Syllabus

Lecutres

Outlines

Assignments

Learning Objectives:
A. National Income Accounts, relation between key macro variables
B. Gross domestic product - the main measure of output
C. Saving and wealth - private and government
D. Price indexes, inflation, and interest rates.
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Lecture Outline:

I. National Income and Product Accounts (NIPA):

A. BEA's accounting method for measuring the level of output, income, and expenditure in the U.S.;

1. Data obtained from government agencies (Census Bureau, BLS, IRS), private sources, industry associations.

2. Results published in the Survey of Current Business, and the Economic Report of the President.

B. Three Ways to Measure Economic Activity:
1. Product Approach: output (value added) by all firms.
2. Income Approach: Income received by producers of output.
3. Expenditure Approach: Amount spent by ultimate buyers.

C. Three approaches equivalent!
1. Must be, by definition,
2. Any output produced (product approach) is purchased by someone (expenditure approach) and results in income to someone (income approach)
3. The fundamental identity of national income accounting:
total production = total income = total expenditure

Example: NIPA for a simple two-sector economy
- Farm sector: Produce wheat
- Bakery sector: Produce bread

Transactions in the farm sector (in $1000)
Wages paid to employees 15
Taxes paid to government 5
Revenues received from the sale of wheat 35
Wheat sold directly to public 10
Wheat sold to bakeries 25

Transactions in the Bakery Sector
Wages paid to employees 10
Taxes paid to government 2
Wheat purchased from the farm sector 25
Revenues received from the sale of bread 40

" Product Approach: Value added by the farm and bakery sectors = 35+15 = 50

" Income Approach: Sum of wages, after-tax profits, and taxes = 15+10)+(15+3)+(5+2) = 50

" Expenditure Approach: Public's expenditure on wheat and bread = 10+40 = 50

II. Gross Domestic Product: Broadest measure of economic activity.

A. The Product Approach: market value of final goods and services newly produced within a nation during a fixed period of time.

1. Market value = allows adding up unlike items;
a. Problem: misses non-market items such as home-making,
b. Some adjustment for underground economy.
c. Government services (not sold in markets) are measured by their cost of production.

2. Newly Produced = Produced in current, not previous years.

3. Final goods and services
a. Do not count intermediate goods
b. Consumption goods, capital goods, government purchases, and inventory investment are treated as final good,
c. Adding up value added works well since it excludes intermediate goods.

4. GNP versus GDP:
a. GNP = output produced by domestically owned factors of production anywhere in the world,
b. GDP = output produced within a nation's boundary,
c. Some of our factors of production work overseas and some of foreign factors work in the U.S.
d. Net factor payment (NFP) = payments to our factors located abroad minus payments to foreign factors located in the U.S.
e. GNP = GDP + NFP; or GDP = GNP - NFP

B. The Expenditure Approach: Total spending on final goods and services produced within a nation during a specified time period.

1. Four categories of spending:
a. Consumption (C), investment (I), government purchases of goods and services (G), and net exports (NX).
b. Income - expenditure identity:
GDP = C (68%) + I (15%) + (18%) G + NX (-1%)

2. Consumption: spending by households
a. Categories: Durable (8%), non-durable (20%), services (40%)

3. Investment: Fixed (10%), residential (4%), inventory (0.2%)

4. Government purchases: Federal (7%), state and local (12%)
a. most purchases by state and local, not federal
b. Not all payments are for goods and services
" Transfer payments = S.S. payment, welfare, u. comp.
" Interest payments on national debt
c. Some purchases are capital goods (infrastructure)
d. Some are for current gov't consumption

5. Net Exports: Exports (11%), imports (12%)

C. The Income Approach:
1. Add up incomes generated by production
a. National Income = compensation of employees + Proprietor's income + rental income + corporate profits + net interest.

b. National income + indirect business taxes = net national product
c. Net national product + depreciation = GNP
d. GNP - NFP = GDP

2. Private sector income and government sector income:

a. Private disposable income: Three components:
Income earned domestically (GDP) +
net income from abroad (NFP) +
net payments by the government (TR+INT -T)
PDI = GDP+NFP+TR+INT-T

b. Government Net Income = T - TR - INT

Note: GNP = Private disposable income + Government net income

III. Saving and Wealth

A. Wealth
1. Household Wealth: household's (assets - liabilities)
2. National wealth: Total wealth of an economy's households, firms, and government
1. Components of national wealth:
c. The nation's domestic real assets (stocks of physical capital, human capital, and land)
d. Net holdings of foreign assets (real and financial)

Note: Financial assets (money, stocks, bonds) are not part of national wealth because each $ of these assets is matched by a $1 of domestic liability.

B. Saving
1. saving = current income - current expenses;
2. saving rate = saving / current income
3. private saving = private disposable income - consumption
Sp = (GDP+NFP+TR+INT-T) - C

4. Government saving (Sg) = Net gov't income - gov't purchases
Sg = (T-TR-INT) - G

5. National Saving (S) = private saving + gov't saving
S = Sp + Sg
= GDP + NFP - C - G
= GNP - C - G

Uses of Private Saving:
1. S = Sp + Sg
= GDP+NFP - C - G
= (C+I+G+NX) +NFP - C - G
= I + (NX+NFP)
= I + CA
National saving is used to finance (1) domestic and foreign investments.

2. Sp = I + (-Sg) + CA USES OF SAVING IDENTITY

3. Private saving is used for

(1) financing private investment,
(2) financing budget deficit,
(3) financing foreign investments (buying foreign assets: stocks, bonds, real estate.

C. Relating Saving and Wealth

2. Stocks and flows
a. Flow variables: measured per unit of time (GDP, income, saving, …)
b. Stock variables: measured at a point in time (money stock, wealth, capital stock, …)
c. Flow variables often equal rates of change of stock variables.

3. Wealth a stock variable; saving a flow variable.

4. Wealth (t+1) = Wealth (t) + S(t)
5. National wealth can change if there is a change in the:
a. market value of domestic real assets,
b. depreciation rate,
c. value of net foreign assets
d. the saving rate.
V. Real GDP, Price Indexes, Inflation, and Interest Rates

1. Real GDP: value of GDP measured at constant (base year) prices; a measure of a country's physical volume of production.

Real GDP = Nominal GDP/GDP deflator
a. GDP-Deflator = price index for a basket of currently produced output.
Production and Price data

Product Year 1 Year 2 Percentage change
Computers 5 10 +100
Bicycles 200 250 +25

Price
Computers $1,200 $600 -50
Bicycles $200 $240 +20

Value
Computers $6,000 $6,000 0
Bicycles $40,000 $60,000 50

Total
$46,000 $66,000 43.5

A. Calculate real GDP using base year = year 1

GDP for year 1: 5*1200+200*200 = 46,000
GDP for year 2: 10*1200+250*200 = 62,000
Percentage growth rate = 34.8%

B. Calculate real GDP using base year = year 2
GDP for year 1: 5*600+200*240 =51,000
GDP for year 2: 10*600+250*240 = 66,000
Percentage growth rate = 29.4%

A. Price Indexes:
1. A price index is a weighted average of prices for some specified set of items, relative to the prices in a specified base year.

a. GDP-Deflator: a price index that measures the overall level of prices for items included in GDP.
b. GDP-deflator = Nominal GDP/Real GDP

2. Consumer Price Index (CPI): A price index for a basket of consumer goods.
Construction of CPI:
Year 0:
Good Quantity $Price Total Spending Weight (w)
1 10 2 20 20/80 = 0.25
2 20 1.5 30 30/80=0.375
3 30 1 30 30/80=0.375
80 1
Year 1
Good Quantity $Price Total Spending Weight (w)
1 20 1.5 30 30/80 = 0.375
2 12 1.5 30 30/80 = 0.375
3 40 0.5 20 20/80 = 0.25
80 1
How to Construct Weighted Average of prices for year 0?
= (2)(0.25)+(1.5)(0.375)+(1)(0.375)

Let
p11 = price of good 1 in year 1,
p21 = price of good 2 in year 1,
p10 = price of good 1 in year 0,
p20 = price of good 2 in year 0, and so on,
w10 = weight of good 1 in year 0
w20 = weight of good 2 in year 0
w11 = weight of good 1 in year 1
w21 = weight of good 2 in year 1, and so on.

Then,
1. Laspeyres index(IL) (fixed weight):= [p11*w10+p21*w20+p31*w30]/[p10*w10+p20*w20+p30*w30]

2. Paasche index (IP)(current weight) = [p11*w11+p21*w21+p31*w31]/[p10*w11+p20*w21+p30*w31]:

Note: IL>IP because it ignores substitution effect of a rise in relative prices.

3. Chain Index (or Fisher Ideal Index)
Chain Index = (IL*IP)0.5 = 1.04185

B. Inflation:
1. The rate of change in the general price level.

a. CPI inflation (fixed weight) overstates the true inflation by close to 2% (Boskin Commission report)
b. Reasons:
. Price do not reflect changes in quality over time,
. Prices do not reflect the substitution by consumers as price change.
. Solution: used the chain index

E. Interest Rates
1. Real versus nominal interest rates
a. Real interest rate (r): return in terms of purchasing power
b. Nominal interest rate (i) : return in terms of money
c. Fisher equation:
Actual real interest rate: r = i -
Expected real interest rate: re = i - e

d. If e = , then re = r.