MACROECONOMICS CHAPTER 1 1.1 WHEN IS THE ECONOMY PERFORMING WELL?

? At the broad level, we would say that a macroeconomy is performing well if it meets the following criteria: Rising Living Standards in the Long Run

Providing a framework within which contrives can grow and increase standards of living for the people is an important responsibility of governments and international organisations such as the World Bank. Macroeconomists study these long-run growth issues, using what is known as growth theory. GROWTH THEORY The study of the long-run growth performance of economies Avoiding extremes of short-run macroeconomic performance

Where countries experience the short-run business cycle. SHORT-RUN BUSINESS CYCLE The tendency for economies to pass through periods of economic expansion followed by economic contraction. And, although governments like to see their economies expanding, there is such a thing as too rapid an expansion. Maintaining the real value of the currency

Depending on their size, both inflation and deflation can create significant costs for the economy. Inflation = decrease in value of currency; Deflation = increase in value of currency INFLATION AND DEFLATION The tendency for the general level of prices in an economy to change over time. Inflation occurs when prices rise over time; deflation, when prices fall over time. Ensuring sustainable levels of public and foreign debt

PUBLIC DEBT The amount owed by the government to the non-government sector FOREIGN DEBT The amount owed by the nation to other countries Balancing current expenditure against the need to provide resources for the future

Logic tells us that there exists some optimal amount of saving that a nation should be aspiring towards; one that achieves the best balance between current consumption needs and the need to carry resources forward into the future. Providing employment for all individuals seeking work

Broadly speaking, macroeconomics are concerned with unemployment when it is systematic, affecting the entire economy and caused by identifiable national (or international) factors. 1.2 GROSS DEOMSTIC PRODUCT: MEASURING THE NATIONS OUTPUT Our first 2 indicators of good macroeconomic performance rising long-run living standards and the avoidance of extremes in short-run macroeconomic performance are usually judged in the context of a nations GDP. GROSS DOMESTIC PRODUCT (GDP) The market value of the final goods and services produced in a country during a given period Components of the GDP Definition: Market value

Market Value aggregates the quantities of the many different goods and services into a single number by adding up the market values of the different goods and services the economy produces. A drawback of using market values is that not all economically valuable goods and services are sold in markets (eg. unpaid housework as a result not counted in GDP)

Final goods and services

Since GDP is interested in measuring only those items that are of direct economic value, only final goods and services are included in GDP. Intermediate goods and services are not included. FINAL GOODS OR SERVICES Goods or services consumed by the ultimate u ser because they are the end products of the production process they are counted as part of GDP INTERMEDIATE GOODS OR SERVICES Goods or services used up in the production of final goods and services and therefore not counted as part of GDP However if the production spans over many periods, GDP is calculated using the value added method to ensure that production output is matched with the right period. VALUE ADDED For any firm, the market value of its product or service minus the cost of input purchased from other firms. Produced within a country during a given period

The word domestic in the term GDP tells us that GDP is a measure of economic activity within a given country. Thus, only production that takes place within a countrys borders is counted. 3 WAYS TO MEASURE GDP Production Method

As mentioned above (ie. Market value of all goods and services produced) Expenditure Method

From the Accounting Identity that states Expenditure on goods and services by final users must equal the value of their production Components of Expenditure: o o o o Consumption (C) purchased by Households Investment (I) purchases by Firms Government (G) Government purchases [excludes Transfer payments & Interest paid on govt. Debt] Net Exports (NX) Net purchases by foreign sector (NX = Exports Imports)

From this GDP (Y) = Expenditure (ie. National Income Accounting Identity) Therefore Y = C + I + G + NX Income Method

GDP also equals the aggregate incomes paid to: o o Labour (L) Capital (K) properties, profits etc.

in the production of goods and services. Hence GDP = Labour Income + Capital Income NOMINAL VS REAL GDP Nominal values quantities of goods and services produced at CURRENT YEAR prices Real values quantities of goods and services produced at BASE YEAR prices measure of the actual physical volume of production

CHOICE OF BASE YEAR IN REAL GDP 2 Methods Laspeyres Index using initial prices Paasche Index Using final prices

CHAIN WEIGHTING For any 2 consecutive years compute the growth rates of real GDP implied by both the Laspeyres and the Paasche indexes. Then take the average of the 2 growth rates and this is the chain-weighted growth rate. This can be used to compute a real chain-weighted GDP. Finally to compute a change index over a long period, the above approach is applied on a year to year basis. 1.3 REAL GDP IS NOT THE SAME AS ECONOMIC WELLBEING To understand why an increase in real GDP does not always promote economic wellbeing, we must look at some factors that are not included in GDP but do affect whether people are better off. Leisure Time

The increased leisure time available to workers in industrialised countries (eg. time with family and friends, sports etc.) is a major benefit of living in a wealthy society. These extra hours of leisure time are not priced in markets, however, and therefore are not reflected in GDP. Non-Market Economic Activities (inc. Household production)

Not all economically important activities are bought and sold in markets; with a few exceptions, such as government services, non-market economic activities are omitted from GDP (eg. housekeeping services, volunteer services etc.). The fact that these unpaid services are left out of GDP does not mean that they are unimportant. The problem is that, because there are no market prices and quantities for unpaid services, estimating their market values is very difficult. Closely related to non-market activities is the underground economy which encompasses both legal and illegal activities, from informal babysitting jobs to criminal activities such as narcotics production. Economists who have tried to estimate the value of such services have concluded that these sorts of transactions are quite important, even in advanced industrial economies. Environmental Quality and Resource Depletion

Environmental Quality depletion in Air and Water Quality at the price of an increased GDP. Resource Depletion the inability of GDP to take into account the natural resources used to produce Goods and/or services (eg. oil reserves) Measuring these factors into GDP is difficult due to their intangibility, but this does not mean they are unimportant. Quality of Life

Encompasses many factors not taken into account by GDP crime rate, traffic congestion, community organisations, open space eg. while a new shopping centre may increase GPD its locality may reduce the quality of life of the local community. Poverty and Economic Inequality

GDP measures the total quantity of goods and services produced and sold in an economy, but it conveys no information about who gets to enjoy them ie. Wealth distribution

GDP Positive Correlation Factors Clearly, in evaluating the effects of a proposed economic policy, considering only the likely effects on GDP is not sufficient. Planners must also ask whether the policy will affect aspects of economic wellbeing that are not captured in GPD. Although looking at the effects or a proposed policy on real GDP is not a good enough basis on which to evaluate a policy, real GDP per person does tend to be positively associated with many things people value, including a high material standard of living, better health and life expectancies and better education: Availability and Variety of Goods and Services

Citizens of a country with high GDP are likely to possess more and better goods and services (after all this si what GDP measures) Life Expectancy and Health

A child born in a high-income country has a life expectancy of nearly 80 years, compared to about 58 years for a child born in one of the low-income countries. Superior nutrition, sanitation and medical services in the richer countries account for these large discrepancies. Education

1.4 THE CONSUMER PRICE INDEX: MEASURING THE PRICE LEVEL CONSUMER PRICE INDEX (CPI) For any period, measures the cost in that period of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year. The CPI is the basic tool economists use to measure the price level and inflation. CPI = (Eg. If CPI = 1.25, then cost of living and average prices are 25% higher than they were in the base year) Australian CPI o o o Published Quarterly by ABS Household Expenditure Survey used to determine typical basket Base year changes every 5 years

Inflation The annual percentage rate of change in the price level as measured by the CPI (or other measures) over a given period. ( ) Inflation Rate = [ ] ( ) Inflation Rate = 0 Prices are constant Inflation Rate > 0 Prices are rising (inflation) Inflation Rate < 0 Prices are falling (deflation) Limitations with CPI Quality Adjustment and New Goods Bias o Quality improvements may show up as higher prices for goods and services o New goods are often not included until CPI is rebased Substitution Bias o Use of a fixed basket means that no allowance is made for consumers substitution towards relatively less expensive goods

RULE OF THUMB CPI tends to overstate the rate of inflation Costs of Inflation Important to distinguish between relative price change and a change in the general price level. There are 6 main costs imposed on society by inflation: Shoe-Leather Costs

Inflation reduces the real purchasing power of a given amount of money. Shoe-leather costs are probably not a great problem for countries such as Australia today, where inflations is only 203% every year. But in economies with high rates of inflation they can become quite significant. Noise in the price system

Price changes are the markets way of communicating information to suppliers and demanders. But, in the presence of inflation, prices are affected not only by changes in the supply and demand for a product but also by changes in the general price level. Inflation crates static or noise, in the price system, obscuring the information transmitted by prices and reducing the efficiency of the market system. This reduction in efficiency imposes real economic costs. Distortions of the tax system

One clear way in which inflation imposes a cost to society in countries such as Australia where tax rates are not indexed to the rate of inflation. Without indexing, an inflation that raises peoples nominal incomes would force them to pay an increasing percentage of their income in taxes as they move into higher tax brackets, even though their real incomes may not have increased. Unexpected Redistribution of Wealth

A concern about inflation is that it may redistribute wealth from one group to another, arbitrarily creating winners and losers. Although redistributions caused by inflation do not directly destroy wealth but only transfer it from one group to another, they are still bad for the economy As a high inflation economy encourages people to use up resources in trying to anticipate inflation and protect themselves against it. Interference with long run planning

High and erratic inflation can make long-term planning for households and firms very difficult. (eg. saving too much or too little as a result of changes in inflation). Menu Costs

Although this problem is not confined to restaurants any firm that publicly lists its prices in some form will incur costs when those prices are changed economists refer to this using the generic term men costs . (ie. The cost of printing new menus due to changes in prices due to large changes in inflation). Therefore, inflation damages the economy in a variety of ways. Some of its effects are difficult to quantify and are therefore controversial. But most economists agree that a low and stable inflation rate is instrumental in maintaining a healthy economy. 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 purchasing power of a financial asset

FISHER EFFECT Nominal Interest = Real Rate + (expected) Inflation rate