Macroeconomy
Investigation of the economic outcomes affecting every household, firm and market - i.e. the economy as a whole

A few macroeconomic questions:

  • Why do output and the employment rate fluctuate ?
  • How can we explain the increase (or the stagnation) in prices ?
  • How can we explain the existing per-capita income disparities existing between nations ?

A macroeconomic specificity
aggregate variables

Some examples of individual variables/aggregate variables:

  • price of a given good/price index
  • wage for a given worker/average wage within the economy
  • the quantity produced by a firm/GDP

Warning : an aggregate variable and one of the individual variables entering its composition may vary in different directions !

  • An increase in the production price index is compatible with the price of some goods having decreased...
  • Some sectors of a given economy might experience a recession even though the GDP has increased...
  • A decrease in the overall unemployment rate might cover some strong disparities depending on the workers’ qualifications/gender/residence location...

So as to describe a given economy, one needs synthetic indicators summing up the evolution of a whole group of individual variables
⇒ Those indicators are called aggregate variables

Measuring a nation’s income

GDP

GDP estimation methods
To sum up, there exists 3 different methods of GDP estimation:

  1. The “production” approach (i.e. the value-added approach)
  2. The “income” approach
  3. The “expenditures” approach

By definition, those 3 methods should yield equivalent results

A country’s income and expenditures:
1) This first definition is based on an “output-oriented” approach of a country’s wealth

  • The GDP can however also be considered as a measure of...
    -2) the total income earned by all the agents operating within the economy
    -3) the total expenditures realised by all the agents operating within the
    economy
  • Indeed, accounting identity : at the whole economy level, the income has to be equal to expenditures
    • each transaction pertaining to a produced good/service features a buyer and a seller...
    • ...in other words, each euro spent by a given buyer is a euro earned by a given seller
      ⇒ for the economy as a whole, INCOME=EXPENDITURES=FINAL GOODS OUTPUT

Associated notions and important remarks :
1) “Market value...’ : necessity to build a single measure for an infinity of different outputs
⇒ use of the market prices, which all the inherent complications (inflation, exchange rate, etc.)


2) “...of all...” : the GDP however exludes...

  • illegal productions (narcotics, moonlighting, etc.)
  • the goods/services produced and consumed directly within households
    (no market)

3) “...the final...” : risk of double counting

  • the value of the flour sold by the miller to the baker is included in the value of the bread sold by the baker to the final consumer...
  • ...as a consequence, and so as to avoid double counting, only the income generated by the sale of the bread is taken into account when computing the GDP (see below)

4) “....goods and services...” : the GDP includes both tangible goods (food,
cars, etc.) and intangible services (haircuts, doctor visits, etc.)


5) “...within a country...” : the GDP measures the added value produced within the borders of a given country, regardless of the producer’s nationality (as opposed to the Gross National Product)


6) “...over a given period of time” : the GDP is a flow, and only provides information about the economic activity of the considered period (usually a quarter or a year)

In order to assess a country’s economic soundness, analysts consider the total income generated by its population. The most commonly used indicator is the Gross Domestic Product


The GDP provides a measure of the market value of all the final goods and serviced produced within a country over a given period of time.

The income approach


The added value generated by a production process will be used so as to pay the factors of production : the GDP is also a measure of total income generated within an economy. An output which generates an added value:
-has been sold at a value that is superior to the costs pertaining to the purchase of intermediate inputs...
-...which means this output has generated revenues for the firm
Primary revenues are revenues that are generated by the creation of added value

The expenditure approach


The added value generated by a firm’s output results from the purchase of the firm’s output
→ The GDP can also be measured by adding up all the expenditures pertaining to the purchase of an economy’s final output
National accounting identity present in almost all macroeconomic models : Y=C+I+G+X−M


Y = an economy’s total output, economy’s total expenditures, economy’s total income


C = Consumption, i.e. household’s purchases of final goods and services


I = Investment, i.e. firm’s purchases of new equipment goods > IMPORTANT : the stock variations are also accounted for in the “investment” category.
Volkswagen produces a car in November 2000, but only sells it in march 2001, for a total value of 7000 euros.> added value” approach : the car is included in the GDP measure for the year during which it was produced, i.e. 2000


“Income” approach : the remuneration of the production factors that were used for the production of this car will occur in 2000 “Expenditure” approach : the car was finally bought in 2001, meaning that its purchase will appear in the “C” category in 2001 ! → Compatibility problem between different GDP computation methods
⇒ Solution : explicitly account for stock variations ! (as mentioned above, included in category “I”). In 2000 : +7000 in the I category (stock increase). In 2001 : -7000 in the I category (stock decrease) and +7000 in the C category (private consumption expenditure)→ 7000-7000=0 : nullified operation in 2001


G= Government expenditures, i.e. the final goods and services purchased by the State.
Includes teachers’ payroll...
...but not the social transfers such as unemployment benefits !


X = eXports, i.e. the domestic final goods and services purchased by foreign economic agents


M = iMports, i.e. foreign final goods and services purchased by domestic economic agents


NX = X - M = Net eXports. More precisely, when a household/firm/government buys a foreign product, this purchase appears negatively in -M, but also positively in C, I or G → again, nullified operation

The production approach


The term “added value” is actually more accurate than production/output
Added value = revenue - purchases of intermediate goods/services
Indeed, by adding all the domestic firms’ revenues, we end up counting several times the intermediate goods and services supplied by firms to one another ! !
⇒ This is why we rather use the added value, which measures the net contribution of a given firm to the total output value

Example:
We consider two economies, A and B
The only economic activity in those two economies is the production of bread
Economy A: 3 transaction stages(farmers→millers →bakers)
Economy B: 2 transaction stages(farmers→bakers)


Economy A:Farmers produce 10 tons of wheat, that they sell to the millers for 100e perton;Millers transform the wheat into 8 tons of flour, that they sell to the bakersfor250e perton;Bakers produced 10000 breads, that sell sell for 1e each
Economy B:Farmers produce 10 tons of wheat, which they themselves transform into 8 tons of flour, that they sell to the bakers for 250e per ton;Bakers produced 10000 breads, that sell sell for 1e each


f we were to measure the economic activity by counting the value of output as estimated at each transaction stage, we would obtain:
Economy A: (10∗100)+(8∗250)+ (10000∗1)=13000e
Economy B: (8∗250)+(10000∗1)= 12000e
The economic activity seems greater in A than in B, even though the goods produced within the two economies are strictly similar !>>double counting


Solution : to measure the economic activity by only considering the added value for each production stage
Economy A :
(10∗100)+(8∗250−10∗100)+(10.000∗1−8∗250)=10000e
Economy B: (8∗250)+(10000∗1−8∗250)=10000e
RQ : a method that would yield strictly equivalent results consists in adding only the revenues of firms producing final goods/services (as opposed to intermediate) > In our example, counting only the value of the final bread production


The distinction between intermediate and final goods is not made based on the nature of the product, but on its use
Intermediate good: a good which is used as an input in the production process of another tradable good or service
Final good: a good that is consumed by the end user and does not require any further processing

Among which economic agents are those primary revenues shared ?

  1. The production factors :


    (a) Labour : the share of added value allocated to the firm’s employees (taxes included) is referred to as “payroll”


    (b) Capital : the share of added value allocated to a firm’s capital inputs is referred to as “gross operating surplus”


    Physical capital : machinery, buildings


    Financial capital : owner’s equity, borrowed funds


  2. Public administrations : a share of the added value accrues to the State through input taxes :


    Indirect taxation (VAT)


    All the other taxes pertaining to the output process : land value tax, royalty payment (blueprints), etc.



As defined above, the primary revenues encompass all the revenues generated by the creation of added value
Secondary revenues : all the revenues generated by the redistribution of the different taxes (social security, labor taxes, capital gains taxes, etc.) levered at the primary revenues→ unemployment benefits, child benefits, retirement benefits, etc.
Those secondary revenues are not counted when computing the GDP, since
they are not the result of the creation of added value (transfer revenues)

GDP growth : real and nominal GDP

As outlined above, the GDP is computed in monetary units
We now assume that a country’s GDP has increased by 2,5% from one year
to the next. This increase can be due to 2 distinct causes :

  1. “Real” increase : an increase in the total output of final goods and services within the considered country
  2. “Nominal” increase : an increase in the prices of the final goods and services produced within the considered economy !

A nominal variable is a variable measured in units of current monetary units, i.e. measured using the current price levels
PROBLEM : a GDP growth that can totally explained by an increase in the price levels is artificial, as it does not imply an increase in the welfare of the domestic economic agents !
⇒ It is of utmost importance to quantify the contribution of each channel (real/nominal) to the total increase
So as to isolate the 2 channels, we use a concept called the real GDP.


The real GDP measures the value of goods and services produced within a year, using the price levels as observed at a given moment in the past
It is then possible to compute the growth of both the nominal and the real GDP :
Nominal GDP growth : output growth measured at current price levels
Real GDP growth : output growth measured as constant price levels (implies the choice of a reference year)
WARNING : this last measure only makes sense when comparing GDP levels/growths measured using the same reference year !


The GDP deflator measures the current price level compared to the base year price level
GDP deflator = (nominal GDP / real GDP) x 100
The GDP deflator is an index : it does not have any unit of measure, and is used so as to track the evolution of a variable (here, the price level) over time


Measuring Inflation

Measuring price variations using the GDP deflator


The evolution of price levels between two dates t and t′ can be estimated using the deflator’s growth rate over the period :
variationin%=(Dt′ −1)∗100 Dt
WARNING : it is of course absolutely necessary for the two deflators to be computed using the same base year, otherwise the comparison is meaningless (and wrong !)
In our example, the price level evolution between 2010 and 2011 measured using the deflator is the following : (171/100 −1) ∗100=71%
The price variation measured using the deflator captures only the variations in the prices of the final consumption goods produced in the considered economy...
...but cannot capture the variations in the prices of imported goods
→ Those “imported” price variations may however have a strong impact on
consumers’ welfare !
Gasoline price : the evolution of prices measured using the Belgian GDP deflator will not capture the variations in the gasoline price, since it is an imported product !
⇒ Use of another index : the Consumption Price Index (CPI)


The consumption price index
CPI : an index used so as to measure the price variations of a basket of goods and services representative of households’ expenditures


It is a monthly index : it is computed using the ratio between the price of the basket for the current month and the average price of the same basket for the base year
The basket of goods and services comprises items that are representative of the household’s expenditures during the base year (in Belgium, 2013)
Belgian “indice sant ́e” : computed by taking out of the reference basket all the alcohol-based drinks, as well as tobacco and gasoline
There are however a few caveats regarding the ability of the CPI to measure the evolution of consumers’ purchasing power : 1. No substitution mechanism. An increase in the price of a good entails modifications in consumers’ behavior.Problem : the consumption basket is fixed for a long period of time.

  1. Late inclusion of new products. The consumption basket only includes a good once it has become a mass consumption product (low prices)...
    ...the possible strong declines in the good’s price when entering mass consumption are not captured !
  2. Difficult to efficiently capture a good’s quality. Inclusion of one product per category. f the price increases along the product’s quality, it is right to consider that you have to pay a higher price for the same product ?

Measuring inflation : CPI vs. deflator


The price evolution between two dates t and t′ is measured by the rate of growth of a price index PI (it can be either the deflator Dt or the CPI) between t and t′ :inflation rate % = (PIt′/PIt − 1) ∗ 100
WARNING : the inflation rate measured using the GDP deflator Dt is totally different from the inflation rate measured by the CPI !
Main explanation : the products for which a price evolution is computed are not the same, whether we use the deflator of the CPI !
The “deflator inflation” (formula above with PIt = Dt ) measures the price evolution of all the final consumption goods produced in an economy, some of which are not even consumed by households
The “CPI inflation” (formula above with PIt = CPIt ) measures the price evolution of all goods consumed by households, some of which being imported.

GDP and welfare


The GDP per capita can be interpreted as the amount of primary income accruing to a country’s citizen if all the revenues were evenly distributed. Is it really relevant to focus on this variable so as to measure a nation’s welfare level ?the most immediate answer is “of course not’...The development concept cannot be subsumed to the monetary
concept of income per capita.Numerous other dimensions to take into account (demographical, sociological, political, etc.)
...but two arguments may say otherwise :income per capita is an easily observable and comparable variable,
both through time and across countries ;more importantly, it is positively and significantly correlated to numerous development indicators
It is however of utmost importance to keep in mind the important limitations of the GDP per capita as a measure of welfare. economic growth is generally beneficial, but necessarily entails winners and losers... increase or decrease in the inequality level within a country ? (pro-poor growth ?)Example of South Africa : from 1900 to the end of the apartheid, the per capita income has significantly increased, while the real wages of the black majority has actually decreased over the period.
Necessity to include other dimensions in the evaluation of a country’s welfare level :HDI : life expectancy, health indicators, literacy indicator... Wealth distribution, Sustainable development, Education.
The Human Development Index (HDI): statistical index create by the United Nations Development Program (UNDP) in 1990 so as to measure the level of human development across the world.
3 major criteria : Life expectancy at birth, Education level, Purchasing power
⇒ Encompasses more dimensions than the GDP