Chapter 7

THE BUSINESS CYCLE ILLUSTRATED:

Indicators of the Business Cycle[The leading indicators have predicted 11 of the last 15 recessions]

Coincident IndicatorsWhere we are nowPayroll employmentPersonal incomeFactory ordersLagging IndicatorsWhere we have beenLabor cost, unempl. durationprime interest rates, etc.

Leading IndicatorsAve work week Building permitsUnempl claims Delivery timesNew orders InventoriesNew businesses Materials pricesStock prices Money supplyNew orders Credit

Had a recession in 2001 Peak temporary maximum in Real GDP. At this point the unemployment rate (u%) is probably below the natural rate of unemployment, and the inflation rate (%) is probably increasing.Recession/ContractionaryThe contractionary phase of the business cycle. A period of decline in Real GDP accompanied by an increase in u%. To be classified as a recession, the economic decline must be at least 6 months long.TroughThe bottom of the business cycle. The u% is probably high and % is probably low.Recovery/ExpansionaryThe phase of the business cycle where the economy is returning to full employment.

Four Phases of Business Cycle

Productivity refers to the amount of goods and services produced from each unit of labor input.A nations standard of living is determined largely by the productivity of its workers.Production and GrowthProduction FunctionY = A F(L, K, H, N) Y = quantity of outputA = available production technologyL = quantity of laborK = quantity of physical capitalH = quantity of human capitalN = quantity of natural resourcesF( ) is a function that shows how the inputs are combined. PRODUCTION FUNCTIONSetting x = 1/L,Y/ L = A F(1, K/L, H/L, N/L)Where:Y/L = output per workerK/L = physical capital per workerH/L = human capital per workerN/L = natural resources per workerPRODUCTION FUNCTIONProductivity (Y/L) depends on:physical capital per worker (K/L),human capital per worker (H/L), and natural resources per worker (N/L),as well as the state of technology (A).Diminishing Returns and the Catch-Up EffectAs the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns.Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while.In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these areas.

Sectors:B. Business Firms

D. Consumer Households

C. Where goods and services are supplied and demanded (bought and sold)A. Where factors of production (LLCE) are supplied and demanded (bought and sold).Product MarketResource / FactorMarketPayments for goods and services (expenditures)Payments for factors of production (income)

Goods and servicesFactors of Production Money FlowsReal Flows:Economic Flows

Leakages and Injections from Income/Expenditure Flows:GovernmentLeakage Taxes (T)Injection Government Expenditures (G)Financial InstitutionsLeakage Saving (S) (income not spent)Injection Business Investment (I)Foreign SectorLeakage Expenditures for Imports (M)Injection Expenditures for Exports (X)Aggregate (total) Expenditures = C + I + G + X-M(AE) = GDP = ADTHE MEASUREMENT OF GDPGross domestic product (GDP) is a measure of the income and expenditures of an economy. GDP is the total market value of all final goods and services produced within a country in a given period of time.THE MEASUREMENT OF GDPGDP is the Market Value . . .Output is valued at market prices.. . . Of All. . .Includes all items produced in the economy and legally sold in markets. . . Final . . .It records only the value of final goods, not intermediate goods (the value is counted only once).. . . Goods and Services . . .It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). THE MEASUREMENT OF GDP. . . Produced . . .It includes goods and services currently produced, not transactions involving goods produced in the past. . . . Within a Country . . .It measures the value of production within the geographic confines of a country. . . . In a Given Period of Time.It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

THE COMPONENTS OF GDPGDP (Y) is the sum of the following:Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NXConsumer HouseholdsSymbolNameSignificance

Other DataCConsumptionLargest sector/Significant impactDurable goodsNondurable goodsServicesWhat do consumers purchase?Business FirmsSymbolName

Significance

Other DataIgGross Private Domestic InvestmentAffects productive potential of economyCapital goodsAll construction (houses, etc.)Changes in inventoryVery important.TotalHow does business investment affect the productive capacity of the economy?IG = Depreciation + Net Investmentreplacement capitaladditions to thestock (amount) of capitalin the economyMachines worn out / used up while producing the nations output.Depreciation is also called:Consumption of fixed capital

Capital consumption allowance (CCA)Government (Public) SectorSymbolName

Significance

Other DataGGovernment ExpendituresSignificantly largeIncludes gov. purchasesof goods and servicesTransfer Payment:Money that is transferred from one person to another (or group or business). Usually government is doing the redistribution.Key characteristic --- no good or service or factor of production is exchanged in return (purely financial transaction)Examples of transfer payments:Private: Aunt Suzie gives you a check for your birthday.Public: subsidies to businesses, social security payments, veterans benefits, welfare payments, unemployment compensation.Note: work may have been done in the past for which the recipient is receiving the payment (social security, unemployment compensation, veterans benefits); however, no CURRENT PRODUCTION is taking place for receipt of the money NOW.FINANCIAL MARKETS

The Bond MarketA bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.Characteristics of a BondTerm: The length of time until the bond matures.Credit Risk: The probability that the borrower will fail to pay some of the interest or principal.Tax Treatment: The way in which the tax laws treat the interest on the bond.Municipal bonds are federal tax exempt.Bond Prices react to interest rates.If a bond is paying 10% and interest rates go to 5% is the bonds price going to go up or down?What if interest rates go to 15% what is that bond going to be worth?So if interest rates go up bond prices go down and vice versa.

FINANCIAL MARKETS The Stock MarketStock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes.The sale of stock to raise money is called equity financing.Compared to bonds, stocks offer both higher risk and potentially higher returns.The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.THE IMPORTANCE OF SAVING AND INVESTMENTAs the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns.Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while.28GDP AND ECONOMIC WELL-BEINGSome things that contribute to well-being are not included in GDP.The value of leisure.The value of a clean environment.The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.Second Hand Sales[no production]Public/Private Transfer PaymentsPurely Financial TransactionsIntermediate Goods5. U.S. Corporations producing overseas6. Non-market transactions [household or volunteer work]Underground Economy7. Illegal business activity8. Unreported legal business activityEight Things Not Counted in GDP[no production]

30HOUSING IS WEIRDThe value of housing services is somewhat difficult to measure.a.If housing is rented, the value of the rent is used to measure the value of the housing services.b.For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services.Is It Counted In GDP?___ ___ 1. You buy a purple Tinky Winky from Wal-Mart.___ ___ 2. You and your family paint your house. [labor involved]___ ___ 3. You marry your housemaid. [working-for-love] [her services]___ ___ 4. You buy 100 shares of Microsoft Corporation.___ ___ 5. You volunteer to babysit your little sister to help your parents while they work.___ ___ 6. Bob buys a 1965 ford Mustang convertible, in 2010, which is in mint condition.___ ___ 7. The salesman gets a commission [pay] for selling that 1965 Ford Mustang in 2010.___ ___ 8. You and your friend volunteer to cook at the senior class picnic.___ ___ 9. Dr. Payne does $1,000 worth of dental work but reports only $500 of it. Does the $500 the dentist keeps and doesnt report count?___ ___ 10. You are given s suitcase full of $100 bills from the sale of smuggled drugs.___ ___ 11. Your mother is teaching you to read ___ ___ 12. Your dad bakes you a home-baked loaf of bread. YCN6N6N3N6N1YCN8NN7N66N6

2nd Hd salesTransfersFinancialIntermediateOverseasNon-marketIllegalUnreported

32___ ___ 13. You buy a loaf of bread from Krogers Grocery Store.___ ___ 14. The U.S. government purchases 5 B-2 Bombers for $2 B each.___ ___ 15. Ford buys a ton of sheet metal used in making car doors.___ ___ 16. You buy a new iPad from the Apple store. ___ ___ 17. You send in a $90 check to your dentist for cleaning your teeth.___ ___ 18. Your family buys a new house next to the mansion of Bill Gates.___ ___ 19. 100 additional teachers are hired by the Frisco ISD.___ ___ 20. GM invest in $500 million worth of robots to assemble their cars.___ ___ 21. You volunteer 10 hours a week of your time to work for senior citizens.___ ___ 22. Ford produces 25,000 F150s in Denver which are not sold by the end of the year.___ ___ 23. Russia buys 3,000 Dell computers, produced in NY, as they become Rusky Dell Dudes.___ ___ 24. A mans wife does all his cooking and sewing, working for him 16 hours per day.___ ___ 25. Nike produces $10 million worth of Nikes in Vietnam.2nd Hd salesTransfersFinancialIntermediateOverseasNon-marketIllegalUnreported

YCYGN4YCYCYIgYGYIgN6YIgYXN6N5Lets take a look at some Is It Included In GDP questions on the 2007 FRQ.3. [8 pts] Indicate whether each of the following is counted in the U.S. GDP for the year 2006. Explain each of your answers. (a) The value of used textbook sold through online auction in 2006.Answer: No, it was counted the year it was produced. Because it was not produced again, it would not be counted. That would be double counting.[2 pts: 1 pt for saying not included and 1 pt for saying not produced in 2006]b. Rent paid in 2006 by residents in an apartment building built in 2000Answer: Yes, payment is being made for productive services of the broker. So the purchase of stocks would not count but his work would.[2 pts: 1 pt for yes and 1 pt for saying this is the payment for services]c. Commissions earned in 2006 by a stockbrokerAnswer: Yes, rents consist of the income received by the households andbusinesses that supply property resources. The properties have to be maintainedor serviced each year. It is included in the income approach to GDP. [2 pts: 1 pt for yes and 1 pt for saying this is the payment for services]d. The value of autos produced in 2006 entirely in South Korea by a firm fully owned by U.S. citizensAnswer: No, GDP measures production inside the U.S. regardless of ownership. These autos were produced in South Korea.[2 pts: 1 pt for not included and 1 pt for saying produced in Korea]FRQ 2007

35REAL VERSUS NOMINAL GDPNominal GDP values the production of goods and services at current prices.Real GDP values the production of goods and services at constant prices. Nominal [money] GDP v. Real GDPAn increase in prices and/or output will increasenominal GDP.

Only an increase in output will increase real GDP.Nominal GDP could increase even if output falls.

Real GDP = Nominal Y/GDP deflator x 100

So, nominal GDP measures output & prices.

Real measures only output [actual production]

Constant (real) GDP v. current (money) GDP

37 GROSS DOMESTIC PRODUCT MARKET VALUE OF ALL FINAL LEGAL OUTPUT PRODUCED IN A COUNTRY IN ONE YEAR.

Year one$2.00$2.00$2.00Nominal (money) GDP=$6.00Year Two$3.05$3.05Nominal (money) GDP=$6.10[Recession - decrease in real output]

Real GDP measures only output. [measures current output at base-year prices ($4), not current prices ($6.10)].[Real or constant-dollar GDP]

Nominal GDP measures current output valued at current prices.The base year is the benchmark yearto which other years are compared.38 GDP Deflator more broadGDP Deflator includes prices for all goods that we produce:

What householders are buyingWhat businesses are buyingWhat the government is buyingWhat foreigners are buying [does not include imports because we dont produce imports]

GDP DeflatorThe GDP deflator is calculated as follows:

The GDP Balloon

takes Nominal measured in terms of money.

Real measured in terms of goods/services.$6,736.9/126.1 x 100 = $5,342.5

$4,839$3,492$4,848THE INCOME APPROACHW+I+R+PW=COMPENSATION OF EMPLOYEESI=NET INTEREST=INTEREST YOU RECEIVE FROM INVESTMENTS(CDS, AND STOCKS)R=RENTAL INCOME-RENTING OF HOUSES, etcP=PROFITS-PROFITS EARNED BY BUSINESSESSA= STATISTICAL ADJUSTMENTS (Corporate Income Taxes, Dividends, Undistributed Corporate Profits)Expenditure ApproachGross Domestic ProductionIncome ApproachGross Domestic SalesGDP==+Consumption byHouseholdsInvestment byBusinessesGovernmentPurchasesExpendituresBy Foreigners+++++RentsInterestProfitsStatistical Adjustments[corporate income taxes, Dividends, undistributedCorporate profits]Wages+Two Approaches to GDP44Other Measures of IncomeGross National Product (GNP)Net National Product (NNP)National IncomePersonal IncomeDisposable Personal Income45Gross National ProductGross national product (GNP) is the total income earned by a nations permanent residents (called nationals).

It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here.46Net National Product (NNP)Net National Product (NNP) is the total income of the nations residents (GNP) minus losses from depreciation.

National Income is the total income earned by a nations residents in the production of goods and services.It differs from NNP by excluding indirect business taxes (such as sales taxes) and including business subsidies.

NATIONAL INCOME47PERSONAL INCOMEPersonal income is the income that households and noncorporate businesses receive.Unlike national income, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners. In addition, it includes households interest income and government transfers. Disposable Personal IncomeDisposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government.It equals personal income minus personal taxes and certain nontax payments.48Breaking down National SavingsNS=(Y-T-C) + (TR-G)

Private Savings-is the amount of income that households have left after paying their taxes and paying for their consumptionPublic Savings-is the amount of tax revenue that the government has left after paying for it spendingCompounding and the Rule of 70ACCORDING TO THE RULE OF 70, IF SOME VARIABLE GROWS AT A RATE OF X PERCENT PER YEAR, THEN THAT VARIABLE DOUBLES IN APPROXIMATELY 70/X =YEARS.50An Example of the Rule of 70$5,000 invested at 7 percent interest per year, will double in size in 10 years 70/ 7 = 10

51The Importance of Saving and InvestmentTHE CATCH-UP EFFECT REFERS TO THE CONDITION THAT, OTHER THINGS BEING EQUAL, IT IS EASIER FOR A COUNTRY TO GROW FAST IF IT STARTS OUT RELATIVELY POOR.52Poor Countries Favor Present GoodsRich Countries FavorFuture Goods

Goods for the PresentGoods for the FutureCURRENTCURVEFUTURECURVECONSUMPTIONGoods for the PresentGoods for the FutureFUTURECURVECONSUMPTIONCURRENTCURVE

Capital Goods & Growth in Poor & Rich Countries

Poor countries devote more resources to consumer production than rich countries do.

As more resources flow into capital production, the rate of economic growth in rich countries increases, and so does the gap between rich and poor countries.

200920092019201953Can the economy grow too fast?Yes, if there is Full Employment.The speed limit for GDP growth is 4%.

But, if the economy is in recession,There is no speed limit for GDP growth.54

Maintainingour productionpossibilitiesExpanding Productive CapacityStatic Productive CapacityDeclining Productive CapacityincreaseddecreasedNo change55Check for UnderstandingWhats included / Excluded in GDP and how is it classified?

REAL AND NOMINAL GDP

nGDP in Year 1 = ($10 120) + ($12 200) = $3,600nGDP in Year 2 = ($12 200) + ($15 300) = $6,900nGDP in Year 3 = ($14 180) + ($18 275) = $7,470YearPL Footballs Q Footballs PL Basketballs Q BasketballsYear 1$10 120 $12 200Year 212 200 15 300Year 314 180 18 275Nominal GDP year 1?Nominal GDP Year 2?Nominal GDP year 3?Using Year 1 as the Base Year:Real GDP in Year 1 = ($10 120) + ($12 200) = $3,600Real GDP in Year 2 = ($10 200) + ($12 300) = $5,600Real GDP in Year 3 = ($10 180) + ($12 275) = $5,100(Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.)

YearPL Footballs Q Footballs PL Basketballs Q BasketballsYear 1$10 120 $12 200Year 212 200 15 300Year 314 180 18 275Real GDP year 1?Real GDP Year 2?Real GDP year 3?1. You spend $5 to attend a movie.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)2. You pay a contractor $100,000 for a new house.IC counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)3. You pay $60,000 to the owner to purchase a ten year old home.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)4. The government increases its military expenditures by $1 billion.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)5. The government sends a $600 social security check to a retired person.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)6. You purchase $2000 of Microsoft stock on the stock market.Security (stock) transaction / nonproduction or purely financial transactionC counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sectorN NOT COUNTED (WHY?)7. At the end of the year, a car dealer finds that its inventories of cars are $300,000 higher than the beginning of the year.Additions to inventories are unsold output. They are counted as Ig. Even though they are not sold, they must be counted because they were produced.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sectorN NOT COUNTED (WHY?)A HOUSEWIFE DOES A LOT OF WORK CARING FOR HER HUSBAND AND KIDS.Nonmarket Transaction (underground economy)C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)GENERAL MOTORS BUYS NEW ROBOTS FOR ITS ASSEMBLY-LINE.Robots are new capital goods.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)10. Apple builds a new IPOD factory.All new construction is counted as business investment. Buildinga factory is also adding to the economys capital stock.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)11. R.J. REYNOLDS COMPANY BUYS CONTROL OF NABISCO.Security (stock) transaction / nonproduction or purely financial transactionC counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)12. You buy a new Toyota made in Japan.Imports must be subtracted because the expenditure by Americansis for a car produced in another country (Japan).C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)13. You pay tuition to attend an economics course at the local college.IBM PAYS YOU THE INTEREST ON YOUR IBM BOND.Tricky question: Although stock and bond sales ARE NOT counted, dividends from stock and interest from corporate (but not government) bonds are counted because they represent income currently earned from the production of the current years output. This is tricky because no answer is correct. Interest payments would be part of the income approach not the expenditures approach to GDP calculation.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sectorN NOT COUNTED (WHY?)15. A new truck is produced but not sold in 2005. In 2006, the truck is sold..The truck is counted as negative change in inventory in 2005 and a positive change in inventory in 2006.The truck is counted as a positive change in inventory in 2005 and as consumption and a negative change in inventory in 2006.The truck is counted as consumption in 2005.Because it was not sold in the year it was produced, the truck is not counted in the GDP of either year.

The truck, although unsold in 2005, must be counted in 2005 because that was the year it was produced; therefore, in 2005 it is counted as part of Ig. In 2006 it was purchased (increase in C) but also the purchase reduced Ig by the same amount the C increased; therefore, the net effect for 2006 is zero.C counted as consumptionIg counted as business investmentG counted as government expendituresXn added or subtracted in the foreign sector

N NOT COUNTED (WHY?)16. A painter paints his own home.Nonmarket Transaction underground economy.