49003 ECONOMIC EVALUATION
MACROECONOMICS
©Suwin Sandu
FACULTY OF ENGINEERING AND INFORMATION TECHNOLOGY
UNIVERSITY OF TECHNOLOGY SYDNEY
2SUBJECT CONTENT
• INTRODUCTION
– Overview of economics
– History of economic ideas
• PROJECT EVALUATION
– Financial evaluation
– Economic evaluation
– Risk assessment
• MACROECONOMICS
– National output/income
– Multiplier effect
– International trade
– Macroeconomic policy
• MICROECONOMICS
– The theory of the consumer
– The theory of the producer
– The theory of the market
3• MACROECONOMICS IS CONCERNED WITH THE
OPERATION OF THE ECONOMY AS A WHOLE; IT IS THE
STUDY OF BROAD ECONOMIC AGGREGATES
– National Output (National Income/ National Expenditure)
– Employment
– Inflation
– Foreign Trade
• PERFORMANCE OF A COUNTRY MEASURED IN TERMS OF
THESE BROAD AGGREGATES IS A REFLECTION OF THE
STATE OF ECONOMIC HEALTH OF THE COUNTRY
MACROECONOMICS
• Mankiw (2021)
– Chapter 23: Measuring a Nation’s Income
– Chapter 24: Measuring the Cost of Living
– Chapter 26: Saving, Investment, and the Financial System
– Chapter 31: Open-Economy Macroeconomics
• Alternatively – Hubbard et al (2018); online text from the UTS
Library
– Chapter 4: GDP – Measuring total production, income and economic
growth
– Chapter 8: Inflation
– Chapter 9: Aggregate expenditure and output in the short run
– Chapter 14: Macroeconomics in an open economy
4
SUGGESTED READINGS
5MACROECONOMICS: KEY TOPICS
• NATIONAL OUTPUT/INCOME
– Circular flow of the economy
– Gross Domestic Product (GDP)
– Value added
• INVESTMENT
– Multiplier effect
• TRADE
– Absolute VS Comparative advantage
• MACROECONOMIC POLICY INSTRUMENTS
• POTENTIAL USES OF GDP AND ITS LIMITATIONS
6• NATIONAL OUTPUT – MOST IMPORTANT ENTITY
DISCUSSED IN MACROECONOMICS
• OTHER EQUIVALENTS OF NATIONAL OUTPUT
- Gross Domestic Product (GDP)
- Net Domestic Product (NDP)
- Gross National Income (GNI)
- Gross National Expenditure (GNE)
- Gross National Product (GNP)
NATIONAL OUTPUT
7Primary
Production
Goods & Services
Secondary
Production
Goods & Services
Final
Consumption
Intermediate input (consumption)
Entrepreneurship
Primary Factors of Production Final Goods and Services
Man-made Resources
- Capital
- Labour
Natural Resources
THE ECONOMY
THE CIRCULAR FLOW OF MACROECONOMY
(A simplified two-sector model)
8
MARKETS FOR
GOODS &
SERVICES
MARKETS FOR
FACTORS OF
PRODUCTION
HOUSEHOLD BUSINESS
EXPENDITURE REVENUE
INCOME INPUT COSTS
(INTEREST, WAGES,
RENT, PROFITS)
PRODUCTS CONSUMED PRODUCTS SOLD
(OUTPUTS)
SUPPLY RESOURCES
(CAPITAL, LABOUR, LAND,
ENTREPRENEURSHIP)
INPUTS FOR
PRODUCTION
FLOW OF EARNINGS
– income
– expenditure
FLOW OF PRODUCTS
– outputs
– inputs
(Upper loop; at market prices)
(Lower loop; at factor prices)
Entities
Markets
• Flow-of-products VS Flow-of-earnings approaches
• At market prices (upper loop) VS factor prices
(lower loop)
9
MEASUREMENT OF GDP
GROSS DOMESTIC PRODUCT: GDP
10
• FLOW-OF-PRODUCTS APPROACH
- total money value of the flow of final products (goods &
services)
- double counting is avoided by including in GDP only final
G&S and not intermediate G&S that are absorbed in the
final goods
11
• FLOW-OF-EARNINGS APPROACH
- total earnings from primary factor of production
- expenditure/income approach
- double counting is avoided by using the concept of value
added, where only the increase in the value of goods or
services as a result of the production process is considered
12
PRODUCTION
PROCESS
FIRM 1
FACTORS OF PRODUCTION
MATERIAL INPUTS
FROM OTHER FIRMS
OUTPUT
PRODUCTION
PROCESS
FIRM 2
OUTPUT
FACTORS OF
PRODUCTION
MATERIAL INPUTS
FROM OTHER FIRMS
VALUE ADDED
13
• Value added by a firm is the value of its output
minus the value of intermediate inputs purchased
from other firms
• Value that the firm adds by means of its factor
services
Value Added (contd.)
14
ECONOMY
Total output
Final output
(Products approach)
Intermediate output
Intermediate input Bold arrow-line is included in a national output/income.
Primary factor input
(Earnings approach)
GDP (contd.)
15
MARKETS FOR
GOODS &
SERVICES
MARKETS FOR
FACTORS OF
PRODUCTION
HOUSEHOLD BUSINESS
TAXES/SUBSIDIES GOVERNMENT
(STATE)
FOREIGN
(TRADE)
EXPENDITURE
EXPENDITURE
EXPORTS
RESOURCES
PRODUCTS
INCOME FROM EXPORTS
BANKING
(FINANCE)
SAVINGS INVESTMENTS
TAXES/SUBSIDIES
EXPENDITURE
INCOME
RESOURCES
(KLLe)
FACTOR INPUTS
EXPENDITURE
(i, w, r, p)
THE CIRCULAR FLOW OF MACROECONOMY
IMPORTS
EXPENDITURE ON IMPORTS
PRODUCTSPRODUCTS
REVENUE
16
GDP (contd.)
17
GDP (products approach) = C + G + Ig + (X - M)
GDP is the dollar value of a nation’s production.
It comprises:
– private consumption expenditure (C),
– government expenditure (G); exclude
transfer payments (i.e., taxes and subsidies),
– gross domestic investment (Ig), and
– net of exports (X) and imports (M).
GNE
(Gross National Expenditure)
Net Exports
(Trade)
CLOSED vs OPEN ECONOMY
18
GDP (contd.)
GDP (earnings approach) = σ
Value added = i + w + r + p
GDP is also the dollar value of a nation’s earnings.
It comprises earnings from the use of:
– capital, in the form of interests (i),
– labour, in the form of wages and salaries (w),
– land, in the form of rents (r), and
– entrepreneurship, in the form of profits (p).
19
GDP (contd.)
Gross VS Net Domestic Products (GDP vs NDP)
GDP = C + G + IGross + (X - M)
NDP = C + G + INet + (X - M)
GDP = NDP + depreciation (of capital assets)
20
GDP (contd.)
Domestic VS National Products (GDP vs GNP)
GDP is a measure of output produced in a particular country. It
includes income of foreign multinationals operate in that
country. Its measurement is based on a country’s border, both
from citizens and non-citizens.
GNP is equivalent to GDP, but exclude the value of output that
foreign multinationals sent back to other countries, and include
the value of output that its citizens bring back to a county. Its
measurement is based on a country’s citizens, both domestically
and abroad.
GDP is more commonly used.
21
Government (G)
Sources of government’s income
– Mostly from taxes
– Some from bonds, borrowings, printing new money
TAXES
DIRECT
INDIRECT
• Total income (from flow-of-earnings approach) is spent
on direct taxes that go directly to the government. The
rest is spent on private consumption (C), and savings,
which become investments (I)
• Disposable income: net income (exclude direct taxes)
• E.g.: income tax, property/asset tax, tax on interests
received
• Taxes that are applied on the manufacture or sale of
goods and services, and paid indirectly to the
government by an intermediary
• E.g.: consumption taxes (GST/VAT), excise duties
GDP (contd.)
22
• INDIRECT TAXES
Loaf of bread
Value Added Costs $1.00
Indirect Taxes $0.20
Market prices (Upper Loop) $1.20
Factor price (Lower Loop) $1.00
GDP (contd.)
23
• Price in Upper Loop = Price in Lower Loop + Indirect
Taxes
• We must subtract from the market value the amount
of indirect taxes less any subsidies (subsidies are
negative indirect taxes) paid to the consumers
•
• GDP at market prices = GDP at factor prices + Indirect
Taxes
GDP (contd.)
GDP at market prices GDP at factor prices
(value added)
≠
24
Consumption (C) & Investment (I)
C & I play crucial roles in a nation’s economy
High C, Low I → Low Growth
Low C, High I → High Growth
GDP (contd.)
Country sample C
(%GDP)
I
(%GDP)
Per-capita GDP
growth (%pa)
China 39 44 6.2
India 59 31 6.0
Indonesia 57 34 3.8
Singapore 36 28 3.6
S. Korea 48 31 2.6
Italy 61 18 1.8
Brazil 64 15 0.3
Afghanistan 80 19 0.1
Nigeria 80 15 -1.8
Source: World Bank’s World Development Indicators (2017 data)
25
• INVESTMENT IS THE MOST CRITICAL COMPONENT OF
GDP
• WHY?
• MULTIPLICATIVE EFFECT OF INVESTMENT
- Increase in investment will increase national income
by a multiplied amount – by an amount greater than
itself!
Significance of Investment
INVESTMENT
26
• CONCEPTS
- Increase in income = Consume + Save
- Propensity to consume: Response of consumption to
change in income
- Marginal Propensity to Consume (MPC): Extra amount
consumed when income increases by a dollar
- Marginal Propensity to Save (MPS): Extra amount
saved when income increases by a dollar
Investment (contd.)
27
• MARGINAL PROPENSITY TO CONSUME (MPC)
e.g. ↑$1 (income) = 70c (consumption) + 30c (saving)
MPC = 0.7
MPC for Society = ƩMPC/Individuals
• MARGINAL PROPENSITY TO SAVE (MPS)
MPS = 1 – MPC
= 1 – 0.7
MPS = 0.3
• DETERMINANTS OF ‘C’ (Or Savings)
- Income
- Tax structure
- Price levels
Investment (contd.)
28
MULTIPLICATIVE (MULTIPLIER) EFFECT
PRODUCERS INCREASE IN
INCOME ($)
SPENDING ($)
LUMBERJACK ∆Y0 = 1000 MPC
1 x ∆Y0 = 667
CARPENTER (Producer I) ∆Y1 = 667 MPC x ∆Y1 = MPC
2
x ∆Y0 = 444
Producer II ∆Y2 = 444 MPC x ∆Y2 = MPC
3 x ∆Y0 = 296
Producer III ∆Y3 = 296 MPC x ∆Y3 = MPC
4 x ∆Y0 = 197
Producer IV ∆Y4 = 197 MPC x ∆Y4 = MPC
5 x ∆Y0 = 132
… … …
TOTAL (ECONOMY-WIDE) ∆Y = ∑ ∆Yn = ∆Y0 x (MPC
0 + MPC1 + MPC2 + MPC3 + MPC4 + …)
= ∆ ×

−
= 3000
EXAMPLE: $1000 INVESTMENT IN FORESTRY (Assume MPC = 2/3)
Source: Samuelson (1980)
29
• One unit increase in investment results in more than
one unit increase in national income
• Investment (∆) = $1000
• Total change in income (∆) = 3 × $1000 = $3000
$1000 investment resulted in increase in national
income by $2000
• Investment Multiplier:

−
• Increase in Income: ∆ =

−
× ∆
Multiplier effect (contd.)
30
• Typical Sources of Investment
Purchase of
residential
structures
Business fixed
plant &
equipment
Additions to
inventory
Generally, the most important component of I
Investment (contd.)
31
• ROLE OF INVESTMENT
- Short-run: increase of total demand, output, and
employment
- Long-run: capital formation (additions of capital stock)
• RECESSIONARY TIMES
- Low private consumption
- Low business investment
• POSSIBLE WAY TO INCREASE NATIONAL INCOME
Increase I through G (Taxes) — Keynesian
Increase I through private sources — Neo-classical
Investment (contd.)
32
INCOME
DETERMINANTS OF INVESTMENT
LEAKAGES
33
• INCOME
- Level of GDP – an important determinant
• COST OF INVESTING
- Interest rates (cost of borrowing)
- Taxes (e.g., personal, corporate)
• EXPECTATIONS
- Business confidence (domestic and abroad)
Determinants of Investment (contd.)
34
TRADE ↔ THE FOREIGN CONNECTION
• GDP = GNE + (exports - imports)
• OPEN ECONOMIES TRADE WITH EACH OTHER
• Why?
TRADE
35
• International trade is the exchange of capital and
consumption goods (and services) between countries
• PRINCIPLES
Absolute Advantage: ability to produce more of a given
product or service using less of a given resource (Adam
Smith)
Comparative (Relative) Advantage: ability to produce a
particular product or service at a lower opportunity
cost over another (David Ricardo)
• BASIS OF TRADE – COMPARATIVE ADVANTAGE
Trade (contd.)
36
Absolute advantage in:
– food Japan
– car Japan
* Ref: Samuelson et.al (1992)
Australia Japan
1 unit of food 1.25 hrs 1 hr
1 unit of car 100 hrs 50 hrs
• Example*: Australia vs Japan (food/car)
Trade (contd.)
37
Comparative advantage in:
– food Australia
– car Japan
Cost per hr. Australia Japan
Car
Food
1/1.25 UF
1/100 UC
1 UF
1/50 UC
Price of a unit of car 80 UF 50 UF
Price of a unit of food 0.0125 UC 0.020 UC
Trade (contd.)
39
• Balance of payments of a country is a record of economic
transactions between the country & the rest of the world
• Current account … difference between a country’s total
exports and total imports of goods (i.e., merchandise) and
services (e.g., shipping/air transport, tourism, insurance,
financial/consultancy services)
– exports ˃ imports → Trade Surplus
– exports < imports → Trade Deficit
• Capital account … tracks the ownership of assets held by
foreigner and ownership of foreign assets. It is the capital
inflow (outflow) that is needed to offset the deficit
(surplus) on the current account
BALANCE OF PAYMENTS
40
Source: Australian Bureau of Statistics (www.abs.gov.au)
Balance of payments (contd.)
42
TRADE IN REALITY!
• most nations will keep some level of production of all goods and
services regardless of comparative advantage – trying to be
partially self-sufficient (e.g., food security)
• markets are not perfectly competitive
• things are more complex than the simplistic two-product/two-
country model that comparative advantage relies on
• countries export surpluses whenever they can
• changes in relative prices and exchange rates affect trade
• extreme specialisation could result in structural unemployment
• comparative advantage is not static
• …
Trade (contd.)
43
Definition:
A policy instrument is an economic variable under the
direct or indirect control of the government; changes in
policy instruments affect one or more of the
macroeconomic objectives (e.g., increase GDP, increase
employment, stabilize price levels, balance trade)
MACROECONOMIC POLICY INSTRUMENTS
44
POLICY
INSTRUMENTS
FISCAL POLICY
(C & G)
MONETARY POLICY
(I)
INTERNATIONAL
SECTOR POLICY
(X&M)
WAGE & INCOME
POLICIES (C)
STRUCTURAL
POLICIES (Overall)
GOVT. EXPENDITURE
TAXATION
MONEY IN CIRCULATION
INTEREST RATES
PRICES
LONG-TERM
STRUCTURE/GROWTH
TRADE POLICIES (TARIFFS, QUOTAS)
EXCHANGE RATES
WAGES
Instruments of macroeconomic policy (contd.)
45
• A change in macroeconomic policy through any of the
policy instruments will affect all national objectives
(output, employment, prices, trade)
• Each policy instrument has a marked impact on a
specific objective, but affects other as well
• ‘Trade-offs’ are inevitable
• Choice depends on objectives
Instruments of macroeconomic policy (contd.)
46
• Size of the economy (international comparisons)
• Growth of the economy (expansions, contractions)
• Contribution & significance of various components of
GDP (C, I, G, X - M)
• Analysis of changes in national output (GDP) in
response to policy changes
POTENTIAL USES OF GDP
47
• International comparisons: GDP or Per-capita GDP
Source: World Bank’s World Development Indicators
SIZE OF THE ECONOMY
48
• International comparisons: GDP adjusted with Exchange
rate or Purchasing Power Parity (PPP)
Source: World Bank’s World Development Indicators
PPP is a theoretical exchange rate that allows you to buy the same amount of goods and
services in every country
Size of the economy (contd.)
49
• Time series comparisons
• Nominal (Current) vs Real (Constant) GDP
• Nominal GDPs cannot be directly compared
• Price indices: increases in general price levels (a proxy
for inflation)
- Consumer Price Index (CPI)
- Wholesale price Index (WPI)
- Retail Price Index (RPI)
- GDP Deflator =


×
ECONOMIC GROWTH
50
Example
Agriculture Industry Services Nominal
GDP
Real
GDP
GDP
deflator
PA
($/unit)
QA
(unit)
PI
($/unit)
QI
(unit)
PS
($/unit)
QS
(unit) ($) ($, 2000
prices)
(index)
2000 2 100 10 50 15 20 1000 1000 100
2015 3 118 15 70 25 35 2279 1461 156
Base year = 2000
Increase in GDP over the period 2000 – 2015
(A) 1000 → 2279 … 128% OR (B) 1000 → 1461 … 46% ?
Nominal GDP for year 2000 = (2x100) + (10x50) + (15x20) = 1000
Nominal GDP for year 2015 = (3x118) + (15x70) + (25x35) = 2279
Real GDP for year 2015 (in year 2000 prices) = (2x118) + (10x70) + (15x35) = 1461
GDP deflator in year 2015 (with year 2000 as a base) = (2279 ÷ 1461) x 100 = 156
Economic growth (contd.)
51
Comparison of Australia’s GDP in Nominal and Real Terms
Source: Australian Bureau of Statistics (www.abs.gov.au)
Real/Constant
Nominal/Current
Economic growth (contd.)
52
Australia’s GDP account for 2017-2018
Current Prices $bn (2017-2018)
Flow of Products Approach Flow of Earning Approach
Consumption, C 1044 Wages 0871
Investment, I 0447 Interest, Profit, Rent 0791
Government, G 0346 GDP (factor prices) 1662
Change in Inventories 0003
GNE 1840
Export, X 0401
Import, M 0394
Net Export (X - M) 0007
Statistical Discrepancy 0001 Indirect Taxes 0186
GDP (market prices) 1848 GDP (market prices) 1848
Source: Australian Bureau of Statistics (www.abs.gov.au)
COMPONENTS OF GDP
53
• Contributions of each component to Australia’s GDP in
2017-2018
- Consumption 56%
- Investment 24%
- Government 19%
- Net Export <1%
Components of GDP (contd.)
54
G
D
P
f
o
r
1
9
8
9
-1
9
9
0
(
$
b
n
)
Consumption, C 0223 (55%) Wages 0199 (49%)
Investment, I 0112 (28%) Interest, Profit, Rent 0164 (40%)
Government, G 0070 (17%) Indirect Taxes 0042 (11%)
Export, X 0061 (15%)
Import, M 0069 (17%)
Nominal GDP 0404 Nominal GDP 0404
G
D
P
f
o
r
2
0
1
7
-2
0
1
8
(
$
b
n
)
Consumption, C 1044 (56%) Wages 0871 (47%)
Investment, I 0447 (24%) Interest, Profit, Rent 0791 (43%)
Government, G 0346 (19%) Indirect Taxes 0186 (10%)
Export, X 0407 (22%)
Import, M 0396 (21%)
Nominal GDP 1848 Nominal GDP 1848
Relative Contribution of Various Components (C, I, G, X-M)
Source: Australian Bureau of Statistics (www.abs.gov.au)
Components of GDP (contd.)
55
• Not within the scope of this subject
• Example from Sharma, Sandu & Misra (2014), Energy Efficiency Improvements in
Asia: Macroeconomic impacts, ADB Working Paper No. 406. (estimate using a
General Equilibrium model)
MACROECONOMIC IMPACTS OF POLICY CHANGES
56
APPROPRIATENESS OF GDP AS A MEASURE OF
ECONOMIC WELFARE?
• does not verify distribution of income; according to Kuznets (1934),
“economic welfare cannot be adequately measured unless the
personal distribution of income is known … the welfare of a nation
can, therefore, scarcely be inferred from a measurement of national
income”
• does not consider externalities, unpaid activity, domestic work, etc
• does not consider difference in exchange rate … partially accounted
for by using PPP
• a country with large income disparities (lower standard of living)
may look economically stronger than another country with smaller
income disparities (higher standard of living)
LIMITATIONS OF GDP
The circular flow of an
economy in a narrow sense
Source: Tim Jackson (2009), Prosperity without growth: Economics for a
finite planet, Earthscan, London ; Sterling, VA.
The circular flow of an
economy in a broader sense 57
• Example: Genuine Progress Indicator (GPI)
58Source: Talberth et.al. (2007) The Genuine Progress Indicator 2006, The Nature of Economics. Redefining Progress, Oakland, CA.
ALTERNATIVE TO GDP
59
• GDP vs GPI for
Australia
Source: Kenny et.al. (2019) Australia's Genuine Progress
Indicator Revisited, Ecological Economics, Vol. 158, pp.1-10.
Alternative to GDP (contd.)
60
Other indices?
• Better Life Index
• Gallup Happiness Survey
• World Values Survey
• …
No measure can be totally objective, not even income numbers or GDP.
Alternative measures may similarly give us a sense of false consciousness
Not everything that counts can be measured. Not everything that can be
measured counts – Albert Einstein
Despite weaknesses the measures in economics are still important. We just
need to be fully aware of what these measures do and don’t tell us
Alternative to GDP (contd.)
61
Any Questions?

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