Introductory Macroeconomics Lecture 3: Fundamental Concepts II PDF

Introductory Macroeconomics Lecture 3: Fundamental Macro Concepts, Part Two Jonathan Thong Daniel Minutillo 2nd Semester 2024 1 Australian GDP Growth 2  Nominal GDP vs. Real GDP Level of nominal GDP a...

Introductory Macroeconomics Lecture 3: Fundamental Macro Concepts, Part Two Jonathan Thong Daniel Minutillo 2nd Semester 2024 1 Australian GDP Growth 2  Nominal GDP vs. Real GDP Level of nominal GDP and level of real GDP linked by {z GDP} = (GDP nominal | deflator ) × (real GDP ) | {z } | {z } ≡P Yt ≡Pt ≡Yt Growths in nominal GDP and real GDP are linked by growth(P Yt ) = growth(Pt ) + growth(Yt ) GDP deflator is a price index Growth in GDP deflator is a measure of inflation 3 Australian Inflation 4  This Lecture More fundamental macro concepts Inflation and interest rates – measurement and costs of inflation – nominal vs. real interest rates BOFAH Chapters 3 and 5 5 Measurement and Costs of Inflation 6  Alternative Price Index Measures GDP deflator is an index of prices of all goods and services GDP But many of these prices not directly experienced by most people Often the consumer price index (CPI) is more relevant We will use the symbol Pt for both and refer to it as the price level. The precise meaning will be clear in context CPI and GDP deflator have quite similar trends 7 Similar Trends in Price Measures 8  Consumer Price Index (CPI) Measures the cost of purchasing a given basket of goods and services relative to a base year In Australia, calculated on a quarterly basis (monthly in the US) – data on prices collected each quarter – data on household expenditure collected each quarter – the ABS has recently begun publishing a monthly CPI series Basket of goods gradually updated over time to reflect changing consumption patterns 9  Measuring CPI Suppose a basket with I goods i = {1, 2, 3,... , I} so that we have prices pit and quantities qit for each period t ∈ {0, 1, 2,... , T } Prices measured in currency per unit of good (e.g., dollars per kg) Let P0 denote expenditure on the basket in the base period X P0 = pi0 qi0 i Let Pt denote expenditure in period t required to consume base period quantities qi0 , that is X Pt = pit qi0 i These measure of the price level are in currency units (e.g., dollars) 10  Measuring the CPI To create an index, we scale Pt by base period P0 Pt Indext = P0 With this scaling, the index in the base period is 1 However, we often scale indices so that the base period is 100 P0 CP I 0 = × 100 = 100 P0 Pt CP I t = × 100 P0 11  Inflation and the Cost of Living Inflation refers to the price index rising over time That is, when purchasing power of currency is falling, i.e., it costs more dollars to buy the same fixed basket of goods and services In other words "cost of living" is rising, i.e., a given amount of nominal income buys a smaller amount of goods and services in real terms Deflation refers to the price index falling over time 12  The Rate of Inflation Let Pt denote the price index (either CPI or GDP deflator) Let πt denote the inflation rate Pt − Pt−1 Pt πt = ⇔ 1 + πt = Pt−1 Pt−1 Caution: It is traditional in economics to use π to denote the inflation rate. This is not 3.1416... Inflation implies πt > 0, price level rising. Deflation implies πt < 0. Often multiplied by 100 to express in percent. 13 Inflation Measures 14  Quarterly vs. Annual Rates πt gives us a measure of inflation from one period to the next Pt − Pt−1 πt = Pt−1 If periods t are – in years then it is the annual inflation rate – in quarters then it is the quarterly inflation rate If periods t are in quarters then the annual inflation rate is Pt − Pt−4 πt = Pt−4 Quarterly inflation focuses on recent information. Annual inflation is a smoother (less volatile) moving average of quarterly inflation. 15  Measurement Issues As with GDP index, inflation measure face various issues Substitution bias – consumers may substitute away from goods that are becoming relatively more expensive, if so this causes fixed-basket CPI to overstate consequences of inflation Quality bias – even if notional prices of goods unchanged, rising quality may mean consumers are getting more for their expenditure, again fixed-basket CPI may be misleading 16  Costs of Inflation Costs can depend on if nominal income keeps pace with inflation – if so, real income is unchanged, mitigates burden on households – but indexing wages etc to inflation can build in inflation expectations as business internalise higher expected costs Costs include – reduced real income if nominal income unchanged – redistributes wealth, loans are often nominal (not HECS/HELP!) – bracket creep, tax system is nominal – menu costs, costs incurred in changing prices and planning – noise in the price system, less information about underlying demand/supply fundamentals 17  RBA Inflation Target Costs of inflation are likely to be – substantial for high and volatile (unpredictable) inflation – small for low and stable (predictable) inflation The Reserve Bank of Australia (RBA) conducts monetary policy One of its goals is price stability, i.e., low and stable inflation Since 1996 this has been formalised as an inflation target. RBA targets an inflation rate of: ‘ 2 to 3% on average per year ’ RBA conduct monetary policy through changes in interest rates 18 Nominal vs. Real Interest Rates 19  Interest Rates Interest rates are a way of expressing a financial return Suppose invest $10,000 principal today and receive $500 interest payment in a year. The annual interest rate is i = 0.05 or 5%. This i is a nominal interest rate, payment is in currency (dollars) But if the price level is rising over time, i.e., if there is inflation, then $1 in a year is worth less than $1 today Want a measure of the real interest rate that adjusts for inflation 20  Calculating the Real Interest Rate Let Pt denote period t price level in dollars Sacrificing 1 unit of goods gives P0 dollars to invest in period t = 0 Gives (1 + i)P0 dollars principal and interest in period t = 1 Each dollar in period t = 1 gives 1/P1 units of goods Each unit of goods sacrificed at t = 0 gives me P0 (1 + r) = (1 + i) P1 units of goods at t = 1. This r is the real interest rate. 21  Calculating the Real Interest Rate Recall that inflation rate is P1 1+π = P0 So real interest rate can also be written 1+i 1+r = 1+π When i and π are small, a good approximation to this is r ≈i−π Example: if i = 0.05 and π = 0.03 then exact r = (1.05)/(1.03) − 1 = 0.0194 and approximation is r ≈ 0.02. 22  Expected vs. Realised Real Rates This definition of the real rate involves the change in the price level from period t to t + 1 Pt 1 + rt = (1 + it ) ⇔ rt ≈ it − πt+1 Pt+1 But we don’t usually know the price level Pt+1 in the future Should better be thought of as the expected real rate The realised real rate is often measured as it − πt using the change in the price level from period t − 1 to t Expected and realised real rates close when inflation is stable, i.e., πt ≈ πt+1. This is part of the reason for the RBA’s inflation target. 23 Nominal and Real Rates 24  Learning Outcomes 1 Understand the different measures of a price level. 2 Understand how to use a price index to calculate inflation. 3 Understand the costs of inflation and recognize the difference between this and the "cost of living". 4 Understand measurement issues associated with inflation. 5 Understand the difference between the nominal and real interest rates and how they relate through inflation. 25  New Formula(s) and Notation (1 + i) = (1 + r)(1 + π) or r ≈ i − π (Fisher Equation) P price level i *sometimes index PY nominal GDP I *sometimes max index i nominal interest rate t time period r real interest rate T maximum time period π inflation {·}t variable at time t {·}it variable of item i at time t 26  Next Lecture More fundamental macro concepts Employment and unemployment – Labour market states – Hours and underutilisation – Labour market transitions – Long term unemployment BOFAH Chapter 5 27