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Principles of Macroeconomics
Lecture 1
INTRODUCTION TO MACROECONOMICS
&
MEASURING ECONOMIC ACTIVITY
PART 1: INTRODUCTION TO MACROECONOMICS
An Overview of Macroeconomics
1. What is Macroeconomics
2. Macroeconomic Goals
3. Key Macroeconomic
Principles
What is Macroeconomics?
- Microeconomics study of behaviour of individuals households and firms.
- Macroeconomics study the aggregate measures of the economy
Macroeconomic aims
- Low Unemployment
- Price Stability (Low Inflation or Deflation)
- Economic Growth and Development
Low Unemployment
0%
5%
10%
15%
20%
25%
1930 1940 1950 1960 1970 1980 1990 2000
Un
em
plo
ym
en
t ra
te,
%
Great Depression(1929 - 1933)
World War II(1941 - 1945) 1973 - 1975
recession
1981 - 1982recession
1990 - 1991recession
Source: Bureau of Labour Statistics www.bls.gov
Price Stability
Long Run Economic Growth
PART 2: MEASURING ECONOMIC ACTIVITY
Learning outcome
Define GDP and the four expenditure components of aggregate output.
Calculate GDP in a simple example, avoiding double counting.
Distinguish between “net” and “gross” and between “national” and “domestic.”
List the four components of aggregate income.
Aims
Discuss the shortcomings of using GDP
Distinguish between real GDP and
nominal GDP
How an economy works
National Income Accounting
National income accounting – a set of rules and definitions for measuring economic activity in the aggregate economy – that is, in the economy as a whole.
National income accounting is a way of measuring total, or aggregate production.
Gross Domestic Product (GDP) is the total value of all final goods and services produced in an economy in a one-year period.
Calculating GDP
Calculating GDP requires adding together millions of goods and services
All of the quantities of goods and services produced are multiplied by their market price per unit to determine a value measure of the good or service
The sum of all of these values is GDP
The Expenditure Approach
GDP is equal to the sum of the four categories of expenditures.
GDP = C + I + G + (X – M) C for Consumption I for Investment G for Government Spending X for Exports, M for Imports and (X-M) for
Net Exports
GDP is a Flow Concept
GDP is a flow concept, the amount of total final output a country produces per year
A flow concept has a time period associated with it; GDP is reported on an annual basis
Wealth accounts – a balance sheet of an economy’s assets and liabilities – is a stock concept
A stock is the amount of something at a given point in time; no time interval is associated with it
GDP Measures Final Output
GDP does not measure total transactions in the economy
It counts final output, but not intermediate goods. Final output – goods and services purchased for final
use. Intermediate products are used as an input in the
production of some other product
Counting the sale of both final and intermediate goods would result in double counting.
Two Ways of Dealing with the problem of Double Counting
Calculate only final output. A firm would report how much it sold to
consumers and how much it sold to producers (intermediate goods)
Follow the value added approach Value added is the increase in value that a firm
contributes to a product or service. It is calculated by subtracting intermediate goods
(the cost of materials that a firm uses to produce a good or service) from the value of its sales.
Value Added Approach
Participants Cost ofMaterials
Value ofSales
Value Added
Farmer €0 €100 €100
Dairy factoryand cheesemaker
100 250 150
Middleperson 250 400 150
Vendor 400 500 100
Totals €750 €1,250 €500
What is Counted in GDP
Not counted Value of resale goods Government transfer payments Sales of stocks or bonds Work of housespouses
Counted Value added by a used car dealer Commissions of stock brokers
GDP and NDP
Net Domestic Product is GDP adjusted for depreciation – the amount of capital used up in producing that year’s GDP
NDP = C + I + G + (X-M) –
depreciation
NDP measures output available for purchase
National and Domestic Concepts
Gross Domestic Product (GDP) is the total value of all final goods and services produced in an economy in a one-year period
Gross National Product (GNP) is the aggregate final output of citizens and businesses of an economy in one year
GDP is output produced within a country’s borders
GNP is output produced by a country’s citizens (both inside and outside the country)
GNP = GDP + Net foreign factor income
The Income Approach Aggregate income is the total income
earned by individuals and firms in a country on an annual basis.
Aggregate income consists of: employee salary profits rents interests
Equality of Income and Expenditure
Whenever a good or service is produced (output), somebody receives income for producing it
Aggregate Income = Aggregate Production
Profit is a residual that causes income and expenditures to become equal
Comparison of output among countries
Per capita GDP can be used to compare relative standards of living among various countries
Because of differences in non-market activities and difference in product prices, per capita GDP may be a misleading measure of living standards.
Purchasing power parity adjusts for relative price differences before making comparisons.
Economic Welfare Over Time
If increases in GDP are due to increases in prices, then welfare does not increase
Changes in welfare over time are best represented by changes in real GDP, that is nominal GDP adjusted for inflation
100deflator GDP
GDP Nominal GDP Real
Consumer Price Index
The most widely used measure of inflation
Measures the cost of a standard basket of goods at specific points of time
Items in the basket are assigned a relative weight according to their relative importance
Some Limitations of National Income Accounting
GDP measures economic activity, not welfare. GDP does not measure happiness, nor does it
measure economic welfare
Subcategories are often interdependent. For example, the line between consumption and
investment may be unclear
Measurement problems are in existence
Summary
Aggregate accounting is a set of rules and definitions for measuring economic activity in the aggregate economy
GDP is the total market value of all final goods and services produced in an economy in one year
GDP is the sum of four expenditures: GDP = C + I + G + (X – M)
Summary
Intermediate goods can be eliminated from GDP by: Measuring only final sales. Measuring only value added
Net domestic product is GDP less depreciation. NDP represents output available for purchase because production used to replace worn out plant and equipment (depreciation) has been subtracted
GDP measures output produced within the borders of a country; GNP measures the economic output produced by the citizens of a country.
Summary
Aggregate income = Compensation of employees + Rent + Interest + Profit
Aggregate income equals aggregate production because whenever a food is produced somebody receives income for producing it. Profit is crucial to maintain that equality
Because GDP measures only market activities, GDP can be a poor measure of relative living standards among countries.
Summary
To compare income over time, we must adjust for price-level changes. After adjusting for inflation, nominal measures are changed to “real” measures
% change in real GDP = % change in nominal GDP - inflation
100deflator GDP
GDP Nominal GDP Real
Summary
GDP presents the following shortcomings:
does not measure economic welfare
does not incorporate transactions taking place within the underground economy
the price index used to calculate real GDP is problematic
subcategories of GDP are often interdependent
Exercises
1. Let us assume that GDP equals €10000. Investment is €2000 and Government Purchases are €2500. Exports are €500 and Imports are €750. How much is Consumption?
Solution: As GDP = C + I + G + (X – M) by substitution,
10000 = C + 2000 + 2500 + (500-750)
10000 = C + 4250
C = €5750
2. Let us assume that the Consumer Price Index (CPI) consists of a list of goods and services as in the Table below:
CPI COMPONENT WEIGHT
Milk 0.20
Bread 0.20
Education 0.10
Heating 0.15
Bus Transportation 0.15
Medical services and medicines
0.20
Let 2000 be the base year and suppose that in 2010, bread’s price has doubled, milk has become more expensive by 20%, education has become 40% cheaper whereas the price for Medical Services and Medicines has increased by 10% and decreased 20% for heating. The ticket for Bus Transportation has retained the same price. What is the Consumer Price Index (CPI) for 2010?
2. Solution: The year 2000 is set as the base year and the CPI equals the base, that is 100%. Therefore, the sum of the CPI components multiplied by the coefficients of their importance should equal 100:
CPI2000 = 0,2 X 100 + 0,2 X 100 + 0,1 X 100 + 0,15 X 100 + 0,15 X 100 + 0,2 X 100 = 100
Hence, in 2010 and taking into account the changes in the prices of goods and services, the CPI can be computed as follows:
CPI2010 = 0,2 X 120 + 0,2 X 200 + 0,1 X 60 + 0,15 X 80 + 0,15 X 100 + 0,2 X 110
= 24 + 40 + 6 + 12 + 15 + 22 = 119
Therefore the level of prices has risen by 19% in 2010 in comparison with the respective level of 2000.
In year 2009 the nominal GDP amounted to $20000 whereas in year 2010, $22000. The GDP deflator is 120 and 125, respectively. What is the change in the nominal GDP? How much of the change is attributed to a real increase in production and how much stems from changes in the price level?Solution:
%1010020000
20000-22000 GDP nominal%
%17.4100120
120-125price%
5.83% GDP real%
4.17% GDP real% 10%
Inflation GDP real%GDP nominal%
Helpful reading
Economics. Samuelson, & Nordhaus (2005) Ch. 20-21
Macroeconomics. Mankiw, (2007) Ch. 1-2