Macroeconomics Principles

Posted on Aug 19, 2024 in Economy

Measuring a Nation’s Income

Microeconomics

The study of how individual households and firms make decisions and how they interact with one another in markets.

Macroeconomics

The study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once. It answers questions like:

  • What determines the average income?
  • Why do some prices rise rapidly in some time periods?
  • Why do production and employment expand?

Gross Domestic Product (GDP)

A measure of the income and expenditures of an economy. It’s the total market value of all final goods and services produced within a country in a given period of time. Income = Expenditure because:

  • Every transaction has a buyer and a seller.
  • Every dollar of spending by some buyer is a dollar of income for some seller.

This concept can be illustrated with a circular flow diagram.

GDP is the market value of all final goods and services produced within a country in a given period of time.

Not Counted in GDP

  • Home-consumed items
  • Illegal activities

GDP Components

GDP = Consumption + Investment + Government Purchases + Net Exports

  • Consumption: Spending by households on goods and services.
  • Investment: Spending on capital equipment, inventories, and structures.
  • Government Purchases: Spending on goods and services by all levels of government.
  • Net Exports: Exports – Imports

Transfer Payments

Payments for which no good or service is exchanged (e.g., Social Security benefits).

GDP Per Capita

Gross Domestic Product / Population of a country, used to give a measure of national income per person.

Nominal GDP

The production of goods and services valued at current prices.

Real GDP

The production of goods and services valued at constant prices.

GDP Deflator

(Nominal GDP / Real GDP) x 100

The GDP deflator reflects the prices of all goods and services produced domestically, whereas the Consumer Price Index (CPI) reflects the prices of all goods and services bought by consumers.

Real GDP Calculation

Real GDP20XX = (Nominal GDP20XX / GDP Deflator20XX) x 100

Measuring the Cost of Living

Inflation Rate

The percentage change in the price level from the previous period.

Consumer Price Index (CPI)

A measure of the overall cost of the goods and services bought by a typical consumer.

5 Stages to Calculating CPI

  1. Fix the Basket: Determine what prices are most important to the typical consumer.
  2. Find the Prices: Find the prices of the items in the basket for each point in time.
  3. Compute the Basket Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.
  4. Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared.
  5. Compute the Inflation Rate: Calculate the percentage change in the price index from the preceding period.

Inflation Rate Calculation

Inflation Rate in Year 2 = (CPI in Year 2 – CPI in Year 1) / CPI in Year 1 x 100

3 Key Issues That Cause the CPI to Overstate the True Cost of Living

  1. Substitution Bias: Consumers may substitute away from goods that have become relatively more expensive.
  2. Introduction of New Goods: New goods provide consumers with more choices, which reduces the cost of maintaining a given standard of living.
  3. Unmeasured Quality Changes: If the quality of a good deteriorates from one year to the next, the effective value of a dollar falls, even if the price of the good stays the same.

Producer Price Index (PPI)

Measures the cost of a basket of goods and services bought by firms rather than consumers.

GDP Deflator vs. CPI

  • The GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.
  • The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year.

Indexed

When some money amount is automatically corrected for inflation by law or contract.

Nominal Interest Rate

The interest rate usually reported and not corrected for inflation.

Real Interest Rate

The nominal interest rate corrected for the effect of inflation.

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Production and Growth

Productivity

Refers to the amount of goods and services produced for each hour of a worker’s time.

Rule of 70

A simple way to estimate the number of years it takes for a variable to double. For example, a growth rate of 7% would see income per person doubling in 10 years (70 / 7 = 10).

Factors of Production

  1. Physical Capital: The stock of equipment and structures used to produce goods and services.
  2. Human Capital: The knowledge and skills that workers acquire through education, training, and experience.
  3. Natural Resources: The inputs into the production of goods and services that are provided by nature, such as land, rivers, and mineral deposits.
  4. Technological Knowledge: Society’s understanding of the best ways to produce goods and services.

Diminishing Returns

The property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. In other words, when the stock of capital rises, the extra output produced from an additional unit of capital falls.

The Catch-Up Effect

The property whereby countries that start off poor tend to grow more rapidly than countries that start off rich.

Foreign Direct Investment

Capital investment owned and operated by a foreign entity.

Foreign Portfolio Investment

Investment financed with foreign money but operated by domestic residents.

Brain Drain

The emigration of highly educated people from poor countries to rich countries.

Property Rights

Refer to the ability of people to exercise authority over the resources they own.

Inward-Oriented Trade Policies

Policies that aim to raise living standards by avoiding interaction with other countries.

Outward-Oriented Trade Policies

Policies that encourage interaction with other countries.

Saving, Investment, and the Financial System

Financial System

Made up of financial institutions that coordinate the actions of savers and borrowers.

Financial Markets

Institutions through which savers can directly provide funds to borrowers (e.g., stock market, bond market).

Financial Intermediaries

Financial institutions through which savers can indirectly provide funds to borrowers (e.g., banks).

Bond

A certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond.

Stock

Represents a claim to partial ownership in a firm and, therefore, a claim to the profits that the firm makes.

Investment Fund

An institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds.

Other Financial Institutions

  • Pension funds
  • Insurance companies
  • Pawnbrokers
  • Credit unions
  • Loan sharks

Credit Default Swaps

A means by which a bondholder can insure against the risk of default.

Subprime Market

Lending to individuals with high credit risks.

National Saving

Total income in the economy that remains after paying for consumption and government purchases.

Private Saving

The amount of income that households have left after paying their taxes and paying for consumption.

Public Saving

Tax revenue that the government has left after paying for its spending.

Budget Surplus

Occurs when tax revenue (T) is greater than government spending (G): T > G

The Monetary System

Bartering

The exchange of one good or service for another.

Money

A set of assets in an economy that people regularly use to buy goods and services from other people.

3 Functions of Money

  1. Medium of Exchange: An item that buyers give to sellers when they purchase goods and services.
  2. Unit of Account: The yardstick people use to post prices and record debts.
  3. Store of Value: An item that people can use to transfer purchasing power from the present to the future.

Liquidity

The ease with which an asset can be converted into the economy’s medium of exchange.

Commodity Money

Money that takes the form of a commodity with intrinsic value (e.g., gold).

Fiat Money

Money that has no intrinsic value and is used as money because of government decree (e.g., paper currency).

Currency

The paper bills and coins in the hands of the public.

Demand Deposits

Balances in bank accounts that depositors can access on demand by writing a check or using a debit card.

Central Bank

An institution designed to oversee the banking system and regulate the quantity of money in the economy.

Money Supply

The quantity of money available in the economy.

Monetary Policy

The set of actions taken by the central bank to affect the money supply.

European Central Bank (ECB)

The overall central bank of the 19 European Union countries that have adopted the euro.

Eurosystem

Made up of the ECB plus the national central banks of the 19 eurozone countries.

Reserves

Deposits that banks have received but have not loaned out.

Fractional-Reserve Banking

A banking system in which banks hold only a fraction of deposits as reserves and lend out the rest.

Reserve Ratio

The fraction of deposits that banks hold as reserves.

Central Bank Tools

  1. Open Market Operations: The purchase and sale of U.S. government bonds by the Fed.
  2. Changing the Refinancing Rate: The interest rate at which commercial banks can borrow money from the central bank.
  3. Changing the Reserve Requirement: The minimum amount of reserves that banks must hold against deposits.