ECO1000 Economics Semester One, 2004 Lecture Six.

ECO1000EconomicsSemester One, 2004

Lecture Six

Workshops for First Week Back After Recess

Monday April 26 is a holiday Alternative workshops are:

TUES 10-12 T124 TUES 12-2 T121 TUES 2-4 T124 THURS 8-10 T121

Assignment Advice Assignment One is due in about 4 weeks. You will need to start it over the holidays. The course leader will be available to

provide advice and assistance on this matter during the recess break.

Questions can also be directed by phone and email.

Please seek guidance if necessary.

Outline or Plan of Today’s Lecture Material Covered: Module

Three Reading: Text Chapters

Seven and Eight and Chapters Seven and Eight of Hakes and Parry

Topics: Macroeconomics

Purpose or Objectives of the Lecture

You will learn about: Introductory macroeconomics GDP and its use as an economic indicator Allowing for the effects of inflation Calculating real prices and real GDP The effect of inflation on interest rates

Relevant Economic Principles 8. A Country’s Standard of Living Depends

on its Ability to Produce Goods and Services

9. Prices Rise When Governments Print too Much Money

10. Society Faces a Short-Run Trade-Off Between Inflation and Unemployment

MacroeconomicsThe Economy as a Whole

Macroeconomics

Macroeconomics is the study of the economy as a whole.

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

Macroeconomic Issues

National income and growth Equity and income distribution Inflation Employment opportunities Economic stability

The Purposes of National Income Measurement Estimate growth/decline Comparisons over time Comparisons with other countries Social indicator Government budget forecasts Prospects for firms & investors

The Economy’s Income and Expenditure For an economy as a whole, income must

equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar

of income for some seller.

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 time period.

Gross Domestic Product

Reviewing the Circular-Flow Spending (= GDP)

Goods andservices

bought

Revenue (= GDP)

Goods andservicessold

Labor, land,and capital

Income (= GDP)

Inputs forproduction

Wages, rent, and profit (= GDP)

FIRMS HOUSEHOLDS

MARKETS FORFACTORS OFPRODUCTION

Flow of goodsand services

Flow of dollars

MARKETS FORGOODS AND

SERVICES

GDP Includes:

Only the value of final goods, not intermediate goods (used in production)

All items produced in the economy and sold legally in markets.

Both tangible goods (food, clothing, cars) and intangible services (haircuts, doctor visits).

Goods and services currently produced, not transactions involving goods produced in the past.

GDP Estimates Are based on the value of output at

market prices Measure the value of production within

the geographic confines of a country. Measure the value of production that

takes place within a specific interval of time, usually a year or a quarter (three months).

What Is Not Counted in GDP?

GDP excludes most items that are produced and consumed at home and that never enter the marketplace.

It excludes items produced and sold illicitly, such as illegal drugs.

Gross National Product

Gross national product (GNP) is the total market value of all final goods and services produced within a given period of time by a nation’s permanent residents, regardless of where they are.

Used in many other countries as the main measure of output

Three Approaches to Calculating GDP

Income approach Sum of factor incomes, consumption of fixed capital

(depreciation) and net indirect taxes

Production approach The market value of goods and services produced and,

less the cost of goods and services used up in the productive process

Expenditure approach* * We use this one

The Four 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

The Four Components of GDP

Consumption (C): The spending by households on goods

and services, with the exception of purchases of new housing.

Investment (I): The spending on capital equipment,

inventories, and structures, including new housing.

The Four Components of GDP

Government Purchases (G): The spending on goods and services by

local, state, and federal governments.

Does not include transfer payments because they are not made in exchange for currently produced goods or services.

Net Exports (NX): Exports minus imports.

Net Exports 1 %

Breakdown of Australian GDP: 1997

Consumption 62%

Investment17%

Government Purchases

20%

GDP in Australia 1998 ($ A b) Consumption = 336.9 + Investment = 101.6 + Government spending = 108.1 + Exports = 113.3 - Imports = 116.4 GDP = 543.5

Comparative GDP data (1998)Country GDP $US

(billion)

US 8,210

Japan 3,049.1

Australia 364.2

Indonesia 94.2

GDP and Economic Well-Being

GDP is a single measure of the economic well-being of a society.

GDP per person tells us the income and expenditure of the average person in the economy.

Higher GDP per person indicates a higher standard of living.

GDP is not a perfect measure of the happiness or quality of life.

GDP and Economic Well-Being

Some things that contribute to well-being are not included in GDP.

The value of leisure.

The value of a clean environment.

The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children.

Allowing for Inflation

Calculating Real Prices and Real GDP

Inflation

An increase in price from one year to the next without any change in the value or nature of the good or service same product but you pay more

Therefore, economic calculations need to allow for inflation in order to allow comparisons of economic performance across time

An Example A car costs $20,000 in 2001 The same car costs $22,000 in 2002

because of general inflation of all prices Price increase = 22,000 - 20,000 = 2000 As a proportion of starting price: 2000/20,000 = 0.1 x 100 = 10% There has been a 10% increase in price

The Real Price A price adjusted to allow for inflation Based on purchasing power A year (which could be any) is selected

and it becomes the base year Changes in prices are related to that

year Calculated using an index

The Consumer Price Index The GDP Deflator

Used to adjust prices on goods & services

includes only consumer goods and services

includes imports is measured using a

fixed basket of goods and services.

Used to adjust GDP includes all goods

and services produced domestically.

excludes imports. is measured using

currently produced goods and services.

Consumer Price Index

The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.

It is used to monitor changes in the cost of living over time.

It reports the movement of prices using an index number.

How the Consumer Price Index Is Calculated Fix the Basket: Determine what goods are

most important to the typical consumer. The Australian Bureau of Statistics (ABS)

identifies a market basket of goods and services the typical consumer buys.

The ABS conducts regular consumer surveys to determine what they buy and how much

they pay.

What’s in the CPI basket?Household equipmentand operationFood

Transport

Clothing

Health and personalcareTobacco and alcohol

Recreation andeducationHousing

How the Consumer Price Index Is Calculated Choose a Base Year and Calculate the

Index: Designate one year as the base year, which is the

benchmark used for comparison. Compute the index by dividing the price of the

basket in one year by the price in the base year and multiplying by 100.

Deriving the CPI (hypothetical figures)

Year Total cost of basket

Difference from 1999

basket

Fraction change

% difference from 1999

Consumer Price index

1999 1000 0 0 0 1

2000 1100 100 100/1000 10 1.10

2001 1120 120 120/1000 12 1.12

2002 1140 140 140/1000 14 1.14

The CPI and Business Analysis All business comparisons should be in real

terms Calculations based on:

Real costs Real returns Real profit

Otherwise you may be ‘losing ground’

The Effect of Inflation on a Wage

Year Nominal wage/wk

Consumer Price index

Deflating the nominal wage

Real wage in 1999 terms

1999 150 1 150/1 $150

2000 150 1.02 150/1.02 $147

2001 160 1.05 160/1.05 $152

2002 160 1.08 160/1.08 $148

Points to Note

The nominal wage (amount paid) went up but the real wage went down over time

This person could not buy quite as much, in terms of goods and services in 2002 as they could in 1999

Inflation erodes the buying power of anyone on a fixed income or an income that does not increase as much as the inflation rate.

The Limits of CPI as a ‘Measure’

Substitution Bias

The basket does not change to reflect consumer reaction to changes in relative prices.

Consumers substitute toward goods that have become relatively less expensive.

The index overstates the increase in cost of living by not considering the substitution by the consumer.

Introduction of New Goods

The bundle does not reflect the effects of new products.

New products result in greater variety, which in turn makes each dollar more valuable.

Consumers need fewer dollars to maintain any given standard of living.

Unmeasured Quality Changes

If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.

If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.

The Result

The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. The CPI overstates the increase in the cost of

living by about 0.5 to 2.0 percentage points per year.

Real GDPAllowing for Price Changes in the

Whole Economy

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.

An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

GDP Deflator

The GDP deflator measures the current level of prices relative to the level of prices in the base year.

It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

GDP Deflator

100GDP Real

GDP Nominal=deflator GDP

The GDP deflator is calculated as follows:

Converting Nominal GDP to Real GDP Nominal GDP is converted to real GDP as

follows:

100 X)deflator (GDP

) GDP (Nominal =GDP Real

year

yearyear

Nominal Spending in an Economy

Yr C Consum

ption

I Investment

G Govt.

spending

X Exports

M Imports

Total spending

$b 1999 290 80 90 100 110 450

2000 300 90 95 110 115 480

2001 310 100 100 120 120 510

2002 330 100 110 110 100 550

Calculating Real GDP

Year Deflator Nominal GDP ($b)

Real GDP

1999 100

This means the actual inflation rate from one

year to the next is 450 450/1 = 450

2000 105 5/100 = 5% 480 480/1.05 = 457

2001 110 5/105 = 4.76 510 510/1.1 = 463

2002 108 -2/110 = -1.8 550 550/1.08 = 509

Calculating Growth Rates

Year Real GDP

Change in Real GDP

% change in real GDP

1999 450

2000 457 457-450 = 7 7/450 = 1.5%

2001 463 463-457 = 6 6/457 = 1.3%

2002 509 509-463 = 46 46/463 = 9.9%

Inflation and Interest Rates

The Real Interest Rate The interest rate calculated to allow for the

loss of buying power Real interest rate = nominal rate - expected

inflation. You receive 8% on savings. The expected inflation rate is 2% Therefore your real interest rate is 6%

The Effect of Inflation on Interest Investor invests $10,000 @ 6% interest At end of year investor has nominally

gained 6% of $10,000 = $600 But if inflation is 2% through that year then

the investor has lost value (buying power) of investment by 2% of $10,000 = $200

Net gain is $400 or 4%

Points to Note Inflation ‘erodes’ the value of money

invested Lenders will try to seek a higher nominal

interest rate in order to compensate Those living off savings (relying on interest

for income) need to account for inflation

Correcting Economic Variables for the Effects of Inflation

Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.

When some dollar amount is automatically corrected for inflation by law or contract the amount is said to be indexed for inflation.

Points to Note

When comparing dollar values from different times, it is important to keep in mind that a dollar today is not the same as a dollar in the past.

The CPI and the GDP deflator are ways of measuring the overall level of prices and can be used to correct economic variables for the effects of inflation.

Conclusions Macroeconomics is the study of the

economy as a whole. To study the economy as a whole we need

to look at total consumption, total investment, national income, inflation etc.

Our key analytical tools are GDP, CPI, and GDP deflator.

In Light of the Objectives of this Lecture…

We now know how to: Calculate GDP and use it as an economic

indicator Allow for the effects of inflation Calculate real prices and real GDP Identify the effect of inflation on interest rates

THE END and HAPPY EASTER