ECON 1102 Macroeconomics 1
PRINCIPLES
OF MACROECONOMICS
LECTURE 1: INTRODUCTION
You
are required to suggest:
Definition
of Macro economics
Macroeconomics
is the study of the behaviour of large collections of economic agents
(aggregates). It is the study of the economy as a whole. It focuses on
explaining economic changes that affect many households, firms, and markets
simultaneously. Some of the important macroeconomic questions are: Why is
income high in some countries while it is low in others? why do prices rise
rapidly sometimes and are stable at other times? Why does production and
employment rise in some years and decline in others? What can the government do
to increase economic growth, lower inflation and increase employment? By
contrast, microeconomics deals with the economic decisions of individuals (a
typical consumer, a single firm, etc.) and how they interact with one another
in the market. For example: the decision by a firm to buy or not a particular
machine used in its production process is a microeconomic problem. The effect
of a decrease in the interest rate on the saving decisions of Kenyan households
is a macroeconomic problem. Therefore, the objective of macroeconomics is to
explain some features of an economy as a whole, and toward this end,
macroeconomists collects data on many aggregate variables and try to create
theoretical models that can explain the behavior of such variables. In
macroeconomics, 3 aggregate variables are normally very important to describe
the economic situation in a given economy/country: GDP (Gross Domestic Product:
the value of goods and services produced in a country in a given period of
time), the Inflation Rate (the percentage change of the general level of prices
from one period to another) and the Unemployment Rate (how many people in the
labour force are unemployed in a given period of time, in percentage). We shall
now explore some of these important macro variables in more detail.
National Income
National Income refers to the monetary value of the flow of final goods and services arising from the productive activities of a nation in any one period. National Income is measured using Gross Domestic Product (GDP). GDP measures the total income of everybody in the economy in a given period and the expenditure of everybody on the economy’s output of goods and services. GDP measure the income and expenditure simultaneously because the two are really the same. For an economy as a whole, Income must be equal to expenditure. I = E
To further explain this, consider a worker w ho renders a service and is paid an income: The worker receives an income while the recipient of the service incurs an expenditure. In aggregate therefore, income is equal to expenditure. The Circular Flow of Income diagram is used to further illustrate the equality of Income and Expenditure. The Circular Flow of Income
This diagram describes all the transactions between households and firms in a simple economy.It simplifies matters by assuming that all goods and services produced by firms are bought by households and that households spend all their income. When households buy goods and services from firms, this flow is through the markets for goods and services. Firms in turn spend the money from sales to pay workers’ wages, rents and profits to owners. Money therefore continuously flows from households to firms and then back to households. This is of course oversimplifies because households do not spend all their income and there is also the government that apart from receiving taxes also buys some goods and services. Regardless of whether a household, government or firm buys goods, every transaction has a buyer and a seller. Therefore, for an economy as a whole, expenditure and income are always the same. See the circular flow diagram on pp. 197, chapter 10, Mankiw.
Measurement of Gross Domestic Product
Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. Components of GDP
GDP is measured by considering all the various forms of expenditure. GDP (Y) is divided into 4 components:- Consumption ©, Investment (I), Government Spending (G) and Net exports (NX).The GDP measurement formula is there an identity of the form: Y = C + I + G + NX
Consumption ©
Consumption is the spending by households on goods and services. These are both consumption goods like food and clothing and durable goods like electronics, automobile etc. It also includes services like medical services, education etc. Investment (I)
This is the purchase of goods that will be used in future to produce more goods and services. It is the sum of purchases of capital equipment, inventories and structures. The purchase of a new home by a household is considered part of investment. Note that the word investment is used differently from what you may know of it: stocks, bonds etc. Government Purchases (G)
This includes spending on goods and services by county and national government. It includes salaries paid to civil servants as well as spending on infrastructure and public utilities. Net Exports
This refers to exports (foreign purchase of domestically produced goods) minus imports (local purchase of foreign goods). Exercise:
The US aggregate data for 2009 is a presented in the table below:
USD Billions
Consumption
10,093
Investment
1,623
Government Purchases
2,933
Net exports
(390)
US Population
370 million
i) Compute the US GDP in 2009. (14259)
ii) What is the contribution of consumption to GDP in the US in the period? iii) Compute the GDP per capital
GDP per capita is the GDP per person.
Real Versus Nominal GDP
GDP is the measure of total expenditure on goods and services in all markets in an economy. If GDP increases from one period to the next, then it means that either the output is larger or the prices the goods are sold at is higher. To separate the two effects economists use a measure called Real GDP. Real GDP shows the increase in a country output of goods and services. Nominal GDP is the production of goods and services measured at current prices. Real GDP is the production of goods and services measured at constant base year prices. Since real GDP is not affected by changes in prices, changes in real GDP reflects only changes in amounts being produced. It is therefore a measure of the economy’s production of goods and services. Since economists measure a country’s well-being and its ability to support its citizenry through GDP then Real GDP is a better gauge of economic well-being than nominal GDP. The GDP Deflator
This is the ratio of nominal GDP to real GDP. Nominal GDP measures production at curren prices while Real GDP only reflects the quantities produced. The GDP deflator measures the current level of prices relative to the base year. GDP Deflator = Nominal GDP X 100
Real GDP
Since real and nominal GDP are equal in the base year, the GDP deflator is equal to 100.
Example:
GDP Class Exercise: Computing real and nominal GDPs Mankiw pp. 204 (own example of tea and coffee)
LECTURE 2: MEASURING THE COST OF LIVING
I NTRODUCTION
Recap: The GDP deflator and changes in Price level
Discussion and review of class exercise of lecture 1.
The Consumer Price Index
The Consumer Price Index (CPI) is a measure of the overall cost of goods and services bought by a typical consumer. It is used to monitor the cost of living over time. When the CPI rises, a typical family has to spend more money to keep the same the same standard of living. When the general price level is persistently rising, we say that there is inflation. Inflation refers to a situ ation where the overall price level is rising. Inflation rate is the percentage change in price level from the previous period. Calculating the CPI and Inflation Rate
In Kenya the KNBS is responsible for compiling the National CPI. This is done on a monthly basis and the results disseminated. The CPI is computed as follows:
Step 1: Select and fix the basket
This is done by determining which goods (prices) are most important to a typical consumer and assigning them weights that reflect that importance. For instance, if the typical consumer buys more maize flour than wheat flour, then maize flour should be allocated a higher weight. The selected goods prices constitute what is called a consumption basket. Step 2: Find the prices
A survey is carried to obtain the prices of the basket of goods at each point in time. In Kenya, the KNBS carries out price checks in designated markets for the basket of goods at a given date each month. Step 3: Compute the basket’s cost
Using the data collected the cost of the basket of goods is computed at each point. The basket is kept constant to ensure that only price effects are reflected in the computation of the cost of the basket.
Step 4: Choose a base year and compute the index
Designate one year as the base year, the benchmark against which other periods prices are compared.The choice of this year is arbitrary. The CPI is then computed as follows: CPI = Price of basket in current year / price of basket in base year X 100 i.e the price of the basket in each year divided by the price of the basket in the base year. The computation up this stage gives us the CPI. How do we determine the inflation rate from the CPI?
Step 5: Compute the Inflation Rate
The inflation rate is the percentage change in the price index from the preceding period. It is computed as: Inflation rate = (CPI in year 2 – CPI in year 1) / CPI in year 1 X 100 Problems in measuring CPI
i) Substitution bias
The assumption of the CPI construction methodology is that consumers are rigid and are not able to substitute expensive goods for cheaper ones. This is not true. If the price of maize meal rises more than that of wheat meal, consumers can buy less of maize meal and more of wheat meal. This means that with a fixed basket, the CPI continues to reflect higher cost of living than is being experienced by the typical consumer. ii) Introduction of new goods and services
When new goods are introduced in the market, consumers enjoy greater flexibility in their quest to maintain standard of living. For instance the introduction of the DVD reduced the need to attend movie theater.
iii) Unmeasured quality change
When the quality of a good deteroriates with the price remaining constant, there is a loss of purchasing power. Similarly, quality increases with price increases do not represent loss of purchasing power. While the Statistics bureaus try to take account of quality changes, to ensure that same quality comparisons are made, some unmeasured quality changes are not reflected in the CPI. Importance of CPI and Inflation Statistics
1. Helps the government in its economic management programs by disclosing the changes in the cost of living and the effect it is having on various segments of the economy. 2. It is used to adjust incomes and set minimum wages
3. It is used as a guide to investors on the level of returns they are receiving. 4. It helps to understand the money equivalents between different periods of time.
GDP Deflator Versus the CPI
As earlier learnt, the DDP deflator is the ration of nominal GDP to Real GDP. The GDP deflator reflects the level of current prices relative to the prices in the base year. Economists monitor both the GDP deflator and the CPI to gauge the rate at which prices are rising in the economy. While the two statistics tell the same story, there can be a divergence due to the following reasons: 1. The GDP deflator measures reflects all goods and prices produced domestically. On the other hand the CPI measures the prices of all goods and services bought by consumers. Effects of large military or government imports costs may not reflect in the CPI but will show in the GDP deflator. 2. The GDP deflator reflects the price changes of all goods under current production. The CPI on the other hand is based on a fixed basket of goods that is only changed occasionally. Adjusting Economic Variables for the effects of inflation
The CPI is often used to compare money equivalents from different periods of time. How much is KES 1,000 in 1990 equivalent to in 2014? This question can be answered by using the CPI. Amount in 2014 = Amount in 1990 X CPI in 2014/CPI in 1990
This is similar to inflating the 1990 amounts to know their current equivalent. When an amount is automatically corrected for changes in price level by law or contract it is said to be indexed for inflation. Indexation is a common feature in collective bargaining agreement where a cost of living adjustment is often built in. The same applies to social security payments. Inflation and Interest rates
When one saves and earns interest, it is important to consider the effects of inflation on the interest return due to passage of time. To measure whether one is better off given a certain return earned on savings, you look at the real interest rate and not the nominal interest rate as quoted by the bank. The interest rate that measures the change in dollar amounts is called the nominal interest rate. When the interest rate is corrected for inflation it is called the real interest rate. Real Interest rate = Nominal Interest rate – inflation rate
National Income
National Income refers to the monetary value of the flow of final goods and services arising from the productive activities of a nation in any one period. National Income is measured using Gross Domestic Product (GDP). GDP measures the total income of everybody in the economy in a given period and the expenditure of everybody on the economy’s output of goods and services. GDP measure the income and expenditure simultaneously because the two are really the same. For an economy as a whole, Income must be equal to expenditure. I = E
To further explain this, consider a worker w ho renders a service and is paid an income: The worker receives an income while the recipient of the service incurs an expenditure. In aggregate therefore, income is equal to expenditure. The Circular Flow of Income diagram is used to further illustrate the equality of Income and Expenditure. The Circular Flow of Income
This diagram describes all the transactions between households and firms in a simple economy.It simplifies matters by assuming that all goods and services produced by firms are bought by households and that households spend all their income. When households buy goods and services from firms, this flow is through the markets for goods and services. Firms in turn spend the money from sales to pay workers’ wages, rents and profits to owners. Money therefore continuously flows from households to firms and then back to households. This is of course oversimplifies because households do not spend all their income and there is also the government that apart from receiving taxes also buys some goods and services. Regardless of whether a household, government or firm buys goods, every transaction has a buyer and a seller. Therefore, for an economy as a whole, expenditure and income are always the same. See the circular flow diagram on pp. 197, chapter 10, Mankiw.
Measurement of Gross Domestic Product
Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. Components of GDP
GDP is measured by considering all the various forms of expenditure. GDP (Y) is divided into 4 components:- Consumption ©, Investment (I), Government Spending (G) and Net exports (NX).The GDP measurement formula is there an identity of the form: Y = C + I + G + NX
Consumption ©
Consumption is the spending by households on goods and services. These are both consumption goods like food and clothing and durable goods like electronics, automobile etc. It also includes services like medical services, education etc. Investment (I)
This is the purchase of goods that will be used in future to produce more goods and services. It is the sum of purchases of capital equipment, inventories and structures. The purchase of a new home by a household is considered part of investment. Note that the word investment is used differently from what you may know of it: stocks, bonds etc. Government Purchases (G)
This includes spending on goods and services by county and national government. It includes salaries paid to civil servants as well as spending on infrastructure and public utilities. Net Exports
This refers to exports (foreign purchase of domestically produced goods) minus imports (local purchase of foreign goods). Exercise:
The US aggregate data for 2009 is a presented in the table below:
USD Billions
Consumption
10,093
Investment
1,623
Government Purchases
2,933
Net exports
(390)
US Population
370 million
i) Compute the US GDP in 2009. (14259)
ii) What is the contribution of consumption to GDP in the US in the period? iii) Compute the GDP per capital
GDP per capita is the GDP per person.
Real Versus Nominal GDP
GDP is the measure of total expenditure on goods and services in all markets in an economy. If GDP increases from one period to the next, then it means that either the output is larger or the prices the goods are sold at is higher. To separate the two effects economists use a measure called Real GDP. Real GDP shows the increase in a country output of goods and services. Nominal GDP is the production of goods and services measured at current prices. Real GDP is the production of goods and services measured at constant base year prices. Since real GDP is not affected by changes in prices, changes in real GDP reflects only changes in amounts being produced. It is therefore a measure of the economy’s production of goods and services. Since economists measure a country’s well-being and its ability to support its citizenry through GDP then Real GDP is a better gauge of economic well-being than nominal GDP. The GDP Deflator
This is the ratio of nominal GDP to real GDP. Nominal GDP measures production at curren prices while Real GDP only reflects the quantities produced. The GDP deflator measures the current level of prices relative to the base year. GDP Deflator = Nominal GDP X 100
Real GDP
Since real and nominal GDP are equal in the base year, the GDP deflator is equal to 100.
Example:
GDP Class Exercise: Computing real and nominal GDPs Mankiw pp. 204 (own example of tea and coffee)
LECTURE 2: MEASURING THE COST OF LIVING
I NTRODUCTION
Recap: The GDP deflator and changes in Price level
Discussion and review of class exercise of lecture 1.
The Consumer Price Index
The Consumer Price Index (CPI) is a measure of the overall cost of goods and services bought by a typical consumer. It is used to monitor the cost of living over time. When the CPI rises, a typical family has to spend more money to keep the same the same standard of living. When the general price level is persistently rising, we say that there is inflation. Inflation refers to a situ ation where the overall price level is rising. Inflation rate is the percentage change in price level from the previous period. Calculating the CPI and Inflation Rate
In Kenya the KNBS is responsible for compiling the National CPI. This is done on a monthly basis and the results disseminated. The CPI is computed as follows:
Step 1: Select and fix the basket
This is done by determining which goods (prices) are most important to a typical consumer and assigning them weights that reflect that importance. For instance, if the typical consumer buys more maize flour than wheat flour, then maize flour should be allocated a higher weight. The selected goods prices constitute what is called a consumption basket. Step 2: Find the prices
A survey is carried to obtain the prices of the basket of goods at each point in time. In Kenya, the KNBS carries out price checks in designated markets for the basket of goods at a given date each month. Step 3: Compute the basket’s cost
Using the data collected the cost of the basket of goods is computed at each point. The basket is kept constant to ensure that only price effects are reflected in the computation of the cost of the basket.
Step 4: Choose a base year and compute the index
Designate one year as the base year, the benchmark against which other periods prices are compared.The choice of this year is arbitrary. The CPI is then computed as follows: CPI = Price of basket in current year / price of basket in base year X 100 i.e the price of the basket in each year divided by the price of the basket in the base year. The computation up this stage gives us the CPI. How do we determine the inflation rate from the CPI?
Step 5: Compute the Inflation Rate
The inflation rate is the percentage change in the price index from the preceding period. It is computed as: Inflation rate = (CPI in year 2 – CPI in year 1) / CPI in year 1 X 100 Problems in measuring CPI
i) Substitution bias
The assumption of the CPI construction methodology is that consumers are rigid and are not able to substitute expensive goods for cheaper ones. This is not true. If the price of maize meal rises more than that of wheat meal, consumers can buy less of maize meal and more of wheat meal. This means that with a fixed basket, the CPI continues to reflect higher cost of living than is being experienced by the typical consumer. ii) Introduction of new goods and services
When new goods are introduced in the market, consumers enjoy greater flexibility in their quest to maintain standard of living. For instance the introduction of the DVD reduced the need to attend movie theater.
iii) Unmeasured quality change
When the quality of a good deteroriates with the price remaining constant, there is a loss of purchasing power. Similarly, quality increases with price increases do not represent loss of purchasing power. While the Statistics bureaus try to take account of quality changes, to ensure that same quality comparisons are made, some unmeasured quality changes are not reflected in the CPI. Importance of CPI and Inflation Statistics
1. Helps the government in its economic management programs by disclosing the changes in the cost of living and the effect it is having on various segments of the economy. 2. It is used to adjust incomes and set minimum wages
3. It is used as a guide to investors on the level of returns they are receiving. 4. It helps to understand the money equivalents between different periods of time.
GDP Deflator Versus the CPI
As earlier learnt, the DDP deflator is the ration of nominal GDP to Real GDP. The GDP deflator reflects the level of current prices relative to the prices in the base year. Economists monitor both the GDP deflator and the CPI to gauge the rate at which prices are rising in the economy. While the two statistics tell the same story, there can be a divergence due to the following reasons: 1. The GDP deflator measures reflects all goods and prices produced domestically. On the other hand the CPI measures the prices of all goods and services bought by consumers. Effects of large military or government imports costs may not reflect in the CPI but will show in the GDP deflator. 2. The GDP deflator reflects the price changes of all goods under current production. The CPI on the other hand is based on a fixed basket of goods that is only changed occasionally. Adjusting Economic Variables for the effects of inflation
The CPI is often used to compare money equivalents from different periods of time. How much is KES 1,000 in 1990 equivalent to in 2014? This question can be answered by using the CPI. Amount in 2014 = Amount in 1990 X CPI in 2014/CPI in 1990
This is similar to inflating the 1990 amounts to know their current equivalent. When an amount is automatically corrected for changes in price level by law or contract it is said to be indexed for inflation. Indexation is a common feature in collective bargaining agreement where a cost of living adjustment is often built in. The same applies to social security payments. Inflation and Interest rates
When one saves and earns interest, it is important to consider the effects of inflation on the interest return due to passage of time. To measure whether one is better off given a certain return earned on savings, you look at the real interest rate and not the nominal interest rate as quoted by the bank. The interest rate that measures the change in dollar amounts is called the nominal interest rate. When the interest rate is corrected for inflation it is called the real interest rate. Real Interest rate = Nominal Interest rate – inflation rate
It will important to read
out following chapters:
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