Dr. Mohammed Alwosabi

Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

Chapter 1 MEASURING GDP AND PRICE LEVEL

MEASURING EONOMIC ACTIVITY — Macroeconomics focuses on the economic activity of a country. Overall, economic activity is the pattern of transactions in which things of real useful value-resources, goods and services--are created, transformed, and exchanged. — Macroeconomics studies the aggregate (or total) concept of economic activity. Its focus is on the aggregate output, the aggregate income, the general price level of goods and services, the total jobs in the entire economy, etc. — Macroeconomics discusses the issues and policies concerning economic growth, unemployment, inflation, the government budget deficit, and the international trade balance. — Economic activity is measured by calculating gross domestic product (GDP). This measurement is sometimes called national Income accounts. — There are three ways to measure economic activity or GDP: o Product (or Value Added) Approach: output produced by all firms to be sold o Expenditure Approach: amount spent by ultimate buyers o Income Approach: income received by producers from the sale of the total output — The three approaches are equivalent. Any output produced (product approach) is purchased by someone (expenditure approach) which results in income to someone (income approach) ⇒ total production = total expenditure = total income. — GDP provides a measure of total production, total expenditures, and total income. — It can be used to make comparisons over time and across countries. — So, what’s GDP?

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

GDP DEFINED (THE PRODUCT APPROACH) — Gross Domestic Product (GDP) is the market value of all final goods and services produced within the border of a country in a given time period. — This definition contains four parts: 1. Market value 2. Final goods and services produced 3. Within the border of a country 4. In a given period of time 1. Market value: o

To measure total production we must add together the production of all final goods and services produced in a country. Since we cannot add fruits to clothes, computers to rice, and since we cannot add tons to units to meters to gallons, it is necessary to convert all output to the same unit of measurement. Conversion is to calculate the market value (market price) of each good and service and then add them together. Thus, market value means valuing production according to market price.

o

Market value of a good = (Price of the good) * (Quantity of the good) = P*Q

o

Example: Suppose a country produces only three final goods. Quantities and prices of these goods for two different years are given in the table below: Good 1

Year

Good 2

Good 3

GDP

Q

$P/unit

Q

$P/unit

Q

$P/unit

2005

2000

1

3500

3

500

10

$ 17500

2006

3000

2

4000

2.5

700

11

$ 23700

GDP in 2005 = P1 Q1 + P2 Q2 + P3 Q3 = ($1) (2000) + ($3) (3500) + ($10) (500) = $17500 GDP in 2006 = P1 Q1 + P2 Q2 + P3 Q3 = ($2) (3000) + ($2.5) (4000) + ($11) (700) = $23700

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Dr. Mohammed Alwosabi

o

Econ 141: Macroeconomics - Ch.1

Using market value allows us to add goods and services produced together, and to compare the GDP of one year to that of another. We can see here that GDP increases in 2006. This means the economy has grown from 2005 to 2006.

2. Final Goods and Services: o

To calculate GDP we count only the value of the final goods and services produced. We do not count intermediate goods.

o

A final good (or service) is the good that does not require any further processing in the market and is available for immediate consumption or use. In other words, it is an item bought by its final user during a specified time period.

o

The bread bought by a consumer is a final good but the flour bought by the baker is not. The flour bought by the baker is an intermediate good.

o

An intermediate good (or service) is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service in the same period. In other words, it is the good that requires additional processing before it is sold to consumers for final use.

o

Examples of intermediate goods: flour used to produce bread, tires used on the car, and Intel Pentium chip inside a computer.

o

Some goods can be intermediate goods in some situations and final goods in other situations. For example, eggs may be used as a final good or an intermediate good.

o

Consumption goods, capital goods, government purchases, and inventory investment are treated as final goods

o

GDP counts only final goods and does not directly include intermediate goods to avoid double counting, counting the same intermediate goods twice.

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Dr. Mohammed Alwosabi

o

Econ 141: Macroeconomics - Ch.1

Exercise: Which of the following expenditures of a country is an intermediate good? a. The government of a country buys new batteries for its military trucks b. You buy a new battery for your used car c. A car producer in the country buys new batteries to install in the cars it is producing d. A battery company in the country sells new batteries to other countries

o

Exercise: Which of the following is not considered a final good? a. The purchase of a car by a household b. A tailor buys textiles to make shirts c. The purchase of food by household d. A company buys a new machine for its production of goods

o

Exercise Bahrain Aluminum Company (BAC) produces and sells aluminum products. If BAC sold an oven to a bakery that used it to produce breads, do you consider this oven as an intermediate good or a final good?

3. Produced within the border of a country: o

Only goods and services that are produced within the border of a country counted as part of that country’s GDP, irrespective of who produces them.

o

Examples: a. The income received by a Bahraini worker working in Dubai is part of UAE’s GDP. b. The market value of the product provided by a Malaysian company working in Bahrain is part of Bahrain’s GDP. c. Profits generated by a U. S. bank in Bahrain are included in Bahrain’s GDP.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

4. In a given time period: o

GDP includes only goods and services that are newly produced within the current year.

o

GDP does not include purchases or sales of goods and services that were produced in previous years. All used goods traded during that year are excluded.

o

The year of production not the year of sale determines the allocation of GDP.

o

Goods that are produced this year, kept in inventories, and then sold to consumers next year count in this year’s GDP

o

Example: Suppose a house newly built in 2003 but sold in 2004. The market price of the house counted in the GDP of 2003 not in the GDP of 2004.

EXPENDITURE APPROACH: — In this approach of measuring GDP, the expenditures on all final goods and services made by all sectors of the economy are added to calculate GDP. — Expenditures are divided into 4 different categories: consumption expenditure (C), investment (I), government expenditure on goods and services (G), and net exports over a period of time, which is exports minus imports (NX = X – M). — Using expenditure approach, the largest component of GDP is usually personal consumption expenditures. — GDP can be computed as the sum of total expenditures of personal consumption, gross private investment, government purchase of goods and services, and net export over a period of time. — If GDP denoted by Y then, GDP = Y = aggregate expenditure = C + I + G + X – M = C + I + G + NX

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

Consumption (C) — Firms sell and households buy consumers’ goods and services in the goods markets. The total payments for these goods and services are called consumption expenditure. — Personal consumption expenditure (C) includes expenditures spent on goods and services produced inside the country and the rest of the world. — Buildings and houses are not included in the consumption expenditure. They are part of the investment. — Purchased of stocks and bonds are not part of consumption expenditure.

Investment (I) — Investment (also called gross private domestic investment) (I) as used in macroeconomics refers to 1. The purchase of new capital. Firms buy from each other new capital goods such as machines, tools, equipments and buildings in the goods markets. These new capital goods are used to produce other goods and services. 2. Some of what firms produce is not sold but is added to inventory (can be considered as if the firm is buying from itself). Inventories include a firm’s stock of unsold goods, goods in process and raw materials. 3. Purchases of all new residential buildings are also part of investment. — Both capital goods and inventory investment are treated as final goods and included in the GDP. — Note - Investment does not include stocks or bonds or other financial assets. These assets only involve transfers of ownership - no physical asset is directly created because of these assets — Example: Goods that are produced this year, stored in inventories, and then sold to consumers next year count in this year’s GDP

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— Example: If a Bahraini firm buys new machines from Japan, Bahrain’s investment would increase. — Exercise: True or False: An example of investment in calculating this year GDP using expenditure approach is the purchase of one year old beautiful house by a newly married couple. — Exercise: A computer manufacturer makes a computer this year to be sold next year. This computer will be counted in a. next year ‘s GDP b. next year’s investment c. this year’s investment and this year’s GDP d. next year’s investment and next year’s GDP

Government Expenditure (Purchase) (G) — Government expenditure on goods and services (also called government purchase) (G) may include buying goods and services from firms, building roads and bridges, purchase of military equipment, purchase of furniture for offices, etc. — Government collects taxes and uses tax revenue to pay for its purchase. — Net tax = tax paid to government – transfer payments – interest payments on government debt. — Transfer payments are cash transfers from government to households such as social security, unemployment compensation, and to firms such as subsidies. — Transfer payments are government expenditures that do not represent purchase of final goods or services and they are not related to current production so they are not included in G and therefore not included in GDP. — Exercise: Which of the following is not included in 2004 GDP?

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

a. A landlord rents an apartment for BD400 per month during 2004 b. Bahraini government purchase of new tanks for its defense force in 2004 c. Bahraini government pays money for a student to attend college in 2004 d. A company buys new machines in 2004 for its production line.

Net Export: — Countries trade with each other. — Our country sells goods and services to the rest of the world. This is called the value of exports (X). Exports are added because they are produced domestically but not measured as part of C, I, or G. — Our country buys goods and services from the rest of the world. This is called the value of imports (M). Imports subtracted because they are typically included in C, I, or G, but they are not domestic production. — Total adjustment results in adding net export (NX) NX = Exports – Imports = X – M If X > M ⇒ NX > 0 ⇒ trade surplus If X < M ⇒ NX < 0 ⇒ trade deficit — Example: If a Bahraini firm buys new machines from Japan, Bahrain’s net export would decrease. — Exercise: If a furniture company makes 300 dining tables in 2003 and sold 200 of them in the same year, using expenditure approach, how to count the unsold dining tables? — Exercise: Bahrain Aluminum Company (BAC) produces and sells aluminum products. Place each of the following transaction in one of the four components of expenditure a. BAC sells its product to the Bahrain Defense Force b. BAC sells its product to a private company c. BAC sells its product to a housewife

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

d. BAC sells its product to a company in Saudi Arabia e. Some of BAC products are unsold this year

INCOME APPROACH: — Since total value of a product is equal to the amount of income generated by its production, GDP can also be calculated by adding all the income generated in the production of GDP. — The income approach of calculating GDP is the sum of incomes paid to resources of production. — National Income and Product Accounts divide incomes into five categories: compensation to employees, rental income, net interest, corporate profits, and proprietors' income. 1. Compensation to employees. It is the labor Income, which includes all wages, salaries, and benefits paid to labor, plus social security contributions. This is the largest component of GDP, using income approach. 2. Rent for the use of land. It is the income earned by the owners of land, and any other rented resources. 3. Net interest for the use of the capital. It is the income earned by the owners of machines and equipments. It equals the interest the domestic owners of the capital receive minus the interest they pay 4. Corporate profit. It refers to what is left to the firm after all payments. It includes both of profits distributed as dividend plus undistributed profits. 5. Proprietor’s income. It is the income of self employed small businesses such as private doctor’s clinics, Attorney’s office, mini-mart stores, small farms and so on. Proprietors' income might be a mix of incomes from labor, capital and land. — The sum of these five incomes results in national income or net domestic income at factor cost (NDI).

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— Net Domestic Income (NDI) = compensation of employees + rental income + net interest + corporate profit + proprietor's income. — Factor cost is the cost of factors of production used to produce final goods and services. — To calculate GDP using market value we must make two adjustments: 1. Net indirect tax (NIT), which is indirect taxes minus subsidies, must be added to get from factor cost to market prices. This gives net domestic product at market prices. 2. Depreciation (D) (or capital consumption) must be added to get from net domestic product to gross domestic product. Thus, GDP = NDI + net indirect tax (NIT) + Depreciation (D), or GDP = NDI + (indirect tax – subsidies) + Depreciation o Indirect tax is a tax paid by consumers when they buy goods and services. Because of indirect taxes consumers pay more for the goods and services than producers receive ⇒ market price > factor cost. o Subsidy is a payment made by a government to a producer. Because of subsidies consumers pay less for some goods and services than producers receive ⇒ factor cost > market price o Depreciation (D) is the decrease in the capital stock because of the wearing out of machines and equipments (is the consumption of the capital). It is treated as a cost of production and is subtracted in calculation NDI. So it must be added back to get the GDP. — Gross and Net Domestic Product o “Gross” means before accounting for the depreciation of capital. o “Net” means after accounting for the depreciation of capital. o Net domestic product = GDP – depreciation

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— Exercise: Government purchase

$400

Gross private domestic investment

$500

Personal consumption expenditure

$700

Personal income taxes

$150

Depreciation

$200

Net taxes

$100

Net exports

$200

Net interest

$130

a. Calculate GDP b. Calculate Net domestic product — Exercise: Net interest

$200

Net indirect tax

$300

Corporate profits

$400

Proprietors’ income

$150

Compensation of employees

$1200

Depreciation

$350

Rental income

$100

Personal consumption expenditure Net exports

$1500 $50

Government purchase

$600

a. Calculate GDP b. Calculate net domestic product c. Calculate gross private domestic investment

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— Exercise: Item

Billions of dollars

C G T I M X D

80 30 35 20 10 20 10

Calculate: a. GDP b. Net domestic product c. the value of net exports d. the value of private saving e. the value of government saving f. Is there government budget deficit or surplus?

GROSS NATIONAL PRODUCT (GNP) — GNP is the market value of all final goods and services newly produced by the citizens (nationals) of a country whether they are inside or outside the country in a given period time. — While GDP allocates product (income) according to the location of the owners of factors of production regardless of who produce it whether they are nationals or foreigners, GNP allocates product (income) according to the nationality of the owners of the factor whether they are inside the country or abroad. — Example: The income of an Indian working in Bahrain is part of Bahrain's GDP as well as India's GNP

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

NOMINAL GDP vs. REAL GDP: — Recall that GDP is calculated by adding the market value of all final goods produced. — The market value of production and hence GDP can increase either because the increase in production of goods and services or because of the increase in the prices of goods and services, or by the increase in both. — To determine whether the increase in only due to the increase in production rather than in the price level, economists distinguish real from nominal GDP to determine whether real production has changed. — Nominal GDP is the value of final goods and services produced in a given year valued at the prices that prevailed in that same year (current prices). — Nominal GDP increases when the prices and quantities of goods and services increase. — Real GDP is the value of GDP measured at constant (base year) prices. — Real GDP is a measure of a country's actual production. — Real GDP allows the quantities of production to be compared across time. — We use constant prices to remove the effects of inflation. Thus, the first step to calculate real GDP is to choose a base year. — The base-year method of calculating GDP compared quantities produced in different years using prices from a year chosen as a reference year. The base year is like a benchmark year. — The base year is the year in which real GDP=nominal GDP — Example Suppose a country produces two final goods. Quantities and prices of each good for three different years are given in the table below. Suppose 2002 is the base year.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

Good 1

Good 2

P

Year Q

$/ unit

Q

Nominal

Real

P

GDP

GDP

$/unit

in $

in $

GDP Deflator

2001

2500 15

600 20

49500

66200

75

2002

2300 20

500 27

59500

59500

100

2003

2800 23

700 30

85400

74900

114

Nominal GDP in 2001 = (P1, 2001) (Q1, 2001) + (P2, 2001) (Q2, 2001) = ($15) (2500) + ($20) (600) = 49500 Nominal GDP in 2002 = (P1, 2002) (Q1, 2002) + (P2, 2002) (Q2, 2002) = ($20) (2300) + ($27) (500) = 59500 Nominal GDP in 2003 = ((P1, 2003) (Q1, 2003) + (P2, 2003) (Q2, 2003) = ($23) (2800) + ($30) (700) = 85400 — We can see that nominal GDP of 2002 is higher than that of 2001. This may be because the country produced more in 2002 than 2001 or may be because the prices in 2002 are higher than prices in 2001. (If producing more goods and services the standard of living would increase. If paying higher prices the cost of living would increase). — We can see in our case that the country produces fewer goods and services in 2002 and prices were higher. People were worse off in 2002 than in 2001. But still nominal GDP was higher in 2002. — GDP in 2003 was the highest for the two reasons: higher production and higher price level. — Thus, using nominal GDP to compare among different years does not give us the actual picture of the performance of the economy. We cannot say for sure that a country produces more in a particular year than any other year. Nominal GDP tells us the change in price level that affects our cost of living. — Cost of living is the amount of money it takes to buy goods and services.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— To calculate real GDP (RGDP) we select a base year, and then we use the price of that year (the constant price) to calculate GDP in different years. In our example, the base year was 2002. Thus, goods will be added up using 2002 prices. RGDP in 2001 = (P1, 2002) (Q1, 2001) + (P2, 2002) (Q2, 2001) = ($20) (2500) + ($27) (600) = 66200 RGDP in 2002 = P1, 2002) (Q1, 2002) + (P2, 2002) (Q2, 2002) = ($20) (2300) + ($27) (500) = 59500 RGDP in 2003 = P1, 2002) (Q1, 2003) + (P2, 2002) (Q2, 2003) = ($20) (2800) + ($27) (700) = 74900 — Comparing RGDP of different years allows us to say for sure that a country produces more (or less) goods and services in one particular year than any other year if the RGDP of that year is higher (or lower) than the other years. — RGDP tells us the change in production and it is used to measure the size of the economy and the growth in the economy (the change in the quantities of goods and services). — If Real GDP > Nominal GDP then prices were higher in the base period than the current period. — If Real GDP < Nominal GDP, current prices are higher than base period prices. — Real GDP = Nominal GDP for the base period. — In years with inflation, nominal GDP increases faster than real GDP.

MEASURING ECONOMIC GROWTH: — Economic Growth is an increase in a country’s output (real GDP). In other words, it is an expansion of production possibilities in a country. — It is represented by an outward shift of the production possibility frontier (PPF) of the country.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— RGDP is a good measure with which we compare the economy at two points in time. That comparison can then be used to formulate the growth rate of total output within a country. — The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next. Economic Growth Rate =

RGDP this year - RGDP last year RGDP last year

× 100

From the example above The growth rate from 2001 to 2002 = -10.1% The growth rate from 2002 to 2003 = 25.9% The growth rate from 2001 to 2003 = 13.1% — The new method of calculating real GDP, which is called the chain-weighted output index method, uses the prices of two adjacent years (or the average of several years) to calculate the real GDP growth rate and then uses the growth rates to create a chain linking the base year real GDP to the real GDP in future years. — Example Real GDP in 2002 is $100. Between 2002 and 2003, using 2002 prices GDP grew 8 percent and using 2003 prices real GDP grew 4 percent. What does real GDP in 2003 equal? Answer: $106 Example: If real GDP in 2003 is $9 billion and real GDP in 2004 is $9.27 billion, then the economic growth rate in 2004 is 3.0 percent — We use the economic growth rate to make: o economic welfare comparisons o international comparison o business cycle forecasts

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

Economic Welfare Comparisons (Measuring Living Standards) — Economic welfare is a measure of economic well being. It improves when production increases. — RGDP is a useful number when describing the size and the growth of a country's economy. To measure the standard of living we use the RGDP per person (RGDP per head, per capita). — A standard of living is the level of consumption that people enjoy, on the average, and is measured by the average income per person. — RGDP per person is the GDP divided by the size of the population. This measure gives the amount of GDP that each individual can get, on average, and thereby provides a fairly good measure of the standard of living of the people within an economy. RGDP per person =

RGDP Population

— RGDP per person is a more useful measure than RGDP for determining standard of living because of differences in population across countries. If a country has a large RGDP and a very large population, each person in the country may have a low income and thus may live in poor conditions. On the other hand, a country may have a moderate RGDP but a very small population and thus a high individual income. — When the increase in RGDP is greater than the increase in population RGDP per person increases. — Example: If Bahrain’s GDP (using PPP) in 2005 was $15.83 billion at constant prices and the population was 698,585 then GDP per person =

$15,830,000,000 = $22 ,660 698,585

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

Shortcomings of Using GDP to Measure Output and Well-being — While GDP measures are informative and are widely used in many countries to summarize the state of the economy, it is important to realize that they are by no means perfect. RGDP can be criticized as a measure of economic welfare because: 1.

It does not include non-market activities. Because we use market prices to value the goods that are being sold, only market activities are included in GDP. Goods and services that are not marketed are not included in GDP. It excludes what we produce for ourselves at home such as preparing meals, doing laundry, gardening, etc. It also excludes any activity that has no price such as friends helping each other. Most of agricultural production in less developed countries is not included in the GDP because farmers consume what they produce (self-sufficient) so most of their production does not reach the market.

2.

It does not include underground economy transactions such as production of illegal goods. It also excludes economic activity that people hide and do not report to government to avoid taxes and other government regulation or because the activity is illegal. Official statistics ignore this underground economy, which is very substantial in some countries.

3.

The quality of the environment. An increase in production will raise real GDP and at the same time it may lead to an increase in pollution. So, RGDP does not measure a clean environment and does not account for natural resource depletion or degradation of environmental quality.

4.

Leisure time, a valuable component of an individual’s welfare, is not included in real GDP.

5.

GDP per person is only a measure of the average level of output per person in the economy. Economic well-being depends both on the size of the income as well as the distribution of the income.

6.

Health and life expectancy are not directly included in real GDP.

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Dr. Mohammed Alwosabi

7.

Econ 141: Macroeconomics - Ch.1

Over-adjustment for inflation: The measured growth rate is deflated by price increases, but some price increases reflect quality improvements, which make us better off.

8.

Government services (not sold in markets) are measured by their cost of production

9.

RGDP per person focuses only on income but there are other important things that make life better such as faith, security, freedom, justice, education, health, the sense of belongings, etc. And even if we address only income it does not show the real distribution of income.

10. Governments overstate or understate GDP for different political, economic, or social reasons. 11. New goods create problems in calculating Real GDP. Recall that we used some base year’s prices to calculate the value of Real GDP for a particular year. But what if there are goods that were not around in the base year? What is the appropriate price for those goods?

International Comparisons and Purchasing Power Parity (PPP) — Real GDP comparisons among countries have two problems: first, the RGDP of one country has to be converted into the same currency unit as the RGDP of the other country. Second, the same prices must be used to value the goods and services in the countries being compared. — To avoid the problems of fluctuating currency exchange rate, and to account for the differences in the cost of living, the international comparison project (ICP) of the UN and University of Pennsylvania (Summer and Heston, Penn World Tables) have calculated a purchasing power parity (PPP) index. — The Purchasing Power Parity (PPP) between two countries is the rate at which the currency of one country needs to be converted into that of a second country to ensure that a given amount of the first country’s currency will purchase the same volume of goods and services in the second country as it does in the first.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— As it is used by the international organizations, purchasing power parity (PPP) of a country’s currency is the number of units of that currency required to purchase the same representative basket of goods and services that a US dollar would buy in the US. This index allows for a more direct comparison of living standards in different countries. — A simple example can illustrate the concept. GDP per person in Nigeria in 2003 was about $370 while GDP per person in U.S. in 2003 was about $37400. However, this number is misleading because $370 in Nigeria can buy a lot more goods and services than $370 in the U.S. would because prices are much lower in Nigeria. — GDP per capita measured at PPP, i.e. the per-capita value of Nigerian GDP using a common set of prices (typically U.S. prices) is about $1000. In other words, the average Nigerian earns about $370 a year, which because of the fact that prices are lower there than in the U.S., is equivalent to earning $1000 in the U.S. — So, PPP prices are used to construct GDP data that can be used to make more valid comparison between one country and another. — While using PPP exchange rates for comparison is an improvement over using actual exchange rates, it is still imperfect, and comparisons using the PPP method can still be misleading. o Comparing standards of living using the PPP method implicitly assumes that the real value placed on goods is the same in different countries. In reality, what is considered a luxury in one culture could be considered a necessity in another culture! The PPP method does not account for this. o A PPP exchange rate varies depending on the choice of goods used for the index. Hence, it is possible to deliberately or accidentally bias a PPP exchange rate by the choice of the basket. o PPP could also have difficulty accounting for differences in quality between goods in one country and equivalent goods in another.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

APPENDIX: — Capital and Investment o The term capital, as used in macroeconomics, refers to the plant, equipment, buildings, manufactured input, and inventories of raw materials and semi-finished goods, etc. o Investment is the flow that changes the stock of capital. o Depreciation is the decrease in the capital stock that results from wear and tear, and obsolescence. Capital consumption is another name for depreciation. o Gross investment is the purchases of new capital. o Net investment is the change in the stock of capital and equals gross investment minus depreciation. — A flow is a quantity per unit of time such as GDP, saving, income, investment — A stock is the quantity that exists at a point in time such as wealth, capital — Exercise At the beginning of the year, your wealth is $20,000. During the year, you have an income of $60,000 and you spend $40,000 on consumption. You pay no taxes. What is your wealth at the end of the year?

How Investment Is Financed? — Financial markets are used to finance deficits, pay for investment, and save. Investment is financed from three sources: 1. Private saving (S), is the amount that households have left after they have paid their taxes and bought their consumption goods and services 2. Government budget surplus (T – G) 3. Borrowing from the rest of the world (M – X).

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— We can see these three sources of investment finance by using the fact that aggregate expenditure equals aggregate income. — Households’ income is consumed, saved, or paid in taxes: Y = C + S + T — RGDP can be written as; o Y = C + I + G + X - M (reflecting its aggregate expenditure), or o Y = C + S + T (reflecting the use of RGDP, income) o So we have C + I + G + (X –M) = C + S + T o Cancel the C's and move X - M to the financing side you get I + G = S + T + (M – X) o This equation shows us that financing for I and G come from private saving, taxes, and foreign sources. o Move G to the financing side and you have I = S + (T – G) + (M – X) — This formula shows that investment is financed using saving, a government budget surplus, (T − G) and borrowing from the rest of the world, (X − M) o Private saving (S) = disposable income – consumption = income – tax – consumption = Y – T – C o Government (Public) saving = T – G ƒ If (T – G) > 0 ⇒ surplus ƒ If (T – G) < 0 ⇒ deficit — Private investment = National Saving + borrowing from the rest of the world — National saving = private saving + government saving = (Y – T – C) + (T – G) = Y – C – G — Example: Suppose an economy has the following data (in million of dollars) Y = 200, C = 130, T = 30, and G = 20, then Private saving

= Y – C – T = 200 – 130 – 30 = 40

Public saving

= T – G = 30 – 20 = 10

National saving = Y – C – G = 200 – 130 – 20 = 50,

or

= private saving + public saving = 40 + 10 = 50

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— Exercise: If you have the following data: government saving = 0, RGDP = $2500 million, private consumption = $1300 million, tax = $350 million; calculate the country’s national saving — Exercise: If national saving is $200,000, net taxes equal $100,000 and government purchases of goods and services are $50,000, how much are households and businesses saving?

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

PRICE LEVEL (PRICE INDEX) — To see how the change in prices changes the cost of living we should analyze the changes in price level. — Price level (also called price index) is a weighted average of prices of goods and services in a given year relative to the prices in a specified base year. — Price level is a unit free measure. — There are many types of price level measurements but we will focus only on the most popular two of them. 1. The GDP Deflator 2. The Consumer Price Index (CPI)

THE GDP DEFLATOR: — Nominal GDP captures both changes in quantity and changes in prices. — Real GDP, on the other hand, captures only changes in quantity. — Because of this difference, after computing nominal GDP and real GDP, a third useful statistic can be computed -- the GDP deflator, which captures the changes in the price level. — GDP deflator is a measure of the price level of goods and services included in GDP. It is an average of the prices of the goods in GDP in the current year expressed as a percentage of the base year prices. — GDP deflator is a general indicator of inflation because it measures changes in prices of goods and services included in GDP. It takes the contribution of rising prices (inflation) out of nominal GDP so that we can see what happen to RGDP. — It is equal to 100 times nominal GDP divided by real GDP.

GDP Deflator =

Nominal GDP × 100 Real GDP

— Real GDP = (Nominal GDP*100)/GDP deflator — Nominal GDP = (Real GDP * GDP deflator)/100

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

— The larger the nominal GDP for a given RGDP the higher is the price level and the larger is the GDP deflator. — Example: From the example in pages 14-15, the GDP Deflator is as follows:

GDP deflator in 2001 =

Nominal GDP 49500 × 100 = × 100 ≈ 75 Real GDP 66200

GDP deflator in 2002 =

59500 × 100 = 100 59500

GDP deflator in 2003 =

85400 × 100 = 114 74900

— Price level in 2001 is less than that of the base year by 25%. — Price level in the base year (here, 2002) is always 100. — Price level in 2003 is higher than that of the base year by 14%. — Example: Suppose the nominal GDP per person is $10,000 in 2004, the 2000 GDP deflator is 100 and the 2004 GDP deflator is 110 then the real GDP per person is $9091 — Example: If nominal GDP is $5 billion and the GDP deflator is 125, then RGDP = (5*100) / 125 = $4 billion — Exercise: Why if GDP deflator for 2004 is 125, this means nominal GDP is greater than real GDP in 2004?

Shortcomings of Using GDP Deflator to Measure Price Level 1. It is unable to fully incorporate the increased purchasing power that comes with improvements in quality so this tends to push the deflator to overestimate inflation.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

2. The introduction of new goods poses a problem when calculating Real GDP; therefore, it poses a problem in calculating the GDP deflator because the deflator is the ratio of nominal to Real GDP. 3. If prices of imported goods fall but prices of domestic goods are high, consumer’s purchasing power may not fall by much even if the GDP deflator indicates a high price level.

THE CONSUMER PRICE INDEX (CPI): — The consumer price index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed “basket” of consumer goods and services. — CPI compares the cost in the current period to the cost in a base period of a basket of goods typically consumed in the base period. CPI =

Cost of the CPI basket at the current year prices × 100 Cost of the CPI basket at the base year prices

— The CPI is defined to equal 100 for the reference base period. — Example: Suppose a typical family consumes three goods: breads, gasoline and haircut. Quantities and prices of the three goods in three different years are given in the table below (assuming no weights given to any item). Suppose the base year is 2001 Good

Quantities

P in

P in 2002

P in 2003

bought

2001

Bread

2000 bread

$0.50

$0.55

$0.60

Gasoline

1000 liter

$1.00

$1.20

$1.30

Haircut

600 times

$1.5

$2.00

$2.50

Cost of the CPI basket at 2001 prices = ($0.50)(2000) + ($1)(1000) + ($1.5)(600) = $2900

Cost of the CPI basket at 2002 prices = ($0.55)(2000) + ($1.2)(1000) +($2)(600) = $3700 Cost of the CPI basket at 2003 prices = ($0.60)(2000) + ($1.30)(1000) + ($2.5)(600) = $4000

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

CPI in 2001 (the base year) = CPI in 2002 =

2900 × 100 = 100 (always 100) 2900

3700 × 100 ≈ 128 ⇒ the cost of living has increased from 2001 to 2900

2002 by 28% CPI in 2003 =

4000 × 100 ≈ 138 ⇒ the cost of living has increased from 2001 to 2900

2003 by 38% — Exercise: Redo the above example assuming 2002 is the base year. — Exercise An average urban family consumes only bread, meat and cloth. In the base year the family spent $300 on bread, $450 on meat, and $800 on cloth. Prices in the base year were $1 per bread, $3 per kg of meat, and $5 per yard of cloth. Prices in the current year are $1.5 per bread, $5 per kg of meat, and $8 per yard of cloth. a.

What was the cost of living for this family in the current year?

b.

What was the CPI for the current year?

Shortcomings of Using CPI to Measure Price Level — CPI is not a perfect measure of the price level. It overstates the true inflation because: 1. It does not reflect the substitution by consumers as price change. For example, suppose that chicken is an item in the CPI basket. If chicken becomes more expensive than beef then some consumers may stop eating chicken altogether and start eating beef, however, the same quantity of chicken remains part of the CPI basket even though people are consuming less. 2. It does not account for changes in quality which improve purchasing power- the average computer today is much faster and more powerful than computers two years ago and price may be the same if not falling. This causes the CPI to

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

overestimate inflation; the price of computing has decreased even though the price of the computer is unchanged. 3. The introduction of new goods that render old goods obsolete may pose a problem because the old goods still remain in the CPI basket until the basket is revised again.

The Differences between the GDP Deflator and the CPI — There are three differences between the GDP deflator and the CPI: 1. The GDP deflator measures the prices of all goods and services produced whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by the firms or government will be included in the GDP deflator but not in the CPI. 2. The GDP deflator includes only those goods and services produced domestically. Imported goods are not part of the GDP and not included in the GDP deflator; but they are included in the CPI because consumers buy imported goods as well. 3. GDP deflator is not based on a fixed market basket of goods and services. The basket is allowed to change with people’s consumption and investment patterns. CPI quantity is the same for different years. It is based on a fixed basket of goods and services. — Exercise The average price of the imported food in Bahrain has increased in recent years. This increase must show up c. in Bahrain’s GDP deflator d. in Bahrain’s CPI e. both in Bahrain’s CPI and Bahrain’s GDP deflator f. neither in Bahrain’s CPI nor in Bahrain’s GDP deflator — To measure changes in the cost of living and in the value of money we need to calculate the inflation rate using price indexes.

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Dr. Mohammed Alwosabi

Econ 141: Macroeconomics - Ch.1

INFLATION RATE: — The inflation rate is the percentage change in the price level from one year to the next. Inflation Rate =

GDP Deflator this year - GDP Deflator last year × 100 GDP Deflator last year

From the examples in page 23 For 2003 Inflation rate =

114 − 100 × 100 = 14 100

OR Inflation Rate =

CPI this year - CPI last year × 100 CPI last year

From the examples in page 24-25 For 2003 Inflation rate =

138 − 128 × 100 ≈ 8 128

So far, we have described how aggregate measures of output and price level of the economy are constructed.

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