Macroeconomics: concepts and measurement École des Hautes Études Commerciales (HÉC), MBA Program, October 2001

Macroeconomics: the basic concepts of national accounting

What macroeconomics is about F Macroeconomics studies the overall performance of national economies. F In order to get a global understanding of how a national economy works, macroeconomics does four things: –It groups economic agents in broad categories (households, firms, governments and non-residents). –It merges thousands of individual markets into larger aggregate markets (the market for goods and services, the labor market, the domestic and foreign financial markets, etc.). –It focuses on the variables which tend to affect large segments of the national economy (the price of foreign currency, the level of real interest rates, etc.). –It stresses the interdependence between markets.

An illustration: the circular flow model of income and expenditure F The circular flow model of income and expenditure is a good starting point to understand the concepts of aggregate markets and interdependence. F In its simplest form, the model considers only two sectors: the households and the firms. F Furthermore, it abstracts from saving considerations. F Here it goes.

AGGREGATE SPENDING (consumption) (monetary flow) AGGREGATE INCOME (monetary flow) HOUSEHOLDS FIRMS GOODS AND SERVICES (real flow) PRODUCTIVE SERVICES (real flow)

In this simple model: F We can identify two markets implying the exchange of a real flow against a monetary flow. –The labor market where households exchange their productive services (real flow) against an income (monetary flow).labor market –The market for goods and services where the firms exchange the goods and services they produce (real flow) against an income (the monetary flow).market for goods and services F The two monetary flows are equal: Aggregate income = Aggregate expenditure

AGGREGATE SPENDING (consumption) (monetary flow) GOODS AND SERVICES (real flow) AGGREGATE INCOME (monetary flow) HOUSEHOLDS FIRMS PRODUCTIVE SERVICES (real flow)

The equality between income and expenditure F Why did we obtain the equality between aggregate income and aggregate expenditure ? –Notice that we did not consider the non-residents. The firms are therefore owned by the domestic residents and any revenue not paid in wages is necessarily a profit earned by the domestic household sector. –We did not consider saving: All profits are distributed and all income (wages and profits) is spent on consumer goods and services. F Because of the equality between aggregate income and aggregate expenditure: –Any event affecting the labor market will affect the market for goods and services and vice versa. Examples ?

AGGREGATE SPENDING (consumption) (monetary flow) GOODS AND SERVICES (real flow) AGGREGATE INCOME (monetary flow) HOUSEHOLDS FIRMS PRODUCTIVE SERVICES (real flow) Discussion in class

Adding complexity: Saving and gross fixed capital formation F In general, the firms save a portion of their profits:  retained earnings F The households do not consume all of their income:  households saving F The sum of these savings can finance another type of expenditure:  gross fixed capital formation

Gross fixed capital formation and investment F By gross fixed capital formation (GFCF) we mean the purchase of physical assets which increase the productive capacity of the economy (investment goods): –Expenses made to build residential and non-residential structures, to acquire machinery and equipment, etc. F Investment spending is a slightly larger concept as it also includes the change in the value of final goods inventories (with saving, income earned in one period can be spent in the next period). F Many firms and households finance their investment spending with their own saving. F However, it is the role of financial markets to intermediate between agents who save more than they invest and agents who invest more than they save.

AGGREGATE SPENDING (monetary flow) GOODS AND SERVICES (real flow) AGGREGATE INCOME (monetary flow) HOUSEHOLDS FIRMS PRODUCTIVE SERVICES (real flow) Households saving Firms saving Gross fixed capital formation +  inventories

What has changed ? F Fundamentally we have added a third aggregate market, the financial market whose role is to channel excess savings towards investment. F Within the aggregate market for goods and services, we have introduced a distinction between consumer goods and investment goods (productive physical assets). F The equality between aggregate income and aggregate expenditure remains but the latter is now defined as the sum of consumption, gross fixed capital formation and  inventories.

Adding the government sector F Here we state the general principles without spelling out the details onto the diagram. F What does it change to add the government sector ? (excluding public enterprises which we have included in the firms sector) : –Not all income earned by the firms and the households is available for “private” consumption or saving. The government is taking its share by taxing firms and households. –On the other hand, the government is transferring part of its tax revenues back to the households and firms. –Net government revenue is equal to the difference between taxes and transfers. –The government is using its net revenue (plus the funds it borrows in case of a budget deficit) to finance public consumption and public gross capital formation.

Adding the government sector –The equality between aggregate income and aggregate expenditure is not affected except that we must now include government expenditures (public consumption and public gross capital formation) in the definition of aggregate expenditure. F It’s time to sum up before introducing the non- residents sector: –Let’s denote private consumption by C, public consumption by G and gross fixed capital formation (public and private) plus  inventories by I. –When there are no relations with the non residents: u Aggregate expenditure is equal to C + I + G u Aggregate expenditure is equal to aggregate income –The introduction of the non-residents changes these results.

Introducing the non-residents: the balance of payments F The transactions between the residents of a country and the residents of the rest of the world are recorded into the balance of payments. F We make a distinction between two general types of transactions: –Current transactions (recorded in the current account). –Capital and financial transactions (recorded in the capital and financial account). F For now we will consider only the current account, the capital and financial account will be treated in more details later in the course.

The current account F The current account of a country constitutes its consolidated statement of income and expenditure. F A country receives an income from the non-residents whenever: –It exports goods and services. –The non-residents pay for the use of the factors of production (capital and workers) owned by the residents. –Transfers are received from the non-residents. F The same country spends whenever: –It imports goods and services. –The residents pay for the use of the factors of production (capital and workers) owned by the non-residents –Transfers are made to the non-residents.

The current account F The current account (CA) results from the consolidation of these sources of income and expenditure: F CA = NX + NFP + NT –where NX (net exports) is the difference between all exports of goods and services and all imports of goods and services. –NFP (net factor payments) is the difference between the factor payments (payments made to workers and capital owners) received from and made to the non-residents. –NT (net transfers) is the difference between the transfers received from and the transfers paid to the non-residents.

Canada’s current account 2000 (Can$ m, source: Statistics Canada’s Web site) Revenues Exports goods Exports services Factor (investment) income earned Current transfers earned Expenditure Imports goods Imports services Factor (investment) income paid Current transfers paid Current account NX NFP NT

The current account and the equality between aggregate income and expenditure F Before considering the non-residents, we had found that aggregate expenditure was equal to C+I+G. F These expenditures were made by the domestic residents only. Therefore and from now on, we will define C+I+G as domestic absorption (DA): –DA = C + I + G F Let’s add net exports to domestic absorption: –DA + NX = C + I + G + NX F How should we interpret this sum ?

The current account and the equality between aggregate income and expenditure F NX is the difference between all exports (X) and all imports (M). F We can re-arrange the terms of the equation defining DA + NX in the following way: F DA + NX = [ (C+I+G)-M ] + X. F The term in square brackets is domestic spending on goods and services from which we have netted out imports. These are the expenditures made by the domestic residents to buy domestic production only.

The current account and the equality between aggregate income and expenditure F The second term is the expenditure made by the non- residents to acquire domestic goods. F Summing the two terms we thus obtain the value of all expenditures made to acquire domestic production. The value of DA + NX is therefore equal to the value of domestic production. F The value of domestic production is a very important concept in macroeconomics. We call it Gross Domestic Product (GDP). We just learnt that we can measure GDP by summing domestic absorption and net exports: GDP = C + I + G + NX

The current account and the equality between aggregate income and expenditure F GDP, the value of domestic production, is the primary source of income for domestic residents. F However, as we have seen with the current account, this is not the only source of income. F For this reason, we can non longer say that aggregate expenditure (now DA+NX) is equal to aggregate income. F The two remaining components of the current account (NFP and NT) must be added to GDP in order to obtain aggregate income.

The current account and the equality between aggregate income and expenditure F Summing NFP to GDP: –GDP + NFP = (C + I + G) + (NX +NFP) –We call this new term Gross National Product (GNP) –Conceptually, GNP is the value of the income earned by the domestic residents from the use of their factors of production. F Summing NT to GNP –GNP + NT = GDP + NFP + NT –GNP + NT = (C + I + G) + (NX + NFP +NT) –GNP + NT = DA + CA –We call this new term Gross National Disposable Income (GNDI). –Conceptually GNDI is the total revenue a nation can use either for consumption or for saving purposes.

A useful interpretation of the current account F GNDI = (C + I + G) + CA F Subtract C and G from both sides: F (GNDI - C - G ) = I + CA F The portion of GNDI which is not consumed (either C or G) is called national saving (S). F We obtain ( S - I ) = CA F Interpretation ?

Summing up F GDP is the value of domestic production and the primary source of income for the residents of a country. –GDP can be measured as DA + NX, that is (C+I+G)+NX –GDP can be measured as DA + NX, that is (C+I+G)+NX. F GNP is the value of the income earned by the domestic residents from the use of their factors of production (which can either be used domestically (GDP) or abroad (NFP). –GNP = GDP + NFP F Gross national disposable income is the value of the revenue a nation can use either for consumption or for saving purposes. –GNDI = GNP + NT = (C+I+G) +CA F The current account can be interpreted as the difference between national saving and investment –CA = S - I

Macroeconomics: Measurement issues

Among the indicators used to assess a country’s performance, three are particularly important: The growth rate of GDP The rate of inflation The unemployment rate The unemployment rate will be addressed later in the course. We start with the first two indicators.

GDP and its growth rate We saw that we could measure GDP by summing DA (C+I+G) and NX (X-M). We now mention that only the expenditures which buy final goods and services are to be included. Purchases of intermediate goods (intermediate from the point of view of the domestic economy) should not be counted because this would result in the overestimation of the value of production. Why ? (A few examples ?)

GDP and its growth rate Now, there is a trickier problem. Since GDP is the value of domestic production, it can increase for two reasons:  The volume of production increases  Prices increase Economic growth refers to the growth in the volume of production, not the growth in the level of prices which would be pure inflation. We solve this problem by constructing two GDP series  One in which the numerous components of expenditures C, I, G, X and M are measured at current prices.  Another one in which the same quantities are measured at constant prices (brief discussion of the new method).

GDP and its growth rate GDP measured at constant prices is called real GDP and GDP measured at current prices is called nominal GDP. Usually, GDP is measured every quarter expressed in annualized terms, the yearly figure being the simple average of the four quarters. The GDP growth rate can be computed:- - sometimes over the previous quarter (quarterly growth figures) - more often over the same quarter of the preceding year (yearly growth figures) When economists refer to economic growth, they refer to the growth rate of real GDP, not of nominal GDP and a recession refers to an episode of negative real growth lasting at least two consecutive quarters.

Canada’s latest GDP growth statistics

The inflation rate Inflation is defined as a sustained process of increases in the average level of prices. In order to track the evolution of the average level of prices, we construct various price indices among which we can cite the consumer price index (CPI) and the GDP price deflator. We first explain how we measure the GDP price deflator. Later we discuss the differences between this particular price index and the consumer price index.

The inflation rate Computing the GDP price deflator is quite simple once we know nominal and real GDP. The price deflator is computed as: P = ( Nominal GDP / Real GDP ) As we usually want the price index to be equal to 100 for the base period, we multiply the result by 100. GDP price deflator = P 100 The growth rate of this index is one particular measure of the rate of inflation.

Inflation measured by the consumer price index Even if the rate of inflation measured by the GDP price deflator is important, it is the rate of inflation measured by the consumer price index which attracts most attention. The consumer price index is based on the cost of a fixed basket of goods and services bought every month by a typical household. Again, a base period must first be chosen. The value of the index for a particular period is computed by dividing the cost of the basket in that period by its cost in the base period, the result being multiplied by 100. For the base period, the value of the index is obviously equal to 100.

The consumer price index: a simplified example Base period ItemQuantityPriceCost Cheese2 kilos10$/kilo 20,00$ Water12 liters1$/liter. 12,00$ Metro25 tickets1,50$ each 37,50$ Total 69,50$ CPI(69,50/69,50) * 100 = 100 Current period QuantityPriceCost 2 kilos11$/kilo 22,00$ 12 liters1,50$/liter. 18,00$ 25 tickets2,00$ each 50,00$ 90,00$ (90,00 / 69,50) * 100 = 129,5

Inflation measured by the consumer price index Usually, the consumer price index is measured every month and the rate of inflation is computed as its growth rate - over the previous month for monthly inflation - over the same month of the preceding year for yearly inflation - we can also compare the 12-month average of a particular year with the 12-month average of the preceding year

Canada’s latest CPI inflation statistics

Macroeconomics: concepts and measurement École des Hautes Études Commerciales (HÉC), MBA Program, October 2001