IntroductionNational accounting and the wealth of nations

Lecture 1Nicolas Coeurdacier

nicolas.coeurdacier@sciencespo.fr

Understanding the World Economy

Master in Economics and Business

Course website

http://econ.sciences-po.fr/staff/nicolas-coeurdacier

Link to Master E&B

Contact

nicolas.coeurdacier@sciencespo.fr

No office hours but meetings can be easily organized. Just drop me an email.

Practical matters

Suggested textbooks

• Macroeconomics, S. Williamson, 4th edition.

• Macroeconomics, Charles. I. Jones, 2nd edition.

Other material

Slides for the course as well as additional readings/references

posted on my website.

Practical matters

Grading

– 40% homework (group of 4 people). To be handed back at

lecture 9.

Find an important policy question (YES/NO) which deals with

a subject of macroeconomics. Find related academic articles

(IMF, OECD, Economic Policy, World Bank, NBER or CEPR

WP…) and press articles (FT, The Economist,…) which tackle

the question. In a 5 pages (max) document, provide a critical

answer to the question.

– 60% final exam: Multiple choice, short exercise(s), short

essay.

Practical matters

Homework suggestions

• Will Chinese growth slowdown?

• Is ICT a Third Industrial Revolution?

• Should the Anglo-Saxon labour market be the inspiration for reform in continental Europe?

• Should governments reduce legal working hours to fight unemployment?

• Should monetary policy target asset prices as well as consumers prices?

• Should the ECB tolerate more inflation?

• Should governments bailout banks in difficulties?

• Should governments use actively fiscal policy to stabilize output?

• Should governments make reductions of public debt and fiscal deficits their immediate priority?

• Is the euro too strong?

• Have global financial markets spread the recent financial crisis worldwide?

• Should Greece leave the eurozone? (or should Iceland, U.K. join?)

…..

These are just suggestions. You are free to choose another topic as long as related to macrotopics covered in class! Avoid very broad questions. Please contact me once you have chosenyour question.

Practical matters

6

1. What is macroeconomics?

2. Defining GDP

3. Welfare & Income

4. GDP: The production function

Lecture 1 : Introduction

National accounting and the wealth of nations

Microeconomics

• Focuses on the behavior of a single agent (firms,

households, government)

• or a single market (the market for tomato soups)

• Partial equilibrium

Macroeconomics

• Focuses on the behavior of the aggregate variables

• Prices and quantities

• General equilibrium

Micro and Macro

8

Macroeconomic discussion often focuses on the short/medium term…

What will happen

to house prices?

Outlook for the

World Economy?

Should ECB raise

interest rates?

Will governments

increase deficits ?

Will unemployment

fall next year?

Macroeconomic discussion often focuses on the short/medium term…

US business cycle fluctuations

(% deviations from trend)

Source: Federal Reserve Economic Data

US

…but also long term-issues

…but also long term-issues

• Introduction (1)

• Long-term economic growth (2/3)

• Labour Market and Unemployment (4)

• Money and Inflation (5)

• Business cycle fluctuations (6/7)

• Monetary Policy (8)

• Fiscal Policy (9)

• Exchange rates and open economy macroeconomics (10/11)

• Financial crises (12)

Course Syllabus

13

1. What is macroeconomics?

2. Defining GDP

3. Welfare & Income

4. GDP: The production function

Lecture 1 : Introduction

National accounting and the wealth of nations

• GDP (Gross Domestic Product) is the most important variable

in macroeconomics.

• GDP measures aggregate production or aggregate output.

• GDP is a flow variable measured usually during a yearly or a

quarterly period.

• GDP per capita indicates the level of development of a

country. Massive variations across countries

Definition of GDP

Real income per capita, in 2000 USD

Copyright©2004 South-Western

Output has grown faster than population so GDP per capita has risen sharply although

not at the same rate across countries

• Fictional Island Economy

• Coconut Producer, Restaurant, Consumers, Government

• Coconut producer collect coconuts

• Restaurant: buys coconuts to the coconut producer and

serves “coconut soup” to its client

• Consumers: consume coconut soup, lend capital and work

• Government: collects taxes and provides national defense

Measuring GDP: National Income Accounting

Private sector

Production Price Labour Capital Taxes

Restaurant 250

coconut soups

@$20 each 2000 800 200

Coconut

Producer

1000 coconuts @$2 each 1000 800 200

Measuring GDP: National Income Accounting

Government

Tax revenues 400

Wages to soldiers 400

Three different ways to compute GDP

1. Expenditure approach

2. Income approach

3. Value added approach

Measuring GDP: National Income Accounting

• GDP = total spending on all final goods and services

produced in the economy

Y = C + I + G + NX

• Y : Nominal GDP

• C: Consumption Expenditures

• I : Investment Expenditures

• G: Government Expenditures

– Transfer payments not included. Why?

• NX : Net exports NX = total export of goods & services minus total imports of goods & services

Expenditure approach

• Expenditure approach in the coconut economy

GDP = Final consumption by clients & government

GDP = C + G

GDP = $ 5000 + $ 400

GDP = $ 5400

Expenditure approach

U.S and China expenditure components

(% of GDP, 2007-2011 average)

-10%

0%

10%

20%

30%

40%

50%

60%

70%

Personal consumption

expenditures

Government

consumption

expenditures

Private domestic

investment

Net exports

U.S. China

Source: Bureau of Economic Analysis and United Nations

• GDP = all income received by economic agents

contributing to production

– Taxes are government income.

• Income approach in the coconut economy

GDP = all income received by agents contributing to production

GDP = Labour income after taxes + Capital income after taxes + Taxes

GDP = $ 3400 + $ 1600 + $ 400

Income approach

The U.S. labour share (1929-2012)

50%

60%

70%

80%

19

29

19

34

19

39

19

44

19

49

19

54

19

59

19

64

19

69

19

74

19

79

19

84

19

89

19

94

19

99

20

04

20

09

U.S. Compensation of employees (% of GDP)

Source: Bureau of Economic Analysis

• GDP = sum of value-added to goods and services across

all productive units in the economy

Value Added = increase in the value of goods as a result of the

production process

Value Added = Value of production - Value of intermediate goods

• Value added approach in the coconut economy

GDP = Value added of coconut producers, restaurants & government

GDP = $ 2000 + $ 3000 + $ 400

– Remark: Government production is not sold at market prices

Value added of the government = cost of the inputs to production

GDP as value-added

Firms valued added

Value added across sectorsTop 750 European companies, 2007

• Graph on value added?

Source: Value added scoreboard, 2007

• Gross Domestic Product (GDP) denotes value of output of goods

and services produced within a country (including nationals and

resident foreigners). Measures value added in the country.

• Gross National Income (GNI) denotes value of output of goods and

services produced by the nationals of a country (excluding foreign

residents remittances but including remittances from nationals

resident abroad). Measures income of country’s citizens.

GDP and GNI

Deduct transfers from overseas [non UK nationals]

- remitted profits from foreign firms UK operations

- interest payments and dividends received from foreign investments in the UK

- remittances from overseas residents based in the UK

- grants paid by UK government

Add transfers from overseas [UK nationals]

- remitted profits from UK firms foreign operations

- interest payments and dividends received from overseas

investments

- remittances from UK residents based overseas

- grants received from foreign governments

From GDP to GNI

Source: OECD Main Economic Indicators and Quarterly National Accounts, International Monetary Fund, 2009.

Difference between GDP and GNI (% of GDP, 2009)

-15 -10 -5 0 5 10 15 20

Bangladesh

Poland

Japan

Ireland

United States

% GDP

• GDP fails to capture:

– Non-Market Activity such as home production, informal sector and/or black market activity

• GDP excludes:

– Capital gains on assets, financial and non-financial.

• Not all GDP based activity is welfare enhancing – e.g prices may not capture social value – environmental pollution and Green GDP.

Some important issues with GDP

Size of the underground economy: estimates(% of GDP, 1999-2006 average)

Source: World Bank

0

10

20

30

40

50

60

70B

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Ge

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Bra

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Swit

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USA

• According to international statistics, (real) consumptiongrowth has been 1% over the period 1991-2004. Lower thanworld average (roughly 2% and much lower than manydeveloping countries).

• International statistics fail to capture the informal economy.– Consumption = GDP - other components of GDP.

– Issue also in comparing prices across countries (see later).

• A. Young (2012) uses survey data over the period on realconsumption of durables, health, housing equipment.Important discrepancy with International Statistics.

• African growth over the period might have been between 3%and 3.5%. Africa is converging, although at a slower pace,despite large variations across countries.

Issues with measuring GDP

The African Growth Miracle?

Production

Year 1

Production

Year 2

Price

Year 1

Price

Year 2

Restaurant 250

coconut soups

250

coconut soups

@$20 each @$24 each

Coconut

Producer

1000 coconuts 1000 coconuts @$2 each @$2 each

Nominal and Real GDP

Between year 1 and year 2:

Real GDP unchanged = 250 coconut soups

Nominal GDP has increased by 20%, from 5000$ to 6000$

Inflation = 20%

Production

Year 1

Production

Year 2

Price

Year 1

Price

Year 2

Restaurant 250

coconut soups

275

coconut soups

@$20 each @$24 each

Coconut

Producer

1000 coconuts 1100 coconuts @$2 each @$2 each

Nominal and Real GDP

Between year 1 and year 2:

Real GDP has increased by 10%, from 250 coconut soups to 275

Nominal GDP has increased by 32%, from 5000$ to 6600$

Inflation = 20%

• Quality?

– Quantity produced and prices can stay constant despite growthand innovation.

– Happens if goods quality increases. Think of computers.

– Real GDP needs to be adjusted for goods quality (increase inquality = equivalent to a fall in price).

• New goods?

– Similar issue arises with new goods (cf. Brad de Long (2000)).Difficult to compare prices across time and thus real GDP if newgoods.

– Example: suppose GDP made of computers and coconuts. In1900 and 2000, country produces 1000 coconuts sold at 1 USD.No computer are produced in 1900 but 10 are produced in 2000sold at price 1000 USD. Real growth between 1900 and 2000?

Issues with deflating

• Cross country comparisons– Comparison in the same currency

GDP per capita in the US in US dollars = Sum price of goods in US ($) x output of goods in US / US population

GDP per capita in India in Rupees= Sum price of goods in India (Rupees) x output of goods in India / Indian Population

GDP per capita in India in US dollars = GDP per capita in India in Rupees x Dollar/Rupee exchange rate

– Might mask price differences across countries for same goods. Adjustment for prices differences “PPP-adjusted” GDP per capita.

– Particularly important adjustment for countries with different standards of living since prices tend to be lower in poorer countries.

Issues with deflating

PPP-adjustment: a simple example

Output is made of coconuts.

Coconuts costs 1 USD in the US and 20 rupees in India.

Exchange rate is 40 rupees per USD.

An Indian worker produces 4000 coconuts/year while a US

worker produces 40 000 coconuts/year.

in USD, GDP per worker in India = 4000 x 20 /40 = 2000 USD

(compared to 40 000 USD in the US).

In PPP terms, the Indian worker is only 10 times poorer and

not 20.

GDP per capita, PPP-adjusted and in current USD, in 2011

(% of U.S. GD per capita)

0%

20%

40%

60%

80%

100%

120%N

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Ma

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Be

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Sen

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Eg

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Real GDP per capita PPP / U.S. Real GDP per capita USD / U.S.

Source: Penn World Tables and World Bank

40

1. What is macroeconomics?

2. Defining GDP

3. Welfare & Income

4. GDP: The production function

Lecture 1 : Introduction

National accounting and the wealth of nations

“Gross National Happiness is more important than Gross

National Product.” Bhutan’s King Jigme Singye Wangchuk

“The gross national product does not allow for the health of our

children, the quality of their education, or the joy of their play. It

does not include the beauty of our poetry or the strength of our

marriages, the intelligence of our public debate or the integrity

of our public officials. It measures neither our courage, nor our

wisdom, nor our devotion to our country. It measures

everything, in short, except that which makes life worthwhile,

and it can tell us everything about America except why we are

proud to be Americans.” U.S. Senator Robert F. Kennedy, 1968

Some conceptual failure of GDP

• HDI is defined as (L + S + I)/3 where

L = (Life Expectancy –25)/(85-25)

S = 0.67 x Literacy Rate + 0.33 x School Enrollment Rate

I = (log(GDP per capita) –log(100))/(log(U.S. GDP per capita)– log(100))

• The HDI (and each of components) is scaled between 0 and 1

• Note that the HDI is linear in Life Expectancy and Education but

not in income: a 10% increase in health or education always has

the same impact but not a 10% rise in income

Measuring WelfareThe UN’s Human Development Index (Amartya Sen)

UN’s HDI, Selective countries (2009)

HDI L S I1 Norway 0.987 0.925 0.989 1.0482 Australia 0.970 0.940 0.993 0.9773 Iceland 0.969 0.945 0.980 0.9814 Canada 0.966 0.927 0.991 0.9825 Ireland 0.972 0.912 0.985 1.018

13 United States 0.964 0.902 0.968 1.02221 United Kingdom 0.947 0.905 0.957 0.97892 China 0.772 0.798 0.851 0.665

134 India 0.612 0.640 0.643 0.553169 Liberia 0.442 0.548 0.562 0.215172 Mozambique 0.402 0.380 0.478 0.347176 Congo (Democratic Republic of the) 0.389 0.377 0.608 0.182179 Central African Republic 0.370 0.362 0.419 0.328180 Sierra Leone 0.365 0.372 0.403 0.320

Source: UN Human Development Index.

GDP and HDI

The correlation between GDP rank and HDI rank (excl. GDP)=0.87!

GDP per capita is on average a good measure of welfare – but clearly measures

diverge for some countries.

0

20

40

60

80

100

120

140

160

180

0 20 40 60 80 100 120 140 160 180

Rank by HDI excluding GDP

Ra

nk

by

GD

P p

er

Ca

pit

a

Income and Happiness

In richer countries there is increasing interest in

happiness rather than income as a focus on policy

• The relationship between income and happiness gets

weaker as people get richer.

• Relationship holds better across countries and

individuals than across time within a given country.

•Is GDP really flawed and redundant as a policy

concept?

Source: Gallup World Poll

Happiness and income across countries

Life satisfaction and real GDP per capita across countries, 2010

Happiness and income across individuals in the U.S.

Happiness and income across time in the U.S.

Source: U.S. General Social Survey

Does money buy happiness?

Source: Layard, R (2005), ‘Happiness: Lessons from a new science’

51

1. What is macroeconomics?

2. Defining GDP

3. Welfare & Income

4. GDP: The production function

Lecture 1 : Introduction

National accounting and the wealth of nations

• Output ��(at date t) is produced using inputs (capital

�� and labour ��) more or less efficiently.

• Production function:

�� = ��(��)(��)

��

�� is an efficiency parameter (think ‘technology’). Also

called ‘Total Factor Productivity’ (TFP).

0 < � < 1: share of capital in value added.

�� is increasing in inputs �� and ��and efficiency ��.

The neoclassical production function

�� = ��(��)(��)

��

Constant returns to scale with respect to both inputs.

Double �� and ��, double ��.

Decreasing returns to scale to each input (0 < � < 1):

each additional unit of input brings less and less output.

Output per capita (with �� =��

��=capital per capita):

��/�� = �� = ��(��/��) = ��(��)

The neoclassical production function

Higher capital stock per capita increases output per capita

Output per worker y

Capital per worker �

� = ��

Low � high �

Higher TFP increases output per capita

Output per worker y

Capital per worker �

� = ��

�

Increase in �

�� = ��(��)(��)

��

Take log- of both sides and first time difference:

log ������

= log ������

+� log ������

+(1 − �) log ������

!� = !� + �!� +(1 − �)!�

Output growth !� comes from TFP growth !� and

growth in inputs !� and !� .

Output per capita:�� = ��(��)

!# = !� + �!$

Growth Accounting

Growth Accounting in China and India (1993-2004)

Employment

Physical Capital

Education

TFP

Employment

Physical Capital

Education

TFP

Source: Bosworth & Collins, 2007 ‘Accounting for growth: Comparing China and India’

Shares of the different factors of growth

China India

• Macroeconomics is about short/medium-term fluctuations of

the main aggregate economic variables but also about long-

term issues, such as long-term economic development.

• GDP is the most regarded aggregate variables. It describes the

quantity of goods and services produced in a given economy

and can be measured looking at incomes of residents, their

expenditures on final goods and services or the value added

of the different producers. When measured per capita, GDP

provides a good approximation of welfare.

• The neoclassical model describes GDP as the outcome of a

production process mixing inputs (capital & labor) and a given

technology (TFP). GDP growth comes from the growth of

these inputs or TFP improvements.

Summary