CAPE UNIT 2: Macroeconomic

1. CAPE UNIT 2: Macroeconomic LECTURE 1: FUNDAMENTALS OF MACROECONOMICS & ANALYSIS OF THE MACROECONOMY Wendell Long

2. DIFFERENCES BETWEEN MICROECONOMICS & MACROECONOMICS • Microeconomics looks at the economy through a microscope - studying the behaviour of an economy's individual molecules, like firms or households / prices or quantities. An example of the implication of microeconomic theory is the examination of why bread prices fall when the price of flour falls. As such microeconomics deals with the intricate systems of relationships known as the market mechanism.  • Macroeconomics by contrast, deals with the behaviour of the economy as a whole - or with broad aggregates of economic life. It is the study of economic growth (the expansion of output over the long-run) and the business cycle. Macroeconomics focuses on inflation and unemployment, seeking to explain their causes, consequences and cures. • Therefore, macroeconomic studies attempts to outline the flow of income in the economy (see illustration 1). In contrast, microeconomics deals with the behaviour of individual markets, such as the market for Flour, tomatoes, oil…. WLong(2012)

3. MACROECONOMICS VARIABLES & MEASURES ( B GUIDER ) • Four macroeconomic variablesare central to good macroeconomic performance - those variables concerning output, employment, prices and the foreign sector. These variables can further be subdivided as follows - Balance of Payment, Growth ~ economic, Unemployment, Inflation, Deficit ~ fiscal, Exchange Rate, Rate of Interest WLong(2012)

4. Measurement: National Income Accounting • National income refers to sum value of all goods and services produced in a given country over a year. • National Income or national product is the term used to describe the total of all the output of goods and services produced in an economy over a specific period of time – usually a year. As this output is the real income of the economy for the period. Its size is of vital important to the well being of society because such things as employment and the standard of living are closely related to it. WLong(2012)

5. Three Methods of Measuring National Income, Namely: • Expenditureapproach: This method measures national product (Income) by looking at the total money value of final demand. It uses the identity: Y =C + I + G + (X - M) • Income approach: This measures national income directly by adding the compensations paid to the factor of production. These components are rents, wages and salaries, interest and profits. N.B. transfer payments such as welfare and social security are not included in any measure of national income because these payments are made without any output in return. • Output approach: This measures the value of the total flow of goods and services by breaking the information down into industrial classifications determined by the kind of industries present in the economy. When calculating GDP by this method it is important to avoid double counting. To do this only the value added by each business should be included. WLong(2012)

6. Households Income (Y) (Wages, rent, interests, profit) Firms The Circular flow of Income in an Open Economy savings Imports taxes Withdrawals (-) National Income $1 billion National Expenditure $1 billion Factor services – land, labour, capital, enterprise Consumption (C) (Money paid for g/s purchased from firms) National Output $1 billion Goods and services investments Exports government spending Injections (+) savings + taxation + imports = investment + government spending + exports or: S + T + M = I + G + X (planned withdrawals) (planned injections) WLong(2012)

7. GDP, GNP & NNP gross domestic product (GDP) • GDP at market prices is the value of the national product (net of foreign trade) in terms of money actually spent. However this is misleading as the prices of many goods includes taxes and subsidies. Therefore, in order to obtain the value of national product in terms of resources used to produce it we must make factor cost adjustments. To do this under the expenditure approach - we must subtract the taxes on expenditure and add the subsidies given to business. When this has been done we arrive at a figure known as gross domestic product at factor cost – the most common used measure of national income. WLong(2012)

8. Gross national Product (GNP) • When net property factor income from abroad is added or subtracted from GDP we get a more comprehensive measure called GNP • To obtain net property factor income from abroad we: less Income paid to foreigners, add income received from overseas. Thus this figure may either be positive or negative. WLong(2012)

9. Components of National Income • Personal Income: is the portion of National Income that is received by the household • Personal income = National Income – Retained Business – Income received by government WLong(2012)

10. Disposable Income • The income of individuals that is available for spending or savings • Disposable income = Personal income – personal income taxes + transfer payments WLong(2012)

11. Net National Product • Net National Product is a more realistic measure than GNP because it includes an allocation for capital consumption or depreciation. • Approach: in order to calculate NNP you must first calculate GDP at factor cost and GNP at factor cost, as below:  • GDPFC = GDPMP - Indirect taxes + subsidies • GNPFC = GDPFC - Income paid to foreigners + income received by overseas • Then substitute into: NNPFC = GNPFC - Depreciation WLong(2012)

12. Calculating National Income • To calculate national income (N.I.) or Net National Product at factor cost (N.N.P.FC) you will need the following three equations: • G.D.P.FC = G.D.P.MP – Indirect taxes + subsidies • G.N.P.FC = G.D.P.FC – Income to foreigners + income from overseas • N.N.P.FC = G.N.P.FC – Capital Consumption (depreciation) WLong(2012)

13. E.g.1 GDP, GNP and National Income (NNP) using the expenditure approach $ • Consumer personal expenditure (C) 1 000 • Gross private domestic investment or capital formation ( I ) 500 • Government expenditure or purchases of goods and services (G) 1 000 • Export (X) 300 • Less Imports (M) 200 • = GDP at market prices2 600 • FACTOR COST ADJUSTMENTS • Less indirect taxes 500 • Plus subsidies 200 • = GDP at factor costs 2 300 • Net property income from abroad (rent, profits interest and dividends) (300) • = GNP 2 000 • Less Capital consumption allowance (depreciation) (200) • National Income, i.e. NNP1 800 WLong(2012)

14. E.g.2 GDP using the income approach $ • Income from employment (wages and salaries) 1 000 • Income from self employment (e.g. proprietors’ income) 500 • Corporate profits 500 • Rental income (including rent for owner occupied houses) 250 • Net interest (e.g. interests on savings deposits, bonds) 50 • GDP at factor costs2 300 • Net property income from abroad (rent, profits interest and dividends) (300) • = GNP 2 000 • Less Capital consumption allowance (depreciation) (200) • National Income, i.e. NNP1 800 • ** N.B. The same adjustment as the expenditure approach (e.g.1) are made to arrive at GNP and NNP WLong(2012)

15. E.g. 3 GDP using the output approach $ • Petroleum Industry 1 300 • Agriculture 200 • Manufacturing 500 • Services 300 • GDP at factor costs2 300 • Net property income from abroad (rent, profits interest and dividends) (300) • = GNP 2 000 • Less Capital consumption allowance (depreciation) (200) • National Income, i.e. NNP1 800 • ** N.B. The same adjustment as the expenditure approach (e.g.1) are made to arrive at GNP and NNP WLong(2012)

16. National Income Measurement Issues • AVOIDANCE OF DOUBLE COUNTING • MARKET PRICES & FACTOR COSTS • REAL & NOMINAL GDP • NATIONAL INCOME & ECONOMC PERFORMANCE OVER TIME & SPACE • NATIONAL INCOME & ECONOMIC WELFARE WLong(2012)

17. AVOIDANCE OF DOUBLE COUNTING • This act constitutes the inclusion of a given figure more than once. This may take place in respect to transfer payments/transfer incomes. These transfers may be put into four categories: Government transfers e.g. unemployment benefits, welfare payments, grants… Private transfers e.g. monetary gifts from husband to wife Second hand goods Buying of shares • Secondly, double counting may also take place in respect of intermediaries. An intermediate good is a good used to make other goods e.g. flour is an intermediate good used to make a final good such as bread. To avoid double counting the value of the intermediate good should be recorded and onlythe value added to obtain the final product should be included • Finally, double counting is likely to occur with stock appreciation. Stocks are valued at price including inflation. Thus there is a danger of overstating its value. WLong(2012)

18. MARKET PRICES & FACTOR COSTS • GDP at market prices is the value of national product (net of foreign trade) in terms of money actually spent. This however is misleading, since the price of many articles includes indirect taxes and expenditure on subsidies. Therefore in order to obtain the value of the national product in terms of the resources used to produce it we must make factor cost adjustments. Thus we must subtract taxes on expenditure (indirect taxes) levied by the government and add on the amount of subsidies. When this is done we arrive at GDP at factor cost. WLong(2012)

19. REAL & NOMINAL GDP • It is important to distinguish between real and nominal measures of National Income. When we add up money values of output, spending or incomes (prices x quantities) we end up with what is called nominal values. When effects of price changes are held to a constant year (base year) we get real GDP. WLong(2012)

20. NATIONAL INCOME & ECONOMC PERFORMANCE OVER TIME & SPACE • A major aim of national income statistics is to compare performances of a country over time i.e. how well the country is doing this year in relation to previous years? A major disadvantage of this comparison is that countries have different rates of price movement (inflation) over time. Thus it is important that some implicit price index is used, such as the RPI or the GDP deflator, to compare changes in real GDP rather than Nominal GDP over time. • In using national income statistics to compare performances of country over space i.e. how well the country is doing in relation to other countries, many problems may be encountered. It is important to take population size into considerations before comparing by using per capita output measure. Also, given the complexities of economies some components of national income are estimates causing countries to run the risk of under or over estimating them. WLong(2012)

21. NATIONAL INCOME & ECONOMIC WELFARE • In countries such as ours poverty continues to be a serious economic problem and it is therefore necessary that we have some means of measuring the level of poverty or economic welfare. We use national income levels to do this. However GDP and GNP concepts are not particularly good measures of welfare mainly because it was design to measure economic performance in terms of volume of goods and services produced and not society’s well-being. WLong(2012)

22. NATIONAL INCOME & ECONOMIC WELFARE(Cont’d) The following are serious limitations of using national income as a measure of welfare: • GNP says nothing about the household distribution of income. The manner in which income is distributed is important in gauging poverty levels in an economy. • Further welfare relates to the quality of life rather than simply the quantity of goods produced. • It fails to indicate real improvements in welfare, which can occur through quality changes in goods and services available for consumption. • It ignores important elements of welfare such as illegal activity, crime, unemployment levels, and leisure levels. • It is difficult to have an accurate measurement of the level of subsistent activity in an economy. • There may be an inverse relationship between the growth in goods and services and the decline in environmental quality. For instance, striving for improved GDP might result in significant negative externalities (air and water pollution). WLong(2012)