ECONOMICSwhy should we study it?

Economic development = quality of life

Life expectancy is strongly correlated with economic activity (GDP per capita, based on PPP)

Using WDI data for 2004, the correlation coefficient between the life expectancy at birth and the GDP per capita, PPP method: 0.63

The statistical relationship can be approximated by the following expression (click here for the source file):

capitaper GDP * 0.000758 58.829 Expectancy Life

This suggests that $1319 in GDP per capita translates into 1 year difference in expected lifespan

Economics

• Defining Economics– Social Science– Unlimited Wants– Scarce Resources

• Efficiency– What to Produce (allocative efficiency)– How to Produce (productive efficiency)– For Whom to Produce (allocative efficiency)

Economic Resources

• Agricultural Economy (Feudalism)– Labor

• Immigration, population growth– Land

• Inclusive of natural resources• Industrialization (Capitalism)

– Capital• Encouragement of saving and capital formation (IRA)

• Advanced Industrialization and Post Industrial – Human Capital

• Subsidized education– Entrepreneurship

• Establishing favorable business environment

Economic systems

• Capitalism• Socialism• Communism

These systems differ in the allocation of the ownership of productive resources

The differences in these systems can also be formulated in terms of how they address the fundamental questions (e.g. command economy versus market economy)

• Feudalism• Mercantilism

–Natural emergence• Adam Smith’s “invisible hand” concept

–Simplified role of the government• Institutional support for economic activity

– Property rights laws– Stable political system– Well defined legal system– Transparent business regulations– System of checks and balances for gov’t officials

Capitalism

Socialism

• Philosophical Foundation

• Socialist Movement of the mid XIX century

• Role of the government– Includes economic decisions in terms of

allocation of resources and output, and possibly production

Modern Economies• Mixed system (capitalism + socialism)

– EU versus US versus RU versus China

General government final consumption expenditure (% of GDP) in 2001

Switzerland 13.31

China 13.69

United States 14.23

Russian Federation 14.32

Italy 18.47

Germany 19.06

France 23.27

Sweden 26.66

Source: World Bank, WDI 2003

Unemployment rate comparison

Unemployment, total (% of total labor force), 2000

Switzerland 2.7

China 3.1

United States 4.1

Sweden 5.1

Germany 8.1

France 10.0

Italy 10.8

Russian Federation 11.4

Source: World Bank, WDI 2003

The Concept of Cost in Economics

• Every undertaken activity has a foregone sacrifice associated with it

• Opportunity Cost– The value of the next BEST (highest valued)

alternative (the value of the sacrifice that would have become the next choice)

– E.g. opportunity cost of this class– E.g. Opportunity cost of the Colander’s book

(relative price)– E.g. Opportunity cost of physical capital

The world of trade-offs

• Budget Constraint and Relative Price

• Production Possibilities Frontier

Gains from Trade

• Specialization and increased output• Two-country two-product world• Absolute advantage principle

– Why specialize in the production of something that is cheaper to purchase from abroad?

• Comparative advantage principle– Specialize in the production of those products in which

you have the lowest relative (opportunity) cost of production

• Shape of PPF and lack of complete specialization• US trade data available on BEA website at:

http://www.bea.gov/bea/di/home/trade.htm

Trade (% of GDP)

2003

World 47.84

Upper middle income 68.53

Middle income 61.98

High income 45.29

Lower middle income 57.10

Low income 44.61

Sub-Saharan Africa 64.28

South Asia 33.33

Middle East & North Africa 58.16

Latin America & Caribbean 45.53

European Monetary Union 68.25

East Asia & Pacific 74.17

United States 23.66

Definition:

Trade is the sum of exports and imports of goods and services measured as a share of gross domestic product.

For the USsee BEA

Globalization and International Risks

• Globalization = economic integration

– Trade

– Investment

– Labor mobility

– Economic union (EU)

• Globalization and spread of economic recessions

  China Canada MexicoUnited

States

China 1

Canada 0.038296 1

Mexico -0.21368 0.126047 1

United States 0.174459 0.759405 0.391163 1

Correlation in economic growth (GDP growth rates: 1990-2005)between the US and some of its major trading partners)

Markets

• Defining a market– Product definition (and competition)– Geographical boundaries (internet, shipping

cost reduction – globalization and outsourcing)

• Market forces: Buyers (demand) versus Sellers (supply)– Price and quantity as the outcome

demand

• Quantity = f (price, other factors)• Price and the Law of Demand • Other factors

– Income (normal versus inferior)– Related in consumption goods

• Substitutes• Complements

– Expectations about the future– OTHER FACTORS ………

supply

• Quantity = f ( price, other factors)• Price and the Law of Supply• Other factors

– Costs of Production (MC, and price as MB)– Goods related in production

• Substitutes: (agricultural products)– Note, identical to costs of production since is based on

opportunity cost concept

• Complements: (like gold and silver)

– Producer expectations of future prices

• Other factors…

Market equilibrium

• Qs = Qd

• Shortage and surplus as unstable states and the stability property of the equilibrium

• Market efficiency

• Shifts in demand and supply

• Is the equilibrium really efficient?– Productive and allocative efficiency

Market example: ForEx

• How can the US run a trade deficit consistently? Or, differently put, can one live on credit forever?

Does Dollar Matter?EURO/USD

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1/2

/01

3/2

/01

5/2

/01

7/2

/01

9/2

/01

11

/2/0

1

1/2

/02

3/2

/02

5/2

/02

7/2

/02

9/2

/02

11

/2/0

2

1/2

/03

3/2

/03

5/2

/03

7/2

/03

9/2

/03

11

/2/0

3

1/2

/04

3/2

/04

5/2

/04

7/2

/04

9/2

/04

11

/2/0

4

1/2

/05

3/2

/05

Should We Be Concerned With The Fluctuating Dollar?

• TRADE and Currency Fluctuations– Price Changes– Standard of Living – Commodity Prices

Date USD per EURO USD Price of OIL Euro Price of OIL

March 1, 2002 0.8652 22.40 25.89

March 3, 2003 1.0835 35.88 33.11

March 1, 2004 1.2431 36.86 29.65

March 1, 2005 1.3189 51.68 39.18

% change over the period 52.44 130.71 51.35

The ForEx market

• Supply of the USD– Imports to the US

• Goods (trade)• Services (tourism)

– US investment abroad• Foreign Financial

Markets• Direct investment

abroad– Central Banks– Speculation

• Demand for the USD– US Exports

• Goods• Services (tourism)

– Foreign Investment into US

• US Financial markets• Direct investment

– Central Banks– Speculation

The Interesting 90’s• 1991-92: Collapse of the USSR Block, beginning of the Transitional

Recession in Eastern Europe• 1994 Mexican Currency Crisis• 1991(2)-95 The Balkan Wars• 1998 Recession in Japan• 1997 (July) Beginning of the Asian Financial Crisis• 1998 major Rouble Crisis

US ECONOMY

  average % rates

 1992-2000

2001-2004

Real GDP 3.7 2.5

Gross Domestic Private Investment 8.7 1.8

Non-Residential Investment 9.1 0.2

The market for USD in the 90’s

D S

Influx of investment stimulated Demand

Increase in imports stimulated Supply

Demand Effect Dominated(thus positively effecting consumers’ standard of living)

P of USD

The post 90’s era• United Europe

– 10 New Countries Entered the Union on May 1st of 2004, bringing the total number of member states to 25, with combined population of over 430 million (US population is 293 million).

• Strong Growth in Russia and China• Emerging Economies of Brazil and India• Threat of Terrorism to the US• Continuous Growth in US Trade Deficit• More Recently, the French and Dutch

Referendums on the EU Constitution

The BIG picture

• Rise in Imports Increase in Supply Depreciation• Rise in Exports Increase in Demand Appreciation• Influx of Investment Increase in Demand Appreciation• Outflow of Investment Increase in Supply Depreciation

• BALANCE OF PAYMENTS – An Economy’s International Balance Sheet (www.bea.gov)

Demand for the dollardifferent economic agents that purchase the dollar:

•Foreigners who wish to purchase US goods or services, foreign tourists who wish to travel to the US (US exports)

•Foreigners who wish to invest in the US (higher US interest rate, attractive US stock market returns)

Supply of the dollardifferent economic agents that sell the dollar:

•US consumers/firms that want to purchase foreign goods or services, US tourists who wish to travel abroad (US imports)•US residents who wish to invest abroad (higher interest rates abroad, etc.)

The dollar will appreciate if demand exceeds supply at the current exchange rate. The increase in the demand creates a temporary shortage, but that shortage disappears due to the increase in the price. The price adjustment is the market’s correction mechanism to the changing conditions.Note that when you purchase a foreign made product, the cost of the production of that product is paid in foreign currency, hence somewhere between the production process and your purchase someone would have to convert your currency into that foreign currency in order to pay for the production.

Measuring Economic Activity

• OUTPUT

• EMPLOYMENT

• INFLATION

• Gross Domestic Product

the total market value of all final goods and services produced by factors of production located within a nation’s borders over a period of time (usually one year)

• Gross National Product

the total market value of all final goods and services produced by factors of production owned by a nation over a period of time (usually one year)

Output

• Measuring production– Time period– Final goods and services (value added)– Market prices– Defining an economy (geographical boundaries

versus resource ownership)

• Gross Domestic Product• Gross National Product• www.bea.gov Table 1.7.5 http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=43&FirstYear=2003&LastYear=2005&Freq=Qtr

United States -12,100.00United Kingdom 10,907.59Switzerland 25,209.39Russian Federation -9,793.48Pakistan -872.918India -2,698.42France 4,911.81Mexico -13,741.58Japan 68,421.59China -19,173.22European Monetary Union -33,802.12High income 41,967.63Low income -23,770.11

Net income from abroad in 2001 (current US$) (mill)

GDP per capita in 2005 (using 2000 USD)

Greater than $9910 (2445, 9910) (1172, 2445) (430, 1172)less than $430 no data available

The World Economy in 2004

GDP (constant 2000 USD)

% of World GDP

Population% of World Population

GDP per capita (constant 2000

USD)

GDP per capita, PPP (constant

2000 USD)in billions in millions

World 35111 100 6365 100 5516 8187High income 27820 79 1004 16 27705 28482Upper middle income 2490 7 576 9 4322 9614Middle income 6244 18 3018 47 2069 6210Lower middle income 3754 11 2442 38 1538 5422Low income 1052 3 2343 37 449 2111Sub-Saharan Africa 390 1 726 11 537 1781South Asia 755 2 1447 23 522 2635Middle East & North Africa 521 1 300 5 1736 5346Latin America & Caribbean 2132 6 546 9 3906 7314East Asia & Pacific 2344 7 1870 29 1254 4920European Monetary Union 6476 18 309 5 20934 25847United States 10764 31 294 5 36655 36465

Source: WDI: 2006, World Bank

2003: Health expenditures per capita

(current USD)

2004: cases of TB per

100,000

2004: Internet Users

per 1000

Life expectan

cy at birth

Mobile phone subscribers per 1000

Infant mortality rate per

1000

PCs per 1000 people

World 587.79 139.47 139.93 67.32 279.34 54.09 129.77

Upper middle income 279.96 112.15 159.33 69.15 484.18 23.36 121.75

Middle income 116.29 113.63 91.83 70.22 293.61 30.02 60.86

High income 3449.40 17.11 544.93 78.74 771.72 6.12 574.14

Lower middle income 77.49 113.97 75.91 70.47 248.86 31.58 46.20

Low income 29.62 223.99 24.34 58.68 42.15 79.45 11.29

Sub-Saharan Africa 36.42 363.14 19.44 46.22 74.08 100.47 15.05

South Asia 23.78 177.21 26.14 63.41 41.31 66.41 12.14

Middle East & North Africa 92.41 53.91 58.00 69.35 128.61 44.09 48.55

Latin America & Caribbean 221.68 63.51 114.53 72.19 318.36 26.52 92.40

European Monetary Union 2552.10 13.00 443.22 79.38 904.19 4.11 420.84

East Asia & Pacific 64.11 137.75 73.79 70.28 243.47 29.16 38.19

United States 5711.00 4.70 629.99 77.43 616.73 6.70 749.18

Correlation between life expectancy and the standard of living as measured by theGDP per capita (PPP) is positive 0.65, see the stats table; correlation betweenGDP per capita and life expectancy is 0.57 (based on the 2005 data from WDI of 2007

The planet Earth in the darkness of the night*

* Image source: NASA (http://antwrp.gsfc.nasa.gov/apod/ap001127.html)

Issues in GDP computation/comparison

• Survey of economic activity– Self-employed/small businesses

• Market prices and the government sector• Illegal activities

– Underground economy (“shadow” sector)– Tax compliance– Defining legal vs illegal

• Labor force participation/wages– Household vs market setting

Equivalence between expenditure and income approaches in GDP computation

• Circular flaw concept– Production of output creates income– Income finances consumption of output

Households Businesses

Input markets

Output markets

Wages, interest, profitsLabor, capital…

prices output

Income = output

• GDP = GNP – NET FOREIGN INCOME

• NI = GNP – depreciation – indirect business taxes

• PI = NI - (Transfer payments from Gov’t, net non-business interest income) + (Social Insurance tax, corporate retained earnings)

• DI = PI – Personal Taxes

• See Table 1.7.5 (www.bea.gov)

Income approach• Disposable Income (in 2004: 8,646.9 billion $)

– Income that households actually receive– Available for consumption and saving

• Personal Income (in 2004: 9,689.6 billion $)– Household income prior to personal taxes and transfers– PI= DI + Personal Taxes

• National Income– Summation of factor payments

• Employment compensation• Interest received from private business• Profits• Rental income

– NI = PI + (Transfer payments from Gov’t, net non-business interest income) – (Social Insurance tax, corporate retained earnings)

• Gross National Product– GNP = NI + Dep.Allowance + Indirect Business Taxes

• GDP = GNP - Net Foreign Income

Expenditures Approach•Personal Consumption

–Goods

•Durable

•Non-durable

–Services

•Gross Private Domestic Investment

–Fixed Investment

•Non-residential

–Structure

–Equipment and software

•Residential

–Business

–Government Spending (all levels)

–Exports of goods and services

–Imports of goods and serviceshttp://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=35&FirstYear=2003&LastYear=2005&Freq=Qtr Table 1.5.5

employment

• Labor force– Labor force participation rate

• Unemployment– Unemployment rate

BLS www.bls.gov US statisticsIndustry data: ftp://ftp.bls.gov/pub/suppl/empsit.ceseeb3.txt

• Categorizing unemployment– Cyclical– Structural– Seasonal– Frictional

More on unemployment• Accuracy of unemployment statistics

– Discouraged worker phenomenon– Two surveys

Emploment values are in 000's March April May June JulyTotal nonfarm Employment in 000's 130084 130062 129986 129914 129870Total Employment 137348 137687 137487 137738 137478Total Unemployed 8445 8786 8998 9358 9062Civilian Labor Force 145793 146473 146485 147096 146540Labor Force Participation Rate 66.2 66.4 66.4 66.6 66.2

Unemployment Rate 0.05792459 0.05998375 0.06142608 0.06361832 0.06183977

Statistics for the US economyFor March-July 2003 (seasonally adjusted). Source: BLS

Discouraged Worker Phenomenon

% 1997 1998 1999 2000 2001 2002 2003Labor Force Participation Rate 67 67.1 67.3 67.3 67.2 66.4 66.3

For the month of January

Historical unemployment rate in the US

inflation

• Rate of growth of the average of all prices– Average price: weighted price

• Weight represents relative importance of the good• Average price converted into index: price index

• Measuring inflation– Consumer Price Index (CPI)

• www.bls.gov (http://www.bls.gov/news.release/cpi.t01.htm)

– Producer Price Index (PPI)• www.bls.gov

Real versus Nominal Measures

Nii iiQPGDP 1

US Real and Nominal GDP. Source: BEA

   1992       1998       1999       2000       2001       2002        Real GDP 6,880.00 8,508.90 8,859.00 9,191.40 9,214.50 9,440.20Nominal GDP 6,318.90 8,781.50 9,274.30 9,824.60 10,082.20 10,445.60

Costs of (unanticipated) Inflation

• Menu Cost• Redistribution of Wealth• Changes in Standard of Living• Inflation and relative prices• High inflation tends to be more volatile• Increased Uncertainty in Forward Looking

Financial Arraignments• Impact on the Exchange Rate (Purchasing Price

Parity for internationally traded goods)

Growth in Real GDPRecessions in RecentUS history:

2000-2001:QIII:00QI:01QIII:01

1990-1991:QIV:90QI:91

1981-1982:QIV:81QI:82(QIII:82)

1980: QII & QIII

1974-1975QIII:74QIV74QI:75

-10

-5

0

5

10

15

20

   1974       1977       1981       1984       1988       1991       1995       1998       2002       2005   

Real Business Cycle - US Real GDP: 1974-2006

0.00

2,000.00

4,000.00

6,000.00

8,000.00

10,000.00

12,000.00

14,000.00

   1

974 

  

   1

976 

  

   1

978 

  

   1

980 

  

   1

982 

  

   1

984 

  

   1

986 

  

   1

988 

  

   1

990 

  

   1

992 

  

   1

994 

  

   1

996 

  

   1

998 

  

   2

000 

  

   2

002 

  

   2

004 

  

   2

006 

  

Unemployment Rate: 1974-2006

Source: BLS

Core Consumer Prices

Source: BLS

The Business Cycle

• Glut of goods and subsequent reduction in production

Real GDP(per capita)

time

Recession – a period of two or more consecutive quarters of decline in real output

Business Cycle

• Relationship between Output, Employment, and Inflation– Causes of inflation

• Natural unemployment• Other sources: monetary policy, currency depreciation,

decreases in the supply of resources [oil] ….

– Business Inventories and start of recession– Deflation in the costs of production

• Foreign economy effect• Change in confidence

business cycle, unemployment and inflation

• Inflation and unemployment are related. Inflation will decline, and even deflation may begin when unemployment rate is above the natural rate of unemployment. In fact, the natural rate of unemployment is defined as the rate of unemployment at which the inflation rate remains constant. Another way of defining the natural rate of unemployment is to simply tie it to the level of real GDP. Natural rate of unemployment is the rate of unemployment that occurs when the real GDP is at its long term trend. Note that at the start of a recession the unemployment rate may still be above the natural rate of unemployment and hence the rate of inflation may continue to increase. Similarly, early in the recovery, unemployment rate remains higher than the natural rate of unemployment which may further reduce inflation.

• Inflation is dependent on unemployment. If unemployment is high then there is little pressure on prices to go up, but if unemployment is low, then people can bid up prices because they have disposable incomes. There are some additional factors that can change inflation, including currency fluctuations, but that topic will be covered later in the semester when we get to the international finance section.

This slide merely provides you with somedefinitions and a basic discussion (for your reading)

Can future be predicted? Magical art of forecasting

• Examples of Leading Indicators– Average work hours in manufacturing– Business inventories– New orders for non-defense capital goods– Sales tax receipts– Stock index (index futures)– Construction Employment– Residential permits

• Examples of Coincident Indicators– Total Tax Receipts– Corporate Income Tax Receipts – Average weekly claims for unemployment insurance

• Examples of Lagging Indicators– Unemployment Rate

Real GDP Growth

-1

0

1

2

3

4

5

GDP Growth in US 1992-2002

5.6

5.1

6.2

4.9

5.6

6.5

5.6 5.65.9

2.6

3.6

3.02.7

4.0

2.7

3.6

4.4 4.34.1

3.8

0.3

2.4

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Nominal Real

1994 – Mexican currency crisis 1997 - Asian financial crisis 1998 – Russian currency crisis

Recession in Japan Slow Growth in Europe

Consumption Spending Growth

0

1

2

3

4

5

6

Gross Domestic Investment Growth

-10

-5

0

5

10

15

Average Growth Rates by Component, 1996-2000

Average Growth Rates by Component, 1996-2000

44

8%8%

Growth of Components of GDP, 1995-2002

-15

-10

-5

0

5

10

15

 1995       1996       1997       1998       1999       2000       2001       2002  

Personal Consumption Private Investment   Exports Imports Government Expenditures

   2000   

   2000   

   2000   

   2000   

   2001   

   2001   

   2001   

   2001   

   2002   

   2002   

   2002   

   2002   

   2003   

   2003   

I II III IV I II III IV I II III IV I II

GDP 2.6 4.8 0.6 1.1 -0.6 -1.6 -0.3 2.7 5 1.3 4 1.4 1.4 2.4

Consumption 5.3 3 3.8 2.1 2.4 1.4 1.5 6 3.1 1.8 4.2 1.7 2 3.3

   Durable goods 17.8 -3.7 8.1 -5.3 11.5 5.3 4.6 33.6 -6.3 2 22.8 -8.2 -2 22.6

   Nondurable goods 2.2 4.9 2 2.7 2.3 -0.3 1.3 3.6 7.9 -0.1 1 5.1 6.1 0.1

   Services 4.4 3.6 3.9 3.3 0.6 1.5 0.9 2.1 2.9 2.7 2.3 2.2 0.9 1.5

Gross Priv. Investment 2.3 17.3 -6 -3.4 -19.7 -17.6 -5.2 -17.3 18.2 7.9 3.6 6.3 -5.3 1.3

   Fixed investment 13.3 6.7 0.2 -2.4 -2.2 -11.1 -4.3 -8.9 -0.5 -1 -0.3 4.4 -0.1 6.6

      Nonresidential 15 10.2 3.5 -3.2 -5.4 -14.5 -6 -10.9 -5.8 -2.4 -0.8 2.3 -4.4 6.9

        Structures 13.8 8.2 12.1 3.6 -3.1 -8.4 2.9 -30.1 -14.2 -17.6 -21.4 -9.9 -2.9 4.8

       Equipment and soft 15.5 10.9 0.9 -5.4 -6.3 -16.7 -9.2 -2.5 -2.7 3.3 6.7 6.2 -4.8 7.5

      Residential 8.3 -3 -9.3 0 8.2 -0.5 0.4 -3.5 14.2 2.7 1.1 9.4 10.1 6

   Exports 7.7 14.6 11.6 -4 -6 -12.4 -17.3 -9.6 3.5 14.3 4.6 -5.8 -1.3 -3.1

      Goods 6.7 16.1 19.5 -7.1 -6.1 -16.1 -18.6 -7.9 -3.4 15.9 4.1 -11.5 1.9 -2.6

      Services 10.2 11.2 -5.9 4.4 -6 -2.5 -13.9 -13.8 21.7 10.7 5.9 8 -8 -4.2

   Imports 14.7 18.6 13.8 -1.6 -7.9 -6.8 -11.8 -5.3 8.5 22.2 3.3 7.4 -6.2 9.2

      Goods 13.7 20.3 13.6 -1.8 -9.2 -9.4 -9.6 -3.3 3.7 27.9 3.4 6.2 -6.7 15.7

      Services 20.6 9.6 15.1 -0.5 0.3 8.5 -23.2 -16.5 35.7 -2.1 3.1 13 -4 -17.6

Gov't expenditures -1.2 4.6 -1 2.9 5.7 5.6 -1.1 10.5 5.6 1.4 2.9 4.6 0.4 7.5

   Federal -13.2 16 -7.2 2 9.5 6 1.2 13.5 7.4 7.5 4.3 11 0.7 25.1

      National defense -19.9 15 -6.1 4.7 8.3 2.7 4.6 14.3 11.6 7.8 6.9 11 -3.3 44.1

      Nondefense 0.3 17.9 -9.2 -2.6 11.8 12 -4.5 12.1 0.4 6.9 -0.3 11.1 8.4 -4.1

Growth in components of Real GDP, 2000-2003Seasonally adjusted at annual rates

Jobless Recovery

                                                               

Seasonally adjusted US unemployment rateSource: BEA

Economy of Atlanta in the recession and jobless recovery

                                                               

Source: BLS

A side-note: Job recovery in Atlanta

Sectorweekly wages 1990-91 2001 1990-91 2001

Manufacturing 883 11 -12 -274 -1011Local Government 672 -3 6 255 25Professional and Business services 907 20 21 516 -102 Business services 508 10 22 396 81 Mgmt/Sci/Tech 1304 1 -1 38 -3Construction 818 0 2 -152 17Trade 460 7 0 -39 -110Hospitality 324 8 6 303 117Education and Health 704 11 9 567 607Transportation 739 7 -9 45 -97Information 1097 8 -6 -25 -240Other Services 479 3 18 42 -10

total 739 79 33 1135 -699

Employment changes in 000's in Atlanta and the US during the 18 month period following the recession

Source: GSU Economic Forecasting CenterAtlanta US

Aggregate Framework• GDP = C + I + G + X – M• Relationship between income (GDP),

expenditures and saving– Y =C + S– Consumption function: C = a + mpc (Y)

• Autonomous versus induced expenditures• a = f (wealth, expectations, real interest, subsistence needs..)• Incorporating income and non-income taxes into consumption

function• Solving for the GDP

– Multiplier and its role

mxGITAXmpcampc

Y

)()1(

1

Autonomous Expenditures Induced Expenditures Independent of current income• Autonomous Consumption

– Consumption that does not depend on current income but depends on other factors (like future income, confidence, subsistence needs)

• Domestic Investment– Is not a function of current income,

but may be a function of future income, expected profitability, relative profitability, interest rate…

• Government Spending– Function of policy, and hence should

not be considered as induced spending

• Exports– Exports tend to be a function of

economic condition of the importing country. The wealthier it is, the more likely it is to purchase more

Function of current income• Induced Consumption

– Consumption that is driven by current income

• Imports– note that imports do depend on the current income level. We will buy more of all goods, domestic or foreign in our incomes increase. Thus, it is an induced expenditure, but we will ignore this in our class and treat it as autonomous! There are also other factors (other than income) that influence imports: relative prices, and hence the exchange rate, preferences…)

More on the multiplier – simple example• Consider the following case

– The level of private consumption spending is 500 million– The level of investment is 100 million– Current government spending is 100 million– Exports: 100 million; Imports: 50 million

• Given this information we can conclude that the level of the GDP is 750 million. Now imagine that the government wants to increase that level to 800 million. What can the government do?– Natural conclusion is to increase the government spending by 50 million to

close the gap between the actual and targeted GDP, but that actually is wrong. This ignores the multiplier effect. Assume that the MPC is 0.8, in other words, 80% of the marginal dollar earned is directed into consumption, and hence becomes an income to someone else. In this case, using the math from our previous slides, the multiplier is 1/0.2=5. Thus, an increase in government spending (autonomous expenditures component) will increase the GDP by 5 times the initial change through the multiplication effect. In this case, an increase in government spending of only 10 million to 110 million would suffice.

More on the previous example

• Now consider the example from the previous slide, but assume that the investment level declines by 5 million what will the implication to the GDP will be and what should the government do?– Note that investment is an autonomous component, and hence its

decline will create a multiplication effect. The total decline will be 25 million, hence the GDP declines to 725 million

– If the government selects to offset this change in investment spending through government spending, the change would have to be exactly equal to the drop in investment, i.e. 5 million. Note that although this policy will cure the recession caused by the investment decline, it will create another problem, the size of the government sector relative to the private sector has just increased…

Further complication – note this slide will not appear on the exam

• Now, let’s introduce income taxes….• C = a + mpc (Y – t Y)

– Here t represents the income tax rate, the rest of the function is the same

• The new multiplier is: 1/(1-mpc[1-t])– Note that income tax tends to reduce the multiplier

effect as it increases the flow out of the consumption cycle.

– Income taxes also present a second fiscal policy instrument: change in taxes

• More complications can be introduced into the model, but as you can see their introduction does not complicate the math of the model

Multiplier • Dollar spent on domestic consumption

becomes an income of domestic workers/capital owners…

• Marginal propensity to consume – fraction of the next dollar earned that will be directed into consumption

• Multiplier = 1 / marginal leakage rate from the consumption stream

“Through the so called wealth effect, recent stock market gains have tended to foster increases in aggregate demand beyond the increases in

supply. It is this imbalance that contains the potential seeds of rising inflationary pressures that could undermine the current expansion. Our

goal is to extend the expansion by containing its imbalances and avoiding the very recession that would complete the business cycle.”

-Alan Greenspan, January 13, 2000

Extending the demand-supply framework to the economy as a whole:

Aggregate Demand – Aggregate Supply Model

Last two US recessions:Recession of 2001: Decline in the Aggregate DemandRecession of 2007-2010: Decline in the Aggregate Demand

Stock Market and the Wealth Effect

WFE - YTD Monthly

May June July August September October November December

NASDAQ OMX 3,483,629.7 3,174,512.3 3,230,774.5 3,300,155.9 2,903,915.5 2,453,577.8 2,180,838.4 2,248,976.5NYSE Euronext (US) 15,071,483.3 14,413,303.1 13,418,169.4 13,567,084.6 13,045,902.7 10,312,695.0 9,169,946.8 9,208,934.1Total 56,911,591.1 52,519,954.9 50,338,918.6 48,634,575.2 42,559,050.2 33,528,240.4 31,131,277.9 32,400,134.7

Americas

Exchange2008

How do such fluctuations in wealth effect the economy?Can the effects be modeled and understood?

Aggregate Demand

• Demand for domestically produced goods and services aggregate across all sectors of the economy (the demand for the Real GDP)

• AD = C + I + G + x – m– U.S. Department of Commerce. Bureau of Economic Analysis - Real

GDP

Constructing AD

Framework:

Any Demand Aggregate Demand

Quantity of the product Real Output (Real GDP)

Price of the product Price Level

Quantity = f (price, other factors)

U.S. Department of Commerce. Bureau of Economic Analysis - Price Level

Slope:

Constructing AD continued

Any Demand Aggregate Demand

Income Effect Real Balances Effect

Price level changes effect the real value of accumulated savings> changes in Consumption

Substitution Effect Open Economy Effect

Domestic price level changes change the competitive position of our export/import firms>changes in exports/imports

Interest Rate Effect

Price level changes cause changes in the interest rate (money supply is assumed to be fixed)> changes consumption/investment

Multiplier Effect

marginal propensity to consume

Determinants of ADfactors that shift AD

• Anything (other than the price level) that will cause changes in the expenditure components of the GDP

Examples of Determinants of AD

Consumption Confidence (expectations) don't panic!Wealth importance of housing and stock marketstax policy (current stimulus packages) give me money! (actually, let me keep my money)monetary policy make consumption cheaper

Investment Expectations improve future expected rate of return (stability, tech)monetary policy reduce the cost of capital

Government fiscal policy spend, spend, spend, who cares about tomorrow

Exports exchange rate do we really need a strong currency?foreign economic conditions can they afford our goods?(recessions are contagious) Canada and the US…

Imports exchange ratetrade policy

• Why do we have a jobless recovery today?– Need for non-residential investment in job

creation• U.S. Department of Commerce. Bureau of Economic Analysis - GDP growth

– How can you explain what is going on with the investment function?

– How would you incorporate the minimum wage increase into the model at this point?

Profit Function of a small perfectly competitive firm (self-employed) versusa large firm with labor contracts.

Profit = Price x Output – Wage x Labor

8 hr = 16 output

P=10

P=2

What is the real wage?How does it change?

4 hr = 8 output

1

2

3

Supply Side

Inflation does not matter in the long run (do we take into consideration the inflationrates of the 70’s and 80’s in our decisions today?)

In the long term, recessionary pressure translates into deflation

In the short term CPI inflation/deflation causes real output changes

Short - Run Long - Run

Nominal Wages move slowly; changes in output prices cause changes in real wages

Nominal Wages fully match output price adjustments

> Output price changes cause changes in real wages

>Output price changes keep real wages constant

>>Reductions in demand make workers more expensive, and therefore not profitable to keep

Wage rigidity may be due to labor contracts (my wage is independent of your enrollment!)

>Input Prices are sticky > Input Prices are fully flexible

>>changes in output prices matter>> changes in output prices are irrelevant

Long-Run Aggregate Supply

• Capacity Based– Full employment (cyclical = zero)

• Long – Run Equilibrium– Corresponds to the expansion path in the

business cycle

• Shifts:– Economic development

Short-Run Aggregate Supply

• Fixed input prices

• Short – Run Equilibrium– Corresponds to the actual business cycle– We are always in the short run equilibrium

• Shift factors– Changes in input costs– Changes in input productivities

Supply Driven Recession

• The Oil Crisis of the 1970’s• Supply side threat with the rising oil prices in

2008• Supply driven recessions are induced by rising

input costs or reduced productivity• Consequences:

– Stagflation• Correction

– Time cures all• Will redistribute wealth: shares of output value will shift

between the input suppliers– Rising price of fuel and Delta’s labor negotiations in 2007.

– Government Stabilization Policy

Demand Driven Recession

• Recession of 2001: pull back in investment spending• Recession of 2007-2010: pull back in investment/consumption

spending• The recessions of 2001 and 2007-2010 underscore the importance

of asset bubbles

May June July August September October November December

NASDAQ OMX 3,483,629.7 3,174,512.3 3,230,774.5 3,300,155.9 2,903,915.5 2,453,577.8 2,180,838.4 2,248,976.5NYSE Euronext (US) 15,071,483.3 14,413,303.1 13,418,169.4 13,567,084.6 13,045,902.7 10,312,695.0 9,169,946.8 9,208,934.1Total 56,911,591.1 52,519,954.9 50,338,918.6 48,634,575.2 42,559,050.2 33,528,240.4 31,131,277.9 32,400,134.7

Americas

Exchange2008

WFE - YTD Monthly

The wealth effect of a bubble burst

Recessions can be contagious: Canada tends to follow the US business cycle2000 – 2009: Correlation between the US and Canadian GDP is 0.55

Consequences: Deflation

Real GDP growth rate in 2000 World Bank Development Indicators 2003

Less than –0.6-0.6 < . < 0.80.8 < / <2.1

2.1 < . < 4.2Over 4.2No data available

Real GDP growth rate in 2001 World Bank Development Indicators 2003

Less than –0.6-0.6 < . < 0.80.8 < / <2.1

2.1 < . < 4.2Over 4.2No data available

Overheating

• Short-run equilibrium above the capacity level

• Demand rise– Usually induced by a bubble

• Aggregate Demand rise in 2000

“Through the so called wealth effect, recent stock market gains have tended to foster increases in aggregate demand beyond the increases in

supply. It is this imbalance that contains the potential seeds of rising inflationary pressures that could undermine the current expansion. Our

goal is to extend the expansion by containing its imbalances and avoiding the very recession that would complete the business cycle.”

-Alan Greenspan, January 13, 2000

How will each of the following affect the AD-AS diagram?

• Stock market growth

• Fiscal expansionary policy

• Increase in taxes

• Capital investment

Classical View

• The Invisible Hand logic

• Flexible Economy– Dominated by small firms– Recessionary pressure translates into deflation – Price mechanism as a corrective tool– Rapid price adjustments

• Say’s Law: Supply Creates Its Own Demand

Keynesian Points

• Price flexibility is too strong of an assumption– Non-flexible input prices in the short-run leading to

output adjustments

• Decline in Expenditures Components of the GDP (Aggregate Demand)– The Thrift Paradox– Consumption spending and other factors

• Under-Production as an equilibrium in the short-run

Aggregate Supply

• Long-Run– Classical view– Capacity level– Long-term Growth

• Short-Run– Fixed input prices– Relationship between the price level and the

output: CPI and Q

equilibrium

• Long-Run and Short-Run• Demand Driven Recession

– Deflationary pressure– Long-run input cost adjustment– Possible need for government intervention in the

short-run• Supply Driven Recession

– Input cost rise– Inflationary pressure

• Eliminating Recession through Demand Side Policy

Fiscal Stabilization Policy

• Instruments– Government Spending– Taxes– Transfers– Budget

• Ability to be targeted– State level– Municipality level

Drawbacks of Fiscal Expansionnote that this is in chapter 30

• crowding-out effects [these refer to the replacement of one sector by another, in the case of expansionary fiscal policy, the public sector displaces the private sector]– direct [direct provision. GSU reduces the demand for

Emory]– indirect [this works through the interest rate

mechanism, expansionary fiscal policy results in government borrowing, the current tax cut and budget deficit is a perfect example of that, government borrowing may lead to an increase in the interest rates and hence higher costs for private sector investment]

– open-economy effect [an increase in the interest rate due to government borrowing may cause an influx of foreign investment and therefore drive up the value of domestic currency]

– Time lags (decision, recognition, effect)

Ideally the second exam will be here

Monetary Side

MONEY• Functions of money

– Medium of exchange– Unit of account– Store of value

• Measuring the supply of money (liquidity and transaction principles)– M1

• Cash, checking accounts, traveler’s checks

– M2• M1+savings accounts, CD accounts, money market accounts

Money Creation by Banks

• Creation of money balances by banks– Fractional reserve system and lending– Money multiplier

• Potential• Actual

• Regulatory institutions– Federal Reserve Bank– FDIC

Monetary Policy

• Federal Reserve Bank of the US (Central Bank)• Goal of the Policy

– Influence consumption and investment spending– Change the exchange rate side effect more than a goal

• Policy Instruments– Open Market Operations– Discount Rate– Reserve Requirements

• Policy Operating Targets– Federal Funds Rate

• Weaknesses of the Policy– Liquidity trap– Recognition/time lags

Economic Policy and the Exchange Rate Regime

• Float– Monetary– Fiscal

• Fixed– Monetary– Fiscal

Currency Trade and Exchange Regime

(History – optional)

Floating Exchange Rate Regime– Currency Trade by Central Banks– (Forward looking instruments – optional)

Fixed Exchange Rate Regime– Does Recent Dollar Depreciation Impact the Trade

Deficit with CHINA?– Price Stabilization and Fixed Exchange Rate Regime– Risk to CB