Principles of Macroeconomics Lecture 1 INTRODUCTION TO MACROECONOMICS & MEASURING ECONOMIC ACTIVITY

PART 1: INTRODUCTION TO MACROECONOMICS

An Overview of Macroeconomics 1.What is Macroeconomics 2.Macroeconomic Goals 3.Key Macroeconomic Principles

What is Macroeconomics? - Microeconomics study of behaviour of individuals households and firms. - Macroeconomics study the aggregate measures of the economy

Macroeconomic aims - Low Unemployment - Price Stability (Low Inflation or Deflation) - Economic Growth and Development

Low Unemployment Great Depression ( ) World War II ( ) recession recession recession Source: Bureau of Labour Statistics

Price Stability

Long Run Economic Growth

PART 2: MEASURING ECONOMIC ACTIVITY

Learning outcome  Define GDP and the four expenditure components of aggregate output.  Calculate GDP in a simple example, avoiding double counting.  Distinguish between “net” and “gross” and between “national” and “domestic.”  List the four components of aggregate income.

Aims  Discuss the shortcomings of using GDP  Distinguish between real GDP and nominal GDP

How an economy works

National Income Accounting  National income accounting – a set of rules and definitions for measuring economic activity in the aggregate economy – that is, in the economy as a whole.  National income accounting is a way of measuring total, or aggregate production.  Gross Domestic Product (GDP) is the total value of all final goods and services produced in an economy in a one-year period.

Calculating GDP  Calculating GDP requires adding together millions of goods and services  All of the quantities of goods and services produced are multiplied by their market price per unit to determine a value measure of the good or service  The sum of all of these values is GDP

The Expenditure Approach  GDP is equal to the sum of the four categories of expenditures. GDP = C + I + G + (X – M)  C for Consumption  I for Investment  G for Government Spending  X for Exports, M for Imports and (X-M) for Net Exports

GDP is a Flow Concept  GDP is a flow concept, the amount of total final output a country produces per year  A flow concept has a time period associated with it; GDP is reported on an annual basis  Wealth accounts – a balance sheet of an economy’s assets and liabilities – is a stock concept  A stock is the amount of something at a given point in time; no time interval is associated with it

GDP Measures Final Output  GDP does not measure total transactions in the economy  It counts final output, but not intermediate goods.  Final output – goods and services purchased for final use.  Intermediate products are used as an input in the production of some other product  Counting the sale of both final and intermediate goods would result in double counting.

Two Ways of Dealing with the problem of Double Counting  Calculate only final output.  A firm would report how much it sold to consumers and how much it sold to producers (intermediate goods)  Follow the value added approach  Value added is the increase in value that a firm contributes to a product or service.  It is calculated by subtracting intermediate goods (the cost of materials that a firm uses to produce a good or service) from the value of its sales.

Value Added Approach ParticipantsCost of Materials Value of Sales Value Added Farmer€0€100 Dairy factory and cheese maker Middleperson Vendor Totals€750€1,250€500

What is Counted in GDP  Not counted  Value of resale goods  Government transfer payments  Sales of stocks or bonds  Work of housespouses  Counted  Value added by a used car dealer  Commissions of stock brokers

GDP and NDP  Net Domestic Product is GDP adjusted for depreciation – the amount of capital used up in producing that year’s GDP NDP = C + I + G + (X-M) – depreciation  NDP measures output available for purchase

National and Domestic Concepts  Gross Domestic Product (GDP) is the total value of all final goods and services produced in an economy in a one-year period  Gross National Product (GNP) is the aggregate final output of citizens and businesses of an economy in one year  GDP is output produced within a country’s borders  GNP is output produced by a country’s citizens (both inside and outside the country)  GNP = GDP + Net foreign factor income

The Income Approach  Aggregate income is the total income earned by individuals and firms in a country on an annual basis.  Aggregate income consists of:  employee salary  profits  rents  interests

Equality of Income and Expenditure  Whenever a good or service is produced (output), somebody receives income for producing it  Aggregate Income = Aggregate Production  Profit is a residual that causes income and expenditures to become equal

Comparison of output among countries  Per capita GDP can be used to compare relative standards of living among various countries  Because of differences in non-market activities and difference in product prices, per capita GDP may be a misleading measure of living standards.  Purchasing power parity adjusts for relative price differences before making comparisons.

Economic Welfare Over Time  If increases in GDP are due to increases in prices, then welfare does not increase  Changes in welfare over time are best represented by changes in real GDP, that is nominal GDP adjusted for inflation

Consumer Price Index  The most widely used measure of inflation  Measures the cost of a standard basket of goods at specific points of time  Items in the basket are assigned a relative weight according to their relative importance

Consumer Price Index  The most widely used measure of inflation  Measures the cost of a standard basket of goods at specific points of time  Items in the basket are assigned a relative weight according to their relative importance

Some Limitations of National Income Accounting  GDP measures economic activity, not welfare.  GDP does not measure happiness, nor does it measure economic welfare  Subcategories are often interdependent.  For example, the line between consumption and investment may be unclear  Measurement problems are in existence

Summary  Aggregate accounting is a set of rules and definitions for measuring economic activity in the aggregate economy  GDP is the total market value of all final goods and services produced in an economy in one year  GDP is the sum of four expenditures: GDP = C + I + G + (X – M)

Summary  Intermediate goods can be eliminated from GDP by:  Measuring only final sales.  Measuring only value added  Net domestic product is GDP less depreciation. NDP represents output available for purchase because production used to replace worn out plant and equipment (depreciation) has been subtracted  GDP measures output produced within the borders of a country; GNP measures the economic output produced by the citizens of a country.

Summary  Aggregate income = Compensation of employees + Rent + Interest + Profit  Aggregate income equals aggregate production because whenever a food is produced somebody receives income for producing it. Profit is crucial to maintain that equality  Because GDP measures only market activities, GDP can be a poor measure of relative living standards among countries.

Summary  To compare income over time, we must adjust for price- level changes. After adjusting for inflation, nominal measures are changed to “real” measures  % change in real GDP = % change in nominal GDP - inflation

Summary  GDP presents the following shortcomings:  does not measure economic welfare  does not incorporate transactions taking place within the underground economy  the price index used to calculate real GDP is problematic  subcategories of GDP are often interdependent

Exercises 1. Let us assume that GDP equals € Investment is €2000 and Government Purchases are €2500. Exports are €500 and Imports are €750. How much is Consumption? Solution: As GDP = C + I + G + (X – M) by substitution, = C ( ) = C C = €5750

2. Let us assume that the Consumer Price Index (CPI) consists of a list of goods and services as in the Table below: CPI COMPONENTWEIGHT Milk0.20 Bread0.20 Education0.10 Heating0.15 Bus Transportation0.15 Medical services and medicines0.20 Let 2000 be the base year and suppose that in 2010, bread’s price has doubled, milk has become more expensive by 20%, education has become 40% cheaper whereas the price for Medical Services and Medicines has increased by 10% and decreased 20% for heating. The ticket for Bus Transportation has retained the same price. What is the Consumer Price Index (CPI) for 2010?

2. Solution: The year 2000 is set as the base year and the CPI equals the base, that is 100%. Therefore, the sum of the CPI components multiplied by the coefficients of their importance should equal 100: CPI 2000 = 0,2 X ,2 X ,1 X ,15 X ,15 X ,2 X 100 = 100 Hence, in 2010 and taking into account the changes in the prices of goods and services, the CPI can be computed as follows: CPI 2010 = 0,2 X ,2 X ,1 X ,15 X ,15 X ,2 X 110 = = 119 Therefore the level of prices has risen by 19% in 2010 in comparison with the respective level of 2000.

In year 2009 the nominal GDP amounted to $20000 whereas in year 2010, $ The GDP deflator is 120 and 125, respectively. What is the change in the nominal GDP? How much of the change is attributed to a real increase in production and how much stems from changes in the price level? Solution:

Helpful reading Economics. Samuelson, & Nordhaus (2005) Ch Macroeconomics. Mankiw, (2007) Ch. 1-2