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MGEA06 LEC 01, LEC 02 & LEC 60 Introduction to Macroeconomics:

A Mathematical Approach

Winter 2017

Introduction

Professor: Iris Au

Class format:

Lecture:

There are 2 regular sections and 1 online section.

Lectures will be taped and will be available on WebOption.

Tutorials:

Weekly tutorials had been taped and will be available on WebOption.

Teaching Assistants’ office hours:

We have 12 TAs and they will hold weekly office hours (start in Week 2).

TA office: IC 225

The schedule of their office hours has been posted on Blackboard.

Professor Au’s office hours:

Office: IC 282

Office hours: Monday, 11:00am 12:00pm & Tuesday, 9:30am 11:00am

Course Coordinator:

Email:

He handles issues related to the administrative part of the course such as technical difficulties in viewing online materials, TAs’ office hours, and etc.

Arif Toor

mgea06headta@utsc.utoronto.ca

Required text: Krugman, Wells, Au, and Parkinson, Macroeconomics, 2 nd Canadian edition, Worth, 2014.

The new course text package in the bookstore comes in 2 options: a paperback and a loose leaf. It includes the Sapling access code. The study guide also comes at NO additional cost with the package. Although it is not mandatory, the study guide is strongly recommended because it provides additional practice.

Grading schemes:

Online assignments (best 5 out of 6)

15%

Midterm

35%

Final Exam

50%

For those who have attempted the midterm, improvement will be taken nto consideration when assigning the overall grade. If you do better in the final exam, your midterm marks will be replaced by your final exam marks (i.e., your final exam will count for 85%).

If anyone miss the midterm with legitimate reason, you must submit proper documentation to the course coordinator within one week after the midterm is written in order for us to transfer your midterm weight to the final exam. If proper documentation is NOT being submitted in a timely manner, you will receive a grade of ZERO in the midterm (i.e., your midterm weight will not be transferred to the final exam and your final exam will count for 50%).

Assignments:

Six online assignments will be given out throughout the term.

Only the best 5 assignments out of 6 will be counted for grades.

You need a Sapling access code to complete the assignments. If you get a new course package, the code is already included. If you get a used text, the option of getting a stand-alone access code is available from the Sapling site.

See instructions posted on Blackboard on how to set up an account.

Chapters 6 & 7 Introduction & The Measurement of GDP

Outline

What is macroeconomics? (Chapter 6)

The national accounts. (Chapter 7)

What is Gross Domestic Product (GDP)?

3 approaches to measure GDP.

Nominal GDP vs. Real GDP

Price indexes. (Chapter 7)

Consumer price index (CPI) vs. GDP deflator.

Chapter 6 Macroeconomics: The Big Picture

Macroeconomics is about the big picture, i.e., it is the study of the behaviour of the economy as a whole.

Macroeconomics look at things in a different way than microeconomics, we focus on:

The interactions of different sectors in an economy (instead of what happens in a specific market and we cannot just add things up).

Macro has a strong policy focus.

Issues that macroeconomists will look at:

Causes of the business cycles the short-run alternation between recessions and expansions. Factors that affecting the unemployment rate. What should policy makers (the government and the central bank) do to smooth out the business cycles? Causes and costs of inflation. What determine the long-run economic growth? Our interactions with the rest of the world (exchange rate, trade balance).

Figure 7-1 An Expanded Circular-Flow Diagram

Figure 7-1 – An Expanded Circular-Flow Diagram Note:  Total spending on final goods and services

Note:

Total spending on final goods and services = consumer spending + investment spending + government purchases of goods and services + exports imports

Total spending on final goods and services = Total value of all final goods and services produced within a country (Gross domestic product)

Chapter 7 GDP and the CPI: Tracking the Macroeconomy

The National Account Gross Domestic Product

Gross domestic product (GDP) is the total value of all final goods and services produced in the economy during a given year. It only includes goods and services sold to final/end users, i.e., intermediate goods and services are not counted.

It looks at the value of products produced within the economy.

There are 3 ways to measure GDP, and they are:

1) The value-added approach. 2) The expenditure approach. 3) The income approach.

The Value-Added Approach

This approach focuses on the value added of each producer in the economy. Value added = Value of the sales Value of the purchases of intermediate goods and services.

Example: An economy consists of 3 firms only Canadian Ore, Inc. (CO),

Canadian Steel, Inc. (CS), and Canadian Motors, Inc. (CM).

 

Canadian Ore

(ore

sold to

Canadian Steel

(steel sold

to

Canadian Motors

(car

sold

to

CS)

CM)

consumers)

 

Sales

$4200

$9000

$21500

Intermediate goods

$0

$4200

$9000

Wages

$2000

$3700

$10000

Interest payments

$1000

$600

$1000

Rent

$200

$300

$500

Profit

$1000

$200

$1000

Using the value-added approach to find the GDP.

Value-added of Canadian Ore =

Value-added of Canadian Steel =

Value-added of Canadian Motors =

GDP =

The Expenditure Approach

It adds up expenditure on domestically produced final goods and services by households, firms, governments, and foreign buyers.

Total expenditure is the sum of 4 major categories:

1) Consumption (C) spending by households on goods and services. 2) Investment (I) spending on goods that are not for present consumption. There are 3 types of investment:

Business fixed investment the purchases of capital equipment, machinery and production plants.

Residential investment the building of new houses.

Inventory investment the change in the quantity of goods that firms hold in storage, including materials and supplies, work in process, and finished goods.

3) Government spending (G) spending on goods and services by different levels of government, exclusive of government transfer payments. 4) Net exports (NX), NX = Exports (X) Imports (IM)

Consumption, investment, and government spending may include imported goods (goods made in foreign countries), and these imported goods should not be included in the country’s GDP; thus, we need to subtract imports.

According to the expenditure approach, GDP is given by:

GDP = C + I + G + X IM = C + I + G + NX

Example (continued):

 

Canadian Ore

(ore

sold to

Canadian Steel

(steel sold

to

Canadian Motors

(car

sold

to

CS)

CM)

consumers)

 

Sales

$4200

$9000

$21500

Intermediate goods

$0

$4200

$9000

Wages

$2000

$3700

$10000

Interest payments

$1000

$600

$1000

Rent

$200

$300

$500

Profit

$1000

$200

$1000

Using the expenditure approach to find the GDP.

GDP, Expenditure Base, at market price, 2015, in billions of dollars

Billions of dollars

% of GDP

Consumption Investment Government spending Net exports Exports Imports Statistical discrepancy

$1112.636

56.0%

$472.372

23.8%

$447.517

22.5%

$47.4

2.4%

$622.832

31.6%

$670.232

32.5%

$0.529

0.0%

GDP

$1985.654

100%

Source: Statistics Canada, Table 380-0064.

The Income Approach

It looks at income earned from production of goods and services.

There are two sources of income:

1) Factor incomes income earned by factors of production or inputs such

as wages, salaries, interest, rent, business profits.

2) Non-factor payments the difference between the prices paid for final

goods and services and the amount received by production factors before

income taxes are removed. Non-factor payments include net indirect

taxes, capital depreciation.

Example (continued):

 

Canadian Ore

(ore

sold to

Canadian Steel

(steel sold

to

Canadian Motors

(car

sold

to

CS)

CM)

consumers)

 

Sales

$4200

$9000

$21500

Intermediate goods

$0

$4200

$9000

Wages

$2000

$3700

$10000

Interest payments

$1000

$600

$1000

Rent

$200

$300

$500

Profit

$1000

$200

$1000

Using the income approach to find the GDP.

Wages =

Interest payments =

Rent =

Profit =

GDP, Income Base, at market price, 2015, in billions of dollars

Billions of dollars

% of GDP

Factor income Wages & salaries Business profits Other income Non-factor payments Capital depreciation Net indirect taxes Statistical discrepancy

$1430.889

72%

$1024.229

$231.094

$175.566

$555.294

28%

$338.811

$216.483

$0.529

0.0%

GDP

$1985.654

100%

Source: Statistics Canada, Table 380-0063.

Both expenditure approach and the income approach gave the same GDP.

Why?

What GDP Tells Us

GDP is the most commonly used measure of the size of an economy, which allows us to compare a country’s economic performance to other countries’.

However, the following items are not included in the GDP:

Inputs and intermediate goods and services.

Used goods.

Financial assets such as bonds, stocks, mutual funds.

Foreign-produced goods and services.

Household production and volunteer work.

Underground economy transactions and illegal activities.

Harm done to the environment during the production or consumption of goods.

Gross domestic product (GDP) vs. Gross national product (GNP)

GDP measures the sum of all final goods and services produced within a country.

GNP measures the sum of all final goods and services produced by a country’s residents. GNP = GDP + (Income earned by Canadian outside Canada Income earned by foreigners in Canada) GNP = GDP + Net factor income earned abroad

Real GDP: A Measure of Aggregate Output

We have to be careful when using GDP to make comparisons over time because an increase in GDP might cause by increases in prices of goods and services, an increase in production, or a combination of both.

To have an accurate measure of economic growth, we look at real GDP.

Calculating Real GDP

Nominal GDP measures the value of all final goods and services produced in the economy during a given year, calculated using the prices in the year in which the output is produced (i.e., the current year prices).

Nominal GDP t (NGDP t ) = P 1,t Q 1,t + P 2,t Q 2,t …+ P n,t Q n,t =

n

P Q

i, t

i

1

i,t

where P i,t = price of good i in time t Q i,t = quantity of good i produced in time t

Real GDP measures the total value of all final goods and services produce in the economy during a given year, calculated using the prices of a selected base year.

Real GDP t (RGDP t ) =

n

P

i, Base year

i

1

Q

i,t

Example: Let Year 1 be the base year.

 

Price

Quantity

Year

Good X

Good Y

Good X

Good Y

1

$1

$2

10

15

2

$1.5

$3

20

30

3

$2

$4

20

30

Find the nominal GDP. (Use current year quantities & current year prices).

Compute the real GDP (Use current year quantities & base year prices).

What Real GDP Doesn’t Measure

Real GDP takes out the effect of price changes on the value of production. However, a country with a larger population tends to have a higher GDP.

To eliminate the effect of differences in population size, we look at real GDP per capita.

Real GDP per capita =

Real GDP

Population

Real GDP per capita is a commonly used measure to compare labour productivity across countries. Some even use it to compare living standard across countries because countries with higher real GDP per capita tend to have higher living standard. But, we need to use it with caution because:

It only gives us a measure of the economy’s average output per person; it ignores the distribution of output.

It does not address how a country uses that output to affect living standards.

Price Indexes and the Aggregate Price Level

In this section, we will learn how to measure the aggregate price level, the measure of the overall level of prices in the economy.

Market Baskets and Price Indexes

There are different price indexes such as the consumer price index (CPI), the producer price index, and the GDP deflator.

The inflation rate is the percentage change of a price index.

The Consumer Price Index (CPI)

It measures how fast the cost of a basket of goods and services bought by a typical Canadian household has changed over time, which is the most commonly used measure to compute inflation rate

It uses a fixed basket of goods and services because the quantities in the basket, i.e., the weights of the basket, are held fixed at the base-year level.

To construct the CPI, Statistics Canada will:

Choose a base year. Determine the market basket of goods and services purchased by a typical household.

Compute the cost of that basket in different year, i.e.,

n

P Q

i, t

i

1

CPI in year t =

Cost of (fixed) market basket in year t

Cost of (fixed) market basket in base year

× 100

i, Base year

Figure 7-6 The Makeup of the Consumer Price Index in 2011

Figure 7-6 – The Makeup of the Consumer Price Index in 2011 MGEA06 – Week 1

Other Price Measures

The other price measures that are widely used to track changes in prices are:

1) Industrial producer price index (IPPI) It measures the wholesale cost of a typical fixed basket of good purchased by producers, items enter IPPI include raw materials such as coal, steel, and other inputs such as electricity. The IPPI tends to respond to inflationary or deflationary pressure more quickly than the CPI, it serves as a “leading indicator” of changes in the inflation rate.

2) GDP deflator It is a current weighted price index, i.e., it uses the currently quantities of all goods and services that enter into GDP as weights. The GDP deflator for a year t is given as:

GDP deflator in year t = Nominal GDP in year t

Real GDP in year t

× 100

Example:

households only.

The economy only produces 2 goods & they are bought by

 

Year 1 (Base year)

Year 2 (Current year)

 

Price

Quantity

Price

Quantity

Good X

$3

4

$5

6

Good Y

$10

2

$30

1.5

Use the CPI to find the % in Prices from Year 1 to Year 2

Cost of base-year basket in year 1, COB 1 :

Cost of base-year basket in year 2, COB 2 :

CPI 1 =

CPI 2 =

COB

1

COB

base year

COB 2

COB

base year

× 100

× 100

 

Year 1 (Base year)

Year 2 (Current year)

 

Price

Quantity

Price

Quantity

Good X

$3

4

$5

6

Good Y

$10

2

$30

1.5

Use the GDP Deflator to find the % in Prices from Year 1 to Year 2

Nominal GDP in year 2, NGDP 2 :

Real GDP in year 2, RGDP 2 :

GDP defalotr 1 = 100 (because year 1 is the base year)

GDP deflator 2 = NGDP 2

× 100

RGDP 2

Differences between the GDP deflator and the CPI 1) The CPI uses the bundle purchased by a typical household; while the GDP deflator uses the bundle produced within the country. Changes in the prices of imported consumption goods. GDP deflator:

CPI:

Changes in the prices of domestically produced goods that are only bought by firms or government. GDP deflator:

CPI:

2) The GDP deflator uses the bundle that is currently produced and the CPI uses a fixed bundle (the base-year bundle)

Figure 7-9 The CPI, the IPPI, and the GDP Deflator

Figure 7-9 – The CPI, the IPPI, and the GDP Deflator MGEA06 – Week 1 Iris