▪ Microeconomics:

– study of how households and firms make decisions and

– how these decision-makers interact in the market
– pursue own interests (profit /utility optimization)

▪ Macroeconomics: focuses on the behavior of an economy as a

whole
– Eg. Why some countries experience rapid growth in
incomes while others seem to be trapped in poverty?
Objective: meaning and measurement of the most important
macroeconomic statistics:
– GDP
– CPI

▪ The statistic(s) that economists and policymakers use most

often
– Gross domestic product (GDP)
– the nation’s total income and the total expenditure on its
output of goods and services

▪ Consumer price index (CPI)

– measures the level of prices.
The Circular Flow
In every transaction, the buyer’s expenditure becomes the seller’s
income.
Thus, the sum of all expenditure equals the sum of all income.

GDP
1.Total expenditure on domestically-produced final goods and services

2.Total income earned by domestically-located factors of production

Expenditure equals income because

every Rs spent by a buyer
becomes income of the seller.
▪ Gross domestic product (GDP)
= the market value of all final goods and
services produced within an economy in a
given period of time
 Real vs. Nominal GDP
▪ GDP = value of all final goods and services produced.

Eg. GDP = (Price of Apples × Quantity of Apples) + (Price of

Oranges × Quantity of Oranges)

▪ Nominal GDP measures these values using current prices.

▪ Can we use Nominal GDP to measure economic well being of a

country?
Changes in nominal GDP can be due to:
▪ changes in prices
▪ changes in quantities of output produced

▪If all prices doubled without any change in quantities, nominal

GDP would double

▪it would be misleading to say that the economy’s ability to

satisfy demand has doubled, because the quantity of every good
produced remains same
▪ Real GDP measures GDP using the prices of a “base year”
– value of goods and services measured using a constant set
of base year prices

▪ Real GDP shows what would have happened to expenditure on

output if quantities had changed but prices had not.

Changes in real GDP can only be due to changes in quantities,

because real GDP is constructed using constant base-year prices.
 how real GDP is computed
▪ Suppose we want to compare output in 2009 with output in
subsequent years

▪ Choose a set of prices, called base-year prices = prices that

prevailed in 2009

▪ Real GDP (2009)

= (2009 Price of Apples × 2009 Quantity of Apples)+ (2009
Price of Oranges × 2009 Quantity of Oranges)

▪ Real GDP (2010)

= (2009 Price of Apples × 2010 Quantity of Apples)
+ (2009 Price of Oranges × 2010 Quantity of Oranges).
 2002 2003 2004
P Q P Q P Q
good A 30 900 31 1,000 36 1,050

good B 100 192 102 200 100 205

▪ Compute nominal GDP in each year

▪ Compute real GDP in each year using
2002 as the base year.
Nominal GDP multiply Ps & Qs from same year
2002: 46, 200 = 30 × 900 + 100 × 192
2003: 51, 400
2004: 58, 300

Real GDP multiply each year’s Qs by 2002 Ps

2002: 46, 200
2003: 50, 000
2004: 52, 000 = 30 × 1050 + 100 × 205
 GDP Deflator
▪ One measure of the price level is
the GDP Deflator, defined as

▪ reflects what’s happening to the overall level of prices in the

economy.
 ▪ Using GDP deflator to compute the inflation
rate
GDP Inflation
Nom. GDP Real GDP
deflator rate
2002 46,200 46,200 100.0

2003 51,400 50,000 102.8 2.8%

2004 58,300 52,000 112.1 9.04%

 Understanding the GDP deflator
Example with 3 goods
For good i = 1, 2, 3
Pit = the market price of good i in month t
Qit = the quantity of good i produced in month
t
NGDPt = Nominal GDP in month t
RGDPt = Real GDP in month t
Understanding the GDP deflator

The GDP deflator is a weighted sum of prices.

The weight on each price reflects that good’s relative importance
in RGDP.
Note that the weights change over time.
Measuring Cost of Living: CPI
▪ Rs x today cannot buy as much as it did twenty years ago.

▪ The cost (price) of almost everything has gone up.

▪ increase in the overall level of prices is called inflation

▪ CPI is one measure of Cost of Living

1. Survey consumers to determine composition of the typical
consumer’s “basket” of goods.
2. Every month, collect data on prices of all items in the basket;
compute cost of basket
3. CPI in any month equals
▪ suppose that the typical consumer buys 5 apples and 2
oranges every month.

▪ Then the “basket” consists of 5 apples and 2 oranges

▪ CPI with 2009 base year=

(5 × Current Price of Apples + 2 × Current Price of Oranges)
/
(5 × 2009 Price of Apples + 2 × 2009 Price of Oranges)
 Suppose a typical student basket contains
20 pizzas and 10 DVDs

prices: For each year, compute

pizza DVD ▪ the cost of the basket
2002 10 15 ▪ the CPI (use 2002 as
2003 11 15 the base year)
2004 12 16 ▪ the price change from
2005 13 15 the preceding year
 cost of
basket CPI
2002 350 100.0
2003 370 105.7 5.7%
2004 400 114.3 8.1%
2005 410 117.1 2.5%
 Understanding the CPI
Example with 3 goods
For good i = 1, 2, 3
Ci = the amount of good i in the CPI’s
basket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month t
Eb = the cost of the basket in the base
period
 Understanding the CPI

The CPI is a weighted sum of prices.

The weight on each price reflects that good’s relative importance in
the CPI basket.
Note that the weights remain fixed over time.
 CPI vs. GDP Deflator
▪ GDP deflator measures the prices of all goods and services
produced
▪ whereas the CPI measures the prices of only the goods and
services bought by consumers.
– Thus, an increase in the price of goods purchased only by
firms or the government will show up in the GDP deflator
– but this will not be reflected in the CPI.
▪ GDP deflator includes only those goods produced domestically.
Imported goods are not part of GDP and do not show up in
the GDP deflator.

Eg. increase in the price of Toyota (made in Japan) which is

purchased (imported) by Indians

- this would affect the CPI, because the cars are purchased
by consumers
- but it does not affect the GDP deflator.
 CPI vs. GDP Deflator
The “basket of goods”
● CPI: fixed
● GDP deflator: composition of goods changes every year

▪ Implication
▪ Suppose a major earthquake in North India affects entire tea
production.
▪ The quantity of tea produced =0, and the price of tea remaining in
the market increases.
▪ Tea is no longer part of GDP, the increase in the price of tea does
not show up in the GDP deflator.
▪ Since CPI is computed with a fixed basket of goods that includes
tea, the increase in the price of tea causes a substantial rise in the
CPI
 CPI may overstate inflation
▪ Substitution bias:
▪ The CPI uses fixed weights, so it cannot reflect consumers’ ability to
substitute toward goods whose relative prices have fallen.
– Thus CPI overstates the impact of the increase in tea prices on
consumers
 Why do we care about GDP
▪ how a person is doing economically
– income is an indicator

▪ When judging whether the economy is doing well or poorly, it

is natural to look at the total income that everyone in the
economy is earning.

▪ GDP is a measure of how well the overall economy is

performing
 GDP = market value of all final goods
and services produced within a
country in a given period of time
“GDP IS THE MARKET VALUE . . .”
– GDP adds together different kinds of products and services
into a single monetary measure of the value of economic
activity

“OF ALL . . .”
- Comprehensive measure
– It includes all items produced in the economy and sold
legally in markets

– Note: excludes items that are produced and consumed at

home and, therefore, never enter the marketplace
– Vegetables you buy at the grocery store are
part of GDP
- vegetables you grow in your garden are not
▪ “FINAL . . .”
- International Paper makes paper, which Hallmark uses to
make a greeting card
- the paper is an intermediate good, and the card is final
good.
- GDP includes only the value of final goods

▪ Adding the market value of the paper to the market value of

the card would be double counting.
▪ That is, it would (incorrectly) count the paper twice.
 “GOODS AND SERVICES . . .”
– GDP includes both tangible goods (food, clothing, cars) &
– intangible services (haircuts, doctor visits, music concert)

“PRODUCED . . .”
– GDP includes goods and services currently produced.
– It does not include transactions involving items produced in
the previous years.

– Eg. Tata produces and sells a new car, the value of the car
is included in GDP.
– When one person sells a used car to another person, the
value of the used car is not included in GDP.
“WITHIN A COUNTRY . . .”
▪ GDP measures the value of production within the geographic
boundary of a country.

Indian citizen works temporarily in the US:

- his/her production is part of US GDP.
- It is not part of India’s GDP

Ford owns a car factory in Gujarat:

- the production of the factory is not part of US GDP.
- It is part of India’s GDP.

Items are included in a nation’s GDP if they are produced

domestically, regardless of the nationality of the producer
 COMPONENTS OF GDP
▪ Consider different types of expenditure on goods & services:

▪ Consumer having lunch at McD

▪ TATA builds a car factory in Gujarat
▪ Navy procures a submarine produced in India
▪ Indian Railways buys a train from local manufacturer

▪ GDP includes all of these various forms of spending /

expenditure on domestically produced goods and services

Key: output produced within boundary of a country

 Some conventions
▪ Important to understand the composition of GDP in terms of
various types of spending
– Understand whose expenditure

Y =C + I + G + X-M
Aggregate Income = Aggregate Expenditure

C: Consumption spending by households on goods

and services
- eg. cars, food, clothing, air travel, education
- exception: purchases of new housing

I: Investment is the purchase of capital equipment,

inventories
- eg. Spending on plant and equipment that firms use to
produce other goods & services
- includes expenditure on new housing
 Some conventions
Y = C + I + G + X-M
▪ G: government purchases
- spending on goods and services by government
- eg. expenditure on defense goods, primary education
- purchase of domestically produced cars for govt. employees

▪ X-M (net exports)

= domestically produced goods/services purchased by foreigners
(exports)
– purchases of foreign produced goods/services (imports) by
domestic consumers

▪ Exported goods/services
▪ TCS exports IT services to BritishTelecom

▪ Imported goods/services are produced abroad

– Hence subtracted to obtain the expenditure on g&s produced
within a country
 Evaluation of GDP
GDP is not a perfect measure of well-being

GDP does not measure the health of children

– but nations with larger GDP can afford better health care
for their children

– GDP uses market prices to value goods and services, it

excludes the value of activities that takes place outside of
markets.

– In particular, GDP omits the value of goods and services

produced at home.

– When a chef prepares a meal and sells it at his restaurant,

the value of that meal is part of GDP
– GDP excludes food cooked at home
▪ GDP excludes the quality of the environment

▪ Suppose government eliminates all environmental regulations.

▪ Firms could then produce goods and services without
considering the pollution they create, and GDP would increase!

▪ Yet well-being would most likely fall.

▪ The deterioration in the quality of air and water would more
than offset the gains from greater production (increased GDP)
▪ GDP also says nothing about the distribution of income.

▪ A society in which100 people have annual incomes of 50,000

has GDP of 5 million and, GDP per person of 50,000.

▪ So does a society in which 10 people earn 500,000 and 90

suffer with nothing at all !
INTERNATIONAL DIFFERENCES IN GDP AND
THE QUALITY OF LIFE
▪ Rich and poor countries have vastly different levels of GDP per
person.

▪ If large GDP leads to a higher standard of living, then we

should observe GDP to be strongly correlated with measures of
the quality of life.

▪ In rich countries, (United States, Japan, Germany), people can

expect to live longer, and almost entire population is literate.

▪ In poor countries, (Nigeria, Bangladesh, Pakistan), people

typically have shorter life expectancy, and only about half of
the population is literate.
▪ Goods and services that are not sold in markets, such as food
produced and consumed at home, are not included in GDP.

▪ this might cause the numbers to be misleading in a

comparison of the economic wellbeing of the United States
and India
▪ In general, international data reveals:
▪ Countries with low GDP per person tend to have
– more infants with low birth weight,
– higher rates of infant mortality, maternal mortality,
– higher rates of child malnutrition,
– less access to food and safe drinking water

▪ GDP is closely associated with its citizens’

standard of living.
 exercise
▪ Volvo raises the price of its cars.
▪ Volvo cars are made in Sweden, the car is _____ of India’s
GDP.

▪ Indian consumers buy Volvos, and suppose car is part of the

typical consumer’s basket of goods & services
▪ Hence, a price increase in an imported consumption good
shows up in the ________ but not in the ____________
▪ Volvo raises the price of its cars.
▪ Volvos are made in Sweden, the car is not part of India’s GDP.
– Its import (our expenditure on foreign output) and hence
subtracted

▪ Indian consumers buy Volvos, and so the car is part of the

typical consumer’s basket of goods.
▪ Hence, a price increase in an imported consumption good
shows up in the CPI but not in the GDP deflator
▪ >75% of the oil we use is imported

▪ As a result, oil and oil products comprise a much larger share

of consumer spending

▪ When the price of oil rises, the CPI rises by much more than
does the GDP deflator.
Y=C+I+G+X-M