Macroeconomics & The global Economy Ace Institute of Management Session 1

1. Macroeconomics & The global EconomyAce Institute of ManagementSession 1 Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

2. Objectives • To acquaint students with basic knowledge of macroeconomic theories • Define, explain and analyze macroeconomic terms, theories and indicators in general • Apply learning in decision making processes and solve real world issues • Use and explain the macroeconomic and developmental problems in a country

3. Evaluation Criteria • Class Participation 5% • Group Presentation 10% (5 Groups) • Midterm exams 15% • Term exam 40% (End Term) • Class Tests 10% (2 Tests) • Assignments 10% (1 Assignment) • Group Term Paper 10% (Submit at end)

4. Case study presentations • Case study oriented classes • Possibility of external evaluator • Evaluation Criteria: (10 x 3 = 30 marks) • Did the presentation reflect a team work among its members? • Were the students prepared for the presentation? • Did the students look confident while deliberating? (including eye contact & voice clarity)

5. Case study presentations • Case Study Presentation Schedule • Group1 Session 3 • Group2 Session 5 • Group 3 Session 6 • Group 4 Session 9 • Group 5 Session 10

6. Class tests, Assignment & Term paper • Class Test 1: Session 4 • Class Test 2: Session 11 • Assignment: Session 9 • Term Paper: • Preliminary Selection of Topic for term paper Session 3 • Development of Research idea on term paper Session 5 • Submission and Approval of the Topic with plan Session 7 • Submission of term paper Session 12

7. What you studied in Microeconomics.. • Basic demand and supply functions of individuals and markets • Profit maximizations of individual firms in different markets • Consumers and Producers welfare theories • Cost and benefits of firms in different markets. • And so on… • But NOW ….

8. Introduction to Macroeconomics Macroeconomics, the study of the economy as a whole, addresses many topical issues: • Why does the cost of living keep rising? • Why are millions of people unemployed, even when the economy is booming? • What causes recessions? Can the government do anything to combat recessions? Should it?

9. Introduction to Macroeconomics Macroeconomics, the study of the economy as a whole, addresses many topical issues: • What is the government budget deficit? How does it affect the economy? • Why does Nepal have such a huge trade deficit? • Why are so many countries poor? What policies might help them grow out of poverty? And our analysis look...

10. 9/11/2001 First oil price shock Great Depression Second oil price shock World War II U.S. Real GDP per capita (2000 dollars) long-run upward trend…

11. U.S. inflation rate(% per year)

12. U.S. unemployment rate(% of labor force)

13. Why learn macroeconomics? 1. The macroeconomy affects society’s well-being. Each one-point increase in the unemployment rate is associated with: • 920 more suicides • 650 more homicides • 4000 more people admitted to state mental institutions • 3300 more people sent to state prisons • 37,000 more deaths • increases in domestic violence and homelessness

14. change from 12 mos earlier percent change from 12 mos earlier Why learn macroeconomics? 2. The macroeconomy affects your well-being. In most years, wage growth falls when unemployment is rising.

15. Introduction to Macroeconomics Macroeconomics: • Deals with the economy as a whole. Study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

16. Don’t forget to floss! How do Macroeconomists think? • Theory as a Model: • Used to describe the real world eliminating unnecessary details The model teeth A model of human anatomy A road map

17. How do Macroeconomists think? • Macroeconomic models :Symbols and Equations • Two important variables in a models: • Exogenous variables; and • Endogenous variables. • Exogenous (Independent) variables : that a model takes as given. • Endogenous (dependent) variables : which the model tries to explain. (What happens to..??)

18. The model of supply and demand • Assume the following two relationships for CD market: • Qd = D(P,Y) …………………(i) • Qs = S(P,Pm) …………………(ii) • Equation (i): shows that Quantity of the CD demanded is the function of the Price of the CD and Income level of the consumer or the aggregate income of the economy. • Equation (ii): shows that Quantity of the CD supplied is the function of the Price of the CD and Input price of the materials. • The equilibrium in the CD market is given by: • Qd = Qs

19. Price Supply, Qs * P Demand, Qd Quantity * Q The model of supply and demand

20. Price Supply * P Demand Quantity * Q The model of supply and demand Exogenous Variables: Aggregate Income, and Price of the materials (taken as given) Endogenous Variables: Price of the CD, and Equilibrium quantity of CD The model explains what happens to Endogenous variables (Price and Equilibrium Quantity of CD sold) when one of the Exogenous variables (Aggregate Income and Price of the materials ) changes.

21. S P D' D Q S S' P D Q Example: changes in Exogenous variables SHIFTS IN DEMAND SHIFTS IN SUPPLY

22. Prices: flexible vs. sticky • General Assumption: Market equilibrium of supply and demand, (market clearing process). • Markets clearing continuously, is unrealistic. • Need prices to adjust instantly to changes in supply and demand. But, prices and wages often adjust slowly. • Although market clearing models assume that wages and prices are flexible, in actuality, some wages and prices are sticky. But they do depict the equilibrium toward which the economy gravitates. • Short term analysis vs Long term analysis for Price Sticky vs Price Flexibility

23. Gdp, cpi and unemployment Three statistics that economists and policymakers use: Gross Domestic Product (GDP)is the dollar value of all final goods and services produced within an economy in a given period of time. The consumer price index (CPI) measures the level of prices. The unemployment rate tells us the fraction of workers who are unemployed.

24. Gross Domestic Product (GDP) Total income of everyone in the economy Two ways of viewing GDP Total expenditure on the economy’s output of goods and services Income $ Labor Households Firms Goods/ Services Expenditure $ For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in the economy.

25. $0.50 $1.00 Expenditure Rules for Computing GDP In general, to compute the total value of different goods and services, the national income accounts use market prices. Thus, if GDP = (Price of apples Quantity of apples) + (Price of oranges  Quantity of oranges) = ($0.50  4) + ($1.00  3) GDP = $5.00

26. Total demand for domestic output (GDP) Investment spending by businesses and households Net exports or net foreign demand Consumption spending by households Government purchases of goods and services GDP: Components of Expenditure Y = C + I + G + NX This is the called the national income accounts identity.

27. Calculating GDP

29. World Top 10 GDP in Millions of US Dollars in Market Price (Source: IMF2008/2009) 12. India - 1,235,975 109. Nepal - 12,615 160. Maldives- 1,357 162. Bhutan - 1,269 181. Kiribati - 130

30. Expenditure Rules for Computing GDP • 1) Used goods are not included in the calculation of GDP. • 2) The treatment of inventories depends on if the goods are stored or if they spoil. • If the goods are stored, their value is included in GDP. • If they spoil, GDP remains unchanged. • When the goods are finally sold out of inventory, they are considered used goods (and are not counted).

31. Expenditure Rules for Computing GDP 3) Some goods are not sold in the marketplace and therefore don’t have market prices. We must use their imputed value as an estimate of their value. For example, home ownership and government services. 4) Intermediate goods are not counted in GDP– only the value of final goods. Reason: the value of intermediate goods is already included in the market price. Value addedof a firm equals the value of the firm’s output less the value of the intermediate goods the firm purchases.

32. Measuring GDP by the Value Added Method FIRM VALUE OF PRODUCT VALUE ADDED Cotton Farmer Value of raw cotton = $1.00 Value added by cotton farmer = $1.00 Textile Mill Value of raw cotton woven into cotton fabric = $3.00 Value added by cotton textile mill = ($3.00 – $1.00) = $2.00 Value added by shirt manufacturer = ($15.00 –$3.00) = $12.00 Shirt Company Value of cotton fabric made into a shirt = $15.00 Value added by L.L. Bean = ($35.00 – $15.00) L.L. Bean Value of shirt for sale on L.L. Bean’s Web site = $35.00 = $20.00 Total Value Added = $35.00

33. Exercise: (Problem 2, p. 40) • A farmer grows a bushel of wheat and sells it to a miller for $1.00. • The miller turns the wheat into flour and sells it to a baker for $3.00. • The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00. • The engineer eats the bread. Compute & compare value added at each stage of production and GDP

34. Other Exclusions from Expenditures • Expenditure on purchase of goods and services during specified time period. • Previous expenditure reflects the change in ownership only. • Avoid “neither good nor a service” • Does not reflect production such as bonds/ stocks • Avoid expenditure by governments for which it does not receive a good or service in return • Eg.: Transfer payments such as Social security,, unemployment compensation etc.

35. Measuring GDP from Income side • Sum of income of all factors of production gives the GDP from income side • GDP = Rent + Wages + Interest + Profits

36. Calculating GDP

37. Calculating GDP • Compensation of employeesincludes wages, salaries, and various supplements—employer contributions to social insurance and pension funds, for example—paid to households by firms and by the government. • Proprietors’ incomeThe income of non-corporate businesses such as small farms, shops. • Rental incomeThe income received by property owners in the form of rent. • Corporate profits The income of corporate businesses. • Net interest The interest received by the businesses minus interest they pay plus interests earned from the foreigners.

38. Remember: Gross Domestic Product (GDP) • Gross domestic product (GDP) is a measure of the income and expenditures of an economy which includes all items produced in the economy and sold legally in markets. But: • It excludes items produced and sold illicitly, such as illegal drugs.

39. Other Measures of income • Gross National Product (GNP) • Net National Product (NNP) • National Income (NI) • Personal Income (PI) • Personal Disposable Income (DI)

40. National Income Accounting contd.. • GDP + NFI from Abroad = GNP GNP is the monetary value of final goods and services produced by the nationals (income earned by the nationals on foreign countries minus income earned by foreigners at home) • GNP – Depreciation (Capital Consumption) = NNP Depreciation is the net capital consumption during the accounting year • NNP – Indirect Business Tax = NI (National Income)

41. National Income Accounting contd.. • NI – Social contributions – net interests paid by individuals – corporate profit tax –undistributed corporate profit + Dividends + Govt. & business transfers to individuals + Net interest paid to individual = PI (Personal Income) • PI – Personal tax and non-tax payments (such as parking tickets) = DI (Disposable Income) Disposable income is the final income that a consumer spends on the purchase of goods and services • DI – Saving – Personal Interest Payment – Household Transfer Payment = Personal Consumption Expenditure

42. Calculating other measures of Income

43. Calculating other measures of Income

44. Real vs. nominal GDP • GDP is the value of all final goods and services produced. • Nominal GDP measures these values using current prices. • Real GDPmeasure these values using the prices of a base year.

45. Practice problem, part 1 • Compute nominal GDP in each year. • Compute real GDP in each year using 2006 as the base year.

46. Answers to practice problem, part 1 nominal GDPmultiply Ps & Qs from same year2006: $46,200 = $30  900 + $100  192 2007: $51,400 2008: $58,300 real GDPmultiply each year’s Qs by 2006 Ps2006: $46,2002007: $50,000 2008: $52,000 = $30  1050 + $100  205

47. Real GDP controls for inflation Changes in nominal GDP can be due to: • changes in prices. • changes in quantities of output produced. Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.

48. U.S. Nominal and Real GDP, 1950–2006 Real GDP(in 2000 dollars) Nominal GDP

49. GDP Deflator • The inflation rateis the percentage increase in the overall level of prices. • One measure of the price level is the GDP deflator, defined as

50. Practice problem, part 2 • Use your previous answers to compute the GDP deflator in each year. • Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.