Chapter 23 Introduction to Macroeconomics & Measuring the Economy s Performance

Transcription

1 PRINCIPLES OF MACROECONOMICS Chapter Introduction to Macroeconomics & Measuring the Economy s Performance Overview So far in the course, we dealt with the following issues: the laws of supply and demand and the mechanism of the price system which regulates the functioning of the free enterprise system, the decision-making process and behavior of the individual and household (consumer equilibrium using utility analysis), the economics of the firm (production and costs, and profit-maximization decisions by the individual firm under different market structures), the functioning of the labour markets and the determination of wages and employment, and the role of the government in the economy as the provider of public goods, the agent that corrects market failures (externalities), and the regulator of competition policy. All these issues fall under the realm of Microeconomics. We focussed on examining the trees. From here onwards we make the shift from examining the trees (the individual economic agents) to examining the forest (the national economy oriented issues). In this context, we will examine how economy-wide phenomena such as national income, economic growth, inflation, unemployment, taxation, interest rates, or the banking system affect our everyday lives and the entire economic system. Therefore, Macroeconomics is concerned with broad aggregates, whereas microeconomics focused on the detailed understanding of the behavior of individual economic agents and particular markets. Below we see the trend in Cyprus in the period for economic growth, inflation and unemployment. A major task in macroeconomics is to examine the reasons we have these trends in economic variables. Unemployment Rate in Cyprus Inflation Rate in Cyprus Real GDP Growth in Cyprus,5,5,5 0,

2 That macroeconomic issues are important is verified by the fact that these issues are in the daily news. Newspaper or TV news headlines may be: the economy recorder a rate of growth of 0.5 last quarter, or the central bank lowered the interest rates by a quarter per cent, or the consumer price index rose by 0.5% last month, or the value of the Cyprus pound gained versus the dollar, fears of a War in Iraq, lower bookings in the hotel industry by 5%, etc, etc. These are issues which you may be more familiar than the economics of the individual firms, and for which you will probably more easily associate with and be able more easily to comment on and express your views; in other words, we will more easily enter into the realm of Normative Economics. Class discussion thus may be more lively. Of course, we will concentrate on the accepted body of economic theory, that is, on Positive Economics. Macroeconomic issues affect the lives of all economic agents in society: Business managers base the forecasts of the sales of their companies on the prospects of GDP growth; people on social security (fixed incomes) are concerned about the rate of growth of inflation; workers are concerned that a recession may leave them without a job, or unemployed people are hoping for a rebound in economic activity; investors are looking forward to a rebound in the stock market so that the value of their investments (their wealth) rise, and so on, and so on. All are affected directly or indirectly by the state of the economy. Four Big Questions of Macroeconomics (a) What determines the growth of output and why do we have variations in output growth over time? Why do we have business cycles (ups and downs of economic activity)? (b) What happens when the demand for goods and services by the total population is greater than what the economy can produce? (c) Why are economic resources or factors of production (land, labour, capital, etc) sometimes idle? (d) How can workers and business firms compete internationally? GNP and GDP Some Definitions The Gross Domestic Product, GDP (or gross National Product, GNP) are accounting measures devised by economists to calculate the value of economic activity in a certain period (usually a year). GDP equals The total income of everyone in the economy, and The total expenditure by all economic agents for the economy s output (the total of goods and services produced). How are these measures indicators of economic activity? From the point of view of people s incomes, the higher the incomes the better off they are because they can buy more things. From the point of view of output, the more the goods and services that an economic system can make available to its people, the higher the standard of living of these people, by satisfying more of their demands. Gross Domestic Product (GDP): The value of all final goods and services produced in one year by factors of production located in the domestic economy, measured in current market prices.

3 Gross National Product (GNP): Measures the total income (or expenditures) of citizens of a country, whether domestically or internationally. Thus, GNP = GDP + Net Factor Income from abroad What are final goods? These are goods that are consumed by the final user( such as the consumer) and not used for the production of other goods. What are Intermediate goods? These are goods that are used as inputs for the production of other goods and services for sale to final users. Thus, flour bought by the consumer to bake cakes at home is a final good, but flour bought by the baker to bake bread for sale is an intermediate good. The Circular Flow of Income Model This simple model is a first approximation of presenting the functioning of an economic system. However, you should bear in mind that the model makes some very strong assumptions which add to its simple exposition, but which make the model deviate substantial from reality. These assumptions are:. There are only two groups of economic players: the firms and the households.. Whatever income the households earn, they spend on consumption (that is, there is no saving).. There are no government expenditures on goods and service, and. There is no international trade (that is, no exports or imports). Therefore, in such a closed economy (shown below in the schematic): Y (income) = C (Consumption) C irc u la r F lo w o f In c o m e M o d e l Revenue (= GDP) G & S Sold M arket for Goods & Services Spending (= GDP) G & S Bought Firm s Households In p u ts fo r W ages, Rent & Profit Market For Factors of Flow of Money Land, Labor & Capital In c o m e (= G D P ) Flow of G & S As we have sketched out the relationship between the firms and the households, there are two distinct flows:

4 (a) the flow physical goods and services from firms to households, in exchange for the supply by HH of resources (labour, capital, land, inputs) to firms to use in the production process. Here you have to understand that all resources by definition within this (simplified) free market are ultimately owned by private individuals (it is individuals and households that ultimately own the business firms); this is the inner loop. (b) The flow of money (financial payments in the form of wages, interest, rents, and profit) from the Firms to the Households (HH), financed by the people s expenditures on these goods and services; this is the outer loop. Since we assumed that all income is spent (by assuming that there is no saving), then it is clear that the incomes (including rent, interest, etc) that the owners of the factors of production (in other words, the HH) earn must equal the total spending by household on goods and service (again this is the outer loop of the schematic). In other words, in an exchange between two people, someone gets the good (or service) and the other gets the money. Someone s expenditure is someone else s income! We can view the total value of economic activity from the flow of money aspect in another way: GDP is the total income from the production of goods and services, which equals the sum of wages, profit, rent etc (the remuneration of the factors of production); this is the bottom half of the circular flow of income schematic. GDP is also the total expenditure on purchases of goods and services by HH; this is the top half of the circular flow in money terms. Methods of Measuring Economic Activity (National Income) Economists have developed three () ways to measure national income. (a) By the value of total expenditures (b) By the value of total incomes, and (c) By the value of all goods and service produced (in value-added terms). By carefully examining the various flows between HH and Firms in the simple circular flow of income model above, we can find these three ways. Why have ways, you might ask? Economists use different measures in different situations. When studying employment, the output method is important. Any study of income distribution will be built upon the concepts of the income method. When we study consumer behavior and the demand side of the economy, the expenditure method is more useful. In the table below we present the National Accounts of Cyprus from the expenditures side. NATIONAL ACCOUNTS OF CYPRUS 00* 00* % change %of GDP

5 Gross Domestic Product by category of expenditure at current market prices (C mn) Government final consumption.08,.097, 5,67 7,7 Private final consumption.999,., 5,6 68, Gross fixed capital formation.07,8.57,,7 8,69 Increase in stocks 60,0 7, 0,50,7 Exports of goods and services.75,7.668, -,0,0 Less: Imports of goods and services.0,.068,8, 9,56 Statistical discrepancy,, -6,80 0,66 G.D.P. at market prices 5.880,0 6.9,5 5,0 Plus: Net factor income from abroad,6, 5,7 G.N.P. at market prices 5.89,6 6.0,7 5,0 Less:Consumption of fixed capital 68,6 65, 5,0 National Income 5.7,0 5.55, 5,0 Per capita G.N.P. at current market prices (C ) , Source: Department of Statistics, Government of Cyprus. Investment and Saving Leakages and Injections We said that by keeping the model simple and by abstracting from the complexities of real life, it helps us understand the basics. Having analysed above the simple circular flow of income, we can now move on to relax some of the assumptions. The first relaxation is the realization that households don t spend all the income they earn during a year. Part of it is saved. This means then that there is a leakage from the spending stream, the spending cycle. Thus, from the income side: Y = C + S (income can be used for consumption expenditures and savings) or S = Y C (saving is income that is not spent) On the other hand, we also realize that as firms buy capital goods (plant, equipment, etc) they spend money. So it is not only households that add purchasing power to the spending stream. Businesses do too. Thus we introduce the concept of injections. From the expenditure side, Y = C + I (total expenditures are comprised by consumption and investment) In the simplified model, then investment and savings must always be equal, in equilibrium. S = I 5

6 C irc u la r F lo w o f In c o m e M o d e l Revenue (= GDP) G & S Sold Market for Goods & Services Spending (= GDP) G & S Bought Business Investment Firm s Households In p u ts fo r W ages, Rent & Profit Market For Factors of Flow of M oney Land, Labor & Capital In c o m e (= G D P ) Household Saving Flow of G & S The Government and Foreign Sector We can now introduce further realism to our basic model by relaxing the assumption that the government does not contribute to economic activity and that there is no trade (exports or imports). By introducing the government sector (and taxes and subsidies), we differentiate between GDP at market prices and GDP at basic prices. Thus, with just the government as the new additional variable, the definition of GDP at market prices becomes Y = C + I + G. We can go further to subtract indirect taxes (net of subsidies) to derive Y = C + I + G T e, our first definition of GDP at basic prices. Taking account of direct taxes and benefits, and bringing in savings and investment brings a large dose of realism to our basic system of national accounts, as shown below (total leakages from the circular flow = total injections to the circular flow). Finally, if we add foreign trade our system of national accounts is complete. This complete model can be shown in the circular flow of income framework as follows: Exports Exports C ircu la r F lo w o f In co m e M o d e l Revenue (= GDP) G & S Sold Market for Goods & Services Spending (= GDP) G & S Bought Government Spending Business Investment Firm s Households In p u ts fo r W ages, Rent & Profit Market For Factors of Flow of Money Land, Labor & Capital In c o m e (= G D P ) Household Saving Taxes Flow of G & S Algebraically, these relationships can be developed as follows: GDP = Final Spending = C + I + G 6

7 Personal Disposable Income = Y + B (Benefits) Td (Income Taxes) S = ( Y + B Td ) C è Y = S + C + Td B Y = C + I + G Te (Indirect Taxes) S + Td + Te B = I + G or Td + Te B G = I S Leakages Injections Gov t surplus Private deficit The complete national accounting model then is: Y = C + I + G T + (X M) From GDP to GNP You may wonder why we use both concepts. For economists, GDP may be more relevant when considering employment (irrespective of the ownership of factories etc), whereas GNP may be more useful when looking at issues such as income, expenditure, and wealth. Finally, subtracting depreciation (the value of the wear and tear of capital equipment), we have National Income defined as Net National Product. National Incom e Accounting: A Summary Spending on GNP Definition of GDP Definition of NNP Definition of Nat l Incom e Factor earnings GNP (and GNI) at market prices NYA G I NX C NYA GDP at market prices Deprec'n NNP at basic prices Indirect taxes National incom e Profits, rents Selfemployment Wages and salaries 7