CHAPTER 11

MEASURING NATIONAL ECONOMIC PERFORMANCES

CIRCULAR FLOW OF INCOMEInjections: money that enters the system.

• Government spending (subsidy, etc)

• Export

• Investments (capital, household, etc)

Leakages: money that exist the system.

• Saving money

• Import

• Tax

The idea is that firms pay households through paying wages, rents, interests, and profit to people (factors of production). The same household will spend the earned income to purchase goods and services produced by the firms. And thus, there is a cycle.

GROSS NATIONAL PRODUCT (GDP)Expenditure approach: count the total spending on new final goods and services in a given year.

C+I+G+(X-M)

• C: consumption of all durable and non durable goods and services.

• I: investment, in which firms spend money on capitals and household spend money on housing and construction.

• G: Government spending, except for transfer payment (tax revenue redistributed to pensioners and unemployed.)

• X-M: Export-import

Income approach: counts all income received in a given year. This is because the circular flow of income suggests that all spending is income to firms and households, and thus income= value of goods and services produced.

GDP: is the value of all final goods and services produced in a country within a given time period. There are three ways to calculate GDP.

Output approach: counts all income received in a given year. This is because the circular flow of income suggests that all spending is income to firms and households, and thus income= value of goods and services produced.

GNP AND NNPGross National Product (GNP): is the GDP plus the value of goods and services produced by oversea residents ,for for instance Japan, minus the value of goods and services produced by foreign residents in, for instance Japan.

Simply, it is GDP + net property income from abroad.

For instance, for Japan’s GNP the revenue earned by Japanese Toyota workers in China would be included, while the revenue of American workers in P&G of Japan would not be included.

GNP>GDP: many foreign domestic workers.

GNP<GDP: many significant foreign firms or workers within the country.

Net national product (NNP): is the GNP minus the depreciated values of capital goods.

Depreciated values means the old capital replaced by a new capital in order to maintain the same level of service provided. Thus, no actual goods are produced.

NOMINAL & REAL GDP & GDP/CAPITANominal GDP: is the value in current prices of all final goods and services produced in a country within a given time period

• In case of inflation: overestimate the value of output compared to real output.

• In case of deflation: underestimate the value of output compared to real output.

Real GDP: is the value in constant prices of all final goods and services produced in a country in a given time, measured against prices of predetermined base year. It is more accurate GDP.

GDP/Capita: is the GDP divided by the population.

1. Low income economy: GNI per capita ~$995

2. Lower middle income economy: GNI per capita $966~$3945

3. Upper middle income economy: GNI per capita $3946~12195

4. High income economy: GNI per capita $12196~

PURCHASDING POWER PARITY (PPP)

Purchasing power parity: is the theory that, in the long-run, identical products and services that are sold in different countries should cost the same. The exchange rate is adjusted to make the price of the goods the same.

For instance, in India $10 can buy 20 ice-creams, while in Japan $10 can only buy 10 ice creams.

BUSINESS CYCLERecession: is when economy contracts for two consecutive quarters (6 months)

Trough: is the peak of recession, or the lowest drop of economy until recovery/expansion.

Business cycle: is a term used to describe fluctuations of national income from expansion to contraction to recovery.

The trend line is going up, suggesting that the economy is eventually growing.

PRACTICE QUESTION1. Distinguish between GDP and GNP/GNI as measures of economic activity

Gross domestic product (GDP) is the market value of all goods and services produced within a country in a given time. GDP, according to the expenditure approach, is the sum of consumption, investments, government spending, and net exports.

Gross national product (GNP) is the market value of all goods and services produced in a given time by the labor and capital supplied by the residents of the country. For instance PNG’s (located in Japan) revenue produced by foreign workers would not be included in Japan’s GNP, but the revenue of Japanese workers in Toyota located in China would be included in Japan’s GNP.To put it more simply, GNP disregards the income of foreigners in Japan and includes income of Japanese residents who are living overseas. Simply, it is just the GDP + net property income from abroad. The definition goes similar with the GNI.

PRACTICE QUESTION2. Explain how circular flow of income functions as a system with leakages and injections

Circular flow of income basically means that firms pay households through wages, rent, interests, and profit to people (factors of production). The same household will spend the earned income to purchase goods and services produced by the firms. And thus, there is a cycle. But, in this cycle there are injections, meaning money flows into the system, and leakages which means money is flowing out of the system.

Injections are created when government spends money through subsidies: paying its workers, and etc. Or, firms inject money to the system through investments, such as opening up a new headquarter in New York (Households can also invest by buying houses). Or when there is an export because export means that the country has gained money not from the spending of domestic households but from the spending of foreign households.

Leakages are created when government put taxes (both direct and indirect) . Or households/ firms not spend money but save money. Or when there is an import because it means that households are spending money to not domestic firms but foreign firms, which means money goes out from the country,

PRACTICE QUESTION3. A) Explain the process by which nominal GDP is calculated and distinguish it from real GDP.

There are three ways to calculate GDP: expenditure approach, income approach, and output approach (to see what they are read previous slides).Same approach is used to calculate nominal GDP and real GDP.

Nominal GDP is the value of all goods and services, in current prices, produced in a country in a given time. For instance in 1995 Gameboy’s price was $100 and sold 100 units, but in 2000 the price increased to $500 and also sold 100 units. The amount Gameboy contributed to the nominal GDP of 1995 was $10,000 (100*100) and was $50,000 (500*100) for 2000. As you can see the changed price ($500) was used to calculate the nominal GDP of 2000. Therefore, the nominal GDP does not care about inflation and deflation and simply uses the changed or the new price.

Real GDP is the value in constant prices of all final goods and services produced in a given year, measured against prices of predetermined base year. Continuing with the same Gameboy example, in 1995 Gameboy’s price was $100 and sold 100 units but in 2005 the price increased to $500 and also sold 100 units. Real GDP thinks that the value of Gameboy has actually not changed but the price was only inflated or increased. By definition since utility of the Gameboy has not changed value actually stays the same. Therefore, real GDP sets the base value of Gameboy at $100 because $100 is the price at which Gameboy was first sold at and is the actual price that shows the utility of Gameboy accurately. Thus the amount the Gameboy contributed to real GDP in 1995 is $10,000 (100*100) and amount in 2000 (100*100) is also $10,000.

The difference between Nominal GDP and Real GDP is that nominal GDP use current prices and does not care about change in price, while Real GDP uses a constant price and takes account of the change in price.

PRACTICE QUESTION3. B) To What extend do measures of GDP accurately estimate national well-being

GDP is limited and is inaccurate because it does not show standard of living due to fourbasic reasons.

First, GDP does not take account of population, which means that China has higher GDP than Germany but people are happier in Germany, GDP per capita of Germany is higher, gini coefficient is lower in Germany, and environment is cleaner in Germany. Well-being of people are better in Germany than in China.

Second, GDP does not take account of Purchasing Power Parity (for more information read previous slides). Lets compare Vietnam and Japan. In Japan $20 can only buy you 1 pizza but in Vietnam $20 can buy you 5 pizza. It basically means that value of one dollar is higher than Vietnam than it is in Japan. So, a Vietnamese who is earning $10,000 a year will have much much higher living standards than Japanese who is earning $10.000. Thus, it is difficult to see the living standards just by looking at GDP since value of dollar is so different.

Third, GDP does not tell you about equality within the country. For instance, China has higher GDP than Germany but Germany has much much better equality.

Fourth, volunteer workers are not counted.

PRACTICE QUESTION4. A) Analyse the use of GNP per capita to compare living standards in different countries

Again it is same as the limitations of GDP mentioned in question 3 b). It is more accurate than GDP because population is accounted, but there exists the other 3 remaining weakness of GDP.

But, in reality living standards can be roughly estimated by looking at GNP per capita:1. Low income economy: GNI per capita ~$9952. Lower middle income economy: GNI per capita $966~$39453. Upper middle income economy: GNI per capita $3946~121954. High income economy: GNI per capita $12196~

4. B) Assess the value of two other measures which might be used to compare living standards.

Gini coefficient, which if the coefficient of 1 is perfect inequality and coefficient of 0 is perfect equality, could be used to compare living standards. It is common pattern that country with lower gini coefficient have better living standards. For instance country with green color are generally high good living standards and country with red color have low living standards.

Human development index (HDI) can also compare living standards. Human development index basically measures life expectancy (health), literacy rate (education), and income. For instance, country with darker blue tend to have better living standards than country with light blue.

CHAPTER 12

AGGREGATE DEMAND AGGREGATE SUPPLY

AGGREGATE DEMAND

Aggregate demand: The total amount of goods and services demanded in the economy at a given overall price level and in a given time period.

Components: C+I+G+(X-M)

C+I+G+(X-M)

• C: consumption of all durable and non durable goods and services.

• I: investment, meaning firm’s total spending on capital equipment

• G: Government spending, except for transfer payment (tax revenue redistributed to pensioners and unemployed.)

• X-M: Export-import

DETERMINANTS OF CONSUMPTIONNational income: how much money households make. If national income increases consumption increase and AD shifts right. If national income decreases AD shifts left.

Wealth: is the total value of accumulated assets. For instance: houses and stocks.

If the value of accumulated assests increase (wealth), for instance a house, AD will shift right.

Real interest rates: is the opportunity cost of spending money, and interest is the extra money you have to pay back to the banks when you.

If interest rate go up AD shifts left and if interest rates go down AD shifts right.

Household debts and expectations of future income. In the short-run debts will cause consumption to go up because households temporarily have more money. But, in the long-run debts have to paid and thus consumption decreases.

Consumer confidence: or the animal spirit, is an indicator that measures the level of optimism of consumers.

During stable economic growth, in which unemployment decreases and price is stable, confidence goes up. During economic uncertainty, in which prices are not stable and unemployment is rising, confidence falls.

DETERMINANTS OF INVESTMENTSInterest rate: If interest rate increases, firms have incentive to save money (as saving money has higher returns) because the costs of investment has increased.

If interest rate decreases, firms have incentive to invest money (as spending money has higher returns) because costs of investments (such as capital) has decreased and saving became less attractive since interest rates are lower.

• Inflation: increases investment because firms can sell goods at higher prices

• Deflation: decreases investment because average price of goods have decreased.

• Technology: leads to increased investment as firms invest to adapt to the new and more efficient technology.

• Business taxes: leads to decreased investment because government takes larger share of revenue

• Inventories: If inventories or leftover goods increases investment falls.

• Excess capacity: if there is excess capacity firms are unlikely to invest and if there is no excess capacity, firms are more likely to invest.

Business confidence: or the animal spirit, is an indicator that measures the level of optimism of firms .

Consumer confidence has a direct or proportional effect on business confidence because of the circular flow of income. If there is higher demands firms are willing to invest more.

DETERMINANTS OF GOVERNMENT SPENDING

Fiscal policy: is government spending policy and influences the rate of tax.

DETERMINANTS OF NET EXPORTSIncome abroad: determines the amount of export and import. For instance, if Japan is importing cars to China and China’s national income has increased, then the demand for Japanese cars will also likely increase and exports of Japanese cars will increase for Japan and imports of Japanese cars will increase for China.

Exchange rates: is the currency expressed in units of another currency. Strong currency means that the exchange rates are high and thus prices are high.

Consumer taste and preference: For instance people like German cars more than Indian cars, and therefore, the imports and exports of German cars are much higher than that of Indian cars.

Protectionism: are just barriers to entry countries make to protect itself from too much imports through tariffs, quotas, and etc.

SHIFT IF AD

IF ANY OF THE C+I+G+(X-M) CHANGE DUE TO THE DETERMINATS OF C+I+G+(X-M), AD WILL

SHIFT

AGGREGATE SUPPLYAggregate supply: The total supply of goods and services produced within an economy at a given overall price level in a given time period.

There are basically two types of AS: Keynesian model and Neo-classical model.

Full employment: is achieved when people who are wanting to work gets a job. Therefore, it is possible to achieve a point beyond full employment. It just means that people who don’t want to work gets a job

KEYNESIAN MODEL: ASKeynesian model is the short-run AS curve. They believe that wages are sticky (due to contracts, labor unions, government laws, etc): meaning inflexible, and therefore, firms cannot change wages in the short-run but only fire people.

Keynesian model is the short-run AS curve. They believe that wages are sticky (due to contracts, labor unions, government laws, etc): meaning inflexible, and therefore, firms cannot change wages in the short-run but only fire people.

The line is vertical or supply is almost perfectly inelastic because there is a limit to labor and other factors of production. This can be demonstrated by the PPC curve, as there is a limit on the line.

The point is beyond full employment, meaning that people who are not wanting to work has to now work.

The line is horizontal or almost perfectly elastic because wages are fixed and thus price cannot change too much. Therefore, firms react to the decreased AD by firing workers. Thus, since price cannot change output (workers) changes by a greater amount.

SHIFT IN AS Shift to the left or decrease in AS

• Increase in resource costs

• Increase in trade union power

• Increase in minimum wage

• Higher business taxes

• Weaker currency (makes imported raw materials more expensive)

Shift to the right or increase in AS

• Decrease in resource costs

• Improvements in the productivity of land or capital

• Technological advancement

• Reduction in minimum wage

• Government subsidies

• Reduction in trade union power

• Increase in population

• Better infrastructure

• Stronger currency (as imported resources become cheaper)

• Better educated or skilled workforce.

PRACTICE QUESTION1. A) Use an AD/AS diagram to analyse the likely effects of an increase in interest rates.

Interest rate is a determinant of both consumption and investment for AD. In both consumption and investment, if interest rates increases there will be more savings than spending because saving has greater returns than spending. This is because if someone spends money, he will have to pay increased interest rates, while if he saves money he will gain more money from the increased interest rate from the bank. Thus, AD will shift left,

As a result, there will no longer be full employment in the short-run. But, in the long-run the workers will be willing to take lower wages due to fear of un-employment and there will be full employment once-again. Since wages have decreased, the AS will eventually shift right.

Looking at the diagram, the AD has shifted left, causing the short-term employment to be moved to E1 and price falling to P2. But, AS has shifted right, which results in achieving full employment again. But, the average price has decreased to P3.

PRACTICE QUESTION1. B) To what extent is the interest rate in an economy the primary factor business consider when

making investment decisions?As previously stated, interest rate is a factor of investment. This is because firms aim for profit maximization. With this in mind, lets compare three different interest rates and use a cost of production graph.

In scenario 1. the interest rate is only 10% and thus the fixed cost has only increased by 10% to the original price of 6 dollar . The orange dotted line is the representation of scenario 1. It shows that price is now $6.60.

In scenario 2, the interest rate is 25% and thus the fixed cost has added 25% to the original price of $6. Blue dotted line is the representation of scenario 2. It shows that price is now $7.50.

In scenario 3, the interest rate is 50% and thus fixed cost has added 50% to the original price of $6. Red dotted line is the representation of scenario 3. It shows that price is now $9.00.

As you can see with this example, as interest rate goes up fixed cost increases, meaning that since profit= total revenue- total cost, profit is also decreasing. Therefore, interest is a large factor of investment. But, there are also other determinants of investment such as business confidence, future prices, business tax, etc, but interest rate is one of the larger determinants of investment.

PRACTICE QUESTION2. A) Use an AD/AS diagram to analyze the likely effects of an increase in income tax

Income tax is a determinant of consumption, and an increase in income tax will decrease household consumption through decreasing disposable income. Thus AD shifts left. As AD shifts left, there is no longer a full employment. Due to fear of unemployment workers accept lower wages and AS shifts to the right.

This can be explained by using a diagram. AD shifts to AD2 and FE temporarily moves to E1. But as SRAS moves to SRAS2 due to decreased wage, E1 shifts back to FE. But, the average prices has changed from P1 to P2 and finally to P3.

PRACTICE QUESTION2. B) Compare and contrast the levels of household consumption relative to total aggregate

demand in countries with relatively high income taxes to those with relatively low income taxes.We can compare Mexico and Denmark. In Mexico the income tax rate is about 30% while in Denmark, the income tax rate is about 50%. In Mexico consumption is extremely high while government spending is low while in Denmark the consumption is low and government spending is high. Similar pattern can be seen throughout. The pattern is that as income tax rises, the government spending makes higher portion of AD and as income tax falls the consumption makes higher portion of AD.

PRACTICE QUESTION3. A) Using AD/AS diagrams, analyse the likely impact on an economy of the following: general

rise in wage costs, discovery of new raw material sources, and capital stock increases.

If wage cost rises consumption will increase because there is more disposable income and households expectation of future becomes better. Thus AD shifts right. But, AS will shift left since wages have increased. Thus there will once again be full employment, but the average price would have increased. DIAGRAM=LEFT

If there is a discovery of new raw material sources, assuming that the new resource is cheaper or is superior in quality, the AS will shift right because resources have become cheaper and things became more efficient or productive. But, at the same time creative destruction will occur. For instance discovery of alternative resource to coal will kill coal industry. Therefore, the AS will not shift as much as it would have shifted. In the short-run there will be a employment beyond full employment, but in the long run, due to creative destruction and etc the employment will fall back to or behind full employment. The AD will also shift right in the short-run as there is employment beyond full employment, but in the long-run as employment settle back to full employment, AD will shift back. DIAGRAM=Middle

If there is a capital stock increase similar event will happen with that of 2008 house asset bubble. People’s wealth will increase while their disposable income actually stays the same. Thus, in the short-run the AD will shift right because people will consume and borrow money. But in the long-run ,due to debts, consumption will rapidly drop as households have to pay debts and this will result in a recession. There will be unemployment and animal spirit will die out. Thus AD shifts back to the left. In the short-run the AS will shift left because the currency has become stronger (making resources expensive) because people have spent more money and the economy of the country is doing better. But in the long-run currency will become weaker again because people are in debt and economy is not doing so well. This will cause AS to shift right again. Thus, in the end there will not be too much changes. DIAGRAM=RIGHT

PRACTICE QUESTION3. B) Examine the likely effect of one of the events above on a nation’s economy in the short run

and the long run

Already kind of did in the previous answer…

PRACTICE QUESTION4. A) identify the components of aggregate demand and briefly explain two factors which might

determine each of those components.

Aggregate demand is the total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is composed of C+I+G+(X-M)Consumption (C): is the total goods and services a household consumes• Wealth, which is the value of accumulated assets. Example can the increase in house value of 2008, which caused

consumption to increase. • Real interest rates. As interest rates increase consumption decrease because saving has higher returns than spending. As

interest rate decreases consumption increases because spending has higher returns than saving.Investment (I): is the investments by firms on capital goods and investment by households on houses and etc.• Interest rate. Interest rate has same affect on investment and it does on consumption.• Business confidence: as household confidence goes up businesses confidence goes up because it means that consumer

demand has increased.Government spending: are injections by government through subsidies, quotas, and etc.• Fiscal policy, which is the government spending policy. Change in spending policy will also change tax rates.Net export: is the export minus import and measures amount of injections into the economy. • Currency: as currency becomes stronger the export decreases because the price of the good has increased. This is what is

happening to Japan.• Income abroad: as income abroad increases disposable income also increases. Thus, theoretically consumer has more

purchasing power and thus there is a higher demand/ export.

OTHER QUESTIONS

MONDAY QUIZ

PRACTICE QUESTION1. Explain using diagrams the difference between progressive, regressive and proportional

taxation.All those taxes are direct taxes or income taxes.

Progressive tax is a taxation system in which as income increases tax increases. It is similar to an ad-vorlem tax. The blue line represents progressive tax.

Regressive tax is a taxation system in which as income decreases tax increases. The black line represents regressive tax.

Proportional tax is a taxation system in which poor and the rich and everyone pay the same amount of percent tax. The redline represents proportional tax.

PRACTICE QUESTION2. Explain the advantages and disadvantages of the minimum wage and its effects on employment

rates. Use diagrams.

Minimum wage is essentially a price floor, meaning that a wage below a certain point is illegal. Thus, equilibrium point cannot be achieved and there is a surplus. Surplus in this case is the unemployment rates, which is a disadvantage. Also, as with any price floor there might be black markets formed and other means of rationing might be used. But, a advantage of minimum wage is that it helps bring life standards up for those who have a job. But those are theoretical. In reality, if you look at Germany which is a country without minimum wage, the unemployment rate is 7.4% which is similar to many OECD countries and worse than Japan, which has a strict minimum wage system. Thus, in reality there is not much relationship between minimum wage and employment rates.

PRACTICE QUESTION3. Explain using diagrams how government intervention to correct market failure may make

things worse. Use at least one example for your answer.Market failure occurs when there is no allocative efficiency, meaning MC does not equal MB. Government tries to correct those market failures by creating regulations and by creating price floors and ceiling. But, often times does attempts backfire and make things worse.

An example can be Manhattan rent price ceiling. This was created by politicians to protect students, policeman, or people who wants to live in Manhattan but cannot afford to. The results were horrible. Even before the rent price floor too many people wished to live in Manhattan, and due to high demand relative to low supply, prices were high. But even at that high price demand were still rising. But the government have decided to intervene and created a price ceiling which increased the already existing shortage into much much much larger shortage. People could not find houses in Manhattan. As a result black markets are formed and other means of rationing were introduced. In conclusion, in this case of price ceiling worse shortages were created and people who could afford high prices could not find houses.