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ECO120 Macroeconomics Rod Duncan. Lecture 5- The business cycle, or why we do well in some years and worse in others. Announcement. Your first Econlab homework is due in your tutorial this week.
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ECO120 MacroeconomicsRod Duncan Lecture 5- The business cycle, or why we do well in some years and worse in others
Announcement • Your first Econlab homework is due in your tutorial this week. • Go to MyEconLab, click on Homework and do the assigned homework. Print your answers out and bring them to your tutorial. • Each one is worth 2% of your final grade!
Measuring GDP • Alternative methods of calculating GDP • Expenditure approach: add up the total spent by all members of the economy (value of all goods and services bought) • Income approach: add up the incomes of all members of the economy (value of all goods and services sold) • Value-added approach: add up the value added to goods at each stage of production
Expenditure approach • GDP is calculated as the sum of: • Consumption expenditure by households (C) • Investment expenditures by businesses (I) • Government purchases of goods and services (G) • Net spending on exports (Exports – Imports) (NX) Aggregate Expenditure: AE = C + I + G + NX
Expenditure approach • Later on in the subject we will introduce the aggregate demand-aggregate supply model (AD-AS). The expenditure approach underlies the AD curve in the AD-AS model. • Factors that shift components of demand will then also shift the AD curve. • If income taxes change, household consumption (C) will change, so the AD curve will shift.
The big picture P, Wealth, H/h Expectations, H/h Taxes C P, i, Business Expectations, Business Taxes I AE AD Government policy, and? G NX P, and?
Income approach • The income approach is probably the next most straight-forward way of measuring economic activity. • When you buy a good, the cash that you pay (the market value) to a firm doesn’t stay with the firm. The value gets returned to households. • The firm pays its employees (households). • The firm pays other firms for its purchases. • The rest gets returned as profits to shareholders (households).
Firms as fictions • In that sense, firms don’t really exist. They are just convenient accounting fictions. • A firm is a representation of the households who own the shares in the firm (or for a private firm, own it outright). • Firms were invented as a way of allowing people to own a business, but not be personally liable if the business fails. • To say “firms don’t pay enough taxes” is really to say “shareholders don’t pay enough taxes”.
Income approach • We measure the value of the income earned by households in the production of goods- think of the cash a firm receives on a sale: • Wages paid to employees (suppliers of labour) • Profits/rent/bonds payments returned to suppliers of capital • Indirect taxes (GST) paid to government • Since the Tax Office collects all these details to calculate income taxes, we can have a reasonably good measure of this.
Value-added (production) approach • This approach is probably the most difficult to understand. • Why can’t we simply add up the value of all the goods and services bought in a year? The problem is that a lot of sales of goods are “intermediate” goods- that is goods that will be used to make other goods. • If we simply added up the sales of all the goods in a year, we would wildly over-calculate GDP.
Ford as a car assembler • Ford is more of a car-assembler than a car-maker. Ford buys seats from one supplier, brake systems from another and tires from a third. • Imagine Ford uses $20,000 worth of components in a $30,000 car. Adding up the sales, we get $50,000, but the consumer buys a $30,000 car!?! • The answer is that Ford adds only $10,000 worth of value. The rest of the value of the car is the $20,000 in components.
Valuing economic activity • In the end, we can either value (1) the $30,000 car purchased by the consumer, (2) the $30,000 income returned by Ford to workers, capitalists and suppliers, or (3) the $20,000 in components plus the $10,000 in value-added by Ford. • All 3 approaches result in the same answer… $30,000- the value of the car.
What is a business cycle? • If we measure GDP, we find that there are two major patterns we can identify over time: • GDP grows larger over time, so we saw Australian GDP in 2000 was 40 times larger than Australian GDP in 1960; and • GDP is not steady, but tends just jump up sometimes and jump down other times.
So what is the real view? • If you take a very long-term view of GDP, the growth is by far the most important feature of GDP. • If you take a very short-term view, the sudden swings in GDP can seem the most important feature. • Which aspect do you think newspapers take if the aim of the papers is to make news seem important? • Which aspect do you think politics concentrates on?
Growth in GDP • The growth in GDP is the rate at which GDP is increasing relative to the last time you measured it. • Growth is usually expressed as a percentage of the previous observation, so you take the change in GDP and divide it by the last GDP measurement.
Growth in GDP • There is a long-run average rate of quarterly growth- and it’s greater than zero. • But growth is not the same quarter after quarter, and some periods seem to have higher levels of dispersion of growth rates. • We might want to: • 1. raise the average rate of growth, and • 2. lower the dispersion (variance) in growth rates.
Why is it called a cycle? • Some of the early economists studying macroeconomic data had physics/engineering backgrounds. • When they saw the up and down nature of GDP over time, they were reminded of the motions of waves (cycles) from physics. • So they brought over all the physical descriptions of cycles or waves into macroeconomics.
Real GDP Actual GDP Trend GDP or Full-employment GDP Peak Trough 1993 2006 Year Parts of the business cycle