Macroeconomic IndicatorsWhat They Are & How to Use Them

Chapter 21, 22, 25, 26

Outline

• Introduction

• GDP

• Comparing GDP Across Time

• Comparing GDP Across Countries

Monetary policy affects financial markets.

Hang Seng slide continues Hong Kong's stocks dropped for a fourth timein five days after a US central banker said the

Federal Reserve may need to raise interest rates further. 8/24/06

Fed rate hopes lift regionAsian markets rose Wednesday in anticipation that the latest US economic data would persuade the Federal Reserve to keep US interest rates on hold. 8/17/2006

US rate pause

buoys AsiaMost Asian bourses gained ground Wednesday in reaction to the US Federal Reserve's decision to keep interest rates unchanged. 8/10/2006

Euro rate rise puts heat on the Fed… after the central banks of the euro region and the United Kingdom raised interest rates to restrain inflation after economic growth accelerated. Stocks and bonds fell as investors bet borrowing costs are headed higher. 8/4/2006

Other Connections

• Macroeconomists study government fiscal policy. Government major borrower (or saver) in financial markets.

• Values of financial assets a major determinants of decisions of consumers.

• Financial theory emphasizes diversified portfolios whose performance depends on aggregate performance of the economy.

Gross Domestic Product

Quantity Aggregates• To understand the macroeconomy, we need to measure it.

Chief measure of economy is the level of production: GDP

• We need to combine the many goods produced or consumed in an economy into one measure.

++

++

=?

Gross Domestic Product (GDP)

• GDP is the sum of the value of new, final goods produced within the domestic borders of an economy.

All goods sold in an economy share a common unit of measure: the price at which they are sold.

Final goods are goods sold to their end-users

Sum up the value of goods

GDP does not include:

• Intermediate goods which are sold from one firm to another for immediate transformation into other goods.

• financial transactions like buying stocks.

• purchases of used goods which have been sold before.

• goods produced overseas by domestic firms.

Three Methods for Calculating GDP

1. Expenditure Method - The sum of the domestic spending on final goods (less domestic demand satisfied by imports).

2. Production Method - The value added created in all the sectors of the economy.

3. Income Method – The Wage, Rent, Interest and Profit Income generated by the domestic economy.

Expenditure MethodC

+Consumption Consumer durables, non-

durables, services

I

+Investment Structures (incl. Residential),

Equipment, and Inventory

G

+Government Consumption

Government Spending on Goods, Services, and Salaries.

X

-EXports Goods & Services Shipped

Abroad

IM IMports Goods & Services from Abroad

= GDP A + NX = (C + I + G) + (X – IM)

Production Method

• At the plant level, Value added = Sales + Change in inventories

- materials, intermediate inputs and energy costs.

• Value added at the firm level is directly taxed in the EU (VAT)

• GDP is the sum of VA across establishments.

• The value of a final good is equal to the value added at each stage of production.

Ag

ricu

lture

Min

ing

Ma

nu

fact

uri

ng

Util

itie

s

Co

nst

ruct

ion

Tra

de

Tra

nsp

ort

FIR

E

Se

rvic

es

La

nd

lord

19802006 #

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

Hong Kong: Value Added by Sector

Hong Kong Census and Statistics

Some Asian Expenditure Shares: 2008

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

Household Government Investment Exports Imports

PRC Japan Korea

Source: United Nations Main Aggregates Database

Earnings or Income Approach to Measuring GDP

• Measuring overall economic activity by adding the earnings or income generated by selling the output produced in the economy. (Not calculated for HK on an annual basis.)

GDP = compensation of employees + proprietor’s income + rental income +

corporate profits + net interestCopyright © 2010 Pearson Education, Inc.

Publishing as Prentice Hall 16

National Income• Compensation of employees: the wages and salaries and

the fringe benefits paid by employers to employees.• Proprietors’ income: the income of unincorporated

businesses, such as medical practices, law firms, small farms, and retail stores.

• Rental income : the income households receive from the rental of their property.

• Corporate profits: the excess of revenues over costs for the incorporated business sector of the economy.

• Net interest: the interest private businesses pay to households for lending money to the firms minus the interest businesses receive plus interest earned from foreigners.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

17

GNP vs. GDP

• Net Factor Income [NFI] is income earned on overseas work or investments minus income generated domestically but paid to foreigners.

GNP GDP

Gross National Product Gross Domestic Product

= income earned by domestic residents

= income created within national borders.

GNP = GDP +NFI

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

%

1993 1995 1997 1999 2001 2003 2005 2007#

Hong Kong NFI/GDP

Hong Kong Census and Statistics

Table 1.7.5. Relation of Gross Domestic Product, Gross National Product, Net National Product,

National Income, and Personal Income 

[Billions of dollars]

http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=Y

Compare Macau and the Philippines GDP or GNP

• Macau produces a lot of profits paid to overseas owners of casinos.

• Philippines workers earn a lot of income overseas.

• Which is larger Philippines’ GDP or Philippines GNP?

• Does Macau have greater GDP or GNP?

Income=Expenditure=Value Added

• Value of final good expenditure is equal to value added at each stage of production. (Expenditure = Value Added)

• Value Added would be paid to workers, creditors, or kept as profits. (Income = Value Added)

Comparing GDP levels across time

• GDP measures the value of the goods produced by an economy by using the market price of each good to assign it a value.

• Problem: Prices of goods in terms of money are changing overtime making comparisons in overall value difficult. – Bias: Money prices are growing over time as money supply

grows.

• Solution: Choose a Base Year’s prices as a fixed yardstick of value for different goods.

Real GDP: Yt

• GDP aka Nominal GDP aka Current Dollar GDP is the weighted sum of the number of goods produced using their current prices as the weight.

• Real GDP aka Constant Dollar GDP aka GDP adjusted for inflation is the weighted sum of the number of goods produces using the Base Year prices as yardsticks.

Solved ProblemReal GDP: 2005 (2004 Base Year)

2005 2004

P Q P Q

Kitkat 8 150 6 135

M&Ms 10 150 4 135

Nominal GDP

Real GDP

USA

0.0

2000.0

4000.0

6000.0

8000.0

10000.0

12000.0

14000.0

16000.0

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Bill

ion

US

$

Nominal GDP Real GDP

Real GDP vs. Nominal GDPSt. Louis Federal Reserve

Inflation

Price Indices: Pt

• Two most commonly used price indices are GDP Deflator and Consumer Price Index (CPI)

• The GDP deflator is the ratio of nominal GDP to Real GDP (multiplied by 100).

100

100

Nominal GDPP GDP Deflator

Real GDP

GDPP

Y

Consumer Price Index

• The CPI is the price of a representative market basket of goods relative to the price of that same basket during a benchmark/base year (multiplied by 100).

100t

Cost of Market Basket in year tCPI

Cost of Market Basket in Base year

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

CPI

GDP Deflator

Hong Kong’s History of Prices

Q: What is Inflation?A: The Growth Rate of Price Level

1

1

100%t tt

t

P PInflation Rate x

P

•What is the CPI inflation rate in Candyland in 2005 using 2004 as the base year?

• Inflation: prices are growing• Disinflation: inflation is slowing down but still positive• Deflation: inflation is negative and prices are actually

dropping.

Hong Kong CPI

-6

-4

-2

0

2

4

6

8

10

12

14

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

%

http://www.imfstatistics.org/imf/

Inflation

Disinflation

Deflation

Adjusting for Inflation

• We can use price indices to “adjust for inflation” - converting values measured in money into values measured in the prices of some reference year, r.

• Measured in $, observed at time t: Nt

• Price level at time t: Pt

• Price level in reference year Pr

• Measure adjusted for inflation –

$r rt t

t

PN N

P

r$tN

Housing Price: Hong Kong Island

• Compare the price of housing in HK average price of an apartment on HK Island with an area between 100m2 and 160m2 – in September 2009 : HK$173,762 /m2

– in December 1982: HK$14,742/m2

• How much did an apartment cost back then when expressed in today’s dollars?

Housing Price: Hong Kong Island

• The Hong Kong CPI (2000=100) was 35.5 in December 1982 and 109.2 in December 2009.

• Calculate:

• In real terms, luxury housing in 2009 is almost 4 times as expensive as in 1982!

$ 109.2$14,742 $45,347.2

35.5r rt t

t

PN N

P

Example

• Compare the box office take of “Shrek 2” and “Sound of Music” in 2004 dollars.

Movie Year Box Office PShrek 2 2004 436,471,036 189

Sound of Music 1965 163,214,286 32

Comparing GDP across Countries

Two Methods

• Exchange Rate Method: divide national GDP by the exchange rate.– How many US$ needed to buy DCU$ needed to

purchase domestic GDP.

• PPP Method: divide national GDP by PPP (Purchasing Power Parity).– How much domestic GDP would cost if sold at US

prices.

• Exchange Rate: S - # of domestic currency units purchased for 1 US$.

• An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation.

Exchange Rates

• Construct an international market basket of goods produced and purchased around the world.

• For a country, calculate PPP = Purchasing Power Parity as the price of the market basket (in DCU) relative to price of the market basket in US (in US$). World Bank Data

Exchange Rate vs. PPP

0

5

10

15

20

25

30

35

40

45

Brazil China Version 1 India Russia

DC

U/$ S

PPP

Convert sums into another economy’s currency

• Nj is a number measured in country j’s currency & you want to convert it into the reference country’s currency.

r$ rj j

j

SN N

S

Exchange Rate Conversion

r$ rj j

j

PPPN N

PPP

PPP Conversion

PPP vs. Exchange Rate Conversion

• Exchange rates are easily available so exchange rate is a “quick and dirty” comparison. – Measures how many US dollars someone could buy with

average income.

• However, money goes farther in some countries as many types of goods are relatively cheap (especially in developing countries).– PPP conversion measures how much the goods purchased

by the average person would cost in the US. Better measure of living standards.

Big Mac Index

• Economist magazine advocates the use of the price of McDonald’s fast food sandwich Big Mac as a substitute for PPP.

• Big Mac is a bundle of different goods and services which can be a reasonable sample.

Economist Magazine

S vs. PPP Converted GDP Per Capita Gross National Income

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

Brazil Russia India China

$

Current US$ PPP

http://ddp-ext.worldbank.org/ext/DDPQQ/member.do?method=getMembers

Comparison of China vs. HK

• Goods are cheaper in China than in HK

LocalCurrency 2005GDP S PPP

Hong Kong HK$202,934 7.8 5.69China ￥14,095.00 8.19 3.45

World Bank Conversion Factors

Conversion

in RMB S PPPHong Kong 213,080.70 123,044.34China ￥6,423.00

Which exchange rate conversion to use?

• Depends on where the money will be spent.• If you have a value of foreign currency that

you will want to spend at home, convert using exchange rate because foreign prices are irrelevant.

• If you want to spend the money in foreign country, then using PPP conversion may be more helpful.

Problem

• You are a Chinese multinational that wants to construct salaries to be paid to employees in Canada that will provide same living standard as salary of RMB20,000.

• Canada PPP in 2005 is 1.21.

Learning Outcomes

Students should be able to:• Explain the different methods of calculating GDP• Calculate simple real aggregates like real GDP.• Use price indices to calculate inflation rates.• Adjust nominal series for inflation. • Compare values measured in different currencies

using the PPP and exchange rate method.