GDP: Measuring the nation's output

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1 ECON1002 NOTES Week 1: Introduction Indication of good macroeconomic performance - Rising living standards o Usually indicated by increase in HDI and GDP o Although many developed economies (e.g. USA, UK) experienced significant increase in living standards since the turn of the 20th century, many developing economies (particularly LDCs in Africa) did not. - Avoiding extremes of the business cycle o That is, moderating expansion and peaks (inflationary pressures - distorts economy + social costs) while also subduing recessions and contractions (unemployment - brings social and economic costs) - Providing unemployment for all individuals seeking work o This involves the unemployment rate being relatively low and at NAIRU - Maintaining the real value of the currency o Minimising fluctuations in short term (few years),particularly rapid depreciation which can have adverse repercussions throughout the economy - Sustainable levels of public and foreign debt o Debt accumulation is justifiable and sustainable if it generates returns exceeding its costs, reflecting the cost-benefit principle o Running large budget deficits for several years exacerbates public debt - Balancing current expenditure against future needs o An adequate level of national savings which aids to reduced foreign borrowings + allows greater investment GDP: Measuring the nation's output - GDP is the market value of the final goods and services produced in a country during a given period of time o In the short run GDP fluctuates noticeably (business cycle) o In the long run generally follows a smooth increase o Market value: Q g/s x P The value goods/services are traded for in the market (allows unrelated goods to be compared e.g. apples and shoes with respect to their market value)

2 This means unpaid work e.g. housewife cleaning (since price=0) is not counted - main criticism against GDP indicator Public g&s don't have market prices and are counted at their cost of provision e.g. defence/public education o Final and Intermediate G&S Final direct to consumer Intermediate goods used to produce others goods GDP can be measured using both (but not together-double counting) however, the GDP measures ONLY the final goods and services o GDP only includes goods and services produced WITHIN a given country o Measured in monthly, quarterly and annual figures - Methods of measuring GDP 1. Production method o Units of production x value of production o This isn t really a method of measuring GDP the next three are 2. Value added method to measure GDP o Summing up the value added by each firm in production process (sum = market price of final good hence GDP is the same) o That is, Value added = Market Value Input costs o This is often used to measure GDP because complications may arise when measuring final goods and services that stretch over time periods: Time lapse between intermediate and final good different GDP periods e.g. wheat of bread is produced in late December 2011 while bread is produced in 2012 calculating the final good in either period wouldn t make sense because part of the good was produced in the other time period hence only the value of the good produced in current time period is counted 3. The expenditure method for measuring GDP o All G&S produced are bought by: Households other firms government foreigners As well as the production firm stocking up inventories o Thus, the GDP can be measured as the sum of expenditure by such buyers on domestic production

3 GDP= Y = C + I + G + NX I = Business fixed investment (capital firms buy) + Residential investment (purchase of new houses by residents) + Inventory investment ( prod > sales = +ve inventory I) o NOTE: for micro this method is price of good x quantity. 4. The income method for measuring GDP o When goods and services are produced or sold in an economy, the revenue from the production is distributed to its workers and owners of capital used in the production o This indicates that GDP, can also be measured using the total level of income in the economy GDP = Labour income + capital income = Y o Labour income includes wages, salaries and self-employed income o Capital income includes payments to owners of physical capital (e.g. land) and financial or intangible capital (e.g. shares receive dividends) as well as any profits made by firm o Basically, you add the profits and wages of labour. - The production, income and expenditure are all ways to measure the same thing, GDP. - The firms produce goods and services using the factors of production from households and in return provide them income. - This income is then spent on buying goods and services from firms, hence expenditure. Nominal GDP and Real GDP - Nominal GDP measures the final value of goods and services at current market prices in a given period of time, usually a year. - Real GDP is GDP adjusted to inflation measures the final value of goods and services using current quantities but the prices from a previous year (base year the year in which the reference prices are selected from used to be every 5 years, but now it s every year to increase relevance and accuracy of prices used in GDP calculation) - To adjust to inflation and calculate the real increase in GDP, economists chose a common set of prices of different years, usually the prices in the base year, and multiply them with quantity of goods - This indicates the actual increase in physical production Real GDP is not the same as economic wellbeing

4 Although the GDP provides a tractable and broad value of an economy, it excludes many other factors that contribute to economic wellbeing such as: - Leisure time o GDP does not take into account leisure time people enjoy since they are not priced o Leisure time allows for individuals to pursue their hobbies and other activities which is a major benefit of living in a wealthy society, yet not reflected in GDP doesn t measure eco wellbeing - Non-Market Economic activities o Does not take into account non market activities such as housekeeping services and volunteer work o Underground economy both legal and illegal e.g. informal baby sitting or illegal criminal activities such as narcotics production - Environmental quality and resource depletion o Adverse effects on the environment are not represented in the GDP, neither are the resources depleted to produce goods and services o For instance, despite China s tremendous economic growth, averaging around 9% each year during , the economic and social costs of the several environmental damages such as air pollution, are not reflected in GDP - Quality of life o GDP is not a holistic measure of quality of life which involves life expectancy, literacy rates and GDP per capita. o It also involves other indicators such as low crime rates, minimal traffic congestions which are not given market value and hence not reflected in GDP - Poverty and Inequality o GDP does not take into account the income inequality in the economy or poverty levels Despite such limitations of GDP, it is still related to economic wellbeing as countries that experience increases in GDP generally enjoy higher quality of life in the long run due to increased income levels, greater government spending on health and education, better infrastructure and more investment in technology usually result from rising GDP. The Consumer Price index: Measuring the price level - The CPI measures the change in price level of a basket of goods and services relative to their prices in the base year (usually previous year). - It is the primary tool used by the RBA in Australia to measure Inflation

5 - Example of CPI calculations - - Does the CPI measure true inflation: o Quality adjustment bias the bias that causes measured inflation to overstate changes in the cost of living caused by the failure to adjust adequately for improvements in the quality of goods and services e.g. a new drug for AIDs o Substitution bias The bias that causes measured inflation to overstate changes in the cost of living causes by the failure to take into account people s substitution towards relatively less expensive goods and services o Also, CPI does not measure all goods in the economy, only those in the basket Inflation - Inflation is a SUSTAINED increase in the general price level in an economy - The CPI is used to calculate the rate of inflation which is the percentage change in CPI over a specified time period, usually annually or quarterly. - - NOTE: do not confuse inflation and relative price changes (which occur due to changes in demand and supply of a particular good not all goods and services) - Also CPI and inflation rate are not the same CPI is an index while inflation rate is the change in CPI relative to previous year/quater Real costs of Inflation 1. Unexpected redistribution of wealth and income

6 a. Those on fixed income such as wage earners in contract with wages not indexed to inflation experience reduced REAL income reduction in purchasing power lower living standards. However, the employers of these workers will experience a rise in real purchasing power as the real cost of paying workers is less than anticipated hence purchasing power redistributed from worker to employers b. Furthermore, since high inflation generally results in tighter monetary policy higher interest rates result. This increases burden on those with mortgages reduces consumption lower living standards. However, increased interest rates mean savings get better returns and since high income earners usually have larger saved funds experience a rise in total wealth increasing inequality of wealth distribution c. Borrowers/debt repayment have to pay the same amount of funds back to lenders which will now have a reduced purchasing power due to inflation. This will shift income from the lender to the borrower (however no wealth is lost as it is merely transferred) 2. UNCERTAINTY and interference with long term planning 3. International competitiveness falls a. High inflation results in increased prices for Australia s exports because higher inflation is also associated with rising production costs such as labour wages (cost-push inflation), reducing international competitiveness and the quantity of exports. b. This means, foreigner s costs of production become lower than Australians thus giving them a competitive advantage in foreign markets c. Also, inflation causes the prices of domestic goods to rise thus making imports more attractive and leading to a fall in market share for domestic businesses in import competing industries as overseas firms can produce the same goods at lower prices 4. Exchange rate impacts a. Speculators expect RBA to raise cash rate to control inflation investment in Australian assets increase in the process, appreciate currency. However, long term high inflation will reduce currency as investors lose confidence 5. Noise in the price system a. Price works as an indicator to demanders and suppliers of goods and services in the market b. When the price of a particular good increases, suppliers are attracted to producing that good c. However, due to inflation, the cause of the increase in price, whether inflation or increased demand, causes suppliers to be more tentative with their response to change in price d. To discern if the increase was from relative price changes, suppliers need to find out the changes in prices of other goods which takes time and thus prolongs the natural process of market mechanism, creating noise or disturbance leads to inefficiency.

7 6. Distortions of tax system a. Especially for countries with progressive tax that is not indexed to inflation such as Australia b. Bracket creep goes to higher tax bracket and is charged greater percentage of tax but results in reduced real income 7. Shoe-leather costs + menu costs (resource costs) a. Inflation decreases the purchasing power of money over time b. To minimise this effect, individuals and firms are likely to deposit as much funds as possible in a bank which provides interest to counter the effect of inflation c. This means individuals and firms need to travel more frequently to the bank to withdraw cash to complete transactions d. This inconvenience of increased frequency of bank trips is the REAL cost of inflation e. E.g. some businesses might need to hire additional staff for this activity f. However, not prominent in countries like Australia with low inflation g. Secondly, more relevant to current times during times of high inflation, buyers will check prices from different stores more often by walking around e.g. from Myer to David jones) still fucking stupid h. Menu costs menus need to be printed every day or at last regularly because of rapidly increasing prices When inflation is anticipated correctly, households can take measures to counteract the effects of inflation. Moreover, firms, governments etc can adjust to change in inflation e.g. increase tax bracket or firms increasing prices accordingly. However, unanticipated inflation creates more problem as it can lead to uncertainty and increased inflationary expectations which will further increase inflation (wage price etc). However, real costs of anticipated inflation still exists e.g. menu costs and shoe-leather cost The main causes of Inflation - The main causes of inflation arise from both the Demand and Supply side of the economy 1. Demand pull 2. Cost push 3. Imported inflation/depreciation of AUD 4. Inflationary expectations wage price inflationary spiral 5. Excessive increase in money supply 6. Government tax/policies tax of G&S, tariff rates, public sector good prices e.g. cityrail Interest rate and Inflation

8 - Inflation is a core part of the economy and effects several economic variables, one such variable is the interest rate, namely the real interest rate - The fisher equation describe the relationship between the real interest rate (r), I = nominal IR and π = inflation rate: o r = i π - The real interest rate is the percentage increase in the real purchasing power of a financial asset - The nominal interest rate is the percentage increase in the nominal or dollar value of a financial asset - Fisher argued that savings and investment determined the real interest rate but these forces changed very slowly and thus over reasonable periods of time, real interest would experience minute changes - This implies a one to one correspondence between nominal interest rate and inflation as if inflation increased, nominal rates would also have to increase to prevent lenders from losing real purchasing power to borrowers - This effects borrowers and lenders o The higher the rate of inflation over the contract period of loan, the more the lender is penalised through a fall in purchasing power of the money lent when they receive it(hence a rise in expected inflation rate raises the nominal of interest which lenders demand) o Borrowers gain from inflation since the money they pay back has less real purchasing power compared to the money they borrowed Deflation - Deflation is a situation where there is a sustained fall in the general level of prices in the economy - Deflation has several negative effects in the economy 1. Real value of debt rises purchasing power of money payed back is greater than money borrowed 2. Consumers put off purchases since future purchasing power will increase further encourage deflation spiral 3. Firms profit margins decline reduced sales bankruptcy and unemployment rises - Another major problem with deflation is its effect on real interest rates - When deflation in the economy increases to a point where nominal interest can t fall as no one will loan at 0% or a negative nominal interest rate (why buy financial assets or lend money with 0% interest if you can hold money and receive 0% and have the added liquidity), the real interest rate rises. E.g. r = i pi, since deflation, r = i + pi thus if pi is 3% and i is zero, r will be 3% too this

9 Savings: increase in real interest rate due to deflation will have undesirable effects on the economy (particularly in PAE) (page 32) Balance sheet identities: Balance sheets: allow accountants to list the assets and liabilities of an economic unit to determine it s value. Assets: anything of value that one owns. Liabilities: are the debts that one owns. Net worth = Assets Liabilities. Saving: Current income Spending on current needs. (stock). Saving rate: the proportion of total income devoted to saving. In a closed economy savings is equal to investment. Capital gains/losses: are changes in the values of assets owned. Changes in net worth = Saving + (Capital gains Capital losses). Higher savings lead to greater wealth and a better standard of living for the future. Stock and flow variables: A flow variable is measured over a period of time. A stock variable is measured at a point in time. Why do households save? Life cycle saving: saving to meet long-term objectives, such as retirement, university attendance or the purchases of a home. Precautionary saving: saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency. Bequest saving: saving done for the purpose of leaving an inheritance. Saving and the real interest rate Most people do not save by putting cash under the mattress. Instead, they make financial investments that they hope will provide a good return on their savings. The measurement of national saving: GDP = Y = C + I + G + NX (NX=0) National saving is current income less spending on current needs. Spending on current and future needs: Consumption [C]: Spending largely on current needs, but also durable goods which provide services into the future Investment [I]: Spending on capital equipment to expand the economy s future productive capacity, it is saving.