saving
Income that is not spent on consumption or taxes. In a closed economy, national saving equals investment.
Investment (in economics)
Spending on new capital goods (factories, equipment, housing, inventories). This is different from the everyday use of "investment" to mean buying financial assets like stocks.
Marginal propensity to consume (MPC)
The fraction of each additional dollar of disposable income that is spent on consumption. If MPC = 0.8, a household spends 80 cents of each extra dollar earned.
Marginal propensity to save (MPS)
The fraction of each additional dollar of disposable income that is saved. MPS = 1 - MPC.
Expenditure multiplier
The factor by which a change in autonomous expenditure is magnified into a larger change in equilibrium expenditure and real GDP. Multiplier = 1 / (1 - MPC) = 1 / MPS. In simple terms: a $1 increase in spending can raise GDP by more than $1, because one person's spending becomes another person's income.
Aggregate demand (AD)
The relationship between the price level and the quantity of real GDP demanded, holding everything else constant. The AD curve slopes downward for three reasons: the wealth effect, the interest-rate effect, and the international-substitution effect.
Aggregate supply (AS), short-run (SAS)
The relationship between the price level and the quantity of real GDP supplied in the short run, when the money wage rate and other resource prices are fixed. The SAS curve slopes upward.
Aggregate supply, long-run (LAS)
The relationship between the price level and the quantity of real GDP supplied in the long run, when all prices (including wages) have fully adjusted. The LAS curve is vertical at potential GDP.
Potential GDP
The level of real GDP produced when the economy is at full employment. It corresponds to the position of the LAS curve.
Recessionary gap
When real GDP falls short of potential GDP. The economy is producing below its capacity, unemployment is above the natural rate, and there is downward pressure on wages and prices.
Inflationary gap
When real GDP exceeds potential GDP. The economy is overheating, unemployment is below the natural rate, and there is upward pressure on wages and prices.
Stagflation
A combination of stagnant (falling) real GDP and rising prices. It results from a decrease in short-run aggregate supply (a leftward shift of SAS), typically caused by a supply shock like rising energy prices.
GDP can be calculated by the expenditure approach (C + I + G + NX), the income approach (summing wages, rent, interest, profit), or the value-added approach.
Only final goods and services count. Intermediate goods are excluded to avoid double counting. A tyre sold to Ford is intermediate; a tyre sold to you at a shop is final.
GDP omits non-market production (household work, volunteer labour), the underground economy, leisure, and environmental degradation. It is a measure of market output, not wellbeing.
Nominal GDP can rise simply because prices rose. Real GDP strips out inflation and is the relevant measure for comparing output across years.
The GDP deflator links nominal and real GDP: GDP deflator = (Nominal GDP / Real GDP) x 100.
The Bureau of Labor Statistics (BLS) classifies the working-age population into employed, unemployed, and not in the labour force. You must know these categories and how they feed into the unemployment rate and participation rate.
The unemployment rate understates joblessness because it excludes discouraged workers (people who have stopped looking) and does not capture underemployment (part-time workers who want full-time work).
Inflation is measured by the CPI. The CPI tracks the cost of a fixed basket of goods, so it suffers from substitution bias (people switch to cheaper alternatives), quality-change bias (improvements in goods are not fully accounted for), and new-goods bias.
Core CPI strips out food and energy to give a less noisy picture of underlying inflation.
The real interest rate = nominal rate - inflation rate. This matters because borrowing and saving decisions respond to real rates, not nominal ones.
Small differences in growth rates compound dramatically over time. The Rule of 70 illustrates this: a country growing at 1% doubles its GDP in 70 years; at 3.5%, it doubles in 20 years.
Labour productivity is output per hour of labour. Growth in GDP per person is driven almost entirely by growth in labour productivity.
The sources of productivity growth: physical capital accumulation, human capital growth, and technological progress. Of these, technology is the most important for sustained long-run growth.
The classical growth model, the neoclassical growth model, and new growth theory offer different accounts of what drives technological change. New growth theory emphasises that research and development responds to economic incentives (profit), making growth partly self-sustaining.
In the loanable funds market, the real interest rate brings the quantity of saving (supply of loanable funds) into balance with the quantity of investment (demand for loanable funds).
An increase in expected profit shifts the demand for loanable funds rightward, raising the real interest rate and increasing both saving and investment.
A government budget deficit increases the demand for loanable funds (the government borrows), which raises the real interest rate and crowds out some private investment. This is the crowding-out effect.
A government budget surplus does the reverse: it increases the supply of loanable funds, lowers the real interest rate, and encourages more private investment.
The key insight: one person's spending is another person's income. When income rises, consumption rises by MPC times the income change, which becomes someone else's income, and so on.
The simple multiplier = 1 / (1 - MPC). If MPC = 0.75, the multiplier is 4. A $10 billion increase in investment spending raises equilibrium GDP by $40 billion.
MPC + MPS = 1 always. If MPC is 0.8, MPS is 0.2.
The multiplier works in both directions. A fall in spending is also multiplied, leading to a larger fall in GDP. This helps explain why recessions can be deep relative to the initial shock.
In the real world, taxes, imports, and price-level changes all reduce the size of the multiplier relative to the simple formula. The exam will likely stick with the simple version.
The AD curve slopes downward because:
Wealth effect: a higher price level reduces the real value of money and assets, reducing spending.
Interest-rate effect: a higher price level increases the demand for money, pushing up interest rates and reducing investment.
International-substitution effect: a higher domestic price level makes domestic goods expensive relative to foreign goods, reducing net exports.
AD shifts when C, I, G, or NX change for reasons other than a change in the price level. Fiscal policy (changes in G or T), monetary policy, and changes in consumer/business confidence all shift AD.
The SAS curve slopes upward because firms' output prices rise while their input costs (especially wages) are temporarily fixed. Higher prices mean higher profit margins, so firms produce more.
SAS shifts when input prices change. A rise in the money wage rate or energy prices shifts SAS leftward. A fall in input prices shifts SAS rightward.
The LAS curve is vertical at potential GDP because in the long run, all input prices adjust fully to output prices, so the price level has no effect on real GDP.
Short-run equilibrium is where AD intersects SAS. If this equilibrium is below potential GDP, there is a recessionary gap; if above, an inflationary gap.
Long-run adjustment: in a recessionary gap, wages eventually fall, shifting SAS rightward until real GDP returns to potential. In an inflationary gap, wages rise, shifting SAS leftward. The economy self-corrects in the long run, but the process can be slow.
GDP (expenditure approach):
GDP = C + I + G + (X - M)
Unemployment rate:
Unemployment rate = (Number unemployed / Labour force) x 100
Labour force participation rate:
Participation rate = (Labour force / Working-age population) x 100
Inflation rate (using CPI):
Inflation rate = [(CPI this year - CPI last year) / CPI last year] x 100
Real interest rate:
Real interest rate = Nominal interest rate - Inflation rate
Rule of 70:
Doubling time (years) ≈ 70 / Annual growth rate (%)
Expenditure multiplier:
Multiplier = 1 / (1 - MPC) = 1 / MPS
MPC + MPS = 1
GDP figures are reported quarterly and make headlines because they tell us whether the economy is growing or contracting. Two consecutive quarters of negative real GDP growth is the informal rule-of-thumb for a recession.
The unemployment rate is a lagging indicator: it tends to keep rising even after the economy has started recovering, because firms wait to see sustained demand before hiring. This is why policy makers watch initial jobless claims (a leading indicator) alongside the headline rate.
The expenditure multiplier is the logic behind stimulus packages. When the government increases spending during a recession, the idea is that the multiplied effect on GDP is larger than the initial outlay. Whether the multiplier is large or small in practice is one of the most debated questions in macroeconomics.
Students often think GDP measures how well off people are. It does not. It measures market output. A country can have high GDP and still have large inequality, poor health outcomes, or environmental problems. GDP is useful but narrow.
A common error is adding the unemployment rate and the labour force participation rate and expecting them to sum to 100%. They measure different things and are drawn from different populations.
Students frequently confuse investment in the economic sense (spending on capital goods) with the everyday sense (buying stocks or bonds). When your exam asks about investment, it means factories, equipment, and inventories.
Many students assume the multiplier means the government can generate unlimited GDP growth by spending more. The multiplier effect is real but bounded, and in practice it is reduced by taxes, imports, and rising prices. It also does not apply when the economy is already at full employment, because additional spending then mainly drives up prices rather than output.
⚠️ Be able to calculate GDP using the expenditure approach, and know what is and is not included (e.g. used goods, intermediate goods, and transfer payments are excluded).
⚠️ Know the three types of unemployment and which type(s) exist at full employment (frictional and structural).
⚠️ The multiplier formula and its application are nearly guaranteed to appear. Make sure you can go from a given MPC to the multiplier and then to the total change in GDP.
⚠️ Diagram questions on AS-AD will ask you to identify the type of gap, predict the direction of wage adjustment, and show the long-run outcome. Practise drawing and labelling these diagrams.
⚠️ Know the difference between a movement along AD or SAS (caused by a price-level change) and a shift of AD or SAS (caused by everything else). Same logic as demand vs. supply in Module 1.
⚠️ The real interest rate = nominal - inflation. Simple but easy to fumble under exam pressure.
True or False: If nominal GDP rises, the economy must be producing more goods and services.
Fill in the blank: A discouraged worker is classified as _______ (employed / unemployed / not in the labour force).
True or False: The expenditure multiplier is larger when the MPC is smaller.
Fill in the blank: The long-run aggregate supply curve is vertical at _______.
True or False: If real GDP is below potential GDP, the economy has an inflationary gap.
Answers:
False. Nominal GDP can rise purely because of inflation, with no change in real output.
Not in the labour force.
False. A larger MPC means a larger multiplier (1 / (1 - MPC)).
Potential GDP.
False. That describes a recessionary gap.
Q: An economy has consumption of $800 billion, investment of $200 billion, government spending of $300 billion, exports of $100 billion, and imports of $150 billion. What is GDP?
A: GDP = C + I + G + (X - M) = 800 + 200 + 300 + (100 - 150) = $1,250 billion.
Q: The working-age population is 200 million. The labour force is 150 million. The number of unemployed is 12 million. Calculate the unemployment rate and the labour force participation rate.
A: Unemployment rate = (12 / 150) x 100 = 8%. Labour force participation rate = (150 / 200) x 100 = 75%.
Q: The MPC is 0.6. The government increases its spending by $50 billion. By how much does equilibrium GDP change (using the simple multiplier)?
A: Multiplier = 1 / (1 - 0.6) = 1 / 0.4 = 2.5. Change in GDP = 2.5 x $50 billion = $125 billion.
Q: The economy is in short-run equilibrium with a recessionary gap. Describe the self-correcting mechanism.
A: With real GDP below potential, unemployment is above the natural rate. Surplus labour puts downward pressure on wages. As the money wage rate falls, firms' costs decrease, shifting the SAS curve to the right. This process continues until SAS has shifted far enough that real GDP returns to potential GDP at a lower price level.
Q: An increase in oil prices shifts the SAS curve to the left. What happens to the price level and real GDP in the short run? What is this combination called?
A: The price level rises and real GDP falls. This combination of rising prices and falling output is called stagflation.
The AS-AD model built here is the main framework for Module 3. Fiscal policy shifts AD through government spending and taxes. Monetary policy shifts AD through interest rates and the money supply. You cannot analyse those policies without the AS-AD diagram.
The loanable funds market and the real interest rate connect directly to monetary policy in Module 3. When the central bank changes the money supply, it affects interest rates, which affects investment, which shifts AD.
GDP and its components reappear when you study the balance of payments in Module 3, because net exports (X - M) link the domestic economy to the rest of the world.
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