01 Measuring a Nation s Income Econ 111

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1 01 Measuring a Nation s Income Econ 111 Measuring a Nation s Income (Chapter 10) Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets simultaneously. Macroeconomics answers questions such as the following: Why is average income high in some countries and low in others? Why do prices rise rapidly in some time periods while they are more stable in others? Why do production and employment expand in some years and contract in others? The Economy s Income and Expenditure When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. For an economy as a whole, income must equal expenditure because every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Gross Domestic Product (GDP) A measure of the income and expenditures of an economy. It is the total market value of all final goods and services produced within a country in a given period of time. It must be final goods or there is double counting. There are three methods of measuring GDP: Income method Expenditure method Output method All three should theoretically end up with the same answer. The equality of income and expenditure can be illustrated with the circular-flow diagram.

2 01 Measuring a Nation s Income Econ 111 The Measurement of Gross Domestic Product GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is the market value: Output is valued at market prices. Of all: It includes al items produced in the economy and sold legally in markets. Final: It includes only the value of final goods. Goods and Services: It includes both tangible goods (food, clothing, cars, etc.) and intangible services (haircuts, housecleaning, doctor visits, etc.). Produced: It includes goods and services currently produced, not transactions involving goods produced in the past. Within a country: It measures the value of production within the geographic confines of a country - The territory of NZ (doesn t matter where the company is from). GNP is different - it measures goods produced by the nationals of a country. In a given period of time: It measures the value of production that takes place within a specific interval of time. Usually a year or a quarter (three months). Components of GDP GDP includes all items produced in the economy and sold legally in markets. GDP only includes current production (to not double count). Only new goods (no second hand ones). Otherwise, GDP would be overstated. GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (X-M) Y = C + I + G + X - M Imports are taken away to not double count (as they would have been counted in Consumption. Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing. Investment (I): The spending on capital equipment, inventories and structures, including new housing. Government Purchases (G): The spending on goods and services by local, state and federal governments. This does not include transfer payments because they are not made in exchange for currently produced goods and services. Net Exports (NX or X-M): Exports minus imports. This can be positive or negative.

3 01 Measuring a Nation s Income Econ 111 What is not counted in GDP? (Shortcomings) GDP is understated due to non-market economic activity (black economy). These cannot be captured even though they contribute to GDP. GDP excludes most items that are produced and consumed at home and that never enter the market. These are unpaid economic activity. GDP excludes items produced and sold illicitly, such as illegal drugs. Developed countries have more cash/trade transactions especially in rural places that are not recorded. GDP excludes output produced abroad or income earned abroad by the citizen of a country. Gross National Product (GNP) tracks down total income of all citizens of a country. However, GDP is more closely associated with other macroeconomic variables that GNP. Other Measures of Income (Refer to the FYI box on Pg. 194) Gross National Income (GNI) or Gross National Product (GNP): The total income earned by a nation s permanent residents (called nationals). It differs from GDP by including income that our nationals earn overseas and excluding income that foreign nationals earn in NZ. Gross National Disposable Income (GNDI) is the GDP + NFI. Net Foreign Income (NFI): Y D (Also GNDI) = Y (GDP) + NFI. This equation is an important equation for understanding macroeconomic fluctuations in a small open economy such as New Zealand. NFI includes net transfers (money coming in by migrants less money going out by immigrants) and net factor income (profits going into NZ less profits going out of NZ). NFI = Net Factor Income + Net Current Transfers Real versus Nominal GDP Nominal GDP values the production of goods and services as current prices. Real GDP values the production of goods and services at constant prices (deflated). An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator. There are two effects on nominal GDP - price and quantity. Removing the price effect leaves real GDP. Use constant prices of the base year (year 1, if not specified) to find real GDP. The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in quantities produced. It tells us the price effect. GDP Deflator = (Nominal GDP / Real GDP) x 100 For the base year, it will always be 100.

4 01 Measuring a Nation s Income Econ 111 GDP and Economic Wellbeing GDP is the single best measure of the economic wellbeing of a society. GDP per person tells us the income and expenditure of the average person in the economy. Per capital real GDP in a country, however, is only an average. It can be misleading as it gives no idea about the distribution of income. Higher GDP per person indicates a higher standard of living. However, GDP is not a perfect measure of happiness or quality of life. There is a difference between the standard of living and the quality of life (wellbeing). GDP makes no distinction between constructive and destructive economic activities. E.g. During a civil war, weapons would be produced which does not raise standard of living. Restorative activities are counted in GDP. Rebuilding damage does not improve standard of living - it only brings you back to the same level. Some things that contribute to wellbeing are not included in GDP. Some of these cannot be quantified in dollars. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. Level of crime. However, it should be noted that goods/services are still needed to wellbeing. Summary Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross Domestic Product (GDP) measures an economy s total expenditure on newly produced goods and services, and the total income earned from the production of these 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 is divided among four components of expenditure: Consumption, investment, government purchases and net exports. Nominal GDP uses current prices to value the economy s production. Real GDP uses constant base year prices to value the economy s production of goods and services. The GDP deflator (calculated from the ratio of nominal to real GDP) measures the level of prices in the economy. GDP is a good measure of economic wellbeing because people prefer higher to lower incomes. GDP is not a perfect measure of wellbeing because some things, such as leisure time and a clean environment, are measured. Problems and Applications Pg : Q1 (a - g), Q5, Q8, Q10, Q11 & Q12

5 02 Measuring the Cost of Living Econ 111 Measuring the Cost of Living (Chapter 11) Inflation refers to a situation in which the economy s overall price level is rising. The inflation rate is the percentage change in the price level fro the previous period. How should we measure the overall price level? The Consumer Price Index The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer (normal goods consumed by everyone, usually no luxuries). Statistics New Zealand reports CPI for the NZ economy every quarter while the Bureau of Labour Statistics reports the CIP for the US each month. CPI is used to monitor changes in the cost of living over time. We want to measure the cost of living, and for which we have to find a way to use the dollar to measure purchasing power. When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. You can download the CPI data from the website of the RBNZ. The base period is June 2006 where CPI is From September 1999 the index excludes interest charges. How the CPI is Calculated 1. Fix the Basket: Determine what prices are most important to the typical consumer. In NZ, Statistics New Zealand has a market basket of goods and services the typical consumer buys and gathers information via Household Expenditure Survey (HES) on a quarterly basis to set the weights for the prices of those goods and services. Greater weights are given to the more important items (ones purchased more). In US, the Bureau of Labour Statistics conducts monthly consumer surveys for a similar purpose. 2. Find the Prices: Find the prices of each of the good and services in the basket for each point in time. 3. Compute the Basket s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. 4. Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by The price index for the base year is always Compute the Inflation Rate: The inflation rate is the percentage change in the price index from the preceding period.

6 02 Measuring the Cost of Living Econ 111 Formulas The CPI in Yr 1 = (Price of Basket of Goods & Services in Yr 1 / Price of the same basket in Base Year) x 1000 The Inflation Rate in Yr 2 = ((CPI in Yr 2 CPI in Yr 1)/CPI in Yr 1) x 100 CPI and GDP CPI is the opposite of GDP. CPI finds the price effect so we fix the quantity. Benchmarks against other years would be compared. To do this, the price of the basket in each year is divided by the price of the basket in the base year and multiplied by 100. Categories of Inflation Tradable Inflation: This series is calculated by the Reserve Bank and comprises all those goods and services in the CPI that are imported or that are in competition with foreign goods either in domestic or foreign markets. Non-Tradable Inflation: This series is created by the Reserve Bank comprises all those goods and services in the CPI that do not face foreign competition e.g. government charges. Excludes interest rates. Tradable and non-tradable inflation together are the co-inflation. Tradable inflation comprises all goods and services in the CPI that are imported or in competition with foreign goods in domestic or foreign markets. This is influenced by world prices and the exchange rate. Dairy prices are included in tradable inflation because prices are determined in world markets. Non-tradable inflation included all goods and services that do not include foreign competition, for example, government charges. This affects prices not affected by international competition or the exchange rate. Problems in Measuring the Cost of Living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. CPI is less than accurate but we do not have a better method. The substitution bias, introduction of new goods and unmeasured quality changes cause the CPI to overstate the true cost of living usually by around 0.5-1%. The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices (e.g. welfare payments). 1. Substitution Bias The basket does not change to reflect consumer reaction to changes in relative prices. As rational consumers, we always substitute. Consumers substitute towards goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution. CPI does not recognise this as CPI uses a fixed basket of goods.

7 02 Measuring the Cost of Living Econ Introduction of New Goods The basket does not reflect the change in purchasing power brought on by the introduction of new products. There are always new goods being introduced. New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living. 3. Unmeasured Quality Changes If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. Quality cannot be quantified. The Bureau of Labour Statistics tries to adjust the price for constant quality, but such differences are hard to measure. Producers Price Index The producer price index measures the cost of a basket of goods and services bought by firms rather than consumers. Because firms pass on their costs to consumers, PPI can influence CPI. The inputs index measures the change in costs of production (excluding labour). The outputs index measures the change in prices received by producers. The outputs index is exclusive of GST and the inputs index excludes GST for most industry groups. Base (both indexes) is the December quarter The GDP Deflator This is the amount in the increase in nominal GDP that can be attributed to price. The GDP deflator is the ratio of nominal GDP to real GDP. Real GDP is output at the base year prices. The GDP deflator is calculated as follows: GDP Deflator = (Nominal GDP/Real GDP) x 1000 Price Index that the Economists Monitor Economists and policy makers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. They are similar in that hey tell you about increases in price (indication of inflation) but there are two important differences between the indexes that can cause them to diverge: The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the Statistics NZ or the BLS change the basket). Whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. CPI is fixed, GDP deflator is not. The GDP deflator reflects the prices of all goods and services produced domestically whereas the CPI reflects the prices of all goods and services bought by consumers. E.g. when the world oil prices goes up, the USA CPI is above the GDP deflator as they consume more than they produce. Note: The PPI provides an estimate of the cost of production.

8 02 Measuring the Cost of Living Econ 111 Correcting Economic Variables for the Effects of Inflation Price indices are used to correct for the effects of inflation when comparing dollar figures from different times. Example: A bricklayer s wage in 1905 is $6.80 per hour. How much would a wage need to be in 2005 to match this? Price Level in 1905 = 17.3 Price Level in 2005 = 1159 Do the following to convert (inflate) the bricklayer s wage in 1905 to dollars in W2005 = W1905 x (Price Level in 2005 / Price Level in 1905) = 6.80 x (1159/17.3) = $ Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. E.g. wages and salaries are usually indexed to compensate for inflation. Many long term contracts between firms and unions include partial or complete indexation of the wage to the CPI. Such a provision is called the cost of living allowance (COLA) which automatically raises the wage when the consumer price index rises. Price indices are used to correct figures for effects of inflation when comparing dollar figures from different times. Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past. Nominal Interest Rate: The interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays. Real Interest Rate: The nominal interest rate that is corrected for the effects of inflation. This measures how much our purchasing power increases. Example: You borrowed $1000 for one year. Nominal interest rate was 15% and during the year inflation was 10%. Real Interest Rate = Nominal Interest Rate Inflation = 15% - 10% = 5% The gap between nominal and real interest rates is inflation.

9 03 Saving, Investment, and the Financial System Econ 111 Saving, Investment, and the Financial System (Chapter 13) Macroeconomics has two clear aspects: Measuring and modelling macroeconomic aggregates such as national income (Y), price level (P) and interest rate (r). Examining how economic policies can bring desirable changes in some of those variables. For example, how to design policies to raise income (Y) in the long run. Financial systems bring savers and borrowers together. Economic policies can change financial systems. Key ideas and skills to learn: How the financial system of a country mobilise capital (an essential ingredient for the growth of national income) and its price, the interest rate. How the government policy interact with the financial system to change the interest rate and thereby to affect (positively or negatively) the mobilisation of capital. Description of the Financial System and its relationship with macro variables. Policy analysis. Especially the effects of fiscal surplus or deficit. New Zealand in general is a country does not save so there is not enough investment. The Financial System The financial system consists of the group of institutions in the economy that helps to match one person's saving with another's investment. It moves the economy's scarce resources from savers to borrowers. It is important to have a sound financial system. The financial statement is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: Financial markets (direct) and financial intermediaries (indirect). Financial Markets - Saving and Investment The Bond Market: A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Bonds are IOUs. Characteristics of a bond: Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principle. There is always a risk. The rule is the greater the risk, the greater the return. Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempt. Perpetual bonds are bonds where you never get the principle back but it pays a high interest for the rest of your life. Junk bonds are very risky bonds. They are done by companies called 'fly by night' companies. They have a high return due to high risk.

10 03 Saving, Investment, and the Financial System Econ 111 Financial Intermediaries Financial institutions through which savers can indirectly provide funds to borrowers. This is sometimes the only way for investors to borrow (e.g. small businesses). Stocks and bonds are only issued by large corporations and governments. Banks: Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. Depositors are paid interest and borrower are charged a slightly higher interest on their loans. Banks help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchange is an item that people can easily use to engage in transactions. This facilitates the purchases of goods and services. Stocks and bonds are a store of value for people just like bank deposits. Mutual Funds: A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio of various types of stocks, bonds or both. They allow people with small amounts of money to easily diversify (spread the risk). This reduces the risk, but the shareholder has to accept both loss or gain. The mutual fund will charge a small commission for their services. Other Financial Institutions Credit Unions Pension Funds Insurance Companies Loan Sharks All these institutions of the financial system coordinate savings and investment in the economy. They determine long term economic growth, GDP and living standards. A Model of Financial System - Saving and Investment National income (Y) is both total income in an economy and total expenditure on the economy's output of goods and services: Y = C + I + G + X - M Assume a closed economy (one that does not engage in international trade): Y = C + I + G Now transfer C and G to the other side of the equation: Y - C - G = I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is defined as national saving or just saving (S). Substituting S for Y - C - G, the equation can be written as: S = I