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ECON 521 Special Topics in Economic Policy CHAPTER ONE Introduction to Macroeconomics Variables The Macro Goal Variables • The coverage of Macroeconomics is to study how the economy works as a whole. • In this chapter, we define the key variables to measure the “health” of an economy, and briefly discuss how the variables are measured and interpreted. • Also, we will define Definitions, Realistic Goals, and Recent Performance. Goal one: Production or Output • Measured by Real Gross Domestic Product (Real GDP). • Real GDP (Y) -- The total production or output of final goods and services over a period of time, expressed in constant prices of a base year. • Why Real GDP (GDP in constant dollars), instead of Nominal GDP (GDP in current dollars)? • Why is Production or Output Important ? • Realistic Goal : Realistic Goal for Real GDP -- to be as high as possible without accelerating inflation (overstimulated economy). • The Natural Level of the goal: The Natural Level of Real GDP (YN) -- that level of real GDP in which inflation has no tendency to accelerate or decelerate. Comparing Real GDP to the Natural Level of Real GDP Y = YN -- economy with constant inflation rate Y < YN -- sluggish economy with decelerating inflation (inflation rate) Y > YN -- economy with accelerating inflation Example: USA case • If Y = YN, then seek annual real GDP growth = 2.5%. • If Y < YN, then seek annual real GDP growth > 2.5%, for awhile. • If Y > YN, then seek annual real GDP growth < 2.5%, for awhile. • Special Case -- The Recession Recession -- A Special Case • Recession -- The situation where the level of real GDP decreases, or exhibits negative growth, for at least two consecutive quarters. • Clearly, in a recession, Y < YF. Converting Nominal GDP to Real GDP • Example -- find Real GDP2008 Real GDP2008 = Nominal GDP2008 P2008 • Real GDP for other years is computed the same way. • Real GDP Growth = Percentage Change in Real GDP. Goal Two: The Inflation Rate • Inflation Rate is the growth or percentage change in the overall price level. • Inflation rate measures the price level (P), through: -- Consumer Price Index (CPI) -- GDP Deflator • Inflation Rate = Percentage Change in (P) • Inflation erodes the purchasing power of money, causes distortions in decisions. • Inflation can erode people’s standard of living, put pressure on labor markets. Example -- Compute the Inflation Rate for 2008, given that the CPI for 2007 and 2008 have been calculated. Inflation = Rate2008 CPI2008 – CPI2007 x 100 CPI2007 • Ideal Goal: Inflation Rate = 0% • Realistic Goal : For USA ----- |Inflation Rate| < 3%. Goal Three: The Unemployment Rate • Realistic Goal : As low as possible without inflation accelerating (overstimulated economy). • The Natural Level of the goal: Natural Rate of Unemployment (uN) -- The lowest unemployment rate the economy can achieve without accelerating inflation. • Recall Realistic Goal : Realistic Goal: u = uN Interpretation for the three goals • u = uN Inflation Rate Unchanged (Desired) • u > uN Inflation Rate (Sluggish Economy) • u < uN Inflation Rate (Overstimulated Economy) As a Result: • u = uN Y = YN, (Desired) • u > uN Y < YN, (Sluggish Economy) • u < uN Y > YN, (Overstimulated Economy) • Real GDP Growth Employment Growth u • Real GDP and unemployment -- not independent problems. • Focus on getting one of them to the desired goal, and the other one will automatically follow (although not a perfect correlation). Goal Four: The Government Budget • Budget = Tax Revenues - Government Expenditure(over a given period) • Budget = Tax Revenues - (Government purchases of goods and services + Transfer Payments + Interest on the National Debt) Budget Definitions: • • • • Budget < 0 -- Budget Deficit Budget > 0 -- Budget Surplus Budget = 0 -- Balanced Budget Realistic Goal -- Balanced Budget when Y = YN. Note: Sluggish economies tend toward deficits. Goal Five: The Balance of Trade • Balance of Trade (BOT) -- approximated by net exports. • BOT = Exports - Imports • BOT < 0 -- Balance of Trade Deficit • BOT > 0 -- Balance of Trade Surplus • BOT = 0 -- Balanced Trade Position • Realistic Goal -- BOT close to zero.