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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