Lecture%203:%20Basics%20of%20Macroeconomics

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Lecture 3 Basics of Macroeconomics

• Dr. Rajeev Dhawan
• Director

Given to the EMBA 8400 Class January 18, 2008
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Basics of MacroeconomicsChapter 23
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The Economys Income 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.
• Gross domestic product (GDP) is a measure of the
  income and expenditures of an economy.
• It is the total market value of all final goods
  and services produced within a country in a given
  period of time.

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Definition of GDP

• GDP is the market value of all final goods and
  services produced within a country in a given
  period of time.

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Definition of GDP

• GDP is the Market Value . . .
• Output is valued at market prices.
• . . . Of All Final . . .
• It records only the value of final goods, not
  intermediate goods (the value is counted only
  once).
• . . . Goods and Services . . .
• It includes both tangible goods (food, clothing,
  cars) and intangible services (haircuts,
  housecleaning, doctor visits).

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Definition of GDP

• . . . Produced . . .
• It includes goods and services currently
  produced, not transactions involving goods
  produced in the past.
• . . . Within a Country . . .
• It measures the value of production within the
  geographic confines of a country.
• . . . In a Given Period of Time.
• It measures the value of production that takes
  place within a specific interval of time, usually
  a year or a quarter (three months).

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Definition of GDP

• What Is Not Counted in GDP?
• GDP excludes most items that are produced and
  consumed at home and that never enter the
  marketplace.
• It excludes items produced and sold illicitly,
  such as illegal drugs.

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Simple GDP Example

• This simple economy has 2 people Baker and
  Miller.
• Baker buys flour for 350. He also uses a worker
  and pays 200 in wages. He also pays a rent of
  25. He makes a profit as 25 on the bread he
  sells for 600.
• The miller pays his worker 300, a rent of 25,
  and his profit is 25 on a sale of 350.
• The GDP of this economy is 600!
• Why? 2 sides of a coin, IncomeExpenditures
• ExpendituresValue of final Goods sold600
• IncomewagesRentprofits30020025252525600

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NIPA Definition of GDP

• YCIGNX
• Y GDP
• C Consumption
• I Investment
• G Government Purchases
• NX Net Exports Exports-Imports
• 
  

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GDP and Its Components
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GDP Components (2005)
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NIPA Definition 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 new housing.
• 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.

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Real vs. 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 Deflator deflates for Inflation!
• Inflation is rate of change of prices.

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Recessions

• A recession is a significant decline in activity
  lasting more than a few months and is visible in
  industrial production, employment, real income
  and wholesale-retail sales (NBER definition).
  NBER uses monthly data.
• Rule of thumb is 2 consecutive quarters of
  negative Real GDP growth or GDP decline.

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Article Business Cycles
BUSINESS CYCLE REFERENCE DATES BUSINESS CYCLE REFERENCE DATES DURATION IN MONTHS DURATION IN MONTHS DURATION IN MONTHS DURATION IN MONTHS
Peak Trough Contraction Expansion Cycle Cycle
Quarterly datesare in parentheses Quarterly datesare in parentheses Peak to Trough Previous trough to this peak Trough from Previous Trough Peak from Previous Peak
May 1937(II)February 1945(I)November 1948(IV)July 1953(II)August 1957(III)April 1960(II)December 1969(IV)November 1973(IV)January 1980(I)July 1981(III)July 1990(III) June 1938 (II)October 1945 (IV)October 1949 (IV)May 1954 (II)April 1958 (II)February 1961 (I)November 1970 (IV)March 1975 (I)July 1980 (III)November 1982 (IV)March 1991(I) 138111081011166168 50803745392410636581292 638848554734117526428100 939345564932116477418108
March 2001 (I) November 2001 (IV) 8 120 128 128
NBER Report Cycle Dates 2003
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Mar 01 Nov 01 9 -0.1 -4.0 4.2 5.6
Forecast of the Nation, 2003
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2001 Recession vs. History
For Details Refer http//www.nber.org/
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Real GDP and Consumption
FRBSF Economic Letter, June 2003
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Investment and Stock Market
FRBSF Economic Letter, June 2003
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Article NBERs FAQs

• Q The financial press often states the
  definition of a recession as two consecutive
  quarters of decline in real GDP. How does that
  relate to the NBER's recession dating procedure?
• Most of the recessions identified by our
  procedures consist of two or more quarters of
  declining real GDP, but not all of them
• We consider the depth as well as the duration of
  the decline in economic activity.
• Second, we use a broader array of indicators than
  just real GDP
• Third, we use monthly indicators to arrive at a
  monthly chronology
• Q Could you give an example illustrating this
  point?
• The two-quarter-decline rule of thumb would not
  have allowed the declaration of the recession
  until August 2002
• Q How does the NBER balance the differing
  behavior of employment and output?
• There is no fixed rule for how the different
  indicators are weighted

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Article NBERs FAQs

• Q. You emphasize the payroll survey as a source
  for data on economy-wide employment. What about
  the household survey?
• Although the household survey is a large,
  well-designed probability sample of the U.S.
  population, its estimates of total employment
  appear to be noisier than those from the payroll
  survey
• Q. How do the movements of unemployment claims
  inform the Bureau's thinking?
• A bulge in jobless claims would appear to
  forecast declining employment, but we do not use
  forecasts and the claims numbers have a lot of
  noise
• Q What about the unemployment rate?
• Unemployment is generally a lagging indicator.
  Its rise from a very low level to date is
  consistent with the employment data

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Peak Trough Announcements
The November 2001 trough was announced July 17,
2003.The March 2001 peak was announced November
26, 2001. The March 1991 trough was announced
December 22, 1992.The July 1990 peak was
announced April 25, 1991. The November 1982
trough was announced July 8, 1983.The July 1981
peak was announced January 6, 1982. The July
1980 trough was announced July 8, 1981.The
January 1980 peak was announced June 3, 1980.
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Chapter 24

• Measuring the Cost of Living

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Consumer Price Index Inflation

• Inflation refers to a situation in which the
  economys overall price level is rising.
• The inflation rate is the percentage change in
  the price level from the previous period.
• The Consumer Price Index (CPI) is a measure of
  the overall cost of goods and services bought by
  a typical consumer (produced by BLS).
• Inflation rate is change in CPI.
  

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Steps to Calculate CPI Index

• Fix the Basket Determine what prices are most
  important to the typical consumer.
• The Bureau of Labor Statistics (BLS) identifies a
  market basket of goods and services the typical
  consumer buys.
• The BLS conducts monthly consumer surveys to set
  the weights for the prices of those goods and
  services.
• Find the Prices Find the prices of each of the
  goods and services in the basket for each point
  in time.
• Compute the Basket's Cost Use the data on prices
  to calculate the cost of the basket of goods and
  services at different times.
• Choose a Base Year and Compute the Index

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Steps to Calculate CPI Index

• 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.
• Compute the index by dividing the price of the
  basket in one year by the price in the base year
  and multiplying by 100.

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How the Inflation Rate Is Calculated

• The Inflation Rate
• The inflation rate is calculated as follows

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A Simple Example of CPI and Inflation Calculations

• Calculating the Consumer Price Index and the
  Inflation Rate
• Base Year is 2002.
• Basket of goods in 2002 costs 1,200.
• The same basket in 2003 costs 1,236.
• CPI (1,236/1,200) ? 100 103.
• Prices increased 3 percent between 2002 and 2003.

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FYI What Is in the CPIs Basket?
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Calculating the Consumer Price Index and the
Inflation Rate An Example
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Calculating the Consumer Price Index and the
Inflation Rate An Example
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The GDP Deflator vs. CPI

• The BLS calculates other prices indexes
• The index for different regions within the
  country.
• The producer price index, which measures the cost
  of a basket of goods and services bought by firms
  rather than consumers.

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CPI and GDP Deflator
Percent
per Year
15
10
5
0
1965
1970
1975
1980
1985
1990
2000
1995
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Problems in Measuring CPI

• Substitution bias
• Introduction of new goods
• Unmeasured quality changes

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Use of Price Indexes

• Price indexes are used to correct for the effects
  of inflation when comparing dollar figures from
  different times.
• Do the following to convert (inflate) Babe Ruths
  wages in 1931 to dollars in 2005

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The Most Popular Movies of All Times, Inflation
Adjusted
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Real and Nominal Interest Rates

• The nominal interest rate is the interest rate
  usually reported and not corrected for inflation.
  
• This 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.

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Real and Nominal Interest Rates

• You borrow 1,000 for one year.
• Nominal interest rate is 15.
• During the year inflation is 10.
• Real interest rate Nominal interest rate
  Inflation
• 15 - 10 5

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Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15
Nominal interest rate
10
5
0
Real interest rate
-5
1965
1970
1975
1980
1985
1990
1995
2000
2005
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Article Con Job Redux (PIMCO) by Bill Gross

• Bill claims that CPI inaccurately calculates
  Americans cost of living.
• Example Say you buy 1 bag of gumdrops for 1
  which has 100 of those. Productivity makes it 110
  gumdrops but for 1.10. Hedonic pricing says that
  CPI hasnt gone up as per-capita cost is the same
  (1 cent). But you have to shelve out 1.10 to get
  the bag, which is an increase in cost of 10.
  They must fork out an extra dime even though
  theyre getting more for their money.
• We cant buy individual pieces of memory in a
  computer-we have to buy the entire package!