Macroeconomics
Measurement, Business Cycles
and Growth
Students should be able to
• Define GDP and its components, describe expenditures
that belong in GDP from those that don’t. .
• Distinguish main price indices
• Define the inflation rate and describe the costs of
anticipated and unanticipated inflation.
• Define the unemployment rate and its components.
• Describe business cycle expansions and contractions
and the behavior of the economy during business cycles.
• Describe the ex post and ex ante real interest rate.
Quantity Aggregates
• We need to combine the many goods
produced or consumed in an economy into
one measure.
• All goods sold in an economy share a
common unit of measure: the price at which
they are sold.
• Quantity aggregates sum up market value of
a group of goods.
• Most commonly measured aggregate is
aggregate goods produced within an
economy.
Gross Domestic Product (GDP)
•
GDP is the sum of the new, final goods
produced within the domestic borders of an
economy.
– GDP does not include intermediate goods.
• Final goods are goods which are sold to their end-users
• Intermediate goods are sold from one firm to another
for intermediate transformation into other goods.
– GDP does not include purchases of used goods
produced in another period.
– GDP does not include financial transactions.
– GDP does not include goods produced by
domestic firms outside the border of an economy.
Expenditure Method
• The Expenditure Method adds up the domestic
spending (less domestic demand satisfied by
imports).
Expenditure Categories
GDP = Consumption
+ Investment (including inventory investment)
+ Government Consumption
+ Exports – Imports
Expenditure Categories in Hong
Kong: 2001
160.00%
140.00%
120.00%
100.00%
% of GDP
80.00%
60.00%
40.00%
20.00%
0.00%
Household Government
Consumption Consumption
Investment
Exports
Imports
Japanese Expenditure
Fiscal Year
(Billion Yen)
Items
1.7 Private final consumption expenditure (2.1)
1.8 Government final consumption expenditure (2.2)
(regrouped)
Actual final consumption of households
Government actual final consumption
1.9 Gross domestic fixed capital formation (3.1)
Of which intangible fixed assets
1.10 Changes in inventories (3.3)
1.11 Exports of goods and services (5.1)
1.12 (less) Imports of goods and services (5.6)
Gross domestic expenditure
(cf) Incomes from the rest of the world
‚to the rest of the world
(less) Income‚
Gross national income
2003
283,547.5
88,002.0
332,970.6
38,578.9
120,238.8
10,810.2
270.0
60,375.7
51,180.5
501,253.5
12,787.4
4,001.1
510,039.8
Production Method
• GDP is the sum of the value added
created in all the sectors of the economy.
• Value added is sales minus materials,
intermediate inputs and energy costs.
• The value of a final good is equal to the
value added at each stage of production.
• Expenditure method = Production Method.
Production shares in HK have changed
over time.
Production Account
0.25
0.2
0.15
% of GDP
0.1
1980
0.05
2001
1980
Landlord
Services
FIRE
Transport
Trade
Construction
Utilities
Manufacturing
Mining
AFF
0
Income Method
• The value added of a firm is the income
available to pay workers, t and credit
costs. Any left over income is profits.
• Income from domestic sources is another
way of calculating GDP
– Not done, annually for HK
Income Method, Japan 2003
(Billion Yen)
Items
Compensation of employees ,payable
(1) Wages and salaries
(2) Employers' social contributions
Taxes on production (less) Subsidies
Proprieters Income
Corporate Profits and Interest Payments
Depreciation
(regrouped) Value added ,gross/gross domestic product
2003
265,484.8
223,445.0
42,039.8
36,562.4
19,884.5
71,160.3
101,301.0
494,393.0
GNP vs. GDP
• Gross National Product or GNP is the
income of national residents.
• GDP is the income created within national
borders.
• GNP is GDP plus Net Factor Income
• Net Factor Income is income earned on
overseas work or investments minus
income generated domestically but paid to
foreigners.
GDP Deflator
• GDP deflator is an index of the price level
relative to some base year.
• It is the cost of purchasing the goods that
represent GDP relative to the cost of
purchasing the exact same goods if they
had been sold at the prices prevailing in
the base year.
Price Indices
• Two most commonly used price indices are GDP
Deflator and Consumer Price Index (CPI)
• In constructing the CPI, statisticians calculate
the total expenditure of the average household
during a benchmark year.
• The current CPI is the price of that market
basket relative to its cost in the base year
(multiplied by 100).
• Price index in the base year is always 100.
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
CPI vs. GDP Deflator
120
100
80
60
40
20
0
CPI
GDP Deflator
CPI vs. GDP Deflator
• CPI is calculated monthly, GDP deflator is
calculated quarterly.
• CPI measures the price of consumer goods.
GDP deflator measures the price of all goods
produced including investment or government
goods.
• CPI measures the change in price of a constant
market basket. Market basket of GDP deflator
changes as goods produced changes.
What is Inflation?
• Define Inflation as the
growth rate of prices.
• The greek letter π is
often used as a
symbol of inflation
Pt
1 t 
Pt 1
t 
Pt  Pt 1
Pt 1
Pt  Pt 1
Inflation Rate 
x100%
Pt 1
Inflation means that prices are growing
Disinflation means that inflation is slowing
down but still positive
Deflation means that inflation is negative and
prices are actually dropping.
•
•
•
Adjusting for Inflation/
Converting Current Price Series into
Constant Price Series
One may have a time series of an aggregate,
Nt, (in current prices)
We can use some price index to “adjust for
inflation” effectively converting into a variable
measured in the prices of some reference
year.
Real series measures the value of goods that
could have been purchased with that amount
of money in the reference year.
N
Real
t
PRef
 Nt 
Pt
Example
• In 1966, Howard Hughes was forced to
sell TWA and received a single check for
US$650 million. How much is that in 2004
dollars?
• The GDP deflator in USA in 1966 was
22.855. The deflator in 2004 was 107.958.
• In 2004 dollars this is
P2004
107.958
650 
 650 
 3044.63294
P1966
22.855
Real GDP/GDP Adjusted for
Inflation/ Constant Price GDP
• When you compare production levels
across time, you want to adjust for
changes in the market price level.
• Real GDP measures output if the goods
were sold at the prices that prevailed in a
base year.
GDPt
REAL GDP 
100
GDP Deflatort
GDP vs. Real GDP
HK 1960-2004
1,600,000
1,400,000
1,000,000
800,000
600,000
400,000
200,000
0
19
61
19
64
19
67
19
70
19
73
19
76
19
79
19
82
19
85
19
88
19
91
19
94
19
97
20
0
20 0
03
#
Mill. HK$
1,200,000
GDP
Real GDP
Trend and Cycles
• We observe that real GDP is growing over
time but at a non-constant rate.
• We call the growth path, if the economy
were always growing at its average
rate,the trend path.
• Fluctuations around the trend are called
business cycles.
Business Cycle Terms
• As the economy fluctuates around the trend, the
economy is experiencing business cycles.
• When economy is moving from a peak level to
trough level, the economy is in a contractionary
phase.
• When economy is moving from trough to peak,
the economy is in an expansionary phase.
• When economy is moving from peak to trough
the economy is in a contractionary phase.
Recessions and Booms
• Business cycle positions are sometimes
characterized as booms and recessions.
• These names have many definitions
– a boom occurs roughly when real output is
above the trend growth path (detrended
output is positive).
– A recession occurs roughly when real output
is below trend growth.
• In the USA, recessions are sometimes defined as
2 consecutive periods of negative growth.
HK Booms & Recessions
Hong Kong Business Cycle
0.06
0.04
Peak
0.02
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
-0.02
19
80
0
19
78
% Difference from Trend
Peak
Peak
Trough
Trough
-0.04
-0.06
Trough
-0.08
Trough
Business Cycles & Co-movement
• Business cycles are fluctuations in the
economy as a whole.
• Different sub-categories of GDP tend to
co-move with business cycles though to
different degree.
• Business cycles tend to co-move across
countries though not as strongly as within
countries.
Business Cycles & Sub-Categories
• Expenditure. Consumption and Investment comove with output. Investment is more volatile
than consumption. Consumer durables are most
volatile part of consumption.
• Production – Production sectors co-move with
business cycles. Manufacturing & Construction
most volatile. Services least volatile.
• Income – Worker Compensation & Capital
Income are both pro-cyclical. Capital Income
tends to be more volatile.
Hong Kong Expenditure Cycles
.20
.15
.10
.05
.00
-.05
-.10
-.15
1975
1980
1985
1990
1995
GDP
Household Consumption
Fixed Investment
2000
Corporate Profits
• We find that corporate profits are strongly
pro-cyclical and volatile.
• When the economy is doing well,
corporations tend to earn high real profits.
• Corporate profits fluctuate far more than
the economy as a whole.
HK Corporate Earnings & the
Business Cycle
.4
% Deviation from Trend
.3
.2
.1
.0
-.1
-.2
-.3
-.4
-.5
86
88
90
92
94
96
Real Corporate Earnings
98
00
Real GDP
02
Using financial market data to
predict business cycles
• It has been joked that stock markets have
predicted 7 out of the last 5 recession.
(In fact there does seem to be a moderately strong,
positive correlation between cyclical variation in stock
prices and business cycles)
• In the USA, some financial market indicators
have been shown to predict business cycles.
– Default Spread : Interest rates on lower rated bonds
vs. Interest rates on better rated bonds.
– Term Spread: Interest rates on long-term bonds vs.
short-term bonds (when this is inverted, recession is
likely)
Unemployment Rates
• The population resides in 1 of 3 categories
– Employed: Currently working.
– Not in the Labor Force: Not working and not
actively seeking work
– Unemployed: Not working but seeking work.
Unemployment Rate
Unemployed
UR 
100%
Employed  Unemployed
Oct-04
Oct-03
Oct-02
Oct-01
Oct-00
Oct-99
Oct-98
Oct-97
Oct-96
Oct-95
Oct-94
Oct-93
Oct-92
Oct-91
Oct-90
Oct-89
Oct-88
Oct-87
Oct-86
Oct-85
Oct-84
Oct-83
Oct-82
Oct-81
Level of Unemployment in HK
Hong Kong Unemployment Rate
10
9
8
7
6
5
4
3
2
1
0
Types of Unemployment
3 Types of Unemployment
1. Cyclical Unemployment – Unemployment
associated with business cycles.
When demand falls, demand for labor falls.
Workers may not be at first willing to work at
new market wage rate at may sit idle.
Types of Unemployment
2. Structural Unemployment
When specific demands for workers (location or
skills) does not match the characteristics of
the workforce.
Restrictions on job conditions may make it
difficult for firms to find workers that match
their needs under given conditions
Minimum wage means only high skill workers
may be hired.
Firing costs may mean that jobs for young or
difficult to evaluate workers may not appear.
Types of Unemployment
3. Frictional Unemployment
Unemployment that occurs as a part of the
movement in and out of the workforce.
Very frequently when a worker changes
their employment situation there is some
period of unemployment.
Differences in Unemployment
Rates (http://www.oecd.org)
Standardized Unemployment Rates
Japan
Italy
Germany
France
USA
0
1
2
3
4
5
6
7
8
9
10
US Treasury offers bonds whose payoff is
indexed to inflation. Yield is tantamount to ex
ante real interest rate.
5.00
4.00
3.00
2.00
1.00
0.00
Fe
TIPS
10 Year
05
b
Ap
5
-r 0
J
-0
n
u
5
A
-0
g
u
5
Why is unemployment so high in
W. Europe?
• Tightly regulated labor markets increase
structural unemployment.
• High social welfare benefits increase
frictional costs as workers have little
incentive to search diligently until the
benefits work out.
What is Inflation?
• Define Inflation as the
growth rate of prices.
• The greek letter π is
often used as a
symbol of inflation
Pt
1 t 
Pt 1
t 
Pt  Pt 1
Pt 1
Pt  Pt 1
Inflation Rate 
x100%
Pt 1
Inflation means that prices are growing
Disinflation means that inflation is slowing
down but still positive
Deflation means that inflation is negative and
prices are actually dropping.
Costs of Anticipated Inflation
• Shoe Leather Costs – Money is a technology for
engaging in transactions. The greater is inflation,
the greater the cost for individuals of holding
money. Individuals must make efforts as a
substitute for the convenience of holding money.
• Menu Costs – Firms must engage in costs of
changing posted prices. More generally, when
prices change rapidly over time, more time and
effort must be put into calculating relative prices.
Interest Rates
• Nominal Interest Rate (1+it): Number of $ a
borrower will pay you in one year if they borrow
$1 today.
$PAYOFF  1  i   $PRINCIPAL
• Real Interest Rate (1+rt): Number of goods a
borrower will pay you in one year if they borrow
1 good today. $ PAYOFF
$ PRINCIPALt
t 1
 1  r  
Pt 1
But inflation is not known ex ante.
To guess real interest rate when we
make a loan we must anticipate
inflation.
Pt
 1 r 
1 i
1   1
• Fischer Hypothesis
ir
EA

– Nominal interest rates are set according to
some target real interest rate plus
anticipated inflation.
• When actual inflation is greater than
expected inflation, ex post real interest
rates are less than actual real interest
rates.
A
Fischer Equation Rough Guide to
HK Interest Rates
Hong Kong Inflation & Nominal Interest Rates
16
12
8
4
0
-4
-8
80
82
84
86
88
CPI_Inflation
90
92
94
96
98
Time_Deposit_Rate
00
Average Ex Post Real Returns
• If we put Principal into an investment for T
periods at nominal interest rate i, we get a
pay-off. Payoff = (1+i)T Principal
• If we put money into an investment, the
1
average return is

T
Payoff +T
Payoff +T
1 i  T


Principal  Principal 
• Average Real Return is
 Payoff +T
PT 
PT

Principal
Principal
P 
P
Payoff +T
1 r  T





1
T
Costs of Unexpected Inflation
• When inflation is faster than is expected,
the purchasing power of the payoff to an
investment will decline unexpectedly.
– Borrowers will win, but lenders will lose.
Inflation Risk
• When inflation is variable, lenders will
demand some premium for inflation risk.
This will put cost on borrowers.
• High inflation rates tend to be associated
with unpredictable inflation .
Inflation: HK GDP Deflator
Inflation
20.0
15.0
10.0
5.0
19
61
19
64
19
67
19
70
19
73
19
76
19
79
19
82
19
85
19
88
19
91
19
94
19
97
20
00
20
03
#
0.0
-5.0
-10.0
HK Real Interest Rate
Real Interest Rate
20
15
10
5
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
-5
Per Capita GDP
• GDP is national income.
• Average income or per capita GDP can be
obtained by dividing GDP by population
level.
• Since income is unevenly distributed this
may not measure the income of the
representative individual.
International Comparisons Project
• Researchers at U. of Pennsylvania periodically
choose a representative world market basket
and go to different countries to collect prices of
that market basket of good.
• For a country, we calculate PPP = Purchasing
Power Parity as the price of the market basket
relative to price of the market basket in US.
• For any country, the exchange rate, St, is the
number of domestic dollars per US$.
Comparing GDP across Countries
• When you compare income in two different
countries, each country’s GDP per capita is
measured in local currency. You need to
measure both with common yardstick to
compare.
• Typically, the common yardstick will be
US$. GDP can be converted to US$ by
Exchange Rate Method (divide national
GDP by the exchange rate) or PPP Method
(divide national GDP by PPP).
PPP vs. Exchange Rate
Conversion
• Exchange rates are easily available so
exchange rate is a “quick and dirty” comparison.
– Measures how many US dollars someone could buy
with average income.
• However, money goes farther in some countries
as many types of goods are relatively cheap
(especially developing countries).
– PPP conversion measures how much the goods
purchased by the average person would cost in the
US. Better measure of living standards.
Comparison of China vs. HK
• Goods are cheaper in
China than in HK
Hong Kong
China
Local
Currency
GDP
HK$192,776
￥6,423.00
2002
S
PPP
7.8 6.666667
8.2644628 1.915709
Hong Kong
China
US Dollar GDP
Exchage Rate
Conversion
$24,714.87
$777.18
PPP
Conversion
$28,916.40
$3,352.81
Wide Variation in Income per
Capita, 2000
GDP per Capita
30000
25000
15000
10000
5000
et
na
m
Vi
Th
ai
la
nd
ng
ap
or
e
Si
Ph
ilip
pi
ne
s
al
ay
sia
M
Ko
re
a,
Re
p.
Ja
pa
n
In
do
ne
sia
Ko
ng
,C
hi
na
0
Ho
ng
US$
20000
Determinants of Income Levels
• GDP per capita can be decomposed into
labor productivity and average hours
worked.
Hours Worked
GDP
GDP


Population Hours Worked
Population
• Amongst developed countries there are
large difference in output per capita due to
variations in employment per person
Large Variations in Labor per
Person (www.ggdc.net)
Hours per Worker 2001
Taiwan
South Korea
Singapore
Hong Kong
Japan
USA
EU
0
500
1,000
1,500
2,000
2,500
3,000
Variation in Labor Force
Participaton
Employment as a share of Population
52.00%
50.00%
48.00%
46.00%
44.00%
42.00%
40.00%
38.00%
Europe
U.S.A
Japan
Hong Kong
Singapore South Korea
Taiwan
Main Differences in Countries are
Due to Variation in Labor
Productivity
GDP per Worker
50000
45000
40000
35000
30000
25000
20000
15000
10000
5000
Th
ai
la
nd
Ta
iw
an
ng
ap
or
e
Si
Ph
illi
pp
in
es
al
ay
sia
M
Ko
re
a
In
do
ne
sia
Ho
ng
Ko
ng
0
Determinants of Labor Productivity
•
•
•
Capital per Worker: Capital, K, is the
value of machines, structures and
equipment used to produce goods.
Human Capital – Education and
experience of the workforce
Technology – Available Techniques and
Ideas for using goods and efficiency with
which they are used.
Capital Productivity and Capital Labor Ratio
• Returns to corporate investment are
determined by capital productivity.
• Ceteris parabis, countries with low capitallabor ratios will have high capital productivity.
• As a country increases its capital per worker, it
will push down capital productivity but
increase labor productivity
Equalization of Capital Returns
• With efficient capital markets, capital will flow to
those places where capital productivity is high
until return on investment is equalized across
countries (adjusted for risk and tax differences).
• Capital per worker will be low in those countries
where capital is heavily taxed or risk premiums
are high. Risk premiums are high if investment is
risky, or financial systems are less sophisticated.
• In reality, limitations to international capital
markets mean that much investment in capital
equipment is financed by domestic savings.
Measuring Technology
• Main measure of technology differences is Total
Factor Productivity or TFP.
• TFP measures efficiency with which a country is
using all of its resources
• TFP is measured as a geometrically weighted
average of capital and labor productivity
• Weights measure the relative importance of
each factor (what share of income is paid to
labor)


GDP

TFP  
 Value of Capital 


weight K


GDP


 Hours Worked 


weight L
The Case of Korea
• Over the last 50 years, South Korea has enjoyed
some of the highest growth in per capita GDP.
• Korean success story mostly about increasing
the education of the workforce and rapidly
building the countries physical plant.
• Still, however, Korea remains far behind world
leaders in terms of labor productivity.
High Investment Rates, Low
Capital Productivity
Investment Rates
45
40
% of GDP
35
30
25
20
15
10
5
0
65 9 67 9 69 9 71 9 73 9 75 9 77 9 79 9 81 9 83 9 85 9 87 9 89 9 91 9 93 9 95 9 97 9 99
9
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
U.S.A
South Korea
Relatively Stable Capital Productivity in
USA, decline in South Korea
1.2
1
0.8
U.S.A
0.6
South Korea
0.4
0.2
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
0
Korean Labor Productivity goes from less than
10% of USA to more than 40%.
Output per Hour
40.00
35.00
1999 US$
30.00
25.00
20.00
15.00
10.00
5.00
0.00
65 9 68 9 71 9 74 9 77 9 80 9 83 9 86 9 89 9 92 9 95 9 98
9
1
1
1
1
1
1
1
1
1
1
1
1
U.S.A
South Korea
Allocative Efficiency
• Korea is advanced in a technological
sense and has a highly educated work
force.
• Korea accumulated a high level of capital
per worker.
• Korean financial system may have
allocated capital for political ends rather
economic.