Economics is the study of decision making

Transcription

1 TOPIC 1 - INTRODUCTION TO THE GLOBAL ECONOMY WHAT IS ECONOMICS Economics is the study of decision making Every time we take a decision, we are choosing between at least two possibilities How do you take that decision? You weigh up the costs and the benefits You take into account any incentives for taking one decision over another And we have to make decisions because we cannot have everything there is always a limitation: The money we earn The time we have The pure physical existence of a particular resource These are resources, and they are scarce; there will always be more wants then there are means to meet these wants. Economics therefore analyses what we DO chose to make/produce, how/where we make this and who/how do we distribute these things to? WHY IS ECONOMICS IMPORTANT It addresses the questions: Why is there such a gap between rich and poor countries? How the prices of goods and services are determined and what determines them? Why do we have governments, how do governments work and why do we have the type of governments we have? What causes financial crises and how can we avoid them in the future? Why global warming has become such a problem and what are some of the best ways to deal with environmental pollution?

2 Why are some things made locally yet other manufacturing is outsourced? Why do international students choose to study in Australia? Why did you enroll in university and get out of bed this morning!! Economics provides a framework through which the world we live in can be understood MACROECONOMICS Macroeconomics is the study of aggregates or whole systems (the economy) A central concern of macroeconomics is how the economy as a whole grows and changes over time MACROECONOMIC AGGREGATES: Gross domestic product (GDP): total output of goods and services produced in a country over a given period of time, normally a year General price level: measure of the average price of all the goods and services in an economy MACROECONOMICS VS MICROECONOMICS Microeconomics: the branch of economics that examines individual decision making by firms and households, and the way in which they interact in specific industries and markets Macroeconomics: the branch of economics that examines the workings and problems of the economy as a whole ECONOMIC MODELS Economic models are explanations of how the economy or part of the economy works. Example: If the output of an economy grows by 10 per cent this year, what is likely to happen to the inflation rate? There are other disturbances and variables that influence output and inflation outcomes

3 To make the analysis manageable, we hold these other things constant so we can think through the effects of output change on inflation Economic models use a ceteris paribus assumption, which means that our models hold other things equal MACROECONOMIC MODELS Economic models and theories are used to describe and explain economic facts and observations A macroeconomic model is an explanation of how the economy or a large part of the economy works Macroeconomic models are abstractions, or simplifications, of the real world that can be described with words, numerical tables, graphs and algebra MACROECONOMICS IN PRACTICE At the June meeting the RBA decided to leave the cash rate unchanged at 2.5 per cent What macroeconomic factors are essential to making this decision? What are the implications of this decision for individuals and firms? POSITIVE VS NORMATIVE ECONOMICS Positive economics is about how the economy works Normative economics is about whether we approve of these economic processes and the resulting outcomes Normative economics is about whether the policy outcome, or the method chosen to reach it, is desirable NORMATIVE ECONOMICS Normative economics recommends particular policies that encourage a desired amount (or type) of growth Example: The unemployment rate is too high

4 The government must take action in order to reduce the unemployment rate POSITIVE ECONOMICS Positive Economics is about how the economy in fact works. Positive economics is about whether an economic policy is likely to be effective Examples: What would happen in response to an interest rate cut? Observing or deducing that there is an inverse relation between the unemployment rate and inflation rate of one country CONFLICTING POLICY GOALS Societies cannot achieve all their policy goals simultaneously Some goals are quite compatible, but others tend to conflict Ideally decision makers are looking for the best trade-off Examples: Efficiency and less government intervention vs job security Moving closer to a dynamic, prosperous and innovative world that is based on the freedom of individual choice tends to take you away from a stable, secure and egalitarian world GROSS DOMESTIC PRODUCT (GDP) The market value of final goods and services produced in a country during a given period GDP is the most common measure of total output The total value of output is the sum of the price of each good or service times the quantity of each produced GDP is one of the most keenly monitored of all macroeconomic indicators: GDP is an indicator of how well an economy is working

5 GDP influences macroeconomic outcomes such as the rate of unemployment, and the ability of households to purchase goods and services Countries with a high level of GDP per person (GDP/population) also tend to be countries with high standards of living REAL GROSS DOMESTIC PRODUCT OVER TIME Real gross domestic product (real GDP) is a measure of the value of all goods and services newly produced in the economy during a specified period of time, adjusted for inflation. Most recent GDP figures National Accounts, Australian Bureau of Statistics. Inflation: The increase in the overall price level over time Inflation rate: The annual percentage rate of change in the price level, as measured, for example, by the CPI Economists use the consumer price index (CPI) to measure the price level and inflation The CPI for any period measures the cost of living during a particular period of time Real GDP has increased a bit over five-fold since 1960 Nominal GDP has risen by more than 60-fold The price level has increased by over 11-fold Real GDP has grown but has also fluctuated around its trend Economic growth is the upward trend in real GDP, reflecting the expansion of the economy over time The large increase in real GDP means that each year in the last decade, people in Australia produced a much greater amount of goods and services than they did 30 or 40 years ago

6 Economic fluctuations (or business cycles) are swings in real GDP that lead to deviations of the economy from its long-term growth trend A boom is when GDP is above trend A slump is when GDP is below trend Potential GDP is the long-term trend value of real GDP ECONOMIC FLUCTUATIONS: TEMPORARY SETBACKS AND RECOVERIES Economic fluctuations (business cycles): Swings in the real GDP that cause the economy to deviate from its long-term trend. Phases of business cycles: Peak Recession Trough Recovery Recession: a decline in real GDP that lasts for at least six months Peak: the highest point in real GDP before a recession Trough: the lowest point of real GDP at the end of a recession Expansion: the period from the trough of a recession to the next peak, consisting of a general rise in output and employment Recovery: the early part of an economic expansion, immediately after the trough of the recession

7 LECTURE 2: MEASURING THE ECONOMY A key issue in macroeconomics is whether is allocate resources to making consumption goods or capital goods Capital goods provide a long stream of value through time LEARNING OBJECTIVES Interpret circular flow models of a simple economy Distinguish between consumption goods and capital goods Outline the three different approaches to measuring gross domestic product (GDP) Identify the principal components of GDP Distinguish between real and nominal GDP Appreciate the uses and shortcomings of the GDP measure THE CIRCULAR FLOW DIAGRAM: A MODEL OF THE MACROECONOMY A circular flow diagram illustrates the flow of funds through the economy This two-sector circular model shows how firms and households interact in markets and how funds flow through the economy

8 Owners of factors of production (households) supply and sell inputs to firms and earn income (wage) Firms create output and earn income as they sell the outputs in the market Households use their earned income to buy outputs in the market Income, goods and services and spending are connected MEASURING GDP Gross Domestic Product is a measure of the value of all the final goods and services newly produced during some period of time - Only newly produced goods and services are included - Only goods and services produced within the borders of a country are included in GDP - Goods and services produced in Australia by foreigners is not included in GDP How do you add different goods together? GDP is a single number, but it measures the production of many different things like cars, insurance and CDs. GNS Gross National Product Everything that is produced by Australians includes goods/services produced by Australians overseas GDP Per Capita - A measure of the total output of a country that takes the gross domestic product (GDP) and divides it by the number of people in the country. The per capita GDP is especially useful when comparing one country to another because it shows the relative performance of the countries. A rise in per capita GDP signals growth in the economy and tends to translate as an increase in productivity. EXAMPLE: In the economy of country A, production consists of 10 CDs and 20 bus trips. If each CD has a price of $25 and a bus trip is $10, how much is the GDP of country A? GDP = (10 $25) + (20 $10) = = $ THE PRODUCTION APPROACH TO MEASURING GDP This method adds up the production of each firm or industry in the economy In this method we must avoid the double-counting of intermediate goods and only count the value added in production Value added is the value of a firm s production minus the value of intermediate goods An intermediate good is a good that undergoes further processing before it is sold

9 VALUE ADDED IN COFFEE FROM BEANS TO ESPRESSO divided into four categories: Consumption Investment Government expenditure Net exports (exports minus imports) 2. THE SPENDING APPROACH TO MEASURING GDP Total spending is Consumption (C): The first category, consumption (C), includes purchases of final goods and services by individuals or households. In the Australian national accounts, this item is called household expenditure, or private final consumption expenditure. CONSUMPTION AS A SHARE OF GDP CONSUMPTION AS A SHARE OF GDP

10 I nv est me nt (I) co nsi sts of pu rchases of final goods by firms as well as construction (including housing) and inventory investment. Investment takes the form of newly produced capital goods Note: spending by governments on capital goods is not included in this grouping; it is included under government spending INVESTMENT AND CONSUMPTION AS A SHARE OF GDP

11 Business fixed investment: investment by businesses in physical capital, such as factories and equipment Inventory investment: a change in the inventory from one date to another Disinvestment: negative investment Residential investment: purchases of new houses and apartments Depreciation: the decrease in an asset s value over time. For physical capital, it is the amount by which physical capital wears out over a period of time Net investment: gross investment minus depreciation Gross investment: the total amount of investment, including that which goes to replacing worn-out capital Government purchases: purchases by federal, State/Territory and local governments of new goods and services Not all items in the government s budget are counted as part of government purchases. Welfare and retirement payments made by the government are not counted as part of these purchases Public infrastructure investment is purchases of capital by the government for use as public goods, which add to the productive capacity of the economy. Transfer payments: payments that do not relate to the purchase of current output Government expenditure (G) = government outlays government transfer payments Government expenditure, (private) investment and (household) consumption as a share of GDP

12 Exports: the total value of the goods and services that people in one country sell to people in other countries Imports: the total value of the goods and services that people in one country buy from people in other countries Net exports (X): the value of exports minus the value of imports Trade balance: the value of exports minus the value of imports; another term for net exports If net exports are positive, the country has a trade surplus If net exports are negative, the country has a trade deficit For example in 2010, exports equaled $1838 billion and imports equaled $2354 billion. The Australian trade deficit for 2010 was $516 billion Algebraic summary: Y(Income) C + I + G + X 3. THE INCOME APPROACH TO MEASURING GDP The income approach: the sum of labour income, capital income and indirect taxes less subsidies gives a measure of GDP. AGGREGATE INCOME AND GDP, Labour income: the sum of wages, salaries and supplements paid to workers. LABOUR S SHARE OF TOTAL INCOME,

13 Capital income: the sum of profits, rental payments and interest payments. THE CAPITAL S SHARE OF TOTAL INCOME,

14 In the aggregate income table, the first two items are called factor incomes The total of these factor incomes gives GDP at factor cost This is not the same as the GDP figure calculated from the expenditure approach, which is based on the market prices of final goods and services If the government raised the GST, GDP measured at market prices would suddenly rise. But the measurement of GDP at factor cost removes this misleading increase. Indirect taxes: taxes, such as the GST, that are levied on products when they are sold Net indirect taxes: indirect taxes minus subsidies THE CIRCULAR FLOW OF INCOME AND EXPENDITURE

15 THE CIRCULAR FLOW OF INCOME AND EXPENDITURE REVISITED This figure shows how aggregate expenditure equals aggregate income Consumption (C) is joined by government expenditure (G), investment (I) and net exports (X) to sum to aggregate expenditure on the left At the top of the figure, this aggregate spending is received by firms that produce the output and then pay out aggregate income (Y) in the form of wages, rents, interest payments and profits The government also takes direct taxes from income and makes transfer payments to households REAL GDP AND NOMINAL GDP Nominal GDP is GDP without any correction for inflation. It is the value of all goods and services newly produced in a country during some period of time, usually a year Real GDP is a measure of the value of all goods and services newly produced in a country during some period of time, adjusted for inflation CONVERTING NOMINAL GDP INTO REAL GDP In country A, total production consists of the production of TVs and computers. We want to compare this total production in two different years: 2005 and 2006

16 The quantities of both TVs and computers produced in the year 2006 are exactly twice the quantities produced in the year 2005 Because of the increase in the prices of TVs and computers from 2005 to 2006, the market value of production grew more than the physical volume of production If we want to use GDP to compare economic activity at different points in time, we should exclude the effect of price changes or adjust GDP for inflation To calculate the change in real GDP: Assume that 2005 is the base year. By how much did real GDP in country A grow between 2005 and 2006? To find GDP for the year 2006, we must value the quantities produced that year using the prices in the base year real GDP = (2006 quantity of computers 2005 prices of computers) + (2006 quantity of TVs 2005 prices of TVs) 2006 real GDP = (20 $10) + (30 $5) = $350 The real GDP of country A in the year 2006 is $350 Suppose total production consists of the production of music CDs and bus trips, and we want to compare this total production in two different years: 2013 and 2014 Nominal GDP in 2013 = ($ ) + ($ ) = $ Nominal GDP in 2014 = ($ ) + ($ ) = $ Production (in 2013 prices) in 2013 = ($ ) + ($ ) = $ Production (in 2013 prices) in 2014 = ($ ) + ($ ) = $ Keeping prices constant at 2013 levels, or using 2013 as the base year, we see that the increase in production is from $ in 2013 to $ in 2014, an increase in real terms of 16 per cent REAL GDP VS NOMINAL GDP OVERTIME

17 Real GDP increases much less than nominal GDP because real GDP is adjusted for rising prices Most of the increase in nominal GDP is due to rising prices. The chart shows real GDP in dollars Note: ABS uses chain volume measures this year s production at last year s prices. ALTERNATIVE INFLATION MEASURES Consumer price index (CPI): a price index equal to the current price of a fixed market basket of consumer goods and services in a base year. How the CPI is constructed: Suppose the government of Australia has chosen 2000 as the base year Assume a typical Australian family will only spend on three items Monthly household budget of the typical family in 2000 (base year) Cost (in 2000) Rent (three-bedroom apartment) $500 Fish and chips (60 at $2 each) $120 Holiday $60

18 Total expenditure $680 Suppose that in 2010, the prices of these items are rising. By how much did the family s cost of living increase between 2000 and 2010? Cost of buying (base-year) basket of goods and services in 2010 Cost (in 2010) Rent (three-bedroom apartment) $630 Fish and chips (60 at $2.50 each) $150 Holiday $70 Total expenditure $850 The tables demonstrate that if the typical family wanted to consume the same basket of goods and services in the year 2010 as they did in 2000, they would have to spend $850 per month, or $170 more than their total expenditure in 2000 The CPI in any given year is computed using the following formula: CPI = Cost of base - year basket of goods and services in current year Cost of base - year basket of goods and services in base year CPI in year 2010 = $850 $680 = 1.25 The cost of living in the year 2010 is 25 per cent higher than in 2000 SHORTCOMINGS OF THE GDP MEASURE Real GDP per capita has shortcomings as an indicator of wellbeing in a society. Items are omitted, such as: Work and production in the home Leisure activity The underground economy

19 Quality improvements There are other aspects of the wellbeing of individuals that are not counted in GDP like: Vital statistics on the quality of life Environmental quality