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Measuring the Economy
• Measure economic activity by
– Output produced, or
– Income earned
• Gross Domestic Product (GDP)
– Final products from labor/property located in U.S.
– At market prices
• National Income (NI)
– Costs of production, plus
– Profits earned Revised by khurram Shamim Khan
Measuring the Economy (cont.)
• GDP = C + I + G + (X - M)
C=
I=
G=
X=
M=
consumption
gross private domestic investment
government
exports
(X - M) = net exports
imports
• NI = GDP + NR - CC - IBT
NR = net factor income from abroad
CC = capital consumption (depreciation allowances)
by khurram Shamim Khan
IBT = indirectRevised
business
taxes
Measuring the Economy (cont.)
• DI = NI + TR + INT - RE - Tp - Tc - INF
DI = disposable income (available for spending
by individuals)
TR = transfer payments from government
INT = interest paid on government debt
RE = retained corporate earnings
Tc = corporate tax payments
Tp = personal tax payments
INF = interest on government debt paid to
Revised by khurram Shamim Khan
foreigners
Measuring the Economy (cont.)
• DI = C + PS
PS = personal savings
• I + NFI = PS + BS + GS
NFI (net foreign investment) = X - M - INF + NR
BS (business savings) = RE + CC
GS (gov’t savings) = taxes - gov’t outlays
Taxes = Tp + Tc + IBT
Gov’t outlays = G + TR + INT
Revised by khurram Shamim Khan
Indices
• Nominal GDP: Si Qit Pit
• Real GDP (period 0 prices): Si Qit Pi0
• Implicit price deflator = ratio of real to
nominal GDP
• Price index = weighted average of price
relatives = It = Si wit (Pit / Pio)
Revised by khurram Shamim Khan
Indices (cont.)
• Paasche index: based on current period basket
It = {Si Qit Pit} / {Si Qit Pi0}
• Laspeyres index: based on base period basket
It = {Si Qi0 Pit} / {Si Qi0 Pi0}
• Paasche: may understate true inflation rate
• Laspeyres: overstates true inflation rate
(because it neglects the fact that people search
for cheaper substitutes over time in an
Revised by khurram Shamim Khan
inflationary environment)
Indices (cont.)
• Chain-linked index: mixture of Paasche and
Laspeyres; quantity weights are from the
immediate past period
It = It-1{Si Qi,t-1 Pit} / {Si Qi,t-1 Pi,t-1}
• Chain-linked measure of rate of real GDP
growth (from t-1 to t):
[{Si Qit Pi,t-1} / {Si Qi,t-1 Pi,t-1}] - 1
Revised by khurram Shamim Khan
Other Major Price Indices
• Consumer Price Index (CPI): representative
basket of consumed goods
– Laspeyres-type index
– Issues: overstates true inflation (since Laspeyres);
quality improvements, new products
• Producer Price Index (PPI): changes in costs
of production
– Laspeyres-type index
Revised by khurram Shamim Khan
Data Sources and Presentation
• Sources of data
– Product side: surveys and samples
– Income side: tax collection system
• Presentation characteristics
– Quarterly data usually shown as annual rates
– Usually seasonal adjustments
– Due to volatility, quarterly growth rates often not
best measure with respect to trends in output or
inflation
Revised by khurram Shamim Khan
Balance of Payments
• Current account balance = receipts + payments
+ net transfers
– Receipts (a positive entry): by U.S. residents from
abroad
– Payments (a negative entry): made abroad
Revised by khurram Shamim Khan
Business Cycles
• Business cycle: recurring changes in economic
activity
– No fixed periodic pattern
– Phases (e.g., expansion, recession)
• Peak: start of a recession
• Trough: end of a recession
– Leading / coincident / lagging indicators (see lists
for specific examples)
Revised by khurram Shamim Khan
Interest Rates
• Yield curve: time to maturity versus yield to
maturity
– Expectations hypothesis:
(1+r2)2 = (1+r1)(1+Er1)
ri = i-year spot rate (yield)
Er1 = expected future one-year yield
• Real rate of interest:
(1+r) / (1+p) = (1+rreal)
where p is the inflation rate
• Fisher relationship: nominal rate = real rate +
inflation rate Revised by khurram Shamim Khan
Exchange Rates
• Exchange rate: number of units of foreign
currency per dollar
• Real exchange rate:
ereal = enominal (P / Pforeign)
P:
domestic price level
Pforeign: foreign price level
• Appreciation of U.S. dollar: e (exchange rate)
increases; U.S. dollar purchases more foreign
currency
by khurram Shamim Khan
• Depreciation ofRevised
U.S.
dollar: e decreases
Growth (cont.)
• Elasticities can also be looked at in terms of total
factor returns as shares of output
K 
N
cK
Y
 w
  N
p
 
Y
c = return on capital
w/p = real wage
Revised by khurram Shamim Khan
Banks (cont.)
• Suppose R=kD, where
R = banking system reserves
D = demand deposits
k = fraction of deposits held as reserves
• Money supply: M = C + D + T, where
C = currency
T = time (savings) deposits
• Total reserves: TR = RR + RE, where
RR = required reserves
RE = excess reserves
Revised by khurram Shamim Khan
Banks (cont.)
• Central bank
– Assets = Q + B
• Q = securities portfolio; B = loans to banks
– Liabilities = TR + C
• TR = total reserves held by banks at central bank (assume
banks do not hold cash reserves); C = currency in
circulation
– Balance sheet identity: Q+B = TR+C
– Using prior definitions and defining free reserves as
RF = RE - B, then money supply is
M = (1/k){Q - (1-k)C - RF} + T
– Note: RF = RF(r,rd), where rd = Fed discount rate
– Borrowing: increasing function of r, decreasing
function of rd Revised by khurram Shamim Khan
Federal Reserve System
• Money supply increases when central bank
– Increases its bond portfolio (Q increases)
– Reduces its reserve requirements (k decreases)
– Reduces the discount rate (rd decreases) (discount
rate is interest rate on Fed loans)
• Structure of system
– 1913: Federal Reserve Act
– 12 regional banks (each owned by the member
banks)
– 7-member Board of Governors
– Profits of Federal Reserve banks go to Treasury
Revised by khurram Shamim Khan
Federal Reserve System (cont.)
• Functions of Federal Reserve banks
–
–
–
–
Examine member banks
Review merger applications
Check-clearing and transfer services
Agent for sale of Treasury securities and distribution
of new currency
• Policy functions
– Set discount rate
– Discount window (how much borrowing to allow)
by khurram
ShamimMarket
Khan
– Participate on Revised
Federal
Open
Committee
Federal Reserve System (cont.)
• Formal Board functions
–
–
–
–
Approve bank mergers
Set commercial banking activity regulations
Set reserve requirements, discount rate
Direct open market operations
Revised by khurram Shamim Khan
Monetary Policy Tools
• Open market operations
– Most actively used tool
– Open market purchase of government securities ==>
increases Fed’s portfolio of such securities; paid for
by creating reserve deposits ==> increases public’s
deposit balances
– Fed Funds rate: rate at which reserve deposits are
lent between financial institutions; a marketdetermined rate
– Purchase securities ==> adds to banking system
reserves ==> Fed Funds rate declines
– Sell securities ==> decreases banking system
reserves ==> Fed
Funds rate increases
Revised by khurram Shamim Khan
Monetary Policy Tools (cont.)
• Discount rate
– Increase in rate reduces money supply (due to costly
borrowing from Fed)
– Typically, kept 1/4 point below the Fed Funds rate
(allows small banks to use discount window)
• Reserve requirements
– Increase in requirement reduces the money supply
(forces banks to hold more in reserve ==> reduce
loans, etc.)
– Changes to requirements made infrequently
Revised by khurram Shamim Khan
Fiscal Policy
• Fiscal policy tools
– Tax policy
• Corporate
• Personal
– Expenditure policies
• Problems with fiscal policies
– Uncertain responses to policy changes
– Lags / delays in implementation
Inside
lags
• Recognition lag: between economic disturbance and
policymaker recognition
• Decision lag: between recognition and policy decision
• Implementation lag: between decision and implementation
• Outside lag: between implementation and impact
Revised by khurram Shamim Khan