Lecture 1 Endogenous variables: Exogenous variables: Pizza example:

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1 Lecture 1 Behavior of the whole is greater than the sum of individual actions and market outcomes Paradox of thrift: expectations of possible hardship in economy by families/businesses will cause them to cut spending ultimately depressing the economy: consumers spend less + businesses react by laying off workers Society may end up worse off than if they had not started cutting spending due to expectations to begin with Endogenous variables: explained within model Exogenous variables: taken as given Pizza example: QD depends on price and aggregate income QS depends on price and price of materials Endogenous: quantity supplied/demanded and price Exogenous: income and price of materials Changes in endogenous: movements along the curve Changes in exogenous: shifts of s & d For each model know: ASSUMPTIONS, ENDO/EXO VARS., QUESTIONS IT ANSWERS + THOSE IT DOES NOT ANSWER GDP: total market value of all final goods and services produced within a country in a given period of time GDP excludes: produced + consumed at home & items produced + sold illicitly (illegal drugs) Higher GDP p.p. indicates a higher standard of living Well-being missing from GDP: value of leisure, clean environment and all activity taking place outside of markets CPI: accurate measure of the selected goods that make up the typical bundle but it is not perfect measure of the cost of living: substitution bias, introduction of new goods, unmeasured quality changes (these overstate the cost of living) CPI vs. GDP Capital goods (investments): IN GDP (if produced domestically), NOT CPI Imported consumer goods: IN CPI, NOT GDP (not domestically produced) CPI: fixed, GDP: changes as composition of GDP changes Harmonized index of consumer prices: measures overall level of prices for countries in the EU Retail price index: includes housing costs, mortgage interest, payments, council tax Producer price index: measures cost of basket of goods and services bought by firms rather than consumers Interest: payment in the future for a transfer of money in the past Fisher equation: nominal inflation = real 1

2 Chapter 23 GDP: measures the total income of everyone in the economy and the total expenditure on the economy s output of goods and services Add total income/expenditure to get GDP Exceptions from circular flow: taxes, savings, exports, imports but transaction always has a buyer and a seller Definition: GDP is the market value of all final goods and services produced within a country in a given period of time GDP adds together many different kinds of products into a single measure GDP includes rentals and if people own the place they live their rental value is estimated therefore rent will be income and expenditure for the house owner GDP excludes illegal transactions 2

3 Vegetables you grow in garden NOT in GDP, veggies bought from store ARE House work, child care by grandparents, mowing the lawn when you re married NOT included work never ENTERS market place John mows lawn for Rebecca for 100$ but then they get married and he does it for free GDP falls GDP includes only final goods: problem when intermediate goods are placed as inventory and sold later, called inventory investment it s value is added to GDP but then when sold/used is reduced again Only includes original sales no resales ( NO SECOND HAND TRADES) Geographic confines apply to the measure: Australian company s profits are part of GDP in UK if it operates in UK produced domestically Measured quarterly and annually (quarterly x4 for annually) easy comparison Quarterly GDP modified by a statistical procedure called seasonal adjustment: more shopping in December for Christmas and more shopping before Ramadan in other countries GDP sophisticated measure of economic activity Other measures of income: GNP (gross national product: total income earned by a nation s permanent residents) NNP (total income of nation s residents GNP (NNP minus depreciation) NI (national income: total income by national residents but excludes indirect business taxes and includes business subsidies NNP & NI differ due to statistical discrepancies in data collection PI (personal income: income of households and non-corporate businesses excluding retained earnings, subtracts corporate income taxes + contributions for social insurance. Also includes interest income received from holdings of govt. debt and from transfer programs (welfare & social security) 3

4 DPI (disposable personal income: income of households and noncorporate businesses) left after tax + some non tax payments Y = C + I + G + NX I = capital equipment, inventories and structures (new housing) If total spending rises from one year to the next one of two things must be true: 1) economy is producing a larger output of goods and services 2) goods and services are being sold at higher prices Real GDP evaluates current production using prices that are fixed at past levels Definition: nominal GDP: the production of goods and services valued at current prices Real GDP: the production of goods and services valued at constant prices How to calculate real GDP: 1. Choose base year 2. Calculate nominal GDP by multiplying amount of product with its price for each year 3. Then calculate the real GDP by multiplying amount of product with base year price 4. Nominal/real gdp x 100 = GDP deflator 5. Note: if real GDP increases its due to increased production not increased price levels GDP deflator for base year must always be 100 GDP deflator reflects what s happening to prices not quantities 100 -> 171 is an increase of 71% in prices Problems with GDP: underrepresentation of price of house remodeling as a method of tax evasion, choice of base year (lead to inconsistencies in data because circumstances change new products available the more you update base year the more accurate), annual chain linking: does not update base year every five years but rather does it every year. 4

5 GDP per person natural measure of economic well-being of the average individual Arguments: we shouldn t be obsessed with material things and income, health, quality of education, beauty of poetry are not measured in GDP Counter arguments: large GDP does help us lead a good life GDP measures our ability to obtain the inputs into a worthwhile life Argument: GDP rises but leisure time is cut, doesn t account for goods and services produced at home or volunteer work, excludes quality of living environment, distribution of income (behind the average ) Concl. GDP is a good measure for most but not all purposes what it includes and excludes Components of GDP Y = C+I+G+NX Consumption: spending by households on (final) goods and service Investment: purchase of goods that will be used in the future to produce more goods and services when a car company buys a car its considered as investment and then when it sells the car inventory investment will be negative (because GDP wants to measure value of economy s production and goods added to inventory are a part of that period s production) Government purchases: spending on goods and services by local and national govts. (including salaries + spending on public) not transfer payments (because they are not income from production of goods and services) Net exports: imports exports can be negative if they spend more on imports Real vs. nominal GDP For total spending to arise either economy is producing a larger output of goods and services or they are being sold at higher prices Need to separate these 2 effects 5

6 Real GDP: what would be the value of the goods and services if they were valued at prices from the past? Total spending: multiply quantity x price = nominal GDP Measure not affected by changes in prices: real GDP To do this: use prices from base year - in base year real = nominal Use base year prices with quantities of new years If there is an increase in GDP using base year prices we know the increase is attributable to increase in quantities GDP Deflator Formula: Nominal GDP/Real GDP x 100 GDP deflator for base year is always a 100 It measures the change in nominal GDP from the base year that cannot be attributable to change in real GDP If prices remain the same but quantity increases real/nominal GDPs will increase so GDP deflator is constant But if prices rise and quantities stay the same: only nominal GDP will rise but real GDP would stay the same so GDP deflator rises GDP deflator reflects what s happening to prices not quanitites GDP deflator = 171, prices rose by 71% This is one method they use to monitor avg. price levels Summary Transaction: buyer vs. seller: total expenditure = total income GDP measures economy s total expenditure on produced goods and services: GDP is the market value of all final goods and services produced within a country in a given period of time GDP deflator: calculated from the ratio of nominal to real GDP (measures price levels in the economy) Good measure of economic well-being (high income is preferred over low) Not a perfect measure of well-being: excludes value of leisure + clean environment 6