MacroEconomicsNotes & reminders

Gross Domestic Product and more

Gross domestic product or GDP is a most commonly used measure of output produced in an economy.

GDP is a measure of all legally marketed output produced in an economy within that economy.

GDP in NZ is such output produced in NZ.

GNP is a similar measure output.

But it is adjusted for output produced by New Zealanders outside of NZ (positive) and for output produced by non-residents in NZ (negative). This adjustment is not necessarily large. BUT GDP is a better measure of what is actually produced within a country.

GDP adjusted for price change (real GDP) is the best measure (the only) for real output.

Nominal GDP gives us output estimates for GDP in current dollar (currency) value.

So, for nominal GDP if GDP increases by 10% for example, we really dont know if more goods and services have been produced unless we know something about price changes (inflation or deflation).

If prices increased by 10%, in this case, GDP would not have increased at all.

Measures of price change:

Consumer price index (CPI)survey based, related to goods and services purchased by the average consumer.

GDP deflator (based on a broader range of goods & services than the CPI)

Nominal GDP is adjusted by the price index to generate real GDP.

Per capita GDP

Total real GDP tells us little about the potential output available per person.

This information is generated only using per capita (per person) real GDP.

Here one devised total real GDP by the population of a country.

Chinas total real GDP is much larger than NZs, but it per capita GDP is much smalleronce you adjust for population size.

Some problems with GDP

A shortcoming of real GDP is that it does not incorporate illegal output or household (non-marketed output).

Therefore whats produced in the black-market is not counted nor is child care provided by the stay-at-home parent.

GDP also does not take into account negative outputs such as pollution.

More pollution can yield higher real GDP, but lower levels of socio-economic wellbeing.

Calculating GDP There are different methods of calculating GDP.

But the first thing to note is that output must be first converted into monetary values.

You cant add up apples, oranges, milk, wool, and wine.

So what is done each output is weighted by their respective price (an apple by the price of that apple, a bottle of wine by the price of that wine, etc.)

These nominal values are then added up to generate nominal GDP.

Recall our discussion of real GDP.

Well, another way of calculating real GDP is by weighting output by the price of a particular year.

So, real GDP given in 2001 prices, means that the output of 2014, is given in terms of 2001 prices, output of 2002 is also given in terms of 2001 prices.

By translating all output in terms of 2001 prices we have real GDP in terms of 2001 prices.

One common method is the value added approach.

Here one added the value added in production to get GDP.

One example of this would be to subtract total output minus inputs.

In this case, value added consists largely of wages and profits.

Another example would be when you determine the value added of bread, you dont include the value of flour and yeast, you simply count the value added to the inputs.

Flour is counted when one estimates the VA in the production of flour.

This avoids double-counting.

Another measure of total output is the expenditure approach.

Here one is measuring the expenditure on final output.

This is given by:

GDP=C (consumption)+I (investment)+G(government spending)+(X[exports]-M[imports])

This should generate the same value for GDP as would the VA approach.

Note the definitions discussed for C, I, G, X, and M.

Business Cycles

We discussed briefly business cyclesfluctuation in real GDP over time.

Recall the peak and trough, recessions, depressions, booms and busts.

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GDP

Time

Peak

Trough

Boom

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Supply & Demand Some Key Points

One method of understanding macroeconomic dynamics is using basic supply & demand analysis.

Another approach is using the Keynesian cross whilst inserting a supply curve into the model.

Please note that you need to know the various definitions related to these analysis.

Supply & Demand One has an aggregate demand curve that is negatively slope in both the short and

long run.

The slope is given by the wealth effect, the interest rate effect, and the international trade effect.

The aggregate supply curve is assumed to by positively sloped in the short run and perfectly inelastic in the long run (given by long run determinants of potential output)

This type of vertical supply curve assumes that inflation can have no long run effect on real wages.

That is, it is assumed that inflation will not reduce real wages in the long run.

Therefore, it is assumed that in the LR workers do not suffer from what is referred to as money illusion.

Supply & Demand

On the demand side, demand can be changed by changing any of the expenditure variables, such as C, G, I, or X-M.

Note that these variables can be changed simply by changing expectations (or animal spirits).

One can start of assuming full employment equilibrium at G1.

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If government attempt to increase GDP

by increasing AD from AD1 to AD2,

in the short run GDP increases from G1 to G3.

But in the LR, GDP reverts to G1 & Prices increase to

P3we simply end up with inflation.

Keynesian economics never recommends increasing LR

GDP through shifts in the D-curve.

Note that the D-curve can be shifted through fiscal or

monetary policy.

Once one is at full potential GDP (LRS), increasing GDP and

increasing employment requires shifting outward the LRS.

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Pric

e (C

PI)

Real GDP

G1

LRS

SRSAD1AD2

AD3

G2 G3

P0P1P2

P3

A depression or recession can be caused by a shift inward in the AD curve, through a drop in animal spirits or through government cutbacks or through increasing interest rates, for example.

AD shifts from AD1 to AD3.

GDP fall to G2 along the SR supply curve.

Some economists argue that if the economy is left to its own devices, prices will eventually fall and full employment at potential GDP will be restored to G1 at price level P0.

But the problem posed by Keynes and many contemporary economists is that prices tend to be sticky downward and a fall in prices also has the effect of deflating animal spirits which would cause a further shift to the left of the AD curve.

In this case, the market, on its own, cannot easily restore full employment.

Evidence of this is the Great Depression on the late 1920s-1930s and the recent maker recession-depression that began 20098-09.

So, one solution to a drop in GDP below its potential is to increase AD back to its former level through fiscal and/or monetary policy.

Note that when animal spirits are down, reducing interest rates have little effect on AD as individuals are too pessimistic to respond (this is referred to as the liquidity trap).

In this case, monetary policy cant shift AD outward.

Keynesian Cross

One can use the Keynesian Cross model to illustrate how one might be stuck in a low income (below potential GDP) equilibrium and how fiscal and monetary policy affects the Keynesian Cross equilibrium.

Key point about the Keynesian Cross model is that equilibrium is possible even in the longer run with less than full potential GDP (less than full employment) being achieved.

With the Keynesian Cross, one has a 450 line where Expenditure equals GDP (output).

This is a measure of equilibrium.

Therefore equilibrium can be achieved anywhere along the 450 line.

The equilibrium (GDP) is given where the aggregate expenditure curve (AE) cuts the 450 line.

AE=C+I+G+(X-M).

Equilibrium changes with changes to AE.

Please note how the AE curve is constructed.

In the Keynesian Cross model real GDP cant go beyond potential GDP given by LRS.

If one starts with equilibrium at the potential GDP at G1, increasing AE can have no real effect on GDP.

But a drop in AE from AE1 to AE2 results in a drop in equilibrium GDP to G2 at less than potential GDP.

Restoring GDP to G1 requires an increase in AE.

Also note that AE>GDP, at F, GDP increases until GDP is at G2, where

AE=GDP at G2.

If GDP>AE such as at K, GDP

falls until GDP=AE at G2.

Notice that G2 is an equilibrium even though it is below

potential GDP.

A drop in animal spirits can can long term equilibrium consequences

for an economy unless dealt with by fiscal or monetary policy.

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450

AE

GDP

AE1

LRS

G1

AE2

G2

EF

K

Phillips Curve & more

NZ born and raised economist A.W. Phillips (from the London School of Economics), found an inverse relationship between UK unemployments rates and the rate of inflation for the 1861-1957 period (this specific relationship was clearly specified by American economists Samuelson and Solow.

Idea here is that there was a clear correlation between higher rates of inflation and lower rates of unemployment,

This empirical relationship has come to be know as the Phillips curve.

This curve suggested a possible trade-off between inflation rates and unemployment rates.

Phillips Curve

The Phillips Curve trade-off relationship is still debated, although many economist still argue that their is some causal relationship between inflation rates and the unemployment rate.

If the Phillips Curve represents a causal relationship then there some LR positive relationship between the supply curve and the price level or the rate of inflation.

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Infla

tion

rate

Unemployment rate

The Phillips Curve

Another look at the Phillips Curve

One interpretation of the Phillips Curve is that one begins with an equilibrium at G1and P1, where P1 presents a certain rate of inflation, say 4%.

Next, LR supply shifts to LRS2.

If demand shifts to AD2 this clears the market at G2 at price P2, where P2 is consistent with a rate of inflation of 4% and this is consistent with the rate of unemployment given by G1 or, lets say 5%.

If AD only increases to AD3, then the rate of inflation falls to one given by P3, say 2%, and output increases to only G3. This yields a higher rate of unemployment, say 6%.

Weaker demand increases yield a lower rate of inflation and a higher rte of unemployment.

A key public policy question is, to what extent is higher inflation required to reduce the rate of unemployment: mixed evidence and much debate.

Another question is, to what extent does lower inflation rates yield higher unemployment rates.

The evidence does suggests that if AD does not increase sufficiently to match increases in the increases in LRS, inflation rates will fall and the unemployment rates will increase.

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AD1

Pric

e (C

PI)

SRS1

LRS1

Real GDPG1

P1

LRS2AD2 SRS2

P2

AD3

P3

G2

G3