Transcript Thinking Like an Economist

Thinking Like an Economist
Basic Questions: Macro
 Macroeconomic
 How
Questions
can sufficient growth be attained
so that the well being of society
increases?
 How should productive capacity be
utilized so that there will be full
employment with stable prices?
The Economy as a Circular
Flow
Resources
Income
Firms
Households
Expenditures
Goods and Services
Saving and Investment
Income
Firms
Households
Expenditures
Borrowings
Financial Markets
Savings
Financial Markets
Savers
Individuals
Businesses
Government
Financial Intermediaries
Banks
Pension funds
Mutual funds
Borrowers
Individuals
Businesses
Government
Financial Intermediaries
Financial intermediaries include banks,
insurance companies, investment
companies, etc
 Financial intermediaries act as the gobetween in arrangements between savers
and borrowers.
 They reduce the uncertainty facing
individual households or businesses
through diversification.

Interest Rates: Facts
 Interest
rates serve many roles:
 Interest
rates are the price of
credit.
 Interest rates are a premium paid
to forego consumption.
 Interest rates are the return to
capital as a factor of production.
Real and Nominal Rates
 Nominal
interest rates are rates
unadjusted for the effect of
inflation or deflation.
 Real rates are adjusted for price
level changes.
Inflation and Interest Rates
 Nominal
interest rates are not
adjusted to reflect changes in the
price level.
 They
are the percentage by which
the money a borrower pays back
exceeds the money he borrowed,
making no adjustment for any
change in purchasing power.
Inflation and Interest Rates
 Real
interest rates are the percentage
increase in purchasing power that the
borrower pays to the lender for the
privilege of borrowing.
Real interest rates are nominal interest
rates minus the rate of inflation.
 Real interest rates may be positive, zero,
or negative.

Nominal Rates: The Fisher
Effect
THE FISHER EFFECT:
NOMINAL RATE
=
REAL RATE +
EXPECTED INFLATION
Circular Flow with
Government
Income
Firms
Households
Investment
Taxes
Government
Purchases of
Goods and Services
Subsidies
Borrowing
Expenditures
Taxes
Government
Government
Government
Government Salaries
and Transfers
Borrowing
Saving
Financial Markets
Savings
The Role of Government:
Market Failure
 Inequity
 Standards
of fairness are determined
by society and may not be met by the
market’s distribution of benefits.
 Failure
of Competition
 Markets may
• Regulation
• Anti-trust
not be competitive.
The Role of Government:
Market Failure
 Public

Goods
Some goods cannot be produced
profitably by the private market and as a
result must be provided by government.
•
Free Rider Problem
 Externalities

Some activities provide benefits or impose
costs on others that are not captured by the
the price system.
The Role of Government:
Market Failure
 Underutilized
Resources
 Macroeconomic stabilization
• Fiscal Policy
• Monetary Policy
• Exchange Rate Policies
Circular Flow with Government and
the Rest of Foreign
the World
Countries
Foreign Borrowing
Foreign Savings
Exports
Investment
Imports
Income
Households
Firms
Taxes
Taxes
Expenditures
Government
Purchases of
Goods and Services
Subsidies
Borrowing
Government
Government
Government
Borrowing
Saving
Financial Markets
Government Salaries
and Transfers
Savings
The Rest of the World
 An
economy has two basic kinds of
economic interactions with the rest
of the world.
 Buying
and selling goods and
services
 Buying and selling assets.
The Rest of the World
 Exports
are those goods we produce
for sale in the rest of the world.
Imports are those goods we buy from
the rest of the world.
 We also lend to the rest of the world
and borrow from them.
Measuring GDP
What Is GDP?

GDP, Gross Domestic Product, is the
total dollar value of all final goods and
services produced in a country during a
year.

Current market prices are used to
aggregate different outputs to a dollar
total. Government purchases, many of
which do not occur in markets, are valued
at their cost of production.
What Is GDP?



Only final goods and services are included.
Intermediate goods are not included to avoid
double counting.
The measure is an annual flow, a rate of
production. A GDP of $10 trillion implies that
the economy is producing $10 trillion worth of
goods and services per year.
GDP measures production by U.S. citizens and
foreigners alike inside the geographic borders of
the USA and thus unequivocally reflects
economic activity in the USA.
Real and Nominal GDP

Nominal GDP

The market value of a nation’s final output
based on current prices for the goods and
services produced during the year.
• Nominal GDP in 2001 = the sum of all the
goods and services produced in 2001 multiplied
by their 2001 prices

Real GDP

An estimate of the value of a nation’s final
products adjusted for changes in prices
since a certain base year.
Components of GDP:
Expenditure Viewpoint
 Consumption
Non-durable Goods (last less than 3 years)
 Durable Goods (last more than 3 years)
 Services

 Gross
Domestic Investment
Non-residential lnvestment (plant and
equipment)
 Inventory Change
 Residential Investment

Components of GDP:
Expenditure Viewpoint
 Government
Spending
Local and State
 Federal

 Net

Exports
Exports Minus Imports
Components of GDP:
Income Viewpoint
 Employee
 Income
Compensation
from the sale of labor
services during the year. It includes
wages, salaries, and fringe benefits
such as employer provided insurance
and employer contributions to
pension funds.
Components of GDP: Income
Viewpoint
 Net
Interest
 The
portion of business receipts used
to pay for borrowed funds that
finance investment purchases.
Components of GDP:
Income Viewpoint
 Rental
Income
 Rental
income is earned by those
who supply the services of land,
mineral rights, and buildings for use
by others.
 Also included in rental income is an
estimate of the imputed rent earned
by homeowners who live in their
own homes less the expenses of
maintaining their homes.
Components of GDP: Income
Viewpoint
 Profits.
 Profits
of corporations and
unincorporated business
•
Profits = Total revenues - Indirect
business taxes - Capital consumption
allowance - labor costs - net interest rents paid
Components of GDP:
Expenditure and Income
 Expenditure
 GDP
= C + I + G + (X-M)
 Income
 NI
(Y) = W + i + R + profits
 Since
NI and GDP measure
aggregate production, they must
be equal.
GDP = NI 2001
Consumption
6,987.1
Durable Goods
Nondurables
Services
835.9
2,041.3
4,109.9
Investment
Nonresidential
Residential
Inventory Change
Government
Federal
State & Local
Net Exports
Exports
Imports
GDP
1,586.0
1,201.6
444.7
-60.3
1,858.0
628.1
1,229.9
-348.9
1,034.1
1,383.0
10,082.2
Employee Compensation
5874.9
Corporate Profits
731.6
Proprietors’ Income
727.9
Net Interest
649.8
Rental Income
137.9
National Income
8,122.1
+ CCA
1329.3
+ Indirect Business Taxes
774.8
+ Business Transfers
42.5
- Subsidies
47.3
+Statistical Discrepancy
-117.3
GNP
10,104.1
+Net Foreign Payments
-21.9
GDP
10,082.2
The Economy as a Circular
Flow
Resources
Income
Firms
Households
Expenditures
Goods and Services
Saving and Investment

Economists make a clear distinction
between saving and investment.
Saving is the act of abstaining from
consumption.
 Investment is the result of purchasing a
new capital good.

Saving and Investment: Closed
Economy

Y=C+I+G


G = IGOV + CGOV
Y = CNAT + INAT
CNAT = C + CGOV
 INAT = I + IGOV

Y – CNAT = INAT
 SNAT = INAT

Savings = Investment: Closed
Economy

In a closed economy, savings must just
equal investment.
If S > I, interest rates will fall and I will
rise.
 If S < I, interest rates will rise and I will
fall.

Saving and Investment: Open
Economy

Y = CNAT + INAT + NX

NX = Exports – Imports
Y – CNAT – INAT = NX
 SNAT – INAT = NX

If SNAT = INAT, NX =0, trade balance
 If SNAT > INAT, NX >0, trade surplus
 If SNAT < INAT, NX <0, trade deficit

Looking at X - M

X represents the exports of a country.


X is the income a country receives from
the rest of the world through exporting
goods and services.
M represents the imports of a country.

M is a country’s consumption of goods
and services produced by the rest of the
world.
Looking at X - M

X – M then is income minus consumption
vis a vis the rest of the world.
If X > M, a country has excess funds to
lend to the ROW, or S > I.
 If X < M, the country’s trading partner has
excess funds to lend to it or domestically
S < I.

S – I = NX

Net foreign investment (S - I) always
equals the trade balance (NX).

The international flow of funds to finance
capital accumulation and the international
flow of goods and services are two sides
of the same coin.
Government and the Private
Sector
YD = Y + TR – T
 S = YD – C

YD = C + I + G + NX + TR – T
 YD = S + C


Set YD = YD and solve for NX
S + C = C + I + G + NX + TR – T
 S + C – C – I – G – TR + T = NX


(S – I) + (T – TR – G) = NX
Government and the Private
Sector

(S – I) + (T – TR – G) = NX
(S – I) = Private saving
 (T – TR – G) = Government saving


There are two ways the government can
raise funds if G +TR > T
It can borrow at home, if S > I or
 It can borrow from the ROW, if S < I or
NX < 0.

Twin Deficits Problem

T < G + TR
Federal government budget deficit.
 If S <=I, we must borrow from abroad.
 This will be possible only if the ROW has
excess funds or a trade surplus with us.

Twin Deficits Problem

T > G + TR
Federal government budget surplus.
 If S >= I, we may lend to the ROW.
 This will be occur only if the ROW has
insufficient saving or a trade deficit with
us.

Macroeconomic Problems
Unemployment
Inadequate Growth
Inflation
Unemployment
 The
unemployment rate is the
number of unemployed people,
expressed as a percentage of the labor
force.
 Labor
Force = (Civilian noninstitutional population over age 15
minus people not in the labor force
(students, homemakers, retirees,
discouraged workers)
Definitions
Labor Force = Number of Employed + Number of Unemployed
Unemployment Rate = Number of Unemployed
Labor Force
X 100
Labor Force Participation Rate = Labor Force
X 100
Adult Population
Types of Unemployment
 Frictional
Unemployment
 Occurs
due to normal turnover in the
labor market. People changing jobs.
 Structural
Unemployment
 Refers
to workers who are not employed
because their skills are not in demand.
 Cyclical
Unemployment
 Occurs
cycle.
due to changes in the business
Natural Rate of
Unemployment

The natural rate of unemployment is the
percentage of the labor force that can normally
be expected to be unemployed for reasons
other than cyclical fluctuations in real GDP.

The natural rate of unemployment is related to the
willingness of workers to voluntarily separate
from their jobs, job loss, the duration of
unemployment periods, the rate of change in the
pattern of demand, and changes in technology.
Costs of Unemployment
 Loss
in productivity is measured by the gap
between potential GDP and actual GDP.
 A conservative
estimate of the cumulative gap
between actual and potential GDP over the
years 1974-1992 (evaluated in 1987 prices) is
approximately $1300 billion.
 At 1993 levels, this loss in output would be
about 3 months’ worth of production.
 It cannot be made up.
Inflation
 Inflation
refers to a sustained rise in
the average level of prices.
 Inflation
does not mean that all prices
are rising. Some prices may be
falling, but on average the overall
level of prices is rising.
Inflation
Creeping inflation is an inflation that
proceeds for a long time at a moderate
and fairly steady pace.
 Galloping inflation is an inflation that
proceeds at an exceptionally high rate,
often for only a brief period.


In 1993, Brazil experienced inflation rates
of 2,700%
The Costs of Inflation

The main cost of inflation is the loss of
efficiency that results because inflation
distorts price signals. For example…

People invest in assets designed to protect
them against inflation, such as real estate,
rather than in productive investments that
enhance the growth and efficiency of the
economy.
The Costs of Inflation
Business collect bills more promptly, using
resources that could otherwise have been
used to produce goods and services.
 Individuals reduce money holdings, which is
inconvenient and misallocates the
individual’s personal resources of time,
energy , and leisure.
 In the case of hyperinflation, inflation over
100%, the currency system breaks down and
the economy reverts to barter.

Purchasing Power and
Inflation
 Inflation
erodes the purchasing
power of a given sum of money.
 Assume
you have $10,000 and the
price level is 1.
• In current dollars, you have $10,000,
and in constant dollars you have
$10,000.
Purchasing Power and Inflation
 Now
let the price level rise to 2.
• In current dollars, you still have
$10,000, but in constant dollars you
now have ??? ?
 The
rise in the price level has
decreased the purchasing power of
your money.
Price Indexes
 Consumer
Price Index (CPI)
 Producer Price Index (PPI)
 GDP Deflator
 GDP Price Index
 PCE Price Index
Price Indexes: Use
GDP in 2000 = P2000 times Q2000
 GDP in 2002 = P2002 times Q2002
 If we wish to compare GDP in 2002 with
GDP in 2000, we must remove any price
changes that have occurred.
 Why?

Price Indexes: Use
GDP 2002 = P2002 x Q2002
 Divide by a price index = P2002/P2000

P2002Q2002
P2002
= P2002Q2002 x P2000 = Q2002P2000
P2000
P2002
The
End