1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-1 CHAPTER 2 Measuring the Macroeconomy

2. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-2 Questions What key data do macroeconomists look at? How are key macroeconomic data estimated and calculated? What is the difference between “nominal” and “real” values? How are stock market values related to interest rates?

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-3 Questions How are interest rates related to the price level and the inflation rate? How is unemployment related to total production? What is right--and what is wrong-- with the key measure of economic activity, real GDP?

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-4 The Importance of Data Economists use quantitative data to examine and understand behavior –prices –quantities –values Data can be used in two ways –make quantitative forecasts –test economic theories

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-5 Most Important Macroeconomic Data real GDP the unemployment rate the inflation rate the interest rate the level of the stock market the exchange rate

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-6 Table 2.1 - The Six Key Economic Variables

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-7 The Exchange Rate The nominal exchange rate is the relative price of two different currencies –determined in the foreign exchange market Example –€1.00 equals $1.20 –$1.00 equals €0.83

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-8 The Exchange Rate Domestic exporters earn foreign currency when they export products –need to trade the foreign currency for dollars Foreign producers earn dollars when U.S. residents import their products –need to trade the dollars for foreign currency

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-9 Figure 2.1 - The Market for Foreign Exchange

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-10 The Exchange Rate The real exchange rate is the nominal exchange rate adjusted for changes in the value of the currency –depends on the nominal exchange rate and the price level

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-11 The Exchange Rate Example 1 –nominal exchange rate changes from $1.20 = €1.00 to $2.40 = €1.00 –price level doubles –real exchange rate is unchanged Example 2 –nominal exchange rate remains at the same level ($1.20 = €1.00) –price level doubles –real exchange rate falls by half

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-12 The Exchange Rate Example 3 –nominal exchange rate increases from $1.20 = €1.00 to $2.30 = €1.00 –price level remains the same –real exchange rate doubles

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-13 The Exchange Rate To calculate the real exchange rate (), you need three pieces of information –price level in the home country (P) –price level abroad (P*) –nominal exchange rate (e)

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-14 The Exchange Rate There are many different currencies in the world –many different exchange rates Economists construct an exchange rate index to represent “the” exchange rate –each country receives a weight equal to its share of total U.S. trade

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-15 The Exchange Rate The exchange rate index is by averaging each country’s current exchange rate relative to its exchange rate in the base year (1992)

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-16 Figure 2.2 - The Exchange Rate Index, 1992-1998

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-17 The Stock Market The most representative index of the U.S. stock market is the Standard and Poor’s Composite Index (S&P 500) The most commonly discussed index of the U.S. stock market is the Dow- Jones Industrial Average

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-18 The Stock Market Stock market averages are in nominal terms –must divide by some measure of the price level to get the real value of the stock market The real value of the stock market is a sensitive indicator of the relative optimism or pessimism of investors –can forecast future investment spending

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-19 The Stock Market Investors face a choice between holding stocks and holding bonds –stocks are shares of ownership of a corporation entitles you to a portion of the company’s profits –bonds are debts that the corporation owes you pays periodic interest payments and returns principal to you at maturity

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-20 The Stock Market Rates of return –for bonds, the rate of return is the interest rate (r) –for stocks, the rate of return is the ratio of earnings per share (E s ) to the price paid (P s ) Stocks are risky –investors may require a risk premium ( s )

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-21 The Stock Market Investors will hold only stocks if Investors will hold only bonds if

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-22 The Stock Market Investors will hold both stocks and bonds if This means that the value of a stock is equal to

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-23 The Stock Market How can we measure E s ? –newspaper reports what the firm’s accountants have calculated (E a ) –investors are interested in some long-run average of expected future earnings (E s ) –need an estimate of the relationship between E a and E s

24. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-24 Figure 2.3 - Calculating the Value of a Basket of Stocks

25. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-25 The Stock Market provides information on –the current level of profits (earnings) –whether investors are optimistic or pessimistic –the current cost of capital –attitudes toward risk

26. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-26 The Interest Rate is the price at which purchasing power can be shifted from the future into the present is not a single lump sum, but an ongoing stream of payments made over time –is a flow variable

27. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-27 The Interest Rate There is a large number of different interest rates that vary by –risk –duration –tax treatment Published interest rates are nominal interest rates

28. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-28 Figure 2.4 - The Real versus the Nominal Interest Rate

29. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-29 The Price Level is most frequently measured by the Consumer Price Index (CPI) which –is calculated monthly by the Bureau of Labor Statistics –is an expenditure-weighted index

30. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-30 Table 2.5 - Calculating a Price Index for Fruit: An Example

31. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-31 The Consumer Price Index Price index formula

32. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-32 The Consumer Price Index In the base year, the price index will equal 100

33. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-33 The Consumer Price Index In the subsequent year, the price index will equal 138

34. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-34 Kinds of Index Numbers Laspeyres index –uses relative expenditure levels in a fixed base year as weights –example: Consumer Price Index Paasche index –uses current, variable expenditure levels as weights –example: GDP deflator

35. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-35 Kinds of Index Numbers All price indices are imperfect –the Laspeyres index overstates the effects of price increases based on a fixed market basket does not take into account that consumers substitute relatively cheaper goods for relatively more expensive goods when prices rise (substitution bias)

36. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-36 Kinds of Index Numbers All price indices are imperfect –the Paasche index understates the effects of price increases does take account of substitution does not take into account the fact that substituted items are less-valued than the items they replace

37. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-37 The Inflation Rate is a measure of the rate of change in the price level over time –is a flow variable can be measured using different price indices –Consumer Price Index (CPI) –GDP deflator

38. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-38 Figure 2.5 - Different Measures of U.S. Inflation, 1960-2000

39. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-39 The Unemployment Rate is the fraction of people who –want a job –are looking for a job –cannot find a job is calculated using the Current Population Survey –monthly survey by the Bureau of Labor Statistics

40. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-40 The Unemployment Rate Individuals are classified into one of four categories –those who are employed –those who are out of the labor force and do not want a job currently –those who do want a job currently, but have given up looking for one –those who do want a job and are currently looking for one

41. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-41 The Unemployment Rate

42. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-42 Figure 2.6 - The U.S. Unemployment Rate since 1950

43. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-43 The Unemployment Rate is a stock variable may underestimate the real experience of unemployment –discouraged workers –workers who are part-time for economic reasons vary by demographic group

44. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-44 Figure 2.7 - U.S. Unemployment Rates by Demographic Group, 1960-2000

45. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-45 Okun’s Law describes the relationship between unemployment and output in the U.S. implies that a 1 percentage-point fall in unemployment is associated with an extra 2.5 percentage points of growth in real GDP

46. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-46 Figure 2.8 - Okun’s Law

47. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-47 Real GDP is calculated by adding up the value of all final goods and services produced in the economy –is a flow variable includes final goods and services purchased by –consumers –firms –the government

48. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-48 Nominal versus Real GDP Nominal GDP measures current output using current-year prices –changes in nominal GDP can occur from changes in either output or prices Real GDP measures current output using prices from a base year –changes in real GDP can only occur if output changes

49. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-49 Nominal versus Real GDP Example

50. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-50 Base Year –Nominal GDP = $10.00 –Real GDP = $10.00 Current Year –Nominal GDP = $13.10 –Real GDP = $11.50 Nominal versus Real GDP

51. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-51 More on GDP Intermediate goods –are goods sold to a firm for use in further production –are excluded from GDP Changes in inventories –are counted as part of investment Imputations –are made for goods and services not sold through markets

52. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-52 Components of Real GDP (Y) Consumption (C) Investment (I) –residential structures –non-residential structures –producers’ durable equipment –changes in business inventories Government purchases (G) Net exports (NX)

53. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-53 Table 2.8 - Components of GDP, Third Quarter of 2000

54. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-54 What Is and Is Not in GDP Included in GDP (but should not be) –replacement of worn-out or obsolete capital –government purchases which could be counted as intermediate goods Not included in GDP (but should be) –household production –depletion of scarce natural resources –“bads”

55. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-55 Figure 2.9 - Labor Force Participation Rates by Gender, 1948-1996

56. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-56 Chapter Summary Because goods and services are bought and sold with prices attached, economists have a lot of quantitative data to work with The real exchange rate is the relative price at which two countries’ goods exchange for each other –calculated by adjusting the nominal exchange rate for changes in the price levels of the two countries

57. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-57 Chapter Summary The level of the stock market reflects the variables which affect investment –current profits –investors’ optimism or pessimism –the real rate of interest –attitudes toward risk The real interest rate is calculated by subtracting the inflation rate from nominal interests rates

58. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-58 Chapter Summary The most-commonly seen measure of the price level is the Consumer Price Index (CPI) –the inflation rate is the rate of change in the CPI Unemployment and output are linked through Okun’s law –a 1 percentage-point decrease in the unemployment rate leads to a 2.5 percent increase in output

59. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-59 Chapter Summary Real GDP is the most commonly-seen measure of the overall level of economic activity –calculated using prices from a base year What is and what is not included in GDP is the result of economists’ beliefs in the 1940s and 1950s about what would be possible to measure easily