The Big Picture GDP & Inflation Macroeconomics The Big Picture GDP & Inflation

Modern Macro is “new.” Before 1930s, the economy was thought to be primarily self-regulating (thought that markets would ‘clear’ by themselves). Production and Unemployment in the Great Depression changed that view. Production was extremely low. Employment was extremely low. John Maynard Keynes argues a depressed economy is the result of inadequate spending and ‘sticky’ prices.

Business Cycle 3 Key Economic Indicators Production (GDP) Employment (The Unemployment Rate) Inflation (CPI, PPI, GDP Deflator)

The Business Cycle

Government Policies Fiscal Policy Monetary Policy Spending and Taxes Changes in the money supply

The Business Cycle

The Business Cycle The National Bureau of Economic Research determines when recessions begin and end. Up to date data can be found here: http://www.nber.org/cycles/cyclesmain.html

The Business Cycle & Employment

Gross Domestic Product Measuring production

Definition GDP – the total value of all final goods and services produced for the market place during a given year within a nation’s border Attempts to measure what has been produced.

Definition GDP – the total value of all final goods and services produced for the market place during a given year within a nation’s border

the total value Advantages Disadvantages Common unit of measurement (GDP allows you to compare “apples to oranges.” Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods) Allows items that use more resources / higher valued goods to be counted as more If prices rise, GDP rises, but society isn’t any better-off (that is to say society doesn’t have more goods and services to consume)

final goods and services Only goods that are sold to the “final consumer” are counted Does not count intermediate goods Counting the value of intermediate goods constitutes “double counting” An important exception to this principle arises when an intermediate good is produced and, rather than being used, is added to a firm’s inventory of goods for use or sale at a later date. In this case, the intermediate good is taken to be “final” for the moment, and its value as inventory investment in included as part of GDP. Thus additions to inventory add to GDP, and when the goods in inventory are later used or sold, the reductions in inventory subtract from GDP.

produced Does not include every transaction – only those that involve new production. Excludes items like selling stocks and bonds, used cars, winning the lottery, etc…

for the market place Does not include non market production (because it is not reported). House cleaning Child Care “Black Market” activity

during a given period Usually discussed as yearly or quarterly Typically reported as an annual number Measured with quarterly data though

within a nation’s borders Inside the borders – regardless of ownership

How to Calculate GDP Three Approaches Expenditure Approach Income Approach (Factor Payment Approach) Value Added Approach (Theory) All three methods yield the same value (Reality) The income numbers are considered more reliable

Expenditure Approach GDP = C + I + G + NX C – consumption (Household spending) I – investment (Spending on capital) G – Government (Government Spending) NX – Net Exports (Exports minus Imports)

Goods & Services Market Extended Circular Flow Model (Open Economy) Sprivate Households Government T Y C G Spublic Factor Market Goods & Services Market Loanable Funds Market I X GDP NCO Y M Firms Rest of the World Iplanned

Extended Circular Flow Model (Open Economy) Red Arrows Represent GDP Sprivate Households Government T Y C G Spublic Factor Market Goods & Services Market Loanable Funds Market I X GDP NCO Y M Firms Rest of the World Iplanned

Goods & Services Market Extended Circular Flow Model (Closed Economy) Sprivate Households Government T Y C G Spublic Factor Market Goods & Services Market Loanable Funds Market I GDP Y Firms Iplanned

Goods & Services Market Supply: Factor Market Demand: Supply: Goods & Services Market Demand: Supply: Loanable Funds Market Demand:

Goods & Services Market Supply: Households Factor Market Demand: Firms Supply: Firms Goods & Services Market Demand: Households + Firms + Government + Rest of the World Supply: Households + Government Loanable Funds Market Demand: Firms + Rest of the World

Expenditure Approach GDP = C + I + G + NX Note: For the economy as a whole, income must equal expenditure. Therefore GDP also equals income! So, GDP = Y = C + I + G + NX

C – consumption (Household spending) Includes Excludes Value of food produced on farms that is consumed by farmers Total value of housing services provided by owner-occupied homes Used goods Stocks, bonds, land New home construction

I - Investment Investment is capital formation Capital formation is the change in the capital stock The capital stock is the sum of the value of all capital goods

I - Investment Includes Excludes Business purchases of factories, equipment and software. New-home construction Changes in inventories (changes in unsold goods) Government investment Consumer durables Human capital Depreciation (ignores all depreciation)

G - Government Spending by the local, state & federal levels on goods and services Includes Gov’t Consumption and Gov’t Investment Excludes transfer payments – such as social security

NX – net exports NX = Exports - Imports

Income Approach (Factor Payment Approach) The sum of all rents, wages, interests and profits (or dividends). We are summing the payments of all factors of production used to produce all goods and services

Value Added Approach Measures the value added to a good or service at each stage of production Value-added – revenues received for a given good or service minus the costs of all intermediate goods used to produce it

Problems with GDP Quality changes Underground Economy Nonmarket Production Depends largely on goods and services (what about leisure?) Ignores economic “bads” (like war, disease, crime, etc…) Ignores inflation (see Nominal GDP vs. Real GDP)

Real GDP vs Nominal GDP Nominal GDP – GDP at current prices Real GDP – Adjusts for inflation with constant prices from a base year. GDP Deflator – A measure of the price level using the ratio of Nominal GDP to Real GDP times 100.

Nominal GDP in the US

Real GDP in the US

Real GDP (RGDP) vs Nominal GDP (NGDP) Country: Venezuela Increases in Nominal GDP do not represent growth – only increases in Real GDP represent growth – also see Zimbabwe… they had the fastest NGDP growth in the world a few years back, and was deep in recession.

Real GDP vs Nominal GDP We can use GDP Deflator as one way to track the price level (that is to say we can track inflation). Inflation is viewed to be an increase in the overall price level. Deflation is viewed to be a decrease in the overall price level. The inflation rate is the percent change in the price level from one time period to another.

Calculating GDP Deflation and the Inflation Rate Charlotte, NC produces two goods: Panther’s footballs and Hornet’s basketballs. Below is a table showing prices and quantities of output for three years: Year Price of Footballs Quantity of Footballs Price of Basketballs Quantity of Basketballs Year 1 $10 120 $12 200 Year 2 $15 300 Year 3 $14 180 $18 275 Calculate Nominal GDP in each year. Calculate Real GDP in each year (using Year 1 as the base year) Calculate the GDP Deflator for each year. Calculate the Inflation Rate from Year 1 to Year 2. Calculate the Inflation Rate from Year 2 to Year 3.

Calculating GDP Deflation and the Inflation Rate Year Price of Footballs Quantity of Footballs Price of Basketballs Quantity of Basketballs Year 1 $10 120 $12 200 Year 2 $15 300 Year 3 $14 180 $18 275 Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900 Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470 Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600 Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100 GDP deflator for Year 1 = ($3,600/$3,600) × 100 = 1 × 100 = 100 GDP deflator for Year 2 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21 GDP deflator for Year 3 = ($7,470/$5,100) × 100 = 1.4647 × 100 = 146.47

Calculating GDP Deflation and the Inflation Rate Year Price of Footballs Quantity of Footballs Price of Basketballs Quantity of Basketballs Year 1 $10 120 $12 200 Year 2 $15 300 Year 3 $14 180 $18 275 Inflation from Y1 to Y2 = ((123.21–100)/100)*100 = 23.21% Inflation from Y2 to Y3 = ((146-123.21)/123.21)*100 = 18.49%

Real GDP Deflator in the US

Comparing Recessions

Comparing Recessions

Comparing Recessions Current vs. Great Depression

Economic Growth

Economic Growth

Economic Growth Economic Growth is a relatively new concept. Only recently did countries see what we think of as “growth.” Are you richer than the “richest man ever” ? Net worth estimated up to $663 Billion in today’s dollars (adjusting for inflation)

Inflation

Define Inflation / Deflation Inflation – a general increase in the price level Deflation – a general decrease in the price level Hyperinflation – extraordinarily high inflation (Germany 1923 – prices doubled roughly every 2 days)

Measuring Inflation Question: How do we measure inflation? Answer: With a price index!

Measuring Inflation Common Price Indexes CPI (Consumer Price Index) PPI (Producer Price Index) GDP Deflator Each focuses on a different part of the economy CPI uses a market basket typically faced by the household sector. PPI uses a market basket typically faced by the private sector (the Firms). CPI and PPI is tracked by the Bureau of Labor Statistics

Measuring Inflation

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Hornet’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Calculate Cost of the Basket for each year. Calculate the CPI for each year (using Year 1 as the base year) Calculate the Inflation Rate from Year 1 to Year 2. Calculate the Inflation Rate from Year 2 to Year 3.

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Bobcat’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Compute the Cost of the Basket: Cost in Year 1 = (3 × $10) + (4 × $12) = $78 Cost in Year 2 = (3 × $12) + (4 × $15) = $96 Cost in Year 3 = (3 × $14) + (4 × $18) = $114

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Bobcat’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Calculate the CPI for each year (using Year 1 as the base year): CPI in Year 1 = ($78/$78) × 100 = 1 × 100 = 100 CPI in Year 2 = ($96/$78) × 100 = 1.2308 × 100 = 123.08 CPI in Year 3 = ($114/$78) × 100 = 1.4615 × 100 = 146.15

Calculating Inflation Charlotte, NC produces two goods: Panther’s footballs and Bobcat’s basketballs. Assume a market basket of 3 footballs and 4 basketballs: Year Price of Footballs Price of Basketballs Year 1 $10 $12 Year 2 $15 Year 3 $14 $18 Calculate the Inflation Rate from Year 1 to Year 2. Calculate the Inflation Rate from Year 2 to Year 3. Inflation rate for Year 2 = [(123.08 – 100)/100] × 100% = 23.08% Inflation rate for Year 3 = [(146.15 – 123.08)/123.08] × 100% = 18.74%

CPI, PPI & GDP Deflator History

Comparisons CPI vs. GDP Deflator CPI measures the prices of only the goods and services bought by the households GDP Deflator measures the prices of all goods and services produced Thus an increase in the price of goods bought by firms or the government would not show up in the CPI, but would increase the GDP Deflator GDP Deflator does only includes domestic goods GDP Deflator allows the market basket of goods to change over time

Comparisons The difference in each price index is usually not large. CPI usually overstates inflation Estimated to overstate inflation between 0.8 and 1.6 %... with 1.1% being a “best estimate” GDP Deflator tends to understate inflation

Biases in the CPI Substitution Bias Introduction of New Goods Prices go up, households substitute away from the higher priced goods Introduction of New Goods Effectively increases the purchasing power of the dollar. CPI does not account for this. Unmeasured Changes in Quality Not all price increases are due to cost of living increases

Nominal & Real Interest Rates We see inflation in interest rates as well. Real Interest Rate = Nominal Interest Rate – Inflation Rate What matters is the purchasing power of money.

Nominal & Real Interest Rates Real Interest Rate = Nominal Interest Rate – Inflation Rate Example: Sally deposits $1,000 into a bank account that pays an annual interest rate of 10%. A year later, she withdraws $1,100. (remember to focus on the purchasing power of the money) If there is zero inflation, her purchasing power has risen by 10%. If there is 10% inflation, her purchasing power has remained the same. If there is 12% inflation, her purchasing power has declined by about 2%.

Inflation Winners & Losers Borrowers vs. Lenders Expected Inflation vs. Unexpected Inflation Unexpected Inflation can transfer wealth from lenders to borrowers The payments on a 30 year fixed mortgage remain constant, but the value of the dollar decreases with inflation. The lenders in these cases receive less “real money.”

Biggest Movie Ever? What is the biggest movie ever? Star Wars (Episode 7) Box Office Receipts were roughly $936 million domestically. What if we adjust other movies for inflation? Nominal Records – Real Records