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Gross Domestic Product (GDP) and Business Fluctuations

Gross Domestic Product (GDP) and Business Fluctuations. MSc EPS Hilary term 2011 (S2) Professor Dermot McAleese. OUTLINE.  Definition of GDP  Real vs. nominal GDP  GDP vs. GNP  GDP estimation  Shadow vs Official Economy  PPP vs. current exchange rate

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Gross Domestic Product (GDP) and Business Fluctuations

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  1. Gross Domestic Product (GDP) and Business Fluctuations MSc EPS Hilary term 2011 (S2) Professor Dermot McAleese

  2. OUTLINE Definition of GDP  Real vs. nominal GDP  GDP vs. GNP  GDP estimation  Shadow vs Official Economy  PPP vs. current exchange rate  Potential GDP and the output gap  Business Fluctuations

  3. GROSS DOMESTIC PRODUCT (GDP) GDP refers to the output of goods and services produced in an economy during a specific period of time. The importance of GDP statistic Business forecasts  Monetary and fiscal policy  Political significance International comparisons

  4. Real vs. Nominal GDP Nominal GDP is the current value of output (goods and services) produced in an economy. Real GDP measures volume of output.  computed by valuing the quantities of goods and services produced in 2 periods with the same set of prices. Year 1: P1x X1 + P1y Y1 (5, 10) (8, 12) €146 Year 2: P2x X2 + P2y Y2 (6, 11) (9, 14) €192 (+31%) To compute real GDP: (1) Calculate value of Year 2 quantities at Year 1 prices P1x X2+ P1y Y2 = 5 x 11 + 8 x 14 = 55+112= 167 (2) Express this as % of base year GDP. Real GDP increased by 14%.

  5. GDP vs GNP GDP is output produced by productive factors located in the country, regardless of their owners’ nationality. GNP refers to output produced by productive factors owned by permanent residents of a country. For most countries the difference is very small

  6. (GDP – GNP)/GNP for 181 countries

  7. Countries with GDP > GNP -- Top 16 GDP-GNP (% of GDP) WDI 2007 World Bank CDRom

  8. Countries with GNP > GDP -- Top 16 % gap GNP-GDP (% of GDP) Memo: China 0.5% US 0.3% World Bank Indicators 2007

  9. Production Income Expenditure HOW TO COMPUTE GDP Disposal income of households + Non distributed profits + Net direct taxes = National Income Private consumption + Gross Investment (incl.  inventories) + Public Consumption + Exports - Imports (including income flows)  Value added = Gross Domestic Product ___________ ______ Net Indirect Taxes ____________ Depreciation

  10. GDP = C + I + G + X - M C = private sector consumption I = investment (capital formation) G = government current spending X = exports of goods and services M = imports of goods and services

  11. Source: China Statistical Yearbook 2008 Note: Consumption still at 35% of GDP in 2009, compared with 50% in S Korea at similar stage of development. Economist Oct 23 2010

  12. Which sectors contribute most to GDP? Source: WTO Trade Policy Review “European Communities” 22 Jan 2007; EIU China Country Report March 2007

  13. Purchasing Power Parity (PPP) 1. Nominal exchange rate in 2008 was 6.9 Yuan = US$1 . Hence $1000 = 6,900 yuan. 2. Buy a representative basket of goods and services in Washington DC. A representative basket might, for example, contain 2 kilos of rice 1 kilo beef 5 inner city bus rides one month’s rent of a two-bed apartment 1 personal computer 2 visits to doctor etc. (the list could run into hundreds of items) 3. Suppose this representative basket costs $1,000 to buy in Washington. Now buy exactly the same basket in China. Suppose it costs 3,800 yuan. Purchasing Power Parity (PPP) rate of exchange = 3,800 yuan divided by $1000 PPP exchange rate: 3.8 yuan = $1    4. GDP per head in China (2008) = 22,640 Yuan = $3,260 at nominal exchange rate [6.9 yuan per dollar]. China’s GDP per head of 22,64 yuan per head = $5,962 at PPP (3.8 yuan per dollar].

  14. GDP calculated from nominal exchange rates underestimates the living standards of developing countries • This happens because non traded goods (services) are much cheaper in developing countries  Divergences in prices of traded goodsare much less because of the law of one price  The gap between GDP measured at current exchange rate and GDP measured at PPP can be substantial

  15. Exercise/ Review Question • In UN HDR 2010 (table16), GDP is higher in PPP than in current exchange rates for most countries. • For which countries is the opposite true? • Are there any developing countries in this category? Can you explain why?

  16. Share of world production -- PPP vs current exchange rates (%) Source: Bank of America 2006

  17. 18 Source: The Economist Feb 27, 2010

  18. Source: The Economist Feb 27, 2010

  19. The basic purpose of development is to enlarge people’s choices. People often value achievements that do not show up at all, or not immediately, in income or growth figures: greater access to knowledge, better nutrition and health services, more secure livelihoods, security against crime and physical violence, satisfying leisure hours, political and cultural freedoms and sense of participation in community activities. The objective of development is to create an enabling environment for people to enjoy long, healthy and creative lives. Mahbub ul Haq, Founder of the Human Development Report.

  20. Human societies are based on the human tendency to want things, and are geared to satisfying those wants: possessions or facilities that bring ease and personal satisfaction. The results are frequently disappointing, and always terminate in the embarrassing non-sequitur of death. Diarmaid MacCulloch A History of Christianity: the first three thousand years. Allen Lane London 2009 p 200

  21. Classwork pp 273-274 • E1, E2, E3 • Q1 (p 273)

  22. Which of the following transactions should be included as part of GDP?(a) A consumer pays €10 for a meal at the restaurant(b) A company buys a plant from another firm for €1 million.(c) A supplier sells computer chips to another firm that makes personal computers.(d) A person buys a second-hand car from a dealer for €5,000.(e) A person buys a new car for €15,000.(f) A factory exports €2m worth of PCs and sells €5m on the domestic market. It imports €2m component parts for the PCs.(g) Chinese residents abroad send €5m to their relatives in China; China gives €5m aid to UN; Chinese temporary workers earn €5m in foreign countries

  23. 2. A person saves €10,000 of this year's income and spends it on new machinery. Explain how this would be recorded in the national accounts. Another person takes €10,000 from under the mattress and buys shares on the stock market. Would this be recorded in GDP?

  24. Consider an economy with only three goods. Their market prices are P1 = 5, P2 = 10 and P3 = 15. The production (and consumption) of each good during 1995 was Q1 = 20, Q2 = 25 and Q3­ = 10.(a) What is the value of nominal GDP?(b) Assume that in 1996 prices rise to P1 = 6, P2 = 12 and P3 = 17, and quantities produced (and consumed) go to Q1 = 21, Q2 = 27 and Q3 = 11. Calculate the value of nominal GDP. Compute real GNP, using 1995 prices as the base year. What is the real rate of growth of the economy? What is the rate of inflation? (c) Calculate the change in real GDP using 1996 prices as the base year. Explain why your answer is different to that in (b).

  25. 1. Considerable resources are spent by the statistical authorities in deriving estimates of GDP. From a business perspective, would you say that this exercise is a worthwhile and valuable one?

  26. Shadow vs Official Economy (DMcA p.150) TOTAL ECONOMIC ACTIVITY FORMAL ECONOMY SHADOW ECONOMY Non-marketed economic activity Non-marketed economic activity Marketed economic activity Marketed economic activity TOTAL MARKET ECONOMY

  27. Estimates of size of shadow economy March 2002 study shows from sample of 85 countries • 35-44% average range in developing countries (Nigeria and Egypt 77 and 69%, Thailand 70%, while only 14% in HK and Singapore, 19% in Chile) • 21-30% in transition countries Georgia 64%, Russia 44% • 14-16% in developed countries (US 10%) Source: F Schneider and D. Enste “Hiding in the Shadows: the Growth of the Underground Economy” IMF Economic Issues 30, Washington DC 2002

  28. Size of the shadow economy (% GDP) Source: F. Schneider, ‘The shadow economies of Western Europe’, Economic Affairs, September 1997; 2002 from F Schneider IMF paper

  29. Note: China 13.1%!

  30. QUESTIONS Does the existence of a shadow economy imply that the market system is not working? Is its existence consistent with the laws of demand and supply? Estimation of the shadow economy activities has been described by Schneider as a scientific passion for knowing the unknown. Discuss

  31. POTENTIAL GDP and the OUTPUT GAP Potential GDP is the maximum output that an economy can produce if capital, labour and other factors of production are fully utilised, consistent over the medium term with price stability. The Output Gap is the difference between actual GDP and potential GDP, as a percentage of potential GDP. [(actual GDP - potential GDP)/ potential GDP] x 100

  32. POTENTIAL VS. ACTUAL GDP Actual GDP > Potential GDP  price stability in jeopardy, indicators point to inflation Actual GDP < Potential GDP  resources being wasted, unemployment, indicators point to recession Actual > Potential Real GDP Actual < Potential Actual Potential time time

  33. Output gaps for 2009 and 2010 Notes: Output gap = [(actual GDP - potential GDP)/ potential GDP] Source: OECD, Economic Outlook, June 2010 34

  34. Question for class Output gaps have declined in 2010 relative to 2009. Can you suggest reasons why this has happened?

  35. ESTIMATION OF POTENTIAL GDP Trend extrapolation  Production function approach Growth in potential output Growth in government sector Growth in the business sector Growth in capital stock Growth in employment Growth in TFP Advances in technology Enterprise-friendly economic policies

  36. Business Fluctuations (ch 16) • What are business fluctuations? • Why do they matter? • What causes them? • What can be done about them? --- next sessions – MONETARY AND FISCAL POLICY

  37. What are business fluctuations? Business fluctuations are fluctuations in aggregate economic activity that are widely diffused throughout the economy and have identifiable “peaks” and “troughs” FLUCTUATIONS  CYCLES

  38. THE BUSINESS CYCLE WILL NOT DISAPPEAR …. The inevitability of the business cycle, as it used to be called, I take for granted. Good times bring into existence: first, incompetent business executives; second, wrongful government policies; and, third, speculators. Working together, they ensure the eventual bust. J K Galbraith “Challenges of the New Millennium” Finance and Development December 1999 p 5

  39. A MORE UPBEAT VIEW …. It is not enough to assert that since there have always been business cycles there always will be business cycles. Understanding what causes business cycles and how these causes have changed suggests that business cycles will not be as important in the future as they were in the past. S. Weber “The end of the business cycle”Foreign Affairs July 1997

  40. Average growth rate 2.93%

  41. Source: The Economist Jan 2009

  42. UNITED KINGDOM Real GDP Growth 1964-2010 Av growth 2.3% p.a.

  43. GERMANY: Real GDP annual % growth Average 3.2% p.a.

  44. World Output: Growth rate (% pa) 1960-2010 Source: IMF Weo april 2009

  45. Facts About Fluctuations • Negative growth infrequent • Irregular periodicity • No evidence of systematic long run cycles • Sustained period of growth followed by relative or absolute downturn  Industrial countries stay 3 times longer in the expansion phase of the cycle than in recession • Strong synchronisation (contagion) effects – few cycles “made at home” • Expanding role of emerging countries (now account for 2/3rds of world economy growth)

  46. Two Strong Forces at work in advanced country • macro economy • Downward Force due to adverse deflation dynamic effect • Upward Force due to: • Automatic Stabilisers • Demand stimulation policies (countercyclical)

  47. Why Do Business Fluctuations Matter? • Long term economic growth is higher when stability is greater. Volatility not independent of trend. Fluctuations affect trend growth rate negatively. • Most people prefer stability to an unstable, boom-and-bust growth path.

  48. Source: The Economist Nov 2008 *Based on calendar year data

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