Download Price and Inflation

Macroeconomic Measures
The focus of this lecture is the macroeconomic measures. Students
should understand the significance of Gross Domestic Product, Price
levels, and unemployment in our economic systems.
OBJECTIVES
1. Understand price level and how to calculate inflation rate.
2. Measure unemployment rate and explain its content.
3. Define Gross Domestic Product (GDP) and understand GDP
computation.
4. Evaluate the validity of GDP as a measure of economic welfare and
productivity.
TOPICS
Please read all following topics.
PRICES AND INFLATION
UNEMPLOYMENT
GDP DEFINITION
COMPUTATION OF GDP AND OTHER NATIONAL ACCOUNTS
Price and Inflation
One of the macroeconomic goals is price stability. It means that the average price level remains relatively
stable. Price level is a weighted average of the prices of all good and services. A price index provides us with
a reliable estimate of the price level. The most common price indices adopted by economists are: consumer
price index and GDP deflator.
Consumer Price index (CPI) tracks the prices of a representative market basket of consumer goods.
CPI = (Total dollar expenditure on market basket in current year/ Total dollar expenditure on market basket in base year) X 100
Base year is a benchmark year that serves as the basis for price comparisons. The CPI compares the current
prices of the market basket to the prices of those goods in base year. Here is a simple example of CPI
computation.
Assuming there are only 3 items in the market basket of Country A.
Market Basket
1995 prices 1995 Quantity
1996 prices
Toys
$10
3
$10
Pencils
2
5
2.2
Books
5
8
5.1
1996 Quantity
3
5
8
Total dollar expenditure on market basket in 1995 = $10x3 + $2x5 + $5x8= $80
Total dollar expenditure on market basket in 1996 = $10x3 + $2.2x5 + $5.1x8= $81.8
Set 1995 as our base year, then 1996 CPI = ($81.8 / $80) X 100 = 102.25
Price and Inflation
Real value of an economic variable can be found using the CPI (or any price indexes). Nominal
dollar income or dollar prices in different years can be compared using the real value concept.
Real value = (Nominal value / CPI) X 100
Using the data from the above example: if an individual's annual income was $40,000 in 1996,
his real income = ($40,000 / 102.25) X 100 = $39119.80
Inflation is a rising general level of prices. It is an economic instability, which the U.S.
government has to face.
Inflation rate = [(current year’s price index – last year’s price index) / (last year’s price index)] X 100%
Using the data from the above example:
1995 (base year) CPI = 100 and 1996 CPI = 102.25
Inflation rate between 1996 and 1995 = [(102.25– 100) / 100] X 100% = 2.25%
Rule of 72 is a short cut for calculating the time it takes for the price level to double.
# of years for price level to double = 72 / inflation rate.
For example, inflation rate in the above example is 2.25%, then the number of years for the
price level to double is about 32 years. (72/ 2.25 = 32)
Unemployment
High unemployment rate is one of the results of an economic downturn. It is defined as the
percentage of the labor force which is not employed. Population is divided into 3 groups:
1) those under age 16 or institutionalized,
2) those not in the labor force,
3) the labor force which includes those age 16 and over who are willing and able to work.
Part-time workers and discouraged workers who want a job, but are not actively seeking one,
are not in the labor force. So they are not included in the unemployment rate.
Unemployment rate (U) = (unemployed workers of the labor force / labor force) X 100%
The economic cost of unemployment can be calculated by using Okun’s law:
GDP Gap ( %)= ( U – Un ) X 2 where Un = natural rate of unemployment
As we can see that the size of the labor force is crucial in determining the unemployment rate.
Therefore, the Labor Force Participation rate is often calculated to see the percentage of the
civilian non-institutional population that is in the labor force. Group 2 (those not in the labor
force) and Group 3 (the labor force which includes those age 16 and over who are willing and
able to work) form the non-institutional population.
Labor Force Participation rate (%) = (Labor force / non-institutional population) X 100%
Three Types of Unemployment
Three types of unemployment are:
1. Frictional unemployment (Uf) includes those looking for jobs or waiting to take jobs
soon. It indicates the mobility in the labor market.
2. Structural unemployment (Us)is due to changes in the structure of demand for labor,
such as geographic distribution of job changes or obsolescence of certain skills.
3. Cyclical unemployment(Uc) is caused by the recession phases of the business cycle.
Full employment does not mean zero unemployment, it means cyclical unemployment rate
is zero. At this rate, job seekers are equal to job openings. This is also called the natural rate
of unemployment (Un) where real GDP is at its potential GDP. Un does not stay the same
but depends on the demographics of the labor force. The current Un of U.S. is about 4-5%.
U = Uf+Us+Uc Un= Uf+Us
GDP
Gross Domestic Product (GDP) measures the total market value of all final goods and services produced
within a country in one year.
1. Intermediate goods (goods that are input in the production of other goods) are not included in GDP to
avoid double counting. In another words, only the value added is counted.
Example: We use seed to produce wheat, wheat to produce flour, and flour to produce bread. In order to
produce $5000 worth of bread, we need $3500 worth of flour, which require $2500 worth of wheat, which
require $1000 worth of seed. The value added in each process is illustrated below:
Seed ----------------------- $1000 ----------- Value added = 1000 – 0 = 1000
Wheat --------------------- $ 2500 ------------Value added = 2500 – 1000 = 1500
Flour ----------------------- $ 3500 ------------Value added = 3500 – 2500 = 1000
Bread ---------------------- $ 5000 ------------Value added = 5000 – 3500 = 1500
The sum of Value added = 1000 + 1500 + 1000 + 1500 = 5000.
The sum of value added is the value of the final product, bread in the above example. Therefore, value
added approach is the same as counting only the value of the final products.
2. GDP only counts the value of final products produced within a geographical boundary of a country. If
U.S. citizens are working in Canada, they do not contribute to the U.S. GDP, but Canada’s GDP and U.S.
GNP. Gross National Product (GNP) is the total market value of all final goods and services produced
annually by the citizens of a country.
3. GDP sums the dollar value of what has been produced in the economy over the year, not what was
actually sold. For example, used car sales are not included.
GDP
4. GDP was not designed to be a measure of well being of the society. GDP omits the following:
a. Non-marketable goods and services: tasks that do not involve market transactions, such as baby
sitting, house cleaning, lawn mowing etc. Some very useful output is excluded because it is unpaid
employment.
b. Underground activities: illegal or cash transactions have no record. Government’s estimates on these
transactions are not accurate.
c. Sales of used items: GDP measures only current output. Used car and thrift stores’ transactions are
not counted.
d. Financial transactions: trading existing assets, such as stock or bond purchases.
e. Transfer payments: either government or private transfer payments are not included because goods
and services are not produced in this process. Examples are social security benefits or kid’s allowances.
f. Leisure: individuals consume leisure, just as they consume all the other tangible goods, which
generate satisfactions. But leisure has no price tag, so it is not included in GDP.
g. Social costs: production processes may cause pollution. Polluted air and water may have social costs
like bad air quality, and cancer patients. These social costs reduce our economic well being. If money is
not spent to clean up the oil spill or to cure the cancer patients, those expenses are not added to the
GDP.
h. GDP does not measure quality or nature of the product, which contributes to the satisfaction level of
the consumers. Nominal GDP simply adds the dollar value of the product; it makes no differences if the
product is a weapon, or a book.
Per capita real GDP (= real GDP / population) gives more information on the standard of living.
GDP Calculation
Two approaches of calculating GDP:
What is spent on a product is the income to those who helped to produce and sell it. GDP can be
measured either from the expenditure approach or the income approach.
1. Expenditure approach
The economy is divided into four sectors: household, business, government, and foreign sector.
C: Consumption is the expenditures of the household sector. It includes spending on 1) durable goods
which last for more than one year, 2) non-durable goods, and 3) services.
I: Investment is the expenditure of the business sector, including 1) purchases of new capital goods which
are equipment or tools that aids in the production process, 2) changes in business inventories, 3)
purchases of new residential housing.
G: Government Purchases is the expenditure of the public sector, such as education and defense
expenses. Transfer payments are not included. If Government’s expenditure is greater than taxes
collected from business and household sector, government is having a deficit; if government’s
expenditure is smaller than the taxes collected, government is having a surplus; if the two amounts are
equal, government’s budget is balanced. When there is a budget deficit, government needs to borrow
debt from the business, household or the foreign sectors. Government’s debt is usually higher in recession
than in an expansion phrase of the business cycle because government needs funding to finance their
deficit.
Xn: Net Exports is the differences between exports (goods and services sold to the foreign markets) and
imports (goods and services produced and imported from abroad). Xn = X – M (X=exports, M=imports)
Computing GDP: GDP = C + I + G + Xn
GDP Calculation
2. Income approach
All final goods and services are produced using factors of production. By summing up the factor
payments, we can find the value of GDP. Some adjustments are required to balance the account.
Compensation of employees includes the wages, salaries, fringe benefits, Social Security contributions,
and health and pension plans.
Rent is the income of the property owners.
Interest is the income of the money capital suppliers.
Proprietor’s Income is the income of incorporated business, sole proprietorships, and partnerships.
Corporate Profits is the income of the corporations’ stockholders whether paid to stockholders or
reinvested.
Sum of the above items is the National Income (NI).
Adjustments:
Indirect business Taxes (general sales taxes, business property taxes, license fees etc.) should be added
to NI. They are not considered to be payments to a factor of production, but they are part of total
expenditures.
Depreciation is another cost, which should be added.
Net foreign factor income (income earned by the rest of the world – income earned from the rest of the
world) should be added to adjust GNP to GDP.
Computing GDP: GDP = Compensation of employees + Rent + Interest + Proprietor’s Income + Corporate
Profits + Indirect business taxes + Depreciation + Net foreign factor income
Some statistical discrepancy should be considered to balance expenditure and income approach.
Nominal Vs Real GDP
Nominal GDP = Sum of (Price X Quantity) for every item produced in the economy, using
the current year’s price. When comparing nominal GDP figures between different years,
you cannot determine whether the increase is due to the increase in price level or
increase in output. Real GDP is adjusted for price level, that is, GDP measured at the same
price level.
Real GDP = (Nominal GDP / price index) X 100
If real GDP increases from one year to the next, then economic growth has occurred.
Growth rate =[(Real GDP of last year – Real GDP of earlier year) / Real GDP of earlier year] X 100 %
The rise and fall of GDP over time is referred to as the business cycle. Phases of the
business cycles are peak, recession, trough, recovery, and expansion (when economy has
expanded beyond the initial peak).
The U.S. economy’s longest growth period is from 1991 to 2001. From the second quarter
of 2001, the U.S. economy has entered a recession. According to the statistics in the
second quarter of 2002, U.S. is experiencing a growth rate of 1.1% annually.
GDP Example
The following table illustrates an example of the computation process of GDP and some other national accounts.
Personal consumption expenditures
Net foreign factor income earned
$245
Compensation of employees
4
$223
Indirect business taxes
18
Transfer payment
12
Undistributed corporate profits
21
Rents
14
Personal taxes
26
Consumption of fixed capital (depreciation)
27
Corporate income taxes
19
Social security contributions
20
Corporate profits
56
Interest
13
Government purchases
72
Proprietors' income
33
Net private domestic investment
33
U.S. exports of goods and services
20
Personal savings
20
Dividends
16
U.S. imports of goods and services
Expenditure approach:
Income approach
GDP=C+Ig+G+Xn
GDP=WAGE+RENT+INTEREST+OWNERS'
INCOME+CORPORATE PROFIT+ ADJUSTMENTS
C:
Personal consumption expenditures
Ig=In+Dep
Net private domestic investment
33
RENT:
Consumption of fixed capital (depreciation)
27
INTEREST: Interest
13
G:
Xn=X-M
$245 WAGE:
Compensation of employees
9
Rents
223
14
Gross private domestic investment
60
OWNER'S
Proprietors' income
INCOME
33
Government purchases
72
CORPORA
Corporate profits
TE PROFIT
56
ADJUSTM
Indirect business taxes
ENTS:
18
U.S.exports of goods and services (X)
20
U.S.imports of goods and services(M)
-9
Net export (Xn)
Gross domestic product
Consumption of fixed capital (depreciation)
11
$388
Net foreign factor income earned
Gross domestic product
27
4
388
Additional National Accounts
Net domestic product:
NDP= GDP – Depreciation
=$361 - 4 - 18
=$361
National income:
NI=NDP-Net foreign income earned in U.S.- Indirect tax
=$388 -27
=$339
Personal income:
PI= NI - S.S. - Corporate income taxes - Undistributed corporate profit + Transfer
payment
=$339 - 20 -19 - 21 + 12
= $291
Disposable Income
DI= PI - Personal tax
= $291 - 26
= $265
Business Cycle
Business cycles are the rises and falls of real GDP over time. Business Cycles are divided into
four or five phases. Some textbooks combine the recovery and expansion into the same
phase and called that expansion phase.
1. Peak: This occurs when real GDP is at a temporary maximum.
2. Recession: Two consecutive quarterly decline in total output (real GDP) is
called recession.
3. Trough: This is the bottom of the recession. After this point, GDP will start rising.
4. Recovery: This is the period between trough and the peak when real GDP is expanding .
5. Expansion: If real GDP rises beyond the recovery, this period is referred to as expansion.
By observing the AD and AS model, business cycles can be determined. If the real GDP is
below full employment GDP, the economy is in recession. Trough will be reached before the
economy rebounds to the full employment level. If the economy's AD is strong enough to
expand the real GDP to a new level, then recovery and expansion will be experienced before
the economy reaches a temporary new high, peak.