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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