Lecture notes 2 - Professor Chandini Sankaran PDF

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PRI NCI PLESOFMACROECONOMI CS ECON222 SPRI NG 2012

LECTURE NOTES: Chapters 5, 6, 7,8 PROFESSOR: DR. CHANDINI SANKARAN NIXON Department of Economics, Moore School of Business University of South Carolina

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Chapter 5: Measuring a Nation’s Income  Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.  Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once. Macroeconomics answers questions such as why is average income high in some countries and low in others? Why do prices rise rapidly in some time periods while they are more stable in others? Why do production and employment expand in some years and contract in others? Before we can answer these macroeconomic questions, we need to understand the economy as a whole and several important definitions. 1. Understanding the Economy  Identify the important areas: o Total output (and income) o The average of prices o Resource Employment  Measure the important areas using: o Real Gross Domestic Product (RGDP) o Consumer Price Index (CPI) o Monthly Unemployment Rate 2. The Circular-Flow Diagram (i) When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. (ii) For an economy as a whole, income must equal expenditure because:

a. Therefore, there are three methods of computing an Economy’s Income:

DIAGRAM: THE CIRCULAR FLOW

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3. a. b.

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Gross Domestic Product (GDP) Gross domestic product (GDP) is a measure of the income, expenditure, or total output of an economy. GDP is

c.

The Measurement of GDP i. Output is valued at market determined prices. ii. Output is measured in dollar terms. iii. GDP records only the value of final goods, not intermediate goods (we want to “count” production” only once). iv. It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). v. It includes goods and services currently produced, not transactions involving goods produced in the past. vi. It measures the value of production within the geographic confines of a country. vii. It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). viii. What Is Counted in GDP? GDP includes all items

ix. What Is Not Counted in GDP? GDP excludes

Examples:

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More Examples:

Quick Quiz: Which contributes more to GDP: the production of a pound of caviar or the production of a pound of hamburger? Why?

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4. a.

Other Measures of Income Gross National Product (GNP) (i) The total market value of all final goods and services produced during a given period of time by the nation’s nationals, regardless of the place produced. (ii) Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals). (iii) It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here. GNP VS GDP examples

5.

The Components of GDP (Expenditure Method)

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GDP is the sum of all expenditures in the economy. The Four Components of GDP are:

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6.

Real versus Nominal GDP Nominal GDP (NGDP) is the value of the economy’s current production at current prices Real GDP (RGDP) is the value of the economy’s current production at constant, baseyear prices.

 

An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator. GDP Deflator  The GDP deflator measures the current level of prices relative to the level of prices in the base year.  It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.  An accurate view of the economy requires adjusting nominal to real GDP, using the GDP price deflator.  The GDP price deflator is a price index and is calculated by: NGDP x100 GDP _ deflator  RGDP Examples of Calculating NGDP, RDGP and GDP Price Deflator: Example 1: Isoland: 2008 Q P NGDP2008 50 $20 timber

2009 timber

Q 50

P $30

NGDP2009

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Example 2: Kansas: 2003

Q

P

Wheat

50

$20

Corn

100

$10

2004

Q

P

Wheat

60

$18

Corn

90

15

NGDP2003

RGDP2003

NGDP2004

RGDP2004

Example 3: USA: 2009

P footballs 10

2010

12

Q footballs 120 200

P basketballs 12 15

Q basketballs 200 300

Quick Quiz! Define Real and Nominal GDP. Which is a better measure of economic well-being?

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7.

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Real GDP in the United States

Fluctuations in the Real GDP over the short-run/ BUSINESS CYCLES

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8.

RGDP and Economic Well-Being



RGDP per person is the best single measure of the economic/material well-being of a

society.



RGDP per person tells us the income and expenditure of the average person in the economy. Example 4:

 More RGDP per person means that we have a higher material standard of living by being able to consume more goods and services.  GDP is NOT intended to be a measure of the happiness or quality of life, however.  Some things that contribute to well-being are not included in GDP.  The value of leisure.  The value of a clean environment.  The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

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Summary  Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.  Gross Domestic Product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.  GDP is the market value of all final goods and services produced within a country in a given period of time.  GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.  Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services.  The GDP deflator--calculated from the ratio of nominal to real GDP-measures the level of prices in the economy.  GDP is a good measure of economic well-being because people prefer higher to lower incomes.  It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren’t measured by GDP.

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MEASURING THE COST OF LIVING Chapter 6  GDP measures the economy’s total output of goods and services, or total income. Because prices go up and down over time, it is difficult to compare the standard of living with information about income only.  Standard of living instead depends on the purchasing power of one’s income. The Consumer Price Index measures the cost of living over time, and helps turn dollar figures into meaningful measures of purchasing power. This second measure of economic performance involves reporting prices and changes in prices over time. This is not a problem if we are dealing with the price of a single item, say, pizza. It is easy to follow a single price over time and measure its change. However, trying to report the movement of several hundreds or thousands of different prices is a challenge.  When the CPI rises, the typical family has to spend more to maintain the same standard of living, or there has been inflation. Inflation refers to a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. A. The Consumer Price Index (CPI) : is a measure of the overall cost of the goods and services bought by a typical consumer. 1. It is computed and reported each month by the Bureau of Labor Statistics, a part of the Department of Labor. It is used to monitor changes in the cost of living over time. 2. The goal of the CPI is to measure changes in the cost of living (i.e. the selected “market basket”) over time. 3. Computing the CPI is a five-step process using data on the prices of thousands of goods and services: i) Fix the basket - In determining the cost of living, the Bureau of Labor Statistics (BLS) first identifies a “market basket” of goods and services the typical consumer buys. Annually, the BLS surveys consumers to determine what they buy. They determine which goods and services are most important for a typical consumer and the relative importance of each. (Note: For our class purposes, we will simplify this concept and just use the quantities purchased by consumers. However, the BLS calls these “weights” based on the importance of the product to consumers). You could develop a price index of your own where important goods might be gas, textbooks, tuition, notebooks, pencils, candy bars, rent, food, and football tickets. EXAMPLE 1: BLS surveys consumers and designates the typical basket as 10 bananas, 20 backrubs, and 40 margaritas

ii)

Find the prices - Once you've established the goods, find out what the prices are now and what they were at specific times in the past. Year 2011 2012

Price of Bananas $1 $2

Price of Backrubs $6 $12

Price of Margaritas $3 $6

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iii) Compute the basket's cost - Using the quantities established in Step (i), determine the total cost of the basket at each set of prices found in Step (ii). (Note: remember that the market basket isn't changing, only the prices.) COB11 = COB12 =

iv) Choose a base year and compute the index - The base year is just a benchmark against which all other years can be compared; normally, the earliest year is chosen as the base year. The consumer price index for each year is the cost of the basket in that current year divided by the cost of the basket in the base year, multiplied by 100. CPI11 = CPI12 =

v) Compute the inflation rate - When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. Compute the inflation rate as the change in the price index from the preceding period. Inflation rate =

EXAMPLE 2: 1. Fix the basket: 3 footballs and 4 basketballs. 2. Find the prices: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 12 15 3. Compute the Cost of the Basket: Cost in Year 1 = Cost in Year 2 =

4. Using Year 1 as the base year, compute the index: CPI in Year 1 = CPI in Year 2 =

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EXAMPLE 3: Typical basket = 20 pizzas, 30 beer, and 100 gum Year 2010 2011

Pizza $12 $12

Beer $4 $6

Gum $1 $2

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4. Problems in Measuring The Cost of Living: The CPI is an accurate measure of the selected goods that make up the “typical bundle,” but it is not a perfect measure of the “cost of living” in its precise sense. Problems of the CPI include: (i) The Consumer Price Index is based only on a small fraction of the many goods and services that are available. If a person's buying habits differ substantially from the market basket on which the index is based, that person may experience a very different change in the cost of living than what the CPI shows. To represent this problem in terms of the example of the previous section, consider a person who never eats pizzas, drinks water rather than beer, and does not like to chew gum. A price index built on the buying pattern of this person might be totally different from the one above. The Labor Department addresses this problem to some extent by constructing two price indexes, one for all urban consumers (the CPI-U), and another for urban wages earners and clerical workers (the CPI-W). B. The GDP Deflator versus the Consumer Price Index: The CPI and GDP price deflator are similar measures of changing prices over time but not identical because:

THE FOLLOWING THREE PROBLEMS EXPLAIN WHY THE CPI tends to overstate the cost of living: (ii) Substitution bias - The bundle does not change in the short run to reflect consumer reaction to changing relative prices. When the price of a good goes up, people react (economize) by purchasing less of that good and substituting other goods in its place. When the price of a good decreases, consumers purchase more of it. However, the CPI holds all quantities constant over time, regardless of how consumers respond to changing prices. This causes the cost of the bundle to be higher because of a constant amount of higher and lower priced goods. If the actual quantities purchased were used, the cost of the bundle would be less. Thus the substitution of lower priced goods for higher priced goods produces a substitution effect. When the price of one product rises, consumers tend to substitute like products to avoid the price increases. Even when sharply higher prices force substitution to avoid price increases, the CPI methodology assumes that consumer spending on each item is an unchanged proportion of the index over time, and thus price increases tend to be overstated. Likewise, when the price of one good drops, more of it may be purchased, but this increase is not reflected in changing weights in the CPI.

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Example 4: Items

Price of Apples

Price of Oranges

2003

.50

.50

2004 $1 .50 BLS surveys consumers in 2003 and fixes the basket at 50 apples and 50 oranges. COB03 computed by BLS = COB04 computed by BLS = But in real life, we substitute to the cheaper good. 2004 quantities = 0 apples and 100 oranges COB03 in reality = COB04 in reality = Beginning in January of 2002, the Labor Department began to update the “basket” every two years. Prior to the 1990s, the Department only updated them in ten-year intervals. The CPI for 1990 was based on a market basket formed from consumer buying patterns that existed in 1982. If the Department of Labor had done another survey of consumer buying patterns in 1990, it would have found that consumers would been buying more of those items that had dropped in price or that had risen in price by small amounts. They would be buying less of items that had risen in price much more than average. If these new weights were used to recompute the price index, the large price rises would have a smaller impact on the total. The smaller price rises would have more of an impact on the total because they would be more heavily weighted. Therefore the resulting price rises would look smaller, which is what the example above explained. With more frequent updating of weights, the CPI should be a more accurate measure of inflation. iii) Introduction of new goods - New goods mean more choices and more choices mean that the purchasing power of your dollar may go up if producers compete with each other aggressively for your business. Therefore, it is possible for you to maintain your standard of living with less money. The CPI would miss that change. The bundle does not reflect the effects of new products that typically go down in price after introduction. Cellular phones and computers were not in the 1982 bundle. The falling prices of computers and cellular phones are not in the CPI although they cause the true cost of living to decrease.

iv) Unmeasured quality change - It is difficult to compare one period to the next because, even though the BLS tries to adjust for it, the quality of a good may change making it more or less valuable relative to its price to the consumer. Higher market prices usually include quality changes that do not necessarily represent a higher cost of living. If we take into account longer product life, improved features, and lower operating costs, the true cost of living may be less even though some goods cost more. Changes in the quality of products are difficult to incorporate into the CPI. If a product becomes better with time and the price also rises, how much of the change in price is due to the improved quality? Changes in quality are rather common over long periods of time. The automobile of the 1990s was very different from that of the 1970s, which in turn was very different from that of the 1950s. Sometimes changes in quality are evident in short periods. The tremendous improvement of electronics products--televisions, audio equipment, and

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computers--has changed the way we live and work. The Department of Labor tries to make adjustments for quality changes, but by their very nature such adjustments are in part subjective. Difference Between the CPI and the GDP price deflator:

C. The Bureau of Labor Statistics also reports the Producer Price Index which measures the cost of a basket bought by a typical firm, rather than a consumer. The PPI measures the producers’ costs of resources. The PPI is useful in predicting changes in the CPI since firms often pass on rising costs to consumers. D. Comparing a dollar figure from the past to a dollar figure today, using the CPI. Example 5:

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E. Real and Nominal Interest Rates 1. Interest

2. Nominal interest rate –

3. Real interest rate –

4. Real interest rate =

Example 6: Assume I lend you $1000 today (March 2012) to be repaid after one year. If prices increase by 10 percent over the next year, I would have to be repaid $1100 in order to receive the purchasing power that was given to you earlier.

Example 7 – Assume you borrow $1,000 for one year from a bank and was quoted interest rates of 15% on this loan. During the year inflation was 10%; the amount that the bank actually makes on this loan (or the real return), after taking into account inflation, is: the real interest rate:

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E. Conclusion 1. When comparing dollar values from different times, it is necessary to keep in mind that a dollar today is not the same as a dollar in the past. Therefore, it is necessary to have a tool to compare dollars over time. A price index is such a tool. The CPI illustrates one way that prices are measured and how to make adjustments for these price changes. 2. The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the price level measures the inflation rate. 3. The consumer price index ...