Handbook Principle of Economics (Macroeconomic)

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INTERNATIONAL SCHOOL OF BUSINESS

Revision on Principle of Macroeconomics

BY ISB ACADEMIC TEAM

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Chapter 23:

Measuring a Nation’s Income I- The Economy’s Income and Expenditure:

- GDP measures two things at once: total income and total expenditure

- Total income = total expenditure (Because money flow from buyer to

seller.)

II- The Measurement of GDP:

● Definition: Gross Domestic Product (GDP) is the market value of all

final goods and services produced within a country in a given period of

time

1 “GDP is the Market Value…” : using market prices, because market

prices measure the amount people are willing to pay for different goods, they reflect the value of those goods

2 “ of All…” :

+ including all legal product

+ excluding illegal drugs, items produced and consumed at home, never get into market (E.g.: Karen cleans her own house instead of hiring people to clean her house => The value Karen spent cleaning her house is not included in GDP)

* NOTE: Housing Services

+ For people who rent their houses, the rent is included in GDP

+ For people who own their houses, estimated rental value is included in GDP (assume that if the owners use their house for rent)

3 “ Final…” :

+ Final goods are goods purchased to consume

+ Intermediate goods are goods purchased to produce other goods for sale For example:

- A purchases $5 of strawberries to eat → Then strawberries are

considered as Final goods and $5 will be added into GDP

- B purchases $5 of strawberries to make a 10-dollar-worth fruit salad to

eat → In this case, even though strawberries is used to make another good, B didn’t sale the salad but instead ate it Therefore, strawberries

are still considered as Final good and $5 is included in GDP

- C purchases $5 of strawberries to decorate a cake sold in his bakery for

$15 → In this case, strawberries is used to make a cake for sale

Therefore, strawberries are considered as Intermediate goods and a cake is a Final good → $15 will be added to GDP

4 “ Goods and Services…”: tangible goods (food, clothing, car) and

intangible services (haircuts, housecleaning, doctor visits)

5 “ Produced…” : GDP includes goods and services currently produced

and does not includes transactions involving items produced in the past

For example: Ford produced a $500 car in 2018 but did not sale it until 2019

➔ $500 is included in GDP of 2018 not GDP of 2019

6 “ Within a Country…” : within the geographic confines of a country,

regardless of the nationality of the producer

For example:

- If a Vietnamese owns a Pho restaurant in the USA, the Vietnamese

owner’s income will be included in the GDP of the USA

- In contrast, if Ford builds a car factory in Ho Chi Minh city, the

production of the factory will be included in the GDP of Vietnam

7 “ In a Given Period of Time.” : Usually a year or a quarter (3 months)

The Government reports the GDP for a quarter “at an annual rate” (the amount

of income and expenditure during the quarter multiplied by 4) with seasonal

adjustment

* NOTE: Another Measures of Income.

GNP = GDP + income nationals earn abroad - income foreigner earn here = GDP + net transfer (net transfer = cash inflow - cash outflow) For example:

- If a Vietnamese owns a Pho restaurant in the USA, the Vietnamese

owner’s income will be included in the GNP of Vietnam

- In contrast, if Ford (a US company) builds a car factory in Ho Chi Minh

city, the production of the factory will be included in the GNP of the

USA

III- The Components of GDP:

Consumption is spending by households on goods and services, with the

exception of purchases of new housing

For example: My purchases a Pizza for $15 and pays rent for $200

➔ $215 is included in GDP as consumptions

2 Investment:

- Investment is the purchase of goods that will be used in the future to

produce more goods and services

- Including: capital, equipment, inventories, structures, and household

purchases of new housing

- Investment is different from financial investment (stocks, bonds, and mutual funds are called saving)

For example: Apple produces $1000 of computers and adds all into inventory

➔ Inventory is included in Investment So $1000 is included in GDP and counted as Investment

3 Government Purchases:

- Government Purchases is spending on goods and services by local, state,

and federal governments

- Including: the salaries of government workers as well as expenditures on

public works

*NOTE: Social Security benefit to the elderly and Unemployment Insurance

are called transfer payments, they do not produce any goods or services Therefore, they are not included in Government Purchases (not included in

GDP)

For example: The government pays the salary of an Army general

4 Net Exports:

- Net Exports equal the foreign purchases of domestically produced goods

(exports) minus the domestic purchases of foreign goods (imports)

- Domestic buyers buy goods from abroad do not affect GDP

For example: A Vietnamese buy a Honda car from Japan

→Net export decreases (Import increases), but Consumption increases by the same amount → GDP is unaffected

IV- Real versus Nominal GDP:

● Nominal GDP: the production of goods and services valued at current

prices (P x Q) → Not corrected for inflation

● Real GDP: the production of goods and services valued at constant

prices (Fixed Pbase x Q) → Corrected for inflation

1 A Numerical Example:

2 The GDP Deflator:

GDP Deflator =𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 x100

- At the base year: Nominal GDP = Real GDP - GDP deflator reflects P level

- GDP Deflator base year = 100 - GDP Deflator > 100 ⇒ inflation

Inflation = 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑦𝑒𝑎𝑟 2 − 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑦𝑒𝑎𝑟 1

V- Is GDP a Good Measure of Economic Well-being?

- GDP doesn’t measure what make life worthwhile, but it measures the ability to achieve it

- Things contributing to good life are excluded in GDP E.g.: leisure

- GDP excludes value of activity take place out of the market, quality of environment, distribution of income among the economy

EXERCISE

1 Which of the following is included in GDP?

A The sale of stocks and bonds B The sale of used goods

C The sale of services such as visits to a doctor D All of above are correct

2 To compute GDP we

a Simply sum the number of final goods and services b Sum the cost of producing final goods and services

c Use weights determined by a survey regarding how much people value different sorts of goods and services to compute GDP as a weighted average

d Sum the market value of final goods and services

3 The simple circular-flow diagram illustrates that

a Production generates income so that income and production are the same b The economy’s income exceeds its production

c The production of an economy exceeds its income d None of the above are correct

4 The local Chevrolet dealership has an increase in inventory of 25 cars in 2003 In 2004, it sells all 25 cars

a The value of increased inventory will be counted as part of GDP in 2003, but the value of the cars sold in 2004 will not cause 2004 GDP to

increase

b The value of increased inventory will not affect GDP in 2003, but will be included in 2004 GDP

c The value of increased inventory will be counted as part of GDP in 2003 and the value of the cars sold in 2004 will increase 2004 GDP

d None of the above are correct

5 In the U.S real GDP is reported each quarter

a These numbers are adjusted to make them measure at annual and seasonally adjusted rates

b These numbers are adjusted to make them measure at annual rates, but no adjustment for seasonal variations are made

c These numbers are at quarterly rates that have been seasonally adjusted d These numbers are at quarterly rates and have not been seasonally

adjusted

6 Flour is

a Always counted as an intermediate good

b Counted as an intermediate good if it is used by a company to make bread

c Counted as a final good if it is used by a consumer who bakes bread for his own consumption

d Both b and c are correct

7 U.S GNP is calculated from U.S GDP by

a Including income earned by foreigners in the U.S and excluding income earned by U.S citizens abroad

b Including income earned by U.S citizens abroad and excluding income earned by foreigners in the U.S

c Including income earned by foreigners in the U.S d Excluding income earned by U.S citizens abroad

8 Greg, a U.S citizen, works only in Canada The value added to production from his employment is

a Included in both U.S GDP and U.S GNP b Included in only U.S GDP

c Included in only U.S GNP

d Not included in either U.S GDP or U.S GNP

9 If in a given year an economy has consumption of $3000, investment of $2000, government purchases of $1500, tax of $1200, transfer payments of

$400, depreciation of $300, export of $500 and import of $600 Then GDP

10 A firm produces consumer goods and adds some to inventory in the third quarter of 2018 In the fourth quarter the firm sells the goods at a retail outlet which leave their inventory diminished As a result of these

actions, what component(s) of 2019 real GDP change in the fourth quarter?

A Only investment and it decreases B Only consumption and it increases

C Investment decreases and consumption increases D None of the above is correct

11 Steph buys a designer dress produced by an American-owned fashion shop in France As a result, U.S consumption increases, U.S net export

A Decreases, U.S GDP is unaffected, but U.S GNP increases B Decreases, U.S GDP increases, but U.S GNP is unaffected

C Decreases, U.S GNP increases, but French GDP is unaffected D Are unaffected, U.S GDP is unaffected, but French GDP increases

12 Which of the following is included in the investment component of

GDP?

A Purchases of stocks and bonds

B Purchases of capital equipment that were manufactured in a foreign country by a foreign firm

C The estimated rental value of owner-occupied housing D None of the above is correct

13 Transfer payments are

A Included in GDP because they represent income to individuals B Not included in GDP because they are not payments for currently

produced goods or services

C Included in GDP because the income will be spent for consumption D Not included in GDP because taxes will have to be raised to pay for them

14 What components of US GDP (if any) would each of the following

transactions affect?

a A family buys a new refrigerator

b Aunt Jane builds a new house

c Ford sells a Mustang from its inventory d You buy a pizza

e California repaves Highway 101

f Your parents buy a bottle of French wine g Honda expand its factory in Marysville, Ohio

15 Which of the following statements about nominal GDP and real GDP

d Whether real GDP or nominal GDP is a better measure of economic well-being depends on what sort of goods are produced

16 Suppose GDP consists of wheat and rice In 2002, 20 bushels of wheat

are sold at $4 per bushel, and 10 bushels of rice are sold at $2 per bushel If

the price of wheat was $2 per bushel and the price of rice was $1 per bushel in 2001, the base year, nominal 2002 GDP is

a $100, real 2002 GDP is $50, and the GDP deflator is 50 b $50, real 2002 GDP is $100, and the GDP deflator is 200 c $100, real 2002 GDP is $50, and the GDP deflator is 200 d $40, real 2002 GDP is $100, and the GDP deflator is 50

17 The GDP deflator can be used to identify the

a increase in nominal GDP that is due to an increase in prices rather than an increase in production

b increase in real GDP that is due to an increase in prices rather than an increase in production

c increase in the cost of living for typical U.S consumers

d reduction in government spending required to balance the federal budget

18 Suppose that the country of Wakanda produces only eggs and ham The table below shows price of each goods throughout the years Supposed

that consumers always buy 100 units of eggs and 50 units of ham

Using 2016 as the base year, calculate the inflation rate

a Inflation rate in 2017 is 65 percent, inflation rate in 2018 is 4.8

19 If a country reported nominal GDP of 100 billion in 2017 and 75 billion in 2016 and reported a GDP deflator of 125 in 2017 and a deflator of 120 in 2016 then from 2016 to 2017

a real output and prices both rose b real output rose and prices fell c real output fell and prices rose d real output and prices both fell

ANSWER AND EXPLANATION

1 C The sale of services such as visits to a doctor

GDP is the market value of all final goods and services produced → used goods, stocks and bonds are inappropriate

2 d Sum the market value of final goods and services

(according to definition of GDP textbook page 486-488)

3 a Production generates income so that income and production are the same

(according to circular-flow diagram, figure 1 textbook page 485)

4 a The value of increased inventory will be counted as part of GDP in 2003, but the value of the cars sold in 2004 will not cause 2004 GDP to increase

Explain: An increase in inventory will be counted as an increase in Investment,

so the 2003 GDP will increase 25 cars that are sold in 2004 were produced in 2003, so it will not counted in the 2004 GDP

5 a These numbers are adjusted to make them measure at annual and

seasonally adjusted rates (according to PE textbook page 488)

6 d Both b and c are correct

(Explain: Because an intermediate good is a good that is used to make another

good to sell, whereas a final good is a good that is consumed by a consumer for his own consumption.)

7 b Including income earned by U.S citizens abroad and excluding income earned by foreigners in the U.S

(Explain: GNP is the income of all people of that nationality For example, US

GNP includes income of all American, even abroad So GNP is GDP including income earned by US citizens abroad and excluding income earned by

foreigners in the US)

8 c Included in only U.S GNP

Explain: Since Greg is a US citizen, his employment will be added to the

USA’s GNP But since he works only in Canada, he will not contribute to the USA’s GDP

9 A $6400

(Explain: GDP = $3000 + $2000 + $1500 + $500 - $600 = $6400)

10 C Investment decreases and consumption increases

(Explain: Because inventory is included in the investment, the diminishing of

inventory means the investment decreases And when the firm sells the goods at a retail outlet, the consumption increase.)

11 A.Decreases, U.S GDP is unaffected, but U.S GNP increases

(Explain: Because the fashion shop is in France, the dress is recognized as an

imported good which leads to the decrease in net export However, U.S

consumption increases because U.S citizen bought the dress, so the increase in consumption off set the decrease in net export, which leaves the U.S GDP unchanged The owner of the fashion shop in France is American, so U.S GNP increases.)

12 B Purchases of capital equipment that were manufactured in a foreign country by a foreign firm

(Explain: Because the purchases of capital equipment is included in the

investment regardless of where they were made Stocks and bonds are not

included in the investment, they are included in the saving The estimated rental value of owner-occupied housing is included in the consumption, the purchase of new housing is included in the investment.)

13 B Not included in GDP because they are not payments for currently

produced goods or services (according to textbook page 490 part 23-3c)

14

a Consumption b Investment

c Investment, Consumption (Investment decreases, Consumption increases)

15 b Real GDP is a better gauge of economic well-being than is nominal GDP

(Explain: Real GDP answers a hypothetical question: What would be the value

of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past? By

evaluating current production using prices that are fixed at past levels, real GDP shows how the economy’s overall production of goods and services changes over time)

16 c $100, real 2002 GDP is $50, and the GDP deflator is 200

17 a increase in nominal GDP that is due to an increase in prices rather than

an increase in production (according to textbook page 494)

18 d Inflation rate in 2017 is -10 percent, inflation rate in 2018 is -5.56

percent

19 a real output and prices both rose

Compute the Real GDP, we got 2016 Real GDP = 62.5, 2017 Real GDP = 80 Since Real GDP and GDP Deflator both increase from 2016 to 2017, Price level and real output increase

Chapter 24:

Measuring the Cost of Living I/ The consumer price index (CPI):

1/ How the CPI is calculated:

CPI: a measure of the overall cost of the goods and services bought by a

* Producer Price Index: measure cost of basket for producers

2/ Problems with CPI:

1 Substitution bias:

Suppose there are 2 goods in the basket, A and B When price of A increases more rapidly than price of B Consumers will be more likely to buy less A and more B CPI ignores this change in quantity bought because the basket is fixed

2 Introduction of new good:

Consumers have greater set of choice from which to choose => Less dollars are needed to maintain the same level of well-being => Each dollar becomes more valuable Because CPI has fixed basket, it does not reflect to increase in dollar value

3 Unmeasured quality change:

People try to measure quality in terms of price, but it is hard to measure it correctly when goods’ quality changes over time

● All 3 problems with CPI above overstate the CPI (and in turn Inflation

Rate)

3/ CPI vs GDP Deflators:

a What is included?

The first difference is that the GDP deflator reflects the prices of all goods and services produced domestically, whereas the consumer price index reflects the prices of all goods and services bought by typical consumers

Imported goods are not included in the GDP because when people buy imported goods, the increase in Consumption offsets the decrease in Net Export CPI, on the other hand, will include Imported goods if it is typically bought by consumers

Capital goods are included in the GDP (if it is produced domestically) because it is represented by the increase in Investment CPI, on the other hand, does not include Capital goods because it is not typically bought by consumers

E.g.: Purchase of domestic industrial tractors (capital good) is included in

GDP because it is produced domestically but not in the CPI because a typical consumer does not buy tractors

b Differences:

Fixed prices from base year Fixed basket from base year

G&S produced domestically G&S bought by a typical consumer

Include Capital goods (if domestic) Exclude Capital goods

Exclude Imported goods Include Imported goods (if typically bought by consumers)

II/ Correcting economic variables for the effects of inflation:

1/ Dollar figures in different times:

Value of dollars is different in different times due to changes in inflation

Formula:

𝑇𝑜𝑑𝑎𝑦 $ = 𝑌𝑒𝑎𝑟 𝑇 $ × 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑇𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 𝑡𝑜𝑑𝑎𝑦

The Price Level can be determined by CPI

E.g.: Determine how much does an amount of 2018 $500 worth in 2019,

today Given that the CPI in 2018 is 169, CPI in 2019 is 225

Indexation: Auto correction of a dollar amount for the effect of inflation

E.g.: Cost-of-living allowance (COLA) automatically changes when CPI (and

Inflation Rate) changes

3/ Real vs Nominal Interest Rate:

Formula:

Real interest = Nominal interest - Inflation

* Real interest: how fast your purchasing power increases, corrected for

EXERCISE 01/ True or False

a Suppose that the USA import cameras from Canada An increase in the price of imported cameras is captured by the USA’s CPI but not by the USA’s GDP deflator

b An increase in the price of helicopters purchased by the UK armed forces is captured by the CPI

c The "base year" in a price index is the benchmark year against which other years are compared

d If the CPI rises at 5 percent per year, then every individual in the country needs exactly a 5 percent increase in their income for their standard of living to remain constant

e The largest category of goods and services in the CPI is food and non-alcoholic beverages

02/ An inflation rate calculated using the CPI shows the rate of change of

a all prices

b the prices of all final goods and services c the prices of all consumer goods

d the prices of some consumer goods

03/ Which one of these is a problem arisen from the measurement of CPI?

a When price of good A rises faster and price of good B, people will buy less A and more B

b When a new good enters the market, it is not counted in the CPI c Increased quality are hard to be measured in terms of price

d All of the above

04/ The following table shows the prices and the quantities consumed in the

country known as the University States Suppose the base year is 2003 This is the year the typical consumption basket was determined so the quantities consumed during 2003 are the only quantities needed to calculate the CPI

a What is the value of the CPI in 2003?

b What is the value of the CPI in 2004?

c What is the value of the CPI in 2005?

d What is the inflation rate in 2004?

e What is the inflation rate in 2005?

f What type of bias do you observe in the CPI and corresponding inflation rates you generated above?

05/ Suppose that you lend your flatmate $100 for one year at a nominal interest rate of 9%

a How many dollars of interest will your flatmate pay you at the end of the

year?

b Suppose at the time you both agreed to the terms of the loan, you both expected the inflation rate to be 5 per cent during the year of the loan What do you both expect the real interest rate to be on the loan?

c In the case described above, actual inflation turned out to be higher than expected Which of the two of you had the unexpected gain or loss? Your

flatmate (the borrower), or you (the lender)? Why?

d What would the real interest rate on the loan have been if the actual

inflation rate had turned out to be 11 per cent?

e Explain what it means to have a negative real interest rate

f Suppose that after 1 year, you have already paid back your loan and interest A few days later he complained that your $109 can buy 4% less

good than before What is the inflation rate?

06/ Andrew is offered a job in Des Moines where the CPI is 80 and a job in New York where the CPI is 125 Andrew’s job offer in Des Moines is for $42,000 How much does the New York job need to pay in order to make the two salaries have almost the same purchasing power?

07/ If your wage rises from €500 per week to €625 per week while the CPI rises from 112 to 121, how should you feel about your standards of living?

08/ 20 years ago, a typical accountant earned a salary of $2000 What should the salary of a typical accountant now in order to have the same purchasing power as before? Given that the CPI in 2019 is 148 and the CPI

in 1999 is 80

ANSWER AND EXPLANATION

1

A True Explain: Camera is a good typical consumers buy, so it’s in the basket

and an increase in price leads to an increase in CPI On the other hand, the camera is imported from Canada, so it increases Consumption but decreases Net Export, so it is counted in USA’s GDP Deflator

B False Explain: Helicopter is not the kind of goods a typical consumers

would buy so it does not show up on the CPI C True

(Explain: Theoretical Information)

Explain: Because the CPI calculated the price of the goods in the basket, so

only some of the goods, not all of them

3 D (Explain: Theoretical Information)

F (Answer: Substitution bias since the price of pen rises faster than the price of other two goods, people will buy more books and pencils and less pens)

5

A ( = 100 * ( 1 + 9%)) = $109)

B (Answer: Real i = Nominal i - Inflation = 9 - 5 = 4%)) C (Answer: Borrower gains, Lender loses)

D (Answer: Real i = Nominal i - Inflation = 9 - 11 = - 2%)

E (Answer: You will receive more in terms of money, but in terms of purchasing power, you receive less)

F ( Answer: Inflation=13%)

6 (Answer: Applying the formula of Inflation, we can see that the Price level in New York is 56.25% greater than one in Des Moines

NY’s Salary = 42000 * ( 1 + 56.25% ) = $65,625) 7 (Answer: % increased in wage = 25%

Inflation = 8.03%

So Wage rises more than the price level => Increased standards of living) 8 (Answer: Using the formula of exchanging money

Chapter 25:

Production and Growth I/ Determinant of Productivity:

a/ Physical Capital (Capital): the stock of equipment and structures that are

used to produce goods and services

E.g.: To produce a table, the workers needs equipment like saws, drills, etc So

drills, saws, etc are Physical Capital

b/ Human Capital: the knowledge and skills that workers acquire through

education, training, and experience

E.g.: skills accumulated throughout the life of a worker are called Human Capital

c/ Natural Resources: the inputs into the production of goods and services that

are provided by nature, such as land, rivers, and mineral deposits

E.g.: To build a hydropower plant, people need a fast-current river So the river

is Natural Resource

produce goods and services

*Note:

- Technological Knowledge and Human Capital are closely related but distinct

- To use a relevant metaphor, technological knowledge is the quality of society’s textbooks, whereas human capital is the amount of time that the population has devoted to reading them

EXERCISE

1/ What are the main determinant of productivity:

a Physical capital, human capital, natural resources, and technological knowledge

b Government purchase, human capital, natural resources and technique

c Physical capital, human capital, natural resources and consumption d Physical capital, quantities demanded, natural resources and

technological knowledge

2/ Choose the correct answer:

(i) Human Capital refers to workers’ knowledge and skills

(iii) The builder use saw, hammer, to build a house Saw, hammer, are

3 Which of the following statements is WRONG:

a Technological knowledge is the quality of society’s textbooks, whereas human capital is the amount of time that the population has devoted to read them

b Although technological knowledge and human capital are closely related, there is an important difference

c To evaluate the economy’s efficiency, economists base mostly on technological knowledge rather than human capital

d Natural resource are both renewable and nonrenewable

ANSWER AND EXPLANATION

1 a Physical capital, human capital, natural resources, and technological knowledge

(Explain: Theoretical Information)

2 b (i), (iii)

(Explain:

(i) is correct Human Capital definition

(ii) is wrong Technological Knowledge is closely related to Human Capital, but they are different To put it simply, technological knowledge is the quality of society’s textbooks, whereas human capital is the amount of time that the population has devoted to reading them

(iii) is correct Saw, hammer, are tools used to build a house, so they are Physical Capital

(iv) is wrong Ruby ore is provided by nature so it is Natural Resources

technological knowledge rather than human capital