Principles of Macroeconomics

Transcription

1 Principles of Macroeconomics Academic Program: MSc in Banking and Finance Semester: Spring 2012/13 Instructor: Dr. Nikolaos I. Papanikolaou Office: Luxembourg School of Finance, KB2-E02-21 Phone: (00352) Home Page: Office hours: Thursday 10:00-12:00 or by appointment Course web site: (use your enrollment key to access the course content) 1 Principles of Macroeconomics-MSc in Banking & Finance

2 Lecture notes Set 2 The Classical view vs. the Keynesian view Gross Domestic Product & Economic activity Business cycles Economic activity and Business cycles Consumer Price Index & Inflation rate GDP Deflator vs. CPI Unemployment The Circular Flow of Income The National Income Identity Exercises 2

3 Classical view vs. Keynesian view The Classical approach It relies upon the invisible hand hypothesis of Adam Smith: if there are free markets, the laws of demand and supply will drive the overall economy to an equilibrium (market-clearing process). It assumes that prices and wages are flexible (and not sticky). If there is a shortage (surplus) of labour, wages will rise (fall), which implies that the level of employment is determined by prices and wages. Government should have only a limited role in the economy. 3

4 Classical view vs. Keynesian view The Keynesian approach The Great Depression: Classical theory failed because high unemployment was persistent. Keynesian approach: Persistent unemployment occurs because wages and prices adjust slowly, so markets remain out of equilibrium for long periods. The level of employment is determined by the level of aggregate demand for goods and services. Government should intervene to restore full employment through the increase in spending. 4

5 GDP & Economic activity Gross Domestic Product (GDP) is the main measure of economic activity and an indicator of well-being. It is calculated as the market value of all final goods and services produced within a nation during a specific time period, usually one calendar year. For those goods that are not traded in the market place, we use an estimation of their value, which is called imputed value. Nominal GDP is measured at current market prices, whereas Real GDP is measured at constant prices taking some specific calendar year as the basis year. This conversion from nominal to real units allows us to eliminate the problems created by having a measuring stick that essentially changes length over time, as the price level changes. The ratio of Nominal GDP to Real GDP produces the so-called GDP Deflator, which accounts for price changes over time. 5

6 Business cycles The term business cycles refers to the fluctuations of the overall activity and performance in an economy. Expansions vs. contractions: An expansion refers to the improvement of economic performance and an increase in economic activity; the converse holds true in a contraction (or recession). The economy is expanded when moving from a trough to a peak; it is contracted between a peak and trough. Rule of thumb: two consecutive quarters of negative economic growth rate define a recession. 6 An economic variable X can be either procyclical or countercyclical to GDP. When X increases (decreases) in economic expansions and decreases (increases) in recessions (i.e., it is positively linked to GDP), then it is called procyclical (countercyclical).

7 Economic activity and business cycles 7

8 CPI & Inflation rate The Consumer Price Index (CPI) is a composite indicator that relies on the weighted prices of a number of goods and services consumed by a typical (representative) household. CPI is the weighted price of this basket of goods and services relative to the price of the same basket in some base year (or month). π t+1 = (P t+1 P t ) P t where: π t+1 = inflation rate P t can be either measured by CPI or by GDP deflator An increase (decrease) in π t+1 implies an increase (decrease) in the average level of prices. The so-called core inflation excludes energy and food prices as they tend to be very volatile. 8

9 GDP deflator vs. CPI GDP deflator measures the prices of all goods produced, whereas CPI measures prices of only the goods and services bought by the representative household. GDP deflator includes only those goods and services produced domestically. Imported goods are not a part of GDP and therefore do not show up in the GDP deflator. CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights. 9

10 Unemployment The labour force (L) is the sum of the employed (E) and unemployed (U) individuals: L = E + U, where U consists of all individuals that do not have a job and have actively sought for one during the past four weeks. The unemployment rate (u) is defined as the percentage of the labour force that is unemployed: u = U/L The employment-population ratio is the percentage of the adult population (N) who are in the labour force (L): Employment-population ratio = L/N 10

11 The Circular Flow of Income GDP can be viewed as: the total income of everyone in the economy the total expenditure on the economy s output of goods and services Income Households Labour Goods Expenditure Firms For the entire economy it must hold that: Total income = Total expenditure 11

12 The National Income Identity Y = C + G + I + (X-M) Y = Total Income (Total Expenditure, or Total Production) C = Total Consumption spending on durables and non-durable goods and services G = Total Government Expenditure (consumption & investment) I = Total Private Investment (residential & non-residential) augmented by the change in inventories X-M = Exports of domestic goods and services Imports of foreign goods and services (Net Exports) 12

13 The National Income Identity GDP = C + G + I + (X-M) GNP = GDP + Receipts from the rest of the world + Payments to the rest of the world NNP = GNP Depreciation National Income (NI) = NNP + Subsidies Taxes Personal Income (PI)= NI +Other personal income Other personal expense Disposable PI = PI Personal taxes 13

14 Exercise 1 Consider the following economy that produces only soda and pizza: a) Calculate nominal GDP for all three years. b) Calculate real GDP for all three years using 2005 as the basis year. c) Why does real GDP not increase between 2006 and 2007 but nominal GDP does? d) Calculate the GDP deflator for

15 Exercise 2 Answer the following questions using the information provided in the Table below: 15 a) Calculate the private consumption. b) What is the value of gross domestic investment? c) What is the value of net exports? d) Calculate the value of government spending. e) Calculate the gross domestic product.

16 Exercise 3 Consider an economy that is described by the following relationships: C = cy, with c = 0.75 G = 250 NX = 250 I = I br, with I = 500 and b = 5,000 a) Assume that the autonomous investment decreases from 500 units to 300 units. What will be the effect on output, ceteris paribus? b) At the same time with what is happening in (a), the interest rate decreases from 0.06 to 0.05; calculate the resulting change in Y. 16

17 Exercise 4 Consider an economy that is described by the following relationships: C = c(y - T), with c = 0.75 G = 250 NX = 250 I = I br, with I = 500 and b = 5,000 Assume that the government increase expenditure by 500 units. This increase is financed 50% by taxes (T) and the rest by bond issuance. The increased demand in the bonds market drives up interest rate from 0.05 to a) What is the effect of the aforementioned changes on the equilibrium income? b) Would it have been better to finance the expenditure entirely by taxes? 17