Lecture 15 – academic year 2014/15Introduction to Economics

Fabio Landini

Main Macroeconomic Aggregates (II)

Questions of the day?

• What is the role of prices in the determination of GDP?

• What is inflation and how it is measured?

• What is unemployment and how it is measured?

• How can you decompose the GDP?

The role of prices: Real GDP and nominal GDP

GDP = value of the goods

Value of the goods = quantities x market prices

Which prices?

Nominal GDP: Value of the final goods and services computed using the current quantities and prices

Real GDP: Value of the final goods and services computed using current quantities and prices of a specific year (called “the base year”)

Real GDP and Nominal GDP

A single good

Year Quantity Price2000 100 1002001 103 102

Nominal GDP2000 =

price2000 x q.ty2000 = 100x100 =10000

Nominal GDP2001 =

price2001 x q.ty2001 = 102x103=10506

Nominal GDP growth=

= 0,0506 = 5,06%

The growth of GDP is computed in order to know how much the production has increased.

But 5,06% considers both the variation of products and the variation of prices.

10000

0000105061

Real GDP and Nominal GDP

In order to know the actual increase in production we must use the Real GDP

Base year = 2000

Real GDP2000 = price2000 x q.ty2000 = 100x100 =10000

Important: Real GDP is equal to the nominal GDP2000

Real GDP2001=price2000 x q.ty2001 = 100x103 = 10300

Important: It is different from the Nominal GDP2001 = 10506

Real GDP and Nominal GDP

Real GDP growth=

= 0,03 = 3%

It differs from the growth of nominal GDP = 5,06%

The growth of real GDP measures the variation of production given a certain set of fix prices

What differentiate the growth of nominal GDP from the growth of real GDP? The variation of prices, namely inflation

10000

0000103001

Real GDP and Nominal GDP

Inflation

Inflation rate (π) = Rise in the general level of prices in an economy over a period of time

Two ways to measure the level of prices:•GDP deflator•Consumer price index (CPI)

Inflation

1) GDP deflator: Diversity in the growth of nominal and real GDP -> price variation

GDP Deflator

πt

InflationIn the preceding example:

Nominal GDP2000 10000; Nominal GDP2001 10506

Base year = 2000 Real GDP2000 = 10000 ; Real GDP2001 10300

On the basis of the preceding formula we obtain:

Inflation

It is also possible to show that

π = n – g

where g annual rate of growth of real GDP n annual rate of growth of nominal GDP

InflationIn our example we have•n = 5,06%•g = 3%•π = 2%

Using the above formula we obtain π = n – g = 5,06% - 3% = 2,06% ≅ 2%

The GDP deflator considers the prices of of all final goods produced in the economy.

In many cases it is more interesting to look at the price increase that characterize the goods that are purchased by the consumers.

2) Consumer price index (CPI) = considers only the average goods that are purchased by the consumers

Example• Two goods: bread and clothes• On average a consumer buys 1 cloth and 10 kg of

bread every year

Bread ClothesPrice 2000 1 100Price 2001 1,1 101

Inflation

Price bread2000 = 1 -> Price bread2001=1,1 -> Δ = 10%Price clothes2000 = 100 -> Price clothes2001101 -> Δ = 1%

Inflation -> average of the two variation

Important: no simple average, but average weighted by the quantity consumed and the value of the goods

Inflation

Computation of the CPI:

Expenditure 2000 q.ty bread x price bread2000 + + q.ty clothes x price clothes2000 =10x1+1x100 110

Expenditure 2001 q.ty bread x price bread2001 + + q.ty clothes x price clothes2001 10x1,1+1x101 112

Inflation

π

0,0181 = 1,81%

Inflation computed using the CPI measures the average growth in the consumers’ expenditure

Important: 1,8% is an intermediate value between 10% (Δ price of bread) and 1% (Δ price of clothes)

Important: CPI considers a fixed basket of goods which is updated periodically

110110 - 112

Inflation

Inflation in Italy 1970-2011

0,0

5,0

10,0

15,0

20,0

25,0

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

INF

LA

ZIO

NE

(IN

%)

ANNO

Inflation is usually positive (prices increase over time)

0,0

5,0

10,0

15,0

20,0

25,0

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

INF

LA

ZIO

NE

(IN

%)

ANNO

Inflation is different depending on the period(>10% between 1974 and 1984 ; < 3% since 1997)

0,0

5,0

10,0

15,0

20,0

25,0

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

INF

LA

ZIO

NE

(IN

%)

ANNO

• Why do prices increase?• What is it that determines the level of

inflation?

Some answers during the course….

Inflation

Labour market

Employed = Those who currently have a job

Unemployed = Those who are looking for a job or are going to start a new job (+ those who are under unemployment protection programs)

Important: those who are not looking for a job are not considered unemployed (e.g., housewife and students are not unemployed)

Labour force Employed + Unemployed

Unemployment rate (u)

Important: Those who are not looking for a job are counted neither in the numerator nor in the denominator

The unemployment rate measures the portion of workers who are unemployed

Labour market

Another problem: how to measure the portion of workers over the total population -> participation rate

Participation rate =

Labour market

Unemployment rate in Italy, EU, US 1995-2011

The unemployment rate is usually positive (there are workers who do not find a job)

The unemployment rate is different across countries

3

4

5

6

7

8

9

10

11

12

13

TASS

O D

I DIS

OCC

UPA

ZIO

NE

(IN %

)

ANNO

ITA

UE

USA

• Why is there unemployment?

• Why is unemployment different across countries?

Some answers during the course…..

Labour market

Decomposition of GDP

GDP – Measures the value of production of goods and services

Goods and services are exchange din the market -> Supply and Demand

It is possible to decompose GDP both on the side of supply and on the side of demand

From the point of view of supply the GDP is equal to the sum of the sectorial A.V. (2° definition examined in Lecture 14)

From the point of view of demand it is possible to decompose the GDP in different categories of expenditure

a) Consumption (C) – Households’ purchase of goods and services

•Durable goods (average life >3 years)•Non-durable goods (average life <3 years)•Services

Decomposition of GDP

b) Investment (I) – Firms’ purchase of capital goods that are used as inputs in future production activities (e.g. machines, plants, etc.)

A particular category is represented by the investment in stockpile (goods that are not sold)

• It is not financial investment

Decomposition of GDP

c) Government expenditure (G) – Purchase of goods and services by the public administration (Government, public bodies, etc.)

Decomposition of GDP

The sum C+I+G = expenditure in goods and services by the residents of a country (national expenditure)

To compute the total demand of goods and services (=demand of goods and services produced in the economy) we must consider that:

•Some goods that are produced in the country are sold abroad

•Some goods that are produced abroad are purchased in the country

Decomposition of GDP

Therefore, to the national expenditure we must add

•Export (X) – Purchase of national goods and services by the rest of the world (e.g. Italian wine sold in Germany)

and subtract

•Import (Q) – Purchase of goods and services produced abroad by the residents of the country (e.g. Swiss cheese sold in Italy)

Decomposition of GDP

Therefore, the aggregate demand of national goods and services (Z) is equal to:

Z C + I + G + X - Q

Some other important aggregate measures are:

•Commercial balance Difference between import and export

•Public deficit Difference between Government’s expenditure and Government’s revenues

Decomposition of GDP