chapter 1_introduction to economics

8/3/2019 Chapter 1_introduction to Economics

1/58

slide 0

Introduction to

Macroeconomics

CHAPTER 1 Introduction to Macroeconomics


2/58

slide 1

Learning Objectives

This chapter introduces you to

the issues macroeconomists study

the tools macroeconomists use

some important concepts in macroeconomic

analysis



3/58

slide 2

Why are call centers located in India? why textilesmade in Bangladesh? Why do we buy so much inChina?

Why does cost of living keep rising? Why do goods

prices rise? Are gas/ oil / gold prices really that high? What causes recessions? Can the government do

anything to combat recessions? Should it? Why doesrecession in US affect India?


Important issues in Macroeconomics

Macroeconomics, the study of the economy as

a whole, addresses many topical issues:


4/58

slide 3

What is the government budget deficit?

How does it affect the economy?

What causes unemployment? Why are millions

of people unemployed, even when the

economy is booming?

Why do people migrate?


Important issues in macroeconomics




5/58

slide 4

Why is US so rich? Why are so many countriespoor? What policies might help them grow outof poverty?

What is the best way to measure well being

Why do government intervene in an economy? ...........................


Important issues in macroeconomics




6/58

slide 5

Why learn macroeconomics?

1. Macro economy affects societys well-

being.

Each one-point increase in the unemployment rate

is associated with:

920 more suicides

650 more homicides

4000 more people admitted to state mentalinstitutions

3300 more people sent to state prisons 37,000 more deaths

increases in domestic violence and homelessness



7/58slide 6CHAPTER 1 Introduction to Macroeconomics


2.Macro economy affects your well-being.

-3

-2

-1

0

1

2

3

4

5

1965 1970 1975 1980 1985 1990 1995 2000 2005

-7

-5

-3

-1

1

3

5

unemployment rate inflation-adjusted mean wage (right scale)

change

from1

2mosearlier

percentcha

ngefrom1

2

mosearlierIn most years, wage growth falls

when unemployment is rising.


8/58

slide 7CHAPTER 1 Introduction to Macroeconomics


The popularity of the political party oftenrises when the economy is doing well and

falls when it is doing poorly.

3. Macro economy affects politics.


9/58

slide 8

study of economics actions of individuals. Includes individual prices, quantities and

markets, thus it studies how resources areallocated to the production of particulargoods and services and how efficiently theyare distributed.

It does not necessarily study the allocationof resources to the economy as a whole.

Thus it looks into the micro aspects of theeconomy,


Microeconomics


10/58

slide 9

Study of aggregates or averages covering theentire economy.

The aggregates or averages includes

Total employment, National income and output

Total investment, Total consumption andsavings

Aggregate supply, Aggregate demand

General price level, Wage level

Thus, macro economics studies the broaderaspects of the economy and studies thebehavior of an economy as a whole.


Macro economics


11/58

slide 10

Next, you will learn

the meaning and measurement of the

most important macroeconomic statistics:

Gross Domestic Product (GDP)

Real GDP and Nominal GDP

The Consumer Price Index (CPI)

Calculating Inflation



12/58

slide 11

Gross Domestic Product:

Expenditure and Income

Two definitions:

Total expenditure on domestically-produced

final goods and services.

Total income earned by domestically-located

factors of production.

Expenditure equals income becauseevery rupee spent by a buyer

becomes income to the seller.



13/58

slide 12

The Circular Flow

Households Firms

Goods

Labor

Expenditure (Rs)

Income (Rs)



14/58

slide 13fig

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

Investment (I)

Government

expenditure (G)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

GOV.

Nettaxes (T)

ABROAD

Import

expenditure (M)

The circular flow of income

WITHDRAWALS

INJECTIONS


15/58

slide 14

Value added

definition:

A firms value added is

the value of its output

minusthe value of the intermediate goods

the firm used to produce that output.



16/58

slide 15

Exercise:

A farmer grows a bushel of wheatand sells it to a miller for Rs. 2.00.

The miller turns the wheat into flourand sells it to a baker for Rs. 6.00.

The baker uses the flour to make a loaf ofbread and sells it to an engineer for Rs.12.00.

The engineer eats the bread.

Compute & comparevalue added at each stage of production

andGDP



17/58

slide 16

Final goods, value added, and GDP

GDP = value of final goods produced

= sum of value added at all stages

of production.

The value of the final goods already includes the

value of the intermediate goods,

so including intermediate and final goods in GDP

would be double-counting.



18/58

slide 17

The expenditure components of

GDP

consumption

investment

government spending

net exports



19/58

slide 18

Consumption (C)

durable goodslast a long timeex: cars, homeappliances

nondurable goodslast a short timeex: food, clothing

serviceswork done forconsumersex: dry cleaning,air travel.

definition: The value of allgoods and services boughtby households. Includes:



20/58

slide 19

Investment (I)

Spending on goods bought for future use

Includes:

business fixed investmentSpending on plant and equipment that firms will use to

produce other goods & services. residential fixed investment

Spending on housing units by consumers / landlords.

inventory investment

The change in the value of all firms inventories.

Note: Investment is spending on new capital



21/58

slide 20

Stocks vs. Flows

A flow is a quantity measured per unit of time.

E.g., Indian investment was Rs.2.5 billion during 2006.

Flow Stock

A stock is aquantity measured

at a point in time.

E.g.,The Indian capital

stock was Rs.26 billion

on January 1, 2006.



22/58

slide 21

Stocks vs. Flows - examples

the govt budget deficitthe govt debt

No. of new college

graduates this year

No. of people with

college degrees

persons

saving/income/expenditure

a persons wealth

flowstock



23/58

slide 22

Now you try:

Stock or flow?

the balance on your credit card statement

how much you study economics outside ofclass

the size of your compact disc collection

the inflation rate



24/58

slide 23

Government spending (G)

G includes all government spending on goodsand services..

G excludes transfer payments

(e.g., unemployment insurance payments),because they do not represent spending on

goods and services.



25/58

slide 24

Net exports: NX = EX IM

def: The value of total exports (EX)

minus the value of total imports

(IM).



26/58

slide 25

An important identity

Y = C + I + G + NX

aggregateexpenditurevalue of

total output



27/58

slide 26

GDP:

An important and versatile concept

We have now seen that GDP measures

total income

total output

total expenditure

the sum of value-added at all stages

in the production of final goods



28/58

slide 27

GNP vs. GDP

Gross National Product (GNP):Total income earned by the nations factors of

production, regardless of where located. (ownership)

Gross Domestic Product (GDP):Total income earned by domestically-locatedfactors of

production, regardless of nationality.

(GNP GDP) = (factor payments from abroad) (factor payments to abroad)

=NFIA (net factor income from abroad)



29/58

slide 28

Discussion question:

In your country,

which would you want

to be bigger, GDP, or GNP?

Why?



30/58

slide 29

Other Measures of Income

GDP at factor cost =GDP at market priceindirecttaxes + subsidies.

GDP at market price + net factor income from abroad

= GNP at market price NNP: found out by deducting depreciation charges

from national income. NNP = GNP depreciation

NDP = GDP depreciation

Note: factor cost = market price indirect tax +

subsidies



31/58

slide 30

Example: National Income

Accounting The following

particulars are given

for an economy for

the year 2008-09.

Compute

Depreciation

NDP at factor cost

GNP at factor cost

GDP at market price

NNP at market price


Particulars Rs. In Crore

GDP at factor cost 6000

Subsidies 400

Factor income receivedfrom abroad 1200

Factor income paidabroad

1800

Indirect taxes 800

Gross investment 800

Net investment 400


32/58

slide 31

Solution Depreciation = gross investment net investment =

800 400 = 400

NDP at FC = GDP at FC Depreciation = 6000

400 = 5600

GNP at FC = GDP at FC + NFIA =6000 + (-600) =

5400

GDP at MP = GDP at FC + indirect taxes

subsidies = 6000 + 800 400 = 6400

NNP at MP = GNP at MP(GDP at MP + NFIA)

depreciation = 5000 400 = 4600



33/58

slide 32

Real vs. nominal GDP

GDP is the value of all final goods and services

produced.

nominal GDP measures these values using

current prices.

real GDPmeasure these values using the prices

of a base year.



34/58

slide 33

Real vs. nominal GDP

GDPt= P

itQ

it

i1

n

RGDPt= P

iBQ

it

i1

n



35/58

slide 34

Practice problem, part 1

Compute nominal GDP in each year.

Compute real GDP in each year using 2006 as

the base year.

2006 2007 2008

P Q P Q P Q

good A Rs.30 900 Rs. 31 1,000 Rs.36 1,050

good B Rs.100 192 Rs.102 200 Rs.100 205



36/58

slide 35

Answers to practice problem, part 1

nominal GDP multiply Ps & Qs from same year

2006: Rs.46,200 = Rs.30 900 + Rs.100 192

2007: Rs.51,400

2008: Rs.58,300

real GDP multiply each years Qs by 2006 Ps

2006: Rs.46,200

2007: Rs.50,000

2008: Rs.52,000 = Rs.30 1050 + Rs.100 205



37/58

slide 36

Real GDP controls for inflation

Changes in nominal GDP can be due to:

changes in prices.

changes in quantities of output produced.

Changes in real GDP can only be due to

changes in quantities,

because real GDP is constructed using

constant base-year prices.



38/58

slide 37

GDP Deflator

The inflation rateis the percentage increase in

the overall level of prices.

One measure of the price level is

the GDP deflator, defined as

Nominal GDP

GDP deflator = 100

Real GDP



39/58

slide 38

Practice problem, part 2

Use your previous answers to computethe GDP deflator in each year.

Use GDP deflator to compute the inflation rate

from 2006 to 2007, and from 2007 to 2008.

Nom. GDP Real GDP GDPdeflator

Inflationrate

2006 Rs.46,200 Rs.46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000



40/58

slide 39

Answers to practice problem, part 2

NominalGDP

Real GDP GDPdeflator

Inflationrate

2006 Rs.46,200 Rs.46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.1%



41/58

slide 40

Understanding the GDP deflator

Example with 3 goodsFor good i = 1, 2, 3

Pit

= the market price of good iin monthtQit = the quantity of good i produced in montht

NGDPt

= Nominal GDP in montht

RGDPt = Real GDP in montht



42/58

slide 41

Consumer Price Index (CPI)

A measure of the overall level of prices

Published by the Bureau of Labor Statistics

(BLS)

Uses:

tracks changes in the typical households

cost of living

adjusts many contracts for inflation (COLAs)

allows comparisons of dollar amounts over time



43/58

slide 42

How the BLS constructs the CPI

1. Survey consumers to determine compositionof the typical consumers basket of goods.

2. Every month, collect data on prices of all items

in the basket; compute cost of basket

3. CPI in any month equals

Cost of basket in that month

Cost of basket in base period100



44/58

slide 43

Exercise: Compute the CPI

Basket contains 20 pizzas and 10 compact discs.

prices:

pizza CDs

(Rs.) (Rs.)

2002 10 15

2003 11 15

2004 12 162005 13 15

For each year, compute

the cost of the basket

the CPI (use 2002 as

the base year)

the inflation rate from

the preceding year



45/58

slide 44

Cost of Inflationbasket CPI rate

2002 Rs.350 100.0 n.a.

2003 370 105.7 5.7%

2004 400 114.3 8.1%

2005 410 117.1 2.5%

Answers:



46/58

slide 45

The composition of the CPIs basket

15.1%

42.4%

3.8%

17.4% 6.2% 5.6%

3.0%

3.1%

3.5%

Food and bev.

Housing

Apparel

Transportation

Medical care

Recreation

Education

Communication

Other goodsand services



47/58

slide 46

Understanding the CPI

Example with n goods

For good i= 1, 2, 3, ., n

QiB = the amount of good iin the CPIs basket

Pit

= the price of good iin monthtE

t= the cost of the CPI basket in montht

Eb

= the cost of the basket in the base period



48/58

slide 47


TheCPI is a weighted average of prices.

The weight on each price reflectsthat goods relative importance in the CPIs basket.

Note that the weights remain fixed over time.

CPI in month t EtE

b

P1tC1 + P2tC2 + P3tC3E

b

C

1

Eb

P1t

C2

Eb

P2t

C3

Eb

P3t



49/58

slide 48


CPIEt

EB

=QiBPit

i1

n

Q

iBPiB

i1

n

=

QiBPiB

Pit/ P

iB

i1

n

QiBPiB

i1

n



50/58

slide 49


CPI EtE

B

= iB

Pit/ P

iB

i1

n

iB

Q

iBPiB

QiBPiB

i1

n

where the weights aregiven by:



51/58

slide 50


TheCPI is a weighted average of prices relative

to their value in the base period.

The weight on each price relative reflectsthat goods relative importance in the CPIs

basket.

Note that the weights remain fixed over time.



52/58

slide 51

Reasons whythe CPI may overstate inflation

Substitution bias: The CPI uses fixed weights,so it cannot reflect consumers ability to substitutetoward goods whose relative prices have fallen.

Introduction of new goods: The introduction of

new goods makes consumers better off and, in effect,increases the real value of the dollar. But it does notreduce the CPI, because the CPI uses fixed weights.

Unmeasured changes in quality:

Quality improvements increase the value of the dollar,but are often not fully measured. Has to do with howprices of goods are measured.



53/58

slide 52

Discussion questions:

If your grandmother receives Social Security,how is she affected by the CPIs bias?

Where does the government get the money to pay

COLAs to Social Security recipients?

If you pay income and Social Security taxes,

how does the CPIs bias affect you?

Is the government giving your grandmother

too much of a COLA?

How does your grandmothers basket

differ from the CPIs?



54/58


CPI vs. GDP Deflator

Prices of Capital Goods included in GDP deflator (if produced domestically)

excluded from CPI

Prices of Imported Consumer Goods included in CPI

excluded from GDP deflator

The Basket of Goods CPI: fixed

GDP deflator: changes every year


55/58

slide 54

Categories of the population

employedworking at a paid job

unemployednot employed but looking for a job

labor forcethe amount of labor available for producinggoods and services; all employed plus

unemployed persons not in the labor force

not employed, not looking for work



56/58

slide 55

Chapter Summary

1. Gross Domestic Product (GDP) measures bothtotal income and total expenditure on the

economys output of goods & services.

2. Nominal GDP values output at current prices;real GDP values output at constant prices.

Changes in output affect both measures,

but changes in prices only affect nominal GDP.

3. GDP is the sum of consumption, investment,

government purchases, and net exports.



57/58

slide 56

Chapter Summary

4. The overall level of prices can be measured byeither

the Consumer Price Index (CPI),the price of a fixed basket of goodspurchased by the typical consumer, or

the GDP deflator,

the ratio of nominal to real GDP



58/58

Thank You

chapter 1_introduction to economics

Documents