ECON 1102: MACROECONOMICS 1 Chapter 1: Measuring Macroeconomic Performance, Output and Prices

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1 ECON 1102: MACROECONOMICS 1 Chapter 1: Measuring Macroeconomic Performance, Output and Prices 1.1 Measuring Macroeconomic Performance 1. Rising Living Standards Economic growth is the tendency for output per capita (quantity and quality of goods and services) to increase over time. Output per capita = Output Population Since aggregate output (GDP) in an economy equals the aggregate income, output per capita roughly represents the average income per person, or the income distribution for an economy. 2. Stable Business Cycle A stable business cycle is where there is low volatility in fluctuations of actual output around its trend or potential output for an economy. Potential output refers to the output an economy can achieve when resources (e.g. labour and capital) are utilised at normal levels. Actual output is the output being produced at a given time. A business cycle refers to the tendency of an economy to go through periods of expansions and contractions in the short run. 3. Relatively Stable Price Level Generally, a low but positive rate of inflation is desirable. Inflation refers to an increase in aggregate price level (or consumer price index) over time. An increase in inflation usually corresponds to economic growth, but high levels of inflation are undesirable due to the associated costs such as reduced purchasing power of money, and reduced real value of assets.

2 4. Sustainable Levels of Public and National Debt Public debt borrowing by public sector from private sector. Influenced by government budget deficits/surpluses. A budget surplus is a situation where tax revenues exceed government expenditure. A budget deficit occurs when government expenditures exceed tax revenue. Budget Surplus = Tax Revenue Government Expenditure National debt borrowing by domestic residents from foreign countries. Influenced by an economy s current account deficit/surplus (current accounts are covered in more detail in balance of payments, chapter 16). Current account surplus when a country is owed money by foreign borrowers. When national savings exceeds investments, a country can lend excess savings to other countries. Current account deficit a country owes money to foreign lenders. When domestic investments exceed national savings, a country needs to borrow from other countries to fund these investments. 5. Balance Between Current and Future Consumption There needs to be a balance between current consumption and future consumption so that resources are not immediately exhausted, and continue to benefit future generations. Individuals make decisions whether to consume now or tomorrow. In the aggregate economy, the decision is whether to save or invest. Consumption decisions affect aggregate demand and hence equilibrium output. This in turn affects an economy s short run business cycle (fluctuations in output). Current consumption can be excessive because the benefits are felt today, whereas the benefits of saving now and spending later are felt in the future. 6. Full Employment The economy provides employment for all individuals seeking work. 1.2 Standard Desired Variables for Macro Variables Relatively high and stable growth rate of real per capita output. Stable and low (but positive) rate of inflation. Low unemployment rate. Sustainable level of public/external debt. Balance between current and future consumption.

3 1.3 Measuring National or Aggregate Output GDP (Gross Domestic Product) is the market value of final goods and services produced in a country during a given period. GDP is a flow variable and is measured over a period of time; usually a quarter of a year. It is measure of aggregate output and uses market prices to value (weight) quantities of various goods and services. Goods and services with no market value are generally excluded, however some are included in GDP at cost, such as national defence and roads. What is not included in GDP? Goods and services produced in other countries, but consumed in Australia Imports. Goods and services produced in an earlier period, but re-sold in the current period - Second-hand goods. Household production such as unpaid housework. Intermediate goods and services which are used up in production. Transfer payments such as welfare benefits. Transfer of ownership such as a new car given by a relative or receiving an inheritance. Generally, any expenditure that is not on final goods and services. 1.4 Three Equivalent Methods of Measuring GDP 1. Production Method (or Value Added approach). GDP under the production method is found by summing the market values of quantities of goods and services produced in an economy. GDP = Price Quantity (of good or service) GDP is also given by summing the value added of each firm in the economy. GDP = Value added by each firm Value added: the market value of a firm s production less the cost of inputs purchased from other firms. Value Added = Sales Cost of Intermediate Inputs Contribution to GDP: the final market value of a firm s production including cost of intermediate inputs. Refer to lecture slide 30 for an example in detail.

4 2. Expenditure Method GDP is equal to the aggregate expenditure in an economy. National Accounting Identity: expenditure on goods and services by final users must equal the value of their production. Y = C + I + G + NX Y = GDP = Expenditure Y = Real GDP. C = Household consumption. I = Business investment. Business fixed investment; i.e. acquiring new capital such as machinery. Purchases of new residential housing. Unsold inventory stock (excess output is considered to be purchased by the firm). G = Government expenditure. Does not include transfer payments such as unemployment benefits because GDP only includes expenditure on final goods and services. NX = Net exports, or exports minus imports (X M). 3. Income Method Whenever a good or service is produced or sold, the revenue from the sale is distributed to the workers and owners of the capital involved in the production of the good or service. GDP = Labour Income + Capital Income + Indirect Taxes Subsidies GDP at factor cost is the income that goes to factors of production; labour and capital. GDP at factor cost = Labour Income + Capital Income Labour Income: wages and salaries of workers employed in production. Capital Income: income paid to owners of capital Why is the value of GDP the same in all three methods? Each method measures the same thing (aggregate output) in different ways. The total market value of goods and services produced (production method) equals the expenditure by final users to acquire those goods and services (expenditure method). The money spent by final users is the income that goes towards those involved in production i.e. labour and owners of capital (income method). Statistical discrepancies result in small differences in GDP measured using the three methods.

5 1.5 Nominal vs Real GDP Nominal GDP values quantities of goods and services produced at their current year (or year of production) prices. Since both prices and production volume can change each year, it is difficult to tell whether changes in nominal GDP are due to price changes or varying production levels. Inflation (increase in aggregate price level) results in an increase in nominal GDP. Real GDP values quantities of goods and services produced at base year prices and thus measures the actual physical volume of production. By using the same base price each year, the only change from year to year will be the volume of production. Eliminates effects of inflation by keeping prices constant at the base year. Choice of Base Year Prices (for measuring real GDP) Laspeyres Index: using the initial year s prices. Paasche Index: using the final year s prices. Chain Weighted Index: For any two consecutive years compute the growth rates of real GDP implied by both the Laspeyres and the Paasche indexes. Then take the average of the two growth rates and this is the chain-weighted growth rate. Chain Weighted Index = g t g t Is GDP A Good Measure of Economic Wellbeing? Since GDP measures aggregate spending on goods and services, there is some positive correlation between GDP per capita and economic wellbeing. Higher aggregate spending per person indicates that there is a greater availability of goods and services which implies a higher standard of living. Countries with higher GDP per capita tend to have more developed infrastructure, better technology and greater access to healthcare and educational services. However, generally GDP per capita is not a good measure of economic welfare because it is only measures the aggregate spending in the population and does not account for factors that affect happiness and wellbeing. Additionally, the assumption that each individual in the population has an equal share of income is usually not reflected in reality.

6 Omissions from GDP that might matter for economic welfare Leisure Time (e.g. extra week of holidays). Household production (e.g. cooking at home). Environmental Degradation (e.g. pollution from factory production). Quality of Life (i.e. level of happiness). Economic Inequality (i.e. distribution of income). Alternative Measures to GDP 1. Direct Measures of Happiness: direct surveys asking people how happy they are on a scale of 1 to Genuine Progress Indicator: assigns value to life sustaining functions of households, communities, and the natural environment so that their destruction or replacement with commoditised substitutes no longer appears as growth or gain 3. United Nations Human Development Index: measures impact of growth on people, rather than the economy. 1.7 Measuring the Price Level 1. GDP Deflator 2. Consumer Price Index GDP Deflator (price level) = Nominal GDP Real GDP CPI measures the cost of a fixed basket of goods and services in a period relative to their cost in a fixed year, called the base year. In other words, it measures how the cost of buying a specific selection of goods and services changes over time. Keeps the quantity fixed at the base year, and measures changes in price over time. Changes in price over time inflation. Inflation (%) = CPI t CPI t 1 CPI t Inflation rate = 0 implies prices are constant Inflation rate > 0 implies prices are rising Inflation rate < 0 implies prices are falling Deflation

7 1.7.1 Relative Price Change vs General Price Change (Inflation) Relative price changes do not represent inflation. Relative price only measures the price of one good relative to another. Example: the price of a laptop increases by 20% from 2016 to At the same time, the price of all other goods in the economy increases by 50%. Here, inflation is equal to 50% since this represents an increase in general price level across the economy. However, the relative price of the laptop has decreased since the price rise of the laptop is less than the increase in price of all other goods. 1.8 Limitations with CPI 1. Quality Adjustment Bias Quality improvements may show up as higher prices for goods and services. New goods are often not included until CPI is rebased by selecting a new base year basket of goods. 2. Substitution Bias Use of a fixed basket means that no allowance is made for consumers substitution toward relatively less expensive goods. Due to these biases of CPI measurement which overestimate the increase in cost of goods and services over time, CPI overstates inflation. 1.9 Costs of Inflation Expected Costs of Inflation: When inflation is perfectly anticipated, preventative actions can be undertaken in the economy to eliminate certain negative effects of inflation. However, some costs still arise even with perfect predictions of inflation: 1. Shoe Leather Costs: Inflation reduces the real purchasing power of money causing individuals to hold less cash in order to keep more of their money in interest-bearing accounts. Holding less cash requires more trips to the bank and this costs time and effort which could otherwise be spent more productivity (opportunity cost). 2. Menu Costs: As the inflation rate increases, prices on product listings need to be updated to reflect this. This incurs costs such as printing new price lists and menus.

8 Unexpected Costs of Inflation When inflation is not anticipated, financial systems, loans and wages in the economy are not adjusted to inflation, resulting in costs to the economy: 3. Noise in the Price Mechanism: The role of the price system is to allocate resources efficiently: in a competitive market, the price adjusts according to demand and supply forces in order to achieve equilibrium. Inflation makes it difficult to determine whether an increase in price represents increased demand or a rise in the general price level. Producers who interpret inflation as increased demand will increase output resulting in excess supply and market disequilibrium. 4. Distorts Tax Systems: Tax brackets are stated in terms of nominal income rather than real income, and thus are not indexed according to inflation. Hence, an increase in inflation forces people into higher tax brackets even if their real income has not increased. As a result, a higher proportion of income pays for taxes, and this reduces the real purchasing power of income. 5. Unexpected Redistributions of Wealth: Unexpected inflation redistributes wealth between two parties in a fixed wage contract or loan agreement when the wage or interest does not adequately compensate for inflation. If an employer and employee agree to a wage contract according to a fixed inflation level and inflation turns out to be higher than expected, the employee loses and the employer gains. Similarly, if a borrower and lender agree to a loan with a fixed nominal interest rate, then unexpectedly high inflation will benefit the lender and the borrower will lose. 6. Interference with Long Term Planning of Households and Firms As a result of inflation, household savings may be insufficient for planned future consumption or long term goals such as retirement. Inflation increases the cost of current consumption since the purchasing power of money is reduced and more dollars are required to purchase the same quantity of goods over time. This may force people to save more and consume less, potentially reducing their living standards.

9 1.10 Inflation and Interest Rates Nominal Interest Rates percentage increase in the nominal (or dollar) value of a financial asset. Real Interest Rate percentage increase in the real purchasing power of a financial asset. Ex-Post Real Rate: r = i π real interest rate = nominal interest rate inflation rate Fisher Effect: i = r + π e nominal interest rate = real interest rate + expected inflation rate Real interest rate represents the true cost of borrowing. Nominal interest rate is the actual interest rate charged for lending or borrowing and depends on people s expectations of inflation. When inflation is expected to be high, lenders increase the nominal interest rate they charge to compensate for this expected inflation. Deflation Deflation is defined as a decrease in the general price level (negative inflation rate). Deflation is often associated with periods of negative or stagnant economic growth. Problems of Deflation Discourages consumer spending: falling prices causes people to delay purchases until the future. The decrease in consumer spending can lead to a contraction in the economy which may eventually become a recession. Increases real value of debt: deflation increases the real value of debt making it more difficult for debtors to pay off their debts. A higher proportion of disposable income is spent repaying debt and this reduces consumption spending, also leading to an economic contraction. Increased real interest rate: with deflation, the real interest rate cannot fall below zero. Returns are always positive, so people tend to save more instead of spending. Increased unemployment: wages are sticky in the short run since workers resist nominal wage cuts. Hence, deflation cause real wages to rise and firms reduce the amount of labour employed resulting in higher unemployment.

10 ECON 1102: MACROECONOMICS 1 All Chapters: List of Equations Chapter 1: Measuring Macroeconomic Performance, Output and Prices Production Method of Measuring GDP GDP = Price Quantity (of good or service) GDP = Value added by each firm Value Added = Sales Cost of Intermediate Inputs Expenditure Method Y = C + I + G + NX Income Method GDP = Labour Income + Capital Income + Indirect Taxes Subsidies GDP at factor cost = Labour Income + Capital Income Chain Weighted Index GDP Deflator Inflation Ex-Post Real Rate Fisher Effect Chain Weighted Index = g t g t 1 2 GDP Deflator (price level) = Nominal GDP Real GDP Inflation (%)= CPI t CPI t 1 CPI t r = i π i = r + π e