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Transcript
Chapter 5: Production, Income, and Employment Gross Domestic Product (GDP) and the unemployment rate are important because they describe aspects of the economy that dramatically affect each of us individually and our society as a whole. This chapter describes what these statistics tell us about the economy, how the government obtains them, and how they are sometimes misused. GDP is the total value of all final goods and services produced for the marketplace during a given year, within the nation’s borders. Three ways to measure GDP are the expenditure approach, the value-added approach, and the factor payments approach. Understanding these approaches tells us much about the structure of our economy. Definition of GDP: the money value of all final goods and services produced in a country over a given time period. GDP is typically measured for a country for a period of a quarter or a year (though one could theoretically measure the GDP of California for a month). An intermediate good is: a good purchased for resale or for use in producing another good; goods used in producing final goods. Purchase for resale purposes. A final good (or service): is a good sold to its final user; goods ready to be consumed (shelved goods are a good example of final goods) Transfer payment: any payment that is not compensation for supplying goods and services. Transfer payments represent money redistributed from one group of citizens (taxpayer) to another (the poor, the unemployed, and the elderly). While transfers are included in government budgets and spending, they are not purchases of currently produced goods and services, and so are not included in government purchases or in GDP. Government transfers account for 37 percent of all government spending. A transfer payment is a payment made with no expectation of something in exchange. o In the expenditure approach to measuring GDP, we add up the value of the goods and services purchased by each type of final user: households, businesses, government, and foreigners. 1. The Expenditure Approach: This is based on the value of the goods and services sold in the economy for a given period: Consumption Goods and Services: purchases by households. Consumption is the part of GDP purchased by households as final users. We traditionally use the letter (C) to designate such expenditures. Private Investment Goods and Services: purchases by businesses. Private investment has three components: (1) business purchases of plant and equipment (2) new home equipment; and (3) changes in business firms’ inventory stocks (stocks of unsold goods). The traditional term applied to the accumulation of capital goods (including construction), this also includes the accumulation of inventories; which, as unconsumed goods or services, are generally viewed as accumulations of capital. We use the letter (I) to designate such expenditures or accumulations. Government Goods and Services: purchases by government agencies. Spending by federal, state, and local governments on goods and services. The government makes up a huge proportion of the total expenditures in modern American society. All public works projects, military expenditures, and construction of public buildings contribute to the total government participation in the demand for final goods and services (G). Net Exports: purchased by foreigners (NX). Either negative or positive, this represents the total quantity of goods and services we produce domestically relative to the quantity sold abroad. If positive, we are selling more abroad than domestically, and visa versa. The components of GDP: GDP= c + i +g +nx (Supply side) (Demand side) C = Consumer spending I = Investment G = Government spending (federal, state, local) NX = net export (export-import) -If export greater than import=Trade surplus -If import greater than export=Trade deficit C = Consumer spending is usually 70% of a nations GDP (USA) I = Investments usually consists of about 18% of the US GDP G = Governmental spending usually makes up 15% of GDP NX = The US trade deficit is -3% Is the 3% trade deficit a big deal? Relatively speaking, NO! How do we find out if the same is not true for another country? We divide the “deficit” by the GDP or 300 Billion (trade deficit, United States) divided by the GDP which is 10 Trillion dollars, and we see that is a small number considering the whole. On the other hand, there are countries who owe three times their GDP. Foreign debt/GDP gives the percent of the GDP is comprised in debt. GDP = C + I + G + NX Net Investment = Investment – depreciation o The GDP is NOT the sum total of all transactions in the economy. That would be redundant. If we included every transaction for the purposes of evaluating economic performance, we would capture a lot of transactions that didn't reflect the real value of the product of society. As an example, the price of the loaf of bread you buy in the supermarket would be added to the cost of the ingredients sold to the bakery. Used car sales do not contribute to the overall production of society. Once the original car is bought and sold, that represents the last transaction of interest for measuring the production of the economy. If there were intermediary agents involved in the transaction, the total amount of exchange could be quite considerable. The real value of production rests in the opportunity cost of producing the loaf of bread, but the final measure of the value of that bread is found at the point of sale. GDP is traditionally measured as the final value of all goods and services produced in the economy, or the Value-Added from each component of the productive process. 2. The Value Added Approach: GDP = Sum of Value added by all firms: measuring GDP by summing the value added by all firms in the economy. A firm’s value added is the revenue it receives for its output, minus the cost of all the intermediate goods that it buys In the value added approach, GDP is the sum of the values added by all firms in the economy. 3. The Factor Payments Approach: In any year, the value added by a firm is equal to the total factor payments made by that firm. Factor payments: payments to the owners of resources that are used in production. = Sum of factor payments made by all firms = Wages and salaries + interest + rent + profit = Total household income Households own the economy's resources (factors of production; land labor and capital) whose services they rent or sell to firms through factor markets in exchange for factor payments (rental payments, wage payments, interest payments, and profits). Households use their factor income to purchase goods and services in the goods and services markets: consumption goods and services, capital goods. They also use part of their factor income to pay government taxes. Real versus Nominal GDP When a variable is measured over time with no adjustment for the dollar’s changing value, it is called a nominal variable. When a variable is adjusted for the dollar’s changing value it is called a real variable. Since our economic well-being depends, in large part, on the goods and services we can buy, it is important to translate nominal GDP, which is measured in current dollars, to real GDP, which is measured in purchasing power. In general, all nominal variables must be translated into real variables to make meaningful statements about the economy. The unemployment rate is defined as the percentage of the labor force that is unemployed, and is calculated each month. This measure understates unemployment because it fails to account for involuntary part-time employment and discouraged workers. On the other hand, it also overstates unemployment by including as unemployed some people who are not in the labor force. Regardless of these problems, the unemployment rate provides valuable information about conditions in the macroeconomy. The Limitations of GDP GDP is not perfect. Why? 1. It ignores non-market activities. (Mother watching children) 2. It ignores the underground economy. (Illegal market) 3. It ignores the environment. (Damage to the environment should be subtracted from GDP). To calculate the percentage of the economy that is illegal divide the size of the underground economy/GDP. Economic Well Being GDP/population GDP per person Standard of Living The size of the economy GDP is used to guide the economy in two ways. In the short run, changes in real GDP alert us to recessions, and give us a chance to stabilize the economy. In the long run, changes in real GDP tell us whether our economy is growing fast enough to raise output per capita and our standard of living, and fast enough to generate sufficient jobs for a growing population. Although GDP is extremely useful, it suffers from measurement problems. It doesn’t take quality changes into account, it can’t accurately measure underground production, and it does not include nonmarket production. Because of these problems, we must be careful when interpreting long-run changes in GDP. There are four types of unemployment: frictional, seasonal, structural, and cyclical. Our economy is at full employment when there is no cyclical unemployment. Unemployment is costly for individuals and for our society. The purely economic cost of unemployment can be measured as the difference between potential GDP (the amount of GDP that can be produced at full employment) and actual GDP. There are also broader costs of unemployment, both to individuals (psychological and physical effects) and to society (the unemployment burden is not shared equally among different groups). Types of Unemployment: 1. Frictional unemployment is that unemployment caused by information or search costs. Usually when a person quits, is fired, or enters the labor market, there are jobs available for which that person is qualified. The person will be frictionally unemployed because it takes time (and effort) to find the jobs that are available. 2. Seasonal Unemployment: Unemployment is caused by relatively regular and predictable declines in particular industries or occupations over the course of a year, often corresponding with the seasons. Unlike cyclical unemployment, which could occur at any time, seasonal unemployment is an essential part of many jobs. For example, your regular, run-of-the-mill, department store Santa Clause can count on 11 months of unemployment each year. Hotel and catering Tourism Fruit picking 3. Structural Unemployment: Structural unemployment exists when a person is not qualified for any job because the amount he can contribute to any job (his marginal revenue product) is less than the minimum wage payable for that job. The minimum wage can be set legally, by union negotiations, or by the force of public opinion. Structural unemployment can exist even if the minimum wage was zero. Structural unemployment is associated with those that are displaced due to changes in technology or structure of the economy. Here labor must be restrained so their skills match the new technologies. 4. Cyclical Unemployment: is associated with downturns in the economy. Cyclical unemployment is caused by short-term economic changes, whereas structural unemployment covers a range of situations including a mismatch between the skills of the labor force and the available jobs. Cyclical unemployment is associated with an economic recession or a sharp economic slowdown. It occurs due to a fall in the level of national output in the economy causing firms to lay-off workers to reduce costs and protect profits. Frictional and structural unemployment are unavoidable in a dynamic economy. These two combined are called the Natural Rate of Unemployment, or the full-employment rate of unemployment. The Natural Rate of unemployment is estimated to be about 5.5%. How unemployment is measured: Early each month, the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor announces the total number of employed and unemployed persons in the United States for the previous month, along with many characteristics of such persons. These figures, particularly the unemployment rate--which tells you the percent of the labor force that is unemployed--receive wide coverage in the press, on radio, and on television. Unemployment is measured by the Bureau of Labor Statistics (BLS). It surveys 60,000 randomly selected households every month. The survey is called the Current Population Survey. Labor Force: those people who have a job or who are looking for a job. Unemployment rate: the fraction of the labor force that is without a job. The unemployment rate is calculated by dividing the people who want jobs but don't have them by the labor force. Unemployment/Labor Force = Unemployed/(Unemployed + employed) Criticisms of the Unemployment Rate Does not include discouraged workers: those who have given up looking for work because they could not find a job. (understates unemployment) Does not account for the "hidden unemployment." "Hidden" unemployment includes those who are working part-time but wish to have a full-time job, and those who are grossly overqualified for their positions, the underemployed. (understates unemployment) To be unemployed, a person must only "say" he has actively sought work. (overstates unemployment) The Costs of Unemployment: Economic costs: The costs of unemployment are the goods and services that might have been produced and consumed that are lost forever. The costs of unemployment are generally viewed by the society as those related to unemployment insurance and social assistance programs for those who are able to work. Cost of unemployment = Potential output - Actual output Where potential output is the level of GDP the economy would attain if all resources were fully employed. During recessions when unemployment is high, some labor is sitting idle and that lost work can not be made up. There are also significant, noneconomic costs of unemployment such as individual and family stress. Potential Output: the level of output the economy could produce if operating at full employment. Chapter 6:The Monetary System, Prices, and Inflation The Monetary System: A monetary system establishes two different types of standardization in the economy: 1. A monetary system establishes a unit of value. A unit of value is a common unit for measuring how much something is worth. With a standard monetary unit, like the dollar, we can easily price individual goods and services, putting a single price on each item instead of having to compute a different exchange price for every different pair of commodities (e.g., 1 cup of coffee = 2 newspapers = 6 minutes of office work as a temp = 3 minutes of my teaching services). 2. A monetary system concerns the means of payment—the things we can use as payment when we buy goods and services. Means of payment is anything acceptable as payment for goods and services. -- you can use it to buy whatever you want. Money makes it much easier for people to exchange the goods and services they produce for the goods and services that they want. Money "greases the wheels of commerce," by making it much easier for people to exchange the goods and services they produce for the goods and services that they want. Having a generally accepted currency eliminates the need for barter (trading goods and services for each other), and makes the volume of transactions a lot larger than it would otherwise be. Also: 3. Store of value -- money has some use as an asset, because it holds its nominal value over time and, unlike stocks or bonds, its value does not fluctuate from day to day. Unlike stocks or bonds, there is no risk that dollars will suddenly become worthless. In sum, money is a virtually riskless asset. It is also a very liquid (convertible into cash; spendable) asset, which is another desirable quality. In 1913, the Federal Reserve System was created to be the national monetary authority in the United States. The Federal Reserve was charged with creating and regulating the nation’s supply of money, as it continues to do today. The earliest forms of payment were precious metals and other valuable commodities. Eventually, to make it easier to identify the value of precious metals and they were minted into coins whose weight values were declared on their faces. Because gold and silver coins could be melted down into pure metal and used in other ways, they were still commodity money. Commodity money eventually gave way to paper currency. Initially, paper currency was just a certificate representing a certain amount of gold or silver held by a bank. But today, paper currency is no longer backed by gold or any other physical commodity. This type of currency is called fiat money. Fiat money: anything that serves as a means of payment by government declaration. Items designated as money that are intrinsically worthless. -- Ex.: U.S. paper money - only other value is as paper -- Fiat money has value only because the government declares it to be legal tender and because people believe it has value. ---- LEGAL TENDER: money that a government has required to be accepted as payment for debts. Measuring the price level and inflation: The price level is the average level of dollar prices in an economy. Index numbers are a series of number used to track a variable’s rise and fall over time. An index is a series of numbers, each one representing a different period. Index numbers are only meaningful in a relative sense: we compare one period’s index number with that of another period and can quickly see which one is larger and by how much. The actual number for a particular period has no meaning in and of itself. What are index numbers? Value of measure in current period *100 Value of measure in base period Index numbers are values expressed as a percentage of a single base figure. For example, if annual production of a particular chemical rose by 35%, output in the second year was 135% of that in the first year. In index terms, output in the two years was 100 and 135 respectively. An index will always equal 100 in the base period. How to construct a price index: A price index measures the cost of buying a certain "basket" of goods, so one must: (1) total up the dollar cost of buying given quantities of all of the items in the basket, for each of the years we are looking at. Then, so that we may more easily compare price levels for different years, we index those cost totals to the however much it costs to buy that basket of goods in the base year, which is whatever year we choose to be our basis of comparison. Thus, we must (2) choose a base year. Then, for each year, compute the price index by dividing the total cost of the basket of goods in that year by the total cost of that basket of goods in the base year, and then multiply by 100. So the price index for the base year is always 100, because we're dividing a number by itself and then multiplying by 100. If the same basket of goods costs 4% more (i.e., 104% as much) in the next year, then the next year's price index is 104. price index for year t = 100 * (cost total for year t)/(cost total for base year) Example of constructing a price index and calculating the inflation rate from it: Imagine the same small island economy that we used in our nominal-vs.-real GDP example from earlier. In 1995, which we will use as our base year, the average person there consumed just three commodities -- beer, pretzels, and bicycles -- in the following quantities: 1995 Commodity p q p*q Case of beer $20 1 Bag of pretzels $1 $20 20 + $20 Bicycle $200 1 +$200 TOTAL COST OF GOODS $240 -- Since 1995 is the base year, the price index for 1995 is: {$240/$240} * 100 = 100 -- -- In 1996, the price of beer was still $20, and the price of a bag of pretzels rose to $1.50 and the price of a bike rose to $210. Now that same basket of goods costs a bit more: Commodity 1996 1995 p q p*q Case of beer $20 Bag of pretzels $1.50 20 + $30 Bicycle $210 1 +$210 1 TOTAL COST OF GOODS $20 $260 : -- In 1996, the price index was: {$260/$240} * 100 = 1.0833 * 100 = 108.33 -- The 1996 inflation rate was just the difference between the two, or 8.33%. To verify: 1996 inflation rate = {(108.33/100) - 1} * 100 = (1.0833 - 1) * 100 = .0833 * 100 = 8.33% Types of price indexes: GDP price index Consumer price index (CPI) Producer price index (PPI) (previously known as the wholesale price index) Figure 1 The Rate of Infla tion Using the Consumer Price Index Annual Inflation 14 Rate (%) 12 10 8 6 4 2 0 –2 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 1999 Year ECONOMICS 2e / HALL & LIEBERMAN CHAPTER 19 / THE MONETARY SYSTEM, PRICES, AND INFLATION © 2001 So uth-Western 2 The Consumer Price Index: Definition: Consumer Price Index: an index of the cost, through time, of a fixed market basket of goods purchased in some base period. In recent years, the base year for the CPI has been 1983, so following our general formula for price indexes, the CPI is calculated as: Cost of market basket in current year *100 Cost in market basket of 1983 “The Consumer Price Index (CPI) is the ratio of the value of a basket of goods in the current year to the value of that same basket of goods in an earlier year. It measures the average level of prices of the goods and services typically consumed by an urban American family. Parkin, 1990” According to the BLS: “The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected in 87 urban areas across the country from about 50,000 housing units and approximately 23,000 retail establishmentsdepartment stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments. All taxes directly associated with the purchase and use of items are included in the index. Prices of fuels and a few other items are obtained every month in all 87 locations. Prices of most other commodities and services are collected every month in the three largest geographic areas and every other month in other areas. Prices of most goods and services are obtained by personal visits or telephone calls of the Bureau’s trained representatives.” Source: http://www.bls.gov/news.release/cpi.nr0.htm How the CPI has performed, selected years, 1960-2001 base year 1983 not shown = 100: Year Consumer Price Index 1960 29.8 1965 31.8 1970 39.8 1975 55.5 1980 86.3 1985 109.3 1990 133.8 1995 153.5 2000 174.0 2001 176.7 The CPI is a measure of price level in an economy The rate of inflation is determined and measured by the Consumer Price Index (CPI). The (http://www.bls.gov/cpi/home.htm) CPI is comprised of a “basket of goods” of 400 items that include housing (40%), food and beverages (17%), transportation (17%), medical care (7%), apparel (6%), entertainment (5%), other (8%). Each year, the prices of these 400 good and services are added up and compared to the base that was determined by averaging the years 1982-1984. Thus, the CPI for 1950 was 24.1 which means that 1950’s CPI was 24.1% of the base. In other words, prices in 1950 were only 24.1% of the prices being paid in 1982-1984. The CPI for 2001 was 177.1, that is, prices in 2001 were 177.1% of the prices being paid in the base years (77% higher). To see the CPI since 1913 go to ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt Inflation rate: the percent change in the price level from one period to the next. Deflation: a decrease in the price level from one period to the next. -- A major deflation has not occurred in this country since the Great Depression of the 1930s. A very minor one did occur in 1954, when the consumer price index fell 0.4% (the inflation rate was -0.4%). Rate of inflation = New CPI – Old CPI Old CPI Let us suppose that the The Formula used to calculate the inflation rate: Inflation = a percentage change in CPI Inflation = CPI year 2- CPI year 1 *100 CPI year 1 Q: What is the inflation rate between 2002 and 2001? A: 175-100 *100 = 75% inflation 100 Constructing the CPI: step 1: compute the cost of a market basket in each year (prices times quantities), step 2: choose a base year. Step 3: Calculate the CPI for the current year by: (Cost current year)/(cost in base year)*100. Side implication: in the base year the CPI = 100. With inflation, CPI increases. The inflation rate via the CPI: (CPI current year – CPI previous year)/CPI previous year all times 100. Note that this is just a percentage change. The inflation rate is the percentage change in the CPI from one period to the next. How the CPI is used: the CPI is one of the most important measures of the performance of the economy: It is used as: 1) A policy target 2) To index payments; Indexation: adjusting the value of some nominal payment in proportion to a price index, in order to keep the real payment unchanged. A payment is indexed when it is set by a formula so that it rises and falls proportionately with a price index. An indexed payment makes up for the loss in purchasing power that occurs when the price level rises. Whose benefits are indexed to the CPI? Social Security recipients and about ¼ of all union members (5 million+ workers in the US) have labor contracts that index their wages to the CPI. Since the 1980’s, the US income tax has been indexed as well—the threshold income levels at which tax rates change automatically rise at the same rate as the CPI. Real Variables and adjustment for inflation: You can monitor changes in purchasing power by not focusing on the nominal wage—the number of dollars you earn—but on the real purchasing power of your wage. To track real wage, we need to look at the number of dollars you earn relative to the price level. Calculating the real wage: Example from Hall/Liebermann (data above) Real wage in any year = Nominal wage in that year *100 CPI in that year $4.67 *100 $8.41 55.5 $14.64 Re al wage in 2001 = *100 $8.29 176.7 Real wage in 1975 = Thus, although the average worker earned more dollars in 2001 than in 1975, when we use the CPI as our measure of prices, purchasing power seems to have fallen over those years. Thus: When we measure changes in the macroeconomy, we usually care not about the number of dollars we are counting, but the purchasing power those dollars represent. Thus, we translate nominal values into real values by using the formula: Real Value = nominal value *100 price index Inflation and the measurement of real GDP: a special index is used to translate nominal GDP figures into real GDP figures: the GDP price index. Demand-pull inflation - spending increases faster than production Cost-push inflation (or supply side inflation) - prices rise because of rise in per unit cost of production - e.g. oil price, wage push by unions The GDP price index measures the prices of all goods and services that are included in U.S. GDP, while the CPI measures the process of all goods and services bought by U.S. households. The Costs of Inflation/The inflation myth: Most people think that inflation—merely by making goods and services more expensive—erodes the average purchasing power of income in the economy. Because every market transaction involves two parties—a buyer and a seller, the loss in the buyers real income is matched by the rise is seller’s real income. Inflation may redistribute purchasing power among the population, but it does not change average purchasing power, when we include both buyers and sellers in the picture. Inflation can redistribute purchasing power from one group to another, but it cannot, by itself, decrease the average real income in the economy. $$The redistributive cost of inflation: If nominal income rises faster than prices, then your real income will rise; fixed income groups will be hurt by inflation Savers will be hurt by unanticipated inflation Borrowers gain by unanticipated inflation - borrow 'dear' and pay back 'cheap' If inflation is anticipated, the effects will be less severe One cost of inflation is that it often redistributes purchasing power within society; “harming” the needy and helping those who are already well off. Because some workers have nominal wage agreements that span over long periods, even years, such as minimum wage inflation can harm ordinary workers, since it erodes the purchasing power of their pre-specified nominal wage. But the effect can also work the other way; benefiting ordinary households and harming businesses: for example, many homeowners sign a fixed dollar mortgage agreement with a bank. These are promises to pay the bank back the same nominal sum each month. Inflation can reduce the real value of these payments, thus redistributing purchasing power away from the bank and toward the average homeowner. In general, inflation can shift purchasing power away from those who are awaiting future payments specified in dollars, and toward those who are obligated to make such payments. Inflation does not mean that prices of everything in the economy are rising. Inflation means that prices on “average” are rising. Some goods and services prices even fall during the inflation period. For example: Computer prices have fallen. Expected inflation need not shift purchasing power: over any period, the percentage change in a real value (%Real) is approximately equal to the percentage change in the associated nominal value (%Nominal) minus the rate of inflation: %Real = %Nominal – Rate of Inflation If the inflation rate is 10 percent, and the real wage is to rise by 3 percent, then the change in the nominal wage must (approximately) satisfy the equation: 3 % = %Nominal – 10% %Nominal = 13% Thus the required nominal wage hike is 13% If inflation is fully anticipated, and if both parties take it into account, then inflation will not redistribute purchasing power. Nominal interest rate: the annual percent increase in a lenders dollars from making a loan. Real interest rate: the annual percent increase in a lender’s purchasing power from making a loan. Unexpected inflation does shift purchasing power: when inflationary expectations are inaccurate, purchasing power is shifted between those obligated to make future payments and those waiting to be paid. An inflation rate higher than expected harms those awaiting payment and benefits the payers; an inflation rate lower than expected harms the payers and benefits those awaiting payment. The resource cost of inflation: When people must spend time and other resources coping with inflation, they pay an opportunity cost—they sacrifice the goods and services those resources could have produced instead. “Using the Theory: Is the CPI accurate?” Limitations of CPI: Problems in measuring the cost of living In reality, the CPI overestimates the actual inflation by 0.5 – 1.5% Reasons for over calculation: 1) Substitution bias: When the price of one good increases, consumers often respond by substituting another good in its place. a) A good example of substitution bias is often seen between products like Pepsi and Coca-cola. Pepsi Coca-cola Last Month $2 $2 This month $2.10 $2 CPI will include these substitutable products into the CPI even though they might not be purchase. CPI price will go up because of Pepsi. This will bias the cost of living. 2) CPI cannot capture unmeasured quality change: Let us presume that we buy a car today for $15,000. A car could be purchased 10 years ago for $15,000. But did a car 10 years ago have an airbag or a CD player. This is another disadvantage of CPI—that it cannot measure if the quality or standards of quality have decimated. 3) New Technologies: The CPI still counts as inflation many causes in which prices rise because of improvements in quality, not because the cost of living has risen. This causes the CPI to overstate the inflation rate. Example: cars are more reliable now and require less routine maintenance, and have features like airbags and antilock brakes. The BLS struggles to substantiate these changes—although they note that cars have become more expensive, some of these rises in prices are not really inflation, but the consumer is getting more. 4) Growth in discounting: The CPI omits reductions in the prices people pay from more frequent shopping at discount stores and so overstates the inflation rate. The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. Keep in mind that the measure of CPI is used to see if the cost of living has gone up in a given period. What is CPI and how is CPI useful? Many government transfer programs such as social security benefits are tied to the CPI. Indexation: the automatic correction of a dollar amount for the effect of inflation on a contract. Indexation is also used by the private sector. Many private labor contracts include COLA (cost-of-living-allowances) + 5 or 7% A retired person would see his SSI check increase by 5% in the CPI went up by 5%. Another example: President Hoover in 1931 = $75,000 President Bush in 2002 = $400,000 75,000*166 15.2 = $819,079 Nominal Interest Rate vs. Real Interest Rate 1) Nominal interest rate: the rate as usually reported without a correction for the effects of inflation 2) Real interest rate: the rate corrected for inflation Real interest rate = nominal interest rate – inflation Example: Person A borrows $100 from person B. Person B charges 5% interest on the loan for a year. Inflation is 7%. Who is better and worse off? o Answer: Verify, though, person A is better off. Chapter 7: The Classical Long Run Model Macroeconomic Models: Classical versus Keynesian A Brief History of Macro-economic Thinking: - Classical Economists and 'Say's Law' until the 1930's (Say's Law - Supply Creates Its Own Demand - Believed in a perfect market system that would self-correct if there were any deviations from full employment - Then the Great Depression came along, and J.M Keynes emerged to revolutionize macroeconomic thinking - Disputed Say's Law and argued that in some periods not all income is spent on the output produced Producers may respond to unsold inventories by reducing output rather than cutting prices and a recession or depression may follow Since then Keynesian economics has dominated macroeconomic thinking The Aggregate expenditure model is based on Keynesian beliefs and ideas Based on the premise that Savings and Investment decisions may not be coordinated, and prices and wages are 'sticky' downwards Therefore markets fail, causing recessions or depressions without any external events! Assumptions of the Model: - 'Closed economy' - no trade No Government All saving is personal Depreciation and net income earned abroad are zero The classical model: developed by economists in the nineteenth and early twentieth centuries, was an attempt to explain a key observation about the economy: business cycles may come and go, but the economy always returns to full employment. In the classical view, this behavior is no accident; powerful forces are at work that drives the economy towards full employment. Many of the classical economists went even further, arguing that these forces operated within a reasonably short period of time. Until the Great Depression of the 1930’s, there was little reason to question these classical ideas. True, output fluctuated around its trend, and from time to time there were serious recessions, but output always returned to its potential, full employment level within a few years or less, just as the classical economists predicted. But during the Great Depression, output was stuck far below its potential for many years. For some reason, the economy was not working the way the classical economists said it should. In 1936, in the midst of the Great Depression, the British economist John Maynard Keynes offered an explanation for the economy’s poor performance. Keynesian ideas became increasingly popular in universities and government agencies during the 1940’s and 1950’s. By the mid1960’s, the entire profession had been won over: Macroeconomics was Keynesian economics, and the classical model was removed from virtually all introductory economics textbooks. While Keynes’s ideas and their further development help us understand economic fluctuations—movements in output around its long-run trend—the classical model has proven more useful in explaining the long run trend. Hall/Lieberman use the terms “classical view” and “long run view” interchangeably. Assumptions of the classical model: In a properly functioning, competitive market, supply and demand should quickly reach an equilibrium point where quantity supplied and quantity demanded are equal. If the labor market worked that way, then there would be an equilibrium wage that cleared the market and there would be no unemployment. 1. A “critical assumption” in the classical model is that markets clear: the price in every market will adjust until quantity supplied and quantity demanded are equal. When we look at the economy through the classical lens, we assume that the forces of supply and demand work fairly well throughout the economy and that markets do reach equilibrium. Thus, an excess supply of anything traded will lead to a fall in its price; an excess demand will drive the price up. The remainder of this chapter uses the classical model to answer the following questions: 1. How is total employment determined? 2. How much output will we produce? 3. What role does total spending play in the economy? 4. What happens when things change? The focus = real variables (real GDP, the real wage, real saving, and so on). These values are typically measured in the dollars of some base year, and their numerical values change only when their purchasing power changes. How much output will we produce? In the classical view, all production arises from one source: our desires for goods and services. In order to earn income so we can buy goods and services, we must supply labor and other resources to firms. The Classical Labor Market: This labor demand curve diagram represents graphically the behavior of potential workers and of firms. On Figure One, the horizontal axis represents the level of labor services (N). This can be measured in hours, number of workers, or however. The vertical axis is the average level of wages (W) in the macroeconomy. The curve on the graph, labeled Nd, is the demand for labor by firms. Its negative slope can be explained as follows: Firms are rational, greedy, and they like to trade. Their primary goal is to produce just enough output for sale to maximize their profit given demand (i.e., given the price they can charge and the volume of sales they will have). If they produce too much (or sell at a lower price), then the costs they incurred in the production of those goods and services they did not sell have reduced their profits needlessly. If they produce too little (or sell at a higher price) then they have foregone profit opportunity because they could have sold more. To avoid either of these unpleasant possibilities, firms try to set output at the level that will maximize profits. The reason for the negative slope of the labor demand curve is this: given that the production and hiring decision are the same, and given that firms' production decision is based on their goal of profit maximization, as wages rise the potential for profit falls, forcing firms to cut back on production and therefore employment. As wages rise, the demand for employees falls, so the slope of the line is negative. The labor supply curve explains the behavior of potential labor force participants (those who are employed and those who would work under different labor market conditions). As you can see from Figure Two, the slope of this line is positive. The simplest way to understand this is that as wages rise, the willingness of laborers to work rises. As the wage rises, more and more people in the economy are willing to work. So the labor supply curve shows the number of people willing to work at each possible wage rate and the labor demand curve shows the number of people firms wish to hire at each possible wage rate. Figure Three shows the complete labor market. The interaction of the labor supply and labor demand determine the wage rate (W0) and the actual level of employment (N0). If the wage were at a level lower than the intersection, then, at that wage, there would be fewer people willing to work than the number demanded by firms. In the classical view, the economy achieves full employment on its own. Determining the Economy’s Output: (classical model) The economy’s level of output depends on: 1. The amount of other resources (land and capital) available for labor to use 2. The state of technology, which determines how much output we can produce with given inputs, as well as the types of inputs available (horse-drawn wagons or trucks; pencil and paper or a laptop computer). In the classical model, we hold one of two variables constant to answer these questions: i. What would be the long-run equilibrium of the macroeconomy for a given state of technology and a given capital stock? ii. What happens to this equilibrium when capital or technology changes? The Production Function: Aggregate production function: the relationship between the quantity of labor employed in the economy and the total quantity of output produced. In the labor market, the supply and demand curves intersect to determine employment of 100 million workers (graph below). The aggregate production function shows the total output the economy can produce with different quantities of labor, given constant amounts of land and capital and the current state of technology. The declining slope of the aggregate production function is the result of diminishing returns to labor: output rises when another worker is added, but the rise is smaller and smaller with each successive worker. In the classical, long run view, the economy reaches its potential output automatically—output tends toward its potential, full employment level “on its own” with no need for government to steer the economy toward it. Example: Use a diagram similar to Figure 2 [page 154] to illustrate the effect—on aggregate output and the real hourly wage—of (a) an increase in labor demand, and (b) an increase in labor supply. Solution: An increase in labor demand: Both the real wage and output increase. An increase in labor supply: Now output still increases, but the real wage decreases. The Role of Spending: Circular Flow of Income Is based on the premise we are dealing with a market system Depicts the interaction between different parts (markets) of the economy Economic agents: 1. Households 2. Firms 3. Government What happens in the factor market? Households supply resources directly (labor) or indirectly (through ownership of companies) Businesses demand resources in order to produce goods and services Flow of payments from businesses for resources constitutes business costs, and resource owners' income What happens in the product market? Households are on the demand side of these markets by purchasing goods and services Businesses are on the supply side, offering products for sale The flow of consumer (HH) expenditures constitutes sales receipts for businesses NOTE: 1. HH and businesses participate in both markets, but on different sides of each 2. There are two flows: Real flow Monetary flow Limitations of the Model: Does not depict transactions between HH and between businesses Does not explain how prices of products and resources are actually determined This simple model ignores government, and the "rest of the world." Circular flow diagram: The circular-flow diagram shows how households supply labor and savings to firms, who use that labor and invest those savings so as to produce goods and services, which they in turn sell back to those households. In other words, resources flow from households to firms in the form of labor services and savings, and they flow back from firms to households in the form of goods and services. Or we could think of income flowing from firms to households in the form of wages, interest, and dividends, and then flowing back to firms in the form of revenues for the goods they produce and sell. Factor payments: Wage, interest, rent, and profit payments for the services of scarce resources, or the factors of production (labor, capital, land, and entrepreneurship), in return for productive services. Factor payments are frequently categorized according to the services of the productive resource. Wages are paid for the services of labor, interest is the payment for the services of capital, rent is the services for land, and profit is the factor payment to entrepreneurship. In the circular flow, these are payments made by the business sector for factor services purchased from the household sector through the financial markets. Say’s Law: In a simple economy with just households and firms, in which households spend all of their income, total spending must be equal to total output. Says Law states that supply creates demand. Say’s Own words: “A product is no sooner created than it, form that instant, affords a market for other products to the full extent of the value…Thus, the mere circumstance of the creation of one product immediately opens a vent for other products.”(J.B. Say, A Treatise on Political Economy, 4th Edition (London: Longman, 1821), Vol. I, p.167. Example: Say's Law can be illustrated with a three-person, three-commodity, barter economy. Let our three persons be Crusoe, who is a fisherman, Friday, who collects coconuts, and Saturday, who grows bananas. Crusoe will catch fish for two reasons, either because he wants to eat them himself, or because he wants to trade them for coconuts and bananas. Friday and Saturday also work either to consume their own output or to trade it. If initially each banana and coconut are worth one fish, Crusoe may plan to trade five fish for two coconuts and three bananas. (These numbers are made up and have no special significance.) In the table below these plans are shown with a positive number indicating that a person plans to supply a commodity to the marketplace and a negative number indicating that a person plans to demand a commodity from the marketplace. The numbers show what each wants to do at the existing set of prices, not necessarily what each actually does. Total Spending in a More Realistic Economy: In the “real world” [Hall/Lieberman]: 1. Households don’t spend all their income. Rather, some of their income is saved or goes to pay taxes. 2. Households are not the only spenders in the economy. Rather, businesses and the government buy some of the final goods and services produced by households. 3. In addition to markets for goods and resources, there is also a loanable funds market where household saving is made available to borrowers in the business or government sectors. Net taxes and The Circular Flow With Government Net taxes flow from both House-holds and Business sectors to government in exchange for public goods and services Government expenditures flow to Households and Business sectors in exchange for resources (such as labor) or goods and services provided to the govt (such as computers, office equipment, etc) These flows to and from govt suggest ways that govt might stabilize the economy, alter income distribution and re-allocate resources such as 'Net taxes' include transfer payments to households and subsidies to business - “taxes in reverse." Federal poverty statistics are based on a measure of total household income that includes earnings and any cash transfers received by the household. Transfer payments are defined as any payment for which no good or service is provided in return. Examples of cash transfers include social security benefits, unemployment compensation, and disability payments. Transfer payments are the part of tax revenue that the government takes from one set of households and gives right back to another set of households. Government tax revenues minus transfer payments = Net taxes Let “T” represent net taxes: T = Total Taxes – Transfer Payments Household saving: (saving) is the part of the household sector’s income that is left after deducting what it pays to the government in taxes and what it spends on consumption. Let S = household saving Let Y = total income Let C = consumption spending S=Y–T–C Leakages and Injections: “By definition, total output equals total income. Leakages—net taxes and saving— reduce consumption spending below total income. Injections—government purchases plus investment spending—contribute to total spending. When leakages equal injections, total spending equals total output.” Hall/Liebermann Table: Flows in the economy of Classica Total Output $7 Trillion Total Income $7 Trillion Consumption Spending (C) $4 Trillion Planned Investment Spending (IP) $1 Trillion Government Spending (G) $2 Trillion Net Tax Revenue (T) $1.25 Trillion Household Savings (S) $1.75 Trillion Leakages from the Circular Flow Leakages represent Income (Y) not spent by US consumers on US goods Leakages are: S = saving T = taxes M = imports Leakages are important because they seem to threaten Say’s Law—the classical idea that total spending will always equal output. Injections into the Circular Flow Injections are spending on US goods not done by US consumers Injections are: I = business investment spending G = government spending X = exports There are two types of injections in the economy: 1. Government purchases of goods and services. 2. Planned investment spending represented with the symbol IP. Planned investment spending: business purchases of plant and equipment (sometimes called investment spending), represented with the symbol IP. Do not forget that actual investment (I) consists not just of planned investment in new capital, but also the unplanned changes in inventories. Example: If Calvin Klein produces $40 million in clothing during the year, but actually ships and sells only $35 million, the $5 million in unsold output will be an unplanned increase in inventories. But if the company sells $45 million one year—more than it had previously produced—it must have had some goods out of the inventories it had previously built up. Macro Equilibrium Leakages = Injections GDP = Y at equilibrium GDP = C + I + G + (X – M) Y=C+S+T So, cancel C on each side: I+G+X–M=S+T Or, I + G + X = S + T + M Which is leakages = injections “Total spending will equal total output if and only if total leakages in the economy are equal to total injections—that is, only if the sum of saving and net taxes is equal to the sum of investment spending and government purchases.” Hall/Lieberman The Loanable Funds Market: “Is where households make their saving available to those who need additional funds.” Definition: Arrangements through which households make their saving available to borrowers. o A simple supply-demand model of the financial system. One asset: “loanable funds” Demand for funds: investment o Supply of funds: saving “Price” of funds: real interest rate “When government purchases of goods and services (G) are greater than net taxes (T), the government runs a budget deficit equal to G – T. When government purchases of goods and services (G) are less than net taxes (T), the government runs a budget surplus equal to T – G.” Hall/Liberman Budget deficit: the excess of government purchases over net taxes Budget surplus: the excess of net taxes over government purchases Classica is running a budget deficit: Table: Flows in the economy of Classica Total Output $7 Trillion Total Income $7 Trillion Consumption Spending (C) $4 Trillion Planned Investment Spending (IP) $1 Trillion Government Spending (G) $2 Trillion Net Tax Revenue (T) $1.25 Trillion Household Savings (S) $1.75 Trillion G = $2 Trillion T = $1.25 trillion Thus, G – T = $0.75 Trillion This deficit is financed by borrowing in the loanable funds market. “When the government runs a budget deficit, it demands loanable funds equal to its deficit. When the government runs a budget surplus, it supplies loanable funds equal to its surplus” Definition: National Debt: The total amount of government debt outstanding. The Supply of Funds Curve: indicates the level of household saving at various interest rates. As the interest rate rises, saving or the quantity of loanable funds supplied increases. “The quantity of funds supplied to the financial market depends positively on the interest rate. This is why the saving, or supply of funds, curve slopes upward.” The Demand for Funds Curve: When the interest rate falls, investment spending and the businesses borrowing needed to finance it rise. The investment demand curve slopes downward. As the interest rate falls, business firms demand more loanable funds for investment projects. Definition: Investment demand curve: indicates the level of investment spending firms plan at various interest rates. Example: What is the source of funds supplied to the loanable funds market? Explain why the supply of funds curve slopes upward, and why the curve depicting business demand for funds slopes downward. Solution: Savings is the source of funds supplied to the loanable funds market. The savings curve slopes upward because an increase in the real interest rate means there is a higher opportunity cost for consumption, so people will save more and consume less (the income from savings is higher hence the price of consumption is higher). The investment curve slopes downward because the opportunity cost of investing increases as the interest rate increases so a firm will invest less at higher interest rates. Definition: Government demand for funds curve: indicates the amount of government borrowing at various interest rates. Definition: Total demand for funds curve: indicates the total amount of borrowing at various interest rates. a. Summing the governments demand for loanable funds b. And business firms’ demand for loanable funds at each interest rate c. Gives us the economy’s total demand for loanable funds at each interest rate “The government sector’s deficit and, therefore, its demand for funds are independent of the interest rate” As the interest rate decreases, the quantity of funds demanded by business firms increases, while the quantity demanded by the government remains unchanged. Therefore, the total quantity of funds demanded rises.” Example: How will the slope of the demand for funds curve be affected if the government runs a budget deficit? Why? Solution: If the government runs a budget deficit the demand for funds curve will shift outwards, but we generally assume that the slope will not be affected because the government does not base its decisions to run a deficit based on the interest rate (as firms do for their investment decisions). The government requires a certain amount of funds to pay for the deficit and will borrow the same amount at any interest rate. By adding a set amount to the x-value of each point on the demand curve, it shifts outwards without changing the slope (play with it in Excel if you want to see this happening). Slope = change in Y/change in X. If you add the same amount to X1 and X2, the change remains the same so the slope is unchanged. Equilibrium in the Loanable Funds Market: Suppliers and demanders of funds interact to determine the interest rate in the loanable funds market. At an interest rate of 5%, quantity supplied and quantity demanded are both equal to $1.75 trillion.” Table: Flows in the economy of Classica Total Output $7 Trillion Total Income $7 Trillion Consumption Spending (C) $4 Trillion Planned Investment Spending (IP) $1 Trillion Government Spending (G) $2 Trillion Net Tax Revenue (T) $1.25 Trillion Household Savings (S) $1.75 Trillion The Loanable Funds Market and Say’s Law Remember that total spending will equal total output if and only if total leakages (saving plus net taxes) are equal to total injections (planned investment plus government purchases). Classical theory believes in the flexible market clearing mechanism, long run full employment equilibrium, Say's Law (supply creates its own demand) and savings being an engine of growth. Savings will be equated with investment in the loanable funds market according to classical theory. Loanable funds: S = supply of loanable funds I+(G-T) = private + public borrowing = demand for loanable funds Interest rate adjustments ensure that loanable funds market clears. Therefore Say's Law must hold. Let S = Saving IP = Planned Investment G – T (Deficit) Quantity of funds supplied = S Quantity of funds demanded = IP + G – T Thus, S = IP+ G – T Move T to the left side and: S + T = IP + G In other words, market clearing in the loanable funds market assures us that total leakages in the economy will equal total injections, which in turn assures us that there will be enough spending in the economy to purchase whatever output level is produced. o As long as the loanable funds market clears, Say’s law holds—total spending equals total output—even in a more realistic economy with saving, taxes, investment, and a government deficit. Example: Show that Say’s law still holds when the government is running a surplus, rather than a deficit. Solution: If the government is running a surplus rather than a deficit, then G – T is negative rather than positive. When the loanable funds market clears, then demand for funds, which now only includes private investment since the government does not need any funds, must equal supply of funds, which now includes both private savings and government savings (the amount of the surplus). In the classical model it is assumed that the interest rate will adjust to make the loanable funds market clear, hence: S + T – G = I. We can rearrange the equation to see that leakages (S + T) then equals injections (I + G) so that Say’s Law holds. “Saving is transformed into business and government spending in the loanable funds market. The interest rate adjusts to guarantee that saving plus net taxes will equal government spending purchases plus investment. As a result, total income will equal total spending Say’s law shows that the total value of spending in the economy will equal the total value of the output, which rules out a general overproduction or underproduction of goods in the economy. It does not promise that each firm will be able to sell all of its output…but don’t forget about the market clearing assumption. In each market, prices adjust until quantities supplied and demanded are equal. For this reason, the classical, long-run view rules out over or under production in individual markets, as well as the generalized overproduction ruled out by Say’s Law. Summary of The Classical Model: The economy will achieve and sustain output on its own. We need never worry about there being too little or too much spending; Say’s law assures us that total spending is always just right to purchase the economy’s total output. Fiscal Policy in the Classical Model: G or T, used to stabilize the economy. Fiscal policy the spending and taxing policies used by the government to influence the economy; a change in government purchases or in net taxes designed to change total spending in the economy and thereby influence the levels of employment and output. When the government either increases taxes in order to influence the level of economic activity, it is engaging in fiscal policy. In the classical view, fiscal policy is both ineffective and unnecessary because the classical view holds that the economy achieves and sustains full employment on its own. 1. The higher interest rate will retard private investment and consumption. This is called the crowding-out effect. As a result of the increase in government purchases, both investment spending and consumption spending decline. The government’s purchases have crowded out the spending of households (C) and businesses (IP). Definition: “Crowding out is a decline in one sector’s spending caused by an increase in some other sector’s spending” Hall/Lieberman “In the classical model, a rise in government purchases completely crowds out private sector spending, so total spending remains unchanged.” Hall/Lieberman Definition: Complete crowding out: a dollar for dollar decline in one sector’s spending caused by an increase in some other sector’s spending.