Handout 1: Monitoring Macroeconomic Performance http://pages.stern.nyu.edu/~nroubini/NOTES/HAND1.

HTM

Understanding the World Macroeconomy

Nouriel Roubini

Handout for Chapter 1:

Monitoring Macroeconomic Performance

Economic Growth and Business Cycles

Figure 1: US real GDP (Gross Domestic Product)
Figure 2: International Comparison (US , Japan, Argentina)
Figure 3: International Comparison (US , China, Korea)
LEVEL AND GROWTH RATE OF GDP
Figure 4: "year-on-year'' growth rate of US GDP in quarterly data
(GDPt - GDPt-4) /GDPt-4
where GDPt is GDP in quarter t and GDPt-4 isGDP four quarters before.
NINE DOWNWARD SPIKES: RECESSIONS (DEFINED AS 2 CONSECUTIVE
QUARTERS OF DECLINING GDP)

The National Bureau of Economic Research is the de facto arbiter of

business cycles in the US.
Figure 4': Alternative way to define the growth rate of the economy
(used by the US Government). Measure the growth rate of GDP in a
particular quarter relative to the previous quarter and annualize such
quarterly rate of growth by multiplying by four (quarterly growth rate
of the economy at an annual rate (AR)):
4 x [(GDPt - GDPt-1) /GDPt-1 ]
To create quick charts of macro variables using these alternative
definitions, see the Economic Chart Dispenser on the Web.
A table with the most recent GDP data is available from the Bureau of

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Economic Analysis at the Department of Commerce.

Figure 5: Growth rates of real GNP (total, not per capita) in Germany
and Japan.

Gross Domestic Product

We use the National Income and Product Accounts (NIPA) constructed
by the Bureau of Economic Analysis at the Department of Commerce.
GDP (Gross Domestic Product): total production of goods and services
of the US economy.
Sales revenue 40,000,000

Expenses 26,000,000

Wages 20,000,000
Cost of Intermediate
Inputs (Parts) 6,000,000

Net Income 14,000,000

FIRM'S CONTRIBUTION TO THE US ECONOMY = VALUE

ADDED = SALES - COST OF INTERMEDIATE INPUTS = 40m - 6m
= 34m
OTHER WAY TO COMPUTE VALUE ADDED = SUM OF
PAYMENTS TO LABOR AND CAPITAL
VALUE-ADDED = FACTOR PAYMENTS = 20m+14m=34m
GDP = VALUE-ADDED PRODUCED BY FIRMS OPERATING IN
THE US
GNP = VALUE-ADDED GENERATED BY "FACTOR INPUTS",
CAPITAL AND LABOR, OWNED BY AMERICANS.
Example: An American working in London for Salomon Brothers would
count in US GNP but not US GDP. She would also count in British
GDP, since she's working there. EXAMPLE:
Sales revenue 40,000,000

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Expenses 26,000,000

Wages 20,000,000
Paid to US workers 18,000,000
Paid to Japanese managers 2,000,000
Cost of Int. Inputs(Parts) 6,000,000

Net Income 14,000,000

Paid to American owners 9,000,000
Paid to Japanese owners 5,000,000

GDP = 34m = 40m - 6m = 20m + 14m

GNP = GDP - 2m - 5m = 27m = 18m + 9m
GNP = GDP - factors payments to foreigners (dividends, interest, rent
to foreign residents owning assets in the US and wages of foreign
residents working in the US) + factor payments from abroad to US
residents (dividends, interest, rent to US residents owning assets abroad
and wages of Americans working abroad).
Difference between GDP and GNP not very large in the U.S but can be
large for other countries. Examples (1987 data):
GDP + Net Factor = GNP % Difference
Income(+) between the two
Payments(-)
from abroad
US 4540 4 4544 0.08%
Mexico 192 -9 183 -4.9%
Ireland 19.9 -1.9 18 -10%

The Net Foreign Assets (NFA) of a country (say the U.S):

NFA = Net Foreign Assets = Assets owned by Americans abroad -
Liabilities of Americans towards foreigners
Assets (and liabilities) include stocks, bonds, loans from banks and
other sources, real estate, firm ownership and so on.
If NFA > 0, the country is a creditor country.
If NFA < 0, the country is a debtor country.
i = average interest rate (rate of return) on net foreign assets
(foreign assets - foreign liabilities)

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i NFA = Net factor income from abroad = interest rate times net
foreign assets.
GNP = GDP + i NFA = GDP + Net factor income from abroad

Accounting Identities
Sales revenue 40,000,000

Expenses 32,000,000

Wages 20,000,000
Cost of Parts 6,000,000
Interest 2,000,000
Depreciation of capital 4,000,000

Net Income 8,000,000

Net Domestic Product = GDP - Depreciation = 34m-4m= 30m

1994 US data for factor payments (in billions of dollars):
1. National Income 5,495.1
2. Compensation of employees 4,008.3
3. Proprietor's income 450.9
4. Corporate Profits 526.2
5. Rents 116.6
6. Net Interest 392.8

Second way to look at GDP: who purchases the final goods.

GDP = consumer expenditures + investment + government
purchases of goods and services + net exports
GDP = C + I + G + NX = C + I + G + (X - M).
.
1994 US data in Tables published in the Economic Report of the President.
.

% Share of GDP
GDP 6931.4 100%
Consumption 4698.7 67.8%
Durable Goods 580.9
Non-Durable Goods 1429.7
Services 2688.1
Gross Private Domestic Investment 1014.4 14.6%
Non Residential 667.2
Residential 287.7
Change in Bus. Inventories 59.5
Government Consumption 1314.7 18.9%
Net Exports of Goods and Services -96.4 -1.3%

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Exports 722.0 10.5%

Imports 818.4 11.8%
.............................................
Net Factor Incomes from abroad -9.0

GNP 6922.4

Importance of investment in Business Inventories to explain the business cycle

(recessions) : When aggregate demand falls (as when there is an exogenous fall in
consumption and investment, i.e. capital spending), firms at first do not cut production but
increase their inventories of goods (change in inventories = production minus sales/demand);
but if the fall in demand is sustained they start to cut production to desired ratio of the stock
of inventories to sales; this fall in production reduces incomes (as workers are laid off) and
leads to further fall in consumption and investment. Thus demand falls even further leading
to further reductions in output. This is the typical dynamics of the onset of a recession.

GDP + M = C + I + G + X
GNPt = GDPt + it NFAt = Ct + It + Gt + (NXt + it NFAt )=
= Ct + It + Gt + CAt
CAt = NX t + it NFAt
Current Account = Trade Balance + Net Factor Income from abroad

Difference between NX and CA can be large if a country is a large

creditor or debtor. Example: Brazil in 1986.
NX = + $ 8.3b

CA = - $ 5.3b

i NFA = -$ 13.6b

Current Account Balance (% of GDP)

1990 1991 1992 1993 1994 1995 1996

Korea -1.24 -3.16 -1.70 -0.16 -1.45 -1.91 -4.89

Indonesia -4.40 -4.40 -2.46 -0.82 -1.54 -4.25 -3.41
Malaysia -2.27 -9.08 -4.06 -10.11 -11.51 -13.45 -5.99
Philippines -6.30 -2.46 -3.17 -6.69 -3.74 -5.06 -5.86
Singapore 9.45 12.36 12.38 8.48 18.12 17.93 16.26
Thailand -8.74 -8.61 -6.28 -6.50 -7.16 -9.00 -9.18
Hong Kong 8.40 6.58 5.26 8.14 1.98 -2.21 0.58
China 3.02 3.07 1.09 -2.17 1.17 1.02 -0.34
Taiwan 3.70 4.10

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CA = GNP - (C + G + I)
(C +G +I) is "absorption" (domestic spending for consumption and investment purposes)

S = GNP - C - G S: National Savings

CA = S - I
Similarity between a country and an individual

Insight in the Asian economic crisis:

If a country runs a current account deficit (a flow) the country is
borrowing from the rest of the world and its foreign debt (a stock) will
increase over time.
FLOWS AND STOCKS
A stock is measured at a particular point in time such as the stock of
capital at the end of 1996.
A flow represents the change in the stock over a particular period of
time: for example net investment in capital in the year 1997 is equal to
the difference between the stock of capital between the end of 1997 and
the end of 1996.
Kt+1 = Kt + It - Depreciationt
Stock of K at time t+1 = Stock of K at time t
+ (Net Investment in new capital in period t)
It - Depreciationt = Kt+1 - Kt

Similarly, the current account in the year 1997 is equal to the difference in the stock of net
foreign assets of the country between the end of 1997 and the end of 1996. A CA surplus
results in an increase in the net foreign assets of a country while a CA deficit results in a
decrease of these assets or, if the country is already a net debtor, it results in an increase in
the net foreign debt of the country.

NFAt+1 - NFAt = CAt

Similarity between a country and an individual

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A current account surplus (flow) results in an increase in the net foreign assets of a country
(change in stocks). In fact, the net foreign assets at the beginning of next period (t+1) must be
equal to those in period t plus total national income (GNP) minus the part of national income
that is consumed (C and G) or invested (I):

NFAt+1 = NFAt + GDPt + it NFAt - Ct - G t - It =

NFAt+1 = NFAt + CAt = NFAt + NXt + it NFAt
A CA > 0 leads to a larger NFA (larger net assets or smaller net
liabilities).
A CA< 0 leads to a lower NFA.
A persistent current account deficit (CA<0) lead a creditor country to
become a debtor country (NFA<0)
Example: the US is the largest debtor country in the world (-$1,900b in
2001) because of a long period of CA<0. Chart
During the 1990s, all the Asian countries that went into a crisis in 1997
run very large and increasing current account deficits; this led to a large
accumulation of foreign debt that eventually became unsustainable.

What Causes Current Account Deficits? Are Such Deficits Bad?

Are They Unsustainable (i.e. Do They Necessarily Lead to a
Currency and Debt Crisis)?

(GNPt -Tt -Ct ) = It + (Gt -Tt ) + CAt ,

GNPt - Tt - Ct = Stp= Private Savings

Tt are taxes collected by the government (TXt ) net of transfer payments
(TRt) and interest payments on the public debt (it Debtt ):
Tt = TXt - TR t - it Debtt
G - T = government budget deficit
GNP-T = disposable income of households

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GNP-T-C = the amount of income households do not spend on goods

and services, namely private saving Sp.

Sg = public (government savings) are the difference between

government revenues and spending

Deft = (G t - Tt ) = Gt - TXt + TRt + it Debtt = - Stg

Stg = - Deft = Tt - G t

[Debtt+1 = Debtt+ Gt - Tt = Debtt+ (G t + TRt - TXt) + it Debtt]

Stp = It+ Deft + CAt (1)

St = Stp - Deft = Stp+ Stg = It + CAt

St = It + CAt (2)

CAt = St - It = Stp - Deft - It (3)

INTERPRETATION OF (3)
A current account deficit may be caused by:
1. An increase in national investment
2. A fall in national savings; specifically:
2a. A fall in private savings and/or
2b. An increase in budget deficits (a fall in public savings).
1. Current account deficits caused by a boom in investment are usually
good and sustainable.
Forms of the capital inflow:
1. The country/firms could directly borrow from foreign banks;
2. The domestic firms could borrow from domestic banks but these in turn borrow from
foreign banks;
3. The country/firms could issue new bonds that are bought by foreign investors;
4. The country/firms can issue new equity that is purchased by foreign investors.

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5. If the new investment is made by a foreign firm that decides to build a new plant in the
domestic economy, the flow of foreign capital that finances this investment project is called
Foreign Direct Investment (FDI).

Two caveats:
a. It may be dangerous to run a current account deficit (and borrow from
abroad) to finance excessive investments in non-traded sectors of the
economy (such as real estate).
b. Governments in Asia gave incentives (subsidies) to firms to invest too
much and incentives to the domestic banks (promises of bail-out) to
borrow too much from abroad to finance dubious investment projects by
the firms.
Banks borrowed too much from abroad for many reasons, mostly related to the implicit
promise of a government bail-out in case things went wrong:

1. Their risk capital was usually small and owners of banks risked relatively little if the banks
went bankrupt ("moral hazard" problem);
2. Several banks were public or controlled indirectly by the government that was directing
credit to politically favored firms, sectors and investment projects;
3. Depositors of the banks were offered implicit or explicit deposit insurance and therefore
did not monitor the lending decisions of banks;
4. The banks themselves were given implicit guarantees of a government bail-out if their
financial conditions went sour because of excessive foreign borrowing;
5. International banks lent vast sums of money to the domestic Asian banks because they
knew that governments would bail-out the domestic banks if things went wrong;

Outcome of all this:

1. Banks borrowed too much from abroad and lent too much to domestic firms;

2. Because of all the implicit public guarantees of bail-out, the interest rate at which domestic
banks could borrow abroad and lend at home was low (relative to the riskiness of the projects
being financed) so that domestic firms invested too much in projects that were marginal if not
outright not profitable.

Once these investment projects turned out not to be profitable, the firms (and the banks that
lent them large sum) found themselves with a huge amount of foreign debt (mostly in foreign
currencies) that could not be repaid. The exchange rate crisis that ensued made things only
worse as the currency depreciation dramatically increased real burden in domestic currencies
of the debt that was denominated in foreign currencies.
.
.
.

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2. A current account deficit caused by a fall in national savings: a

fall in private savings or an increase in budget deficits (a fall in
public savings)
2.a. Current account deficits caused by large budget deficits are
dangerous and eventually unsustainable (1980s Debt Crisis)
2.b. Current account deficits caused by falls in private savings may or
may not be dangerous.
- Consumption boom in face of high expected future income
- Role of financial liberalization in consumption boom

Other factors affecting the sustainability of a large current account

deficit:
1. the country's growth rate;
2. the composition of the current account deficit;
3. the degree of openness of the economy;
4. the size of the current account deficit (relative to GDP).

HIGH CORRELATION BETWEEN BUDGET DEFICITS AND

TRADE DEFICITS
RELATION BETWEEN SAVINGS RATE AND GROWTH (Table 1):
INTERNATIONAL COMPARISON

Prices and Real Quantities

NOMINAL AND REAL GDP
CURRENT DEBATE IN THE US ON THE RIGHT MEASURE OF
INFLATION AND THE RIGHT MEASURE OF GDP:
1. CONTROVERSIAL SWITCH IN DECEMBER 1995 FROM A
FIXED-WEIGHT TO A CHAIN-WEIGHT METHOD OF

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MEASURING GDP
2. IN DECEMBER 1996, THE BOSKIN COMMISSION REACHED
THE CONCLUSION THAT THE CPI OVERESTIMATES THE
INFLATION RATE BY 1% TO 2% PER YEAR
Home Page on the recent controversies on the correct measurement of
GDP and inflation.
Nominal GDP Real GDP
1987 4539.9 4539.9
1992 6020.2 4979.3
1993 6343.3 5134.5
The growth rate of nominal GDP in 1993:
5.3% = 100 x (6343.3 - 6020.2)/6020.2
"Fixed-weight" method: measure quantities of goods in different years
at the prices prevailing in a base year (1987).
The growth rate of real GDP in 1993:
3.1% = 100 x (5134.5 - 4979.3)/4979.3
2.2 percent (5.3%-3.1%) of the growth in current dollar GDP was
simply inflation (a general increase in dollar prices of goods).
A measure of the average price is the ratio of GDP in current prices to
GDP in 1987 prices: the GDP implicit price deflator.
GDP Price Deflator = GDP in current prices (Nominal GDP) / GDP in
base year prices (Real GDP)
Nominal GDP (NY) = Real GDP (Y) x GDP deflator (P)
NYt = Yt x Pt
1987 100
1992 120.9 = 100 x 6020.2/4979.3
1993 123.5 = 100 x 6343.3/5134.5
1993 inflation rate of 2.2 percent (= 123.5/120.9 -1).

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The inflation rate p is the % rate of change of the price level (the GDP
deflator) between period t-1 and period t, or:
pt = (P t - Pt-1)/P t-1 = inflation rate in year t.
The rate of growth of nominal GDP (nyt) is equal to the rate of growth
of real GDP (yt ) plus the rate of inflation (pt):
(ny)t = (NYt - NYt-1)/NYt-1 = (NYt / NYt-1) -1
= (Yt x Pt) / (Yt-1 x Pt-1) - 1 = (Yt / Yt-1) x (Pt / Pt-1) - 1
ny = ( 1 + y) x (1 + p) - 1 = y + p + yp (*)
Since yp is a small number, the expression (*) is approximately equal to:

nyt = yt + pt = 5.3 = 3.1 + 2.2

(NYt - NYt-1)/NYt-1 = (Yt - Yt-1)/Yt-1 + (P t - Pt-1)/P t-1
Figure 6: Levels of nominal and real GDP for the U.S. economy (1992
base year).
Figure 7: Rate of growth of nominal and real GDP for the U.S.

ALTERNATIVE PRICE INDEX (DEFLATOR): CPI = CONSUMER PRICE INDEX: It

measures the dollar price of a fixed "basket'' of goods.

Conceptual problem: it's not clear how to measure the purchasing power of the dollar when
the dollar prices of different goods are changing at different rates.

Example (made-up numbers).

Price of Chips Quantity of Chips Price of Fish Quantity of Fish

Date 1 0.5 10 0.25 10

Date 2 0.75 12 0.50 8

Note: the relative price of chips to fish has fallen from 2 (=.50/.25) to 1.5 (=.75/.50).

Fixed-weight GDP deflator and fixed-weight real GDP.

Date 1 Nominal GDP = $7.50 (= .50x10 + .25x10)

Date 2 Nominal GDP = 13.00 (= .75x12 + .50x8).

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Date 2 real GDP in date 1 prices = 8.00 (= .50x12 + .25x8).

GDP deflator (the ratio of current price GDP to GDP in base year prices):

Date 1: 100 in the base year

Date 2: 162.5 (= 100 x 13/8)

Inflation rate: 62.5%.

Real GDP growth measured with fixed weights: 6.66% = 100 x (8-7.5)/7.5

(1 + ny) = ( 1 + y) x (1 + p)

y = [(1 + ny) / (1+p)] -1 = [(1 + 0.733)/(1 + 0.625)] -1 = 0.066

Fixed-basket CPI deflator and 'fixed-basket' real GDP.

The consumer price index uses quantities in a base year to compute the costs of the same
basket of goods at 2 different dates.

CPI at date 1 = 7.50 (= .50x10 + .25x10).

CPI at date 2 = 12.50 (= .75x10 + .50x10).

Implied CPI inflation rate: 66.6% (= 100 x (12.50-7.50)/7.50).

Difference between the two indexes: the CPI uses date 1 quantities while the GDP deflator
uses date 2 quantities to compute the date 2 price index. (Check out the CPI Calculation
Machine).

Since nominal GDP growth is again 73.3% and the fixed-basket (CPI based) measure of
inflation is 66.6%, now the fixed basket measure of real GDP is 4% rather than the higher
6.66% obtained by using the fixed-weight method.

y = [(1 + ny) / (1+p)] -1 = [(1 + 0.733)/(1 + 0.666)] -1 = 0.04

How can we compute directly the real GDP growth if we use the CPI deflator ?

Compute real GDP in the second period by taking period 2 as the base year (rather than
period 1 as in the fixed-weight method).

Period 2 Real GDP using date 2 as the base year: 13 = 0.75x12+0.5x8

Period 1 Real GDP using date 2 as the base year: 12.5 =0.75x10+0.5x10

Implied Real (fixed-basket) GDP growth using period 2 as base year: 4% =(100 x
(13-12.5)/12.5)

Note: depending on which deflator we use, our estimate of real GDP growth will be different
(6.66% versus 4%).

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So which method is better ?

There is no unique or best way to separate relative price movements from general
movements in the price level, even in theory.

The movements in different prices indexes are similar. See the graphs of the CPI and GDP
deflator in levels and rates of change (Figure 8 and Figure 9).

Note: the fixed-weight method used by the US until 1995 had the disadvantage that it was
giving too much weight in the calculation of real GDP to the good whose relative price had
fallen over time (in this example and reality chips and computers).

To see this issue in more detail consider the following example:

Price of Chips Quantity of Chips Price of Fish Quantity of Fish

Date 1 1 10 1 10

Date 2 0.5 20 2 5

Date 1 Nominal GDP = 20 (= 1x10+1x10)

Date 2 Nominal GDP = 20 (= 0.5x20+2x5)

Intuitively: in this example real GDP has not changed in period 2 relative to period 1.

Fixed-weight approach:

Date 2 Real GDP (in date 1 prices) = $ 25 (= 1x20 + 1x5)

Real 'fixed weight' GDP growth: 25% = (25/20)-1

GDP deflator inflation: -20%

Nominal GDP growth = 0 = (20-20/20) = (1 - 0.2)(1 + 0.25) -1 [ny=(1+p)(1+y)-1]

CPI (fixed basket) approach:

CPI inflation: 25% = [(0.5x10 + 2x10) / 20] - 1

Period 1 Real GDP using date 2 as the base year: 25

Period 2 Real GDP using date 2 as the base year: 20

Real GDP growth using date 2 as the base year: -20%

Nominal GDP growth = 0 = (20-20/20)=(1 + 0.25)(1 - 0.20) -1 [ny=(1+p)(1+y)-1]

In fixed-weight approach, too much weight is given to production of the good (chip) whose
price has fallen over time: so, the estimate of the output level and its growth rate is biased
upward (25% real growth).

It is like computing the real output of a PC computers in 1997 by taking the 1987 price of an

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equivalent machine (approximately $6,000) as the base for valuing the real value added of a
PC that is priced only at $2,000 today.

When the U.S. relied on the fixed-weight method, it was giving too much weight in the
calculation of real GDP to the goods whose relative price had fallen over time (computers,
semiconductors and other high tech sectors of the economy).

Because of this bias, the value of the real output of computers was overestimated and led to
an overestimation of the growth rate of the economy. This issue became serious over the
1980's as the price of computers was falling.

In order to eliminate such a bias, the Department of Commerce switched at the end of
1995 to a chain-weight method of measuring real GDP.

Chain weight method: it is a combination of the fixed-weight method and the fixed-
basket method.

Real GDP is estimated twice, first using the previous year prices as the base (fixed-weight)
and the second time using the current year prices as the base and the previous year quantities
to compute real GDP in the previous year. Then, an average of the two is taken. Using this
method:

Growth rate of chained GDP = {[(1 + 0.25)(1- 0.2)-1]/2} = 0

The growth rate of chained GDP is equal to zero that is the right economic answer.

There are however several potential problems also with the chain-weight method:

1. Quality changes are not correctly measured (examples: computers, light) leading to under-
estimate of the product of industries where such quality changes occur.

2. Major productivity growth in the service industries (ATM's, telecommunications, quality of

health care) not measured by standard GDP measures.

Many have criticized the switch from fixed-weights to chain-weights.

Other issue: the CPI inflation rate also tends to overestimate the true level of inflation rate in
the US economy because of a number of biases.

In December 1996, the Boskin Commission reached the conclusion that the CPI overstates
the true inflation rate by 1% to 2% per year.

Note: if inflation is overestimated, then our measure of real GDP growth is underestimated as
well, as more of the growth of nominal GDP is imputed to an increase in prices rather than to
an increase in quantities produced.
.
.
.
.
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BIASES IN CPI INFLATION:

1. SUBSTITUTION BIAS
2. OUTLET BIAS
3. QUALITY CHANGES
4. NEW PRODUCTS
5. FORMULA BIAS

Table 1
Saving and Investment Rates for Developed Countries.
Entries are percentages, averages of quarterly data over the period 1970:1 to 1989:4.
Country S/Y I/Y CA/Y Y Growth

Australia 24.1 24.6 1.1 3.33

Austria 26.6 25.2 0.1 2.95
Canada 23.7 22.1 1.2 2.82
France 23.3 22.2 0.2 2.83
Germany 25.1 21.4 3.1 2.51
Italy 22.8 22.7 -0.1 3.06
Japan 33.6 31.2 1.5 4.49
United Kingdom 18.2 18.2 0.0 2.38
United States 16.0 15.5 0.1 2.77

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Figure 1. US Real GDP

FIGURE 2. Per Capita GDP: International Comparisons

Figure 3. Per Capita GDP: International Comparison 2

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FIGURE 4

FIGURE 4'

Figure 5. GNP Growth in Germany and Japan

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Figure 6
Nominal and Real GDP

Figure 7
Nominal and Real Growth Rate of GDP

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Figure 8. CPI Level

and its Percentage Annual Rate of Change

Figure 9. GNP Deflator Index

and its Percentage Annual Rate of Change

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Copyright: Nouriel Roubini, Stern School of Business, New York University, 1998.

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