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CHAPTER 2 MEASURING THE PERFORMANCE OF THE CANADIAN ECONOMY Chapter Outline: Measuring Gross Domestic Product Measuring Supply: Factor Payments Approach Measuring Demand: Components of Spending Allocation of Income and Savings Real and Nominal GDP and Inflation Price Indexes and Inflation Inflation and Real and Nominal Interest Rates The Unemployed and the Unemployment Rate Measuring the Unemployment Rate The Relationship Between Unemployment and GDP: Okun’s Law Working With Data Changes from the Previous Edition: This chapter has been rewritten so that there is less emphasis on GDP and more emphasis on measuring data, and how it fits the structure of the Canadian economy. There is a new section on unemployment and Okun’s Law, so that the chapter now covers GDP, inflation, nominal and real interest rates and unemployment. The section on supply side measurement and the production function has been rewritten, with a new example, which is carried out for the rest of the chapter. Section 2-2 has been rewritten to incorporate as discussion about savings and investment, the current account and wealth accumulation. There is a new figure (2-1) which summarizes the discussion. The discussion on nominal and real GDP is expanded and clarified, with worked out examples. In Tables 2-3 and 2-4. New Box 2-3 on GDP deflator and CPI New Figure 2-3 Okun’s Law Learning Objectives: Students should be able to understand gross domestic product, and the concepts of measuring this from a demand or supply perspective. Students should understand allocation of income beyond the level of simply adding up GDP. In an economy total savings is composed of private savings plus the government budget deficit, which is public savings. Total savings must equal investment spending plus the current account balance. Therefore, savings adds to the stock of wealth of a country by increasing the capital stock through investment or by increasing the stock of net foreign assets. Students should understand that the dollar value of gross domestic product can change if the level of physical production changes or if the price level changes. Therefore inflation could be measured through changes in the GDP deflator or through changes in the Consumer Price Index. 7 Students should understand that the real interest rate is equal to the nominal interest rate minus the inflation rate Students understand that the unemployment rate can change if the participation rate change or if the number of people employed changes. Students should be introduced to Okun’s Law which shows the relationship between changes in GDP and the unemployment rate. Accomplishing These Objectives Chapter 2 examines the meaning of gross domestic product (GDP), the basic measure of a nation's economic performance. Explaining GDP in terms of factor payments will help in the study of aggregate supply and economic growth, while dividing GDP into its four main spending components-consumption (C), investment (I), government purchases (G) and net exports (NX)--will help in the study of aggregate demand. On the production side, the factors of production (inputs), such as labour and capital, are transformed into goods and services (output). To understand this relationship, students will need to understand the concept of an aggregate production function. This concept will be used throughout the book. Students can gain a deep understanding of the working of the economy by understanding the relationships amongst GDP, savings, investment and wealth. This section allows for a good discussion of the ambiguities in cause and effect that are often present in macroeconomics, especially when it comes to the relationship between private domestic saving, investment, the budget surplus, and the trade deficit. An in-depth discussion of these relationships will, of course, have to be delayed until later. Nonetheless, students will find it exciting and motivating to see that even the simple equations presented here can be used to address some rather complex real world problems. It is particularly important to discuss the following two equations Y C + I + G + NX and S = I + CA since they will later also be used as equilibrium conditions. It is important to point out early on the difference between treating these equations as national income identities, as is done here, and using them, slightly redefined, as equilibrium conditions in later chapters, especially in Chapter 3. In Section 2-3 students will learn some valuable lessons concerning the difference between a situation where the production of real goods and services has increased and a situation where prices have increased. This will also show students that there is more than one way to measure inflation. Box 2-3 will be helpful in discussing the difference between the consumer price index and the GDP deflator as measures of price change. The CPI measures the average price increase of a market basket of goods and services that an average urban household might consume. The GDP-deflator is the most comprehensive measure and includes all goods and services currently produced. The distinction between real and nominal interest rates is also very important. Nominal interest rates represent the actual rate of return on financial instruments as they are stated in the newspapers. However, a financial investor should be interested much more in the real rate of return, that is, the stated interest rate adjusted for inflation. Very few financial instruments guarantee a real rate of return. However the Canadian government has issued inflation-indexed government bonds since 1991. 8 Suggestions and Pitfalls Students find the national accounts to be very boring. This is largely an artifact of the manner in which national accounts material has been presented. Rather than emphasize concepts such as double counting, with long stories about a farmer taking his wheat to the mill etc., we believe that you should relate measures of GDP to the supply and demand material introduced in Chapter 1. In addition, students can be shown how to get the actual data from CANSIM II. Because of the mind numbing amount of data that can be retrieved on the national accounts, you may want to help students work through the Working With Data section in this chapter. This will give students more of an understanding of the GDP figures when they are released, as the press always seems to confuse nominal and real, as well as adjusted and unadjusted. You should be careful in discussing Section 2-2, as the equations presented are identities. Theory will be put into this in later chapters. Most students have no idea what happens to savings, and tying this to current account and capital accumulation can help explain. Equation (11) is particularly helpful in generating discussion S S P S G I CA or S I CA S G P which states that the difference between private domestic saving and investment is equal to the difference between the current account deficit and the government budget deficit. In other words, this equation implies that an increase in the budget deficit (unless accompanied by an equal increase in private domestic saving) will lead to the crowding out of investment and/or net exports. This equation can therefore be used to explain the development of the "twin deficits" in the early 1980s. This is discussed in detail in Chapter 5. Students will find a class discussion on the technical aspects of calculating inflation very rewarding. Each month that the CPI is released it is covered very extensively in the press. Something that is not well understood by students (or the press for that matter) is the difference between the monthly inflation rate which is defined as tm Pt P t 1 Pt 1 the annualized inflation rate which is defined as tm Pt P t 1 *12 Pt 1 and the annual inflation rate, which is defined as tm Pt P t 12 Pt 12 9 Students should understand that these are all valid measures of inflation. However, we generally think of inflation in an annual framework. When discussing real and nominal variables and measurements for inflation, it is important to discuss the difference between nominal and real interest rates. This is presented in Section 2-4. Notice that the link between equation (16) and equation (17) is contained in application question (2). This is a rather difficult question (the answer is below), so you may want to help students with it in class. Working through this has some payoffs, as the students will understand the difference between nominal and real variables in general and the nominal and real interest rates in particular. Solutions to Problems in the Textbook: Discussion Questions: 1. The article that students are referred to is rather lengthy, and does not really come to any general conclusions. The paper actually raises more questions than it answers. However, it is important for students to understand the concepts involved in expanding the current definition of what is contained in the National Accounts. Many of the issues in this area are still unresolved. Students may want to discuss these unresolved issues, which are summarized on page xxxix. 2. Rebasing has some effects that students will not have thought of. The basic conclusion of this article is that rebasing changes the estimates of growth over the period before 1992, so that the 1990-91 recession appears to be slightly worse. The rebasing takes into account the effects of the GST, the Free Trade agreement and the rapid growth of technology over this period. More generally, you may want to discuss the chain weighted measures that were introduced in the text. 3. Increases in real GDP do not necessarily mean increases in welfare. For example, if the population of a country increases by more than real GDP, then the population of the country is on average worse off. Also some increases in output come from welfare reducing events. For example, increased pollution may cause more lung cancer, and the treatment of the lung cancer will contribute to GDP. Similarly, an increase in crime may lead to overtime work for police officers, whose increased salary will increase GDP. But the welfare of the people in the country may not have increased in either case. On the other hand, GDP does not always accurately measure quality improvements in goods or services (faster computers or improved health care) that improve people's welfare. 4. Assume the loan you made yields you an annual nominal return of 7%. If the rate of inflation is 4%, then your rate of return in real terms is only 3%. If, on the other hand, if inflation rate is 10%, then you will actually get a negative real rate of return, that is, you will lose 3% of your purchasing power. One way to protect yourself against such a loss of purchasing power is to adjust the interest rate for inflation, that is, to index the loan. In other words, you can require that, in addition to the specified interest rate of the loan of, let’s say, 3%, the borrower also has to pay an inflation premium equal to the percentage change in the CPI. In this case, a real rate of return of 3% would be guaranteed. You are better off if you are a borrower with unanticipated inflation. 5. Clearly the level of GDP would go up, as some items are now being included that were not included previously. Whether or not the growth rate of GDP would increase, depends on the growth rate of housework. Students should realize, that the economy is not performing any differently, it is just being measured differently. 10 Application Questions: 2. Like any nominal variable, the nominal interest rate is expressed in units of currency. We define a nominal interest rate as: it ( Pt B1 Pt B ) Pt B Where Pt B1 is the nominal price of a bond in period t+1, and Pt B is the nominal price of a bond in period t. We know that a nominal variable can be converted into a real variable by dividing by price. Clearly then, the real value of the bond in time t is Pt B Pt Where Pt is the general level of prices at time t. (Think of this as the consumer price index). The real value of the bond in t 1 Pt B1 Pt 1 We ignore any problem involving expectations of the unknown future price level. Now, in the same manner that the nominal interest rate is the rate of change in the nominal value of the bond, the real interest rate is the rate of change in the real value of the bond: Pt B1 Pt B Pt 1 Pt rt Pt B Pt Although this expression is mathematically correct, it is not very useful, and students probably have never seen a real interest rate written this way. To put this in a more convenient form, notice that this equation can be written as 11 Pt B1 P rt t B1 1 Pt Pt Therefore: Pt B1 P 1 rt t B1 Pt Pt P B P t 1 tB Pt 1 Pt P B P t B1 t Pt Pt 1 The first term is equal to 1 it and the second term is equal to P Pt 1 , Where t t 1 , i.e. the 1t Pt inflation rate. Upon substitution, you should be able to show that: rt it t 5.a. Since nominal GDP is defined as the market value of all final goods and services currently produced in this country, we can only measure the value of the final product (bread), and therefore we get $2 million (since 1 million loaves are sold at $2 each). 5.b. An alternative way of measuring total GDP would be to calculate all the value added at each step of production. The total value of the ingredients used by the bakeries can be calculated as: 1,200,000 pounds of flour ($1 per pound) = 1,200,000 100,000 pounds of yeast ($1 per pound) = 100,000 100,000 pounds of sugar ($1 per pound) = 100,000 100,000 pounds of salt ($1 per pound) = 100,000 __________________________________________________________ = 1,500,000 Since $2,000,000 worth of bread is sold, the total value added at the bakeries is $500,000. 12 Additional Problems 1. Explain the initial effect of the following events on GDP. a. You sell your used car to a friend. b. Firms decrease their inventories. c. The value of your Nortel stock holding decreases. d. You buy a piece of land with the intention of building a new house. e. A sports card dealer sells a Bobby Orr rookie card for $100. f. A German tourist drinks U.S. beer in an Canadian restaurant. a. GDP will not change, since a used car is not currently produced. (Only if you sell the car through a dealer will GDP increase by the value of the services rendered.) b. Inventory changes are part of investment, so investment will decrease. But somebody will have to buy these inventories, so consumption will increase. If the inventories are sold at a price higher than invoice, then GDP will increase by the value added. c. A loss in stock values means a loss in wealth, therefore GDP is not directly affected. Only if your dividends decrease will your income (and thus GDP) be affected. d. When you use savings to buy land, a transfer of wealth takes place and GDP is not affected. (Only if a real estate agent receives a commission will GDP go up by the value of the services rendered.) e. When the card dealer sells the rookie card, inventory decreases, so investment goes down. Selling the card to a customer increases consumption. Thus GDP increases only by the value added at the dealer for his services rendered. f. GDP will increase by the value added in the Canadian restaurant. If the beer was imported from the United States for $1.20 and sold (exported) to a German tourist for $3.00, then net exports will increase by $1.80. 2. How will the following events affect GDP and why? a. A hurricane destroys part of Edmonton. b. You sell your old macroeconomics textbook to another student. c. You sell your holdings of IBM stock. d. Your local car dealership decides to reduce its inventory by offering price reductions. e. A retired worker gets an increase in Social Security benefits. a. When a hurricane destroys property, wealth is affected, not income (or GDP). However, if a significant amount of the capital stock is destroyed, then less can be produced later, leading to a decrease in GDP. On the other hand, the rebuilding of destroyed property means that increased economic activity will take place, leading to an increase in GDP. b. The sale of your old textbook will not constitute an official market transaction (since you probably will not report your income to the IRS). In addition, the textbook has already been used and is not currently produced. Therefore GDP will not be affected. 13 c. The sale of existing stock holdings is a transfer of wealth and, as such, does not affect GDP. Any fees that you may have to pay your broker for his or her services, however, constitute payment for services rendered. GDP will increase by that amount. d. Inventory changes are counted as part of investment. A reduction in business inventories will lower the level of investment (I) and thus GDP. However, the sales of the cars count as consumption (C) if consumers buy them, or investment (I) if firms buy them. Thus the net effect on GDP depends on the difference between the cost of the cars to the dealership and the sales price of the cars, that is, the value added. e. Transfer payments that do not arise from productive activity are not counted in GDP. Thus GDP will not be affected when Social Security benefits are paid. (Only later, when these payments are spent, will consumption increase.) 3. If nominal GDP in Germany increased by 2.8% last year, but Canadian GDP increased by 4.2%, can we conclude that the welfare of Canadian citizens increased by more than that of German citizens? Why or why not? A country's nominal GDP is not a good measure of the economic welfare of its people, since nominal GDP can change solely due to inflation. Only if real GDP grows faster than population, will real income per capita increase. But real GDP per capita still does not take into account changes in income distribution, changes in environmental quality, or leisure, all of which influence the economic welfare of the people in a country. Therefore we cannot say whether the welfare of the people in the Canada has increased more than that of the people in Germany. 4. "Real per capita GDP is a good measure of economic welfare." Comment on this statement. Real GDP per capita is an imperfect measure of economic welfare as it does not include non-market activities which affect well being, such as the value of household services, volunteer work, pollution, the loss of natural wilderness areas resulting from development, and so on. In spite of these limitations, however, real GDP per capita still does provide some measure of economic welfare. 5. Assume real GDP in 1992 was $7,000 billion, nominal GDP in 1997 was $8,316 billion, and the GDP-deflator has increased from 100 to 110 from 1992 and 1997. What is the average annual growth rate of real GDP from 1992 to 1997? Do you think the welfare of all people in Canada has increased during that time. Why or why not? RGDP = (NGDP/deflator)*100 = (8.316/110)*100 = 7.56 Growth rate of GDP = (7.56 - 7.0)/7.0 = 0.56/7 = 0.08 = 8% Thus real GDP has grown 8% in five years, or at an average annual growth rate of 1.6%. An increase in a country's GDP is not a good measure for an increase in the economic welfare of its people. For example, nominal GDP can change solely due to inflation, and real GDP has to grow faster than the population, for real income per capita, and thus living standards, to increase. But real GDP per capita still does not take into account changes in the income distribution, changes in environmental quality, or changes in leisure, all of which influence the economic welfare of the people in a country 14 6. Explain why indirect taxes are deducted from NDP to calculate national income (Y). Indirect taxes are not paid to factors of production for the use of their services. Therefore they are not included in national income, which measures the income of all factors of production. 7. Comment on the following statement: "Any accumulation of inventories by firms is not included when measuring GDP." National income accounts do include changes in inventories when measuring investment. Inventories rise when production exceeds sales, but fall if production falls short of demand. These changes must be allowed to affect investment. But if investment is affected, so is GDP. Otherwise total economic activity will be over- or underestimated to the extent that inventory changes are not accounted for. 8. Assume a Hyundai dealership in Calgary bought 30 Hyundais from Korea at a cost of $13,000 per car in September of 2000, and by December 31, 2000 they have sold 20 of these Hyundais at a price of $16,000 each. The remaining Hyundais were sold in January 2001 at a price of $14,000 each. How exactly does this affect the GDP in 2000 and 2001, and which categories of GDP (C, I, G, or NX) are affected? NX = - (30*13,000) = - 390,000 C = + (20*16,000) = + 320,000 I = + (10*13,000) = + 130,000 _____________________________________ GDP = + 60,000 2000: Check: The value added in 1999 is: 20*3,000 = 60,000 C = + (10*14,000) = + 140,000 I = - (10*13,000) = - 130,000 ______________________________________ GDP = + 10,000 2001: Check: The value added in 2000 is: 10*1,000 = 10,000 9. Comment on the following statement: "I bought a new home last year. If I sell it today, I will raise the level of economic activity." This statement would be true if a realtor sold your home, as the realtor would have provided a current service for which she would be paid. Transactions in existing assets such as artwork and residential housing do not create economic activity in an amount equal to the value of the sale. New home construction, on the other hand, is included in the calculation of current GDP as it does represent current economic activity. 15 10. True or False? Why? "The PPI measures the cost of buying a fixed bundle of consumer goods." False. The Consumer Price Index (CPI) measures the cost of buying a market basket of consumer goods. The Producer Price Index (PPI) measures the cost of commodities at an early stage of the distribution system. Changes in the PPI signal a future change in the general price level, as costs are passed on to consumers. 11. True or false? Why? "Using the consumer price index or the GDP-deflator to calculate changes in the average price level should produce identical the inflation rates." False. The CPI measures the cost of a representative household's consumption bundle whereas the GDPdeflator is a more comprehensive measure of the prices of all goods and services produced in the economy. Rates of change in these indices vary due to the differences in their construction. 12. Do the CPI and the GDP-deflator always show the same increase in the rate of inflation? The GDP-deflator measures the average price increase of all final goods and services that are currently produced. These goods differ from year to year depending on what is produced. The CPI measures only the average cost increase of a specified market basket of goods and services. The CPI also includes prices of import goods that the GDP-deflator does not include. Thus, when import prices go up, the CPI will most likely increase more than the GDP-deflator. 13. Briefly describe the advantages and disadvantages of using the CPI, the IPPI, and the GDP-deflator as economic indicators. The consumer price index (CPI) measures the average price increase of a fixed market basket of goods and services purchased by an average urban wage earner. Not all goods and services are reflected in this market basket and substitution among these goods is not possible. So the CPI is not a perfect measure for inflation. However, the CPI is easily available on a monthly basis and is fairly reliable. The industrial product price index (IPPI) measures the average price increase of a fixed market basket of intermediate goods up to the retail stage, but it does not include services or interest payments. The PPI is relatively easily available on a monthly basis and it is used to show future price trends. One has to be careful to avoid double counting, since the PPI deals with intermediate goods. The PPI does not necessarily correspond with the CPI, since firms can't always shift higher producer prices onto consumers. The GDP-deflator is probably the most useful price index for macroeconomists since it measures the average price increase of all goods and services currently produced in this country. It does not include import goods, used goods, or interest payments, and early estimates are often unreliable and have to be revised repeatedly. However, the GDP-deflator is the most complete of the price indexes. 16 14. Assume last year's real GDP was $7,000 billion, this year's nominal GDP is $8,820 billion, and the GDP-deflator for this year is 120. What was the growth rate of real GDP? RGDP(1) = [NGDP(1)/GDP-deflator]*100 = [8,820/120]*100 = 7,350 Since RGDP(0) = 7,000 it follows that the growth rate of RGDP is y = [7,350 - 7,000]/7,000 = 0.05 = 5%. 15. Comment on the following statement: “A country that spends more than its total national income must have a trade deficit.” National income is defined as Y = C + I + G + NX. The four main components of aggregate demand are consumption (C), investment (I), government purchases (G) and net exports (NX). But if the spending on consumption, investment, and government purchases is greater than national income, it follows that net exports (NX = X - Q) must be negative, that is, imports (Q) must exceed exports (X), and the country must have a trade deficit. 16. Calculate the values for government outlays (G), saving (S), and investment (I) from the following information. national income Y = 5,200 budget deficit BuD = 150 disposable income YD = 4,400 trade deficit TD = 110 consumption C = 4,100 From YD = C + S ==> S = YD - C = 4,400 - 4,100 = 300 From S - I = BuD - TD ==> 300 - I = 150 - 110 ==> I = 260 From Y = C + I + G + NX ==> G = Y - C - I - NX ==> G = 5,200 - 4,100 - 260 + 110 = 950 17. From the following information (all variables are in billions of dollars) calculate the value of government spending (G), consumption (C), and investment (I). national income Y = 6,000 tax revenues TA = 1,500 saving S = 1,000 transfer payments TR = 700 net exports NX = - 120 budget deficit BuD = 230 From YD = Y - TA + TR ==> YD = 6,000 - 1,500 + 700 ==> YD = 5,200 From YD = C + S ==> C = YD - S = 5,200 - 1,000 = 4,200 From S - I = BuD - TD ==> 1,000 - I = 230 - 120 ==> I = 890 From Y = C + I + G + NX ==> G = Y - C - I - NX ==> G = 6,000 - 4,200 - 890 + 120 = 1,030 17 Check: BuS = TA - TR - G ==> -230 = 1,500 - 700 - G ==> G = 1,030 18. From the information below, calculate the level of investment (I), consumption (C), and national income (Y). government spending G = 1,200 budget surplus BuS = 60 disposable income YD = 4,500 net exports NX = -110 saving S = 500 From YD = C + S ==> C = YD - S = 4,500 - 500 = 4,000 From S - I = BuD - TD ==> 500 - I = - 60 - 110 ==> I = 670 From Y = C + I + G + NX ==> Y = 4,000 + 1,200 + 670 - 110 = 5,760 19. Assume the government cuts its purchases by $60 billion. As a result, the budget deficit is reduced by $20 billion, savings increases by $10 billion, disposable personal income decreases by $15 billion and the trade deficit is reduced by $5 billion. By how much have investment (I), consumption(C), and national income (Y) changed? From S - I = (G + TR - TA) + NX ==> I = S - (G + TR - TA) - NX ==> I = S - BD - NX ==> I = 10 - (-20) - 5 = + 25 From YD = C + S ==> C = YD - S = - 15 - 10 = - 25 From Y = C + I + G + NX ==> Y = C + I + G + NX ==> Y = - 25 + 25 - 60 + 5 = - 55. 20. Will an increase in the federal budget surplus necessarily lead to a decrease in the foreign trade deficit? Why or why not? The equation I - S = BS - NX states that the difference between investment and private domestic saving is equal to the difference between the budget surplus and the trade surplus. If the budget surplus increases (or the budget deficit decreases), then U.S. interest rates are likely to decrease. This will cause an outflow of funds, depreciating the value of the U.S. dollar and making the U.S. more competitive on world markets. Therefore we will see an increase in the trade surplus (or a decrease in the trade deficit). However, this does not necessarily always happen, since the other two variables in this equation, that is, investment and saving, may also change. For example, if there is a significant increase in investment spending due to the lower interest rates, then we may not see a change in the trade surplus. 18 21. "High budget deficits ultimately lead to foreign trade deficits." Comment on this statement. From S + TA - TR = I + G + NX ==> S - I = - (TA - G - TR) - (-NX) = BuD - TD, that is, the difference between saving and investment is equal to the difference between the budget deficit and the trade deficit. Throughout the late 1970’s and the 1980's the size of the budget deficit increased sharply. Saving remained low and thus interest rates increased. However, an increase in the budget deficit, does not necessarily increase the trade deficit, since the other two variables in this equation, i.e., investment and saving may also be affected. As long as we can finance the increase in the budget deficit domestically, no trade deficit has to result. Instead saving may increase or investment may be crowded out. 22. Assume you are a banker and you’d like a 4% real rate of return on your loans. If you expect that the inflation rate is likely to average about 6% over the next thirty years, what would be the most likely mortgage interest rate that you would charge your customers for a thirty year fixed rated mortgage? How would your answer change if you expected a 4% average inflation rate over the length of the mortgage? Explain your answers. The Fisher equation states that the nominal interest rate is the expected real rate of interest (r e) plus the expected rate of inflation (e), or i = re + e. In other words, if you expected an inflation rate of 6%, you would charge your customers a 10% mortgage interest rate since i = 4% + 6% = 10%. But if you expected only a 4% inflation rate, you would charge your customers a mortgage interest rare of i = 4% + 4% = 8%. 23. Assume a government bond pays you a fixed interest rate of 5.5% per year and the average annual rate of inflation is 4.2%. What is your real rate of return? How would this real rate of return change if inflation increased to 6.8%? The real interest rate is defined as the nominal interest rate minus the inflation rate, that is, r=i- Therefore your real rate of return is r = 5.5% - 4.2% = 1.3% if the inflation rate is 4.2%. But if the inflation rate increases to 6.8%, then your real rate of return will be negative, that is, r = 5.5% - 6.8% = - 1.3%. 19