Nation’s Income IMBA Managerial Economics Macroeconomics I

Economy’s Income and Expenditure When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. 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.

Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES Copyright © 2004 South-Western

Gross Domestic Product 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”.

Components of GDP GDP includes all items produced in the economy and sold legally in markets. 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.

Formula of GDP GDP (Y) is the sum of the following:  Consumption (C)  Investment (I)  Government Purchases (G)  Net Exports (NX) Y = C + I + G + NX

Components: C and I 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.

Components: G and NX 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.

Nominal Versus Real 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 An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator. The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

The GDP Deflator Converting Nominal GDP to Real GDP  Nominal GDP is converted to real GDP as follows:

GDP and Economic Well- Being GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy. Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life, however.

GDP and Economic Well- Being Some things that contribute to well- being are not included in GDP.  The value of leisure.  The value of a clean environment.  The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

GDP(PPP) Gross Domestic Product (GDP) at Purchasing Power Parity (PPP)

Gross National Product GNP is the total income earned by a nation’s permanent residents. It differs from GDP by including income that citizens earn abroad and excluding income that foreigners earn here.

Green GDP Green GDP is an index of economic growth with the environmental consequences of that growth factored in. Green GDP=Traditional GDP- environmental/ecological costs

GDP Per Capita Ranking ntries_by_GDP_%28nominal%29_per _capita ntries_by_GDP_(PPP)_per_capita

Consumer Price Index The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. It is used to monitor changes in the cost of living over time. When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

Calculating CPI: steps Fix the Basket Find the Prices Compute the Basket ’ s Cost Choose a Base Year and Compute the Index Choose a Base Year and Compute the Index

Calculating Inflation Rate Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

GDP deflator and CPI Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are two important differences between the indexes that can cause them to diverge. The GDP deflator reflects the prices of all goods and services produced domestically, whereas... … the consumer price index reflects the prices of all goods and services bought by consumers.

GDP deflator and CPI The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year … whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

Correcting Economic Variables for Effects of Inflation Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.

Example

Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.

Business Cycle I The term business cycle or economic cycle refers to the fluctuations of economic activity (business fluctuations) around its long-term growth trend.

Business Cycle II The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession).

Business Cycle III These fluctuations are often measured using the real GDP. Despite being termed cycles, these fluctuations in economic growth and decline do not follow a purely mechanical or predictable periodic pattern.

Types of Business Cycle A number of types of business cycles, in the traditional sense of a fluctuation within a regular period have been proposed. The main types of business cycles enumerated by Joseph Schumpeter.

Juglar Cycle In 1860, French economist Clement Juglar identified the presence of 8 to 11 year cycles. In Business Cycles, Schumpeter suggested this cycle be named after Juglar. These cycles are made up of four stages, each linked to the variation in prices, production and interest rates.

Four stages expansion = increase in production and prices, and low interests rates. crisis = stock exchanges crash and bankruptcies of several companies occur. recession = decrease in price and in output, high interests rates. recovery= stocks recover thanks to the fall in prices and incomes.

Recession A recession is a contraction phase of the business cycle, or "a period of reduced economic activity.

Recession and Depression The U.S. based NBER defines a recession more specifically as "a significant decline in economic activity spread across the economy, lasting more than a few months. A sustained recession may become a depression.

Attributes of Recession A recession has many attributes that can occur simultaneously and can include declines in coincident measures of overall economic activity such as employment, investment, and corporate profits.

Causes of Recession Recessions are the result of falling demand and may be associated with falling prices (deflation), or sharply rising prices (inflation) or a combination of rising prices and stagnant economic growth (stagflation). A severe or prolonged recession is referred to as an economic depression.

Possible Predictors of Recession A significant stock market drop has often preceded the beginning of a recession. The three-month change in the unemployment rate. Index of Leading Indicators

The Index of Leading Indicators is an economic index intended to estimate future economic activity. The index is calculated based on ten key variables that have historically turned downward before a recession and upward before an expansion.

Recession’s Warning System The index of leading indicators can provide an early warning system so that policymakers can shift toward macroeconomic stimulus when the index fails.

Ten key variables Average number of initial applications for unemployment insurance Number of manufacturers' new orders for consumer goods and materials Speed of delivery of new merchandise to vendors from suppliers Amount of new orders for capital goods unrelated to defense Amount of new building permits for residential buildings The S&P 500 stock index Inflation-adjusted money supply (M2) Spread between long and short interest rates Consumer sentiment Average weekly hours worked by manufacturing workers

Monitoring Indicators Red Light: Very hot Yellow Red light: hot Green light: stable Yellow blue light: cool/poor Blue light: very cool/poor