MACROECONOMICSEC 620

Lecture 1

6 November 2010

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Lecture Outline

What is macroeconomics? Why do we study macroeconomics? Macroeconomics variables The national income accounting

The output measure of GDP The expenditure measure of GDP The income measure of GDP

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What is Macroeconomics?

What is macroeconomics? The study of the economy as a whole and the interactions of

various variables. Variables include: aggregate (total) output, employment, the

rate of unemployment, inflation, interest rates, exchange rates and economic growth.

Macroeconomics is policy oriented. e.g. effects of certain govt policies, whether govt/central

bank should intervene in the foreign exchange market.

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Macroeconomic Variables

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A flow variable measures a value per unit of time, e.g. GDP of a country per year or per quarter.

A stock is a value at a point in time, e.g. value of a car or a house, value of equipments.

Personal income and disposable personal income Personal income – income received by persons from all

sources. Disposable personal income – personal income LESS tax

payments.

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Frequently Used Terms

Output, Income and Expenditure Output (product) – the value of the output of the economy. Income – the sum of the incomes of all factors of

production (labour, capital and land) employed in the economy.

Expenditure – the sum of all expenditures in the economy on final goods and services.

Domestic and National Domestic economy – all economic activities taking in

Thailand. National economy – all activities of the residents of

Thailand regardless of where the activities take place.

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Frequently Used Terms (cont)

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Gross and Net Gross – measured before deducting depreciation of assets used in

production process. Net – measured after deducting depreciation of assets used in

production process. Market Price and Factor Cost

Market Price – prices paid by the purchasers (include the effects of indirect taxes and subsidies)

Factor Cost – effects of indirect taxes and subsidies are removed (subtracting indirect taxes and adding subsidies)

Real and Nominal

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Gross Domestic Product

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Gross Domestic Product (GDP) – measure of total output on an economy during a particular period.

GDP can be measured as:

qit is the amount of the final good i produced in the economy during period t.

pit is the price of good i in period t. The sum is known as nominal aggregate output.

In the next period, t+1, the value of GDP will be

Ni

iitit pq

1

.

Ni

iitit pq

111.

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GDP (cont)

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Real GDP in period t:

Real GDP in period t+1:

Changes in real GDP can only occur because of changes in the quantities of goods and services.

Ni

iiit pq

12000.

Ni

iiit pq

120001.

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Inflation and Prices

Inflation, π, is the rate of change of prices:

where Pt is today’s price and Pt-1 is last period’s price If π > 0, prices are increasing over time inflation If π < 0, prices are decreasing over time deflation How do we measure prices?

There are several price indices, but most common are CPI, PPI, and the GDP deflator.

1

1

t

tt

P

PP

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The General level of Prices

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GDP deflator:

The ‘base year’ in this case is the year 2000. GDP deflator is based on a calculation involving all goods produced

in the economy, it is frequently used to measure inflation Measures the change in prices between the base year and the

current year If nominal GDP in 2009 is £6.25 and real GDP in 2009 is £3.50, then

the GDP deflator for 2009 is £ 6.25/ £3.50 = 1.79 prices have increased by 79% since the base year

Ni

iiit

Ni

iitit

pq

pq

12000

1

.

.

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Consumer Price Index (CPI)

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Consumer Price Index (CPI) – measures the retail prices of a ‘basket’ of goods and services purchased by households. Measure of the cost of living for the average household

CPI differs from GDP deflator in three ways:1. CPI measures prices of a more limited basket of goods and

services (only household goods and services).2. The bundle of goods in the consumer basket is fixed, while

that of the deflation is allowed to vary.3. CPI includes prices of imports, while GDP deflator only

considers those goods produced within the domestic country.

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Producer Price Index (PPI)

PPI measures the cost of buying a fixed basket of goods and services representative of a firm. Captures the cost of production for a typical firm. Market basket includes raw materials and semi-finished

goods. PPI is constructed from prices at an earlier stage of the

distribution process than the CPI. PPI signals changes to come in the CPI and is thus closely

watched by policymakers. Over long periods of time, the two measures yield similar

values and trends for inflation.

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Problem with price indices – how to deal with goods that did not exist in previous years or whose quality has improved.

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Components of Expenditure on GDP

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There are five categories of expenditure: Consumption expenditure – total amount which private

consumers spend on consumption goods and services. Investment expenditure – total amount which private sector

spends on investment goods. Government expenditure – total amount which government

spends on goods and services. Exports – total amount which the rest of the world spends on

goods and services produced domestically. Imports – total amount which is spent on goods and services

produced abroad.

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National Income Accounting

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Three measures: the output measure, the expenditure measure and the income measure.

Suppose firm A produces 1,000 units of steel, priced at £1 per unit, i.e. £1,000 worth of steel.

Firm A keeps 250 units of steel and sell 750 units to firm B. Firm B then converts it into 12,000 nails worth 10p each, i.e.

£1,200 worth of nails. Output measure: total value added OR value of the final

goods and services. Value added by firm A is £1,000, and £450 (1,200-750) by firm B. So the total value added is £1,450.

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National Income Accounting (cont)

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Alternatively, the sum of total output can be calculated as the value of final goods and services produced.

Final output from firm B is £1,200 and the value of steel (which was not used to produce anything) is £250.

So the total value of final goods produced is 1,200+250 = £1,450.

The other £750 worth of steel is known as an intermediate good.

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National Income Accounting (cont)

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The expenditure measure: Any final goods must be bought by someone. From our example, firm A stored £250 of its output. Firm A bought £250 of its output classified as investment

expenditure (stock building). If firm B sells all of its nails to consumers and/or government,

the sum of expenditures would be £1,200. Thus the total expenditure is 250+1,200=1,450.

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National Income Accounting (cont)

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The income measure: In principle, for every act of expenditure, there must be a

recipient. Assume that firm A pays wages of £600, and firm B pays £

300. So income from employment is £900. Profit of firm B: 1,200-750-300 = £150 Profit of firm A: 1,000-600 = £400 So the total income is £900+ £150 + £400 = £1,450

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Putting all three together

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Output-based

Expenditure- based

Income- based

Value added:

C 600 Income type:

Firm A 1000 I 250 Employment

900

Firm B 450 G 600 Profits 550

Total 1450 1450 1450

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Problems with GDP

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GDP is a welfare measure? Production where no money changes hands do not

appear in GDP e.g. unpaid household work and child care.

Unpaid charity work and activity are excluded. Underground economy is left out – e.g. gambling,

drug trades and other unreported activities to avoid taxes.

When comparing GDP of different countries, it requires exchange rate. But exchange rates fluctuate.

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Macro Variables

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Unemployment – the fraction of workforce that is out of work and looking for a job. Important indicator of well-being of an economy as being without a

job suggests a reduction in income. Interest rate = rate of payment on a loan or other investment over

and above the principle repayment in terms of an annual percentage Cost of borrowing money OR benefit of lending money

Nominal interest rate – interest rate in terms of a currency. Real interest rate – interest rate in terms of a basket of goods (i.e.

interest rate adjusted for inflation). If R is the nominal rate, and r is the real rate, then we can define

the nominal rate as: r = R-π

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Exchange Rate

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Exchange rate is the price of one currency in terms of another currency.

It can be quoted as a number of foreign currency per one unit of domestic currency. For example, 1 baht = 0.283 HKD, 1 baht= 25 won

Or it can be quoted as number of domestic currency per one unit of foreign currency. For example, 1HKD= 4.03 baht, $1=32.11 baht, 1 GBP= 46.62 baht.

Exchange rates allow us to denominate the cost or price of a good or service in a common currency.

A bottle of Evian costs 45p in England 0.45x46.62 = 21 baht A movie ticket costs £5.75 5.75x46.62 = 268 baht.

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Depreciation

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Depreciation is a decrease in the value of a currency relative to another currency.

A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.

For instance, 1USD= 39.48 baht 1USD= 32.11 baht. The USD has depreciated against the baht, it is less valuable. The Baht has appreciated relative to the USD, it is now more

valuable.

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Appreciation

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Appreciation is an increase in the value of a currency relative to another currency.

An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.

For example, 1USD= £1.5 1USD= £1.8 The USD has appreciated against the £ and is now more

valuable. The £ has depreciated against the USD and is less valuable.

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A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency.

A depreciated currency means that imports are more expensive and exports are less expensive.

An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency.

An appreciated currency means that imports are less expensive and exports are more expensive.

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Floating exchange rate - price of a currency is determined by supply and demand.

Fixed exchange rate - price of a currency is fixed.