Chapter 8
The macroeconomic
environment and its
measurement
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Learning objectives
1. Describe the major components of Australia’s
national accounts and the measurement and
construction of gross domestic product (GDP).
2. Discuss the differences between nominal GDP
(GDP at current prices) and real GDP (GDP at
constant prices).
3. Explain how GDP figures can be adjusted to
account for changes in the price level.
4. Analyse and interpret the nature and structure of
the balance of payments (BOP) accounts.
5. Discuss the relationship between the current
account balance and the level of national savings.
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Learning objectives (cont.)
6. Examine the consequences of the structure of the
BOP accounts for achieving external balance.
7. Describe the business cycle—the periodic
fluctuations in output, employment and price levels
that have characterised our economy.
8. Examine unemployment in detail—its definition and
measurement and the structure of unemployment.
9. Discuss the economic and social problems
associated with unemployment.
10. Understand the causes and consequences of
inflation, a problem that plagued us through the
1970s and 1980s.
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Measuring the economy
The purpose of national accounts is to:
1. measure the level of production in the economy
2. explain the immediate causes of the level of
performance of the economy
3. uncover underlying problems in the economy
4. plot the long-run course of the economy over time
5. provide foundations for public policies.
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Gross domestic product
• GDP is:
• the total market value of all final goods and
services produced in the economy during a
specific period.
• measured in money terms and not in physical
units
• usually measured over a year.
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What is included in GDP?
• Only final goods and services
– These are goods and services that are being
purchased for final use and are not to be subject to
further processing, manufacturing or resale.
• Intermediate goods are excluded to avoid double
counting.
• To avoid double counting calculate only the value
added by each firm.
– Value added is the market value of a firm’s output less
the value of intermediate components.
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What is not included in GDP?
• GDP excludes non-productive transactions
– Transactions where no production of goods or
services occurs
• Two major types of non-productive transactions:
1. Purely financial transactions
2. Sales of second-hand goods
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What is not included in GDP?
(cont.)
• Financial transactions are excluded
– Public transfer payments
– Private transfer payments
– Buying and selling of shares and securities
• Sales of second-hand goods are excluded
– Do not reflect current production
– Involve double counting
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Two sides to GDP
• Expenditure approach
– Measures GDP as the sum of all the expenditures
involved in buying up that total output
• Income approach
– Sum of the incomes derived from the production of
the GDP
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Expenditure approach
GDP is derived as a sum of:
• personal consumption expenditure (C)
• gross private investment (I)
• government purchases of goods and services (G)
• net export expenditures (NX)
• GDP = C + I + G + NX
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Personal consumption
expenditure (C)
• Also called household final consumption,
expenditure includes expenditure on durable
consumer goods
– Cars, refrigerators, videos, etc.
• Non-durable consumer goods
– Milk, bread, shirts, etc.
• Services
– Doctors, mechanics, cleaners, etc.
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Gross private investment (I)
Defined as:
• final purchases of machinery, equipment and tools
• all building and construction
• changes in stocks (or inventories)
• does not include financial investment or transfer of
paper assets, e.g. buying of shares.
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Government purchases of
goods (G)
Includes all government spending (federal, state
and local) on:
• final government consumption expenditure
• final government gross fixed capital expenditure
• increases in stocks of government authorities.
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Net exports (NX)
• Net exports is the:
• difference between the value of exports (X) and
imports (M), or NX.
• amount by which foreign spending on Australian
goods and services exceeds Australian spending
on foreign goods and services.
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Income approach to GDP
• GDP(I) is calculated as the sum of all income
derived from the production of goods and services.
• Complicated by two-income charges:
– depreciation allowances
– indirect taxes.
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Compensation of employees
• Largest component
• Payments to suppliers of labour, including:
–
–
–
–
–
wages
salaries
superannuation
direct pensions
compensation payments.
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Gross operating surplus (GOS)
• Basically put this is rents, interest and profits.
• Accounts for the fact that rents, interest and profits
are difficult to separate out in practice
• Excess of gross output value over sum of:
– intermediate consumption
– wages
– salaries
– supplements
– indirect taxes less subsidies.
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Net operating surplus
• GOS less depreciation
• Depreciation:
– The annual charge that estimates the amount of capital
equipment used up in each year’s production
– Also called capital consumption allowance
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Taxes less subsidies
• Indirect taxes are treated as costs of production by
businesses and added to the prices of goods and
services.
– Indirect business taxes to the government is not
earned income.
• Subsidies are payments to business to encourage
production of a particular commodity, or negative
indirect taxes.
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Non-market transactions
• Comprise the relatively large and expanding
underground economy
• Engaged in illegal activities such as gambling
• Also include legal activities that do not fully report
their income
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Money GDP vs real GDP
• Money GDP is GDP measured in current prices
(nominal GDP).
• Real GDP is money GDP adjusted for inflation
by an implicit price deflator, also called
constant price GDP.
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Real and nominal GDP
The formula used for deflating
Real
GDP
Money GDP
=
Price index
(as decimal)
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Inflating and deflating
Two indices of price adjustment
• Consumer price index (CPI)
– Measures the price level of a ‘market basket’ of goods
and services for a typical family
• Implicit price deflator (IPD)
– Measures the average level of price changes of C, I, G
and net exports
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Balance of payments
• Reflected in international balance of payments
account
– Records all transactions between the entities in
Australia and those in foreign nations
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Balance of payment accounts
• Two basic subcategories of accounts:
– Current account—reflecting current
transactions
– Capital and financial accounts
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Current account
• Balance on current account equals sum of:
• Goods and services balance
– Goods and services credits less goods and services
debits
• Primary income balance
– Primary income credits less primary income debits
• Secondary income balance
– Secondary income credits less secondary income
debits
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Current account components
1. Goods and services account
–
–
Exports and imports of merchandise goods and services
Balance of merchandise exports and imports sometimes
called ‘balance of trade’
2. Primary income balance
–
Net interest, dividend payments & re-invested earnings, net
investment incomes associated with pensions & life
insurance investments plus net payments made to workers
employed outside their official country
3. Secondary income balance
–
Net transfers, both public & private, from the rest of the
world to residents of Australia, including monies paid
to/from Australia to students and net remittances to/from
relatives abroad
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Capital account
A. Capital account balance = capital transfers
credits – debits plus net acquisition of nonproduced, non-financial assets
• The sum of net capital transfers (migrants’ transfers
& aid flow related to capital formation) and net sales
of patents, copyrights, trademarks, franchises and
embassy land (non-produced, non-financial assets)
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Financial account
B. Financial account balance
• Direct versus portfolio investment
– Direct investment occurs when ‘controlling’ investment
is made by non-residents in an Australian company, or
when Australians make investment in a foreign
company controlled by Australian interests.
– Portfolio investment occurs when non-residents buy
non-controlling (i.e. less than 10%) shares/bonds from
Australian companies, or Australians buy shares in
foreign companies. Also includes institutional loans
– Net financial derivatives, other net investments &
reserve assets
– Net errors and omissions
Capital & financial account balance = A + B
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Australia’s current account
problem
• Three factors
– Gradual deterioration in the terms of trade
 Terms of trade is the ratio of the average price of the
goods and services exported by a country to the
average price of its imports.
– High freight and transport cost
– Dependence on large levels of capital inflow
• Current account problems in the 1970s, 1980s and
1990s and into the 2000s.
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Components of the current account
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Components of the capital and
financial accounts
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National savings
• National savings represents savings from national
income.
• This is used to finance gross capital formation.
• Secular fall in household savings in Australia
reversed in late 2000s and compensated at times
by business saving
• Government has traditionally been a net borrower
in Australia, up until the later part of the 1990s and
first half of 2000s, when it moved to be a net
saver.
• Government became a net borrower due to its
fiscal response to the global financial crisis in
2008–9
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Australia: net national savings
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The balance of payments and the
concept of external balance
• A level of the current account consistent with the
maintenance of existing (or growing) levels of
consumption, employment and national output
over the long term.
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The Australian business cycle
• The long-run economic growth in Australia has not
been steady. There were ‘ups and downs’ in the
level of economic growth over the years.
• The recurrent, cyclical increases and decreases in
the level of economic activity is termed the
business cycle.
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The Australian business cycle
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Phases of the business cycle
• Peak
– Temporary maximum economic activity
• Recession
– Decline in output and employment to low or
negative levels
– Depression—severe and prolonged recession
• Trough
– Output bottom out at their lowest level
• Recovery
– Output and employment expand towards the
full-employment level
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Phases of the business cycle (cont.)
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Unemployment
Types of unemployment
• Frictional
– New entrants and workers ‘between jobs’,
temporarily laid off due to seasonality
– Inevitable and partly desirable
• Structural
– Mismatch in skills and geographic location
– Not employable without additional training,
education and/or geographical movement
• Cyclical
– Unemployment caused by the business cycle, or
due to insufficient aggregate demand or total
spending
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Full employment
• Full employment
– A situation of labour market balance consistent with
output at the economy’s potential output level
• The full-employment rate of unemployment is called
the natural rate of unemployment.
– Equals the sum of frictional and structural
unemployment
– Cyclical unemployment = zero
– Domestic output consistent with the natural rate of
unemployment is potential output or GDP.
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Australia: unemployment rate
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Labour market definitions
• Part-time employment not counted as unemployed
– Underemployed: part-time employees who want to
work more hours but are unable to do so
• Discouraged workers
– Those who become discouraged and drop out of
the labour force but would return if a suitable job
prospect arose
– ‘Hidden unemployed’
– ‘Not in labour force’ but not officially classified as
unemployed
• Participation rate = % civilian population in a specified
labour force group
• Unemployment rate =% of labour force who are
unemployed
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Economic cost of unemployment
• Economic cost
– Output foregone, measured in terms of the GDP
gap
– Okun’s law shows the quantified relationship
between the unemployment rate and the GDP gap.
 For every 1% of unemployment above the
natural rate, a GDP gap of more than 3.5 per
cent is generated.
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Inflation
• Inflation is a continuous rise in the general price level
• The inflation rate is measured as follows:
Inflation
rate
=
Current year index – Previous year
index
x
100
Previous year index
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Theories of inflation
Two general causes/theories of inflation
• Demand-pull inflation
– Caused by excess demand for output
• Cost-push or supply-side inflation
– Rise in prices arising from increased cost of production
due to:
 wage push
 profit push.
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Demand-pull inflation
Range 3
Price level
P
Range 1
Fullemployment
output
Q
Output and employment
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Inflation and redistribution
• Unanticipated inflation can harm:
– fixed-money-income receivers
– savers
– creditors.
• Unanticipated inflation can benefit:
– debtors.
• Anticipated inflation
– Income outcomes less severe if transactors can
adjust their money incomes to compensate for
expected inflation
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Output effects of inflation
• Demand-pull inflation can provide real stimulus
• Cost-push inflation and unemployment
– Hyperinflation
– Wage-price inflationary spiral
• Hyperinflation
– Sustained, very rapid increase in the level of prices
leading to rapid erosion in the value of money
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Next chapter
Aggregate demand and
aggregate supply
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