Ostoni Monica IPLE 2023/2024
INTERNATIONAL MACROECONOMICS
I. Introduction and Key Macroeconomic Variables
• What is Macroeconomics about?
• The Variables that Describe the Economy (Aggregate Output, Unemployment, Inflation)
• Gross Domestic Product (GDP): Definitions, Measurement, and Components (C, I, G, NX)
• GDP and the Standard of Living; Measuring Economic Growth (Nominal vs. Real GDP)
• The Unemployment Rate, Labor Force, and Okun's Law
• Inflation and Deflation (Costs, Optimal Rate, Price Indexes: GDP Deflator and CPI)
II. Output Determination in the Long Run
• The Aggregate Production Function (K, L, H, Technology, Institutions)
• Returns to Scale and Decreasing Returns to Factors
• Perfect Competition and Flexible Prices/Wages
• The Natural Level of Output (Potential Output, Flexible-Price Equilibrium)
• Supply Shocks (Temporary and Permanent)
III. The Business Cycle and Aggregate Demand in the Short Run
• Output Fluctuations and the Business Cycle (Recessions, Expansions, Shocks)
• Output Determination in the Very Short Run (Fixed Prices)
• Components and Determinants of Aggregate Demand (C, I, G, NX)
• The Interest Rate (Nominal and Real)
• Equilibrium on the Market for Goods and Services: The IS Curve
IV. Financial Markets and Monetary Policy Tools
• Money (Functions, Liquidity, Monetary Aggregates)
• Interest Rate Determination and Open Market Operations (OMOs)
• Commercial Banks, Reserves, and Money Supply (Inside vs. Outside Money)
• The Central Bank's Control of the Interest Rate (The Corridor, MROs, DFR)
V. The AS-AD Model and Stabilization Policy
• The Monetary Policy Curve (MPC/MPE) and the Taylor Rule/Principle
• The Aggregate Demand (AD) Relation (Negative relation between output and inflation)
• The Aggregate Supply (AS) Curve (Derived from the Phillips Curve and Okun’s Law)
• The Phillips Curve and the Natural Rate of Unemployment (NAIRU)
• Short-Run and Long-Run Equilibrium (General Equilibrium)
• Dynamic Effects of Fiscal and Monetary Policy (Expansion/Contraction)
• The Neutrality of Money in the Long Run
VI. Shocks, Policy Effectiveness, and Limits
• Macroeconomic Policy Objectives and Stabilization
• Monetary Policy Reaction to Demand and Permanent Supply Shocks (Divine Coincidence)
• Temporary Supply Shocks and the Output/Inflation Trade-off
• Limits of Monetary Policy: Deflation, the Lower Bound (ZLB), and Liquidity Trap
• Unconventional Monetary Policy: Quantitative Easing (QE)
• Case Studies: The Great Recession, Covid-19, and the Ukraine Invasion
• Lags and Constraints of Stabilization Policies (Fiscal vs. Monetary Policy differences)
1
,Ostoni Monica IPLE 2023/2024
What is Macroeconomics about?
Macroeconomics is the study of economic activity, i.e. of:
o The structure, functioning and performance of national economies
o The fiscal and monetary policies that improve economic performance
Macroeconomics focuses on:
▪ The functioning of the economic system as a whole (general equilibrium);
▪ The relationships between economic aggregates (variables);
▪ The aggregate behavior of economic agents;
▪ The relations between markets (goods, financial, labor markets).
The economic outcome depends on the interactions of markets, and the aggregate behavior and expectations
of economic groups.
Macroeconomics studies:
▪ The relations between aggregate variables;
▪ How such variables are determined and change over time, depending on people’s behavior, economic
policy, etc.
The main issues are:
- Output fluctuations (recessions, expansions) → Business Cycle
- Inflation
- External economic relations
- Macroeconomic policy
- Long-run economic growth
A main objective is to understand how authorities can improve the functioning of the economy with fiscal and
monetary policies.
Why is Macroeconomics important?
Macroeconomics helps us understand the world in which we live → understanding economic events improves
our general understanding.
Macroeconomics affects our life:
A good economic performance improves our standard of living;
Understanding the evolution of economic activity, interest rates, inflation, exchange rates, helps us to
take informed decisions.
Macroeconomics is a focal point of politics:
It helps us to evaluate politics and International relations
Macroeconomics is important for Governments and Central Bankers
Understanding the economy is needed for fiscal and monetary policy
2
,Ostoni Monica IPLE 2023/2024
THE VARIABLES THAT DESCRIBE THE ECONOMY
To study economic activity we must first identify the variables that best represent it, and then measure and
interpret the data.
We shall focus on three variables:
1. Aggregate Output: the value of Total Production in the economy or Gross Domestic Product (GDP).
→ Economists mainly focus on the growth rate of output (GDP growth).
2. The unemployment rate: the percentage of unemployed people seeking work in the labor force.
3. The inflation rate: the rate of growth of the price level (the general level of prices).
Gross Domestic Product - GDP
The measure of total production (or aggregate output) in the national income accounts (NIA) is called Gross
Domestic Product, GDP.
There are 3 different measures/definitions of GDP:
a) GDP is the sum of values added in the production of goods and services during a given period –
Output/Production based
b) GDP is the value of final goods and services produced in the economy during a given period – Expenditure
based
c) GDP is the sum of incomes in the economy/period – Income based
Equivalent Measures → Fundamental Identity of NIA: Total Production = Total Expenditure = Total Income
NB: in all three definitions we are summing up monetary values and not quantities. For example, in the first
definition: GDP = Price A x Quantity A + Price B x Quantity B +…..
Production Approach: Market Value
Prices are used to value production, i.e. we measure production at Market Value which makes sense as prices
indicates how goods and services are worth for us. Summing up quantities would not make sense!
NB: market prices includes taxes on products (e.g. VAT)
For goods and services that are not on the market (cleaning, cooking, childcare) or whose production is hidden
from govt (underground economy: drugs, tax evasion) we must find alternative measures → Imputed Values
(an estimate of what the price of the good/service would be if it was traded in the market):
Imputed rent is used for owner-occupied housing;
The income of government employees is imputed for government services that have no market
(education, health, public order, defence).
GDP is an imperfect, estimated measure of economic activity:
- It is an imperfect measure; e.g. the value of services performed in the household are not included.
- It is an estimate; e.g. it includes an estimate of the underground economy (illegal and informal
activities).
GDP is very difficult to measure but almost all countries in the world have data!
Common Elements of GDP definitions:
- Produced in the economy - GDP considers the goods and services produced within a country’s
boundaries (it differs from Gross National Income which is the income of residents).
- During a given period - GDP is a flow variable; it can only be measured per unit of time, a year or a
quarter. It includes the flow of constructions of new houses but not the existing stock of houses.
3
, Ostoni Monica IPLE 2023/2024
Definition 1 only considers the value of final goods and services (at market prices); it excludes intermediate
goods and services used as inputs in production since their value is already accounted for in the value of final
goods (it avoids double counting) → NB: the value of imported inputs must be subtracted.
Definition 2 sums up the Values Added, i.e. the difference between the revenues from sales and the cost of
intermediate inputs, in the various stages of production plus taxes less subsidies on products and imports.
Definition 3 sums up the various incomes in which the value of production is distributed: compensation of
employees + gross mixed income + gross operating surplus + taxes less subsidies on products and imports.
Gross operating surplus ≈ Gross profits = capital income + capital depreciation expenses
Expenditure Approach
The final goods and services produced in the economy are sold and their value is thus equal to total spending.
The expenditure approach decomposes total spending and thus GDP in its different expenditure components.
National Income Account Identity:
GDP: C + I + G + NX
C = Consumption expenditure (or personal consumption expenditure) → largest component of GDP : consumer
durables, non-durable goods and services.
I = Investment* → Fixed investment (equipment and structures) + Inventory investment + Residential
investment (new houses & apartments). In National Accounts, it includes Government investment.
G = Government consumption → government purchased for short-lived goods and services (health care, police
protection)
NX = Net Exports = Exports – Imports → value of currently produced goods and services exported, or sold to
other countries, minus the value of goods and services imported, or purchased from abroad.
NB:* Gross Investment; i.e. it includes investment to replace depreciated Capital. This is the reason we have
Gross Domestic Product.
Income Approach
GDP versus National Income
Definition 3 of GDP sums up the various incomes in which the value of production is distributed → all the
incomes received by households and firms in the economy, including profits and tax revenue to the govt:
• Income based GDP = compensation of employees + gross mixed income + gross operating surplus +
taxes less subsidies on products and imports.
This definition refers to income generated in the domestic economy; not the income of domestic residents. To
obtain the Gross National Income (once called Gross National Product):
• Gross National Income (GNI) = Income based GDP + primary (factor) income received from the rest
of the world – primary income paid to foreign residents.
A more meaningful concept is
• Net National Income (NNI) = GNI – Consumption of fixed capital (depreciated capital that is replaced)
4
INTERNATIONAL MACROECONOMICS
I. Introduction and Key Macroeconomic Variables
• What is Macroeconomics about?
• The Variables that Describe the Economy (Aggregate Output, Unemployment, Inflation)
• Gross Domestic Product (GDP): Definitions, Measurement, and Components (C, I, G, NX)
• GDP and the Standard of Living; Measuring Economic Growth (Nominal vs. Real GDP)
• The Unemployment Rate, Labor Force, and Okun's Law
• Inflation and Deflation (Costs, Optimal Rate, Price Indexes: GDP Deflator and CPI)
II. Output Determination in the Long Run
• The Aggregate Production Function (K, L, H, Technology, Institutions)
• Returns to Scale and Decreasing Returns to Factors
• Perfect Competition and Flexible Prices/Wages
• The Natural Level of Output (Potential Output, Flexible-Price Equilibrium)
• Supply Shocks (Temporary and Permanent)
III. The Business Cycle and Aggregate Demand in the Short Run
• Output Fluctuations and the Business Cycle (Recessions, Expansions, Shocks)
• Output Determination in the Very Short Run (Fixed Prices)
• Components and Determinants of Aggregate Demand (C, I, G, NX)
• The Interest Rate (Nominal and Real)
• Equilibrium on the Market for Goods and Services: The IS Curve
IV. Financial Markets and Monetary Policy Tools
• Money (Functions, Liquidity, Monetary Aggregates)
• Interest Rate Determination and Open Market Operations (OMOs)
• Commercial Banks, Reserves, and Money Supply (Inside vs. Outside Money)
• The Central Bank's Control of the Interest Rate (The Corridor, MROs, DFR)
V. The AS-AD Model and Stabilization Policy
• The Monetary Policy Curve (MPC/MPE) and the Taylor Rule/Principle
• The Aggregate Demand (AD) Relation (Negative relation between output and inflation)
• The Aggregate Supply (AS) Curve (Derived from the Phillips Curve and Okun’s Law)
• The Phillips Curve and the Natural Rate of Unemployment (NAIRU)
• Short-Run and Long-Run Equilibrium (General Equilibrium)
• Dynamic Effects of Fiscal and Monetary Policy (Expansion/Contraction)
• The Neutrality of Money in the Long Run
VI. Shocks, Policy Effectiveness, and Limits
• Macroeconomic Policy Objectives and Stabilization
• Monetary Policy Reaction to Demand and Permanent Supply Shocks (Divine Coincidence)
• Temporary Supply Shocks and the Output/Inflation Trade-off
• Limits of Monetary Policy: Deflation, the Lower Bound (ZLB), and Liquidity Trap
• Unconventional Monetary Policy: Quantitative Easing (QE)
• Case Studies: The Great Recession, Covid-19, and the Ukraine Invasion
• Lags and Constraints of Stabilization Policies (Fiscal vs. Monetary Policy differences)
1
,Ostoni Monica IPLE 2023/2024
What is Macroeconomics about?
Macroeconomics is the study of economic activity, i.e. of:
o The structure, functioning and performance of national economies
o The fiscal and monetary policies that improve economic performance
Macroeconomics focuses on:
▪ The functioning of the economic system as a whole (general equilibrium);
▪ The relationships between economic aggregates (variables);
▪ The aggregate behavior of economic agents;
▪ The relations between markets (goods, financial, labor markets).
The economic outcome depends on the interactions of markets, and the aggregate behavior and expectations
of economic groups.
Macroeconomics studies:
▪ The relations between aggregate variables;
▪ How such variables are determined and change over time, depending on people’s behavior, economic
policy, etc.
The main issues are:
- Output fluctuations (recessions, expansions) → Business Cycle
- Inflation
- External economic relations
- Macroeconomic policy
- Long-run economic growth
A main objective is to understand how authorities can improve the functioning of the economy with fiscal and
monetary policies.
Why is Macroeconomics important?
Macroeconomics helps us understand the world in which we live → understanding economic events improves
our general understanding.
Macroeconomics affects our life:
A good economic performance improves our standard of living;
Understanding the evolution of economic activity, interest rates, inflation, exchange rates, helps us to
take informed decisions.
Macroeconomics is a focal point of politics:
It helps us to evaluate politics and International relations
Macroeconomics is important for Governments and Central Bankers
Understanding the economy is needed for fiscal and monetary policy
2
,Ostoni Monica IPLE 2023/2024
THE VARIABLES THAT DESCRIBE THE ECONOMY
To study economic activity we must first identify the variables that best represent it, and then measure and
interpret the data.
We shall focus on three variables:
1. Aggregate Output: the value of Total Production in the economy or Gross Domestic Product (GDP).
→ Economists mainly focus on the growth rate of output (GDP growth).
2. The unemployment rate: the percentage of unemployed people seeking work in the labor force.
3. The inflation rate: the rate of growth of the price level (the general level of prices).
Gross Domestic Product - GDP
The measure of total production (or aggregate output) in the national income accounts (NIA) is called Gross
Domestic Product, GDP.
There are 3 different measures/definitions of GDP:
a) GDP is the sum of values added in the production of goods and services during a given period –
Output/Production based
b) GDP is the value of final goods and services produced in the economy during a given period – Expenditure
based
c) GDP is the sum of incomes in the economy/period – Income based
Equivalent Measures → Fundamental Identity of NIA: Total Production = Total Expenditure = Total Income
NB: in all three definitions we are summing up monetary values and not quantities. For example, in the first
definition: GDP = Price A x Quantity A + Price B x Quantity B +…..
Production Approach: Market Value
Prices are used to value production, i.e. we measure production at Market Value which makes sense as prices
indicates how goods and services are worth for us. Summing up quantities would not make sense!
NB: market prices includes taxes on products (e.g. VAT)
For goods and services that are not on the market (cleaning, cooking, childcare) or whose production is hidden
from govt (underground economy: drugs, tax evasion) we must find alternative measures → Imputed Values
(an estimate of what the price of the good/service would be if it was traded in the market):
Imputed rent is used for owner-occupied housing;
The income of government employees is imputed for government services that have no market
(education, health, public order, defence).
GDP is an imperfect, estimated measure of economic activity:
- It is an imperfect measure; e.g. the value of services performed in the household are not included.
- It is an estimate; e.g. it includes an estimate of the underground economy (illegal and informal
activities).
GDP is very difficult to measure but almost all countries in the world have data!
Common Elements of GDP definitions:
- Produced in the economy - GDP considers the goods and services produced within a country’s
boundaries (it differs from Gross National Income which is the income of residents).
- During a given period - GDP is a flow variable; it can only be measured per unit of time, a year or a
quarter. It includes the flow of constructions of new houses but not the existing stock of houses.
3
, Ostoni Monica IPLE 2023/2024
Definition 1 only considers the value of final goods and services (at market prices); it excludes intermediate
goods and services used as inputs in production since their value is already accounted for in the value of final
goods (it avoids double counting) → NB: the value of imported inputs must be subtracted.
Definition 2 sums up the Values Added, i.e. the difference between the revenues from sales and the cost of
intermediate inputs, in the various stages of production plus taxes less subsidies on products and imports.
Definition 3 sums up the various incomes in which the value of production is distributed: compensation of
employees + gross mixed income + gross operating surplus + taxes less subsidies on products and imports.
Gross operating surplus ≈ Gross profits = capital income + capital depreciation expenses
Expenditure Approach
The final goods and services produced in the economy are sold and their value is thus equal to total spending.
The expenditure approach decomposes total spending and thus GDP in its different expenditure components.
National Income Account Identity:
GDP: C + I + G + NX
C = Consumption expenditure (or personal consumption expenditure) → largest component of GDP : consumer
durables, non-durable goods and services.
I = Investment* → Fixed investment (equipment and structures) + Inventory investment + Residential
investment (new houses & apartments). In National Accounts, it includes Government investment.
G = Government consumption → government purchased for short-lived goods and services (health care, police
protection)
NX = Net Exports = Exports – Imports → value of currently produced goods and services exported, or sold to
other countries, minus the value of goods and services imported, or purchased from abroad.
NB:* Gross Investment; i.e. it includes investment to replace depreciated Capital. This is the reason we have
Gross Domestic Product.
Income Approach
GDP versus National Income
Definition 3 of GDP sums up the various incomes in which the value of production is distributed → all the
incomes received by households and firms in the economy, including profits and tax revenue to the govt:
• Income based GDP = compensation of employees + gross mixed income + gross operating surplus +
taxes less subsidies on products and imports.
This definition refers to income generated in the domestic economy; not the income of domestic residents. To
obtain the Gross National Income (once called Gross National Product):
• Gross National Income (GNI) = Income based GDP + primary (factor) income received from the rest
of the world – primary income paid to foreign residents.
A more meaningful concept is
• Net National Income (NNI) = GNI – Consumption of fixed capital (depreciated capital that is replaced)
4
