cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Macroeconomics II §Ondřej Krčál §Department of Economics §Office 611 §Consultation hours: Monday 16:30 – 18:00 §E-mail: krcalo@mail.muni.cz > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Literature §MANKIW, G. (2010): Macroeconomics. 7th edition. Worth Publishers. § § § > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Exam qTest – 50 questions a/b/c/d (1 correct answer) qCorrect answer +1 p., wrong answer and no answer 0 p. qA: 50 – 45 points qB: 44 – 42 points qC: 41 – 39 points qD: 38 – 36 points qE: 35 – 33 points qF: 32 points and less > MACROECONOMICS cover art ROW 1 (90) C H A P T E R © 2008 Worth Publishers, all rights reserved SIXTH EDITION PowerPoint® Slides by Ron Cronovich N. GREGORY MANKIW The Science of Macroeconomics 1 This is the 2007 annual update to the PowerPoints for the 6^th edition of Mankiw’s Macroeconomics. The purpose of the annual updates is to update the data to the most recent available, and correct any typos reported by users or found by myself. If you find an error or have a suggestion, please email me at roncron@unlv.nevada.edu. I will fix any errors and incorporate the best user suggestions in the 2008 update, or in the next major revision of these slides (which will coincide with the next edition of the textbook, probably coming in 2009). To help you get the most from these slides, I have prepared a README file with User Instructions, and I have annotated many individual slides with notes – visible only to you – that appear in this area of your screen. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Learning Objectives §This chapter introduces you to §the issues macroeconomists study §the tools macroeconomists use §some important concepts in macroeconomic analysis > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Important issues in macroeconomics §What causes recessions? Can the government do anything to combat recessions? Should it? §What is the government budget deficit? How does it affect the economy? §Why does the U.S. have such a huge trade deficit? Macroeconomics, the study of the economy as a whole, addresses many topical issues: This slide and the next contain a list of some topical issues that macro can help students understand. Feel free to substitute others as new issues emerge. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Important issues in macroeconomics §Why are millions of people unemployed, even when the economy is booming? §Why does the cost of living keep rising? §Why are so many countries poor? What policies might help them grow out of poverty? Macroeconomics, the study of the economy as a whole, addresses many topical issues: > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. Real GDP per capita (2000 dollars) Great Depression World War II First oil price shock Second oil price shock 9/11/2001 long-run upward trend… source: same as textbook through 2004. More recent values from U.S. Census Bureau (for population figures) and Bureau of Economic Analysis (for GDP figures), both obtained from FRED, the Economic database of the St. Louis Fed’s Economic Research Division, http://research.stlouisfed.org/fred2/ cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. inflation rate (% per year) source: same as textbook through 2004. More recent values from Bureau of Labor Statistics, http://www.bls.gov cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. unemployment rate (% of labor force) source: same as textbook through 2004. For more recent years, BLS. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Social problems like homelessness, domestic violence, crime, and poverty are linked to the economy. For example… Why learn macroeconomics? §1. The macroeconomy affects society’s well-being. U.S. Unemployment and Property Crime Rates unemployment (left scale) property crime (right scale) This slide replaces one in earlier versions of my PowerPoint slides that contained estimates – first published in 1983 - on the statistical association of unemployment with suicides, homicides, mental institution and prison populations, and so forth. I was increasingly uncomfortable with using such out of date estimates, but could not find more recent ones. For the 2007 update (to the PowerPoints for Mankiw’s 6^th edition that first appeared in 2006), I have scrapped the 1983 estimates and instead provide this graph of property crime and unemployment. While the correlation is clearly not perfect, there is a strong, visible association between unemployment, an economic indicator, and crime, a social indicator. Sources: unemployment rates - BLS crime rates - Bureau of Justice Statistics, Data Online at http://www.ojp.usdoj.gov/bjs cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Why learn macroeconomics? 2. The macroeconomy affects your well-being. In most years, wage growth falls when unemployment is rising. Macroeconomics helps students understand forces that will affect their financial well-being. Here’s an example. When the unemployment rate is rising, tens or hundreds of thousands of people are losing their jobs. This affects even those who don’t lose their jobs: As the graph shows, during most years there is a clear negative relationship between the (12-month) change in unemployment and the annual growth rate of real wages. In plain English, rising unemployment is associated with falling (and often negative) wage growth. So when the economy goes into recession, even if our students get to keep their jobs, they will find it much harder to get a raise, and may have to accept a real wage cut. Students find this relationship intuitive. When unemployment is rising, the supply of workers is rising faster than demand, so wages grow more slowly or even fall. Conversely, falling unemployment gives workers more bargaining power over wages, as it becomes increasingly hard for employers to replace their workers, and increasingly easy for workers to find good opportunities with other companies. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Why learn macroeconomics? Unemployment & inflation in election years year U rate inflation rate elec. outcome 1976 7.7% 5.8% Carter (D) 1980 7.1% 13.5% Reagan (R) 1984 7.5% 4.3% Reagan (R) 1988 5.5% 4.1% Bush I (R) 1992 7.5% 3.0% Clinton (D) 1996 5.4% 3.3% Clinton (D) 2000 4.0% 3.4% Bush II (R) 2004 5.5% 3.3% Bush II (R) §3. The macroeconomy affects politics. I’d also suggest you briefly define the inflation rate (as the percentage increase in the cost of living) to help students understand this slide. Main point of this data: The state of the economy has a huge impact on election outcomes. When the economy is doing poorly, there tends to be a change in the party that controls the White House. 1976: The rates of inflation () and unemployment (u) both high. Incumbent (Ford, R) loses. 1980: u still high,  even higher. Incumbent (Carter, D) loses. 1984: u still high, but  much lower. Incumbent (Reagan) wins. 1988:  the same, u much lower. Incumbent party wins. 1992:  low, but u much higher (and was higher yet in 1991). Incumbent loses. 1996: u much lower, incumbent wins. 2000: Economy doing great, and incumbent party candidate (Gore, D) wins majority of popular vote, but loses electoral college to challenger. 2004: u somewhat higher, but lower than in 2001 recession;  low; incumbent wins cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Economic models §…are simplified versions of a more complex reality §irrelevant details are stripped away §…are used to §show relationships between variables §explain the economy’s behavior §devise policies to improve economic performance cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Example of a model: Supply & demand for new cars §shows how various events affect price and quantity of cars §assumes the market is competitive: each buyer and seller is too small to affect the market price §Variables: §Q d = quantity of cars that buyers demand §Q s = quantity that producers supply §P = price of new cars §Y = aggregate income §Ps = price of steel (an input) > Students will realize that the auto market is not competitive. However, if all we want to know is how an increase in the price of steel or a fall in consumer income affects the price and quantity of autos, then it’s fine to use this model. In general, making unrealistic assumptions is okay, even desirable, if they simplify the analysis without affecting its validity. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The market for cars: Demand Q Quantity of cars P Price of cars D The demand curve shows the relationship between quantity demanded and price, other things equal. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The market for cars: Supply Q Quantity of cars P Price of cars D S The supply curve shows the relationship between quantity supplied and price, other things equal. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The market for cars: Equilibrium Q Quantity of cars P Price of cars S D equilibrium price equilibrium quantity cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The effects of an increase in income Q Quantity of cars P Price of cars S D1 Q1 P1 An increase in income increases the quantity of cars consumers demand at each price… …which increases the equilibrium price and quantity. P2 Q2 D2 cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The effects of a steel price increase Q Quantity of cars P Price of cars S1 D Q1 P1 An increase in Ps reduces the quantity of cars producers supply at each price… …which increases the market price and reduces the quantity. P2 Q2 S2 cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Endogenous vs. exogenous variables §The values of endogenous variables are determined in the model. §The values of exogenous variables are determined outside the model: the model takes their values & behavior as given. §In the model of supply & demand for cars, cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics A multitude of models §No one model can address all the issues we care about. §e.g., our supply-demand model of the car market… §can tell us how a fall in aggregate income affects price & quantity of cars. §cannot tell us why aggregate income falls. > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics A multitude of models §So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth). §For each new model, you should keep track of §its assumptions §which variables are endogenous, which are exogenous §the questions it can help us understand, and those it cannot > Chapter Summary §Macroeconomics is the study of the economy as a whole. §Macroeconomists attempt to explain the economy and to devise policies to improve its performance. §Economists use different models to examine different issues. CHAPTER 1 The Science of Macroeconomics slide 23 cover R3,C1 > MACROECONOMICS cover art ROW 1 (90) C H A P T E R © 2008 Worth Publishers, all rights reserved SIXTH EDITION PowerPoint® Slides by Ron Cronovich N. GREGORY MANKIW The Data of Macroeconomics 2 This PowerPoint chapter contains in-class exercises requiring students to have calculators. To help motivate the chapter, it may be helpful to remind the students that much of macroeconomics---and this book---is devoted to understanding the behavior of aggregate output, prices, and unemployment. Much of Chapter 2 will be familiar to students who have taken an introductory economics course. Therefore, you might consider going over Chapter 2 fairly quickly. This would allow more class time for the subsequent chapters, which are more challenging. Instructors who wish to shorten the presentation might consider omitting : •a couple of slides on GNP vs. GDP •a slide on chain-weighted real GDP vs. constant dollar real GDP •some of the in-class exercises (though I suggest you ask your students to try them within 8 hours of the lecture, to reinforce the concepts while the material is still fresh in their memory.) •The slides on stocks vs. flows. Subsequent chapters do not refer to these concepts very much. There are hidden slides you may want to “unhide.” They show that the GDP deflator and CPI are, indeed, weighted averages of prices. If your students are comfortable with algebra, then this material might be helpful. However, it’s a bit technical, and doesn’t appear in the textbook, so I’ve hidden these slides--they won’t appear in the presentation unless you intentionally “unhide” them. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics In this chapter, you will learn… §…the meaning and measurement of the most important macroeconomic statistics: §Gross Domestic Product (GDP) §The Consumer Price Index (CPI) §The unemployment rate § § > These are three of the most important economic statistics. Policymakers and businesspersons use them to monitor the economy and formulate appropriate policies. Economists use them to develop and test theories about how the economy works. Because we’ll be learning many of these theories, it’s worth spending some time now to really understand what these statistics mean, and how they are measured. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Gross Domestic Product: Expenditure and Income §Two definitions: §Total expenditure on domestically-produced final goods and services. §Total income earned by domestically-located factors of production. Expenditure equals income because every dollar spent by a buyer becomes income to the seller. Most students, having taken principles of economics, will have seen this definition and be familiar with it. It’s not worth spending a lot of time on. It might be worthwhile, however, to briefly review the factors of production. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The Circular Flow Households Firms Goods Labor Expenditure ($) Income ($) cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The expenditure components of GDP §consumption §investment §government spending §net exports > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Consumption (C) §durable goods last a long time ex: cars, home appliances §nondurable goods last a short time ex: food, clothing §services work done for consumers ex: dry cleaning, air travel. RF5232234 definition: The value of all goods and services bought by households. Includes: > A consumer’s spending on a new house counts under investment, not consumption. More on this in a few moments, when we get to Investment. A tenant’s spending on rent counts under services -- rent is considered spending on “housing services.” So what happens if a renter buys the house she had been renting? Conceptually, consumption should remain unchanged: just because she is no longer paying rent, she is still consuming the same housing services as before. In national income accounting, (the services category of) consumption includes the imputed rental value of owner-occupied housing. To help students keep all this straight, you might suggest that they think of a house as a piece of capital which is used to produce a consumer service, which we might call “housing services”. Thus, spending on the house counts in “investment”, and the value of the housing services that the house provides counts under “consumption” (regardless of whether the housing services are being consumed by the owner of the house or a tenant). cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. consumption, 2006 41.4 20.5 8.1 70.0% 5,483.7 2,714.9 1,070.3 $9,268.9 Services Nondurables Durables Consumption % of GDP $ billions source: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.gov cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Investment (I) §Definition 1: Spending on [the factor of production] capital. §Definition 2: Spending on goods bought for future use §Includes: §business fixed investment Spending on plant and equipment that firms will use to produce other goods & services. §residential fixed investment Spending on housing units by consumers and landlords. §inventory investment The change in the value of all firms’ inventories. > In definition #1, note that aggregate investment equals total spending on newly produced capital goods. (If I pay $1000 for a used computer for my business, then I’m doing $1000 of investment, but the person who sold it to me is doing $1000 of disinvestment, so there is no net impact on aggregate investment.) The housing issue §A consumer’s spending on a new house counts under investment, not consumption. §A tenant’s spending on rent counts under services -- rent is considered spending on “housing services.” §So what happens if a renter buys the house she had been renting? Conceptually, consumption should remain unchanged: just because she is no longer paying rent, she is still consuming the same housing services as before. §In national income accounting, (the services category of) consumption includes the imputed rental value of owner-occupied housing. §To help students keep all this straight, you might suggest that they think of a house as a piece of capital which is used to produce a consumer service, which we might call “housing services”. Thus, spending on the house counts in “investment”, and the value of the housing services that the house provides counts under “consumption” (regardless of whether the housing services are being consumed by the owner of the house or a tenant). Inventories §If total inventories are $10 billion at the beginning of the year, and $12 billion at the end, then inventory investment equals $2 billion for the year. §Note that inventory investment can be negative (which means inventories fell over the year). cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. investment, 2006 0.4 5.8 10.5 16.7% 49.6 766.7 1,396.2 $2,212.5 Inventory Residential Business fixed Investment % of GDP $ billions source: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.gov cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Stocks vs. Flows §A flow is a quantity measured per unit of time. §E.g., “U.S. investment was $2.5 trillion during 2006.” Flow Stock A stock is a quantity measured at a point in time. E.g., “The U.S. capital stock was $26 trillion on January 1, 2006.” The bathtub example is the classic means of explaining stocks and flows, and appears in Chapter 2. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Stocks vs. Flows - examples the govt budget deficit the govt debt # of new college graduates this year # of people with college degrees a person’s annual saving a person’s wealth flow stock Point out that a specific quantity of a flow variable only makes sense if you know the size of the time unit. If someone tells you her salary is $5000 but does not say whether it is “per month” or “per year” or otherwise, then you’d have no idea what her salary really is. A pitfall with flow variables is that many of them have a very standard time unit (e.g., per year). Therefore, people often omit the time unit: “John’s salary is $50,000.” And omitting the time unit makes it easy to forget that John’s salary is a flow variable, not a stock. Another point: It is often the case that a flow variable measures the rate of change in a corresponding stock variable, as the examples on this slide (and the investment/capital example) make clear. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Government spending (G) §G includes all government spending on goods and services.. §G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services. § Transfer payments are included in “government outlays,” but not in government spending. People who receive transfer payments use these funds to pay for their consumption. Thus, we avoid double-counting by excluding transfer payments from G. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. government spending, 2006 Federal 19.1% $2,527.7 Govt spending State & local Defense 7.0 12.1 4.7 2.3 926.6 1,601.1 621.0 305.6 Non-defense % of GDP $ billions source: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.gov Net exports: NX = EX – IM §def: The value of total exports (EX) minus the value of total imports (IM). cover R1,C4 source: FRED Database, The Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/ Before showing the data graph, the following explanation might be helpful: Remember, GDP is the value of spending on our country’s output of goods & services. Exports represent foreign spending on our country’s output, so we include exports. Imports represent the portion of domestic spending (C, I, and G) that goes to foreign goods and services, so we subtract off imports. NX, therefore, equals net spending by the foreign sector on domestically produced goods & services. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics An important identity §Y = C + I + G + NX aggregate expenditure value of total output A few slides ago, we defined GDP as the total expenditure on the economy’s output of goods and services (as well as total income). We can also define GDP as (the value of) aggregate output, not just spending on output. An identity is an equation that always holds because of the way the variables are defined. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics A question for you: §Suppose a firm §produces $10 million worth of final goods §but only sells $9 million worth. § §Does this violate the expenditure = output identity? If you do not wish to pose this as a question, you can “hide” this slide and skip right to the next one, which simply gives students the information. Suggestion (applies generally, not just here): When you pose a question like this to your class, don’t ask for students to volunteer their answers right away. Instead, tell them to think about it for a minute and write their answer down on paper. Then, ask for volunteers (or call on students at random). Giving students this extra minute will increase the quality of participation as well as the number of students who participate. Correct answer to the question: Unsold output adds to inventory, and thus counts as inventory investment – whether intentional or unplanned. Thus, it’s as if a firm “purchased” its own inventory accumulation. Here’s where the “goods purchased for future use” definition of investment is handy: When firms add newly produced goods to their inventory, the “future use” of those goods, of course, is future sales. Note, also, that inventory investment counts intentional as well as unplanned inventory changes. Thus, when firms sell fewer units than planned, the unsold units go into inventory and are counted as inventory investment. This explains why “output = expenditure” -- the value of unsold output is counted under inventory investment, just as if the firm “purchased” its own output. Remember, the definition of investment is goods bought for future use. With inventory investment, that future use is to give the firm the ability in the future to sell more than its output. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Why output = expenditure §Unsold output goes into inventory, and is counted as “inventory investment”… § …whether or not the inventory buildup was intentional. §In effect, we are assuming that firms purchase their unsold output. > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics GNP vs. GDP §Gross National Product (GNP): Total income earned by the nation’s factors of production, regardless of where located. §Gross Domestic Product (GDP): Total income earned by domestically-located factors of production, regardless of nationality. § (GNP – GDP) = (factor payments from abroad) – (factor payments to abroad) > Emphasize that the difference b/w GDP and GNP boils down to two things: location of the economic activity, and ownership (domestic vs. foreign) of the factors of production. From the perspective of the U.S., factor payments from abroad includes things like •wages earned by U.S. citizens working abroad •profits earned by U.S.-owned businesses located abroad •income (interest, dividends, rent, etc) generated from the foreign assets owned by U.S. citizens Factor payments to abroad includes things like •wages earned by foreign workers in the U.S. •profits earned by foreign-owned businesses located in the U.S. •income (interest, dividends, rent, etc) that foreigners earn on U.S. assets Chapter 3 introduces factor markets and factor prices. Unless you’ve already covered that material, it might be worth mentioning to your students that factor payments are simply payments to the factors of production, for example, the wages earned by labor. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics (HNP – HDP) jako % HDP vybrané země, 2005 zdroje: World Development Indicators, World Bank Makroekonomická predikce MFČR HNP mld. Kč 3.449 HDP mld. Kč 3.693 Rozdíl % HDP -7.1 ČR: 2010 cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Real vs. nominal GDP §GDP is the value of all final goods and services produced. §nominal GDP measures these values using current prices. §real GDP measure these values using the prices of a base year. > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Practice problem, part 1 §Compute nominal GDP in each year. §Compute real GDP in each year using 2006 as the base year. 2006 2007 2008 P Q P Q P Q good A $30 900 $31 1,000 $36 1,050 good B $100 192 $102 200 $100 205 > This slide (and a few of the following ones) contain exercises that you can have your students do in class for immediate reinforcement of the material. This problem requires calculators. If most of your students do not have calculators, you might “hide” this slide and instead pass out a printout of it for a homework exercise. Tell students that if they don’t have Or: just have them write down the expressions that they would enter into a calculator if they had calculators, i.e. Nominal GDP in 2001 = 30*900 + 100*192. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Answers to practice problem, part 1 §nominal GDP multiply Ps & Qs from same year 2006: $46,200 = $30 ´ 900 + $100 ´ 192 2007: $51,400 2008: $58,300 §real GDP multiply each year’s Qs by 2006 Ps 2006: $46,200 2007: $50,000 2008: $52,000 = $30 ´ 1050 + $100 ´ 205 > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Real GDP controls for inflation §Changes in nominal GDP can be due to: §changes in prices. §changes in quantities of output produced. §Changes in real GDP can only be due to changes in quantities, §because real GDP is constructed using constant base-year prices. > Suppose from 2006 to 2007, nominal GDP rises by 10%. Some of this growth could be due to price increases, because an increase in the price of output causes an increase in the value of output, even if the real quantity remains the same. Hence, to control for inflation, we use real GDP. Remember, real GDP is the value of output using constant base-year prices. If real GDP grows by 6% from 2006 to 2007, we can be sure that all of this growth is due to an increase in the economy’s actual production of goods and services, because the same prices are used to construct real GDP in 2006 and 2007. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics U.S. Nominal and Real GDP, 1950–2007 Nominal GDP Real GDP (in 2000 dollars) Source: http://research.stlouisfed.org/fred2/ Notice that the brown line (nominal GDP) is steeper than the blue line. That’s because prices generally rise over time. So, nominal GDP grows at a faster rate than real GDP. If you’re anal like me, you might ask students what is the significance of the two lines crossing in 2000. Answer: 2000 is the base year for this real GDP data, so RGDP = NGDP in 2000 only. Before 2000, RGDP > NGDP, while after 2000, RGDP < NGDP. This is intuitive if you think about it for a minute: Take 1970. When the economy’s output of 1970 is measured in the (then) current prices, GDP is about $1 trillion. Between 1970 and 2000, most prices have risen. Hence, if you value the country’s 1970 using the higher year-2000 prices (to get real GDP), you get a bigger value than if you measure 1970’s output using 1970 prices (nominal GDP). This explains why real GDP is larger than nominal GDP in 1970 (as in most or all years before the base year). cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics GDP Deflator §The inflation rate is the percentage increase in the overall level of prices. §One measure of the price level is the GDP deflator, defined as After revealing the first bullet point, mention that there are several different measures of the overall price level. Your students are probably familiar with one of them---the Consumer Price Index, which will be covered shortly. For now, though, we learn about a different one , the GDP deflator. The GDP deflator is so named because it is used to “deflate” (remove the effects of inflation from) GDP and other economic variables. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Practice problem, part 2 §Use your previous answers to compute the GDP deflator in each year. §Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008. Nom. GDP Real GDP GDP deflator Inflation rate 2006 $46,200 $46,200 n.a. 2007 51,400 50,000 2008 58,300 52,000 cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Answers to practice problem, part 2 Nominal GDP Real GDP GDP deflator Inflation rate 2006 $46,200 $46,200 100.0 n.a. 2007 51,400 50,000 102.8 2.8% 2008 58,300 52,000 112.1 9.1% cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Consumer Price Index (CPI) §A measure of the overall level of prices §Published by the Bureau of Labor Statistics (BLS) §Uses: §tracks changes in the typical household’s cost of living §adjusts many contracts for inflation §allows comparisons of dollar amounts over time > Regarding the comparison of dollar figures from different years: If we want to know whether the average college graduate today is better off than the average college graduate of 1975, we can’t simply compare the nominal salaries, because the cost of living is so much higher now than in 1975. We can use the CPI to express the 1975 in “current dollars”, i.e. see what it would be worth at today’s prices. Also: when the price of oil (and hence gasoline) shot up in 2000, some in the news reported that oil prices were even higher than in the 1970s. This was true, but only in nominal terms. If you use the CPI to adjust for inflation, the highest oil price in 2000 is still substantially less than the highest oil prices of the 1970s. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics How the BLS constructs the CPI §1. Survey consumers to determine composition of the typical consumer’s “basket” of goods. §2. Every month, collect data on prices of all items in the basket; compute cost of basket §3. CPI in any month equals cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Exercise: Compute the CPI §Basket contains 20 pizzas and 10 compact discs. prices: pizza CDs 2002 $10 $15 2003 $11 $15 2004 $12 $16 2005 $13 $15 For each year, compute §the cost of the basket §the CPI (use 2002 as the base year) §the inflation rate from the preceding year From 2002 to 2003, it’s not obvious that the inflation rate will be positive (that the basket’s cost will increase): the price of pizza rises by $1, the price of CDs falls by $1. However, since the basket contains twice as many pizzas as CDs, a given change in the price of pizza will have a bigger impact on the basket’s cost (and CPI) than the same sized price change in CDs. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics § Cost of Inflation § basket CPI rate §2002 $350 100.0 n.a. §2003 370 105.7 5.7% §2004 400 114.3 8.1% §2005 410 117.1 2.5% Answers: cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The composition of the CPI’s “basket” Each number is the percent of the “typical” household’s total expenditure. source: Bureau of Labor Statistics, http://www.bls.gov/cpi/ Ask students for examples of how the breakdown of their own expenditure differs from that of the typical household shown here. Then, ask students how the typical elderly person’s expenditure might differ from that shown here. (This is relevant because the CPI is used to give Social Security COLAs to the elderly; however, the elderly spend a much larger fraction of their income on medical care, a category in which prices grow much faster than the CPI.) The website listed above also gives a very fine disaggregation of each category, which enables students to compare their own spending on compact discs, beer, or cell phones to that of the “typical” household. cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Reasons why the CPI may overstate inflation §Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen. §Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights. §Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured. > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics The size of the CPI’s bias §In 1995, a Senate-appointed panel of experts estimated that the CPI overstates inflation by about 1.1% per year. §So the BLS made adjustments to reduce the bias. §Now, the CPI’s bias is probably under 1% per year. > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics CPI vs. GDP Deflator §prices of capital goods §included in GDP deflator (if produced domestically) §excluded from CPI §prices of imported consumer goods §included in CPI §excluded from GDP deflator §the basket of goods §CPI: fixed §GDP deflator: changes every year > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Two measures of inflation in the U.S. source: http://research.stlouisfed.org/fred2/ In 1980, the CPI increased much faster than the GDP deflator. Ask students if they can offer a possible explanation. In 1955, the CPI showed slightly negative inflation, while the GDP deflator showed positive inflation. Ask students for possible explanations. (For possible answers, just refer to previous slide.) cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Categories of the population §employed working at a paid job §unemployed not employed but looking for a job §labor force the amount of labor available for producing goods and services; all employed plus unemployed persons §not in the labor force not employed, not looking for work > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Two important labor force concepts §unemployment rate percentage of the labor force that is unemployed §labor force participation rate the fraction of the adult population that “participates” in the labor force > cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Exercise: Compute labor force statistics §U.S. adult population by group, June 2007 § Number employed = 146.1 million § Number unemployed = 6.9 million § Adult population = 231.7 million Use the above data to calculate §the labor force §the number of people not in the labor force §the labor force participation rate §the unemployment rate source: Bureau of Labor Statistics, U.S. Department of Labor. http://www.bls.gov cover R1,C4 slide ‹#› CHAPTER 1 The Science of Macroeconomics CHAPTER 1 The Science of Macroeconomics Answers: §data: E = 146.1, U = 6.9, POP = 231.7 §labor force L = E +U = 146.1 + 6.9 = 153.0 §not in labor force NILF = POP – L = 231.7 – 153 = 78.7 §unemployment rate U/L x 100% = (6.9/153) x 100% = 4.5% §labor force participation rate L/POP x 100% = (153/231.7) x 100% = 66.0% > Chapter Summary §1. Gross Domestic Product (GDP) measures both total income and total expenditure on the economy’s output of goods & services. §2. Nominal GDP values output at current prices; real GDP values output at constant prices. Changes in output affect both measures, but changes in prices only affect nominal GDP. §3. GDP is the sum of consumption, investment, government purchases, and net exports. slide 64 cover R3,C1 CHAPTER 2 The Data of Macroeconomics > Chapter Summary §4. The overall level of prices can be measured by either §the Consumer Price Index (CPI), the price of a fixed basket of goods purchased by the typical consumer, or §the GDP deflator, the ratio of nominal to real GDP §5. The unemployment rate is the fraction of the labor force that is not employed. slide 65 cover R3,C1 CHAPTER 2 The Data of Macroeconomics >