Theory and Measurement in the macroeconomyKey measures used by governments and consider differences between the Keynesian and Monetarist approach

CAMBRIDGE A’LEVELS ECONOMICS

Kalaiarasi Danabalan

http://www.youtube.com/watch?v=yUiU_xRPwMc

A government uses a variety of measures of the country’s output. These collectively known as NATIONAL INCOME. It cover the total country output is equal to total income.

Gross Domestic Product (GDP) = National Income

Gross Total, domestic refers to the home economy.

Product Output

GDP = C+I+G+ (X-M)

C- consumption

I- investment

X- Export

M- Import

• GDP + net property income from abroad = GNP (Gross National Product)

• Net Property Income = Income which the country’s residents earn on their physical assets (factories & leisure parks) owned abroad and foreign financial assets – the returns on assets held in the country owned by foreigners.

Expenditure

NNP ( Net National Product)= GNP- capital consumption / depreciation

NDP (Net Domestic Product) = GDP – Capital Consumption

Market Price = The prices charged for goods and services in shops and other types of retail business.

Factor Cost = Market price – Indirect Tax + Subsidies

Ways of Measuring GDP Output measure

Income measure

Expenditure measure

Expenditure Measure

What is produced in a year will either be sold or added to stocks.

This method necessary to (+)expenditure on exports and (- ) expenditure on imports.

Find GDPFC , GDPMC, and GNP.

Output Measure(Value of output produced by industries)

economic activity by adding the market values of goods and services produced, excluding any goods and services used up in intermediate stages of production.  

This approach makes use of the value‐added concept. 

The value added of any producer is the value of its output (- the value of the inputs it purchases from other producers.  

The product approach computes economic activity by summing the values added by all producers.

If someone bought it, then someone is being paid to make it. The income components include

- Wages and salaries

- Corporate profits

- Proprietors income (the profits of partnerships and solely owned businesses, like a family restaurant)

- Farm income

- Rent

- Interest

- Sales taxes

- Depreciation (the amount of capital that has worn out during the year)

Income measure/ Approach

Find GDP

1st step : find Nominal Income

NI = W + R + i + PR

2nd Step : GDP = NI + Indirect Business Taxes + Depreciation

Your answer : GDP = $602

Did you get this answer?

Three formula:

GDP at market price=C+I+G+(X-M)

GDP at factor cost=sum of value added

GDP at factor cost = wage+rent+interest+gross profits+depreciation

GDP at factor cost + indirect business taxes –subsidies = GDP at market price

GDP vs GNP

Under what situation when GDP is greater than GNP?

Income earned by non-residents locally is greater than income earned by residents abroad

Net Income from abroad is negative

Money and real GDP Money (nominal) GDP = GDP measured in the prices operating terms in

the year in which the output is produced.

GDP at current prices & measure which has not been adjusted for inflation.

Money GDP may give a misleading impression of how well a country is performing.

The money GDP value may rise because prices have risen.

Convert money into real GDP show what happening to output.

By measuring GDP at constant price, it remove the distorting effect of inflation.

Real GDP = money GDP x

Real GDP

To remove the effects of price change,

We have Real GDP,

= GDP at constant market price

= Price in base year x Output in current year

GDP deflator = Price index used to convert money into real GDP

Let we try

In 2008 a country’s GDP is $1000 billion. In 2009 nominal GDP rises to $1092 billion and the price index increases by 4%. Calculate

a.) real GDP

b.) the percentage increase in real GDP.

Comparison of economic growth over time and between countries

Changes in real GDP- economic growth

Official real GDP- the true change in output hidden, informal/ underground economic activity

Reasons of people didn’t declare their earned income to the authorities

1.) seeking to evade paying tax

2.) not declaring economic activity is itself illegal (smuggling goods).

Effects of the Size of the Hidden Economy

Measuring gap between GDP as measured by the expenditure and income methods.

Make international comparisons of economic growth rates difficult. It’s happen because of the hidden economy size varies between economies.

Factors influence comparing economic growth

The nature of economic growth

Living standard over time

Living standard between countries

Money supply

total amount of money . It consists of currency in circulation plus relevant deposits.

2 types of money supply

Narrow money – medium of exchange and consists of notes and coins in circulation and notes and coins consists and cash held in banks and balances held by banks at the central bank.

Broad money – Consists of the above plus a items range that are commensurate with money’s function as a value store.

The circular flow of income Refers to a simple economic model which

describes the reciprocal income circulation between producers and consumers.

The interdependent producers and consumer entities are referred to as “firms” and “households” respectively and provide each other with factors in order to facilitate income flow.

A continuous production flow, income and expenditure is known as income circular flow. It is circular because it has neither any beginning nor an end. The income circular flow involve 2 basic assumptions:

1.) In any exchange process, the seller/ producer receives the same amount what buyer or consumer spends.

2.) Goods and services flow in one direction.

Aggregate Expenditure

Total amount which will be spent at different levels of income in a given time period.

Consumption ( C ), Investment (I), Government Spending (G) and net exports (X-M).

CONSUMPTION (consumer spending)

It’s spending by households on goods and services to satisfy current wants.

Main influence- the level of disposable income

Income Total spending

Total spending rises with income, the disposable income proportion which is spent tends to fall.

MPC (Marginal Propensity to Consume)

The change in consumption that occurs with a change in income.

The MPC is less than one because individuals consume only a portion of an increase in income.

MPC = C/YD MPS (Marginal Propensity to Save)

the fraction of a change in disposable income that is saved.

calculated as the change in saving, S, divided by the change in disposable income, YD, that brought it about.

That is:

MPS = S/YD

Fixed Prices and Expenditure Plans The MPC plus the MPS equals one. This is because the way we define disposable

income, the only things that can be done with it is consume it or save it. So the fraction of a change consumed plus the fraction saved must equal one – all of it.

In symbols,

C + S = YD.

Divide this equation by YD to obtain,

C/YD + S/YD = YD/YD,

or

MPC + MPS = 1

Consumption Function

C= a+bY

Saving Function

S= -a +sY

a = Autonomous consumption / dissaving

Investment

Spending by firms on capital goods such as factories, offices, machinery and delivery vehicles.

The investment amount undertaken is influenced by changes in consumer demand, interest rate, technology change, capital cost goods, expectations and government policy.

Ir fall---I rise = investment cost fall & lower interest rate raise consumer demand.

Technology rise

Government spending

Spending on items such as the teachers wages in state schools, medicine used in state hospitals and government investment in new roads and new hospitals.

The government spending amount undertaken in any period is influenced by government policy, tax revenue, demographic changes etc.

Net export

Influenced by the country’s GDP, other countries GDP, the relative price and quality competitiveness of the country’s product and it’s exchange rate.

Exchange rate fall- export become cheaper- import become expensive.

Income Determination

The level of income in an economy is determined where aggregate expenditure = output.

If aggregate expenditure is below current output, firms will reduce production.

Output will change until it matches aggregate expenditure.

Money GDP- horizontal and aggregate expenditure- vertical

line shows the points at which aggregate expenditure = national income (GDP).

Output determined where the C+I+G+(X-M) cuts this line.

AE- PLANNED SPENDINGGDP – ACTUAL SPENDING

The Keynesian diagram Y= C+I+G

What if AE and Y are not Equal?

If AE< Y

People want to buy less than what has been produced so firms will accumulate inventories.

Firms will reduce production.

If AE > Y

What people want to buy is greater than actual production so inventories will decline

Firms will increase production

Impact of rise in aggregate

Expenditure

Withdrawals and injections

Withdrawal- S, T, M (Leakages)

Injection - I,G,X (Extra Spending)

Inflationary and Deflationary Gaps

Economy may not achieve full employment in short run and long run.

Short run - period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. Some inputs variable, some fixed. New firms do not enter the industry, and existing firms do not exit.

Long run - period of time in which the quantities of all inputs can be varied. All inputs variable, firms can enter and exit the market place.

Inflationary gap- AE exceeds the potential output of inflationary. Limited resources

Deflationary gap – The E level of GDP may below the full employment level.

Inflationary and Deflationary Gaps

How to escape from Inflationary and Deflationary gaps?

The Multiplier

Measures the change in E income as a result of a one-peso change in the sum of the autonomous components of AE.

The multiplier is used determine the amount by which Y* changes in response to a change in investment.

3 Sector =

MRT - Marginal Rate of Taxation

4 Sector =

MPM- Marginal Propensity to import

Lets Try

In an economy, MPS is 0.4, MRT is 0.2 and MPM is 0.2. GDP is $300 billion. The government raises its spending by $6 billion in a bid to close gap of $20 billion. Calculate

a.) The Value of the multiplier for 2 sector, 3 sector and 4 sector

b.) The increase in GDP

C.) Whether the injection of extra government spending is sufficient, too high or too low to close the deflationary gap.

Autonomous investment- Investment which is undertaken independently of changes in income

Induced investment- Contrast to autonomous investment.

Accelerator – Focus on induced investment and emphasizes the volatility of investment.

Ex: If GDP is rising but at a constant rate, induced investment will not change. Firms can continue to buy the same number of machines each year to expand the capacity.

Increase in the Money supply and the creation of credit

The cause of an increase in aggregate demand is an increase in the money supply.

The main cause of an increase in the money supply:

1.) An increase in commercial money spending

2.) An Increase in government spending financed by borrowing from the banking sector.

3.) More money entering than leaving the country.

Credit Creation

Commercial bank make their profits by lending to customers and when they lend they create money.

Every loan created as deposit.

Payments involve a money transfer using entries in the records that banks keep of their customers’ deposits rather than by paying out cash.

The Credit Multiplier

used in the analysis of money supply.

the ratio of additional credit creation (Δ CC) to the total cash reserves (Δ R).

Or

/

The change in liquid assets is deducted from the change in liabilities. This is because the change in liabilities will include deposits given to those putting in the liquid assets.

In practice, a bank may not lend as much as the credit implies it can. There may be a lack of households and firms wanting to borrow / a lack of credit-worthy borrowers.

A bank may also change its liquidity ratio if people alter the proportion of their deposits they require as cash, if other banks alter their lending policies / if the country central bank requires banks to keep a set liquidity ratio.

A central bank may seek to influence commercial banks ability to lend.

Deficit Financing Planned expenditure by a government to put more money into the

economy than it takes out by taxation, with the expectation that increased business activity will bring enough additional revenue to cover the shortfall.

Total Currency Flow The TCF of the balance of payments refers to the total outflow / inflow of

money resulting from international transactions as recorded in the current account, financial account, capital account and balancing item.

Relationship between money supply, price level and output

Change in money supply will effect on the price level and output in an economy.

Although the change in the money supply has some relevance, there are other factors that must be taken into account when explaining a change in the price level.

Interest rate determination and the demand for money

Monetarist support the loanable funds theory.

The DD for loanable funds comes from firms wanting to invest, households wanting to buy a car on credit & from the G seeking to fund a budget deficit.

The SS comes from S. A higher ir will increase the return from savings & so the supply curve is upward sloping.

Keynes Liquidity preference- Explain the demand for money.

There are 3 motives to show why households 7 firms may decide to hold part of their wealth in a money form

Transaction motive

The desire to hold money to make everyday purchases & meet everyday payments. The more income received & the more infrequently the payments are received, the higher the amount which will be held

Precautionary motive

Firms & households hold money rather more of their wealth than they anticipate they will spend. They can meet unexpected expenses, take advantage of unforeseen bargains.

Speculative motive

Holding money balances is interest elastic. Households & firms will hold what are sometimes called idle balances when they believe tht the returns from holding financial asset which firms & households may decide to hold is government bonds.

Figure shows the combined transactions, precautionary & speculative motives for holding money in the form of liquidity preference/ DD for money.

An Increase in Money supply- ir fall some households & firms having higher money balances than they want to hold.

Liquidity Trap

Speculators would expect the price of bonds to fall in the future, so if the money supply was to be increased they would hold all the extra money; they would not buy bonds for fear of making a capital loss & the return from holding such securities would be low.

The interest rate , the DD for money become perfectly elastic & rise in money supply has no effect on the interest rate.