Second PartMacroeconomics

Lecture 7Macroeconomic Aggregates

Macroeconomics• Macroeconomics is the field of economics that studies the behaviour of the

economy as a whole. It is the study of aggregate measures of the economy and this aggregation is done by understanding how individual economic units function. So it deals with the issues like growth, inflation, unemployment etc.

• Macroeconomics can be best understood by comparing it with microeconomics which considers the decisions made at an individual or firm level. Macroeconomics considers the larger picture, or how all of these decisions sum together. An understanding of microeconomics is crucial to understand macroeconomics. To understand why a change in interest rates leads to changes in real GDP, we need to understand how lower interest rates influence decisions, such as the decision of how much to save, at the firm or household level. Once we understand how an individual, on average, will change their behaviour we will then understand the large scale relationships in an economy.

• Examples of macroeconomic aggregate are GDP, GNP, CPI, inflation etc.

Economic Agent

• In economics, an agent is a decision maker in a model. Every agent takes part in transaction with another agent.

• In microeconomics there are two agents:a) Consumer / Buyer/Householdb) Producer / Seller/Firm• In macroeconomics there are four agents:a) Consumers/Householdsb) Producers/Firmsc) Governmentd) Foreign Country

Factor MARKET

BUSINESS FIRMS

PRODUCT MARKET

HOUSEHOLDS

COST

RESOURCES Labor, land

capital

Wages, rent,

profit

goods

expe

nses

Goods &

services

revenue

Savings(Leakage)

Capital marketInvestment( Injection)

Circular flow model (A Simple Model of Economic Interaction)

GDPGross Domestic Product (GDP) is the total market value of all

final goods and services produced within a country in a given period of time.

Breaking down the definition:“GDP is the Market Value . . .”

- Output is valued at market prices.

“. . . Of All Final . . .”-Records only the value of final goods, not intermediate goods (as value is counted only once).

“. . . Goods and Services . . . “- Includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

• “. . . Produced . . .”– Includes goods and services currently produced, not

transactions involving goods produced in past (Used goods)• “ . . . Within a Country . . .”

– Measures the value of production within the geographic confines of a country.

• “. . . In a Given Period of Time.”– Measures the value of production that takes place within a

specific interval of time, usually a year or a quarter (three months).

Calculating GDP

• Suppose there are two goods in the economy.For example: Rice and Wheat

• Formula isGDP= ( Price of Rice X Quantity of Rice) + ( Price

of Wheat X Quantity of Wheat)• Here we can use either current price or base

price.

REAL VERSUS NOMINAL GDP

• Depending on which price we are using in GDP calculation we can make two classification of GDP. Nominal GDP and Real GDP

1) Nominal GDP values the production of goods and services at current prices.

2) Real GDP values the production of goods and services at constant prices.

Source: books and web materials Dr. Aminul I Akanda

Table: Real and Nominal GDP

Gross national product (GNP): If we add receipts of factor income (wages, profit, rent and interest) and grant/aid from the rest of the world and subtract payments of factor income and grant/aid to the rest of the world from GDP then we get GNP .

GNP = GDP + Factor Payments from Abroad + aid received from Abroad - Factor Payments to Abroad - aid given to Abroad

GDP VERSUS GNP

Whereas GDP measures the total income domestically, GNP measures the total income earned by nationals.

Question: What are the other differences between GDP and GNP?

Gross national product (GNP):

Price Index: GDP Deflator and CPI

• Price Index is a measure of the economy's price level or a cost of living.

• Most popular price index: 1) GDP Deflator 2) Consumer Price Index (CPI)

GDP Deflator

• It shows the state of overall level of prices in the economy.

• It is also known as implicit price deflator.• The GDP deflator is calculated from the ratio of

nominal GDP to real GDP for same year times 100.

GDP Deflator= (Nominal GDP)/(Real GDP) X 100

CPI ( Consumer Price Index)

• A consumer price index (CPI) is price index that measures changes in the price level of consumer goods and services purchased by households.

• It is used to monitor changes in the cost of living over time by a typical household

• When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

• Fix the Basket: Determine what goods and services are most important to the typical consumer.– So first identify a basket of goods and services that

a typical consumer buys. – Then through a survey identify the amount of

these goods and services consumed by the typical consumer every month.

How the Consumer Price Index Is Calculated

Example of a CPI’s Basket?

16%Food andbeverages

17%Transportation

Medical care

6%

Recreation

6%

Apparel

4%

Other goodsand services

4%

41%Housing

6%Education and communication

How the Consumer Price Index Is Calculated

• Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

• Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

How the Consumer Price Index Is Calculated

• Choose a Base Year and Compute the Index: – Designate one year as the base year, making it the

benchmark against which other years are compared.

– Compute the index by dividing the cost of the basket in one year by the cost of that basket in the base year and multiplying by 100.

Calculating CPI

• Formula:CPI = (Total cost of a bundle of goods or service at current price)/ ( Total cost

of a bundle of goods or service at base price)X 100

Example:Suppose a typical household consumes 30kg rice and

20 kg flour in a month. So the basket of goods is consisted of rice and flour. The quantity of rice and flour will be held constant across years. In this case

CPI = ( 30 X Current Price of Rice) + ( 20 X Current Price of Flour)( 30 X base year Price of Rice) + ( 20 X base year Price of Flour)

X 100

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example