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Introduction to Economics Macroeconomics The US Economy Llad Phillips 1 Questions About the News What is the economic significance of the following story in today’s business section of the LA Times? Llad Phillips 2 Llad Phillips 3 Questions About Your Reading What do we mean by specialization? What is comparative advantage? What is a factor market? What is circular flow? Chapter 3 Llad Phillips 4 Households as Sellers and Buyers In labor markets, households sell their labor to firms for wages. About 75% of income is earned by households. Llad Phillips 5 The Circular Flow Diagram • The circular flow diagram is a diagram showing the flow of money and goods between markets. Llad Phillips 6 Questions about your reading What are the functions of government? Llad Phillips 7 Government in a Market Economy The government has five general responsibilities in a market-based economy: • Providing goods and services. • Redistributing income. • Taxation. • Regulation of business practices. • Trade policy. Llad Phillips 8 Percentage of Government Spending on Various Programs Local Expenditures (1996) Administration and other 32% Public welfare 5% Highways 5% Health and hospitals 9% Police protection 5% Education 42% State Expenditures (1998) Administration and other 20% Police and corrections 4% Highways 8% Health and hospitals 8% Public welfare 25% Education 35% Federal Expenditures (1999) Net interest 13% Social security 23% Other 14% Llad Phillips National defense 16% International affairs 1% Income security 14% Medicare 11% Health 8% 9 Sw e D de en n m a Fi rk nl a B nd el gi u Fr m an Au ce st N ria or w ay Lu x Ita N em ly et bu he r rla g n C ze Hu ds ch n R gar ep y ub Po lic la U ni n te Ca d na d K in da g G dom N er ew m a Z n Sw eal y itz and er la nd Sp Po ain rt ug Ic al el an Ire d la n Au d st ria U S Tu A rk e Ja y pa K n or M ea ex ic o Tax Rates in Different Nations 60 52 50 40 30 20 49.8 46.2 45.9 45.2 44.4 43.6 42.7 41.5 41 38.7 38.3 37.9 37.4 37.2 37 35.2 35.1 34.2 34.2 33.6 33.2 29.9 28.9 28.7 28.4 21.1 16 10 0 Questions About Your Reading What is the law of demand? Chapter 4 Llad Phillips 11 The Individual Demand Curve and the Law of Demand The individual demand curve shows the relationship between the price of a good and the quantity that a single consumer is willing to buy, or quantity demanded. • The law of demand states that the higher the price, the smaller the quantity demanded, ceteris paribus (everything else held fixed). Summary of Part I: Personal Finance Advice Llad Phillips 13 Summary of Personal Finance Spend Learn Earn Choice ?% Save Life Span Llad Phillips 14 Choice: What to Build Equity In? Housing Save Invest & Build Equity Financial, Including cash reserve Llad Phillips 15 Who Wants to be a Millionaire? Stocks @ 11% ( we hope) One Time Investment 3 M Treasury Bills @ 1.66% Mattress @ 0% Save 6% of Wealth Per Year & Invest Llad Phillips Stocks + Savings : 17% 5 Y Treasury Bonds @ 3.14% + Savings: 9.14% Mattress + Savings: 6% 16 Your Stocks Market Indices corporate earnings(profits) The Economy Llad Phillips Index of Leading Economic Indicators Gross Domestic Product Unemployment Rate 17 Outline: Lecture Seven Two major types of policy fiscal policy: spending and taxation monetary policy: the goals are low unemployment and low inflation. What are the tools? Keynesian Models of the Economy two-legged stool model three-legged stool model Inflation Llad Phillips 18 Review: lecture 6 Keynesian “ Two - Legged Stool” Model a Llad Phillips weakness of the economy in the 1930’s 19 National Economy Spending The Stool and Two Legs Total Spending Consumers Llad Phillips Businesses 20 Expenditure Perspective Consumption spending by households, C Investment spending by firms, I GDP = C + I Llad Phillips 21 The Consumption Function consumption, C autonomous consumption, C0 C = C0 + mpc* Y the slope of the consumption function, the marginal compensity to consume, mpc, is the increase in consumption per $ increase in income Income, Y Llad Phillips 22 Autonomous Investment Investment, I I Income, Y Llad Phillips 23 Gross Domestic Product Equals Consumption Plus Investment GDP = C + I Consumption, C Investment, I GDP GDP* autonomous consumption, C0 C = C0 + mpc* Y I C* I* Y* Llad Phillips Income, Y 24 Gross Domestic Product Equals Consumption Plus Investment Consumption, C Investment, I GDP GDP = C + I autonomous consumption, C0 Income, Y Llad Phillips 25 : Chapter Twenty Conceptual Framework: Circular Flow Firms Income Firms Labor Supply Goods Demand Goods Households Households Income Perspective Expenditure Perspective Y Llad Phillips = GDP 26 Squares with Equal Sides and 45 degree Lines Y=Y Income, Y Y1 450 Y1 Llad Phillips Income, Y 27 Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I Total Expenditure GDP Line Aggregate Expenditure 45 0 GDP = Y Llad Phillips National Income, Y 28 Economy in 2001: a decline in I leads to a decline in GDP Consumption, C Investment, I GDP autonomous consumption, C0 GDP = C + I C = C0 + mpc* Y I 1st Income, Y Llad Phillips 29 Boom Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I Total Expenditure GDP Line Aggregate Expenditure Unemployment Rate Oct. 2000 = 3.9% 45 0 GDP = Y Llad Phillips National Income, Y 30 Bust Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I Total Expenditure GDP Line Aggregate Expenditure Unemployment Rate Oct. 2000 = 3.9% 45 0 Unemployment Rate Sept 2001 = 4.9 % Llad Phillips GDP = Y National Income, Y 31 Lecture 7 Keynesian “Three Legged Stool Model” federal Llad Phillips government spending as a stabilizer 33 National Economy Spending The Stool and Three Legs Total Spending Consumers Llad Phillips Businesses Government 34 Government, G Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I +G Aggregate Expenditure Total Expenditure GDP Line 45 0 GDP = Y Llad Phillips National Income, Y 35 Bust Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I +G Total Expenditure GDP Line Aggregate Expenditure Unemployment Rate Oct. 2000 = 3.9% 45 0 Unemployment Rate Sept 2001 = 4.9 % Llad Phillips GDP = Y National Income, Y 36 Unemployment Rate: unemployed/ (employed + unemployed) Unemployment Rate: unemployed/ (labor force) Llad Phillips 37 In the Great Depression We did not have the sea anchor (third stool leg) of federal government spending to stabilize the economy Llad Phillips 38 Gross Domestic Product Components in 1929 . . net exports 0% investment 16% government 9% federal government was 1.6%, while state & local government was 7.3% consumption 75% Llad Phillips 39 Consumption + Investment + Government , 2001 II government 17% investment 16% consumption 67% Llad Phillips 40 Keynesian Fiscal Policy Option Government As a Fraction of GDP . 0.5 0.45 0.4 0.3 0.25 0.2 0.15 0.1 0.05 Year Llad Phillips 41 97 93 89 85 81 77 73 69 65 61 57 53 49 45 41 37 33 0 29 Fraction 0.35 Why was Expenditure Too Low to Support Full Employment? Consumption had dropped because of fear Investment had dropped because of fear Llad Phillips 42 Policy Option: Reassure the Public “The only thing we have to fear is fear itself” Franklin Delano Roosevelt Llad Phillips 43 Fiscal Policy Option in 2001 Use Federal Government Spending to Make up for the Shortfall in Consumption and Investment prime Llad Phillips the pump 44 Less than Full Employment Equilibrium GDP = C+ I+G Consumption, C GDP = C + I Investment, I GDP C = C0 + mpc* Y I 45 0 GDP = Y YFE Income, Y Full Employment Income Llad Phillips 45 Are we missing any policy options? Keynesian model and using more government spending during downturns is called fiscal policy Federal Reserve conducts monetary policy Llad Phillips 46 Llad Phillips 47 Federal Reserve Policy Goals Full employment stable prices (low inflation) Llad Phillips 48 Lecture 5 Inflation Http://stats.bls.gov/eag/eag.us.htm Llad Phillips 49 What is the current rate of inflation? - Lab 4, Ch.21, Internet Exercises, “Inflation in the US”, Bureau of Labor Statistics, 0.3% for August, Year to date: 0.2+0.2+0.3+0.5+0.0+0.1+0.1+0.3=1.7% Source:http://www.yardeni.com Llad Phillips 50 Inflation: % rate of increase of CPI 100*[CPI(August) - CPI(July)]/CPI(July) What is the Consumer Price Index? What is a price Index? Llad Phillips 51 Assigned reading O’Sullivan and Sheffrin and Lab Four Ch. 21 “Unemployment and Inflation” What is the Consumer Price Index? What is its purpose? What effect could a higher inflation rate have on the US economy? Llad Phillips 52 Consumer Price Index Prices of a Market Basket of Goods and Services Index of the Cost of Living but it leaves out public goods like safety and clean air which are hard to price Based on a Monthly Survey of Prices by the Bureau of Labor Statistics(BLS) and the expenditure pattern (or mix of goods) of a sample of households. Lab Four: Internet Exercises, “Inflation in the US, BLS and Consumer Price Info 53 Llad Phillips Components of the CPI, Corresponds to Fig. 21.2 Household Services 9% Rent 26% Transportation 7% Medical 5% Other Services 7% Durables 11% Food & Beverages 18% Apparel 6% Llad Phillips Nondurables 11% 54 Consumer Price Index: CPI prepared by the Bureau of Labor Statistics, BLS, US Dept. of Labor, USDOL 1982-84=100 weights for urban consumers, 10,000 families in the survey housing = 42.6% transportation = 18.7% food & beverages = 17.8% apparel & upkeep = 6.5% other goods & services = 5.1% medical care = 4.8% Llad Phillips entertainment = 4.4% 55 What Impact Could a Rising Inflation Rate Have on US Economy? Federal Reserve Bank of the US may raise short term interest rates to combat inflation Raising interest rates could discourage consumers from purchasing durable goods, house, and cars Raising interest rates could discourage business from borrowing to invest in new equipment and expansion Prospect of higher interest rates affects stock market Llad Phillips 56 Economic Policy on a Knife Edge If Federal Reserve raises interest rates to slow down the risk of inflation, it slows consumption and investment, which needs to recover to end a recession A decrease in investment spending could slow down the growth in worker productivity, which has been permitting rapid growth at low rates of inflation Llad Phillips 57 Impact of War on Prices Llad Phillips 58 Cost of Living Index, 1913=100, Massachusetts: Jan. 1910 - Dec. 1943 225 200 175 150 weights: food: 37.6% clothing: 12.8% shelter: 21.8% fuel & light: 5.0% sundries: 22.8% 125 100 75 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 Year cost of living index, Massachusetts 42 Historical Cost of Living: Mass. World War I & aftermath: inflation rapid increases in 1917, 1918; peak in 1920 twenties: price stability early thirties: deflation World War II: inflation Llad Phillips 60 Consumer Price Index, http://www.globalexposure.com/ Last Ten Years/ 1948- Llad Phillips 61 Inflation Rate: CPI Llad Phillips 62 Summary-Vocabulary-Concepts national income circular flow economy value added gross domestic product consumption gross private domestic investment government expenditures net exports aggregate production Llad Phillips function nominal GDP closed economy John Maynard Keynes aggregate expenditures uncertainty expectations consumption function autonomous consumption marginal propensity to consume equilibrium GDP 63 Inflation Historical Cost of Living Consumer Price Index GDP Deflator Real GDP and Growth of the Economy Rate of Inflation Impact of Inflation on You Social Impact of Inflation Inflation Forecast Cause of Inflation Llad Phillips 64 Rate of Inflation For example, the annual rate: [P(t) - P(t-1)]/P(t-1) = P(t)/P(t-1) [CPI(1997) Llad Phillips - CPI(1996)]/CPI(1996) 65 GDP Deflator Nominal Value $ = Price * Quantity Nominal GDP = GDP Deflator * Real GDP Nominal GDP/Real GDP = GDP Deflator Real GDP = Nominal GDP/GDP Deflator Llad Phillips 66 GDP Deflator, 1992=100 . 120 100 60 40 20 Year Llad Phillips 67 97 93 89 85 81 77 73 69 65 61 57 53 49 45 41 37 33 0 29 Index 80 GDP Deflator, 1992=100, Proportional Scale . 1000 Index 100 10 Year Llad Phillips 68 97 93 89 85 81 77 73 69 65 61 57 53 49 45 41 37 33 29 1 GDP Deflator: History early thirties: deflation World War II: inflation Korean War: inflation fifties and sixties: price stability Vietnam War: inflation Lyndon seventies: inflation OPEC: Johnson: “guns and butter” energy prices nineties: price stability Llad Phillips 69 Is the economy growing less rapidly? Growth in real GDP over time Llad Phillips 70 Real GDP Billions 96$, 1929-1999 12000 10000 GDP 8000 Real GDP Billions 96$ exponential trendline 6000 4000 y = 8E-29e0.0369x R2 = 0.9767 2000 0 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 year Llad Phillips 71