Measuring Macroeconomic Performance: GDP PDF

Topic 1 Measuring macroeconomic performance: GDP 1. Introduction to the Unit 1 Readings/references Stevenson and Wolfers OR Holden, Stevenson and Wolfers: Chapter 9 Sizing up the Economy: Using GDP The Economy: 13.3 and 13.4 3.Measuring Aggregate Ou...

Topic 1 Measuring macroeconomic performance: GDP 1. Introduction to the Unit 1 Readings/references Stevenson and Wolfers OR Holden, Stevenson and Wolfers: Chapter 9 Sizing up the Economy: Using GDP The Economy: 13.3 and 13.4 3.Measuring Aggregate Output (GDP) 2 Learning objectives 1. Learn how to measure the size of an economy using gross domestic product. 2. Analyze GDP as a measure of total spending, output, and income. 3. Assess GDP as a measure of living standards. 4. Distinguish between real changes in quantities and the effects of changing prices. 5. Scale large numbers into something more manageable. 3.Measuring Aggregate Output (GDP) 3 Learning objectives 1. Learn how to measure the size of an economy using gross domestic product. 2. Analyze GDP as a measure of total spending, output, and income. 3. Assess GDP as a measure of living standards. 4. Distinguish between real changes in quantities and the effects of changing prices. 5. Scale large numbers into something more manageable. 3.Measuring Aggregate Output (GDP) 4 Gross domestic product: measuring the nation’s output Gross domestic product (GDP) is the market value of the final goods and services produced in a country during a given period. commonly used macroeconomic indicator: – Short-run fluctuations in GDP indicates the business cycle. – Long-run growth in GDP is associated with better living standards over time. 3.Measuring Aggregate Output (GDP) 5 Learning objectives 1. Learn how to measure the size of an economy using gross domestic product. 2. Analyze GDP as a measure of total spending, output, and income. 3. Assess GDP as a measure of living standards. 4. Distinguish between real changes in quantities and the effects of changing prices. 5. Scale large numbers into something more manageable. 3.Measuring Aggregate Output (GDP) 6 Gross domestic product: 4 sectors of the economy 1. Households 2. Firms 3. Government 4. Rest of the world 3.Measuring Aggregate Output (GDP) 7  Households provide factors of Households receive production income from firms Firms sell goods and services Firms receive revenue to households from households (consumption expenditure) 1. Introduction to the Unit 8 The Circular flow: insights 1. The 4 sectors interact in the markets for both inputs and outputs. 2. All flow of resources = flow of money 3. Total income = total output = total spending 3.Measuring Aggregate Output (GDP) 9 3 approaches of measuring GDP THE PRODUCTION APPROACH THE EXPENDITURE APPROACH THE INCOME APPROACH (Y) (Y) (AE) TOTAL OUTPUT 3.Measuring Aggregate Output (GDP) 10 The expenditure method for measuring GDP All current production by firms must be either: – bought by households, other firms, government and foreigners; or – left unsold as inventories bought by the firm which makes it. As such, GDP can also be measured as the sum of ‘expenditure’ on domestic production by – households, – all firms, – government and – foreigners. 3.Measuring Aggregate Output (GDP) 11 The expenditure method for measuring GDP Components of the expenditure method: – Consumption expenditure: C – Investment: I – Government expenditure/purchases: G – Net exports: NX GDP = Y = C + I + G + NX 3.Measuring Aggregate Output (GDP) 12 The expenditure method for measuring GDP Consumption expenditure: C spending by households for goods and services. Investment: I (spending by firms on final goods and services + residential + inventories) Government expenditure: G (excluding transfer payments and interest paid) Net exports: NX (exports-imports) 3.Measuring Aggregate Output (GDP) 13 3 approaches of measuring GDP THE PRODUCTION APPROACH THE EXPENDITURE APPROACH THE INCOME APPROACH (Y) (Y) TOTAL SPENDING TOTAL INCOME TOTAL OUTPUT 3.Measuring Aggregate Output (GDP) 14 Measuring GDP (the production approach) GDP is the market value of the final goods and services produced in a country during a given period. Market value – Goods and services are counted at their market price times quantity. – Unpaid work? – Public goods and services? – Aggregate measure of quantities produced – More expensive items receive a higher weighting Output Price (per unit) Price*quantity Example 10 apples $2 20 oranges $1 2 haircuts $5 GDP 3.Measuring Aggregate Output (GDP) 15 Measuring GDP (the production approach) GDP is the market value of the final goods and services produced in a country during a given period. Final goods and services: consumed by the consumer. Intermediate goods: used in the production of the final good. Need to avoid double counting 3.Measuring Aggregate Output (GDP) 16 Alternative methods for GDP (the production approach) Complications arise in trying to count the final goods and services only. Count only FINAL goods (and services) measures the production of final goods and services only. The market value of final goods embody the cost of intermediate products. OR Value-added method for GDP –Sum up only the value added by each firm in the production process. 3.Measuring Aggregate Output (GDP) 17 Measuring GDP: The production approach Output (Q) Price (per unit) P*Q Value added Coffee beans $10/kg 2 kg Roasted coffee beans $20/kg 2 kg Coffee $5/cup 200 cups GDP 3.Measuring Aggregate Output (GDP) 18 Measuring GDP GDP is the market value of the final goods and services produced in a country during a given period. GDP includes only goods produced within a given country. (domestic) GDP is measured over a period of time such as monthly, quarterly or annual GDP. 3.Measuring Aggregate Output (GDP) 19 3 approaches of measuring GDP THE PRODUCTION THE EXPENDITURE THE INCOME APPROACH (Y) APPROACH (AE) APPROACH (Y) 3.Measuring Aggregate Output (GDP) 20 The income method for measuring GDP When a good or service is sold, the revenues from the sale are distributed to the workers and the owners of the capital involved in the production. GDP also = labour income + capital income from the production. – Labour income is wages, salaries and self-employed income. – Capital income includes payments to physical capital, intangible capital and profits. 3.Measuring Aggregate Output (GDP) 21 The income method for measuring GDP 3.Measuring Aggregate Output (GDP) 22 The income method for measuring GDP Capital gains and losses? 3.Measuring Aggregate Output (GDP) 23 Learning objectives 1. Learn how to measure the size of an economy using gross domestic product. 2. Analyze GDP as a measure of total spending, output, and income. 3. Assess GDP as a measure of living standards. 4. Distinguish between real changes in quantities and the effects of changing prices. 5. Scale large numbers into something more manageable. 3.Measuring Aggregate Output (GDP) 24 What does GDP measure? 3.Measuring Aggregate Output (GDP) 25 Real GDP same as economic wellbeing? Prices versus values Leisure time? Non-market economic activities? Environmental quality and resource depletion? Quality of life? Poverty and economic inequality? 3.Measuring Aggregate Output (GDP) 26 The Economy Exercise 13.1 The OECD Better Life Index The Better Life Index, was created by the Organization for Economic Cooperation and Development (OECD). It lets you design a measure of the quality of life in a country by deciding how much weight to put on each component of the index. Should a better life index include the following elements: income, housing, jobs, community, education, environment, civic engagement, health, life satisfaction, safety, and work-life balance? For each of these elements, explain why or why not. Use the Better Life Index tool to create your own better life index for the country where you are living. How does this country score on the topics that are important to you? Rank the countries in the database using your own newly created better life index, and compare it with a ranking based exclusively on income. For both of these indices, choose two countries with contrasting rankings and briefly suggest why this may be the case. 3.Measuring Aggregate Output (GDP) 27 Learning objectives 1. Learn how to measure the size of an economy using gross domestic product. 2. Analyze GDP as a measure of total spending, output, and income. 3. Assess GDP as a measure of living standards. 4. Distinguish between real changes in quantities and the effects of changing prices. 5. Scale large numbers into something more manageable. 3.Measuring Aggregate Output (GDP) 28 Nominal vs real GDP Nominal GDP is current production at ‘current prices’. – Problem ? – Why? Macroeconomists are more interested in changes to the production level over time. Real GDP rises when quantities rise (or when higher valued items are being produced.) 3.Measuring Aggregate Output (GDP) 29 Nominal vs real GDP Output Price (per unit) Nominal GDP Real GDP 2021 10 apples $2 20 oranges $1 GDP in 2021 2022: Scenario A 10 apples $4 20 oranges $1 GDP in 2022 2022: Scenario B 20 apples $2 20 oranges $1 GDP in 2022 3.Measuring Aggregate Output (GDP) 30 Learning objectives 1. Learn how to measure the size of an economy using gross domestic product. 2. Analyze GDP as a measure of total spending, output, and income. 3. Assess GDP as a measure of living standards. 4. Distinguish between real changes in quantities and the effects of changing prices. 5. Scale large numbers into something more manageable. 3.Measuring Aggregate Output (GDP) 31 Big Numbers 1. Convert to per person 2. Use GDP as a comparison point 3. Compare over time 4. Rule of 70 3.Measuring Aggregate Output (GDP) 32 ECC1100 Principles of Macroeconomics Topic 12 Economic Growth 1 Topic 12 Economic Growth Readings/ references Stevenson and Wolfers: Chapter 10 Holden, Stevenson and Wolfers: Chapter 10 Economic Growth 2 Learning objectives 1. Learn about how economies have grown over time. 2. Uncover the ingredients for economic growth. 3. Understand how workers, capital accumulation, and technological progress work together to create economic growth. 4. Find out why government institutions matter for economic growth. Economic Growth 3 Learning objectives 1. Learn about how economies have grown over time. (Economic Growth Facts) 2. Uncover the ingredients for economic growth. 3. Understand how workers, capital accumulation, and technological progress work together to create economic growth. 4. Find out why government institutions matter for economic growth. Economic Growth 4 How has economic growth varied throughout history? It is estimated that between 1 million B.C. and 1200 A.D. GDP per person was around $200 per year. People lived as hunters and gatherers. Around 12,000 years ago, people began to farm. Economic Growth 5 What finally changed economic growth rates? Agricultural advances resulted in more food and less hunger. Fewer people needed to work on farms. The Industrial Revolution sparked tremendous economic growth. Economic growth led to higher standards of living and longer lives. Economic Growth 6 Economic Growth over the Past Two Centuries Economic Growth 7 Growth Disasters and Miracles Economic Growth 8 Review: Why does economic growth matter? Before modern civilization, there was little to no economic growth. Each generation lived exactly the same as its ancestors, largely hand-to-mouth. With advancements in agriculture, fewer people needed to work on farms. This led to the Industrial Revolution, which resulted in levels of economic growth never before experienced. Small differences in economic growth amplify over time, resulting in “rich” countries. Economic Growth 9 Review: Why does economic growth matter? Before modern civilization, there was little to no economic growth. Each generation lived exactly the same as its ancestors, largely hand-to-mouth. With advancements in agriculture, fewer people needed to work on farms. This led to the Industrial Revolution, which resulted in levels of economic growth never before experienced. Small differences in economic growth amplify over time, resulting in “rich” countries. Economic Growth 10 Learning objectives 1. Learn about how economies have grown over time. 2. Uncover the ingredients for economic growth. 3. Understand how workers, capital accumulation, and technological progress work together to create economic growth. 4. Find out why government institutions matter for economic growth. Economic Growth 11 The Production Function The production function describes the methods by which inputs are transformed into outputs. Provides a “cookbook” for economic growth Economic Growth 12 The Production Function The production function describes the management techniques your company uses to transforms inputs into outputs. Managers must acquire the right ingredients and mix them in appropriate proportions. Economic Growth 13 The Aggregate Production Function The aggregate production function relates total output (GDP) to the quantity of inputs employed. Economic Growth 14 The Aggregate Production Function Human capital: Skills that workers bring to the job Physical capital: Tools, machinery, and structures Economic Growth 15 The Aggregate Production Function Mathematically, can be represented as Economic Growth 16 The Aggregate Production Function Economic growth? A country will produce more output if: 1. it employs more workers. 2. its workers become more highly skilled. 3. it accumulates more physical capital. 4. Improving the recipe can also lead to more output. Economic Growth 17 Ingredient One: Labor and Total Hours Worked Labor input is measured as the total number of hours worked across the whole economy. The more labor that workers do, the more output gets produced. Population boosts total GDP but not GDP per person. Economic Growth 18 Ingredient One: Labor and Total Hours Worked Some demographic factors can inhibit economic growth. The dependency ratio is the number of people too young or too old to work per 100 people of working age. The dependency ratio rose sharply due to the post-WWII baby boom. Economic Growth 19 Ingredient One: Labor and Total Hours Worked Some demographic factors can enhance economic growth. Share of Working-Age Women Who Are Employed Women entered the labor force in large numbers during WWII. Women were responsible for a large share of the growth in GDP per person. Economic Growth 20 Ingredient Two: Human Capital Output reflects the quantity of hours worked and the productivity of people at work. Labor productivity is the quantity of goods and services that each person produces per hour of work. Your labor productivity depends in part on your human capital. Economic Growth 21 Ingredient Two: Human Capital Adult Literacy Rates Vary Across Regions U.S. High School and College Graduation Rates Economic Growth 22 Ingredient Two: Human Capital The United States Leads the World in Average Exam Scores of 15 Years Around Education the World Economic Growth 23 Ingredient Three: Capital Accumulation The equipment you work with also determines how much you can produce per hour. Capital stock is the total quantity of physical capital used in the production of goods and services. You are more productive when you have the right equipment. Economic Growth 24 Ingredient Three: Capital Accumulation Characteristics of Capital 1. Physical capital is a complement to labor. 2. Investment depends on the savings rate. 3. Foreign investment builds the capital stock. Economic Growth 25 Something else: New Recipe for Combining Ingredients→ Technological Progress Technological progress refers to new methods for using existing resources. makes it possible to produce more from given resources. is embodied by computers. Economic Growth 26 Review: The Ingredients of Economic Growth The production function describes the methods by which inputs are transformed into outputs. The aggregate production function links GDP to labor, human capital, and physical capital. A country will produce more by accumulating more labor, more human capital, or more physical capital. Technological progress also leads to economic growth. Economic Growth 27 Learning objectives 1. Learn about how economies have grown over time. 2. Uncover the ingredients for economic growth. 3. Understand how workers, capital accumulation, and technological progress work together to create economic growth. 4. Find out why government institutions matter for economic growth. Economic Growth 28 Analyzing the Production Function The production function generates a number of important insights into the process of economic growth. Economic Growth 29 Insight one: Constant returns to scale Constant returns to scale refers to the situation when all inputs are increased by some proportion and output increases by the same proportion. The replication argument states that to double output in your business you can replicate everything you are already doing → doubling inputs will double outputs. Economic Growth 30 Insight two: diminishing returns The law of diminishing returns states that when one input is held constant, increases in the other inputs will, at some point, begin to yield smaller and smaller increases in output. Economic Growth 31 Insight two: diminishing returns Step 1 Economic Growth 32 Insight two: diminishing returns Step 2 Economic Growth 33 Insight two: diminishing returns Step 3 Economic Growth 34 Insight three: catch up growth Diminishing returns implies Less developed countries can catch-up to developed ones. Investment in capital will have a large return for a relatively less developed country. Economic Growth 35 Additional Insights into Capital Accumulation: The Solow Model The capital stock will grow as long as investment > depreciation. Capital per worker (K/L) will eventually stop growing. Economic Growth 36 Additional Insights into Capital Accumulation: The Solow Model Key take-away Capital accumulation can’t sustain long-term economic growth. Economic Growth 37 Impact of Technological Progress The key to sustained economic growth is technology. Technology shifts the production function. The shift yields more output for a given capital-labor ratio. Economic Growth 38 Technological Progress Shifts the Production Function Step 1 Economic Growth 39 Technological Progress Shifts the Production Function Step 2 Economic Growth 40 Technological Progress Shifts the Production Function Step 3 Economic Growth 41 Where does technological progress come from? Technological progress relies on new ideas. Specifically, technological progress is driven by how quickly new ideas are created and how many resources are devoted to generating new ideas. Economic Growth 42 Why did growth take so long to occur? Technological progress requires resources. Before the agricultural revolution, there were no spare resources to devote to generating new ideas. Agricultural improvements freed people to pursue other tasks including new ideas. Economic Growth 43 Technological progress allowed us to break the cycle of poverty. Thomas Malthus, an 18th-century economist, believed that the world was forever doomed to subsistence living. He failed to predict technological progress outpacing population growth. Economic Growth 44 Is economic growth unlimited? Economic growth is limited only by our imagination. New ideas are key to long-run economic growth. Idea-driven economic growth can be sustained because 1. ideas can be freely shared. 2. ideas do not depreciate with use. 3. ideas may promote other ideas. However, the nonexcludable nature of ideas often leads to too little investment. Economic Growth 45 Is economic growth unlimited? In a 2019 speech at the United Nations, Swedish youth climate activist Greta Thunberg stated "People are suffering. People are dying. Entire ecosytems are collapsing. We are at the beginning of a mass extinction and all you can talk about is money and fairytales of eternal economic growth.” Discuss her quote. Can we have “eternal economic growth”? If so, what are the costs? If not, why not? Economic Growth 46 Review: Analyzing where economic growth comes from and if it will continue. Increases in output depend on whether constant or diminishing returns to capital exist. Diminishing returns means relatively poor countries may be able to catch up. The Solow model shows that investment in capital can led to economic growth but that the economy eventually enters into a steady state. Sustainable economic growth is driven by new ideas. Economic Growth 47 Learning objectives 1. Learn about how economies have grown over time. 2. Uncover the ingredients for economic growth. 3. Understand how workers, capital accumulation, and technological progress work together to create economic growth. 4. Find out why government institutions matter for economic growth. Public Policy Economic Growth 48 The Role of Incentives Institutions (ex. government) can provide incentives for people to invent new ideas and invest in human or physical capital. Key examples are 1. property rights. 2. government stability. 3. efficiency of regulation. 4. policy to encourage innovation. Economic Growth 49 Property Rights → Economic Growth Property rights grant control over a tangible or intangible resource. Without property rights, there is no incentive to create wealth. Economic Growth 50 Government Stability → Economic Growth A stable government makes economic growth more likely. Corruption and political instability discourage investment and innovation. Economic Growth 51 Efficient Regulation → Economic Growth Bureaucratic obstacles, including excessive regulatory oversight, can hinder economic growth. Economic Growth 52 Policy to Encourage Innovation → Economic Growth Government strategies to encourage innovation include the following: 1. Create incentives through intellectual property laws. 2. Subsidize research and development Economic Growth 53 Key Takeaways The key ingredients to economic growth are labor, human capital, physical capital, and technological progress. Capital accumulation leads to growth. Technology is key to ongoing growth. Institutions can incentivize economic growth. Economic Growth 54 ECC1100 Principles of Macroeconomics Measuring Macroeconomic performance Topic 3 Unemployment and the Labour Market 1 Wages, Unemployment and the labour market Readings/ references Stevenson and Wolfers: Chapter 11 Holden, Stevenson and Wolfers: Chapter 11 The Economy: 9.2 Wages, unemployment and the labor market 2 Learning objectives 1. Understand what unemployment is and how it’s measured. 2. Learn how people move in and out of jobs and in and out of the labor market. 3. Analyze the causes of unemployment. 4. Learn about the economic and social costs of unemployment. Wages, unemployment and the labor market 3 Learning objectives 1. Understand what unemployment is and how it’s measured. 2. Learn how people move in and out of jobs and in and out of the labor market. 3. Analyze the causes of unemployment. 4. Learn about the economic and social costs of unemployment. Wages, unemployment and the labor market 4  The Australian Bureau of Statistics (ABS) categorises people who are 15 years old or over Measuring unemployment into three categories: Out of the labour Employed: those Unemployed: those force: those who did who worked one who did not work in not work in paid hour or more in paid paid employment, employment and are employment, or are and actively sought on leave. work. not actively seeking employment. Wages, unemployment and the labor market 5 Wages, unemployment and the labor market 5-6 Measuring unemployment Working age population Labour force = employed + unemployed Number of unemployed x 100 Unemployment = Labour force Labour force x 100 Participation rate = Working-age population Wages, unemployment and the labor market 7 Unemployment rate Fluctuates over time but is never zero The equilibrium unemployment rate is the long-run unemployment rate to which the economy tends to return. Wages, unemployment and the labor market 8 Other measures of unemployment Marginally attached Discouraged workers would like to have a job but they have not looked for work in the past four weeks (but have in the past year) – Counted as out of the labour force – Could be counted as unemployed but they are not Wages, unemployment and the labor market 9 Other measures of unemployment Underemployment Not enough hours Not using your skills Involuntary part-time workers are people who like to work full-time but cannot find a full-time job. – Counted as employed Wages, unemployment and the labor market 10 Learning objectives 1. Understand what unemployment is and how it’s measured. 2. Learn how people move in and out of jobs and in and out of the labor market. 3. Analyze the causes of unemployment. 4. Learn about the economic and social costs of unemployment. Wages, unemployment and the labor market 11 Duration of unemployment Costs of unemployment are directly related to the length of time a person has been unemployed. – Unemployment spell is the period during which an individual is continuously unemployed. – Duration of unemployment is the length of the unemployment spell. Wages, unemployment and the labor market 12 Duration of unemployment Long-term unemployed have been out of work for six months or longer. Short-term unemployed have several possible outcomes. – Find a permanent job after searching a few weeks (economic costs are low) – Leave the labour force – Take a short-term or temporary job that leads to unemployment again These chronically unemployed have costs similar to the long- term unemployed Wages, unemployment and the labor market 13 Dynamics of unemployment A dynamic labour market makes it easier for people to find new jobs. Most job seekers are unemployed Most unemployment spells are short Long term unemployed and discrimination Wages, unemployment and the labor market 14 Learning objectives 1. Understand what unemployment is and how it’s measured. 2. Learn how people move in and out of jobs and in and out of the labor market. 3. Analyze the causes of unemployment. 4. Learn about the economic and social costs of unemployment. Wages, unemployment and the labor market 15  Supply and Demand in the Labor Market ▪ The labor market is an input market. ▪ Businesses demand labor. ▪ Households supply labor. ▪ The market price is the wage rate. ▪ Equilibrium is where the supply Co pyright © 2020 by Macmillan Learning. All rights res erved of labor equals the demand for labor. 16 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Types of unemployment : 1. Frictional unemployment Frictional unemployment the short-term unemployment associated with the process of workers searching for job. when people are between jobs and currently searching for another job. Caused by “frictions” in labour markets Wages, unemployment and the labor market 17 Types of unemployment : 1. Frictional unemployment Frictional unemployment Skills mismatch Location mismatch high unemployment benefits which raise the opportunity cost of working Wages, unemployment and the labor market 18 Types of unemployment : 2. Structural unemployment Structural unemployment There are structural barriers preventing wages from adjusting where labour demand = labour supply. can be the result of: – minimum wage laws and other government regulation of employment conditions – workplace discrimination Wages, unemployment and the labor market 19 Types of unemployment : 2. Structural unemployment Structural unemployment – Efficiency wages – Unions – Regulations – Minimum wage Wages, unemployment and the labor market 20 Example 1: Efficiency wages Wages, unemployment and the labor market 21 Example 2: Minimum wage laws Wages, unemployment and the labor market 22 Example 3: Labour unions Union power may raise minimum wages and thus lower employment levels using the threat of strike action. This can be represented in the previous diagram as the imposition of a minimum wage. Wages, unemployment and the labor market 23 Example 4: Other government regulations Other government regulations include health and safety legislation and unfair dismissal legislation. These increase costs and decrease the productivity of labour, thereby reducing the demand for labour. Wages, unemployment and the labor market 24 Types of unemployment : 3. Cyclical unemployment Cyclical unemployment refers to the extra unemployment that occurs during periods of economic contraction and especially recessions. Wages, unemployment and the labor market 25 Natural rate of unemployment exists independently of whether the economy is in an expansion or contraction. The part of the total unemployment rate that is attributable to frictional and structural unemployment Equilibrium unemployment is above zero Wages, unemployment and the labor market 26 Learning objectives 1. Understand what unemployment is and how it’s measured. 2. Learn how people move in and out of jobs and in and out of the labor market. 3. Analyze the causes of unemployment. 4. Learn about the economic and social costs of unemployment. Wages, unemployment and the labor market 27 Economic Costs of Unemployment ▪ The unemployed often end up with lower wages and worse career opportunities. ▪ Hysteresis occurs when a period of high unemployment leads to a higher equilibrium unemployment rate. ▪ lower tax revenues and higher govt expenditure spends more.  Social Costs of Unemployment Unemployment is isolating and painful. Long-term unemployment is Life expectancy, morbidity, associated with worse outcomes. clinical depression Children whose parents Worse academic, mental, and Co pyright © 2020 by Macmillan Learning. All rights res erved experience unemployment suffer. future economic outcomes 29 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition ECC1100 Principles of Macroeconomics Measuring Macroeconomic performance Topic 4 Prices: CPI and Inflation Price level and inflation 1 Inflation Readings/ references Stevenson and Wolfers: Chapter 12 Holden, Stevenson and Wolfers: Chapter 12 The Economy: 13.8 and 15.1 Price level and inflation 2 Learning objectives 1. Understand what inflation is and how to measure it. 2. Pick the right inflation measure for the task at hand. 3. Learn to account for the influence of inflation before making big decisions. 4. Analyze the role of money so that you can assess the costs of inflation. Price level and inflation 3 Learning objectives 1. Understand what inflation is and how to measure it. 2. Pick the right inflation measure for the task at hand. 3. Learn to account for the influence of inflation before making big decisions. 4. Analyze the role of money so that you can assess the costs of inflation. Price level and inflation 4 Measuring the price level: The consumer price index Performance of the economy: Maintaining the real value of the currency Consumer price index (CPI) provides an objective measure of: – average price level – inflation Is a weighted average of the percentage change in the prices of a basket of goods purchased by Australian households. Price level and inflation 5 Example: CPI calculation Cost of base-year consumption basket of goods and services in current year CPI = Cost of base-year consumption basket of goods and services in base year Step 1: Identify the basket Good Quantity Price in 2017 Price in 2018 % change (per unit) (per unit) Apples 20 $1 $1 Oranges 10 $2 $4 Haircuts 1 $20 $25 CPI Price level and inflation 6 Example: CPI calculation Cost of base-year consumption basket of goods and services in current year CPI = Cost of base-year consumption basket of goods and services in base year Step 2: Calculate the CPI Good Quantity Price in 2017 Price in 2018 % change (per unit) (per unit) Apples 20 $1 $1 Oranges 10 $2 $4 Haircuts 1 $20 $25 CPI Price level and inflation 7 Inflation The CPI is used to calculate the rate of inflation. This is the percentage change in the CPI over the specified time period. Inflation rate as (CPIDec2013 – CPIDec2012) = x 100 at December 2013 CPIDec2012 Note: inflation is the change in average prices (CPI) The consumer price index (CPI) is an index that tracks the average price consumers pay over time for a representative “basket” of goods and services. Price level and inflation 8 Example: CPI calculation Cost of base-year consumption basket of goods and services in current year CPI = Cost of base-year consumption basket of goods and services in base year Step 3: Calculate the inflation rate CPI Base year (2017) Price in 2018 % change Price of basket CPI Price level and inflation 9 Does the CPI measure ‘true’ inflation? The CPI overstates the actual level of inflation in the economy for two significant reasons: 1. Quality adjustment bias Changes in quality cannot be captured 2. New products 3. Substitution bias People’s consumption basket is not fixed but responds to price changes. Price level and inflation 10 Learning objectives 1. Understand what inflation is and how to measure it. 2. Pick the right inflation measure for the task at hand. 3. Learn to account for the influence of inflation before making big decisions. 4. Analyze the role of money so that you can assess the costs of inflation. Price level and inflation 11 Different measures of inflation 1. Change in CPI 2. Core inflation 3. producer price index (PPI): A price index that tracks the price of inputs into the production process. 4. GDP deflator: A price index that tracks the price of all goods and services produced domestically. Price level and inflation 12 Learning objectives 1. Understand what inflation is and how to measure it. 2. Pick the right inflation measure for the task at hand. 3. Learn to account for the influence of inflation before making big decisions. 4. Analyze the role of money so that you can assess the costs of inflation. Price level and inflation 13 Compare over time How do we compare monetary values over time when prices are changing? Price level and inflation 14 Real versus nominal variable A variable measured in dollars is a nominal variable. A variable that has been adjusted to account for inflation is a real variable. Real value in 2012 dollars Price level in 2012 = Nominal value in year t dollars × Price level in year t Price level and inflation 15 Real versus nominal variable Real wage Real wealth Real revenues Price level and inflation 16 Real versus nominal variable Interest rates The stated interest rate without a correction for the effects of inflation is a nominal interest rate. The interest rate in terms of changes in your purchasing power is a real interest rate. Real rate = Nominal rate – Inflation rate Price level and inflation 17 Money illusion The (mistaken) tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts is called money illusion. distort prices. lead to mispricing. create nominal wage rigidity. Nominal wage rigidity is the reluctance to cut nominal wages. Price level and inflation 18 Learning objectives 1. Understand what inflation is and how to measure it. 2. Pick the right inflation measure for the task at hand. 3. Learn to account for the influence of inflation before making big decisions. 4. Analyze the role of money so that you can assess the costs of inflation. Price level and inflation 19 What is money? Money is any asset regularly used in transactions. 20  Functions of Money Medium of exchange Money is used to buy goods and services. Money is a common unit used to Unit of account measure economic value. Store of value Money can be saved. Co pyright © 2020 by Macmillan Learning. All rights res erved 21 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition The costs of inflation: not what you think Policy dealing with changes in the price level and changes in relative prices is quite different. – To deal with changes in the price level, the government must resort to changes in macroeconomic policies. – To deal with changes in relative prices, the government must implement policies that affect the supply and demand for the specific goods. Be aware of money illusion! Price level and inflation 22 Hyperinflation an extremely high rate of inflation. makes most aspects of life harder and erodes all the functions of money. Extreme example Price level and inflation 23 Costs of Expected Inflation 1. menu costs. 2. shoe-leather costs. Price level and inflation 24 Costs of Unexpected Inflation 3. confusing the signals that prices send. 4. redistributing income. Price level and inflation 25 The Inflation Fallacy The mistaken belief that inflation destroys purchasing power is the inflation fallacy. Often all prices are rising, including wages and salaries. Real values matter! Price level and inflation 26 ECC1100 Principles of Macroeconomics Topic 5 Consumption and Saving 1 1. Introduction to the Unit 2 Readings/ references Stevenson and Wolfers: Chapter 13 Holden, Stevenson and Wolfers: Chapter 13 Consumption and saving 3 The expenditure method for measuring GDP Consumption expenditure: C spending by households for goods and services. Investment: I (spending by firms on final goods and services + residential + inventories) Government expenditure: G (excluding transfer payments and interest paid) Net exports: NX (exports-imports) 3.Measuring Aggregate Output (GDP) 4 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Consumption and saving 5 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Consumption and saving 6 Consumption Household spending on final goods and services One of the main driver: income Consumption and saving 7 Consumption and Income A consumption function Plots the level of consumption associated with each level of income. the marginal propensity to consume the fraction of each extra dollar of income that households spend on consumption. The slope of the consumption function Consumption and saving 8  The Consumption Function - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 9 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Consumption Function - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 10 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Consumption Function - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 11 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Saving and Income The portion of income that you set aside, rather than spending on consumption, is called saving. Saving = Income − Consumption Consumption and saving 12 Saving and Income Dissaving the excess amount you consume above your income in a given period therefore must pay for – either by withdrawing money from your savings or – by borrowing money. Consumption and saving 13 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Consumption and saving 14 Consumption decisions How do you make your consumption decisions? Consumption and saving 15 Consumption decisions The interdependence principle choices available to you in the future depend on the decisions that you make today. Consumption and saving 16 Consumption decisions The marginal principle it is simpler to break the decision of how many dollars should you spend today into increments. cost-benefit analysis opportunity cost Consumption and saving 17 Consumption decisions Rational Rule for Consumers you should consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar plus interest in the future. Consumption and saving 18 Consumption decisions Consumption Smoothing Maintaining a steady or smooth path for your consumption spending over time Consumption and saving 19  Smooth Your Consumption - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 20 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Smooth Your Consumption - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 21 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Smooth Your Consumption - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 22 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Consumption decisions Permanent Income Hypothesis Consider income, consumption and saving over the life cycle. Consumption and saving 23 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Consumption and saving 24 Total Consumption Main forces Permanent income Consumption Smoothing Consumption and saving 25 Consumption and Income 1. A temporary change in income leads to a small change in consumption. 2. A permanent change in income leads to a large increase in consumption. MPCtemporary < MPCpermenant Consumption and saving 26 Consumption and Income 3. An anticipated change in income leads to no change in consumption. 4. Learning about a future income change leads to a change in consumption 5. It is hard to forecast changes in consumption. Consumption and saving 27 Consumption and Income Do people actually behave this way? Credit constraints deliberate forward-looking plans are hard to make and to follow. Consumption and saving 28 Consumption and Income Two types 1. Hand-to-mouth consumers spend their current income. 2. Consumption smoothers spend permanent income. Consumption and saving 29 Consumption and Income Consumption and saving 30 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Consumption and saving 31 Main factors influencing Consumption Income + 1. Real interest rates 2. Expectations 3. Taxes 4. Wealth Consumption and saving 32  Movement Along the Consumption Function versus Shifts in the Consumption Function - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 33 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Movement Along the Consumption Function versus Shifts in the Consumption Function - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 34 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Movement Along the Consumption Function versus Shifts in the Consumption Function - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 35 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Movement Along the Consumption Function versus Shifts in the Consumption Function - Step 4 Co pyright © 2020 by Macmillan Learning. All rights res erved 36 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Consumption Shifter 1: Real interest rates Higher real interest rates incentivize saving today and reduce consumption (substitution effect). increase income for lenders (income effect) and raise their consumption. decrease income for borrowers (income effect) and reduce their consumption. Net effect could go either way. Consumption and saving 37 Consumption Shifter 2: Expectations Expectations Permanent income Consumption 38 Consumption Shifter 3: Taxes Taxes Disposable income Consumption 39 Consumption Shifter 3: Wealth Wealth Consumption 40 Consumption Shifter 3: Wealth 41 Consumption Shifters 42 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Consumption and saving 43 What motivates saving? Consumption and saving 44 What motivates saving? Saving Motive 1: Changing income over the life cycle Due to typical income patterns over the life cycle, national saving depends on demographics (age). Consumption and saving 45 What motivates saving? Saving Motive 2: Changing needs over the life cycle Consumption and saving 46 What motivates saving? Saving Motive 3: Bequests Consumption and saving 47 What motivates saving? Saving Motive 4: Precautionary saving Consumption and saving 48 ECC1100 Principles of Macroeconomics Topic 5 Investment 1 Readings/ references Stevenson and Wolfers: Chapter 14 Holden, Stevenson and Wolfers: Chapter 14 Investment 2 Learning objectives 1. Learn what macroeconomists mean by investment, and assess the role that it plays in the economy. 2. Master two tools for comparing sums of money at different points in time: compounding and discounting. 3. Evaluate whether an investment opportunity is worth pursuing. 4. Assess how macroeconomic conditions drive investment. 5. Forecast the long-run real interest rate. Investment 3 Learning objectives 1. Learn what macroeconomists mean by investment, and assess the role that it plays in the economy. 2. Master two tools for comparing sums of money at different points in time: compounding and discounting. 3. Evaluate whether an investment opportunity is worth pursuing. 4. Assess how macroeconomic conditions drive investment. 5. Forecast the long-run real interest rate. Investment 4 Investment Spending on new capital assets that increase the economy’s productive capacity ▪ drives the business cycle. ▪ changes quickly. ▪ is a key driver of long-term prosperity. Investment 5 Investment capital stock: The total quantity of capital at a point in time Depreciation: the decline in capital due to wear and tear, obsolescence, accidental damage, and aging. Investment 6 Investment Business investment: Spending by businesses on new capital assets. Inventories: Spending on accumulated raw materials, work-in-progress, and unsold goods. Housing investment: Spending on building or improving houses or apartments. Investment 7 Learning objectives 1. Learn what macroeconomists mean by investment, and assess the role that it plays in the economy. 2. Master two tools for comparing sums of money at different points in time: compounding and discounting. 3. Evaluate whether an investment opportunity is worth pursuing. 4. Assess how macroeconomic conditions drive investment. 5. Forecast the long-run real interest rate. Investment 8 Making investment decisions Compare costs and benefits Two tools 1. compounding. 2. discounting. Investment 9 Making investment decisions: Compounding The opportunity cost of an up-front investment = what would happen to that money if you put it somewhere to accumulate interest. Investment 10 Making investment decisions: Compounding Future value: initial amount + interest Future value in t years = Present value × (1 + r)t Investment 11  The Compounding Formula - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 12 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Compounding Formula - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 13 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Compounding Formula - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 14 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Use a spreadsheet! Co pyright © 2020 by Macmillan Learning. All rights res erved 15 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Making investment decisions: Discounting Comparing present and future Present value The amount of money that you need to invest today in order to produce an equivalent benefit in the future Discounting Converting future values into their equivalent present values Investment 16 Making investment decisions: Discounting 1 Present value = Future value in t years × t 1+r Investment 17  Compounding and Discounting Co pyright © 2020 by Macmillan Learning. All rights res erved 18 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Use a spreadsheet again! Co pyright © 2020 by Macmillan Learning. All rights res erved 19 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Investment: interest rate? You can use either interest rate in the compounding and discounting formulas. If you’re evaluating the nominal value of your funds (how many bills you’ll have in a few years’ time), use the nominal interest rate. If you’re evaluating the real value of your funds (changing purchasing power, after adjusting for inflation), use the real interest rate. Investment 20 Learning objectives 1. Learn what macroeconomists mean by investment, and assess the role that it plays in the economy. 2. Master two tools for comparing sums of money at different points in time: compounding and discounting. 3. Evaluate whether an investment opportunity is worth pursuing. 4. Assess how macroeconomic conditions drive investment. 5. Forecast the long-run real interest rate. Investment 21 Invest? Present value of benefits versus present value of costs Adjust for depreciation rate Next year′s revenue Present value of a stream of payments = r+d Investment 22 Invest? Investment 23 Invest? Yes, if Present value of (future) benefits > present value of costs Next year′s revenue > Cost r+d The user cost of capital is User cost of capital = (r + d) × C Investment 24 Learning objectives 1. Learn what macroeconomists mean by investment, and assess the role that it plays in the economy. 2. Master two tools for comparing sums of money at different points in time: compounding and discounting. 3. Evaluate whether an investment opportunity is worth pursuing. 4. Assess how macroeconomic conditions drive investment. 5. Forecast the long-run real interest rate. Investment 25 Saving and Income Dissaving the excess amount you consume above your income in a given period therefore must pay for – either by withdrawing money from your savings or – by borrowing money. Investment 26 Learning objectives 1. Understand how consumption and saving vary with income. 2. Apply the core principles of economics to make good consumption decisions. 3. Predict the behavior of aggregate measures of consumption. 4. Assess how changing macroeconomic conditions shift consumption. 5. Learn how to form a smart saving plan. Investment 27 Investment at aggregate level The framework that you use to make individual investment decisions can be used to assess how changing macroeconomic conditions will affect total investment across the economy. Investment 28 Investment at aggregate level: real interest rate Key driver Inverse relationship between I and real interest rate Investment 29  The Investment Line - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 30 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Investment Line - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 31 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Other Factors Shift the Investment Line - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 32 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Other Factors Shift the Investment Line - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 33 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Investment at aggregate level: other drivers 1. Technological advances 2. Expectations 3. Corporate taxes 4. Lending standards and cash reserves Investment 34 Learning objectives 1. Learn what macroeconomists mean by investment, and assess the role that it plays in the economy. 2. Master two tools for comparing sums of money at different points in time: compounding and discounting. 3. Evaluate whether an investment opportunity is worth pursuing. 4. Assess how macroeconomic conditions drive investment. 5. Forecast the long-run real interest rate. Investment 35 What determines the real interest rate? The real interest rates Long run drivers A slow evolution in response to the balance of saving and investment Price in the market for borrowing and lending Investment 36 Loanable funds market the market for the funds used to buy, rent, or build capital. Supply of funds from savers Demand for funds for investing Supply and demand meet in the financial sector Investment 37  The Market for Loanable Funds - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 38 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Market for Loanable Funds - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 39 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Market for Loanable Funds - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 40 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Market for Loanable Funds - Step 4 Co pyright © 2020 by Macmillan Learning. All rights res erved 41 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Main factors influencing Supply Real interest rate + 1. Personal saving rates 2. Govt saving (budget surplus or deficit) 3. Foreign saving (global shocks) Investment 42  Shifts in the Supply of Loanable Funds - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 43 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Shifts in the Supply of Loanable Funds - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 44 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Main factors influencing Demand Real interest rate + 1. Technological advances 2. Expectations 3. Corporate taxes 4. Lending standards and cash reserves Investment 45  Shifts in the Demand for Loanable Funds - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 46 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Shifts in the Demand for Loanable Funds - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 47 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition ECC1100 Principles of Macroeconomics Topic 7 International Finance and the Exchange rate 1 The Financial Sector Readings/ references Stevenson and Wolfers: Chapter 16 Holden, Stevenson and Wolfers: Chapter 16 Exchange rates and Balance of payments 2 Learning objectives 1. See the connections between the domestic economy and the global economy. 2. Analyze prices that are quoted in different currencies. 3. Analyze the market for currencies and forecast the nominal exchange rate. 4. Assess how exchange rates and relative prices affect exports and imports. 5. Track how money flows around the world using the current account and the financial account. Exchange rates and Balance of payments 3 Learning objectives 1. See the connections between the domestic economy and the global economy. (International trade and global financial flows) 2. Analyze prices that are quoted in different currencies. 3. Analyze the market for currencies and forecast the nominal exchange rate. 4. Assess how exchange rates and relative prices affect exports and imports. 5. Track how money flows around the world using the current account and the financial account. Exchange rates and Balance of payments 4 International Trade Exports Goods or services produced domestically and purchased by foreign buyers. Imports Goods or services produced in a foreign country and purchased by domestic buyers. Exchange rates and Balance of payments 5 Global Financial Flows Financial inflows Investments by foreigners in the “domestic economy/home country” Financial outflows Investments by “home/domestic country” in foreign countries Exchange rates and Balance of payments 6 Global Financial Flows Financial inflows Investments by foreigners in the “domestic economy/home country” Financial outflows Investments by “home/domestic country” in foreign countries Exchange rates and Balance of payments 7 Trends in Financial Flows Financial flows are large and include investment in foreign physical assets, financial assets, and loans. Foreign ownership is becoming more common. Financial linkages are increasingly important. Exchange rates and Balance of payments 8 Trade and Financial Flows Globalization is an important trend with large implications for the U.S. economy. Reductions in the cost of international transport and communication have led to tremendous growth in trade. There has also been tremendous growth in global financial flows. Exchange rates and Balance of payments 9 Learning objectives 1. See the connections between the domestic economy and the global economy. 2. Analyze prices that are quoted in different currencies. (exchange rates) 3. Analyze the market for currencies and forecast the nominal exchange rate. 4. Assess how exchange rates and relative prices affect exports and imports. 5. Track how money flows around the world using the current account and the financial account. Exchange rates and Balance of payments 10 Nominal exchange rate The price of a country’s currency (in terms of another country’s currency) Exchange rates and Balance of payments 11  An Example: Dollars and Yen If the price of a U.S. dollar is 120 yen, then the nominal exchange rate is 120 yen per U.S. dollar. Co pyright © 2020 by Macmillan Learning. All rights res erved 12 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Nominal exchange rate Number of yen Nominal exchange rate = Number of dollars Number of yen = Number of dollars × Nominal exchange rate Number of yen Nominal of dollars = Nominal exchange rate Exchange rates and Balance of payments 13 You step out of your hotel in Paris and find a Starbucks. An espresso costs 2.5 euros. Currently, the exchange rate is 0.91 euro per dollar. What is the cost of the espresso in dollars? A. $2.75 B. $2.28 C. $0.36 Co pyright © 2020 by Macmillan Learning. All rights res erved 14 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Price of Foreign Goods Currencies appreciate when they become more expensive and depreciate when they become cheaper. Appreciation makes imports cheaper and exports more expensive. Depreciation makes imports more expensive and exports cheaper. Exchange rates and Balance of payments 15 Different Ways to Describe Currency Fluctuation Exchange rates and Balance of payments 16 Currency Fluctuation Exchange rates and Balance of payments 17 Exchange rates The nominal exchange rate defines the ratio at which you exchange units of a foreign currency for U.S. dollars. Currency values are constantly fluctuating. When the dollar appreciates, imports are cheaper, and exports are more expensive. When the dollar depreciates, imports are more expensive, and exports are cheaper. Exchange rates and Balance of payments 18 Learning objectives 1. See the connections between the domestic economy and the global economy. 2. Analyze prices that are quoted in different currencies. 3. Analyze the market for currencies and forecast the nominal exchange rate. (supply and demand of currencies) 4. Assess how exchange rates and relative prices affect exports and imports. 5. Track how money flows around the world using the current account and the financial account. Exchange rates and Balance of payments 19 The demand for US $ The demand for dollars reflects foreigners buying American exports and investing in the United States. Exchange rates and Balance of payments 20 The supply of US $ The supply of dollars reflects Americans buying imports and investing abroad Exchange rates and Balance of payments 21 The market for US $ The exchange rate is determined by supply and demand. The foreign exchange market is where you can exchange one currency for another. Exchange rates and Balance of payments 22  The Market for U.S. Dollars - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 23 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Market for U.S. Dollars - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 24 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Market for U.S. Dollars - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 25 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Everyday Economics: How to Keep Exchange Rates Straight 1. Clarify which market you’re analyzing. 2. Specify what price you’re evaluating. 3. State origins and destinations. Exchange rates and Balance of payments 26 The demand for US $ Demand for U.S. dollars shifts due to shifts in exports from the United States. shifts in financial inflows into the United States. It does not shift because of the exchange rate. Exchange rates and Balance of payments 27  The Demand for Dollars - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 28 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Demand for Dollars - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 29 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Demand for Dollars - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 30 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Demand for Dollars - Step 4 Co pyright © 2020 by Macmillan Learning. All rights res erved 31 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition The demand for US $ An increase in the demand for exports will increase the demand for dollars due to an increase in world GDP. a decrease in barriers to foreign markets. an increase in domestic innovation and marketing. an increase in foreign prices. a decrease in domestic prices. Exchange rates and Balance of payments 32 The demand for US $ Financial inflows will increase and thereby increase the demand for dollars due to an increase in U.S. interest rates relative to foreign interest rates. an increase in U.S. business profitability relative to foreign businesses. an increase in foreign political risk relative to U.S. political risk. an increase in expected future value of the dollar. Exchange rates and Balance of payments 33 The supply of US $ The supply of U.S. dollars shifts due to shifts in imports into the United States. shifts in financial outflows. It does not shift because of the exchange rate. Exchange rates and Balance of payments 34  The Supply of Dollars - Step 1 Co pyright © 2020 by Macmillan Learning. All rights res erved 35 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Supply of Dollars - Step 2 Co pyright © 2020 by Macmillan Learning. All rights res erved 36 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Supply of Dollars - Step 3 Co pyright © 2020 by Macmillan Learning. All rights res erved 37 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Supply of Dollars - Step 4 Co pyright © 2020 by Macmillan Learning. All rights res erved 38 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition The supply of US $ Imports increase, thereby increasing the supply of dollars due to an increase in U.S. GDP. a decrease in barriers protecting domestic producers. an increase in foreign innovation and marketing. an increase in domestic prices. a decrease in foreign prices. Exchange rates and Balance of payments 39 The supply of US $ Financial outflows increase, thereby increasing the supply of dollars due to a decrease in U.S. interest rates relative to foreign interest rates. a decrease in U.S. business profitability relative to foreign businesses. a reduction in foreign political risk relative to U.S. political risk. a reduction in expected future value of the dollar. Exchange rates and Balance of payments 40  Symmetry Between Financial Outflows and Financial Inflows Co pyright © 2020 by Macmillan Learning. All rights res erved 41 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Factors That Shift the Demand and Supply of Dollars Co pyright © 2020 by Macmillan Learning. All rights res erved 42 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Forecasting exchange rate movements Apply the three-step recipe: 1. Is the supply or demand curve shifting (or both)? 2. Is this an increase that will shift the curve to the right or a decrease that will shift the curve to the left? 3. How will the price (exchange rate) change in equilibrium? Exchange rates and Balance of payments 43 Forecasting exchange rate movements: example Germany imposes a 30% tariff on U.S. cars. How will this affect the exchange rate? Exchange rates and Balance of payments 44 Forecasting exchange rate movements: example Germany imposes a 30% tariff on U.S. cars. How will this affect the exchange rate? 1. A shift in demand for U.S. dollars occurs. 2. A decrease in exports from the United States will shift the demand for U.S. dollars to the left. 3. The U.S. dollar depreciates. Exchange rates and Balance of payments 45 How Government Intervention Affects Exchange Rates Some countries fix their exchange rate. A fixed exchange rate is where the government sets the price of the currency. Others use a managed exchange rate. This is also called a “dirty” float, which can lead to trade frictions. Exchange rates and Balance of payments 46 Fixed versus Managed Exchange Rates Exchange rates and Balance of payments 47 Review: Supply and Demand of Currencies a floating exchange rate in which price is determined by supply and demand. Demand for currency shifts due to shifts in exports or financial inflows. Supply of currency shifts due to shifts in imports or financial outflows. Exchange rates and Balance of payments 48 Learning objectives 1. See the connections between the domestic economy and the global economy. 2. Analyze prices that are quoted in different currencies. 3. Analyze the market for currencies and forecast the nominal exchange rate. 4. Assess how exchange rates and relative prices affect exports and imports. (real exchange rate and net exports) 5. Track how money flows around the world using the current account and the financial account. Exchange rates and Balance of payments 49 Measuring the Competitiveness The domestic price divided by the foreign price and expressed in the domestic currency is the real exchange rate. 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 Exchange rates and Balance of payments 50 Competitiveness: real exchange rate and Net exports An economy-wide real exchange rate reflects broad changes in competitiveness. The real exchange rate drives imports and exports. Real Exchange Rate Falls → Net Exports Rise. 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 Exchange rates and Balance of payments 51 Review: real exchange rate and net exports The real exchange rate is an important measure of the competitiveness of products. When the real exchange depreciates, import less and export more. When the real exchange rate appreciates, import more and export less. Exchange rates and Balance of payments 52 Learning objectives 1. See the connections between the domestic economy and the global economy. 2. Analyze prices that are quoted in different currencies. 3. Analyze the market for currencies and forecast the nominal exchange rate. 4. Assess how exchange rates and relative prices affect exports and imports. 5. Track how money flows around the world using the current account and the financial account.(the balance of payments) Exchange rates and Balance of payments 53 Current account balance The current account balance measures the difference between the income that Americans receive from abroad and the income that Americans pay to people abroad. Current account balance = Income from abroad − Income paid abroad Exchange rates and Balance of payments 54  The Current Account Co pyright © 2020 by Macmillan Learning. All rights res erved 55 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Financial account balance The financial account balance is the difference between financial inflows and financial outflows. Financial account balance = Financial inflows − Financial outflows Exchange rates and Balance of payments 56  The Financial Account Co pyright © 2020 by Macmillan Learning. All rights res erved 57 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  The Current account and the Financial Account Co pyright © 2020 by Macmillan Learning. All rights res erved 58 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition  Inflows=Outflows Co pyright © 2020 by Macmillan Learning. All rights res erved 59 PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition Saving, Investment, and the Current Account A current account deficit arises when we spend more than we earn. The current account deficit reflects the imbalance between saving and investment. Investment is funded by a combination of domestic saving and savings from abroad. Exchange rates and Balance of payments 60 Saving, Investment, and the Current Account Understanding the controversies A current account deficit can reflect people living beyond their means. A current account deficit can reflect valuable investments in the future. A bilateral trade balance is how much we buy from a specific country compared to how much they buy from us. Exchange rates and Balance of payments 61 Review: the balance of payments Current account reflects income flows. Financial account reflects financial flows. When a country spends more income than it receives, it runs a current account deficit. The deficit is a financial account surplus. The deficit is a concern only if repayment seems unlikely. The deficit can be a side