Week 1 - Chapter 3 Measures of Macroeconomic Performance: Output and Prices

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1 INTRODUCTORY MACROECONOMICS Week 1 - Chapter 3 Measures of Macroeconomic Performance: Output and Prices 3.1 When is the Economy Performing Well? Broadly, we say that a macroeconomy is performing well if it meets the following criteria: - rising living standards in the long run! many of the world s economies have experienced significant growth in the material wellbeing of their populations, including the US, Europe and Australia, showing that positive growth outcomes are possibly. However, the fact that many countries, like Bangladesh, have not shared in this growth shows us that such outcomes are not inevitable! growth theory refers to the study of the long run growth performance of economies - avoiding extremes of short run macroeconomic performance! virtually all economies have experienced what is known as the short run business cycle; the tendency for economies to pass through relatively prosperous times followed by relatively lean times! when output is expanding at a rapid pace and where people have little difficulty in finding employment are known as expansions. When economic performance is disappointing, there is said to be a contraction! recessions are two consecutive quarters in which the economy s output falls and are very costly in terms of the output that is lost to the economy and the economic and social hardships faced by people unable to find work (e.g. the Great Depression)! although Governments like to see their economies expanding, there is such a thing as too rapid an expansion, which may be subject to inflation - maintaining the real value of the currency! throughout the 1970s and 1980s, inflation the tendency for the overall level of prices in the economy to rise through time was a major policy concern in Australia and many other industrialised countries! inflation occurs when prices rise over time, whereas deflation occurs when prices fall over time - ensuring sustainable levels of public and national debt! public debt is the amount owed by the government to the non-government sector! a budget deficit occurs when the government spends more money than it receives as tax revenue, forcing it to borrow money from the private sector. This does not necessarily cause any difficulties. However, excessive borrowing can be problematic and an unsustainable public debt is one that cannot be paid off! budget surpluses arise when the government s expenditure falls short of its available taxation revenue. This allows the government to pay off some of its accumulated debt from past budget deficits. However, there is an opportunity cost here, as the money could have been used to finance a public expenditure, like the health or education systems! national debt is the amount owed by the nation to other countries. As with public debt, this need not be problematic if the debt is sustainable - balancing current expenditure against the need to provide resources for the future! there exists an optimal amount of savings that a nation should be aspiring towards; one that achieves the best balance between current consumption needs and the need to carry resources forwards into the future! however, it is not easy to determine this level, as we do not know what the future holds for us - providing employment for all individuals seeking work 3.2 Gross Domestic Product: Measuring the Nation s Output Gross Domestic Product the market value of the final goods and services produced in a country during a given period (usually a quarter of a year)

2 Countries with relatively high levels of GDP per person tend to be countries with high standards of living Over reasonably short periods of time, GDP can fluctuate quite markedly, growing relatively strongly at times (called expansions) and relatively sluggishly at other times (called contractions). These fluctuations are called the business cycle Over longer periods of time (like decades or centuries), most countries experience reasonably steady growth in their GDP Real GDP involves an adjustment to the raw GDP figures to removes distortions introduced by inflation GDP The Fine Print: Market Value Market values provide a convenient way to add together, or aggregate, the many different goods and services produced in a mode4rn economy A drawback of using market values, however, is that not all economically valuable goods and services are bought and sold in markets (e.g. the unpaid work of a homemaker) With a few exceptions, like publicly provided goods and services, GDP is calculated by adding up market values! as market prices for publicly provided goods and services do not exist, economic statisticians add to the GDP the costs of providing those goods and services as rough measures of their economic value Final Goods and Services A final good or service is the end product of a process and is counted in the GDP Intermediate goods or services are goods or services used up in the production of final goods and services and are therefore not counted as part of the GDP Value added for any firm, the market value of its product or service minus the cost of inputs purchased from other firms. Summing the value added by all firms (including producers of both intermediate and final goods and services) gives the same answer as simply adding together the value of final goods and services. However, the value added method eliminates the problem of dividing the value of a final good or service between two periods Produced Within a Country during a Given Period: The word domestic in GDP tells us that it is a measure of economic activity within a given country. Thus, only production that takes place within the country s borders is counted The Expenditure Method for Measuring GDP: GDP is a measure of the quantity of goods and services produced by an economy. But, any good or service that is produced will also be purchased and used by some economic agent. For many purposes, knowing not only how much is produced, but who uses it and how, is important. Goods that are produced but not sold in a period are inventories. By convention, economists regard these unsold goods as having been purchased by the firms that produced them. GDP can be measured with equal accuracy by either of the following two methods: 1. Adding up the market values of all the final goods and services that are produced domestically 2. Adding up the total amount spent by each of the four groups (households, firms, governments, foreign sector) on final goods and services and subtracting spending on imported goods and services Corresponding to the four groups of final users are four components of expenditure: consumption, expenditure, investment, government purchases and net exports (exports minus imports). That is, households consume, firms invest, governments make government purchases (consumption and investment) and the foreign sector buys the nation s exports The relationship between GDP and expenditures on goods and services can be summarised by the following equation, known as the national income accounting identity. Let:

3 Y = GDP or output C = consumption expenditure I = investment G = government purchases NX = net exports Y = C + I + G + NX GDP and the Incomes of Capital and Labour A third way to think of the GDP is as the incomes of capital and labour Whenever a good or service is produced or sold, the revenue from the sale is distributed to the workers and the owners of the capital involved in its production Thus, GDP also equals labour income plus capital income, highlighting the fact that all three approaches should give the same figure for GDP. Nominal GDP vs. Real GDP: GDP can often be a misleading gauge of economic growth, since the physical quantities of the goods and services produced in any given year, not the dollar values, are what determine people s economic wellbeing If we want to use GDP to compare economic activity at different points in time, we need some method of excluding the effects of price changes. In other words, we need to adjust for inflation - economist use a common set of prices to value quantities produced in different years - the standard approach is to pick a base year, and use the prices from that year to calculate the market value of output When GDP is calculated using the prices from a base year, rather than the current year s prices, it is called real GDP, to indicate that it is a measure of real physical production Real GDP is GDP adjusted for inflation, whereas nominal GDP is a measure of GDP in which the quantities produced are valued at current year prices The advantage of using real GDP is that, unlike nominal GDP, it does not change if only the price of output has changed. Changes in reap GDP occur only if the actual quantity of goods and services produced in the economy changes 3.3: Real GDP is not the same as Economic Wellbeing GDPisactuallyanimperfectmeasureofeconomicwellbeing.Thisisbecausenotallofthe factorsthatcontributetopeople squalityoflifearemeasuredingdp,including:?leisure'time'!theincreasedleisuretimeavailabletoworkersinindustrialisedcountries, whicharenotreflectedingdp,isamajorbenefitoflivinginawealthysociety?environmental'quality'and'resource'depletion'!includingairquality;howdoyouplacea dollarvalueonintangibles??quality'of'life'!someindicatorsofthe goodlife areomittedfromgdp,e.g.alowcrimerate, minimaltrafficcongestionandopenspace?poverty'and'economic'inequality'!twocountriesmayhaveidenticalgdpsbutdifferradically inthedistributionofeconomicwelfareacrossthepopulation;doesnotcapturetheeffectsof inequality?availability'of'goods'and'services'!onaverage,peopleinhigh?gdpcountriesenjoymore comfortablehomes,higherqualityfoodandclothing,agreatervarietyofentertainmentand culturalopportunities,betteraccesstotransportationandbettersanitation.

4 3.4: The Consumer Price Index: Measuring the Price Level The basic tool economists use to measure the price level and inflation is the consumer price index. The CPI is a measure of the cost of living during a particular period TheCPIcanmeasurethe cost%of%living bymeasuringthecostinthatperiodofastandardset ofgoodsandservicesrelativetothecostofthesamesetofgoodsinthebase'year. Inflation: TheinflationrateissimplythepercentagechangeintheCPIoveraspecifiedtimeperiod.For example,tocalculatetheannualrateofinflationasofdecember2006,wefindthepercentage increaseinthecpioverthe12monthsleadinguptodecember2006: Theeconomy srateofinflationisakeenlymonitoredeconomicvariablebecausetherateof inflation,ifhigh,imposesrealcostsupontheeconomy,includingtheshoe?leathercost,noisein thepricesystem,distortionsofthetaxsystem,unexpectedredistributionofwealth, interferencewithlong?runplanningandmenucosts Inflationisasustainedchangeintheeconomy spricelevel;itisnotsimplyariseinthepriceof individualgoodsofservices Costs of inflation: Shoe leather cost inflation erodes the real purchasing power of any given amount of cash, and thus people normally leave as much money possible in the bank where interest is paid, to counteract the effects of inflation. However, there is a trade-off with this behaviour, as individuals have to visit their banks more frequently in order to withdraw the cash needed to complete transactions, and thus more trips to the bank implies wearing out shoe leather at a greater rate Noise in the price system price changes are the market s way of communication information to suppliers and demanders. An increase in the price of a good or service, for example, tells demanders to economise on their use of the good or service, and tells suppliers to bring more of it to the market. But in the presence of inflation, prices are affected not only by changes in the supply and demand for a product, but also by changes in the general price level. Inflation creates static, or noise, in the price system, obscuring the information transmitted by prices and reducing the efficiency of the market system. This reduction in efficiency imposes real economic costs Distortions of the tax system inflation imposes a cost to society in countries such as Australia, where tax rates are not indexed to the rate of inflation. Without indexing, an inflation that raise people s nominal incomes would force them to pay an increasing percentage of their income in taxes as they move into high tax brackets, even though their real incomes may not have increased. If taxes are indexed (like in the US) a family whose nominal income is rising at the same rate as inflation does not have to pay a higher percentage of income in taxes Interference with long run planning inflation often interferes with the long run planning of households and firms. For example, if you want to enjoy a certain standard of living when you retire, it is very hard to predict what the inflation rate will do to the money that you save up for later. You may end up saving too little and have to compromise on your retirement plans, or you may save too much, sacrificing more than you need to during your working years

5 12.1: Saving and Wealth Chapter 4 Saving is current income minus spending on current need, and the saving rate is saving divided by income Wealth is the value of assets minus liabilities Like many issues in economics, saving involves a trade-off. In this case, the trade-off involves the decision to postpone the current consumption of goods and services in order to provide resources for the future - the optimal amount of saving will be where the opportunity cost, in terms of forgone consumption in the present, is balanced against the gains that can be achieved in the future by having more resources available National saving is total saving in the economy undertaken by households, firms and the Government Stocks and Flows: Saving is an example of a flow, a measure that is defined per unit of time (e.g. Meagan s saving is 100 per week) Wealth, in contrast, is a stock, a measure that is defined at a point in time (e.g. Meagan s wealth on 23 rd of April 2009 is 6000) In many cases, a flow is the rate of change in a stock. The close relationship between saving and wealth explains why saving is so important to an economy. Higher rates of saving today lead to faster accumulation of wealth, and the wealthier a nation is, in general the higher its standard of living Capital Gains and Losses: Though saving increases wealth, it is not the only factor that determines wealth - wealth can also change because of changes in value of the real or financial assets one owns Changes in the value of existing assets are called capital gains when an asset s value increases, and capital losses when an asset s value decreases Capital gains and losses are not counted as part of savings. Instead, the change in a person s wealth during any period equals the saving done during the period plus capital gains or minus capital losses during that period, that is: Change in wealth = Saving + Capital gains Capital losses 4.2: Why Do People Save? Life cycle saving saving to meet long term objectives, such as retirement, university attendance, or the purchase 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: Therealinterestrateisrelevanttosaversbecauseitisthe reward forsaving.thehigherthis rate,thefasterone ssavingswillgrow Whileahigherrealinterestrateincreasestherewardforsaving,anotherforcecounteracts thisincentive.ahigherrateofreturnmeansthathouseholdscansavelessandstillreachtheir goal,andthuspeopleareinvestinglessintheeconomybecausethehighinterestrateallows themtodoso Despitethisnegativity,evidencesuggeststhat,inpractice,higherrealinterestratesleadto modestincreasesinsaving

6 Saving, Self-Control and Demonstration Effects: Many people lack the self-control to save as much as they ought each month One way to strengthen self-control is to remove temptations from the immediate environment. A person who is not saving enough might arrange to use an automatic savings plan An implication of the self-control hypothesis is that consumer credit arrangements that make borrowing and spending easier may reduce the amount that people save (e.g. credit cards) Downward pressure on the saving rate may also occur when additional spending by some consumers stimulates additional spending by others. Such demonstration effects arise when people use the spending of others as a yardstick by which to measure the adequacy of their own living standards Why do Australian households save so little? One possible reason for low saving is the availability of government assistance to the elderly. From a life-cycle perspective, an important motivation for saving is to provide for retirement. To the extent that Australians believe that the Government will ensure them an adequate living standard in retirement, however, their incentive to save for the future is reduced The ready availability to mortgages with low down payments reduced the need to save for the purchase of a home In regards to precautionary saving, Australia has not endured sustained economic hardship since the Great Depressions of the 1930s, and thus Australians are more confident about the future and are hence less inclined to save for economic emergencies than other nations Demonstration effects may have also reduced saving in recent decades. Increased spending by households at the top of the earnings scale on houses, cars and other consumption goods may have led those just below them to spend more as well, and so on. To the extent that demonstration effects lead families to spend beyond their means, they reduce their saving rate 4.3: National Saving and its Components If we treat all consumption spending and government purchases as spending on current needs, then the nation s saving is its income Y less its spending on current needs, C + G. I (investment by firms) is not in the equation because it involves expanding the economy s future productive capacity, and is thus long term. So, we can define national saving as: S = Y C G Private and Public Components of National Saving: Private saving, Y T C, is the saving of the private sector of the economy, where T equals private sector tax payments minus the benefits and interest payments the private sector receives from the Government Private saving can be further broken down into saving by households and business firms. Household saving, also called personal saving, is saving done by families and individuals Public saving, T G, is the saving of the government sector (including the local, state and federal governments) Thus national saving can be written as: S = (Y T C) + (T G) or S = S private + S public Public Saving and the Government Budget: Governments finance the bulk of their spending by taxing the private sector - if taxes and spending in a given year are equal, the government is said to have a balanced budget - if in any given year, the government s spending exceeds its tax collections, the difference is called the government budget deficit (G T). If the government runs a deficit, it must make up the difference by