Macroeconomics. Part 1: Issues in Macroeconomics. Chapter 1: Measuring macroeconomic performance - output and prices

Transcription

1 Macroeconomics Part 1: Issues in Macroeconomics Chapter 1: Measuring macroeconomic performance - output and prices A macroeconomy is performing well if it meets the following criteria: o Rising living standards - through economic growth and increases in the quantity and quality of goods and services o Stable business cycle - low volatility in fluctuations of growth as economies experience short run business cycles o Price stability - maintaining low levels of inflation (sustained increases in the overall level of prices in an economy through time) o Sustainable levels of public and foreign debt - public debt refers to borrowing by the public sector from the private sector while foreign debt refers to the amount owed by the nation to other countries o Balance current expenditure against the need to provide resources for the future - determining how much to consume/save/invest o Full employment - providing employment for all individuals seeking work GDP refers to the market value of final goods and services produced in a country during a given period. It is a flow variable that tends to fluctuate with the business cycle in the short run, but remains relatively steady in the long run o It is a measure of aggregate output using market prices as weightings o The cost of providing public goods is included, but unpaid housework is not o GDP excludes intermediate goods, which are the goods and services used up in the production process o We can sum the value added by all firms to calculate GDP, which is the market value of a firm's production less the cost of inputs. This eliminates the problem of dividing the value of a final good or service between two periods GDP can be calculated using the expenditure method, through the assumption that all goods produced are consumed o The national income accounting identity: Y = C+I+G+NX Consumption refers to household spending on durables and non durables Investment refers to spending by firms on capital goods, new homes and apartments and unsold inventory Government expenditure refers to government purchases but excludes transfer payments and interest payments Net exports is exports minus imports GDP can be calculated using the income method, considering the aggregate incomes paid to labour and capital; whenever a good or service is produced or sold, the revenue from the sale is distributed to workers and the owners of capital o Y = Labour Income + Capital Income Labour income refers to wages, salaries and incomes of the self employed Capital income refers to profits, rents, interest and royalties which are paid to owners of physical capital and intangible capital

2 Nominal GDP measures the current dollar value of production while Real GDP is nominal GDP adjusted for inflation, measuring the actual physical volume of production using base year prices o Using initial prices as the base year is known as the Laspeyres index o Using final prices is known as a Paasche index o Chain weighting involves averaging two growth rates given by the Laspeyres and Paasche index Real GDP is not the best measure of economic well being as it omits numerous factors: o Leisure time - time for hobbies, family, educational activities, etc. are not reflected in GDP o Non market economic activities - volunteer services, underground activities and household production are not included o Environmental degradation - growth in GDP tends to coincide with increased pollution and the depletion of resources o Quality of life - quality of life indicators such as low crime rates, minimal traffic, etc. are not reflected in GDP o Economic inequality - GDP does not consider the distribution of output and income Real GDP tends to be positively correlated with greater economic well being as it leads to higher quality and more variety for material goods, as well as improved health and education To measure the average level of prices in the economy, we use the CPI, which measures the cost of a basket of goods and services for a given period, relative to their cost in the base year o CPI = cost of base year consumption in current year/cost of base year consumption in base year The inflation rate is measured as the % change in the CPI over the specified time period o Relative price changes occur in response to changes in demand and supply but this does not imply inflation has occurred, as inflation is a change in the general price level, not a change in the price of individual goods/services o The CPI can be used to adjust nominal quantities (deflating) or real quantities (indexing) o CPI tends to overstate the rate of inflation due to: quality adjustment bias - quality improvements may show up as higher prices new goods bias - new goods are not included until the CPI is re-based substitution bias - overstatement of changes to costs of living by not accounting for consumers' substitution towards relatively less expensive goods There are six main costs of inflation: o Shoe leather costs - inflation reduces the real purchasing power of a given amount of money. In response individuals and firms leave money in the bank, creating more inconvenience with more bank visits o Noise in the price system - inflation creates noise by obscuring the information transmitted by prices and reducing the efficiency of the market system, as suppliers need to consider both changes in supply and demand and changes in the general price level to determine how much of a good to supply o Distortion of the tax system - with a non indexed tax system, inflation may lead to bracket creep, pushing income earners into a higher tax bracket, lowering real incomes o Unexpected redistributions of wealth - the benefits and costs of inflation are redistributed to different groups o Interference with long run planning - high and erratic inflation makes it hard to determine how much money is needed for future plans as there is a trade off between current and future consumption o Menu costs - costs of changing prices as a result of inflation

3 The nominal interest rate is the annual percentage increase in the nominal value of a financial asset while the real interest rate is the annual percentage increase in the real purchasing power of a financial asset o Real interest = nominal interest - inflation rate o Irving Fisher explained that: Nominal interest rate = real rate + expected inflation rate Deflation is an issue due to its impact on real interest rates in an economy, discouraging expenditure in the economy and making monetary policy harder to implement Chapter 2: Measuring macroeconomic performance - saving, investment and wealth Saving is: current income - spending on current needs o Saving rate = savings/income In a closed economy, this is equal to the investment rate Wealth: value of assets - liabilities Savings is a flow variable (occurs over a period of time) while wealth is a stock variable (accumulated over time) o Higher rates of savings leads to faster accumulations of wealth, which leads to high standards of living in the future Capital gains and losses refer to fluctuations in the market value of existing assets, which impacts overall wealth o Change in wealth = Savings + Capital gains - Capital losses o Current Wealth = Previous wealth + Savings + Net Capital Gains There are three main motives for saving: o Life cycle saving - saving to meet long term objectives such as retirement or for costly items such as education expenses, new homes or new cars o Precautionary saving - saving as a form of insurance against unexpected setbacks such as unemployment or medical emergencies o Bequest saving - saving for the purpose of leaving an inheritance for heirs or dependants The real interest rate has a significance impact on savings incentives. o We expect savings to increase with increases in the real interest rate, ceteris paribus o However, a higher real interest rate reduces the amount that people need to save to meet certain targets While rational decision makers will choose a saving rate to maximise their long run welfare, people generally lack the self control and willpower to undertake an optimal level of saving. Factors that reduce saving include: o Widespread availability of consumer credit - borrowing and spending has become a lot easier o Demonstration effect - satisfaction depending on relative living standards may stimulate higher consumption o Government provision of retirement benefits - individuals may reduce their own savings in response Compulsory superannuation is a policy response to increase savings according to the belief that individuals are not making fully rational savings decision - they will only increase total savings if individuals do not reduce voluntary savings by an equal amount in response

4 National saving measures aggregate saving in an economy, including the savings of households, business firms and the government o Households savings are the proportion of income not spent on consumption or taxes o Business savings include an allowance for depreciation and retained earnings o Government savings are determined by the budget balance National Accounting Identity - Y = C + I + G + NX o Asssume NX = 0 o Exclude Investment since it is spending for future needs and not current ones o For simplicity, we treat (C) and (G) as spending on current needs when they in fact include spending for future needs in the form of durable goods o National saving = Income - spending on current needs S = Y - C - G S = Y - C - G + T - T T (net taxes) = taxes paid by the private sector to the govt. less transfer payments and interest payments from govt. to private sector S = (Y-T-C) + (T-G) Y-T-C is private saving T-G is public saving Low household savings is not necessarily an issue, as this may be offset by increases to business or public savings - it is national savings which determines the ability of the economy to invest in new capital goods National savings provides the resources for investment in new capital goods, housing and infrastructure, contributing to improved productivity and standards of living o The cost-benefit principle determines if and how much firms choose to invest o The real interest rate affect investment decisions as it influences both the monetary and opportunity cost of capital investment o Rising prices of capital goods will make investments less attractive o Rising value of marginal product will stimulate investment o The change in output for an increase in capital is called the marginal product of capital: Invest if the value of marginal product of capital (benefit) > or = Cost of capital (cost) o In an economy without international borrowing and lending, national saving = investment Cost of capital = Price of capital (beginning) + interest cost - price of depreciated capital (end)

5 Savings are supplied by households, firms and the government, and are demanded by borrowers wishing to invest in new capital good - equilibrium occurs where the real interest rate equates the quantity of savings supplies and demanded o Technological breakthroughts raise the marginal product of new capital goods, increasing the demand for funds by investors - real interest rate, national saving and investment all rise o An increase in the government budget deficit will reduce national savings, forcing investors to compete for a smaller quantity of available savings, driving up the real interest rate - this leads to a crowding out effect as it makes investment less attractive, leading to slower capital formation and lower economic growth Note however, that the increased integration of financial markets has reduced the relevance of the crowding out effect, as firms can easily finance investments through international borrowings Chapter 3: Measuring macroeconomic performance - wages, employment and the labour market Using the perfectly competitive model of the labour market, we assume that firms and workers are price takers