Download SESSION 3: MACROECONOMICS LECTURE

SESSION 3: MACROECONOMICS LECTURE
THE MACROECONOMY
Macro Basics: The Macroeconomy
Topic: An Economy
Let's start with a definition:
An economy is an interactive system of production, distribution, and consumption
of resources, goods, and services that addresses the basic economic problem of
scarcity.

Economic functions are divided into four basic macroeconomic sectors:
1.
2.
3.
4.
Household: the consumers.
Business: the producers.
Government: the regulators and taxers.
Foreign: the others.
The household sector of the macroeconomy is everyone in an economy who
consumes goods and services.
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Consumption is the use of natural resources, goods, or services to satisfy
wants and needs.
In a complex economy, consumption is expenditures by the household sector
for the purchase of final goods and services.
Household sector is a term that indicates the consuming, wants-and-needssatisfying population. Everyone in society is included in the household sector.
The household sector is responsible for consumption.
The business sector of the macroeconomy produces the goods and services that are
consumed by the household sector.
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The business sector is responsible for production by combining the four basic
resources: labor, capital, land, and entrepreneurship.
A business is a method of combining resources for production.
While the business sector buys raw materials, intermediate goods, and other
things. The most important purchase of the business sector is capital goods,
or investment in capital.
The business sector is responsible for capital investment.
The government sector affects resource allocation and production by imposing laws
and regulations that force decisions not otherwise made.
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
Three levels of government: Federal, State and Local.
The government sector collects taxes and buys a share of the economy's

production, termed government purchases. These are goods such as national
defense, highway and street construction, education, and police protection.
Government purchases do not include transfer payments (Social Security
benefits, welfare or unemployment compensation).
The government sector is responsible for government purchases.
Economic activity is divided into domestic, everything within the political boundaries
of a nation, and foreign, everything outside the boundaries.
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Any citizen of the U.S., any firm owned by a U.S. citizen, and the government
of any U.S. city are part of the domestic economy.
Any resident, business or government of another country is part of the foreign
sector.
Exports are goods purchased by the foreign sector that are produced by the
domestic economy.
Imports are goods purchased by the domestic economy that are produced by
the foreign sector.
Net exports are the difference between exports and imports, or exports minus
imports.
The foreign sector is responsible for net exports.
Macro Basics: The Macroeconomy
Topic: Macroeconomics
Macroeconomics is the study of the entire economy, the aggregate economy.
Microeconomics is the study of parts of the economy.
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
Economists first studied parts of the economy (markets, demand, supply, and
prices), what we now call microeconomics.
The Great Depression of 1930's, motivated economists led by John Maynard
Keynes, to study macroeconomics.
Microeconomics and macroeconomics have their own principles, theories, and
phenomena. Both are part of economics and each is intertwined with the other.
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The macroeconomy affects microeconomic decisions.
Microeconomic decisions affect the macroeconomy.
Macro Basics: Macro Problems
Topic: The Goals
A modern, complex economy like the U.S. economy pursues three macro goals:
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Full employment: Using all available resources for production.
Stability: Avoiding inflation and/or fluctuations in the economy.
Growth: Lessening the problem of scarcity by increasing production
capabilities.
We always pursue these goals but conflicts mean we cannot reach them at
the same time.
More conflicts result from pursuit of the micro goals of efficiency and equity.
Macroeconomic problems from not reaching this goals are: production,
unemployment, and inflation.
Macro Basics: Macro Problems
Topic: Unemployment
Unemployment exists when resources, specially labor, are willing and able to
produce goods but are not employed because no one is buying production.
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Voluntary unemployment occurs when people choose not to work.
Involuntary unemployment occurs when people are willing to work, but can't
find employment.
Unemployment problems:
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The economy suffers because unemployed resources are not producing goods
to lessen the scarcity problem.
The unemployed suffer personal hardships and a lower living standard.
Production lost from unemployed resources can never be recouped.
Macro Basics : Macro Problems
Topic: Inflation
Inflation is a stability problem that typically results because the four macro sectors
of the economy demand more goods that the economy can produce.
Inflation problems:
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Future prices become increasingly uncertain.
Financial assets like money, bank accounts, stocks and bonds decrease in
value with higher prices.
Income and wealth are haphazardly redistributed because prices change at
different rates.
Hyperinflation can reduce production because money becomes almost
worthless and people revert to barter exchanges.
Macro Basics | Business Cycles
Topic: Instability
The macroeconomy is unstable. It has periods of falling production, rising inflation,
and/or high unemployment.
Business cycles are recurring expansions and contractions of the aggregate
economy.
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Expansion is a general period of increasing economic activity, or rising
production, which is associated with low or falling unemployment and high or
rising inflation.
Contraction is a general period of decreasing economic activity, or falling
production, which is associated with high or rising unemployment and low or
falling inflation.
Counter-cyclical policies to stabilize the business cycle:
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During an expansion, try to cause a contraction.
During a contraction, try to cause an expansion.
Macro Basics: Business Cycles
Topic: Causes
To understand business cycles, we need the causes:
1. Consumption: If households decide to buy more or less, the rest of the
economy follows suit.
2. Capital Investment: Big swings can set in motion upward or downward spirals
of total production.
3. Government Purchases and Taxes: Government purchases can be
contractionary or expansionary effect over the economy. Taxes affect the
ability of the household and business sectors to buy production.
4. Net Exports: Changes in exports can trigger expansions and contractions of
the domestic economy.
5. Circulating Money: Too much money can trigger and inflationary expansion,
too little money can trigger contraction and unemployment.
6. Resource Supply Considerations: Resource supply changes (energy prices,
technology, wages, etc.) can trigger expansions and contractions.
Macro Basics: Policies
Topic: Government
Government tries to bring the economy closer to the macro goals of full
employment, stability and growth, and to lessen the scarcity problem.
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Economic policies are government actions designed to affect the economy to
pursue the economic goals.
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Stabilization policies (or counter-cyclical policies) are designed to limit
economic instability and business cycles and avoid high rates of
unemployment and inflation.
Key macroeconomic stabilization policies:
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Fiscal policy is the use of government spending and taxes to stabilize the
economy.
Monetary policy is the use of the amount of money in circulation to stabilize
the economy.
Macro Basics: Policies
Topic: Viewpoints
People can take different views of government and economic polices that depend
on political philosophies.
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Liberal Democrat: The view that government is the only way to keep the
economy running smoothly, using paternalistic, hands-on policies. If a
problem arises, then government is the answer.
Conservative Republican: The view that government is the problem, not the
solution. The best government is the least government because it is a
tyrannical oppressor of individual rights and freedoms.
One view or the other is usually the basis of an economic policy.
The government can be the solution and it can be the problem.
Macro Basics: Issues
Topic: Politics
Policy perspectives are filled with differing politics and political philosophies.
Reasons for differing views of the 'best' economic policies:
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First: Human beings are different, with different likes, dislikes, tastes,
preferences, values, beliefs, ideologies and opinions. This is the source of
differences on what is considered the 'best' for the economy.
Second: Human beings often have vested interests in the consequences of
the policies. They personally benefit from a policy. While self-interest is okay,
the question is whether self-interests of the few prevent greater welfare of
the many.
Macro Basics: Issues
Topic: Theories
Using the scientific method to test macroeconomic theories is an evolving process.
Over time, more hypotheses are tested and macroeconomic theories grow, expand
and improve.
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Hypotheses from macroeconomic theories are not easily subject to
experimental testing. Economists can't control the economy but must wait for
it to cooperate.
The result of combining different political philosophies and vested interests
with the inability to provide definitive explanations, creates alternative,
competing theories that seek to explain the world.
GROSS DOMESTIC PRODUCT
Gross Domestic Product: Measuring
Production
Topic: An Indicator
Economists use numerical measurements to
indicate the health and well-being of the
economy.
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Economic diagnosis relies on several
indicators.
Gross domestic product is the most
comprehensive measure of the
economy's production and one of the
most basic measures of the economy's
well-being.
Gross domestic product, as well as
other economic measures, are
indicators of our economic health.
A GDP Definition:
Gross domestic product (GDP) is the total market value of all final goods and
services produced in the economy in a given period of time, usually one year.
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The goal of GDP is to measure the total production of goods and services
produced in the economy each year.
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A larger GDP means that we have more goods and services that can be used
to satisfy our unlimited wants and needs.
The chart presents recent numbers for GDP in the United States.
Gross Domestic Product: Measuring
Production
Topic: Total Market Value
Let's highlight the phrase 'total market value' in this definition of GDP.
First, total. GDP seeks to measure ALL production of goods and services in the
economy.
Second, market value. Market prices indicate the value of goods. We measure the
total value of production by multiplying the quantity produced and traded through
markets by market prices. GDP is the aggregation of the market value of all goods.
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Market transactions provide an excellent source of information that can be
used for calculating GDP.
Dollars (market prices) provide a common denominator for aggregating
different goods.
Gross Domestic Product: Measuring
Production
Topic: Final Goods and Services
A second phrase to highlight is 'final goods and services'.
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Production generally involves several intermediate steps which involves
market exchanges of intermediate goods. GDP measures only the market
value of final goods.
The cost of intermediate goods is already included in the price and thus the
market value of finished product when sold to final users.
To avoid double counting, GDP does not separately include the market value
of any intermediate goods.
Final goods are those reaching their final user and include: household consumption,
business investment in capital, government purchases, and exports.
Gross Domestic Product: Measuring
Production
Topic: Given Year
The third GDP highlight phrase is 'a given period of time'.
GDP is production that takes place during a specific period, usually one year.
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GDP is a flow. Current production takes place during the specific period of
time under study.
Flows are measured over a period of time. GDP is measured from January 1st
to December 31st.
Stocks are measured at a point in time. The quantity of money is measured at
an instant in time, like July 26th at 8:15.
In addition to GDP, other production and income measures in this lesson are
flows.
In addition to money, employment, business inventories, and labor force are
stocks.
Lesson 10: Gross Domestic Product:
Looking Behind GDP
Topic: Ins and Outs
Measuring GDP in the U.S. economy uses
data involving $8 trillion of production, 270
million consumers, hundreds of thousands of
businesses, and a huge number of market
transactions.
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The circle on the left represents all
current economic production in the
economy. This is what GDP seeks to
measure.
But GDP can not measure this
directly. Information for measuring
GDP comes from market transactions.
The circle on the right represents all
market transactions.
Much of the economic production
circle overlaps the market transaction circle. But each circle has a slice not
contained in the other.
Gross Domestic Product: Looking Behind
GDP
Topic: Past and Future
Slice A includes market transactions that are
NOT economic production, and are excluded
from GDP.
Two activities in slice A:
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Future production. Intermediate
goods will become part of GDP in the
future when production is finished. To
avoid double counting, we exclude
these market transactions.
Past production. Used items (cars,
houses) produced before the start of
our current time period. Because they
are not current production and were
included in GDP in a previous year,
they are excluded from GDP
Slice A is excluded from GDP.
Gross Domestic Product: Looking Behind
GDP
Topic: Estimated Value
Slice B includes economic production that
does NOT involve market transactions.
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The market value of nonmarket
economic production for some goods
can be estimated and included in
GDP.
In-kind payments: This is
nonmarketed production obtained by
business owners or employees in lieu
of money payment. Although no
market transaction, GDP includes the
estimated value of these transactions.
Owner-occupied housing: The value
of owner-occupied housing services
are not measured by market
transaction. GDP includes the estimate the value of these services.
At least part of slice B is included in GDP.
Gross Domestic Product: Looking Behind
GDP
Topic: Home Production
Chunk C also is economic production that
does NOT involve market transactions.
It includes household productive activities,
such as cooking, cleaning, home repairs, and
entertainment.
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Hiring others for these tasks would be
market transactions included in GDP.
If tasks are done personally, without
pay, there is no market transaction
and no record of production.
While information needed to estimate
the value of household production
could be collected, it might be more
trouble than it's worth.
Chunk C is excluded from GDP.
Gross Domestic Product: Looking Behind
GDP
Topic: Illegal Goods
Chunk D also is economic production that
DOES involve market transactions. Lack of
information about market transactions
prevent these activities from being included
in GDP
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Chunk D includes illegal activities,
such as gambling, drug sales, and
prostitution.
Because they satisfy wants and needs
they are economic production.
Because they are illegal activities
'official market transaction records
are not available.
Chunk D is excluded from GDP.
Gross Domestic Product: Looking Behind
GDP
Topic: GDP
Economic production that involves market
transactions is the foundation of GDP. This is
area E. It is combined with area B to
measure GDP.
A summary of measuring GDP:
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Start with all market transactions of
record.
Toss out past and future production in
Slice A.
Add the estimated value of
nonmarket 'in-kind' production in
Slice B.
Don't include the value of nonmarket
production in chunk C and the value
of illegal production in chunk D.
Combine areas B and E for the final tabulation of GDP.
Gross Domestic Product: Looking Behind
GDP
Topic: Real GDP
GDP is the total MARKET VALUE of current economic production, that is, GDP
measures current production at current market prices.
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If we measure current economic production, current prices work fine. If we
compare GDP from one year to the next year, current prices can be
misleading.
For example... a 10% increase in GDP could result from changes in
production, prices, or both. Production could be 10% higher will prices do not
change. Or prices could 10% higher while production does not change. Or this
could be a mix of changes in production and prices.
All we know is that GDP has risen by 10%, but it is difficult to know what has
happened to physical production.
We need something more, we need real GDP.
Gross Domestic Product: Two Views of
GDP
Topic: Demand and Supply
GDP can be measured in two different ways.
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Demand-side: In a market transaction, the buyer pays a price for a good or
a service based on the value of the good. This indicates that the value of GDP
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can be measured from expenditures.
Supply-side: For seller's, the revenue received from selling a good is used to
pay resources--the cost of production. This indicates that the value of GDP
can be measured by the resource cost of production.
These two sides--expenditures and resources--give us two ways of measuring
GDP.
Each can be used to check the other.
Gross Domestic Product: Two Views of
GDP
Topic: Expenditures
The four sectors of the economy buy ALL current economic production and when
aggregated give us GDP.
The four sectors and their expenditures:
1.
2.
3.
4.
Household: Consumption (C).
Business: Investment (I).
Government: Government Expenditures (G).
Foreign: Net Exports (X-M), the difference between Exports (X) and Imports
(I).
Expenditures on GDP: GDP = C + I + G + (X-M)
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C, I and G buy not just domestic goods and services, but also imports.
When we aggregate C, I, G and X we have domestic production plus imports.
To measure only domestic production, we subtract imports (M).
Gross Domestic Product : Two Views of
GDP
Topic: Resources
Calculating GDP from the resource side is based on the fact that ALL revenue
received by the business sector is paid to or claimed by a factor of production.
Factor payments and the productive factors are:
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o Wages are paid to labor.
o Interest is paid to capital.
o Rent is paid to land.
o Profit is paid to entrepreneurship.
Official government names are compensation to employees (wages) and
corporate profit (profit).
Proprietors' income is a combination of wages, interest, rent and profit,
collected by the owner of a proprietorship.
Gross Domestic Product : Measuring
Income
Topic: National Income
The first three related, but slightly different
income measures is national income (NI),
income earned by the factors of
production.
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National income is the sum of
wages (W), interest (I), rent (R),
profit (P) and proprietors' income
(PI):
NI = W + I + R + P + PI

National income is also found by
subtracting capital consumption
allowance (CCA) and indirect
business taxes (IBT) from, and
adding net foreign factor income
(NFFI) to, GDP:
NI = GDP - CCA - IBT + NFFI

And because NDP = GDP - CCA:
NI = NDP - IBT + NFFI
Gross Domestic Product: Measuring
Income
Topic: Personal Income
Personal income (PI) is the second income measure.
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Personal Income is income RECEIVED by households.
Compare this with national income which is income earned by the factors of
production.
These two income measures are similar, but not exactly the same.
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Some income earned by the factors of production is not received by the
household sector. Let's call it IEBNR.
Some income received by the household sector is not earned by a factor of
production. Let's call it IRBNE.
Gross Domestic Product: Measuring
Income
Topic: IEBNR
Income earned by the factors of
production that is not received by the
households (IEBNR) is subtracted from
national income to derive personal income.
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Social Security taxes: This is
income earned by workers for their
production, but paid to the
government and not received by
households.
Corporate profit taxes: Part if profit
redirected to government.
Undistributed corporate profits:
Retained earnings kept by business
for future capital investment.
Workers, entrepreneurship and/or
capital owners earn this income,
but do not receive it.
Gross Domestic Product: Measuring
Income
Topic: IRBNE
Income received by households but not
earned by the factors of production
(IRBNE) is added to national income to
derive personal income. IRBNE are
transfer payments.
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Households without factors of
production receive income through
transfer payments such as:
1. Social Security benefits.
2. Welfare payments.
3. Unemployment
compensation.
To calculate personal income,
income earned but not received
(IEBNR) is subtracted from and
income received but not earned
(IRBNE) is added to national income.
PI = NI - IEBNR + IRBNE
Gross Domestic Product: Issues
Topic: What It Does
The study of gross domestic product is important for at least for two reasons.
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First, Scarcity. Real GDP indicates how well the economy is addressing the
economic problem of scarcity.
Second, Stability. Real GDP is a key measurement for analyzing economic
instability and business cycles.
Gross Domestic Product: Issues
Topic: What It Doesn't Do
GDP and related measures are not perfect.
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GDP is only an indicator of economic activity. Because it requires
interpretation and analysis it is subject to misinterpretation and misanalysis.
GDP is an aggregate measure for the economy. It measures total production,
but it does not indicate who receives the production, the distribution of
production.
GDP does not measure the satisfaction of wants and needs. GDP can increase
even though welfare does not increase, or even decreases. GDP might even
decrease even though welfare is greater.
CIRCULAR FLOW
Circular Flow: Basic Flow
Topic: Overview
Economic activity can be separated according to the four basic macroeconomic
sectors--household, business, government, and foreign. The circular flow model
helps us analyze the interaction among these sectors.
The circular flow is a model of the continuous production and consumption
interaction among the four major sectors (household, business, government, and
foreign), that takes place through the three aggregated macroeconomic markets
(product, factor and financial).
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The circular flow is a simple model that helps us understand the complex real
world economy.
Circular Flow: Basic Flow
Topic: Four Sectors
The four basic macroeconomics sectors:
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Household sector: This includes everyone, all people, seeking to satisfy
unlimited wants and needs. This sector is responsible for consumption.
Business sector: This includes those undertaking the task of combining
resources to produce goods and services. This sector is responsible for the
production.
Government sector: This includes the ruling bodies of the federal, state, and
local governments. Regulation is the prime function, especially to pass laws,
collect taxes, and force other economic sectors to do things that they
wouldn't do voluntary.
Foreign sector: Includes everyone and everything beyond the boundaries of
the domestic economy.
Circular Flow: Basic Flow
Topic: Three Markets
The three aggregated markets in the circular flow are:
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Product markets: The combination of all markets in the economy that
exchange final goods and services. These markets are the mechanism that
exchanges gross domestic product. These are also termed the aggregate
market.
Factor markets: These markets exchange the services of the economy's
resources, or factor of production--labor, capital, land, and entrepreneurship.
These are also called resource markets.
Financial markets: These are markets that trade financial instruments, like
stocks and bonds. They play an important role in capital investment.
Circular Flow: Basic Flow
Topic: The Physical Flow
Two sectors: household and business.
Two markets: product and factor.
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The physical flow is the counterclockwise flow of resources from the
household to business sector and
production from the business to
household sector.
Production flows from the business
sector (supply) to the household
sector (demand) through the product
markets.
Resources flow from the household
sector (demand) to the business
(supply) sector through the factor markets.
The household sector sells the resources through the factor markets and buy
goods through the product markets.
The business sector buys resources through the factor markets and sells
goods through the product markets.
Circular Flow: Basic Flow
Topic: The Payment Flow
The payment flow goes in the opposite
direction of the physical flow. A physical
commodity goes one direction through
markets and payment goes the other.
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The household sector buys
production from the business sector
(counter-clockwise flow) in exchange
for payment (clockwise flow) through
product markets.
The business sector buys resources
from the household sector (counterclockwise flow) in exchange for
payment (clockwise flow) through
factor markets.
Revenue received by the business sector for selling goods is used to pay the
factors of production.
Factor payments become income used by household sector to buy production
from the business sector.
The circular flow makes about six cycles around the economy each year.
Circular Flow: Financial Markets
Topic: The Paper Economy
Financial markets divert national income from household consumption to business
investment.
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Real side: Goods and resources, physical production used to satisfy wants and
needs.
Paper side: Legal claims on these physical goods and resources. Examples:
Corporate stocks, government bonds, money, bank statements, mortgage
contracts.
Trading legal claims through financial markets diverts income from
consumption to investment.
A legal claim buyer gets the legal claim, but gives up income. The legal claim
seller gives up the claim and takes possession of the income.
Income is diverted from a legal claim buyer (lender, saver) to a legal claim
seller (borrower) through the financial markets.Two additional flows: Saving
and Investment.
Circular Flow: Financial Markets
Topic: Saving
Saving is a nonconsumption use of income,
making a loan or supplying income to the
financial markets in exchange for a legal
claim.
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The red financial markets box is a
third set of aggregate markets.
The green flow is saving supplied to
the financial markets. It is income
diverted from the household sector.
Why save?
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To get paid. Interest is the payment
for using income.
Income is needed later more than now. Income is set aside this year to buy
more production next year.
Saving does not disappear, it is income diverted away from the consumption flow
and supplied, or loaned, to the financial markets.
Circular Flow: Financial Markets
Topic: Investment
Investment is business expenditures on
gross domestic product for capital goods.

The green flow from the business
sector to the product markets is
investment. The physical flow of
capital goods moves in the opposite
direction.
The process:
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Financial markets have buyers
(savers) and sellers (borrowers).
Savers buy legal claims that divert
income TO financial markets.
Borrowers sell legal claims that divert income OUT of the financial markets.
The business sector borrows income through financial markets, which is used
to finance capital investment.
Circular Flow: Government
Topic: What It Does
The government sector plays a key role in the economy and the circular flow with
government spending, especially for the purchase of GDP, and taxes.
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Government purchases include: national defense, roads, educational system,
post offices, fire and police protection, parks, sewage treatment plants, and
more.
Taxes are used to divert household sector income to the government sector
to pay for these purchases.
The diversion of income into taxes used to purchase government production
shows up in the circular flow model.
Circular Flow: Government
Topic: Taxes
The government sector tends to be in the
middle of most economic activity.
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Taxes are collected by all levels of
government, federal, state, and
local.
The green flow from the household
sector to the government sector is
taxes.
This flow is household income
diverted to the government sector.
Three basic uses of national income:
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Consumption: Income used by the
household sector to buy GDP.
Saving: Income diverted to the financial markets for business sector
borrowing for capital purchases.
Taxes: Income diverted to the government sector for government purchases.
All three come from national income.
Circular Flow:Government
Topic: Government Purchases
Government spending is divided into
government purchases of GDP and transfer
payments.
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Transfer payments include welfare to
the poor, unemployment
compensation, and Social Security
benefits.
Transfer payments are like negative
taxes, but flow from the government
sector to the household sector.
The circular tax flow is the net tax
flow from households to government,
taxes minus transfer payments.
Government purchases are the green
flow from the government sector to the product markets.
As an expenditure on GDP, government purchases are comparable to
consumption by the household sector and investment by the business sector.
Circular Flow: Government
Topic: Government Borrowing
When government does not collect enough
taxes to pay for purchases, it borrows
through the financial markets.
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The federal deficit is borrowing by
the federal government to make up
the difference between taxes and
spending.
State and local governments also
borrow through financial markets.
The green flow leaving the financial
markets and entering the
government sector is government
borrowing.
Government sector purchases can be
less than taxes, which means government saves to the financial markets.
Many state and local governments actually save. State and local saving
reduces total government sector borrowing in times of high federal deficits.
Circular Flow: Foreign
Topic: Foreign Trade
The foreign sector is the fourth and last circular flow sector.
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The foreign sector is households, businesses, and governments outside the
domestic economy (including other planets).
Market exchanges are a natural means of addressing the scarcity problem.
Mutually beneficial exchanges aren't limited by geographic location or political
boundaries.
Foreign trade, the exchange among buyers and sellers in different nations, is
an extension of mutually beneficial exchanges among people of the same
country.
Foreign trade gives us the terms exports and imports.
Circular Flow: Foreign
Topic: Exports and Imports
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Exports are goods and services
produced by the domestic economy
and purchased by the foreign sector.
Imports are goods and services
produced by the foreign sector and
purchased by the domestic economy.
Exports are the green flow coming
from the foreign sector and joining
GDP before reaching the business
sector.
Imports are the green flow leaving
the consumption, investment,
government purchases stream and
going to the foreign sector.
Note that the physical flow of
production (exports and imports)
moves in opposite direction as the
green payment flows.
Circular Flow: Real World
Topic: Expenditures
Gross domestic product (GDP) is the sum of
consumption, investment, government
purchases, and net exports.
Circular Flow: Real World
Topic: Production And Income
Measures of production and income.
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Net domestic product (NDP) is GDP
minus capital consumption
allowances CCA).
National income (NI) is NDP minus
indirect business taxes (IBT).
Personal income (PI) is NI minus
undistributed corporate profits (UCP),
corporate profits taxes (CPT) and
Social Security Taxes (SST), plus
transfer payments.
Disposable income (DI) is PI minus
personal taxes.
Circular Flow: Real World
Topic: Investment
Investment expenditures are financed from
the capital consumption allowance (CCA),
undistributed corporate profits (UCP), and
investment borrowing.
Circular Flow: Real World
Topic: Government Spending
Government spending, purchases and transfer payments, is financed by indirect
business taxes (IBT), Social Security taxes (SST), corporate profits taxes (CPT),
personal taxes, and borrowing.
BUSINESS CYCLES
Business Cycles: Instability
Topic: Overview
It's a fact of life that the economy is unstable. Like a roller coaster rises and falls,
the economy expands and contracts.
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The economy goes up and down, twisting and turning along the way.
In general, we prefer the good that comes with a rising, expanding economy
and don't like the bad that comes with a falling, contracting one.
The fluctuations in the economy never stop.
It is difficult for the economy to run full speed at all times.
Economic fluctuations go by the term business cycles.
Business Cycles: Instability
Topic: Business Cycles
Business cycles are irregular, nonperiodic fluctuations in aggregate economic
activity. Life is good, then it's bad. It's a roller coaster ride.
For example, the Great Depression was the worst economic period in this century.
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Unemployment reached 25%.
Total production declined by about 40%.
Investment declined by 90%.
During the 1920s, production was up, unemployment was down, life was good, then
it got bad.
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Although we use the term 'cycle', we don't know how long an expansion or a
contraction will last. The economy might expand for a year or it might expand
for a decade before it declines.
Business Cycles: Instability
Topic: Expansionary Good Times
Expansionary good times are almost always good. But here is a bad side.
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The good side: The economy is growing, more goods are produced, living
standards rise, businesses are profitable, and scarcity problems are lessened.
The bad side: Inflation and inefficiency.
Inflation tends to worsen when the economy expands too rapidly. Inflation is
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usually a bigger problem for some than for others, including those on fixed
incomes and with financial wealth.
Inefficiency is likely during an expansion. With the entire economy expanding,
and everyone becoming better off, the incentive to be efficient is reduced.
Business Cycles: Instability
Topic: Contractionary Bad Times
Contractionary bad times give us the most problems.
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First: Real GDP declines during a contraction. This means less production for
the four sectors to buy.
Second: Unemployment increases. Resources, especially labor, produce less
and receive less income. 3-5 million workers newly employed.
Third: The incomes of employed resources also tend to fall, or at least not rise
as much as an expansion.
Fourth: Business profits decline and bankruptcies increase.
Fifth: Social problems, including crime, poverty, and alcoholism, worsen.
But contractions have some good:
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Inflation remains low or declines.
Some resources are more efficiently allocated.
Business Cycles: A Simple Cycle
Topic: Long-Run Trend
A closer look to the business cycle.
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The red line represents the pattern
of actual real GDP over time.
The blue line is the long-run trend,
the historical average of real GDP
growth, about 3% each year.
In general, real GDP increases.
But real GDP occasionally declines,
frequently rises faster the long-run
trend, and seldom rises exactly
equal to the long-run trend.
A business cycle is combination of
the two periods, (1) expanding
economic activity moves the
economy up to and above the
long-run trend and (2) declining
activity that drops it below this
trend.
Business Cycles: A Simple Cycle
Topic: Contraction
Contractions generally last about a year,
but some have persisted for 1 1/2 years
and some end after six months.
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A contraction, also termed
recession, is the decline of real
GDP, from A to B.
A contraction is officially
designated as at least six months
of declining economic activity.
The 1930s Great Depression had
two contractions, one lasting 43
months.
A contraction takes the economy
from above the long-run trend to
below the long-run trend. The
long-run trend is full-employment
production.
Below the long-run trend resources are not fully employed, unemployment
increases.
Business Cycles: A Simple Cycle
Topic: Trough
Contractions don't last forever. The end of
a contraction is the trough, the turning
point to an expansion.
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Point B is the end of the
contraction and the beginning of
the expansion, the trough.
A trough is the turning point
between a contraction and an
expansion.
A trough is the lowest level
reached by the economy before an
expansion begins, the dark before
the dawn.
Turning points are important
because they are the transition
from bad to good of good to bad.
A turning point might not be
identified until well after it has happened.
Business Cycles: A Simple Cycle
Topic: Expansion
An expansion is a period of increasing
aggregate economic activity, indicated by
the growth of real GDP from B to C.
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Expansions typically last about 2-4
years, but can continue up to a
decade.
The economy generally grows
faster than, often surpassing, the
long-run trend.
A recovery is the early part of an
expansion.
As the economy approaches point
C, above the long-run trend,
inflation is most likely to become a
problem, as we try to buy more
output than our resources can
produce.
At or above the full-employment, long-run trend line, unemployment is less of
a problem.
Business Cycles: A Simple Cycle
Topic: Peak
Expansions don't last forever. The end of
an expansion is the peak, the turning
point to a contraction.
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Point C is the end of the expansion
and the beginning of the
contraction, the peak.
A peak is the turning point
between an expansion and a
contraction.
A peak is the highest level reached
by the economy before a
contraction begins, the high before
the drop.
Anticipating a peak turning point
helps avoid the problems of
unemployment, a bankrupt
business, or lower income.
Business Cycles: Measurement
Topic: Indicators
Since the 1930s Great Depression, when the modern study of economics was
prompted, economists have sought indicators of business cycles.
Some indicators are:
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Real GDP, the unemployment rate, and the inflation rate are useful measures,
but they measure only specific aspects of the economy. These may not be the
best indicators of overall business cycle activity.Economists have identified
three sets of indicators to track business cycles:
o Leading indicators.
o Coincident indicators.
o Lagging indicators.
Business Cycles: Measurement
Topic: Leading
Leading economic indicators indicate
business-cycle activity 3 or 12 months
ahead. If leading indicators decline now,
then the economy is likely to decline in 3
to 12 months.
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Leading indicators are eleven
statistics that precede changes in
the economy.
Three notable leading indicators
are stock market prices, the
money supply, and consumer
confidence.
The Composite Index of Leading
Indicators, displayed in this chart,
combines all eleven into a single
number.
The Composite Index works better than individual indicators, but they are not
perfect. Some declines not followed by a contraction.
Business Cycles: Measurement
Topic: Coincident
Coincident economic indicators move
along with the aggregate economy. They
mark the business cycle.
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We don't know how the economy
is doing until after the fact. Real
GDP is released every three
months. Coincident indicators are
available monthly.
The four coincident indicators are
measures of production,
employment, income, and sales.
The Composite Index of Coincident
Indicators, displayed in the graph,
combines all four. Turns in this
index mark business cycle peaks
and troughs.
Leading and coincident indicators work together. Leading indicators forecast
turning points. Coincident indicators turn 3 to 12 months later.
Business Cycles: Measurement
Topic: Lagging
Lagging economic indicators lag the
turning points of business cycles by 3 to
12 months.
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Lagging indicators 'seal the deal'
by certifying that a contraction or
an expansion is over.
The next turning point usually
doesn't begin until lagging
indicators confirm that the last one
has happened.
Seven statistics are used as
lagging indicators, including in the
inflation rate, consumer debt, and
the prime interest rate.
The Composite Index of Lagging
Indicators, displayed in this graph, combines all seven into a single number.
This index turns after the official business cycle.
Business Cycles: Causes
Topic: Complexity
Business cycle instability happens, 3 to 4 years of expansion and a year or so of
contraction. During each new expansion, we think the business cycle contraction
problem has been solved.
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Every expansion, except the current one, has ended with a contraction.
Perhaps we have found THE cause of business cycles and can avoid future
contractions.
Economy is complex, with many different business cycle causes. Hard to
juggle a cell phone, remote control, and lit candle. Eventually you stop and
begin again.
Aggregate economic activity is delicate balancing act, with numerous reasons for a
contraction.
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Note that explanations are often influenced by politics and vested interests.
Business Cycles: Causes
Topic: Investment
Instability of business investment is one explanation of business cycles.
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During the Great Depression, production declined by 40% and investment
declined by over 90%. Did this big drop in investment cause the overall drop
in production?
Investment can trigger changes in production through the circular flow. A
decrease in investment, causes a decrease in production, which reduces
household income, which reduces consumption, which causes further
reductions in production, income, and consumption.
Small changes in investment can cause magnified changes in aggregate
production. A $10 billion decrease in investment might cause a $50 billion
decrease in GDP.
Business Cycles: Causes
Topic: The Process
Three points about investment and business cycles:
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First: Investment is sensitive to interest rates. Higher interest rates increase
the cost of investment borrowing and discourages investment.
Second: Interest rates rise and fall with the business cycle. During an
expansion, interest rates rise enough to discourage investment, and trigger a
contraction. During a contraction, interest rates fall enough to encourage
investment and cause a new expansion.
Third: Investment doesn't react immediately to interest rates. The production
of capital goods takes time and does not respond instantly to interest rate
changes.
Interest-rate-induced changes in investment seem to be a natural cause-and-effect
part of business cycles.
Business Cycles: Causes
Topic: Politics
Re-election seeking politicians is a second explanation for business cycles. Four
propositions lay the foundation:
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An elected leader remains an elected leader only if re-elected.
Government can influence economic activity through stabilization policies.
Fiscal policy, lower taxes and more spending, can trigger an expansion. The
opposite can cause a contraction.
Voters re-elect current leader during good times and elect new leaders during
bad times. They vote their pocketbooks.
Elected leaders know how this process works and give us the recipe for a
politically induced business cycles.
Business Cycles: Causes
Topic: The Process
Here's how the political business cycle would work:
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First: Elected leaders start promoting an expansion 2 to 3 years before an
election.
Second: One means of inducing an expansion is fiscal policy, with lower taxes
and more spending.
Third: The economy expands, voters are happy, leaders are re-elected. But
the expansion causes problems, such as inflation or budget deficits.
Fourth: These problems are solved with a contraction after the election, which
ends in time for the next pre-election expansion.
Fifth: With major elections every 4 years, many leaders have a vested
interest making this happen.
Business Cycles: Policies
Topic: Options
Stabilization policies try to avoid or
correct the problems caused by business
cycle instability.
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The two most popular are fiscal
policy and monetary policy.
Do nothing 'nonpolicies' might be
best in some cases, but are seldom
used because people often demand
immediate solutions to problems.
Business cycle instability is
indicated by the red line rising
above and falling below the longrun trend line.
The flatter, smoother line is the
goal of stabilization policy, to limit
business cycle instability.
Stabilization policies can be either
expansionary or contractionary.
Business Cycles: Policies
Topic: Expansionary
Expansionary policies avoid or limit the problems of business cycle contractions.
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Expansionary fiscal policy is increasing government spending or reducing
taxes. More spending can offset the decline in investment, directly. Lower
taxes leaves households with more income from consumption.
Expansionary monetary policy is increasing in the amount of money in
circulation. More money means more spending.
Business Cycles: Policies
Topic: Contractionary
Contractionary policies avoid or limit the problems of business cycle expansions.
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Contractionary fiscal policy is decreasing government spending or increasing
taxes. Less spending can directly offset an inflation-inducing expansion.
Higher taxes reduces spending indirectly by reducing household income.
Contractionary monetary policy is decreasing in the amount of money in
circulation. Less money means less spending.