Class 3 – Post Grad!
Gross Domestic Product
Measuring a nation’s income
• Macroeconomics answers questions like
the following:
– Why is average income high in some
countries and low in others?
– Why do prices rise rapidly in some periods
of time while they are more stable in other
periods?
– Why do production and employment expand
in some years and contract in others?
The economy’s income
and expenditure
• For an economy as a whole, income
must equal expenditure because:
– Every transaction has a buyer and a seller.
– Every dollar of spending by some buyer is a
dollar of income for some seller.
The measurement of GDP
“GDP is the market value of all final goods and services
produces within a country in a given period of time”
Y = C + I + G + NX
Y = GDP
C – Consumption
I – Investment
G – Government Purchases
NX – Net Exports
The measurement of GDP
GDP is the Market Value
Since market prices measure the amount people are willing to pay for different goods they
accurately reflect their value
If a price of an apple is twice that of an orange, the apple contributes twice as much to GDP as the
orange
Of All
GDP tries to be comprehensive.
Includes all items produced in the economy and sold legally in the market
GDP also includes the market value of housing services. If people own their houses the govt
estimates rent.
GDP excludes illegal items (drugs)
GDP excludes items that are produced and consumed at home (Vegetable Gardens)
Within a country
GDP measures the value of production within the geographic confines of a country.
In a given period of time
GDP measures the value of production that takes place within a specific interval of time
The components of GDP
• Consumption (C):
– The spending by households on goods and
services, with the exception of purchases of
new housing.
• Investment (I):
– The spending on capital equipment,
inventories and structures, including
household purchases of new housing.
The components of GDP
• Government purchases (G):
– The spending on goods and services by
local, state and federal governments.
– Does not include transfer payments because
they are not made in exchange for currently
produced goods or services.
• Net exports (NX):
– Exports minus imports.
GDP and its components
Real versus nominal GDP
• Nominal GDP values the production of
goods and services at current prices.
• Real GDP values the production of
goods and services at constant prices.
GDP and economic wellbeing
• GDP is the best single measure of the
economic well being of a society.
• GDP per person tells us the income and
expenditure of the average person in
the economy.
GDP and economic wellbeing
• Higher GDP per person indicates a
higher standard of living.
• However, GDP is not a perfect measure
of the happiness or quality of life.
GDP and economic wellbeing
• Some things that contribute to
wellbeing are not included in GDP.
– The value of leisure.
– The value of a clean environment.
– The value of almost all activity that takes
place outside of markets, such as the value
of the time parents spend with their
children and the value of volunteer work.
Inflation
Inflation
• Inflation refers to a situation in which
the economy’s overall price level is
rising.
• The inflation rate is the percentage
change in the price level from the
previous period.
The consumer price index
• The consumer price index (CPI) is a
measure of the overall cost of the goods
and services bought by a typical
consumer.
How the CPI is calculated
1.
Fix the basket: Determine which prices are most important to the typical
consumer.
2.
Find the prices: Find the prices of each of the goods and services in the
basket for each point in time.
3.
Calculate the basket’s cost: Use the data on prices to calculate the cost of the
basket of goods and services at different times.
4.
Choose a base year and compute the index: Designate one year as the base
year, making it the benchmark against which other years are compared.
5.
Compute the inflation rate: The inflation rate is the percentage change in the
price index from the preceding period
How the CPI is calculated
• The inflation rate is calculated as
follows:
C
P
I
i
n
Y
e
a
r
2
C
P
I
i
n
Y
e
a
r
1
I
n
f
l
a
t
i
o
n
R
a
t
e
i
n
Y
e
a
r
2
=

1
0
0
C
P
I
i
n
Y
e
a
r
1
What’s in the CPI’s basket?
Copyright©2004 South-Western
Correcting economic
variables
• Price indexes are used to correct for the
effects of inflation when comparing
dollar figures from different times.
Dollar figures from different
times
Real and nominal interest rates
• The nominal interest rate is the interest
rate usually reported and not corrected
for inflation.
– It is the interest rate that a bank pays.
• The real interest rate is the nominal
interest rate that is corrected for the
effects of inflation.
Real and nominal interest rates
•
•
•
•
You borrowed $1,000 for one year.
Nominal interest rate was 15%.
During the year inflation was 10%.
Real interest rate = Nominal interest
rate – Inflation
• = 15 per cent − 10 per cent = 5 per
cent
Revisiting
Demand and
Supply
And the Role of
Governments
Short-run economic
fluctuations
• A recession is a period of declining real
incomes and rising unemployment.
• A depression is a severe recession.
Three key facts about
economic fluctuations
1. Economic fluctuations are irregular and
unpredictable.
–
Fluctuations in the economy are often
called the business cycle.
Three key facts about
economic fluctuations
1. Most macroeconomic quantities
fluctuate together.
–
–
Most macroeconomic variables that
measure some type of income or
production fluctuate closely together.
Although many macroeconomic variables
fluctuate together, they fluctuate by
different amounts.
Three key facts about
economic fluctuations
1. As output falls, unemployment rises.
–
–
Changes in real GDP are inversely related
to changes in the unemployment rate.
During times of recession, unemployment
rises substantially.
The basic model of
economic fluctuations
• The basic model of aggregate demand
and aggregate supply
– The aggregate-demand curve shows the
quantity of goods and services that
households, firms and the government
want
to buy
at each
price level. demand
• The
basic
model
of aggregate
and aggregate supply
– The aggregate-supply curve shows the
quantity of goods and services that firms
choose to produce and sell at each price
level.
Aggregate demand and
aggregate supply
Price
level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
output
The aggregate-demand curve
• The four components of GDP (Y)
contribute to the aggregate demand for
goods and services.
Y = C + I + G + NX
The aggregate-demand curve
Price
level
P
P2
1. A decrease
in the price
level ...
0
Aggregate
demand
Y
Y2
2. ... increases the quantity of
goods and services demanded.
Quantity of
output
Why the aggregate-demand
curve is downward sloping
• The
The
• The
The
• The
The
price level and consumption:
wealth effect
price level and investment:
interest-rate effect
price level and net exports:
exchange-rate effect
Why the aggregate-demand
curve is downward sloping
• The price level and consumption −
The wealth effect:
– A decrease in the price level makes
consumers feel more wealthy, which in turn
encourages them to spend more.
– This increase in consumer spending means
larger quantities of goods and services are
demanded.
Why the aggregate-demand
curve is downward sloping
• The price level and investment −
The interest-rate effect:
– A lower price level reduces the interest rate,
which encourages greater spending on
investment goods.
– This increase in investment spending means
a larger quantity of goods and services
demanded.
Why the aggregate-demand
curve is downward sloping
• The price level and net exports −
The exchange-rate effect:
– When a fall in the Sri-Lankan price level
causes Sri-Lankan interest rates to fall, the
real exchange rate depreciates, which
stimulates Sri-Lankan net exports.
– The increase in net export spending means
a larger quantity of goods and services
demanded.
Why the aggregate-demand
curve might shift
• Shifts arising from:
– consumption
– investment
– government purchases
– net exports
Price
level
Shifts in the aggregate
demand curve
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
output
The aggregate-supply curve
• In the long run, the aggregate-supply
curve is vertical.
• In the short run, the aggregate-supply
curve is upward-sloping.
The long-run aggregatesupply curve
Price
level
Long-run
aggregate
supply
P
P2
2. ... does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level ...
0
Natural rate
of output
Quantity of
output
Why the long-run aggregatesupply curve might shift
• Shifts arise due to:
– labour
– capital
– natural resources
– technological knowledge
Long-run growth and inflation
2. ... and growth in the
money supply shifts
aggregate demand …
Long-run
aggregate
supply,
LRAS1980 LRAS1990 LRAS2000
Price
level
1. In the long run,
technological
progress shifts
long-run aggregate
supply ...
P2000
4. ... and
ongoing inflation.
P1990
Aggregate
Demand, AD2000
P1980
AD1990
AD1980
0
Y1980
Y1990
Quantity of
output
3. ... leading to growth
in output ...
Y2000
Copyright © 2004 South-Western
How fiscal policy influences
aggregate demand
• Fiscal policy refers to the government’s
choices regarding the overall level of
government purchases or taxes.
• Fiscal policy influences saving,
investment, and growth in the long run.
• In the short run, fiscal policy primarily
affects the aggregate demand.
Changes in government
purchases
• When policymakers change the money
supply or taxes, the effect on aggregate
demand is indirect — through the
spending decisions of firms or
households.
• When the government alters its own
purchases of goods or services, it shifts
the aggregate-demand curve directly.
Changes in government
purchases
• There are two macroeconomic effects
from the change in government
purchases:
– The multiplier effect
– The crowding-out effect
The multiplier effect
• Government purchases are said to have
a multiplier effect on aggregate
demand.
– Each dollar spent by the government can
raise the aggregate demand for goods and
services by more than a dollar.
The multiplier effect
• The multiplier effect refers to the
additional shifts in aggregate demand
that result when expansionary fiscal
policy increases income and thereby
increases consumer spending.
A formula for the spending
multiplier
• The formula for the multiplier is:
Multiplier = 1/(1 − MPC)
• An important number in this formula is
the marginal propensity to consume
(MPC).
– It is the fraction of extra income that a
household consumes rather than saves.
A formula for the spending
multiplier
• If the MPC is 3/4, then the multiplier
will be:
Multiplier = 1/(1 − 3/4) = 4
• In this case, a $20 billion increase in
government spending generates
$80 billion of increased demand for
goods and services.
The crowding-out effect
• Fiscal policy may not affect the
economy as strongly as predicted by
the multiplier.
• An increase in government purchases
causes the interest rate to rise.
• A higher interest rate reduces
investment spending.
The crowding-out effect
• This reduction in demand that results
when a fiscal expansion raises the
interest rate is called the crowding-out
effect.
• The crowding-out effect tends to
dampen the effects of fiscal policy on
aggregate demand.
Changes in taxes
• When the government cuts personal
income taxes, it increases households’
take-home pay.
– Households save some of this additional
income.
– Households also spend some of it on
consumer goods.
– Increased household spending shifts the
aggregate-demand curve to the right.
Automatic stabilisers
• Automatic stabilisers are changes in
fiscal policy that stimulate aggregate
demand when the economy goes into a
recession without policymakers having
to take any deliberate action.
• Automatic stabilisers include the tax
system and some forms of government
spending.
Market Failure
Market Failure – “A condition that arises when unrestrained operations in the
markets yield socially undesirable outcomes”
What do governments do to prevent market failure?
Establishing and Enforcing the Rules of the game
Market efficiency depends on people using your resources to maximize your
utility.
Promoting Competition
Preventing firms from colluding.
Regulating Natural Monopolies
Natural monopolies – when one first serves the market at a lower cost than other
firms. (and charges a higher price than socially optimal)
Providing Public Goods
What is a Public Good
A public good is a good that is non-rival and non excludable.
Non-Rival – Means consumption of the good by one person does not reduce the
availability of the good for others.
Non Excludable – means that no one can effectively be excluded from using the
product
Examples: Air, Mp3 Songs, Youtube
Excludable
Non-Excludable
Rivalries
Private goods – Food, Clothing Cars
Common Goods –
Fish Stocks, timber
Non-Rivalries
Club Goods – Cinema, Private parks, satellite
television
Public goods –
National TV, Defense
Taxes are used to pay for public goods!
Externalities
Dealing with Externalities
Externality – a cost or benefit that falls on a third party and therefore ignored by
the two parties to the market transaction. ‘
Negative externalities - pollution
Positive externalities – beautification of the neighborhood
Market prices do not reflect externalities
Governments use the items below to discourage negative externalities and
promote positive positions
Taxes
Subsidies
Regulations
What do governments do to prevent market
failure?
A more equal distribution of wealth
Resource markets does not guarantee a minimum level of income.
TRANSFER PAYMENTS – Reflect societies attempts to provide a basic standard
of living.
This is also called welfare economics
Minimum Wages
Price Floors
Price Ceilings (Rent Control)
Taxes
Subsidies
Minimum Wage
This is relatively prevalent in Western Countries
Price Floors
A price floor is a government or group imposed limit on how low a price can be
charged for a product
Effective Price floors are when the price floor is greater than the equilibrium price.
Price Ceiling
A imposed limit of the price charged for a product
Only if the price ceiling is below the equilibrium price will it be effective.
Consequences of Price Ceilings
Black Markets
Reduction in Quality
Discrimination