Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-1 Chapter 1 Measuring macroeconomic performance: output and prices

Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-2 Learning objectives 1.What does gross domestic product (GDP) mean 2.What are the three ways of measuring a country’s GDP? 3.What is the distinction between nominal and real GDP? 4.What does the consumer price index (CPI) mean? 5.How is the CPI measured? 6.What is inflation and how is it measured? 7.What are the economic costs associated with inflation? 8.What is the relationship between the rate of interest and the rate of inflation? 9.What is deflation and why is it regarded as a problem?

Chapter organisation 1.1 When is the economy performing well? 1.2 Gross domestic product: Measuring the nation’s output 1.3Real GDP is not the same as economic wellbeing 1.4The consumer price index: Measuring the price level Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-3

When is the economy performing well? Rising living standards –Many countries have experienced increased living standards since the turn of the twentieth century. Avoiding extremes of macroeconomic performance –Short-run expansions and contractions in economic activity cause hardships and costs to the society. Maintaining the real value of the currency –Rapid changes in the prices of goods and services alter the real purchasing power of a dollar and create significant costs to the society. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-4

When is the economy performing well? (cont.) Ensuring sustainable levels of public and foreign debt –Debt accumulation is justifiable and sustainable if it generates returns exceeding its costs. Balancing current expenditure against future needs –Saving means postponing consumption today to provide more for the future. Providing employment for all individuals seeking work –Employment is an important but complicated topic as it covers both microeconomic and macroeconomic elements. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-5

Chapter organisation 1.1 When is the economy performing well? 1.2 Gross domestic product: Measuring the nation’s output 1.3Real GDP is not the same as economic wellbeing 1.4The consumer price index: Measuring the price level Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-6

Gross domestic product: Measuring the nation’s output Gross domestic product (GDP) is the market value of the final goods and services produced in a country during a given period. GDP is a commonly used macroeconomic indicator: –Short-run fluctuations in GDP are associated with the business cycle. –Long-run growth in GDP is associated with better living standards. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-7

Australia’s historical GDP experience Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-8 Figure 1.1 Australia’s real GDP

Measuring GDP – Market value GDP is the market value of the final goods and services produced in a country during a given period. Market value –Goods and services are counted at their market price times quantity. –Unpaid work is not counted. –Public goods and services do not have market prices and are counted at their cost of provision. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-9

Measuring GDP – Final goods and services GDP is the market value of the final goods and services produced in a country during a given period. Final goods and services –Many goods and services are subjected to production processes. –Example: To make a loaf of bread, a farmer grows wheat and sells it to the miller for $0.50, the miller grinds the wheat into flour and sells to the baker for $1.20 and the baker makes the flour into bread and sells it for $2.00. –The final good is the good that is consumed by the consumer: the ‘bread’. The wheat and flour are ‘intermediate goods’, which are goods used in the production of the bread. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-10

Measuring GDP – Final goods and services (cont.) GDP measures the production of final goods and services only. –Example: The $2.00 market price of the bread takes account of the production costs of the wheat and flour inputs. The market value of final goods embody the cost of intermediate products. –Including the market value of intermediate products would mean ‘double counting’. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-11

Value-added method for GDP Complications arise in trying to count the final goods and services only. Value-added method for GDP –Summing up the value added by each firm in the production process. –Example: Value-added method for bread Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-12

Measuring GDP – Produced within a country during a given period GDP is the market value of the final goods and services produced in a country during a given period. GDP includes only goods produced within a given country. –Example: Cars produced by Toyota Australia count towards Australia’s GDP. But cars produced by Toyota Japan do not count towards Australia’s GDP. GDP is measured over a period of time such as monthly, quarterly or annual GDP. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-13

The expenditure method for measuring GDP All current production by firms must be either: –Bought by households, other firms, government and foreigners; or –Left unsold as inventories bought by the firm which makes it As such, GDP can also be measured as the sum of ‘expenditure’ on domestic production by households, all firms, government and foreigners. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-14

The expenditure method for measuring GDP (cont.) Household spending is consumption: C Firm’s spending is investment: I Government spending: G Foreign spending on our exports: X Domestic spending on foreign production, or our imports: M X – M is net exports: NX GDP = Y = C + I + G + NX Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-15

The income method for measuring GDP When a good or service is sold, the revenues from the sale are distributed to the workers and the owners of the capital involved in the production. GDP also equals labour income plus capital income from the production. –Labour income is wages, salaries and self-employed income. –Capital income includes payments to physical capital, intangible capital and profits. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-16

The income method for measuring GDP (cont.) Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-17 Figure 1.3 The circular flow of income

Example: Three methods for GDP A MacBook sold for $1500 –The expenditure method: C = $1500 if bought by a household. –The value-added approach: CPU $450 value-added LED display $300 value-added Apple design $750 value-added GDP = $1500 –The income approach: Incomes generated from the production = $1000 Profit from sale = $500 GDP = $1500 Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-18

Nominal vs real GDP Nominal GDP is current production at ‘current prices’. –Problem: It can mislead when comparing GDP over time. –Why: Nominal GDP can rise simply due to a higher general price level rather than the production level. Macroeconomists are more interested in changes to the production level over time. –Efficient allocation of scarce factors of production Real GDP rises when quantities rise or when higher valued items are being produced. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-19

Example: Two years Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-20 Can we say that the size of the economy has increased by 240%?

Chapter organisation 1.1 When is the economy performing well? 1.2 Gross domestic product: Measuring the nation’s output 1.3Real GDP is not the same as economic wellbeing 1.4The consumer price index: Measuring the price level Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-21

Real GDP is not the same as economic wellbeing Leisure time is excluded. Non-market economic activities are excluded. Environmental quality and resource depletion are excluded. Quality of life is excluded. Poverty and economic inequality is excluded. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-22

Real GDP is related to economic wellbeing Given the aforementioned deficiencies, real GDP is nevertheless closely related to economic wellbeing. In general, higher real GDP per capita is associated with many positives, such as: –availability of goods and services –life expectancy. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-23

Chapter organisation 1.1 When is the economy performing well? 1.2 Gross domestic product: Measuring the nation’s output 1.3Real GDP is not the same as economic wellbeing 1.4The consumer price index: Measuring the price level Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-24

The consumer price index: Measuring the price level Maintaining the real value of the currency is another important criteria for a well-performed economy. Consumer price index (CPI) provides an objective measure of: –average price level –inflation. The CPI measures the cost in a certain period of a standard basket of goods and services relative to the cost of the same basket in the base year. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-25

Example: CPI calculation Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-26 Cost of base-year consumption basket of goods and services in current year CPI = Cost of base-year consumption basket of goods and services in base year $850 CPI in year 2000 == 1.25 $680

Inflation Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-27 The CPI is used to calculate the rate of inflation. This is the percentage change in the CPI over the specified time period. Inflation rate as (CPI Dec2009 – CPI Dec2008 ) = x 100 at December 2009CPI Dec2008 This calculates the inflation rate for the year leading to December 2009.

Australia’s historical inflation rates Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-28 Figure 1.4 Australia’s rate of inflation

A common misperception about inflation Inflation is the rate of change of the average price level. Relative price is the price of one good relative to other goods. –If some prices rise while others remain constant, there is both a change in relative prices and a positive rate of inflation. –If some prices rise while others fall, there is a change in relative prices, but the rate of inflation may be zero, positive or negative, depending on the relative frequency of price rises and falls. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-29

The costs of high inflation Shoe leather costs: –The costs associated with holding less cash on hand and more in the bank so as to offset the reduction of purchasing power with interest. Noise in the price system: –Increasing prices should signal increased demand, but a high inflation environment interferes with the signal. Distortions of the tax system: –Higher effective tax rates caused by ‘bracket creep’ in a progressive, non-indexed tax system. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-30

The costs of high inflation (cont.) Unexpected redistribution of wealth: –Inflation redistributes rather than destroys purchasing power. This can have adverse effects on the economy if wealth becomes a matter of inflation ‘luck’ rather than earned through the incentives of productive work. Interference with long-run planning: –Long-run business and personal decisions become more difficult to make with high & erratic inflation. Menu costs: –Uncertainty and cost is caused by frequent changes in price lists. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-31

The costs of high inflation (cont.) Falling output and consumption in the economy caused by high inflation reduces the economic wellbeing of households and firms. This has a disproportionate effect on poorer members who are less likely to have their incomes increased. Reduced investment also leads to reduced growth rates of future output. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-32

Inflation and interest rates The nominal interest rate is the rate of interest specified in the loan contract. The real rate of interest is the nominal rate of interest minus the rate of inflation. –It measures the reward to lenders, in terms of purchasing power, paid by borrowers for lenders giving up spending over the contract period. –It is the nominal interest rate minus the rate of inflation (approximately). Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-33

Inflation and interest rates (cont.) Borrowing and lending contracts specify how much money will be paid back to the lender at a given time. The higher the rate of inflation over the contract period, the more the lender is penalised through a fall in the purchasing power of the money lent. –So a rise in the expected inflation rate raises the rate of interest which lenders demand. Likewise, borrowers gain from inflation and a fall in the purchasing power of money, so they tend to offer higher interest rates with inflation. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-34

Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-35 Example: One-year loan Inflation rate Price of bread at end of year Purchasing power of repayment Real interest rate 6%$ /1.06 = 104 loaves4% 10%$ /1.10 = 100 loaves0% 2%$ /1.02 = 108 loaves8% Assume the nominal interest rate is 10% per annum so the borrower will repay the lender $110 at the end of the year. Assume that price of bread at the beginning of the loan is $1 per loaf. Then the lender is aiming to give up the equivalent of 100 loaves of bread now, so as to receive more in the future. The real interest rate is the real increase in purchasing power the lender gains.

Deflation Deflation is a sustained fall in the average price level. –Problem: It can lead to high real interest rates, and high real interest rates discourage important expenditure types such as a firm’s investment in plant and equipment. This is due to the fact that the nominal interest rate must be above 0% or loans would not be made. –Why would you loan money out, just to get the same amount of money back? Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-36

Example: Effects of real interest rate Assume the real interest rate is 2%. Real interest rate = Nominal interest rate – inflation rate. But no-one would make loans at nominal interest rates of 0% and below. This implies that deflation rates of –2% and below cause the real interest rate to rise. Example: –3% inflation would need real interest rates of more than 3% to get a loan. If the inflation rate is:Expect a nominal interest rate of: 0%2% – 2%0% – 3% – 1% 1-37 Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank

Does the CPI measure ‘true’ inflation? The CPI overstates the actual level of inflation in the economy for two significant reasons: 1.Quality adjustment bias  Inflation can be overstated because quality improvements over time in goods and services are difficult to adjust for. 2.Substitution bias  The basket of goods and services is fixed, but higher prices in one good leads consumers to substitute cheaper goods. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-38

Chapter organisation 1.1 When is the economy performing well? 1.2 Gross domestic product: Measuring the nation’s output 1.3Real GDP is not the same as economic wellbeing 1.4The consumer price index: Measuring the price level Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-39

Summary GDP is the market value of final goods and services produced within a country during a given period of time. GDP can be measured by the expenditure, income and value-added methods. GDP is not the same as economic wellbeing as many things are excluded from the measurement. Living standards are positively correlated with real GDP per capita. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-40

Summary (cont.) The CPI measures the cost in that period of a standard basket of goods and services relative to the cost of the same basket in the base year. Inflation is the rate of change in CPI between two periods. High and persisted inflation can be extremely costly to the society. Real interest rates reflect the true cost of borrowing. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 1-41