Week 1: General notes: o Macroeconomics studies the aggregate impact of individual decisions. Microeconomics studies decision-making by individual economic agents o In the study of macroeconomics, an economist must: Identify any issues Analyse data Apply the theory Design policy response Design a reform strategy o A change across all levels of a variable refers to an exogenous change When is the economy performing well? Rising living standards Industrialised economies (Europe, US, Australia, newly industrialised South-East Asia) have experienced a rise in material wellbeing Long run growth issues: o Growth theory: The study of the long-run growth performance of economies (evaluating why some economies have experienced increases in living standards while some others have not) Living standards are measured by: o Quality of life (crime rates, pollution, etc), life expectancy, mortality rates, inequality, access to goods and service Avoiding extremes of macroeconomic performance Short-run expansions and contractions in economic activity (the short run business cycle) cause hardships and costs to society o This is because they create uncertainty Governments aim to prevent large volatility in GDP growth Maintaining the real value of the currency Rapid changes in the prices of goods and services alter the real purchasing of a dollar and create significant costs to the society Ensuring sustainable levels of public and foreign debt Debt accumulation is justifiable and sustainable if it generates returns exceeding its costs o Public debt is the amount owed by the government to the non-government sector o Foreign debt is the amount owed by the nation to other countries Balancing current expenditure against the need to provide resources for the future Saving means postponing consumption today to provide more for the future Trade-off between spending today to maximize current utility, or saving to expend on goods and services that will increase utility in the future Providing employment for all individuals seeking work Unemployment contains elements of both macroeconomics and microeconomics Page 1 of 82
Gross domestic product: Measuring the nation s output GDP the fine print Gross domestic product (GDP) refers to the market value of final goods and services produced in an economy over a given time period o Market value: Goods and services are counted at their market price times quantity Unpaid work is not counted Eg. when women participation in workforce increased, GDP increased due to 1. The quantity of goods and services directly produced by women; and 2. The increase in paid childcare (as previously, childcare from mothers was unpaid) Public goods and services do not have market prices and are counted at their cost of provision Only production that takes place within a country s borders is counted for GDP Eg. Production by a US-based company in an Australian factory would be counted in Australian GDP, not US GDP Final goods and services Final goods or services are those consumed by the ultimate user because they are the end products of the production process they are counted as part of GDP Intermediate goods or services are those used up in the production of final goods and services and therefore not counted as part of GDP The final good is the good that is consumed by the consumer, eg. bread. The wheat and flour are intermediate goods which are used in the production of the bread GDP is the total market value of all final goods and services Often difficult to distinguish intermediate and final goods To avoid double counting, value-added method is used. Example of an economy that produces $6 bread: o Wheat farmers value-added = $2 (wheat) - $0 (no intermediate input costs) = $2 o Flour-making factory = $3.5 (flour) - $2 (wheat) = $1.5 o Bakery shop = $6 (bread) - $3.5 (wheat) = $2.5 GDP measures the sum of the value added of all goods and services produced in an economy o If part of the good is produced in one year, and the rest produced in another, the value added approach enables the value of the partially produced good to be included in GDP calculations The expenditure method for measuring GDP GDP = C + I + G + (X-M) o This equation is known as the national income accounting identity Consumption (C) o Spending by households on goods and services o Subcategories: Durables: Long-lived consumer goods such as cars and furniture (note houses are considered investment) Non-durables: Shorter-lived goods like food and clothing, and all services Page 2 of 82
Investment (I) o Spending by firms on final goods and services, primarily capital goods and housing o Subcategories: Business fixed investment: The purchase by firms of new capital goods such as machinery, factories and office buildings (long-lived capital goods are treated as final goods rather than as intermediate goods) Residential investment: The construction of new homes and apartment buildings (for GDP, residential investment is treated as investment by the business sector, which then sells homes to households) Inventory investment: The addition of unsold goods to company inventories (as if the firm had bought the good itself) Government expenditure (G) o Purchases by federal, state and local governments of final goods, such as fighter jets, and services, such as teaching in public schools o These do not include transfer payments or interest paid on government debt Net exports (X-M) GDP and the incomes of capital and labour GDP is where payments for goods and services go: o Compensation of employees (wages) o Gross operating surplus of producers (profits) o Taxes on production less subsidies (indirect taxes) Wages + profits + indirect taxes = GDP Nominal GDP versus real GDP Nominal GDP: the value of goods and services produced during a given year valued at the price that prevailed in that same year o Nominal GDP is just a more precise name for GDP Real GDP: the value of final goods and services produced in a given year when valued at the prices of a reference base year o Real GDP moves with changes in the quantity of goods and services produced, not with changes in prices o Measure of economic growth Page 3 of 82
Often we focus on growth (not level) of real GDP o % change in real GDP over the last year: ( GDP Year t GDP Year t 1 GDP Year t 1 ) 100% Real GDP is not the same as economic wellbeing Leisure time In most industrialised countries, many work less hours than older generations. This enables them to pursue many worthwhile activities, including being with family and friends, participating in sports and hobbies and pursuing cultural and educational activities which is a benefit of living in a wealthy society These extra hours of leisure activities are not priced in markets, and subsequently are not reflected in GDP Non-market economic activities Volunteer services, such as the volunteer fire fighters that serve many small rural towns, are not included in GDP because there are no market prices and quantities for unpaid services Page 4 of 82
Environmental quality and resource depletion Increased pollution detracts from the quality of life in an economy, but as air and water quality are not bought and sold in markets, GDP does not reflect the environmental degradation resulting from economic growth Quality of life Some quality of life indicators are not sold in markets, and subsequently are omitted from GDP, eg. low crime rates and low traffic congestion Poverty and economic inequality GDP reflects the total quantity of goods and services produced and sold in an economy but it omits information about who gets to enjoy those goods and services o There could be a high middle class with little extreme wealth or poverty, or high extremes of wealth and poverty GDP is related to economic wellbeing GDP is correlated with economic wellbeing, however GDP omits many characteristics of economic wellbeing, as discussed above o It is a causal relationship typically; economic wellbeing is concomitant to a high GDP Availability of goods and services A country with a high GDP is likely to have citizens who posses more and better goods and services Life expectancy Superior nutrition, sanitation and medical services in richer countries account for higher life expectancy in countries with higher GDPs To consider whether an economy is likely to be in a recession, look specifically at investment and inventory. If inventory is building up and there is lower investment in one country comparative to another, it is more likely to be in a recession than the other. Week 2: The consumer price index: Measuring the price level Note: substitution bias = CPI subs CPI orig Note that change (delta) means that if CPI = 1.25, change in CPI is 0.25 The Price Level Consumer Price Index (CPI) Define a base year Determine basket of goods and services consumed Cost of base year basket in current year CPI = Cost of base year basket in base year CPI = 1.25 prices 25% higher in current year compared to base year Cost of Living Indices 1 Page 5 of 82
Ideal cost of living index o A Determine the cost of the utility-maximising consumption basket in the base year (say year 2000) (what goods and services would individuals in 2000 consume to be as satisfied as possible) o B Determine the minimum cost of the current year (eg. 2015) consumption basket required to yield base year utility at current year prices (goods and services are similarly utility-maximising for the current year and thus may be different from base year) o Index value = B A Calculated based on preferences, not purchases This is how CPI should be calculated Cost of Living Indices 2 Laspeyres Index o A Determine the cost of the (utility-maximizing) consumption basket in the base year o B Determine the cost of purchasing the same consumption basket in the current year o Index value = B A Does not account for changes in demand due to price changes; therefore consumption basket will not look the same today as it did in the base year (ie, as price does change (as measured by index), demand should also shift) o Hence, Laspeyres Index should overestimate inflation compared to the Ideal Index (if price is increasing) Cost of Living Indices 3 Paasche Index o A Determine the cost of the current year consumption basket o B Determine the cost of purchasing the same consumption basket in the base year o Index value = A B Does not account for changes in demand due to price changes (ie, if prices change (as measured by index), demand should shift, hence changing the basket of goods and services from current year to base year) Paasche < Ideal < Laspeeyres (if price is increasing) Cost of Living Indices 4 A chain-weighting process is used to measure the CPI o Weights updated every 5 years using consumption data from the Household Expenditure Survey (HES) o New series formed and linked to earlier series RBA measures: o Excluding volatile items However, sometimes volatility is unavoidable and should be measured due to its permanence (eg. increases in oil prices if oil is running out in the world and there is no fuel alternative) o Trimmed mean (middle 70% of price changes) Page 6 of 82
o Weighted median Cost of Living Indices 5 GDP Deflator o Not based on a fixed basket of goods nominal GDP GDP deflator = real GDP If there is inflation, GDP deflator is greater than one (as nominal GDP is grater than real GDP) If there is deflation, GDP deflator is less than one (as nominal GDP is less than real GDP) GDP Deflator measures inflation based on prices of goods and services produced in an economy rather than goods and services consumed by an economy Inflation Inflation rate = ( CPI this period 1) 100 CPI last period An aggregate of price changes Can be yearly, quarterly, etc o Typically done yearly to eliminate seasonal trends presented by quarters Alternative measures of inflation o Underlying inflation o The trimmed mean Deflation A common misperception about inflation Note: inflation is the sustained increase in the price of goods and services in an economy Thus, relative price change of an individual good or service is not considered to be inflation Adjusting for inflation Real income = nominal income/cpi Social welfare income to be paid to individuals = real purchasing power * CPI The practice of increasing a nominal quantity according to changes in a price index to prevent inflation from eroding purchasing power is called indexing Does the CPI measure true inflation? Asset prices As asset prices vary, so to does the cost of inflation, leading to over and under estimations of CPI, making CPI volatile because of the volatility of asset prices Quality adjustment bias The bias that causes measured inflation to overstate changes in the cost of living caused by the failure to adjust adequately for improvements in the quality of goods and services (eg. a 20% better computer would cost 20% more; which would be Page 7 of 82