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Understanding the Macroeconomy Chapter 1

Understanding the Macroeconomy Chapter 1. Output. Preview. National Income Accounting and Measurement International Trade and Balance of Payments Economic Growth and Public Policy Business Cycles. Understanding the Macroeconomy: Output. Output

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Understanding the Macroeconomy Chapter 1

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  1. Understanding the MacroeconomyChapter 1 Output

  2. Preview • National Income Accounting and Measurement • International Trade and Balance of Payments • Economic Growth and Public Policy • Business Cycles

  3. Understanding the Macroeconomy:Output • Output The amount of goods and services a country produces • Foundation of economic prosperity: -How much we can consume - How much we can invest (save)for the future - How much we can lend or borrow to/from other countries

  4. The Allocation of Output • Economics: studying how scarce resources (output) can be allocated to many competing needs • Incentives play a critical role in determining this allocation • What determines incentives? • Government policy • Institutions • Social and cultural environment

  5. How is National Output Measured? • Gross Domestic Product (GDP) The market value of final goods and services produced within a country over a year • Why “final” and not “all” ? • What is relevant for measuring output is the amount of “value-added” to every stage of production

  6. How is National Output Measured? • Two common methods of measurement: A. “Value-added” method: Sales price of a good or service minus the cost of all material inputs used to produce it B. “Expenditure” method: Value of final sales of goods and services • Both are equivalent; the expenditure method is more commonly used

  7. Value-added versus Expenditure: An Example Value-added Method Expenditure Method

  8. The Expenditure Method • How is GDP calculated using this method? • National Output (GDP)= C + I+ G + X – IM C : consumption expenditures by households I : investment expenditures by firms G : government spending X : exports to rest of the world IM: imports from rest of the world

  9. GDP Data • Locating GDP data • Go to www.bea.gov (Bureau of Economic Analysis) • Under the “National” section, select “Gross Domestic Product (GDP)” • Select “Interactive Tables” • Use the list of “Frequently Requested NIPA Tables” • Select Table 1.1.6 (Real GDP) • Use the “Data Table Options” to create a table

  10. Exchange of Output across Countries: International Trade • Why do countries trade with each other? - some countries produce more than they need and some less -a country does not produce all types of goods

  11. International Trade • What type of goods should countries produce and export? • Theory of Comparative Advantage • Based on the idea of opportunity costs: The opportunity cost of producing somethingmeasures the cost of not being able to produce something else because resources have already been used.

  12. Theory of Comparative Advantage • Developed by British economist David Ricardo (1817) • A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries. • A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.

  13. Trade and Specialization • International trade leads to specialization in production with each country producing and exporting the good in which it has a comparative advantage • Since all resources are being used efficiently across the world, free trade is the best (optimal) outcome

  14. International Trade • What determines comparative advantage? • Differences across countries in • Labor productivity (Ricardo) • Resources: natural or physical (Heckscher and Ohlin) • The above represent the “first generation” theories of international trade • But do we really see specialization in production across the world?

  15. New Trade Theory • Market size and the ability to produce varieties matter: economies of scale (Paul Krugman) • Helps us understand “intra-industry” trade • Countries don’t specialize, but produce different varieties of the same good • Example: US sells Fords to Germany and imports BMWs

  16. New Trade Theory: The “Gravity” Model • Country size matters: large countries tend to trade more with each other • Distance matters: inverse relationship between distance (between countries) and trade • Other factors: culture, borders, language, geography, and trade agreements

  17. Total U.S. Trade with Major Trading Partners 2005

  18. How Wide is the Border?

  19. Trade with British Columbia, as Percent of GDP, 1996

  20. The Composition of World Trade2005

  21. The Changing Composition of Trade: Does Comparative Advantage Change over Time?Evidence from Developing Countries

  22. Exchange of Output across Countries: International Trade • International trade in goods and services leads to lending and borrowing through international capital markets • China exports personal computers to the US: generates a claim on future US output (and vice versa) • Therefore, China’s trade surplus = US trade deficit

  23. Recording International Transactions: The Balance of Payments (BOP) • Balance of Payments (BOP) Accounts: tracks a country’s international transactions • The Current Account: Exports and imports of goods and services • The Financial Account: Sales of stocks, bonds, or financial assets to/from foreigners • Current account deficit  capital inflow on financial account (borrowing) • Deficit in one account = Surplus in the other

  24. Are Current Account Deficits “Bad”? • Depends on how the “borrowed” output is used: for consumption or investment • If borrowing is for consumption: current account deficit may be unsustainable in the long run • If borrowing is for investment: the deficit may be sustainable (why?) • GDP is the “ultimate” budget constraint for a country

  25. Economic Growth • What is economic growth? • What causes countries to grow? - Increases in labor force - Increase in the stock of capital - Technological progress (efficiency of production)

  26. Economic Growth • Growth is a consequence of individuals sacrificing current consumption in favor of future consumption • Households save from current income => firms invest these savings => creation of capital goods => production of output increases => economic growth

  27. Economic Growth Theory: An Overview • “First Generation” theories of growth: • Sir Roy Harrod (1939), Evsey Domar (1946), Robert Solow (1959) • Focus on four key determinants • The savings rate • Population growth • Output-capital ratio • Technological progress • Let’s think about the role of each of these factors…

  28. New Growth Theory • The first generation models did not explain how the factors affecting growth were themselves determined • Growth was “exogenous”: determined by factors that were assumed to be “given” • “Second Generation” models • Paul Romer (1986), Robert Lucas (1988), Robert Barro (1990) • Growth is an equilibrium (endogenous) outcome of individual decisions

  29. New Growth Theory • Main engines of growth • Knowledge creation (Romer, Lucas) • Government spending on economic infrastructure (Barro) • The above factors create “externalities” • Actions of one individual/entity affect many others • Social benefits may be different from private benefits • Creates a role for the government to affect economic growth

  30. Economic Growth and the Government • The issue: what role does public policy play in determining economic growth? • Two approaches: - The “supply-side” approach: lower taxes - The “demand-side” approach: increase government spending

  31. Business Cycles • Business cycles: temporary fluctuations in GDP • Recession: when GDP falls (or contracts) for two consecutive quarters  leads to an economic slowdown • Expectations play a crucial role by creating speculative behavior  “ripple” effect on the economy

  32. Real GDP growth rate Consumption growth rate Average growth rate Growth rates of real GDP and Consumption 10 Percent change from 4 quarters earlier 8 6 4 2 0 -2 Pink bars denote actual recessions -4 1970 1975 1980 1985 1990 1995 2000 2005

  33. Real GDP growth rate Investment growth rate Consumption growth rate Growth rates of real GDP, Consumption, and Investment Percent change from 4 quarters earlier 40 30 20 10 0 -10 -20 -30 1970 1975 1980 1985 1990 1995 2000 2005

  34. 1970 1975 1980 1985 1990 1995 2000 2005 Unemployment Percent of labor force 12 10 8 6 4 2 0

  35. Index of Leading Economic Indicators (LEI) • Published monthly by the Conference Board. • Aims to forecast changes in economic activity 6-9 months into the future. • Widely used in planning by businesses and govt, despite not being a perfect predictor.

  36. Components of the LEI index • Average workweek in manufacturing • Initial weekly claims for unemployment insurance • New orders for consumer goods and materials • New orders, non-defense capital goods • Vendor performance • New building permits issued • Index of stock prices • M2 • Yield spread (10-year minus 3-month) on Treasuries • Index of consumer expectations

  37. Index of Leading Economic Indicators 160 LEI Forecast Actual Recession 140 120 100 1996 = 100 80 60 40 20 0 Source: Conference Board 1970 1975 1980 1985 1990 1995 2000 2005

  38. What is More Important: Wealth or Output? • Financial assets (wealth) are simply a claim on future output • Why do we buy financial assets (accumulate wealth)? • Why do we sell financial assets? • What good would financial wealth do if there were nothing to buy?

  39. Caveat:Gross Domestic Product or “Grossly Distorted Picture”? • Critical Question: is GDP an accurate reflection of a country’s “prosperity” or standard of living? • Example: U.S. per-capita GDP is 26% higher than Germany’s; do American’s enjoy a 26% higher standard of living than Germans?

  40. A Few Things to Think About… • Should the following be accounted for in GDP? - Value of leisure time vacations, shorter work-weeks, social interactions - “Home” produced goods home-makers, cooking, taking care of children - Distribution of income (inequality) the gap between the rich and poor

  41. Problems with Measurement • Difficult to assess “market” value or prices of certain non-market goods • GDP is data is readily available • Even when GDP is adjusted for these factors, relative rankings of countries remain unchanged • However, the “gaps” in per-capita incomes across countries diminishes

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