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Macro economics
INTRODUCTION
1
Ten Principles of Economics
Economy. . .
. . . The word economy comes from a
Greek word for “one who manages a
household.”
Ten principles of economics

A household and an economy
face many decisions:
◦ Who will work?
◦ What goods and how many of them should be
produced?
◦ What resources should be used in production?
◦ At what price should the goods be sold?
Ten principles of economics
(Contd….)

Society and Scarce Resources:
◦ The management of society’s resources is
important because resources are scarce.
◦ Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have.
Ten principles of economics
(Contd….)

Economics is the study of how society
manages its scarce resources.
Ten principles of economics
(Contd….)

How people make decisions.
◦ People face tradeoffs.
◦ The cost of something is what you give up to
get it.
◦ Rational people think at the margin.
◦ People respond to incentives.
Ten principles of economics
(Contd….)

How people interact with each other.
◦ Trade can make everyone better off.
◦ Markets are usually a good way to organize
economic activity.
◦ Governments can sometimes improve
economic outcomes.
Ten principles of economics
(Contd….)

The forces and trends that affect how the
economy as a whole works.
◦ The standard of living depends on a country’s
production.
◦ Prices rise when the government prints too
much money.
◦ Society faces a short-run tradeoff between
inflation and unemployment.
Principle #1: People face tradeoffs.
“There is no such thing as a free lunch!”
Principle #1: People face tradeoffs
(Contd….)
To get one thing, we usually have to give
up another thing.
◦
◦
◦
◦
Guns v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity
Making decisions requires trading
off one goal against another.
Principle #1: People face tradeoffs
(Contd….)

Efficiency v. Equity
◦ Efficiency means society gets the most that it
can from its scarce resources.
◦ Equity means the benefits of those resources
are distributed fairly among the members of
society.
Principle #2: The cost of something is
what you give up to get
it.

Decisions require comparing costs and
benefits of alternatives.
◦ Whether to go to college or to work?
◦ Whether to study or go out on a date?
◦ Whether to go to class or sleep in?

The opportunity cost of an item is what you
give up to obtain that item.
Principle #2: The cost of something is
what you give up to get
it. (Contd….)
LA Laker basketball
star
Kobe
Bryant
chose to skip college
and go straight from
high school to the pros
where he has earned
millions of dollars.
Principle #3: Rational People
Think at the Margin.

Marginal changes are small, incremental
adjustments to an existing plan of action.
People make decisions by
comparing costs and benefits at
the margin.
Principle #4: People Respond to
Incentives.
Marginal changes in costs or benefits
motivate people to respond.
 The decision to choose one alternative
over another occurs when that
alternative’s marginal benefits exceed its
marginal costs!

Principle #5: Trade Can Make
Everyone Better Off.
People gain from their ability to trade with
one another.
 Competition results in gains from trading.
 Trade allows people to specialize in what
they do best.

Principle #6: Markets Are Usually a
Good Way to Organize
Economic Activity.

A market economy is an economy that
allocates resources through the
decentralized decisions of many firms and
households as they interact in markets for
goods and services.
◦ Households decide what to buy and who to
work for.
◦ Firms decide who to hire and what to produce.
Principle #6: Markets Are Usually a
Good Way to Organize
Economic Activity.

Adam Smith made the observation that
households and firms interacting in markets
act as if guided by an “invisible hand.”
◦ Because households and firms look at prices when
deciding what to buy and sell, they unknowingly take
into account the social costs of their actions.
◦ As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.
Principle #7: Governments Can
Sometimes Improve
Market Outcomes.
Market failure occurs when the market fails
to allocate resources efficiently.
 When the market fails (breaks down)
government can intervene to promote
efficiency and equity.

Principle #7: Governments Can
Sometimes Improve
Market Outcomes (Contd…)

Market failure may be caused by
◦ an externality, which is the impact of one person
or firm’s actions on the well-being of a
bystander.
◦ market power, which is the ability of a single
person or firm to unduly influence market prices.
Principle #8: The Standard of Living
Depends on a Country’s
Production.

Standard of living may be measured in
different ways:
◦ By comparing personal incomes.
◦ By comparing the total market value of a
nation’s production.
Principle #8: The Standard of Living
Depends on a Country’s
Production.(Contd….)
Almost all variations in living standards are
explained by differences in countries’
productivities.
 Productivity is the amount of goods and
services produced from each hour of a
worker’s time.

Principle #8: The Standard of Living
Depends on a Country’s
Production.(Contd….)

Standard of living may be measured in
different ways:
◦ By comparing personal incomes.
◦ By comparing the total market value of a
nation’s production.
Principle #9: Prices Rise When the
Government Prints Too
Much Money.
Inflation is an increase in the overall level
of prices in the economy.
 One cause of inflation is the growth in the
quantity of money.
 When the government creates large
quantities of money, the value of the
money falls.

Principle #10: Society faces a short-run
tradeoff between
inflation & unemployment.

The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!
Summary
When individuals make decisions, they
face tradeoffs among alternative goals.
 The cost of any action is measured in
terms of foregone opportunities.
 Rational people make decisions by
comparing marginal costs and marginal
benefits.
 People change their behavior in response
to the incentives they face.

Summary (Contd….)
Trade can be mutually beneficial.
 Markets are usually a good way of
coordinating trade among people.
 Government can potentially improve
market outcomes if there is some market
failure or if the market outcome is
inequitable.

Summary (Contd….)
Productivity is the ultimate source of
living standards.
 Money growth is the ultimate source of
inflation.
 Society faces a short-run tradeoff
between inflation and unemployment.

What is macroeconomics?
Macroeconomics considers the
performance of the economy as a whole.
 We try to understand changes in

◦
◦
◦
◦

The rate of economic growth
The rate of inflation
Unemployment
Our trade performance with other countries
Macroeconomics also includes an
evaluation of the relative success or
failure of government economic policies
So what is ‘the economy’?





The economy is made up of four sectors sometimes
called economic agents:
Households who receive payments (income) for
their services (eg labour and land) and use this
money to buy the output of firms (ie consumption or
household spending).
Firms who use land labour and capital to produce
goods and services for which they pay wages rent etc
(income) and receive payment (expenditure)
Government (also known as the public or state
sector) and
International eg consumers buying overseas
products (M) and Foreigners buying UK products (X)
Difference between micro & macro
Microeconomics
 Recession in the tourist industry due to
the global downturn
 A government subsidy to steel
producers
 A recession in the textiles industry
 Increased spending on the National
Health Service

Microeconomics and
Macroeconomics
Microeconomics
focuses on the
individual parts of the economy.

How households and firms make decisions
and how they interact in specific markets
Macroeconomics
as a whole.

looks at the economy
How the markets, as a whole, interact at the
national level.
Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
broader marketplace. In microeconomics, an individual chooses to
maximize his or her utility subject to his or her budget constraint.
Macroeconomic events arise from the interaction of many
individuals trying to maximize their own welfare. Because
aggregate variables are the sum of the variables describing
individuals’ decisions, the study of macroeconomics
is based on microeconomic foundations.
The Essence of MicroeconomicsBuyers and Sellers
The Many Facets of
Macroeconomics
Key Concepts

Gross Domestic Product (GDP)
◦ The monetary value of all goods and services produced
within India in a given time period

Real GDP
◦ The volume of goods and services produced within the
UK (i.e. GDP adjusted for changes in the price level)

Economic Growth
◦ The percentage rate of increase of real GDP

Inflation
◦ The annual percentage rate of change of the general
price level
The Economy’s
Income and Expenditure

For an economy as a whole, income must
equal expenditure because:
Every
transaction has a buyer and a seller.
Every rupee of spending by some buyer is a
rupee of income for some seller.
 Say’s
Law-Supply creates it’s own demand
 This process can be seen using a Circular Flow
Diagram.
Gross Domestic Product



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.
How much is the current GDP?
The Circular-Flow Diagram
Revenue
Goods &
Services
sold
Market for
Goods
and Services
Firms
Inputs for
production
Wages,
rent, and
profit
Spending
Goods &
Services
bought
Households
Market for
Factors
of Production
Labor, land,
and capital
Income
The Components of the
Macroeconomy

Everyone’s expenditure is
someone else’s receipt. Every
transaction must have two sides.
43
of
31
National Income Accounting:
Important Identities
Microeconomics
Microeconomics
is the study of
how individual households and
firms make decisions and how
they interact with one another in
markets.
Macroeconomics
 Macroeconomics
is the study of
the economy as a whole.
Its
goal is to explain the economic
changes that affect many households,
firms, and markets at once.
Macroeconomics
 Macroeconomics
answers
questions like the following:
Why
is average income high in some countries
and low in others?
Why do prices rise rapidly in some time periods
while they are more stable in others?
Why do production and employment expand in
some years and contract in others?
The Economy’s Income and
Expenditure
When judging whether the economy is
doing well or poorly, it is natural to
look at the total income that everyone
in the economy is earning.

IN
ORDER
TO
EVALUATE
THE
PERFORMANCE
OF
OUR
ECONOMIC
SYSTEM IN TERMS OF:
How rapidly it is growing,
 How stable it is,
 How it allocates its productive resources
to different end products- we need some
measure of output & income


Strangely enough however, it was not
until the 1930’s that reliable overall
figures on Y & output were produced.

The main reason was that until the
1930’s most economists concerned
themselves not so much with the overall
performance of the economy (i.e.
macroeconomics) but with the price
system& the allocation of resources (i.e.
microeconomics)
The coming of the GREAT DEPRESSION
of the 1930’s forced economists to
devote attention to the overall level of
economic activity.
 To measure the depth of depression &
the extent of recovery, it was important
to construct data on National Output &
Y
 These accounts supply the most
valuable data we have about our
economy

Are we interested in forecasting the
level of economic activity next year???
-data on output, spending & Y—available
to base our forecast
-Do we wish to study long term economic
growth????- the historical data in NIA
show output growth in the past, its
growth compared with population or
labour force, & proportion of output
devoted to growth stimulating I


Are we intersted in the distribution of Y
between wages & profit???—data
available in components of Y
The Economy’s Income and
Expenditure
 For
an economy as a whole, income
must equal expenditure because:
Every transaction has a buyer and a
seller.
Every Rs. of spending by some
buyer is a dollar of income for some
seller.

◦
◦
◦
National Income Accounts:
•Provide the formal structure for our macro-theory models
Aggregate Demand….aggregate income..consumed or invested
Aggregate Supply….Total output..paid as wages, interest and
dividends
In equilibrium….Aggregate Demand=Aggregate Supply (growth)
Inputs=Outputs
Real output
price level
Broad magnitudes to characterize the economy
GROSS DOMESTIC PRODUCT
It is the value of all goods & services
produced annually in the nation.
 GDP is a flow, it is an amount of
production
Per unit of time

Basic Measures:
•Gross Domestic Product (GDP) is the value of final goods
and services produced in the country within a given period
Notable terms
final goods
Intermediate goods
•Value Added
•Past output vs. current outputs
•Measure of welfare
•Use of resources to avoid bads such as crime
•Improvement in the quality
in the country

GDP = ALL THE FINAL GOODS & SERVICES
PRODUCED IN THE DOMESTIC TERRITORY
OF INDIA
GNP = GDP + NET EXPORTS
 NNP = GNP – DEPRICIATION
 NI = NNP – INDIRECT TAXES + SUBSIDIES

PRODUCTIVE & NON-PRODUCTIVE
ACTIVITIES

Goods & services which enter into the
circle of exchange = PRODUCTIVE

-FRANCE= SATELITE ACOUNTS
Factors of production….labor, capital,
land
GDP= sum of payments to labor,
capital, land and profits
˸Gross National Product (GNP)
GDP+receipts from abroad made as
factor payments to domestically
owned factors of production.
•
Net Domestic Product
◦ GDP minus depreciation
◦ Depreciation is usually 11%
◦ NDP=89% of GDP
•
National Income
◦ NDP-Indirect taxes that Business pay
◦ Indirect taxes that Business pay nearly 10%
◦ NI is nearly 90% of NDP

PI is the total income received – whether it is
earned or unearned – by the households of
the economy before the payment of personal
taxes.

It is found by adding transfer payments to
and subtracting social security contributions,
corporate income taxes and undistributed
corporate profits from the NI.

DI is the total income available to
households after the payment of personal
taxes. It is equal to PI less personal taxes
and also equal to personal consumption
expenditures plus personal saving.
S.
No.
Countries
GDP in 2003
$million
GDP in 2010
$million *
1.
United States
10,881,609
14,580,000
2.
Japan
4,326,444
5,500,000
3.
Germany
2,400,655
3,310,000
4.
U.K.
1,794,858
2,250,000
5.
France
1,747,973
2,560,000
6.
Italy
1,465,895
2,050,000
7.
China
1,409,852
5,880,000
8.
Spain
836,100
1,410,000
9.
Canada
834,390
1,570,000
10.
Mexico
626,080
1,040,000
* Source: World Bank, World Development Indicators
GDP:
An important and versatile concept
We will see that GDP measures
§ total income
§ total expenditure
§ total output
§ the sum of value-added at all stages
in the production of final goods
With government and foreign
agents

Need to account for :
a. Government purchases of goods and
services.
b. Government payments for factor services
(wages, rent, interest).
c. Transfer payments between different agents.
d. Firms and households pay taxes to
government.
e. Taxes paid on income, property, goods and
services.
f. Transactions with the foreign sector.
Transfer payments

Transfer payments – are transactions wherein
one party is not obliged to deliver a good or
service in return for the payment.
◦ Examples: retirement benefits, unemployment
benefits, scholarships, and donations.
Transactions with foreign sector
Includes sales of goods and services,
assets, and transfers
 Exports - sales of domestically produced
goods to other countries
 Imports - goods bought from other
countries

Measurement of economy’s output:
The Gross Domestic Product (GDP)

The GDP measures the market value of all final goods and
services produced within an economy in a given period.

GDP only measures current production. Transfer payments
and transactions involving goods produced in other periods are
not included in the calculation of GDP.

GDP is usually expressed in the currency of a particular
country, e.g., Philippine peso….indicates the market value of
the goods and services
Definition of GDP

The market value of good i (Vi) is equal to PiQi

GDP = sum of the market values of all final goods
and services produced within the year.
GDP 
n
n
 V  P
i1
i
i1
i
 Qi
GDP includes final goods and
services only

Final goods - goods and services that are not
purchased for the purpose of producing other goods
and services or for resale
◦ Eg. Rice (final) and palay or unhusked rice
(intermediate product)

Including intermediate goods and final goods will
result in “double counting”.
3 Approaches for measuring
GDP
1. Expenditure Approach (upper loop) – measures GDP
as the sum of expenditures on final goods and services.
2. Income Approach (lower loop) – measures GDP as
the sum of incomes of factors of production (wages, rent,
interest and profit.
3. Value-added Approach – measures GDP as the sum of
value added at each stage of production (from initial to
final stage)
Expenditure Approach


Uses the upper loop of the circular flow diagram.
Example: Suppose the economy has only one product,
namely, rice.
Good
Rice
Price per
unit
20
Q sold
Expenditure
1000
20,000
GDP
20,000
Income Approach


Uses the lower loop of the circular flow diagram:
sum of payments to the various factors of
production.
Suppose that in the production of rice the sales
and expenses are as follows:
Sales
Expenses:
Wages
Rent
Interest
Total
Profit
GDP=Sum of Payments to factors
P 20,000
8000
4000
2000
14,000
6,000
20,000
P 20,000
Value Added Approach

Suppose that rice is the only final product of an economy:
It goes through several (3) stages of production.
Stage of Prod’n
Value of
intermediate
good
Farmer - Palay
Value of
Sales
Value-added
12,000
12,000
Rice Miller -Milled Rice
12,000
15,000
3,000
Retailers - Rice
15,000
20,000
5,000
GDP= Total Value
Added
20,000
Notes of the 3 approaches

The expenditure approach, income approach, and the valueadded approach all come up with the same estimate of the
GDP. They are equivalent approaches.

In the income approach, profit is also considered a payment to
the entrepreneur. So the incomes are (1) wages, (2) rent, (3)
interest, and (4) profit. Profit adjusts to make the sum equal to
the final value of the good.
Notes of the 3 approaches
(Contd…)

In the value added approach, only the value added in each stage
of production are included. If we add the value of intermediate
product with the value of the final product, we commit the sin
of “double-counting.”

At each stage of production, the value-added is equal to wages,
interest, rent, and profit. Therefore the value of the final
product is likewise the same of all payments to the factors of
production
Additional Topics
GDP vs GNP
 Real vs current GDP
 Inter-country comparisons of GDP

◦ Convert to international currency like US
dollars
◦ Convert to per capita measures
THE NATIONAL ACCOUNTS OF THE
PHILIPPINES
Same principles as above but need to make
adjustments in order to accommodate the realities
in modern economies
 Expenditure approach
◦ GDP = C + G + I + X –M+ SD
Table. Expenditures on GDP, 2002 in million
pesos.
Item
Symbol
Value
Personal Consumption Expenditure
C
2,750,9000
Government Consumption
Expenditure
G
488,700
Gross Domestic Capital Formation
I
776,200
Exports of Goods and Services
X
1,968,500
Less: Imports of Goods and Services
M
1,989,100
Statistical Discrepancy
SD
27,500
Gross Domestic Product
GDP
4,022,700
Expenditure Approach

C - spending of households and private non-profit institutions on goods and
services
◦ Non-durables - goods and services that are consumed rapidly
◦ Durable goods - that last for a longer period of time

I - investment spending of domestic agents. Its major components are
“changes in” Fixed Capital and Changes in Stocks

G - government’s payments for the salaries of its workforce as well as
purchases of goods and services  used for the government’s day to day
operations and projects.
Expenditure Approach (Contd…)

X - the spending of the rest of the world on goods and non-factor services
produced in the country

Mthe country’s purchases of goods and non-factor services from the
rest of the world.

SD - accounts for accounting and reporting errors in the accounts. Needed
to ensure that GDP value from all approaches are the same
Income Approach
ITEMS
SYMBOLS
VALUE
Compensation of Employees
COE
1,093,800
Net Operating Surplus
NOS
2,215,100
Depreciation
Indirect Business Taxes less
Subsidies
Gross Domestic Product
D
IBTS
357,200
356,600
GDP
4,022,700
Income Approach

GDP = COE + NOS + D + IBTS

In a simple world, GDP = COE + NOS. In practice, require
two adjustments (D and IBTS)

D - accounts for the wear and tear of physical capital

“D” is treated as a business cost  not included in NOS.
However, “D” is part of “I” in the expenditure side of the
national accounts
Income Approach (Contd….)

IBTS - includes taxes on the use or purchase goods and
services and grants from government to firms. E. g sales
taxes, value added tax

Not included in NOS but is part of the market prices, of which
the items in the expenditure accounts are quoted
Value added or Industrial Origin
approach

GDP = value added of different activities
(sectors)
ITEM
Agriculture, Fishery and Forestry
VALUE
519,400
Industry
1,307,400
Services
2,123,900
Gross Domestic Product
4,022,700
The distinction between GDP and
GNP

GNP = GDP + Net Factor Income from the Rest of
the World (NFIRW)

NFIRW - measures the difference between the
earnings of Philippine residents in other countries
and foreign residents in the Philippines
The distinction between GDP and
GNP
Gross Domestic Product
GDP
Net Factor Income from
the Rest of the World
NFIRW
Gross National Product
GNP
4,022,700
267,500
4,290,200
Nominal and Real GDP




GDP at current prices or nominal GDP - GDP measured using
the prices of the year for which it is calculated
Nominal GDP can be a misleading indicator of changes in
output or income because it also embodies changes in the
prices of goods and services.
Real GDP or GDP at constant prices  measures the total
value of output using the prices of a selected year (the base
year).
Real GDP better for analysis overtime because it eliminates
the effects of price changes
Table 8.5
YEAR 1
YEAR 2
QUANTITY
Ice Cream
Buko Pie
PRICE
Ice Cream
Buko Pie
VALUE
Ice Cream
Buko Pie
NOMINAL GDP
100
100
100
100
50
100
100
200
5,000
10,000
15,000
10,000
20,000
30,000

GDPyear 1 = (100) (50) + (100) (100) = 15,000

GDPyear 2 = (100) (50) + (100) (100) = 15,000

In practice, calculating real GDP using the
previous approach is a tedious process because
there are so many goods and services are
produced in an economy. Can simplify the
calculation process by using the GDP deflator.

GDP deflator - a price index that allows us to
convert nominal GDP into real GDP. (note: price
index to be defined later)
Real GDP
Nominal GDP
Real GDP 
 100.
GDP deflator
Investment vs. Capital
§
Capital is one of the factors of production.
At any given moment, the economy has a certain overall stock of
capital.
§
Investment is spending on new capital.
Investment vs. Capital
Example (assumes no depreciation):
§
1/1/2002: economy has $500b worth of capital
§ during 2002: investment = $37b
§
1/1/2003: economy will have $537b worth of capital
Stocks vs. Flows
Flow
Stock
More examples:
stock
flow
a person’s wealth
a person’s saving
# of people with
# of new college
college degrees graduates
the govt. debt
the govt. budget deficit
A question for you:
Suppose a firm
§ produces $10 million worth of final goods
§ but only sells $9 million worth.
Does this violate the expenditure = output identity?
Why output = expenditure
§
Unsold output goes into inventory,
and is counted as “inventory investment”… .
….whether the inventory buildup was intentional or not.
§
In effect, we are assuming that firms purchase their unsold
output.
The Income Approach
The income approach divides GDP
according to who receives the income
from the spending flow.
 In addition to aggregate income,
national income and personal income
are also used as measures of income.

The income approach

The Income Components Include:
◦ Wages and salaries
◦ Corporate profits
◦ Proprietors income (the profits of partnerships and soley
owned businesses, like a family restaurant)
◦ Farm income
◦ Rent
◦ Interest
◦ Sales taxes
◦ Depreciation (the amount of capital that has worn out
during the year)
Interest (only the interest payments made by business firms
are included and the interest payments made by government are
excluded).
Corporate profits which are subdivided into
Corporate income taxes
Dividends
Undistributed corporate profits
Three additions are made to the income side to balance it with
expenditures.
1.Indirect business taxes are added because they are
initially income that later gets paid to government.
2.Depreciation or the consumption of fixed capital is added
because it is initially income to businesses that later gets
deducted in calculating profits.
3.Net foreign factor income is added because it reflects
income from all domestic output regardless of the foreign
or domestic ownership of domestic resources.
The Production Approach

The production approach looks at GDP from the
standpoint of value added by each input in the
production process.

The three approaches--spending, income, and
production– (should) result in equivalent values for
GDP.
Below is a list of domestic output and national income figures for a given year. All figures are in
billions. Determine the major national income measures by both the Expenditures and income
methods.
Personal consumption expenditures
$245
Net foreign factor income earned in the U.S.
0004
Transfer payments
0012
Rents
0014
Consumption of fixed capital (depreciation)
0027
Social security contributions
0020
Interest
0013
Proprietors’ income
0033
Net exports
0011
Dividends
0016
Compensation of employees
0223
Indirect business taxes
0018
Undistributed corporate profits
0021
Personal taxes
0026
Corporate income taxes
0019
Corporate profits
0056
Government purchases
0072
Net private domestic investment
0033
Personal saving
0020
Simple Economy…..No govt…no foreign trade
C=consumption
I=investment
S=saving
Y= Income
Output produced=output sold
Y= C+I………….(1)
I=S
Y=C+S…………(2)
Introducing govt. in the above identity
G= govt. purchases of goods and services
TA=all taxes
TR=transfers to private sector (including interest)
NX=net exports (exports-imports)
YD=disposable income
Y=C+I+G+NX……….(3)
YD=Y+TR-TA………..(4)
YD= C+S………………(5)
C+S=Y+TR-TA
•
LEAKAGES (Withdrawals (W) : (T + S + IM) out of the system must equal
INJECTIONS (J): (G + I + X) for the circular flow to balance (be in
EQUILIBRIUM).
•
Withdrawals [ T + S + IM] = Injections [G + I + X]
can be broken down to three important balances in the economy:
1.
T - G: the Government's Budgetary Balance;
2.
S - I: the Private Sector's Saving/Investment Balance;
1.
IM - X: the Country's Trade Balance (current account of Balance of
Payments)
C=YD-S=Y+TR-TA-S……………………..(6)
Consumption is disposable income less saving
Or consumption is equal to income plus transfers less taxes and saving
Using RHS of (6) in (3):
Y=C+I+G+NX……….(3)
Y= (Y+TR-TA-S)+ I+G+NX
S-I=(TR-TA+G)+NX…………………………(7)
Govt. budget deficit,I.e., total govt. expenditure consisting of govt.
Purchases of goods and services(G) plus govt. transfer payments (TR)
Minus amount of taxes (TA) received by govt. equals excess of private
saving over investment and net exports
The budget deficit, trade, saving and investment(in Rs. Billion)
Saving (S)……………1000
1000 1000 1000
Investment(I)…………1000
850
900 950
Budget Deficit(BD)…..0
150
0 150
Net Exports (NX)……0
0
100 -100
Exercises
Q.1 What would happen to GDP if the govt. hired unemployed
Workers, who had been receiving amount $TR in unemployment
Benefits, as govt. employees and now paid them $TR to do nothing?
Explain.
Q.2In the national income accounts, what is the difference between:
a)A firm’s buying an auto for an executive and the firm’s paying the
Executive additional income to buy the automobile herself?
b)Your hiring your spouse (who takes care of the house) rather
than having him or her do the work without pay?
c)Your deciding to buy an Indian car rather than a German car?
3. The following is information from the national income accounts for a
hypothetical country:
GDP
Gross investment
Net investment
Consumption
Government purchases of goods and services
Government budget surplus
What is:
a. NDP?
d. Disposable personal income?
b. Next exports?
e. Personal saving?
c. Government taxes minus transfers?
$6, 000
800
200
4, 000
1, 100
30
GDP and GDP deflator
§
We would like to convert different goods
quantities and prices into one single quantity of composite good and
one general price level. How?
§
We use the concepts of nominal GDP, real GDP and
GDP deflator to achieve such aggregation.
Real vs. Nominal GDP
§
§
.
§
year.
GDP is the value of all final goods and services
produced domestically.
Nominal GDP measures these values using current prices
Real GDP measure these values using the prices of a base
Real and Nominal GDP
2001 Nominal 2006
GDP
Nominal
GDP
2006 Real
GDP
Bread
(ton)
1 at Rs.1 thousand
… Rs. 1thousand
2 at Rs.2
thousand
.. Rs. 4 thousand
2 at Rs. 1
thousand………
…Rs.2 thousand
Milk
(thousand
Litres)
1 at Rs 0.5
thousand………....R
s. 0.5 thousand
3 at Rs.0.75
thousand………
…..Rs. 2.25
thousand
3 at Rs.0.50
thousand………
…..Rs.1.50
thousand
Total GDP
Rs. 1.5
thousand
Rs. 6.25 thousand Rs. 3.50 thousand
Real GDP and living standard
Changes in nominal GDP can be due to:
§ changes in prices
§ changes in quantities of output
produced
Changes in real GDP can only be due to
changes in quantities, because real GDP is
constructed using constant base-year
prices. Therefore, changes in real GDP
measure changes in living standard.
GDP Deflator
While real GDP captures living standard,
cost of living is measured by general price level.
One measure of the general price level is the GDP Deflator, defined
as
GDP deflator = 100 * Nominal GDP /Real GDP
Measuring the Cost of Living
§
Inflation refers to a situation in which the economy’s
overall price level is rising.
§
The inflation rate is the percentage change in the price level
from the previous period.
Exercise: The following table shows nominal GDP and an appropriate price
index for a group of selected years. Compute real GDP. Indicate in each
calculation whether you are inflating or deflating the nominal GDP data
Nominal GDP
billions
Price index
(1992=100)
Real GDP billions
1959
$ 507.2
23.0
$______
1964
663.0
24.6
$______
1967
833.6
26.6
$______
1973
1382.6
35.4
$______
1988
5049.6
86.1
$______
1995
7265.4
107.8
$______
CPI vs. GDP deflator
prices of capital goods
• included in GDP deflator (if produced domestically)
• excluded from CPI
prices of imported consumer goods
• included in CPI
• excluded from GDP deflator
the basket of goods
•
CPI: fixed
•
GDP deflator:
changes every year
International Comparisons of GDP

In any attempt to compare GDP between countries,
some account must be taken of differences in prices.

Adjustment for GDP based on exchange rates makes
some improvement in the comparison of GDP
figures.

However, if we wish to determine the value of GDP
in another country, some information on the price
differences of goods is needed.
Purchasing power parity exchange rates
attempt to adjust exchange rates for
differences in the prices of goods across
borders through the use of a ratio of price indexes.
The exchange rate is adjusted to reflect this ratio
•Once this adjustment is made, international rankings of countries
• based on GDP or per capita GDP tend to fluctuate
•as exchange rates vary, while the corresponding prices do not.
•Despite their variability due to exchange rate fluctuations,
• purchasing power parity exchange rates provide a better basis
for international comparisons than an adjustment based
solely on exchange rates.
The Measurement of GDP
GDP is:
the market value
of all final goods and services
produced within a country
in a given period of time.
What Is Counted and Not Counted
in GDP?
 GDP includes all
items produced in the economy and sold
legally in markets.
 GDP excludes
services that are produced and consumed at
home and that never enter the marketplace. Eg: Caring labor,
the work that is normally produced by women.
 Because
GDP does not count it, it diminishes its importance.
 GDP also
excludes black market items, such as illegal drugs.
Other Measures of Income
 Gross
National Product (GNP)
 Net National Product (NNP)
 National Income
 Personal Income
 Disposable Personal Income
The Components of GDP
GDP (Y ) is the sum of the
following:




Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)
Y = C + I + G + NX
GDP and Its Components (1998)
Per Person (In
Rs)
$31,522
% of
Total
100%
Consumption C 5,808
21,511
68%
Investment I
1,367
5,507
16
Government G
1,487
5,507
18
-559
-2
GDP (Y)
Total (Billions of
Rs)
$8,511
Net Exports NX -151
GDP and Its Components (1998)
Government Purchases
Investment
Net Exports
18%
16%
-2 %
Consumption
68 %
Measuring Economic Growth
◦ We use real GDP to calculate the economic
growth rate.
◦ The economic growth rate is the percentage
change in the quantity of goods and services
produced from one year to the next.
◦ We measure economic growth so we can make:
◦ Economic welfare comparisons
◦ International welfare comparisons
◦ Business cycle forecasts
Measuring Economic Growth

Business Cycle Forecasts
◦ Real GDP is used to measure business cycle
fluctuations.
◦ These fluctuations are probably accurately
timed but the changes in real GDP probably
overstate the changes in total production and
people’s welfare caused by business cycles.
Real versus 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.

Deflating
the GDP Balloon
◦Nominal GDP increases because production—
real GDP– increases.
Real GDP and the Price Level

Deflating the GDP Balloon
Nominal GDP also increases because prices rise.
Real GDP and the Price Level

We use the GDP Deflator to take the air out of
Nominal GDP.
Real GDP and the Price Level
What makes a stable economy?
Macro stability can be measured by the volatility of key
indicators:
 1. Consumer price inflation (annual % change in prices)
2. Real GDP growth over one or more business cycles
3. Changes in measured unemployment / employment
4. Fluctuations in the current account of the balance of
payments
5. Changes in government finances (i.e. the size of the fiscal
deficit or surplus)
6. Volatility of short term policy interest rates and long term
interest rates such as the yield on government bonds
7. Stability of the exchange rate in currency markets



A stable economy provides a framework for an improved supply-side
performance i.e.
• Stable low inflation encourages higher investment which is a determinant of
improved productivity and non-price competitiveness

• Control of inflation helps to main price competitiveness for exporters and
domestic businesses facing competition from imports

• Stability breeds higher levels of consumer and business confidence –
sentiment drives spending in the circular flow

• The maintenance of steady growth and price stability helps to keep short term
and long term interest rates low, important in reducing the debt-servicing costs
of people with mortgages and businesses with loans to repay

• A stable real economy helps to anchor stable expectations and this can act as
an incentive for an economy to attract inflows of foreign direct investment