Macro Wk7: GDP and Price Indicies - In Depth Notes

Key Topics Covered

• Measurement of GDP and prices.

• Inflation and Unemployment.

• Model fluctuations using the AD/AS model.

• Monetary and Fiscal Policy - smoothing business cycles.

• Exchange rates - how foreign markets impact business cycle fluctuations.

Gross Domestic Product (GDP)

• Definition: GDP is the market value of all final goods and services produced within a country in a specified time frame.

• Measurement:

  • GDP components formula: Y = C + I + G + X - M

  • Where:

    • C = Consumption Expenditure

    • I = Investment Expenditure

    • G = Government Expenditure

    • X = Exports

    • M = Imports

    • NX = X - M = Net Exports (Trade Balance)

Economic versus Financial Investment

• General Meaning of Investment: Purchase of assets expecting monetary return.

• Economic Meaning of Investment: Spending on new physical capital, including:

  • Inputs: Machines, computers, buildings.

  • Outputs: Inventories, new housing.

• Inclusion:

  • Private sector investment is part of I.

  • Public sector investment is part of G.

Real vs. Nominal GDP

• Nominal GDP: Measured at current (variable) prices.

• Real GDP: Measured at constant prices, adjusted for inflation.

• GDP Deflator: Measure of the price level, calculated as the ratio of Nominal GDP to Real GDP:

  • GDP Deflator = rac{Nominal \, GDP}{Real \, GDP}

GDP Growth Example

• Consider the following years of bicycle production:

• Question: Has the economy grown?

Calculating GDP

• Example Calculation for Two Goods (Pizza and Instant Noodles):

Inflation Measurement

• Inflation Definition: A persistent increase in the average price level of goods and services.

• Effects:

  • Reduces purchasing power of money.

  • Leads to increased costs for firms.

  • Creates uncertainty for business planning.

• Measurement: Using price indexes, notably the Consumer Price Index (CPI).

Consumer Price Index (CPI)

• Definition: Represents the weighted average price of goods/services bought by consumers.

• Components of Basket (2024):

  • Housing: 22%

  • Food: 17%

  • Recreation: 13%

  • Transportation: 12%

  • Household Contents & Services: 9%

  • Etc.

• Calculation Steps:

  1. Choose base year and determine fixed basket of goods.

  2. Find annual prices for each good.

  3. Calculate cost of the basket for each year.

  4. Calculate CPI:
     CPI = rac{Cost \, of \, Basket}{Cost \, of \, Basket \, in \, Base \, Year} imes 100

Inflation Rate Calculation Example

• For the GDP Deflator and CPI:

Key Takeaways

• Difference Between Nominal and Real Variables:

  • Nominal = Measured in monetary value (e.g., wages, wealth).

  • Real = Adjusted for purchasing power; reflects actual quantity of goods/services.

• Interest Rates:

  • Nominal Interest Rate: Return on deposits in monetary terms.

  • Real Interest Rate: Adjusted for inflation:
    R = r - ext{inflation rate}

• Conclusion: Understanding GDP helps assess economic performance, while price indexes inform about living costs and inflation trends.