should ECONOMICS
why 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):
Life Expectancy = 58.829 + 0.000758 * GDP per capita
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
Capitalism
Natural emergence
Adam Smiths 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 govt officials
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 Colanders 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 US
see BEA
Globalization and International
Risks
Globalization = economic integration
Trade
Investment
Labor mobility
Economic union (EU)
Globalization and spread of economic recessions
Correlation in economic growth (GDP growth rates: 1990-2005)
between the US and some of its major trading partners)
China
China
Canada
United
States
Mexico
1
Canada
0.038296
1
Mexico
-0.21368
0.126047
1
United States
0.174459
0.759405
0.391163
1
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 LawofDemand
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 LawofSupply
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?
3 /2 /0 5
1/2 /0 5
11 /2 /04
9 /2/04
7/2 /0 4
5/2/04
3 /2 /04
1 /2 /0 4
11 /2 /03
9/2/03
7/2 /0 3
5/2/0 3
3 /2/03
1 /2/03
11 /2/02
9/2/0 2
7 /2 /0 2
5 /2 /0 2
3/2/02
1/2/0 2
1 1/2 /0 1
9/2/0 1
7 /2/01
5/2 /0 1
3/2 /0 1
1/2/0 1
Does Dollar Matter?
EURO/USD
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
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 90s
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
19922000
20012004
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 90s
P of USD
Influx of investment stimulated Demand
D
S
Increase in imports stimulated Supply
Demand Effect Dominated
(thus positively effecting consumers
standard of living)
The post 90s 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 Economys International
Balance Sheet (www.bea.gov)
Demand for the dollar
different 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 dollar
different 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 markets 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 nations 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
Net income from abroad in 2001 (current US$) (mill)
United States
United Kingdom
Switzerland
Russian Federation
Pakistan
India
France
Mexico
Japan
China
European Monetary Union
High income
Low income
-12,100.00
10,907.59
25,209.39
-9,793.48
-872.918
-2,698.42
4,911.81
-13,741.58
68,421.59
-19,173.22
-33,802.12
41,967.63
-23,770.11
GDP per capita in 2005 (using 2000 USD)
Greater than $9910
(2445, 9910)
(1172, 2445)
less than $430
no data available
(430, 1172)
The World Economy in 2004
GDP (constant
2000 USD)
% of World
GDP
in billions
World
High income
Upper middle income
Middle income
Lower middle income
Low income
Sub-Saharan Africa
South Asia
Middle East & North Africa
Latin America & Caribbean
East Asia & Pacific
European Monetary Union
United States
35111
27820
2490
6244
3754
1052
390
755
521
2132
2344
6476
10764
Source: WDI: 2006, World Bank
Population
% of World
Population
GDP per capita
(constant 2000
USD)
GDP per capita,
PPP (constant
2000 USD)
100
16
9
47
38
37
11
23
5
9
29
5
5
5516
27705
4322
2069
1538
449
537
522
1736
3906
1254
20934
36655
8187
28482
9614
6210
5422
2111
1781
2635
5346
7314
4920
25847
36465
in millions
100
79
7
18
11
3
1
2
1
6
7
18
31
6365
1004
576
3018
2442
2343
726
1447
300
546
1870
309
294
2003: Health
expendit
ures per
capita
(current
USD)
2004: cases of
TB per
100,000
2004: Internet
Users
per 1000
World
587.79
139.47
139.93
Upper middle income
279.96
112.15
Middle income
116.29
High income
Mobile phone
subscrib
ers per
1000
Infant mortality
rate per
1000
PCs per 1000
people
67.32
279.34
54.09
129.77
159.33
69.15
484.18
23.36
121.75
113.63
91.83
70.22
293.61
30.02
60.86
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
64.11
137.75
73.79
70.28
243.47
29.16
38.19
5711.00
4.70
629.99
77.43
616.73
6.70
749.18
East Asia & Pacific
United States
Life
expectan
cy at
birth
Correlation between life expectancy and the standard of living as measured by the
GDP per capita (PPP) is positive 0.65, see the stats table; correlation between
GDP 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
Labor,capital
Input markets
Wages,interest,profits
Businesses
Households
prices
Output markets
output
Income = output
GDP = GNP NET FOREIGN INCOME
NI = GNP depreciation indirect business taxes
PI = NI - (Transfer payments from Govt, net nonbusiness 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 Govt, 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 services
http://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 statistics
Industrydata: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
Statistics for the US economy
For March-July 2003 (seasonally adjusted). Source: BLS
Emploment values are in 000's
Total nonfarm Employment in 000's
Total Employment
Total Unemployed
Civilian Labor Force
Labor Force Participation Rate
Unemployment Rate
%
Labor Force
Participation Rate
March
130084
1 37348
8445
145793
66. 2
April
May
June
July
130062
137687
8786
146473
66. 4
129986
137487
8998
146485
66. 4
129914
137738
9358
147096
66. 6
129870
137478
9062
146540
66. 2
0.05792459 0.05998375 0.06142608 0.06361832 0.06183977
Discouraged Worker Phenomenon
For the month of January
1997
1998
1999
2000
2001
67
67.1
67.3
67.3
67.2
2002
2003
66.4
66.3
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
i= N
GDP = i =1 PiQi
US Real and Nominal GDP. Source: BEA
Real GDP
Nominal GDP
1992
6,880.00
6,318.90
1998
8,508.90
8,781.50
1999
8,859.00
9,274.30
2000
2001
2002
9,191.40 9,214.50 9,440.20
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
ImpactontheExchangeRate(PurchasingPrice
Parityforinternationallytradedgoods)
Growth in Real GDP
Recessions in Recent
US history:
20
2000-2001:
QIII:00
QI:01
QIII:01
15
10
1990-1991:
QIV:90
QI:91
5
1981-1982:
QIV:81
QI:82
(QIII:82)
0
-5
-10
1974
1980: QII & QIII
1974-1975
1977
1981
1984
1988
1991
1995
1998
2002
2005
QIII:74
QIV74
QI:75
Real Business Cycle - USRealGDP:1974-2006
14,000.00
12,000.00
10,000.00
8,000.00
6,000.00
4,000.00
2,000.00
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
0.00
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
This slide merely provides you with some
definitions and a basic discussion (for your reading)
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.
Can future be predicted? Magical
art of forecasting
Examples of Leading Indicators
Average hours work 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
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
Real GDP Growth
5
4
3
2
1
0
-1
GDP Grow th in US 1992-2002
7.0
6.5
6.2
6.0
5.9
5.6
5.6
5.1
5.6
5.6
4.9
5.0
4.4
4.3
4.0
4.0
4.1
3.8
3.6
3.6
3.0
3.0
2.7
2.7
2.6
2.4
2.0
1.0
0.3
0.0
1992
1993
1994
1995
1996
1997
Nom
inal
1994 Mexican currency crisis
Recession in Japan
1998
1999
2000
2001
2002
Real
1997 - Asian financial crisis
1998 Russian currency crisis
Slow Growth in Europe
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
19
Consumption Spending Growth
6
5
4
3
2
1
0
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
Gross Domestic Investment Growth
15
10
5
0
-5
-10
Average Growth Rates by
Component, 1996-2000
8%
4
Grow th of Components of GDP, 1995-2002
15
10
5
0
1995
1996
1997
1998
1999
2000
2001
-5
-10
-15
Personal Consumption
P rivate Investment
Exports
Imports
Government Expenditures
2002
Growth in components of Real GDP, 2000-2003
Seasonally adjusted at annual rates
2 000
2 000
2 000
II
I
2 000
III
IV
2 001
2 001
2 001
2 001
I
II
III
IV
2 002
2 002
2 002
II
I
2 002
III
IV
2 003
I
2 003
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
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
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
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
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
I mports
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
-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
-13.2
16
-7.2
2
9.5
6
1.2
13.5
7.4
7.5
4.3
11
0.7
25.1
-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
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
Durable goods
Gross Priv. Investment
Residential
Services
Gov't expenditures
Federal
National defense
Nondefense
Jobless Recovery
Seasonally adjusted US unemployment rate
Source: BEA
Economy of Atlanta in the recession and jobless recovery
Source: BLS
A side-note: Job recovery in Atlanta
Employment changes in 000's in Atlanta and the US during the 18 month period
following the recession
Source: GSU Economic Forecasting Center
Atlanta
US
weekly
Sector
w ages 1990-91
2001
1990-91
2001
Manufacturing
Local Government
Professional and Business services
B usiness services
Mgmt/Sci/Tech
Construction
Trade
Hospitality
Education and Health
Transportation
Information
Other Services
883
672
907
508
1304
818
460
324
704
739
1097
479
11
-3
20
10
1
0
7
8
11
7
8
3
-12
6
21
22
-1
2
0
6
9
-9
-6
18
-274
255
516
396
38
-152
-39
303
567
45
-25
42
-1011
25
-102
81
-3
17
-110
117
607
-97
-240
-10
total
739
79
33
1135
-699
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
1
{ a mpc(TAX ) + I + G + x m}
Y=
(1 mpc)
Autonomous Expenditures
Independent of current income
AutonomousConsumption
DomesticInvestment
Is not a function of current income,
but may be a function of future
income, expected profitability,
relative profitability, interest rate
GovernmentSpending
Consumption that does not depend
on current income but depends on
other factors (like future income,
confidence, subsistence needs)
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
Induced Expenditures
Function of current income
InducedConsumption
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 notethisslidewillnotappearonthe
exam
Now, lets 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
Extending the demand-supply
framework to the economy as a whole:
Aggregate Demand Aggregate
Supply Model
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
Last two US recessions:
Recession of 2001: Decline in the Aggregate Demand
Recession of 2007-2010: Decline in the Aggregate Demand
Stock Market and the Wealth Effect
WFE - YTD Monthly
2008
Exchange
Americas
NASDAQ OMX
NYSE Euronext (US)
Total
May
3,483,629.7
15,071,483.3
56,911,591.1
June
3,174,512.3
14,413,303.1
52,519,954.9
July
3,230,774.5
13,418,169.4
50,338,918.6
August
3,300,155.9
13,567,084.6
48,634,575.2
September
2,903,915.5
13,045,902.7
42,559,050.2
How do such fluctuations in wealth effect the economy?
Can the effects be modeled and understood?
October
2,453,577.8
10,312,695.0
33,528,240.4
November
2,180,838.4
9,169,946.8
31,131,277.9
December
2,248,976.5
9,208,934.1
32,400,134.7
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 = f (price, other factors)
Quantity of the product
Real Output (Real GDP)
Price of the product
Price Level
U.S. Department of Commerce. Bureau of Economic Analysis - Price Level
Constructing AD continued
Slope:
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 AD
factors 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)
Wealth
tax policy (current stimulus packages)
monetary policy
don't panic!
importance of housing and stock markets
give me money! (actually, let me keep my money)
make consumption cheaper
Investment
Expectations
monetary policy
improve future expected rate of return (stability, tech)
reduce the cost of capital
Government
fiscal policy
spend, spend, spend, who cares about tomorrow
Exports
exchange rate
foreign economic conditions
(recessions are contagious)
do we really need a strong currency?
can they afford our goods?
Canada and the US
Imports
exchange rate
trade 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?
Supply Side
Profit Function of a small perfectly competitive firm (self-employed) versus
a large firm with labor contracts.
Profit = Price x Output Wage x Labor
What is the real wage?
How does it change?
P=10
3
1
2
P=2
4 hr = 8 output
8 hr = 16 output
Short - Run
Long - Run
Nominal Wages move slowly; changes in
Nominal Wages fully match output price
output prices cause changes in real wages
adjustments
> Output price changes cause changes in
>Output price changes keep real wages
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
>>changes in output prices matter
> Input Prices are fully flexible
>> changes in output prices are
irrelevant
Inflation does not matter in the long run (do we take into consideration the inflation
rates of the 70s and 80s in our decisions today?)
In the long term, recessionary pressure translates into deflation
In the short term CPI inflation/deflation causes real output changes
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 1970s
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 Deltas 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
The wealth effect of a bubble burst
2008
Exchange
Americas
NASDAQ OMX
NYSE Euronext (US)
Total
May
3,483,629.7
15,071,483.3
56,911,591.1
June
3,174,512.3
14,413,303.1
52,519,954.9
July
3,230,774.5
13,418,169.4
50,338,918.6
August
3,300,155.9
13,567,084.6
48,634,575.2
September
2,903,915.5
13,045,902.7
42,559,050.2
October
2,453,577.8
10,312,695.0
33,528,240.4
November
2,180,838.4
9,169,946.8
31,131,277.9
December
2,248,976.5
9,208,934.1
32,400,134.7
WFE - YTD Monthly
Recessions can be contagious: Canada tends to follow the US business cycle
2000 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 < . < 0.8
0.8 < / <2.1
2.1 < . < 4.2
Over 4.2
No data available
Real GDP growth rate in 2001
World Bank Development Indicators 2003
Less than 0.6
-0.6 < . < 0.8
0.8 < / <2.1
2.1 < . < 4.2
Over 4.2
No 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 InvisibleHand logic
Flexible Economy
Dominated by small firms
Recessionary pressure translates into deflation
Price mechanism as a corrective tool
Rapid price adjustments
Says Law: SupplyCreatesItsOwnDemand
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 shortrun
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 Expansion
note 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, travelers 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
Changetheexchangeratesideeffectmorethanagoal
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