Introductory Macroeconomics Lecture 2 PDF

Introductory Macroeconomics Lecture 2: Fundamental Macro Concepts, Part One Jonathan Thong Daniel Minutillo 2nd Semester 2024 1 Australian GDP Growth 2  This Lecture Beginning of fundament...

Introductory Macroeconomics Lecture 2: Fundamental Macro Concepts, Part One Jonathan Thong Daniel Minutillo 2nd Semester 2024 1 Australian GDP Growth 2  This Lecture Beginning of fundamental macro concepts. Aggregate economic activity – measuring GDP, circular flow of income – national income accounting – nominal vs. real GDP – GDP levels vs. GDP growth BOFAH chapters 1 and 2 3 Measuring GDP, Circular Flow of Income 4 Three Sector Circular Flow Model 5  Aggregate Economic Activity We want a summary measure of aggregate economic activity The most common measure is gross domestic product (GDP) G: gross i.e., does not subtract depreciation D: domestic i.e., activity in an economy regardless of ownership P: product refers to one way to measure GDP, as value of production of final goods and services 6  Market Value Use market prices to add up over many goods and services Because of this, non-market economic activity not in GDP – home production: childcare, cleaning, cooking – black market economy Government production often has no market price, valued at cost – defense, public education, public health 7  Final Goods and Services GDP is the sum of final goods and services Avoids double-counting of intermediate goods used in production wheat (farmer) → flour (miller) → bread (baker) Measures economic activity per period (e.g., per year, per quarter) Does not count purchases of goods produced in previous periods (e.g., second-hand cars, second-hand houses) Does not count purchases of things that are not good or services (doesn’t count purchases of financial assets, e.g., stocks and bonds) 8 National Income Accounting 9  National Income Accounts There are three ways to measure GDP per period 1- market value of production of all final goods and services (production approach) 2- sum of all domestic expenditures (expenditure approach) 3- sum of all domestic income (income approach) By accounting construction, all three approaches give the same answer (up to a statistical discrepancy) Details recorded in each country’s national income accounts 10  National Income Accounts Intuitive idea – output produced sold at market prices so must equal expenditure – expenditure on output becomes income to producers (either capital income or labour income) What about goods produced but not sold? – treated as inventory accumulation, a form of expenditure 11  Circular Flow of Income Households own factors of production, e.g., labour and capital. They receive income from supplying labour and capital to firms. Firms use factors of production to produce goods and services. They receive revenue from selling goods and services to households. 12  Aggregate Income Traditional to use the symbol Y to represent aggregate income Income approach to GDP Y = wL + rK where wL denotes labour income and rK denotes capital income Every final good purchase transfers money from household to firm Firm revenues paid to factors of production (labour and capital) 13  Example: Production and Income Steel Company (Firm #1) Car Company (Firm #2) Revenue $100 Revenue $210 Inputs Inputs labour $80 labour $70 capital $20 capital $40 steel $100 What is GDP in this example? 14  Example: Production and Income Value of production of all final goods and service – steel is used to produce cars – steel is an intermediate good – the market value of final goods (just cars) is $210 Also sum all value-added – value of steel production $100 – value-added of cars $210 − 100 = $110 – total value-added $100 (steel) + $110 (cars) = $210 And also sum of all income – labour $80 (steel) + $70 (cars) = $150 – capital $20 (steel) + $40 (cars) = $60 also known as gross operating surplus (gross output minus prod. costs) – total income $150 (labour) + $60 (capital) = $210 15  Aggregate Expenditure Expenditure approach to GDP is written Y = C + I + G + (X − M ) where Y = aggregate income (= GDP) C = private consumption I = private investment G = government purchases X − M = net exports = exports − imports 16  Aggregate Expenditure Consumption: spending by households on goods and services – Durables: long lived goods like cars, white goods, and furniture. – Non-Durables: services and short lived goods like food and clothing. Investment: spending by firms on final goods and services – Business Fixed Investment: capital goods like computers/factories that are not used up in production (unlike intermediate goods). – Changes in Inventories: goods not sold in year of production. – Residential Investment includes newly constructed homes. Government Expenditure excludes transfers and interest. Exports foreign purchases of domestic-produced goods/services. Imports domestic purchases of foreign-produced goods/services. 17  National Income Accounting Identity National income accounting says Y =C +I +G+X −M It’s important to note what this does and does not say. An accounting identity is always true because of how its components are defined. Does not mean that an increase in C causes GDP to increase. Does not mean that an increase in M causes GDP to decrease. We ’−M ’ to avoid double-counting imported goods and services. 18  GDP Caveats GDP is a measure of average income at market prices – it leaves out non-market activity – we may want to value things at other than market prices GDP does not account for the depletion of natural resources and the impact of pollution and environmental degradation GDP per person tells us nothing about income distribution – two countries may have very similar GDP per person but very different amounts of inequality Put simply, GDP is not a measure of national well-being – No need to treat it like it’s the only thing worth caring about 19 Nominal vs. Real GDP 20 Comparisons Over Time and Across Countries So far, have looked at GDP for one time period and one country This can be expressed in dollars (or some other currency) This is known as nominal GDP To make comparisons – over time, we need to adjust for the changing purchasing power of current units – across countries, we need to adjust for changing value of domestic currency relative to foreign currency 21  Nominal GDP vs. Real GDP Goal: separate nominal GDP into quantity index and price index nominal GDP = (real GDP ) × (GDP deflator ) | {z } | {z } quantity index price index We refer to – the quantity index as real GDP – the price index as the GDP deflator Indexes summarise complex distributions of quantities and prices Real GDP then gives a measure of aggregate quantity controlling for changing purchasing power of currency 22  Constructing Real GDP Index Traditional Approach Use base year prices to calculate value of output in given year Pros: simple, captures changes in economic activity over time Cons: base year prices may not reflect changing economy – innovation: new types of goods – innovation: new quantities or varieties of existing goods – changing tastes, demographics 23  Constructing Real GDP Index There are goods i = {1, 2, 3,... , I} We wish to measure GDP over time periods t = {0, 1, 2,... , T } Prices pit and quantities qit for each i and t Value of GDP in base year t = 0 (i.e., Nominal/Current GDP) I X GDP0 = pi0 qi0 = p10 q10 + p20 q20 + · · · + pI0 qI0 i=1 Scaled in currency units – uses period t = 0 prices to value t = 0 output 24  Constructing Real GDP Index Fixing prices to some base year t = 0, we may write real GDP as I X RealGDPFixed,t = pi0 qit i=1 The Real GDP fixed based index in period t using base year t=0 is P RealGDPFixed,t pi0 qit JFixed,t = = Pi GDP0 i pi0 qi0 Note the index is now scaled as a ratio and not in currency units Another way of writing the above, say at t = 4 P P P P i pi0 qi4 i pi0 qi3 i pi0 qi2 pi0 qi1 JFixed,4 = P ×P ×P × Pi i pi0 qi3 i pi0 qi2 i pi0 qi1 i pi0 qi0 25  Constructing Real GDP Index Modern Approach Uses chain-weighting index to prevent prices being too outdated P P P pit−1 qit pi1 qi2 pi0 qi1 JChained,t = P i × · · · × Pi × Pi p q i it−1 it−1 p q i i1 i1 i i0 qi0 p e.g., at t = 4 P P P P i pi3 qi4 i pi2 qi3 i pi1 qi2 pi0 qi1 JChained,4 =P ×P ×P × Pi i pi3 qi3 i pi2 qi2 i pi1 qi1 i pi0 qi0 Assuming a reference year of t = 0, Real GDP can be recovered RealGDPChained,t = JChained,t × GDP0 26 Australian GDP: Nominal vs. Real 27 Australian GDP Per Person 28 GDP levels vs. GDP growth 29 Australian GDP Growth 30  Learning Outcomes 1 Understand national accounting including the three approaches to measuring GDP. 2 Critically reflect on the merits and demerits of GDP as a measure. 3 Understand the difference between nominal and real GDP. 4 Understand how to calculate real GDP using the Traditional Approach and the Modern (Chain-Weighting) Approach. 5 Understand the difference between GDP levels and GDP growth. 31  New Formula(s) and Notation Y = C + I + G + (X − M ) Y = aggregate income C = private consumption I = private investment G = government purchases X − M = net exports = exports − imports What do I do with this? Learn it! Do I just memorise it? Yes and no. You should understand the logic of the formula, e.g., what would it mean for the composition of the macroeconomy if we didn’t include X − M ? Practice re-arranging equations, e.g., re-arrange the the above to work out C =... ? Warning: There is no formula sheet in the exam so start facing the maths head-on in tutorials! If unsure, ask your tutor. Remember, there is no ChatGPT in the exam! 32  Next Lecture More fundamental macro concepts Inflation and interest rates – measurement and costs of inflation – nominal vs. real interest rates BOFAH Chapters 3 and 5 33