MacroeconomicsMeasurement, Business Cycles

and Growth

Students should be able to

• Define GDP and its components, describe expenditures that belong in GDP from those that don’t. .

• Distinguish main price indices• Define the inflation rate and describe the costs of

anticipated and unanticipated inflation.

• Define the unemployment rate and its components.• Describe business cycle expansions and contractions

and the behavior of the economy during business cycles.• Describe the ex post and ex ante real interest rate.

Quantity Aggregates• We need to combine the many goods

produced or consumed in an economy into one measure.

• All goods sold in an economy share a common unit of measure: the price at which they are sold.

• Quantity aggregates sum up market value of a group of goods.

• Most commonly measured aggregate is aggregate goods produced within an economy.

Gross Domestic Product (GDP)• GDP is the sum of the new, final goods

produced within the domestic borders of an economy. – GDP does not include intermediate goods.

• Final goods are goods which are sold to their end-users • Intermediate goods are sold from one firm to another

for intermediate transformation into other goods.

– GDP does not include purchases of used goods produced in another period.

– GDP does not include financial transactions.– GDP does not include goods produced by

domestic firms outside the border of an economy.

Expenditure Method• The Expenditure Method adds up the domestic

spending (less domestic demand satisfied by imports).

Expenditure CategoriesGDP = Consumption

+ Investment (including inventory investment)

+ Government Consumption

+ Exports – Imports

Expenditure Categories in Hong Kong: 2001

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

% of GDP

HouseholdConsumption

Government Consumption

Investment Exports Imports

Japanese Expenditure Fiscal Year(Billion Yen)

Items 2003

1.7 Private final consumption expenditure (2.1) 283,547.51.8 Government final consumption expenditure (2.2) 88,002.0 (regrouped) Actual final consumption of households 332,970.6 Government actual final consumption 38,578.91.9 Gross domestic fixed capital formation (3.1) 120,238.8 Of which intangible fixed assets 10,810.21.10 Changes in inventories (3.3) 270.01.11 Exports of goods and services (5.1) 60,375.71.12 (less) Imports of goods and services (5.6) 51,180.5

Gross domestic expenditure 501,253.5

(cf) Incomes from the rest of the world 12,787.4 (less) Income � � to the rest of the world 4,001.1 Gross national income 510,039.8

Production Method

• GDP is the sum of the value added created in all the sectors of the economy.

• Value added is sales minus materials, intermediate inputs and energy costs.

• The value of a final good is equal to the value added at each stage of production.

• Expenditure method = Production Method.

AF

F

Min

ing

Man

ufac

turin

g

Util

ities

Con

stru

ctio

n

Tra

de

Tra

nspo

rt

FIR

E

Ser

vice

s

Land

lord

1980

0

0.05

0.1

0.15

0.2

0.25

% of GDP

Production Account

1980

2001

Production shares in HK have changed over time.

Income Method

• The value added of a firm is the income available to pay workers, t and credit costs. Any left over income is profits.

• Income from domestic sources is another way of calculating GDP– Not done, annually for HK

Income Method, Japan 2003

(Billion Yen)

Items 2003

Compensation of employees ,payable 265,484.8 (1) Wages and salaries 223,445.0 (2) Employers' social contributions 42,039.8Taxes on production (less) Subsidies 36,562.4Proprieters Income 19,884.5Corporate Profits and Interest Payments 71,160.3Depreciation 101,301.0 (regrouped) Value added ,gross/gross domestic product 494,393.0

GNP vs. GDP

• Gross National Product or GNP is the income of national residents.

• GDP is the income created within national borders.

• GNP is GDP plus Net Factor Income• Net Factor Income is income earned on

overseas work or investments minus income generated domestically but paid to foreigners.

GDP Deflator

• GDP deflator is an index of the price level relative to some base year.

• It is the cost of purchasing the goods that represent GDP relative to the cost of purchasing the exact same goods if they had been sold at the prices prevailing in the base year.

Price Indices

• Two most commonly used price indices are GDP Deflator and Consumer Price Index (CPI)

• In constructing the CPI, statisticians calculate the total expenditure of the average household during a benchmark year.

• The current CPI is the price of that market basket relative to its cost in the base year (multiplied by 100).

• Price index in the base year is always 100.

CPI vs. GDP Deflator

0

20

40

60

80

100

120

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

CPI

GDP Deflator

CPI vs. GDP Deflator

• CPI is calculated monthly, GDP deflator is calculated quarterly.

• CPI measures the price of consumer goods. GDP deflator measures the price of all goods produced including investment or government goods.

• CPI measures the change in price of a constant market basket. Market basket of GDP deflator changes as goods produced changes.

What is Inflation?

• Define Inflation as the growth rate of prices.

• The greek letter π is often used as a symbol of inflation

1

1

1

1

1

1

100%

tt

t

t tt

t

t t

t

P

P

P P

P

P PInflation Rate x

P

Inflation means that prices are growing

Disinflation means that inflation is slowing down but still positive

Deflation means that inflation is negative and prices are actually dropping.

Adjusting for Inflation/Converting Current Price Series into

Constant Price Series• One may have a time series of an aggregate,

Nt, (in current prices) • We can use some price index to “adjust for

inflation” effectively converting into a variable measured in the prices of some reference year.

• Real series measures the value of goods that could have been purchased with that amount of money in the reference year.

Real Reft t

t

PN N

P

Example

• In 1966, Howard Hughes was forced to sell TWA and received a single check for US$650 million. How much is that in 2004 dollars?

• The GDP deflator in USA in 1966 was 22.855. The deflator in 2004 was 107.958.

• In 2004 dollars this is 2004

1966

107.958650 650 3044.63294

22.855

P

P

Real GDP/GDP Adjusted for Inflation/ Constant Price GDP

• When you compare production levels across time, you want to adjust for changes in the market price level.

• Real GDP measures output if the goods were sold at the prices that prevailed in a base year.

100t

t

GDPREAL GDP

GDP Deflator

GDP vs. Real GDP

HK 1960-2004

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

#

Mil

l. H

K$

GDP

Real GDP

Trend and Cycles

• We observe that real GDP is growing over time but at a non-constant rate.

• We call the growth path, if the economy were always growing at its average rate,the trend path.

• Fluctuations around the trend are called business cycles.

Business Cycle Terms

• As the economy fluctuates around the trend, the economy is experiencing business cycles.

• When economy is moving from a peak level to trough level, the economy is in a contractionary phase.

• When economy is moving from trough to peak, the economy is in an expansionary phase.

• When economy is moving from peak to trough the economy is in a contractionary phase.

Recessions and Booms

• Business cycle positions are sometimes characterized as booms and recessions.

• These names have many definitions – a boom occurs roughly when real output is

above the trend growth path (detrended output is positive).

– A recession occurs roughly when real output is below trend growth.

• In the USA, recessions are sometimes defined as 2 consecutive periods of negative growth.

HK Booms & RecessionsHong Kong Business Cycle

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

% D

iffe

ren

ce f

rom

Tre

nd

Trough

Trough

Trough

Trough

PeakPeak Peak

Business Cycles & Co-movement

• Business cycles are fluctuations in the economy as a whole.

• Different sub-categories of GDP tend to co-move with business cycles though to different degree.

• Business cycles tend to co-move across countries though not as strongly as within countries.

Business Cycles & Sub-Categories

• Expenditure. Consumption and Investment co-move with output. Investment is more volatile than consumption. Consumer durables are most volatile part of consumption.

• Production – Production sectors co-move with business cycles. Manufacturing & Construction most volatile. Services least volatile.

• Income – Worker Compensation & Capital Income are both pro-cyclical. Capital Income tends to be more volatile.

Hong Kong Expenditure Cycles

-.15

-.10

-.05

.00

.05

.10

.15

.20

1975 1980 1985 1990 1995 2000

GDPHousehold ConsumptionFixed Investment

Corporate Profits

• We find that corporate profits are strongly pro-cyclical and volatile.

• When the economy is doing well, corporations tend to earn high real profits.

• Corporate profits fluctuate far more than the economy as a whole.

HK Corporate Earnings & the Business Cycle

-.5

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

86 88 90 92 94 96 98 00 02

Real Corporate Earnings Real GDP

% D

evi

atio

n fr

om

Tre

nd

Using financial market data to predict business cycles

• It has been joked that stock markets have predicted 7 out of the last 5 recession.(In fact there does seem to be a moderately strong,

positive correlation between cyclical variation in stock prices and business cycles)

• In the USA, some financial market indicators have been shown to predict business cycles.– Default Spread : Interest rates on lower rated bonds

vs. Interest rates on better rated bonds.– Term Spread: Interest rates on long-term bonds vs.

short-term bonds (when this is inverted, recession is likely)

Unemployment Rates

• The population resides in 1 of 3 categories– Employed: Currently working.– Not in the Labor Force: Not working and not

actively seeking work– Unemployed: Not working but seeking work.

Unemployment Rate

100%Unemployed

UREmployed Unemployed

Level of Unemployment in HK

Hong Kong Unemployment Rate

0

1

2

3

4

5

6

7

8

9

10

Oct

-81

Oct

-82

Oct

-83

Oct

-84

Oct

-85

Oct

-86

Oct

-87

Oct

-88

Oct

-89

Oct

-90

Oct

-91

Oct

-92

Oct

-93

Oct

-94

Oct

-95

Oct

-96

Oct

-97

Oct

-98

Oct

-99

Oct

-00

Oct

-01

Oct

-02

Oct

-03

Oct

-04

Types of Unemployment

3 Types of Unemployment

1. Cyclical Unemployment – Unemployment associated with business cycles.

When demand falls, demand for labor falls. Workers may not be at first willing to work at new market wage rate at may sit idle.

Types of Unemployment

2. Structural Unemployment When specific demands for workers (location or

skills) does not match the characteristics of the workforce.

Restrictions on job conditions may make it difficult for firms to find workers that match their needs under given conditions

Minimum wage means only high skill workers may be hired.

Firing costs may mean that jobs for young or difficult to evaluate workers may not appear.

Types of Unemployment

3. Frictional Unemployment

Unemployment that occurs as a part of the movement in and out of the workforce. Very frequently when a worker changes their employment situation there is some period of unemployment.

Differences in Unemployment Rates (http://www.oecd.org)

Standardized Unemployment Rates

0 1 2 3 4 5 6 7 8 9 10

USA

France

Germany

Italy

Japan

US Treasury offers bonds whose payoff is indexed to inflation. Yield is tantamount to

ex ante real interest rate.

0.00

1.00

2.00

3.00

4.00

5.00

Feb-

05

Apr-0

5

Jun-

05

Aug-0

5

TIPS

10 Year

Why is unemployment so high in W. Europe?

• Tightly regulated labor markets increase structural unemployment.

• High social welfare benefits increase frictional costs as workers have little incentive to search diligently until the benefits work out.

What is Inflation?

• Define Inflation as the growth rate of prices.

• The greek letter π is often used as a symbol of inflation

1

1

1

1

1

1

100%

tt

t

t tt

t

t t

t

P

P

P P

P

P PInflation Rate x

P

Inflation means that prices are growing

Disinflation means that inflation is slowing down but still positive

Deflation means that inflation is negative and prices are actually dropping.

Costs of Anticipated Inflation

• Shoe Leather Costs – Money is a technology for engaging in transactions. The greater is inflation, the greater the cost for individuals of holding money. Individuals must make efforts as a substitute for the convenience of holding money.

• Menu Costs – Firms must engage in costs of changing posted prices. More generally, when prices change rapidly over time, more time and effort must be put into calculating relative prices.

Interest Rates

• Nominal Interest Rate (1+it): Number of $ a borrower will pay you in one year if they borrow $1 today.

• Real Interest Rate (1+rt): Number of goods a borrower will pay you in one year if they borrow 1 good today.

$ 1 $PAYOFF i PRINCIPAL

1

1

$ $1t t

t t

PAYOFF PRINCIPALr

P P

1

11

1

ir

But inflation is not known ex ante. To guess real interest rate when we make a loan we must anticipate inflation.

• Fischer Hypothesis

– Nominal interest rates are set according to some target real interest rate plus anticipated inflation.

EA Ai r

• When actual inflation is greater than expected inflation, ex post real interest rates are less than actual real interest rates.

Fischer Equation Rough Guide to HK Interest Rates

-8

-4

0

4

8

12

16

80 82 84 86 88 90 92 94 96 98 00

CPI_Inflation Time_Deposit_Rate

Hong Kong Inflation & Nominal Interest Rates

Average Ex Post Real Returns

• If we put Principal into an investment for T periods at nominal interest rate i, we get a pay-off. Payoff = (1+i)T Principal

• If we put money into an investment, the average return is

• Average Real Return is

1

+T +TPayoff Payoff1

Principal Principal

T

Ti

1

+T +TPayoff Payoff

1Principal Principal

T

T TTP P

r

P P

Costs of Unexpected Inflation

• When inflation is faster than is expected, the purchasing power of the payoff to an investment will decline unexpectedly.– Borrowers will win, but lenders will lose.

Inflation Risk

• When inflation is variable, lenders will demand some premium for inflation risk. This will put cost on borrowers.

• High inflation rates tend to be associated with unpredictable inflation .

Inflation: HK GDP Deflator

Inflation

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

HK Real Interest Rate

Real Interest Rate

-5

0

5

10

15

20

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Per Capita GDP

• GDP is national income.

• Average income or per capita GDP can be obtained by dividing GDP by population level.

• Since income is unevenly distributed this may not measure the income of the representative individual.

International Comparisons Project

• Researchers at U. of Pennsylvania periodically choose a representative world market basket and go to different countries to collect prices of that market basket of good.

• For a country, we calculate PPP = Purchasing Power Parity as the price of the market basket relative to price of the market basket in US.

• For any country, the exchange rate, St, is the number of domestic dollars per US$.

Comparing GDP across Countries

• When you compare income in two different countries, each country’s GDP per capita is measured in local currency. You need to measure both with common yardstick to compare.

• Typically, the common yardstick will be US$. GDP can be converted to US$ by Exchange Rate Method (divide national GDP by the exchange rate) or PPP Method (divide national GDP by PPP).

PPP vs. Exchange Rate Conversion

• Exchange rates are easily available so exchange rate is a “quick and dirty” comparison. – Measures how many US dollars someone could buy

with average income.

• However, money goes farther in some countries as many types of goods are relatively cheap (especially developing countries).– PPP conversion measures how much the goods

purchased by the average person would cost in the US. Better measure of living standards.

Comparison of China vs. HK

• Goods are cheaper in China than in HK

LocalCurrency 2002GDP S PPP

Hong Kong HK$192,776 7.8 6.666667China ￥6,423.00 8.2644628 1.915709

US Dollar GDPExchage Rate PPPConversion Conversion

Hong Kong $24,714.87 $28,916.40China $777.18 $3,352.81

Wide Variation in Income per Capita, 2000

GDP per Capita

0

5000

10000

15000

20000

25000

30000

Hong K

ong, C

hina

Indo

nesia

Japa

n

Korea,

Rep.

Mala

ysia

Philipp

ines

Singap

ore

Thaila

nd

Vietnam

US

$

Determinants of Income Levels

• GDP per capita can be decomposed into labor productivity and average hours worked.

• Amongst developed countries there are large difference in output per capita due to variations in employment per person

Hours WorkedGDP GDP

Population Hours Worked Population

Large Variations in Labor per Person (www.ggdc.net)

Hours per Worker 2001

0 500 1,000 1,500 2,000 2,500 3,000

EU

USA

Japan

Hong Kong

Singapore

South Korea

Taiwan

Variation in Labor Force Participaton

Employment as a share of Population

38.00%

40.00%

42.00%

44.00%

46.00%

48.00%

50.00%

52.00%

Europe U.S.A Japan Hong Kong Singapore South Korea Taiwan

Main Differences in Countries are Due to Variation in Labor

ProductivityGDP per Worker

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

50000

Hong K

ong

Indo

nesia

Korea

Mala

ysia

Phillip

pines

Singap

ore

Taiwan

Thaila

nd

Determinants of Labor Productivity

• Capital per Worker: Capital, K, is the value of machines, structures and equipment used to produce goods.

• Human Capital – Education and experience of the workforce

• Technology – Available Techniques and Ideas for using goods and efficiency with which they are used.

Capital Productivity and Capital Labor Ratio

• Returns to corporate investment are determined by capital productivity.

• Ceteris parabis, countries with low capital-labor ratios will have high capital productivity.

• As a country increases its capital per worker, it will push down capital productivity but increase labor productivity

Equalization of Capital Returns

• With efficient capital markets, capital will flow to those places where capital productivity is high until return on investment is equalized across countries (adjusted for risk and tax differences).

• Capital per worker will be low in those countries where capital is heavily taxed or risk premiums are high. Risk premiums are high if investment is risky, or financial systems are less sophisticated.

• In reality, limitations to international capital markets mean that much investment in capital equipment is financed by domestic savings.

Measuring Technology• Main measure of technology differences is Total

Factor Productivity or TFP. • TFP measures efficiency with which a country is

using all of its resources • TFP is measured as a geometrically weighted

average of capital and labor productivity • Weights measure the relative importance of

each factor (what share of income is paid to labor)

GDP GDP

Capital

K Lweight weight

TFPValue of Hours Worked

The Case of Korea

• Over the last 50 years, South Korea has enjoyed some of the highest growth in per capita GDP.

• Korean success story mostly about increasing the education of the workforce and rapidly building the countries physical plant.

• Still, however, Korea remains far behind world leaders in terms of labor productivity.

High Investment Rates, Low Capital Productivity

Investment Rates

0

5

10

15

20

25

30

35

40

45

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

% o

f G

DP

U.S.A South Korea

Relatively Stable Capital Productivity in USA, decline in South Korea

0

0.2

0.4

0.6

0.8

1

1.2

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

U.S.A

South Korea

Korean Labor Productivity goes from less than

10% of USA to more than 40%.

Output per Hour

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

1999

US

$

U.S.A

South Korea

Allocative Efficiency

• Korea is advanced in a technological sense and has a highly educated work force.

• Korea accumulated a high level of capital per worker.

• Korean financial system may have allocated capital for political ends rather economic.