Thinking Like an Economist

Macroeconomic QuestionsHow can sufficient growth be attained

so that the well being of society increases?

How should productive capacity be utilized so that there will be full employment with stable prices?

Basic Questions: Macro

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

Saving and Investment

Firms Households

Income

Expenditures

Financial Markets SavingsBorrowings

SaversIndividualsBusinesses

Government

BorrowersIndividualsBusinesses

Government

Financial IntermediariesBanks

Pension fundsMutual funds

Financial Markets

Financial Intermediaries Financial intermediaries include banks,

insurance companies, investment companies, etc

Financial intermediaries act as the go-between in arrangements between savers and borrowers.

They reduce the uncertainty facing individual households or businesses through diversification.

Interest Rates: Facts

Interest rates serve many roles:Interest rates are the price of

credit.Interest rates are a premium paid

to forego consumption.Interest rates are the return to

capital as a factor of production.

Real and Nominal Rates

Nominal interest rates are rates unadjusted for the effect of inflation or deflation.

Real rates are adjusted for price level changes.

Inflation and Interest Rates

Nominal interest rates are not adjusted to reflect changes in the price level.They are the percentage by which

the money a borrower pays back exceeds the money he borrowed, making no adjustment for any change in purchasing power.

Inflation and Interest Rates

Real interest rates are the percentage increase in purchasing power that the borrower pays to the lender for the privilege of borrowing.Real interest rates are nominal interest

rates minus the rate of inflation.Real interest rates may be positive, zero,

or negative.

Nominal Rates: The Fisher Effect

THE FISHER EFFECT:

NOMINAL RATE = REAL RATE + EXPECTED INFLATION

Circular Flow with Government

SavingsBorrowing

Investment

Government

HouseholdsFirms

Financial Markets

Income

Expenditures

Government Salaries and Transfers

Government Purchases ofGoods and Services Subsidies

Taxes Taxes

Government BorrowingGovernment Saving

The Role of Government: Market FailureInequity

Standards of fairness are determined by society and may not be met by the market’s distribution of benefits.

Failure of CompetitionMarkets may not be competitive.

• Regulation• Anti-trust

Public GoodsSome goods cannot be produced

profitably by the private market and as a result must be provided by government.

• Free Rider Problem

ExternalitiesSome activities provide benefits or impose

costs on others that are not captured by the the price system.

The Role of Government: Market Failure

The Role of Government: Market Failure

Underutilized ResourcesMacroeconomic stabilization

• Fiscal Policy• Monetary Policy• Exchange Rate Policies

Circular Flow with Government and the Rest of the World

SavingsBorrowing

Investment

Foreign Borrowing Foreign Savings

Foreign Countries

Government

HouseholdsFirms

Financial Markets

Income

Expenditures

ExportsImports

Government Salaries and Transfers

Government Purchases ofGoods and Services Subsidies

Taxes Taxes

Government BorrowingGovernment Saving

The Rest of the World

An economy has two basic kinds of economic interactions with the rest of the world.Buying and selling goods and

servicesBuying and selling assets.

Exports are those goods we produce for sale in the rest of the world. Imports are those goods we buy from the rest of the world.

We also lend to the rest of the world and borrow from them.

The Rest of the World

Measuring GDP

What Is GDP?

GDP, Gross Domestic Product, is the total dollar value of all final goods and services produced in a country during a year.Current market prices are used to

aggregate different outputs to a dollar total. Government purchases, many of which do not occur in markets, are valued at their cost of production.

Only final goods and services are included. Intermediate goods are not included to avoid double counting.

The measure is an annual flow, a rate of production. A GDP of $10 trillion implies that the economy is producing $10 trillion worth of goods and services per year.

GDP measures production by U.S. citizens and foreigners alike inside the geographic borders of the USA and thus unequivocally reflects economic activity in the USA.

What Is GDP?

Real and Nominal GDP Nominal GDP

The market value of a nation’s final output based on current prices for the goods and services produced during the year.

• Nominal GDP in 2001 = the sum of all the goods and services produced in 2001 multiplied by their 2001 prices

Real GDPAn estimate of the value of a nation’s final

products adjusted for changes in prices since a certain base year.

Components of GDP: Expenditure Viewpoint

ConsumptionNon-durable Goods (last less than 3 years)Durable Goods (last more than 3 years)Services

Gross Domestic InvestmentNon-residential lnvestment (plant and

equipment)Inventory ChangeResidential Investment

Government SpendingLocal and StateFederal

Net ExportsExports Minus Imports

Components of GDP: Expenditure Viewpoint

Components of GDP: Income ViewpointEmployee Compensation

Income from the sale of labor services during the year. It includes wages, salaries, and fringe benefits such as employer provided insurance and employer contributions to pension funds.

Net InterestThe portion of business receipts used

to pay for borrowed funds that finance investment purchases.

Components of GDP: Income Viewpoint

Components of GDP: Income ViewpointRental Income

Rental income is earned by those who supply the services of land, mineral rights, and buildings for use by others.

Also included in rental income is an estimate of the imputed rent earned by homeowners who live in their own homes less the expenses of maintaining their homes.

Profits.Profits of corporations and

unincorporated business• Profits = Total revenues - Indirect

business taxes - Capital consumption allowance - labor costs - net interest - rents paid

Components of GDP: Income Viewpoint

Components of GDP: Expenditure and IncomeExpenditure

GDP = C + I + G + (X-M)Income

NI (Y) = W + i + R + profitsSince NI and GDP measure

aggregate production, they must be equal.

GDP = NI 2001

Consumption 6,987.1 Durable Goods 835.9 Nondurables 2,041.3 Services 4,109.9

Investment 1,586.0 Nonresidential 1,201.6 Residential 444.7

Inventory Change -60.3 Government 1,858.0 Federal 628.1 State & Local 1,229.9

Net Exports -348.9 Exports 1,034.1 Imports 1,383.0

GDP 10,082.2

Employee Compensation 5874.9Corporate Profits 731.6 Proprietors’ Income 727.9Net Interest 649.8Rental Income 137.9National Income 8,122.1+ CCA 1329.3+ Indirect Business Taxes 774.8+ Business Transfers 42.5 - Subsidies 47.3+Statistical Discrepancy -117.3 GNP 10,104.1+Net Foreign Payments -21.9GDP 10,082.2

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

Saving and Investment

Economists make a clear distinction between saving and investment.Saving is the act of abstaining from

consumption.Investment is the result of purchasing a

new capital good.

Saving and Investment: Closed Economy

Y = C + I + GG = IGOV + CGOV

Y = CNAT + INAT

CNAT = C + CGOV

INAT = I + IGOV

Y – CNAT = INAT

SNAT = INAT

Savings = Investment: Closed Economy

In a closed economy, savings must just equal investment.If S > I, interest rates will fall and I will

rise.If S < I, interest rates will rise and I will

fall.

Saving and Investment: Open Economy

Y = CNAT + INAT + NXNX = Exports – Imports

Y – CNAT – INAT = NX SNAT – INAT = NX

If SNAT = INAT, NX =0, trade balanceIf SNAT > INAT, NX >0, trade surplusIf SNAT < INAT, NX <0, trade deficit

Looking at X - M

X represents the exports of a country.X is the income a country receives from

the rest of the world through exporting goods and services.

M represents the imports of a country.M is a country’s consumption of goods

and services produced by the rest of the world.

Looking at X - M

X – M then is income minus consumption vis a vis the rest of the world.If X > M, a country has excess funds to

lend to the ROW, or S > I.If X < M, the country’s trading partner has

excess funds to lend to it or domestically S < I.

S – I = NX

Net foreign investment (S - I) always equals the trade balance (NX).The international flow of funds to finance

capital accumulation and the international flow of goods and services are two sides of the same coin.

Government and the Private Sector YD = Y + TR – T S = YD – C

YD = C + I + G + NX + TR – TYD = S + C

Set YD = YD and solve for NXS + C = C + I + G + NX + TR – TS + C – C – I – G – TR + T = NX

(S – I) + (T – TR – G) = NX

Government and the Private Sector

(S – I) + (T – TR – G) = NX(S – I) = Private saving(T – TR – G) = Government saving

There are two ways the government can raise funds if G +TR > TIt can borrow at home, if S > I orIt can borrow from the ROW, if S < I or

NX < 0.

Twin Deficits Problem

T < G + TRFederal government budget deficit.If S <=I, we must borrow from abroad.This will be possible only if the ROW has

excess funds or a trade surplus with us.

Twin Deficits Problem

T > G + TRFederal government budget surplus.If S >= I, we may lend to the ROW.This will be occur only if the ROW has

insufficient saving or a trade deficit with us.

Macroeconomic Problems

Unemployment Inadequate Growth Inflation

Unemployment

The unemployment rate is the number of unemployed people, expressed as a percentage of the labor force.Labor Force = (Civilian non-

institutional population over age 15 minus people not in the labor force (students, homemakers, retirees, discouraged workers)

Definitions

Labor Force = Number of Employed + Number of Unemployed

Unemployment Rate = Number of Unemployed Labor Force

Labor Force Participation Rate = Labor Force Adult Population X 100

X 100

Types of Unemployment Frictional Unemployment

Occurs due to normal turnover in the labor market. People changing jobs.

Structural UnemploymentRefers to workers who are not employed

because their skills are not in demand. Cyclical Unemployment

Occurs due to changes in the business cycle.

Natural Rate of Unemployment

The natural rate of unemployment is the percentage of the labor force that can normally be expected to be unemployed for reasons other than cyclical fluctuations in real GDP.The natural rate of unemployment is related to the

willingness of workers to voluntarily separate from their jobs, job loss, the duration of unemployment periods, the rate of change in the pattern of demand, and changes in technology.

Costs of Unemployment

Loss in productivity is measured by the gap between potential GDP and actual GDP.A conservative estimate of the cumulative gap between

actual and potential GDP over the years 1974-1992 (evaluated in 1987 prices) is approximately $1300 billion.

At 1993 levels, this loss in output would be about 3 months’ worth of production.

It cannot be made up.

Inflation

Inflation refers to a sustained rise in the average level of prices.Inflation does not mean that all prices

are rising. Some prices may be falling, but on average the overall level of prices is rising.

Creeping inflation is an inflation that proceeds for a long time at a moderate and fairly steady pace.

Galloping inflation is an inflation that proceeds at an exceptionally high rate, often for only a brief period.In 1993, Brazil experienced inflation rates

of 2,700%

Inflation

The Costs of Inflation

The main cost of inflation is the loss of efficiency that results because inflation distorts price signals. For example…People invest in assets designed to protect

them against inflation, such as real estate, rather than in productive investments that enhance the growth and efficiency of the economy.

Business collect bills more promptly, using resources that could otherwise have been used to produce goods and services.

Individuals reduce money holdings, which is inconvenient and misallocates the individual’s personal resources of time, energy , and leisure.

In the case of hyperinflation, inflation over 100%, the currency system breaks down and the economy reverts to barter.

The Costs of Inflation

Purchasing Power and Inflation Inflation erodes the purchasing

power of a given sum of money.Assume you have $10,000 and the

price level is 1.• In current dollars, you have $10,000,

and in constant dollars you have $10,000.

Now let the price level rise to 2.• In current dollars, you still have

$10,000, but in constant dollars you now have ??? ?

The rise in the price level has decreased the purchasing power of your money.

Purchasing Power and Inflation

Price Indexes

Consumer Price Index (CPI)Producer Price Index (PPI)GDP DeflatorGDP Price IndexPCE Price Index

Price Indexes: Use

GDP in 2000 = P2000 times Q2000

GDP in 2002 = P2002 times Q2002

If we wish to compare GDP in 2002 with GDP in 2000, we must remove any price changes that have occurred.

Why?

Price Indexes: Use

GDP 2002 = P2002 x Q2002

Divide by a price index = P2002/P2000

P2002Q2002 P2002 = P2002Q2002 x P2000 = Q2002P2000

P2000 P2002

The

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