Lecture 3 Basics of Macroeconomics Dr Rajeev Dhawan

Lecture 3: Basics of Macroeconomics Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class Buckhead Center March 21, 2009

Macro Framework ¨ Households: Consume & Work ¨ Firms: Production & Investment ¨ Government: Money Supply, Taxes, Expenditures ¨ Foreign Sector: Exports, Imports & Exchange Rate

Basics of Macroeconomics Chapter 23

The Economy’s Income & Expenditure ¨ For an economy as a whole, income must equal expenditure because: – Every transaction has a buyer and a seller. – Every dollar of spending by some buyer is a dollar of income for some seller. ¨ Gross domestic product (GDP) is a measure of the income and expenditures of an economy. ¨ It is the total market value of all final goods and services produced within a country in a given period of time.

Definition of GDP ¨ GDP is the market value of all final goods and services produced within a country in a given period of time.

Definition of GDP ¨ “GDP is the Market Value. . . ” – Output is valued at market prices. ¨ “. . . Of All 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).

Definition 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).

Definition of GDP ¨ What Is Not Counted in GDP? – GDP excludes most items that are produced and consumed at home and that never enter the marketplace. – It excludes items produced and sold illicitly, such as illegal drugs.

GDP and Economic Well-Being ¨ GDP person tells us the income and expenditure of the average person in the economy. Higher GDP person indicates a higher standard of living. ¨ However…GDP is not a perfect measure of the happiness or quality of life. ¨ Some 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.

Table 3 GDP and the Quality of Life

NIPA Definition of GDP Y=C+I+G+NX Y = GDP C = Consumption I = Investment G = Government Purchases NX = Net Exports = Exports-Imports

NIPA Definition of GDP ¨ Consumption (C): – The spending by households on goods and services, with the exception of purchases of new housing. ¨ Investment (I): – The spending on capital equipment, inventories, and structures, including new housing. ¨ Government Purchases (G): – The spending on goods and services by local, state, and federal governments. – Does not include transfer payments because they are not made in exchange for currently produced goods or services. ¨ Net Exports (NX): – Exports minus imports.

Simple GDP Example This simple economy has 2 people: Baker and Miller. Baker buys flour for $350. He also uses a worker and pays $200 in wages. He also pays a rent of $25. He makes a profit as $25 on the bread he sells for $600. The miller pays his worker $300, a rent of $25, and his profit is $25 on a sale of $350. The GDP of this economy is $600! Why? 2 sides of a coin, Income=Expenditures=Value of final Goods sold=600 Income=wages+Rent+profits=300+25+25+25+25=600

Real vs. Nominal GDP ¨ Nominal GDP values the production of goods and services at current prices. ¨ Real GDP values the production of goods and services at constant prices. • GDP Deflator deflates for Inflation! • Inflation is rate of change of prices.

GDP and Its Components

GDP Components (2005) Government Purchases 19% Net Exports Investment -5 % 16% Consumption 70%

Recessions ¨ A recession is a significant decline in activity lasting more than a few months and is visible in industrial production, employment, real income and wholesaleretail sales (NBER definition). NBER uses monthly data. ¨ Rule of thumb is 2 consecutive quarters of negative Real GDP growth or GDP decline.

Article: Business Cycles BUSINESS CYCLE REFERENCE DATES Peak DURATION IN MONTHS Trough Quarterly dates are in parentheses Contraction Expansion Cycle Peak to Trough Previous trough to this peak Trough from Previous Trough Peak from Previous Peak May 1937(II) February 1945(I) November 1948(IV) July 1953(II) August 1957(III) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) 13 8 11 10 8 50 80 37 45 39 63 88 48 55 47 93 93 45 56 49 April 1960(II) December 1969(IV) November 1973(IV) January 1980(I) July 1981(III) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) 10 11 16 6 16 24 106 36 58 12 34 117 52 64 28 32 116 47 74 18 July 1990(III) March 1991(I) 8 92 100 108 March 2001 (I) November 2001 (IV) 8 120 128 December 2007 (IV) 73 NBER Report Cycle Dates 2003 81

Article: NBER’s FAQs Q: The financial press often states the definition of a recession as two consecutive quarters of decline in real GDP. How does that relate to the NBER's recession dating procedure? – Most of the recessions identified by our procedures consist of two or more quarters of declining real GDP, but not all of them – We consider the depth as well as the duration of the decline in economic activity. – Second, we use a broader array of indicators than just real GDP – Third, we use monthly indicators to arrive at a monthly chronology Q: Could you give an example illustrating this point? – The last recession, in 2001, did not include two consecutive quarters of decline. As of the date of the committee's meeting (in November end), the economy had not yet experienced two consecutive quarters of decline. Q. How do the movements of unemployment claims inform the Bureau's thinking? – A bulge in jobless claims would appear to forecast declining employment, but we do not use forecasts and the claims numbers have a lot of noise

Article: NBER’s FAQs Q. Is the expansion of real GDP (as measured using the product- side estimates) in the first quarter of 2008 consistent with the identification of a recession starting in December 2007? – The committee considers a range of indicators of economic activity, and many of them suggest declining activity in the first quarter of the current calendar year such as payroll employment. Q: What about the unemployment rate? – Unemployment is generally a lagging indicator, particularly after the trough in economic activity determined by the NBER. For instance, the unemployment rate peaked 15 months after the NBER trough month in the 1990 -91 recession and 19 months after the NBER trough month in the 2001 recession. The unemployment rate (which the committee does not use) tends to lag behind employment (which the committee does use) on account of variations in labor-force participation.

Peak & Trough Announcements The December 2007 peak was announced December 1, 2008. The November 2001 trough was announced July 17, 2003. The March 2001 peak was announced November 26, 2001. The March 1991 trough was announced December 22, 1992. The July 1990 peak was announced April 25, 1991. The November 1982 trough was announced July 8, 1983. The July 1981 peak was announced January 6, 1982. The July 1980 trough was announced July 8, 1981. The January 1980 peak was announced June 3, 1980.

Mar 01’ ~ Nov 01’ 9 -0. 1% Forecast of the Nation, 2003 -4. 0% 4. 2 5. 6

At Historic Lows Is Crashing

Troubled Asian Tigers

DOW 30 Revenues Excl. Big Oil

2001 Recession vs. History For Details Refer: http: //www. nber. org/

Real GDP and Consumption FRBSF Economic Letter, June 2003

Investment and Stock Market FRBSF Economic Letter, June 2003

Real GDP Employment

Chapter 24 Measuring the Cost of Living

Consumer Price Index & Inflation ¨ Inflation refers to a situation in which the economy’s overall price level is rising. ¨ The inflation rate is the percentage change in the price level from the previous period. ¨ The Consumer Price Index (CPI) is a measure of the overall cost of goods and services bought by a typical consumer (produced by BLS). ¨ Inflation rate is change in CPI.

Steps to Calculate CPI Index ¨ Fix the Basket: Determine what prices are most important to the typical consumer. – The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. – The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services. ¨ Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. ¨ Compute the Basket's Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. ¨ Choose a Base Year and Compute the Index:

Steps to Calculate CPI Index ¨ Choose a Base Year and Compute the Index: – Designate one year as the base year, making it the benchmark against which other years are compared. – Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

How the Inflation Rate Is Calculated ¨ The Inflation Rate – The inflation rate is calculated as follows:

Calculating the Consumer Price Index and the Inflation Rate: An Example

Calculating the Consumer Price Index and the Inflation Rate: An Example

Another Example of CPI and Inflation Calculations ¨ Calculating the Consumer Price Index and the Inflation Rate: – Base Year is 2002. – Basket of goods in 2002 costs $1, 200. – The same basket in 2003 costs $1, 236. – CPI = ($1, 236/$1, 200) 100 = 103. – Prices increased 3 percent between 2002 and 2003.

FYI: What Is in the CPI’s Basket? 17% Transportation 15% Food and beverages Education and communication 6% 42% Housing 6% 6% 4% 4% Medical care Recreation Apparel Other goods and services

Use of Price Indexes ¨ Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. ¨ Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2005:

The Most Popular Movies of All Times, Inflation Adjusted

The GDP Deflator vs. CPI ¨ The BLS calculates other prices indexes: – The index for different regions within the country. – The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

CPI and GDP Deflator Percent per Year 15 CPI 10 5 0 GDP deflator 1965 1970 1975 1980 1985 1990 1995 2000

Real and Nominal Interest Rates ¨ The nominal interest rate is the interest rate usually reported and not corrected for inflation. – This is the interest rate that a bank pays. ¨ The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

Real and Nominal Interest Rates You borrow $1, 000 for one year. Nominal interest rate is 15%. During the year inflation is 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5%

Real and Nominal Interest Rates (percent per year) 15% Nominal interest rate 10 5 0 Real interest rate -5 1965 1970 1975 1980 1985 1990 1995 2000 2005

Problems in Measuring CPI ¨ Substitution bias ¨ Introduction of new goods ¨ Unmeasured quality changes

Article: Con Job Redux (PIMCO) by: Bill Gross Ø Bill claims that CPI inaccurately calculates Americans’ cost of living. Ø Example: Say you buy 1 bag of gumdrops for $1 which has 100 of those. Productivity makes it 110 gumdrops but for $1. 10. Hedonic pricing says that CPI hasn’t gone up as per-capita cost is the same (1 cent). But you have to shelve out $1. 10 to get the bag, which is an increase in cost of 10%. They must fork out an extra dime even though they’re getting more for their money. Ø We can’t buy individual pieces of memory in a computer-we have to buy the entire package!

Chapter 26 Saving, Investment and the Financial System

Savings And National Income Math ¨ GDP (as the sum of expenditures) has been defined as: Y = C + I + G + NX In a closed economy: Y=C+I+G ¨ Rearranging terms gives: Y-C-G=I ¨ The left-hand side, which is the nation's income (GDP) leftover after consumption and government spending, is defined as National Savings. Since Y - C - G is defined as being equal to "S": S=I

Continued. . ¨ This relationship must hold for the economy as a whole (when the economy is closed). Now, with S=Y-C-G ¨ Add and subtract the government's tax revenue (T) to the right-hand side S=Y-C-G+T-T ¨ Then rearrange terms on the right hand side to get S = (Y - T - C) + (T - G)

Continued. . ¨ This expression breaks down national savings into two components: private savings and public savings. ¨ Private savings (Y - T - C) is the income left in the economy after taxes and consumption have each been paid for. ¨ Public savings (T - G) is equal to the taxes collected by the government, minus government spending. This is also an expression for the government surplus/deficit (surplus if T > G, deficit if T < G).

Market For Loanable Funds Interest Rate Supply 5% Demand 0 $1, 200 Loanable Funds (in billions of dollars)

Increase in Supply of Loanable Funds Interest Rate Policy 1: Saving Incentives Supply, S 1 S 2 1. Tax incentives for saving increase the supply of loanable funds. . . 5% 4% 2. . which reduces the equilibrium interest rate. . . Demand 0 $1, 200 $1, 600 3. . and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars)

Increase in Demand of Loanable Funds Interest Rate Policy 2: Investment Incentives Supply 1. An investment tax credit increases the demand for loanable funds. . . 6% 5% 2. . which raises the equilibrium interest rate. . . 0 D 2 Demand, D 1 $1, 200 $1, 400 3. . and raises the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars)

Effect Of A Government Budget Deficit Policy 3: Budget Deficit Interest Rate S 2 Supply, S 1 1. A budget deficit decreases the supply of loanable funds. . . 6% 5% 2. . which raises the equilibrium interest rate. . . Demand 0 $800 $1, 200 3. . and reduces the equilibrium quantity of loanable funds. Loanable Funds (in billions of dollars)

The U. S. Government Debt Percent of GDP 120 World War II 100 80 60 Revolutionary War 40 Civil War World War I 20 0 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 Copyright© 2004 South-Western