Understanding Macroeconomics and GDP

Macroeconomics

• Macroeconomics is the study of the economy as a whole
• Microeconomics studies how individual households and firms make decisions and interact in markets
• This course focuses on commonly used macroeconomic variables: GDP, inflation, and unemployment
• The goal of macroeconomics is to explain the economic changes that affect many households, firms, and markets at once

Gross Domestic Product (GDP)

• GDP measures the income and expenditures of an economy
• GDP is the total market value of all final goods and services produced within a country in a given period of time
• Income must equal expenditure for an economy as a whole
• Every transaction has a buyer and a seller
• Every dollar of spending by a buyer is a dollar of income for some seller
• The circular-flow diagram illustrates the equality of income and expenditure
• GDP can be measured from the income side or the expenditure side
• Some countries measure GDP from both sides
• The UK measures GDP from the expenditure side
• Value-added method may be used, where value added in each production stage is measured
• GDP includes the market value of output, valued at market prices
• GDP records only the value of final goods, not intermediate goods to avoid double-counting
• GDP includes tangible goods like food and clothing, and intangible services like haircuts and house cleaning
• GDP includes goods and services produced in the period considered, excluding transactions involving goods produced in the past
• GDP measures production value within a country's geographic confines
• GDP measures production within a specific time interval, usually a year or a quarter (three months)

What's Not Counted in GDP

• GDP excludes most items that are produced and consumed at home and that never enter the marketplace
• GDP excludes items produced and sold illicitly
• Washing a car or taking care of children are also excluded

Components of GDP

• GDP (Y) is the sum of Consumption (C), Investment (I), Government Purchases (G), and Net Exports (NX)
• Y = C + I + G + NX
• Consumption (C) is household spending on goods and services, excluding new housing purchases
• Investment (I) is firm spending on capital equipment, inventories, and structures, including new housing (by households)
• Government Purchases (G) is spending on goods and services by local and central governments
• Government Purchases do not include transfer payments, since they are not made in exchange for currently produced goods or services
• Net Exports (NX) equals exports minus imports (X-M), where X is exports and M is imports
• Imports represent domestic consumption of foreign-produced goods
• Exports represent foreign consumption of domestically produced goods
• Exports are included and imports are excluded in GDP
• Transfer payments are not included in GDP, since they are payments for which no good or service is exchanged
• In most developed countries, consumption typically constitutes the largest share of GDP

Real vs. 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

Numerical Example: Apples and Potatoes Economy

• The theoretical economy produces only apples and potatoes
• Table 3a shows the quantities of the two goods produced and their prices in the years 2013, 2014 and 2015

Table 3a: Prices and quantities for apples and potatoes

Table 3b: Nominal and Real GDP

• Nominal GDP is calculated using current prices
• Real GDP is calculated using a base year (2013) prices | Year | Calculation | | --- | ----------- | | 2013 (Nominal) | (€1 per kg apples × 100 kg) + (€2 per kg potatoes × 50 kg) = €200 | | 2014 (Nominal) | (€2 per kg apples × 150 kg) + (€3 per kg potatoes × 100 kg) = €600 | | 2015 (Nominal) | (€3 per kg apples × 200 kg) + (€4 per kg potatoes × 150 kg) = €1,200 | | 2013 (Real GDP base year 2013) | (€1 per kg apples × 100 kg) + (€2 per kg potatoes × 50 kg) = €200 | | 2014 (Real GDP base year 2013) | (€1 per kg apples × 150 kg) + (€2 per kg potatoes × 100 kg) = €350 | | 2015 (Real GDP base year 2013) | (€1 per kg apples × 200 kg) + (€2 per kg potatoes × 150 kg) = €500 |
• The rise is attributable to increase in quantities of apples and potatoes and increase in prices. To factor out the effect of prices, use Real GDP

GDP Deflator

• GDP deflator measures the price level
• It's calculated as the ratio of nominal GDP to real GDP times 100
• This deflator indicates the rise in nominal GDP attributable to price increases rather than increased production
• GDP deflator = (Nominal GDP / Real GDP) × 100

Table 3c: GDP Deflator Calculations

For the year 2013, nominal GDP is €200, and real GDP is €200, so the GDP deflator is 100.

GDP and Economic Well-being

• Real GDP per capita is the best single measure of a society's economic well-being
• It reflects the mean income and expenditure of the population
• A higher GDP per person generally indicates a higher standard of living
• GDP is not a perfect measure of happiness or overall quality of life
• Key components such as leisure, clean environment, and volunteer work are not included

GDP per Capita, Life Expectancy, and Literacy

• GDP per capita is calculated by dividing gross domestic product by a country's population
• This metric provides a measure of national income per head
• The percentage change in real GDP is referred to as GDP growth

Components of GDP growth in the U.S.A. (2009 Example)

• In 2009: -2.8 = -1.06 - 3.52 + 0.64 + 1.14
• Although consumption makes up about 70% of US GDP, the effect of investment on GDP was more than three times larger

UK GDP

• In the UK, GDP is calculated by the ONS (Office for National Statistics)
• The ONS collects data from government statistical offices in each constituent country, e.g., NISRA in Northern Ireland
• The 13 British overseas territories and 3 crown dependencies are not included in the calculation
• GDP data for the UK can be found on www.ons.gov.uk
• Within the ONS resources, "chained volume measure" signifies real GDP, and “current prices" refers to nominal GDP
• "Year-on-year" refers to GDP growth over the previous year
• "Quarter-on-quarter" refers to GDP growth over the previous quarter

UK GDP: Current Trends

• UK real GDP per capita barely changed post-pandemic
• ONS reported in Quarter 2 (Apr to June) 2024 that real GDP per head was 0.6% below its pre-coronavirus (COVID-19) pandemic level
• The slowdown in real GDP per head is due to:
  • Population increasing at a faster rate than output production
  • The UK population increased by an average of 1% per year in 2022 and 2023 due to higher immigration from non-EU nationals; This was the fastest pace of UK population growth in over 75 years
  • The decline in real GDP per head in 2023 was caused by a slower pace of hourly productivity and lower average hours worked

Inflation

• Inflation is a situation where the economy's overall price level is rising
• The inflation rate is the percentage change in the price level from the previous period

Consumer Price Index (CPI)

• The Consumer Price Index (CPI) measures the overall cost of goods and services bought by a typical consumer
• The Office of National Statistics (ONS) for the UK and Eurostat for Europe report the CPI monthly
• CPI is used to monitor changes in the cost of living over time
• When the CPI rises, the typical family must spend more money to maintain their standard of living

Five Stages to Calculating CPI

• Fix the Basket: Determine what prices are most important to typical consumers
  • The ONS identifies a market basket of goods and services the typical consumer buys
  • The ONS conducts regular consumer surveys to set the weights for the prices of core goods and services
• Find the Prices: Find the prices of each good and service in the basket at each point in time
• Compute the Basket's Cost: Use the price data to calculate the cost of the basket of goods and services at different times
• Choose a Base Year and Compute the Index
  • Designate one year as the base year, making it a benchmark to compare against
  • Calculate the index by dividing the price of the basket in one year by the price in the base year and then multiply by 100
• Compute the inflation rate
  • The inflation rate is equal to the percentage change in the price index from the preceding period

Formula for Calculating Inflation Rate

• Inflation Rate in Year 2 = [(CPI in Year 2 - CPI in Year 1) / CPI in Year 1] × 100

Example: Survey on Consumers to Determine Basket of Goods

• The Consumer Price Index is calculated and the survey is to determine goods
• The basket includes: 4 hot dogs, 2 burgers
• Table data showing values of items for the survey consumer | Year | Price of hot dogs (€) | Price of burgers (€) | | --- | --- | --- | | 2014 | 1 | 2 | | 2015 | 2 | 3 | | 2016 | 3 | 4 |

Table 5b Example Calculations for the Basket of Goods

Calculating the Consumer Price Index and the Inflation Rate: Another Example

• Base Year: 2008
• Basket of goods in 2008 cost: €1,200
• The same basket costs €1,436 in 2014
• CPI Calculation: (€1,436/ €1,200) * 100 = 119.7
• Prices increased 19.7 percent between 2008 and 2014.

Problems with CPI

• Problems with CPI include:
  • The basket used is changed only periodically
  • This can create problems and biases
  • Consumers substitute towards goods that have become relatively less expensive
  • The index overstates the increase in the cost of living by not considering consumer substitution
  • The basket does not reflect the change in purchasing power from new products
  • New products result in greater variety, making each unit of currency more valuable
  • Consumers need less money to maintain a given standard of living

More CPI Issues

• CPI is subject to unmeasured quality changes
• If the quality of a good rises from one year to the next, the value of home currency rises, even if the price remains the same
• If the quality of a good falls from one year to the next, the value of home currency falls, even if the price of the good remains the same
• The ONS tries to control for these differences but such differences are hard to measure
• This is important because CPI guides many government programs to adjust for changes in overall price levels

CPI and RPI Product Group Weightings since 1987

• Weights are specified as parts per 1000 of the all items RPI
• Various data points show specific trends in product group weighting over the years, like the reduction in food, or the general increase in housing

Inflation Pressures

• Harmonized indices of consumer prices use the same method to calculate CPI throughout the EU and the UK
• This enables the direct comparison of inflation rates across EU member states and the UK
• Supply chain disruptions due to Brexit, COVID-19, and the Ukraine war have pushed inflation far above the 2% target of the Bank of England in 2022
• Inflation Pressures have eased recently

The GDP Deflator versus the Consumer Price Index

• Economists and policymakers monitor GDP deflator and consumer price index to gauge how quickly prices are rising
• There are two differences between the indexes that cause divergence:
  • The GDP deflator reflects the prices of all goods and services produced domestically
  • The consumer price index reflects the prices of all goods and services bought by consumers
  • The Consumer Price Index compares the price of a fixed basket of goods and services to the price of the basket in the base year
  • The GDP Deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year

Correcting Economic Variables for the Effects of Inflation

• Price indexes are used to correct for the effects of inflation when comparing money figures from different times
• Formula: Salary = Salary × (Price level in 2012 / Price level in 1911)
• Example: £400 * (973.6 / 9.6) = £40,567

Indexed Value Calculation

• When some money amount is automatically corrected for inflation by law or contract, the amount is indexed for inflation
• In the United Kingdom, government salaries, child benefits, state pensions, disability allowance, job seeker's allowance, and universal credit are all indexed for inflation

Real and Nominal Interest Rates

• Interest is a payment in the future for a transfer of money in the past
• The nominal interest rate is the reported interest rate, not corrected for inflation
• The real interest rate is corrected for the effects of inflation
• Fisher's equation (named after Irving Fisher) governs the relation between real and nominal interest rates
• Real interest rate = Nominal interest rate – Inflation