CHAPTER 2
Measuring the Macroeconomy
2-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What key data do macroeconomists
look at?
• How are key macroeconomic data
estimated and calculated?
• What is the difference between
“nominal” and “real” values?
• How are stock market values related
to interest rates?
2-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• How are interest rates related to the
price level and the inflation rate?
• How is unemployment related to total
production?
• What is right--and what is wrong-with the key measure of economic
activity, real GDP?
2-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Importance of Data
• Economists use quantitative data to
examine and understand behavior
– prices
– quantities
– values
• Data can be used in two ways
– make quantitative forecasts
– test economic theories
2-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Most Important
Macroeconomic Data
• real GDP
• the unemployment rate
• the inflation rate
• the interest rate
• the level of the stock market
• the exchange rate
2-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Table 2.1 - The Six Key Economic Variables
2-6
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The Exchange Rate
• The nominal exchange rate is the
relative price of two different
currencies
– determined in the foreign exchange
market
• Example
– €1.00 equals $1.20
– $1.00 equals €0.83
2-7
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The Exchange Rate
• Domestic exporters earn foreign
currency when they export products
– need to trade the foreign currency for
dollars
• Foreign producers earn dollars when
U.S. residents import their products
– need to trade the dollars for foreign
currency
2-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 2.1 - The Market for Foreign Exchange
2-9
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The Exchange Rate
• The real exchange rate is the
nominal exchange rate adjusted for
changes in the value of the currency
– depends on the nominal exchange rate
and the price level
2-10
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The Exchange Rate
• Example 1
– nominal exchange rate changes from
$1.20 = €1.00 to $2.40 = €1.00
– price level doubles
– real exchange rate is unchanged
• Example 2
– nominal exchange rate remains at the
same level ($1.20 = €1.00)
– price level doubles
– real exchange rate falls by half
2-11
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The Exchange Rate
• Example 3
– nominal exchange rate increases from
$1.20 = €1.00 to $2.30 = €1.00
– price level remains the same
– real exchange rate doubles
2-12
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The Exchange Rate
• To calculate the real exchange rate (),
you need three pieces of information
– price level in the home country (P)
– price level abroad (P*)
– nominal exchange rate (e)
P
  e
P*
2-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Exchange Rate
• There are many different currencies in
the world
– many different exchange rates
• Economists construct an exchange
rate index to represent “the”
exchange rate
– each country receives a weight equal to its
share of total U.S. trade
2-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Exchange Rate
• The exchange rate index is by
averaging each country’s current
exchange rate relative to its exchange
rate in the base year (1992)
Index  100 

all
c ountries
2-15
(Current exchange rate)


(1992
share
of
trade)


 (1992 exchange rate)

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 2.2 - The Exchange Rate Index,
1992-1998
2-16
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The Stock Market
• The most representative index of the
U.S. stock market is the Standard and
Poor’s Composite Index (S&P 500)
• The most commonly discussed index
of the U.S. stock market is the DowJones Industrial Average
2-17
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Stock Market
• Stock market averages are in nominal
terms
– must divide by some measure of the
price level to get the real value of the
stock market
• The real value of the stock market is a
sensitive indicator of the relative
optimism or pessimism of investors
– can forecast future investment spending
2-18
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Stock Market
• Investors face a choice between
holding stocks and holding bonds
– stocks are shares of ownership of a
corporation
• entitles you to a portion of the company’s
profits
– bonds are debts that the corporation
owes you
• pays periodic interest payments and returns
principal to you at maturity
2-19
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Stock Market
• Rates of return
– for bonds, the rate of return is the
interest rate (r)
– for stocks, the rate of return is the ratio
of earnings per share (Es) to the price
paid (Ps)
• Stocks are risky
– investors may require a risk premium (s)
2-20
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Stock Market
• Investors will hold only stocks if
Es
s

r


Ps
• Investors will hold only bonds if
Es
s

r


Ps
2-21
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Stock Market
• Investors will hold both stocks and
bonds if
Es
s

r


Ps
• This means that the value of a stock is
equal to
s
E
s
P 
s
r
2-22
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Stock Market
• How can we measure Es?
– newspaper reports what the firm’s
accountants have calculated (Ea)
– investors are interested in some long-run
average of expected future earnings (Es)
– need an estimate of the relationship
between Ea and Es
2-23
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 2.3 - Calculating the Value of a
Basket of Stocks
2-24
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The Stock Market
• provides information on
– the current level of profits (earnings)
– whether investors are optimistic or
pessimistic
– the current cost of capital
– attitudes toward risk
2-25
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Interest Rate
• is the price at which purchasing power
can be shifted from the future into the
present
• is not a single lump sum, but an
ongoing stream of payments made
over time
– is a flow variable
2-26
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Interest Rate
• There is a large number of different
interest rates that vary by
– risk
– duration
– tax treatment
• Published interest rates are nominal
interest rates
real interest rate  nominal interest rate - inflationrate
2-27
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Figure 2.4 - The Real versus the Nominal
Interest Rate
2-28
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The Price Level
• is most frequently measured by the
Consumer Price Index (CPI) which
– is calculated monthly by the Bureau of
Labor Statistics
– is an expenditure-weighted index
2-29
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Table 2.5 - Calculating a Price Index for
Fruit: An Example
2-30
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The Consumer Price Index
• Price index formula
Price of oranges today
Index 
 (orange index weight) 
Base - year price of oranges
Price of apples today
 (apple index weight) 
Base - year price of apples
Price of pears today
 (pear index weight) 
Base - year price of pears
Price of bananas today
 (banana index weight)
Base - year price of bananas
2-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumer Price Index
• In the base year, the price index will
equal 100
$0.75
$1.20
Index 
 (45) 
 (42) 
$0.75
$1.20
$0.90
$0.40
 (9) 
 (4)  100
$0.90
$0.40
2-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumer Price Index
• In the subsequent year, the price
index will equal 138
$1.50
$1.00
Index 
 (45) 
 (42) 
$0.75
$1.20
$0.90
$0.40
 (9) 
 (4)  138
$0.90
$0.40
2-33
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Kinds of Index Numbers
• Laspeyres index
– uses relative expenditure levels in a
fixed base year as weights
– example: Consumer Price Index
• Paasche index
– uses current, variable expenditure
levels as weights
– example: GDP deflator
2-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Kinds of Index Numbers
• All price indices are imperfect
– the Laspeyres index overstates the
effects of price increases
• based on a fixed market basket
• does not take into account that consumers
substitute relatively cheaper goods for
relatively more expensive goods when prices
rise (substitution bias)
2-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Kinds of Index Numbers
• All price indices are imperfect
– the Paasche index understates the
effects of price increases
• does take account of substitution
• does not take into account the fact that
substituted items are less-valued than the
items they replace
2-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Inflation Rate
• is a measure of the rate of change in
the price level over time
– is a flow variable
• can be measured using different price
indices
– Consumer Price Index (CPI)
– GDP deflator
2-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 2.5 - Different Measures of U.S. Inflation,
1960-2000
2-38
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The Unemployment Rate
• is the fraction of people who
– want a job
– are looking for a job
– cannot find a job
• is calculated using the Current
Population Survey
– monthly survey by the Bureau of Labor
Statistics
2-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Unemployment Rate
• Individuals are classified into one of
four categories
– those who are employed
– those who are out of the labor force and
do not want a job currently
– those who do want a job currently, but
have given up looking for one
– those who do want a job and are
currently looking for one
2-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Unemployment Rate
Labor force  (Employed)  (Looking for Work)
Looking for Work
Unemployment Rate 
Labor Force
Looking for Work

(Employed)  (Looking for Work)
2-41
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Figure 2.6 - The U.S. Unemployment Rate
since 1950
2-42
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Unemployment Rate
• is a stock variable
• may underestimate the real
experience of unemployment
– discouraged workers
– workers who are part-time for economic
reasons
• vary by demographic group
2-43
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 2.7 - U.S. Unemployment Rates by
Demographic Group, 1960-2000
2-44
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Okun’s Law
• describes the relationship between
unemployment and output in the U.S.
% change in real GDP  (% growth in potential output) 2.5  (percentage - point change in unemployme nt)
• implies that a 1 percentage-point fall
in unemployment is associated with
an extra 2.5 percentage points of
growth in real GDP
2-45
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 2.8 - Okun’s Law
2-46
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Real GDP
• is calculated by adding up the value of
all final goods and services produced
in the economy
– is a flow variable
• includes final goods and services
purchased by
– consumers
– firms
– the government
2-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Nominal versus Real GDP
• Nominal GDP measures current
output using current-year prices
– changes in nominal GDP can occur from
changes in either output or prices
• Real GDP measures current output
using prices from a base year
– changes in real GDP can only occur if
output changes
2-48
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Nominal versus Real GDP
• Example
2-49
Product
BaseYear
Output
BaseYear
Price
($/lb.)
Current
Output
Current
Price
($/lb.)
Oranges
6 lbs.
$0.75
8 lbs.
$1.00
Apples
3.5 lbs.
$1.20
3.5 lbs.
$1.20
Pears
1 lb.
$0.90
1 lb.
$0.50
Bananas
1 lb.
$0.40
1 lb.
$0.40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Nominal versus Real GDP
• Base Year
– Nominal GDP = $10.00
– Real GDP = $10.00
• Current Year
– Nominal GDP = $13.10
– Real GDP = $11.50
2-50
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More on GDP
• Intermediate goods
– are goods sold to a firm for use in further
production
– are excluded from GDP
• Changes in inventories
– are counted as part of investment
• Imputations
– are made for goods and services not sold
through markets
2-51
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Components of Real GDP (Y)
• Consumption (C)
• Investment (I)
Y  C  I  G  NX
– residential structures
– non-residential structures
– producers’ durable equipment
– changes in business inventories
• Government purchases (G)
• Net exports (NX)
2-52
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Table 2.8 - Components of GDP, Third
Quarter of 2000
2-53
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What Is and Is Not in GDP
• Included in GDP (but should not be)
– replacement of worn-out or obsolete
capital
– government purchases which could be
counted as intermediate goods
• Not included in GDP (but should be)
– household production
– depletion of scarce natural resources
– “bads”
2-54
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Figure 2.9 - Labor Force Participation Rates
by Gender, 1948-1996
2-55
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Chapter Summary
• Because goods and services are
bought and sold with prices attached,
economists have a lot of quantitative
data to work with
• The real exchange rate is the relative
price at which two countries’ goods
exchange for each other
– calculated by adjusting the nominal
exchange rate for changes in the price
levels of the two countries
2-56
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The level of the stock market reflects
the variables which affect investment
– current profits
– investors’ optimism or pessimism
– the real rate of interest
– attitudes toward risk
• The real interest rate is calculated by
subtracting the inflation rate from
nominal interests rates
2-57
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The most-commonly seen measure of
the price level is the Consumer Price
Index (CPI)
– the inflation rate is the rate of change in
the CPI
• Unemployment and output are linked
through Okun’s law
– a 1 percentage-point decrease in the
unemployment rate leads to a 2.5
percent increase in output
2-58
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Real GDP is the most commonly-seen
measure of the overall level of
economic activity
– calculated using prices from a base year
• What is and what is not included in
GDP is the result of economists’
beliefs in the 1940s and 1950s about
what would be possible to measure
easily
2-59
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.