Macro economics

INTRODUCTION

1
Ten Principles of Economics

Economy. . .
. . . The word economy comes from a Greek word for one who manages a household.

Ten principles of economics

A household and an economy face many decisions:

Who will work? What goods and how many of them should be produced? What resources should be used in production? At what price should the goods be sold?

Ten principles of economics (Contd.)

Society and Scarce Resources:

The management of societys resources is important because resources are scarce. Scarcity. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have.

Ten principles of economics (Contd.)

Economics is the study of how society manages its scarce resources.

Ten principles of economics (Contd.)

How people make decisions.

People face tradeoffs. The cost of something is what you give up to get it. Rational people think at the margin. People respond to incentives.

Ten principles of economics (Contd.)

How people interact with each other.

Trade can make everyone better off. Markets are usually a good way to organize economic activity. Governments can sometimes improve economic outcomes.

Ten principles of economics (Contd.)

The forces and trends that affect how the economy as a whole works.
The standard of living depends on a countrys production. Prices rise when the government prints too much money. Society faces a short-run tradeoff between inflation and unemployment.

Principle #1: People face tradeoffs.

There is no such thing as a free lunch!

Principle #1: People face tradeoffs

(Contd.)

To get one thing, we usually have to give up another thing.

Guns v. butter Food v. clothing Leisure time v. work Efficiency v. equity

Making decisions requires trading off one goal against another.

Principle #1: People face tradeoffs

(Contd.)

Efficiency v. Equity
Efficiency means society gets the most that it can from its scarce resources. Equity means the benefits of those resources are distributed fairly among the members of society.

Principle #2: The cost of something is what you give up to get it.

Decisions require comparing costs and benefits of alternatives.

Whether to go to college or to work? Whether to study or go out on a date? Whether to go to class or sleep in?

The opportunity cost of an item is what you give up to obtain that item.

Principle #2: The cost of something is what you give up to get it. (Contd.)
LA Laker basketball star Kobe Bryant chose to skip college and go straight from high school to the pros where he has earned millions of dollars.

Principle #3: Rational People Think at the Margin.

Marginal changes are small, incremental adjustments to an existing plan of action.

People make decisions by comparing costs and benefits at the margin.

Principle #4: People Respond to Incentives.

Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternatives marginal benefits exceed its marginal costs!

Principle #5: Trade Can Make Everyone Better Off.

People gain from their ability to trade with one another. Competition results in gains from trading. Trade allows people to specialize in what they do best.

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity.

A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.
Households decide what to buy and who to work for. Firms decide who to hire and what to produce.

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity.

Adam Smith made the observation that households and firms interacting in markets act as if guided by an invisible hand.
Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole.

Principle #7: Governments Can Sometimes Improve Market Outcomes.

Market failure occurs when the market fails to allocate resources efficiently. When the market fails (breaks down) government can intervene to promote efficiency and equity.

Principle #7: Governments Can Sometimes Improve Market Outcomes (Contd)

Market failure may be caused by

an externality, which is the impact of one person or firms actions on the well-being of a bystander. market power, which is the ability of a single person or firm to unduly influence market prices.

Principle #8: The Standard of Living Depends on a Countrys Production.

Standard of living may be measured in different ways:

By comparing personal incomes. By comparing the total market value of a nations production.

Principle #8: The Standard of Living Depends on a Countrys Production.(Contd.)

Almost all variations in living standards are explained by differences in countries productivities. Productivity is the amount of goods and services produced from each hour of a workers time.

Principle #8: The Standard of Living Depends on a Countrys Production.(Contd.)

Standard of living may be measured in different ways:

By comparing personal incomes. By comparing the total market value of a nations production.

Principle #9: Prices Rise When the Government Prints Too Much Money.
Inflation is an increase in the overall level of prices in the economy. One cause of inflation is the growth in the quantity of money. When the government creates large quantities of money, the value of the money falls.

Principle #10: Society faces a short-run tradeoff between inflation & unemployment.

The Phillips Curve illustrates the tradeoff between inflation and unemployment: Inflation Unemployment Its a short-run tradeoff!

Summary
When individuals make decisions, they face tradeoffs among alternative goals. The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits. People change their behavior in response to the incentives they face.

Summary (Contd.)
Trade can be mutually beneficial. Markets are usually a good way of coordinating trade among people. Government can potentially improve market outcomes if there is some market failure or if the market outcome is inequitable.

Summary (Contd.)
Productivity is the ultimate source of living standards. Money growth is the ultimate source of inflation. Society faces a short-run tradeoff between inflation and unemployment.

What is macroeconomics?
Macroeconomics considers the performance of the economy as a whole. We try to understand changes in

Macroeconomics also includes an evaluation of the relative success or failure of government economic policies

The rate of economic growth The rate of inflation Unemployment Our trade performance with other countries

So what is the economy?

The economy is made up of four sectors sometimes called economic agents: Households who receive payments (income) for their services (eg labour and land) and use this money to buy the output of firms (ie consumption or household spending). Firms who use land labour and capital to produce goods and services for which they pay wages rent etc (income) and receive payment (expenditure) Government (also known as the public or state sector) and International eg consumers buying overseas products (M) and Foreigners buying UK products (X)

Difference between micro & macro

Microeconomics Recession in the tourist industry due to the global downturn A government subsidy to steel producers A recession in the textiles industry Increased spending on the National Health Service

Microeconomics and Macroeconomics

Microeconomics

focuses on the individual parts of the economy.

How households and firms make decisions and how they interact in specific markets

Macroeconomics

as a whole.

looks at the economy

How the markets, as a whole, interact at the national level.

Microeconomics is the study of how households and firms make decisions and how these decision makers interact in the broader marketplace. In microeconomics, an individual chooses to maximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many individuals trying to maximize their own welfare. Because aggregate variables are the sum of the variables describing individuals decisions, the study of macroeconomics is based on microeconomic foundations.

The Essence of MicroeconomicsBuyers and Sellers

The Many Facets of Macroeconomics

Key Concepts

Gross Domestic Product (GDP)

The monetary value of all goods and services produced within India in a given time period

Real GDP
The volume of goods and services produced within the UK (i.e. GDP adjusted for changes in the price level)

Economic Growth
The percentage rate of increase of real GDP

Inflation
The annual percentage rate of change of the general price level

The Economys Income and Expenditure

For an economy as a whole, income must equal expenditure because:

Every

transaction has a buyer and a seller. Every rupee of spending by some buyer is a rupee of income for some seller.
Says

Law-Supply creates its own demand This process can be seen using a Circular Flow Diagram.

Gross Domestic Product

Gross domestic product (GDP) is a measure of the income and expenditures of an economy. It is the total market value of all final goods and services produced within a country in a given period of time. How much is the current GDP?

The Circular-Flow Diagram

Revenue Goods & Services sold

Market for Goods and Services

Spending Goods & Services bought

Firms

Households

Inputs for production Wages, rent, and profit

Market for Factors of Production

Labor, land, and capital Income

The Components of the Macroeconomy

Everyones expenditure is someone elses receipt. Every transaction must have two sides.

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National Income Accounting: Important Identities

Microeconomics

Microeconomics

is the study of how individual households and firms make decisions and how they interact with one another in markets.

Macroeconomics
Macroeconomics
Its

is the study of the economy as a whole.

goal is to explain the economic changes that affect many households, firms, and markets at once.

Macroeconomics
Macroeconomics
Why

answers questions like the following:

is average income high in some countries and low in others? Why do prices rise rapidly in some time periods while they are more stable in others? Why do production and employment expand in some years and contract in others?

The Economys Income and Expenditure

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.

IN ORDER TO EVALUATE THE PERFORMANCE OF OUR ECONOMIC SYSTEM IN TERMS OF:

How rapidly it is growing, How stable it is, How it allocates its productive resources to different end products- we need some measure of output & income

Strangely enough however, it was not until the 1930s that reliable overall figures on Y & output were produced. The main reason was that until the 1930s most economists concerned themselves not so much with the overall performance of the economy (i.e. macroeconomics) but with the price system& the allocation of resources (i.e. microeconomics)

The coming of the GREAT DEPRESSION of the 1930s forced economists to devote attention to the overall level of economic activity. To measure the depth of depression & the extent of recovery, it was important to construct data on National Output & Y These accounts supply the most valuable data we have about our economy

Are we interested in forecasting the level of economic activity next year??? -data on output, spending & Yavailable to base our forecast -Do we wish to study long term economic growth????- the historical data in NIA show output growth in the past, its growth compared with population or labour force, & proportion of output devoted to growth stimulating I

Are we intersted in the distribution of Y between wages & profit???data available in components of Y

The Economys Income and Expenditure

For

an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every Rs. of spending by some buyer is a dollar of income for some seller.

National Income Accounts: Provide the formal structure for our macro-theory models Aggregate Demand.aggregate income..consumed or invested Aggregate Supply.Total output..paid as wages, interest and dividends In equilibrium.Aggregate Demand=Aggregate Supply (growth) Inputs=Outputs Real output price level Broad magnitudes to characterize the economy

GROSS DOMESTIC PRODUCT

It is the value of all goods & services produced annually in the nation. GDP is a flow, it is an amount of production Per unit of time

Basic Measures:
Gross Domestic Product (GDP) is the value of final goods and services produced in the country within a given period

Notable terms final goods Intermediate goods Value Added Past output vs. current outputs Measure of welfare Use of resources to avoid bads such as crime Improvement in the quality in the country

GDP = ALL THE FINAL GOODS & SERVICES PRODUCED IN THE DOMESTIC TERRITORY OF INDIA

GNP = GDP + NET EXPORTS NNP = GNP DEPRICIATION NI = NNP INDIRECT TAXES + SUBSIDIES

PRODUCTIVE & NON-PRODUCTIVE ACTIVITIES

Goods & services which enter into the circle of exchange = PRODUCTIVE

-FRANCE= SATELITE ACOUNTS

Factors of production.labor, capital, land GDP= sum of payments to labor, capital, land and profits
Gross National Product (GNP) GDP+receipts from abroad made as factor payments to domestically owned factors of production.

Net Domestic Product

GDP minus depreciation Depreciation is usually 11% NDP=89% of GDP

National Income
NDP-Indirect taxes that Business pay Indirect taxes that Business pay nearly 10% NI is nearly 90% of NDP

PI is the total income received whether it is earned or unearned by the households of the economy before the payment of personal taxes.
It is found by adding transfer payments to and subtracting social security contributions, corporate income taxes and undistributed corporate profits from the NI. DI is the total income available to households after the payment of personal taxes. It is equal to PI less personal taxes and also equal to personal consumption expenditures plus personal saving.

S. No.
1.

Countries
United States

GDP in 2003 $million

10,881,609

GDP in 2010 $million *

14,580,000

2. 3. 4. 5. 6. 7. 8. 9. 10.

Japan Germany U.K. France Italy China Spain Canada Mexico

4,326,444 2,400,655 1,794,858 1,747,973 1,465,895 1,409,852 836,100 834,390 626,080

5,500,000 3,310,000 2,250,000 2,560,000 2,050,000 5,880,000 1,410,000 1,570,000 1,040,000

* Source: World Bank, World Development Indicators

GDP: An important and versatile concept We will see that GDP measures total income total expenditure total output the sum of value-added at all stages in the production of final goods

With government and foreign agents

a. Government purchases of goods and services. b. Government payments for factor services (wages, rent, interest). c. Transfer payments between different agents. d. Firms and households pay taxes to government. e. Taxes paid on income, property, goods and services. f. Transactions with the foreign sector.

Need to account for :

Transfer payments

Transfer payments are transactions wherein one party is not obliged to deliver a good or service in return for the payment. Examples: retirement benefits, unemployment benefits, scholarships, and donations.

Transactions with foreign sector

Includes sales of goods and services, assets, and transfers Exports - sales of domestically produced goods to other countries Imports - goods bought from other countries

Measurement of economys output: The Gross Domestic Product (GDP)

The GDP measures the market value of all final goods and services produced within an economy in a given period. GDP only measures current production. Transfer payments and transactions involving goods produced in other periods are not included in the calculation of GDP. GDP is usually expressed in the currency of a particular country, e.g., Philippine peso.indicates the market value of the goods and services

Definition of GDP

The market value of good i (Vi) is equal to PiQi GDP = sum of the market values of all final goods and services produced within the year.

GDP

V P
i1 i i1

Qi

GDP includes final goods and services only

Final goods - goods and services that are not purchased for the purpose of producing other goods and services or for resale

Eg. Rice (final) and palay or unhusked rice (intermediate product)

Including intermediate goods and final goods will result in double counting.

3 Approaches for measuring GDP

1. Expenditure Approach (upper loop) measures GDP
as the sum of expenditures on final goods and services.

2. Income Approach (lower loop) measures GDP as

the sum of incomes of factors of production (wages, rent, interest and profit.

3. Value-added Approach measures GDP as the sum of

value added at each stage of production (from initial to final stage)

Expenditure Approach
Uses the upper loop of the circular flow diagram. Example: Suppose the economy has only one product, namely, rice.

Good Rice

Price per unit 20

Q sold 1000

Expenditure 20,000

GDP

20,000

Income Approach

Uses the lower loop of the circular flow diagram: sum of payments to the various factors of production. Suppose that in the production of rice the sales and expenses are as follows: P 20,000 8000 4000 2000

Sales Expenses: Wages Rent Interest

Total Profit GDP=Sum of Payments to factors

14,000 6,000 20,000

P 20,000

Value Added Approach

Suppose that rice is the only final product of an economy: It goes through several (3) stages of production. Value of intermediate good 12,000 15,000

Stage of Prodn Farmer - Palay Rice Miller -Milled Rice Retailers - Rice GDP= Total Value Added

Value of Sales 12,000 15,000 20,000

Value-added 12,000 3,000 5,000 20,000

Notes of the 3 approaches

The expenditure approach, income approach, and the valueadded approach all come up with the same estimate of the GDP. They are equivalent approaches.

In the income approach, profit is also considered a payment to the entrepreneur. So the incomes are (1) wages, (2) rent, (3) interest, and (4) profit. Profit adjusts to make the sum equal to the final value of the good.

Notes of the 3 approaches (Contd)

In the value added approach, only the value added in each stage of production are included. If we add the value of intermediate product with the value of the final product, we commit the sin of double-counting. At each stage of production, the value-added is equal to wages, interest, rent, and profit. Therefore the value of the final product is likewise the same of all payments to the factors of production

Additional Topics
GDP vs GNP Real vs current GDP Inter-country comparisons of GDP

Convert to international currency like US dollars Convert to per capita measures

THE NATIONAL ACCOUNTS OF THE PHILIPPINES

Same principles as above but need to make adjustments in order to accommodate the realities in modern economies Expenditure approach

GDP = C + G + I + X M+ SD

Table. Expenditures on GDP, 2002 in million pesos.

Item
Personal Consumption Expenditure Government Consumption Expenditure Gross Domestic Capital Formation Exports of Goods and Services Less: Imports of Goods and Services Statistical Discrepancy Gross Domestic Product

Symbol
C G

Value
2,750,9000 488,700

I X M SD GDP

776,200 1,968,500 1,989,100 27,500 4,022,700

Expenditure Approach

C - spending of households and private non-profit institutions on goods and services Non-durables - goods and services that are consumed rapidly Durable goods - that last for a longer period of time

I - investment spending of domestic agents. Its major components are changes in Fixed Capital and Changes in Stocks

G - governments payments for the salaries of its workforce as well as purchases of goods and services used for the governments day to day operations and projects.

Expenditure Approach (Contd)

X - the spending of the rest of the world on goods and non-factor services produced in the country

Mthe countrys purchases of goods and non-factor services from the rest of the world.

SD - accounts for accounting and reporting errors in the accounts. Needed to ensure that GDP value from all approaches are the same

Income Approach
ITEMS Compensation of Employees Net Operating Surplus SYMBOLS COE NOS VALUE 1,093,800 2,215,100

Depreciation Indirect Business Taxes less Subsidies Gross Domestic Product

D IBTS
GDP

357,200 356,600
4,022,700

Income Approach

GDP = COE + NOS + D + IBTS In a simple world, GDP = COE + NOS. In practice, require two adjustments (D and IBTS)

D - accounts for the wear and tear of physical capital

D is treated as a business cost not included in NOS. However, D is part of I in the expenditure side of the national accounts

Income Approach (Contd.)

IBTS - includes taxes on the use or purchase goods and services and grants from government to firms. E. g sales taxes, value added tax

Not included in NOS but is part of the market prices, of which

the items in the expenditure accounts are quoted

Value added or Industrial Origin approach

GDP = value added of different activities (sectors)

ITEM Agriculture, Fishery and Forestry Industry Services Gross Domestic Product

VALUE 519,400 1,307,400 2,123,900 4,022,700

The distinction between GDP and GNP

GNP = GDP + Net Factor Income from the Rest of the World (NFIRW)

NFIRW - measures the difference between the earnings of Philippine residents in other countries and foreign residents in the Philippines

The distinction between GDP and GNP

Gross Domestic Product GDP 4,022,700

Net Factor Income from the Rest of the World Gross National Product

NFIRW

267,500

GNP

4,290,200

Nominal and Real GDP

GDP at current prices or nominal GDP - GDP measured using the prices of the year for which it is calculated Nominal GDP can be a misleading indicator of changes in output or income because it also embodies changes in the prices of goods and services. Real GDP or GDP at constant prices measures the total value of output using the prices of a selected year (the base year). Real GDP better for analysis overtime because it eliminates the effects of price changes

Table 8.5
YEAR 1 QUANTITY YEAR 2

Ice Cream Buko Pie PRICE Ice Cream Buko Pie VALUE Ice Cream Buko Pie NOMINAL GDP

100 100 50 100 5,000 10,000 15,000

100 100 100 200 10,000 20,000 30,000

GDPyear 1 = (100) (50) + (100) (100) = 15,000

GDPyear 2 = (100) (50) + (100) (100) = 15,000

In practice, calculating real GDP using the previous approach is a tedious process because there are so many goods and services are produced in an economy. Can simplify the calculation process by using the GDP deflator.
GDP deflator - a price index that allows us to convert nominal GDP into real GDP. (note: price index to be defined later)

Real GDP

Nominal GDP Real GDP 100. GDP deflator

Investment vs. Capital Capital is one of the factors of production. At any given moment, the economy has a certain overall stock of capital. Investment is spending on new capital.

Investment vs. Capital Example (assumes no depreciation): 1/1/2002: economy has $500b worth of capital during 2002: investment = $37b 1/1/2003: economy will have $537b worth of capital

Stocks vs. Flows Flow Stock

More examples: stock flow a persons wealth a persons saving # of people with # of new college college degrees graduates the govt. debt the govt. budget deficit

A question for you: Suppose a firm produces $10 million worth of final goods but only sells $9 million worth. Does this violate the expenditure = output identity?

Why output = expenditure Unsold output goes into inventory, and is counted as inventory investment . .whether the inventory buildup was intentional or not. In effect, we are assuming that firms purchase their unsold output.

The Income Approach

The income approach divides GDP according to who receives the income from the spending flow. In addition to aggregate income, national income and personal income are also used as measures of income.

The income approach

The Income Components Include: Wages and salaries Corporate profits Proprietors income (the profits of partnerships and soley owned businesses, like a family restaurant) Farm income Rent Interest Sales taxes Depreciation (the amount of capital that has worn out during the year)

Interest (only the interest payments made by business firms are included and the interest payments made by government are excluded). Corporate profits which are subdivided into Corporate income taxes Dividends Undistributed corporate profits

Three additions are made to the income side to balance it with expenditures.

1.Indirect business taxes are added because they are initially income that later gets paid to government.
2.Depreciation or the consumption of fixed capital is added because it is initially income to businesses that later gets deducted in calculating profits. 3.Net foreign factor income is added because it reflects income from all domestic output regardless of the foreign or domestic ownership of domestic resources.

The Production Approach

The production approach looks at GDP from the standpoint of value added by each input in the production process. The three approaches--spending, income, and production (should) result in equivalent values for GDP.

Below is a list of domestic output and national income figures for a given year. All figures are in billions. Determine the major national income measures by both the Expenditures and income methods.
Personal consumption expenditures Net foreign factor income earned in the U.S. Transfer payments Rents Consumption of fixed capital (depreciation) $245 0004 0012 0014 0027

Social security contributions Interest

Proprietors income Net exports Dividends Compensation of employees Indirect business taxes Undistributed corporate profits Personal taxes Corporate income taxes Corporate profits Government purchases Net private domestic investment Personal saving

0020 0013
0033 0011 0016 0223 0018 0021 0026 0019 0056 0072 0033 0020

Simple Economy..No govtno foreign trade C=consumption I=investment S=saving Y= Income Output produced=output sold Y= C+I.(1) I=S Y=C+S(2)

Introducing govt. in the above identity

G= govt. purchases of goods and services TA=all taxes TR=transfers to private sector (including interest) NX=net exports (exports-imports) YD=disposable income Y=C+I+G+NX.(3) YD=Y+TR-TA..(4) YD= C+S(5) C+S=Y+TR-TA

LEAKAGES (Withdrawals (W) : (T + S + IM) out of the system must equal INJECTIONS (J): (G + I + X) for the circular flow to balance (be in EQUILIBRIUM). Withdrawals [ T + S + IM] = Injections [G + I + X] can be broken down to three important balances in the economy:

1.
2. 1.

T - G: the Government's Budgetary Balance;

S - I: the Private Sector's Saving/Investment Balance; IM - X: the Country's Trade Balance (current account of Balance of Payments)

C=YD-S=Y+TR-TA-S..(6) Consumption is disposable income less saving Or consumption is equal to income plus transfers less taxes and saving Using RHS of (6) in (3): Y=C+I+G+NX.(3) Y= (Y+TR-TA-S)+ I+G+NX S-I=(TR-TA+G)+NX(7) Govt. budget deficit,I.e., total govt. expenditure consisting of govt. Purchases of goods and services(G) plus govt. transfer payments (TR) Minus amount of taxes (TA) received by govt. equals excess of private saving over investment and net exports

The budget deficit, trade, saving and investment(in Rs. Billion) Saving (S)1000 1000 1000 1000 Investment(I)1000 850 900 950 Budget Deficit(BD)..0 150 0 150 Net Exports (NX)0 0 100 -100

Exercises Q.1 What would happen to GDP if the govt. hired unemployed Workers, who had been receiving amount $TR in unemployment Benefits, as govt. employees and now paid them $TR to do nothing? Explain. Q.2In the national income accounts, what is the difference between: a)A firms buying an auto for an executive and the firms paying the Executive additional income to buy the automobile herself?

b)Your hiring your spouse (who takes care of the house) rather than having him or her do the work without pay?
c)Your deciding to buy an Indian car rather than a German car?

3. The following is information from the national income accounts for a hypothetical country: GDP Gross investment Net investment Consumption Government purchases of goods and services Government budget surplus What is: a. NDP? d. Disposable personal income? b. Next exports? e. Personal saving? c. Government taxes minus transfers? $6, 000 800 200 4, 000 1, 100 30

GDP and GDP deflator

We would like to convert different goods

quantities and prices into one single quantity of composite good and one general price level. How? We use the concepts of nominal GDP, real GDP and

GDP deflator to achieve such aggregation.

Real vs. Nominal GDP . year. GDP is the value of all final goods and services produced domestically. Nominal GDP measures these values using current prices Real GDP measure these values using the prices of a base

Real and Nominal GDP

2001 Nominal 2006 GDP Nominal GDP Bread (ton) Milk (thousand Litres)
Total GDP 1 at Rs.1 thousand Rs. 1thousand 1 at Rs 0.5 thousand....R s. 0.5 thousand Rs. 1.5 thousand 2 at Rs.2 thousand .. Rs. 4 thousand 3 at Rs.0.75 thousand ..Rs. 2.25 thousand

2006 Real GDP

2 at Rs. 1 thousand Rs.2 thousand 3 at Rs.0.50 thousand ..Rs.1.50 thousand

Rs. 6.25 thousand Rs. 3.50 thousand

Real GDP and living standard Changes in nominal GDP can be due to: changes in prices changes in quantities of output produced Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. Therefore, changes in real GDP measure changes in living standard.

GDP Deflator While real GDP captures living standard, cost of living is measured by general price level.

One measure of the general price level is the GDP Deflator, defined as GDP deflator = 100 * Nominal GDP /Real GDP

Measuring the Cost of Living Inflation refers to a situation in which the economys overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

Exercise: The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data

Nominal GDP billions 1959 1964 1967 $ 507.2 663.0 833.6 23.0 24.6 26.6

Price index (1992=100)

Real GDP billions

$______ $______ $______

1973
1988 1995

1382.6
5049.6 7265.4

35.4
86.1 107.8

$______
$______ $______

CPI vs. GDP deflator prices of capital goods included in GDP deflator (if produced domestically) excluded from CPI prices of imported consumer goods included in CPI excluded from GDP deflator
the basket of goods CPI: fixed GDP deflator:

changes every year

International Comparisons of GDP

In any attempt to compare GDP between countries, some account must be taken of differences in prices. Adjustment for GDP based on exchange rates makes some improvement in the comparison of GDP figures. However, if we wish to determine the value of GDP in another country, some information on the price differences of goods is needed.

Purchasing power parity exchange rates attempt to adjust exchange rates for differences in the prices of goods across

borders through the use of a ratio of price indexes.

The exchange rate is adjusted to reflect this ratio

Once this adjustment is made, international rankings of countries

based on GDP or per capita GDP tend to fluctuate as exchange rates vary, while the corresponding prices do not. Despite their variability due to exchange rate fluctuations, purchasing power parity exchange rates provide a better basis for international comparisons than an adjustment based solely on exchange rates.

The Measurement of GDP

GDP is: the market value of all final goods and services produced within a country in a given period of time.

What Is Counted and Not Counted in GDP?

GDP includes all

items produced in the economy and sold

legally in markets.
GDP excludes

services that are produced and consumed at

home and that never enter the marketplace. Eg: Caring labor,
the work that is normally produced by women.
Because

GDP does not count it, it diminishes its importance. excludes black market items, such as illegal drugs.

GDP also

Other Measures of Income

Gross

National Product (GNP) Net National Product (NNP) National Income Personal Income Disposable Personal Income

The Components of GDP

GDP (Y ) is the sum of the following:

Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NX

GDP and Its Components (1998)

Total (Billions of Rs) $8,511 Per Person (In Rs) $31,522 21,511 5,507 5,507 -559 % of Total 100% 68% 16 18 -2

GDP (Y)

Consumption C 5,808 Investment I Government G 1,367 1,487

Net Exports NX -151

GDP and Its Components (1998)

Government Purchases Investment Net Exports 18% 16% -2 %

Consumption 68 %

Measuring Economic Growth

We use real GDP to calculate the economic growth rate. The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next. We measure economic growth so we can make: Economic welfare comparisons International welfare comparisons Business cycle forecasts

Measuring Economic Growth

Business Cycle Forecasts

Real GDP is used to measure business cycle fluctuations. These fluctuations are probably accurately timed but the changes in real GDP probably overstate the changes in total production and peoples welfare caused by business cycles.

Real versus Nominal GDP

Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices.

Deflating

Nominal GDP increases because production real GDP increases.

the GDP Balloon

Real GDP and the Price Level

Deflating the GDP Balloon

Nominal GDP also increases because prices rise.

Real GDP and the Price Level

We use the GDP Deflator to take the air out of Nominal GDP.

Real GDP and the Price Level

What makes a stable economy?

Macro stability can be measured by the volatility of key indicators: 1. Consumer price inflation (annual % change in prices) 2. Real GDP growth over one or more business cycles 3. Changes in measured unemployment / employment 4. Fluctuations in the current account of the balance of payments 5. Changes in government finances (i.e. the size of the fiscal deficit or surplus) 6. Volatility of short term policy interest rates and long term interest rates such as the yield on government bonds 7. Stability of the exchange rate in currency markets

A stable economy provides a framework for an improved supply-side performance i.e. Stable low inflation encourages higher investment which is a determinant of improved productivity and non-price competitiveness

Control of inflation helps to main price competitiveness for exporters and domestic businesses facing competition from imports

Stability breeds higher levels of consumer and business confidence sentiment drives spending in the circular flow

The maintenance of steady growth and price stability helps to keep short term and long term interest rates low, important in reducing the debt-servicing costs of people with mortgages and businesses with loans to repay

A stable real economy helps to anchor stable expectations and this can act as an incentive for an economy to attract inflows of foreign direct investment