EC 205 Lecture 3-16/02/15 Reminders: 1. Syllabus and lecture slides are on the course webpage (Accessible via Econ Department website) 2. First outside reading (A short piece on GDP as a measure of well-being) is posted on the webpage. 3. PSes start next week: Times: T9, W9, Th9 (Classrooms will be announced on Monday mornings) Today: Finish Chapter 2 Start, Chp 3: National Income: Where It Comes From and Where It Goes 1
List of Countries by GDP (2013) Rank Country Nominal GDP ($M) 1 United States 16,768,100 2 China 9,240,270 3 Japan 4,919,563 4 Germany 3,730,261 5 France 2,806,428 16 Indonesia 868,346 17 Netherlands 853,539 18 Turkey 822,135 Rank Country PPP Adj. GDP per Capita 1 Qatar 145,894 2 Luxembourg 90,333 3 Singapore 78,762 4 Brunei 73,823 5 Kuwait 70,785 61 Panama 19,080 62 Turkey 18,874 63 Venezuela 18,453 2
Real vs. nominal GDP GDP is the value of all final goods and services produced. nominal GDP measures these values using current prices. N = NGDP P Q i= 1 current i current i real GDP measure these values using the prices of a base year. RGDP N = i= 1 P Q base i current i Nominal GDP may increase over time because prices increase or quantities increase Intention: measure production & how it changes over time Thus, we need to isolate the effects of the changes in quantity. Hence, we need real GDP 3
NOW YOU TRY Real and Nominal GDP 2010 2011 2012 P Q P Q P Q good A $30 900 $31 1,000 $36 1,050 good B $100 190 $102 200 $100 205 Compute nominal GDP in each year. Compute real GDP in each year using 2010 as the base year. 4
NOW YOU TRY Answers nominal GDP multiply Ps & Qs from same year 2010: $46,000 = $30 900 + $100 190 2011: $51,400 2012: $58,300 real GDP multiply each year s Qs by 2010 Ps 2010: $46,000 2011: $50,000 2012: $52,000 = $30 1050 + $100 205 5
Terminology Nominal GDP also called: Dollar (TL) GDP GDP in current prices GDP in current dollars (TLs) Real GDP: GDP in terms of goods GDP in constant prices GDP adjusted for inflation GDP in (base) year dollars (liras, etc.) 6
U.S. Nominal and Real GDP, 1960-2014 $18.000 $16.000 $14.000 (billions) $12.000 $10.000 $8.000 $6.000 $4.000 Real GDP (in 2009 dollars) $2.000 Nominal GDP $0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 7
Turkish Nominal and Real GDP, 1987-1997 Nominal GDP vs Real GDP (Base Year=1987) 35 GDP in YTL Billions 30 25 20 15 10 REAL GDP NOMINAL GDP 5 1986 1988 1990 1992 1994 1996 1998 Year 8
Turkish Nominal and Real GDP, 1998-2013 1800 Nominal GDP vs Real GDP (Base Year=1998) GDP in YTL (Billions) 1600 1400 1200 1000 800 600 400 200 REAL GDP NOMINAL GDP 0 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Year 9
Real or Nominal? Şimşek vs Rodrik Discussion on Twitter: Read more about it here: http://tinyurl.com/rodriksimsek 10
Measures of Aggregate Prices Inflation rate: the percentage increase in the overall level of prices 1- GDP Deflator: One measure of the price level: GDP deflator Definition: Nominal GDP GDP deflator = 100 Real GDP Inflation rate = % in GDP deflator 11
Example: Nominal GDP Real GDP (Base=2006) GDP deflator Inflation rate 2006 $5000 $5000 100 n.a. 2007 7350 6600 111.4 11.4 2008 7600 7000 108.6-2.51 Note that the actual level of the GDP deflator is meaningless. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008. 12
Chain-Weighted Real GDP Over time, relative prices change, so the base year should be updated periodically. In essence, chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP. Your textbook usually uses constant-price real GDP, because: the two measures are highly correlated. constant-price real GDP is easier to compute. 13
Other Problems in RGDP Calculations Technological Progress: qualities of the goods change over time, not just prices & quantities Basic examples: computers, education, health care, One Theoretical Solution: Hedonic Pricing An approach to calculating real GDP that treats goods as providing a collection of characteristics each with an implicit price REQUIRED READING ON WHETHER GDP IS A GOOD MEASURE IS ON THE WEBSITE! 14
Part 2: Measures of Aggregate Prices Inflation rate: the percentage increase in the overall level of prices 1- GDP Deflator: One measure of the price level: GDP deflator Definition: Nominal GDP GDP deflator = 100 Real GDP Inflation rate = % in GDP deflator 15
Example: Nominal GDP Real GDP (Base=2006) GDP deflator Inflation rate 2006 $5000 $5000 100 n.a. 2007 7350 6600 111.4 11.4 2008 7600 7000 108.6-2.51 Note that the actual level of the GDP deflator is meaningless by itself. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008. 16
Measures of Aggregate Prices 2- Consumer Price Index (CPI) Retail prices of consumer goods A fixed basket of goods market basket In Turkey: 1987, 1994, 2003 are the base years. Household income and consumption expenditure surveys conducted Number of goods in the representative basket and their weights determined How is the CPI calculated? In Turkey: TÜİK Monthly 432 goods & services 17
Components of the Market Basket CPI(1994=100) CPI(2003=100) Food, beverages & tobacco 31.09% Food and beverages 29.42% Alcoholic drinks & tobacco 4.67% Clothing and shoes 9.71% Clothing and shoes 8.09% Housing 25.80% Housing 16.90% House ware 9.35% House ware 6.47% Health 2.76% Health 2.71% Transportation 9.30% Transport 10.42% Communication 4.82% Entertainment&culture 2.95% Entertainment & culture 3.60% Education 1.59% Education 2.15% Restaurant,café & hotels 3.07% Restaurant, café & hotels 5.87% Miscellaneous 4.38% Miscellaneous 4.87% 18
The composition of the US CPI s basket Food and bev. Housing Apparel Transportation 3.4% 16.4% 7.6% 5.8% 3.2% 3.8% 3.4% Medical care Recreation Education 14.9% Communication Other goods and services 41.4%
One other index:wpi/ppi WPI Wholesale Price Index Wholesale prices A fixed basket In Turkey, as of February 2005, PPI (Producer Price Index) replaced the WPI The basket weights did not change much WPI (1994=100) PPI (2003=100) Agriculture 22.22% 20.65% Mining & Stone Quarrying 2.47% 1.51% Manufacturing Industry 71.12% 72.07% Electricity, Gas,Water 4.19% 5.77% 20
Why the CPI may overstate inflation Substitution bias: Price of natural gas rises & people switch to coal Price of gasoline rises & taxi drivers switch to LPG Introduction of new goods and Unmeasured changes in quality: Computer chips- faster chips with higher prices and also with higher quality 21
CPI vs. GDP Deflator Prices of capital goods: included in GDP deflator (if produced domestically) excluded from CPI Prices of imported consumer goods: included in CPI excluded from GDP deflator The basket of goods: CPI: fixed (Laspeyres Index) GDP deflator: changes every year (Paasche Index) Which one is a better measure of cost of living? Neither is superior If prices of different goods are changing by different amounts Laspeyres Index overstates inflation but Paasche Index understates inflation 22
Two measures of inflation in the U.S. 14 12 CPI Percentage change from 12 months earlier 10 8 6 4 2 0 GDP deflator -2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Part 3: Measuring the Unemployment Rate Labor force = N + U L Employed Unemployed Unemployment rate = u = U/L Labor force participation rate = Labor force/adult Population 24
How do we actually measure it? Until recently, mostly people who were registered at unemployment offices were counted as unemployed Today most countries rely on large surveys of households For example, the Current Population Survey (CPS) in the US 60000 households are interviewed every month If an individual has a job during the month of interview employed If an individual is looking for a job during the month of interview unemployed If not employed and not looking for a job not in the labor force Discouraged workers: This method tends to underreport the rate of unemployment 25
Measuring the Unemployment Rate US (2008) Turkey (2008) Population 305,952,000 70,166,000 Population 16+ 234,739,000 51,211,000 Labor Force 153,716,000 23,799,000 Employment 142,099,000 20,466,000 Unemployed 11,616,000 3,332,000 Unemployment Rate 7.6% 14.0% L-force Participation Rate 65.5% 46.5% Note: Non farm unemployment rate: 16.8% 48% of the economy is informal in Turkey (estimate) 26
CHAPTER 3 National Income: Where it Comes From and Where it Goes 27
In this chapter, you will learn: what determines the economy s total output/income how the prices of the factors of production are determined how total income is distributed what determines the demand for goods and services how equilibrium in the goods market is achieved 28
Classical Theory - Outline of model A closed economy, market-clearing (LR) model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market 29
Supply side - Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers 30
The production function: Y = F(K,L) shows how much output (Y) the economy can produce from K units of capital and L units of labor reflects the economy s level of technology exhibits constant returns to scale 31
Returns to scale: A review Initially Y 1 = F (K 1, L 1 ) Scale all inputs by the same factor z: K 2 = zk 1 and L 2 = zl 1 (e.g., if z = 1.2, then all inputs are increased by 20%) What happens to output, Y 2 = F (K 2, L 2 )? If constant returns to scale, Y 2 = zy 1 If increasing returns to scale, Y 2 > zy 1 If decreasing returns to scale, Y 2 < zy 1 32
Returns to scale: Example 1 F( K, L) = KL F( zk, zl) = ( zk)( zl) = 2 z KL = z 2 KL = = z KL zf( K, L) constant returns to scale for any z > 0 33
Returns to scale: Example 2 FKL (, ) = K+ L F( zk, zl) = zk + zl = z K + z L = z( K + L) = zf( K, L) decreasing returns to scale for any z > 1 34
Assumptions 1. Technology is fixed. 2. The economy s supplies of capital and labor are fixed at K = K and L = L 35
Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Y = FKL (, ) 36
The distribution of national income determined by factor prices, the prices per unit firms pay for the factors of production wage = price of L rental rate = price of K Assumptions: 1. Fixed technology 2. Perfect competition in all markets 37
Notation W R P W /P = nominal wage = nominal rental rate = price of output = real wage (measured in units of output) R /P = real rental rate 38
How factor prices are determined Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand? 39
Demand for labor Assume markets are competitive: each firm takes W, R, and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. cost = real wage benefit = marginal product of labor 40
Marginal product of labor (MPL) definition: The extra output the firm can produce using an additional unit of labor (holding other inputs fixed): MPL = F(K,L+1) F(K,L) More formally: MPL = F ( K, L) L 41