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AF1605 Introduction to Economics

Topic 7: Introduction to Macroeconomics

Lecturer: Chau Tak Wai

School of Accounting and Finance

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Introduction to Macroeconomics

v National income accounting

v Major macroeconomic issues

 Introduction to Macroeconomics
3
v Macroeconomics is the study of the operation of the aggregate economy of a
place.

v There are three kinds of economic institutions in the economy: Households,

Firms and Government.

v Households
v Households are individuals or people living together as decision-making
units.
v Households supply the factor of production to the firms for production, and
receive income for spending.
v Firms
v Firms are institutions that organize production of goods and services.
v Firms employ factors of production supplied by the households for
production, sell the output and receive the revenue.

v Government collects tax, makes expenditure and implement macroeconomic

policies.
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 Gross Domestic Product (GDP)
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v Gross Domestic Product (GDP) is the total market value of production

within an economy in a given time period.

v GDPt = ∑ (Pi,t × Qi,t)

v Nominal GDP
v The value of current output measured at current prices.
v Nominal GDP in 2017 = ∑ (Pi,2017 × Qi,2017)

v Real GDP
v The value of current output measured at base-period prices.
v This is used to hold price constant and compare the volume of output
over time.
v Real GDP in 2017 (using 2016 as the base period)
= ∑ (Pi,2016 × Qi,2017)
6 GDP Deflator

v One measure of the price level of an economy is the GDP deflator.

v This measures the price level weighted by mix of produced goods and
services of this economy.

v GDP deflator = (Nominal GDP / Real GDP) × 100

v If GDP deflator is larger than 100, price level in the current period is
higher than the price level in the base period.

v Inflation rate implied by the GDP deflator

= (GDP deflator at t – GDP deflator at (t-1))/(GDP deflator at (t-1)) x
100%
 Example
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v Consider an economy with only two products: X and Y.

Output Output
Price of Price of Nominal Real GDP
of Good of Good
Good X Good Y GDP GDP Deflator
X Y
Base
$5 20 $8 15 $220 $220 100
period

Period 1 $6 25 $10 20 $350 $285 122.8

Period 2 $6 22 $10 18 $312 $254 122.8

Period 3 $4 22 $7 18 $214 $254 84.25

Inflation rate from period 2

to period 3 $5 x 25 + $8 x 20 = $285
350/285 = 122.8
= (84.25-122.8)/122.8 x 100%
= -31.4%
 Hong Kong’s Nominal and Real GDP (Base=2017)
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Nominal GDP Real GDP GDP
(in $ million) (in $ million) Deflator
1997 1,373,083 1,400,876 98.0
2000 1,337,501 1,455,090 91.9
2010 1,776,332 2,168,744 81.9
2011 1,934,430 2,273,162 85.1
2012 2,037,059 2,311,812 88.1
2013 2,138,305 2,383,514 89.7
2014 2,260,005 2,449,356 92.3
2015 2,398,280 2,507,842 95.6
2016 2,490,438 2,562,249 97.2
2017 2,659,384 2,659,384 100.0
2018 2,835,131 2,735,484 103.6
2019 2,868,171 2,702,979 106.1
9 National Income Accounting

v National Income Accounting refers to the rules and techniques for

measuring the total flow of output produced and the total flow of
income generated by this production.
v Three approaches of measuring GDP:
v Output/Production approach
v Value-added to the outputs in each production process
v Expenditure approach
v Who has paid and how much is paid for the outputs
v Income approach
v How the sales revenue of the outputs is shared between factors
of production
v The three approach should give you the same level of GDP.
Practically, there are errors and omissions in collection of data.
 Circular Flow of Incomes and Expenditures
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v Consider an economy with only

households and firms.

v Expenditure on goods and

services by the households
= Revenue from sales of these
goods and services by the firm
= Income to various factor
inputs, including profit to
entrepreneurs.

v Value of expenditure
= Value of output
= Value of income
 Output Approach (Production Approach)
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v GDP is calculated by adding up the contribution to the final output (value-
added) of every firm in the economy.

v Value added = Value of output - Value of intermediate inputs

v Note: Intermediate inputs are goods or services that are used as components
of another good or service. Inputs such as labour and capital are NOT
intermediate inputs.

v Example:
Stage of Production Value of Cost of Intermediate Value
Output Input Added
Wheat $80 $0 $80
Flour $150 $80 $70
Bread $240 $150 $90
$240

v This approach helps us understand the economy by various production

sectors/industries.
 Percentage Contribution to Hong Kong’s GDP by Output Approach
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Economic % in % in % in % in
Activity 1980 1990 2000 2018
Agriculture & Fishing, Mining & Quarrying 1.0 0.2 0.1 0.1
Manufacturing 22.8 16.7 4.8 1.0
Electricity, Gas & Water 1.5 2.4 2.9 1.4
Construction 6.5 5.2 4.9 4.5
Services (Breakdown as follows) 68.3 75.4 87.3 93.1
Wholesale and Retail, Import/Export trades, 19.4 23.7 24.5 24.8
Restaurants and Hotel
Transport, Storage & Communication 6.9 9.0 10.9 9.3
Financing, Insurance, Real Estate and Business 21.7 18.9 22.0 30.1
service
Community, Social and Personal services 11.9 14.1 19.0 18.4
Ownership of Premises 8.4 9.7 10.8 10.5

Source: https://www.censtatd.gov.hk/hkstat/sub/sp250.jsp?tableID=036&ID=0&productType=8
13 The Four Key Industries of Hong Kong

Source: https://www.censtatd.gov.hk/hkstat/sub/sp80.jsp?productCode=FA100099
14 The Four Key Industries of Hong Kong

Source: https://www.censtatd.gov.hk/hkstat/sub/sp80.jsp?productCode=FA100099
15 Expenditure Approach

v It calculates the market value of final production by adding up the

expenditure made to purchase final goods and services.

v Final good or service is a good or service that is produced for its final
user and not as a component of another good or service.

v To avoid double counting, we only consider final goods and services in

the expenditure approach; intermediate goods and services are
excluded.

v This approach focuses on how the outputs of this economy in this

period is sold for what purposes.

v This approach helps us understand the economy by the sources of

aggregate demand.
 Expenditure Approach
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v Consumption expenditure (C) is the expenditure by households on nondurable

goods (e.g., food), durable goods (e.g., furniture) and services (e.g., haircut).

v Investment (I) is the purchase of new capital goods (tools, instruments,

machines, buildings, and other constructions) and change in inventories (goods
that are not sold).
v Gross investment = Net investment + Replacement investment.
v Replacement investment is used to compensate for depreciation.

v Government expenditure on goods and services (G) is the expenditure by

government on goods and services.
v Government expenditure is valued at cost rather than at market value.
v Transfer payments (e.g., welfare payments) that do not result from
productive activities are not included in government expenditure.
 Expenditure Approach
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v Net exports of goods and services (NX) is the value of exports of goods
and services minus the value of imports of goods and services.
v Exports of goods and services (X) are the items that firms in the
domestic country produce and sell to the rest of the world.
v Imports of goods and services (M) are the items that households,
firms, and governments in the domestic country buy from the rest of
the world.
v Note: Tourists’ spending in their destination country is taken as
exports there in national accounts.
v Note that each of the components C, G, I and X has import contents. The
import contents are removed collectively by the subtraction of M.
v GDP = Sum of all expenditures

v GDP = C + I + G + NX = C + I + G + X – M
18 Expenditure Approach

v Expenditures on used goods and financial assets are not included in

GDP.

v Reasons:
v Expenditure on used goods is not part of GDP because the good
itself is not produced in that period of time (or if so, it should be
accounted for separately).
v However, if some work is done on the used good to improve its
quality, then the value of the extra service added to it should be
counted.
v Purchasing of financial assets such as bonds and stocks is not
equivalent to buying goods and services. It is just a transfer of
money or ownership, but not a production itself.
19 United States
20 Hong Kong
 Income Approach
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v The income approach measures GDP by summing the incomes generated

in the production process. (How the sales revenue is distributed to
different factor inputs, including the firm owner’s entrepreneurship.)

v Four types of factor incomes: wage, interest, rent and profit.

v Wage income, or compensation of employees, is the payment for
labor services.
v Interest income is the interest that households receive on capital.
v Rent includes payments for the use of land and other rented inputs.
v Profit includes the profits of corporations and income of proprietors.

v Net domestic product (NDP) at factor cost (national income) is the sum
of wages, interest, rent, and profit.
 Income Approach
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v Factor cost and market price
v Market price equals factor cost plus indirect taxes and minus subsidies.
v Example: Market price of a pair of shoes ($500) equals factor cost ($450)
plus indirect tax ($50).

v Net product and gross product

v Income includes net profit (after deducting depreciation), so the income
approach gives a net measure.
v Expenditure includes investment. Because some new capital is purchased
to replace depreciated capital, the expenditure approach gives a gross
measure.
v To get gross domestic product from the income approach, we must add
depreciation to total income.
23 Income Approach

v Net domestic product (NDP) at factor cost

= Wages + Interest + Rent + Profit

v NDP at market price

= NDP at factor cost + Indirect taxes – Subsidies

v GDP = NDP at market price + Depreciation

v GDP
= Wages + Interest + Rent + Profit + Indirect taxes – Subsidies
+ Depreciation
 Self-Assessment Exercise
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v Peter operates a garage which provides customers with car repairing
services. In March 2016 he bought a 5-year old second-hand car from his
customer at a price of $85,000. He paid his worker $4,000 to repair and
clean up the engine, and then successfully sold the car to another customer
for $96,000 in June 2016.
v Discuss how the 2016 GDP and its components were affected under the
three different approaches of GDP accounting.
v Economic Activity involved:

v Output Approach

v Income Approach

v Expenditure Approach
 GDP and GNP
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v Gross Domestic Product (GDP) measures the value of output produced by

the resources located in the domestic territory in the given period of time.

v Gross National Product (GNP) measures the value of output produced by the
nationals of a country (by factor inputs owned by nationals) in the given
period of time.

v Difference between GDP and GNP:

v Some resources located/provided in the territory are owned by foreigners.
v Some nationals own/provide factors of production located in other
countries.

v GNP = GDP + Factor income derived by nationals from overseas

– Factor income paid to foreigners

v GNP = GDP + Net factor income from abroad

v In Hong Kong, GNP is called GNI (Gross National Income).

26 The Use of GDP

v We use estimates of real GDP for three main purposes:

v To track the course of the business cycle.
v To compare the standard of living over time.
v To compare the standard of living among countries.

v To compare living standards we calculate real GDP per capita: real GDP
divided by the population.

v To compare living standards across countries, we must convert real GDP

into a common currency (e.g., US dollar).
v However, the existing exchange rate may not reflect the actual purchasing
power of currency in different countries.
v A common practice is to apply purchasing power parity (PPP) adjustment
for international comparison.
 27 Hong Kong’s Nominal GDP and GNI (Gross National Income)

GDP GNI GDP GNI

($ million) ($ million) per capita ($) per capita ($)
2006 1,503,351 1,538,864 219,240 224,419
2011 1,934,430 1,987,256 273,549 281,019
2012 2,037,059 2,066,514 284,899 289,019
2013 2,138,305 2,178,824 297,860 303,504
2014 2,260,005 2,360,612 312,609 319,056
2015 2,398,280 2,442,656 328,924 335,010
2016 2,490,438 2,553,031 339,454 347,986
2017 2,659,384 2,774,936 359,780 375,412
2018 2,835,131 2,969,946 380,503 398,597
2019 2,868,171 3,016,340 382,046 401,782

Source: https://www.censtatd.gov.hk/hkstat/sub/sp250.jsp?tableID=030&ID=0&productType=8
https://www.censtatd.gov.hk/hkstat/sub/sp250.jsp?tableID=039&ID=0&productType=8
 28

Source: https://www.statista.com/statistics/725742/countries-with-the-largest-gross-domestic-product-gdp-
at-purchasing-power-parity-per-capita/
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The Limitations of GDP

v Goods and services omitted from GDP:

v Non-market activities, e.g., housewife services.
v Underground production: (i) economic activities hidden from
government to avoid taxes and regulations, (ii) production that is illegal.

v Other influences on the standard of living not reflected in GDP:

v Leisure time.
v Environmental quality.
v Health and life expectancy.
v Political freedom and social justice.
v Income distribution.
v Subjective feeling of happiness and satisfaction.

v Other measures such as Human Development Index (HDI) by the United

Nations were developed to supplement the GDP measure.
v HDI: http://hdr.undp.org/en/content/human-development-index-hdi
30 Potential GDP and Output Gap

v Potential GDP is the value of GDP when the economy is at full

employment – all the economy’s factors of production are fully employed.

v Output gap = Actual GDP – Potential GDP

v If output gap < 0 : Recessionary gap

v If output gap > 0 : Inflationary gap

v The business cycle is a periodic, but irregular, up- and down-movement of

total production and other measures of economic activity.

v The four stages of a business cycle are expansion, peak, recession, and
trough.

v Output gap is generally positive when it is at a peak, and the output gap
will fall to the negative region when it is in a recession.
 Example of Estimates of Output Gap
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Source: Hong Kong inflation dynamics: Trend and cycle relationships with the U.S. and China,
HKIMR working paper No.23/2012.
 Business Cycle of the U.S.
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33 Major Macroeconomic Issue: Economic Growth

v Economic growth is an increase in the economy’s production of

goods and services, usually measured by the growth of real GDP.

v Sources of economic growth:

v Increase in quantity of factor input of production.
v Increase in size of labour force
v Increase in capital investment
v Increase in productivity of existing factors of production
v Increase in education of workers
v Advancement of technology (e.g. innovation from research and
development, R&D)
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 Growth of Output and Labor Productivity in Hong Kong
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Source: Productivity growth in Hong Kong: Sectoral patterns and drivers, Hong Kong Monetary
Authority Research Memorandum 02/2016.
 Investment in Physical and Human Capital in Hong Kong
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Source: Productivity growth in Hong Kong: Sectoral patterns and drivers, Hong Kong Monetary
Authority Research Memorandum 02/2016.
 Major Macroeconomic Issue: Unemployment
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v Labor force: people at age 15 or above who are (a) employed, or (b)
unemployed and looking for job.

v Note that those who are voluntarily not working and not looking for jobs
are not in the labor force. For example: full-time students, housewives,
retired people.

v The unemployment population comprises those in the labor force who

are looking for jobs and have not had jobs.

v The under-employed population comprises those employed persons who

have involuntarily worked for short hours (e.g. less than 35 hours a week)
and have sought additional work.
 Major Macroeconomic Issue: Unemployment
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v Reasons for unemployment:

v Frictional unemployment is the unemployment that arises from people

entering and leaving the labor force, from quitting jobs to find better
ones, and from normal labor turnover.

v Structural unemployment is the unemployment that arises when

changes in technology or competition change the skills needed to
perform jobs or change the location of jobs.

v Cyclical unemployment is the fluctuating unemployment over the

business cycle that increases during a recession and decreases during an
expansion.
39

Source: Hong Kong Census and Statistics Department

https://www.censtatd.gov.hk/hkstat/sub/sp200.jsp?productCode=B1050001
40 Major Macroeconomic Issue: Unemployment

Note that the denominator for the unemployment rate and under-employment
rate are the size of labor force, not working age population.
 Hong Kong’s Labor Market
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Labor Unemployed Unemployment Under-
Force (‘000) Rate (%) employment
(‘000) Rate (%)
1997 3,234.8 71.2 2.2 1.1
2003 3,465.8 275.2 7.9 3.5
2005 3,534.2 197.6 5.6 2.7
2007 3,629.6 145.7 4.0 2.2
2009 3,600.3 192.6 5.3 2.3
2011 3,703.1 126.7 3.4 1.7
2013 3,858.8 130.8 3.4 1.5
2015 3,903.2 129.4 3.3 1.4
2017 3,946.6 123.4 3.1 1.2
2018 3,979.0 112.0 2.8 1.1
2019 3,966.2 116.3 2.9 1.1
Dec 2019-Feb 2020 3,903.0 134.1 3.7 1.5

Source: Hong Kong Census and Statistics Department

https://www.censtatd.gov.hk/hkstat/sub/sp200.jsp?tableID=006&ID=0&productType=8
42 Major Macroeconomic Issue: Unemployment

v Full employment occurs when all the unemployment is frictional and

structural (i.e., when there is no cyclical unemployment).

v Natural rate of unemployment is the unemployment rate when the

economy is at full employment (when there is no cyclical
unemployment).

v This is also the level of employment (unemployment) that is the highest

(lowest) and yet not subject to overheating (not sustainable and causes
accelerating inflation).

v This is not directly observable but is estimated by experts.

43 Major Macroeconomic Issue: Inflation

v Inflation (deflation) is defined as a continuous increase (decrease)

in the average level of prices.
v Inflation (deflation) will reduce (increase) the purchasing power of
money.
v Purchasing power of money – the amount of goods and services
that can be purchased with a given amount of money.
v Consumer Price Index (CPI) is a measure of the average of the prices
paid by consumers for a fixed market basket of consumer goods and
services over time in comparison what that in the base year.
∑$ %
!"#($! %! )
v CPI! = ×100
∑ $!& %!
where Q=(Q1, Q2, …,QN) is the fixed reference bundle an average
consumer will buy (e.g. the base year consumption bundle), and pt and
p0 are prices of period t and base year respectively.
'()% *'()%'#
v In)lation! = ( )×100
'()%'#
44 Inflation Rate

´ CPI2016
= (2 x 10+10 x 5)/(1 x 10 + 8 x 5)
x 100
=(70/50) x 100 = 140
´ CPI2010 (i.e. base year CPI)
= 100

´ Inflation rate between 2010 and

2016
=[(140-100)/100] x100% = 40%

´ Note that the basket of good is

the same as the one
determined in the base year.
45 Inflation Rate
v Hong Kong: Four series of Consumer Price Indices (CPIs)
CPI(A), CPI(B) and CPI(C) are compiled based on expenditure patterns of
households in the relatively low, medium and relatively high expenditure ranges.
A Composite CPI is compiled to reflect the impact of consumer price changes on
the household sector as a whole.
 Inflation Rate
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Source: Hong Kong Economic Report 2019 Q4

47 Procyclical and Countercyclical

v An economic variable is pro-cyclical if its deviations from trend are

positively correlated with deviations from trend in real GDP.
v An economic variable is counter-cyclical if its deviations from trend are
negatively correlated with deviations from trend in real GDP.
v Some variables may have different correlation with real GDP depending
on the driving force behind.
v Other than the real GDP, data from various sectors of the economy can
greatly help us understand the macroeconomic performance of the
economy.

Pro-cyclical Counter-cyclical Uncertain

Productivity Unemployment rate Price level
Investment Inventory Interest rate
Consumption
Stock price
48 Related Materials

´ What is GDP? | CNBC Explains

´ https://youtu.be/iLom1WlqwS0
´ What is a recession? | CNBC Explains
´ https://youtu.be/sTUh-NQ7q3E

´ Office of Government Economist

´ Hong Kong Economic Situation
´ https://www.hkeconomy.gov.hk/en/situation/index.htm
´ Hong Kong Economic Report (Publish quarterly)
´ https://www.hkeconomy.gov.hk/en/situation/report/index.htm
49 Related Materials

´ Hong Kong Census and Statistics Department

´ Understanding the Concepts of Gross Domestic Product and Gross
National Income
´ https://www.statistics.gov.hk/pub/B8XX00262012XXXXB0100.pdf
´ Hong Kong GDP Report
´ https://www.censtatd.gov.hk/hkstat/sub/sp250.jsp?productCode=B10300
01
´ The Four Key Industries in the Hong Kong Economy
´ https://www.statistics.gov.hk/pub/B71912FB2019XXXXB0100.pdf
´ Labour Force Related
´ https://www.censtatd.gov.hk/hkstat/sub/sp200.jsp?productCode=B10500
01