Macroeconomics

What is MacroeconomicsLecture 1

What is macroeconomics

• Macroeconomics is concerned with – The behaviour of economic aggregates

• Total national product, total investment, exports for the entire economy

– The average price of all goods and services

• In macroeconomics, we study – The aggregate national product – value of all

goods and services– The general (average) price level (CPI)

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Major macroeconomic issues

• Economic growth• Business cycles• Productivity• Inflation• Unemployment• Budget deficits• Interest rates

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• The macroeconomic policy problem is to choose appropriate values of the policy instruments in order to achieve the best possible combination of the outcomes of the targets.

• This is a continually hanging problem, because the targets are perpetually being affected by shocks from various parts of the economy (world economy included)

Targets Instruments

Growing living standards, high employment, low unemployment, avoiding inflation and recession

Taxes, government spending, interest rates and money supply (fiscal and monetary policy)

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The GDP Gap

• Potential gross domestic product (GDP) and the GDP gap– Actual GDP – what the economy actually produces– Potential GDP – measures what the economy would

produce if all resources were fully employed at their normal levels of utilization

• GDP (output) gap • Measures the difference between what would have

been produced if potential or full employment GDP had been produced and what is actually produced, as measured by the current GDP

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Measurement of National Output

• Summing up all the value added for each industry or sector gives us a standard measure of national product

• We can arrive at the same measure of national product from the spending side of the economy and from adding up factor incomes

• The national output of the national product is related to the sum of all the outputs produced in the economy by individuals, firms, and governmental organizations

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Measurement of National OutputValue added as output• One firm’s output is another firm’s input• Value added measures each firm’s own

contribution to total output, the amount of market value that is produced by that firm minus the cost of inputs purchased from other firms. Its use avoids the statistical problem of double counting– Intermediate goods and services – outputs of some

firms that are in turn used as inputs for other firms– Final goods and services – goods that are not used as

inputs by other firms

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The circular flow of income, output, and spending

• The circular flow diagram shows how incomes give rise to spending which gives rise to output which gives rise to income

• Withdrawals, or leakages, arise from income that is not passed on in the circular flow through spending– Taxes, saving, and imports

• Injections are spending that does not arise out of incomes but is exogeneous– Investments, government consumption, and exports

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GDP Calculations• There are two ways of measuring national

income– By determining the value of what is produced and – The value of the income claims generated by

production

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GDP Calculations• By adding up the total spending for each of

the main components of final output we get GDP spending-based

• By adding up all the incomes generated by the act of production, we get GDP income-based

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GDP CalculationsGDP spending-based• For a given year, it is calculated by adding up the

spending (consumption, investment, and net exports) going to purchase the final output produced in that year– The GDP spending-based is the sum of private

consumption, government consumption, investment, and net export spending on currently produced goods and services

GDP = C + I + G +(X – IM)• It is GDP at market prices

– Market prices – prices paid by consumers– Basic prices – part of prices (sales revenue) received by

producers

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Private Consumption Spending (C)

• Spending by individuals on goods and services produced and sold to their final users during the year

• Spending by charities (non-profit making institutions serving households)

• Excludes newly built houses (investment)

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Government Consumption Spending (G)

• Goods and services provided by the government (health care, policing, street lighting, pollution control, refuse collection, maintaining parks, services of judges, MPs, etc)

• Include only spending on currently produced goods and services

• Thus, transfer payments are excluded (e.g. pensions, unemployment benefits, income support, student grant, interest on national debt)

• Government output is valued at cost rather than at the market value

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Investment Spending (I)• Spending on the production of goods not for

present consumption, but rather for future use. (investment/capital goods)

• Changes in inventory– firm’s stock held

• Fixed capital formation – creating capital stock in the form of equipments and

buildings used by firms or government agencies in the production of goods and services

• Net acquisition of valuables– Valuables such as jewellery and works of art

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Investment Spending (I) contd• Changes in inventories

– Inventories – stocks of inputs and outputs– Accumulation of stocks and unfinished goods in

the production process counts as current investment because it is not used for current consumption even though produced

– De-stocking is negative investment because it represents reduction in stocks of finished goods available for future use

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Investment Spending (I) contd

• Fixed capital formation– Fixed capital formation is the creation of new

capital goods– Much of the capital stock is in the form of

buildings and equipment used by firms or government agencies in the production of goods and services

– Includes – hospitals, schools, and offices, houses (but transfer of house ownership is not part of current GDP)

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Investment Spending (I) contd

• Gross and Net investment?– Gross investment (total investment) minus

replacement investment is net investment– Replacement investment – the amount of

investment that just maintains the level of existing capital stock. It replaces the bits that have worn out (classified as depreciation or capital consumption allowance)

• All gross investment is included in the calculation of GDP

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Net Exports (X-M = NX)

• Total exports of goods and services minus total imports of goods and services– Private consumption, government consumption,

and investment all have an import content– All goods and services that are produced

domestically and sold to foreigners (exports) must be part of GDP

• When the value of exports exceeds the value of imports, the net export is positive and vice versa

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GDP Income based

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GDP Income-based

• Involves adding up the income claims of owners of resource inputs

• All value must be owned by someone, so the value of production must equal the value of income claims generated by that production

• There are three main categories of income– Operating surplus– Mixed incomes– Compensation of employees

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Operating Surplus

• Net business incomes after payment has been made to hired labour and for material inputs but before direct taxes (corporation tax) have been paid

• They are profits of firms and also the financial surplus of organizations other than companies, such as universities– Profits are paid out (dividends) or retained

(retained earnings). Both included in the GDP

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Mixed Incomes

• Covers people who sell their services but are not employed by any organization– Consultants, Short contract workers, self-

employed, some partnerships

• Mixed incomes because not easy to differentiate between the proportion of their earnings as salary or profit

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Compensation of Employees

• Payment for the services of labour– Wages and salaries (take-home pay, taxes

withheld, national insurance contributions, pension fund contributions, and any other fringe benefits)

• Wages are measured gross• Wages represent that part of the value of

production that is attributable to hired labour

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Market value of

final goods and

services

Consumption

Investment

Government Purchases

Net Exports

Operating Surplus

Mixed Income

Compensation of Employees

Production Expenditure Income

= =

The Three Faces of GDP

GDP, GNI or GNP• GDP measures the output (income) that is produced in the

country• GNI measures the income that is received by the country• To convert GDP to GNI add

– Employees compensation receipts from the rest of the world minus payments to the rest of the world

– (Minus) net taxes on production paid to the rest of the world plus subsidies received from the rest of the world

– Property and entrepreneurial income receipts from the rest of the world minus payment to the rest of the world

• Total output produced in the economy (GDP), differs from total income received (GNI), because of net income abroad.

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Real and Nominal Measures

• When you add up money values of outputs, spending, or incomes, we end up with what are called nominal values

• Suppose for a period of 10 years, nominal GDP rise by 70 percent, this may be due to two things– Due to increases in the general price level or– Due to increases in quantities of goods and

services producedLecture 1, 2013-11-22 26

Real and Nominal Measures• GDP valued at current prices is a nominal

measure. GDP valued at base-period prices is a real measure of the volume of national output and national income

• Any change in nominal GDP reflects the combined effects of changes in quantities and changes in prices

• However, when real income is measured over different periods by using a common set of base-period prices, changes in real income reflect only changes in real output

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Real and Nominal Measures(Price Index)

• Comparing what has happened to nominal and real GDP over the same period implies the existence of a price index measuring the change in prices over that period

• This is because an index can be inferred by comparing these two values

• Such an index is called implicit price index or implicit deflator (GDP Deflator)

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International Comparisons of GDP

• One purpose to which GDP measures are often put is international comparison of living standards of real income

• Normally we are interested in how well off the average individual is in each country

• For this purpose we want to look at GDP per head or per capita (GDP divided by the total population of the country)

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International Comparisons of GDP

• GDP is measured in local currency so comparisons can only be made if currencies are converted using an exchange rate

• To solve the comparison problem using unreliable exchange rates, we use the purchasing power parity (PPP) rate (exchange rate that equates the prices of a representative bundle of goods in two countries)

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What does GDP not Measure• Unreported activities

– Underground or black economy

• Non-marketed activities– Do-it-yourself activities– Leisure

• Economic bads– Pollution, congestion, and other disamenities of

modern living

• But do the omissions matter?Lecture 1, 2013-11-22 31

Summary • What is macroeconomics• Why do we need macroeconomics

– Major macroeconomic issues• The GDP gap• Measurement of national output

– Value added as output• Circular flow of income, out, and spending• GDP, GNI, GNP

– GDP spending-based, income-based– Real and nominal GDP

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Next time…

• Build a model that explains the causes and consequences of deviations of GDP from its potential level (GDP gap)

• We will learn that– The determination of GDP in the short run depends on the

behaviour of key categories of aggregate spending– Consumption spending depends on disposable income and

wealth– Investment spending depends on real interest rates and

business confidence– A necessary condition for GDP to be in equilibrium is that

desired domestic spending is equal to actual output

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? • Assignment

– Explain why an economy’s income must equal its expenditure.

– A farmer sells wheat to a baker for GHC20. The baker uses the wheat to make bread, which is sold for GHC30. What is the total contribution of these transactions to GDP?

– Why do economists use real GDP rather than nominal GDP to gauge economic well-being?

– Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable.

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