CH.3 Output and Prices: Evaluating Macroeconomic Performance Measuring National or Aggregate Output

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1 CH.3 Output and Prices: Main focus: 1. Indicators of macroeconomic 2. Measuring output (GDP) 3. Measuring Prices and inflation Evaluating Macroeconomic Performance 1. Rising Living standards Economic growth Tendency for the level of output (quantity and quality of goods and services) to increase over time Output divided by population = output per capita Distribution of living standards 2. Stable Business Cycle Low volatility in fluctuation of actual output around its trend or potential output 3. Relatively Stable Price Level Low (+ve) rate of inflation Inflation has been concern for most developed countries over the last 40 years. 4. Sustainable Levels of Public and National Debt Public debt Borrowing by public sector from private sector Influence by government budget deficits/surpluses Foreign debt Borrowing by domestic residents from foreign countries Influenced by an economy s current account deficits/surpluses 5. Balance between Current and Future Consumption Save for future usage Spent on current issue 6. Full Employment Provision of employment for all individuals seeking work Measuring National or Aggregate Output GDP (Gross Domestic Product) o The market value of final goods and services produced in a country during a given period o Flow variable which measured over a period of time o Measured Quarterly March, June, September and December o Yearly GDP = Sum of 4 quarters GDP (Different for financial and calendar) o Measure of aggregate production or output o Use market prices to value quantities of various goods and services o E.G. Quantity Market Price 10 cars $20,000 per car 100 apples $1 per apple GDP = 10 x $20, * $1 = $200,100 Goods and services with no observed market price o Included in GDP: National defense use costs of provision (costs of buying equipment, wages of soldiers, etc.) o Excluded in GDP Unpaid housework GDP excludes intermediate goods and services. These goods are used-up in the production process. o E.g. In the production of a loaf of bread, the flour used is an intermediate input and is not counted in GDP

2 VALUE Added: The market value of a firm s production less the cost of inputs purchased from other firms. o E.g. Firm Sales Cost of inputs Value Added Intel Incorp 20, ,000 Macro Soft 5, ,000 Bell 80,000 25,000 55,000 PC Charlie s 100,000 80,000 20,000 PC Charlie s final sales = $100,000 Sum of Value Added = $100,000 Measuring GDP 1. Production Method 2. Expenditure Method 3. Income Method o Expenditure Method Accounting Identity Expenditure on goods and services by final user must equal the value of their production Component of Expenditure Consumption (C) purchases by Households Investment (I) purchases by Firms Government (G) Government purchases Net Exports (NX) net purchases by foreign sector NX = Exports Imports National Income Accounting Identity GDP = Expenditure Y = C + I + G + NX Sum of all expenditure Nominal vs Real GDP Nominal - Values quantities of goods and services produced at current year prices Real values quantities of goods and services produced at base year prices (measure of the actual physical volume of production % Change No. Of Cars Prices of Cars $20,000 $40, No. Of Apples Price of $10 $ Apples Nominal GDP $200,100 $425, Real GDP 2007 Prices $200,100 $210, Laspeyres 2008 Prices Paasche $402,500 $425, Choice of Base Year o Using initial prices is known as a Laspeyres index o Using final prices is known as a Paasche index o Chain Weighting Average of the two growth rates calculated by each index E.g. ( )/2 = 5.25

3 IS GDP A Good Measure of Economic Wellbeing? Omissions o Leisure Time o Household production o Environment Degradation o Quality of Life o Economic Inequality GDP is positively correlated with Economic Wellbeing o Variety of goods and services o Health and Education Measure of the Price Level Measure the average level of prices in the economy o Consumer Price Index (CPI) o GDP Deflator/Price Index CPI For a given period, measures the cost in that period of a given basket of goods and services relative to their cost in a fixed year (base year). Example: Basket 2000(base) 2008 Rent $500 $630 Hamburgers $150 $150 CDs $30 $70 Total Expenditure $680 $850 CPI = = Cost of living is 25% higher in 2008 than it was in 2000 Average prices are 25% higher in 2008 than in 2000 Base year usually change every 5 years Inflation (and Deflation) Measured by the % change in CPI over a given period Inflation rate = () 100 () Inflation rate = 0 implies prices are constant Inflation rate > 0 implies prices are rising Inflation rate < 0 implies prices are falling Deflation Limitation with CPI Quality Adjustment and New Goods Bias o Quality improvements may show up as higher prices for goods and services o New goods often not included until CPI is rebased Substitution Bias o Use of a fixed basket means that no allowance is made for consumers substitution toward relatively less expensive goods CPI tends to overstate the rate of inflation Costs of Inflation Distinguish between relative price change and a change in the general price level o Shoe-leather costs inflation reduces the real purchasing power of a given amount of money o Menu costs real costs of changing prices o Introduces noise into the price mechanism o Distorts tax systems (if not indexed to inflation) o Unexpected re-distributions of wealth Inflation and Interest Rates Nominal Interest rates - % increase in the nominal value of a financial asset Real Interest rate - % increase in the real purchasing power of a financial asset. r = i π, Where r = real interest rate, I = nominal interest rate and pi=inflation rate.

4 Ch.4 Saving and Wealth Main Issues: Definition and Measure of Saving Saving and Wealth Motives for Saving Investment and Capital Accumulation Saving, Investment and the Real Interest Rate Saving Saving = current income current spending Saving rate = Saving is a flow variable Saving >0, assets are being accumulated Saving <0, assets are being DE-cumulated or liabilities (debts) accumulated Capital Gain and Losses Depends on fluctuations in the market value of assets. Capital gains or losses have an important effect on net wealth Change in Wealth = W = W W Where W = W + S + Net Capital Gains Assets, liabilities and wealth are stock variables Wealth Net Wealth = Value of Assets Value of Liabilities Motives For Saving 1. Life-Cycle Saving Typically people only work for part of their lifetime However, consumption is over your entire lifetime Save during working life to provide the consumption during non-working part of lifetime. (Retirement) For other items o House deposit o Education expenses 2. Precautionary Saving Protection on unexpected declines in income or increase in consumption (temporary unemployment, medical expense) 3. Bequest Saving Save for their children or relatives then able to leave a bequest for them Saving and the Real Interest Rate Level of saving will increase with higher real returns to various assets. Real interest rate is directly related to the saving decision. Ceteris paribus saving to increase with the real interest rate. (Other factors equal) r S(r) Saving

5 Psychology and Behavioral Motives for Saving Individuals choose to save at the amount that will maximize their long-run welfare. Factor that stop/discourage saving Lack sufficient self-control or willpower to undertake an optimal level of saving Consumption benefits of saving arise far into future, but costs in terms of forgone consumption are immediate Availability of consumer credit (home equity loans) Demonstration effects. High consumption levels of neighbours may influence us to consume more and save less Government provision of retirement benefits may lead to less private saving for retirement. (Reducing ones own saving in response to government retirement benefits may be rational behavior Method to encourage saving Compulsory superannuation saving Hard to justify Compulsory policy only increase total saving if individuals do not reduce their voluntary saving by an equal amount in response National Saving Households Business Government Measures aggregate saving in an economy National Accounting Identity Y = C + I + G + NX Assume NX = 0 Y = C + I + G Saving = Current income current spending S = Y C G I is ignored since it is spending that provides for future needs not current ones. Durable Goods Consumer Durables (e.g. cars, furniture, appliances) o Provide a flow of consumption services over a period of time Government purchases of durable goods o Roads, bridges, schools, other infrastructure o Provide a future flow of services o Public Capital Private and Public Components of Saving Private Saving o Households o Business Public Saving o Government S = Y C G S = Y C G + T T National S = (Y T C) + (T G) = Private savings + Public Savings T = taxes paid by private sector to government less transfer payments from government to private sector less interest payments from government to private sector bond holders Transfer payments: payments the government makes to the public for which it receives no current goods or service in return Public Saving is equal to the Budget Surplus/Budget Deficit