Macroeconomics & The global Economy

Ace Institute of Management

Session 1
Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

What you studied in Microeconomics..

Basic demand and supply functions of individuals and markets Profit maximizations of individual firms in different markets Consumers and Producers welfare theories Cost and benefits of firms in different markets. And so on But NOW .

Introduction to Macroeconomics
Macroeconomics, the study of the economy as a whole, addresses many topical issues:
Why does the cost of living keep rising? Why are millions of people unemployed, even when the economy is booming? What causes recessions? Can the government do anything to combat recessions? Should it? Why does Nepal have such a huge trade deficit? Why are so many countries poor?

Until 1930, they didnt feel the need to study macroeconomics separately..
but..after 1930..

things changed.. How did the need to study Macroeconomics arise?

U.S. Real GDP per capita

(2000 dollars)
40,000

30,000

long-run upward trend

20,000

Great Great Depression Depression

10,000

0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

U.S. inflation rate

(% per year)
25 20 15 10 5 0 -5 -10 -15 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Very low inflation-Deflation

U.S. unemployment rate

(% of labor force)
30

Very high Unemployment

25 20 15 10 5 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Introduction to Macroeconomics
Macroeconomics:
Deals with the economy as a whole. Study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

HOW DO WE STUDY MACROECONOMICS?

Macroeconomic models : Symbols and Equations

Two important variables in a models: Exogenous variables; and Endogenous variables. Exogenous (Independent) variables : that a model takes as given. Endogenous (dependent) variables : which the model tries to explain. (What happens to..??)

THE MODEL OF SUPPLY AND DEMAND

Assume the following two relationships for CD market: Qd = D(P,Y) (i) Qs = S(P,Pm) (ii) Equation (i): shows that Quantity of the CD demanded is the function of the Price of the CD and Income level of the consumer or the aggregate income of the economy. Equation (ii): shows that Quantity of the CD supplied is the function of the Price of the CD and Input price of the materials.

The equilibrium in the CD market is given by:

Q d = Qs

THE MODEL OF SUPPLY AND DEMAND

Price
P
*

Supply, Qs

Demand, Qd Q
*

Quantity

THE MODEL OF SUPPLY AND DEMAND

Exogenous Variables: Aggregate Income, and Price of the materials (taken as given) Endogenous Variables: Price of the CD, and Equilibrium quantity of CD Price P* Demand Q
*

Supply

Quantity

The model explains what happens to Endogenous variables (Price and Equilibrium Quantity of CD sold) when one of the Exogenous variables (Aggregate Income and Price of the materials ) changes.

EXAMPLE: CHANGES IN EXOGENOUS VARIABLES

P
S
SHIFTS IN DEMAND

D Q

D' P

SHIFTS IN SUPPLY

S'

D Q

PRICES: FLEXIBLE VS. STICKY

General Assumption: Market equilibrium of supply and demand, (market clearing process). Markets clearing continuously, is unrealistic.
Need prices to adjust instantly to changes in supply and demand. But, prices and wages often adjust slowly.

Although market clearing models assume that wages and prices are flexible, in actuality, some wages and prices are sticky. But they do depict the equilibrium toward which the economy gravitates. Short term analysis vs Long term analysis for Price Sticky vs Price Flexibility

IMPORTANT STATISTICS FOR MACROECONOMISTS Three statistics that economists and policymakers use:

Gross Domestic Product (GDP) is the monetary value of all final goods and services produced within an economy in a given period of time-best single measure of economic well being of a society
Inflation rate measures changes in level of prices. The unemployment rate tells us the fraction of workers who are unemployed.

Gross Domestic Product (GDP)

Two ways of viewing GDP
Total income of everyone in the economy Total expenditure on the economys output of goods and services Income $ Labor
Households Firms

Goods/ Services Expenditure $ For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in the economy.

If:
$0.50 $1.00

GDP = (Price of apples Quantity of apples) + (Price of oranges Quantity of oranges) = ($0.50 4) + ($1.00 3) GDP = $5.00

Y = C + I + G + NX
Total demand for domestic output (GDP) Consumption spending by households Investment spending by businesses and households Net exports or net foreign demand Government purchases of goods and services

This is the called the national income accounts identity.

Calculating GDP
Components of U.S. GDP, 2004: The Expenditure Approach
BILLIONS OF DOLLARS PERCENTAGE OF GDP

Personal consumption expenditures (C) Durable goods Nondurable goods Services Gross private domestic investment (l) Nonresidential Residential Change in business inventories Government consumption and gross investment (G) Federal State and local Net exports (EX IM) Exports (EX) Imports (IM) Gross domestic product (GDP)
Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

8,214.3 987.8 2,368.3 4,858.2 1,928.1 1,198.8 673.8 55.4 2,215.9 827.6 1,388.3

70.0 8.4 20.2 41.4 16.4 10.2 5.7 0.5 18.9 7.1 11.8

-624.0

- 5.3

1,173.8 1,797.8
11,734.3 100.0

10.0 15.3

Practice Problem-1.1 Consumption Income earned by the national abroad Investment Income earned by foreigners at home Capital consumption Indirect Business Tax Government Purchase Net Export Undistributed corporate profit Personal tax payment Calculate GDP from the above data Answer: 12485.8 : 8746.2 : 587.8 : 2103.1 : 287 : 86.6 : 700 : 2363.4 : - 726.9 : 350 : 1650

Measuring GDP from Income side

Sum of income of all factors of production gives the GDP from income side (Gross Domestic Income) GDI or GDP (I) = Compensation of employees + Proprietors Income + Rental Income + Corporate Profit + Net Interest

Calculating GDP
U.S. National Income, 1980 (Shapiro: Table 2-1, Pg.27; Adjusted)
BILLIONS OF DOLLARS

Gross Domestic Products (GDP)

Compensation of employees Proprietors income Corporate profits Net interest Rental income

2341.3
1804.4 130.6 183.8 190.6 31.9

Practice Problem-2 Compensation of the employees Personal Income Taxes Corporate Profits Indirect Business Taxes Corporate Tax payment Proprietors Income Net Interest Rental Income Personal Saving NFI Capital Consumption Calculate GDP from the above data Answer: 7469.7 : 5299.8 : 1152.0 : 856.0 : 657.5 : 485.7 : 663.5 : 507.0 : 143.4 : 147.6 : 1818.5 : 1161.0

World Top 10 GDP in Millions of US Dollars in Market Price (Source: IMF 2010)

11. India 1,430,020

107. Nepal - 15,108

162. Bhutan - 1,397

1) Used goods. 2) Intermediate goods (use value added method)

Measuring GDP by the Value Added Method

FIRM VALUE OF PRODUCT VALUE ADDED

Cotton Farmer
Textile Mill

Value of raw cotton = $1.00

Value of raw cotton woven into cotton fabric = $3.00

Value added by cotton farmer

Value added by cotton textile mill = ($3.00 $1.00)

= $1.00
= $2.00

Shirt Company

Value of cotton fabric made Value added by shirt manufacturer = $12.00 = ($15.00 $3.00) into a shirt = $15.00
Value of shirt for sale on L.L. Beans Web site = $35.00 Value added by L.L. Bean = ($35.00 $15.00) Total Value Added = $20.00

L.L. Bean

= $35.00

Other Exclusions from Expenditures

Expenditure on purchase of goods and services during specified time period.
Previous expenditure reflects the change in ownership only.

Avoid neither good nor a service

Does not reflect production such as bonds/ stocks

Avoid expenditure by governments for which it does not receive a good or service in return
Eg.: Transfer payments such as Social security,, unemployment compensation etc.

All expenditure on goods/services sold illegally

Other derivations from GDP

Gross National Product (GNP) Net National Product (NNP) National Income (NI) Personal Income (PI) Personal Disposable Income (DI)

National Income Accounting contd..

GDP + Income earned from domestic national abroad Income paid to foreign national at home = GNP GNP is the monetary value of final goods and services produced by the nationals (income earned by the nationals on foreign countries minus income earned by foreigners at home) GNP Depreciation (Capital Consumption) = NNP Depreciation is the net capital consumption during the accounting year NNP Indirect Business Tax = NI (National Income)

Practice Problem-1.2 Consumption Income earned by the national abroad Investment Income earned by foreigners at home Capital consumption Indirect Business Tax Government Purchase Net Export Undistributed corporate profit Personal tax payment : 8746.2 : 587.8 : 2103.1 : 287 : 86.6 : 700 : 2363.4 : - 726.9 : 350 : 1650

Calculate National Income (NI) from the above data Answer: 12000

National Income Accounting (Narrowing to personalized Income)

National Income (NI) Corporate Profit and Tax Social Insurance contribution Net Interest + Dividends + Government Transfer to Individuals + Personal Interest Income = PI (Personal Income)

National Income Accounting (Narrowing to personalized Income)

Personal Income Personal tax (Income Tax) Non-tax payments (such as parking tickets) = DI (Disposable Income) Disposable income is the final income that a consumer spends on the purchase of goods and services DI Personal Consumption Expenditure = Saving Or, DI Saving = Personal Consumption Expenditure
(Note: PCE is the one we add in GDP)

Calculating other measures of Income

GDP, GNP, NNP and National Income, 1980 (adjusted from Income Method)
DOLLARS (BILLIONS) 2341.3 + 415.4 - 127.9 2628.8 - 287.5 2341.3 - 219.9 2121.4

GDP at factor cost

Plus: Receipts of factor income from the rest of the world Less: Payments of factor income to the rest of the world

Equals: GNP at factor cost

Less: Depreciation or capital consumption

Equals: Net national product (NNP)

Less: Statistical discrepancy

Equals: National income (NI) at factor cost

Calculating other measures of Income

National Income, Personal Income, Disposable Personal Income, and Personal Saving, 1980 (adjusted)
DOLLARS (BILLIONS) 10,275.9 39.6 2161.0 338.7 1822.2

National income Less corporate taxes Equals: Personal income Less: Personal income taxes Equals: Disposable personal income Less: Personal saving Equals: Personal Consumption Expenditure

1671.1

Real vs. nominal GDP

GDP is the value of all final goods and services produced. Nominal GDP measures these values using current prices. Real GDP measure these values using the prices of a base year. (Indicates how much prices have increased over time- Inflation)

Practice problem, part 1

2006
P good A good B $30 $100 Q 900 192 P $31 $102

2007
Q 1,000 200 P

2008
Q 1,050 205

$36 $100

Compute nominal GDP in each year. (Multiply Ps & Qs from same year) Compute real GDP in each year using 2006 as the base year. (Multiply each years Qs by 2006 Ps)

Answers to practice problem, part 1

nominal GDP

multiply Ps & Qs from same year

2006: $46,200 = $30 900 + $100 192

2007: $51,400 2008: $58,300

real GDP

multiply each years Qs by 2006 Ps

2006: $46,200 2007: $50,000 2008: $52,000 = $30 1050 + $100 205

U.S. Nominal and Real GDP,

19502006
14,000 12,000 10,000

(billions)

8,000 6,000 4,000 2,000 0 1950

Real GDP (in 2000 dollars) Nominal GDP

1960

1970

1980

1990

2000

GDP Deflator
The inflation rate is 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

Practice problem, part 2

Nom. GDP 2006 2007 2008 $46,200 51,400 58,300 Real GDP $46,200 50,000 52,000

GDP deflator

Inflation rate
n.a.

Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

Answers to practice problem, part 2

Nominal GDP
2006 2007 2008 $46,200 51,400 58,300 Real GDP $46,200 50,000 52,000

GDP deflator
100.0 102.8 112.1

Inflation rate
n.a. 2.8% 9.3%

Numerical Questions and Solutions for Practice

Suppose that the Nominal and Real GDP for country Z in 1998 were $8,798.1 (in billion) and $8,536, respectively. While for 1999, the figures were $9,295.4 and $8,897.7. a) Calculate the implicit GDP deflator for 1998 and 1999 b) Calculate the Inflation rate (Calculated as the ratio of differences in GDP Deflator with the GDP in base Year). (Related to Mankiw. Pg. 41. Q. 6)

Solutions for Q.2: hint

NGDP 1998 8798.1 Deflator in Year 1998 = ------------------------ = ---------------- = 1.0307 RGDP 1998 8536.0 -----NGDP 1999 9295.4 Deflator in Year 1999 = ------------------------ = ---------------- = 1.0447 RGDP 1999 8897.7 -----Now Calculate Inflations rate yourself

Chain-Weighted Real GDP

Over time, relative prices change, so the base year should be updated periodically. In essence, chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP. But we usually use constant-price real GDP, because:
the two measures are highly correlated.
constant-price real GDP is easier to compute.

Consumer Price Index (CPI)

A measure of the overall level of prices Uses:
tracks changes in the typical households cost of living

Adjusts for inflation

allows comparisons of monetary value over time

How to compute CPI

1.

Survey consumers to determine composition of the typical consumers basket of goods.

2.
3.

Every month, collect data on prices of all items in the basket; compute cost of basket
CPI in any month equals
Cost of basket in that month 100 Cost of basket in base period

The composition of the CPIs basket

Food and bev. Housing Apparel Transportation Medical care Recreation Education Communication Other goods and services 42.4% 15.1% 3.8% 17.4% 6.2% 5.6% 3.0% 3.1% 3.5%

Exercise: Compute the CPI

Basket contains 20 pizzas and 10 compact discs. prices: 2002 2003 2004 2005 For each year, compute the cost of the basket in each year the CPI (use 2002 as the base year) the inflation rate from the preceding year

pizza $10 $11 $12 $13

CDs $15 $15 $16 $15

Answers:

2002 2003 2004 2005

Cost of basket $350 370 400 410

CPI 100.0 105.7 114.3 117.1

Inflation rate n.a. 5.7% 8.6% 2.8%

Numerical Questions and Solutions for Practice

Abby consumes only apples. In year 1, red apples cost 1$ each, green apples cost 2$ each, and Abby buys 10 red apples. In year 2, red apples cost 2$ each, green a. apples cost 1$ each, and Abby buys 10 green apples. Compute a consumer Price index (CPI) for apples for each year. Assume that year 1 is the base year in which the consumer basket is fixed. (Mankiw. Pg. 41. Q. 7)

Solution for Q. 1

Price in Current Year CPI in Year 1 = ------------------------------Price in Base Year ------(PRed1 x QRed1) + (PGreen1 x QGreen1) --------------------------------------------------------- = 1 (PRed1 x QRed1) + (PGreen1 x QGreen1) ------------

Price in Current Year CPI in Year 2 = ------------------------------Price in Base Year ------(PRed2 x QRed1) + (PGreen2 x QGreen1) --------------------------------------------------------- = 2 (PRed1 x QRed1) + (PGreen1 x QGreen1) ------------

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

Categories of the population

employed working at a paid job unemployed not employed but looking for a job labor force the amount of labor available for producing goods and services; all employed plus unemployed persons not in the labor force not employed, not looking for work

Two important labor force concepts

unemployment rate percentage of the labor force that is unemployed labor force participation rate the fraction of the adult population that participates in the labor force

Thank You