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Instructor Sandeep Basnyat

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1 Instructor Sandeep Basnyat 9841 892281
Macroeconomics & The global Economy Ace Institute of Management Session 1 Instructor Sandeep Basnyat

2 Objectives To acquaint students with basic knowledge of macroeconomic theories Define, explain and analyze macroeconomic terms, theories and indicators in general Apply learning in decision making processes and solve real world issues Use and explain the macroeconomic and developmental problems in a country

3 Evaluation Criteria Class Participation 5%
Group Presentation 10% (5 Groups) Midterm exams 15% Term exam 40% (End Term) Class Tests 10% (2 Tests) Assignments 10% (1 Assignment) Group Term Paper 10% (Submit at end)

4 Case study presentations
Case study oriented classes Possibility of external evaluator Evaluation Criteria: (10 x 3 = 30 marks) Did the presentation reflect a team work among its members? Were the students prepared for the presentation? Did the students look confident while deliberating? (including eye contact & voice clarity)

5 Case study presentations
Case Study Presentation Schedule Group1 Session 3 Group2 Session 5 Group 3 Session 6 Group 4 Session 9 Group 5 Session 10

6 Class tests, Assignment & Term paper
Class Test 1: Session 4 Class Test 2: Session 11 Assignment: Session 9 Term Paper: Preliminary Selection of Topic for term paper Session 3 Development of Research idea on term paper Session 5 Submission and Approval of the Topic with plan Session 7 Submission of term paper Session 12

7 What you studied in Microeconomics..
Basic demand and supply functions of individuals and markets Profit maximizations of individual firms in different markets Consumers and Producers welfare theories Cost and benefits of firms in different markets. And so on… But NOW ….

8 Introduction to Macroeconomics
Macroeconomics, the study of the economy as a whole, addresses many topical issues: Why does the cost of living keep rising? Why are millions of people unemployed, even when the economy is booming? What causes recessions? Can the government do anything to combat recessions? Should it?

9 Introduction to Macroeconomics
Macroeconomics, the study of the economy as a whole, addresses many topical issues: What is the government budget deficit? How does it affect the economy? Why does Nepal have such a huge trade deficit? Why are so many countries poor? What policies might help them grow out of poverty? And our analysis look...

10 U.S. Real GDP per capita (2000 dollars)
9/11/2001 First oil price shock long-run upward trend… Second oil price shock Great Depression World War II

11 U.S. inflation rate (% per year)

12 U.S. unemployment rate (% of labor force)

13 Why learn macroeconomics?
1. The macroeconomy affects society’s well-being. Each one-point increase in the unemployment rate is associated with: 920 more suicides 650 more homicides 4000 more people admitted to state mental institutions 3300 more people sent to state prisons 37,000 more deaths increases in domestic violence and homelessness

14 Why learn macroeconomics?
2. The macroeconomy affects your well-being. change from 12 mos earlier percent change from 12 mos earlier In most years, wage growth falls when unemployment is rising.

15 Introduction to Macroeconomics
Deals with the economy as a whole. Study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

16 How do Macroeconomists think?
Theory as a Model: Used to describe the real world eliminating unnecessary details Don’t forget to floss! The model teeth A road map A model of human anatomy

17 How do Macroeconomists think?
Macroeconomic models : Symbols and Equations Two important variables in a models: Exogenous variables; and Endogenous variables. Exogenous (Independent) variables : that a model takes as given. Endogenous (dependent) variables : which the model tries to explain. (What happens to..??)

18 The model of supply and demand
Assume the following two relationships for CD market: Qd = D(P,Y) …………………(i) Qs = S(P,Pm) …………………(ii) Equation (i): shows that Quantity of the CD demanded is the function of the Price of the CD and Income level of the consumer or the aggregate income of the economy. Equation (ii): shows that Quantity of the CD supplied is the function of the Price of the CD and Input price of the materials. The equilibrium in the CD market is given by: Qd = Qs

19 The model of supply and demand
Price Demand, Qd Q * P Supply, Qs Quantity

20 The model of supply and demand
Exogenous Variables: Aggregate Income, and Price of the materials (taken as given) Endogenous Variables: Price of the CD, and Equilibrium quantity of CD Price Demand Q * P Supply Quantity The model explains what happens to Endogenous variables (Price and Equilibrium Quantity of CD sold) when one of the Exogenous variables (Aggregate Income and Price of the materials ) changes.

21 Example: changes in Exogenous variables

22 Prices: flexible vs. sticky
General Assumption: Market equilibrium of supply and demand, (market clearing process). Markets clearing continuously, is unrealistic. Need prices to adjust instantly to changes in supply and demand. But, prices and wages often adjust slowly. Although market clearing models assume that wages and prices are flexible, in actuality, some wages and prices are sticky. But they do depict the equilibrium toward which the economy gravitates. Short term analysis vs Long term analysis for Price Sticky vs Price Flexibility

23 Gdp, cpi and unemployment
Three statistics that economists and policymakers use: Gross Domestic Product (GDP) is the dollar value of all final goods and services produced within an economy in a given period of time. The consumer price index (CPI) measures the level of prices. The unemployment rate tells us the fraction of workers who are unemployed.

24 Gross Domestic Product (GDP)
Two ways of viewing GDP Total income of everyone in the economy Total expenditure on the economy’s output of goods and services Households Firms Income $ Labor Goods/ Services Expenditure $ For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in the economy.

25 Expenditure Rules for Computing GDP
In general, to compute the total value of different goods and services, the national income accounts use market prices. Thus, if $0.50 $1.00 GDP = (Price of apples  Quantity of apples) + (Price of oranges  Quantity of oranges) = ($0.50  4) + ($1.00  3) GDP = $5.00

26 GDP: Components of Expenditure
Y = C + I + G + NX Net exports or net foreign demand Investment spending by businesses and households Total demand for domestic output (GDP) Government purchases of goods and services Consumption spending by households This is the called the national income accounts identity.

27 Calculating GDP Components of U.S. GDP, 2004: The Expenditure Approach
BILLIONS OF DOLLARS PERCENTAGE OF GDP Personal consumption expenditures (C) 8,214.3 70.0 Durable goods 987.8 8.4 Nondurable goods 2,368.3 20.2 Services 4,858.2 41.4 Gross private domestic investment (l) 1,928.1 16.4 Nonresidential 1,198.8 10.2 Residential 673.8 5.7 Change in business inventories 55.4 0.5 Government consumption and gross investment (G) 2,215.9 18.9 Federal 827.6 7.1 State and local 1,388.3 11.8 Net exports (EX – IM) -624.0 - 5.3 Exports (EX) 1,173.8 10.0 Imports (IM) 1,797.8 15.3 Gross domestic product (GDP) 11,734.3 100.0 Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.


29 World Top 10 GDP in Millions of US Dollars in Market Price
(Source: IMF2008/2009) 12. India - 1,235, Nepal - 12, Maldives- 1,357 162. Bhutan - 1, Kiribati - 130

30 Expenditure Rules for Computing GDP
1) Used goods are not included in the calculation of GDP. 2) The treatment of inventories depends on if the goods are stored or if they spoil. If the goods are stored, their value is included in GDP. If they spoil, GDP remains unchanged. When the goods are finally sold out of inventory, they are considered used goods (and are not counted).

31 Expenditure Rules for Computing GDP
3) Some goods are not sold in the marketplace and therefore don’t have market prices. We must use their imputed value as an estimate of their value. For example, home ownership and government services. 4) Intermediate goods are not counted in GDP– only the value of final goods. Reason: the value of intermediate goods is already included in the market price. Value added of a firm equals the value of the firm’s output less the value of the intermediate goods the firm purchases.

32 Measuring GDP by the Value Added Method
FIRM VALUE OF PRODUCT VALUE ADDED Cotton Farmer Value of raw cotton = $1.00 Value added by cotton farmer = $1.00 Textile Mill Value of raw cotton woven into cotton fabric = $3.00 Value added by cotton textile mill = ($3.00 – $1.00) = $2.00 Value added by shirt manufacturer = ($15.00 –$3.00) = $12.00 Shirt Company Value of cotton fabric made into a shirt = $15.00 L.L. Bean Value of shirt for sale on L.L. Bean’s Web site = $35.00 Value added by L.L. Bean = ($35.00 – $15.00) = $20.00 Total Value Added = $35.00

33 Compute & compare value added at each stage of production and GDP
Exercise: (Problem 2, p. 40) A farmer grows a bushel of wheat and sells it to a miller for $1.00. The miller turns the wheat into flour and sells it to a baker for $3.00. The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00. The engineer eats the bread. Compute & compare value added at each stage of production and GDP

34 Other Exclusions from Expenditures
Expenditure on purchase of goods and services during specified time period. Previous expenditure reflects the change in ownership only. Avoid “neither good nor a service” Does not reflect production such as bonds/ stocks Avoid expenditure by governments for which it does not receive a good or service in return Eg.: Transfer payments such as Social security,, unemployment compensation etc.

35 Measuring GDP from Income side
Sum of income of all factors of production gives the GDP from income side GDP = Rent + Wages + Interest + Profits

36 Calculating GDP U.S. National Income, 1980 (Shapiro: Table 2-1, Pg.27; Adjusted) BILLIONS OF DOLLARS Gross Domestic Products (GDP) 2341.3 Compensation of employees 1804.4 Proprietors’ income 130.6 Corporate profits 183.8 Net interest 190.6 Rental income Transfer payments to households if any. 31.9

37 Calculating GDP Compensation of employees includes wages, salaries, and various supplements—employer contributions to social insurance and pension funds, for example—paid to households by firms and by the government. Proprietors’ income The income of non-corporate businesses such as small farms, shops. Rental income The income received by property owners in the form of rent. Corporate profits The income of corporate businesses. Net interest The interest received by the businesses minus interest they pay plus interests earned from the foreigners.

38 Remember: Gross Domestic Product (GDP)
Gross domestic product (GDP) is a measure of the income and expenditures of an economy which includes all items produced in the economy and sold legally in markets. But: It excludes items produced and sold illicitly, such as illegal drugs.

39 Other Measures of income
Gross National Product (GNP) Net National Product (NNP) National Income (NI) Personal Income (PI) Personal Disposable Income (DI)

40 National Income Accounting contd..
GDP + NFI from Abroad = GNP GNP is the monetary value of final goods and services produced by the nationals (income earned by the nationals on foreign countries minus income earned by foreigners at home) GNP – Depreciation (Capital Consumption) = NNP Depreciation is the net capital consumption during the accounting year NNP – Indirect Business Tax = NI (National Income) Note for the students: Indirect business taxes is the official term used i for sales taxes. They are termed INDIRECT sales taxes because the business sector acts as the "collection agency" for the government, collecting the taxes from the household sector. The taxes are paid INDIRECTLY by the household sector. The household sector is considered the ultimate payer of the taxes. Other taxes paid by the business sectors are considered as Direct Business Taxes such as corporate profits taxes, property taxes, and franchise taxes. A VAT is a consumption Tax but is like a sales tax in that ultimately only the end consumer is taxed. It differs from the sales tax in that, with the latter, the tax is collected and remitted to the government only once, at the point of purchase by the end consumer. With the VAT, collections, remittances to the government, and credits for taxes already paid occur each time a business in the supply chain purchases products from another business.

41 National Income Accounting contd..
NI – Social contributions – net interests paid by individuals – corporate profit tax –undistributed corporate profit + Dividends + Govt. & business transfers to individuals + Net interest paid to individual = PI (Personal Income) PI – Personal tax and non-tax payments (such as parking tickets) = DI (Disposable Income) Disposable income is the final income that a consumer spends on the purchase of goods and services DI – Saving – Personal Interest Payment – Household Transfer Payment = Personal Consumption Expenditure

42 Calculating other measures of Income
GDP, GNP, NNP and National Income, 1980 (adjusted from Income Method) DOLLARS (BILLIONS) GDP at factor cost 2341.3 Plus: Receipts of factor income from the rest of the world Less: Payments of factor income to the rest of the world Equals: GNP at factor cost 2628.8 Less: Depreciation or capital consumption Equals: Net national product (NNP) Less: Statistical discrepancy Equals: National income (NI) at factor cost 2121.4

43 Calculating other measures of Income
National Income, Personal Income, Disposable Personal Income, and Personal Saving, 1980 (adjusted) DOLLARS (BILLIONS) National income 10,275.9 Less corporate taxes Plus transfer payments 39.6 Equals: Personal income 2161.0 Less: Personal income taxes 338.7 Equals: Disposable personal income 1822.2 Less: Personal saving 103.6 Less: Personal interest payments 46.5 Less: Transfer payments made by households 1.1 Equals: Personal Consumption Expenditure 1671.1

44 Real vs. nominal GDP GDP is the value of all final goods and services produced. Nominal GDP measures these values using current prices. Real GDP measure these values using the prices of a base year.

45 Practice problem, part 1 Compute nominal GDP in each year.
2006 2007 2008 P Q good A $30 900 $31 1,000 $36 1,050 good B $100 192 $102 200 205 Compute nominal GDP in each year. Compute real GDP in each year using 2006 as the base year.

46 Answers to practice problem, part 1
nominal GDP multiply Ps & Qs from same year 2006: $46,200 = $30  $100  : $51, : $58,300 real GDP multiply each year’s Qs by 2006 Ps 2006: $46, : $50, : $52,000 = $30  $100  205

47 Real GDP controls for inflation
Changes in nominal GDP can be due to: changes in prices. changes in quantities of output produced. Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. Note for students: Suppose from 2006 to 2007, nominal GDP rises by 10%. Some of this growth could be due to price increases, because an increase in the price of output causes an increase in the value of output, even if the real quantity remains the same. Hence, to control for inflation, we use real GDP. Remember, real GDP is the value of output using constant base-year prices. If real GDP grows by 6% from 2006 to 2007, we can be sure that all of this growth is due to an increase in the economy’s actual production of goods and services, because the same prices are used to construct real GDP in 2006 and 2007.

48 U.S. Nominal and Real GDP, 1950–2006
Real GDP (in 2000 dollars) Source: Notice that the brown line (nominal GDP) is steeper than the blue line. That’s because prices generally rise over time. So, nominal GDP grows at a faster rate than real GDP. What is the significance of the two lines crossing in 2000? Answer: is the base year for this real GDP data, so RGDP = NGDP in 2000 only. Before 2000, RGDP > NGDP (Possibly due to declining price level) while after 2000, RGDP < NGDP. Nominal GDP

49 GDP Deflator The inflation rate is the percentage increase in the overall level of prices. One measure of the price level is the GDP deflator, defined as The GDP deflator is so named because it is used to “deflate” (remove the effects of inflation from) GDP and other economic variables.

50 Practice problem, part 2 Nom. GDP Real GDP GDP deflator Inflation rate 2006 $46,200 n.a. 2007 51,400 50,000 2008 58,300 52,000 Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

51 Answers to practice problem, part 2
Nominal GDP Real GDP GDP deflator Inflation rate 2006 $46,200 100.0 n.a. 2007 51,400 50,000 102.8 2.8% 2008 58,300 52,000 112.1 9.3%

52 Chain-Weighted Real GDP
Over time, relative prices change, so the base year should be updated periodically. In essence, chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP. But we usually use constant-price real GDP, because: the two measures are highly correlated. constant-price real GDP is easier to compute.

53 Exercise 1: For your understanding
Make a note of: Real and Nominal GDPs of some of the important countries and compare Prepare a list of top 10 countries with their Real GDP growth rate and PPP growth rate.

54 Consumer Price Index (CPI)
A measure of the overall level of prices Uses: tracks changes in the typical household’s cost of living Adjusts for inflation allows comparisons of dollar amounts over time

55 How to compute CPI 1. Survey consumers to determine composition of the typical consumer’s “basket” of goods. 2. Every month, collect data on prices of all items in the basket; compute cost of basket 3. CPI in any month equals

56 Exercise: Compute the CPI
Basket contains 20 pizzas and 10 compact discs. prices: pizza CDs 2002 $10 $15 2003 $11 $15 2004 $12 $16 2005 $13 $15 For each year, compute the cost of the basket in each year the CPI (use 2002 as the base year) the inflation rate from the preceding year

57 Cost of Inflation basket CPI rate 2002 $350 100.0 n.a.
Answers: Cost of Inflation basket CPI rate 2002 $ n.a. % % %

58 The composition of the CPI’s “basket”

59 Reasons why the CPI may overstate inflation
Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen. Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights. Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured.

60 CPI vs. GDP Deflator prices of capital goods
included in GDP deflator (if produced domestically) excluded from CPI prices of imported consumer goods included in CPI excluded from GDP deflator the basket of goods CPI: fixed GDP deflator: changes every year

61 Categories of the population
employed working at a paid job unemployed not employed but looking for a job labor force the amount of labor available for producing goods and services; all employed plus unemployed persons not in the labor force not employed, not looking for work

62 Two important labor force concepts
unemployment rate percentage of the labor force that is unemployed labor force participation rate the fraction of the adult population that “participates” in the labor force

63 Exercise 1: For your understanding
Make a note of: Real and Nominal GDPs of some of the important countries and compare Prepare a list of top 10 countries with their Real GDP growth rate and PPP growth rate. Find CPI Index of various some important countries and check the inflation rates.

64 Numerical Example 1 Calculate GDP, GNP, NI and DI
Employee compensation (EC) 3,244 Rental income (RI) 16 Net interest (NETI) Capital consumption (CC) 567 Corporate taxes (CT) 145 Social Security taxes (SST) 440 Personal taxes (PT) Undistributed corporate profits (UCP) 37 Corporate profits (CP) 297 Proprietor's income (PROI) 402 Indirect business taxes (IBT) 470 Transfer payments (TP) 660 Population (POP) (billions of people)

65 Solution to Numerical Example 1
GDP = Employee compensation + Rental income + Net interest + Corporate profits + Proprietor's income = Billion $4426 GNP = GDP + NIF = = Billion $4426 NI = NNP – Indirect Business Taxes = GNP – Capital Consumption - Indirect Business Taxes = Billion $3389 DI = PI – Personal tax and non-tax payments = NI – Social contributions– corporate profit tax –undistributed corporate profit + Govt. & business transfers to individuals – Personal tax and non-tax payments = Billion $ 2727 For Further practice: Macroeconomics by N. G. Mankiw, 6th edition. Q.N. 2, 5, 6 and 7.

66 Numerical Questions and Solutions for Practice
1) Abby consumes only apples. In year 1, red apples cost 1$ each, green apples cost 2$ each, and Abby buys 10 red apples. In year 2, red apples cost 2$ each, green apples cost 1$ each, and Abby buys 10 green apples. Compute a consumer Price index (CPI) for apples for each year. Assume that year 1 is the base year in which the consumer basket is fixed. (Mankiw. Pg. 41. Q. 7) a.

67 -------------------------------------- Price in Base Year
Solution for Q. 1 Price in Current Year CPI in Year 1 = Price in Base Year (PRed1 x QRed1) + (PGreen1 x QGreen1) = 1 (PRed1 x QRed1) + (PGreen1 x QGreen1) Price in Current Year CPI in Year 2 = Price in Base Year (PRed2 x QRed1) + (PGreen2 x QGreen1) = 2 (PRed1 x QRed1) + (PGreen1 x QGreen1)

68 Calculate the implicit GDP deflator for 1998 and 1999
Numerical Questions and Solutions for Practice 2) Suppose that the Nominal and Real GDP for country Z in 1998 were $8,798.1 (in billion) and $8,536, respectively. While for 1999, the figures were $9,295.4 and $8,897.7. Calculate the implicit GDP deflator for 1998 and 1999 Calculate the Inflation rate (Calculated as the ratio of differences in GDP Deflator with the GDP in base Year). (Related to Mankiw. Pg. 41. Q. 6)

69 ---------------------------- = ------------------- = 1.0307 RGDP 1998
Solutions for Q.2: hint NGDP 1998 8798.1 Deflator in Year 1998 = = = 1.0307 RGDP 1998 8536.0 NGDP 1999 9295.4 Deflator in Year 1999 = = = 1.0447 RGDP 1999 8897.7 Now Calculate Inflations rate yourself

70 Thank You

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