Thinking Like an Economist

1. Thinking Like an Economist

2. Basic Questions: Macro • Macroeconomic Questions • How 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?

3. The Economy as a Circular Flow Resources Income Firms Households Expenditures Goods and Services

4. Saving and Investment Income Firms Households Expenditures Borrowings Savings Financial Markets

5. Financial Markets Savers Individuals Businesses Government Financial Intermediaries Banks Pension funds Mutual funds Borrowers Individuals Businesses Government

6. Financial Intermediaries • Financial intermediaries include banks, insurance companies, investment companies, etc • Financial intermediaries act as the go-between in arrangements between savers and borrowers. • They reduce the uncertainty facing individual households or businesses through diversification.

7. 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.

8. 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.

9. Inflation and Interest Rates • Nominalinterest 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.

10. 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.

11. Nominal Rates: The Fisher Effect THE FISHER EFFECT: • NOMINAL RATE = REAL RATE + • EXPECTED INFLATION

12. Circular Flow with Government Income Firms Households Investment Taxes Taxes Expenditures Government Purchases of Goods and Services Subsidies Government Salaries and Transfers Government Government Borrowing Government Saving Borrowing Savings Financial Markets

13. 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 not be competitive. • Regulation • Anti-trust

14. 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.

15. The Role of Government: Market Failure • Underutilized Resources • Macroeconomic stabilization • Fiscal Policy • Monetary Policy • Exchange Rate Policies

16. Circular Flow with Government and the Rest of the World Foreign Countries Foreign Borrowing Foreign Savings Exports Imports Income Households Investment Firms Taxes Taxes Expenditures Government Purchases of Goods and Services Subsidies Government Salaries and Transfers Government Government Borrowing Government Saving Borrowing Savings Financial Markets

17. 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.

18. 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.

19. Measuring GDP

20. 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.

21. 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.

22. 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.

23. 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

24. Components of GDP: Expenditure Viewpoint • Government Spending • Local and State • Federal • Net Exports • Exports Minus Imports

25. Components of GDP: Income Viewpoint • Employee Compensation • Income 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.

26. Components of GDP: Income Viewpoint • Net Interest • The portion of business receipts used to pay for borrowed funds that finance investment purchases.

27. 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.

28. 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

29. 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.

30. GDP = NI 2001 Consumption6,987.1 Durable Goods 835.9 Nondurables 2,041.3 Services 4,109.9 Investment1,586.0 Nonresidential 1,201.6 Residential 444.7 Inventory Change -60.3 Government 1,858.0 Federal 628.1 State & Local 1,229.9 Net Exports-348.9 Exports 1,034.1 Imports 1,383.0 GDP 10,082.2 Employee Compensation 5874.9 Corporate Profits 731.6 Proprietors’ Income 727.9 Net Interest 649.8 Rental Income 137.9 National Income8,122.1 + CCA 1329.3 + Indirect Business Taxes 774.8 + Business Transfers 42.5 - Subsidies 47.3 +Statistical Discrepancy -117.3 GNP10,104.1 +Net Foreign Payments -21.9 GDP10,082.2

31. The Economy as a Circular Flow Resources Income Firms Households Expenditures Goods and Services

32. 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.

33. 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

34. 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.

35. 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

36. 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.

37. 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.

38. 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.

39. 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

40. 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.

41. 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.

42. 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.

43. Macroeconomic Problems Unemployment Inadequate Growth Inflation

44. Unemployment • The unemployment rate is the number of unemployed people, expressed as a percentage of the labor force. • Labor Force = (Civilian non-institutional population over age 15 minus people not in the labor force (students, homemakers, retirees, discouraged workers)

45. Definitions Labor Force = Number of Employed + Number of Unemployed Unemployment Rate = Number of Unemployed Labor Force Labor Force Participation Rate = Labor Force Adult Population X 100 X 100

46. 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 due to changes in the business cycle.

47. 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.

48. 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.

49. 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.

50. 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%