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Chapter 3
Measuring Macroeconomic
Performance: Output and Prices
Copyright  2005 McGraw-Hill Australia Pty Ltd
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by Bernanke, Olekalns and Frank
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Chapter 3: Measuring Macroeconomic
Performance: Output and Prices
• When is the economy performing well?
• Gross domestic product: measuring the nation’s
output
• Real GDP is not the same as economic wellbeing
• The consumer price index: measuring the price
level
Copyright  2005 McGraw-Hill Australia Pty Ltd
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A Well-Performing Economy
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Rising living standards
Economic stability
Low inflation
Sustainable levels of debt
Economic growth
Full employment
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Measuring GDP
• The market value of current production valued at
current prices
• Unpaid work is not counted – a defect
• Public goods and services, provided free, are
valued at their cost of production
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Intermediate and Final Products
• Wheat and flour are intermediate products used to
make bread, the final product
• GDP measures the production of final products,
the market value of which already embodies the
cost of intermediate products
• Counting intermediate products separately would
involve ‘double counting’
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Value Added (VA)
• Firms generate GDP by adding value to the
intermediate products they buy from others
• VA is equal to the value of a firm’s output (bread)
minus the value of intermediate products used up
(flour)
• GDP is the sum of VA by all firms within a country
in the current year
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
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Expenditure on GDP
• Current production by firms must be bought by
households, other firms, government and
foreigners
• Exception: production which is not sold is added to
inventories and treated as ‘spending’ or ‘bought’ by
the firm which makes it
• So it follows that GDP may be measured as the
sum of spending on domestic production by
households, all firms, government and foreigners
• Reminder: spending by firms includes that part of
production which is added to their inventories
Copyright  2005 McGraw-Hill Australia Pty Ltd
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GDP = Y + C + I + G + X – M
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Household spending is consumption: C
Firm’s spending is investment: I
Government spending: G
Foreign spending on our exports: X
Domestic spending on foreign production or our
imports: M
• X – M is net exports: NX
• So GDP = Y = C + I + G + NX
Copyright  2005 McGraw-Hill Australia Pty Ltd
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GDP and Household Incomes
• VA is the difference between firms’ sales of output
and payments for their raw materials
• Firms then pay wages to labour and other factors
• The residual is profit or capital income
• It follows that GDP and VA generate equivalent
labour and capital income
• Reminder: profit is always a residual
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Examples
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Sales $100 (200)
Cost of raw materials $40 (100)
Therefore Value Added $60 (100)
Wages, interest and rent $50 (70)
Therefore Residual Profit $10 (30)
Household income from wages, interest, rent and
profit = $60 (100) = Value Added
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Nominal vs Real GDP
• Nominal GDP rises when prices rise
• Real GDP only rises when quantities rise
• To measure changes in real GDP we use constant
prices of the ‘base year’
• Then any rise in GDP is ‘real’ – entirely due to
rises in quantities
• In the ‘base year’ real GDP = nominal GDP
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Example: Two Goods
• Suppose we produce two goods, apples and beer
• In Year 1 the respective (quantities x prices) give
Nominal GDP1 = (10 x 1) + (12 x 2) = $34
• In Year 2 the respective (quantities x prices) give
Nominal GDP2 = (11 x 3) + (13 x 4) = $85
• Nominal GDP has risen by 51/34 = 150%!
• Real GDP2 = (11 x1) + (13 x 2) = $37, a rise of
only 3/34 = 3%
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Influences on ‘Wellbeing’
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Real GDP per capita
Leisure time
Unpaid services provided
Environmental quality and climate
Poverty, inequality and crime
International tension
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Measuring the Price Level
• The CPI measures the cost of a fixed basket of
goods bought by the ‘average’ or typical household
– a measure of the cost of living
• The rate of change of the CPI is one measure of
the rate of inflation
• It exaggerates the true rate of inflation because it
does not allow for quality improvements and for
substitution by households in favour of those
goods which have risen least in price
• If we become vegetarian when the price of meat
rises, has our cost of living risen?
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Measuring the Price Level (cont.)
• Households do not buy everything that the
economy makes
• The average price of everything produced in the
economy is the GDP Deflator
• This is Nominal GDP/Real GDP
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Prices and Quality
• The quality of goods usually improves over time
• A car made in 1990 is quite different to a car made
in 2004
• So measures of inflation based on movements in
price indices exaggerate the true rate of inflation
because they ignore quality improvements
Copyright  2005 McGraw-Hill Australia Pty Ltd
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The Rate of Inflation
• This is the rate of change in the average price
level
• If some prices rise while others remain constant,
there is both a change in relative prices and a
positive rate of inflation
• This is the usual situation
• If some prices rise while others fall, there is a
change in relative prices, but the rate of inflation
may be zero, positive or negative, depending on
the relative frequency of price rises and falls
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The Costs of High Inflation
• Inflation destroys the purchasing power of money
• Loss of confidence in holding money leads to
inconvenience and to inefficiency of barter trading
• The inefficiency of barter trading leads to loss of
specialisation as people make more things for
themselves
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Other Costs of Inflation
• Uncertainty and cost is caused by frequent
changes in price lists
• Adverse effects on incentives are caused by
‘unearned’ redistributions of wealth which cause
people to spend time looking for ‘bargains’ instead
of working productively
• Higher effective tax rates caused by ‘bracket
creep’ in a progressive tax system, reduce the
incentive to work
• Higher nominal interest rates leave debtor
households with less spending power
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
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Inflation and Interest Rates
• Borrowing and lending contracts specify how much
money will be paid back to the lender at a given
time
• The higher the rate of inflation over the contract
period, the more the lender is penalised through a
fall in the purchasing power of the money lent
• So a rise in the expected inflation rate raises the
rate of interest which lenders demand
• Likewise, borrowers gain from inflation and a fall in
the purchasing power of money, so they are willing
to offer higher interest rates with inflation
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Nominal and Real Interest Rates
• The nominal interest rate is the rate of interest
specified in the loan contract
• The real rate of interest is the nominal rate of
interest minus the rate of inflation
• It measures the reward to lenders, in terms of
purchasing power, paid by borrowers for lenders
giving up spending over the contract period
• The real interest rate is the nominal interest rate
minus the rate of inflation (approximately)
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Example: One Year Loan of $100
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Nominal interest rate is 10% p.a.
Dollars repaid to lender: $110
Price of bread at beginning of loan is $1 per loaf
Price of bread at end of year is $1.06 per loaf
Rate of inflation is 6% p.a.
Purchasing power given up by lender: 100 loaves
Purchasing power received back by lender:
110/106 = 104 loaves
• Gain in lender’s purchasing power = 4 loaves
• Real interest rate 4/100 = 10% – 6% = 4%
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
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Inflation Bad, Deflation Good?
• Deflation is a fall in the average price level
• Compared with stable prices, deflation should lead
to lower nominal interest rates to keep the real
interest rate constant
• So deflation should not affect real interest rates
and should do no harm
• But can nominal interest rates go to zero or below?
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Nominal Interest Rates Always > 0
• Deflation raises the purchasing power of both
money and bonds
• The convenience of money means lenders will
always require a positive nominal interest rate to
compensate them for giving up money to hold
bonds
• Once nominal interest rates reach this ‘floor’, any
increase in the rate of deflation will raise real
interest rates and hurt the economy
• Deflation is bad!
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Example
• Suppose nominal interest rate floor = 0%
• When rate of deflation = 2% p.a.
Real interest rate = 0 – (-2) = 2%
• When rate of deflation = 3% p.a.
Real interest rate = 0 – (-3) = 3%
• When rate of deflation = 4% p.a.
Real interest rate = 0 – (-4) = 4%
Copyright  2005 McGraw-Hill Australia Pty Ltd
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Inflation in Health Care Costs
• The cost of health care generally rises faster than
other costs
• One reason is that quality improvements in health
care are rapid
• Another is that health care, like education, is a
personal service in which labour-saving devices
play a smaller role than in the production of goods
like food, clothing and motor cars
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
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