TUTORIAL WEEK 1 (25-29 JULY) Measuring Macroeconomic Performance: Output and Prices Textbook Reference: Chapter 1 Discussion Questions

Question 1 Consider the following indicators of macroeconomic performance. Rising living standards Stable business cycle Low and stable inflation Full employment Sustainable levels of public and national debt Balancing present verses future consumption

(i) Do you think that some outcomes are more important than others? For example, suppose we could have either (a) a volatile business cycle, but full employment or (b) a stable business cycle, but high unemployment. Which would you prefer? Explain the basis for your preference. This question is designed to generate some discussion. There are no right or wrong answers; it really just comes down to individual preferences. Looking at the various indicators of economic performance, do people think some are more important than others? You could ask students to rank the six indicators and see if there are some outcomes that are generally preferred to others. The textbook (BOF) lists 6 indicators of good macroeconomic performance: 1. Rising Living Standards Economic growth reflected in broadly continuous increases in the level of GDP per capita has generally been viewed as a desirable macroeconomic outcome. A lot of effort is directed at trying to understand the mechanics of economic growth and why some countries are rich and others are poor. Presumably the hope is to develop policies that will allow poor countries to increase their levels of GDP and possibly their economic growth rates. There is an alternative view that continuing economic growth is not a sustainable objective for the world economy. It argues the limited supply of resources relative to current world population levels will be a constraint on future growth rates. 2. Relatively Stable Business Cycle It is desirable to minimize business cycle fluctuations i.e. the deviations of output around its potential growth path. Booms tend to be inflationary while recessions produce unemployment.

3. Relatively Stable Prices One reflection of this goal is the adoption of inflation targets by many countries. Targets for inflation are often in the range of 1-3 percent per annum. This suggests that we dont care about having a completely stable general level of prices, since no-one has a target for inflation of 0 percent. There is generally a desire by central banks to avoid deflation (falling prices). No-one seems to think that deflationary situations (e.g. as in Japan) are a good macroeconomic outcome. 4. Sustainable Levels of Public and National Debt The level of public debt (what the government sector owes the private sector) tends to rise during recessions (as is currently occurring) and also times of national crisis such as wars. Sustainability is usually taken to mean that a government is expected to be able to run sufficiently large budget surpluses (tax receipts in excess of expenditures) in the future to pay-off its current debt. National debt refers to what the residents of a country (private and public sector) owe the rest of the world. Sustainability in this case is not an easy concept to define, but one issue that might be considered is whether the debt is being used to fund investment rather than consumption spending. 5. A Balance Between Current and Future Spending The level of national saving and investment will influence the amount of capital accumulation in an economy and its long-run level of output per capita. If current saving and investment is too low (or equivalently current consumption is too high) this may have a cost in terms of lower future capital and living standards (and possibly in terms of lower future growth). 6. Full Employment High levels of unemployment are very costly in terms of production foregone, but also in terms of an unemployed persons welfare. (ii)Is it technically possible to simultaneously achieve good outcomes for all macroeconomic objectives? Are there likely to be trade-offs between achieving various objectives? Provide an example. While Question 1 was about preferences, this is about opportunity sets or technical feasibility. It is possible for an economy to achieve good outcomes for all of these six indicators. The 1960s was a period during which this was achieved (although if you look at my lecture notes you will see that output growth tended to be relatively volatile in the 1960s). However this decade may have been an exceptional period. A classic model in macroeconomics is the Phillips Curve. This predicts a trade-off (at least in the short-run) between the rate of inflation and the level of unemployment. If you want a low rate of inflation, there is a cost in terms of having (at least temporarily) a high rate of unemployment (and vice-versa).

Question 2 (i) What does GDP measure? (ii) Is GDP an adequate measure of economic welfare? Identify some factors that might have an effect on economic welfare but are not measured in GDP. (iii) How do economists usually measure economic growth? (iv)What are some other measures of a countrys economic progress? (v) Is there a case for focusing on happiness rather than economic growth? What problems might arise with trying to measure happiness? (i) GDP is a measure of the market value of final goods and services produced in a country during a given period. See BOF, Chapter 1, section 1.2 for greater detail. (ii) GDP clearly does not include all the things that people value and all the factors which might affect peoples level of wellbeing. There are many goods and services that affect economic welfare but are not priced and sold in the market place and so do not appear in GDP. BOF (Section 1.3) list a number of things that are omitted from GDP but are likely to affect economic welfare: Increased leisure time Non-market (or home) production and the underground economy Natural resource depletion and changes in environmental quality Poverty and economic inequality Although GDP does not capture all elements of economic welfare, the expectation (hope) is that increases in real GDP per capita will be positively related to many of the things that people value. For example, improvements in medicine and health care appear to be positively related to increases in GDP. (iii)Standard approach is to use the growth rate of real GDP per-capita for a country. (iv)There are a number of other measures of economic progress. It general they are broader than GDP. For example the ABS have something called MAP (Measures of Australias Progress). This reports a number of indicators of the economy (eg. income, wealth, productivity), society (eg. health, crime) and the environment (eg. biodiversity); which individuals can use to construct their own measures of the quality of life. The ABS simply report the various measures and leave it up to individuals as to how to one might combine them into a single index. http://www.abs.gov.au/ausstats/abs@.nsf/Lookup/by%20Subject/1370.0~2010~Mai n%20Features~Home%20page%20(1) For anyone who is really interested, the following is a link to an interesting analysis by David Giles of an index produced by the OECD called the Better Life Index. http://davegiles.blogspot.com/2011/05/its-wonderful-life.html (v)Something called the Easterlin hypothesis states that higher income is not systematically associated with increased happiness. He attributes this to people being more concerned about their relative position in society, rather than their absolute level of wealth. So maybe economists and policymakers should be

directly concerned with happiness rather than just output of goods and services. One problem is that happiness is more difficult to measure. It tends to be subjective and most measures are based on surveys. You just ask people if they are happy or not (or to indicate on a scale how happy they are). Question 3 Go to the RBA Website at http://www.rba.gov.au/statistics/tables/index.html#output_labour (i) From Table G11, calculate GDP at current prices (column W) and real GDP (chain volume measure) (column L) for the financial year 2009-10. (Note: The financial year 2008-09 corresponds to sum of quarterly GDP for the September quarter 2009, the December quarter 2009, the March quarter 2010 and the June quarter 2010). Do the figures for current and real GDP differ? Explain why. (If you calculate nominal and real GDP for 2008-09 you find that they are approximately the same. What is going on?) (ii) From Table G11 use the current price measures and calculate for the 2009-10 financial year Private consumption (column M) Private investment (columns N,O,P&Q) Government spending (column R) Change in inventories (columns S & T) Net exports (column U column V)

What proportion of current price GDP is accounted for by each of these components in 2009-10? (i) GDP (Current Prices) $million 310260 316336 323873 335448
1,285,917

Sep-2009 Dec-2009 Mar-2010 Jun-2010 2009-10

GDP (chain vol. measure) $ million 317506 319639 321232 325580

1,283,957

The two figures are different. This is because: GDP at current prices is a measure of nominal GDP for 2009-10, i.e. it is a measure of the current value of goods and services produced in Australia The chain volume measure is a measure of real GDP for 2009-10, i.e. it is a measure of the volume of goods and services produced in Australia In 2008-09 real GDP is 1,255,240 and nominal GDP is 1,256,391 (almost the same). This reflects the fact that 2008-09 is used as the base-year for this set of chainweighted national accounts. In the base year nominal GDP = real GDP. (ii)

2009-10 Expenditure Components $million Consumption Investment Government Change in Inventories Net Exports GDP
698,232 286,334 312,510 1,258 - 3,423 1,294,911

Percent of GDP % 54 22 24 0.10 -0.26 100

Notice that the expenditure components do not quite add-up to the same value as GDP for 2009-10. (There is a small statistical discrepancy.) Household consumption is the largest component of GDP at around 54%. Private investment and government spending each account for of GDP. Both the change in inventories and net exports are relatively small as a percentage of GDP. Question 4 This exercise requires you to calculate real GDP using a Laspeyres-type index, a Paasche-type index and by a chain-weighted index. (It is probably simplest to do the calculations in an Excel spreadsheet.) Suppose we have an economy that produces only oranges and boomerangs. The following table gives the prices and quantities of these commodities for 2009 and 2010. Prices and Quantities of Oranges and Boomerangs 2009 Oranges Price $ 1 Quantity 100 Value ? Boomerangs Price $ 3 Quantity 20 Value ? Nominal GDP ?

2010 1.5 110 ? 2 50 ? ?

(i) Fill-in the missing values in the table. Calculate the percentage change in nominal GDP from 2009 to 2010. (ii) Compute the value of GDP for 2010 using 2009 prices. Then compute the percentage change in real GDP from 2009 to 2010 based on 2009 prices this is a Laspeyres-type index. (iii) Compute the value of GDP for 2009 using 2010 prices. Then compute the percentage change in real GDP from 2009 to 2010 based on 2010 prices this is a Paasche-type index.

(iv) What do you notice about the results from the two indices? Do they give the same increase in real GDP? Explain the reason for any difference? (v) A chain-weighted index can be approximated by taking a simple average of the growth rates from the Laspeyres and Paasche indexes. What is the percentage increase in real GDP between 2009 and 2010 implied by the chain-weighted index? (vi) To calculate an actual chain-weighted value for real GDP we need to choose either 2009 or 2010 as the base year (i.e. year in which nominal = real GDP). Lets pick 2009 as the base year. Use the percentage change in (v) to compute the real value of GDP in 2010. (vii) Calculate price deflators for GDP using all three indices and use them to calculate the rate of inflation between 2009 and 2010. Briefly indicate any important differences. (viii) What are the advantages (and disadvantages) of using a chain-weighted index to compute real GDP over traditional fixed-base indexes like Laspeyres and Paasche. (i) to (vii) Table of calculations are below (small differences can occur due to rounding).
2009 Oranges Price $ Qty Value Boomerangs Price $ Qty Value Nominal GDP Laspeyres Index (2009 prices) Value of Oranges (2009 Prices) Value of Boomerangs (2009 Prices) GDP in 2009 Prices Paasche Index (2010 prices) Value of Oranges (2010 Prices) Value of Boomerangs (2010 Prices) GDP in 2010 Prices Chain-Weighted Index (average) 2009 base-year 160 242 1 100 100 2010 1.5 110 165 %

3 20 60 160

2 50 100 265 65.6

100 60 160

110 150 260 62.5

150 40 190

165 100 265 39.5 51.0 51.0

Price deflator - Laspeyres Price deflator -Paasche Price Index - Chain-weighted

1 0.842 1

1.019 1 1.097

1.9 18.8 9.7

(iv) The Laspeyres and Paasche quantity indexes very different measures of the growth rate of real GDP, about 63 percent vs. 40 percent. The big difference is due to boomerangs. Notice that there is a big increase in the production of boomerangs in 2010 over 2009. In addition boomerangs are more expensive in 2009 than in 2010. So the relative contribution of boomerangs to GDP becomes quite large in 2010, when we use 2009 prices to value them. (Think about boomerangs as being similar to computers. Suppose we used 1990 prices (when PCs were quite expensive) to value our current production of computers.) (viii) Key points: Chain-weighting is less affected by shifts in the production structure of the economy than are traditional fixed-base-year indexes. Produces a more accurate measure of real GDP growth. Fixed-base indices are sensitive to (arbitrary) choice of base year. Entire history of GDP growth changes each time base year is updated. Chain-weighting involves a more complicated calculation (disadvantage). With fixed base indices, real GDP = the sum of real C, real I, real G and real NX. But this is not true for a chain-weighted index (disadvantage).