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Chapter 19: What Macroeconomics is all about? Macroeconomics – study of overall, or aggregate economy Macroeconomics deal with the “big picture”
- overall price level, not individual prices
- adjustment or changes across the whole country Topics in Macro Include
- unemployment
- inflation
- business cycle
- exchange rates
- economic growth Key Macroeconomic Variables: Output & Income: The production of output generates income. The quantity of total output is the total value of all goods and services produced. It is measured in dollars. The dollar value of total output is the nominal or current dollar, national income Called Gross Domestic Product (GDP) at current prices. Can remove effects of price changes overtime.
- then have real national income, or income at base – period prices. Potential National Income (Output) What the economy could produce if all resources were employed at their normal levels of utilization Often called full-employment income. The output gap: The difference between potential and actual output. Denote potential output by Y* and actual output by Y.
Output Gap = Y – Y* Recessionary Gap: when actual income is less than potential income. Inflationary Gap; when actual income exceeds potential income.
- The output gap slows cycle pattern Why GDP matters: When GDP is below potential, output & incomes are lost. Can never recover these losses When GDP is above potential, can generate inflation. Growth is potential GDP can increase future incomes. But….. Increase in average income doesn’t mean increase for all. Not all benefit
Unemployment (U) changes over the business cycle. During recessions, U rises above full employment level. During booms, U falls below this level. When U is greater than the full employment level, have cyclical employment. Also have seasonal U, E.g U may generally rise by 0.3% points in January. StatsCan seasonally adjusts figure to remove this – can see trends more clearly Full employment: all unemployment is frictional and structural – There is no cyclical U. At full employment, GDP is at potential. **The labor force and employment has grown since 1960 with only a few interruptions. The business cycle is apparent n the fluctuations in the employment rate. Effects of unemployment: Economic problems – loss of output, loss of skills, etc. Immense hum suffering: e.g. illness, breakdowns, etc. Social problems – homelessness, crime. Inflation and the price level: Price Level : the average level of all prices in the economy. Inflation : the rate which the price level is changing. The most common measure of the price level – Consumer Price Index (CPI): CPI is based on the price of a typical consumer “basket” of goods and services. CPI for base period (year) is 100. CPI in later years shows prices as a ratio of prices in the base year.
FORMULA
Example: in 1992 (base year) average consumer bought: Product Quantity Price Expenditure Shirts 5 $10 $ Pizza 10 $7 $ Movies 2 12 24 Total Expenditure 144 In 2003, measure cost of same “basket of goods”. Product Quantity Price Expenditure Shirts 5 $12 $ Pizza 10 $8 $ Movies 2 $15 $ Total Expenditure $ In 1992, typical consumer basket of goods cost $ In 2003, same basket of goods costs $ CPI in 2003, with 1992 base year, is: (170/144) * 100 = 1.18 * x 100 = 118 CPI in 2003 was 118 Prices rose by 18% from 1992 to 2003. *** Note: CPI in base year is always 100. Inflation Rate: Percentage change in the CPI. Usually calculated over a year – the annual inflation rate. Can measure inflation rate between any two years:
The Interest Rate Interest rate: the price of borrowing funds. Expressed as a percentage per period of time. (Actually mean interest rates, e.g. mortgage rates, personal loans rate. They tend to move together.) Inflation affects the interest rate.
- speak of nominal vs. real interest rate Nominal Interest Rate:
- No adjustment for inflation Real interest rate:
- adjusted for inflatigmon. e.g. if nominal interest rate is 8% per year. And inflation rate is 3%. Real interest rate is 5%. The burden of borrowing depends on the real, not the nominal, rate of interest. The international economy Some terms: Foreign Exchange: foreign currencies. Foreign exchange market: where foreign countries are traded. Exchange Rate: the umber of Canadian dollars required to purchase one unit of foreign currency – it is the Canadian-dollar price of a foreign currency. A depreciation of the Canadian dollar: Means the Canadian dollar is worth less on the foreign exchange market- The exchange rate increased. Can distinguish between internal and external value of Canadian dollar: Internal: the purchasing power of he dollar in Canada External: the foreign currency price of the Canadian dollar.
- The opposite of the exchange rate.
e.g. Canadian dollar is worth $0.90 U.S.: external value of $CA is %0.90, in $U.S. exchange rate is $1.11 (costs $1.11C for $1.00 U.S) (Calculation: $C1.00/$0.90 = $1.11) International trade accounted for in: Balance of payments accounts: Record all international payments made for goods, services, and assets. Trade account: part of the balance of payments – Records transactions in goods and services, i.e. imports and exports Trade balance: difference between the values of exports and imports. For Canada, international trade is very important. Both imports and exports are very large (roughly 40% of GDP). But the trade balance is usually very small. Growth versus Fluctuations Economic Growth : total output and output per person generally rise in industrialized countries. Rising per capita output leads to rising living standards Some issues Since 1970s, worldwide growth has slowed-why? Can governments do anything to promote economic grow? Should they? Do central banks have a role to play in growth?
Total value added in the economy is Gross Domestic Product (GDP): Measure of all final output that is produced in the economy, valued at market prices, in a time period, e.g. year. Adding up value added is a good way to measure GDP
- avoids double counting. Must not simply add up each firm’s output – this overestimates GDP. e.g. adding up cotton, plus cloth, plus shirt overestimates value of production – price of cotton and cloth are included in price of shirt. National Income Accounting: The Basics Three different ways of measuring national income. o Add up the total value added from domestic production. o Add up the total expenditure on domestic output. o Add up the total income from domestic production. Because of the circular flow of income, these 3 measures yield the same total – Gross Domestic Product (GDP)
GDP FROM THE EXPENDITURE SIDE
add up expenditures needed to purchase final output produced (in year) Four expenditure categories:
- Actual Consumption expenditure (Ca): Expenditure on all final consumer g &
- Actual investment expenditure (Ia): Expenditure on G&S not for present consumption, including: New plant and equipment (additions to capital stock), Also called Business fixed investment; Inventory accumulation; New residential construction. “I” may be used in two ways: a) replacement investment, i.e. Investment to cover depreciation (or capital consumption) - maintains existing capital stock. b) Net investment – The addition to the capital stock. Gross I = Depreciation + Net I e.g. 10 machines = 2 machines + 8 machines since all of gross I is new production (10 machines), it is included in GDP.
- Government purchases of g & s (Ga) Not the same as government spending – Government spending includes transfer payments, e.g. pensions: They do not represent the purchase of G&S by govt. To measure outputs in the economy, count only govt purchases of g&s. Note – govt purchases (costs) represent govt output.
- indirect taxes (e.g. sales taxes) less subsidies
- depreciation of physical capital o (firms subtract “capital consumption allowance” before calculating profits for tax purposes). Must add these back to get the true value of production. GDP from the income side is thus equal to: **GPD = Net domestic income at factor cost + indirect taxes (Less subsidies)
- Depreciation GDP and GNP** GDP measure total output produced in Canada and total income earned from that production – e.g. includes profits earned by foreigners on investments in Canada. GNP (Gross National Product) measure the total income received by Canadian residents, no matter where the income was generated – e.g. includes income earned by Canadian residents on investments abroad. GDP is a better measure of domestic economic activity. GNP is better measure of the economic well-being of country’s residents. Another important measure: Disposable Personal Income: is important to households. DPI is GNP minus part of it that is not actually paid to households: Subtract all taxes paid by households (personal income, sales), interest paid, etc. ADDS transfer payments received by households.
Real and Nominal GDP Total GDP, valued at current prices, is nominal GDP. GDP at constant (base year) prices is real GDP. Convert from nominal to real GDP using GDP deflator: GDP Deflator = GDP at current prices GDP at base year prices Can rearrange terms to get GDP at base year prices: GDP at base year prices = GDP at current prices GDP deflator GDP is the most comprehensive price index – Includes prices of all G&S produced in the country. How is GDP Deflator calculated? Not the same as CPI – Includes all goods and services produced in economy, Not just consumer goods and services. Also, can’t use a fixed basket of goods, Since the G&S produced change each year. Procedure is to calculate value of Current Production at base prices. Example Assume 1992 is the base year, and 2005 is current year. First, calculate production in both years at current prices to get current dollar (nominal) GDP;
X 100
X 100
Implicit GDP deflator for 2005 – GDP in current prices Real GDP = 13200 9000 = 146. Conclusion : Prices of all G&S have risen by 46.7 percent since the base year (1992). The CPI and the GDP Deflator generally move together, Since the same inflationary forces affect both of them. But CPI tracks consumer prices, GDP deflator tracks prices of all G&S produced in Canada. Some differences: e.g. world price of coffee rises, pushes up CPI. But Canada produces no coffee, so no effect on Canadian GDP deflator. Output and Productivity Real GDP increased over past century – two main causes:
- An increase in inputs – more land, labour, and capital used in production; and
- An increase in the amount of output process per unit of input (productivity). Another useful measure: Per capita output is output per person (GDP/population) – Measure the average output, or income, per person. Per capita output is a good measure of changes in average standard of living. x 100 x 100
Omission from GDP GDP measures marketplace activity. Omits: Illegal activities (drugs, prostitution, etc.) The underground economy (tax avoided transactions) Home production (housework, do it yourself projects) Economic “bads” (pollution) e.g. are salaries of police a good thing, or just an offset to the bad (criminals)? GDP thus does not measure all aspects of human welfare. But income is important part of well-being, and GDP is a very good measure of income. And changes in GDP do a good job of measuring changes in economic well being, As long as unmeasured economic activity changes little.
Two uses of deposable income: Consumption (C) or Saving (S) Influences on C given in the consumption function, on S in the saving function. Simple consumption function – C is determined by current real disposable income (YD) (other influences on C are held constant.) The simple consumption function: C = a + bYD Where “a” is autonomous consumption expenditure, and “bYD” is induced expenditure For example: C = 40 + 0.08 YD If YD is 100, C = 40 + 0.08(100) = $40 + $ = $
C = 40 + 0.08 YD
Marginal Propensity to Consume (MPC): The change is desired C when YD Changes – The slope of the consumption function. MPC = ∆C / ∆YD Here, the MPC = 80/100 = 0. (YD increase by $100, C increases by $80)
YD C
45 o 40
