European Finance and Economy Lesson 2 Fundamental Economic Terms

Prof. Dr. Brigitta Herrmann 10/13/2011

Outline
1. How is the GDP measured? 2. Understanding inflation rate 3. Relationship between Inflation rate and
1. 2. 3. 4. Interest rates Savings Investment Employment

4. Budget Deficit 5. Government Debt

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1. How is the GDP measured?

GDP (Gross Domestic Product):
Measure of the economic performance of a national economy over a given period Gives the value of final goods and services produced in the economic territory (without intermediate consumption for the production of other goods and services, without subsistence production, without black market)

13.10.2011

Prof. Dr. Brigitta Herrmann

1. How is the GDP measured?

GDP: 3 Methods of Calculation: Production Expenditure Distribution

13.10.2011

Prof. Dr. Brigitta Herrmann

1. How is the GDP measured?

Calculation of GDP: Production method: example Germany 2005 in bio Output - intermediate consumption = gross value added + taxes less subsidies on products = gross domestic product
13.10.2011 Prof. Dr. Brigitta Herrmann

4,088.72 2,082.36 2,006.36 218.04 2,224.40

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1. How is the GDP measured?

Calculation of GDP:
Expenditure method: example Germany 2005 in bio
Final consumption expenditure of households + investment + government final consumption expenditure + exports imports = gross domestic product Y=C+I+G+X-I 1,306.98 384.13 417.30 919.07 803.08 2,224.04

13.10.2011

Prof. Dr. Brigitta Herrmann

1. How is the GDP measured?

Calculation of GDP:
Distribution method: example Germany 2005 in bio
Compensation of employees (residents) 1,137.64 +property and entrepreneurial income 576.05 =national income (factor costs) 1,713.69 +government taxes on production and imports less subsidies 207.94 +consumption of fixed capital 327.96 =gross national income 2,249.59 primary income from the rest of world (balance)25.19 =gross domestic product 2,224.40

13.10.2011

Prof. Dr. Brigitta Herrmann

2. Understanding inflation rate

1. Inflation: persistent increase of prices Inflation rate: = percentage by which prices of goods and services rise above their average level = rate by which the purchasing power of people in a country has declined in a specified period (month or year (expressed in an annualized figure)

13.10.2011

Prof. Dr. Brigitta Herrmann

2. Understanding inflation rate

Calculation of inflation rate: price indices
Consumer Price Index Cost of Living Index Producer Price Index Commodity Price Index Formula: Inflation Rate = (Po- P-1)* 100 / P-1, Po = present average price P-1 = price that existed last year

13.10.2011

Prof. Dr. Brigitta Herrmann

2. Understanding inflation rate

Causes of inflation:
1. Increase of money supply or 2. Decrease of goods supplied Ad 1. Printing too much money (= expansonary monetary policy) Supply of money is big compared to products one can buy with the money => prices rise High lending levels Declines in exchange rates
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2. Understanding inflation rate

Ad 2. Decrease of goods supplied causes inflation:
Increases in production costs Increases in labour costs Decrease in availability of limited resources (e.g. food, oil)

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Prof. Dr. Brigitta Herrmann

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2. Understanding inflation rate

Effects of inflation: economic and social
Purchasing power decreases (problem especially for low-income groups) Real value of money decreases => effect on interest rates => effect on savings => effect on investments => effect on employment

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Prof. Dr. Brigitta Herrmann

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3. Relationship between Inflation rate and

Effects of inflation rate on interest rates:
if inflation rate increases => interest rates will rise because: people saving money want to be compensated for losses in value of money due to inflation Questions: How fast is adaptation process? What other factors influence adaptation process?

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Prof. Dr. Brigitta Herrmann

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3. Relationship between Inflation rate and

Effects of inflation rate on savings:
if interest rates rise => Savings will rise, if consumers are able to save money (not too poor) if inflation is not too high, if so => Savings decrease but shift to real assets

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Prof. Dr. Brigitta Herrmann

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3. Relationship between Inflation rate and

Effects of inflation rate on investment:
if interest rates and wages have not adapted => investments might rise because of relatively cheap loans and labour costs if interest rates and wages rise investments might decrease, because
loans will be more expensive it is unclear how interest rates will develop in future

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Prof. Dr. Brigitta Herrmann

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3. Relationship between Inflation rate and

Effects of inflation rate on employment: If wages have not adapted: =>Unemployment may be reduced (reduced costs
because of reduced real wages) If wages have adapted (risen) and if investments are reduced => unemployment rises

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Prof. Dr. Brigitta Herrmann

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4. Budget Deficit
Budget Deficit: Government Budget = summarized version of : Anticipated revenues and Anticipated expenses of a government (formulated by the executive and passed by the legislature as a legal document) Government Budget: focus on distribution of wealth for economic political and social purposes
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4. Budget Deficit
Budget Deficit: Public expenditures > public revenues Must be financed by loans Public Debt increases Interest rates on government bonds increase Depending on types of expenditures: Employment might increase Private investment might be crowded out
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5. Government Debt
Overall government debt = accumulated debts Problem: even if no new debts, overall debt is rising because of interest rates on already existing debts Government debt should be seen in relation to growth rate If growth rate is higher than real interest rate => not a big problem
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Thank you very much for your attention !

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Prof. Dr. Brigitta Herrmann

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