1. 3–13–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 3 Measuring Macroeconomic Performance: Output and Prices

2. 3–23–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 3: Measuring Macroeconomic Performance: Output and Prices When is the economy performing well? Gross domestic product: measuring the nation’s output Real GDP is not the same as economic wellbeing The consumer price index: measuring the price level

3. 3–33–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank A Well-Performing Economy Rising living standards Economic stability Low inflation Sustainable levels of debt Economic growth Full employment

4. 3–43–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Measuring GDP The market value of current production valued at current prices Unpaid work is not counted – a defect Public goods and services, provided free, are valued at their cost of production

5. 3–53–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Intermediate and Final Products Wheat and flour are intermediate products used to make bread, the final product GDP measures the production of final products, the market value of which already embodies the cost of intermediate products Counting intermediate products separately would involve ‘double counting’

6. 3–63–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Value Added (VA) Firms generate GDP by adding value to the intermediate products they buy from others VA is equal to the value of a firm’s output (bread) minus the value of intermediate products used up (flour) GDP is the sum of VA by all firms within a country in the current year

7. 3–73–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Expenditure on GDP Current production by firms must be bought by households, other firms, government and foreigners Exception: production which is not sold is added to inventories and treated as ‘spending’ or ‘bought’ by the firm which makes it So it follows that GDP may be measured as the sum of spending on domestic production by households, all firms, government and foreigners Reminder: spending by firms includes that part of production which is added to their inventories

8. 3–83–8 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank GDP = Y + C + I + G + X – M Household spending is consumption: C Firm’s spending is investment: I Government spending: G Foreign spending on our exports: X Domestic spending on foreign production or our imports: M X – M is net exports: NX So GDP = Y = C + I + G + NX

9. 3–93–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank GDP and Household Incomes VA is the difference between firms’ sales of output and payments for their raw materials Firms then pay wages to labour and other factors The residual is profit or capital income It follows that GDP and VA generate equivalent labour and capital income Reminder: profit is always a residual

10. 3–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Examples Sales $100 (200) Cost of raw materials $40 (100) Therefore Value Added $60 (100) Wages, interest and rent $50 (70) Therefore Residual Profit $10 (30) Household income from wages, interest, rent and profit = $60 (100) = Value Added

11. 3–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Nominal vs Real GDP Nominal GDP rises when prices rise Real GDP only rises when quantities rise To measure changes in real GDP we use constant prices of the ‘base year’ Then any rise in GDP is ‘real’ – entirely due to rises in quantities In the ‘base year’ real GDP = nominal GDP

12. 3–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Example: Two Goods Suppose we produce two goods, apples and beer In Year 1 the respective (quantities x prices) give Nominal GDP1 = (10 x 1) + (12 x 2) = $34 In Year 2 the respective (quantities x prices) give Nominal GDP2 = (11 x 3) + (13 x 4) = $85 Nominal GDP has risen by 51/34 = 150%! Real GDP2 = (11 x1) + (13 x 2) = $37, a rise of only 3/34 = 3%

13. 3–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Influences on ‘Wellbeing’ Real GDP per capita Leisure time Unpaid services provided Environmental quality and climate Poverty, inequality and crime International tension

14. 3–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Measuring the Price Level The CPI measures the cost of a fixed basket of goods bought by the ‘average’ or typical household – a measure of the cost of living The rate of change of the CPI is one measure of the rate of inflation It exaggerates the true rate of inflation because it does not allow for quality improvements and for substitution by households in favour of those goods which have risen least in price If we become vegetarian when the price of meat rises, has our cost of living risen?

15. 3–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Measuring the Price Level (cont.) Households do not buy everything that the economy makes The average price of everything produced in the economy is the GDP Deflator This is Nominal GDP/Real GDP

16. 3–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Prices and Quality The quality of goods usually improves over time A car made in 1990 is quite different to a car made in 2004 So measures of inflation based on movements in price indices exaggerate the true rate of inflation because they ignore quality improvements

17. 3–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Rate of Inflation This is the rate of change in the average price level If some prices rise while others remain constant, there is both a change in relative prices and a positive rate of inflation This is the usual situation If some prices rise while others fall, there is a change in relative prices, but the rate of inflation may be zero, positive or negative, depending on the relative frequency of price rises and falls

18. 3–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Costs of High Inflation Inflation destroys the purchasing power of money Loss of confidence in holding money leads to inconvenience and to inefficiency of barter trading The inefficiency of barter trading leads to loss of specialisation as people make more things for themselves

19. 3–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Other Costs of Inflation Uncertainty and cost is caused by frequent changes in price lists Adverse effects on incentives are caused by ‘unearned’ redistributions of wealth which cause people to spend time looking for ‘bargains’ instead of working productively Higher effective tax rates caused by ‘bracket creep’ in a progressive tax system, reduce the incentive to work Higher nominal interest rates leave debtor households with less spending power

20. 3–20 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Inflation and Interest Rates Borrowing and lending contracts specify how much money will be paid back to the lender at a given time The higher the rate of inflation over the contract period, the more the lender is penalised through a fall in the purchasing power of the money lent So a rise in the expected inflation rate raises the rate of interest which lenders demand Likewise, borrowers gain from inflation and a fall in the purchasing power of money, so they are willing to offer higher interest rates with inflation

21. 3–21 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Nominal and Real Interest Rates The nominal interest rate is the rate of interest specified in the loan contract The real rate of interest is the nominal rate of interest minus the rate of inflation It measures the reward to lenders, in terms of purchasing power, paid by borrowers for lenders giving up spending over the contract period The real interest rate is the nominal interest rate minus the rate of inflation (approximately)

22. 3–22 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Example: One Year Loan of $100 Nominal interest rate is 10% p.a. Dollars repaid to lender: $110 Price of bread at beginning of loan is $1 per loaf Price of bread at end of year is $1.06 per loaf Rate of inflation is 6% p.a. Purchasing power given up by lender: 100 loaves Purchasing power received back by lender: 110/106 = 104 loaves Gain in lender’s purchasing power = 4 loaves Real interest rate 4/100 = 10% – 6% = 4%

23. 3–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Inflation Bad, Deflation Good? Deflation is a fall in the average price level Compared with stable prices, deflation should lead to lower nominal interest rates to keep the real interest rate constant So deflation should not affect real interest rates and should do no harm But can nominal interest rates go to zero or below?

24. 3–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Nominal Interest Rates Always > 0 Deflation raises the purchasing power of both money and bonds The convenience of money means lenders will always require a positive nominal interest rate to compensate them for giving up money to hold bonds Once nominal interest rates reach this ‘floor’, any increase in the rate of deflation will raise real interest rates and hurt the economy Deflation is bad!

25. 3–25 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Example Suppose nominal interest rate floor = 0% When rate of deflation = 2% p.a. Real interest rate = 0 – (-2) = 2% When rate of deflation = 3% p.a. Real interest rate = 0 – (-3) = 3% When rate of deflation = 4% p.a. Real interest rate = 0 – (-4) = 4%

26. 3–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Inflation in Health Care Costs The cost of health care generally rises faster than other costs One reason is that quality improvements in health care are rapid Another is that health care, like education, is a personal service in which labour-saving devices play a smaller role than in the production of goods like food, clothing and motor cars