# The level of price and inflation Real GDP: the values of goods and services measured using a constant set of prices

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1 Chapter 2: Key Macroeconomics Variables ECON2 (Spring 20) 2 & (Tutorial ) National income accounting Gross domestic product (GDP): The market value of all final goods and services produced within a country (residence) during a specific time period. Gross national product (GNP): The market value of all final goods and services produced by the citizens of a country (nationality) during a specific time period. Three approaches to calculate GDP. Product approach The value of final goods and services in the economy during a given period The sum of value added in the economy during a given period 2. Income approach The sum of incomes in the economy during a given period Compensation of employees, proprietors income, rental income, corporate profits, net interest, tax 3. Expenditure approach We could find out GDP by looking at the Expenditure of different sectors National income accounts identity: GDP = = C + I + G + (EX IM) The level of price and inflation Real GDP: the values of goods and services measured using a constant set of prices Nominal GDP: the value of goods and services measured at current prices Inflation rate: (P t P t- ) / P t- (where P t could be GDP deflator or CPI) GDP deflator GDP deflator: The ratio of nominal GDP and real GDP GDP Deflator = Nominal GDP / Real GDP = \$/ = (P Q)/ (P base Q) = P/ P base We sometimes multiply the GDP deflator by 00 to make the index base as 00) P/ P base shows the change in the price level Nominal GDP = Real GDP GDP deflator GDP deflator allows us to separate nominal GDP into 2 parts: one part measures quantities (real GDP) and the other measures prices (GDP deflator) Consumer price index (CPI) A measure of the overall price level of prices that shows the cost of a fixed basket of consumer goods relative to the cost of the same basket in a base year CPI in current year = Nominal Expenditure / Real Expenditure = \$/ = (P Q)/ (P base Q) = P/ P base

2 Chapter 3: The Goods Market Composition of GDP GDP = = C + I + G + X IM Consumption (C): purchases of goods and services by consumers Investment (I): purchases of new capital goods (residential and nonresidential investment) Government spending (G): purchases of goods and services by the government. Government transfers are not included. Export (X): purchases of domestic good and services by foreigners Import (IM): purchase of foreign goods and services Consumption function The consumption function shows the relationship between consumption and disposable income C ( D ) = c 0 + c D = c 0 + c ( T) Disposable income: income after tax, i.e. D = T c 0 : Autonomous consumption: the amount of consumption which is independent of c : Marginal propensity to consume (): the ratio of change in consumption to C change in D D Saving function The saving function shows the relationship between the amount of saving and disposable income S = C S( D ) = c 0 + ( c ) D ( c ): Marginal propensity to save (MPS): the ratio between change in saving to S change in D MPS Determining goods market equilibrium The equilibrium GDP is achieved when Demand = Supply i.e. Z = As we assume that price is fixed in SR, supply will respond to demand passively, i.e. any quantity demanded would be supplied. Aggregate demand : Z = C + I + G ( I G c T c c0 ) ( c0 I G ct -intercept of the demand curve is ) and slope is c The GDP is in equilibrium when = Z (Point E) c0 c( T) I G c c c T I G 0 c c0 I G c ( ) T [ c0 I G ct ] where c are autonomous spending c is the multiplier and are (c 0 + I + G c T) 2

3 2 Z 2 Z/ E 45 (Production) Excess Supply Z = C + I + G Suppose = Excess demand (Z > ) The price is fixed and the producer would response to the demand and increases production increases and then Z increases This process continues until point E is reached. Z * 2 Excess Demand Suppose = 2 Excess supply ( 2 > AD 2 ) Producers would reduce production falls and AD falls This process continues until point E is reached. In the goods market equilibrium, Aggregate Saving = Investment I = private saving + public saving I = S P + public saving I = ( C T ) + ( T G ) I = C G = C + I + G = Z The Multiplier () Change in autonomous spending An increase in autonomous demand (autonomous G, I or C) would rise by more than the original increase in demand. Multiplier: the ratio of the change in to a change in the G, i.e. G Effect of an Expansionary Fiscal Policy Period G by 200 AD by 200 by 200 Period 2 by 200 C by (200 ) AD and by (200 ) Period 3 by (200 ) C by (200 2 ) AD and by (200 2 ) Period 4 by (200 2 ) C by (200 3 ) AD and by (200 3 ) Period N by (200 n-2 ) C by (200 n- ) AD and by (200 n- ) G ( G ) ( G ) ( G G Multiplier G 2 n ) The size of the multiplier (i.e. /G) depends on the size of : the higher (lower) the value of, the larger (smaller) the multiplier effect. 3

4 (2) Change in Tax (assuming lump-sum tax) 2 n ( T ) ( T ) ( T ) T Multiplier T (3) Balanced budget multiplier Suppose G and T increases by the same amount, the total effect on would be G Multiplier ( ) G G T Recall in the goods market equilibrium, [ c0 I G ct ] c Suppose both G and T increases by the same amount, that is G T ' [ c0 I G G ct ct ] c ' [ G cg] G c (What is the intuition behind? How would the total demand change?) (4) Automatic stabilizers Automatic stabilizers are features of the tax and transfer systems that tend to offset fluctuations in economic activity without direct intervention by government The Paradox of Saving S = I -c 0 -c 0 S, I S S I As people attempt to save more, the result is both a decline in output and unchanged saving Suppose at a given level of disposable income, consumers decide to save more (reduction in c 0, assuming c remains unchanged). What will happen to output and saving? Given C = c 0 + c D S = c 0 + ( c ) D I I Output (): drops, since in equilibrium, [ c0 I G ct ] c Private saving (S): S does not change. Why? c 0 is higher, D is lower, that is ( c ) D is lower. In the goods market equilibrium, I = S + (T G) and I I Increase c 0 = drop ( c ) D Paradox of saving Suppose consumers decide to save more and increase their MPS (decrease in c and c 0 remains unchanged). What will happen to output and saving? 4

5 Review Questions Question During a given year, the following activities occur: (i) A silver mining company pays its workers \$ to mine 50 pounds of silver. This silver is then sold to a jewelry manufacturer for \$ (ii) The jewelry manufacturer pays its workers \$ to make silver necklaces, which the manufacturer sells directly to consumers for \$ (a) Using the production of final goods approach, what is GDP in this economy? \$,500,000 which is the value of the silver necklaces. (b) What is the value added at each stage of production? Using the value added approach, what is GDP? st Stage: \$500,000 2nd Stage: \$,500,000 \$500,000 = \$,000,000. GDP: \$500,000 + \$,000,000 = \$,500,000. (c) What are the total wages and profits earned? Using the income approach, what is GDP? Wages: \$400,000 + \$450,000 = \$850,000. Profits: (\$500,000 \$400,000) + (\$,500,000 \$450, ,000) = \$00,000 + \$550,000 = \$650,000 GDP: \$850,000 + \$650,000 = \$,500,000 Question 2 Consider an economy that produces only 3 types of fruits: apples, oranges, and bananas. In the base year and current year, the production and price date were as follows: Base ear Current ear Quantity Price Quantity Price Apples Bananas Oranges a) Find nominal GDP in the current year and in the base year. GDP in current year: (4000*3) + (4000*2) + (32000* 5) = b) Find real GDP in current year and in the base year. Real GDP in base year: Real GDP in current year: (4000*2) + (4000*3) + (32000* 4) = c) Find the GDP deflator for the current year and the base year. By what percentage does the price level change from the base year to the current year? GDP deflator = (Nominal GDP / Real GDP) *00 GDP deflator of base year: 00 GDP deflator of current year: (200000/78000)*00 = 2 Percentage change in price level from base year to current year = 2% 5

6 Question 3 Giving the consumption function, C = (a) Derive the saving function. = C + S S = C S = S = (b) Graph the saving function (Try to derive it from the consumption function!). How much is saving/ dissaving when = 400 and = 2000 C C = Saving = S Dissaving = S At = 0, C = 200, which means S = 200 At = 400, C = 520, which means S = 20 At = 000, C = 000, which means S = 0 At = 2000, C = 800, which means S = 200 The saving function is a linear function. The saving function is upward sloping, meaning that and S are positively related. The slope of the saving function is MPS and it is constant at different level of. When MPS changes, the slope of the saving function will change (c) Identify the autonomous saving and the marginal propensity to save (MPS). What is the relationship between MPS and? Autonomous saving = 200 (borrowing) and MPS = 0.2 (MPS = S/). + MPS = 6

7 Question 4 Suppose the economy is characterized by the following equations: C = D I = 50 G = 50 T = 00 Solve for the following questions and put your answers in a graph. (a) Equilibrium output () = ( 00) * = 000 (b) Disposable income ( D ) D = T = = 900 (c) Consumption spending AD AD AD AD E E E C = (900) = 700 (d) Suppose now G falls to 0. Solve for the new equilibrium. **=900 *=000 **=00 Multiplier G = 40, = -40 Multiplier = = -00 ** = * + = 900 (e) For the new equilibrium in part (d), compute the total saving. Is it equal to investment? Total saving = private saving + public saving Private saving = C T = (900 00) 00 = 60 Public saving = T G = 00 0 = -0 Total saving = 50 = Investment (f) Suppose the government increases taxes and government expenditure by 00 at the same time. Solve for the new equilibrium. = ( 00-00) *** = 00 Alternatively, = 00 [/( ) C /( )] = 00 *** = * + = 00 7

8 Question 5: The balanced budget multiplier For both political and macroeconomic reasons, governments are often reluctant to run budget deficits. Here, we examine whether policy changes in G and T that maintain a balanced budget are macroeconomically neutral. Put another way, we examine whether it is possible to affect output through changes in G and T so that the government budget remains balanced. Start from Equation (3.7), (a) By how much does increase when G increases by one unit? In the goods market equilibrium, = c 0 + c ( T) + I + G = Z (equation 3.7), and = [/ ( c )] [c 0 + I + G + c T] / ( c ) is the multiplier, so increases by / ( c ) when G increases by one unit. (b) By how much does decrease when T increases by one unit? c / ( c ) is the tax multiplier, so decreases by c / ( c ) when T increases by one unit. (c) Why are your answers to parts (a) and (b) different? The answers differ because government spending affects demand directly, but taxes affect demand through consumption, and the propensity to consume is less than one. Suppose that the economy starts with a balanced budget: T = G. If the increase in G is equal to the increase in T, then the budget remains in balance. Let us now compute the balanced budget multiplier. (d) Suppose that both G and T increase by one unit. Using your answers to (a) and (b), what is the change in equilibrium GDP? Are balanced budget changes in G and T macroeconomically neutral? The change in equals / ( c ) c / ( c ) =. Balanced budget changes in G and T are not macroeconomically neutral. (e) How does the specific value of the propensity to consume affect your answer to part (d)? Why? The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier process. and T both increase by on unit, so disposable income, and hence consumption, do not change. 8

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