MBA Lectures 1 - 3 Part2

8/6/2019 MBA Lectures 1 - 3 Part2

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ECO 502

BRAC University,Spring, 2006

Lectures 1 3, part 2

Lutfun N. K. Osmani

Chapter 2

The Measurementof Income,Prices, andUnemployment


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Contents

Why we care about income

The Circular flow of national income Components of expenditure

The Magic equation and the twin deficits

Nominal GDP, real GDP and the GDPdeflator


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Why we care about income?

1. Firstly, we have seen in our previouslectures how closely unemploymentand inflation are related to actual GDP.

The key to understanding the changesin unemployment and inflation,therefore, is the change in actual GDP,which is the same thing as total real

product and total real income


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Why we care about income?

2. Second, the level and growth rate ofour standard of living are also measuredby productivity (defined as the ratio ofoutput to the number of hours worked).

And output is the same as real GDP (ortotal income)

Thus any discussion of productivityperformance of any economy incomparison with countrys history orwith other nations requires anunderstanding of the data on real GDP


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Figure 2-1 The CircularFlow of Incomeand Consumption Expenditures


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The CircularFlow of Income andConsumption Expenditures

We are considering here a simpleeconomy consisting of households andbusiness firms who spend their entire

income and save nothing and there isno government.

There are two kinds of transactionsbetween firms and households.

Inner loop shows the transaction of goods and services between firms andthe households and the outer loopshows that of income.


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The CircularFlow of Income and

Consumption Expenditures

In the inner loop households providelabour services to the firms and utilising

their services firms produce goods andservices and sell to the households.

And in the outer loop householdsreceive payment for their labour services as income (say,$1,000, 000)and spend that income on goodspurchased from the firms (say,$1,000,000).


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CircularFlow and GDP Measurement

Circular flow:Income (Y) = labour service

= product= consumption expenditure


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Rules for GDP measurement:

There are three major requirements in the

rule for including items in the total finalproduct or GDP

Currently produced all currently produced

final products (transfer payments andsocial security benefits are excluded fromGDP accounting).


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Rules for GDP measurement:

Sold in the market goods included in thefinal product must be sold in the marketand valued at the market prices pricepeople are willing to pay

Issue: womens household chores, exchange

services are excluded


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But not resold to be included in GDP athing must not be resold in the current time

period.

Issue: Intermediate goods are used inproducing other goods; taking the value

of that in GDP accounting leads to theproblem of double counting.


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Components of Expenditure

Total expenditure has four components:

(1) Consumption expenditure (C)(2) Investment expenditure (I)

(3) Government expenditure (G)

(4) Net exports (NX)

E | C + I + G + NX


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Consumption expenditure (C): made by thehousehold

Investment expenditure (I) made by firms as

Inventory investment all changes in thestock of raw materials, parts and finishedgoods held by business

Fixed investment all final goods

purchased by firms other than additions toinventory ( e.g., factories, office buildings,apartments, etc.


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Government expenditure (G): expendituresmade by the governments (e.g., on parks,hospitals, schools, paying benefits, etc.)

Net exports (NX): exports minus importswhich is also equal to net foreign

investments.


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Figure 2-2 Introduction ofSaving andInvestment to the CircularFlow Diagram


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We now introduce savings and investment toourCircularFlow diagram.

Let say households save 20% of their income($200,000)

Firms invest 20% of their total expenditure

($200,000)


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Figure 2-3

Introduction of

Taxation, GovernmentSpending, and theForeign Sector to theCircularFlow Diagram


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We now introduce government to ourimaginary economy which collect taxes fromthe private sector and makes two kinds ofexpenditures:

Purchases of goods

Paying different kinds of benefits


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Lets say, govt. collects $100,000 in taxrevenue and pays households $100,000 intransfer payments and purchases $100,000

of goods and services.

The total expenditures ($200,000) of the govt.then exceeds its tax revenues ($100,000)

creating a deficit of $100,000 which isfinanced by the bonds and securities to thehouseholds (borrowing from the public).


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Implications of the Equality Between Income

and Expenditure

By definition total income generated equalstotal expenditure on final product. We havealready learnt that form the circular flow of

national income.

Using the identity sign (|) we can show therelationship as:

Y | E


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Implications of the Equality Between Income

and Expenditure

We know,

E | C + I + G + NX

Total personal income that the householdsreceive is the sum of income generated fromproduction (Y) and transfer payments fromthe government (F).

This personal income (Y + F) is either usedfor consumption (C) and saving (S), or paidout as taxes (R).


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CircularFlow in Equations

So,Y + F| C + S + RSubtracting F from both sides gives

Y | C + S + R FF can be treated as negative taxesSo, net tax revenue (T) is defined as taxes(R) minus transfers (F)

So we can writeY | C + S + T (T = net taxes)


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Leakages-Injections Identity

We have

Y | C + I + G + NX [1]

Y | C + S + T [2]

Therefore,

C + S + T | C + I + G + NX -C -C

----------------------------------------

S + T | I + G + NX Leakages out of the income stream (S + T)

must be exactly balanced by injections intothe income stream (I + G + NX).


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Leakages-Injections Identity

The equation: S + T | I + G + NX

is one of the most important relationship in

macroeconomics an called the magicequation.

Also called leakages injection identity


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The Magic Equation and the Twin Deficits

The Magic Equation:

S + T | I + G + NX

The importance of the magic equation is thatit helps us to understand the relationshipsamong investment, private saving, the

government surplus or deficit, and thesurplus or deficit of export versus imports.


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The US govt. is currently running large deficit

govts expenditure is far beyond its

revenue the economy imports far more than its

exports.


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The magic equation helps us to understand

(1) how these twin deficits are financed

(2) what difference would it make if govt. ransurplus while international deficit remains thesame

(3) what would happen if the internationaldeficit were zero while the government deficitremained large


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Impact of Changes in Government

Expenditure

We have

S + T = I + G + NX rearranging

T G = (I + NX) - S

An increase in government budget surplus (T G) can lead to the following:

A decrease in savings (S), without affectingtotal investment (I + NX).

An increase in private domestic investment(I) without a corresponding increase inprivate domestic savings (S).

An increase in foreign investment (NX).


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Formulae to Remember

GDP = C + I + G + NX

NDP = GDP depreciation

Dom.Inc. = NDP indirect taxes

PI = income received byhouseholds from all sources,including earnings and transfer

payments PDI = PI personal income taxes

PDI | PC + PS + interest payments


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Nominal GDP, Real GDP, and the ImplicitGDP Deflator, 19002001

Nominal GDP is the value of gross domesticproduct in current (actual ) prices

Real GDP of any year is measured by takingthe production of that year expressed at theconstant prices


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The implicit GDP deflatoris the economysaggregate price index and is defined as

the ratio of nominal GDP to chain-weightedreal GDP

Chain-weighted index is calculated by valuingthe changes in quantities by the average ofprice charged at the beginning and end of theperiod of change


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Figure 2-4

Nominal GDP,Real GDP, andthe ImplicitGDP Deflator,19002001


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Nominal GDP line lies below the real GDPbefore 2000 but lies above it after2000.

Before 2000 the current prices used tomeasure nominal GDP were lower than the2000 prices used to measure real GDP.

After2000, the current prices used tomeasure nominal GDP were higher than

2000 prices used to measure real GDP.

Nominal and real GDP are equal in 2000, thesame year that the GDP deflator attains thevalue of1.0


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Measuring Inflation [1]

Year1 Year2---------------------------------------------------------------------------------------

Prices (P) and quantities (Q):Apples (0.10, 30) (0.20, 20)Oranges (0.20, 10) (0.25, 20)---------------------------------------------------------------------------------------

Total expenditure:Current prices 5.00 9.00Year1 prices 5.00 6.00Year2 prices 8.50 9.00--------------------------------------------------------------------------------------

Expenditure each year:

At year1 quantities 5.00 8.50At year2 quantities 6.00 9.00


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Measuring Inflation [2]

Year1 Year2

---------------------------------------------------------------------------------------Real GDP (index: year1 = 1.00):At year1 prices 1.00 1.20 = 6.00/5.00At year2 prices 1.00 1.06 = 9.00/8.50Chain weighted 1.00 1.13 = (1.20 x 1.06)--------------------------------------------------------------------------------------

GDP deflator (index: year1 = 1.00)At year1 quantities 1.00 1.70 = 8.50/5.00At year2 quantities 1.00 1.50 = 9.00/6.00Chain weighted 1.00 1.60 = (1.70 x 1.50)---------------------------------------------------------------------------------------

Additional index (year1 = 1.00)Nominal GDP 1.00 1.80 = 9.00/5.00Implicit GDP deflator 1.00 1.59 = 1.80/1.13

Documents

MBA Lectures 1 - 3 Part2