1. CHAPTER 2 THE DATA OF MACROECONOMICS ECN 2003 MACROECONOMICS 1 Assoc. Prof. Yeşim Kuştepeli

2. This chapter focuses on the three economic statistics that economists and policymakers use most often. Gross domestic product or GDP tells us the nation’s total income and the total expenditure on its output of goods and services. The consumer price index, CPI, measures the level of prices. The unemployment tells us the fraction of workers who are unemployed.

3. Measuring the Value of Economic Activity: Gross Domestic Product Assoc. Prof. Yeşim Kuştepeli GDP is considered the best measure of how well the economy is performing. The goal of GDP is to summarize in a single number of dollar value of economic activity in a given period of time. There are two ways to view this statistic. One way to view GDP is as the total income of everyone in the economy. Another way is as the total expenditure on the economy’s output of goods and services. Economy as a whole income must equal expenditure. Because every transaction has both a buyer and seller, every dollar of expenditure by a buyer must become a dollar of income to a seller.

4. Income, Expenditure, and the Circular Flow Assoc. Prof. Yeşim Kuştepeli Imagine an economy that produces a single good, bread, from a single input, labor. Figure 1 illustrates all the economic transactions that occur between households and firms in this economy. The inner loop in Figure 1 represents the flow of bread and labor. The households sell their labor to the firms. The firms use the labor of their workers to produce bread, which the firms in turn sell to the households. Hence, labor flows from households to firms, and bread flows from firms to households.

5. Assoc. Prof. Yeşim Kuştepeli The outer loop in Figure 1 represents the corresponding flow of dollars. The households buy bread from the firms (who themselves are part of the household sector). Hence, expenditure on bread flows from households to firms, and income in the form of wages and profit flows from firms to households. GDP measures the flow of dollars in this economy. GDP is the total income from the production of bread which equals the sum of wages and profit, the top half of the circular flow of dollars. GDP is also the total expenditure on purchases of bread, the bottom half of the circular flow of dollars.

6. Assoc. Prof. Yeşim Kuştepeli A stock: is a quantity measured at a given point in time, whereas a flow is a quantity measured per unit of time. GDP is probably the most important flow variable in economics: it tells us how many dollars are flowing around the economy’s circular flow per unit of time.

7. Some Rules for Computing GDP Assoc. Prof. Yeşim Kuştepeli Adding Apples and Oranges GDP combines the value of these goods and services into a single measure. To compute the total value of different goods and services, the national income accounts use market prices because these prices reflect how much people are willing to pay for a good or service. Thus, if apples cost $0,5 each and oranges cost $1 each, GDP would be; GDP= (price of apples x quantity of apples) + ( price of oranges x quantity of oranges) = ($0,5 x 4) + ($1 x 3) = $5

8. Assoc. Prof. Yeşim Kuştepeli Used Goods GDP measures the value of currently produced goods and services. Thus, the sale of used goods is not included as a part of GDP. The treatment of inventories When a firm increases its inventory of goods, this investment in inventory is counted as expenditure by the firms owners and added in GDP. A sale of inventory however is a combination of positive spending (the purchase) and negative spending (inventory disinvestment) so it does not influence GDP.

9. Assoc. Prof. Yeşim Kuştepeli Intermediate Goods and Value Added GDP includes only the value of final goods. The reason is that the value of intermediate goods is already included as a part of the market price of final goods in which they are used. To add the intermediate goods to the final goods would be double counting that is the meat would be counted twice. Hence GDP is the total value of final goods and services produced. One way to compute the value of all final goods and services is to sum the value added at each stage of production. The value added of a firm equals the value of the firm’s output less the value of the intermediate goods that the firm purchases.

10. Assoc. Prof. Yeşim Kuştepeli Housing services and other imputations Some goods are not sold in the market place and therefore do not have market prices. We must use an estimator of their value. Such an estimate is called an imputed value. GDP also includes the rent that homeowners pay to themselves. Imputation also used for valuing the government services. No imputation is made for the value of goods and services sold in the underground economy.

11. Real GDP versus Nominal GDP Assoc. Prof. Yeşim Kuştepeli Consider once again the economy that produces only apples and oranges. In this economy GDP is the sum of the value of all the apples and value of oranges produced. That is; GDP= (price of apples x quantity of apples) + ( price of oranges x quantity of oranges) If all prices doubled without any change in quantities, GDP would double. Yet it would be misleading to say that the economy’s ability to satisfy demands had doubled, because the quantity of every good produced remains the same. Economists call the value of goods and services measured at current prices nominal GDP.

12. Assoc. Prof. Yeşim Kuştepeli A better measure of economic well-being would tally the economy’s output of goods and services and would not be influenced by the changes in prices. Economists use real GDP which is the value goods and services measured using a constant set of prices. Real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not. We could begin by choosing a set of prices, called base-year prices, such as the price that prevailed in 1998. Goods and services are then added up using these base-year prices to value the different goods in both years. Real GDP for 1998 would be :

13. Assoc. Prof. Yeşim Kuştepeli Real GDP= (1998 price of apples x 1998 quantity of apples) + (1998 price of oranges x 1998 quantity of oranges) Real GDP in 2000 would be; Real GDP= (1998 price of apples x 2000 quantity of apples) + (1998 price of oranges x 2000 quantity of oranges) Because the prices are held constant, real GDP varies from year to year only if the quantities produced vary. Real GDP provides a better measure of economic well-being than nominal GDP.

14. The GDP Deflator Assoc. Prof. Yeşim Kuştepeli The GDP deflator also called the implicit price deflator for GDP. GDP Deflator= Nominal GDP / Real GDP The GDP deflator reflects what’s happening to the overall level of prices in the economy. Nominal GDP = Real GDP x GDP deflator Nominal GDP measures the current dollar value of the output in the economy. Real GDP measures output valued at constant prices. The GDP deflator measures the price of output relative to its price in the base year.

15. The Components of Expenditure Assoc. Prof. Yeşim Kuştepeli The national income accounts divide GDP into four broad categories of spending. Consumption (C) Investment (I) Government purchases (G) Net exports (NX) Y = C+ I +G + NX This equation is an identity- en equation that must hold because of the way the variables are defined. It is called the national income accounts identity.

16. Assoc. Prof. Yeşim Kuştepeli Consumption: goods and services bought by households. nondurable goods, durable goods and services. Investment: goods bought for future use. business fixed investment, residential fixed investment and inventory investment. Government Purchases: goods and services bought by federal, state and local governments. military equipment, highways, and the services that government workers provide. It does not include transfer payments to individuals, such as Social Security and welfare. Net Exports: Net exports are the value of goods and services exported minus the value of goods and services imported.

17. Other Measures of Income Assoc. Prof. Yeşim Kuştepeli GNP = GDP + Factor payments from abroad – Factor payments to abroad Whereas GDP measures the total income produced domestically, GNP measures the total income earned by nationals. (residents of a nation) Net National Product=NNP= GNP – Depreciation Depreciation is called the consumption of fixed capital. Because the depreciation is a cost of producing the output in the economy, subtracting depreciation shows the net result of economic activity.

18. Assoc. Prof. Yeşim Kuştepeli National Income= NNP – Indirect Business Taxes Sales tax is an example of indirect business taxes. Compensation of employees: wages and earnings of workers Proprietor’s income: The income of non-corporate business. Rental Income: The income that landlords receive including the imputed rents. Corporate Profits: The income of corporations after payments to their workers and creditors. Net Interest: The interest domestic business pay minus the interest they receive, plus interest earned from foreigners.

19. Assoc. Prof. Yeşim Kuştepeli Personal Income = National income -Corporate profits -Social insurance contributions -Net interest + Dividends + Government transfer to individuals + Personal Interest Income Disposable Income = Personal income– Personal Tax and Nontax payments

20. Measuring the cost of living: The consumer price index Assoc. Prof. Yeşim Kuştepeli The commonly used measure of the level of prices is the consumer price index. (CPI) The CPI turns the prices of many goods and services into a single index measuring the overall prices. The CPI is the price of the basket of goods and services relative to the price of the same basket in some base year. CPI = (5 x Current Price of apples) + (2 x Current price of oranges) / (5 x 1992 prices of apples) + (2 x 1992 price of oranges) In this CPI, 1992 is the base year. The index tells us how much it costs now to buy 5 apples and 2 oranges relative to how much it cost to buy the same basket of fruit in 1992. Another index is the producer price index, which measures the price of a typical basket of goods bought by firms rather than consumers.

21. The CPI versus the GDP Deflator Assoc. Prof. Yeşim Kuştepeli The GDP deflator and the CPI give somewhat different information about what’s happening to the overall level of prices in the economy. There three key differences between the two measures. 1) GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI.

22. Assoc. Prof. Yeşim Kuştepeli 2)GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. 3) The CPI assigns fixed weights to prices of different goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes.

23. Assoc. Prof. Yeşim Kuştepeli Economists called a price index with a fixed basket of goods a Laspeyres index and a price index with a changing basket a Paasche index. When prices of different goods are changing by different amounts, a Lasperyres (fixed basket) index tends to overstate the increase in the cost of living because it does not take into account that consumers substitute less expensive goods for more expensive ones. Paasche (changing basket) index tends to understate the increase in cost of living. While it accounts for the substitution of alternative goods, it does not reflect the reduction in consumers’ welfare from such substitutions. The difference between the GDP deflator and the CPI is usually not large in practice.

24. Measuring Joblessness: The unemployment Rate Assoc. Prof. Yeşim Kuştepeli A person is employed if he or she spent most of the previous week working at a paid job, as opposed to keeping house, going to school, or doing something else. A person is unemployed if he or she is not employed and is waiting for the start date of a new job, is temporarily layoff, or has been looking for a new job. A person who fits into neither of the first two categories, such as student or retiree, is not in the labor force. A person who wants a job but has given up looking­­– a discouraged worker– is counted as not being in the labor force.

25. Assoc. Prof. Yeşim Kuştepeli The labor force is defined as the sum of the employed and unemployed, and the unemployment rate is defined as the percentage of the labor force that is unemployed. That is Labor Force = Number of employed + number of unemployed Unemployment Rate = (Number of unemployed / Labor force) x 100 A related statistics is the labor force participation rate, the percentage of the adult population that is in the labor force: Labor Force participation rate = (Labor force / Adult population) x 100

26. Unemployment, GDP, and the Okun’s Law Assoc. Prof. Yeşim Kuştepeli The negative relationship between unemployment and GDP is called Okun’s Law, after Arthur Okun, the economist who first studied it. For every percentage point the unemployment rate rises, real GDP growth typically falls by 2 percent. Let’s assume the real GDP grows by 3 %due to population growth, capital accumulation and technological progress. In addition let’s think that unemployment rises from 6% to 8%. Percentage Change in real GDP = 3% – 2 x ( %8– %6) = -1% In this case, Okun’s law says that GDP would fall by 1 percent, indicating that the economy is in a recession.