copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 2-1 chapter 2 measuring...

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.2-1

CHAPTER 2

Measuring the Macroeconomy


Questions

• What key data do macroeconomists look at?

• How are key macroeconomic data estimated and calculated?

• What is the difference between “nominal” and “real” values?

• How are stock market values related to interest rates?


Questions

• How are interest rates related to the price level and the inflation rate?

• How is unemployment related to total production?

• What is right--and what is wrong--with the key measure of economic activity, real GDP?


The Importance of Data• Economists use quantitative data to

examine and understand behavior– prices– quantities– values

• Data can be used in two ways– make quantitative forecasts– test economic theories


Most Important Macroeconomic Data

• real GDP• the unemployment rate• the inflation rate• the interest rate• the level of the stock market• the exchange rate


Table 2.1 - The Six Key Economic Variables


The Exchange Rate

• The nominal exchange rate is the relative price of two different currencies– determined in the foreign exchange

market

• Example– €1.00 equals $1.20– $1.00 equals €0.83


The Exchange Rate

• Domestic exporters earn foreign currency when they export products– need to trade the foreign currency for

dollars

• Foreign producers earn dollars when U.S. residents import their products– need to trade the dollars for foreign

currency


Figure 2.1 - The Market for Foreign Exchange


The Exchange Rate

• The real exchange rate is the nominal exchange rate adjusted for changes in the value of the currency– depends on the nominal exchange rate

and the price level


The Exchange Rate• Example 1

– nominal exchange rate changes from $1.20 = €1.00 to $2.40 = €1.00

– price level doubles– real exchange rate is unchanged

• Example 2– nominal exchange rate remains at the

same level ($1.20 = €1.00)– price level doubles– real exchange rate falls by half


The Exchange Rate

• Example 3– nominal exchange rate increases from

$1.20 = €1.00 to $2.30 = €1.00– price level remains the same– real exchange rate doubles


The Exchange Rate• To calculate the real exchange rate (),

you need three pieces of information– price level in the home country (P)– price level abroad (P*)– nominal exchange rate (e)

*PP

e


The Exchange Rate• There are many different currencies in

the world– many different exchange rates

• Economists construct an exchange rate index to represent “the” exchange rate– each country receives a weight equal to its

share of total U.S. trade


The Exchange Rate• The exchange rate index is by

averaging each country’s current exchange rate relative to its exchange rate in the base year (1992)

countries

all

trade) of share (1992 rate) exchange (1992

rate) exchange (Current 100 Index


Figure 2.2 - The Exchange Rate Index,1992-1998


The Stock Market

• The most representative index of the U.S. stock market is the Standard and Poor’s Composite Index (S&P 500)

• The most commonly discussed index of the U.S. stock market is the Dow-Jones Industrial Average


The Stock Market• Stock market averages are in nominal

terms– must divide by some measure of the price

level to get the real value of the stock market

• The real value of the stock market is a sensitive indicator of the relative optimism or pessimism of investors– can forecast future investment spending


The Stock Market• Investors face a choice between

holding stocks and holding bonds– stocks are shares of ownership of a

corporation• entitles you to a portion of the company’s

profits

– bonds are debts that the corporation owes you• pays periodic interest payments and returns

principal to you at maturity


The Stock Market• Rates of return

– for bonds, the rate of return is the interest rate (r)

– for stocks, the rate of return is the ratio of earnings per share (Es) to the price paid (Ps)

• Stocks are risky– investors may require a risk premium (s)


The Stock Market• Investors will hold only stocks if

ss

s

rPE

ss

s

rPE

• Investors will hold only bonds if


The Stock Market• Investors will hold both stocks and bonds if

ss

s

rPE

• This means that the value of a stock is equal to

s

ss

rE

P


The Stock Market• How can we measure Es?

– newspaper reports what the firm’s accountants have calculated (Ea)

– investors are interested in some long-run average of expected future earnings (Es)

– need an estimate of the relationship between Ea and Es


Figure 2.3 - Calculating the Value of aBasket of Stocks


The Stock Market• provides information on

– the current level of profits (earnings)– whether investors are optimistic or

pessimistic– the current cost of capital– attitudes toward risk


The Interest Rate• is the price at which purchasing power

can be shifted from the future into the present

• is not a single lump sum, but an ongoing stream of payments made over time– is a flow variable


The Interest Rate• There is a large number of different

interest rates that vary by– risk– duration– tax treatment

• Published interest rates are nominal interest rates

rate inflation-rate interest nominalrate interest real


Figure 2.4 - The Real versus the NominalInterest Rate


The Price Level

• is most frequently measured by the Consumer Price Index (CPI) which– is calculated monthly by the Bureau of

Labor Statistics– is an expenditure-weighted index


Table 2.5 - Calculating a Price Index for Fruit: An Example


The Consumer Price Index• Price index formula

weight) index banana(bananas of priceyear -Basetoday bananas of Price

weight) indexpear (pears of priceyear -Base

today pears of Price

weight) index apple(apples of priceyear -Base

today apples of Price

weight) index orange(oranges of priceyear -Basetoday oranges of Price

Index


The Consumer Price Index• In the base year, the price index will

equal 100

100 4)($0.40$0.40

9)($0.90$0.90

42)($1.20$1.20

45)($0.75$0.75

Index


The Consumer Price Index• In the subsequent year, the price

index will equal 138

138 4)($0.40$0.40

9)($0.90$0.90

42)($1.20$1.00

45)($0.75$1.50

Index


Kinds of Index Numbers

• Laspeyres index– uses relative expenditure levels in a

fixed base year as weights– example: Consumer Price Index

• Paasche index– uses current, variable expenditure

levels as weights– example: GDP deflator



• All price indices are imperfect– the Laspeyres index overstates the

effects of price increases• based on a fixed market basket• does not take into account that consumers

substitute relatively cheaper goods for relatively more expensive goods when prices rise (substitution bias)



• All price indices are imperfect– the Paasche index understates the

effects of price increases• does take account of substitution• does not take into account the fact that

substituted items are less-valued than the items they replace


The Inflation Rate• is a measure of the rate of change in

the price level over time– is a flow variable

• can be measured using different price indices– Consumer Price Index (CPI)– GDP deflator


Figure 2.5 - Different Measures of U.S. Inflation, 1960-2000


The Unemployment Rate

• is the fraction of people who – want a job– are looking for a job– cannot find a job

• is calculated using the Current Population Survey– monthly survey by the Bureau of Labor

Statistics



• Individuals are classified into one of four categories– those who are employed– those who are out of the labor force and

do not want a job currently– those who do want a job currently, but

have given up looking for one– those who do want a job and are

currently looking for one



Work)for (Looking(Employed)forceLabor

Work)for (Looking(Employed)Workfor Looking

ForceLabor Workfor Looking

Rate ntUnemployme


Figure 2.6 - The U.S. Unemployment Rate since 1950



• is a stock variable• may underestimate the real

experience of unemployment– discouraged workers– workers who are part-time for economic

reasons

• vary by demographic group


Figure 2.7 - U.S. Unemployment Rates by Demographic Group, 1960-2000


Okun’s Law• describes the relationship between

unemployment and output in the U.S.

• implies that a 1 percentage-point fall in unemployment is associated with an extra 2.5 percentage points of growth in real GDP

nt)unemployme in change point-e(percentag2.5

-output) potential in growth (%GDP real in change %


Figure 2.8 - Okun’s Law


Real GDP• is calculated by adding up the value of

all final goods and services produced in the economy– is a flow variable

• includes final goods and services purchased by– consumers– firms– the government


Nominal versus Real GDP• Nominal GDP measures current

output using current-year prices– changes in nominal GDP can occur from

changes in either output or prices

• Real GDP measures current output using prices from a base year– changes in real GDP can only occur if

output changes


Nominal versus Real GDP• Example

ProductBase-Year

Output

Base-YearPrice

($/ lb.)

CurrentOutput

CurrentPrice

($/ lb.)

Oranges 6 lbs. $0.75 8 lbs. $1.00

Apples 3.5 lbs. $1.20 3.5 lbs. $1.20

Pears 1 lb. $0.90 1 lb. $0.50

Bananas 1 lb. $0.40 1 lb. $0.40


• Base Year– Nominal GDP = $10.00– Real GDP = $10.00

• Current Year– Nominal GDP = $13.10– Real GDP = $11.50

Nominal versus Real GDP


More on GDP• Intermediate goods

– are goods sold to a firm for use in further production

– are excluded from GDP

• Changes in inventories– are counted as part of investment

• Imputations– are made for goods and services not sold

through markets


Components of Real GDP (Y)

• Consumption (C)• Investment (I)

– residential structures– non-residential structures– producers’ durable equipment– changes in business inventories

• Government purchases (G)• Net exports (NX)

NXGICY


Table 2.8 - Components of GDP, Third Quarter of 2000


What Is and Is Not in GDP • Included in GDP (but should not be)

– replacement of worn-out or obsolete capital

– government purchases which could be counted as intermediate goods

• Not included in GDP (but should be)– household production– depletion of scarce natural resources– “bads”


Figure 2.9 - Labor Force Participation Ratesby Gender, 1948-1996


Chapter Summary• Because goods and services are bought

and sold with prices attached, economists have a lot of quantitative data to work with

• The real exchange rate is the relative price at which two countries’ goods exchange for each other– calculated by adjusting the nominal

exchange rate for changes in the price levels of the two countries


Chapter Summary• The level of the stock market reflects

the variables which affect investment– current profits– investors’ optimism or pessimism– the real rate of interest– attitudes toward risk

• The real interest rate is calculated by subtracting the inflation rate from nominal interests rates


Chapter Summary• The most-commonly seen measure of

the price level is the Consumer Price Index (CPI)– the inflation rate is the rate of change in

the CPI

• Unemployment and output are linked through Okun’s law– a 1 percentage-point decrease in the

unemployment rate leads to a 2.5 percent increase in output


Chapter Summary• Real GDP is the most commonly-seen

measure of the overall level of economic activity– calculated using prices from a base year

• What is and what is not included in GDP is the result of economists’ beliefs in the 1940s and 1950s about what would be possible to measure easily

copyright © 2002 by the mcgraw-hill companies, inc. all rights reserved. 2-1 chapter 2 measuring...

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