Macro+First

Macro economics

INTRODUCTION

1Ten Principles of Economics

Economy. . .

. . . The word economy comes from a Greek word for “one who manages a household.”

Ten principles of economics

A household and an economy face many decisions: ◦Who will work?◦What goods and how many of them should be

produced?◦What resources should be used in production?◦At what price should the goods be sold?

Ten principles of economics (Contd….)

Society and Scarce Resources: ◦The management of society’s resources is

important because resources are scarce.◦Scarcity. . . means that society has limited

resources and therefore cannot produce all the goods and services people wish to have.


Economics is the study of how society manages its scarce resources.


How people make decisions.◦People face tradeoffs.◦The cost of something is what you give up to

get it.◦Rational people think at the margin.◦People respond to incentives.


How people interact with each other.◦Trade can make everyone better off.◦Markets are usually a good way to organize

economic activity.◦Governments can sometimes improve

economic outcomes.


The forces and trends that affect how the economy as a whole works. ◦The standard of living depends on a country’s

production.◦Prices rise when the government prints too

much money.◦Society faces a short-run tradeoff between

inflation and unemployment.

Principle #1: People face tradeoffs.

“There is no such thing as a free lunch!”

Making decisions requires trading off one goal against another.

Principle #1: People face tradeoffs (Contd….)

To get one thing, we usually have to give up another thing.

◦Guns v. butter◦Food v. clothing◦Leisure time v. work◦Efficiency v. equity

Principle #1: People face tradeoffs (Contd….)

Efficiency v. Equity◦Efficiency means society gets the most that it

can from its scarce resources.◦Equity means the benefits of those resources

are distributed fairly among the members of society.

Principle #2: The cost of something is what you give up to get it.

Decisions require comparing costs and benefits of alternatives.◦Whether to go to college or to work?◦Whether to study or go out on a date?◦Whether to go to class or sleep in?

The opportunity cost of an item is what you give up to obtain that item.

Principle #2: The cost of something is what you give up to get it. (Contd….)

LA Laker basketball star Kobe Bryant chose to skip college and go straight from high school to the pros where he has earned millions of dollars.

People make decisions by comparing costs and benefits at

the margin.

Principle #3: Rational People Think at the Margin.

Marginal changes are small, incremental adjustments to an existing plan of action.

Principle #4: People Respond to Incentives.

Marginal changes in costs or benefits motivate people to respond.

The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs!

Principle #5: Trade Can Make Everyone Better Off.

People gain from their ability to trade with one another.

Competition results in gains from trading.Trade allows people to specialize in what

they do best.

Principle #6: Markets Are Usually a Good Way to Organize Economic

Activity.A market economy is an economy that

allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.◦Households decide what to buy and who to

work for.◦Firms decide who to hire and what to produce.

Principle #6: Markets Are Usually a Good Way to Organize Economic

Activity.

Adam Smith made the observation that households and firms interacting in markets act as if guided by an “invisible hand.”◦Because households and firms look at prices when

deciding what to buy and sell, they unknowingly take into account the social costs of their actions.

◦As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole.

Principle #7: Governments Can Sometimes Improve Market Outcomes.

Market failure occurs when the market fails to allocate resources efficiently.

When the market fails (breaks down) government can intervene to promote efficiency and equity.

Principle #7: Governments Can Sometimes Improve Market Outcomes (Contd…)

Market failure may be caused by ◦an externality, which is the impact of one person

or firm’s actions on the well-being of a bystander.

◦market power, which is the ability of a single person or firm to unduly influence market prices.

Principle #8: The Standard of Living Depends on a Country’s

Production.Standard of living may be measured in

different ways:◦By comparing personal incomes.◦By comparing the total market value of a

nation’s production.


Production.(Contd….)

Almost all variations in living standards are explained by differences in countries’ productivities.

Productivity is the amount of goods and services produced from each hour of a worker’s time.


Production.(Contd….)

Standard of living may be measured in different ways:◦By comparing personal incomes.◦By comparing the total market value of a

nation’s production.

Principle #9: Prices Rise When the Government Prints Too Much Money.

Inflation is an increase in the overall level of prices in the economy.

One cause of inflation is the growth in the quantity of money.

When the government creates large quantities of money, the value of the money falls.

Principle #10: Society faces a short-run tradeoff between inflation & unemployment.

The Phillips Curve illustrates the tradeoff between inflation and unemployment:

òInflation ð ñUnemploymentIt’s a short-run tradeoff!

Summary

When individuals make decisions, they face tradeoffs among alternative goals.

The cost of any action is measured in terms of foregone opportunities.

Rational people make decisions by comparing marginal costs and marginal benefits.

People change their behavior in response to the incentives they face.

Summary (Contd….)Trade can be mutually beneficial.Markets are usually a good way of

coordinating trade among people.Government can potentially improve

market outcomes if there is some market failure or if the market outcome is inequitable.

Summary (Contd….)Productivity is the ultimate source of living

standards.Money growth is the ultimate source of

inflation.Society faces a short-run tradeoff between

inflation and unemployment.

What is macroeconomics?Macroeconomics considers the

performance of the economy as a whole. We try to understand changes in

◦The rate of economic growth◦The rate of inflation◦Unemployment◦Our trade performance with other countries

Macroeconomics also includes an evaluation of the relative success or failure of government economic policies

So what is ‘the economy’?The economy is made up of four sectors sometimes

called economic agents: Households who receive payments (income) for their

services (eg labour and land) and use this money to buy the output of firms (ie consumption or household spending).

Firms who use land labour and capital to produce goods and services for which they pay wages rent etc (income) and receive payment (expenditure)

Government (also known as the public or state sector) and

International eg consumers buying overseas products (M) and Foreigners buying UK products (X)

Difference between micro & macro

MicroeconomicsRecession in the tourist industry due to

the global downturnA government subsidy to steel

producersA recession in the textiles industryIncreased spending on the National

Health Service

Microeconomics and Macroeconomics Microeconomics focuses on the

individual parts of the economy. How households and firms make decisions

and how they interact in specific markets Macroeconomics looks at the economy

as a whole. How the markets, as a whole, interact at the

national level.

Microeconomics is the study of how households and firmsmake decisions and how these decision makers interact in thebroader marketplace. In microeconomics, an individual chooses tomaximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of manyindividuals trying to maximize their own welfare. Becauseaggregate variables are the sum of the variables describingindividuals’ decisions, the study of macroeconomics is based on microeconomic foundations.

The Essence of Microeconomics-Buyers and Sellers

The Many Facets of Macroeconomics

Key ConceptsGross Domestic Product (GDP)

◦ The monetary value of all goods and services produced within India in a given time period

Real GDP◦ The volume of goods and services produced within the

UK (i.e. GDP adjusted for changes in the price level)Economic Growth

◦ The percentage rate of increase of real GDP Inflation

◦ The annual percentage rate of change of the general price level

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 rupee of spending by some buyer is a

rupee of income for some seller. Say’s Law-Supply creates it’s own demand This process can be seen using a Circular Flow

Diagram.

Gross Domestic Product

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 period of time.

How much is the current GDP?

http://www.bea.doc.gov/

The Circular-Flow Diagram

Firms Households

Market for Factors

of Production

Market for Goods

and Services

SpendingRevenue

Wages, rent, and

profitIncome

Goods & Services

sold

Goods & Services bought

Labor, land, and capital

Inputs for production

The Components of the Macroeconomy

Everyone’s expenditure is someone else’s receipt. Every transaction must have two sides.

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National Income Accounting: Important Identities

Microeconomics

Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.

Macroeconomics

Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic

changes that affect many households, firms, and markets at once.

Macroeconomics

Macroeconomics answers questions like the following: Why is average income high in some countries

and low in others? Why do prices rise rapidly in some time periods

while they are more stable in others? Why do production and employment expand in

some years and contract in others?


When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

IN ORDER TO EVALUATE THE PERFORMANCE OF OUR ECONOMIC SYSTEM IN TERMS OF:

How rapidly it is growing,How stable it is,How it allocates its productive resources

to different end products- we need some measure of output & income

Strangely enough however, it was not until the 1930’s that reliable overall figures on Y & output were produced.

The main reason was that until the 1930’s most economists concerned themselves not so much with the overall performance of the economy (i.e. macroeconomics) but with the price system& the allocation of resources (i.e. microeconomics)

The coming of the GREAT DEPRESSION of the 1930’s forced economists to devote attention to the overall level of economic activity.

To measure the depth of depression & the extent of recovery, it was important to construct data on National Output & Y

These accounts supply the most valuable data we have about our economy

Are we interested in forecasting the level of economic activity next year???

-data on output, spending & Y—available to base our forecast

-Do we wish to study long term economic growth????- the historical data in NIA show output growth in the past, its growth compared with population or labour force, & proportion of output devoted to growth stimulating I

Are we intersted in the distribution of Y between wages & profit???—data available in components of Y


For an economy as a whole, income must equal expenditure because:Every transaction has a buyer and a seller.

Every Rs. of spending by some buyer is a dollar of income for some seller.

Measuring the ◦Production,◦Income and◦Spending of Nations

National Income Accounts:

•Provide the formal structure for our macro-theory models

Aggregate Demand….aggregate income..consumed or investedAggregate Supply….Total output..paid as wages, interest and dividendsIn equilibrium….Aggregate Demand=Aggregate Supply (growth) Inputs=Outputs Real output price levelBroad magnitudes to characterize the economy

GROSS DOMESTIC PRODUCT

It is the value of all goods & services produced annually in the nation.

GDP is a flow, it is an amount of production

Per unit of time

Basic Measures:•Gross Domestic Product (GDP) is the value of final goods and services produced in the country within a given period

Notable termsfinal goodsIntermediate goods•Value Added•Past output vs. current outputs•Measure of welfare•Use of resources to avoid bads such as crime•Improvement in the qualityin the country

GDP = ALL THE FINAL GOODS & SERVICES PRODUCED IN THE DOMESTIC TERRITORY OF INDIA

GNP = GDP + NET EXPORTSNNP = GNP – DEPRICIATIONNI = NNP – INDIRECT TAXES + SUBSIDIES

PRODUCTIVE & NON-PRODUCTIVE ACTIVITIES

Goods & services which enter into the circle of exchange = PRODUCTIVE

-FRANCE= SATELITE ACOUNTS

Factors of production….labor, capital, land

GDP= sum of payments to labor, capital, land and profits

Gross National Product (GNP)˸GDP+receipts from abroad made as factor payments to domestically owned factors of production.

• Net Domestic Product◦GDP minus depreciation ◦Depreciation is usually 11%◦NDP=89% of GDP

• National Income◦NDP-Indirect taxes that Business pay◦Indirect taxes that Business pay nearly 10%◦NI is nearly 90% of NDP

PI is the total income received – whether it is earned or unearned – by the households of the economy before the payment of personal taxes.

It is found by adding transfer payments to and subtracting social security contributions, corporate income taxes and undistributed corporate profits from the NI.

DI is the total income available to households after the payment of personal taxes. It is equal to PI less personal taxes and also equal to personal consumption expenditures plus personal saving.

S. No.

Countries GDP in 2003$million

GDP in 2010$million *

1. United States 10,881,609 14,580,000

2. Japan 4,326,444 5,500,000

3. Germany 2,400,655 3,310,000

4. U.K. 1,794,858 2,250,000

5. France 1,747,973 2,560,000

6. Italy 1,465,895 2,050,000

7. China 1,409,852 5,880,000

8. Spain 836,100 1,410,000

9. Canada 834,390 1,570,000

10. Mexico 626,080 1,040,000

* Source: World Bank, World Development Indicators

GDP:An important and versatile conceptWe will see that GDP measures

§ total income

§ total expenditure

§ total output

§ the sum of value-added at all stagesin the production of final goods

With government and foreign agents Need to account for :

a. Government purchases of goods and services.

b. Government payments for factor services (wages, rent, interest).

c. Transfer payments between different agents.d. Firms and households pay taxes to

government. e. Taxes paid on income, property, goods and

services.f. Transactions with the foreign sector.

Transfer payments

Transfer payments – are transactions wherein one party is not obliged to deliver a good or service in return for the payment.

◦Examples: retirement benefits, unemployment benefits, scholarships, and donations.

Transactions with foreign sector

Includes sales of goods and services, assets, and transfers

Exports - sales of domestically produced goods to other countries

Imports - goods bought from other countries

Measurement of economy’s output:The Gross Domestic Product (GDP)

The GDP measures the market value of all final goods and services produced within an economy in a given period.

GDP only measures current production. Transfer payments and transactions involving goods produced in other periods are not included in the calculation of GDP.

GDP is usually expressed in the currency of a particular country, e.g., Philippine peso….indicates the market value of the goods and services

Definition of GDPThe market value of good i (Vi) is equal to PiQi

GDP = sum of the market values of all final goods and services produced within the year.

n n

i i ii 1 i 1

GDP V P Q

GDP includes final goods and services onlyFinal goods - goods and services that are not

purchased for the purpose of producing other goods and services or for resale ◦Eg. Rice (final) and palay or unhusked rice (intermediate product)

Including intermediate goods and final goods will result in “double counting”.

3 Approaches for measuring GDP1. Expenditure Approach (upper loop) – measures GDP

as the sum of expenditures on final goods and services.

2. Income Approach (lower loop) – measures GDP as the sum of incomes of factors of production (wages, rent, interest and profit.

3. Value-added Approach – measures GDP as the sum of value added at each stage of production (from initial to final stage)

Expenditure ApproachUses the upper loop of the circular flow diagram.Example: Suppose the economy has only one product,

namely, rice.

Good Price per unit

Q sold Expenditure

Rice 20 1000 20,000GDP 20,000

Income ApproachUses the lower loop of the circular flow diagram:

sum of payments to the various factors of production.

Suppose that in the production of rice the sales and expenses are as follows:

Sales P 20,000Expenses:Wages 8000Rent 4000Interest 2000Total 14,000Profit 6,000GDP=Sum of Payments to factors 20,000 P 20,000

Value Added Approach

Suppose that rice is the only final product of an economy: It goes through several (3) stages of production.

Stage of Prod’nValue of

intermediate good

Value of Sales

Value-added

Farmer - Palay 12,000 12,000Rice Miller -Milled Rice

12,000 15,000 3,000

Retailers - Rice 15,000 20,000 5,000GDP= Total Value Added

20,000

Notes of the 3 approaches

The expenditure approach, income approach, and the value-added approach all come up with the same estimate of the GDP. They are equivalent approaches.

In the income approach, profit is also considered a payment to the entrepreneur. So the incomes are (1) wages, (2) rent, (3) interest, and (4) profit. Profit adjusts to make the sum equal to the final value of the good.

Notes of the 3 approaches (Contd…)

In the value added approach, only the value added in each stage of production are included. If we add the value of intermediate product with the value of the final product, we commit the sin of “double-counting.”

At each stage of production, the value-added is equal to wages, interest, rent, and profit. Therefore the value of the final product is likewise the same of all payments to the factors of production

Additional Topics

GDP vs GNPReal vs current GDPInter-country comparisons of GDP

◦Convert to international currency like US dollars◦Convert to per capita measures

THE NATIONAL ACCOUNTS OF THE PHILIPPINES

Same principles as above but need to make adjustments in order to accommodate the realities in modern economies

Expenditure approach

◦GDP = C + G + I + X –M+ SD

Table. Expenditures on GDP, 2002 in million pesos.

Item Symbol ValuePersonal Consumption Expenditure C 2,750,9000

Government Consumption Expenditure

G 488,700

Gross Domestic Capital Formation I 776,200

Exports of Goods and Services X 1,968,500

Less: Imports of Goods and Services M 1,989,100

Statistical Discrepancy SD 27,500

Gross Domestic Product GDP 4,022,700

Expenditure Approach C - spending of households and private non-profit institutions on goods and

services◦ Non-durables - goods and services that are consumed rapidly◦ Durable goods - that last for a longer period of time

I - investment spending of domestic agents. Its major components are “changes in” Fixed Capital and Changes in Stocks

G - government’s payments for the salaries of its workforce as well as purchases of goods and services used for the government’s day to day operations and projects.

Expenditure Approach (Contd…) X - the spending of the rest of the world on goods and non-factor services

produced in the country

M - the country’s purchases of goods and non-factor services from the rest of the world.

SD - accounts for accounting and reporting errors in the accounts. Needed to ensure that GDP value from all approaches are the same

Income ApproachITEMS SYMBOLS VALUE

Compensation of Employees COE 1,093,800

Net Operating Surplus NOS 2,215,100

Depreciation D 357,200Indirect Business Taxes less

SubsidiesIBTS 356,600


Income Approach

GDP = COE + NOS + D + IBTS

In a simple world, GDP = COE + NOS. In practice, require

two adjustments (D and IBTS)

D - accounts for the wear and tear of physical capital

“D” is treated as a business cost not included in NOS.

However, “D” is part of “I” in the expenditure side of the

national accounts

Income Approach (Contd….)

IBTS - includes taxes on the use or purchase goods and

services and grants from government to firms. E. g sales

taxes, value added tax

Not included in NOS but is part of the market prices, of which

the items in the expenditure accounts are quoted

Value added or Industrial Origin approach

GDP = value added of different activities (sectors)

ITEM VALUEAgriculture, Fishery and Forestry 519,400

Industry 1,307,400

Services 2,123,900

Gross Domestic Product 4,022,700

The distinction between GDP and GNP

GNP = GDP + Net Factor Income from the Rest of

the World (NFIRW)

NFIRW - measures the difference between the

earnings of Philippine residents in other countries

and foreign residents in the Philippines

The distinction between GDP and GNP


Net Factor Income from the Rest of the World

NFIRW 267,500

Gross National Product GNP 4,290,200

Nominal and Real GDP GDP at current prices or nominal GDP - GDP measured using

the prices of the year for which it is calculatedNominal GDP can be a misleading indicator of changes in

output or income because it also embodies changes in the prices of goods and services.

Real GDP or GDP at constant prices measures the total value of output using the prices of a selected year (the base year).

Real GDP better for analysis overtime because it eliminates the effects of price changes

Table 8.5YEAR 1 YEAR 2

QUANTITY Ice Cream 100 100 Buko Pie 100 100PRICE Ice Cream 50 100 Buko Pie 100 200VALUE Ice Cream 5,000 10,000 Buko Pie 10,000 20,000NOMINAL GDP 15,000 30,000

GDPyear 1 = (100) (50) + (100) (100) = 15,000

GDPyear 2 = (100) (50) + (100) (100) = 15,000

In practice, calculating real GDP using the previous approach is a tedious process because there are so many goods and services are produced in an economy. Can simplify the calculation process by using the GDP deflator.

GDP deflator - a price index that allows us to convert nominal GDP into real GDP. (note: price index to be defined later)

Real GDP

Nominal GDPReal GDP 100.GDP deflator

Investment vs. Capital§ Capital is one of the factors of production. At any given moment, the economy has a certain overall stock of capital.

§ Investment is spending on new capital.

Investment vs. CapitalExample (assumes no depreciation):§ 1/1/2002: economy has $500b worth of capital

§ during 2002: investment = $37b

§ 1/1/2003: economy will have $537b worth of capital

Stocks vs. FlowsFlow Stock

More examples:stock flowa person’s wealth a person’s saving# of people with # of new collegecollege degreesgraduatesthe govt. debt the govt. budget deficit

A question for you:Suppose a firm

§ produces $10 million worth of final goods

§ but only sells $9 million worth.

Does this violate the expenditure = output identity?

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

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

The Income Approach

The income approach divides GDP according to who receives the income from the spending flow.

In addition to aggregate income, national income and personal income are also used as measures of income.

The income approach

The Income Components Include:◦Wages and salaries ◦Corporate profits ◦Proprietors income (the profits of partnerships and soley owned

businesses, like a family restaurant) ◦Farm income ◦Rent ◦Interest ◦Sales taxes ◦Depreciation (the amount of capital that has worn out during

the year)

Interest (only the interest payments made by business firms

are included and the interest payments made by government are excluded).

Corporate profits which are subdivided into

Corporate income taxes Dividends Undistributed corporate profits

Three additions are made to the income side to balance it with expenditures.

1.Indirect business taxes are added because they are initially income that later gets paid to government.

2.Depreciation or the consumption of fixed capital is added because it is initially income to businesses that later gets deducted in calculating profits.

3.Net foreign factor income is added because it reflects income from all domestic output regardless of the foreign or domestic ownership of domestic resources.

The Production Approach

The production approach looks at GDP from the standpoint of value added by each input in the production process.

The three approaches--spending, income, and production– (should) result in equivalent values for GDP.

Personal consumption expenditures $245Net foreign factor income earned in the U.S. 0004Transfer payments 0012Rents 0014Consumption of fixed capital (depreciation) 0027Social security contributions 0020Interest 0013Proprietors’ income 0033Net exports 0011Dividends 0016Compensation of employees 0223Indirect business taxes 0018Undistributed corporate profits 0021Personal taxes 0026Corporate income taxes 0019Corporate profits 0056Government purchases 0072Net private domestic investment 0033Personal saving 0020

Below is a list of domestic output and national income figures for a given year. All figures are in billions. Determine the major national income measures by both the Expenditures and income methods.

Simple Economy…..No govt…no foreign trade C=consumption I=investment S=saving Y= Income

Output produced=output sold

Y= C+I………….(1)

I=S

Y=C+S…………(2)

Introducing govt. in the above identity

G= govt. purchases of goods and servicesTA=all taxesTR=transfers to private sector (including interest)NX=net exports (exports-imports)YD=disposable income

Y=C+I+G+NX……….(3)

YD=Y+TR-TA………..(4)

YD= C+S………………(5)

C+S=Y+TR-TA

• LEAKAGES (Withdrawals (W) : (T + S + IM) out of the system must equal INJECTIONS (J): (G + I + X) for the circular flow to balance (be in EQUILIBRIUM).

• Withdrawals [ T + S + IM] = Injections [G + I + X] can be broken down to three important balances in the economy:

1. T - G: the Government's Budgetary Balance;

2. S - I: the Private Sector's Saving/Investment Balance;

3. IM - X: the Country's Trade Balance (current account of Balance of Payments)

C=YD-S=Y+TR-TA-S……………………..(6)

Consumption is disposable income less savingOr consumption is equal to income plus transfers less taxes and saving

Using RHS of (6) in (3):

Y=C+I+G+NX……….(3)

Y= (Y+TR-TA-S)+ I+G+NXS-I=(TR-TA+G)+NX…………………………(7)Govt. budget deficit,I.e., total govt. expenditure consisting of govt. Purchases of goods and services(G) plus govt. transfer payments (TR) Minus amount of taxes (TA) received by govt. equals excess of private saving over investment and net exports

The budget deficit, trade, saving and investment(in Rs. Billion)

Saving (S)……………1000 1000 1000 1000Investment(I)…………1000 850 900 950Budget Deficit(BD)…..0 150 0 150Net Exports (NX)……0 0 100 -100

Exercises

Q.1 What would happen to GDP if the govt. hired unemployed Workers, who had been receiving amount $TR in unemployment Benefits, as govt. employees and now paid them $TR to do nothing?Explain.

Q.2In the national income accounts, what is the difference between:a)A firm’s buying an auto for an executive and the firm’s paying theExecutive additional income to buy the automobile herself?

b)Your hiring your spouse (who takes care of the house) rather than having him or her do the work without pay?

c)Your deciding to buy an Indian car rather than a German car?

3. The following is information from the national income accounts for a hypothetical country:

GDP $6, 000Gross investment 800Net investment 200Consumption 4, 000Government purchases of goods and services 1, 100Government budget surplus 30

What is:a. NDP? d. Disposable personal income?b. Next exports? e. Personal saving? c. Government taxes minus transfers?

GDP and GDP deflator

§ We would like to convert different goods

quantities and prices into one single quantity of composite good and

one general price level. How?

§ We use the concepts of nominal GDP, real GDP and

GDP deflator to achieve such aggregation.

Real vs. Nominal GDP

§ GDP is the value of all final goods and services

produced domestically.§ Nominal GDP measures these values using current prices.§ Real GDP measure these values using the prices of a base year.

Real and Nominal GDP2001 Nominal GDP

2006 Nominal GDP

2006 Real GDP

Bread (ton)

1 at Rs.1 thousand… Rs. 1thousand

2 at Rs.2 thousand.. Rs. 4 thousand

2 at Rs. 1 thousand…………Rs.2 thousand

Milk (thousand Litres)

1 at Rs 0.5 thousand………....Rs. 0.5 thousand

3 at Rs.0.75 thousand…………..Rs. 2.25 thousand

3 at Rs.0.50 thousand…………..Rs.1.50 thousand

Total GDP Rs. 1.5 thousand

Rs. 6.25 thousand Rs. 3.50 thousand

Real GDP and living standard

Changes in nominal GDP can be due to:§ changes in prices§ changes in quantities of outputproduced

Changes in real GDP can only be due tochanges in quantities, because real GDP isconstructed using constant base-yearprices. Therefore, changes in real GDPmeasure changes in living standard.

GDP DeflatorWhile real GDP captures living standard,

cost of living is measured by general price level.

One measure of the general price level is the GDP Deflator, defined asGDP deflator = 100 * Nominal GDP /Real GDP

Measuring the Cost of Living§ Inflation refers to a situation in which the economy’s overall price level is rising.§ The inflation rate is the percentage change in the price level from the previous period.

Nominal GDP billions

Price index (1992=100) Real GDP billions

1959 $ 507.2 23.0 $______

1964 663.0 24.6 $______

1967 833.6 26.6 $______

1973 1382.6 35.4 $______

1988 5049.6 86.1 $______

1995 7265.4 107.8 $______

Exercise: The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data

CPI vs. GDP deflatorprices of capital goods• included in GDP deflator (if produced domestically) • excluded from CPIprices of imported consumer goods • included in CPI• excluded from GDP deflator

the basket of goods• CPI: fixed• GDP deflator: changes every year

International Comparisons of GDP In any attempt to compare GDP between countries,

some account must be taken of differences in prices.

Adjustment for GDP based on exchange rates makes some improvement in the comparison of GDP figures.

However, if we wish to determine the value of GDP in another country, some information on the price differences of goods is needed.

Purchasing power parity exchange rates

attempt to adjust exchange rates for

differences in the prices of goods across

borders through the use of a ratio of price indexes.

The exchange rate is adjusted to reflect this ratio

•Once this adjustment is made, international rankings of countries

• based on GDP or per capita GDP tend to fluctuate

•as exchange rates vary, while the corresponding prices do not.

•Despite their variability due to exchange rate fluctuations,

• purchasing power parity exchange rates provide a better basis

for international comparisons than an adjustment based solely on exchange rates.

The Measurement of GDP

GDP is: the market value of all final goods and services produced within a country in a given period of time.

What Is Counted and Not Counted in GDP?

GDP includes all items produced in the economy and sold

legally in markets.

GDP excludes services that are produced and consumed at

home and that never enter the marketplace. Eg: Caring labor,

the work that is normally produced by women.

Because GDP does not count it, it diminishes its importance.

GDP also excludes black market items, such as illegal drugs.

Other Measures of Income

Gross National Product (GNP)Net National Product (NNP)National IncomePersonal IncomeDisposable Personal Income

The 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

GDP and Its Components (1998)

Total (Billions of Rs)

Per Person (In Rs)

% of Total

GDP (Y) $8,511 $31,522 100%

Consumption C 5,808 21,511 68%

Investment I 1,367 5,507 16

Government G 1,487 5,507 18

Net Exports NX -151 -559 -2

Net Exports -2 %

GDP and Its Components (1998)

Consumption 68 %

Investment16%

Government Purchases

18%

Measuring Economic Growth

◦We use real GDP to calculate the economic growth rate.

◦The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next.

◦We measure economic growth so we can make:◦ Economic welfare comparisons◦ International welfare comparisons◦ Business cycle forecasts

Measuring Economic GrowthBusiness Cycle Forecasts

◦Real GDP is used to measure business cycle fluctuations.

◦These fluctuations are probably accurately timed but the changes in real GDP probably overstate the changes in total production and people’s welfare caused by business cycles.

Real versus Nominal GDPNominal GDP values the production

of goods and services at current prices.

Real GDP values the production of goods and services at constant prices.

Real GDP and the Price Level

Deflating the GDP Balloon◦Nominal GDP increases because production—real GDP– increases.


Deflating the GDP BalloonNominal GDP also increases because prices rise.


We use the GDP Deflator to take the air out of Nominal GDP.

What makes a stable economy?Macro stability can be measured by the volatility of key

indicators: 1. Consumer price inflation (annual % change in prices)

2. Real GDP growth over one or more business cycles 3. Changes in measured unemployment / employment 4. Fluctuations in the current account of the balance of payments 5. Changes in government finances (i.e. the size of the fiscal deficit or surplus) 6. Volatility of short term policy interest rates and long term interest rates such as the yield on government bonds 7. Stability of the exchange rate in currency markets

A stable economy provides a framework for an improved supply-side performance i.e.

• Stable low inflation encourages higher investment which is a determinant of improved productivity and non-price competitiveness

• Control of inflation helps to main price competitiveness for exporters and domestic businesses facing competition from imports

• Stability breeds higher levels of consumer and business confidence – sentiment drives spending in the circular flow

• The maintenance of steady growth and price stability helps to keep short term and long term interest rates low, important in reducing the debt-servicing costs of people with mortgages and businesses with loans to repay

• A stable real economy helps to anchor stable expectations and this can act as an incentive for an economy to attract inflows of foreign direct investment

Macro+First

Documents

organize economic

gross domestic

circular flow

improve market

people face

general price

measuring

economic growth