Introduction to MacroeconomicsLecture NotesRobert M. KunstMarch 2006

1MacroeconomicsMacroeconomics (Greek makro ‘big’) describes and explains economicprocesses that concern aggregates. An aggregate is a multitude of economicsubjects that share some common features. By contrast, microeconomicstreats economic processes that concern individuals.Example: The decision of a firm to purchase a new office chair from company X is not a macroeconomic problem. The reaction of Austrian households to an increased rate of capital taxation is a macroeconomic problem.Why macroeconomics and not only microeconomics? The wholeis more complex than the sum of independent parts. It is not possible to describe an economy by forming models for all firms and persons and all theircross-effects. Macroeconomics investigates aggregate behavior by imposingsimplifying assumptions (“assume there are many identical firms that produce the same good”) but without abstracting from the essential features.These assumptions are used in order to build macroeconomic models. Typically, such models have three aspects: the ‘story’, the mathematical model,and a graphical representation.Macroeconomics is ‘non-experimental’: like, e.g., history, macroeconomics cannot conduct controlled scientific experiments (people wouldcomplain about such experiments, and with a good reason) and focuses onpure observation. Because historical episodes allow diverse interpretations,many conclusions of macroeconomics are not coercive.Classical motivation of macroeconomics: politicians should be advised how to control the economy, such that specified targets can be metoptimally.policy targets: traditionally, the ‘magical pentagon’ of good economicgrowth, stable prices, full employment, external equilibrium, just distribution1

of income; according to the EMU criteria, focus on inflation (around 2%),public debt, and a balanced budget; according to Blanchard, focus on lowunemployment (around 5%), good economic growth, and inflation (0—3%).In all specifications, aim is meeting several conflicting targets simultaneously.Examples for further typical questions to macroeconomics: whatcauses business cycles (episodes of stronger and weaker economic growth)?can an increase in the monetary supply by the central bank cause real effects?what is responsible for long-run economic growth? should the exchange rateof a currency be kept at a fixed level? can one decrease unemployment, ifone accepts an increase in inflation?A survey of world economics: three large economic blocks (Europe, USA Canada, Japan Far East) with different problems, the remainder mostly developing countries.1. USA: good growth, low inflation, tolerable unemployment rate, persistent external deficit, increasing income inequality.2. EU: moderate growth, low inflation, in some countries high unemployment, inconspicuous external balance (total EU active, in Austriarecently turned active), for some countries large public debt, currentlyimportant unification process, convergence and heterogeneity of individual countries. ‘Richest’ EU countries Luxembourg, Denmark, then‘mid-field’ with Austria, IRL, B, NL, UK, D, F, FIN, I, S; slightly below E, GR, SLO, P. Last come most ‘new’ (2004 accession) countries(from Malta down to Latvia). Very ‘rich’ non-EU countries Norway,Iceland, and Switzerland.3. Japan: recently weak growth, large external surplus, deflationary tendencies.2

2System of National AccountsBasic idea (not the definition): Summary of all economic activities withina country’s territory and within a given time range (e.g., a year or quarter)yields the gross domestic product (GDP). The value of all goods and services is determined at market prices (final prices, purchasers’ prices). Systemfor compilation of data and bookkeeping of all positions is called the Systemof National Accounts (SNA). In Europe, compilation of the SNA conformsto the ESA (European System of Accounts) standard.Economic activity is mainly measured by transactions. Phrases fromtext books: diversification of labor (not complete self-subsistence) causestransactions, exchange of money for goods or services, exchange of an assetor liability for a different asset or liability, etc. The transactions take place onmarkets. Money makes transactions easier than direct exchange of goods forgoods, which may require ‘double coincidence’ (hungry tailor meets freezingbaker).Purpose of money: apart from payment and storage of value primarilyunit of measurement (numeraire). In economic text books, usually dollar( ), monetary unit (MU), or euro.gross: many activities serve to repair or replace worn or damaged machines and objects (‘depreciation’), therefore it is not the total GDP thatcontributes to the accumulation of aggregate wealth. In the SNA, ‘gross’usually means ‘inclusive of depreciation’, ‘net’ often contains taxes, thoughno depreciation.Consumption of fixed capital (in economics, depreciation) of SNA is theestimated wear and tear of produced means of production (this ‘depreciation’should not be confused with positions in tax declarations or with changes inthe currency exchange rate).3

Capital stock is the stock of fixed capital (machines, buildings, .) inenterprises and in the general government sector. This must be distinguishedcarefully from the informal usage of the word ‘capital’ as ‘money, liquidwealth’. By definition, capital contains all produced means of production.The separation of capital such as machinery from intermediate consumptionsuch as raw materials can be difficult.economic activities: only market activities can be fully accounted for.Therefore, private exchange and domestic services pass by unnoticed. By definition, however, legitimacy of a transaction should not play a role. Therefore, the shadow economy (moonlighting) and illegal drug production arepart of the GDP, but such activities are difficult to measure. A consequenceof this measurement problem is an exaggerated wedge between developingcountries and OECD countries (with the per capita GDP of Angola you cannot survive in Austria). Interest focuses on transactions–bilateral (requited)transactions (purchase etc.) and unilateral (unrequited) transactions (transfers)–while value changes of existing objects are not accounted fully.value added: definition of GDP as the sum of values added in the production process (ore metal screw motor part video recorder) avoidsmultiple counts. Problems in the valuation of public prices: in principle, all goods and services are valued at marketprices, that is, inclusive of all taxes. If data is collected at the net value(without taxes), taxes must be added.economic agents: Resident ‘institutional units’ are classified with regardto their distinctive characteristics. Types of institutional units are: private households, general government, financial and non-financial corporations (comprises most so called firms or enterprises), non-profit institutionsserving households. Foreign (non-resident) units are summarized as the ‘rest4

of the world’, provided there are transactions with resident units. The sameperson can be part of a private household and of an enterprise (rents out anapartment, or even only uses his/her own condo but is assumed to rent itout to him/herself).resident is an institutional unit that is situated on a country’s territory.Citizenship is not the criterion for residence. However, foreign students orshort-term foreign workers are not viewed as resident.private households: produce and invest relatively little, consume, obtainwage and profit income from corporations and from the government. Asself-employed persons, they obtain ‘mixed income’, though the separation ofhouseholds from corporations is occasionally difficult. Small (non-corporate)firms and farms are counted as private households.general government (‘public sector’): receives taxes from enterprises andfrom private households, provides public goods (‘consumes them by itself’according to SNA), no intention of profit.corporations: produce and invest, do not consume, intention of profit.Corporations, not the government sector, comprise also firms in public property, if they cover 50% of their costs from sales. Because depreciation is nowcalled ‘consumption of fixed capital’, it represents a kind of consumption ofcorporations. Corporations are either financial (banks etc.) or non-financial.non-profit institutions serving households (NPIsH): institutions (such asschools, churches) that cover less than 50% of their production costs fromsales; idea: no intention of profit. A small sector, for simplification oftenadded to of the world: consumes goods and services produced by residents(exports) and produces goods and services consumed by residents (imports).imports of services: includes travels abroad by residents5

exports of services: includes consumption of foreign tourists on the territory of the economy (imputed based on valuta purchases etc.)sectors: the activities of individuals of a similar kind are added up (aggregated). The aggregate of all households forms the household sector etc.,whereby transactions within the sector disappear. This ‘consolidation’ eliminates the exchange between households, as it does not increase collectivewealth. Recorded are the production of capital within the firms, the production by private households, public consumption, which by definition isproduced and consumed by the general government itself.ex post: SNA records only after the economic processes have alreadyoccurred, therefore only limited validity for the assessment of future reactionsin the economy. ex ante would be a task for economic theory.flows and stocks: SNA mainly records flows of goods and services within atime period (for example, the consumption of Austrian households in the firsthalf-year of 1996). Sometimes, also stocks are of interest (wealth, numberof unemployed persons, central bank money, capital stock on July 31, 1996)at a fixed time point. Changes of stocks are flows (bath tub: water level attime point 1 water level at time point 0 inflow — outflow; inflow andoutflow are flows; water level is a stock)stocks: also short for ‘common stocks’ (shares) and occasionally for ‘inventories’ (beware of the possibility of confusion)2.1Matrix of transactions between sectorsThe new SNA convention affects this traditional presentation (following Haslinger), though it remains instructive and valid in principle. The NPIsHsector is omitted here, an artificial sector ‘value changes’ completes the transaction matrix.6

Diagram of monetary flows (payments) from the row sectors to the columnsectors, grossly simplified, goods flows partly in the opposite direction: firmsfirmsgovernment householdsTdir,F TindWF ΠdWP trHgovernmentsubv ntschangesImΠund,netSPSHIm Xvalue changesIF,netIP,netnames (notation as used in economics, not necessarily in SNA):C . . . (private) consumption of householdsCP . . . public consumptionIF . . . investment of corporations (enterprises, firms)IP . . . investment of general government (public investment)(‘investment’ always concerns means of production, not purchases of assets)Inet . . . investment without depreciation (wear and tear of the capitalstock)WF . . . wage payments of firms to householdsWP . . . wage payments in the public sectortrH . . . transfers to households (pensions, benefits, superscript indicatesdirection ‘to households’; ‘transfers’ unilateral transactions without counterpart)SH , SP . . . saving (public sector often negative)subv. . . . subsidies to enterprisesT . . . taxes etc.Tind . . . indirect taxes are deductions before the calculation of income7

(mainly value added tax) including customs, officially production taxes.Tdir . . . direct taxes are deductions from earned income (wage tax, incometax etc.), including contributions to social securityΠund . . . undistributed profitsΠd . . . distributed profits (dividends etc.)X . . . exportsIm . . . importsEconomic circuit: row sums column sums (inflow outflow), nothingis lost, often graphical presentation with arrows. (metaphorical analogy water: sector Atmosphere with input evaporation and output rain, sector Continents with input rain and output evaporation from inland water and outflowat estuaries, sector Oceans with input at estuaries and output evaporationfrom seas; earth is a closed circuit, amount of water is globally preserved)open and closed circuit: without value changes, the economic circuitis open, for example at X Im more payments would flow to Austria thanfrom Austria to non-residents. The hypothetical value changes sector (globalbank?) loses X Im and closes the circuit.2.2Accounts of the SNAThe new SNA consists of a sequence of several accounts, in which manysingle positions are recorded, while others result as balancing items (boldtype in the accounts). These accounts are calculated for all sectors (financialand non-financial corporations, public households, private households andNPIsH, rest of the world) and for the total economy.8

2.2.1Sectorial accountingThe accounts that are decomposed according to sectors (financial and nonfinancial corporations, public households, private households and NPIsH) areprimarily income accounts, which focus on the contributions of individualsectors to national income. Point of departure is the production account.Gross output (all production at basic prices, i.e. without value added tax andcustoms) is booked on the credit side of this account. To this correspond,as uses, the intermediate consumption and the depreciation (consumption offixed capital). The balancing item is net value added. The columns ‘resources’and ‘uses’ correspond to the bookkeeping terms ‘credit’ and ‘debit’.UsesResourcesintermediate consumption gross outputdepreciationnet value addedIn the generation of income account, the balancing item of the productionaccount is trans