Download Thinking Like an Economist

Thinking Like an Economist
Economics
 Economics
is a social science which
attempts to explain the behavior and
interactions of economic actors in
terms of the items of value they
exchange.
 Actors = individuals, households,
firms, industries, governments or
countries
Economics
 Economic
 Models:
Reasoning
a model or theory is a
framework that helps us to
understand relationships between
cause and effect. They are a
simplification of reality.
Basic Questions: Micro
 Microeconomic
 What
Questions
should we produce?
 How should we produce?
 For whom should we produce?
Basic Questions: Macro
 Macroeconomic
 How
Questions
can sufficient growth be attained
so that the well being of society
increases?
 How should productive capacity be
utilized so that there will be full
employment with stable prices?
The Economy as a Circular
Flow
Resources
Income
Firms
Households
Expenditures
Goods and Services
Savings and Investment
Income
Firms
Investment
Households
Expenditures
Borrowings
Financial Markets
Savings
Financial Markets
Savers
Individuals
Businesses
Government
Financial Intermediaries
Banks
Pension funds
Mutual funds
Borrowers
Individuals
Businesses
Government
Financial Intermediaries
Financial intermediaries include banks,
insurance companies, investment
companies, etc
 Financial intermediaries act as the gobetween in arrangements between savers
and borrowers.
 They reduce the uncertainty facing
individual households or businesses
through diversification.

Financial Market:
Participants
 The
suppliers of credit or loanable
funds:
 Household
Sector
 Business Sector
 Foreign Sector
 Government Sector
Financial Market: Participants
 The
demanders of credit or
loanable funds:
 Government
Sector
 Business Sector
 Foreign Sector
 Household Sector
Interest Rates: Facts
 Interest
rates serve many roles:
 Interest
rates are the price of
credit.
 Interest rates are a premium paid
to forego consumption.
 Interest rates are the return to
capital as a factor of production.
Real and Nominal Rates
 Nominal
interest rates are rates
unadjusted for the effect of
inflation or deflation.
 Real rates are adjusted for price
level changes.
Inflation and Interest Rates
 Nominal
variables are not adjusted to
reflect changes in the price level.
 They
are the percentage by which
the money a borrower pays back
exceeds the money he borrowed,
making no adjustment for any
change in purchasing power.
Inflation and Interest Rates
 Real
interest rates are the percentage
increase in purchasing power that the
borrower pays to the lender for the
privilege of borrowing.
Real interest rates are nominal interest
rates minus the rate of inflation.
 Real interest rates may be positive, zero,
or negative.

Nominal Rates: The Fisher
Effect
THE FISHER EFFECT:
NOMINAL RATE
=
REAL RATE +
EXPECTED INFLATION
Circular Flow with
Government
Income
Firms
Households
Investment
Taxes
Government
Purchases of
Goods and Services
Subsidies
Borrowing
Expenditures
Taxes
Government
Government
Government
Government Salaries
and Transfers
Borrowing
Saving
Financial Markets
Savings
The Role of Government:
Market Failure
 Inequity
 Standards
of fairness are determined
by society and may not be met by the
market’s distribution of benefits.
 Failure
of Competition
 Markets may
• Regulation
• Anti-trust
not be competitive.
The Role of Government:
Market Failure
 Public

Goods
Some goods cannot be produced
profitably by the private market and as a
result must be provided by government.
•
Free Rider Problem
 Externalities

Some activities provide benefits or impose
costs on others that are not captured by the
the price system.
The Role of Government:
Market Failure
 Underutilized
Resources
 Macroeconomic
• Fiscal Policy
• Monetary Policy
stabilization
Circular Flow with Government and
the Rest of Foreign
the World
Countries
Foreign Borrowing
Foreign Savings
Exports
Investment
Imports
Income
Households
Firms
Taxes
Taxes
Expenditures
Government
Purchases of
Goods and Services
Subsidies
Borrowing
Government
Government
Government
Borrowing
Saving
Financial Markets
Government Salaries
and Transfers
Savings
The Rest of the World
 An
economy has two basic kinds of
economic interactions with the rest
of the world.
 Buying
and selling goods and
services
 Buying and selling assets.
The Rest of the World
 Exports
are those goods we produce
for sale in the rest of the world.
Imports are those goods we buy from
the rest of the world.
 We also lend to the rest of the world
and borrow from them.
Measuring GDP
What Is GDP?

GDP, Gross Domestic Product, is the
total dollar value of all final goods and
services produced in a country during a
year.
Current market prices are used to
aggregate different outputs to a dollar
total.
 Government purchases, many of which do
not occur in markets, are valued at their
cost of production.

What Is GDP?
Only final goods and services are
included. Intermediate goods are not
included to avoid double counting.
 The measure is an annual flow, a rate of
production. A GDP of $10 trillion implies
that the economy is producing $10 trillion
worth of goods and services per year.
 GDP measures production by U.S. citizens
and foreigners alike inside the geographic
borders of the USA and thus
unequivocally reflects economic activity in
the USA.

Real and Nominal GDP

Nominal GDP

The market value of a nation’s final output
based on current prices for the goods and
services produced during the year.
• Nominal GDP in 2001 = the sum of all the
goods and services produced in 2001 multiplied
by their 2001 prices

Real GDP

An estimate of the value of a nation’s final
products adjusted for changes in prices
since a certain base year.
Components of GDP:
Expenditure Viewpoint
 Consumption
Non-durable Goods (last less than 3 years)
 Durable Goods (last more than 3 years)
 Services

 Gross
Domestic Investment
Non-residential lnvestment (plant and
equipment)
 Inventory Change
 Residential Investment

Components of GDP:
Expenditure Viewpoint
 Government
Spending
Local and State
 Federal

 Net

Exports
Exports Minus Imports
Components of GDP:
Income Viewpoint
 Employee
 Income
Compensation
from the sale of labor
services during the year. It includes
wages, salaries, and fringe benefits
such as employer provided insurance
and employer contributions to
pension funds.
Components of GDP: Income
Viewpoint
 Net
Interest
 The
portion of business receipts used
to pay for borrowed funds that
finance investment purchases.
• Interest payments provide earnings for
savers and other suppliers of loanable
funds for investment purchases.
Components of GDP:
Income Viewpoint
 Rental
Income
 Rental
income is earned by those
who supply the services of land,
mineral rights, and buildings for use
by others.
 Also included in rental income is an
estimate of the imputed rent earned
by homeowners who live in their
own homes less the expenses of
maintaining their homes.
Components of GDP: Income
Viewpoint
 Profits.
 Profits
of corporations and
unincorporated business
•
Profits = Total revenues - Indirect
business taxes - Capital consumption
allowance - labor costs - net interest rents paid.
Components of GDP:
Expenditure and Income
 Expenditure
 GDP
= C + I + G + (X-M)
 Income
 NI
(Y) = W + i + R + profits
 Since
NI and GDP measure
aggregate production, they must
be equal.
GDP = NI 2001
Consumption
6,987.1
Durable Goods
Nondurables
Services
835.9
2,041.3
4,109.9
Investment
Nonresidential
Residential
Inventory Change
Government
Federal
State & Local
Net Exports
Exports
Imports
GDP
1,586.0
1,201.6
444.7
-60.3
1,858.0
628.1
1,229.9
-348.9
1,034.1
1,383.0
10,082.2
Employee Compensation
Corporate Profits
Proprietors’ Income
Net Interest
Rental Income
National Income
+ CCA
+ Indirect Business Taxes
+ Business Transfers
- Subsidies
+Statistical Discrepancy
GNP
+Net Foreign Payments
GDP
5,874.9
731.6
727.9
649.8
137.9
8,122.1
1,329.3
774.8
42.5
47.3
-117.3
10,104.1
-21.9
10,082.2
The Economy as a Circular
Flow
Resources
Income
Firms
Households
Expenditures
Goods and Services
What GDP Is Not
 It
is not a measure of a nation’s
overall welfare. Why?
 Some
things are produced but never
sold and so are not included in GDP.
 GDP places no value on leisure
 Some expenditures are hidden from
data collectors
What GDP Is Not
 Production
of some goods and services
while increasing GDP can have a
negative effect on the environment
 Some items are included that do not
reflect net benefits to society.
• Environmental clean-ups bring us back to the
pre-damage state. These expenditures are
included with no offsetting reduction to reflect
the cost of pollution.
Macroeconomic Problems
Unemployment
Inadequate Growth
Inflation
Unemployment
 The
unemployment rate is the
number of unemployed people,
expressed as a percentage of the labor
force.
 Labor
Force = (Civilian noninstitutional population over age 15
minus people not in the labor force
(students, homemakers, retirees,
discouraged workers)
Definitions
Labor Force = Number of Employed + Number of Unemployed
Unemployment Rate = Number of Unemployed
Labor Force
X 100
Labor Force Participation Rate = Labor Force
X 100
Adult Population
Types of Unemployment
 Frictional
Unemployment
 Occurs
due to normal turnover in the
labor market. People changing jobs.
 Structural
Unemployment
 Refers
to workers who are not employed
because their skills are not in demand.
 Cyclical
Unemployment
 Occurs
cycle.
due to changes in the business
Natural Rate of
Unemployment

The natural rate of unemployment is the
percentage of the labor force that can normally
be expected to be unemployed for reasons
other than cyclical fluctuations in real GDP.

The natural rate of unemployment is related to the
willingness of workers to voluntarily separate
from their jobs, job loss, the duration of
unemployment periods, the rate of change in the
pattern of demand, and changes in technology.
Costs of Unemployment
 Loss
in productivity is measured by the gap
between potential GDP and actual GDP.
 A conservative
estimate of the cumulative gap
between actual and potential GDP over the
years 1974-1992 (evaluated in 1987 prices) is
approximately $1,300 billion.
 At 1993 levels, this loss in output would be
about 3 months’ worth of production.
 It cannot be made up.
Unemployment and Okun’s
Law
The relationship between unemployment and
GDP is expressed by Okun’s Law.
 Okun’s Law says that the percentage change
in real GDP equals 3% - 2 times the change in
the unemployment rate. Why?

GDP has grown over the long run by 3%, and
Okun found that for every 1% increase in
unemployment real GDP growth fell by 2%.
 % /\ GDPreal = 3% - 2 x (8% - 6%) = -1%

Inflation
 Inflation
refers to a sustained rise in
the average level of prices.
 Inflation
does not mean that all prices
are rising. Some prices may be
falling, but on average the overall
level of prices is rising.
Inflation
Creeping inflation is an inflation that
proceeds for a long time at a moderate
and fairly steady pace.
 Galloping inflation is an inflation that
proceeds at an exceptionally high rate,
often for only a brief period.


In 1993, Brazil experienced inflation rates
of 2,700%
The Costs of Inflation

The main cost of inflation is the loss of
efficiency that results because inflation
distorts price signals. For example…

People invest in assets designed to protect
them against inflation, such as real estate,
rather than in productive investments that
enhance the growth and efficiency of the
economy.
The Costs of Inflation
Business collect bills more promptly, using
resources that could otherwise have been
used to produce goods and services.
 Individuals reduce money holdings, which is
inconvenient and misallocates the
individual’s personal resources of time,
energy, and leisure.
 In the case of hyperinflation, inflation over
100%, the currency system breaks down and
the economy reverts to barter.

Purchasing Power and
Inflation
 Inflation
erodes the purchasing
power of a given sum of money.
 Assume
you have $10,000 and the
price level is 1.
• In current dollars, you have $10,000,
and in constant dollars you have
$10,000.
Purchasing Power and Inflation
 Now
let the price level rise to 2.
• In current dollars, you still have
$10,000, but in constant dollars you
now have ??? ?
 The
rise in the price level has
decreased the purchasing power of
your money.
Inflation and Capital Gains
 A capital
gain is the difference
between the price at which an asset
is sold and the price at which it was
bought.
 Capital
gains are not indexed for
inflation. People pay taxes on
nominal gains even if the real gains
are zero.
Inflation and Capital Gains

Example:
Between 1979 and 1993, the price level
doubled. If you bought stock in 1979 for
$5,000 and sold it for $7,500 in 1993, you
would have received a nominal capital
gain of $2,500.
 What was the real gain?


Solution: Adjust capital gains for
inflation just as we do income earned
by working.
Price Indexes
 Consumer
Price Index (CPI)
 The
CPI is calculated by observing
changes in the cost of purchasing a
typical bundle of consumer goods and
services.
• The CPI is a weighted average of all prices,
with the weights given by the relative
importance of different goods or services in the
typical bundle of purchases.
Price Indexes
 GDP
Deflator
 The
GDP deflator is the ratio of GDP
valued at current prices and GDP
valued at base year prices. For
example, if 1992 is the base year, the
GDP deflator is:
• (GDP valued in 1999 prices/GDP valued in
1992 prices)100
The GDP Deflator and the
CPI

There are 4 major differences between
the GDP deflator and the CPI.
The CPI reflects prices of only consumer
goods and services: The GDP deflator
includes prices of all output.
 The CPI incorporates prices of imports:
The GDP deflator does not.

The GDP Deflator and the CPI
The CPI is calculated by tracking over
time the cost of a fixed basket of goods
and services: The GDP deflator allows the
output basket to change.
 Once published, the CPI is never revised:
The GDP deflator changes with GDP
revisions.

Which Movies Were Most
Profitable?
E.T.
 Gone with the Wind
 Forrest Gump
 Star Wars
 Jurassic Park
 Empire Strikes Back
 The Sting

Movies: Receipts in Current
Dollars







E.T.
Jurassic Park
Forrest Gump
Star Wars
Empire Strikes Back
The Sting
Gone with the Wind
$357.77
$354.16
$336.38
$273.30
$200.50
$128.67
$ 76.35
Movies: Year Released







The Empire Strikes Back
Gone with the Wind
Forrest Gump
The Sting
Jurassic Park
E.T.
Star Wars
1980
1939
1994
1973
1993
1982
1977
Movies: Adjusted for Inflation







Gone with the Wind
Star Wars
E.T.
The Sting
Jurassic Park
The Empire Strikes Back
Forrest Gump
$859
$628
$552
$397
$375
$361
$343
Millions of 1996 Dollars
Movies: Receipts in Constant
Dollars








Receipts in $1996 = Nominal receipts x (1996 price
level/Year movie released price level).
Gone with the Wind $76.35 x 108/9.61 = $859
Star Wars
$273.3 x 108/47 = $628
E.T.
$357.77 x 108/70 = $552
The Sting
$128.67 x 108/35 = $397
Jurassic Park
$354.16 x 108/102= $375
Empire Strikes Back $200.5 x 108/60 = $361
Forrest Gump
$333 x 108/105 = $343
Movies: Receipts in Current
Dollars








Nominal Receipts = Inflation adjusted receipts x (Year
movie released price level/1996 or base price level).
E.T.
$552 x 70/108 = $357.77
Jurassic Park
$375 x 102/108 = $354.16
Forrest Gump
$346 x 105/108 = $336.38
Star Wars
$628 x 47/108 = $273.30
Empire Strikes Back $361 x 60/108 = $200.55
The Sting
$397 x 35/108 = $128.67
Gone with the Wind $859 x 9.6/108 = $ 76.35
The
End