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MACROECONOMIC MEASURES WHAT THEY ARE & HOW TO USE THEM Chapter 21, 22, 26 Monetary policy affects financial markets. Euro rate rise puts heat on the Fed Hang Seng slide continues Hong Kong's stocks dropped for a fourth time in five days after a US central banker said the Federal Reserve may need to raise interest rates further. 8/24/06 US rate pause buoys Asia Most Asian bourses gained ground Wednesday in reaction to the US Federal Reserve's decision to keep interest rates unchanged. 8/10/2006 … after the central banks of the euro region and the United Kingdom raised interest rates to restrain inflation after economic growth accelerated. Stocks and bonds fell as investors bet borrowing costs are headed higher. 8/4/2006 Fed rate hopes lift region Asian markets rose Wednesday in anticipation that the latest US economic data would persuade the Federal Reserve to keep US interest rates on hold. 8/17/2006 Outline • Introduction • GDP • Comparing GDP Across Time • Inflation • Comparing GDP Across Countries Gross Domestic Product Quantity Aggregates • To understand the macroeconomy, we need to measure it. Chief measure of economy is the level of production: GDP • We need to combine the many goods produced or consumed in an economy into one measure. + + + + =? All goods sold in an economy share a common unit of measure: the price at which they are sold. Sum up the value of goods Gross Domestic Product (GDP) • GDP is the sum of the value of new, final goods produced within the domestic borders of an economy. Final goods are goods sold to their end-users GDP does not include: • Intermediate goods which are sold from one firm to another for immediate transformation into other goods. • financial transactions like buying stocks. • purchases of used goods which have been sold before. • goods produced overseas by domestic firms. • Secondary Transfers How do we measure value-added of nonmarket goods? • Production of government bodies and non- market institutions is measured at cost (sum of labor payments plus capital consumption costs). • Value of housing services of owner-occupied housing valued at imputed rental value, i.e. market rent of similar housing stock. • Value of non-compensated household work valued at zero. How do we measure financial services? • Banking industry output includes interest income on loans minus interest payments on deposits (plus fee income). • Insurance industry output is measured as premiums net of indemnity payments (w/ minor adjustments). GDP is a Gross Concept • One cost of production is depreciation of equipment and structures used for production. • This cost, referred to as consumption of fixed capital, is not subtracted from sales to construct value added. • Net Domestic Product = GDP – Consumption of Fixed Capital Three Methods for Calculating GDP Expenditure Method - The sum of the domestic spending on final goods (less domestic demand satisfied by imports). 2. Production Method - The value added created in all the sectors of the economy. 3. Income Method – The Wage, Rent, Interest and Profit Income generated by the domestic economy. 1. Link • Accounts are created by national statistical agencies • UN System of National Accounts is the “internationally agreed standard set of recommendations” used by most countries. • Annual data for many countries available at the UN Link Expenditure Method C + I + G + Consumption Consumer durables, nondurables, services Investment Structures (incl. Residential), Equipment, and Inventory Government Government Spending on Consumption Goods, Services, and Salaries. X EXports Goods & Services Shipped IM IMports Abroad = A + NX = (C + I + G) + (X – IM) GDP Goods & Services from Abroad Some Asian Expenditure Shares: 2008 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Household Government Investment PRC Japan Exports Imports Korea Source: United Nations Main Aggregates Database Production Method • At the plant level, Value added = Sales + Change in inventories - materials, intermediate inputs and energy costs. • Value added at the firm level is directly taxed in the EU (VAT) • GDP is the sum of VA across establishments. • The value of a final good is equal to the value added at each stage of production. Production Approach Sub-aggregates • Divide production establishments into sectors usually along the line of • Primary: Natural Resources (Agriculture, Forestry, Fishing, Mining, Quarrying) • Secondary: Goods production (Manufacturing, Construction, Utilities) • Tertiary: Intangibles Production Table 035 (GDP) by Economic Activity at Current Price HK$ Mn Economic Activity 2009 r Agriculture, fishing, mining and quarrying 1,090 Manufacturing 28,227 Electricity, gas and water supply, and waste management 34,961 Construction 50,146 Services 1,436,427 Import/export, wholesale and retail trades Import and export trade 365,880 305,458 Accommodation and food services 48,787 Transportation, storage, postal and courier services 99,048 Transportation and storage Postal and courier services Information and communications 93,936 5,112 46,808 Financing and insurance 235,581 Real estate, professional and business services 173,583 Real estate Professional and business services 86,833 86,749 Public administration, social and personal services 279,453 Ownership of premises 187,286 GDP at basic prices Taxes on products GDP at current market prices 1,550,851 55,967 1,622,322 Hong Kong: Value Added by Sector 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% Hong Kong Census and Statistics 2006 # 1980 Landlord Services FIRE Transport Trade Construction Utilities Manufacturing Mining Agriculture 0.00% Dynamics of Industrial Structure Earnings or Income Approach to Measuring GDP • Measuring overall economic activity by adding the earnings or income generated by selling the output produced in the economy. (Not calculated for HK on an annual basis.) Gross Income = compensation of employees + net operating surplus 20 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Net Operating Surplus Sum of • Proprietors’ income: the income of unincorporated businesses, such as medical practices, law firms, small farms, and retail stores. • Rental income : the income households receive from the rental of their property. • Corporate profits: the excess of revenues over costs for the incorporated business sector of the economy. • Net interest: the interest private businesses pay to households for lending money to the firms minus the interest businesses receive 21 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall National Income vs. Domestic Income GNI Gross National Income GDI Gross Domestic Income = income earned by = income created within national residents domestic borders. GNI = GDI +NFI • Net Factor Income [NFI] is income earned on overseas work or investments minus income generated domestically but paid to foreigners. Hong Kong NFI/GDP 4.00% 3.50% 3.00% 2.50% 2.00% % 1.50% 1.00% 0.50% 0.00% -0.50% -1.00% 1993 1995 1997 Hong Kong Census and Statistics 1999 2001 2003 2005 2007# Compare Macau and the Philippines GDP or GNP • Macau produces a lot of profits paid to overseas owners of casinos. • Philippines workers earn a lot of income overseas. • Which is larger Philippines’ GDP or Philippines GNP? • Does Macau have greater GDP or GNP? Income=Expenditure=Value Added • Value of final good expenditure is equal to value added at each stage of production. (Expenditure = Value Added) • Value Added would be paid to workers, creditors, or kept as profits. (Income = Value Added) Comparing GDP levels across time • GDP measures the value of the goods produced by an economy by using the market price of each good to assign it a value. • Problem: Prices of goods in terms of money are changing overtime making comparisons in overall value difficult. • Bias: Money prices are growing over time as money supply grows. • Solution: Choose a Base Year’s prices as a fixed yardstick of value for different goods. Real GDP: Yt • GDP aka Nominal GDP aka Current Dollar GDP is the weighted sum of the number of goods produced using their current prices as the weight. • Real GDP aka Constant Dollar GDP aka GDP adjusted for inflation is the weighted sum of the number of goods produces using the Base Year prices as yardsticks. Solved Problem Real GDP: 2010 (2009 Base Year) 2010 P Kitkat M&Ms Nominal GDP Real GDP Q 2009 P Q 8 150 6 135 10 150 4 135 Calculating Real GDP • Divide GDP into k categories. • Survey dollar value of goods produced at time t for each of k categories vtk • Survey average prices of goods of type k relative P to a base year. • Divide value of each good by the relative price t k P Yt k vtk Base Pt k k k PBASE Real GDP vs. Nominal GDP St. Louis Federal Reserve USA 16000.0 14000.0 10000.0 8000.0 6000.0 4000.0 2000.0 0.0 19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 Billion US$ 12000.0 Nominal GDP Real GDP Notes on Price Indices: Quality • Some categories of goods (computers, cars) observe marked changes in quality over time. • Price growth rates for these components often reflect the price growth for certain characteristics (e.g. MHz,GB HD, etc.). These are referred to as hedonic price indices. Inflation Price Indices: Pt • Two most commonly used price indices are GDP Deflator and Consumer Price Index (CPI) • The GDP deflator is the ratio of nominal GDP to Real GDP (multiplied by 100). Nominal GDP P GDP Deflator 100 Real GDP GDP P 100 Y Consumer Price Index • The CPI is the price of a representative market basket of goods relative to the price of that same basket during a benchmark/base year (multiplied by 100). Cost of Market Basket in year t CPI t 100 Cost of Market Basket in Base year 140.0 120.0 100.0 80.0 CPI GDP Deflator 60.0 40.0 20.0 0.0 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 Hong Kong’s History of Prices Q: What is Inflation? A: The Growth Rate of Price Level Pt Pt 1 t Inflation Rate x100% Pt 1 •What is the CPI inflation rate in Candyland in 2010 using 2009 as the base year? • Inflation: prices are growing • Disinflation: inflation is slowing down but still positive • Deflation: inflation is negative and prices are actually dropping. Hong Kong CPI Inflation 14 Disinflation 12 10 8 4 Deflation 2 20 08 20 06 20 04 20 02 20 00 19 98 19 96 19 94 19 92 19 90 19 88 -4 19 86 -2 19 84 0 19 82 % 6 -6 http://www.imfstatistics.org/imf/ Adjusting for Inflation • • • • • We can use price indices to “adjust for inflation” - converting values measured in money into values measured in the prices of some reference year, r. Measured in $, observed at time t: Nt Price level at time t: Pt Price level in reference year: Pr Measure adjusted for inflation – N r$ t N r$ t Pr Nt Pt Housing Price: Hong Kong Island • Compare the price of housing in HK average price of an apartment on HK Island with an area between 100m2 and 160m2 • in September 2009 : HK$173,762 /m2 • in December 1982: HK$14,742/m2 • How much did an apartment cost back then when expressed in today’s dollars? Housing Price: Hong Kong Island • The Hong Kong CPI (2000=100) was 35.5 in December 1982 and 109.2 in December 2009. • Calculate: N r$ t Pr 109.2 N t $14, 742 $45,347.2 Pt 35.5 • In real terms, luxury housing in 2009 is almost 4 times as expensive as in 1982! Comparing GDP across Countries Two Methods • Exchange Rate Method: divide national GDP by the exchange rate. • How many US$ needed to buy DCU$ needed to purchase domestic GDP. • PPP Method: divide national GDP by PPP (Purchasing Power Parity). • How much domestic GDP would cost if sold at US prices. Exchange Rate Method • Exchange Rate Method can be a useful measure if you are going to convert income in one area and spend it in another. • Ex. Your Swiss food company projects that it can at most get a 20% share of the market for Mexican processed foodstuffs. Converting the size of Mexico’s processed food expenditures from Pesos to Swiss Francs is useful info for estimating profits. . • But macro aggregates are often used to give an idea of living standards, here exchange rates are not as useful because they are highly variable and not so representative.. Link GDP per Capita (Current Prices) Exchange Rate Conversion 350000 330000 310000 290000 HK$ 270000 250000 230000 210000 190000 170000 150000 2003 2004 2005 2006 Hong Kong 2007 Singapore 2008 2009 2010 Big Mac Index • Economist magazine reports big differences in the x-rate converted prices of McDonalds in different countries. • Big Mac is a bundle of different goods and services which can be a reasonable sample. Economist Magazine PPP: Purchasing Power Parities • PPP is the relative price of goods in one country measured in its own currency compared to the price of a reference country. • Example: If Big Macs were only good and cost HK$18.90 in HK and US$3.71 in USA, then PPPHK =5.0943HK$/US$ • Problem: Many goods Market Basket Index? • Construct an international market basket of goods produced and purchased around the world. • For a country, calculate PPP = Purchasing Power Parity as the price of the market basket (in DCU) relative to price of the market basket in US (in US$). PPP Hong Kong SAR, China China Singapore Korea, Rep. Thailand Japan 5.31 3.95 1.03 827.35 17.09 111.39 World Bank Data S 7.77 6.77 1.44 1156.06 31.72 87.78 Convert sums into another economy’s currency Exchange Rate Conversion • Nj is a number measured in country j’s currency & you want to convert it into the reference country’s currency. Sr N Nj Sj r$ j PPP Conversion PPPr N Nj PPPj r$ j Convert sums into another economy’s currency • Nj is a number measured in country j’s currency (e.g. GDP) that you want to convert it into the reference country’s currency. Link Exchange Rate Conversion PPPr N Nj PPPj r$ j Singapore Hong Kong S$ HK$ S$ HKG GDP GDP per Capita PPP $59,812.91 1.03 $246,732.79 5.305734 GDP HK $ HKG HKG PPPS $ PPPHK $ 1.03 HK $246, 732.79 = $47,898.13 5.31 PPP vs. Exchange Rate Conversion • Exchange rates are easily available so exchange rate is a “quick and dirty” comparison. • Measures how many US dollars someone could buy with average income. • However, money goes farther in some countries as many types of goods are relatively cheap (especially in developing countries). • PPP conversion measures how much the goods purchased by the average person would cost in the US. Better measure of living standards. GDP in US$ by Conversion Method 2005 GDP per Capita $7,000 40000 $6,000 35000 $5,000 30000 25000 $4,000 US/Intl$ US/Intl$ 2005 GDP per Capita $3,000 20000 15000 $2,000 10000 $1,000 5000 $0 Low income Lower middle income Middle income Exchange Rate PPP Upper middle income 0 High income: OECD High income: nonOECD Exchange Rate PPP GDP per Capita, PPP Constant 2005 International $ 60,000.00 50,000.00 40,000.00 30,000.00 20,000.00 10,000.00 0.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Singapore Hong Kong Which exchange rate conversion to use? • Depends on where the money will be spent. • If you have a value of foreign currency that you will want to spend at home, convert using exchange rate because foreign prices are irrelevant. • If you want to spend the money in foreign country, then using PPP conversion may be more helpful. Problem • You are a Chinese multinational that wants to construct salaries to be paid to employees in Canada that will provide same living standard as salary of RMB20,000. • Canada PPP in 2005 is 1.21. Learning Outcomes Students should be able to: • Explain the different methods of calculating GDP • Calculate simple real aggregates like real GDP. • Use price indices to calculate inflation rates. • Adjust nominal series for inflation. • Compare values measured in different currencies using the PPP and exchange rate method.