Download Chapter 1: Output

Understanding the
Macroeconomy
Chapter 1
Output
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• National Income Accounting and Measurement
• International Trade and Balance of Payments
• Economic Growth and Public Policy
• Business Cycles
Understanding the Macroeconomy:
Output
Output
The amount of goods and services a country produces
Foundation of economic prosperity:
-How much we can consume
- How much we can invest (save) for the future
- How much we can lend or borrow to/from other
countries
3
The Allocation of Output
• Economics: studying how scarce resources
(output) can be allocated to many competing
needs
• Incentives play a critical role in determining this
allocation
• What determines incentives?
– Government policy
– Institutions
– Social and cultural environment
How is National Output Measured?
 Gross Domestic Product (GDP)
The market value of final goods and services produced
within a country over a year
 Why “final” and not “all” ?
 What is relevant for measuring output is the amount of
“value-added” to every stage of production
5
How is National Output Measured?
 Two common methods of measurement:
A. “Value-added” method:
Sales price of a good or service minus the cost of all material
inputs used to produce it
B. “Expenditure” method:
Value of final sales of goods and services
Both are equivalent; the expenditure method is
more commonly used
6
Value-added versus Expenditure:
An Example
Sale Price
Cost of Inputs
Value-added
Wheat Farmer

$5,000
$0
$5,000
Bakery

$5,500
$5,000
$500
Supermarket
$6,000
$5,500
$500
TOTAL
$16,500
$10,500
$6,000
Expenditure
Method
Value-added
Method
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The Expenditure Method
• How is GDP calculated using this method?
• National Output (GDP)= C + I+ G + X – IM
C : consumption expenditures by households
I : investment expenditures by firms
G : government spending
X : exports to rest of the world
IM: imports from rest of the world
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GDP Data
 Locating GDP data
1. Go to www.bea.gov (Bureau of Economic
Analysis)
2. Under the “National” section, select “Gross
Domestic Product (GDP)”
3. Select “Interactive Tables”
4. Use the list of “Frequently Requested NIPA
Tables”
5. Select Table 1.1.6 (Real GDP)
6. Use the “Data Table Options” to create a table
1
Exchange of Output across Countries:
International Trade
• Why do countries trade with each other?
- some countries produce more than they
need and some less
-a country does not produce all types of
goods
1
International Trade
• What type of goods should countries
produce and export?
• Theory of Comparative Advantage
– Based on the idea of opportunity costs:
The opportunity cost of producing something
measures the cost of not being able to produce
something else because resources have already
been used.
Theory of Comparative Advantage
• Developed by British economist David Ricardo
(1817)
• A country has a comparative advantage in
producing a good if the opportunity cost of
producing that good is lower in the country than it is
in other countries.
• A country with a comparative advantage in
producing a good uses its resources most efficiently
when it produces that good compared to producing
other goods.
Trade and Specialization
• International trade leads to specialization
in production with each country producing
and exporting the good in which it has a
comparative advantage
• Since all resources are being used
efficiently across the world, free trade is
the best (optimal) outcome
International Trade
• What determines comparative advantage?
– Differences across countries in
• Labor productivity (Ricardo)
• Resources: natural or physical (Heckscher and
Ohlin)
• The above represent the “first generation” theories of
international trade
• But do we really see specialization in production across
the world?
New Trade Theory
• Market size and the ability to produce varieties
matter: economies of scale (Paul Krugman)
• Helps us understand “intra-industry” trade
– Countries don’t specialize, but produce different
varieties of the same good
– Example: US sells Fords to Germany and imports
BMWs
New Trade Theory: The “Gravity” Model
• Country size matters: large countries tend to
trade more with each other
• Distance matters: inverse relationship between
distance (between countries) and trade
• Other factors: culture, borders, language,
geography, and trade agreements
Total U.S. Trade with Major Trading Partners
2005
How Wide is the Border?
Trade with British Columbia, as Percent of GDP, 1996
The Composition of World Trade
2005
The Changing Composition of Trade: Does Comparative
Advantage Change over Time?
Evidence from Developing Countries
Exchange of Output across Countries:
International Trade
• International trade in goods and services leads to
lending and borrowing through international capital
markets
• China exports personal computers to the US: generates
a claim on future US output (and vice versa)
• Therefore, China’s trade surplus = US trade deficit
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Recording International Transactions:
The Balance of Payments (BOP)
 Balance of Payments (BOP) Accounts: tracks a country’s
international transactions
 The Current Account:
Exports and imports of goods and services
 The Financial Account:
Sales of stocks, bonds, or financial assets to/from foreigners
 Current account deficit  capital inflow on financial account
(borrowing)
 Deficit in one account = Surplus in the other
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Are Current Account Deficits “Bad”?
 Depends on how the “borrowed” output is used: for
consumption or investment
 If borrowing is for consumption: current account deficit
may be unsustainable in the long run
 If borrowing is for investment: the deficit may be
sustainable (why?)
 GDP is the “ultimate” budget constraint for a country
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Economic Growth
• What is economic growth?
• What causes countries to grow?
- Increases in labor force
- Increase in the stock of capital
- Technological progress (efficiency of
production)
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Economic Growth
• Growth is a consequence of individuals
sacrificing current consumption in favor of
future consumption
• Households save from current income =>
firms invest these savings => creation of
capital goods => production of output
increases => economic growth
Economic Growth Theory: An Overview
• “First Generation” theories of growth:
– Sir Roy Harrod (1939), Evsey Domar (1946), Robert
Solow (1959)
• Focus on four key determinants
–
–
–
–
The savings rate
Population growth
Output-capital ratio
Technological progress
• Let’s think about the role of each of these factors…
New Growth Theory
• The first generation models did not explain how the
factors affecting growth were themselves determined
– Growth was “exogenous”: determined by factors that
were assumed to be “given”
• “Second Generation” models
– Paul Romer (1986), Robert Lucas (1988), Robert
Barro (1990)
– Growth is an equilibrium (endogenous) outcome of
individual decisions
New Growth Theory
• Main engines of growth
– Knowledge creation (Romer, Lucas)
– Government spending on economic infrastructure
(Barro)
• The above factors create “externalities”
– Actions of one individual/entity affect many others
– Social benefits may be different from private benefits
– Creates a role for the government to affect economic
growth
Economic Growth and the Government
• The issue: what role does public policy play in
determining economic growth?
• Two approaches:
- The “supply-side” approach: lower taxes
- The “demand-side” approach: increase government
spending
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Business Cycles
• Business cycles: temporary fluctuations in GDP
• Recession: when GDP falls (or contracts) for two
consecutive quarters  leads to an economic
slowdown
• Expectations play a crucial role by creating
speculative behavior  “ripple” effect on the
economy
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Growth rates of real GDP and Consumption
Percent 10
change
from 4 8
quarters
earlier 6
Real GDP
growth rate
Consumption
growth rate
Average 4
growth
rate 2
0
-2
-4
1970
Pink bars denote
actual recessions
1975
1980
1985
1990
1995
2000
2005
Growth rates of real GDP, Consumption, and Investment
Percent 40
change
from 4 30
quarters
earlier 20
Investment
growth rate
Real GDP
growth rate
10
0
Consumption
growth rate
-10
-20
-30
1970
1975
1980
1985
1990
1995
2000
2005
Unemployment
Percent 12
of labor
force
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
2005
Index of Leading Economic Indicators
(LEI)
• Published monthly by the Conference Board.
• Aims to forecast changes in economic activity
6-9 months into the future.
• Widely used in planning by businesses and govt,
despite not being a perfect predictor.
Components of the LEI index
• Average workweek in manufacturing
• Initial weekly claims for unemployment insurance
• New orders for consumer goods and materials
• New orders, non-defense capital goods
• Vendor performance
• New building permits issued
• Index of stock prices
• M2
• Yield spread (10-year minus 3-month) on Treasuries
• Index of consumer expectations
Index of Leading Economic Indicators
160
1996 = 100
140
120
100
80
LEI
Forecast
60
40
Actual
Recession
20
Source:
Conference
Board
0
1970
1975
1980
1985
1990
1995
2000
2005
What is More Important:
Wealth or Output?
• Financial assets (wealth) are simply a claim on future
output
• Why do we buy financial assets (accumulate wealth)?
• Why do we sell financial assets?
• What good would financial wealth do if there were
nothing to buy?
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Caveat:
Gross Domestic Product or “Grossly Distorted
Picture”?
• Critical Question: is GDP an accurate reflection
of a country’s “prosperity” or standard of living?
• Example: U.S. per-capita GDP is 26% higher
than Germany’s; do American’s enjoy a 26%
higher standard of living than Germans?
A Few Things to Think About…
• Should the following be accounted for in GDP?
- Value of leisure time
vacations, shorter work-weeks, social interactions
- “Home” produced goods
home-makers, cooking, taking care of children
- Distribution of income (inequality)
the gap between the rich and poor
Problems with Measurement
• Difficult to assess “market” value or prices of certain nonmarket goods
• GDP is data is readily available
• Even when GDP is adjusted for these factors, relative
rankings of countries remain unchanged
• However, the “gaps” in per-capita incomes across
countries diminishes