ECON1102-Macroeconomics 1 - S2/2014

Lecturer: Dr. Gonzalo Castex

E-mail : g.castexhernandez@unsw.edu.au
Office Hours: Mon and Wed: 3-4 pm
Office 442C School of Economics

Week 1
Measuring Macroeconomic Performance: Output and
Prices
Reference: Bernanke, Olekalns and Frank (BOF) Chapter 1
Key Issues
Indicators of macroeconomic performance
Measuring output (GDP)
Measuring prices and inflation
2

Learning Objectives:
What does GDP mean?
What are the three ways of measuring a countrys GDP?
What is the distinction between nominal and real GDP?
What does the consumer price index (CPI) mean?
How is the CPI measured?
What is inflation and how it is measured?
What are the economic costs associated with inflation?
What is the relationship between rates of interest and the
rate of inflation?
What is deflation and why is it regarded as a problem?

Evaluating Macroeconomic Performance

1. Rising Living Standards economic growth
Tendency for the level of output (i.e. quantity and quality
of goods and services) to increase over time.
Output divided by population = output per capita
May also care about the distribution of living standards
(very important for developing economies)

Aug2011

Jul2010

Jun2009

May2008

Apr2007

Mar2006

Feb2005

Jan2004

Dec2002

Nov2001

Oct2000

Sep1999

Aug1998

Jul1997

Jun1996

May1995

Apr1994

Mar1993

Feb1992

Jan1991

Dec1989

Nov1988

Oct1987

Sep1986

Aug1985

Jul1984

Jun1983

May1982

Apr1981

Mar1980

Feb1979

Jan1978

Dec1976

Nov1975

Oct1974

Sep1973

$perquarter

Real Quarterly GDP per-capita Australia (1973-2012)

16000

14000

12000

10000

8000

6000

4000

2000

Real output: Cycle vs trend: An example

2. Stable Business Cycle low volatility in fluctuations

of actual output around its trend or potential output.
Australias Real Quarterly GDP Growth Rates Decade
Averages
1960s 1970s 1980s 1990s 2000s
Mean
1.26
0.78
0.82
0.83
0.75
Standard 1.50
1.49
0.97
0.77
0.52
Deviation
Ratio
0.84
0.53
0.85
1.08
1.44

Fluctuations around the trend: some implications

Expansion: Output is expanding at a rapid pace and there
is low unemployment rate. (May cause inflation)
Contractions: Output growth is low (negative) and
unemployment rate is high.
A Recession is usually defined as a two consecutive
quarters in which the economys output declines.

3. Relatively Stable Price Level low (positive) rate of

inflation
Inflation: a sustained increase in the overall level of
prices in an economy through time.
Inflation has been concern for most developed countries
over the last 40 years.
Japan is an exception and has experienced deflation over
the last decade.

Sep1970

2.0
Jul2011

May2010

Mar2009

Jan2008

Nov2006

Sep2005

Jul2004

May2003

Mar2002

Jan2001

Nov1999

Sep1998

Jul1997

May1996

Mar1995

Jan1994

Nov1992

Sep1991

Jul1990

May1989

Mar1988

Jan1987

Nov1985

Sep1984

Jul1983

May1982

Mar1981

Jan1980

Nov1978

Sep1977

Jul1976

May1975

Mar1974

Jan1973

Nov1971

Yearendedpercentagechange

Australian Inflation - Consumer Price Index Measure

20.0

18.0

16.0

14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0

10

11

12

4. Sustainable Levels of Public and National Debt

Public debt borrowing by public sector from private
sector
Influenced by government budget deficits/surpluses
Foreign debt borrowing by domestic residents from
foreign countries
Influenced by an economys current account
deficits/surpluses
13

Budget Balance and Net Government Debt for Australia

8

201315

201314

201213

201112

201011

200910

200809

NetDebt
BudgetBalance

200708

200607

200506

200405

200304

200203

200102

200001
2

14

Australias Net External Liabilities

70.0
60.0

40.0
30.0
20.0
10.0

Net Debt/GDP

Net Equity/GDP

Jun-08

Jun-06

Jun-04

Jun-02

Jun-00

Jun-98

Jun-96

Jun-94

Jun-92

Jun-90

0.0
Jun-88

Per cent

50.0

Net External Liabilities/GDP

15

16

5. Balance between Current and Future Consumption

How much should an economy save/invest?
This decision may affect business cycle and growth.

17

Sep1969

NationalSaving/GDP
Sep2011

Jul2010

May2009

Mar2008

Jan2007

Nov2005

Sep2004

Jul2003

May2002

Mar2001

Jan2000

Nov1998

Sep1997

Jul1996

May1995

Mar1994

Jan1993

Nov1991

Sep1990

Jul1989

May1988

Mar1987

Jan1986

Nov1984

Sep1983

Jul1982

May1981

Mar1980

Jan1979

Nov1977

Sep1976

Jul1975

May1974

Mar1973

Jan1972

Nov1970

%ofGDP

Australian Private Investment and National Saving

30.0

25.0

20.0

15.0

10.0

5.0

0.0

PrivateInvestment/GDP

18

6. Full Employment
Provision of employment for all individuals seeking work

19

Feb1978
Jan1979
Dec1979
Nov1980
Oct1981
Sep1982
Aug1983
Jul1984
Jun1985
May1986
Apr1987
Mar1988
Feb1989
Jan1990
Dec1990
Nov1991
Oct1992
Sep1993
Aug1994
Jul1995
Jun1996
May1997
Apr1998
Mar1999
Feb2000
Jan2001
Dec2001
Nov2002
Oct2003
Sep2004
Aug2005
Jul2006
Jun2007
May2008
Apr2009
Mar2010
Feb2011
Jan2012

Percent

Australian Unemployment Rate Monthly

12.0

10.0

8.0

6.0

4.0

2.0

0.0

20

Measuring National or Aggregate Output

GDP Gross Domestic Product
Definition:
The market value of final goods and services produced in
a country during a given period.

21

The market value of final goods and services produced in

a country during a given period.
GDP is a flow variable measured over a period of time.
Quarter March, June, September, December
Australian GDP in March 2012 = $368.4 billion
Australian GDP in March 2013 = $379.6 billion
Year just add-up GDP over 4 quarters
Calendar Mar-12 + Jun-12 + Sep-12 + Dec-12
Financial Sep-12 + Dec-12 + Mar-13 + Jun-13
Australian GDP in 2012 (Calendar) = $1,488.4 billion
22

The market value of final goods and services produced in

a country during a given period.
GDP is measure of aggregate production or output
Use market prices to value (or weight) quantities of
various goods and services
Example:

Quantity
10 cars
100 apples

Market Price
$20,000 per car
$1 per apple

23

GDP = $200,000 + $100 = $200,100

What about goods and services with no observed
market price?
Some are included in GDP:
National defense use costs of provision (costs of
buying equipment, wages of soldiers, etc.) ; Public
education.
Some are excluded from GDP
Unpaid housework
24

The market value of final goods and services produced in

a country during a given period.
GDP excludes intermediate goods and services. These
goods are used-up in the production process.
Example: In the production of a loaf of bread, the flour
used is an intermediate input and is not counted in GDP.

25

Concept of Value Added: The market value of a firms

production less the cost of inputs purchased from other
firms.
This method eliminates the problem of dividing the value
of a final good or service between two periods.

26

Problem 1.2

IntelligenceIncorporatedproduces100computerchipsandsells
themfor$200eachtoBellComputers.
Usingthechipsandotherlabourandmaterials,Bellproduces
100personalcomputers.
Bellsellsthecomputers,bundledwithsoftwarethatBell
licensesfromMacrosoftat$50percomputer,toPCCharliesfor
$800each.
PCCharliessellsthecomputerstothepublicfor$1000each.
CalculatethetotalcontributiontoGDPusingthevalueadded
method.Doyougetthesameanswerbysummingupthemarket
valuesoffinalgoodsandservices?

27

Value Added in Computer Sales: Chapter 1, Problem 2

(Textbook)
Firm
Intel Incorp
Macro Soft
Bell
PC Charlies

Sales
Cost of inputs Value Added
20,000
0
20,000
5,000
0
5,000
80,000
25,000
55,000
100,000
80,000
20,000

PC Charlies final sales = $100,000

Sum of Value Added = $100,000

28

3 Ways to Measure GDP

1. Production Method
2. Expenditure Method
3. Income Method

29

Expenditure Method
Accounting Identity
Expenditure on goods and services by final users must
equal the value of their production.
Components of Expenditure
Consumption (C) purchases by Households
Investment (I) purchases by Firms
Government (G) Government purchases
Net Exports (NX ) net purchases by foreign sector
NX = Exports Imports
30

National Income Accounting Identity

GDP=Expenditure
Y = C + I + G + NX
consumer
firms, companies
government
net exports/imports

31

Australian GDP March Quarter 2013

Expenditure Approach
Household Consumption
Private Investment
Government (Public) Spending
Change in Inventories
Exports
Less Imports
Total
Statistical discrepancy
GDP

$ billion
210.0
86.8
85.7
-0.5
76.4
76.0
382.4
-2.8
379.6
32

Income Method
GDP also equals the aggregate incomes paid to
Labour (L)
Capital (K)
in the production of goods and services.
e.g. labour= worker/ salaries
capital = return on investment

GDP = Labour Income + Capital Income

loans or investment

33

Australian GDP March Quarter 2013

Income Approach
Compensation of Employees
Gross Operating Surplus
Gross Mixed Income
GDP (at factor cost)
textbook - highlight

Taxes Subsidies
GDP (Market Prices)
Statistical discrepancy
GDP

$ Billion
184.0
126.7
30.1
340.8
37.5
378.3
1.3
379.6
34

Nominal vs. Real GDP

Nominal
values quantities of goods and services produced at
current year prices (current price GDP)
Real
values quantities of goods and services produced at
base year prices measure of the actual physical
volume of production (constant price GDP)

35

Example
No. of Cars
Price of Cars

2007
10
$20,000

2008
% Change
10
0
$40,000
100

No. of Apples
Price of Apples

100
$1

100
$2

Nominal GDP

$200,100

Real GDP
2007 prices
2008 prices

$200,100
$400,200

$400,200

$200,100
$400,200

0
100
100
0
0
36

Choice of Base Year (Bit Technical)

In the above example whether we use 2007 or 2008 as
base year prices gives the same answer for the growth
rate of real GDP
This is not the case in general, particularly if you are
comparing real GDP over a 5-10 year period.
Using initial prices (i.e. 2007) is known as a
Laspeyres index
Using final prices (i.e. 2008) is known as a Paasche
index
37

Chain Weighting
For any two consecutive years compute the growth rates
of real GDP implied by both the Laspeyres and the
Paasche indexes.
Then take the average of the two growth rates and this is
the chain-weighted growth rate. This can be used to
compute a real chained-weighted GDP.
Finally to compute a change index over a long period, the
above approach is applied on a year-by-year basis.

38

Example
No. of Cars
Price of Cars

2007
10
$20,000

2008
% Change
10
0
$40,000
100

No. of Apples
Price of Apples

100
$10

1000
$25

900
150

Nominal GDP

$201,000

$425,000

111

Real GDP
2007 prices
2008 prices

$201,000
$402,500

$210,000
$425,000

4.5
5.6
39

Chain-weighted measure of Real GDP

Take average of growth rates implied by 2007 and 2008
prices.
5.05 %= (4.5% + 5.6%)/2
Choose either 2007 or 2008 as the base-year
(nominal=real GDP). Lets pick 2007
2007
Nominal GDP 201,000
Real GDP
201,000

2008
425,000
211,151 (=201,0001.0505)

40

Is GDP A Good Measure of Economic Wellbeing?

Some Omissions
Leisure Time (eg. Weekend cricket games)
Household production (non-market activities)
Environmental Degradation (eg. Pollution)
Quality of Life (eg. Crime rate, traffic congestion)
Economic Inequality
It is likely that GDP is positively related (correlated) with
economic wellbeing
Variety of goods and services
Health and Education (link)

41

Measures of the Price Level

Want to measure the average level of prices in the
economy.
Main Measures
Consumer Price Index (CPI)
GDP Deflator/Price Index, Producer Price Index (PPI)
CPI For a given period, measures the cost in that period
of a given basket of goods and services relative to their
cost in a fixed year called a base year.
42

Construct a CPI
Choose a basket of goods and services
Basket
2000 (base)
Rent (2 bedroom flat)
$500
Hamburgers (60)
$150
CDs (2)
$30
Total Expenditure
$680

2008
$630
$150
$70
$850

CPI =
Cost of base-year basket of goods and services in current year
Cost of base-year basket of goods and services in base year

43

CPI = $850/$680 = 1.25

Cost of living is 25 percent higher in 2008 than it was
in 2000
Average prices are 25 percent higher in 2008 than in
2000
Australian CPI
Published quarterly by ABS (Australian Bureau of
Statistics)
Household Expenditure Survey used to determine
typical basket
Base year changes every 5 years
44

Inflation (and Deflation)

Inflation is measured by the percentage change in the CPI
over a given period.
Inflation rate =

CPI CPI (1)

] * 100
CPI (1)

Inflation rate = 0 implies prices are constant

Inflation rate > 0 implies prices are rising
Inflation rate < 0 implies prices are falling Deflation
45

2.0
Sep2010

Jan2009

May2007

Sep2005

Jan2004

May2002

Sep2000

Jan1999

May1997

Sep1995

Jan1994

May1992

Sep1990

Jan1989

May1987

Sep1985

Jan1984

May1982

Sep1980

Jan1979

May1977

Sep1975

Jan1974

May1972

Sep1970

AustralianCPI(Yearended%change)

20.0

18.0

16.0

14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0

46

Limitations with CPI

Quality Adjustment and New Goods Bias
Quality improvements may show up as higher prices
for goods and services
New goods are often not included until CPI is rebased
Substitution Bias
Use of a fixed basket means that no allowance is
made for consumers substitution toward relatively
less expensive goods.
CPI tends to overstate the rate of inflation.
47

Costs of Inflation
Important to distinguish between relative price change
and a change in the general price level
Shoe-leather costs inflation reduces the real
purchasing power of a given amount of money
Menu costs real costs of changing prices
Introduces noise into the price mechanism
Distorts tax systems (if not indexed to inflation)
Unexpected re-distributions of wealth

48

Inflation and Interest Rates

Nominal Interest Rates percentage increase in the
nominal (or dollar) value of a financial asset.
Real Interest Rate percentage increase in the real
purchasing power of a financial asset.

r i
r = real interest rate
i = nominal interest rate
= inflation rate

49

50

Fisher Effect
Nominal interest rate = real rate + (expected) inflation
rate

i r

51

Inflation (year-ended)

M ar-08

M ar-06

M ar-04

M ar-02

M ar-00

M ar-98

M ar-96

M ar-94

M ar-92

M ar-90

M ar-88

16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
-2.0

M ar-86

% p er an n u m

Inflation and Nominal Interest Rate

10 Year Bond Rate

52

Why is important price stability:

Link

53