Accounting an Economy Variables of Interest in Macroeconomics

Value of Output Gross Domestic Product- the value of all finished goods or services produced in the borders of an economy in a calendar year. Doesn’t count intermediate goods or goods produced by citizens living abroad. Example: Automobile is finished product. Steel, glass, wiring, etc… not counted individually.

Value of Output in US US GDP in 2010 will be about $14.5 trillion. That’s a big number!

Historic GDP US Economy has been a thoroughbred since WWII. Average annual growth has been 3.3% since 1950.

Historic GDP Not every year sees equal increases in GDP. Why does this happen? Expansions occur. GDP > potential GDP Recessions occur. GDP < potential GDP s/GDP-Growth.aspx?Symbol=USD s/GDP-Growth.aspx?Symbol=USD

Measuring Prices Inflation- the rate at which prices change Consumer Price Index (CPI) Base year is chosen and given a base value of 100. Allows for easy point of comparison.

Measuring Prices CPI Example- Assume 2000 is the base year. So, the CPI for 2000 = 100. If the CPI in 2001 is 103, then prices rose 3% in a year. If the CPI in 2005 was 110, then prices rose 10% in five years.

Measuring Prices Inflation is important because it must be easily estimable in order for credit markets to function and for currency to be used. In US, the Federal Reserve System acts as an inflation watchdog. Many other countries have central banks that serve a similar purpose.

Historic Inflation on_rate/historicalinflation.aspx on_rate/historicalinflation.aspx Generally prices in the US change about 1.5% to 3% every year.

Interest Rates Interest rates are the shadow price of capital. If technologically innovative products are available, then businesses will be willing to enter into loan agreements with higher interest rates because businesses’ productivity levels will increase with capital expansion.

Interest Rates Interest rates are tied closely to inflation because creditors and debtors must be able to make an accurate estimate of expected inflation in order to know the real interest rate. Fisher Equation: Nominal Interest Rate = Expected Real Interest Rate + Expected Inflation

Interest Rates Example: Assume that nominal interest rates are 5%. If Amanda wants to enter into a one-year credit agreement in which she is loaned $1000, then she needs to know what inflation will be in order to understand how much she’ll have to pay back in real terms.

Interest Rates Because she is loaned $1000 at nominal interest rate of 5%, she’ll have to pay back the principal, $1000, and interest, $50. If she expects inflation to be 3%, which is $30, then she’ll have to pay 2%, or $20, of real interest. (5% = 2% + 3%)

Interest Rates If inflation is unexpectedly high, then the creditor gets the short end of the deal because the real interest she collects is less than what she thought it to be. (Above example with 4% actual inflation…)

Historic Interest Rates data.htm data.htm Absolutely critical that inflation be somewhat predictable. If not, then credit markets cannot operate effectively, and long term growth will suffer.

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