BUS 530: ECONOMIC CONDITIONS ANALYSIS LECTURE: 1 Introduction and Data of Macroeconomics

BUS 530: ECONOMIC CONDITIONS ANALYSIS

LECTURE: 1

Introduction and Data of Macroeconomics

1

Prerequisites Bus 525

Requirements and Grading Four class tests (20%) One midterm (20%) Paper (20%) Final (40%)

Class Materials N Gregory Mankiw. Macroeconomics. Sixth Edition. Web-page: http://fkk.weebly.com

Office: NAC 751 Office hours: Friday 2pm-3pm, Sunday 5pm-6:30 pm.

Course Overview

2

Activity Schedule : BUS 530Class Date Exams Test/Paper

1 27May

2 3 June

3 10 June Class test 1

4 14 June(Regular ST)

5 17 June Mid-term

6 24 June Class test 2

7 1 July

8 8 July

9 15 July Class test 3

10 22 July

11 29 July

12 5 August Class test 4

13 10 Aug-30 Aug Final Paper3

• There will be only one make-up for all examinations (mid-terms and final, no make-up for class tests ) towards the end of the course to accommodate force majeure. All examination dates are pre-announced. Please make necessary arrangements with your office.

• Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule.

• I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s).

Make-up Policy

4

Learning Objectives

We will begin with:the issues macroeconomists studythe tools macroeconomists usesome important concepts in macroeconomic analysis

5

Important Issues in Macroeconomics

Macroeconomics, the study of the economy as a whole, addresses many topical issues:

Why does the cost of living keep rising?Why are millions of people unemployed,

even when the economy is booming?What causes recessions? Can the government do anything to combat

recessions? Should it?

6

What is the government budget deficit? How does it affect the economy?

Why does countries such as the U.S. have such a huge trade deficit and China have huge trade surplus ?

Why are so many countries poor? What policies might help them grow out of poverty?

Macroeconomics, the study of the economy as a whole, addresses many topical issues:

Important Issues in Macroeconomics

7

The Historical Performance of Bangladesh Economy

Source: Bangladesh Bank

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010300

350

400

450

500

550

600

Real GDP per capita of Bangladesh

Year

2000

USD

8

GDP versus Population Growth Rates in the 1980’s

1.0

3.0

5.0

7.0

3.80

2.38

4.02

5.18

3.22

4.25

3.73

2.16

2.61

5.94

Gro

wth

Rat

e o

f G

DP

(%

)

GDP Growth Rate in the 1980’s

GDP and Population Growth Rates

Source: BBS and World Bank

1970's 1980's 1990's 2000's0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

4.15

3.22

4.80

5.81

2.502.33

2.15

1.37

GDP Growth Rate

Population Growth Rate

9

The Historical Performance of Bangladesh Economy

Source: Bangladesh Bank

10

FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY113

3.5

4

4.5

5

5.5

6

6.5

7

5.27

4.42

5.26

6.275.96

6.636.43

6.215.88

5.83

6.66

Real GDP Growth Rate

GDP Growth Rate

Gro

wth

rat

e of

GD

P (%

)

Growth rate remains robust…2010

Bangladesh India Pakistan Sri Lanka China0

2

4

6

8

10

12

6.1

8.8

4.1

8

10.4

Gro

wth

Rat

e of

GD

P (%

)

11

The Historical Performance of Bangladesh Economy

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20110.00

2.00

4.00

6.00

8.00

10.00

12.00

Bangladesh Inflation Rate

Year

Perc

enta

ge

Source: Bangladesh Bank

12

Inflation situation

•

Source: Central bank of respective country

Bangladesh India Pakistan Sri Lanka China0

2

4

6

8

10

12 10.8610.36

10.8

5.5

3.98

Comparison of Inflation Rate on April '12

Rate

of i

nflati

on (y

ear t

o ye

ar)

The Historical Performance of Bangladesh Economy

1984 1985 1986 1989 1991 1996 2000 2003 20050

0.51

1.52

2.53

3.54

4.55

Bangladesh Unemployment Rate

Year

Perc

enta

ge

The unemployment rate of Bangladesh does not show the correct picture. According to CIA Factbook, 40% are under employed.

14

Trend in the value of Bangladeshi Taka against US $

Source: Bangladesh Bank

1973-74 1980-81 1990-91 2000-01 2010-110

10

20

30

40

50

60

70

80

90

7.97

16.26

35.68

53.96

82

15

0

10,000

20,000

30,000

40,000

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

U.S. Real GDP Per Capita (2000 dollars)

Great Depression

World War II

First oil price shock

Second oil price shock

long-run upward trend…

9/11/2001

16

U.S. Inflation Rate(% per year)

-15

-10

-5

0

5

10

15

20

25

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

17

U.S. Unemployment Rate(% of labor force)

0

5

10

15

20

25

30

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

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Why Learn Macroeconomics?

1. The macroeconomy affects society’s well-being.

In the US, each one-point increase in the unemployment rate

is associated with: 920 more suicides 650 more homicides 4000 more people admitted to state mental institutions 3300 more people sent to state prisons 37,000 more deaths increases in domestic violence and homelessness

In the US, each one-point increase in the unemployment rate

is associated with: 920 more suicides 650 more homicides 4000 more people admitted to state mental institutions 3300 more people sent to state prisons 37,000 more deaths increases in domestic violence and homelessness

19

Why Learn Macroeconomics?

2. The macroeconomy affects your well-being.

-3

-2

-1

0

1

2

3

4

5

1965 1970 1975 1980 1985 1990 1995 2000 2005

-7

-5

-3

-1

1

3

5

unemployment rate inflation-adjusted mean wage (right scale)

chan

ge fr

om 1

2 m

os e

arlie

r

perc

ent c

hang

e fr

om 1

2 m

os e

arlie

rIn most years, wage growth falls when unemployment is rising. In most years, wage growth falls when unemployment is rising.

20

How Economists Think?Economists use models to understand what goes on in the economy.

Economic models:

…are simplified versions of a more complex reality• irrelevant details are stripped away

…are used to • show relationships between variables• explain the economy’s behavior• devise policies to improve economic

performance

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Endogenous vs. Exogenous Variables

• The values of Endogenous variables are determined in the model.

• The values of Exogenous variables are determined outside the model: the model takes their values & behavior as given.

• In the model of supply & demand for cars,endogenous: , , d sP Q Q

exogenous: , sY P22

A Multitude of Models

No one model can address all the issues we care about. e.g., our supply-demand model of the car market…

can tell us how a fall in aggregate income affects price & quantity of cars.

cannot tell us why aggregate income falls.So we will learn different models for studying different issues

(e.g., unemployment, inflation, long-run growth). For each new model, you should keep track of

its assumptions which variables are endogenous, which are exogenousthe questions it can help us understand, and those it cannot

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What is a Macro Model?

• A macro model is a mathematical structure that describes the economy. A mathematical structure is a set of equations, which allow us to understand the economy more fully and to predict what happens to it.

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Feature of a Good Macro Model

• Should include the variable that we want to predict• Should capture the most important factors whose

effects we want to determine• Its equations should be consistent with the way

the variables are defined and measured• Its equations should be easily defended• Should make predictions that are qualitatively in

line with the real world• Should be easy to use

25

A Simple Sample Model

Y = C + I + GHere, Y = income

C = consumption I = investment G = government spending

This comes from the definition of GDP and the way it is measures. Remember, that GDP is a measure of output, income and spending

26

Another Simple Sample Model

C = 0.9 (Y – T) It relates consumption to income taxes. When

income tax is deducted from a person’s paycheck, disposable income is found.

The equation suggests people spend 90% of their disposable income and save the rest

27

Class Exercise 1

1. Solve for Y, given G = 2000T=2000I = 900

2. What is Y, if taxes fall from 2000 to 1900?

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Now, we will discuss……the meaning and measurement of the most important macroeconomic statistics:– Gross Domestic Product (GDP)– The Consumer Price Index (CPI)– The Unemployment Rate

The Data of Macroeconomics

29

30

Gross Domestic Product (GDP) is the market value of all final goods and services newly produced in a country in a given period of time.

The Consumer Price Index (CPI) measures the level of prices.

The Unemployment Rate tells us the fraction of workers who are unemployed.

GDP, CPI, Unemployment Rate

Gross Domestic Product: Expenditure and Income

Two definitions:– Total expenditure on domestically-produced

final goods and services.

– Total income earned by domestically-located factors of production.

Expenditure equals income because every Taka spent by a buyer

becomes income to the seller.

Expenditure equals income because every Taka spent by a buyer

becomes income to the seller.

Income Expenditure and the Circular Flow

Households Firms

Goods

Labor

Expenditure (Tk.)

Income (Tk.)

32

Value Added

Definition: A firm’s value added is

the value of its output minus

the value of the intermediate goods the firm used to produce that output.

Class Exercise 2

– A farmer grows a bushel of wheat and sells it to a miller for $1.00.

– The miller turns the wheat into flour and sells it to a baker for $3.00.

– The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00.

– The engineer eats the bread.

Compute & compare value added at each stage of production

and GDP

Final goods, Value added, and GDP

• GDP = value of final goods produced = sum of value added at all stages of production.

• The value of the final goods already includes the value of the intermediate goods, so including intermediate and final goods in GDP would be double-counting.

Rules for computing GDP1) To compute the total value of different goods and services, the national income accounts use market prices. Thus, if

GDP = (Price of apples Quantity of apples) + (Price of oranges Quantity of oranges)

= ($0.50 4) + ($1.00 3)GDP = $5.00

If apples cost $0.50 each and oranges cost $1.00 each

2) Used goods are not included in the calculation of GDP.3) The treatment of inventories depends on if the goods are stored orif they spoil. If the goods are stored, their value is included in GDP.If they spoil, GDP remains unchanged. When the goods are finally soldout of inventory, they are considered used goods (and are not counted).

36

4) Intermediate goods are not counted in GDP– only the value offinal goods. Reason: the value of intermediate goods is already included in the market price. Value added of a firm equals the value of the firm’s output less the value of the intermediate goodsthe firm purchases.

5) Some goods are not sold in the marketplace and therefore don’thave market prices. We must use their imputed value as an estimateof their value. For example, home ownership and government services.

Rules for Computing GDP

37

Real GDP Versus Nominal GDP

The value of final goods and services measured at current prices is called nominal GDP. It can change over time either because there is a change in the amount (real value) of goods and services or a change in the prices of those goods and services. Hence, nominal GDP or Y = P y, where P is the price level and y is real output– and remember we use output and GDP interchangeably. Real GDP or, y = YP is the value of goods and services measured using a constant set of prices.

38

39

Real GDP is computed in our apple and orange economy.

For example, if we wanted to compare output in 2002 and output in 2003, we would obtain base-year prices, such as 2002 prices.

Real GDP in 2002 would be: (2002 Price of Apples 2002 Quantity of Apples) +(2002 Price of Oranges 2002 Quantity of Oranges).Real GDP in 2003 would be:(2002 Price of Apples 2003 Quantity of Apples) +(2002 Price of Oranges 2003 Quantity of Oranges).Real GDP in 2004 would be:(2002 Price of Apples 2004 Quantity of Apples) +(2002 Price of Oranges 2004 Quantity of Oranges).

Example

GDP 2008 (nominal) = 500 * 6 + 200 * 30 = 9000GDP 2009 (nominal) = 600 * 5 + 150 * 60 = 12000

GDP 2009 (real) = 600 * 6 + 150 * 30 = 8100

So nominal GDP rose, while real GDP actually fell

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Average prices in 2001and 2002 are used to measurereal growth from 2001 to 2002.Average prices in 2002 and 2003are used to measure real growth from 2002 to 2003 and so on. These growth rates are united to form a chain that is used to compare output between any two dates.

In some cases, it is misleading to use base year prices that prevailed 10 or 20 years ago (i.e. computers and college). In 1995, the US Bureau of Economic Analysis decided to use chain-weighted measures of real GDP. The base year changes continuously over time. This new chain-weighted measure is better than the more traditional measure because it ensures that prices will not be too out of date.

Chain-Weighted Measure of Real GDP

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Chain-Weighted Real GDP

Over time, relative prices change, so the base year should be updated periodically.

In essence, chain-weighted real GDP updates the base year every year,

so it is more accurate than constant-price GDP.Your textbook usually uses constant-price real

GDP, because: the two measures are highly correlated.constant-price real GDP is easier to compute.

42

43

Governmentpurchases of goods

and services

Y = C + I + G + NX

Total demandfor domestic output (GDP)

is composed of

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds Net exports

or net foreigndemand

This is the called the national income accounts identity.

Components of Expenditure

Bangladesh GDP Composition, 2009 - 2010

-8.9

15.38

24.41

79.9%

-62093

110523

169511

BDT 554771

Net Exports

Government

Investment

Consumption

% of GDPTk. crore

Source: Bangladesh Bank & Unnayan Onneshon

44

Consumption (C)

– Durable goods last a long time ex: cars, home appliances

– Nondurable goodslast a short time ex: food, clothing

– Serviceswork done for consumers ex: dry cleaning, air travel.

Definition: The value of all goods and services bought by households. Includes:

45

U.S. Consumption, 2005

41.3

20.5

8.2

70.0%

5,154.9

2,564.4

1,026.5

$8,745.7

Services

Nondurables

Durables

Consumption

% of GDP$ billions

Investment (I)

Definition 1: Spending on [the factor of production] capital.Definition 2: Spending on goods bought for future useIncludes:– Business Fixed Investment

Spending on plant and equipment that firms will use to produce other goods & services.

– Residential Fixed InvestmentSpending on housing units by consumers and landlords.

– Inventory InvestmentThe change in the value of all firms’ inventories.

47

U.S. investment, 2005

0.2

6.1

10.6

16.9%

18.9

756.3

1,329.8

$2,105.0

Inventory

Residential

Business fixed

Investment

% of GDP$ billions

Investment vs. Capital

Note: Investment is spending on new capital.

Example (assumes no depreciation): – 1/1/2006:

economy has $500b worth of capital

– during 2006:investment = $60b

– 1/1/2007: economy will have $560b worth of capital

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Stocks vs. Flows

A flow is a quantity measured per unit of time. E.g., “U.S. investment was $2.5 trillion during 2006.”

Flow Stock

A stock is a quantity measured at a point in time.

E.g., “The U.S. capital stock was $26 trillion on January 1, 2006.”

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Stocks vs. Flows - examples

the govt budget deficitthe govt debt

# of new college graduates this year

# of people with college degrees

a person’s annual saving

a person’s wealth

FlowStock

51

Class Exercise 3

Stock or flow?• the balance on your credit card statement• how much you study economics outside of

class• the size of your compact disc collection• the inflation rate• the unemployment rate

52

Government Spending (G)

• G includes all government spending on goods and services..

• G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services.

53

U.S. Government Spending, 2005

Federal

18.9%$2,362.9Govt spending

State & local

Defense

7.0

11.9

4.7

2.3

877.7

1,485.2

587.1

290.6Non-defense

% of GDP$ billions

Net exports: NX = EX – IM

def: The value of total exports (EX) minus the value of total imports (IM).

Source: Bangladesh Bank 55

Class Exercise 4

Suppose a firm • produces $10 million worth of final goods• but only sells $9 million worth.

Does this violate the expenditure = output identity?

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Why Output = Expenditure

• Unsold output goes into inventory, and is counted as “inventory investment”……whether or not the inventory buildup was intentional.

• In effect, we are assuming that firms purchase their unsold output.

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GDP: An important and versatile concept

We have now seen that GDP measures– total income– total output– total expenditure– the sum of value-added at all stages

in the production of final goods

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Other Measurements of Income

Gross National Product (GNP): Total income earned by the nation’s factors of production, regardless of where located.

Gross Domestic Product (GDP):Total income earned by domestically-located factors of production, regardless of nationality.

(GNP – GDP) = (factor payments from abroad) – (factor payments to abroad)

Net National Product (NNP), we subtract the depreciation of

capital-- the amount of the economy’s stock of plants,

equipment, and residential structures that wears out during the

year:

NNP = GNP – Depreciation National Income = NNP- Indirect Business Taxes Personal Income = National Income- Corporate Profits- Social Security

contributions-Net Interest+ Dividends + Govt. Transfer +Personal Interest Income Disposable Personal Income = Personal Income – Personal Tax

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(GNP – GDP) as a percentage of GDP selected countries, 2010

U.S.A. 0.40% Bangladesh 4.31% Brazil -14.29% China -3.39% India -5.88% U.K. 4.35%

Source: World Bank

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Real vs. Nominal GDP

• GDP is the value of all final goods and services produced.

• Nominal GDP measures these values using current prices.

• Real GDP measure these values using the prices of a base year.

61

Class Exercise 3

• Compute nominal GDP in each year.

• Compute real GDP in each year using 2006 as the base year.

2006 2007 2008

P Q P Q P Q

good A $30 900 $31 1,000 $36 1,050

good B $100 192 $102 200 $100 205

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Answers

Nominal GDP multiply Ps & Qs from same year

2006: $46,200 = $30 900 + $100 192

2007: $51,400 2008: $58,300

Real GDP multiply each year’s Qs by 2006 Ps

2006: $46,2002007: $50,000 2008: $52,000 = $30 1050 + $100 205

63

Real GDP Controls for Inflation

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.

64

Bangladesh Nominal and Real GDP, 1950–2006

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20100

100000

200000

300000

400000

500000

600000

700000

800000

Nominal GDPReal GDP

Year

BDT

in c

rore

65

GDP Deflator

The Inflation Rate is the percentage increase in the overall level of prices.

One measure of the price level is the GDP Deflator, defined as Nominal GDP measures the current Taka value of the output of the

economy.

Real GDP measures output valued at constant prices. The GDP deflator, also called the implicit price deflator for GDP,

measures the price of output relative to its price in the base year. It

reflects what’s happening to the overall level of prices in the economy.

Nominal GDP

GDP deflator = 100Real GDP

66

Class Exercise 4

• Use your previous answers to compute the GDP deflator in each year.

• Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

Nom. GDP Real GDPGDP

deflatorInflation

rate

2006 $46,200 $46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

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Answers

Nominal GDP

Real GDPGDP

deflatorInflation

rate

2006 $46,200 $46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.1%

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Two arithmetic tricks for working with percentage changes

Example: If your hourly wage rises 5% and you work 7% more hours, then your wage income rises approximately 12%.

1. For any variables X and Y,

percentage change in (X Y ) percentage change in X + percentage change in Y

70

Two arithmetic tricks for working with percentage changes

Example: GDP deflator = 100 NGDP/RGDP.

If NGDP rises 9% and RGDP rises 4%, then the inflation rate is approximately 5%.

2. percentage change in (X/Y ) percentage change in X percentage change in Y

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Consumer Price Index (CPI)• A measure of the overall level of prices • Published by the Bureau of Statistics• Uses:

– tracks changes in the typical household’s cost of living

– adjusts many contracts for inflation (“COLAs”)– allows comparisons of Taka amounts over time

72

How the Bureau of Statistics constructs the CPI

1. Survey consumers to determine composition of the typical consumer’s “basket” of goods.

2. Every month, collect data on prices of all items in the basket; compute cost of basket

3. CPI in any month equals

Cost of basket in that month

Cost of basket in base period100

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The Consumer Price Index (CPI) turns the prices of many goods and services into a single index

measuring the overall level of prices.

Computing the CPI

For example, suppose that the typical consumer buys 5 apples and 2 oranges every month. Then the basket of goods consists of 5 apples and 2 oranges, and the CPI is:

CPI= ( 5 Current Price of Apples) + (2 Current Price of Oranges) ( 5 2002 Price of Apples) + (2 2002 Price of Oranges)

In this CPI calculation, 2002 is the base year. The index tells how much it costs to buy 5 apples and 2 oranges in the current year relative to how much it cost to buy the same basket of fruit in 2002.

Class Exercise 5

Basket contains 20 pizzas and 10 compact discs.

prices:pizza CDs

2002 $10 $152003 $11 $152004 $12 $162005 $13 $15

For each year, compute the cost of the basket the CPI (use 2002 as the

base year) the inflation rate from

the preceding year

75

Cost of Inflationbasket CPI rate

2002 $350 100.0 n.a.2003 370 105.7 5.7%2004 400 114.3 8.1%2005 410 117.1 2.5%

Answers

76

The Composition of the CPI’s “basket” of Bangladesh in 2010

54.81

4.95

9.09

5.061.68

3.79

5.68

13.50

Food & beverageCloth & foot wearHousing & Housing rentFuel and& LightingHousehold effectMedicalEducationMiscelleneous

Source: Bangladesh Bureau of Statistics

77

Reasons Why The CPI may Overstate Inflation

• Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen.

• Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights.

• Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured.

80

81

The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI.

Also, another difference is that the GDP deflator includes only those goods and services produced domestically. Imported goods are not a part of GDP and therefore don’t show up in the GDP deflator.

The final difference is the way the two aggregate the prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights.

The CPI versus the GDP Deflator

Two measures of inflation in Bangladesh

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 20100.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

0.00

50.00

100.00

150.00

200.00

250.00

300.00

GDP DeflatorCPI

Year

Ann

ual P

erce

ntag

e

82

The labor force is defined as the sum of the employed and unemployed, and the unemployment rate is defined as the percentage of the labor force that is unemployed.The labor force participation rate is the percentage of the adult population who are in the labor force.

Measuring Unemployment

Unemployment Rate = Number of Unemployed Labor Force X 100

Labor-Force Participation Rate = Labor Force Adult Population

100

83

Categories of the population• Employed

working at a paid job • Unemployed

not employed but looking for a job • Labor force

the amount of labor available for producing goods and services; all employed plus unemployed persons

• Not in the Labor force not employed, not looking for work

84

Class Exercise 6

U.S. adult population by group, June 2006Number employed = 144.4 millionNumber unemployed = 7.0 millionAdult population = 228.8 million

Use the above data to calculate the labor force the number of people not in the labor force the labor force participation rate the unemployment rate

85

Summary

1. Gross Domestic Product (GDP) measures both total income and total expenditure on the economy’s output of goods & services.

2. Nominal GDP values output at current prices; real GDP values output at constant prices. Changes in output affect both measures, but changes in prices only affect nominal GDP.

3. GDP is the sum of consumption, investment, government purchases, and net exports.

slide 86CHAPTER 2 The Data of Macroeconomics 86

Summary

4. The overall level of prices can be measured by either– the Consumer Price Index (CPI),

the price of a fixed basket of goods purchased by the typical consumer, or

– the GDP deflator, the ratio of nominal to real GDP

5. The unemployment rate is the fraction of the labor force that is not employed.

slide 87CHAPTER 2 The Data of Macroeconomics 87