Notes

Measuring a Nation’s Income:

Note:

1. Also included in GDP is the rental price for a house, but if you own the house yourself it is more
difficult. The government then estimates a rental price and assumes you are renting the house
from yourself. GDP also excludes some goods such as illegal drugs or goods that never enter the
market place. If you buy vegetables at a supermarket, then it is included in GDP, but if you grow
it at home, then it is not included.
2. The term “final” refers to the fact that GDP only includes final goods. When International Paper
makes paper, which Hallmark then uses to make a greeting card, the paper is called an
intermediate good, and the card is called a final good. GDP only includes final goods, because
the value of intermediate goods is already included in the prices of final goods. Adding the
market value of the paper to the market value of the card would double the counting.
3. Produced” refers to all goods and services currently produced. If Volvo is selling new cars, then
that is included in GDP. But if someone sells his used Volvo car, then that is not included in GDP.
4. “Within a country” means that all goods and services included in GDP must be produced within
the geographic confines of a country. The wage of a Canadian worker in the US is included in the
GDP of the US, whereas a US company operating in Haiti is not included in GDP of the US but in
the GDP of Haiti.
5. The Real GDP = Nominal GDP – Inflation. And The GDP Deflator measures the amount of
deflation in a country.
6. Nominal GDP uses current prices to place a value on the economy’s production of goods and
services. Real GDP uses constant base-year prices to place a value on the economy’s production
of goods and services. Hence, the value of real GDP is not affected by a change in price.
7. We can now define the GDP deflator:
 GDP deflator = (Nominal GDP)/ (Real GDP) * 100
 The GDP deflator measures the current level of prices relative to the prices in the base
year. This is true because if only production would change and not the prices, then
nominal and real GDP would rise by the same amount and hence the GDP deflator
would be constant. If instead the prices would change too, then the GDP deflator will
also change. For example, if we calculate the GDP deflator for the year 2012 we find
that it is 240. We can use the GDP deflator also as a measure of inflation. Inflation is a
situation in which the economy’s overall price level is rising. We can define the
inflation rate as:
 Inflation rate year 2 = (GDP deflator year 2 – GDP deflator year 1)/ (GDP deflator year
1) *100
for example, the inflation rate in 2012 = 100*(240-171)/171 = 40%.
8. GDP is not a perfect measure of economic well-being, for example it does not incorporate
leisure as a contribution to life. Neither does it incorporate products that never enter the
market place nor does GDP only measure averages. Despite these problems, GDP comes the
closest to measuring economic-well-being.
 9. If the GDP Deflator or inflation is 0% then it means that the PRICES did not increase at all from
the previous year to this year. If the Real GDP did not increase and show 0%, so OUTPUT remain
the same from previous year.
10. We can analyze the economic well-being of two years in this manner. Compare both year’s Real
GDP and GDP Deflator. Suppose Year 1 have 0% (less change) in GDP Deflator so the prices did
not increase that year and have 100% change in Real GDP so Output increased that year so
overall economic well-being increased. Now, We’ll do the same and analyze for the Year 2. At
the end compare economic well-being of each year.
𝑋 𝐹𝑖𝑛𝑎𝑙 1
11. 100 × {((𝑋 𝐼𝑛𝑖𝑡𝑖𝑎𝑙)𝑁 ) − 1} used to find the growth rate between a large gap e.g. we won’t use
power if between 2004 to 2005.
12. Y is GDP = C (Consumption) + I (Investment) + G (Government Spending) + NX (Net Export=
Export – Import)

Questions:

1. What components of GDP (if any) would each of the following transactions affect? Explain?
a. Ford sells a Mustang from its inventory: Consumption increases because a car is a good
purchased by a household, but investment decreases because the car in Ford’s inventory
had been counted as an investment good until it was sold.
b. California repaves Highway 101: Government purchases increase because the government
spent money to provide a good to the public.
c. Your parents buy a bottle of French wine: Consumption increases because the bottle is a
good purchased by a household, but net exports decrease because the bottle was imported.
2. The government purchases component of GDP does not include spending on transfer
payments such as Social Security. Think about the definition of GDP, explain why transfer
payments are excluded. With transfer payments, nothing is produced, so there is no
contribution to GDP.
3. As the chapter states, GDP does not include the value of used goods that are resold. Why
would including such transactions make GDP a less informative measure of economic well-
being? If GDP included goods that are resold, it would be counting output of that particular
year, plus sales of goods produced in a previous year. It would be double-count goods that were
sold more than once and would count goods in GDP for several years if they were produced in
one year and resold in another.

Measuring the Cost of living:

Note:

1. The consumer price index is an imperfect measure of the cost of living for three reasons. First, it
does not take into account consumers’ ability to substitute toward goods that become relatively
cheaper over time. Second, it does not take into account increases in the purchasing power of the
dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the
quality of goods and services. Because of these measurement problems, the CPI overstates true
inflation.
2. The GDP deflator differs from the CPI because it includes goods and services produced rather than
goods and services consumed. As a result, imported goods affect the consumer price index but not
the GDP deflator.
3. The consumer price index is a measure of the overall cost of goods and services bought by a typical
consumer. It consists of a fixed basket and economists study the price changes of the goods in this
basket. The producer price index is used to measure inflation in an economy. There are some
problems attached to the producer price index such as the substitution bias and the introduction of
new goods. The consumer price index does not take products into accountant which have just been
produced or products that are changed in quality.
4. The nominal interest rate = normal interest rate
5. real interest rate = nominal interest rate – inflation. When Nominal value/monetary is value is
corrected for inflation, we say it has been indexed for inflation.
6. We can use price-indexes to compute what someone’s salary is worth now compared to years ago.
Babe Ruth (a famous base-ball player) earned $80.000 per year in 1930. Nowadays, the average
New York Yankee player earns $4 million per year. Government statistics show that the price index
in 1931 was 15.2 and the price index in 2009 was 214.5. Hence Ruth’s salary nowadays would be
$80.000*(214.5/15.2) = $1.128.947. This is still 4 times less than the average base-ball player, but
this has other causes such as increased standards of living and more spectators.
7. REMEMBER IN ORDER TO CALCULATE THE CPI ADD ALL (PRICES 1 X QUANTITY 1) + (PRICES 2 +
QUANTITY 2)
8. Percentage change is {(new-old)/old x 100}
9. NOTE THAT IT IS NOT MENTIONED IN THE BOOK BUT NOTES!!!!!
Real Value of some year (variable) = (Nominal Value of that year)/CPI value of that year.
10. More recent dollars in terms of past dollars = Dollar Amount × Beginning-period CPI ÷ Ending-period
CPI.
AND
Past dollars in terms of recent dollars = Dollar amount × Ending-period CPI ÷ Beginning-period CPI.

QUESTIONS:

1. If you were to learn that a bottle of Gatorade increased in size from 2011 to 2012, should that
information affect your calculation of the inflation rate? If so, how? This would lower the
estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before.
The comparison should be made on a per-ounce basis.
2. If you were to learn that Gatorade introduced new flavors in 2012, should that information affect
your calculation of the inflation rate? If so, how? More flavors enhance consumers’ well-being.
Thus, this would be considered a change in quality and would also lower the estimate of the
inflation rate.
3. See the Question 5 from Makiew Book. Answer is in photo gallery.
4. Which of the problems in the construction of the CPI might be illustrated by each of the following
situations? Explain.
a. the invention of the iPod. introduction of new goods. It can drastically alter the typical basket.
b. the introduction of air bags in cars. unmeasured quality change. The quality of the good might
have improved or decreased.
 c. increased personal computer purchases in response to a decline in their price. substitution
bias. Consumer buy other type of products.
d. more scoops of raisins in each package of Raisin Bran. unmeasured quality change.
e. greater use of fuel-efficient cars after gasoline prices increase. Substitution bias.

Production and Growth

Note:

1. Productivity is Output produced per unit worker. Determinants of Productivity are Physical
capital (stocks that produces goods and services e.g. machines), Human capital (knowledge,
education, and skills a worker have), Natural resources, technological knowledge.
2. Capital accumulation obeys the law of diminishing marginal return. This is why richer countries
experience less economic growth over time, whereas poor countries can experience high growth
rates, this is known as the catch-up effect.
3. As the stock of capital rises, the extra output produced from an additional unit of capital falls.
4. Productivity is equal to Y (GDP)/L (labor)
5. Convergence theory states that poorer countries tend to grow at a faster rate when invested in
them as compare to developed countries because of diminishing marginal return.
6. SEE CLASS NOTES AS THINGS ARE NOT MENTIONED IN BOOK
7. Physical capital, human capital, natural resources cause a shift in the growth of GDP per capita/
time graph. While technological knowledge cause steepness increase or decrease in the graph.
8. The opportunity cost of investing is the loss of consumption due to the redirection of resources.
Over-investing can result in diminishing marginal return.
9. If a country holds a factory in another country, so this kind of investment is direct foreign
investment. The factory would contribute to the GDP of the country where it is located as
productivity is increasing. But GNP of the investing country promotes more.
10. If you want to increase the number of women getting education then invest in human capital by
building more schools, universities.

Questions:

1. Suppose that society decided to reduce consumption and increase investment.

a. How would this change affect economic growth? More investment would lead to faster
economic growth in the short run.
b. What groups in society would benefit from this change? What groups might be hurt? The
change would benefit many people in society who would have higher incomes as the result of
faster economic growth. However, there might be a transition period in which workers and
owners in consumption-good industries would get lower incomes, and workers and owners in
investment-good industries would get higher incomes. In addition, some group would have to
reduce their spending for some time so that investment could rise.
2. What is the opportunity cost of investing in capital? Do you think a country can “overinvest” in
capital? What is the opportunity cost of investing in human capital? Do you think a country can
“overinvest” in human capital? Explain. The opportunity cost of investing in capital is the loss of
consumption that results from redirecting resources toward investment. Over-investment in capital
is possible because of diminishing marginal returns. A country can "over-invest" in capital if people
would prefer to have higher consumption spending and less future growth. The opportunity cost of
 investing in human capital is also the loss of consumption that is needed to provide the resources
for investment. A country could "over-invest" in human capital if people were too highly educated
for the jobs they could get – for example, if the best job a Ph.D. in philosophy could find is managing
a restaurant.
3. In the 1990s and the first decade of the 2000s, investors from the Asian economies of Japan and
China made significant direct and portfolio investments in the United States. At the time, many
Americans were unhappy that this investment was occurring.
a. In what way was it better for the United States to receive this foreign investment than not to
receive it? It made capital stock larger, and created more business opportunities. This also cause
an increase in the economic growth of the U.S.
b. In what way would it have been better still for Americans to have made this investment? It
would have been better for the United States to make the investments itself because then it
would have received the returns on the investment itself, instead of the returns going to China
and Japan.

Savings, Investment, and Financial Systems

NOTES:

1. It is better to read about in notes.

2. In closed economy no net export so zero.
3. National savings denotes the total amount saved in a country and is denoted S. We separate
national savings in private and public savings. Private savings is the amount saved by the people
and public savings is the amount saved by the government. When public savings is negative, we
say that the government runs a budget deficit. When public savings is positive we say that the
government runs a budget surplus. In a closed economy, national savings always equals
investment.
4. Remember the equation for national income: Y = C+I+G+NX.
Closed economy so, 0 NX. That makes Y= C+I+G.
Subtract C and G from both sides making Y-C-G= I.
Y-C-G represents National Savings also denoted by S and is equal to Investment.
5. If we manipulate the equation by addition and subtraction of T which are taxes. So we get:
S= (Y-C-T) + (T-G). The first part of the equation (Y-C-T) denotes the private savings while second
part (T+G) denotes Government spending.
6. If in case of second part of the upper equation, the Tax (T) is greater than the Government
spending (G) which can also be shown as T > G, so government is in Budget Surplus, but is T < G
then the government is in Budget deficit.
7. Note that the upper mentioned in equal to S (National Savings) which is Equal to I (Investment).
So the upper mentioned equation is also equal to I (investment)
8. If the person is keeping his money in banks, then that is Savings not investment.
9. The crowding out effect refers to the reduction in investment due to a rising government deficit.
10. The horizontal axis shows the quantity of money demanded and the vertical axis shows the
interest rate.
Higher the interest rates the more the people are willing to lend money because they will get
higher amount of money in return. Similarly, the person borrowing the money will demand less
of it because of higher interest rates as they have to pay back high.
 11. Suppose the government starts with a balanced budget i.e. T=G. After some time, the
government runs a deficit because of the cut in taxes or increased spending. Now the
government runs a deficit and hence national saving decreases. The effect on the market for
loanable funds is that the supply curve shifts to the left and consequently the interest rate
goes up and the quantity of loanable funds supplied decreases. Because of the higher interest
rate, potential investors are turned off. This is known as the crowding out effect: a decrease in
investment that results from government borrowing. Hence, if the government is running a
budget deficit it decreases economic growth.
12. The company/individual would pay more interest rate who/which seems riskier and less stable.
AND tax is levied or higher tax is levied on people who buy bonds from federal government.
13. To a macroeconomist, saving occurs when a person’s income exceeds his consumption, while
investment occurs when a person or firm purchases new capital, such as a house or business
equipment.
14. Note that if the tax is levied on interest-income then the supply curve shifts left or inwards and
interest rate rises while investment and quantity of funds traded decrease.
An investment tax credit increases the demand for loanable funds and interest rate rises.

Questions:

1. Explain the difference between saving and investment as defined by a macroeconomist.

Which of the following situations represent investment? Saving? Explain.
a. Your family takes out a mortgage and buys a new house. When your family takes out a
mortgage and buys a new house, that is investment because it is a purchase of new capital.
b. You use your $200 paycheck to buy stock in AT&T. When you use your $200 paycheck to
buy stock in AT&T, that is saving because your income of $200 is not being spent on
consumption goods.
c. Your roommate earns $100 and deposits it in her account at a bank. When your roommate
earns $100 and deposits it in her account at a bank, that is saving because the money is not
spent on consumption goods.
d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business. When
you borrow $1,000 from a bank to buy a car to use in your pizza-delivery business, that is
investment because the car is a capital good.
2. Three students have each saved $1,000. Each has an investment opportunity in which he or
she can invest up to $2,000. Here are the rates of return on the students’ investment projects:
 Harry 5% Ron 8% Hermione 20%
Suppose their school opens up a market for loanable funds in which students can borrow and
lend among themselves at an interest rate r. What would determine whether a student would
choose to be a borrower or lender in this market? Each student would compare the expected
rate of return on his or her own project with the market rate of interest (r). If the expected rate
of return is greater than r, the student would borrow. If the expected rate of return is less than
r, the student would lend.
3. c. Among these three students, what would be the quantity of loanable funds supplied and
quantity demanded at an interest rate of 7 percent? At 10 percent? If r = 7%, Harry would want
to lend while Ron and Hermione would want to borrow. The quantity of funds demanded would
be $2,000, while the quantity supplied would be $1,000. If r = 10%, only Hermione would want
to borrow. The quantity of funds demanded would be $1,000, while the quantity supplied would
be $2,000.
4. At what interest rate would the loanable funds market among these three students be in
equilibrium? At this interest rate, which student(s) would borrow, and which student(s) would
lend? The loanable funds market would be in equilibrium at an interest rate of 8%. Harry would
want to lend and Hermione would want to borrow. Ron would use his own savings for his
project, but would want to neither borrow nor lend. Thus, quantity demanded = quantity
supplied = $1,000.
5. At the equilibrium interest rate, how much does each student have a year later after the
investment projects pay their return and loans have been repaid? Compare your answers to
those you gave in part (a). Who benefits from the existence of the loanable funds market—the
borrowers or the lenders? Is anyone worse off? Harry will have $1,000(1 + 0.08) = $1,080. Ron
will have $1,000(1 + 0.08) = $1,080. Hermione will have $2,000(1 + 0.20) – $1,000(1 + 0.08) =
$2,400 – $1,080 = $2,320. Both borrowers and lenders are better off. No one is worse off.

The basic tools of Finance:

Note:

1. What is $100 worth after N years, that is, what is the future value. If the interest rate is R, then
after 1 year the $100 is worth $100*(1+R). After 2 years this is $100*(1+R) ^2 and hence after N
years my $100 is worth $100*(1+R) ^N.
2. If I get $200 after N years, the present value of that $200 is just $200/(1+R) ^N.
3. People often have to make a trade-off between risk and return, because a portfolio with low risk
offers lower return.
4. Suppose you want to spend 60% of your saving into stock. You choose for a diversified portfolio
with 20 different stocks. Which stocks should you buy? To choose the businesses that you are
going to invest in, it is natural to consider 2 things:
the value of that share of the business and the price at which the shares are being sold. If the
price of the share is lower than the value of the business, the share is said to be undervalued. If
the price is more than the value, the share is said to be overvalued. When the share is equal to
the value, it is called fairly evaluated. You would prefer shares which are undervalued because
you are making a good bargain by paying less than the business is worth.
5. The bond rate falls as interest rate increase. And bonds that take more time to reach to maturity
are more sensitive.
 6. Positive relation with stock return and risk.

Questions

1. A company has an investment project that would cost $10 million today and yield a payoff of
$15 million in 4 years.

Should the firm undertake the project if the interest rate is 11 percent? 10 percent? 9
percent? 8 percent? (10 x1.114) = $15.18 million. This is more than the
“expected payoff," so investing in it is essentially a loss of money. The firm
should NOT invest.

10percent? (10 x1.14) = $14.64 million YES! This is less than the expected
payoff, so the firm SHOULD invest!

9 percent? (10 x1.094) = 9% < 10%, so this will automatically be lower than
the expected payoff. YES - INVEST!

8 percent? (10 x1.084) = YES