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1 The Economic Way of Thinking 12 th Edition Chapter 12: The Overall Performance of Economic Systems

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2 Chapter Outline Gross Domestic Product(GDP) GDP or GNP? GDP as Total Income Created in the Domestic Economy GDP is not a Measure of All Purchases in the Economy GDP as Total Value Added Is Value Added Always Positive?

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3 Chapter Outline Loose Ends: Unsold Inventories and Used Goods Aggregate Fluctuations Unemployment and Non-employment Employed, Not Employed and Unemployed Labor-Market Decisions Unemployment and Recessions

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4 Chapter Outline Inflation The Difficulties of Monetary Calculation Recession and Inflation Since 1960 What Causes Aggregate Fluctuations? Appendix: Limitations of National Income Accounting Appendix: The Dangers of Aggregation: A Methodological Approach

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5 Introduction Microeconomic Analysis supply and demand in a particular market or industry. Macroeconomic Analysis performance of the overall economy. Macroeconomic problems are often news topics , and a source of seemingly endless debate among newpaper columnists, political figures, ax- grinders the general public, and even among economists themselves! Everybody seems to have an opinion!

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6 Introduction Macroeconomic problems Is Chinese economy strong, or is it weak? Is it growing, ir is it falling into a recession? Will the future bring us inflation , deflation , or relatively stable prices? Whats happening to the unemploment rate in China? Will the Central Bank (i.e.the Peoples bank of China) raise or lower interest rates?

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7 Introduction Macroeconomic problems(continued) Whats the status of governments budget? Is it balanced , in a surplus , or in deficit ? Should taxes be raised or lowered? What impact will that have on overall economic conditions? What is the present administration doing to improve the economy?

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8 Introduction We shall begin to clear up the muddle by further developing the economic way of thinking on these grand, economy-wide issues in the remaining chapters. This chapter focuses on the most widely used (and, literally, grossest) indicator of overall economic performance, Gross Domestic Product

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9 Gross Domestic Product (GDP) How nice it would be if we have one single concept and, indeed, one single number which could summarize the overall performance of the economy! if we can discover strict interdependencies among, say, the total quantity of money in circulation, total employment, total output of the economy, etc! It is tempting to do so and would simplify economic reasoning enormously!

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10 Gross Domestic Product (GDP) GDP is meant to be such a concept used to measure variations of economic growth and welfare! GDP market value of final goods and services produced within a country in a particular time period.

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11 Gross Domestic Product (GDP) 2008 GDP 30.067 4.333 2008 1 --- 6.8346 9% GDP 3313 2008 GDP 14.265 3.9% 47440

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12 Gross Domestic Product (GDP) Market values measured by market prices. Final goods (and services) purchased by ultimate user , whether or not that user is in a household, business, or government bureau. Purchased without the goal of reselling it or further processed and manufactured. Compare with Intermediate good

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13 Gross Domestic Product (GDP) Within a country, regardless of the nationality or citizenship of the people owning or producing those goods. Time period is usually a year.

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14 GDP or GNP? GDP performance of the domestic economy. GNP (Gross National Product ) The market value of final goods and services produced by permanent citizens of a country in a particular period of time. performance of the nations citizens. regardless of where they are producing.

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15 GDP or GNP? GNP 1991 GDP GNP

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16 GDP as Total Income Created in the Domestic Economy GDP Purchases of final goods. One way for measuring GDP Adding up the monetary value of all the purchases the expenditures on final goods and services. 2008 GDP 30.067 30.067

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17 GDP as Total Income Created in the Domestic Economy A purchase always involves a sale. 30.067 30.067 (income) So, GDP can be regarded as a measure of national income created in the domestic economy.

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18 GDP as Total Income Created in the Domestic Economy Value of national output = value of national income Every dollar paid for output = income for someone Sales taxes = income for government

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19 GDP Is Not a Measure of All Purchases in the Economy GDP Purchases of final goods. All income created in the economy. Not all expenditures,excluding expenditures on intermediate goods. All expenditures would be double counting. An example

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20 Produceer Begins with Ends with value added $50 $50 $50 $75 $25 $75 $250 $175 $250 $400 $150 = $775 = $400 12-1 GDP Is Not a Measure of All Purchases in the Economy

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21 GDP as Total Value Added The last columan, value added, represents the net income enjoyed by each of the producers. Three ways to conceptually measure GDP: Expenditures on final goods and services. Total income generated in the economy. Total value added in the economy.

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22 Is Value Added Always Positive? Nominal wages, rents and interest will be positive. Profit may be positive, or negative (i.e.loss). How are losses accounted for in GDP? The example (continued)

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23 Produceer Begins with Ends with value added $50 $50 $50 $75 $25 $75 $250 $175 $250 $200 -$50 = $575 = $200 12-2 Is Value Added Always Positive?

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24 Loose Ends: Unsold Inventories and Used Goods Unsold Inventories = gross business inventory investment . Estimate market values of unsold goods. Revise GDP with actual market values. Used Goods GDP accounts for added value market value of the service provided.

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25 Aggregate Fluctuations Economic growth occurs through cycles of expansion and contraction . Fluctuations in output and income are significant. The most troubling consequence, in the public mind, of reductions in GDP are the increased levels of unemployment that always follow them

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26 Aggregate Fluctuations The Great Depression in US 1929-1933 Real GDP fell by 30%. 1933 GDP 40% less than would have been forecasted in 1929 (assume 3% annual growth). Unemployment 1929 3.2% 1933 24.9%

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27 Unemployment and Non-Employment Observations Approximately half of the people in the US are not employed neither earning a wage by working for someone else nor working for themselves in a business that they own. A quarter are under the age of 16 One-eighth are over 65 Many of those between 16 and 65 are quite fully employed, although not in the sense just described raising children and caring for a household

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28 Unemployment and Non-Employment How do we distinguish problem unemployment from non-problem unemployment? Above the level of purely fractional unemployment? fractional unemployment : the amount of unemployment that poses no problem because it represents ordinary labor-market turnover. But ordinary labor-market turnover is a variable

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29 Unemployment and Non-Employment How do we distinguish the unemployed from the not employed? It is not easy for an outside observer to make a distinction.

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30 Employed, Not Employed and Unemployed Unemployment data Bureau of Labor Statistics in US (BLS ) Current Population Survey The Bureau of the Census Monthly survey 60,000 households

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31 Employed, Not Employed and Unemployed Who is counted? Non-institutional people over age 16 16 50 Classifications Employed Unemployed Not in the labor force

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32 Employed, Not Employed and Unemployed Unemployed In the non-institutional population. Over age 16. Without employment during survey week. Made efforts to find employment during the last 4 weeks. Be presently available for work.

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33 Employed, Not Employed and Unemployed Deriving Unemployment Data Total population under 15 or institutionalized = noninstitutionalized population not in the labor force = labor force employed = unemployed

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34 Employed, Not Employed and Unemployed Unemployment Rate = Unemployed / Labor Force

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35 Labor Market Decisions Economic theory tries to explain all behavior as the consequence of choice under constraints, of course. Unempolyment results from the choices people make on the basis of ones expected relative costs and benefits This doesnt necessarily means that Everyone has good choices Unemployed people enjoy their condition

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36 Labor Market Decisions Non-institutional Population Seeks employment (in the labor force) Does not seek employment (not in the labor force) Accepts employment (employed) Does not accept employment (unemployed)

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37 Labor Market Decisions BLS definition of unemployed implies: A decision to actively seek employment the fork that leads either to employment or to continued unemployment. A decision not to accept any of the employment opportunities available the fork that leads either to being unemployed or being out of the labor force.

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38 Unemployment and Recessions in US 1950-2000

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39 Unemployment and Recessions in US RecessionsUnemploymentRecoveryUnemployment Rate Peak Rate 19545.5% 19586.8% 19616.7% 19758.5% 19829.7% 19927.4% 19532.9% 19574.3% 19605.5% 19734.9% 19795.8% 19905.5% 19984.4%

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40 Inflation One cannot use unadjusted changes in GDP to measure changes in the total output of goods. Why?

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41 Inflation Nominal GDP Product of prices and quantities (P x Q). If prices increase and quantities remain unchanged, nominal GDP increases. Question If prices increase and quantities remain the same, has the real output of the economy increased?

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42 Inflation Adjusting GDP for Price Changes Real GDP The value of all final goods and services produced in a year stated in unchanging prices , the prices that held in whatever year is being used as the base year .

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43 Inflation GDP Deflator Nominal GDP/Real GDP 100% The most comprehensive measure of changes in the purchasing power of money But not the best-known measure

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44 Inflation Consumer Price Index (CPI ) Measures changes in the money price of all the goods and services that enter into the budgets of typical urban consumers. CPI

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45 Inflation Is not a rise in the cost of living Is basically a fall in the value or purchasing power of money Is a rise in the money price of goods, where the key word is money If inflation does not actually raise the cost of living, why is it a problem?

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46 Inflation Uncertianty caused by inflation! The future value of money cannot be predicted Inflation distorts the signals that are provided through market prices

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47 Inflation Deflation A rise in the value or purchasing power of money It also introduces uncertainty into the calculations of planners Disinflation A slowing down of the inflation rate.

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48 The Difficulties of Monetary Calculation Inflation, deflation and disinflation make monetary calculations difficult. Household budget planning Saving and investment decisions Wage and salary agreements The entrepreneurial calculation of profit and loss

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49 Recession and Inflation Since 1960 1960-2000

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50 Recession and Inflation Since 1960 Recessions in US 1960, 1970, 1974, 1975, 1980, 1982, 1990, and 1991 Inflation in US 1960s 2.5% / year 1970s 7.5% / year

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51 Recession and Inflation Since 1960 Stagflation a stagnating economy with inflation. Inflation can occur during recession. 1974 1975 Severe recession 10% inflation Recession and Inflation are not simple opposites.

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52 What Causes Aggregate Fluctuations? Fluctuations may reflect the natural adjustment of markets to external shocks. Fluctuations may be driven by relatively small changes in one sector of the economy that multiplies through many sectors.

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53 What Causes Aggregate Fluctuations? Fluctuations may reflect the natural adjustment of markets to external shocks. Fluctuations may be driven by relatively small changes in one sector of the economy that multiplies through many sectors.

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54 Appendix: Limitations of National Income Accounting GDP gets some sense of economic performance only imperfectly Some difficulities encountered by GDP

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55 Appendix: Limitations of National Income Accounting Ignores all non-market forms of production Underestimating actual performance of the overall economy Ignores illegal production Underestimating actual performance of the overall economy

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56 Appendix: Limitations of National Income Accounting Ignores economic profits and losses Economic profit will typically be less than accounting profit But GDP accounts cant possibly determinate all the implicit or opportunity costs of all the entrepreneurs across the economy, so only accounting profits are used to measure GDP GDP overestimates actual performance of the overall economy

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57 Appendix: Limitations of National Income Accounting Anything that leads to a transaction in monetary form is recorded as positive, no matter what is being sold This goes against common sense Why should all products and services be treated alike? If I dont like more nuclear weapons, why should I accept a measurement that includes them as part of the growth of the economy? GDP

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58 Appendix: Limitations of National Income Accounting GDP measures, or rather express, as positive the malfunctions of the economic system or society If cars break down and other disasters occur, that require repair up goes the GDP If industry pollutes the air and we creat other industries which remove the polluting substances up goes the GDP. If we pollute less, then GDP may goes down. How can one find a measure which tells simultaneously opposite sides of the functioning of a complex system in one single scalar number?

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59 Appendix: Limitations of National Income Accounting The corrections of GDP figures that are made by elimination of the effect of seasonal variations, of price changes, etc., therefore obtaining a stable basis, eliminating the influence of distortion caused by inflation, in on way touch the fundamental issues and objections!

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60 Appendix: The Dangers of Aggregation Measuring the overall performance of an economy A rather difficult task More broader problem: emphasis on statistical aggregates GDP Price level Unemployment rate Etc.

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61 Appendix: The Dangers of Aggregation One of the temptations of macroeconomic theory To study the economy by focusing largely (if not exclusively) on the relationships between the aggregate variables themselves [ ]

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62 Appendix: The Dangers of Aggregation But this is quite a problem [ ] It appears that somehow the aggregates are interacting with one another [ ] Policymakers be tempted merely to get the aggregates right

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63 Appendix: The Dangers of Aggregation Never forget The economy is always and everywhere composed of individuals Only individuals choose Individuals act and interact Individuals attempt to coordinate their plans through the market process Individuals seek and creat wealth

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64 Appendix: The Dangers of Aggregation The economy is of high complexity Therefore, that its description, or rather its change, could be given and measured accurately by one scalar number is absurd

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65 Appendix: The Dangers of Aggregation A heavy focus on the interactions among clusters of data (the aggregates themselves) might make us lose sight of the specific pieces of information (and often heterogeneous information) Individual decision makers themselves use these information to coordinate their everyday plans and projects E.g. the same increase in the quantity of money will have very different consequences when it goes to consumers rather than to producers. This is obscured when one restricts oneself to the macro entities.

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66 Appendix: The Dangers of Aggregation From 1950s to 1970s macroeconomists Believe that supply and demand theory, and the basic conception of the individual decision maker was inherently limited and couldnt explain overall economic phenomena Placed the individual chooser in the scrapheap of macroeconomic thoughtuseful only for micro but not for macroeconomic theory

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67 Appendix: The Dangers of Aggregation Since 1980s more macroeconomists Believe aggregate analysis itself is limited Search for the microeconomic foundations of macroeconomics Rediscovered the value of supply and demand analysis and the formation of relative market prices, and price expectations

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68 Once Over Lightly Gross Domestic Product GDP GDP Measurements (3) Unsold Goods Market Values of Services Many people not employed are not in the labor force and not unemployed. Difference between not employed and unemployed is not always clear.

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69 Once Over Lightly Expected advantages of alternative opportunities determine decisions as to labor force entry. Inflation is a decrease in purchasing power of money Deflation is a sustained rise in purchasing power of money.

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70 Once Over Lightly Disinflation is a slowing down of the rate of inflation. GDP Deflator is a measure of inflation Economic growth Recession Aggregate Fluctuations Limitations of GDP measurement The Dangers of Aggregation