Principles of Economics

1. Principles of Economics Session 10

2. Topics To Be Covered • Macroeconomics vs. Microeconomics • History of Macroeconomics • Major Concerns of Macroeconomics • Objectives of Macroeconomics • Instruments of Macroeconomics • Markets and Players of Macroeconomics

3. Topics To Be Covered • Definition of Gross Domestic Product • Measurement of GDP • GDP, GNP, NNP, NI, PI, and DPI • Price Indexes • AS, AD, and Macroeconomic Equilibrium

4. Macroeconomics vs. Microeconomics • Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. • Macroeconomicsis the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

5. History of Macroeconomics The Great Depression was a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

6. History of Macroeconomics • Classical economists applied microeconomic models, or “market clearing” models, to economy-wide problems. • The failure of simple classical models to explain the prolonged existence of high unemployment during the Great Depression provided the impetus for the development of macroeconomics.

7. History of Macroeconomics • In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money. • Keynes believed governments could intervene in the economy and affect the level of output and employment. • Fine-tuning was the phrase used to refer to the government’s role in regulating inflation and unemployment.

8. History of Macroeconomics • The use of Keynesian policy to fine-tune the economy in the 1960s, led to disillusionment in the 1970s and early 1980s. • Stagflation occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation).

9. Major Concerns of Macroeconomics Macroeconomics answers questions like: • Why do production expand in some years and contract in others? • Why do prices rise rapidly in some time periods while they are more stable in others? • Why are some people unable to have the opportunity to work although they do want to work?

10. Major Concerns of Macroeconomics • Output (GDP change) • Price level (Inflation) • Employment (Unemployment)

11. Objectives of Macroeconomics • Output growth • Stable prices • High employment

12. Instruments of Macroeconomics • Macroeconomic tools mainly consist of fiscal policy and monetary policy. • Fiscal policy refers to government policies concerning taxes and expenditures. • Monetary policy consists of tools used by the central bank to control the money supply.

13. Markets and Players of Macroeconomy

14. LaborMarket FinancialMarket Goods and ServiceMarket Markets and Players of Macroeconomy

15. Markets and Players of Macroeconomy • Households and the government purchase goods and services from firms in the goods-and services market, and firms supply to the goods and services market. • In the labor market, firms and government purchase labor from households.

16. Markets and Players of Macroeconomy • The financial market consists of money market, capital market, and foreign exchange market in the open economy. • In the money market, the government (central bank) supplies money and households and firms demand money for transaction and speculation.

17. Markets and Players of Macroeconomy • In the capital market, households purchase stocks and bonds from firms. • In the foreign exchange market, those who want to invest in foreign countries exchange domestic currency for foreign currencies, while those foreigners who want to invest in this country supply foreign currencies and demand domestic currencies.

18. Gross Domestic Product GDP is the market value of all final goods and services produced within a country in a given period of time.

19. Gross Domestic Product • GDP is the best single measure of the economic well-being of a society. • GDP per persontells us the income and expenditure of the average person in the economy. • Higher GDP per person indicates a higher standard of living.

20. Gross Domestic Product Country Real GDP per Life Adult Person (1997) Expectancy Literacy United States $29,010 77 years 99% Japan 24,070 80 99 Germany 21,260 77 99 Mexico 8,370 72 90 Brazil 6,480 67 84 Russia 4,370 67 99 Indonesia 3,490 65 85 China 3,130 70 83 India 1,670 63 53 Pakistan 1,560 64 41 Bangladesh 1,050 58 39 Nigeria 920 50 59

21. Gross Domestic Product • It is estimated that: • China's GDP will surpass that of France in 2005 • China is expected to become the world's third economic power in 2020 • China is likely to outstrip Japan in 2050 to become the world’s second largest economic power.

22. Gross Domestic Product • The 16th CPC Party Congress established the objective to double the 2000 GDP by 2010, and further by 2020 quadruple its 2000 GDP. • To attain the goal, what should be the annual GDP growth of China?

23. Gross Domestic Product • A rough solution to such issue can be resorted to the rule of 70. • According to the rule of 70, if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years. • For example, $5,000 invested at 7 percent interest per year, will approximately double in size in 10 years.

24. The Measurement of GDP • Output is valued at market prices. • It records only the value of final goods, not intermediate goods (the value is counted only once). • It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

25. The Measurement of GDP • It includes goods and services currently produced, not transactions involving goods produced in the past. • It measures the value of production within the geographic confines of a country. • It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

26. The Measurement of GDP • The term final goods and services refers to goods and services produced for final use. • Intermediate goods are goods produced by one firm for use in further processing by another firm.

27. The Measurement of GDP Aggregate Output (GDP) = Aggregate Income Aggregate Output (GDP) =Aggregate Expenditure Aggregate Expenditure = Aggregate Income

28. The Measurement of GDP GDP can be computed in two ways: • The expenditure approach (product approach)A method of computing GDP that measures the amount spent on all final goods during a given period. • The income approach (cost approach)A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods.

29. The Expenditure Approach • C = Consumption • I = Investment • G = Government Purchases • NX = Net Exports Y= C + I + G + NX NX = Export - Import

30. The Expenditure Approach • Consumption (C): • Durable goods (cars, televisions, etc.) • Non-durable goods • Services • Investment (I): • Houses purchased by households • Plant and equipment purchased by firms • Inventory changes

31. The Expenditure Approach • Government Purchases (G): • The spending on goods and services by local, state, and federal governments. • Does NOT include transfer payments because they are not made in exchange for currently produced goods or services. • Net Exports(NX): • Exports minus imports.

32. The Income Approach Components of the income approach: • Wages, salaries, and supplements • Net interest • Rental income of persons • Income of unincorporated enterprises • Corporate profits before taxes • Indirect taxes • Depreciation

33. The Income Approach • In calculating GDP, we can either sum up the value added at each stage of production, or we can take the value of sales of final goods and services. • We do not use the value of total sales in an economy to measure how much output has been produced. If we do, we are committing the fault of double counting.

34. The Income Approach • One practical income approach to avoid the problem of double counting is to use the value added method. • Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.

35. The Income Approach

36. GDP and Its Components (1998)

37. GDP and Its Components (1998)

38. GDP and Its Components (1998) Consumption 68 %

39. GDP and Its Components (1998) Investment 16% Consumption 68 %

40. GDP and Its Components (1998) Government Purchases 18% Investment 16% Consumption 68 %

41. GDP and Its Components (1998) Government Purchases 18% Investment 16% Net Exports -2 % Consumption 68 %

42. Inappropriateness of GDP • GDP excludes most items that are produced and consumed at home and that never enter the marketplace. • It excludes value of leisure and clean environment. • It excludes items produced and sold illicitly, such as illegal drugs.

43. Other Measures of Income • Gross National Product (GNP) • Net National Product (NNP) • National Income (NI) • Personal Income (PI) • Disposable Personal Income (DPI)

44. Gross National Product • Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals). • It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here.

45. Net National Product • Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation. • Depreciation is the wear and tear on the economy’s stock of equipment and structures. NNP=GNP– Depreciation

46. National Income • National Income is the total income earned by a nation’s residents in the production of goods and services. • It differs from NNP by excluding indirect business taxes (such as sales taxes). NI=NNP – Indirect Taxes

47. Personal Income • Personal income is the income that households and noncorporate businesses receive. • Unlike NI, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners. • In addition, it includes household’s interest income and government transfers. PI=NI – Retained Earnings+Interest Income + Government Transfers

48. Disposable Personal Income • Disposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government. • It equals personal income minus personal taxes and certain nontax payments. DPI=PI – (Personal Taxes + Nontax Payments)

49. GNP, NNP, NI, PI, and DPI NNP=GNP– Depreciation NI=NNP – Indirect Taxes PI=NI – Retained Earnings+Interest Income + Government Transfers DPI=PI – (Personal Taxes + Nontax Payments)

50. Price Level and Price Indexes • The price level can be expressed in terms of price indexes. • If the economy’s overall price level is rising, we call such situation inflation. If the overall price level is decreasing, we call such situation deflation. • Common price indexes include the consumer price index (CPI), GDP deflator, and producer price index (PPI).