Introduction and measuring nations income

Introduction to Macroeconomics

Copyright © 2004 South-Western

MEANING OF ECONOMICS
The word ‘Economics’ originates from the Greek
work ‘Oikonomikos’ which can be divided into two
parts:
(a) ‘Oikos’, which means ‘Home’, and
(b) ‘Nomos’, which means ‘Management’.

•Thus, Economics means ‘Home Management’.
•The head of a family faces the problem of managing
the unlimited wants of the family members within the
limited income of the family.


MEANING OF ECONOMICS
• If we consider the whole society as a ‘family’
• then the society also faces the problem of tackling
unlimited wants of the members of the society with the
limited resources available in that society.

• Thus, Economics means the study of the way in
which mankind organizes itself to tackle the basic
problems of scarcity.


BROAD SCOPE OF ECONOMICS
Economic Problems
The main economic problems faced by every society
are:
1.Unlimited human wants,
2.Limited availability of resources to satisfy those
wants, and
3.Fulfillment of unlimited wants with limited resources.


BROAD SCOPE OF ECONOMICS
Three Main Economic Questions
In recent times, economists have analyzed economic
systems from a broad perspective. These modern
economists talk about three main economic questions:
(1)What to produce,
(2)How to produce and ,
(3)For whom to produce.


What Is Macroeconomics? What Is Microeconomics?
• Macroeconomics deals with questions about
variables that describe the economy of an entire
nation.
• Microeconomics deals with questions related to
individual economic agents, such as households
and firms.
• Micro-an individual tree
• Macro- the entire forest


The Scope of Economics

Microeconomics and Macroeconomics
TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns
Divisions
of Economics
Microeconomics

Macroeconomics

Production

Prices

Income

Employment

Production/output in
individual industries and
businesses

How much steel
How much office
   space
How many cars

Price of individual
goods and services

Distribution of
income and
wealth

Employment by
individual businesses
and industries

Price of medical care
Price of gasoline
Food prices
Apartment rents

Wages in the auto
  industry
Minimum wage
Executive salaries
Poverty

Jobs in the steel
  industry
Number of employees
  in a firm
Number of
  accountants

National
production/output

Aggregate price level

National income

Employment and
unemployment in
the economy

Total industrial output
Gross domestic
   product
Growth of output

Consumer prices
Producer prices
Rate of inflation

Total wages and
  salaries
Total corporate
  profits

Total number of jobs
Unemployment rate


Macroeconomics
• Macroeconomics deals with the economy as a whole. It
studies the behavior of economic aggregates such as
aggregate income, consumption, investment, and the
overall level of prices.
• Aggregate behavior refers to the behavior of all
households and firms together.
• A macroeconomist would ponder questions such as,
• what would happen to Pakistan’s unemployment rate if
China or EU suddenly stops trading with Pakistan and
• what policy should the government of Pakistan then
follow?
• The focus would always be on Pakistan as a whole.


Areas of concern
•
•
•
•

Unemployment
Prices-inflation
Interest rates-rental price of money
Govt. budget- fiscal deficit
• How much government spends?
• How much revenue government earns through taxes?
• Productivity –with the given amount of resources how
much output do you get
• Value of currency- exchange rates
• Macroeconomic policy
• Fiscal Policy
• Monetary policy

Economic Theory in Practice
Positive versus Normative Economics
• Positive Economics An approach to economics
that seeks to understand behavior and the
operation of systems without making judgments.
It explains what will happen under certain
conditions.
• Normative Economics
An approach to
economics that analyzes outcomes of economic
behavior, evaluates them as good or bad, and
may prescribe courses of action. Also called
policy economics. It explains what should
happen

Introduction to Macroeconomics


Positive vs Normative Economics
• For example, the statement, "government should
provide basic healthcare to all citizens" is a normative
economic statement.
• The statement, "government-provided healthcare
increases public expenditures" is a positive economic
statement.


Positive or Normative?
1. The retirement age should be raised to 70 to
combat the effects of our ageing population
2. A rise in average temperatures will increase
the demand for sun screen products.
3. The government should increase the minimum
wage to £6 per hour to reduce poverty.
4. Higher interest rates will reduce house prices


Measuring a Nation’s
Income


THE ECONOMY’S INCOME AND
EXPENDITURE
• When judging whether the economy is doing
well or poorly, it is natural to look at the total
income that everyone in the economy is
earning.
• For an economy as a whole, income must equal
expenditure because:
• Every transaction has a buyer and a seller.
• Every dollar of spending by some buyer is a dollar
of income for some seller.

THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• Gross domestic product (GDP) is a measure of
the income and expenditures of an economy.
• It is the total market value of all final goods and
services produced within a country in a given
period of time.


DOMESTIC PRODUCT
• The equality of income and expenditure can be
illustrated with the circular-flow diagram.


Figure 1 The Circular-Flow Diagram

MARKETS
FOR
GOODS AND SERVICES
•Firms sell
Goods
•Households buy
and services
sold
Revenue

Wages, rent,
and profit

Goods and
services
bought

HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production

FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production

Factors of
production

Spending

Labor, land,
MARKETS
and capital
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy

Income
= Flow of inputs
and outputs
= Flow of dollars


The Circular-Flow Diagram-with Saving &
investment
Revenue
Goods
and services
sold

MARKETS
MARKETS
FOR
FOR
GOODS AND SERVICES
GOODS AND SERVICES
•Firms sell
•Firms sell
•Households buy
•Households buy

Spending
Goods and
services
bought

Saving
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production

HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production

Financial
Market
Investment

Factors of
production
Wages, rent,
and profit

Labour, land,
MARKETS
and capital
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy

Income
= Flow of inputs
and outputs
= Flow of dollars


DOMESTIC PRODUCT
• GDP is the market value of all final goods and
services produced within a country in a given
period of time.


DOMESTIC PRODUCT
• “GDP is the Market Value . . .”
• Output is valued at market prices.
• Example: If the price of an apple is twice the price of an
orange, then an apple contributes twice as much to GDP as
does an orange.

• “. . . Of All Final . . .”
• It includes all items produced in the economy and sold
legally in markets.
• Example: Vegetable you buy at the grocery store are part of
GDP, vegetables you grow in your garden are not.
• It records only the value of final goods, not intermediate
goods (the value is counted only once).

DOMESTIC PRODUCT
• “. . . Goods and Services . . . “
• It includes both tangible goods (food, clothing, cars) and
intangible services (housecleaning, doctor visits).
• Example: When you buy a CD, you are buying a good, and
the purchase price is part of GDP.

• “. . . Produced . . .”
• It includes goods and services currently produced, not
transactions involving goods produced in the past.
• Example: When Honda produces and sells a new car, the
value of the car is included in GDP. But when a persons
sells a used car to another, the value of the used car is not
included in GDP.

DOMESTIC PRODUCT
• “ . . . Within a Country . . .”
• It measures the value of production within the geographic
confines of a country.
• Example: When a U.S. citizen owns a factory in Pakistan,
the production at his factory is not part of U.S. GDP (It is
part of Pakistan’s GDP).

• “. . . In a Given Period of Time.”
• It measures the value of production that takes place within a
specific interval of time, usually a year or a quarter (three
months).


THE COMPONENTS OF GDP
• GDP includes all items produced in the
economy and sold legally in markets.


• What Is Not Counted in GDP?
• GDP excludes most items that are produced and
consumed at home and that never enter the
marketplace.
• It excludes items produced and sold illicitly, such as
illegal drugs.


• GDP (Y) is the sum of the following:
•
•
•
•

Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)

Y = C + I + G + NX
This equation is an identity.


• Consumption (C):
• The spending by households on goods and services,
with the exception of purchases of new housing.
• Goods include household spending on durable (such
as automobiles and appliances) and non-durable
goods ( such as food and clothing).

• Investment (I):
• The spending on capital equipment, inventories, and
structures, including new housing.


• Government Purchases (G):
• The spending on goods and services by local, state,
and federal governments.
• Does not include transfer payments ( Social
Security benefit to a person or an unemployment
insurance benefit) because they are not made in
exchange for currently produced goods or services.

• Net Exports (NX):
• Exports minus imports.


Table 1 GDP and Its Components

Copyright©2004 South-Western

ACTIVE LEARNING 1

GDP and its components
In each of the following cases, determine how much
GDP and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband a dinner
at the finest restaurant in New York.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on sale
for a great price from a local manufacturer.
D. General Motors builds $500 million worth of cars,

ACTIVE LEARNING 1

Answers
A. Debbie spends $200 to buy her husband a dinner

at the finest restaurant in New York.
Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in
her publishing business. The laptop was built in
China.

Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.
30

ACTIVE LEARNING 1

Answers
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on
sale for a great price from a local manufacturer.

Current GDP and investment do not change,
because the computer was built last year.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million of them.

Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.
31

REAL VERSUS NOMINAL GDP
• Inflation can distort economic variables like GDP, so
we have two versions of GDP:
One is corrected for inflation, the other is not.
• Nominal GDP values production of goods and
services at current prices. It is not corrected for
inflation.
• Real GDP values the production of goods and services
at constant prices (base year). Real GDP is corrected
for inflation.


REAL VERSUS NOMINAL GDP
• The change in nominal GDP reflects both prices and
quantities.
• The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
• An accurate view of the economy requires adjusting
nominal to real GDP by using the GDP deflator.


The GDP Deflator
• The GDP deflator is a measure of the price level
calculated as the ratio of nominal GDP to real GDP
times 100.
• It tells us the rise in nominal GDP that is attributable
to a rise in prices rather than a rise in the quantities
produced.
• The GDP deflator is a measure of the overall level of
prices.
• One way to measure the economy’s inflation rate is to
compute the percentage increase in the GDP deflator
from one year to the next.

The GDP Deflator
• The GDP deflator is calculated as follows:

N o m in a l G D P
G D P d e fla to r =
×100
R eal G D P


The GDP Deflator
• Converting Nominal GDP to Real GDP
• Nominal GDP is converted to real GDP as follows:

R e a l G D P20X X

N o m in a l G D P 20X X
=
×100
G D P d e f la to r2 0 X X


EXAMPLE:
Pizza

Coffee

year

P

Q

P

Q

2005

$10

400

$2.00

1000

2006

$11

500

$2.50

1100

2007

$12

600

$3.00

1200

Compute nominal GDP in each year:
2005: $10 x 400 +

$2 x 1000

= $6,000

2006: $11 x 500 + $2.50 x 1100 = $8,250
2007: $12 x 600 +

$3 x 1200

MEASURING A NATION’S INCOME

= $10,800

Increase:
37.5%
30.9%
41

EXAMPLE:
Pizza

Coffee

year

P

Q

P

Q

2005

400
500

$2.00
$2.00
$2.50

1000

2006

$10
$10
$11

2007

$12

600

$3.00

1200

Compute real GDP in each year,
using 2005 as the base year:
2005: $10 x 400 + $2 x 1000 = $6,000
2006: $10 x 500 + $2 x 1100 = $7,200
2007: $10 x 600 + $2 x 1200 = $8,400

1100

Increase:
20.0%
16.7%
42

EXAMPLE:
year
2005

Nominal
GDP
$6000

Real
GDP
$6000

2006

$8250

$7200

2007

$10,800

$8400

In each year,

 nominal GDP is measured using the (then)
current prices.

 real GDP is measured using constant prices from
the base year (2005 in this example).

43

EXAMPLE:
year
2005

Nominal
GDP
$6000

2006

$8250

2007

$10,800

37.5%
30.9%

Real
GDP
$6000
$7200
$8400

20.0%
16.7
%

 The change in nominal GDP reflects both prices
and quantities.

 The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.

44

EXAMPLE:
year

Nominal
GDP

Real
GDP

GDP
Deflator

2005

$6000

$6000

100.0

2006

$8250

$7200

114.6

2007

$10,800

$8400

128.6

14.6%
12.2%

Compute the GDP deflator in each year:
2005:

100 x (6000/6000) =

100.0

2006:

100 x (8250/7200) =

114.6

2007:

100 x (10,800/8400) =

128.6


45

ACTIVE LEARNING 2

Computing GDP
2007 (base yr)
P
Good A
Good B

$30
$100

Q

2008
P

2009
Q

900
$31 1,000
192 $102
200

P

Q

$36
$100

1050
205

Use the above data to solve these problems:
A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
46

ACTIVE LEARNING 2

Answers
2007 (base yr)
P
Good A
Good B

$30
$100

Q

2008
P

2009
Q

900
$31 1,000
192 $102
200

P

Q

$36
$100

1050
205

A. Compute nominal GDP in 2007.

$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2008.

$30 x 1000 + $100 x 200 = $50,000
47

ACTIVE LEARNING 2

Answers
2007 (base yr)
P
Good A
Good B

Q

$30
$100

2008
P

2009
Q

900
$31 1,000
192 $102
200

P

Q

$36
$100

1050
205

C. Compute the GDP deflator in 2009.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1

48

GDP AND ECONOMIC WELLBEING
• GDP is the best single measure of the economic
well-being of a society.
• GDP per person tells us the income and
expenditure of the average person in the
economy.


GDP AND ECONOMIC WELLBEING
• Higher GDP per person indicates a higher
standard of living.
• GDP is not a perfect measure of the happiness
or quality of life, however.


GDP AND ECONOMIC
WELL-BEING
• Some things that contribute to well-being are
not included in GDP.
• The value of leisure.
• The value of a clean environment.
• The value of almost all activity that takes place
outside of markets, such as the value of the time
parents spend with their children and the value of
volunteer work.


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