Samenvatting
Macroeconomics: summary of the readings
- Instelling
- Universiteit Van Amsterdam (UvA)
summary of the readings of macroeconomics for final exam. UvA year 1
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Summary macroeconomicsComputing GDP
• To keep track of how a country’s production changes over time, economists have invented
real GDP measures. The simplest one is real GDP at constant prices of a certain base year; a
more useful real GDP measure is chain-weighted real GDP. These GDP measures are
explained in section 2. To compare a country’s production with the production of another
country, economists use GDP at Purchasing Power Parity (PPP)
1. Nominal GDP:
• A final good is an item produced for the direct use by end consumers. Final goods are also
referred to as consumer goods
• Nominal GDP in year t depends on the prices and the produced quantities in year t. Often,
however, we want to keep track of how produced quantities change over time. The growth
rate of nominal GDP is not a good measure for this, as nominal GDP does not only change
when produced quantities change but also when prices
change. That is why economists have invented real GDP measures
2. Real GDP
• Real GDP in year t, Yt, is a measure of the produced quantities in year t, such that the growth
rate of real GDP is not affected by changes in the prices of the different goods and is therefore
a good measure of the growth in produced quantities. We first look at real GDP at constant
prices of a certain base year; we then look at chain-weighted real GDP, which is more
complicated to compute, but more useful and therefore in many countries the most common
way to measure real GDP
2.1 Real GDP at constant prices of a certain base year
• Suppose that we want to find out whether the amount of final goods, taking all final goods
together, has increased or decreased between year 1 and year 2
• One way how we could do this is by adding up the quantities produced in year 1,
, and comparing this with sum of quantities in year 2,
But then good 1 would carry the same weight in our computation as good 2, even though in
both years good 1 was substantially cheaper than good 2. That does not seem reasonable.
• Better way: use a set of prices to value each of the final goods, where cheap goods such as
good 1 get a lower price and therefore less weight in our computations, and more expensive
goods such as good 2 get a higher price and carry more weight. However, we then have to
make sure that we use the same set of prices in year 1 and year 2. Otherwise, our results may
be driven by the fact that we use different prices in the two years, rather than by the different
quantities that are produced - which is the very reason why we cannot use nominal GDP to
compare the amount of produced quantities in two different years
• There are many price sets which we could use for this purpose. But a logical choice is to use
the prices of a specific year. This year is called the base year (an choose any year)
• Example: take year 1 as base year. The prices which we use in all three years to compute real
GDP are then 4 for good 1 and 10 for good 2. Real GDP in the three years is then equal to
(from table):
,• real GDP in year 1 is the same as nominal GDP in year 1. Of course, it is, because we used
the same prices to compute nominal GDP as in the real GDP computation above. The growth
rate of real GDP from year 1 to year 2 is then equal to:
\
• Table example:
• the level of real GDP depends on the choice of the base year: the lower the prices in the base
year, the lower the level of real GDP. This is not really a problem, however, because in
general, we are not interested in the level of real GDP, but in the growth rate of real GDP.
Unfortunately, the growth rate of real GDP also depends on the base year. Our computations
show why this is the case:
• Consider, for instance, the growth rate of real GDP between year 1 and year 2. If we take year
1 as base year, good 1 is valued at a very low price (4) compared with good 2 (which is
valued at 10). The decrease in production of good 1 between year 1 and year 2 therefore
carries a low weight compared with the increase in production of
good 2 - which results in a positive growth rate of real GDP. However, if we take year 2 as
base year, good 1 is valued at a higher price (6), while the price of good 2 is still the same
(10). The decrease in production of good 1 therefore carries a heavier weight in the real GDP
computations. It turns out that it even more than offsets the
increase in production of good 2 - which results in a negative growth rate of real GDP. And
real GDP growth is even more negative if we take year 3 as base year: the production of good
1 is then valued at a very high price of 12 (while the production of good 2 is still valued at
10), such that the decrease in production of good 1 between year 1 and year 2 heavily weighs
on real GDP growth between year 1 and year 2. So which base year should we then choose if
we want to measure the change in production between year 1 and year 2? There is no good
choice. Luckily, economists have invented an alternative real GDP measure: chain-weighted
real GDP
2.2 Chain-weighted real GDP
• Suppose we want to measure the increase in production between year 1 and year 2. Which
year should we choose as base year?
• It doesn’t make much sense to use the prices of year 3 to compute the increase in
production between year 1 and year 2 - especially as in year 3, the relative price of good 1
(compared with the price of good 2) is quite different from the relative price of good 1 in
years 1 and 2: in year 3, good 1 is even more expensive than good 2, while it is cheaper
than good 2 in years 1 and 2
• But should we choose year 1 or should we choose year 2 as base year? Most of the time,
there is no obvious reason for preferring year 1 rather than year 2, or vice versa. So a
logical way to proceed is to first compute real GDP growth with year 1 as base year, then
with year 2 as base year, and to take the average of both growth rates
, • Table 3 shows that real GDP growth between year 1 and year 2 with year 1 as base year is
equal to 1.4%, while real GDP growth between year 1 and year 2 with year 2 as base year
is equal to -1.3%.
• Usually, it is a good idea to compute the average of two growth rates with a geometric
(rather than arithmetic) mean, as in the formula:
• Example:
•
• Usually not interested in level of chain-weighted real GDP, often useful to have number
for it. A logical thing to do then is to nail the level of chain-weighted real GDP to the
nominal GDP level in a certain base year.
•
• to compute series of chain-weighted growth rates of real GDP, the weights (i.e. the
prices) which the quantities of the different goods get in the computations are not fixed
(as in the computations of real GDP at constant prices), but change over time. And to
construct a series of chain-weighted levels of real GDP, use the series of chain-weighted
growth rates to link level of chain-weighted real GDP in base period to levels of chain-
weighted real GDP in all other periods. In this way, we make a chain of real GDP levels
by using ever changing weights of the produced quantities of the different goods.
3. GDP at Purchasing Power Parity (PPP)
• Measuring GDP and keeping track of how a country’s production changes over time is
difficult. comparing production in one country with production in another country turns
out to be extremely difficult
• International comparisons rely on methodology worldbank
• Essence of World Bank’s methodology illustrated with simple example:
• Suppose we want to compare the production of final goods in Netherlands (NL) with the
production of final goods in the U.S. To make life easier, let us suppose that both The
Netherlands and the U.S. produce only two final goods, good 1 and good 2. The quantity
and the price of good i in The Netherlands are denoted by:
, • In order to be able to compare GDP in The Netherlands with GDP in the U.S., need to
express both GDP levels in a common currency
• One option: use the market exchange rate between the euro and the U.S. dollar to
convert GDP in Netherlands into U.S. dollars (or vice versa, to convert GDP in the
U.S. into euros). But this is a bad idea because:
1. market exchange rates are quite volatile. It doesn’t make much sense to compare the
production levels in different countries in a way that substantially changes from one
day to another because of day-to-day exchange rate fluctuations.
2. The second problem with market exchange rates is that even though they may be
useful to compare the value of goods and services that are traded internationally, they
are less useful to compare the value of goods and services that are consumed in the
same country as where they are produced (such as haircuts). It turns out that in poor
countries, goods and services that are not traded internationally are relatively cheap,
while in rich countries the same goods and services are often much more expensive
• That is why Mexicans who travel to the U.S. prefer to have hair cut in Mexico before they
leave rather than in the U.S. when they arrive, and why Dutch people - who are on a diet of
expensive “broodje kroket” sandwiches in The Netherlands - indulge in sumptuous meals
when they are holidaying in sunnier but less prosperous countries. Using market exchange
rates to compare the value of production in poor countries with value of the production in
richer countries would then underestimate the purchasing power of GDP in poor countries
compared with richer countries. Economists therefore take a different approach, which
focuses on the purchasing power of GDP. It goes as follows:
1. take a “benchmark” country, for which economists usually choose the U.S. Now split
the complete basket of goods and services that has been produced in the U.S. in a
given year in many identical baskets, each worth exactly $1. As in our example GDP
in the U.S. is $500, there would be 500 of such baskets, each consisting of
2. introduce a fictitious currency (i.e. a currency that does not exist in the real world),
called the international dollar, with symbol I$. Assume that one international dollar
buys exactly one of these tiny baskets of 1/5 units of good 1 and 3/5 units of good 2.
As the total production in the U.S. consists of 500 of such baskets, GDP in the U.S.
expressed in I$ is then simply equal to I$ 500:
3. convert GDP in Netherlands into I$. In the Netherlands, price of one tiny basket of
1/5 units of good 1 and 3/5 units of good 2:
two euro is worth the same as one international dollar. Dividing Dutch GDP
(expressed in euro) by e2 per I$ yields then GDP in The Netherlands expressed in I$:
4. compare GDP in The Netherlands in I$ with GDP in the U.S. in I$. In this way, we
compare GDP inNetherlands with GDP in the U.S. by expressing both GDP levels in
a common currency which has the same purchasing power in both countries. GDP in
I$ is therefore also called “GDP at Purchasing Power Parity (PPP)”. To extend this
analysis over time, economists usually take the prices of the benchmark country in a
base year, and then compute GDP of different countries in different years, all
expressed in I$ in prices of this base year.
Chapter 1: the science of macroeconomics
1.1 What macroeconomists study
• macroeconomies studies the forces that influence the economy as a whole
• macroeconomists collect data on incomes, prices, unemployment and many other variables
from different time periods and different countries. They then attempt to formulate general
theories that help to explain these data.
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