Lecture 3: Basics of Macroeconomics

Dr. Rajeev DhawanDr. Rajeev DhawanDirectorDirector

Given to theGiven to theEMBA 8400 ClassEMBA 8400 Class

January 18, 2008January 18, 2008

Basics of Macroeconomics

Chapter 23

The Economy’s Income & Expenditure

For an economy as a whole, income must equal expenditure because:– Every transaction has a buyer and a seller.– Every dollar of spending by some buyer is a dollar of

income for some seller.

Gross domestic product (GDP)Gross domestic product (GDP) is a measure of the income and expenditures of an economy.

It is the total market value of all final goods and services produced within a country in a given period of time.

Definition of GDP

GDP is the market value of all final goods and services produced within a country in a given period of time.

Definition of GDP “GDP is the Market Value . . .”

– Output is valued at market prices.

“. . . Of All Final . . .”– It records only the value of final goods, not intermediate

goods (the value is counted only once).

“. . . Goods and Services . . . “– It includes both tangible goods (food, clothing, cars) and

intangible services (haircuts, housecleaning, doctor visits).

Definition of GDP “. . . Produced . . .”

– It includes goods and services currently produced, not transactions involving goods produced in the past.

“ . . . Within a Country . . .”– It measures the value of production within the

geographic confines of a country.–

“. . . In a Given Period of Time.”– It measures the value of production that takes place

within a specific interval of time, usually a year or a quarter (three months).

Definition of GDP

What Is Not Counted in GDP?– GDP excludes most items that are produced and

consumed at home and that never enter the marketplace.

– It excludes items produced and sold illicitly, such as illegal drugs.

Simple GDP Example

This simple economy has 2 people: Baker and Miller.Baker buys flour for $350. He also uses a worker and pays

$200 in wages. He also pays a rent of $25. He makes a profit as $25 on the bread he sells for $600.

The miller pays his worker $300, a rent of $25, and his profit is $25 on a sale of $350.

The GDP of this economy is $600!Why? 2 sides of a coin, Income=ExpendituresExpenditures=Value of final Goods sold=600Income=wages+Rent+profits=300+200+25+25+25+25=600

NIPA Definition of GDP

Y=C+I+G+NXY=C+I+G+NXY = GDPC = Consumption I = InvestmentG = Government PurchasesNX = Net Exports = Exports-Imports

GDP and Its Components

GDP Components (2005)

Consumption 70%

Government Purchases

19% Net Exports -6 %

Investment17%

20062001199619911986198119761971

14000

12000

10000

8000

6000

4000

2000

0

(Bil. $)GDP and Consumption

Consumption GDP

NIPA Definition of GDP Consumption (C):Consumption (C):

– The spending by households on goods and services, with the exception of purchases of new housing.

Investment (I):Investment (I):– The spending on capital equipment, inventories, and

structures, including new housing. Government PurchasesGovernment Purchases (G) (G)::

– The spending on goods and services by local, state, and federal governments.

– Does not include transfer payments because they are not made in exchange for currently produced goods or services.

Net Exports (NX):Net Exports (NX):– Exports minus imports.

Real vs. Nominal GDP

Nominal GDP values the production of goods and services at current prices.

Real GDP values the production of goods and services at constant prices. R eal G D P

N o m in a l G D P

G D P d efla to r2 0 X X2 0 X X

2 0 X X

1 0 0

•GDP Deflator deflates for Inflation!•Inflation is rate of change of prices.

2006200119961991198619811976197119661961

72

70

68

66

64

62

60

(%)Consumption Pattern

2006200119961991198619811976197119661961

14

13

12

11

10

9

8

(%)Investment Pattern

2006200119961991198619811976197119661961

12

10

8

6

4

(%)Exports Share

2006200119961991198619811976197119661961

18

16

14

12

10

8

6

4

2

(%)Imports Share

2006200119961991198619811976197119661961

2

0

-2

-4

-6

-8

(%)Net Exports

2006200119961991198619811976197119661961

24

23

22

21

20

19

18

17

(%)Government Share

2006200119961991198619811976197119661961

2

0

-2

-4

-6

(%)Federal Budget Deficit

Recessions

A recession is a significant decline in activity lasting more than a few months and is visible in industrial production, employment, real income and wholesale-retail sales (NBER definition). NBER uses monthly data.

Rule of thumb is 2 consecutive quarters of negative Real GDP growth or GDP decline.

BUSINESS CYCLE REFERENCE DATES

DURATION IN MONTHS

Peak Trough Contraction Expansion Cycle

Quarterly datesare in parentheses

Peak to

Trough

Previous trough

to this peak

Trough from

Previous

Trough

Peak from Previous

Peak

May 1937(II)February 1945(I)November 1948(IV)July 1953(II)August 1957(III)

April 1960(II)December 1969(IV)November 1973(IV)January 1980(I)July 1981(III)

July 1990(III)

June 1938 (II)October 1945 (IV)October 1949 (IV)May 1954 (II)April 1958 (II)

February 1961 (I)November 1970 (IV)March 1975 (I)July 1980 (III)November 1982 (IV)

March 1991(I)

138

11108

1011166

16

8

5080374539

24106365812

92

6388485547

34117526428

100

9393455649

32116477418

108

March 2001 (I) November 2001 (IV) 8 120 128 128

NBER Report Cycle Dates 2003

Article: Business CyclesArticle: Business Cycles

200620021998199419901986198219781974197019661962

12000

10000

8000

6000

4000

2000

(Bil. 2000$)Real GDP and Business Cycles

2006200420022000199819961994199219901988

12000

11000

10000

9000

8000

7000

6000

(Bil. 2000$)Real GDP and Business Cycles

Forecast of the Nation, 2003

Mar 01’ ~ Nov 01’ 9 -0.1% -4.0% 4.2 5.6

2007200620052004200320022001200019991998

115

110

105

100

95

90

138

136

134

132

130

128

126

124

(Index: 1997=100) (Mil.)Industrial Production and Employment

Industrial Production Total Payroll Employment (Right)

DECAUGAPRDECAUGAPRDECAUGAPRDECAUGAPRDECAUGAPRDECAUGAPR200620052004200320022001

340

320

300

280

260

240

(Bil.)Retail Sales

2001 Recession vs. HistoryFor Details Refer:

http://www.nber.org/

FRBSF Economic Letter, June 2003

Real GDP and Consumption

FRBSF Economic Letter, June 2003

Investment and Stock Market

Article:Article: NBER’s FAQsQ: The financial press often states the definition of a recession as

two consecutive quarters of decline in real GDP. How does that relate to the NBER's recession dating procedure?– Most of the recessions identified by our procedures consist of two

or more quarters of declining real GDP, but not all of them– We consider the depth as well as the duration of the decline in

economic activity.– Second, we use a broader array of indicators than just real GDP– Third, we use monthly indicators to arrive at a monthly chronology

Q: Could you give an example illustrating this point?– The two-quarter-decline rule of thumb would not have allowed the

declaration of the recession until August 2002

Q: How does the NBER balance the differing behavior of employment and output?– There is no fixed rule for how the different indicators are weighted

Q. You emphasize the payroll survey as a source for data on economy-wide employment. What about the household survey?– Although the household survey is a large, well-designed

probability sample of the U.S. population, its estimates of total employment appear to be noisier than those from the payroll survey

Q. How do the movements of unemployment claims inform the Bureau's thinking?– A bulge in jobless claims would appear to forecast declining

employment, but we do not use forecasts and the claims numbers have a lot of noise

Q: What about the unemployment rate?– Unemployment is generally a lagging indicator. Its rise from a very

low level to date is consistent with the employment data

Article:Article: NBER’s FAQs

The November 2001 trough was announced July 17, 2003.The March 2001 peak was announced November 26, 2001.

The March 1991 trough was announced December 22, 1992.The July 1990 peak was announced April 25, 1991.

The November 1982 trough was announced July 8, 1983.The July 1981 peak was announced January 6, 1982.

The July 1980 trough was announced July 8, 1981.The January 1980 peak was announced June 3, 1980.

Peak & Trough Announcements

Chapter 24

Measuring the Cost of Living

Consumer Price Index & 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.

The Consumer Price Index (CPI) is a measure of the overall cost of goods and services bought by a typical consumer (produced by BLS).

Inflation rate is change in CPI.

Steps to Calculate CPI Index Fix the Basket: Determine what prices are most important

to the typical consumer. – The Bureau of Labor Statistics (BLS) identifies a market basket of

goods and services the typical consumer buys.

– The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

Compute the Basket's Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

Choose a Base Year and Compute the Index:

Steps to Calculate CPI Index

Choose a Base Year and Compute the Choose a Base Year and Compute the Index:Index: – Designate one year as the base year, making it

the benchmark against which other years are compared.

– Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

How the Inflation Rate Is Calculated

The Inflation Rate– The inflation rate is calculated as follows:

In fla tio n R ate in Y ear 2 =C P I in Y ea r 2 - C P I in Y ea r 1

C P I in Y ea r 1 1 0 0

A Simple Example of CPI and Inflation Calculations

Calculating the Consumer Price Index and the Inflation Rate:

– Base Year is 2002.

– Basket of goods in 2002 costs $1,200.

– The same basket in 2003 costs $1,236.

– CPI = ($1,236/$1,200) 100 = 103.

– Prices increased 3 percent between 2002 and 2003.

FYI: What Is in the CPI’s Basket?

17%Transportation

15%Food and beverages

Medical care

6%

Recreation

6%

Apparel

4%

Other goodsand services

4%

42%Housing

6%Education and communication

Calculating the Consumer Price Index and the Inflation Rate: An Example

Calculating the Consumer Price Index and the Inflation Rate: An Example

The GDP Deflator vs. CPI

The BLS calculates other prices indexes:

– The index for different regions within the country.

– The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

CPI and GDP Deflator

1965

Percentper Year

15

CPI

GDP deflator

10

5

01970 1975 1980 1985 1990 20001995

2006200219981994199019861982

10

8

6

4

2

0

-2

-4

(%)

Japan - GDP Growth and Deflator(smoothed)

Real GDP Growth Nominal GDP Growth GDP Deflator

20062004200220001998199619941992

10

8

6

4

2

0

-2

(%)

Germany - GDP Growth and Deflator(smoothed)

Real GDP Growth Nominal GDP Growth GDP Deflator

Problems in Measuring CPI

Substitution bias Introduction of new goods Unmeasured quality changes

Use of Price Indexes Price indexes are used to correct for the effects of inflation

when comparing dollar figures from different times. Do the following to convert (inflate) Babe Ruth’s wages in

1931 to dollars in 2005:

Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2005:

Salary SalaryPrice level in 2005Price level in 19312005 1931

$80,.

$

000195152

1,026,316

The Most Popular Movies of All Times, Inflation Adjusted

Real and Nominal Interest Rates

The nominal interest rate is the interest rate usually reported and not corrected for inflation. – This is the interest rate that a bank pays.

The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

Real and Nominal Interest Rates

You borrow $1,000 for one year.

Nominal interest rate is 15%.

During the year inflation is 10%.Real interest rate = Nominal interest rate – Inflation

= 15% - 10% = 5%

Real and Nominal Interest Rates

1965

Interest Rates(percentper year)

15%

Real interest rate

10

5

0

-51970 1975 1980 1985 1990 1995 2000 2005

Nominal interest rate

Bill claims that CPI inaccurately calculates Americans’ cost of living.

Example: Say you buy 1 bag of gumdrops for $1 which has 100 of those. Productivity makes it 110 gumdrops but for $1.10. Hedonic pricing says that CPI hasn’t gone up as per-capita cost is the same (1 cent). But you have to shelve out $1.10 to get the bag, which is an increase in cost of 10%. They must fork out an extra dime even though they’re getting more for their money.

We can’t buy individual pieces of memory in a computer-we have to buy the entire package!

Article: Con Job Redux (PIMCO)Article: Con Job Redux (PIMCO)

by: Bill Grossby: Bill Gross