ECF 110 Introduction to Macroeconomics

ECF 110 Introduction to Macroeconomics

Macroeconomics is ... the study of the economy as a whole
It deals with broad aggregates but uses the same style of thinking about economic issues as in microeconomics.

Some key issues in macroeconomics
Inflation the rate of change of the general price level Unemployment a measure of the number of people looking for work, but who are without jobs Output real gross national product (GNP) measures total income of an economy it is closely related to the economy's total output

More key issues in macroeconomics
Economic growth increases in real GNP, an indication of the expansion of the economy’s total output Macroeconomic policy a variety of policy measures used by the government to affect the overall performance of the economy

The Economic Problem Unlimited Wants
Scarce Resources – Land, Labour, Capital Resource Use Choices Discussion can take place here about the key elements of the economic problem – the unlimited wants of humans against the scarce resources that exist to meet those wants. The notion of supply and demand can be introduced here and students can be involved by making a list of all the things they would like to buy if they had unlimited amounts of money! If then asked to trim that list down to meet a budget the more outrageous items disappear. This then introduces the notion of having to make choices – this issue can be discussed further using examples drawn from students own experiences about the choices they have had to make – possibly involving the choice of subjects they have had to make at college or school in relation to the time available, etc! How we use our scarce resources can also be linked into this discussion. The wind turbines highlight an issue raised in the In the News section ( about the intention to build wind farms in areas of the UK and the controversies that it creates – useful to link theory and practice at an early stage. A wind farm. Copyright: iStock.com

The Economic Problem What goods and services should an economy produce? – should the emphasis be on agriculture, manufacturing or services, should it be on sport and leisure or housing? How should goods and services be produced? – labour intensive, land intensive, capital intensive? Efficiency? Who should get the goods and services produced? – even distribution? more for the rich? for those who work hard? This is the traditional three key questions any economic system has to answer. Many students would have difficulty defining what an ‘economy’ actually is! It is useful at this stage to clear this up – a system for the production and exchange of goods and services to satisfy the wants and needs of the population. This is open ended enough to be able to incorporate all manner of economic systems from a barter system that still exists in remote parts of the world to sophisticated economic systems such as the UK and US! The questions and the examples raised can be used for discussion – get the students to express their views at this stage and be as controversial as possible to stimulate discussion and involvement!

Opportunity Cost Definition – the cost expressed in terms of the next best alternative sacrificed Helps us view the true cost of decision making Implies valuing different choices This is a key concept and one that often causes problems and misunderstanding but is central to students thinking like an economist. The crucial thing to knock out of students is their thinking that everything costs ‘money’. Because we have to make choices there are issues surrounding value judgements about what is important and what is not – it should not be difficult to stimulate discussion about what issues of government spending are important and what are not!

Production Possibility Frontiers
Show the different combinations of goods and services that can be produced with a given amount of resources No ‘ideal’ point on the curve Any point inside the curve – suggests resources are not being utilised efficiently Any point outside the curve – not attainable with the current level of resources Useful to demonstrate economic growth and opportunity cost This slide introduces the key features about PPFs. The activity that accompanies this presentation seeks to apply PPFs in a slightly different way – focussing on using health resources. Going through the theory at this stage and then following it up with the activity will be useful in developing early understanding of the issues.

If it devotes all resources to capital goods it could produce a maximum of Ym. If it devotes all its resources to consumer goods it could produce a maximum of Xm If the country is at point A on the PPF It can produce the combination of Yo capital goods and Xo consumer goods Assume a country can produce two types of goods with its resources – capital goods and consumer goods Capital Goods If it reallocates its resources (moving round the PPF from A to B) it can produce more consumer goods but only at the expense of fewer capital goods. The opportunity cost of producing an extra Xo – X1 consumer goods is Yo – Y1 capital goods. Ym A Yo These slides introduce the diagrams and then have animation to show how points on the PPF relate to different resource use and allocation. Moving from point A to point B involves sacrificing some capital goods to gain more consumer goods and thus demonstrates the opportunity cost involved. Students doing history can be reminded about the resource allocation decisions taken by Stalin during the 1930s and the subsequent decisions by successive Soviet premiers since the war about what resources are important for a nation like the USSR! (you might of course have to explain a little bit about what the USSR was!) B Y1 Xo X1 Xm Consumer Goods

It can only produce at points outside the PPF if it finds a way of expanding its resources or improves the productivity of those resources it already has. This will push the PPF further outwards. Production inside the PPF – e.g. point B means the country is not using all its resources Capital Goods C Y1 A .B Yo The next slide allows the lecturer to demonstrate what happens when resources are not used efficiently and production takes place within the PPF. It then allows the expansion of the PPF and can be used to illustrate the issue of economic growth and where opportunity cost does not exist if the economy moves from point A to point C (in a simple context of course – there is always some form of sacrifice of using resources!). Xo X1 Consumer Goods

Positive and Normative Economics
Health care can be improved with more tax funding Pollution control is effective through a system of fines Society ought to provide homes for all Any strategy aimed at reducing factory closures in deprived areas would be helpful Positive Statements: Capable of being verified or refuted by resorting to fact or further investigation Normative Statements: Contains a value judgement which cannot be verified by resort to investigation or research The final slide introduces positive and normative statements. Definitions are given on the right hand side and then successive statements appear on the left – each of these can be used as a basis of discussion as to whether they are positive or normative statements and why!

Circular flow of income
To develop the circular flow assume the following No government sector No foreign sector (domestic economy has no links with the rest of the world) Households own the factors of production or inputs to the production process. i.e they own their own labor, which they can rent out to firms in exchange for wages.

Note that households are ultimate owners of firms. They put up the money as sole traders, partners or shareholders in exchange for the final entitlement to the firm’s profits. Although factors such as capital and land appear to be held by firms , they are ultimately owned by households.

HOUSEHOLDS Goods and services FIRMS Services of productive factors
Spending on goods and services Goods and services Services of productive factors Factor incomes

Note that the inner loop shows flow of real resources Households supply factors of production which firms use to produce goods and services Outer loop shows corresponding payments. Firms pay factor incomes to households but receive revenue from households’ spending on goods and services that the firms produce.

The circular flow above suggests three ways to measuring economic activity in an economy. We can measure economic activity using the following; Value of the goods and services The level of factor earning which represent the value of factor of spending on goods and services. The value of spending on goods and services

The underlying assumption above is that all payments must be spent on purchasing real resources. With that assumption we get the same estimate of total economic activity whether we measure the value of production output, the level of factor incomes, or spending on goods and services.

That is; 1. Factor incomes equal household spending. Why? - We assumed that all incomes are spend on real resources. 2. The value of output equal total spending on goods and services. Why? -We assume that all goods and services are sold. 3. The value of output must equal the value household income. Why? -We always regard the ownership of a business or factors of production is by households.

Note that since profits are residually defined as the value of output sales minus the direct cost of land, labour and capital and since profits accrue to households who own the business It follows that household incomes derived from either supplying labour, land and capital or entitlements to firms, profits must exactly equal the value of production.

Our model is very simple up to this point. In what follows, we ask the questions; What happens if firms do not sell all their output? What happens if firms sell output not to HH but the other firms? What happens if HH do not spend all their incomes? Even after taking into account all these possibilities, we shall see that our conclusions remain unchanged, i.e the level of economic activity can be measured by valuing total spending, total output or total earnings and all three methods give the same answer.

National Income Accounting
Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country in a given period of time. It measures the value of output produced within the economy. Assume the following; No government Closed economy (a country with no external links with the rest of the world) Firms hire labour from households Firms buy raw materials and machinery from other firms Note that GDP can also be quarterly and half year

Based on the discussions, we observe that we can perform national income accounting in three ways: Value Added: value added is the increase in the value of goods as a result of the production process. It is calculated by deducting from the value of the firms’ output the cost of the input goods that were used up in the act of producing that output.

When calculating GDP using the value added method, you have to make a distinction between intermediate goods and final goods. Intermediate goods are partly finished goods which form inputs to another firm’s production process and are used up in that process. Final goods are goods purchased by the ultimate user. They are either consumer goods by households or capital goods such as machinery which are purchased by firms.

Example: Consider the following example to calculate GDP using the value added approach for a simple economy … Assume four firms in the economy: A steel producer A machine producer A tyre producer A car producer who sells to households

Narrative Suppose the steel producer makes 4000 worth of steel, sells 1000 to machine producer and 3000 to car producer. Assuming also the steel producer mines the iron ore from which steel is produced, then the entire 4000 is value added. The firm pays revenue directly or indirectly in wages and rents and the residual profits also accrue to household as income. Assuming the tyre manufacturer also owns the rubber trees from which tyres are made

Good (1) Seller (2) Buyer (3) Transaction value (4) Steel Steel Producer Machine Producer 1000 Car Producer 3000 Machine 2000 Tyres Tyre producer 500 Cars consumers 5000 Total value of transactions 11500 Using the information in the table above, calculate GDP using the value added, expenditure and income approaches

Good (1) Seller (2) Buyer (3) Transaction value (4) Value added (5) Exp on final goods (6) Factor earnings (7) Steel Steel Producer Machine Producer 1000 ----- Car Producer 3000 Machine 2000 Tyres Tyre producer 500 Cars consumers 5000 1500 Total value of transactions 11500 7000

Narrative Note that although two firms, steel and car producer, have bought steel, it does not show up in the final goods. Why? Steel is entirely an intermediate good Machine maker spends 1000 to buy steel produced machine sold to the car maker at 2000, value added is 1000 which accrues directly or indirectly to the household. Since the car producer intends to keep the machine, its full value of 2000 is shown under final expenditure.

Narrative Tyre producer produces an intermediate good which does not show under final expenditure. Since the tyre manufacturer also owns the rubber trees from which tyres are made, the entire 500 is value added and contributes directly or indirectly to household incomes.

Narrative Car producer spends 3000 on steel and 500 on tyres.
Thus, 1500 is the value added of the car producer. The net revenue pays households for factor services supplied or is paid to them as profits. Car producer sells car for 5000 to final consumer. The car is now final good and its full value of 5000 appears as final expenditure.

Narrative The table shows gross value of all transactions is but this overstates the value of the goods the economy has actually produced. For example, the 3000 that the steel producer earned by selling steel to the car producer is already included in the final value of car output. Thus double counting of 3000

Narrative Column 5 shows value added equal to 7000 and is correct way of measuring net output of the economy. Since each producer pays out corresponding net revenue to HH as direct factor payments or indirectly as profits, HH earnings also equal 7000.

We get the same answer if we measure spending on final goods and services. Final users are households buying the cars and the car producer buying (everlasting) machinery In the example, total output and household incomes are 7000 each, but households only spent 5000 on cars What do they do with the rest of their incomes? And who does the rest of the spending?

National Income Accounting: Investment and Saving
This is the purchase of new capital goods by firms Saving This is the part of income which is not spent on buying of goods and services

Saving Investment 2000 2000 HOUSEHOLDS Goods and services FIRMS
Spending on goods and services 5000 Saving 2000 Investment 2000 Goods and services Services of productive factors Factor incomes 7000

Investment and Saving Investment is referred as an injection because money flows to firms without being recycled through households From the example, investment was 2000 Saving is referred to as a leakage because money is no longer recycled from households to firms From the example, saving was also 2000 Two questions immediately arise: Is it coincidental that household savings of 2000 exactly equal investment expenditure of same amount by firms? If not, how is the money saved by households transferred to firms to allow them pay for investment spending?

Note that the type of saving and investment are known as actual saving and actual investment This means that the two variables are different from desired saving and desired investment If firms cannot sell their produce then they will have inventories or stocks which are considered as working capital

To sum it up in a diagram: C + I I C S Households Firms Animation sequence for the circular flow with no government and no foreign sector/international trade.: 1 begin with two sets of agents, Households and Firms 2 Firms produce output 3 which flows as income to households 4 who allocate their income partly to Consumption and partly to Saving 5 Household C is augmented by firms' investment, to create total expenditure (C + I). … so we have the circular flow This is discussed in Section 19-4 of the main text. Y

National Income Accounting: Domestic Government and Foreign Sector
Government raises revenue through direct taxes on income and indirect taxes or expenditure taxes This revenue is spent on goods and services G purchased by government and on transfer payments or benefits B such as pensions, subsidies, employment benefit Note that transfer payments do not affect national income or output as they require no goods or services in return Taxes and transfers redistribute income from people being taxed towards people being subsidized Food for thought: Which of these are injections to and leakages from the circular flow of income?

To incorporate the foreign sector into the circular flow, we must recognise that residents of a country will buy goods and services (imports) from abroad and that domestic firms will sell (export) goods and services abroad. In this course, we denote imports by Z and exports by X

National Income Accounting: Market and Basic Prices

Y C+ I + G+NX I+X C S Households Firms Government C + I + G+NX - Te Te G B - Td Y + B - Td Z No build-up this time, the whole Figure will spiral in to cue, adding the government and foreign sectors into the circular flow.

GDP and GNP

GDP and GNP Hence we write GNP = GDP + Factor Payments From Abroad − Factor Payments to Abroad. We summarize this in a diagram where we begin on the left with GNP or GNI at market prices The second column is the expenditure measure of GNP and the third column takes us from GNP to GDP The fourth column differentiates between gross and net output The fifth column shows the role of indirect taxes to measure GDP at basic prices The last column shows the net incomes that accrue to factor inputs used in production GDP is the most common measure of economic activity worldwide so we discuss further variants of it next

National Income Accounting: A summary
NPI NPI GNP (GNI) at market prices Depreciation G GDP at market prices NNP at market prices Indirect taxes I National Income (NI) =NNP at basic prices Profits, rents NX Income from self- employment C Wages and salaries

National Income Accounting: Example
The data in the table are official statistics for UK in 2008 in billion of pounds: Item Amount Personal consumption 891 Government purchases 350 Investment 245 Net exports -40 Net property income from abroad 25 Depreciation 15 Indirect taxes 164

National Income Accounting: Example
Calculate the following: GDP at market and basic prices GNP at market and basic prices Net National Product or National Income at basic and market prices

National Income Accounting: Real Versus Nominal GDP
GDP measures the total spending on goods and services in all markets in the economy If total spending rises from one year to the next, one of two things must be true: the economy is producing a larger output of goods and services goods and services are being sold at higher prices When studying changes in the economy over time, economists want to separate these two effects

They want a measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services Hence economists use a measure called real GDP Nominal GDP is the production of goods and services valued at current prices Real GDP is the production of goods and services valued at constant prices

By evaluating current production using prices that are fixed at past levels, real GDP shows how the economy’s overall production of goods and services changes over time Thus economists use real GDP which answers a hypothetical question: What would be the value of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past?

National Income Accounting: GDP Deflator

Example: The table shows some data for an economy that produces only two goods, hot dogs and hamburgers. It also shows the quantities of the two goods produced and their prices in the years 2001, 2002, and 2003.

Calculate nominal GDP for each year Calculate real GDP taking 2001 as the base year Calculate the GDP deflator

National Income Accounting: GDP and Economic Wellbeing
GDP was called the best single measure of the economic wellbeing of a society earlier GDP measures the economy’s total output, total income and total expenditure on goods and services Yet some people dispute the validity of GDP as a measure of economic well-being Using per capita real GDP which is real GDP divided by the total population is one attempt to protect GDP as a measure of wellbeing For policymakers concerned about living standards, GDP per person is more important, because it tells quantity of goods and services available for the typical individual in the economy

National Income Accounting: GDP and Economic Wellbeing
Thus, GDP per person tells us the output, income and expenditure of the average person in the economy Because most people would prefer to receive higher income and enjoy higher expenditure, GDP per person seems a natural measure of the economic well-being of the average individual Looking forward to learning from you why GDP as a measure of economic wellbeing has come under serious scrutiny in an assignment to be handed out soon

National Income Accounting: Measuring the Cost of Living
To compare the salary of Mr. Phiri in 1970 or Mr. Banda’s salary of ZMW 8,000 today, we need to find some way of turning kwacha figures into meaningful measures of purchasing power That is exactly the job of a statistic called the consumer price index (CPI) CPI is a measure of the overall cost of the goods and services bought by a typical consumer Each month the Central Statistical Office, which is part of the MoFNP, computes and reports the consumer price index We will consider how this index compares to the GDP deflator which we examined in earlier

There are five steps that are followed: Fix the Basket to determine which prices are most important to the typical consumer Find the Prices of each of the goods and services in the basket for each point in time Compute the Basket’s Cost of the basket of goods and services at different times using the data on prices Choose a Base Year and Compute the Index by designating one year as the base year, which is the benchmark against which other years are compared

To calculate the index, the price of the basket of goods and services in each year is divided by the price of the basket in the base year, and this ratio is then multiplied by 100 Example: Mr. Tembo collects prices of the two most important goods hot dogs and hamburgers fixing the quantities as in the table:

Taking 2001 as the base year, calculate the consumer price index in each year and interpret it inflation rate for 2002 and 2003

Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising Usually, these two statistics tell a similar story, yet there are two important differences that can cause them to diverge The GDP deflator reflects the prices of all goods and services produced domestically, whereas the CPI reflects the prices of all goods and services bought by consumers e.g purchase of a plane The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year while 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

ECF 110 Introduction to Macroeconomics

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