Chapter 5 Macroeconomics the Big Picture Hossain: MSMC

Gross Domestic Product  In simple terms, GDP is the total output produced in an economy  It is often used to measure: Hossain: MSMC2  The size of an economy USA: trillion Japan: 4.91 trillion Germany: 3.65 trillion  The performance of an economy US GDP shrunk by 4% in the 3 rd quarter of 2009 US GDP grew by 2% in the 1 st quarter of 2010  Standard of living in an economy Commonly measured by per capital GDP

2008 GDPs Hossain: MSMC3

Gross Domestic Product  Formal definition:  Nominal GDP Total value of all final goods and services produced in an economy in given year valued at the current price  Real GDP Hossain: MSMC4 Total value of all final goods and services produced in an economy in given year valued at the current price Total value of all final goods and services produced in an economy in given year adjusted to eliminate the effect of price change final current price adjusted to eliminate the effect of price change

Nominal and Real GDP  Consider the following table Hossain: MSMC5 Nominal GDP in 2008 Goods and Services PQPQ Text Book Hair Cuts X X 400=54,000

Nominal and Real GDP Hossain: MSMC6 Nominal GDP in 2008 Goods and Services PQPQ Text Book Hair Cuts X X 400=54,000 Nominal GDP in X X 300=64,500

Nominal and Real GDP Hossain: MSMC7 Real GDP in 2008 Goods and Services PQPQP Text Book Hair Cuts X X 400=39,500 Real GDP in X X 300=31,500

Business Cycle  Economy does not grow at a constant rate  Rather, it has a cyclical pattern, which can be described by following components: Hossain: MSMC8  Expansion  Recession  Peak  Trough

Business Cycle  An expansion is a sustained period in which real GDP is rising.  A recession is a sustained period in which real GDP is falling.  A peak is the point of the business cycle at which an expansion ends and a recession begins.  A trough is the point of the business cycle at which a recession ends and an expansion begins.

Business Cycle Hossain: MSMC10

U.S. Real GDP Hossain: MSMC11

Changes in Price Level  Price Levels are different from Price we learned in chapter 3  It is NOT the price of apple, orange or banana  It is the average price of all goods and services in an economy  Usually, measured by a basket of representative goods and services Hossain: MSMC12

Changes in Price Level  For example CPI or Consumer Price Index tracks the prices of goods and services purchased by a typical urban family of four.  When price level rises, we call this Inflation  When price level falls, we call this deflation Hossain: MSMC13

Inflation in the U.S. Hossain: MSMC14

Impacts of Inflation  Unanticipated inflation has following adverse impacts:  Fall of purchasing power  Redistributes wealth  Creates uncertainty  Hurts lenders and benefits borrowers Hossain: MSMC15

Impacts of deflation  Unanticipated deflation has following adverse impacts:  Redistributes wealth  Creates uncertainty  Hurts borrowers and benefits lenders Hossain: MSMC16

Computation of CPI  Price Index is a number whose movement reflects the changes in average price level  In any index system, we select a base period and compare the changes in price levels from the base period  Typically, indexing is done in such a way that, Price Index for the Base Period= 100 Hossain: MSMC17

Computation of CPI  Lets assume that Base period is So, CPI 1985 = 100  Now, if I tell you that CPI 2000 = 150  What can we say about price level in 2000?  Clearly, price level has increased from 1985  Therefore, economy observed inflation  By how much?  It is 50% compared to the base year  This is the advantage of indexing to 100 Hossain: MSMC18

Another Example  Lets assume again, CPI 1985 = 100  Now, if I tell you that CPI 2005 = 160  What can we say about price level in 2005?  Again, price level has increased from 1985  Therefore, economy observed inflation  By how much?  It is 60% compared to the base year  Can we say anything about inflation compared to 2000 (CPI 2000 =150)? Hossain: MSMC19

Another Example  To compute inflation compared to non-base years, we need some simple computations  Note we have, CPI 1985 = 100 CPI 2000 = 150 CPI 2005 = 160  We like to know how price level had changed form 2000 to 2005  Again looks like its an inflation. But how much?  We want to know, 150 to 160 is an increase of how many percentage points? Hossain: MSMC20

Percentage Computation  All percentage computations, use the same formula:  So, computing percentage change in CPI from 2000 (150) to 2005 (165) 160 – Hossain: MSMC21 NEWOLD X100 X 100= 6.67%

In class Exercise  Assume, CPI 1985 = 100 CPI 1975 = 88 CPI 2002 = 138  Compute the inflation rate in 1975 compared to the base year  Compute the inflation rate in 2002 compared to the base year  Compute the inflation rate in 2002 compared to 1975  Note inflation rate means percentage change in CPI Hossain: MSMC22

Construction of CPI  BLS surveys, computes and publishes CPI  To compute CPI, we first compute the Cost of basket (COB)  Here, COB 2000 =10x4 + 15x1 + 2x3 = 61 Hossain: MSMC23 Price Data Goods and ServicesMarket Basket2000 Price 1985 Price  Apple 10 pounds$4.00$2.00  Banana 15 pounds$1.00$0.50  Cat food 2 bags$3.00$0.25

Construction of CPI  Here, COB 2000 =10x4 + 15x1 + 2x3 = 61  Here, COB 1985 =10x2 + 15x x.25 = 28 Hossain: MSMC24 Price Data Goods and ServicesMarket Basket2000 Price 1985 Price  Apple 10 pounds$4.00$2.00  Banana 15 pounds$1.00$0.50  Cat food 2 bags$3.00$0.25

Formula for CPI  Use COB numbers to the formula for CPI  Using this formula compute  CPI of 1985 (the base year)  CPI of 2000 Hossain: MSMC25 CPI xxxx = COB xxxx COB BaseYear X100