ECON1102 Topic 1 Summary: Measuring Macroeconomic Performance & Wages, Employment and the Labour Market

What is Macroeconomics?

• Economics is the study of how society manages and allocates its scarce resources.
• Macroeconomics is the study of economy-wide phenomena.
• Macroeconomics looks at three broad themes:
  • Under what circumstances is the economy performing well?
  • What factors have produced particular macroeconomic outcomes?
  • How does the government influence macroeconomic performance?
• This topic looks at:
  • How do we know when an economy is performing well?
  • Two criteria used to gauge a country’s macroeconomic performance:
    • Gross Domestic Product (GDP) - The total level of production in the economy.
    • Inflation - The average level of prices in the economy.

What Criteria Suggests That an Economy is Performing Well?

• An economy is performing well if it:
  1. Increases the country’s standard of living.
  2. Avoids extremes in short-run macroeconomic performance.
  3. Maintains the real value of its currency.
  4. Ensures sustainable levels of public and foreign debt.
  5. Balances current expenditure against the need to provide resources for the future.
  6. Provides employment for all individuals seeking work.

What is Gross Domestic Product (GDP)?

• GDP measures the final value of goods and services that are produced in an economy over time.
• It is sometimes referred to as aggregate output for the economy (aggregate = total).
• The change in GDP from one period to the next (usually per year) gives us an indication of how an economy is growing.
• Economic growth = percentage change in GDP.
• An increase in GDP indicates that the economy is expanding (an upward movement on a business cycle).
• A decrease in GDP indicates that the economy is contracting or slowing down (a downward movement on a business cycle).
• In 2016 the output of the Australian economy was:
  • 12 times the level in 1945.
  • More than five times the level in 1965.

Measuring GDP

• Before we look at ways of measuring GDP, there are three important things to note:
  1. GDP looks at the market value of all goods and services produced.
     • We need to aggregate (total, sum) the quantities of many goods and services into one number to get a measure of market value.
     • Not all economically valuable goods and services can be bought and sold in markets and therefore are excluded from the GDP measurement.
       • Unpaid work and caring for your children are excluded from GDP.
       • It has been estimated that the value of unpaid work is equivalent to 50% of Australia’s GDP.
     • Goods provided by the Government (public goods e.g. defence) which do not have a market value have their costs used as rough measures of market value.
  2. GDP is measured using the final goods and services produced.
     • Many goods are used up in the production process.
     • These are not included in the final GDP measurement.
     • Intermediate goods are generally excluded from GDP to avoid ‘double counting’.
     • To deal with the problem, economists determine the market value of final goods, indirectly.
     • They add up the value of each firm producing intermediate goods and final goods in the production process. They calculate GDP using a value added approach.
     • The value added by any firm is equal to the market value of its product minus the costs of inputs (intermediate goods) from other firms.
     • The value added by each firm represents the portion of the value of the final goods or service that each firm creates in its stage of production.
     • Summing up the value added by all firms (including producers of the intermediate goods and final goods) gives us the same value as the adding the final value of the good.
  3. GDP looks at goods produced within a country during a given period of time.
     • Only production that occurs within the borders of a given country is counted.
     • GDP is measured over a period of time such as monthly, quarterly or annually.

There are three methods of measuring GDP:

(i) Value Added (Production) Method:

• The value added or production method, calculates GDP using the value added for each good produced.

(ii) Expenditure Method:

• The expenditure method looks at the total amount of money spent on the goods and services produced in the country.
• The expenditure method assumes that there are four groups who purchase goods and services produced in the country:
  • households
  • firms
  • governments
  • the foreign sector (foreigners who purchase domestic products).
• Also assumes that purchases spent by the four groups equals the market value of those goods and services.
• There are four categories of expenditure:
  • consumption expenditure (C)
  • investment (I)
  • government purchases (G)
  • net exports (NX)
• The relationship between GDP and expenditure can be summarised by an equation:
  • $Y = C + I + G + NX$
  • Y = GDP or Output, C = Consumption Expenditure, I = Investment, G = Government Expenditure, NX = Net Exports (i.e. Exports (X) – Imports (M))
• Y = C + I + G + NX is a very important equation for macroeconomics.
• It is the National Income Accounting Identity, and is the starting point for many macroeconomic models!

(iii) Income Method:

• The income method is a different approach to measuring GDP and looks at the income generated from capital and labour.
• The income method assumes that when a good or service is sold, the revenue from its sale is distributed to the workers and the owners of the capital involved in the production of the good or service.
• GDP also equals labour income + capital income.
• Labour income = wages, salaries and the incomes of the self-employed and is estimated to comprise 75% of GDP.
• Capital income = payments to owners of physical capital and intangible capital and comprises 25% of GDP.
• In the factor market, when households supply labour and capital to firms, they are compensated by wages, interest, dividends, and rents.
• In the product market, households use their earned income to purchase goods and services.

GDP comparisons over time:

• Comparing GDP over different points of time may give misleading answers.
• To make meaningful comparisons of GDP over time, we cannot look at GDP in raw values.
• We need a benchmark to compare one year to the next taking into account the change in price, i.e. to adjust for inflation.
• To do this, we pick a bench year (base year) and use prices from that year to calculate market value output for a given year.
• This is known as calculating Real GDP.
• Real GDP: GDP measured by taking into account the change in prices from one year to the next.
• Nominal GDP: GDP measured by taking into account current prices.
• The Australian Bureau of Statistics (ABS) collects information to measure GDP.
• It calculates GDP slightly different than using a base period price, due to the fact that real economies are much more complicated.
• The ABS uses a method known as Chain Volume Management.
• The ABS rebases every year to conform to the latest international standards.

GDP is different than measuring wellbeing.

• It is noted that GDP improves:
  • The availability of goods and services in an economy.
  • The life expectancy of its population (via many avenues).
• However, GDP measures economic growth not the wellbeing of the people in the economy.
• There are five broad factors which are not included in the measure of GDP but which promote wellbeing:
  • (i) GDP does not include leisure time.
    • Leisure is very important to wellbeing.
    • There is a trade-off between work and leisure.
  • (ii) GDP does not include non-market activities.
    • Non-market activities include unpaid housework, volunteering and childcare.
  • (iii) GDP does not include the underground, black market or barter economies.
  • (iv) GDP does not include quality of life.
    • There are other indicators of a good life which are not accounted for in GDP such as low crime rates, limited traffic congestion, community activities and open space.
  • (v) GDP does not take into account poverty and income inequality.
    • GDP measures the whole economy not who gets what in the economy.
    • High GDP countries may have widespread income inequality.

What is the Consumer Price Index (CPI) and Inflation?

• We study prices in macroeconomics because:
  • Prices tell us how much things cost.
  • The economy is affected by changes in price levels (inflation).
  • We need to maintain a real value for our currency as it’s an important criteria for a good economy.
• We do so using the Consumer Price Index (CPI) which is calculated by the Australian Bureau of Statistics (ABS).
• The CPI is a measure of the ‘cost of living’ based on prices in a period for a typical basket of goods and services.
• The ABS gathers information on the prices of goods and services that a household typically consumes.
• The formula for CPI is:
  • $CPI = Cost \ of \ base-year \ consumption \ basket \ of \ goods \ and \ services \ in \ current \ year \over Cost \ of \ base-year \ consumption \ basket \ of \ goods \ and \ services \ in \ base \ year$

What is Inflation?

• Inflation is essentially the change in prices for an economy over a given period of time.
• In Australia we measure inflation by a change in the CPI (usually over one year).
• The inflation rate is calculated by:
  • $Inflation \ for \ Year2 = CPI<em>{Year2} - CPI</em>{Year1} \over CPI_{Year1} * 100$

Australia’s Inflation Rate

• Australia’s current inflation rate (December 2024) is 2.4%.

Measurement of CPI

• The CPI can be used to adjust real versus nominal data.
• The CPI is a useful tool for adjusting economic data to eliminate the effects of inflation.
• It can also be used to convert real economic data into current dollar terms, (known as indexing).
• It has been suggested that the CPI does not capture the true inflation rate and can over estimate inflation by 1-2% for two reasons:
  • Quality adjustment bias: Sometimes price increases are associated with improved quality of the products e.g. computers, aids medicine, etc.
  • Substitution bias: The CPI focuses on a fixed basket of goods. Consumers may switch from more expensive goods to cheaper goods when prices increase.

Economic Costs of Inflation

• Inflation can cause huge costs to the economy:
  • Shoe leather costs:
    *It increases the costs of holding money to consumers and businesses because of the loss of purchasing power.
    *It is the cost associated with keeping less money in your wallet and more in banks.
  • Noise in the price system:
    • Inflation makes it difficult to see if price changes are associated with changes in demand or supply or are a change in overall price level.
    • This can make markets inefficient as there is ‘noise’ in the price system.
  • Distortion of the tax system:
    • In Australia, taxes are not indexed to inflation.
    • As inflation increases, people’s nominal wages may increase but their real wages may not.
    • If nominal wages increase it may mean that people pay higher income taxes, even though their real wages have fallen.
  • Unexpected redistribution of wealth:
    • Inflation can cause unexpected winners and losers.
  • Interference with long-term planning:
    • Inflation can make long-term planning difficult.
  • Menu Costs:
    • Inflation itself causes the cost of having to keep changing prices.
    • Every time the restaurant owner needs to change their prices due to inflation they need to reprint their menus. This can be costly if inflation is very high.

Inflation and Interest Rates

• Inflation is closely linked to many macroeconomic variables including interest rates.
• Interest rates are among the most important macroeconomic variables in the economy. We use the inflation rate to determine the real interest rate.
• If you deposited $100 in Alpha, after one year, you would have $102 based on the 2% interest rate.
• But inflation is 0% in Alpha so on average, prices are the same as when you deposited your money.
• Therefore, your purchasing power has increased by 2%.
• Hence, the real time for those who bought bonds was in 1985 and the worst was 1975.

Deflation

• Deflation is a situation where the average level of prices are falling and the inflation rate is negative.
• It is quite rare but has been a feature of the economies of Hong Kong and Japan.
• Deflation is problematic. Why? It can discourage spending and lending in the economy.
• Deflation also increases the real interest rate, i.e. when 𝜋 is <0.
• Lenders of money will not lend money once the nominal rate of interest hits 0.

What are Savings and Wealth?

• Savings is defined as current income minus current spending on goods and services.
• The savings rate is the amount of savings as a proportion of income.
• Wealth is equal to assets minus liabilities.
• Assets: anything of value that someone owns, either financial or real.
• Liabilities: debts that someone owes to other parties.
• Net worth = assets minus liabilities.
  What happens to net worth if Elisa increased her savings by $20 per week? Net worth increases by $20.
  What happens to net worth if the value of Elisa’s shares increases from $1000 to $1500? Net worth would increase
• Flow: A measure that is defined per unit of time.
• Stock: A measure that is defined at a point in time.
• A flow changes the stock.
• Change in wealth equals savings plus capital gains minus capital losses.

Why Do People Save?

• There are 3 broad reasons why people save.
  • Lifecycle savings
    Saving to meet long-term objectives, e.g. for retirement, school fees, to buy a home, etc.
  • Precautionary savings
    Saving for a rainy day, to protect oneself against unexpected set-backs, e.g. job loss, poor health.
  • Bequest savings
    *Saving to leave money (inheritance) to heirs, such as children, or a charity.
• Why have saving rates declined in Australia over time?
  • The aged pension and compulsory superannuation have reduced the need to save for retirement.
  • Home ownership with small deposits and the increased availability of mortgages means that people have had to save less to buy a house.
  • Falling unemployment and improved labour market prosperity has reduced the perceived need for precautionary saving.
  • The good performance of the stock market and housing market has brought large capital gains which has reduced the incentive to save.
• People generally save by making financial investments. This may include savings deposits, the purchase of government bonds, stocks etc.
• People receive interest on their financial investment which in turn increases their wealth.
• In savings decisions, the most relevant rate of interest is the real interest rate (r).
  • Remember, r = i (nominal interest rate) - 𝜋 (inflation rate).
• The real interest rate is the “reward” for saving.
• A higher interest rate makes savings more attractive as the “reward” for savings increases.

National Savings

• National savings (also known as aggregate (i.e. total) savings).
• Savings represents current income minus spending on current needs.
• We can apply this concept to three sectors of the economy: (i) firms, (ii) households and (iii) the government.
• The National Income Identity suggests that for the economy as a whole, production (and income) must equal total expenditure: hence Y = C + I + G + NX.
• Let’s assume that the country’s exports equals their imports so NX = 0.
  output, income or production equals total expenditure now becomes: Y=C+I+G.
• Two major components: savings from households and businesses (private savings) and savings by the government (public savings).
• We will call this T where T stands for the taxes from the private sector to the government, minus transfer payments and interest payments made by the government to the private sector. This is net taxes.
• To do this we need to incorporate taxes as well as payments made by the government to the private sector (known as transfer payments) into the savings equation.
• We will call this T where T stands for the taxes from the private sector to the government, minus transfer payments and interest payments made by the government to the private sector. This is net taxes.
• NS = (Y – T – C) + (T – G)Where Y–T–C = private savings and T–G = public savings.
• When government spending is less than the taxes (i.e. T – G is > 0), this is known as an increase in public savings or a Government Budget Surplus
  When government spending is greater than the taxes (i.e. T – G is < 0), this is known as a decrease in public savings or a Government Budget Deficit.

Investment and Capital Formation

• National savings provides the resources for investment.
• Investment is the creation of new capital goods and housing. It is critical to increasing productivity and improving living standards.
• Investment usually takes place via financial markets where people borrow funds for their investment.
• It is the cost benefit principle: I.E. is the expected cost of the investment less than the expected benefit of the investment (equal to the value of the marginal product it provides).
• On the cost side: the factors are the price of capital goods and the real interest rate.
• The real interest rate is the real cost of paying back the debt to borrow funds to purchase the capital goods and measures the opportunity cost of investment.
  On the benefit side: the main factor to consider is the value of the marginal product of new capital.

Savings, Investment and Financial Markets

• In a closed economy, national savings funds investment.
• The supply of savings funds the demand for savings.
• Hence in equilibrium: National Savings = Investment.
• The savings-investment model has national savings and investment on the horizontal axis.
• The vertical axis is the real interest rate.
• The supply of national savings (NS) is an upward sloping curve.
• The supply curve for savings is upward sloping, as evidence suggests that increases in the real interest rate increases savings.
• Savings are demanded by firms wishing to invest in new capital goods.
• The demand for savings is the investment curve (I).
• It is downward sloping because a higher real interest rate raises the cost of borrowing and decreases a firm’s willingness to invest.
• NS = I
• The real interest rate will adjust to keep this condition.
  New technology.Investment tax credit policy.
  This is because as savings is made up of public and private savings. Anything that makes households, businesses or governments choose to change their saving rate will shift the supply curve.

Labour Market

• The perfectly competitive model of the labour market assumes that firms and workers are wage takers.
• Hence, they cannot affect the “price” of labour which is the wage rate. The market sets wages.

Key Labour Market Trends for Australia

• Since the 1970s, Australia has enjoyed substantial growth in real earnings.
• Around 1980 to 2000 real wage growth slowed, particularly for men.
• There has also been an increase in inequality among top-earners and bottom-earners, with top-earners having a higher increase in real wages than those on lower wages.
• The proportion of the population working has increased from about 57% to 64.4% over the last 50 years.
• In December 2024, Australia’s unemployment rate remained relatively low at 4.0%.

Wages and the Demand for Labour

What determines the number of workers that employers want to hire? This is the demand for labour.
The demand for labour depends on the price that the market sets for workers’ output and the productivity of labour.
Firms can do cost benefit analysis to determine the number of workers that they employ.They consider:The additional cost of hiring one more worker (marginal cost).The benefit of hiring one more worker (marginal benefit measured by the marginal value of product or MVP).
A worker is hired if marginal benefit ≥ marginal cost.
If we are talking about the real wage rate, the higher the wage rate, the lower the demand for labour from employers.We can construct a demand curve.
The law of demand says that higher wages leads to a lower demand for workers so the demand curve is downward sloping.

Two factors which could shift the demand curve

• An increase in the relative price of the worker’s output.
  A change in workers’ productivity.
• If the productivity of BBCC’s workers decreases due to a glitch in their machinery then demand shifts to the left.

Wages and the Supply of Labour

• The supply of labour are workers or potential workers.
• People use cost benefit analysis to decide whether to work.
• If the real wage is > than their reservation wage the individual will work in paid employment.
• If the real wage is < than their reservation wage, the individual will not work in paid employment.
• Higher the wage rate, the larger the supply of workers.
• Any factor which affects the quantity of labour will shift the supply curve.
• The most important one is the size of the working-age population which is influenced by factors such as:
  • Birth rates
    Immigration
    Retirement age
    The age starting work.

Equilibrium in the Perfectly Competitive Labour Market

• Equilibrium in the perfectly competitive labour market occurs where the demand for labour equals the supply of labour.
• This gives us the real wage rate and the level of employment.
• Theoretically the real wage rate adjusts to keep the market in equilibrium.

Explaining Trends in Real Wages and Employment

• Australia has seen an increase in real wage growth.
• Has largely been a result of the sustained and improved productivity of workers leading to an increase in the demand for workers.
• Higher levels of education leads to higher productivity of workers.
• Australia has very distinct labour market outcomes from the past 50 years.
• Earnings in WA have outstripped other states of Australia.
• The increased investment in WA lead to an increase in the demand for labour which was not matched with the supply of labour resulting in higher wages.

The gap between the wages of skilled and unskilled workers has risen:Globalisation Many markets for goods and services have become international.Technological Technological has also widened the gap in the wages of skilled and unskilled workers.

Unemployment

• The ABS calculates the unemployment rate in Australia.
• To work out the unemployment rate, the ABS looks at the labour force.
• During Covid-19, Australia saw a 50% increase in the unemployment rate rising from 5.1% in February 2020 and peaking at 7.5% in July 2020. In May 2022, the unemployment rate had fallen to below pre-pandemic levels of 3.9%.
• Three mains costs of unemployment: 1. Economic Costs, 2. Psychological Costs, 3. Social Costs.
• There are two other important unemployment concepts:
  Discouraged workers and underemployed:
  The true unemployment rate may be actually larger
  **Natural rate of unemployment: The unemployment rate never falls to zero
  People changing jobs

There are three types of unemployment

• 1. Frictional unemployment These people are short-term unemployed and are an essential part of a dynamic economy.Their unemployment is not too costly.
• Structural unemployment These workers need to be retrained to find suitable jobs. The cost of this employment is much higher than frictional unemployment as these workers are long-term unemployed.The natural rate of unemployment is made up frictional and structural unemployment.
• Occurs due to the nature of the business cycle. This type of unemployment is very costly to the economy.