ECN102 World Economy Lecture 2 2024 Lecture Notes PDF

ECN102 World Economy Week 2: Measuring Output and making international comparisons Professor Rachel Male ECN102 World Economy Week 2 1 What are we going to look at this week? Measuring output and making intern...

ECN102 World Economy Week 2: Measuring Output and making international comparisons Professor Rachel Male ECN102 World Economy Week 2 1 What are we going to look at this week? Measuring output and making international comparisons Measuring Output:  Real versus nominal variables.  Output as value added.  Output, income and expenditure measures. Making international comparisons  Purchasing power parity. ECN102 World Economy Week 2 2 Learning outcomes By the end of this week you should be able to:  define the difference between real and nominal output, and explain which gives a better measure of output;  calculate GDP using the output (value added), income, and expenditure measures;  explain why a purchasing power parity (PPP) exchange rate should be used for making international comparisons of GDP. ECN102 World Economy Week 2 3 What is ‘output’ and why are we measuring it? What is output? Why do economists measure output? ECN102 World Economy Week 2 4 Definitions: GDP and GNI GDP measures value of final goods and services produced within a country over a specified period of time. GNI measures total income of all residents of a nation wherever they produce or earn this income. GNI = GDP + NPIA per capita? Divide total output (Y) by total population (N) e.g. GDP GDP per capita = Population ECN102 World Economy Week 2 5 Question time! GDP per capita (PPP, constant 2021 international $) in Ireland is $114,120 (World Bank 2024), which ranks it as the 3rd richest country. Ireland has a large number of foreign investors, what does this mean for GNI per capita? Dr Rachel Male ECN102 World Economy 6 ECN102 World Economy Week 2 6 Question time! When making lending decisions, should the World Bank use GDP or GNI? (And why?) Dr Rachel Male ECN102 World Economy 7 ECN102 World Economy Week 2 7 Definitions 𝐺𝐺𝐺𝐺𝐺𝐺 = 𝐺𝐺𝐺𝐺𝐺𝐺 + 𝑛𝑛𝑛𝑛𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 ECN102 World Economy Week 2 8 How is GDP measured? Need to know how to add together the value of all output produced in an economy during a particular period. ∑𝑛𝑛𝑖𝑖=1 𝑝𝑝𝑖𝑖𝑖𝑖 𝑞𝑞𝑖𝑖𝑖𝑖 ? No! This would lead to overestimation. Calculate value added in each sector: i.e. value of output sold (𝑝𝑝𝑖𝑖𝑖𝑖 𝑞𝑞𝑖𝑖𝑖𝑖 ) – cost of inputs (𝑐𝑐𝑖𝑖𝑖𝑖 𝑞𝑞𝑖𝑖𝑖𝑖 ) ECN102 World Economy Week 2 9 How is GDP measured? Three approaches to measuring GDP: The production approach – sum of value added produced by each sector in an economy. The income approach – sum of all income (profits and salaries) generated by production activity. The expenditure approach – sum of expenditure on final goods and services within the economy. Y = C + I + G + (X – M) ECN102 World Economy Week 2 10 How is GDP measured? Calculate GDP using each of the three methods for Economy A: Sector Product Output Price Profits Salaries (units) (£) (£) (£) Farming Cotton 24,000 3 24,000 48,000 Spinning Cotton Thread 18,000 6 12,000 24,000 Knitting Cotton Material 12,000 12 12,000 24,000 Designing T-shirts 7,200 24 9,600 19,200 Manufacturing T-shirts 7,200 30 14,400 28,800 Retailing T-shirts 7,200 48 43,200 86,400 ECN102 World Economy Week 2 11 Intermediate goods and double counting If Economy A also produces cars, are tyres an intermediate good or a final good? (How will this affect the calculation of Economy A’s GDP?) ECN102 World Economy Week 2 12 Measuring GDP: real vs nominal To compare the value of GDP we have calculated for Economy A with the value of GDP in the next year (n+1), what prices should we use? The price of goods in year n+1 or the price of goods in year n? (i.e. current prices or base year prices?) Calculations of Nominal GDP use current prices and calculations of Real GDP use base year prices How will the choice of price affect the value of GDP? ECN102 World Economy Week 2 13 Question time! Real vs Nominal GDP What will give a better measure of welfare? Dr Rachel Male ECN102 World Economy 14 ECN102 World Economy Week 2 14 Concept check! Inflation What is inflation and why does it matter for comparisons of GDP?  inflation is a sustained increase in the overall price level.  as the price level rises, each unit of currency will purchase a smaller quantity of output, so purchasing power falls.  controlling for inflation when making comparisons of GDP values is important to ensure that we can identify changes in the quantity of output produced. Dr Rachel Male ECN102 World Economy 15 ECN102 World Economy Week 2 15 International comparisons Each country’s GDP is measured in its local currency. Need to convert this to a common currency to make international comparisons.  require an exchange rate ECN102 World Economy Week 2 16 International comparisons – the market exchange rate The nominal exchange rate (NER) is: the rate at which you can exchange one currency for another on the foreign exchange market E.g. £1 = $1.13 (or $1 = £0.88) Problems with using the NER:  Subject to fluctuations! o Depreciation of the local currency will reduce the value of GDP (after conversion)  Price reflects tradeable goods and services only. ECN102 World Economy Week 2 17 Question time! Does a Starbucks cappuccino cost the same in all countries? Discuss reasons why the price of a Starbucks cappuccino is, or isn’t, the same in all countries. ECN102 World Economy Week 2 18 International comparisons – purchasing power parity A purchasing power parity (PPP) exchange rate: is a conversion factor that controls for price level differences between countries. Calculated as a ratio of the prices in domestic currency of the same basket of goods and services in different countries E.g. if a Big Mac costs £3.69 in UK and $5.15 in US (The Economist, 2022) ⇒ Implied PPP rate = 3.69 / 5.15 = 0.79 After conversion at the PPP rate, a representative basket of goods and services will cost the same in each country. The World Bank International Comparison programme makes these calculations to construct PPP adjusted GDP data. ECN102 World Economy Week 2 19 International comparisons: The Big Mac Index Big Mac Prices Actual In local Implied Exchange Value Country Currency In Dollars PPP Rate* Rate* Against $ US $ 5.74... … … … UK £3.29 $4.10 0.57 0.80 -28.5% Euro Area € 4.08 $4.57 0.71 0.89 -20.3% Japan Yen 390 $3.59 67.94 108.77 -37.5% China Yuan 21 $3.05 3.66 6.88 -46.9% India Rupee 183 $2.67 31.88 68.55 -53.5% South Africa Rand 31 $2.19 5.40 14.18 -61.9% (Source: The Economist, July 2019) Big Mac Price in Dollars = Price in Local Currency / Actual Exchange Rate PPP Rate = Price in Local Currency / Price in US (in $) ECN102 World Economy Week 2 20 International comparisons – why PPP matters Compare quantity of output produced not differences in relative price levels. - Using market exchange rates yields GDP figures that reflect differences in both quantity and price. - Using a purchasing power parity (PPP) exchange rate yields GDP figures that only reflect differences in quantity. ECN102 World Economy Week 2 21 Economic Size: the world’s largest economy? 2022 China United States GDP (current 17.96 25.46 int.$, trillions) GDP (PPP, current 30.33 25.46 int.$, trillions) World Bank Open Data: https://data.worldbank.org/ ECN102 World Economy Week 1 22 Economic Size: the world’s largest economy? 2022 China United States GDP (current 17.96 25.46 int.$, trillions) GDP (PPP, current 30.33 25.46 int.$, trillions) GDP per capita 21,475.61 76,398.59 (PPP, current int.$) World Bank Open Data: https://data.worldbank.org/ ECN102 World Economy Week 1 23 International comparisons – Why PPP matters Using market exchange rates, the world economy is dominated by rich advanced nations. US 24.0%, Euro Area 15.6%, China 15.2%, Japan 6.0% Using PPP exchange rates to account for differences in price reveals a more substantial size for emerging markets. China 18.3%, US 15.2%, Euro Area 11.7%, India 7.4% ECN102 World Economy Week 2 24 International comparisons – PPP exchange rate Advantages?  Enables volume comparison of economy size Disadvantages?  Estimation of PPP exchange rate is complex  Data availability / quality issues ECN102 World Economy Week 2 25 What are we going to be looking at next week? Inequality, Poverty, and Economic Growth Output and Welfare:  Problems with using GDP as a measure of welfare.  Alternative measures. Growth, poverty, and income inequality  Is there a relationship between economic growth, inequality, and poverty?  Measuring inequality  Poverty traps ECN102 World Economy Week 3 26 Any questions? ECN102 World Economy Week 2 27