Week 8 Economics Lecture Notes PDF

LECON 4205 Introduction to Economics Week 7 Introduction to Macroeconomics, GDP and CPI Juyi Lyu ([email protected])  The differences between Micro and Macro Microeconomics: small-scale and individual aspects of economics. (e.g. behaviour of individual a...

LECON 4205 Introduction to Economics Week 7 Introduction to Macroeconomics, GDP and CPI Juyi Lyu ([email protected])  The differences between Micro and Macro Microeconomics: small-scale and individual aspects of economics. (e.g. behaviour of individual agents, e.g. households and firms – how they make decisions about resource allocation) Macroeconomics: larger-scale or aggregate aspects – deals with the economy as a whole (Macro indicators: gross domestic product (GDP), inflation, and unemployment) 3 primary goals in macro: 1. economic growth (% change in GDP) 2. price stability (2% annual inflation rate) 3. full employment (keep unemployment as low as possible) 2  Origin of Macroeconomics Pre-1930s conventional wisdom : Self-regulating economy: Problems such as unemployment are resolved without government intervention through the working of the invisible hand. The government’s failure to understand what caused the Great Depression (or how it could be tamed) was common at the time. Post-1930s conventional wisdom (initiated by British economist John Maynard Keynes in his book “The general theory of employment, interest, and money” in 1936) Keynesian economics: Economic slumps are caused by inadequate spending, and they can be mitigated by government intervention.  Macroeconomics: Theory and Policy Since the 1930s, the U.S. (and most national governments) uses tools to improve the economy. Monetary policy: uses changes in the quantity of money to alter interest rates and affect overall spending (=aggregate demand AD) Fiscal policy: uses changes in government spending and taxation to affect overall spending (=aggregate demand AD)  The use of taxes and government spending to change the overall level of spending in an economy is called: a) monetary policy. b) fiscal policy. c) either monetary or fiscal policy depending upon what is happening to the interest rate. Long-run Economic Growth and Short-Run Fluctuations GROWTH INTERRUPTED, 1985–2014 Source: Federal Reserve Bank of St. Louis (Shaded areas are recessions) Growth rate = (Current value – Previous value)/ Previous value *100% CHARTING THE BUSINESS CYCLE (short-run focus) Business cycles: short-run alternation between recessions and expansions Recessions (contractions): 2 consecutive quarters of negative GDP growth, when both output and employment are falling. Booms (expansions) : periods of economic upturn, when output and employment are rising.  THE BUSINESS CYCLE The point at which the economy turns from expansion to recession is a business-cycle peak. The point at which the economy turns from recession to expansion is a business-cycle trough. THE PAIN OF RECESSION Recessions: Periods of economic downturn when output and employment is falling for at least two consecutive quarters The most important effect of a recession is its effect on the ability of workers to find and hold jobs.  Real GDP per Capita Growth We have become able to afford many more material goods over time thanks to long-run economic growth. IN THE LONG RUN, WE CARE ABOUT GROWTH Long-run economic growth is the sustained upward trend in the economy’s output over time. Source: W. Michael Cox and Richard Alm, “How Are We Doing?” The American (July/August 2008). http://www.american.com/ archive/2008/july-august-magazine-contents/how-are-we-doing  INFLATION AND DEFLATION A rising overall level of prices is inflation. A falling overall level of prices is deflation (not to be confused with disinflation!) The economy has price stability when the overall level of prices changes slowly or not at all. Rising Prices offset most of the rise in average wages. Source: Bureau of Labor Statistics HOW DO YOU MEASURE AN ECONOMY? 2010 headline: “China Passes Japan as Second- Largest Economy.” How can you compare the sizes of two economies when they produce different things? By comparing the value of their production. GDP (gross domestic product) is the most important and common way to estimate an economy’s size. GDP (gross domestic product) - how much goods and services an economy can produce during a given period (e.g. year) THE NATIONAL ACCOUNTS The national income and product accounts (NIPA)  measure our nation’s economic performance  compare British income and output to that of other nations  track the economy’s condition throughout the business cycle  Consumer THE NATIONAL spending ACCOUNTS (C): household spending on goods and services with the exception of purchases of new housing. Investment spending (I): firms’ spending on productive physical capital, such as plants, machinery and tools. Government transfer (TR): payment by the government to individuals for which no good or service is provided in return. Disposable income (Yd): income plus government transfers minus taxes; available to spend on consumption and to save = wages, profits, interest payment and rent (Y) + government transfer (TR)- taxes (T)  THE NATIONAL ACCOUNTS Households don’t spend all of their disposable income. Some of it is saved in the financial markets. Private savings (Sp): disposable income (Yd) minus consumer spending. Y+TR-T= Yd = C+Sp Financial markets: the banking, stock, and bond markets, which channel private savings and foreign lending into investment spending, government borrowing, and foreign borrowing. Stock: a share in the ownership of a company held by a shareholder that pays dividends over time.  THE NATIONAL ACCOUNTS The government spends and borrows for various reasons. Government spending = government purchases (G) and government transfer (TR) Government purchases (G): government purchases of goods and service i.e. total expenditures on goods and services by federal, state, and local governments. e.g. education, healthcare (NHS), investment in infrastructure (roads, railways), and defence. Government borrowing (B): the total amount of funds borrowed by federal, state, and local governments in the financial markets.  THE NATIONAL ACCOUNTS Exports (EX): goods and services sold to other countries. Imports (IM): goods and services purchased from other countries.  AN EXPANDED CIRCULAR-FLOW DIAGRAM Government purchases of goods and Government services borrowing Taxes Government transfers Consumer spending Private savings Wages, profit, interest, rent Markets for goods and Financial services Factor markets markets Wages, profit, Borrowing interest, rent and stock GDP issues by firms Investment spending Foreign borrowing Exports and sales of stock Foreign lending and purchases of stock Imports  WHAT IS GDP? Gross domestic product (GDP): the market value of all currently produced final goods and services produced within a country during a given period (usually a year) WHAT IS GDP? …Produced… GDP measures production. Sale of used goods: NOT included. The sale of financial assets, such as stocks and bonds, are not included.  CALCULATING GDP GDP (Y) can be calculated in three ways: 1. Value-added (production) method: add up the value-added at different stages of the production process (for all producers). The value added of a producer is the value of its output minus the value of input. Y = value added (stage 1) + value added (stage 2)+… 2. Spending method (expenditure method) : Add up all spending on domestically produced final goods and services. Y =C+I+G+ (EX-IM) - national income identity IM – domestic expenditure on foreign produced goods and services – domestic income that has leaked across the border. 3. Factor Income Method: Add up the total factor income earned by households from firms in the economy Y= wages + profits+ rents+ interest payments CALCULATING GROSS DOMESTIC PRODUCT MORE ABOUT METHOD 2: SPENDING Add up all spending on domestically produced final goods and services. This results in the equation GDP = C + I + G + (EX – IM) where C = consumer spending, I = investment spending, G = government purchases of goods and services, X = sales to foreigners, and IM = imports (purchases here of foreign goods… or income that has leaked across national borders). Net exports (EX-IM): the difference between the value of exports and the value of imports.  Real GDP vs. Nominal GDP We need to be able track the quantity of total output over time. Nominal GDP: the value of all final goods and services produced in the economy during a given year, calculated using the prices in the current year in which the output is produced. Real GDP: the total value of the final goods and services produced in the economy during a given year, calculated using the prices of a selected base year Real GDP is the nominal GDP adjusted for inflation.  REAL VS. NOMINAL GDP Calculating GDP and real GDP in a simple economy: how much would GDP have gone up if prices had not changed? To answer this question, we need to find the value of output in year 2 expressed in year 1 prices (using year 1 as the base year) Except in the base year, real GDP is not the same as nominal GDP: output valued at current prices.  Suppose the base year is 2010. Real GDP in 2011 using 2010 as the base year: a) is greater than nominal GDP in 2011. b) is less than nominal GDP in 2011. c) is equal to nominal GDP in 2011. d) may be greater than, less than, or equal to nominal GDP in 2011.  Using 2011 as the base year, real GDP is greatest in: a) 2010. b) 2011. c) 2012. d) 2010 and 2012, since real GDP using 2011 as the base year is the same for these two years.  REAL GDP PER CAPITA Real GDP per capita: average GDP per person which measures a country’s living standard. It’s a useful measure for comparing labor productivity between country. A country with a higher real GDP per capita in general have a good quality of life. But not a sufficient measure of human welfare, nor is it an appropriate goal in itself. PRICE INDEXES AND THE AGGREGATE PRICE LEVEL Aggregate price level: a measure of the overall level of prices in the economy. To measure the aggregate price level, economists calculate the cost of purchasing a market basket. Market basket: a hypothetical set of consumer purchases of goods and services.  MARKET BASKETS AND PRICE INDEXES Calculating the cost of a market basket The hypothetical basket consists of 200 oranges, 50 grapefruits, and 100 lemons. PRICE INDEXES Price Index: the cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the selected base year Price index in = Cost of market basket in a given year x100 a given year Cost of market basket in base year  What is the value of the price index in 2012, using 2011 as the base year? The basket still consists of 200 oranges, 100 apples, and 100 bananas. a) 0.97 b) 1 c) 100 d) 103 THE CONSUMER PRICE INDEX (CPI) The makeup of the consumer price index in 2010 Source: Bureau of Labor Statistics. INFLATION RATE, CPI, AND OTHER INDEXES The Inflation rate: the yearly percentage change in a price index, typically based upon consumer price index, or CPI, the most common measure of the aggregate price level. The consumer price index, or CPI, measures the cost of the market basket of a typical urban American family Inflation rate = Price index in year 2 – Price index in year 1 x 100 Price index in year 1 OTHER PRICE MEASURES Producer price index (PPI): similar to the CPI but measures changes in the prices of goods purchased by producers. Economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP. The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year. THE CPI, THE PPI, AND THE GDP DEFLATOR The three measures usually move closely together. Source: Bureau of Labor Statistics.