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Foundation of Economic Analysis 3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 134 Administration This Week’s Assignments Farnham Chapter 11 (NIPA) Homework 06 (due next week) Next Week’s Assignments Farnham Chapter 12 (Aggregate Expenditures) Homework 07 (review) 5/23/2017 The University of Akron Decision Tree 2 Decision Tree Review Circular Flow Economic Measurement Measuring price changes Measuring employment activity Policy Issues Circular flow Purpose: To provide an overview of U.S.A. economic activity Focuses on transactions (flows) between groups of participants through markets. To simplify diagram, usually or monetary flows shown 5/23/2017 The University of Akron 4 Circular flow List the main sectors Household, Firm, Government, Foreign List the markets Product and Factor markets Asset markets Flows with foreign sector deserve special attention 5/23/2017 The University of Akron 5 The inner arrows represent the REAL flows Consumption EQUAL Revenues Product Markets Goods and Services Sold Goods and Services Purchased Households The outer arrows represent the MONEY flows Firms So far we have focused on the internal workings of markets Factors Supplied (Labor,product Land, Factors Received (Labor, Land, Capital, Entrepreneurship) Income (Wages, Rent, Interest, Profits) 5/23/2017 Capital, Entrepreneurship) Factor The University of Akron Markets Expenses (Wages, Rent, Interest, Profits) 6 Foreign Sector detail Consumption Imported Goods and Services Revenues Product Markets Import Payments Export Receipts Exported Goods and Services Foreign Sector Households Loans Firms Borrowing Borrowing Imported Production Factors Income 5/23/2017 Financial Markets Import Payments Export Receipts Factor The University of Akron Markets Exported Factors Expenses 7 Imports Consumption Foreign Sector Exports Product Markets Investment Government Expenditures Net Personal Taxes Households Revenues Net Business Taxes Governments Borrowing Firms Borrowing Borrowing Saving Income 5/23/2017 Financial Markets Factor The University of Akron Markets Expenses 8 Decision Tree Review Circular Flow Economic Measurement Measuring price changes Measuring employment activity Policy Issues Economic measurements Introduction of concepts National Income and Product Accounts (NIPA) Finding the data Decision Tree 5/23/2017 The University of Akron 10 Economic measurements Distinguishing Flow and Stock statistics Distinguishing Economic Activity and Social Well-being 5/23/2017 The University of Akron 11 Economic measurements Stock statistics examples Flow statistics examples Volume of water in a pond Rate of water in-flow and out-flow Inventory Production and sales Wealth Saving, Income and Consumption Can you provide other economic examples? 5/23/2017 The University of Akron 12 Economic measurements Remember the definition of each? Stock statistic Measurement of the quantity of an item at a point in time Flow statistic Measurement of the quantity of a rate or quantity per of time Unit of measure must include a unit of time 5/23/2017 The University of Akron 13 Economic measurements Distinguishing Economic Activity and Social Well-being One purpose of economic systems (societies) is to provide for the wellbeing of its individuals Economic activity contributes to that well-being, but is not a complete picture of well-being 5/23/2017 The University of Akron 14 Economic measurements We have seen that exchange and markets tend to provide for the needs and desires of individuals Well working competitive markets provides the highest valued output at the lowest opportunity cost Thus we can measure economic activity (and its contribution to wellbeing) by summing market activity 5/23/2017 The University of Akron 15 Economic measurements Gross Domestic Product is a comprehensive measure of economic activity Individually Write a definition of Gross Domestic Product Groups 5/23/2017 Compare definitions, discuss differences Identify important components of the definition The University of Akron 16 Economic measurements What are the important components of a definition of GDP? Final goods and services What market prices How valued Where within the country during a given time period (1 year) When Provide examples of included items. Provide examples of excluded items. 5/23/2017 The University of Akron 17 Economic measurements Examples of excluded items Household Production Self-supplied goods and services Home care Child care 5/23/2017 The University of Akron 18 Economic measurements Examples of excluded items Underground economy Non-market exchanges Imputed values for owner occupied housing Illegal activities 5/23/2017 The University of Akron 19 Economic measurements Examples of excluded items Transfer payments Public Subsidies to individuals Subsidies to firms Private Voluntary transfers Involuntary transfers (theft) 5/23/2017 The University of Akron 20 Economic measurements Other excluded items Environment Length of work day (leisure time) Health and Life expectancy Justice and Freedom 5/23/2017 The University of Akron 21 Measuring Economic Activity National Income and Product Accounts Methodology for measuring economic activity Let’s return to the circular flow diagram to guide our discussion Real flows = Monetary flows Value of expenditures in the product market = Revenues to firms = Payments to households in the factor markets 5/23/2017 The University of Akron 22 Imports Consumption Foreign Sector Exports Product Markets Investment Government Expenditures Net Personal Taxes Households Revenues Net Business Taxes Governments Borrowing Firms Borrowing Borrowing Saving Income 5/23/2017 Financial Markets Factor The University of Akron Markets Expenses 23 Measuring Economic Activity Thus we can measure activity by summing expenditures in product markets Or summing income payments in the factor markets Measure activity by expenditures Household, Firm, Government, Foreign C + I + G + (X – M) = C + I + G + F 5/23/2017 The University of Akron 24 Minus Imports Foreign Sector Exports Net Exports Consumption Product Markets Government Expenditures Households 5/23/2017 Governments The University of Akron Investment Firms 25 Measuring Economic Activity Measure activity by expenditures Household, Firm, Government, Foreign C + I + G + (X – M) = C + I + G + F Sum the final sales Sum the value added at each stage in the production chain 5/23/2017 Sales – Costs of materials The University of Akron 26 Economic measurements Introduction of concepts National Income and Product Accounts (NIPA) Finding the data Decision Tree 5/23/2017 The University of Akron 27 NIPA Expenditures Consumption Durable goods Nondurable goods Service 5/23/2017 The University of Akron 28 NIPA Expenditures Investment Business and nonresidential fixed investment Changes in business inventories Residential fixed investment NOT INVESTMENT Purchase bonds, equity stocks, mutual funds, etc. Portfolio allocations NOT investment 5/23/2017 The University of Akron 29 NIPA Expenditures Government expenditures Consumption Investment Includes all levels of government Excludes transfer payments 5/23/2017 The University of Akron 30 NIPA Expenditures Net Exports Exports – spending by foreigners on domestically produced goods and services Imports – spending by domestic residents on goods and services produced abroad 5/23/2017 The University of Akron 31 Economic measurements Introduction of concepts National Income and Product Accounts (NIPA) Finding the data Decision Tree 5/23/2017 The University of Akron 32 NIPA Expenditures Bureau of Economic analysis Table 1.1.5 Gross Domestic Product Seasonally adjusted, annual rates Real GDP is found in Table 1.1.6 5/23/2017 The University of Akron 33 NIPA Income Measure activity by incomes Payment for labor services Employee compensation Payment for land (natural resources) Rental income Payment to capital Net interest Payment for entrepreneurship 5/23/2017 Corporate profits The University of Akron 34 What of the self-employed? Labor Land Capital Entrepreneurship Households Firms Factor Markets Rent Employee Compensation 5/23/2017 Interest Profit The University of Akron Proprietor’s Income 35 Measuring Economic Activity Bureau of Economic analysis From GDP to Personal Income Table 1.7.5 Personal Income to Consumption and Saving Table 2.1 5/23/2017 The University of Akron 36 Economic measurements Introduction of concepts National Income and Product Accounts (NIPA) Finding the data Decision Tree 5/23/2017 The University of Akron 37 Decision Tree Review Circular Flow Economic Measurement Measuring price changes Measuring employment activity Policy Issues Measuring Price Changes 5/23/2017 Measuring price changes Price Indexes Calculating Inflation Calculating Real values The University of Akron 39 Measuring Price Changes NIPA uses current market prices to value (and weight) the real (physical) flows Thus, economic activity as measured by GDP can increase if: 5/23/2017 Real (physical) flows increase The price weights increase The University of Akron 40 Measuring Price Changes A thought experiment You are given $5000 to spend. The catch – 1) you must spend all of it on items from Sears 2) you may choose either the 1903 OR the 2005 catalog, BUT ONLY ONE! 5/23/2017 The University of Akron 41 Measuring Price Changes You are given $5000 to spend. Which catalog (1903 or 2005) would you choose? Why? What would be the advantage of choosing the 1903 catalog? What would be the advantage of choosing the 2005 catalog? 5/23/2017 The University of Akron 42 Measuring Price Changes Consumption Revenues Product Markets Goods and Services Sold Goods and Services Purchased The real (physical) flows (inner arrows) are valued (and weighted) by current market prices Households Factors Supplied (Labor, Land, Capital, Entrepreneurship) Income (Wages, Rent, Interest, Profits) 5/23/2017 Factor The University of Akron Markets Firms Factors Received (Labor, Land, Capital, Entrepreneurship) Expenses (Wages, Rent, Interest, Profits) 43 Measuring Price Changes NIPA uses current market prices to value (and weight) the real (physical) flows Thus, economic activity as measured by GDP can increase if: 5/23/2017 Real (physical) flows increase The price weights increase The University of Akron 44 Measuring Price Changes For example Consider an economy with 3 goods In following table, determine total economic activity (GDP) in each year 5/23/2017 The University of Akron 45 Measuring Price Changes Item Draft beer Movie Ticket Pizza GDP Quantity (2002) 400 Price (2002) $5.00 Quantity (2003) 450 Price (2003) $5.00 50 $6.00 75 $6.00 100 $10.00 120 $10.00 $3300 $3900 Increase real output => increase in GDP 5/23/2017 The University of Akron 46 Measuring Price Changes Item Draft beer Movie Ticket Pizza GDP Quantity (2002) 400 Price (2002) $5.00 Quantity (2003) 400 Price (2003) $6.00 50 $6.00 50 $8.00 100 $10.00 100 $10.50 $3300 $3850 Increase prices => increase in GDP 5/23/2017 The University of Akron 47 Measuring Price Changes Item Draft beer Movie Ticket Pizza GDP Quantity (2002) 400 Price (2002) $5.00 Quantity (2003) 450 Price (2003) $4.50 50 $6.00 40 $8.00 100 $10.00 120 $10.50 $3300 $3605 Has the economic activity increased? 5/23/2017 The University of Akron 48 Measuring Price Changes So if we want to compare real (physical) output flows over time, we need to compensate for price changes 5/23/2017 This is the role of price Indexes Consumer price index (CPI) Producer price index (PPI) Gross domestic product deflator The University of Akron 49 Measuring Price Changes 5/23/2017 Measuring price changes Price Indexes Calculating Inflation Calculating Real values The University of Akron 50 Price Indexes A price index uses a fixed basket of goods (quantities) to allow measurement of the impact of changing prices General formula: Basket of Goods * Current Prices Basket of Goods * Base Year Prices 5/23/2017 The University of Akron 51 Price Indexes Consumer price index (CPI) uses a market basket of a typical urban family’s purchasing patterns in the base year Urban Basket in base year * Current Prices Urban Basket in base year * Base Year Prices 5/23/2017 The University of Akron 52 Price Indexes Producer price index (PPI) uses a market basket of goods used in production (raw materials, intermediate products, and wholesale goods) in the base year Producers’ Basket in base year * Current Prices Producers’ Basket in base year * Base Year Prices 5/23/2017 The University of Akron 53 Price Indexes Gross domestic product deflator uses the entire production in the current year as the market basket of goods GDP goods in current year * Current Prices GDP goods in current year * Base Year Prices 5/23/2017 The University of Akron 54 CPI (interpretation) Show graph of CPI What is being shown? Explain what you understand the graph to mean. How might this be used in an essay? Why the difference between the “All items” and the “Core” index? 5/23/2017 The University of Akron 55 CPI: All items and Core 5/23/2017 The University of Akron 56 CPI (interpretation) Groups Do you agree on what is being shown? About how it might be used in an essay? Compare understandings of the graph Compare understanding of the difference between the “All items” and the “Core” index? Has there been a long term inflationary trend? If so, what is it? 5/23/2017 The University of Akron 57 CPI (interpretation) Class Compare team responses and discuss Do we agree on what is being shown? Compare understanding of the difference between the “All items” and the “Core” index? How might this be used in an essay? 5/23/2017 The University of Akron 58 CPI (interpretation) How does this help you understand the recent past? If this is all the information you have, what would be your inflation forecast? 5/23/2017 The University of Akron 59 CPI: All items and Core 5/23/2017 The University of Akron 60 Measuring Price Changes 5/23/2017 Measuring price changes Price Indexes Calculating Inflation Calculating Real values The University of Akron 61 Calculating Inflation Define Inflation General increase in prices Decline in the purchasing power of money Calculation [(Index period 2 / Index period 1) – 1.0] * 100 [(Index period 2 - Index period 1) / Index period 1] * 100 5/23/2017 The University of Akron 62 Measuring Price Changes 5/23/2017 Measuring price changes Price Indexes Calculating Inflation Calculating Real values The University of Akron 63 Calculating Real values So we can compare real (physical) output flows over time, by compensating for price changes Nominal values = Output valued at current prices Real values = Output valued at constant prices 5/23/2017 Adjusted for price changes The University of Akron 64 Calculating Real values In general: Real value = (Nominal value / Index) * 100 (Real value * Index) / 100 = Nominal value Index = (Nominal value / Real value) * 100 Real GDP = (Nominal GDP / GDP deflator) * 100 5/23/2017 The University of Akron 65 Calculating Real Growth It is important to measure the growth in real economic activity Growth is usually measured by percentage increase in a value Growth of real GDP = percentage increase (decrease) in real GDP 5/23/2017 The University of Akron 66 Calculating Real Growth Calculating the percentage rate of growth: [(Real GDP2 / Real GDP1) – 1.0] * 100 [(Real GDP2 – Real GDP1) / Real GDP1] * 100 5/23/2017 The University of Akron 67 Measuring Price Changes 5/23/2017 Measuring price changes Price Indexes Calculating Inflation Calculating Real values The University of Akron 68 Decision Tree Review Circular Flow Economic Measurement Measuring price changes Measuring employment activity Policy Issues Labor Markets Categorizing individuals by their participation in the economy From total population to the labor force Pop – children – institutional = Non-institutionalized population 5/23/2017 The University of Akron 70 Labor Markets Venn Diagram 1 Children Under age of 16 2 Institutionalized persons 4 Not in Labor Force 3 Unemployed persons 5 Employed persons 6 Military personnel 5/23/2017 The University of Akron 71 Labor Markets Categorizing individuals by their participation in the economy Non-institutionalized population Employed if working for pay, etc Unemployed if not employed and looking for work Not in labor force if neither employed or unemployed 5/23/2017 The University of Akron 72 Labor Markets The Current Population Survey (CPS) classifies all individuals in the noninstitutionalized populations into 3 groups (categories) Employed Unemployed Not in Labor Force Labor Force – Employed + Unemployed 5/23/2017 The University of Akron 73 Labor Markets Venn Diagram 1 Children Under age of 16 2 Institutionalized persons 4 Not in Labor Force 3 Unemployed persons 5 Employed persons 6 Military personnel 5/23/2017 The University of Akron 74 Labor Markets 1 1.1 1.2 2.2 2.1 2 5/23/2017 The University of Akron 75 Labor Markets Three measures Labor Force Participation Rate Employment rate LF / Non-institutionalized Pop Employed / Non-institutionalized Pop Unemployment Rate 5/23/2017 Unemployed / LF The University of Akron 76 Labor Markets Four (4) primary types of unemployment based on the reasons for the unemployment and their duration. Frictional Seasonal Cyclical Structural 5/23/2017 The University of Akron 77 Labor Markets Discouraged workers Individuals who stop looking for work but would accept a job if offered Natural rate of unemployment Non-inflationary level of unemployment LM in equilibrium No Cyclical unemployment Definition of “full-employment” 5/23/2017 The University of Akron 78 Labor Markets 1 1.1 1.2 2.2 2.1 2 5/23/2017 The University of Akron 79 Labor Markets Other measures of labor input Aggregate hours Aggregate earnings Labor Productivity 5/23/2017 The University of Akron 80 Decision Tree Review Circular Flow Economic Measurement Measuring price changes Measuring employment activity Policy Issues Policy Issues What determines spending levels How do changes in spending affect economic activity (GDP)? How do policy makers influence the economy? Can policy makers “control” the economy? 5/23/2017 Stable prices, full-employment, economic growth The University of Akron 82 Decision Tree Review Circular Flow Economic Measurement Measuring price changes Measuring employment activity Policy Issues