Economic Analysis for Business

Economic Analysis for Business Chapter 9 Measuring the Economy

Macroeconomic measures • These are measures designed to coincide with the four major macroeconomic issues of • economic growth, • unemployment, • inflation and • balance of payments stability Based on these major areas of economic assessment, there are four major measures of economic activity that are essential in understanding the direction in which an economy is travelling RMIT University

The four major economic measures • The four most important economic indicators: • Gross Domestic Product (GDP) • unemployment rate • the Consumer Price Index (CPI) • balance of payments / exports and imports RMIT University

Purpose of statistical measurement • At the end of the day, the question really is what purpose are the figures to serve • Most statistical collections are expensive. It requires a good deal of thought to be given to the uses to be made of the statistics once they have been collected • Statistics are not naturally occurring numbers that merely require a count, such as with a census • They are highly complex artefacts that occur only at the end of a very long process of thought and methodological refinement RMIT University

Gross Domestic Product (GDP) • The most commonly used measure of the overall strength of the economy is the data on Gross Domestic Product or GDP. It is an attempt to answer the questions: • how much is being produced during some period of time in some particular place • how much more (or less) is being produced during some period in comparison with some earlier period • how much is one country producing relative to another country RMIT University

Need to understand what is not being measured • GDP does not measure the size of an economy, only what is being newly produced • it is intended as a measure of value added • it does not include the stock of already existing goods and capital but only looks at the additions being made • a country experiencing zero growth or even a contraction in GDP is still producing – it is producing either the same amount as in the previous period (zero growth) or even less (a fall in GDP) but it is still producing RMIT University

Measuring growth – what grew? • The problem in estimating an economy’s rate of growth is deciding what to include in the composition of a country’s output, and then in finding some way to add it all up • A country in one year might produce one set of goods and a decade later a different set of goods • In comparing the value of the earlier set with the later set requires a large number of issues to be negotiated RMIT University

GDP measures production • The aim is to have some measure of value adding production. • How much was produced in one time period relative either to another time period or relative to some other place RMIT University

Problems in measuring growth • the enormous variety of kinds of goods and services produced • some of what is produced is sold on the market while some is not • need to find a means to isolate the change in the level of prices from changes in the level of production • the range of goods and services produced changes continuously and is different in different places • most of what is produced is used as inputs – double counting • some inputs disappear almost immediately after being produced while some are used for years on end • capital goods typically last beyond the current time period • seasonal influences RMIT University

Measuring GDP • To measure production during some period of time: • add together the sale price of all of the immense number of goods and services produced during a period of time • find some means to deal with goods and services provided outside the market which do not have sale prices • find some means of incorporating changes in composition • find some means to deal with changes in prices • bring together goods sold on the market and those that are not • recognise that some goods and services are used as inputs into the production of other goods and services while some are produced for final consumers • and for quarterly data, adjust for seasonal influences RMIT University

Basic framework • The basic framework in calculating GDP is therefore to find some mechanism which allows for the addition of: goods and services produced for the domestic market + goods and services produced for government + goods and services produced for overseas buyers RMIT University

Expenditure method • The most commonly used measure • In principle, the value of the sum total of goods and services produced during some period of time • Only final goods and services are counted • If all production included, because produced inputs are embedded into the production of other outputs, there would be a massive level of double counting RMIT University

Methodology • The methodology employed is to add all of the expenditure on all final goodsandservices bought • A final good is therefore classified as: • a good or service sold to its final consumer • or is a form of capital (machinery) that is expected to last for more than one year • The production of such capital goods is classified as investment • Investment is listed as a separate category of final goods RMIT University

Consumption and Investment • There are two categories of final good bought within the private sector, consumption goods and investment goods • These are typically identified in economic discussions as C + I C = Consumption [not intended to contribute to production] I = Investment [intended to contribute to production] RMIT University

Domestic Demand • There are then the goods and services produced by governments • These include the public service and other forms of public outlays not sold on the market • The letter used in economic discussions to refer to public sector expenditures of this kind is the letter G C + I + G RMIT University

Total Domestic Demand • There are then the goods and services purchased by overseas residents – exports • The letter used to designate exports amongst economists is the letter X • The formula for total purchases can now be written: C + I + G + X RMIT University

Imports are bought but not produced in an economy • The total of everything bought from domestic sellers is not the total level of domestic production • Some of what was sold within the domestic economy was imported from other countries. • Imports are designated by the letter M • We thus have everything bought: C + I + G + X • We have everything imported: M RMIT University

Measure of production • If from the total of everything bought is removed those parts which were imported, what is left must be what had been produced • The expenditure measure of production of GDP is therefore: Y ≡ C + I + G + X – M RMIT University

This is an identity – true by definition Y ≡ C + I + G + X – M RMIT University

Adjustment for movements in prices • The total level of GDP as calculated is recorded as a dollar amount • The total is an aggregate of various forms of outlay, whether on goods and services, value added or on incomes • But all are at the price level when the transaction occurred which is of little interest RMIT University

Measuring real growth • Of interest is the growthin real output that has taken place between two periods of time • How much more (or less) output has there been in the second period relative to the first RMIT University

GDP as measured increases for two reasons RMIT University

Measuring growth between periods • In the first period there is the dollar value of output (Q1) at first period prices (P1) GDP1 = Q1 * P1 • In the second period there is the dollar value of output (Q2) at second period prices (P2) GDP2 = Q2 * P2 RMIT University

Real GDP • The answer to the problem is to calculate GDP in the second period at the prices charged during the first period • This is described as the level of real GDP Real GDP2 = Q2 * P1 • The real level of GDP in the second period is calculated as the second period’s output at first period prices RMIT University

Distance between periods • Reasonable measure between recent years but comparisons across time are a problem • Two or three years apart mean what was produced was almost the same but 20 or 30 years apart and the specific goods are almost entirely different RMIT University

Percentage growth in GDP The formula for calculating the increase in GDP between two time periods: Y2 – Y1 %∆ Y = _____________ X 100 Y1 RMIT University

Consumer Price Index • Measurement of price movements in general have a wide number of uses and are essential to the monitoring of the state of the economy • Measures of price movements are needed as a measure of inflation • Possibly even more important is the use of a price index to convert nominal or current price economic indicators into real measures of activity RMIT University

Creating a price index • To create a price index of any kind, it is necessary to know which prices are to be included • But not only do you need to know which prices you need to have some idea of how many units of each item to include • The aim is to mirror the “average” expenditure of whichever group prices relate to • With the purchases of consumers, it is not enough to know a typical household has bought bread, furniture and overseas trips, but also how much is spent on each of these during the measurement period RMIT University

The basket of goods and services • What is whimsically called a “basket of goods and services” is put together • The basket of goods and services is in reality a list of the average amounts spent by the target population on each of the items purchased during the relevant time period • The first step in making price estimates is usually to conduct some kind of household expenditure survey to find out what people buy and in what quantities RMIT University

Partial list of good and services Items Units per Qtr • cartons of milk 45 • loaves of bread 70 • restaurant meals 10 • computers 0.2 • cars 0.1 • visits to doctor 2 RMIT University

Pricing the basket of G&S • The list of items in the basket of goods, and there are typically thousands of items included in the CPI of most major economies, is then priced • Employees of the statistical agency go to places where these items are sold and find the price and these are recorded • If the product is on special and the price is lower than usual, the actual sale price, not its normal price, are included • The total cost of the basket of goods becomes the basis for the Consumer Price Index RMIT University

How the index is constructed • When all of the items are priced, the cost of purchasing this set of goods is calculated • The total is the basis for the index but is not the index itself • Suppose in the base year, that is, the year from which all movements are calculated, the total cost of the basket of goods was $850 • Because it is the base year, the index is arbitrarily given the value of 100.0

Conversion of cost movements into index movements • In the base year the cost of the basket of goods and services is $80 and the index is equal to 100.0 • In the second year, the cost of the same basket of goods and services may have risen to $828 • This is an increase of 3.5% • What is therefore published is a new index, which is 3.5% higher than the previous index, which in this example is 103.5

And in the following year • In the following year, the cost of the same basket of goods and services may have risen again from $828 to $852 • This is an increase of 2.9% • What is therefore published is a new index, which is 2.9% higher than the previous index, which in this example is 106.5 RMIT University

Movement in CPI – First Year 103.5 – 100.0 ∆ CPI = __________________ X 100 100.0 3.5 = ________________ X 100 100.0 = 3.5% RMIT University

Movement in CPI – Second Year 106.5 – 103.5 ∆ CPI = __________________ X 100 103.5 3.0 = ________________ X 100 103.5 = 2.9% RMIT University

Real movements in economic indicators • Price indexes are also of immense value in calculating the “real” movements in economic indicators which are given in current prices • Take, for example, data on wages and the CPI which show the following levels over three years: Year 1 $50,000 100.0 Year 2 $52,000 103.5 Year 3 $53,000 106.5 • the question is whether the purchasing power of the money wage has increased RMIT University

Calculating the Real Wage • Using the CPI calculated in the previous section, the means to estimate the growth in the real wage is as follows: Nominal Wage Real Wage = _______________ X 100 CPI

Real Wage Year 1 $50,000 Real Wage Yr 1 = _________ X 100 100.0 = $50,000 RMIT University

Employment and unemployment • The third measure of economic activity, employment and unemployment, is in many ways the most important • political • economic • human RMIT University

Measuring unemployment • How then to measure the number of unemployed? • At its most simple, the number of unemployed is a ratio of those who would like to have paid work as a proportion of the labour force RMIT University

Measuring the labour force • And who is part of the labour force? • Everyone who is already working plus everyone who is not working but wants to have a job Labour Force = Number of Employed Persons + Number of Unemployed Persons RMIT University

Counting the unemployed • Or to rearrange this expression, we can see that the number of unemployed persons is represented by the following: Number of Unemployed Persons = Labour Force – Number of Employed RMIT University

Measuring the Unemployment Rate Number of Unemployed Persons Unemployment Rate = __________________________ X 100 Labour Force RMIT University

Labour Force Survey • Where does the official unemployment rate come from? • The aim is to turn the concepts into a statistical measure • The means of calculation is therefore preceded by a statistical survey of a sample of households in which individuals are asked questions to determine whether they are employed, unemployed or not in the labour force RMIT University

Three categories of labour market status • The first issue is to separate individuals into three groups: • the employed • unemployed or • outside the labour force RMIT University

The employed • Who is considered to be employed: • need to be above some specified minimum age – each country chooses its own • has the person worked for pay during the previous week for at least one hour • or if not working, whether on holidays or sick leave RMIT University

The unemployed • To be unemployed is not as simple as it sounds: • did not work for at least one hour during the previous week • must want paid employment • actively took steps to find work (eg applied for a job, looked at job ads, etc) • is immediately capable to taking a job (eg not finishing a course, no child minding problems, etc) RMIT University

Economic Analysis for Business