Chapter 2

The Expenditure and Income Component of GNP

Learning Objectives

• The concepts of the circular flow

• National income Accounting

• Computing GDP

a. Expenditure Method

b. Income Method

c. Output Method

• Nominal and Real GDP

2.1 National Income Accounting

Gross domestic product is often considered the best measure of how well the
economy is performing. The goal of GDP is to summarize in the money value of
economic activity in a given period of time. There are two ways to view this statistic.
One way to view,

1. GDP is as the total income of everyone in the economy.

2. GDP is as the total expenditure on the economy's output of goods and 2. services.

To understand the meaning of GDP more fully, we turn to national income

accounting, the accounting system used to measure GDP and many related statistics.
 Imagine an economy that produces single good, bread from a single input, labor.
Figure 2-1 illustrates all the economic transactions that occur between households
and firms in this economy. The inner loop in Figure 2-1 represents the flows of bread
and labor. The households sell their labor to the firms. The firms use the labor of their
workers to produce bread, which the firms in turn sell to the households.

Income

Labor

Households Firms

Goods (Breads)

Expenditures

Figure 2.1 The Circular Flow

Hence, labor flows from households to firms and bread flows from firms to
households.
The outer loop in Figure 2-1 represents the corresponding flow of money. The
households buy goods from the firms. The firms use some of the revenue from these
sales to pay the wages of their workers, and the remainder is the profit belonging to
the owners of the firms (who themselves are part of the household sector). Hence,
expenditure on bread flows from households to firms, and income in the form of
wages and profit flows from firms to households. GDP measures the flow of money in
this economy.
GDP can be computed in two ways. GDP is the total income from the production
of bread, which equals the sum of wages and profit-the top half of the circular flow
of money. GDP is also the total expenditure on purchases of bread-the bottom half of
the circular flow of money.

To compute GDP, we can look at either the flow of money from firms to
households or the flow of money from households to firms.

These two ways of computing GDP must be equal because the expenditure of
buyers on products is, by the rules of accounting, income to the sellers of those
products. Every transaction that affects expenditure must affect income, and every
transaction that affects income must affect expenditure. For example, suppose that s
firm produces and sells one more loaf of bread to a household.

Clearly this transaction raises total expenditure on bread, but it also has an equal
effect on total income. If the firm produces the extra loaf without hiring any more
labor (such as by making the production process more efficient), then profits
increases If the firm produces the extra loaf by hiring more labor, then wages increase.
In both cases, expenditure and income increase equally.

2.2 Rules for Computing GDP

In an economy that produces only bread, we can compute GDP by adding up the
total expenditure on bread. Real economies, however, include the production and
sale of a vast number of goods and services. To compute GDP for such a complex
economy, it will be helpful to have a more precise definition: gross domestic product
(GDP) is the market value of all final goods and services produced within an economy
in a given period of time.

Gross Domestic Product can be calculated in three different ways:

(1) as the sum of all values added by all producers of both intermediate and final
goods and services-output based;
(2) as the income claims generated by the total production of goods and services-
income-based;

(3) as the expenditure needed to purchase all final goods and services during the
period-expenditures-based.

By standard accounting conventions these three aggregations define the same

total, as long as we add taxes on products (minus subsidies) to the first two in order
to measure GDP at market prices. Market prices are the prices paid by consumers.

a. The Components of Expenditure

Economists and policymakers care not only about the economy's total output of
goods and services but also about the allocation of this output among alternative
uses. The national income accounts divide GDP into four broad categories of
spending:

• Consumption (C)

• Investment (1)

• Government purchases (G)

• Net exports (NX)

Thus, letting Y stands for GDP, Y = C+ I+ G +NX

GDP is the sum of consumption (C), Investment (I), government purchases (G)
and net exports (NX). Each dollar of GDP falls into one of these categories "This
equation is an identity - equations that must hold because of the way the variables
are defined. It is called the national income accounts identity

Consumption consists of the goods and services bought by households. It is divided

to three subcategories: nondurable goods, durable goods, and services. Nondurable
goods are goods that last only a short time, such as food and clothing. Durable goods
we goods that last a long time, such as cars and TVs. Services include the work done
for consumers by individual and firms, such as haircuts and doctor visits.

Investment consists of goods bought for future use. Investment is also divided into
three subcategories business fixed investment, residential fixed investment, and
inventory investment, Business fixed investment is the purchases of new plant and
equipment by firms. Residential investment is the purchases of new housing by
households and landlords. Inventory investment is the increase in firms’ inventories
of goods (if inventories are falling, inventory investment is negative).

Government purchases are the goods and services bought by federal, state, and
local governments. This category includes such item as military equipment, highways
and de services that government workers provide. It does not include transfer
payments to Individuals such as social security and welfare. Because transfer
payments reallocate rusting income and are not made in exchange for goods and
services, they are not part of GDP.

Net esports take into account trade with other countries. Net exports are the value
of goods and services exported to other countries minus the value of goods and
services that foreigners provide us. Net exports represent the net expenditure from
abroad on our goods and services, which provides income for domestic producers.

b. Other Measures of Income (Income Method)

The national income accounts include other measures of income that differ slightly
in definition from GDP. It is important to be aware of the various measures.
 To obtain gross national product (GNP), we add receipts of factor income (wag
profit, and rent) from the rest of the world and subtract payments of factor income
the rest of the world.

GNP = GDP + Factor Payments from Abroad - Factor Payments to Abroad

Whereas GDP measures the total income produced domestically, OND measures
the total income earned by nationals (residents of a nation). For instance, if a
Japanese resident owns an apartment building In New York, the rental income he
earns is part of US. GDP because it is earned in the United States. But because this
rental income is a factor payment to abroad, it is not part of U.S. GNP. In the United
States, factor payments from abroad and factor payments to abroad are similar in
size each representing about 3 percent of GDP- so GDP and GNP are quite close.

To obtain net national product (NNP), we subtract the depreciation of capital the
amount of the economy's stock of plants, equipment, and residential structures that
wears out during the year.

NNP = GNP - Depreciation

In the national income accounts, depreciation is called the consumption of fixed

capital It equals about 10 percent of GNP. Because the depreciation of capital is a
cost of producing the output of the economy, subtracting depreciation shows the net
result of economic activity. The next adjustment in the national income accounts is
for indirect business taxes, such as sales taxes. These taxes, which make up about 10
percent of NNP, place a wedge between the price that consumers pay for a good and
the price that firms receive. Because firms never receive this tax wedge, it is not part
of their income. Once we subtract indirect business taxes from NNP, we obtain a
measure called national income.

National Income = NNP - Indirect Business Taxes.

 National income measures how much everyone in the economy has earned. The
national income accounts divide national income into five components, depending
on the way the income is earned. The five categories, and the percentage of national
paid in each category are:

• Compensation of employees (70%): The wages and fringe benefits earned by

workers

• Proprietors income (9%). The income of no corporate businesses, such as small

farms, mom-and-pop stores and law partnerships.

• Rental income (2%): The income that landlord receive including the imputed rent
that homeowners "pay" to themselves, less expenses such as depreciation.

• Corporate profit (12%): The income of corporations after payments to their workers
and creditors:

• Net Interest (7%): The interest domestic businesses pay minus the interest they
receive, plus interest earned from foreigners.

A series of adjustments takes us from national income to personal income, the

amount of income that households and no corporate businesses receive. Three of
these adjustments are most important. First, we reduce national income by the
amount that corporations earn but do not pay out, either because the corporations
are retaining earnings or because they are paying taxes to the government. This
adjustment is made by subtracting corporate profits (which equals the sum of
corporate taxes, dividends and retained earnings) and adding back dividends.
Second, we increase national income by the net amount the government pays out in
transfer payments. This adjustment equals government transfers to individuals minus
social insurance contributions paid to the government. Third, we adjust national
income to include the interest that households earn rather than the interest that
businesses pay. This adjustment is made by adding personal interest income and
subtracting net interest (The difference between personal interest and net interest
arises in part from the interest on the government debt.

Thus, personal income is Personal Income National Income - corporate Profits -

Social Insurance Contributions - Net Interest Dividends + Government Transfers to
Individuals + Personal Interest Income.

Next, if we subtract personal tax payments and certain no-tax payments to the
government (such as parking tickets), we obtain disposable personal income:
Disposable Personal Income = Personal Income - Personal Tax and Non-tax Payments

Economists are interested in disposable personal income because it is the amount

households and non-corporate businesses have available to spend after satisfying
their tax obligations to the government.

c. Output Method

GNP can also be computed by adding up production of goods and services in

different industries. As we observe on the spending side, we must avoid counting the
same items more than once. Many industries specialize in the production of
intermediate goods that are used in the production of other goods. If we want each
Industry's production to include the contribution of those industries to total GNP,
then we want to take the production of intermediate goods into account.

The concept of value added was developed to prevent double counting and to
attribute to each industry a part of the GNP. The value added by a firm is the
difference between the revenue the firm earns by selling its products and the amount
it pays for the products of other firms it uses as intermediate goods. It is a measure
of the value that is added to each product by firms at each stage of production.
 For General Motors, for example, value added is the revenue from selling cars less
the amount it pays for steel glass and the other inputs it buys.

For a car dealer, value added is the revenue from selling cars less the wholesale
cost of the cars. The value added to a car by a car dealer takes the form of a
convenient showroom, sample selection, advice and final preparation and resting.
The car dealer produces these services by hiring sales people and car mechanics,
renting showroom and garage spaces, borrowing money to hold a big inventory of
cars and keeping the profits. Wages, rents, interest and profits are thus what make
up value added at each firm.

GNP is the sum of the vague added by all the firms in a country. If a firm sells a
final product, the sale appears in that firm's value added but does not appear
anywhere else. On the other hand, if a firm sells its output as an input for another
firm, that sale appears negatively in the other firm's value added. Products sold by
one firm to another are called intermediate products. When the two firms are added
together in the process of computing GNP, sales of intermediate products wash out.
When a firm imports a product, the transaction appears positively in the value added
of any other firm in that country.

A breakdown of real GNP of US in terms of the value added by various industries

is given in Table for 1985. These figures tell some interesting stories about the modern
US economy. We tend to think of the economy as producing goods- cars, machines,
and paper clips and so on but the sector that produces the most goods,
manufacturing, contributes only one fourth of GNP. The wholesale and retail trade
sector, whose only function is to take produced goods and make them available to
the public, is almost as large as the manufacturing sector. The finance, insurance and
real estate sector is another large one.
 Table
Valure Added by Industry in 1985 (billions of dollars)
Gross national product 4014.9
Gross domestic product 3974.2
Agriculture 92.0
Mining 114.2
Construction 186.6
Manufacturing 789.5
Transportation and utilities 374.1
Whole sale and retail estate 658.2
Finance, insurance and real estate 639.5
Services 648.1
Government 476.7
Statistical discrepancy -4.8
Rest of the world 40.7
Source: Economic report of the President, 1987

Near the bottom of the list is a small item called statistical discrepancy though the
value-added computation of GNP should give the same answer as total spending, in
practice there are measurement errors that cause a slight discrepancy between the
two.

One of the items in the list of the value added by industry is something called of
the world. How does the rest of the world figure in the computation of US GNP, which
is a national concept? The answer is that Americans contribute productive services to
other economies. They work overseas, and they own capital sed in other countries.
The earnings of this type are counted as exports and the corresponding value added
is assigned to the sector called the rest of the world. The result of including this item
in GNP is to make GNP a measure of the output produced by American-owned factors
of production including factors they are actually used overseas.

There is another concept, called gross domestic product (GDP), which omits net
earnings from the rest of the world GDP measures the output produced by factors in
the United States. While the distinction between and GDP is small for the United
States, it is large for some other countries. They typically use GDP to measure
production.

The national income of a country can be calculated according to the output

method by adding together the values of the net outputs or product, of its economics
sectors, Myanmar.

For example, have thirteen economic sectors, each with its own product value
(obtained by subtracting the value of each sector's raw materials or inter-industry
use value from the sector's output). The additional of these thirteen- value added will
yield the GDP of Myanmar.

Since the product that has worn out and is obsolete should not be included in
estimating actual income, this depreciation in product valued must be subtracted
from the GDP, giving us the Net domestic product. Again, however, the difference
between exports and imports(X-M) must be added to or subtracted from the NDP to
bring us closer to the value of the Net National Product. Finally, we must add the
negative value of NIPA or subtract its positive value to get the NNP or Net National
Product.

2.3 Nominal and Real GDP

 GDP valued at current prices is a nominal measure. GDP valued at base- period
prices is a real measure of the volume of national output and income.

Nominal GDP measures the dollar value of all the goods and services that an
economy produces during a specified time period. In 2000, for example, the nominal
GDP in the United States was $19876 billion. The word nominal means that the GDP
is measured in units of currency, such as pounds, marks, yen, kyat and so on.

ASE Economists construct a measure of real GDP to solve the problem of changing
price levels. Until recently, the most common way to compute real GDP was to
multiply the current quantity of output of each good by the price of that good in a
base year. Then all of these multiples were summed up to get the economy's
aggregate real GDP Because the prices used in the calculation of real GDP do not vary
from year to year, the method just described yields a reasonable measure for the
changes over time in the overall level of production. One problem with this approach,
however, is that it weights the outputs of various goods by their relative prices in the
base year. These weights become less relevant over time as relative prices change.
and the response of the Bureau of Economic Analysis had been to make frequent
shifts in the base year used to calculate real GDP.

Summary

1. There are two ways to view this statistic. One way to view GDP is as the total income
of everyone in the economy Another way to view GDP is as the total expenditure on
the economy's output of goods and services

2. Gross Domestic Product (GDP) can be calculated in three different ways:

(a) as the sum of all values added by all producers of both intermediate and final
goods and services-output based:

(b) as the income claims generated by the total production of goods and services-
income-based;

(e) as the expenditure needed to purchase all final goods and services during the
period-expenditures-based.

3. The national income accounts divide GDP into four broad categories of spending

• Consumption (C)

• Investment (1)

• Government purchases (G)

• Net exports (NX)

4. Personal Income = National Income - Corporate Profit s- Social Insurance

Contributions -Net Interest + Dividends + Government Transfers to Individuals +
Personal Interest Income.

5. GDP valued at current prices is a nominal measure. GDP valued at base-period

prices is a real measure of the volume of national output and income.

6. Nominal GDP measures the dollar value of all the goods and services that an
economy produces during a specified time period.

7. The national income of a country can be calculated according to the output method
by adding together the values of the net outputs or product, of its economic sectors,
Myanmar.
 For example, have thirteen economic sectors, each with its own product value
(obtained by subtracting the value of each sector's raw materials or inter-industry
use value from the sector's output). The additional of these thirteen - value added
will yield the GDP of Myanmar

Key Terms

Gross Domestic Product Personal income

Gross National Product Depreciation

Consumption Net national product

Investment Business tax

Government Purchase Net interest

Net export Real GDP

Compensation Expenditure

Questions for Discussion and Exercises

1. How can we measure our nation's economic performance?

2. Explain the expenditure approach to measuring GDP.

3. How do we compute GDP using the income approach?

4. How is personal income different from national income?

 Chapter 3

Fluctuation in Real GNP

Learning Objectives

• The concepts of business cycles

• The phase of the business cycles

1.1 Business Cycles

Like People, the economy has moods. Sometimes it's in wonderful shape-it's
expansive, at other times, it's depressed. The economy's moods are associated with
various problems. Macroeconomies is the study of the aggregate moods of the
economy, specific focus on the problems associate with those moods-the problems
of growth, business cycles, unemployment, and inflation. These four problems are the
central concern of the macroeconomics.

In analyzing macroeconomic problems economists generally use two frameworks a

short- run and a long-run framework. Issues of the growth are generally considered
in a long-run framework. Business cycles are generally considered in a short-run
framework.

What is difference between the two frameworks? The long run growth framework
focuses on supply because supply is so important in the long run, policies that affect
production-such as incentives that promote work, capital accumulation, and
technological change-are key. The short run business cycle framework focuses on
demand. Much of the policy discussion short run business cycles focus on ways to
increase or decrease components of aggregate expenditures such as policies to get
consumers and businesses to increase their spending
 The term business cycle or economic cycle refers to the fluctuations of economic
activity (business fluctuations) around its long-term growth trend. The cycle involves
shifts over time between periods of relatively rapid growth of output (recovery and
prosperity), and periods of relative stagnation or decline (contraction or recession).
These fluctuations are often measured using the real gross domestic product. Despite
being termed cycles, these fluctuations in economic growth and decline do not follow
a purely mechanical or predictable periodic pattern. While the secular, or long terms
trend is a 2.5 to 3.5 percent increase in ODP, here numerous fluctuations around that
trend. Sometimes real GDP is above the trend other times GDP is below the trend.
This phenomenon has given rise to term business cycle. A business cycle is the
upward or downward movement of economic actions that occurs around the growth
trend.

One way of defining the business cycle is that it is the fluctuations in output
around its trend. The production function tells us that for a given level of capital.
labor and technology, a certain amount of output can be produced. This is what we
have referred to as the trend level of output. However, at any point in time, output
does not have to equal its trend value Firms can always produce less output if they
da not work at full capacity or if they do not work their labor forces at full efficiency
during its working shift. Therefore, output can always be below this trend level. But
output can also exceed the trend level predicted by the production function. For
instance, workers can be persuaded to work overtime for short periods and machines
can be utilized at more than full capacity during intense periods of production, Firms
cannot maintain these high levels of indefinitely eventually the workforce needs a
rest, and if machines are used too intensively they will break down and there will be
stoppages. However, for short periods, this intensive use of factors of production
enables output to be above its trend These fluctuations of output above and below
the trend level provide one definition of the business cycle. When output is above
trend, the economy is in the boom phase of the cycle, and when it is significantly
below trend, the economy is in recession.

Until the late 1930s, economists took such cycles as facts of life. They had no
convincing theory to explain why business occurred, nor did they have policy
suggestions to smooth them out. In fact, they felt that any attempt to smooth them
through government intervention would make the situation worse.

Since the 1940s, however, many economists have not taken business cycles as
facts of life. They have hotly debated the nature and causes of business cycles and of
the underlying growth. Classical economists argue that fluctuations in economic
activity are to be expected in a market economy. Indeed, they say, it would be strange
if fluctuations did not occur when individuals are free to decide what they want to do
People should simply accept these fluctuations. Keynesian economists argue that
fluctuations can and should be controlled. They argue that expansions (the part of
the business cycle above the long-term trend) and contractions (the part of the cycle

Below the long term) are symptoms of underlying problems of the economy, which
should be dealt with government actions: Classical economists respond that
individuals will anticipate government's reaction, thereby undermining government's
attempts to control cycles. Which of these two views is correct is still a matter of
debate.

3.2 The Phase of the business cycles

Business cycles have varying durations and intensities, but economists have
developed in terminology to describe all business cycles and just about any position
on given business cycle, Figure 3.1 gives a visual representation of a business cycle.
 The top of a cycle is called the peak. A boom is a very high peak, representing a
big jump in output. That is when the economy is doing great. Most everyone who
wants a job has one. Eventually an expansion peak.

A downturn describes the phenomenon of economic activity starting to fall ma

peak. In a recession the economy isn't doing so great and many people are
unemployed. A recession is generally considered to be a decline in real output that
persists for more than two consecutive quarters of a year.

A depression is a large recession. There is no formal line indicating when a

recession becomes a depression. In general, a depression is much longer and more
severe than a recession. If unemployment exceeds 12 percent for more than a year,
the economy is in a depression.

The bottom of a recession or depression is called the trough. As total output begins
to expand, the economy comes out of the trough; in an upturn, which may turn into
an expansion-an upturn those last at least two consecutive quarters of a year. An
expansion leads economy back up to the peak.
 This terminology is important because if you are going to talk about the state of
the economy Businesses are so interested in the state of the economy because they
want to be able to predict whether it's going into a contraction or an expansion
Making the right prediction can determine whether the business will be profitable or
not.

3.3 Leading Indicators

Economist have developed a set of signs that indicate when a recession is about
to occur and when the economy is in one. These signs are called leading indicators -
indicators that tell what's likely to happen 12 to 15 months from now. They include:

1. Average workweek for production workers in manufacturing

2. Average weekly claims for unemployment insurance.

3. Manufacturers' new orders for consumer goods and materials.

4. Vendor performance, measured as a percentage of companies reporting slower

deliveries from suppliers

5. Index of consumer expectations.

6. New orders for non - defense capital goods.

7. Number of new building permits issued for private housing units.

8. Stock prices-500 common stocks.

9. Interest rate spread - 10 years government bond less central bank rate.

10. Money supply, M2

 Economists use leading indicators in making forecasts about the economy. They
are called indicators, not predictors, because they are only rough approximations of
what's likely to happen in the future.

Summary

1 The term business cycle or economic cycle refers to the fluctuations of simi activity
(business fluctuations around its long-term cycle is the ward or downward movement
of economic activity A wound the growth trend

2 The top of a cycle is called the peak. A boom is a very high peak presenting a big
jump in output That is when the economy is doing great. Most everyone who wants
a job has one. Eventually an expansion peaks.

A downturn describes the phenomenon of economic activity starting to fall from a

peak in a recession the economy isn't doing so great and many people are employed.
A recession is generally considered to be a decline in real output that persists for
more than two consecutive quarters of a year

4 A depression is a large recession. There is no formal line indicating when a muesion

becomes a depression. In general, a depression is much longer and more severe than
a recession. If unemployment exceeds 12 percent for more than a year, the economy
is in a depression.

The bottom of a recession or depression is called the trough. As total output regions
to expand, the economy comes out of the trough; economists say it's in an upturn,
which may turn into an expansion-an upturn those last at least two consecutive
quarters of a year. An expansion leads economy back up to the peak
Key Terms

Business cycle fluctuation

Peak boom

Recession depression

Trough economic activity

Expansion

Questions for Discussion and Exercises

1. What are the four stages of business cycles? Explain.

2. Write on the following terms

(a)Recession

(b)Business cycle
 Chapter 4

Aggregate demand and supply

Learning Objectives

* Definition of Aggregate Demand

* Definition of Aggregate Supply

* Market Equilibrium

* Market Failure

* Shift Factors of demand and supply curves

4.1 Aggregate demand

The total quantity of output demanded at alternative price levels in a given time
period, ceteris paribus. Economists use the term "aggregate demand" to refer to the
collective behaviors of all buyers in the market place. Specially, aggregate demand
refers to the various quantities of output that all market participants are willing and
able to buy at alternative price levels in a given period. The view here encompasses
the collective demand for all goods and services, rather than the demand for any
single good.

With their income in hand, people then enter the product market. If goods and
services are cheap, people will be able to buy more with their given income. High
price will limit both the ability and willingness to purchase goods and services. Note
that we are here talking about average price level not the price of any single good.
 This simple relationship between average prices and real spending is illustrated
in figure 4.1. The various quantities of output (Real GDP) that might be purchased are
depicted on the horizontal axis. It is referring to real GDP, an inflation- adjusted
measure of physical output. Prices levels are measured on the vertical axis. Specially,
Figure 4.1 depicts alternative levels of average prices.

The aggregate demand curve in figure 4.1 has familiar shape. The aggregate
demand curve illustrates how the volume of purchases varies with average price. The
downward slope of the aggregate demand curve suggests that with a given (constant)
level of income, people will buy more goods and services at lower prices. The curve
doesn't tell which goods and services people will buy, it is simply indicates the total
volume (quantity) of their intended purchases.

A downward-sloping demand curve requires a distinctly macro explanation.

That explanation includes three separate phenomena:
 a. Real balances effect: The primary explanation for the downward slope of the
aggregate demand curve is that cheaper prices make dollars more valuable. That is
to say, the real value of the money is measured by how many goods and services
each dollar will buy. In this report, lower price makes you richer. the cash balances
you hold in your pocket, in your bank account are worth more the price levels fall.

When their real incomes and wealth increase because of a decline in the price
level, consumers respond by buying more goods and services. They end up saving
less of their incomes and spending more. This causes the aggregate demand curve to
slope downward to the right.

b. Foreign- trade effect: The downward slope of the aggregate demand curve is
reinforced by changes in imports and exports. When Myanmar- made products
become cheaper, Myanmar consumers will buy fewer imports and more domestic
output. Foreigners will also step up their purchases of the Myanmar- made goods
when prices are falling in Myanmar.

The opposite is true as well. When domestic price level rises, Myanmar consumers
are likely to buy more imports. At the same time, foreign consumers may cut back on
their purchases of Myanmar-made products.

c. Interest-rate effect: Changes in the price level also affect the amount of money
people need to borrow, and so tend to affect interest rates. At lower price levels,
consumer borrowing needs are smaller. As the demand for loans diminishes, interest
rates tend to declines as well. This cheaper money stimulates more borrowing and
loan-financed purchases. The combined forces of the real-balances, foreign-trade,
and interest-rate effects give the aggregate demand curve its downward slope. People
buy a larger volume of output when the price level falls (ceteris paribus).

4.2 Aggregate Supply

 The total quantity supplied of output producers are willing and able to supply
alternative price levels in a given time period, (ceteris paribus).

While lower price levels tend to increase the volume of output demanded, they
have the opposite effect on the aggregate quantity supplied.

Profit Margins. If the price level falls, producers as a group are being squeezed. In the
short run, producers are saddled with some relatively constant costs like rent, interest
payments, negotiated wages and inputs already contracted for. If output prices fall.
producers will be hard-pressed to pay these costs, much less earn a profit. Their
response will be to reduce the rate of output.

Rising output price have the opposite effect. Because many costs are relatively
constant in the short run, higher prices for goods and services tend to widen profit
margins. As profit margin widen, producers will want to produce and sell more goods.
Thus, we expect the rate output to increase when the price level rises. This
expectation is reflected in the upward slope of the aggregate supply curve in Figure
4.2. Aggregate supply reflects the various quantities of real output that firms are
willing and able to produce at alternative price level, in a given time period.

Cost: The upward slope of the aggregate supply curve is also explained by rising costs.
To increase the rate of output, producers must acquire more resources (e.g Labor)
and use existing plant and equipment more intensively. These greater strains on
productive capacity tend to raise production costs. Producers must therefore charge

higher prices to recover the higher costs that accompany increased capacity
utilization.

Cost pressures tend to intensify as capacity is approached. If there is a lot of

excess capacity, output can be increased with little cost pressure. Hence, the lower
end of aggregate supply (AS) curve is fairly flat. Producers may have to pay over- time
wages, raise base wages, and pay premium prices to get needed inputs. This is
reflected in the steepening slope of the AS curve at higher output levels.

4.3 Macro Equilibrium

Macro equilibrium is the combination of price level and real output that is
compatible with both aggregate demand and aggregate supply.
 In Figure 4.3, Instead of describing the behavior of buyers and sellers in a single
market, aggregate supply and demand curves summarize the market activity of het
whole (macro) economy. These curves tell what total amount of goods and services
will be supplied of demanded at various prices levels.

The aggregate demand and supply curves intersect at only one point (E). At that
point, the price level (PE) and output (QE) combination is compatible with both
buyers' and sellers' intention. The economy will gravitate to those equilibrium price
(PE) and output (QE) levels. We call this situation macro equilibrium-the unique
combination of price level and output that is compatible with both buyers' and
sellers' intention.

At any other price level, the behavior of buyers and sellers is incompatibles.
Suppose that the price level is P., People would want to buy only the quantity D, at
the higher price level P₁. In contract, business firms would want to sell a larger
quantity S₁. This is a disequilibrium situation. Accordingly, a lot of goods will remain
unsold at price level P₁.

To sell these goods, producers will have to reduce their prices. As prices drop.
producers will decrease the volume of goods sent to market. At the same time, the
quantities that consumers seek will increase. This adjustment process will continue
until point E is reached and the quantities demanded and supplied are equal. At that
point, the lower price level PE will prevail. The same kind of adjustment process
would occur if a lower level first existed.

Equilibrium is unique; it is the only price-output combination that mutually

compatible with aggregate supply and demand.

4.4 Macro Failure

There are two potential problems with the macro equilibrium depicted in Figure 4.3.
Undesirability: The price-output relationship at equilibrium may not satisfy
macroeconomic goals.

If full-employment output is QF that is society's full-employment goals, at the

equilibrium point E in figure 4.3. The economy is not fully utilizing its production
possibilities. The short fall in equilibrium output implies that the economy will be
burdened with cyclical unemployment. Full employment is attained only if we
produce at QF. Some workers can't find Jobs.

Similar problems may arise with the equilibrium price level. Suppose that p
represents the most desired price level. In figure, the equilibrium price level P e
exceeds P. If a market behavior determines prices, the price level rises above the
desired level. The resulting increase in average prices is what we call inflation.

Instability: Even if the designated macro equilibrium is optimal, it may be displaced

by macro disturbances. Suppose that the macro equilibrium yielded the optimal
levels of employment and prices (see figure 4.4). However, this equilibrium doesn't
ensure because the aggregate demand and supply curve are not necessarily
permanent. They can shift and they will, whenever the behaviors of buyers and sellers
change.
 Figure 4.4b Demand Shift
Price level
(average price)
AS1

P* E
H
P2 AD1

AD2
Q2 QF
0 Real Output (quantity per year)

For example, when US invaded Iraq in March 2003, the price of oil shot up. This oil
price hike directly increased the cost of production. Thus, the aggregate supply curve
shifted to the left, in Figure 4.4a. The impact of a leftward supply shift on the economy
is evident. The new equilibrium was located at point G. At point G. less output was
produced and prices were higher. Full employment and price stability vanished. This
is the kind of the "external shock" that can destabilize any economy.

A shift of the AD curve could do similar damage. Suppose stock plunged tomorrow.
Consumers might decide to save more and spend less as seeing their accumulated
wealth vanish. At any price level, fewer goods and services would be demanded. This
change in consumer behavior would be reflected in a leftward shift of the aggregate
demand curve, as in Figure 4.46. The resulting disturbance would knock the economy
out of its equilibrium at point E, leaving us at point H with less output.
4.5 Shift Factors

Demand shift- The aggregate demand curve might shift, for example, if consumer
sentiment changed. A stock market plunge might shatter consumer confidence,
causing consumers to pare their spending plans. A tax high might have a similar effect.
Higher taxes reduce disposable incomes, forcing consumers to cut back spending.
Higher interest rates make credit-financed spending more expensive and so might
also reduce aggregate demand. These shifts made it difficult to reach or maintain full
employment.

Supply shift. External forces may also shift aggregate supply. Rising world oil prices
are making producers less willing to supply output at given price level. Higher
business taxes could also discourage production, thereby shifting the aggregate
supply curve to the left. Tougher environmental or workplace regulations could also
raise the cost of doing business, inducing less supply at a given price level. On the
other hand, more liberal immigration rules might increase the supply of labor and
increase the supply of goods and services. (a rightward shift).

Summary

1.The total quantity of output demanded at alternative price levels in a given time
period, ceteris paribus, aggregate demand refers to the various quantities of output
that all market participants are willing and able to buy at alternative price levels in a
given period.

2. Real balances effect: The primary explanation for the downward slope of the
aggregate demand curve is that cheaper prices make dollars more valuable.

3. Foreign trade effect: The downward slope of the aggregate demand curve is
reinforced by changes in imports and exports.
4. Interest-rate effect: Changes in the price level also affect the amount of money
people need to borrow: and so, tend to affect interest rates.

5 The total quantity supplied of output producers are willing and able to supply at
alternative price levels in a given time period. (ceteris paribus).

6. Aggregate supply reflects the various quantities of real output that firms are willing
and able to produce at alternative price level in a given time period.

7 Macro equilibrium is the combination of price level and real output that is
compatible with both aggregate demand and aggregate supply.

8. Demand shift- The aggregate demand curve might shift, for example if consumer
sentiment changed.

- A stock market plunge might shatter consumer confidence, causing consumers

to pare their spending plans.
- Higher taxes reduce disposable incomes, forcing consumers to cut back
spending
- Higher interest rates make credit-financed spending more expensive and so
might also reduce aggregate demand.

9. Supply shift- External forces may also shift aggregate supply.

- Rising world oil prices are making producers less willing to supply output at given
price level.

- Higher business taxes could also discourage production, thereby shifting the
aggregate supply curve to the left.

10. Tougher environmental or workplace regulations could also raise the cost of doing
business, inducing less supply at a given price level.
11. More liberal immigration rules might increase the supply of labor and increase the
supply of goods and services. (a rightward shift).

Key Terms

Aggregate Demand Real balance effect

Equilibrium Aggregate Supply

Interest rate effect Foreign- trade effect

Real output

Questions for Discussion and Exercises

1. Why is the aggregate demand curve downward sloping? Explain.

2. Why is the aggregate supply curve positively slope? Explain.

3. Explain the shift factor of AD and AS.

4. How is the macroeconomic equilibrium determined?

 Chapter 5

Unemployment

Learning Objectives

• Definition of Labour force

• Unemployment rate
• Types of unemployment
• The policy goals

5.1 The Labour Force

The labour force consists of everyone over the age of 16 who is actually working plus
all those who are not working but are actively seeking employment. As figure shows, only
half of the population participates in the labour market. The rest of the population (non-
participants) are too young, in school, retired, sick or disabled, institutionalized, or taking
care of household needs.

Total Population

Under 16 Homemakers Unemployed

In school

Retired Labour Force

Institutionalized

Others Employed

Figure 5.1 Total Population and Labour Force

 Note that definition of labour force participation excludes most household and
volunteer activities. A woman who chooses to devote her energies to household
responsibilities or unpaid charity work is not counted as part of the labour force, no
matter how hard she works. Because she is neither in paid employment nor seeking such
employment in the market place, she is regard as outside the labour market (a non-
participant). But if she decides to seek a paid job outside the home and engages in an
active job search, we would say that she is "entering labour force" Students, too. are
typically out of the labour force until they leave school and actively look for work. either
during summer vacation or after graduation.

5.2 The Unemployment Rate

Unemployment rate is the proportion of the labour force that is unemployed. To

access how well labour force participants are faring in the macro economy, we compute
the unemployment rates as:

Number of unemployed people

Unemployment rate =

Size of the labour force

Unemployment rate: The proportion of the labour force that is unemployed.

The Natural rate of unemployment is the percentage of the labour force that can
normally be expected to be unemployed for reasons other than cyclical fluctuations. In
other words, the natural rate of unemployment rate is the sum of seasonal, frictional and
structural unemployment expected over the year. When the actual rate of unemployment
is less than the natural rate of unemployment, the economy operates at full employment.
The natural rate of unemployment is the unemployment that occurs as a normal part of
the functioning of the economy. To be counted as unemployed, a person must not only
be jobless but also actively looking for work.

5.3 Types of Unemployment

Seasonal Unemployment: Seasonal variation in employment conditions are a persistent

and inevitable source of unemployment. Some Joblessness is inevitable as long as we
continue to grow crops, build house, or go skiing at certain seasons of the year. At the
end of these seasons, thousands of workers must go searching for new jobs, experiencing
some seasonal unemployment in the process.

Frictional Unemployment: are other reasons for prescribing some amount of

unemployment. Many workers have sound financial or personal reasons for leaving one
job to look for another. In the process of moving from one job to another, a person may
well miss a few days or even weeks of work without any serious personal or social
consequences. On the contrary, people who spend more time looking for work may find
better jobs.

The same is true of students first entering the labour market. If you spend some time
looking for work, you are more likely to find a job you like. The jobs are available, hat
skills they require and what they pay. Accordingly, a brief period of job search for persons
entering the labour market may benefit both individual involved and larger economy.
The unemployment associated with this kind of job search is referred to as frictional
unemployment.

Frictional unemployment: unemployment caused by new entrants into the job market
and people quitting a job just long enough to look for and find another one.

Structural Unemployment: For many job seekers, the period between jobs may drag on
for months or even years because they do not have the skills that employers require. In
early 1980s, the steel and auto industries downsized, eliminating over half a million jobs
in US. The displaced workers had years of work experiences. But their specific skills were
no longer in demand. They were structurally unemployed. High school dropouts suffer
similar problems. They simply don't have the skill that today's jobs require. When such
structural unemployment exists, more job creation alone won't necessarily reduce
unemployment. On contrary, more job demand might simply push wages higher for
skilled workers, leaving unskilled workers unemployed. Structural Unemployment:
unemployment cause by the institutional structure of an economy or by economic
restructuring making some skills obsolete.

Cyclical Unemployment. Cyclical Unemployment refers to the joblessness that occurs

when there simply not enough jobs to go around. Cyclical unemployment exists when
the number of workers demand falls short of the number of persons in the labour force.
This is not a case of mobility between jobs or even of job seekers' skills. Rather, it is
simply an inadequate level of demand for goods and services and thus for labour. Cyclical
Unemployment: unemployment resulting from fluctuation in economic activity.

5.4 The Policy Goal

We have seen that zero unemployment is not an appropriate goal. However, there is
no total agreement about the level of unemployment that constitutes full employment.
Most macro economists agree, however, that the optimal unemployment rate lies some
- where between 4 and 6 percent.

Full employment: the lowest rate of unemployment compatible with price stability:
variously estimated at between 4 and 6 percent unemployment.

Unemployment, GDP and Okun's Law

What relationship should we except to find between unemployment and real GDP?
Because employed workers help to produce goods and services unemployed workers do
not, increases in the unemployment rate should be associated with decrease in real GDP.
This negative relationship between unemployment and GDP is called Okun's law, after
Arthur Okun, the economist who first studied it. The magnitude of the Okun's law
relationship tells us that

Percentage Change in Real GDP = 3% - 2 x Change in the Unemployment Rate.

If the unemployment rate remains the same, real GDP grows by about 3 percent; this
normal growth in the production of goods and services is a result of growth in the labor
force, capital accumulation, and technological progress, in addition, for every percentage
point the unemployment rate rises, real GDP growth typically falls by 2 percent. Hence,
if the unemployment rate rises from 6 to 8 percent. then real GDP growth would be

Percentage Change in Real GDP = 3% -2 x (8% - 6%) = -1%

In this case, Okun's law says that GDP would fall by 1 percent, indicating that the
economy is in a recession.

Summary

1.The labour force consists of everyone over the age of 16 who is actually working plus
all those who are not working but are actively seeking employment

2. Unemployment rate: The proportion of the labour force that is unemployed

3. Seasonal Unemployment: Seasonal variation in employment conditions are a

persistent and inevitable source of unemployment.

4. Frictional unemployment: unemployment caused by new entrants into the job market
and people quitting a job just long enough to look for and find another one. 5. Structural
Unemployment: unemployment cause by the institutional structure of an economy or by
economic restructuring making some skills obsolete.
6. Cyclical Unemployment: unemployment resulting from fluctuation in economic
activity.

7. The Natural rate of unemployment is the percentage of the labour force that can
normally be expected to be unemployed for reasons other than cyclical fluctuations. The
natural rate of unemployment rate is the sum of seasonal, frictional and structural
unemployment expected over the year.

8. When the actual rate of unemployment is less than the natural rate of unemployment,
the economy operates at full employment.

9. The natural rate of unemployment is the unemployment that occurs as a normal part
of the functioning of the economy.

Key Terms

Labour force Employment

Full employment Seasonal unemployment

Frictional unemployment Structural unemployment

Cyclical unemployment The natural rate of unemployment

Questions for Discussion and Exercises

1. Mention the types of unemployment and explain any two of them.

2. Define the following terms

(a) Seasonal unemployment

(b)Frictional unemployment

(c) Structural unemployment

(d) Cyclical unemployment

3. Define the labour force and how to calculate the unemployment rate.

4. How do you understand the natural rate of unemployment?

 Chapter 6

Economic Growth and Its Sources

Learning Objectives

• Definition of growth
• The sources of growth

a. Capital accumulation

b. Available resources

c. Compatible institutions

d. Technological development

e. Entrepreneurship

6.1 Growth and the Economy's Potential Output

Economists use changes in real GNP- the market value of final goods and services
produced in an economy, stated in the prices of a given year-as the primary
measurement of the growth. When people produce and sell their goods, they earn
income, so when an economy is growing: both total output and total income are
increasing. Such growth gives most people more this year than they had last year.

Growth is an increase in the amount of goods and services an economy produces.

Growth is an increase in potential output the highest amount of output an economy can
produce from the existing production function and the existing resources

To take into account population growth in economic growth, another measure of

growth change in per capita real output is used. Per capita real output is real GDP divided
by the total population. Output per person is an important measure of growth because,
while total output may be increasing, the population could be growing so fast that per
capita real output is falling.

In the long run, economists consider an economy's potential output changeable.

Growth analysis is a consideration of why an economy's potential shifts out, and growth
policy is aimed at increasing an economy's potential output

6.2 The Sources of Growth

Economists have determined five important sources of growth.

1. Capital accumulation-investment in productive capacity

2. Available resources

3. Growth-compatible institutions

4. Technological development

5. Entrepreneurship

a. Investment and Accumulation of Capital

As one point, capital accumulation (where capital was thought of as just physical
capital) and investment were seen as the key elements in growth. Physical capital
includes both private capital- buildings and machines available for production and public
capital- infrastructure such as highways and water supply. The flow of investment leads
to the growth of stock of capital While physical capital is mill considered a key clement
in growth, it is now generally recognized that the growth recipe is far more complicated
One of the reasons for de-emphasis on capital accumulation is that empirical evidence
has suggested that capital accumulation doesn't necessarily lead to growth. Another
reason is that products change, and buildings and machines useful in one time period
may be useless in another (eg a sis -year-old computer often is worthless). The value of
the capital stock depends on its future expected earnings, which are very uncertain.
Capital's role in growth a extraordinarily difficult to measure with accuracy.

A third reason is that it has become clear that capital includes much more than
machines. In addition to physical capital, modern economics includes human capital (the
skills that are embodied in workers through experience, education and on the job
training or more simply, people's knowledge) and social capital (the habitual way of
doing things that guides people in how they approach production) as types of capital.
The importance of human capital is obvious: A skilled labour force is far more productive
than an unskilled labour force. Social capital is embodied in institutions such as the
government, the legal system, and the fabric of society, despite this modern de-emphasis
on investment and physical capital, all economists agree the right kind of investment at
the right time is central element of growth. If an economy is to grow it must invest. The
debate is about what kinds and what times arte the right ones.

b. Available Resources

If an economy is to grow it will need resources. The United States grew in the 20th
century because it had a major supply of many natural resources, and it imported people,
a resource it needed. However, resources in one time period may not be a resource in
another. For example, at one time oil was simply black gooey stuff that made land
unusable. When people learned that the black gooey stuff could be burned as fuel, oil
became a resource. What's considered a source depends on technology. Creativity can
replace resources, and if you develop new technology fast enough, you can overcome
almost any lack of existing resources. Even if a country doesn't have the physical
resources it needs for growth, it can import them as did Japan following World War II.
 Greater participation in the market is another means by which to increase available
resources. In China at the end of the 20th century, for example, many individuals
migrated into the southern provinces, which have free trade sectors. Before they
migrated they became employed in the market economy. This increased the labour
available to the market, helping push up China's growth rate.

C. Growth-Compatible Institutions

Growth-Compatible Institutions Institutions that faster growth- must have incentives

built into them that lead people to put forth effort and discourage people from spending
a lot of their time in leisure pursuits or creating impediments for others to gain income
for themselves. When individuals get much of the gains of growth themselves, they have
incentives to work harder. That's why markets and private ownership of property play
important role in growth. Another growth-compatible institution is corporation, a legal
institution that gives owners limited liability and thereby encourages large enterprises
(because people are more willing to invest their savings when their potential losses are
limited).

d. Technological Development

Advance in technology shift the production possibility curve out by making workers
more productive. Technological advances increase their ability to produce more of the
things they already produce but also allow them to produce new and different products.
Technology progress results from new and improved ways of accomplishing traditional
tasks such as growing crops, making slothing or building a house. There are three basic
classifications of technological progress: neutral, labour saving and capital-saving

Neutral technological progress occurs when higher output levels are achieved with
the same quantity and combinations of factor inputs. Simple innovations like those that
arise from the division of labour can result in higher total output levels and greater
consumption for all individuals.

By contrast, technological progress may result in savings of either labour or capital.

Computers, the internet, automated looms, high-speed electric drills, tractors,
mechanical ploughs these and many other kinds of modern machinery and equipment
can be classified as products of labour -saving technological progress.

Capital-saving technological progress is a much rarer phenomenon. In the labour-

abundant (capital scarce) developing countries, however, capital-saving technological
progress is what is needed most. Such progress results in more efficient (lower-cost)
labour intensive method of production. For example, hand or rotary powered wielders
and threshers food- operated bellows pumps and back mounted mechanical sprayers for
small scale agriculture. The indigenous LDC development of low-cost, efficient, labour -
intensive (capital saving) techniques of production is one of the essential ingredients in
any long-run employment-oriented development strategy.

e. Entrepreneurship

Entrepreneurship is ability to get things done. That ability involves creativity. vision,
willingness to accept risk, and a talent for translating that vision into reality.
Entrepreneurs have been central to growth. They have created large companies.
produced new products and transformed the landscape of the economy.
 Summary

1. Growth is an increase in the amount of goods and services an economy produces.

Growth is an increase in potential output the highest amount of output an economy can
produce from the existing production function and the existing resources.

2. Physical capital includes both private capital buildings and machines available for
production and public capital infrastructure such as highways and water supply. The flow
of investment leads to the growth of stock of capital. While physical capital is still
considered a key element in growth, it is now generally recognized that the growth recipe
is far more complicated

3. (a)One of the reasons for de-emphasis on capital accumulation is that empirical

evidence has suggested that capital accumulation doesn't necessarily lead to growth

(b)Another reason is that products change, and buildings and machines useful in one
time period may be useless in another (eg, a six years old computer often is worthless).
The value of the capital stock depends on its future expected earnings, which are very
uncertain. Capital's role in growth is extraordinarily difficult to measure with accuracy.

(c) A third reason is that it has become clear that capital includes much more than
machines. In addition to physical capital, modern economics includes human capital and
social capital as types of capital.

4. The importance of human capital is obvious: A skilled labour force is far more
productive than an unskilled labour force.

5. If an economy is to grow it will need resources. The United States grew in the 20th
century because it had a major supply of many natural resources, and it imported people,
a resource it needed. However, resources in one time period may not be a resource in
another.
6. Growth-Compatible Institutions- Institutions that faster growth must have incentives
built into them that lead people to put forth effort and discourage people from spending
a lot of their time in leisure pursuits or creating impediments for others to gain income
for themselves. When individuals get much of the gains of growth themselves

7. Advance in technology shift the production possibility curve out by making workers
more productive. Technological advances increase these ability to produce more of the
things they already produce but also allow them to produce new and different products

8. There are three basic classifications of technological progress: neutral, labour- saving
and capital-saving

9 Entrepreneurship is ability to get things done. That ability involves creativity, vision,
willingness to accept risk, and a talent for translating that vision into reality.

Key Terms

Growth Potential output

Per capita real output Capital accumulation

Resources labour saving technology

Technology Entrepreneurship

Neutral Capital saving technology

Questions for Discussion and Exercises

1. What is "Growth"?

2. List the five important sources of growth and explain two of them.

3. Classify the technological progress and explain them.

4. "Capital accumulation and investment were seen as the key elements in growth"

Discuss.

5. Define economic growth and explain the available resources.

 Chapter 7

The Price level and Inflation

Learning Objectives

• Definition of Inflation
• Definition of Deflation
• Definition of Hyperinflation
• Measurement of Inflation
• The CPI & GDP deflator
• Cost of inflation & effects of inflation

7.1 Definition of Inflation

Inflation is a continual rise in the price level. The price level is an index of all prices
in the economy. Even when inflation itself isn't a problem, the fear of inflation guides
macroeconomic policy. Fear of inflation prevents government from expanding the
economy and reducing unemployment. It prevents governments from using
macroeconomic policies to lower interest rates. One-time rise in the price level is not
inflation. If the price level goes up 10 percent in a month, but then remains constant, the
economy doesn't have an inflation problem. Inflation is an ongoing rise in the price level.

The price level is an indication of how high or low prices are on average in a given
year compared to prices on average in a certain base period. The price level is measured
by a price index whose value is set at 100 for a base period.

Deflation is a decrease in the overall price level. Prolonged periods of deflation can be
just as damaging for the economy as sustained inflation.
Hyperinflation is a period of very rapid increases in the overall price level. Hyperinflations
are rare, but have been used to study the costs and consequences of even moderate
inflation.

7.2 Measurement of Inflation

Since inflation is a sustained time in the general price level, the general price level at
a given time was get by creating a price index, a number that summarizes what happens
to a weighted composite of prices of a selection of goods over time Price indexes
measure the cost of purchasing a bundle of commodities. However, different agents buy
different bundles of commodities, and each bundle defines a different price index

There are a number of different measures of the price level. The most important
indexes are a Consumer Price Indexes (CPIs), b. Producer Price Index (PP) and c. GDP
deflator.

The Consumer Price Index

Consumer Price index (CPI) which measure the cost to the consumer of purchasing
a representative basket of commodities. This basket includes both goods and services,
commodities purchased in shops, through mail order or the Internet, and commodities
produced either domestically or from abroad. Consumer prices also include any
consumption taxes (e.g., general sales tax or goods and services tax (GST) or value added
tax (VAT)). The CPI is the most important inflation measure because central banks often
use it as policy target. Various countries and economies have different ways of measuring
the overall index of consumer prices, which can make inflation measurements hard to
compare.
The Price of a Basket of Goods

The Bureau of Labor Statistics (Central Statistical Organization (CSO) in Myanmar),

which is part of the Department of Labor, has the job of computing the CPL. It begins by
collecting the prices of thousands of goods and services. The CPI turns the prices of many
goods and services into a single index measuring the overall level of prices. Economists
could simply compute an average of all prices. Yet this approach would treat all goods
and services equally. Because people buy more chicken than caviar, the price of chicken
should have a greater weight in the CPI than the prices of caviar. The Bureau of Labor
Statistics weights different items by computing the price of basket of goods and services
purchased by a typical consumer The CPI is the current price of the basket of goods and
services relative to the price of the same basket in some base year. (The base is year
2002) For example, suppose that the typical consumer buys 5 apples and 2 oranges every
month. Then the basket of goods consists of 5 apples and 2 oranges, and the CPI is

(5 x Current Price of Apples) +(2 x Current Price of Oranges)

CPI = x 100

(5 x 2002 Price of Apples) +(2x 2002 Price of Oranges)

In this CPI, 2002 is the base year. The index tells us how much it costs now to buy 5
apples and 2 oranges relative to how much it cost to buy the same basket of fruit in
2002.

In general,

Cost of a marker basket of products at current prices

CPI = x 100

Cost of the same basket of products at base year prices

The Producer Price index (PPI)

The Producer Price index (PPI) is an index of price that measures average change in
selling prices received by domestic producers of goods and services overtime. This index
includes many goods that most consumers do not purchase. It measures price change
from the perspective of the sellers, which may differ from the purchaser's price because
of subsidies, taxes and distribution costs. We can also construct price indexes for
producers input and output prices. Producer input prices measure the cost of the inputs
that producers require for production. Industrialized nations import many of these raw
materials, so that fluctuation in exchange rates will affect changes in producer input
prices. Producer output prices, or "factory gate prices," reflect the price at which
producers sell their output to distributors or retailers. Factory gate prices exclude
consumer taxes and reflect both producer input prices and wage and productivity terms.

Governments and central banks pay attention to producer prices because they can
help predict future changes in consumer prices. Consider an increase in oil prices that
increases producer input price inflation. Because the prices of commodities such as oil
are volatile, the firm may not immediately change its factory gate prices customers
dislike frequent changes of prices. Instead, firms will monitor oil prices, and if they
remain high for several months, eventually output prices will increase. This may not
immediately result in higher consumer price inflation. Instead, retailers may decide to
absorb cost rises and accept a period of low profit margins- they may think that the
increase in output prices is only temporary or intense retail competition may mean they
are unable to raise their own prices. However, if output prices continue to increase
eventually retail price will follow.

The GDP Deflator

 The Gross Domestic Product (GDP) deflator is another common measure of prices and
inflation. Changes in nominal GDP reflect changes in both output and inflation, whereas
changes in real GDP only reflect changes in output. Therefore, we can use the gap
between nominal and real GDP to measure inflation.

From nominal GDP and real GDP we can compute a third statistic: the GDP deflator.
The GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio
of nominal GDP to real GDP.

Nominal GDP

GDP Deflator =

Real GDP

The GDP deflator reflects what's happening to the overall level of prices in the
economy. To better understand this, consider again an economy with only one good,
bread. If P is the price of bread and Q is het quantity sold and then nominal GDP is the
total number of dollars spent on bread in that year, P.Q. Real GDP is the number of
loaves of bread produced in that year times the prices of bread in some base year. Pbase.Q,
The GDP deflator is the price of bread in that year relative to the price of bread in the
base year, P/Pbase. The definition of the GDP deflator allows us to separate nominal GDP
into two parts: one part measure quantities (real GDP) and the other measures prices
(the GDP deflator). That is,

Nominal GDP = Real GDP x GDP Deflator

Nominal GDP measures the current dollar value of the output of the economy Real
GDP measures output valued at constant prices. The GDP deflator measures the price of
output relative to its price in the base year.

We can also write this equation as

 Nominal GDP

Real GDP =

GDP Deflator

In this form, you can see how the deflator earns its name: it is used to deflate (that is
take inflation out of) nominal GDP to yield real GDP. Because it is based on GDP, this
measure of inflation only includes domestically produced output and does not reflect
import prices. Further, because GDP is based on the concept of value added, it does not
include the impact of taxes on inflation.

7.3 The CPI versus the GDP Deflator

Earlier in this chapter we saw another measure of prices the implicit price deflator for
GDP, which is the ratio of nominal GDP to real GDP. The GDP deflator and the CPI give
somewhat different information about what's happening to the overall level of prices in
the economy. There are three key differences between the two measures. The first
difference is that the GDP deflator measures the prices of all goods and services
produced, whereas the CPI measures the prices of only the goods and services bought
by consumers. Thus, an increase in the price of goods bought by firms or the government
will show up in the GDP deflator but not in the CPI.

The second difference is that the GDP deflator includes only those goods produced
domestically. Imported goods are not part of GDP and do not show up in the GDP
deflator. Hence, an increase in the price of a Toyota made in Japan and sold in this
country affects the CPI, because the Toyota is bought by consumers, but it does not
affect the GDP deflator. The third difference results from the way the two measures
aggregate prices in the economy. The CPI assigns fixed weights to the prices of different
goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is
computed using a fixed basket of goods, whereas the GDP deflator allows the basket of
goods to change over time as the composition of GDP changes.

Each of these different inflation measures reflects different commodities, so on a

year-to-year basis, they can behave differently from each other. However, the various
prices tend to move in a similar manner over long periods. The choice of index and
method of calculation used to measure inflation can create significant differences in the
measured inflation among economies, although most commonly used methods reveal
similar trends.

7.4 Costs of Inflation & Effects of Inflation on the Economy

The First problem is that most tax systems are specified in nominal, not real, amounts.
For instance, most countries do not tax income below a certain threshold. But as inflation
increases, so do wages and income, and more people earn above the threshold and have
to pay tax. Wages are only increasing in line with inflation; real incomes are not changing.
But the increase in nominal income means that more people are paying tax, which
actually makes them worse off.

Inflation also exerts a cost by reducing the value of cash. Unlike bank deposits, notes
and coins do not earn interest, so there is no compensation for inflation. As a result, the
value of notes and coins falls as inflation increases. This is called the inflation tax.

As inflation increases, firms and individuals will hold less cash at any one time, so
they will need to make more trips to the bank to withdraw cash, and spend more time
keeping their cash balances at low levels. We call these costs "shoe leather costs." Taken
literally, this phrase refers to the wear and tear that repeated trips to the bank to
withdraw funds exact on people's shoes. But it also captures a more general tendency
to spend time managing finances (when inflation is 20% per month, unpaid invoices
become urgent) rather than engaging in productive activity. Despite the trivial sounding
name, these costs can be substantial shoe leather costs can exceed 0.3% of GDP when
inflation is 5%.

Another cost of inflation is menu costs. Changing prices is costly for firms. One
obvious cost is physically changing prices-printing new menus or catalogs, replacing
price labels and advertisements in stores and the media. The higher inflation is, the more
often these prices have to change and the greater the cost to firms. Moreover, marketing
departments and managers have to meet regularly to review prices, which is also costly.
The lower is inflation the less often these meetings need to be held.

Effects of Inflation on the Economy

1. Inflation can capriciously redistribute income. When it increases unexpectedly, real

wages decline and employers gain at the expense of workers while debtors gain at the
expense of creditors.

2. Inflation can impair incentives to save and invest by reducing the real interest rate and
increasing uncertainty. When anticipated real interest rates are negative, financial
markets can collapse

3. Inflation distorts buying and selling decisions as people make choices not only on the
benefits and costs of alternative but also on their estimates of future inflation.

4. As inflation becomes anticipated, nominal wages will rise and possibly feed a wage-
price spiral.

5. Anticipated inflation can put upward pressure on interest rates as creditors seek to
protect themselves from the effects of inflation on their incomes.

6. Excessive inflation can lead to a recession as central banks cut on credit to control
inflation.
 Summary

1. Inflation is a continual rise in the price level. The price level is an index of all prices in
the economy

2. The price level is an indication of how high or low prices are on average in a given year
compared to prices on average in a certain base period. The price level is measured by
a price index whose value is set at 100 for a base period

3. Deflation is a decrease in the overall price level. Prolonged periods of deflation can be
just as damaging for the economy as sustained inflation.

4. Hyperinflation is a period of very rapid increases in the overall price level. 4.

Hyperinflations are rare, but have been used to study the costs and consequences of
even moderate inflation.

5. Since inflation is a sustained rise in the general price level, the general price level at a
given time was get by creating a price index, a number that summarizes what happens
to a weighted composite of prices of a selection of goods over time. Price indexes
measure the cost of purchasing a bundle of commodities.

6. Consumer Price Index (CPI) which measure the cost to the consumer of purchasing a
representative basket of commodities. This basket includes both goods and services;
commodities purchased in shops, through mail order or the Internet, and commodities
produced either domestically or from abroad.

7. Consumer prices also include any consumption taxes (e.g., general sales tax or goods
and services tax (GST) or value added tax (VAT)) The CPI is the most important inflation
measure because central banks often use it as policy target.

Various countries and economies have different ways of measuring the overall index of
consumer prices, which can make inflation measurements hard to compare.
8. Producer input prices measure the cost of the inputs that producers require for
production. Industrialized nations import many of these raw materials, so that
fluctuations in exchange rates will affect changes in producer input prices. Producer
output prices, or "factory gate prices," reflect the price at which producers sell their
output to distributors or retailers. Factory gate prices exclude consumer taxes and reflect
both producer input prices and wage and productivity terms.

9. The Producer Price index (PPI) is an index of price that measures average change in
selling prices received by domestic producers of goods and services overtime. This index
includes many goods that most consumers do not purchase. It measures price change
from the perspective of the sellers, which may differ from the purchaser's price because
of subsidies, taxes and distribution costs

Key Terms

General Price level Inflation

Deflation Hyperinflation

Price index Consumer price index

Current price Constant price

Producer price index GDP deflator

Nominal GDP Real GDP

Questions for Discussion and Exercises

1. Explain the different measures of the price level.

2. Suppose that the typical consumer buys 5 apples and 2 oranges every month. Then
the basket of goods consists of 5 apples and 2 oranges. The current price of orange is
250 kyats. Using data, calculate the consumer price index.

3. Discuss the CPI versus the GDP deflator.

4. Discuss the cost of inflation.

5. Write short notes on the following:

a. The GDP deflator

b. Effect of inflation on the economy