MACRO I February 21nd, 2014 Class1. The Gross Domestic Product Lecturer: Renata Ivanova Classes: Friday, 12:00-15:00, room S6 Consultation: Fridays (after the class) or by appointment Course page: http://is.muni.cz/el/1456/jaro2014/BPE_MAC1/ Textbook: Mankiw, N. G. (2012). Principles of Macroeconomics (any edition) Course Info • Class is a laptop and cell phones free zone • Late arrivals will not be tolerated • Active participation is encouraged *** Assignments ü Four homework assignments ü Term project *** Grading Final grade (100 %) = Midterm (20 %) +HW (20 %) + +Term Paper (15 %) + Final (40 %) + Class Participation (5 %) Class Policies Macroeconomic goals •Economic growth (increase in output) •Price-level stability (low inflation) •Full employment (low unemployment rate) •External balance (avoiding trade deficit) • Policy tools •Monetary policy: interest rate and money supply •Fiscal policy: taxes and government spending Introduction What determines the level of economy’s output ? Short run: several years •Changes in demand The IS-LM model (goods + financial markets) Medium run: a decade •Supply of factors •Aggregate supply- Aggregate demand model (AD-AS) Long run: several decades/ half a century and more •Technological progress and factors’ accumulation Time Dimension Year GDP (mil CZK) 1990 632,691 1991 815,579 1992 925,476 1993 1,144,645 1994 1,323,328 1995 1,533,676 1996 1,761,575 1997 1,884,924 1998 2,061,583 1999 2,149,023 2000 2,269,695 2001 2,448,557 2002 2,567,530 2003 2,688,107 2004 2,929,172 2005 3,116,056 2006 3,352,599 2007 3,662,573 2008 3,848,411 2009 3,758,979 2010 3,799,547 2011 3,841,370 2012 3,845,926 N!B! Million = 1,000,000 Billion = 1,000,000,000 Trillion= 1,000,000,000,000 In 2012, GDP of Czech Republic ($): 3,845,926/19.58 = $196,4 billion Source: Czech Statistical Office (CSU) • Size of the economy Czech Republic Gross Domestic Product (in current prices) Source: IMF statistics database Czech Republic: 51st place How big is the Czech economy? § Production approach GDP is a market value of all final goods and services produced within an economy in a given period of time. • GDP is a measure of output • Is a single number expressed in monetary units Why do we care? Output is correlated with many important variables: standards of living, wages, unemployment, inflation, budget and trade deficit. Gross Domestic Product (GDP) TE The US economy output in 2012: 2 airplanes + 5 hamburgers GDP is a market value of all final goods and services produced within an economy in a given period of time Market value = Market price Goods Quantity (Q) Unit Price (P) Airplanes 2 $1,000,000 Hamburgers 5 $1 Adding Apples to Oranges TE McDonald’s hamburger costs $1 Ingredients used for production (meat, veg., bread) cost $0.5 per hamburger Contribution to GDP: $1 or $1+$0.5 ? GDP is a market value of all final goods and services produced within an economy in a given period of time Final good/service: consumed by the end user and does not require further processing Intermediate goods: used as inputs for production of other goods N!B! Some goods can be both final and intermediate To GDP will be included only $1 (price of a hamburger) The value of intermediate goods is included in the market price of a final good Multiple Counts • Gross value added = Production – Intermediate consumption • Increase in value that a business creates by undertaking the production process. Producer Price of output Price of inputs Value added McDonalds $1 $0.5 $ 0.5 Farmer $ 0.5 $0 $ 0.5 Total $1.5 $ 0.5 $1 GDP is the sum of value added in the economy during a given period Contribution to GDP • Firms pay taxes on the value added of their activities (VAT) • Firms report sales Value Added • You are buying a Rembrandt’ s painting from another collector at the price of 1,000,000 Euros • You are buying stuff at your neighbor’s garage sale for 20 CZK What is the contribution to GDP? GDP is a market value of all final goods and services produced within an economy in a given period of time GDP includes only the value of currently produced goods and services • Resale of goods represents a transfer of an asset None Used Goods TE Czech Beer Factory operating in Slovakia GDP is a market value of all final goods and services produced within an economy in a given period of time • within a country’s boarder • Output of Volkswagen operating in CR is counted in Czech GDP Gross national product (GNP) is a market value of all final goods and services produced in a given period of time using factors of production owned by the residents of a country GDP vs. GNP (Output vs. Location) Does not account for • Goods and services not sold in the market (home production, child care) • Underground economy: legal activities hidden from government and illegal activities • Imputed values Assumption: The level of inaccuracy in GDP calculations is roughly constant from year to year => Inaccuracy can be neglected GDP Accuracy Fundamental identity Total production = Total income = Total expenditure 2. Income method Def III: GDP is a nation’s total income 3. Expenditure method GDP is the total expenditure on national output of goods and service GDP: Three Equivalent Approaches Firms Households Labor THE CIRCULAR FLOW MODEL OF MARKET ECONOMY Bicycles Expenditure ($) Income ($) The rule of accounting: Expenditure of buyers = Income of sellers Assumptions • A closed economy (no international trade) • No government • No savings • Injections • Government spending (G) • Exports (EX) • Investments (I) • Leakages • Taxation (T) • Imports (IM) • Savings (S) The Circular Flow Model GDP: Expenditure Approach • Group I: Households • Group II: Businesses • Group III: Government • Group IV: Foreign sector GDP: Expenditure Approach (Cont.) § The National Income Account Identity for an open economy § § § § § § § § § § § § § § § Y – total output (production) GDP of Czech Republic: Expenditure Approach Source: Czech Statistical Office. Ministry of development planning and statistics Expenditure category Czech Republic ? Consumption 71.1% 26.9% Investment 23.3% 35.3% Net export 5.6% 37.8% GDP 100% 100% TE Consider an economy consisting of two firms Firm 1: Steel producer Revenues from sale: €100 Wages: €80 Profit: €20 What is the GDP? Firm 2: Car manufacturer Revenues from sale cars: €200 Wages: €70 Profit: €30 Production approach: €200 Income approach: €80+ €20 + €70+ €30 = €200 Expenditure approach: €200 Value added approach: €100+ (€200- €100) = €200 GDP: Three Equivalent Approaches (Cont.) • Goods produced in a certain period but not sold • TE A farm fails to sell milk and the milk spoils Is GDP affected? • Spoiled milk is not sold – no effect on consumer expenditure • The farm does not obtain addition revenue • The farm’s revenue after subtracting wages shrinks => Neither total expenditure, nor total income are affected TE The milk is put into inventory to be sold latter Is GDP affected? • The farm “purchases” milk for its inventory – total expenditures are affected • The farm gets additional revenue => additional profit => income is affected • Later sale out of inventory is treated as a sale of used goods NO NO Treatment of Inventories § Housing services • Home owners pay a “rent” to themselves • Included in homeowner expenditures and income Imputed rent: how much it would cost to rent out the owner’s dwelling unit In the case of no imputations, what effect would the increase in house ownership have on GDP? § Government services (Police officers, politician, etc.) • Wages are used as a value of service Services and Imputations GDP would decline üGDP is a measure of aggregate output üApproaching from production or income side ü Aggregate production = Aggregate income = Aggregate expenditure THREE EQUIVALENT APPROACHES üGDP as the total expenditure on final goods output üGDP as a sum of value added üGDP as a sum of income • In a given period of time • In a particular economy Summary . • A purchase of tires by an automobile manufacturer for the installation on a new line of cars Which of the following will be counted in GDP? • A purchase of the “Principles of Economics” textbook for our course. After the course, you sell your text book to a friend who will take the course next semester. • The value of the teaching service provided by a lecturer to students • Your haircut made by a friend • A purchase of aprons by restaurant chefs • A house constructed in 1950 and sold in 2012 • Sale of the last year fashion collection by ZARA What are the reasons for such increase in GDP? • Comparison Over Time Nominal values: expressed in current prices Nominal GDP in 2011-2012 => Changes in quantity produced or/and prices of goods Real values: expressed in constant prices The base year approach: Fixing prices by choosing a base year (2011) N!B! Nominal GDP = Real GDP in the base year Real GDP Year Nominal GDP Real GDP 2000 2,269,695.00 2,550,148.00 2001 2,448,557.00 2,629,135.00 2002 2,567,530.00 2,685,643.00 2003 2,688,107.00 2,786,789.00 2004 2,929,172.00 2,918,955.00 2005 3,116,056.00 3,116,056.00 2006 3,352,599.00 3,334,815.00 2007 3,662,573.00 3,526,071.00 2008 3,848,411.00 3,635,344.00 2009 3,758,979.00 3,471,494.00 2010 3,790,880.00 3,557,216.00 2011 3,823,401.00 3,621,908.00 2012 3,845,926.00 3,584,924.00 GDP of Czech Republic What is the base year? TE Consider again the pizza-producing economy • Real GDP (100=2005): Real GDP in 2005 prices N!B! Change in the base year will lead to different levels of real GDP Year Q P ($) Nominal GDP Real GDP (100=2005) Real GDP (100=2000) 2000 10 5 2005 10 8 2012 15 10 50 80 150 80 80 120 50 50 75 Real GDP (Cont.) • Percentage change in the quantity of goods produced from year to year • Growth rate Year Q P ($) Nominal GDP Growth rate (%) 2010 10 5 50 -- 2011 10 8 80 60 2012 15 10 150 87.5 GDP Growth Rate • Nominal GDP growth rates reflect changes in both Q & P Year Q P Nominal GDP Growth rate (%) Real GDP (100=2005) Growth rate (%) 2010 10 5 50 -- 80 -- 2011 10 8 80 60 80 0 2012 15 10 150 87.5 120 50 Will the real GDP growth rates be affected by the change in the base year? GDP Growth Rate (Cont.) NO GDP Growth Rate (Cont.) Pizza Haircuts Nominal GDP ($) Year Q P ($) Q P($) 2011 10 5 5 3 65 2012 15 10 10 5 200 TE Multiple goods TE Real GDP TE Real GDP growth rate Real GDP: The Chain-Weighted Approach • The value of output expressed in base year (constant) prices • Þ Any changes in real GDP are due to changes in quantity of the output only § Issues with the base year approach •The GDP growth rate is affected by the choice of the base year What year to be used as the base year? •In practice, the base year is changed every 5 years and GDP is recalculated What are the consequences? => Economic performance is different C-W approach updates prices every year => more accurate Real GDP: The Chain-Weighted Approach (Cont.) Three steps procedure Calculating change in real GDP between year t and year t+1 Step 1. • Use year t as a base year => Real GDP => growth rate • Use year t+1 as a base year => Real GDP => growth rate Step 2. Calculate the average of two growth rates => Chain-weighted real GDP growth rate Real GDP: The Chain-Weighted Approach (Cont.) Step 3. Construct the real GDP index • Chose an arbitrary base year: 2011 • Nominal GDP in the base year is equal to real GDP • Chain-weighted real GDP in the following year • • • N!B! For the years before the base year Chain to the base year: in order to calculate next year real GDP, we need to know the previous year figure GDP as a Measure of Well-Being (Cont.) Source: Mankiw , G. (2011). Principles of Economics N!B! GDP is correlated with a well-being indicators, but is an imperfect measure of the well-being itself Happiness index Income per capita (USD) Next class: Economic Growth N!B! Reading Assignment: Textbook + Handout