Download Principles of Economics

Principles of Economics
Session 10
Topics To Be Covered
Macroeconomics vs. Microeconomics
History of Macroeconomics
Major Concerns of Macroeconomics
Objectives of Macroeconomics
Instruments of Macroeconomics
Markets and Players of Macroeconomics
Topics To Be Covered
Definition of Gross Domestic Product
Measurement of GDP
GDP, GNP, NNP, NI, PI, and DPI
Price Indexes
AS, AD, and Macroeconomic Equilibrium
Macroeconomics vs.
Microeconomics
Microeconomics is the study of how
individual households and firms make
decisions and how they interact with one
another in markets.
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.
History of Macroeconomics
The Great Depression was a period of
severe economic contraction and high
unemployment that began in 1929
and continued throughout the 1930s.
History of Macroeconomics
Classical economists applied microeconomic
models, or “market clearing” models, to
economy-wide problems.
The failure of simple classical models to
explain the prolonged existence of high
unemployment during the Great Depression
provided the impetus for the development of
macroeconomics.
History of Macroeconomics
In 1936, John Maynard Keynes published The
General Theory of Employment, Interest, and Money.
Keynes believed governments could intervene in the
economy and affect the level of output and
employment.
Fine-tuning was the phrase used to refer to the
government’s role in regulating inflation and
unemployment.
History of Macroeconomics
The use of Keynesian policy to fine-tune
the economy in the 1960s, led to
disillusionment in the 1970s and early
1980s.
Stagflation occurs when the overall price
level rises rapidly (inflation) during
periods of recession or high and
persistent unemployment (stagnation).
Major Concerns of
Macroeconomics
Macroeconomics answers questions
like:
 Why
do production expand in some years
and contract in others?
 Why do prices rise rapidly in some time
periods while they are more stable in others?
 Why are some people unable to have the
opportunity to work although they do want
to work?
Major Concerns of
Macroeconomics
Output (GDP change)
Price level (Inflation)
Employment (Unemployment)
Objectives of
Macroeconomics
Output growth
Stable prices
High employment
Instruments of
Macroeconomics
Macroeconomic tools mainly consist of
fiscal policy and monetary policy.
 Fiscal
policy refers to government policies
concerning taxes and expenditures.
 Monetary policy consists of tools used by
the central bank to control the money
supply.
Markets and Players of
Macroeconomy
Markets and Players of
Macroeconomy
Goods and Service
Market
Labor
Market
Financial
Market
Markets and Players of
Macroeconomy
Households and the government purchase
goods and services from firms in the goodsand services market, and firms supply to the
goods and services market.
In the labor market, firms and government
purchase labor from households.
Markets and Players of
Macroeconomy
The financial market consists of money
market, capital market, and foreign
exchange market in the open economy.
In the money market, the government
(central bank) supplies money and
households and firms demand money for
transaction and speculation.
Markets and Players of
Macroeconomy
In the capital market, households purchase
stocks and bonds from firms.
In the foreign exchange market, those who
want to invest in foreign countries exchange
domestic currency for foreign currencies,
while those foreigners who want to invest in
this country supply foreign currencies and
demand domestic currencies.
Gross Domestic Product
GDP is the market value of all
final goods and services
produced within a country in a
given period of time.
Gross Domestic Product
GDP is the best single measure of the
economic well-being of a society.
 GDP per person tells us the income and
expenditure of the average person in the
economy.
 Higher GDP per person indicates a
higher standard of living.

Gross Domestic Product
Country
Real GDP per
Life
Person (1997) Expectancy
Adult
Literacy
United States
$29,010
77 years
99%
Japan
24,070
80
99
Germany
21,260
77
99
Mexico
8,370
72
90
Brazil
6,480
67
84
Russia
4,370
67
99
Indonesia
3,490
65
85
China
3,130
70
83
India
1,670
63
53
Pakistan
1,560
64
41
Bangladesh
1,050
58
39
920
50
59
Nigeria
Gross Domestic Product
It is estimated that:
 China's
GDP will surpass that of
France in 2005
 China is expected to become the
world's third economic power in 2020
 China is likely to outstrip Japan in
2050 to become the world’s second
largest economic power.
Gross Domestic Product
The 16th CPC Party Congress
established the objective to double the
2000 GDP by 2010, and further by 2020
quadruple its 2000 GDP.
 To attain the goal, what should be the
annual GDP growth of China?

Gross Domestic Product
A rough solution to such issue can be
resorted to the rule of 70.
 According to the rule of 70, if some
variable grows at a rate of x percent per
year, then that variable doubles in
approximately 70/x years.
 For example, $5,000 invested at 7 percent
interest per year, will approximately
double in size in 10 years.

The Measurement of GDP
Output is valued at market prices.
 It records only the value of final goods,
not intermediate goods (the value is
counted only once).
 It includes both tangible goods (food,
clothing, cars) and intangible services
(haircuts, housecleaning, doctor visits).

The Measurement of GDP
It includes goods and services currently
produced, not transactions involving goods
produced in the past.
 It measures the value of production within
the geographic confines of a country.
 It measures the value of production that
takes place within a specific interval of time,
usually a year or a quarter (three months).

The Measurement of GDP
The term final goods and services refers
to goods and services produced for final
use.
Intermediate goods are goods produced
by one firm for use in further processing
by another firm.
The Measurement of GDP
Aggregate Output (GDP) = Aggregate Income
Aggregate Output (GDP) =Aggregate Expenditure
Aggregate Expenditure = Aggregate Income
The Measurement of GDP
GDP can be computed in two ways:
The expenditure approach (product approach)
A method of computing GDP that measures the
amount spent on all final goods during a given period.
The income approach (cost approach)
A method of computing GDP that measures the
income—wages, rents, interest, and profits—received
by all factors of production in producing final goods.
The Expenditure Approach
Y= C + I + G + NX




C = Consumption
I = Investment
G = Government Purchases
NX = Net Exports
NX = Export - Import
The Expenditure Approach
 Consumption
(C):
 Durable
goods (cars, televisions, etc.)
 Non-durable goods
 Services
 Investment
 Houses
(I):
purchased by households
 Plant and equipment purchased by firms
 Inventory changes
The Expenditure Approach
 Government
Purchases (G):
 The
spending on goods and services by local,
state, and federal governments.
 Does NOT include transfer payments
because they are not made in exchange for
currently produced goods or services.
 Net
Exports (NX):
 Exports
minus imports.
The Income Approach
Components of the income approach:
 Wages,
salaries, and supplements
 Net interest
 Rental income of persons
 Income of unincorporated enterprises
 Corporate profits before taxes
 Indirect taxes
 Depreciation
The Income Approach
In calculating GDP, we can either sum up the
value added at each stage of production, or
we can take the value of sales of final goods
and services.
We do not use the value of total sales in an
economy to measure how much output has
been produced. If we do, we are committing
the fault of double counting.
The Income Approach
One practical income approach to avoid the
problem of double counting is to use the value
added method.
Value added is the difference between the
value of goods as they leave a stage of
production and the cost of the goods as they
entered that stage.
The Income Approach
STAGE OF
PRODUCTION
(1)Cotton
VALUE OF
SALES
$ 50
VALUE
ADDED
$
50
(2)Yarn
65
15
(3)Cloth
80
15
(4)Coat
100
20
(5)Retail sale
120
20
Total value
added
$
120
GDP and Its Components
(1998)
Total
(in billions of dollars)
Per Person
(in dollars)
% of Total
Gross domestic product, Y
$8,511
$31,522
100 percent
Consumption, C
5,808
21,511
68
Investment, I
1,367
5,063
16
Government purchases, G
1,487
5,507
18
Net exports, NX
-151
-559
-2
GDP and Its Components
(1998)
GDP and Its Components
(1998)
Consumption
68 %
GDP and Its Components
(1998)
Investment
16%
Consumption
68 %
GDP and Its Components
(1998) Government
Investment
16%
Consumption
68 %
Purchases
18%
GDP and Its Components
(1998)
Government Purchases
Investment
Net Exports
18%
16%
-2 %
Consumption
68 %
Inappropriateness of GDP
GDP excludes most items that are produced
and consumed at home and that never enter
the marketplace.
 It excludes value of leisure and clean
environment.
 It excludes items produced and sold illicitly,
such as illegal drugs.

Other Measures of Income
 Gross
National Product (GNP)
 Net National Product (NNP)
 National Income (NI)
 Personal Income (PI)
 Disposable Personal Income (DPI)
Gross National Product
Gross national product (GNP) is the total
income earned by a nation’s permanent
residents (called nationals).
 It differs from GDP by including income
that our citizens earn abroad and
excluding income that foreigners earn
here.

Net National Product
Net National Product (NNP) is the total
income of the nation’s residents (GNP)
minus losses from depreciation.
 Depreciation is the wear and tear on the
economy’s stock of equipment and
structures.

NNP=GNP– Depreciation
National Income
National Income is the total income
earned by a nation’s residents in the
production of goods and services.
 It differs from NNP by excluding indirect
business taxes (such as sales taxes).

NI=NNP – Indirect Taxes
Personal Income
Personal income is the income that households
and noncorporate businesses receive.
 Unlike NI, it excludes retained earnings, which
is income that corporations have earned but
have not paid out to their owners.
 In addition, it includes household’s interest
income and government transfers.

PI=NI – Retained Earnings+Interest Income
+ Government Transfers
Disposable Personal Income
Disposable personal income is the income
that household and noncorporate
businesses have left after satisfying all
their obligations to the government.
 It equals personal income minus personal
taxes and certain nontax payments.

DPI=PI – (Personal Taxes + Nontax Payments)
GNP, NNP, NI, PI, and DPI
NNP=GNP– Depreciation
NI=NNP – Indirect Taxes
PI=NI – Retained Earnings+Interest Income
+ Government Transfers
DPI=PI – (Personal Taxes + Nontax Payments)
Price Level and Price Indexes
The price level can be expressed in terms
of price indexes.
 If the economy’s overall price level is
rising, we call such situation inflation. If
the overall price level is decreasing, we
call such situation deflation.
 Common price indexes include the
consumer price index (CPI), GDP
deflator, and producer price index (PPI).

The Consumer Price Index
The consumer price index (CPI) is a
measure of the overall cost of the goods
and services bought by a typical
consumer.
 It is used to monitor changes in the cost
of living over time.

The Consumer Price Index
Steps to determine the CPI and the
inflation rate:
Fix
the basket
Find the prices
Compute the basket’s cost
Choose a base year
Compute the index
Compute the inflation rate
The Consumer Price Index
 Fix
the Basket: Determine what prices
are most important to the typical
consumer.
 The
Bureau of Labor Statistics (BLS)
identifies a market basket of goods and
services the typical consumer buys.
 The BLS conducts monthly consumer
surveys to set the weights for the prices of
those goods and services.
What’s in the CPI’s Basket?
5%
6%
6% 5% 5%
Housing
Food/Beverages
Transportation
40%
17%
16%
Medical Care
Apparel
Recreation
Other
Education and
communication
The Consumer Price Index
 Find
the Prices: Find the prices of each of
the goods and services in the basket for
each point in time.
 Compute the Basket’s Cost: Use the data
on prices to calculate the cost of the
basket of goods and services at different
times.
The Consumer Price Index
 Choose
a Base Year and Compute the
Index:
 Designate
one year as the base year, making
it the benchmark against which other years
are compared.
 Compute the index by dividing the price of
the basket in one year by the price in the
base year and multiplying by 100.
The Consumer Price Index
 Compute
the inflation rate: The inflation
rate is the percentage change in the price
index from the preceding period.
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year2 
 100
CPI in Year 1
The Consumer Price Index:
An Example
Step 1:Survey Consumers to Determine a Fixed
Basket of Goods
4 hot dogs, 2 hamburgers
The Consumer Price Index:
An Example
Step 2: Find the Price of Each Good in Each Year
Year
Price of
Hot dogs
Price of
Hamburgers
2001
$1
$2
2002
$2
$3
2003
$3
$4
The Consumer Price Index:
An Example
Step 3: Compute the Cost of the Basket of Goods in
Each Year
2001
($1 per hot dog x 4 hot dogs) + ($2 per hamburger x 2 hamburgers) = $8
2002
($2 per hot dog x 4 hot dogs) + ($3 per hamburger x 2 hamburgers) = $14
2003
($3 per hot dog x 4 hot dogs) + ($4 per hamburger x 2 hamburgers) = $20
The Consumer Price Index:
An Example
Step 4: Choose One Year as the Base Year (2001) and
Compute the Consumer Price Index in Each Year
2001
($8/$8) x 100 = 100
2002
($14/$8) x 100 = 175
2003
($20/$8) x 100 = 250
The Consumer Price Index:
An Example
Step 5: Use the Consumer Price Index to Compute the
Inflation Rate from Previous Year
2002
(175-100)/100 x 100 = 75%
2003
(250-175)175 x 100 = 43%
The Consumer Price Index:
Another Example
 Base Year
is 1998.
 Basket of goods in 1998 costs $1,200.
 The same basket in 2000 costs $1,236.
 CPI = ($1,236/$1,200) X 100 = 103.
 Prices increased 3 percent between 1998
and 2000.
Problems with CPI
The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure
of the cost of living.
Problems with CPI
 Substitution
bias
 Introduction of new goods
 Unmeasured quality changes
Substitution Bias
 The
basket does not change to reflect
consumer reaction to changes in relative
prices.
 Consumers
substitute toward goods that
have become relatively less expensive.
 The index overstates the increase in cost of
living by not considering consumer
substitution.
Introduction of New Goods
 The
basket does not reflect the change in
purchasing power brought on by the
introduction of new products.
 New
products result in greater variety, which
in turn makes each dollar more valuable.
 Consumers need fewer dollars to maintain
any given standard of living.
Unmeasured Quality Changes
 If
the quality of a good rises (falls) from
one year to the next, the value of a dollar
rises (falls), even if the price of the good
stays the same.
 The BLS tries to adjust the price for
constant quality, but such differences are
hard to measure.
Problems with CPI
 The
substitution bias, introduction of new
goods, and unmeasured quality changes cause
the CPI to overstate the true cost of living.
 The
issue is important because many government
programs use the CPI to adjust for changes in the
overall level of prices.
 The CPI overstates inflation by about 1
percentage point per year.
GDP Deflator
The GDP deflator measures the current
level of prices relative to the level of
prices in the base year.
 It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than
a rise in the quantities produced.

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.
GDP Deflator
The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator =
 100
Real GDP
Converting Nominal GDP to
Real GDP
Nominal GDP is converted to real
GDP as follows:
Real GDP20xx
(Nominal GDP20xx )
=
X 100
(GDP deflator 20xx )
Real and Nominal GDP
Year
Price of
Hot dogs
Quantity of
Hot dogs
Price of
Hamburgers
Quantity of
Hamburgers
2001
$1
100
$2
50
2002
$2
150
$3
100
2003
$3
200
$4
150
Real and Nominal GDP
Calculating Nominal GDP:
2001
($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002
($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600
2003
($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200
Real and Nominal GDP
Calculating Real GDP (base year 2001):
2001
($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002
($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350
2003
($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500
Real and Nominal GDP
Calculating the GDP Deflator:
2001
($200/$200) x 100 = 100
2002
($600/$350) x 100 = 171
2003
($1200/$500) x 100 = 240
CPI vs. GDP Deflator
Economists and policymakers monitor
both the GDP deflator and the
consumer price index to gauge how
quickly prices are rising, but the results
of the two indexes often differ.
 There are two important differences
between the indexes that can cause
them to diverge.

CPI vs. GDP Deflator
 The
GDP deflator reflects the prices of
all goods and services produced
domestically.
 However, the CPI reflects the prices of
all goods and services bought by
consumers.
CPI vs. GDP Deflator
 The
GDP deflator compares the price of
currently produced goods and services to
the price of the same goods and services in
the base year.
 However, the CPI compares the price of a
fixed basket of goods and services to the
price of the basket in the base year (only
occasionally does the BLS change the
basket).
Two Measures of Inflation
Percent
per Year
15
CPI
10
5
GDP deflator
0
1965
1970
1975
1980
1985
1990
1995
2000
Producer Price Index
The producer price index (PPI), which
measures the cost of a basket of goods
and services bought by firms rather
than consumers.
Nominal and Real Salaries
from Different Times
 Suppose
someone earned $8,000 in 1931 and
we know the price level in 1931 is 15.2 while
the price level in 2000 is 166. Convert the
earning of 1931 to that of 2000.
Salary2000 = Salary1931 
166
 $8,000 
15.2
= $87,368
Price level in 2000
Price level in 1931
The Most Popular Movies of
All Time, Inflation Adjusted
Yeas of
Release
Total Domestic Gross
in millions of 1999 dollars
1.Gone with the Wind
1939
$920
2. Star Wars
1977
798
3. The Sound of Music
1965
638
4. Titanic
1997
601
5. E. T. the Extra Terrestrial
1982
601
6. The Ten Commandments
1956
587
7. Jaws
1975
574
8. Doctor Zhivago
1965
543
9. The Jungle Book
1967
485
10. Snow White and the Seven Dwarfs
1937
476
Film
AS and AD Curves
 The
aggregate demand curve (AD) shows
the quantity of goods and services that
households, firms, and the government
want to buy at each price level.
 The aggregate supply curve (AS) shows
the quantity of goods and services that
firms produce and sell at each price level.
AS and AD Curves
 Aggregate
demand is equal to aggregate
expenditure, so:
AD= C + I + G + NX
Aggregate Demand Curve
Price
Level
P1
1. A
decrease
in the price
level...
P2
AD
0
Y1
Y2
2. …increases the quantity of goods
and services demanded.
Quantity of
Output
Aggregate Supply Curve
AS
Price
Level
P1
1. A decrease
in the price
level
P2
0
2. reduces the
quantity of goods and
services supplied in
the short run.
Y2
Y1
Quantity of
Output
Macroeconomic Equilibrium
AS
Price
Level
Equilibrium
price level
AD
0
Equilibrium
output
Quantity of
Output
Government’s Increase in
Infrastructure Investment
AS
Price
Level
P2
P1
Increased
AD
AD
0
Q1
Q2
Quantity of
Output
Government’s Increase in
Infrastructure Investment
 The
government’s increase in
infrastructure investment leads to an
increase in AD for government purchase
(G) is part of AD.
 The AD increase means a higher price
level and a greater output.
RMB Value Remains Constant
During Asian Financial Crisis
AS
Price
Level
Increased
AS
P1
P2
AD
P3
Decreased AD
0
Q2
Q1 Q3
Quantity of
Output
RMB Value Remains Constant
During Asian Financial Crisis
 In
the Asian financial crisis of 1997, many
countries currencies depreciated.
 Since the RMB value remains constant, the
Chinese goods became relatively more
expensive those those of its neighbors.
 China’s export was negatively affected and
the NX decreased, so the AD curve shifts
left, which means a lower price level and less
output.
RMB Value Remains Constant
During Asian Financial Crisis
Since
some inputs of Chinese firms are
imported from other Asian countries, so
the firms production costs decreased.
With the cost decrease, the AS curve
shifts right, which means a even lower
price level.
Assignment
Review Chapter 20 and 21.
Answer questions on P389 and 410.
Search for information on China’s GDP
in recent years and its prospect in the
future.
Preview Chapter 22, 23, 24.
Thanks