3–13–1 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 3 Measuring

Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank

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Chapter 3Measuring Macroeconomic Performance: Output and Prices


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Chapter 3: Measuring Macroeconomic Performance: Output and Prices

• When is the economy performing well?• Gross domestic product: measuring the nation’s

output• Real GDP is not the same as economic wellbeing• The consumer price index: measuring the price

level


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A Well-Performing Economy

• Rising living standards• Economic stability• Low inflation• Sustainable levels of debt• Economic growth• Full employment


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Measuring GDP

• The market value of current production valued at current prices

• Unpaid work is not counted – a defect• Public goods and services, provided free, are

valued at their cost of production


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Intermediate and Final Products

• Wheat and flour are intermediate products used to make bread, the final product

• GDP measures the production of final products, the market value of which already embodies the cost of intermediate products

• Counting intermediate products separately would involve ‘double counting’


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Value Added (VA)

• Firms generate GDP by adding value to the intermediate products they buy from others

• VA is equal to the value of a firm’s output (bread) minus the value of intermediate products used up (flour)

• GDP is the sum of VA by all firms within a country in the current year


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Expenditure on GDP

• Current production by firms must be bought by households, other firms, government and foreigners

• Exception: production which is not sold is added to inventories and treated as ‘spending’ or ‘bought’ by the firm which makes it

• So it follows that GDP may be measured as the sum of spending on domestic production by households, all firms, government and foreigners

• Reminder: spending by firms includes that part of production which is added to their inventories


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GDP = Y + C + I + G + X – M

• Household spending is consumption: C• Firm’s spending is investment: I• Government spending: G• Foreign spending on our exports: X• Domestic spending on foreign production or our

imports: M• X – M is net exports: NX• So GDP = Y = C + I + G + NX


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GDP and Household Incomes

• VA is the difference between firms’ sales of output and payments for their raw materials

• Firms then pay wages to labour and other factors• The residual is profit or capital income• It follows that GDP and VA generate equivalent

labour and capital income• Reminder: profit is always a residual


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Examples

• Sales $100 (200)• Cost of raw materials $40 (100)• Therefore Value Added $60 (100)• Wages, interest and rent $50 (70)• Therefore Residual Profit $10 (30)• Household income from wages, interest, rent and

profit = $60 (100) = Value Added


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Nominal vs Real GDP

• Nominal GDP rises when prices rise• Real GDP only rises when quantities rise• To measure changes in real GDP we use constant

prices of the ‘base year’• Then any rise in GDP is ‘real’ – entirely due to

rises in quantities• In the ‘base year’ real GDP = nominal GDP


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Example: Two Goods

• Suppose we produce two goods, apples and beer• In Year 1 the respective (quantities x prices) give

Nominal GDP1 = (10 x 1) + (12 x 2) = $34• In Year 2 the respective (quantities x prices) give

Nominal GDP2 = (11 x 3) + (13 x 4) = $85• Nominal GDP has risen by 51/34 = 150%!• Real GDP2 = (11 x1) + (13 x 2) = $37, a rise of

only 3/34 = 3%


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Influences on ‘Wellbeing’

• Real GDP per capita• Leisure time• Unpaid services provided• Environmental quality and climate• Poverty, inequality and crime• International tension


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Measuring the Price Level

• The CPI measures the cost of a fixed basket of goods bought by the ‘average’ or typical household – a measure of the cost of living

• The rate of change of the CPI is one measure of the rate of inflation

• It exaggerates the true rate of inflation because it does not allow for quality improvements and for substitution by households in favour of those goods which have risen least in price

• If we become vegetarian when the price of meat rises, has our cost of living risen?


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Measuring the Price Level (cont.)

• Households do not buy everything that the economy makes

• The average price of everything produced in the economy is the GDP Deflator

• This is Nominal GDP/Real GDP


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Prices and Quality

• The quality of goods usually improves over time• A car made in 1990 is quite different to a car made

in 2004• So measures of inflation based on movements in

price indices exaggerate the true rate of inflation because they ignore quality improvements


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The Rate of Inflation

• This is the rate of change in the average price level

• If some prices rise while others remain constant, there is both a change in relative prices and a positive rate of inflation

• This is the usual situation• If some prices rise while others fall, there is a

change in relative prices, but the rate of inflation may be zero, positive or negative, depending on the relative frequency of price rises and falls


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The Costs of High Inflation

• Inflation destroys the purchasing power of money• Loss of confidence in holding money leads to

inconvenience and to inefficiency of barter trading• The inefficiency of barter trading leads to loss of

specialisation as people make more things for themselves


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Other Costs of Inflation

• Uncertainty and cost is caused by frequent changes in price lists

• Adverse effects on incentives are caused by ‘unearned’ redistributions of wealth which cause people to spend time looking for ‘bargains’ instead of working productively

• Higher effective tax rates caused by ‘bracket creep’ in a progressive tax system, reduce the incentive to work

• Higher nominal interest rates leave debtor households with less spending power


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Inflation and Interest Rates

• Borrowing and lending contracts specify how much money will be paid back to the lender at a given time

• The higher the rate of inflation over the contract period, the more the lender is penalised through a fall in the purchasing power of the money lent

• So a rise in the expected inflation rate raises the rate of interest which lenders demand

• Likewise, borrowers gain from inflation and a fall in the purchasing power of money, so they are willing to offer higher interest rates with inflation


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Nominal and Real Interest Rates

• The nominal interest rate is the rate of interest specified in the loan contract

• The real rate of interest is the nominal rate of interest minus the rate of inflation

• It measures the reward to lenders, in terms of purchasing power, paid by borrowers for lenders giving up spending over the contract period

• The real interest rate is the nominal interest rate minus the rate of inflation (approximately)


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Example: One Year Loan of $100

• Nominal interest rate is 10% p.a.• Dollars repaid to lender: $110• Price of bread at beginning of loan is $1 per loaf• Price of bread at end of year is $1.06 per loaf• Rate of inflation is 6% p.a.• Purchasing power given up by lender: 100 loaves• Purchasing power received back by lender:

110/106 = 104 loaves• Gain in lender’s purchasing power = 4 loaves• Real interest rate 4/100 = 10% – 6% = 4%


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Inflation Bad, Deflation Good?

• Deflation is a fall in the average price level• Compared with stable prices, deflation should lead

to lower nominal interest rates to keep the real interest rate constant

• So deflation should not affect real interest rates and should do no harm

• But can nominal interest rates go to zero or below?


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Nominal Interest Rates Always > 0

• Deflation raises the purchasing power of both money and bonds

• The convenience of money means lenders will always require a positive nominal interest rate to compensate them for giving up money to hold bonds

• Once nominal interest rates reach this ‘floor’, any increase in the rate of deflation will raise real interest rates and hurt the economy

• Deflation is bad!


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Example

• Suppose nominal interest rate floor = 0%• When rate of deflation = 2% p.a.

Real interest rate = 0 – (-2) = 2%• When rate of deflation = 3% p.a.

Real interest rate = 0 – (-3) = 3% • When rate of deflation = 4% p.a.

Real interest rate = 0 – (-4) = 4%


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Inflation in Health Care Costs

• The cost of health care generally rises faster than other costs

• One reason is that quality improvements in health care are rapid

• Another is that health care, like education, is a personal service in which labour-saving devices play a smaller role than in the production of goods like food, clothing and motor cars

Documents

3–13–1 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 3 Measuring