1. MACROECONOMICS

2. What is Macroeconomics? Macroeconomics studies the economy as a whole - composed of many consumers (households), producers (firms), and markets – Instead of individual product prices, study the general price level of the economy – Instead of individual quantities, study GDP – Instead of demand for individual products, examine total demand (aggregate demand) for goods and services – Instead of individual firm and industry supply, examine the total output produced (aggregate supply) in the economy Furthermore, we study total output and employment, total investment, total exports and imports, etc.

3. Important Terminology: Aggregate Aggregate – (adj) formed by the conjunction or collection of particulars into a whole mass or sum; total; combined – e.g. the aggregate amount of savings In macroeconomics, totals or wholes are called “aggregates”. Namely, – Aggregate demand – Aggregate supply

4. Key Variable ------- Y NATIONAL INCOME≈ GROSS DOMESTIC PRODUCT≈ GROSS NATIONAL INCOME = total value of output of goods (&services) produced in an economy (over a time period)

5. First Model Simulation activity  Build up circular flow of income model Initially, assume- NO government and NO overseas sector

6. The Circular Flow Diagram The blue flow (real) is of factors of production from households to firms, and of goods and services from firms to households. The red flow is of money used as payment in sales and purchases of factors of production

7. More complex Circular Flow of Income Diagram Households and firms are linked together through two markets: product markets and resource markets

8. Underlying this flow diagram… This model demonstrates an important principle: the income flow from firms to households is equal to the expenditure flow from households to firms is equal to the value of the total output produced ∑incomes ≡ ∑ expenditures ≡ ∑output In other words, household incomes coming from the sale of the factors of production equals expenditures by households on goods and services  this is the circular flow of income/expenditure in an economy

9. Real World more complex…….. Therefore, as more complexity introduced, will just show monetary flows.

10. More realistically……. The real-world economy is more complicated than the simple model: – It lacks injections and leakages (also known as withdrawals) leakage (w) = occurs when a household (firm) receives a payment and it is NOT passed on to the firm (household) injection (J) = occurs when there is extra spending received by a firm (household) that is not due to the spending of a household (firm)

11. Savings and Investment When households (or firms) save, this is a leakage from the circular flow because it is income that is not spent to buy goods. Households place their savings in financial markets (bank accounts, purchases of stocks and bonds, etc.) Firms obtain funds from financial markets (through borrowing, issuing stocks and bonds, etc.) to finance investment, or the production of capital goods. These funds therefore flow back into the expenditure flow as injections. Investment can also be viewed as firms’ spending on other firms.

12. Adding two more sectors…….. Two more sectors that add to production (output) and to expenditure and to incomes are……….. The government sector The overseas sector

13. Four-sector circular flow (H/O page 3) http://www.slideshare.net/mikergo/circular- flow-of-income-and-expenditure http://www.slideshare.net/mikergo/circular- flow-of-income-and-expenditure Slides 8 onwards

15. Taxes and Government Spending Households and firms pay taxes to the government; this is a …………………… because it is income that is not spent to buy goods and services The government uses the tax funds to finance government expenditures (on education, health, defense, etc.) and this spending is an injection back into the expenditure flow

16. Imports and Exports When an economy has international trade through imports and exports, it is known as an open economy Imports are a ………………………….. because they represent household spending that leaks out as payments to the other countries that produced the goods and services Exports are an …………………… because they are spending by foreigners who buy goods and services produced by the domestic firms

17. 17 ( The Circular Flow of Income in Symbols GDP = C + I + G + (X – M) Factor Incomes = C + S + T (taxes net of benefits) (where C includes imported items) Since every thing produced in the economy generates equivalent factor income Domestic Output (GDP) = Factor Incomes

18. 18 The Circular Flow of Income in Symbols Domestic Output C + I + G + (X – M)C + S + T = Factor Incomes C: Consumption I: Investment G: Government Expenditure X-M: Net exports C: Consumed S: Savings T: Taxes Net of Benefits

19. 19 The Circular Flow of Income in Symbols Domestic Output C + I + G + (X – M)C + S + T = Factor Incomes rearrange I + G + X S + T + M = Total InjectionsTotal Leakages

20. 20 IF ALL THAT IS PRODUCED, IS CONSUMED, THEN Y = C. However all the revenue coming from national production is not used for consumption: © – T – S – M Also the national production is not consumed by national local households. © Part of it goes to: Foreign countries, Government buys part of it and Some of the production is used for producing other goods: Investment. – X – G – I Therefore… I + G + X S + T + M = Total InjectionsTotal Leakages

21. All the injections and leakages

22. Theoretically… C +S+T+M ≡ C+ I+ G+X Are leakages (S+T+M) ≡ injections (I+ G+X) ? If leakages > injections  what will happen to NATIONAL INCOME ? If leakages < injections  what will happen to NATIONAL INCOME ? Which one do you think is the case in Japan?? What happens when there is a financial crisis and economic recession and people’s income and jobs are in jeopardy?

23. Macroeconomic Objectives ) The study of macroeconomics arises because there are important economic OBJECTIVES economic growth (ie increase in real GDP) full employment or low unemployment stable or gently rising price level (inflation, deflation, hyperinflation) external balance (balance of trade and balance of payments, exchange rate) equitable distribution of income In order to achieve these objectives, need a systematic way (ie a model) to portray (and simplify) the underlying mechanisms of the economic system Then need to measure, quantify, and create indicators to measure economic performance and objectives If you make a model or theory, you need to justify and validate it empirically (using data)  task of professors and researchers

24. Measuring the Gross Domestic Product (National Income) Gross Domestic Product (GDP) is the total value of all the final goods and services produced within an economy's borders in a specific time period More simply: GDP is the TOTAL VALUE of the OUTPUT of goods and services If you get confused, look at the words underlying the concept. “gross”, “domestic”, “product” – Note: “value of the output” is output multiplied by its price. To aggregate output, we cannotsimply add the quantity of different goods.

25. Measurement of GDP  can ………. assess an economy’s performance over time compare income and output performance with other economies establish a basis for making policies that will meet economic objectives  THREE approaches, which should all give the same result (refer to circular flow) 1) Output approach 2) Income approach 3) Expenditure approach

26. 1) Output Approach Output approach measures the value of each good and service produced in a time period (usually a year) and then sums them  total value of output produced It is the value of all final* goods and services, in order to avoid double counting (*contrasted with intermediate goods and services i.e. those purchased as inputs for the production of final goods) OR use the VALUE-ADDED approach to get information on intermediate outputs Note: the output foreigners make is also counted as part of GDP But rarely measured by this method (except perhaps in ELDCs)

27. 2) Income Approach The income approach adds up all income earned by the factors of production wages earned by labor rent earned by land interest earned by capital profits earned by entrepreneurship. (includes the income earned by foreigners within that country)

28. 3) Expenditure Approach (  H/O pp.5,6 ) The expenditure approach measures the total amount of spending* to buy final goods and services in a country (usually within a year) – *Consumption spending, includes all purchases by households (but NOT “second-hand goods”) (durable and nondurable goods + services eg transport, entertainment, banking, health care, education but NOT houses) – * Investment spending, (spending on capital goods) i buildings, machinery, equipment, etc changes in inventories (work in progress and unsold goods or STOCKS) new housing But NOT spending on financial capital

29. (continued) Government spending includes: – purchases by the government of factors of production, including labor services – investment by government, ‘public investment’ (including roads, airports, power generators, building schools and hospitals, etc.) – (but NOT transfer payments) Net exports (exports minus imports),= value of all exports minus the value of all imports – Exports are goods and services produced within the country and so are part of total output – Imports have been produced in other countries, and so must be subtracted from expenditures measuring domestic output. (Much of C and I and G include imported components)

30. Example (figures in billions of $ for Jan-Dec 2009) GDP= C + I + G + (X − M) GDP = 11.3 + 3.2 + 3.5 + 2.5 − 2.1 = $18.4 billion in 2009.

31. (Statistical Note) The method used to obtain the value of only final goods and services is to count only the value added in each step of the production process. For example, say the production of a good goes through the following steps. – Firm A sells raw materials for $700 to firm B. Firm B uses the raw materials and produces an intermediate good that it sells to firm C for $1100. Firm C uses this intermediate good to produce a final good that it sells for $1700. How much value has been added in this production process? – Firm A added $700 of value. Firm B added $400 of value ($1100 - $700), and firm C added $600 of value ($1700 - $1100). When we add these up we obtain: $700 + $400 + $600 = $1700. – = value of the final product. – If we had added up the values of the two intermediate products and the final product, we would have: $700 +$1100 + $1700 =$3500, which greatly exaggerates the value of the product due to double counting.

32. Extension of GDP GDP provides an indicator of the value of total output produced OR total income OR total expenditure. However, there are other sources of income. Consider the case where a Japanese multinational firm (MNC) in India remits (sends back) its profits to Japan. The output of the multinational is produced in India, but the profit income is received by residents in Japan – Does the profit income count as Indian or Japanese income and output? – OR suppose a US citizen holds a bond for (has lent money to) a Japanese company or the government and earns interest on it………..

33. Introducing the GNI (or GNP) The concepts ‘domestic’ and ‘national’ are used to distinguish between measures of aggregate output and income that deal with this issue – The term ‘domestic’ in ‘gross domestic product’ means that output has been produced by factors of production within the country, regardless of who owns them (residents or foreigners) – The term ‘national’ is used in another measure of aggregate output known as gross national income (GNI) (formerly known as gross national product (GNP)). The term ‘national’ in GNI means that the income it measures is the income of the country’s residents, regardless where this income comes from – Refer to previous slide, the profits are part of India’s GDP but are part of Japan’s GNI

34. GDP vs GNI (gross national income) GNI = GDP + income from abroad − income sent abroad or GNI = GDP + net income from abroad Note: in the UK and in some other countries, ‘net income from abroad’ may be referred to as ‘net property income from abroad’. In the United States, it is sometimes referred to as ‘net foreign factor income’.

36. To Summarise in words……

37. NOMINAL vs REAL Nominal GDP = P x Q (output method) Need to compare this statistic across countries and across time (within a country) Why might this statistic be a misleading indicator of total output or changes in output ? Nominal GDP is measured in the prices of the current year, but prices change

38. An example of measuring real GDP Assume a simple economy producing three items real GDP is a measure of output valued at constant (unchanging) prices  Growth rate=………  Deflator= ………………….. GoodsOutput in 2010 Price in 2010 Value in 2010 Output in 2011 Price in 2011 Value in 2011 at CURRENT PRICES Value in 2011 At BASE year prices Fish10$211$2.50 Medicine5$54$6 Tractors6$206$21 2010 GDP=2011 Nominal GDP= 2011 Real GDP=

39. Wording…………. in 2011 “real GDP at 2010 prices was $162” Or “real GDP at constant prices was $162” Or “real GDP at base year prices was$162” Note that real GDP might fall even as nominal GDP increases over the same period; price increases caused nominal GDP to rise, while falling quantities meant that real GDP was falling. That is, output actually did not increase between these years

40. (continued) In the real world, the above method of converting nominal values into real values is lengthy and complicated, as there are millions of products whose values must be measured. However, this is not a problem because economists use short-cut methods that calculate the average levels across years to estimate the price index such as the GDP deflator

41. Why is the nominal less than the real GDP?

42. Defining and Measuring Real GDP Group III Real GDP has eliminated the influence of price changes, and gives an indication of how actual output produced has changed Measured at CONSTANT or BASE-YEAR* prices * Governments usually change the base year after 5 years

43. Calculating Real GDP  the formula

44. Measuring the Level of Prices (deflator and other price indices): A price index is a measure of average prices in one period relative to average prices in a base year Many types of index (but ALL are AVERAGES and based on SAMPLES): for example GDP Deflator Consumer Price Index (CPI) measures the average weighted change in prices of a basket of goods consumed by the average household. CORE CPI - to eliminate effect of swings in prices of eg food and oil Producer Price Index-- measures changes in the prices of INPUTS (useful to predict future inflation)

45. “basket” of goods AND services consumed by a “typical household”

46. Consumer Price Index The CPI measures the average prices of goods and services purchased by the typical household in an economy (“cost of living”). The statisticians construct a hypothetical ‘basket’ containing thousands of goods and services that are consumed by the typical household in the course of a year The value of this basket is calculated for a particular year (called a base year) by multiplying price times quantity (the “weights”) for each good and service in the basket, and adding up to obtain the total value of the basket The value of the same basket of goods and services is then calculated for subsequent years. The result is a series of numbers that show the value of the same basket of goods and services for different years. The CPI is then constructed to show how the value of the basket changes from year to year by comparing its value with the base year.

47. The WEIGHTS The quantities in the basket are the “weights” on the prices of each year. Simply multiply the weight by the prices of the two years. (NOTE: weights can be fractions or percents or integers)

48. CPI (continued) Group VI Once the consumer price index is constructed, inflation and deflation can be expressed as a percentage change of the index from one year to the other, (simply a measure of the percentage change in the value of the basket) These percentage changes reflect changes in the average price level. A rising price index indicates inflation; a falling price index indicates deflation

49. Example The CPI value for the current year may then be calculated as follows:

50. And given the CPI value for the base year is always equal to 100, The percentage change in the current year CPI from the base year CPI (which is always 100) is:  new worksheet

51. Weaknesses of a price index Different households experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI (“basket” is only for the “average household) Changes in consumption patterns Changes in the quality of the goods As the prices of some goods rise  substitution effect, BUT the weights are unchanged

52. Two Important Implications and Macroeconomic Objectives from the Above Calculations 1. Inflation and Deflation= % change (usually year on year) in the CPI 2. Economic growth= % change (usually year on year) in real GDP/GNI – Both utilize “percentage change” as the calculation

53. 1. Inflation and Deflation Inflation is a SUSTAINED increase in the AVERAGE price level. Deflation is defined as a sustained decrease in the average price level. Therefore to measure use a price index* (measure of average prices in one period) for each year and calculate the percentage change of the indices year on year – *GDP deflator – *Consumer Price Index – Both measure the value of a basket of goods and services (weighted) in one year relative to the value of the same basket in a base year

57. 2. Economic Growth Economic Growth is the percentage rate of change ( increase/decrease) of Real GDP (or real GNI) refers to increases in the quantity of output produced over a period of time (typically a year), For example, if real GDP was $50 billion in 2004 and increased to $51 billion in 2005, rate of growth = (51 – 50)/50 × 100 = 2% in the period 2005. – DO Page 9 of handout

58. DO Page 9 of handout

59. Limitations of GDP as a Measure of the Economy and Standards of Living If real GDP rises, has economic activity increased and are people better off ? Is it a measure of true value of output? Does an increase imply that the standard of living (quality of life) is better ?

60. First need: Real GDP Per Capita Per capita means per person or per head A per capita measure takes the total value (of output, income, expenditure) and divides this by the total population It is important as it takes into account of: – Population size and population growth – It gives a summary measure of the standard of living of the people eg comparison of China vs. Japan

61. When comparing GDP and GNI between countries – Differing domestic price levels alter the real income (purchasing power )of people giving a misleading picture of standards of living in different countries. – This problem can be effectively dealt with by converting the values of GDP and GNI of different countries into a single common currency. It uses special exchange rates called ‘purchasing power parities’ which take into consideration the differing price levels Handout on PPPs

62. What is the Standard of Living? Standard of living includes factors such as income, quality and availability of employment, class disparity, poverty rate, quality and affordability of housing, hours of work required to purchase necessities (ie inflation rate), number of holiday days per year, affordable (or free) access to quality healthcare, quality and availability of education, life expectancy, incidence of disease, infrastructure, national economic growth, economic and political stability, political and religious freedom, gender equality, environmental quality, climate and safety. The standard of living is closely related to quality of life Human Development Index by the UNDP (UN Development Program) which is a composite statistic of life expectancy, education, and per capita income indicators, which is used to rank countries into four tiers of human development http://hdr.undp.org/en/content/human-development-index-hdi Amartya Sen

63. Why GDP/GNI do NOT accurately measure the ‘true’ value of output GDP and GNI do not include non-marketed output – some output of goods and services is not sold in the market and does not generate any income – e.g. one’s own work on repairing and improving one’s home-- if the home repairs were carried out by hired workers, GDP would be greater by the amount of their wages. In less developed countries, a lot of agriculture does not reach the market (as it is self- consumed) and is not counted in the GDP (subsistence production) GDP and GNI do not include output sold in informal, (parallel or underground) markets – An informal market exists whenever a buying/selling transaction is unrecorded. – e.g. reselling a good at a higher price if there is a price ceiling, a plumber does repairs in your home and does not report the income received to avoid paying taxes; transactions involving illegal goods, such as drugs

64. GDP and GNI do not take into account quality improvements in goods and services – Technological advances often permit improved products to be sold at lower prices (for example, mobile phones and computers). GDP and GNI do not account for the value of negative externalities, such as pollution, toxic wastes and other undesirable by-products of production – environmental degradation, reducing society’s wellbeing GDP and GNI do not take into account the depletion of natural resources – depletion of natural resources (rainforests, wildlife, agricultural soils, etc.) also reduces society’s wellbeing

65. Why GDP/GNI do NOT accurately measure standards of living Even if GDP were improved upon so that they could come closer to measuring the ‘true’ value of output, they would still be inadequate as measures of standards of living: GDP and GNI make no distinctions about the composition of output – military goods (weapons, guns, tanks, etc.) or merit goods (education, health care, clean water supplies, and other services) value of all without any distinctions about the degree to which they contribute to standards of living GDP and GNI cannot reflect achievements in levels of education, health and life expectancy – A society’s levels of health and education contribute significantly to standards of living but not accounted in GDP. Higher education performance, better quality education, improve health outcomes (Increased life expectancy) are not accounted in GDP GDP and GNI provide no information on the distribution of income and output – Are the benefits of a growing GDP concentrated among a small group of beneficiaries, or are they widely distributed? GDP or GDP per capita only provide an indication of average output or average income per person

66. Human Development vs GDP

67. (continued) GDP and GNI do not take into account increased leisure – Hours of work and hours spent on leisure contributes to society’s standard of living GDP and GNI do not account for quality of life factors – society’s well-being depends upon a number of non- economic factors, such as the crime rate, a sense of security and peace arising from relations with other countries, well-functioning institutions, stress levels from working conditions, the degree of political freedom

68. More on negative environmental externalities and depletion – Increase in GDP/GNI often leads to environmental damage – Yet expenditures undertaken for the purposes of cleaning up pollution or health care services to treat the victims are registered as increases in the value of national output. For example, if a country experiences an oil spill, the funds spent to clean up the pollutants are added to the value of national output again In both cases, GDP and GNI overestimate the ‘true’ value of national output and standards of living

69. Environmental economists suggest that countries should measure……. Green GDP = GDP that accounts for the value of resource depletion and environmental destruction Green GDP = GDP − the value of environmental degradation and also should subtract all expenditures resulting from cleaning up pollution, avoiding further environmental damage, and health care costs of pollution-induced illnesses Green GDP can be significantly lower than GDP – Kahn and Yardley (2007) estimated that the 10% rise in real GDP in China was about 0% when environmental degradation were taken into account – Consider also Bhutan which measures Gross Domestic Happiness (GDH)

70. Modelling economic growth

72. The Business (or Trade or Economic) Cycle Whereas the trend is usually for real output to grow, output growth is uneven and irregular (fluctuates). In some time periods real output may grow rapidly, in others it may grow more slowly, and in still others it may even fall, indicating negative growth Economists have described this pattern with a concept, “Business Cycle”

73. The output represented by the long-term growth trend = potential GDP (determined by the resources available to the economy (ie FOPs especially labor)) Therefore employment and unemployment levels will also move cyclically

74. When real GDP fluctuates, so do other macroeconomic variables

75. Inflation Rate also fluctuates Headline inflation rate – unlike core inflation rate (underlying, long run inflation rate) includes the price changes of food and energy

76. Business Cycle: components Expansion = positive growth in real GDP, shown by upward sloping curve.Employment of resources increases, and the general price level of the economy usually begins to rise Peak = cycle’s maximum real GDP. The economy is likely to be experiencing inflation Contraction = falling real GDP (negative growth) or declining growth. If the contraction lasts two quarters or more, it is a recession, characterized by falling real GDP and growing unemployment of resources. Increase in price is likely to slow down a lot (disinflation) and even decrease (deflation) Trough = cycle’s minimum level of GDP, At a trough, there is usually high unemployment. A trough is followed by a new period of expansion (also known as a recovery), marking the beginning of a new cycle

77. Model of cycle, but in reality………. Business cycles are highly irregular, as they do not occur at regular time intervals and expansions and contractions vary in intensity They vary from country to country and case by case (because there are so many different determinants and variables underlying these outcomes) Economists apply a lot of statistics (Econometrics) in an attempt to predict and “forecast” the future outcomes

78. Unemployment and the cycle

79. Full Employment Level of Output The POTENTIAL level of real GDP is when the economy experiences “full employment”. This is known as the “full employment level of real GDP” The term ‘full employment’ does not mean that all resources are employed. Whenever the economy produces its ‘full employment level of output’, there is still some unemployment, known as the ‘natural rate of unemployment’ but there are also unfilled vacancies. The job-openings: job seekers ratio is ……………………….

80. Japan Times: December 2015 The ratio of job openings to job seekers rose 0.01 point from the previous month to 1.25 in November, hitting the highest since January 1992, as offers grew amid an economic recovery, Separately, the Internal Affairs and Communications Ministry said the nation’s seasonally adjusted jobless rate stood at 3.3 percent in November, up from 3.1 percent in October, deteriorating for the first time in three months. The uptick in the jobless rate reflected an increase in people quitting to find better jobs.

81. Natural Rate of Unemployment There are many reasons why unemployment never falls to zero: – at any time, there are some people who are in between jobs – some who are moving from one geographical area to another – some people who are training or retraining to be able to get a new or better job – some people who are temporarily out of work --some people are unemployable

82. Actual GDP fluctuates around potential GDP. When actual GDP equals potential GDP, the economy is achieving” full employment”, where unemployment equals the natural rate of unemployment. When actual GDP is greater than potential GDP, there is an output gap, and unemployment is less than the natural rate. When actual GDP is less than potential GDP, there is an output gap where unemployment is greater than the natural rate.

83. Output Gap (Actual – Potential Output)

84. Potential Output Again… It follows then that along the long-term growth trend, unemployment is equal to the natural rate of unemployment But when actual GDP is greater than potential GDP, unemployment is lower than the natural rate; when actual GDP is less than potential GDP, unemployment is greater than the natural rate – And when actual GDP lies above potential GDP (as at point d), or below potential GDP (as at point e), there results a GDP gap, also known as an output gap. The output gap is simply actual GDP minus potential GDP, and may be positive or negative –  interpretation of a newspaper article on handout