Introduction to Economics

Introduction to Economics Egor Sidorov

Aggregate demand Aggregate supply Gross domestic product (GDP) Nominal vs. real GDP GDP critiques

Aggregate Demand – AD • AD is an amount of products the market agents are willing to buy given the price level. • Aggregate demand consists of : • Demand for final goods and services by households (C), • Demand for production factors by firms (Ig), • Demand for production factors by government (G), • Demand for net exports by foreign agents (X). AD 110 % P C I G X 100 % Q

Factors influencing AD (1) • Consumption (C)isdetermined by disposableincome (personal income after taxes) and wealth of consumers. If the price level goes up, the wealth goes down.Demographical changes also influence consumption. • Investment (I)isdetermined by such factorsas production level,capital costs and future expectations of investors. Monetary policy influences the investment level.

Factors influencing AD (2) • Governmental expenditures (G) – their level is determined by governmental decisions about budgetary expenditures. • Net export (X) is a difference between export and import. Main factors influencing net export are relation between domestic and foreign price level and exchange rates. Economic growth abroad leads to increase of export.

Aggregate demand Aggregate supply Gross domestic product (GDP) Nominal vs. real GDP GDP critiques 13. 11. 2014 6

Aggregate Supply – AS • AS is a total amount of product, which firms and households are willing to supply given the price and wage level. • The supply consists of: • Supply of goods and services by firms, • Supply of production factors by households, • Services of the state, • Foreign imports. AS P Potential product – refers to the full capacity of the given economy with full employment and full resource use. 110 % 100 % Qr Qp

Factors influencing AS and potential product • Production factors (L, R, K), • Technology: • Increases potential product, • Price level and exchange rates, • Exchange rate depreciation makes national currency relatively cheaper and increases export. • State economic policy: • E.g. high taxes may force part of suppliers to leave the market, custom fees defend domestic producers. • Market agents’ expectations: • E.g. willingness to start business, to invest and to save.

AS curve shape.Keynes vs. Neoclassics • 2 controversial economic schools: • Keynes's economics, • Neoclassical economics. • Outgoing points: • Main discussion is about wage and price flexibility. • and possibility of state to intervene into economics. P AS Q Qp

Neoclassical school (1) The main source of inefficiency is state interventions, especially those redistributing factors form private to public sector (supporting less efficient governmental investments instead of private investment). Traditional market economics. “Optimistic viewpoint” stating that the economics is healthy and is on its potential (Qp) ►market mechanism efficiently allocates production factors and market self-regulations enables long-run efficiency and performance with no need of state interventions. P AS Classical shape of AS where wages and prices are flexible Q Qp

Neoclassical school (2) • AD stimulation has no sense. With a view to the fact that economy is on its potential (Qp), this stimulation leads only to price level increase, i.e. inflation. • In this respect the government should aim at providing the stable economic environment(motivate production, business and savings). Monetary policy is a primary tool therefore. P AD2 AS AD1 110 % 100 % Q Qp 11

Keynesian school (1) • The Keynesian theory was developed at the time of economic crisis between the two world wars and therefore has a “pessimist” viewpoint ►assumes that the economy is under its potential and is not able of allocating scarce resources by using only market forces (therefore e.g. unemployment exists) ►state interventions are necessary. John Maynard Keynes 1883-1946

Keynesian AS curve: short and long run AS • (1) Within the short run some costs are not flexible (e.g. wages), therefore the growth of AD involves increase of AS with no price level changes. • (2) In the state close to potential AS goes up as long as firms are willing to increase supply in reaction to growth of demand. The price level also increases however. • (3) Within the long run AS is vertical: costs are flexible and firms are adjusting their prices in reaction to AD growth (since they are on potential).In this way only price level changes. (3) (2) (1) P Qp Keynesian AS curve – prices and wages are flexible within the long run. Within the short run they are not as flexible, since e.g. long-term contracts exist. Q

Keynesian school (2) • Due to low aggregate demand the product is under potential, unemployment and other unused resources are present ►AD should be stimulated by the means of fiscal policy (e.g. governmental expenditures); monetary policy may be applied as well (discount rates). State interventions are efficient within the short run. Presence of economies in crisis still make Keynesian ideas actual. AS P Qp 14 14 Q

Economic performance: Product of the society • “Measuring smth means knowing smth about it; if one can’t express smth in numbers, it means our knowledge isn’t sufficient.” • National economic performance is reflected by the amount of goods and service (in money units)produced during the accounting period (e.g. a year). Lord Kelvin (William Thomson) 1824 – 1907, UK

System of national accounts (SNA) • Basic SNA accounts • Production acct • Generation of income acct • Distribution of income acct • Use of income acct • Capital acct • Financial acct • SNA data is used for: • Economic performance assessment, • Economic policy making, • Economic policy efficiency assessment. Production acct

Gross domestic product (GDP) • Monetary value of final goods and services produced during the accounting period (e.g. a year) by production factors situated on the territory of the country no matter who their owner is. Gross National Product (or Income) – total value of goods and services produced by production factors owned by the nation. • Czech GDP includes output of Czech and foreign companies on the Czech territory.

Calculating GDP • Production approach • Expenditure approach • Income approach • Production approach • GDP as a sum of final goods and services used for final consumption. • GDP omits intermediate consumption, which reflects value of products used for further production processes. CZK 100 CZK 150 CZK 200 GDP = Output – inter. consumption = Value Added

Expenditure approach • All goods and services sold during the accounting period; those include expenditures of • Households (C = consumption): • Households’ final consumption; • Consumer goods (excluding dwellings!). • Government (G = government expenditure): • Building infrastructure, defense, education, etc. (excluding transfers – pensions, social support, etc.). • Firms – (Ig = Gross Investment): • Gross investments into machines, buildings, etc. • Net export (Ex-Im) = export minus import): • Difference between value of goods exported and imported. GDP = C + Ig + G + Ex-Im

Income approach • Production and selling of every product is connected with someone’s incomes as a price paid for production factors: • Labor – wages and salaries, • Land – rent, • Capital –percentandprofit. Notice! Arithmetic sum of incomes is not equal to GDP, since GDP includes gross investments and direct taxes and custom fees among others. Production approach = Income approach = Expenditure approach

Capital services theory • Capital generates flow of services and depreciates. • Depreciation equals to capital value loss over accounting period. Net investments increase capital stock Profit Other costs Renewing investments (=depreciation) return capital stock to initial level

GDP as a flow of capital services • The stock of national capital generates flow of goods and services, i.e. GDP. • Gross investment is equal to net investment plus depreciation. Depreciation + Net invetsment GDP = C + Ig + G + Ex-Im Capital stock Services

Gross domestic product vs.Net domestic product • Net domestic product has a more representative character • Net Domestic Product– NDP • NDP is calculated as GDP less depreciation. • NDP shows the net income, in other words the true level of how the society is better off in this year compared to previous accounting period. NDP = GDP - Depreciation NDP = C + In + G + Ex-Im Only net investment

Nominal vs. real GDP • Nominal GDP is calculated in current prices; • Therefore these indicators are incomparable in time; the solution is calculating GDP in basic prices. 20CZK 11 CZK > = < 2009 1995

Deflator • Is a complex price index. Incorporates price changes of all goods and services in the economy. Price level 2009 Deflator = --------------------------------- Price level 1995 20 Deflator = -------------- = 1,81 = 181 % 11

Real GDP • One can use deflator to calculate the real GDP Nominal GDP in current 2009 prices Real GDP 2009 = ------------------------------------------------ Deflator 2009/1995 20 Real GDP 2009 = ------------- = 11 Kč 1,81 = 1995 2009

GDP • Is an important indicator of economic activity, • Showsif the country is a developed or developing, • Enables getting support from international organizations. • Is generally (however mistakenly) regarded to be an indicator of well-being.

GDP critiques HDP = C + Ig + G + Ex-Im • GDP reflects only those human activities, which are part of market transactions. • GDP ignores everything beyond money exchange. • E.g. environmental services are not traded in the market. Yearly environmental services = 500 x GDP

GDP critiques • Omits goods and services produced for own consumption • Omits goods and services produced on the black market • Illegal activities as drug dealing, prostitution, media piracy, etc.

GDP critiques • GDP makes no difference between productive and destructive activities. • It grows before and after the war, it goes up in connection with natural disasters, divorces, criminal activity, environmental pollution and abatement, etc.

Alternative indicators • e.g. Net Economic Welfare (NEW) – is an adjusted measure of well-being improving some shortcomings of GDP. • NEW = GDP ++ value of the free time+black market production value+goods and services for own consumption + …– natural resource depletion– non-productive commercials– commuting expenses– …

GDP: conclusion • GDP is an important indicator of economic activity. • GDP growth, however, doesn’t necessarily mean that the nation is better off.

Thank you for attention! Refernces: SAMUELSON, P. A., NORDHAUS, W. D. Ekonomie 18. vydání. Praha: Svoboda, 2005. KRAFT, J., RITSCHELOVÁ, I. Ekonomie pro environmentální management. Ústí n. L.: UJEP, 2003. MCDOUGAL LITTELL. Economics: Concept and Choices. Canada: McDougal Littell, 2008. www.iHNed.cz

Introduction to Economics