What is macroeconomics Studies interaction between main aggregate

What is macroeconomics? • Studies interaction between main aggregate economic variables: 1. Output 2. Employment 3. Inflation • Studies impact of main government policies: 1. Fiscal policy 2. Monetary policy • Simplifies and summarizes these interactions with models of the economy Macro/ch 2 1

Difference with microeconomics • Micro studies supply and demand relations in a specific market, production at the level of the firm, consumption at the level of the consumer etc… • Micro make use of relative prices and not price levels • Micro is based on premises which are generally accepted while macro evolves overtime and its premises depend on schools of thought (e. g. Keynesian versus classical assumptions) Macro/ch 2 2

The 3 main measures of macro performance • Aggregate output measures total production in the economy – Total Gross Domestic Product - GDP – GDP per capita (GDP/number of inhabitants) – Rate of growth of GDP or (GDP 1 -GDP 0)/GDP 0 • Unemployment rate measures proportion of people without jobs • Inflation rate measures the overall increase in prices Macro/ch 2 3

Aggregate output: GDP • GDP is the value of the final goods and services produced in the economy during a given period • GDP is the sum of the value added in the economy during a given period • GDP is the sum of income earned in the economy during a given period GDP is a flow (not a stock) Macro/ch 2 4

Calculating GDP Example: • Mine extracts iron ore. • Steel mill buys - $10 worth - of iron ore that it used to produce steel. It then sell the steel for $25 to a cutlery factory. • Cutlery manufacturer transforms the steel - $25 worth - into a cutlery set sold directly to the consumer (at a factory store) for $35. Macro/ch 2 5

Value of final goods: to avoid double counting Value of final good = $35 Including the value of the iron ore or of the steel produced would be double counting. Why? Because the iron ore is included in the value of the steel and the steel is included in the value of the cutlery set Macro/ch 2 6

Value added approach Definition: Value added = value of sale minus value of purchased inputs (the intermediate goods used in production) • Mine: (no purchased input) VA = $10 • Steel mill: VA = $25 - $10 = $15 • Cutlery factory: VA = $35 - $25 = $10 • Total value added Macro/ch 2 = $35 7

Income approach Another interpretation of the value added: The value added is equal to all the production costs incurred by the firm - other than the purchase of material. so what is left? the payments to owners of the factors of production. to the owners of land to the owners of capital to the workers and to the proprietors/entrepreneurs Macro/ch 2 i. e. the rent the interest their wages their profit 8

The value added corresponds to the income of these 4 groups (if a tax is paid to the government, it should also be taken into account). Let’s now set up a table showing the rent, the interest, the wages and the profit in each of the 3 firms and illustrating how the sum of these costs in equals the value added by each firm. Macro/ch 2 9

Income approach Mine Steel mill Cutlery factory $3 $1 Total Rent $1 Interest $2 $8 $2 $12 Wages $5 $3 $4 $12 Profit $2 $1 $3 $6 VA $10 $15 $10 $35 Macro/ch 2 $5 10

Nominal and real GDP • Some data on nominal GDP Nominal GDP in $ billion Growth of nominal GDP since 1960 Macro/ch 2 1960 1994 2000 526 6, 736 9, 872 x 13 x 16 11

Nominal GDP is GDP measured in $ in the specific year quoted. Do these huge increases represent real growth (or growth in the quantity of goods produced)? Remember that GDP is calculated as the sum of the value of the various goods. Value = quantity * price so these large rates of growth include as well as Macro/ch 2 growth in quantity ( or real growth ) growth in price ( or inflation ) 12

Nominal GDP • Definition: sum of value of goods and services produced during the year at current prices • Nominal GDP increases overtime because 1. quantity of goods and services produced increases 2. their price also increases (inflation) • The 2 nd cause does not correspond to real growth but to a change in the measuring yardstick, the dollar (the $ looses its value - it depreciates - it shrinks ). Macro/ch 2 13

The $ looses its value - it depreciates - it shrinks GDP in 2000 1950 $ 2000 $ Macro/ch 2 GDP = 5 GDP = 10 14

How to calculate real GDP? • Nominal GDP is calculated every year. • But these yearly data do not allow us to judge by how much the economy has actually grown, in terms of quantity of goods and services produced. • So we need to calculate real GDP to appraise the real growth of the economy over the years. • Unfortunately there are more than one way to do it! Macro/ch 2 15

• How do we neutralize the effect of the changes in price in order to only retain the effect of the changes in quantity? • The solution is to measure GDP in 2 different years with the same set of prices. Then the difference in the two measures of GDP will only include the change in quantity. • Which set of prices should we use? • Depending of the set of prices chosen we will get slightly different results. Macro/ch 2 16

Calculation of real GDP: the index problem • As price increases are not homogeneous*, the conversion from nominal to real GDP will yield different results according to the base year used – First year - Laspeyres Index – Last year - Paasche Index • This problem can be circumvented by using a chained index * i. e. not the same for every good Macro/ch 2 17

Nominal GDP Growth P 0 Books TV Nominal GDP Q 0 P 0 Q 0 P 1 Q 1 P 1 Q 1 $1 1000 $1. 1 1050 $1155 $500 10 $5000 $600 11 $6600 $6000 $7755 Rate of growth of nominal GDP: Macro/ch 2 18

Real growth versus inflation Macro/ch 2 Real growth %∆Q Inflation %∆P BOOKS 5% 10% TV 10% 20% For the economy ? ? 19

Base: earlier year - Laspeyres P 0 Books TV Real GDP Q 0 P 0 Q 1 P 0 Q 1 $1 1000 $1 1050 $500 10 $500 11 $5500 $6000 $6550 Rate of growth of real GDP: Macro/ch 2 20

Base: latter year - Paasche P 1 Q 0 Books $1. 1 TV $600 Real GDP P 1 Q 0 P 1 Q 1 1000 $1100 $1. 1 1050 $1155 10 $600 11 $6600 $7100 P 1 Q 1 $7755 Rate of growth of real GDP: Macro/ch 2 21

Chained index*: average price Paver Q 0 Books $1. 05 1000 TV $550 10 Real GDP Paver. Q 0 Paver Q 1 $1050 $1. 05 1050 $1102. 5 $5500 $550 $6550 11 Paver. Q 1 $6050 $7152. 5 Rate of growth of real GDP: Macro/ch 2 *Approximation for actual method 22

Terminology • Nominal GDP or $Y – $GDP – GDP in current dollars • Real GDP or Y – GDP in terms of goods – GDP in constant dollars – GDP adjusted for inflation – GDP in 1995 dollar (if base=1995) Macro/ch 2 23

Unemployment rate u • L=N+U – L is labor force – N is number of employed – U is number of unemployed • u = U/L – u is rate of unemployment • Data gathered by Bureau of Labor Statistics (BLS) • Current Population Survey Macro/ch 2 24

Additional employment statistics • A = L + NL – A is adult population – NL is not in the labor force • Discouraged workers (not looking for job anymore) • Retirees, home makers etc. • Participation rate = L/A • When u is high, people stop looking for jobs and # of discouraged workers (in NL) increases, hence the participation rate drops Macro/ch 2 25

Labor statistics problem In a given month in the US, 100 million people are working: N = 100 10 million are not working but are looking for work: U = 10 and 20 million are not working and have given up looking for work: DW = 20. Calculate the labor force: L = N + U = 100 + 10 = 110 Calculate the official unemployment rate: u = U/L = 10/110 = 9. 1% If an additional 40 million adults are not working for various other reasons beside being discouraged (retired, homemaker etc. ) Calculate the adult population: A = L + DW + 40 = 170 Calculate the participation rate: PR = L/A = 110/170 = 65% Macro/ch 2 26

Unemployment & output: Okun’s law ∆ in u 2 * 1 0 %∆ in GDP = 3% - 2* ∆ in u * * * -2 -1 0 * 1 * 2 * * * 3 GDP growth * This is a purely empirical relation showing that high increases in unemployment correspond to low output growth Macro/ch 2 27

The inflation rate • Definition: rate at which the price level increases • Measured – By GDP deflator = nominal GDP / real GDP – By CPI or Consumer Price Index GDP deflator can be calculated by methods similar to those developed for the calculation of real GDP Macro/ch 2 28

Calculation of GDP deflator Using data from previous example Year 0 (as base) Year 1 Nominal $6000 $7755 Real $6000 $6550 GDP Deflator 1 1. 18 That is: the rate of inflation is 18% Macro/ch 2 29

CPI or Consumer Price Index • Based on cost in $ of a fixed basket of goods and services consumed by an average urban consumer • Monthly indicator existing since 1917 (BLS) • Data gathered in 85 cities and 22, 000 retail stores • Revised every 10 years as consumption changes Macro/ch 2 30

Difference between GDP deflator and CPI • Deflator based on all the goods and services produced in the economy so it includes government, investment and exports. • CPI is based on a fixed subset of consumption goods and services so it includes imports. • The set of goods and services on which the deflator is based changes from year to year while the set included in the CPI is adjusted every 10 years. Macro/ch 2 31

Inflation and unemployment: the Phillips curve ∆ in π 4 3 2 1 0 -1 -2 -3 -4 4 Macro/ch 2 It shows a negative relation * * * * * 6 8 10 u 32