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Title: Lecture%203:%20Basics%20of%20Macroeconomics


1
Lecture 3 Basics of Macroeconomics
  • Dr. Rajeev Dhawan
  • Director

Given to the EMBA 8400 Class January 18, 2008
2
Basics of MacroeconomicsChapter 23
3
The Economys Income Expenditure
  • For an economy as a whole, income must equal
    expenditure because
  • Every transaction has a buyer and a seller.
  • Every dollar of spending by some buyer is a
    dollar of income for some seller.
  • Gross domestic product (GDP) is a measure of the
    income and expenditures of an economy.
  • It is the total market value of all final goods
    and services produced within a country in a given
    period of time.

4
Definition of GDP
  • GDP is the market value of all final goods and
    services produced within a country in a given
    period of time.

5
Definition of GDP
  • GDP is the Market Value . . .
  • Output is valued at market prices.
  • . . . Of All Final . . .
  • It records only the value of final goods, not
    intermediate goods (the value is counted only
    once).
  • . . . Goods and Services . . .
  • It includes both tangible goods (food, clothing,
    cars) and intangible services (haircuts,
    housecleaning, doctor visits).

6
Definition of GDP
  • . . . Produced . . .
  • It includes goods and services currently
    produced, not transactions involving goods
    produced in the past.
  • . . . Within a Country . . .
  • It measures the value of production within the
    geographic confines of a country.
  • . . . In a Given Period of Time.
  • It measures the value of production that takes
    place within a specific interval of time, usually
    a year or a quarter (three months).

7
Definition of GDP
  • What Is Not Counted in GDP?
  • GDP excludes most items that are produced and
    consumed at home and that never enter the
    marketplace.
  • It excludes items produced and sold illicitly,
    such as illegal drugs.

8
Simple GDP Example
  • This simple economy has 2 people Baker and
    Miller.
  • Baker buys flour for 350. He also uses a worker
    and pays 200 in wages. He also pays a rent of
    25. He makes a profit as 25 on the bread he
    sells for 600.
  • The miller pays his worker 300, a rent of 25,
    and his profit is 25 on a sale of 350.
  • The GDP of this economy is 600!
  • Why? 2 sides of a coin, IncomeExpenditures
  • ExpendituresValue of final Goods sold600
  • IncomewagesRentprofits30020025252525600

9
NIPA Definition of GDP
  • YCIGNX
  • Y GDP
  • C Consumption
  • I Investment
  • G Government Purchases
  • NX Net Exports Exports-Imports


10
GDP and Its Components
11
GDP Components (2005)
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13
NIPA Definition of GDP
  • Consumption (C)
  • The spending by households on goods and services,
    with the exception of purchases of new housing.
  • Investment (I)
  • The spending on capital equipment, inventories,
    and structures, including new housing.
  • 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.

14
Real vs. 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 deflates for Inflation!
  • Inflation is rate of change of prices.

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22
Recessions
  • A recession is a significant decline in activity
    lasting more than a few months and is visible in
    industrial production, employment, real income
    and wholesale-retail sales (NBER definition).
    NBER uses monthly data.
  • Rule of thumb is 2 consecutive quarters of
    negative Real GDP growth or GDP decline.

23
Article Business Cycles
BUSINESS CYCLE REFERENCE DATES BUSINESS CYCLE REFERENCE DATES DURATION IN MONTHS DURATION IN MONTHS DURATION IN MONTHS DURATION IN MONTHS
Peak Trough Contraction Expansion Cycle Cycle
Quarterly datesare in parentheses Quarterly datesare in parentheses Peak to Trough Previous trough to this peak Trough from Previous Trough Peak from Previous Peak
May 1937(II)February 1945(I)November 1948(IV)July 1953(II)August 1957(III)April 1960(II)December 1969(IV)November 1973(IV)January 1980(I)July 1981(III)July 1990(III) June 1938 (II)October 1945 (IV)October 1949 (IV)May 1954 (II)April 1958 (II)February 1961 (I)November 1970 (IV)March 1975 (I)July 1980 (III)November 1982 (IV)March 1991(I) 138111081011166168 50803745392410636581292 638848554734117526428100 939345564932116477418108
March 2001 (I) November 2001 (IV) 8 120 128 128
NBER Report Cycle Dates 2003
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Mar 01 Nov 01 9 -0.1 -4.0 4.2 5.6
Forecast of the Nation, 2003
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29
2001 Recession vs. History
For Details Refer http//www.nber.org/
30
Real GDP and Consumption
FRBSF Economic Letter, June 2003
31
Investment and Stock Market
FRBSF Economic Letter, June 2003
32
Article NBERs FAQs
  • Q The financial press often states the
    definition of a recession as two consecutive
    quarters of decline in real GDP. How does that
    relate to the NBER's recession dating procedure?
  • Most of the recessions identified by our
    procedures consist of two or more quarters of
    declining real GDP, but not all of them
  • We consider the depth as well as the duration of
    the decline in economic activity.
  • Second, we use a broader array of indicators than
    just real GDP
  • Third, we use monthly indicators to arrive at a
    monthly chronology
  • Q Could you give an example illustrating this
    point?
  • The two-quarter-decline rule of thumb would not
    have allowed the declaration of the recession
    until August 2002
  • Q How does the NBER balance the differing
    behavior of employment and output?
  • There is no fixed rule for how the different
    indicators are weighted

33
Article NBERs FAQs
  • Q. You emphasize the payroll survey as a source
    for data on economy-wide employment. What about
    the household survey?
  • Although the household survey is a large,
    well-designed probability sample of the U.S.
    population, its estimates of total employment
    appear to be noisier than those from the payroll
    survey
  • Q. How do the movements of unemployment claims
    inform the Bureau's thinking?
  • A bulge in jobless claims would appear to
    forecast declining employment, but we do not use
    forecasts and the claims numbers have a lot of
    noise
  • Q What about the unemployment rate?
  • Unemployment is generally a lagging indicator.
    Its rise from a very low level to date is
    consistent with the employment data

34
Peak Trough Announcements
The November 2001 trough was announced July 17,
2003.The March 2001 peak was announced November
26, 2001. The March 1991 trough was announced
December 22, 1992.The July 1990 peak was
announced April 25, 1991. The November 1982
trough was announced July 8, 1983.The July 1981
peak was announced January 6, 1982. The July
1980 trough was announced July 8, 1981.The
January 1980 peak was announced June 3, 1980.
35
Chapter 24
  • Measuring the Cost of Living

36
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37
Consumer Price Index Inflation
  • Inflation refers to a situation in which the
    economys overall price level is rising.
  • The inflation rate is the percentage change in
    the price level from the previous period.
  • The Consumer Price Index (CPI) is a measure of
    the overall cost of goods and services bought by
    a typical consumer (produced by BLS).
  • Inflation rate is change in CPI.

38
Steps to Calculate CPI 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.
  • 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.
  • Choose a Base Year and Compute the Index

39
Steps to Calculate CPI 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.

40
How the Inflation Rate Is Calculated
  • The Inflation Rate
  • The inflation rate is calculated as follows

41
A Simple Example of CPI and Inflation Calculations
  • Calculating the Consumer Price Index and the
    Inflation Rate
  • Base Year is 2002.
  • Basket of goods in 2002 costs 1,200.
  • The same basket in 2003 costs 1,236.
  • CPI (1,236/1,200) ? 100 103.
  • Prices increased 3 percent between 2002 and 2003.

42
FYI What Is in the CPIs Basket?
43
Calculating the Consumer Price Index and the
Inflation Rate An Example
44
Calculating the Consumer Price Index and the
Inflation Rate An Example
45
The GDP Deflator vs. CPI
  • The BLS calculates other prices indexes
  • The index for different regions within the
    country.
  • The producer price index, which measures the cost
    of a basket of goods and services bought by firms
    rather than consumers.

46
CPI and GDP Deflator
Percent
per Year
15
10
5
0
1965
1970
1975
1980
1985
1990
2000
1995
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49
Problems in Measuring CPI
  • Substitution bias
  • Introduction of new goods
  • Unmeasured quality changes

50
Use of Price Indexes
  • Price indexes are used to correct for the effects
    of inflation when comparing dollar figures from
    different times.
  • Do the following to convert (inflate) Babe Ruths
    wages in 1931 to dollars in 2005

51
The Most Popular Movies of All Times, Inflation
Adjusted
52
Real and Nominal Interest Rates
  • The nominal interest rate is the interest rate
    usually reported and not corrected for inflation.
  • This is the interest rate that a bank pays.
  • The real interest rate is the nominal interest
    rate that is corrected for the effects of
    inflation.

53
Real and Nominal Interest Rates
  • You borrow 1,000 for one year.
  • Nominal interest rate is 15.
  • During the year inflation is 10.
  • Real interest rate Nominal interest rate
    Inflation
  • 15 - 10 5

54
Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15
Nominal interest rate
10
5
0
Real interest rate
-5
1965
1970
1975
1980
1985
1990
1995
2000
2005
55
Article Con Job Redux (PIMCO) by Bill Gross
  • Bill claims that CPI inaccurately calculates
    Americans cost of living.
  • Example Say you buy 1 bag of gumdrops for 1
    which has 100 of those. Productivity makes it 110
    gumdrops but for 1.10. Hedonic pricing says that
    CPI hasnt gone up as per-capita cost is the same
    (1 cent). But you have to shelve out 1.10 to get
    the bag, which is an increase in cost of 10.
    They must fork out an extra dime even though
    theyre getting more for their money.
  • We cant buy individual pieces of memory in a
    computer-we have to buy the entire package!
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