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Macroeconomics www.lrjj.cn Macroeconomic objectives • Distinction between microeconomics and macroeconomics • The major macroeconomic issues – Economic growth – Unemployment – Inflation – Balance of payments and exchange rates • balance of payments deficits and surpluses • exchange rate movements www.lrjj.cn Economic Fluctuations • Economic fluctuations are irregular and unpredictable • Most macroeconomic quantities fluctuate together – Most macroeconomic variables that measure some type of income or production fluctuate closely together. – Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. www.lrjj.cn Economic Fluctuations • As output falls, unemployment rises. – Changes in real GDP are inversely related to changes in the unemployment rate. – During times of recession, unemployment rises substantially. www.lrjj.cn Measuring Nation’s Income • Gross Domestic Product (GDP) – A measure of the total income and expenditures of an economy • 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. www.lrjj.cn GDP • Output is valued at market The market value… prices …of all final … • Not intermediate …goods and services… • Tangibles and intangibles …produced… • Currently, not past …within a country… • Geographic boundaries …in a given period of time. • Usually a year or a quarter www.lrjj.cn GDP Y C I G NX Y = C + I + G + NX = GDP = Consumption – household spending = Investment – spending on capital equipment = Government purchases – No transfer payments = net exports – exports-imports www.lrjj.cn 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. www.lrjj.cn Measuring Cost of Living • Consumer Price Index (CPI) – A measure of the overall cost of the goods and services bought by a typical consumer. • When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. www.lrjj.cn Calculating CPI 1. Fix the basket – Determine which prices are most important to the typical consumer. 2. Find the prices – Find the prices of each of the goods and services in the basket for each point in time. 3. Calculate the basket’s cost – Calculate the cost of the basket of goods and services at different times. 4. Choose a base year and compute the index – Divide the price of the basket in one year by the price in the base year and multiplying by 100. www.lrjj.cn Calculating CPI An Example • Step 1: Survey consumers to determine a fixed basket of goods 4 hotdogs and 2 hamburgers www.lrjj.cn Calculating CPI An Example • Step 2: Find the price of each good in each year Year Hotdogs Burgers 2008 $1 $2 2009 $2 $3 2010 $3 $4 www.lrjj.cn Calculating CPI An Example • Step 3: Compute the cost of the basket of goods and services in each year. 2008 ($1x4) + ($2x2) = $8 per basket 2009 ($2x4) + ($3x2) = $14 per basket 2010 ($3x4) + ($4x2) = $20 per basket www.lrjj.cn Calculating CPI An Example • Step 4: Choose one year as a base year (2008) and compute the CPI in each year 2008 ($8 / $8) x 100 = 100 2009 ($14 / $8) x 100 = 175 2010 ($20 / $8) x 100 = 250 www.lrjj.cn Problem in measuring the cost of living • • • • Substitution bias Introduction of new goods Unmeasured quality changes The CPI overstates inflation by about 1 percentage point per year www.lrjj.cn Inflation • 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. CPIyear2 - CPIyear1 Inflation rateyear2 x 100 CPIyear1 www.lrjj.cn Inflation Rate • Use the CPI to compute the inflation rate from previous year (using previous example) 2009 (175 – 100) / 100 x 100 = 75% 2010 (250 – 175) / 175 x 100 = 43% www.lrjj.cn Monetary System • Money? – the set of assets in an economy that people regularly use to buy goods and services from other people. • Three function of money: – Medium of exchange – Unit of account – Store of value www.lrjj.cn The types of money • Commodity money – Takes the form of a commodity with intrinsic value e.g. gold, silver, cigarettes. • Fiat money – used as money because of government decree and it does not have intrinsic value e.g. coins, bank notes, cheque deposits. www.lrjj.cn The Quantity Theory of Money • The quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate • If we would all like more money, why doesn’t the government simply print a lot more? www.lrjj.cn www.lrjj.cn www.lrjj.cn Unemployment • The meaning of 'unemployment' – Those of working age who are without work, but who are available for work at current wage rates Number of unemployed Unemployment rate x 100 Labor force • Labor Force? – Those in employment plus those unemployed • Costs of unemployment? www.lrjj.cn The Banking System • Retail banking – Retail deposits and loans at published interest rates and charges mainly with individual • Wholesale banking – Wholesale deposits and loans at negotiable interest rates and charges mainly with firms and other financial institutions www.lrjj.cn The Central Bank • Note issue • Banking functions • Management of government’s borrowing program • Oversees the activities of banks and other financial institutions • Operates monetary and exchange rate policy www.lrjj.cn Exchange Rate • The rate at which one currency trades for another on the foreign exchange market • Determination of exchange rates ▪ The equilibrium exchange rate (Floating exchange market) ▪ Shifts in currency demand and supply ▪ Appreciation – a rise in the exchange rate ▪ Depreciation – a fall in the exchange rate www.lrjj.cn Determination of the rate of exchange S by UK 2.20 2.00 $ price of £ b a 1.80 Excess supply of pounds leads to a depreciation. 1.60 1.40 1.20 D by USA 1.00 0 QD QS Q of £ www.lrjj.cn Determination of the rate of exchange S by UK 2.20 $ price of £ 2.00 1.80 Shortage of pounds leads to an appreciation. 1.60 d c 1.40 1.20 D by USA 1.00 0 QS QD Q of £ www.lrjj.cn Floating exchange rates: movement to a new equilibrium • • • • • 1.50 1.40 S1 S2 1.30 €/£ fall in interest rate rise in inflation rate rise in aggregate demand inward investment less attractive speculation against depreciation 1.20 1.10 1.00 D1 0.90 D2 0.80 0 Q www.lrjj.cn of £ Fixed vs. Floating • Advantages of fixed exchange rates – certainty – no speculation (if rate is absolutely fixed) – prevents 'irresponsible' government macroeconomic policies • Disadvantages of fixed exchange rates – conflicts with other macro objectives – problems of international liquidity – difficulties in adjusting to shocks – speculation www.lrjj.cn Fixed vs. Floating • Advantages of free-floating rates – automatic correction – no problem of international liquidity – insulation from external events – less constraints on domestic macro policy • Disadvantages of free-floating rates – possibly unstable exchange rates – speculation – uncertainty for business • but use of forward markets – lack of discipline on economy www.lrjj.cn