PART 6 The macroeconomic environment

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1 PART 6 The macroeconomic environment 1 of 38 Economy s Income & Expenditure Gross Domestic Product (GDP) Measures the total income of everyone in the economy Measures the total expenditure on the economy s output of goods and services For an economy as a whole Income must equal expenditure The Circular-Flow Diagram Households buy goods and services from firms, and firms use their revenue from sales to pay wages to workers, rent to landowners, and profit to firm owners. GDP equals the total amount spent by households in the market for goods and services. It also equals the total wages, rent, and profit paid by firms in the markets for the factors of production. 1

2 The Measurement of GDP Gross domestic product (GDP) Market value of all final goods and services Produced within a country In a given period of time GDP is the market value Market prices - reflect the value of the goods The Measurement of GDP of all All items produced in the economy And sold legally in markets Excludes most items Produced and sold illicitly Produced and consumed at home The Measurement of GDP final Value of intermediate goods is already included in the prices of the final goods goods and services Tangible goods & intangible services produced Goods and services currently produced 2

3 The Measurement of GDP within a country Goods and services produced domestically Regardless of the nationality of the producer in a given period of time A year or a quarter The Components of GDP Y = C + I + G + NX Identity Y = GDP C = consumption I = investment G = government purchases NX = net exports The Components of GDP Consumption, C Spending by households on goods and services Exception: purchases of new housing Investment, I Spending on capital equipment, inventories, and structures Household purchases of new housing Inventory accumulation 3

4 The Components of GDP Government purchases, G Government consumption expenditure and gross investment Spending on goods and services By local, state, and federal governments Does not include transfer payments The Components of GDP Net exports, NX = Exports - Imports Exports Spending on domestically produced goods by foreigners Imports Spending on foreign goods by domestic residents GDP and Its Components This table shows total GDP for the U.S. economy in 2012 and the breakdown of GDP among its four components. When reading this table, recall the identity Y = C + I + G + NX. 4

5 Real versus Nominal GDP Real GDP Production of goods and services Valued at constant prices Designate one year as base year Not affected by changes in prices For the base year Nominal GDP = Real GDP Real versus Nominal GDP The GDP deflator Ratio of nominal GDP to real GDP times 100 Is 100 for the base year Measures the current level of prices relative to the level of prices in the base year Can be used to take inflation out of nominal GDP ( deflate nominal GDP) Real and Nominal GDP This table shows how to calculate real GDP, nominal GDP, and the GDP deflator for a hypothetical economy that produces only hot dogs and hamburgers. 5

6 The difference between Real & Nominal GDP Nominal GDP the production of goods and services valued at current prices Real GDP is the production of goods and services valued at constant prices GDP deflator as measure of the price level is calculated as the ratio of nominal GDP to real GDP times 100 Nominal GDP and real GDP must be the same in the base year 16 of 38 Consumer Prices Index (CPI) The inflation rate is the percentage change in the price level from the previous period The consumer prices index (CPI) is a measure of the overall prices of the goods and services bought by a typical consumer Four steps in calculating CPI 1. Fix the basket of typical goods and services 2. Survey the prices 3. Compute the basket s cost 4. Choose a base year and compute the index 17 of 38 Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers. 18 of 38 6

7 Calculating the Consumer Price Index and the Inflation Rate: An Example This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers. 19 of 38 Problems in Measuring the Cost of Living Substitution bias Consumers substitute towards goods that have become relatively less expensive so basket isn t fixed Introduction of new goods Unmeasured quality change Computers are much more powerful each year People are not typical consumers. Pensioners have different buying habits to young people, to families 20 of 38 The GDP Deflator vs. the Consumer Prices Index These indicators can diverge First GDP deflator reflects the prices of all domestically produced goods/services CPI reflects the prices of all goods and services bought by consumers no matter where made A large rise in the price of consumer imports would affect CPI but not the GDP deflator Second CPI compares the price of a fixed basket of goods The goods and services used in calculating the GDP deflator change automatically over time 21 of 38 7

8 Real & Nominal Interest Rates The interest rate that the bank pays is the nominal interest rate The interest rate corrected for inflation is the real interest rate Real interest rate = Nominal interest rate Inflation rate 22 of 38 Production & Growth Standards of living worldwide vary enormously Growth rates between countries also vary Emerging economies have high growth rates A growth rate of around 7% per year would double the populations average living standard in a decade Productivity is a key determinant of living standards and growth 23 of 38 Economic Growth & Public Policy For society to invest more in capital, it must consume less and save more of its current income Sacrificing some consumption of goods and services in the present enables higher consumption in the future Investment from Abroad Foreign direct investment Where a foreign company builds a new factory Foreign portfolio investment Where foreign companies of people buy equity Equity can be used to invest in capital County s stock of capital increases However, some benefits go back to the foreign company in profits or dividends Education A good education raises people s incomes. Education is a merit good in many countries 24 of 38 8

9 Economic Growth & Public Policy continued Health and Nutrition Healthier workers are more productive Property Rights, Political Stability and Good Governance Poor contracts, corruption, fraud and political instability are a problem to business in less developed countries Other methods Eliminating trade restrictions promotes economic growth Encourage research and development 25 of 38 Unemployment Unemployment is the number of people of working age who are able and available for work at current wage rates and who do not have a job. Unemployment is measured by: Claimant count Labour Force Surveys Labour force = Number of employed + number of unemployed Unemployment rate = (Number of unemployed/labour force x 100 Labour force participation rate = (Labour force/adult population) x 100 Natural rate of unemployment the normal rate of unemployment around which the unemployment rate fluctuates Cyclical unemployment the deviation of unemployment from its natural rate 26 of 38 The International Flows of Goods & Services Trade balance = value of a nation s exports minus the value of imports It can be in: Surplus Deficit Balance 27 of 38 9

10 The Flow of Financial Resources Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners Important variables that influence net capital outflow: The real interest rates being paid on foreign assets The real interest rates being paid on domestic assets The perceived economic and political risks of holding assets abroad The government policies that affect foreign ownership of domestic assets 28 of 38 Nominal Exchange Rates The nominal exchange rate is the rate at which a person can trade one currency for another Currencies are subject to the supply and demand and can: Appreciate (gain in value) Depreciate (go down in value) 29 of 38 10