Macroeconomics Module 6 Macroeconomic Measures GDP and Economic

Macroeconomics Module 6: Macroeconomic Measures: GDP and Economic Growth

The Macroeconomic Perspective • • • Macroeconomics focuses on the economy as a whole (or on whole economies as they interact) Macroeconomic externality - occurs when what happens at the macro level is different from and inferior to what happens at the micro level. The economy as a whole is massive. Economic indicators - statistics that measure one or more aspects of the macro economic • • • Measures of aggregate production, like GDP Measures of employment and unemployment, and measures of inflation, like the percent change in the Consumer Price Index Misery Index - the sum of the inflation and unemployment rates as a measure of how bad (i. e. , miserable) the economy is.

Macroeconomic Goals, Framework, and Policies

Goals In thinking about the overall health of the macroeconomy, it is useful to consider three primary goals: economic growth, full employment (or low unemployment), and stable prices (or low inflation): • Economic growth ultimately determines the prevailing standard of living in a country. • Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who do not have a job. • Inflation is a sustained increase in the overall level of prices.

Frameworks • • • Economists use theories and models to explain and understand economic principles. In microeconomics, we used theories of supply and demand; in macroeconomics, we use theories of aggregate demand (AD) and aggregate supply (AS). This book presents two perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which has its own version of AD and AS. Between the two perspectives, you will obtain a good understanding of what drives the macroeconomy

Policy Tools • National governments have two sets of tools for influencing the macroeconomy: • • Monetary policy, which involves managing the interest rates and the availability of credit. Fiscal policy, which involves changes in government spending/purchases and taxes.

What is Gross Domestic Product? • • • Gross Domestic Product (GDP): the value of the output of all goods and services produced within a country in a year The measurement of GDP involves counting up the production of millions of different goods and services— smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services produced in the current year—and summing them into a total dollar value. Take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2016, the U. S. GDP totaled $18. 6 trillion, the largest GDP in the world

Gross Domestic Product (GDP) cont. Final goods and services: goods or services at the furthest stage of their production at the end of a year; that is, they have either been sold to consumers, or they are intermediate goods or raw materials that have not yet been used to produce final goods What is counted in GDP? • • • Final goods and services Intermediate goods that have not yet been used in final goods and services Raw materials that have been produced, but not yet used in the production of intermediate or final goods What is not included in GDP? • • • Intermediate goods that have been turned into final goods and services Used goods Transfer payments Non-market activities Illegal goods

Calculating GDP If we know that GDP is the measurement of everything that is produced, we should also ask the question, who buys all of this production? This demand can be divided into four main parts: 1. Consumer expenditure (consumption) 2. Investment expenditure 3. Government expenditure on goods and services 4. Net export expenditure

Components of U. S. GDP Table 1. Components of U. S. GDP in 2016: From the Expenditure Side Category Components of GDP (in trillions of dollars) Percentage of Total Consumption $12. 8 68. 7% Investment $3. 0 16. 3% Government $3. 3 17. 6% Net Exports 50. $- 2. 7 - Exports $2. 2 12. 0% Imports –$2. 7 14. 7%– Total GDP $18. 6 100% Source: http: //bea. gov/ Table 1. 1. 5 Gross Domestic Product

Calculating GDP Vocabulary • • • Durable Good: a good that last three years or more, such as a car or refrigerator Inventory: good that has been produced, but not yet been sold National Income: includes all income earned: wages, profits, rent, and profit income Nondurable Good: a good that lasts less than three years, such as food and clothing Service: product which is intangible (in contrast to goods) such as entertainment, healthcare, or education Structure: building used as residence, factory, office building, retail store, or for other purposes

Calculating GDP Vocabulary (cont. ) • • • Trade Balance: gap between exports and imports Trade Deficit: exists when a nation’s imports exceed its exports and is calculated as imports – exports Trade Surplus: exists when a nation’s exports exceed its imports and is calculated as exports – imports

Gross National Product • Gross National Product (GNP): includes what is produced domestically and what is produced by domestic labor and business abroad in a year • • • Includes only what is produced within a country’s borders Adds what is produced by domestic business and labor abroad Subtracts out any payments sent home to other countries by foreign labor and businesses located in the U. S.

Net National Product • • Net National Product (NNP): GDP minus depreciation Depreciation: the process by which capital ages and loses value National Income: all income to businesses and individuals Personal Income: income made by individuals Net national product (NNP) is calculated by taking GNP and then subtracting the value of how much physical capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital ages and loses value is called depreciation. The NNP can be further subdivided into national income, which includes all income to businesses and individuals, and personal income, which includes only income to people

Nominal and Real Value • • Nominal Value: an economic statistic measured using actual market prices; i. e. nominal values are not adjusted for inflation; contrast with real value Real Value: an economic statistic measured after it has been adjusted for inflation; contrast with nominal value

Comparing Nominal and Real GDP •

Comparing Nominal and Real GDP Vocab • • Simple Growth Rate Formula: the growth rate (or percentage change) of any variable X over time is (the value of X in the final period – the value of X in the initial period)/(the value of X in the initial period) Real-To-Nominal Formula: the nominal value of some economic variable (e. g. GDP) is the price level times the real value of that economic variable

Comparing Nominal and Real GDP Year Price of Apples Quantity of Apples Value of Apples Price of Xylophones Quantity of Xylophones Value of Xylophones Year One $0. 50 2000 lbs $1, 000 $10 100 $1, 000 Year Two $0. 55 2182 lbs $1, 200 $12 150 $1, 800 • Nominal output is the value of what’s produced, while real output is the quantity of what’s produced (in the previous case, pounds of apples). If we produce more apples we can say our real output has increased. • Now suppose our apply economy from above now produces two goods: apples and xylophones.

Comparing Nominal and Real GDP 2 • • Year Price of Apples Quantity of Apples Value of Apples Price of Xylophones Quantity of Xylophones Value of Xylophones Year One $0. 50 2000 lbs $1, 000 $10 100 $1, 000 Year Two $0. 55 2182 lbs $1, 200 $12 150 $1, 800 Year 1: the value of apples produced was $1000, and the value of xylophones produced was $1000, so nominal GDP was $2000. Year 2: the value of apples produced was $1200, and the value of xylophones produced was $1800, so nominal GDP was $3000. Thus, nominal GDP increased by $1000 (the increase)/$2000 (the nominal GDP in year one)= 50%. But what has happened to real GDP? Real output of apples has increased from 2000 lbs to 2182 lbs. Real output of xylophones has increased from 100 to 150. How much has real output increased?

Comparing Nominal and Real 3 Year Price of Apples Quantity of Apples Value of Apples Price of Xylophones Quantity of Xylophones Value of Xylophones Year One $0. 50 2000 lbs $1, 000 $10 100 $1, 000 Year Two $0. 55 2182 lbs $1, 200 $12 150 $1, 800 • We use price as a common denominator to “add” quantities of apples and xylophones together. We can choose the prices from any year as long as we use them with each year’s quantities. • Year 1 REAL GDP: Price of apples year 1×Quantity of apples year 1+Price of xylophones year 1×Quantity of xylophones year 1 • Year 2 REAL GDP: Price of apples year 1×Quantity of apples year 2+Price of xylophones year 1×Quantity of xylophones year 2

Comparing Nominal and Real GDP 4 Year Price of Apples Quantity of Apples Value of Apples Price of Xylophones Quantity of Xylophones Value of Xylophones Year One $0. 50 2000 lbs $1, 000 $10 100 $1, 000 Year Two $0. 55 2182 lbs $1, 200 $12 150 $1, 800 • • • In other words, we compute real GDP in every year using the prices that existed in a single year, in this case year 1. That’s why real GDP is often described as being based on “constant dollars” or “year one dollars”. Plugging in the values from the table above, yields: Real GDP year 1=($0. 50× 2000)+($10× 100)=$2000 real GDP year 1=($0. 50× 2000)+($10× 100)=$2000

Comparing Nominal and Real GDP 5 Year Price of Apples Quantity of Apples Value of Apples Price of Xylophones Quantity of Xylophones Value of Xylophones Year One $0. 50 2000 lbs $1, 000 $10 100 $1, 000 Year Two $0. 55 2182 lbs $1, 200 $12 150 $1, 800 • • Real GDP year 2=($0. 50× 2182)+($10× 150)=$2591 real GDP year 2=($0. 50× 2182)+($10× 150)=$2591 In other words real GDP increased by $591/$2000 = 29. 6%, which is significantly less than the increase in nominal GDP of 50%.

Converting Nominal to Real GDP • • • In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP, so that we’re left with is real GDP, the increase in the quantity of goods and services produced. This can be easily done using a concept known as the GDP deflator. The GDP deflator is a price index measuring the average price of all goods and services included in the economy.

Converting Nominal to Real GDP (cont. ) • • • The price level in 2010 was almost six times higher than in 1960 (the deflator for 2010 was 110 versus a level of 19 in 1960). Clearly, much of the apparent growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output.

Converting Nominal to Real GDP (cont. II) •

Converting Nominal to Real GDP (cont. III) • • A price index (like the GDP Deflator) is a two-digit decimal number like 1. 00 or 0. 85 or 1. 25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. When we “deflate” nominal figures to get real figures (by dividing the nominal by the price index), we also need to remember to divide the published price index by 100 to make the math work. So the formula becomes:

Business Cycles • • • Business Cycle: the relatively short-term movement of the economy from recession to expansion Depression: an especially lengthy and deep decline in output Peak: during the business cycle, the highest point of output before a recession begins Recession: a significant decline in national output typically a minimum of six months Trough: during the business cycle, the lowest point of output in a recession, before a recovery begins

Phases of the Business Cycle

Tracking Real GDP Over Time Figure 1 shows the pattern of U. S. real GDP since 1900. The generally upward long-term path of GDP has been regularly interrupted by short-term declines. A significant decline in real GDP is called a recession. Recessions typically last at least six months (or two quarters). An especially lengthy and deep recession is called a depression. The severe drop in GDP that occurred during the Great Depression of the 1930 s is clearly visible in the figure, as is the Great Recession of 2008– 2009. Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment.

The Business Cycle • • • The most significant human problem associated with recessions and depressions is that a slowdown in production means that firms need to lay off or fire some of the workers they have. The highest point of the economy, before the recession begins, is called the peak; conversely, the lowest point of a recession, before a recovery begins, is called the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. The movement of the economy from peak to trough and trough to peak is called the business cycle.

Other Business Cycle Vocabulary • • Overheating, which means the economy is picking up speed leading to increased inflation. Stagflation, which means the simultaneous occurrence of stagnant growth (or recession) and inflation. It is a situation where the inflation rate is high, the economic growth rate slows down, and unemployment is also high.

GDP and Standard of Living • • GDP per capita: GDP divided by the population; often used as a measure of standard of living Standard of Living: all elements that affect people’s happiness, whether these elements are obtained through market transactions or not When economists talk about the standard of living, they are referring to the average quantity (and quality) of goods and services that people in a country can afford to consume. Since real GDP measures the quantity of goods and services produced, it is common to use GDP per capita, that is real GDP divided by population, as a measure of economic welfare or standard of living in a nation.

GDP Per Capita •

Limitations of GDP as a Measure of the Standard of Living • • The level of GDP per capita clearly captures some of what we mean by the phrase “standard of living” GDP includes spending on recreation and travel, however, it does not cover leisure time While GDP includes what is spent on environment protection, healthcare, and education, it does not include actual levels of environmental cleanliness, health, and learning Includes production that is exchanged in the market, but it does not cover production that is not exchanged in the market

Labor Productivity and Economic Growth • • Aggregate per Capita Production Function: aggregate production function expressed in per capita terms: inputs including physical capital person, human capital person, and technology person are transformed into output measured as GDP per capita Aggregate Production Function: the process whereby an economy as a whole turns economic inputs such as human capital, physical capital, and technology into output measured as GDP Human Capital: the accumulated skills and education of workers Innovation: Putting advances in knowledge to use in a new product or service Invention: advances in knowledge Labor Productivity: Quantity of output produced per worker, or per hour worked Production Function: the process whereby a firm turns economic inputs like labor, machinery, and raw materials into outputs like goods and services used by consumers Technological Change: a combination of invention–advances in knowledge–and innovation

Labor Productivity and Economic Growth (cont. ) • • The easiest way to understand labor productivity is to imagine a Canadian worker who can make 10 loaves of bread in an hour versus a U. S. worker who in the same hour can make only two loaves of bread. In this fictional example, the Canadians are more productive. Being more productive essentially means you can do more in the same amount of time. This in turn frees up resources to be used elsewhere Physical capital can affect productivity in two ways: • • • (1) an increase in the quantity of physical capital (for example, more computers of the same quality); and (2) an increase in the quality of physical capital (same number of computers but the computers are faster, and so on) Another factor that determines labor productivity is technology. Technological change is a combination of invention—advances in knowledge—and innovation, which is putting that advance to use in a new product or service

The Aggregate Production Function • • A production function is the process of turning economic inputs like labor, machinery, and raw materials into outputs like goods and services used by consumers. In macroeconomics, the aggregate production function is the relationship between all the inputs in the economy and GDP

Components of the Aggregate Production Function • • The aggregate production function determines those maximum quantities. Economic growth is illustrated by an increase in the production possibilities frontier, which we show in Figure 2 The inner PPF corresponds to the maximum GDP obtainable given the resources available in 2010. The outer PPF shows the maximum GDP obtainable given the resources available in 2010. Economic growth is illustrated by the outward shift in the PPF.

Measuring Productivity and Growth Rates • An economy’s rate of productivity growth is closely linked to the growth rate of its GDP per capita, although the two are not identical. For example, if the percentage of the population who holds jobs in an economy increases, GDP per capita will increase but the productivity of individual workers may not be affected. Over the long term, the only way that GDP per capita can grow continually is if the productivity of the average worker rises.

Measuring Productivity • • According to the Department of Labor, U. S. productivity growth was fairly strong in the 1950 s but then declined in the 1970 s and 1980 s before rising again in the second half of the 1990 s and the first half of the 2000 s. The rate of productivity measured by the change in output per hour worked averaged 3. 2% per year from 1950 to 1970; dropped to 1. 9% per year from 1970 to 1990; and then climbed back to over 2. 3% from 1991 to the present, with another modest slowdown after 2001.

Capital Deepening • • Capital Deepening: an increase by society in the average level of physical and/or human capital person When society increases the level of capital person, the result is called capital deepening. The idea of capital deepening can apply both to additional human capital per worker and to additional physical capital per worker

Capital Deepening (cont. ) • • One way to measure human capital is to look at the average levels of education in an economy. As recently as 1970, for example, only about half of U. S. adults had at least a high school diploma; by the start of the twentyfirst century, more than 80% of adults had graduated from high school.

Growth Accounting Studies For studies of the U. S. economy, three lessons commonly emerge from growth accounting studies 1. First, technology is typically the most important contributor to U. S. economic growth 2. Second, while investment in physical capital is essential to growth in labor productivity and GDP per capita, building human capital is at least as important 3. A third lesson is that these three factors of human capital, physical capital, and technology work together

The Power of Sustained Economic Growth Nothing is more important for increasing people’s standard of living than sustained economic growth. Even small changes in the rate of growth, when sustained and compounded over long periods of time, make an enormous difference in the standard of living. Consider Table 1, in which the rows of the table show several different rates of growth in GDP per capita and the columns show different periods of time. Assume for simplicity that an economy starts with a GDP per capita of 100. The table then applies the following formula to calculate what GDP will be at the given growth rate in the future: Table 1. Growth of GDP over Different Time Horizons Growth Rate Value of an original 100 in 10 Years Value of an original 100 in 25 Years Value of an original 100 in 50 Years 1% 110 128 164 3% 134 209 438 5% 163 338 1, 147 8% 216 685 4, 690

The Power of Sustained Economic Growth Vocab • • Compound Growth Rate: the rate of growth when multiplied by a base that includes past GDP growth Rule of 72: an approximation to figure out doubling time. 72 is divided by the annual growth rate to obtain the approximate number of years it will take for income to double

Relatively Recent Economic Growth • • Industrial Revolution: the widespread use of power-driven machinery and the economic and social changes that occurred in the first half of the 1800 s Modern Economic Growth: the period of rapid economic growth from 1870 onward

Global Economic Growth • • • Every country worries about economic growth. In the United States and other highincome countries, the question is whether economic growth continues to provide the same remarkable gains in our standard of living as it did during the twentieth century. Meanwhile, can middle-income countries like South Korea, Brazil, Egypt, or Poland catch up to the higher-income countries? Or must they remain in the second tier of per capita income? As the 1995 Nobel laureate in economics, Robert E. Lucas Jr. , once noted: “The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else. ” Dramatic improvements in a nation’s standard of living are possible

The Relatively Recent Arrival of Economic Growth • • • Modern economic growth-rapid and sustained economic growth is a relatively recent experience for the human race. Before the last two centuries, although rulers, nobles, and conquerors could afford some extravagances and although economies rose above the subsistence level, the average person’s standard of living had not changed much for centuries Progressive, powerful economic and institutional changes started to have a significant effect in the late eighteenth and early nineteenth centuries The Industrial Revolution refers to the widespread use of power-driven machinery and the economic and social changes that resulted in the first half of the 1800 s

A Healthy Climate for Economic Growth • • • Contractual Rights: the rights of individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance Rule of Law: the process of enacting laws that protect individual and entity rights to use their property as they see fit. Laws must be clear, public, fair, and enforced, and applicable to all members of society Special Economic Zone (SEZ): area of a country, usually with access to a port where, among other benefits, the government does not tax trade

A Healthy Climate for Economic Growth (cont. ) • • While physical and human capital deepening and better technology are important, equally important to a nation’s well-being is the climate or system within which these inputs are cultivated Both the type of market economy and a legal system that governs and sustains property rights and contractual rights are important contributors to a healthy economic climate A healthy economic climate usually involves some sort of market orientation at the microeconomic, individual, or firm decision-making level Markets that allow personal and business rewards and incentives for increasing human and physical capital encourage overall macroeconomic growth

Rule of Law and Economic Growth • • • Economic growth depends on many factors. Key among those factors is adherence to the rule of law and protection of property rights and contractual rights by a country’s government so that markets can work effectively and efficiently Laws must be clear, public, fair, enforced, and equally applicable to all members of society Property rights are the rights of individuals and firms to own property and use it as they see fit

Rule of Law and Economic Growth (cont. ) The following examples highlight some important areas that governments around the world have chosen to invest in to facilitate capital deepening and technology: • Education • Savings and investment • Infrastructure • Special economic zones • Scientific research

Quick Review • • • What is macroeconomics and what are the major economic indicators used to asses the state of the macroeconomy? What is gross domestic product (GDP) and what is counted as a final good or service? How is GDP measured as a component of total expenditure (demand) How can GDP be broken down and measured as different types of product? What is the difference between GDP, GNP, and NNP? What is the difference between nominal and real measurements of economic statistics? What is the difference between nominal and real GDP? Calculate real GDP based on nominal GDP values. Calculate the real growth rate in GDP What are business cycles, including recessions, depressions, peaks, and troughs? How do you calculate GDP per capita using population data? What are the limitations of GDP as a measure of the standard of living?

More Quick Review • • • Describe factors that contribute to labor productivity. What are the sources of economic growth using the aggregregate production function? How do you measure productivity in an economy? Explain capital deepening and its significance. Analyze growth accounting studies and the lessons learned from these studies. Explain the Power of Compound Growth, including the rule of 72. Explain the conditions that have allowed for modern economic growth in the last two centuries. What factors contribute to a healthy climate for economic growth? Explain the importance of the rule of law, property rights, and contractual rights in supporting economic growth