Macroeconomics in the World Economy: Theory and ...€¦ · General Economics Economic (Logical) Fallacies Understanding Behavioral Equations Measurement of the National Economy Gross

Macroeconomics in the World Economy:Theory and Applications

Topic 1: Macroeconomics – Principles & Extensions

Dennis Plott

University of Illinois at ChicagoDepartment of Economics

http://blackboard.uic.edu

Spring 2014

Plott (ECON 221) Spring 2014 0 / 105

http://blackboard.uic.edu

Outline

1 Topic 1: Macroeconomics – Principles & ExtensionsAnalytical Tools

Economic Theory & Models

General Economics

Economic (Logical) Fallacies

Understanding Behavioral Equations

Measurement of the National EconomyGross Domestic Product (GDP)

Prices and Inflation

Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) Spring 2014 1 / 105

Outline



General Economics





Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) Analytical Tools Spring 2014 2 / 105

Time Subscripts

The time subscript (t) allows us to be more specific about the timing of

a variable

The subscript t (current), t −1 (past), or t +1 (future) tells us in which

period something is happening

The time subscript (t) can represent any type of data; e.g. annually,

quarterly, monthly, etc.

Examples:

if we have annual data and t = 2010, then t −1 = 2009 and t +1 = 2011if we have monthly data and t = January 2010, thent −1 = December 2009 and t +1 = February 2010


Growth Rates

growth rate = %∆X = Xt+1 −Xt

Xt×100% = Xt+1

Xt−1×100%

Example: Suppose your nominal wage per hour is currently Wt = $12.00

and your boss states will will get a sixty cent raise per hour;

i.e.,Wt+1 = $12.60. What is this in percentage terms?

%∆W = Wt+1 −Wt

Wt×100%

%∆W = $12.60−$12.00

$12.00×100%

%∆W = 5%

At this rate, assuming you received a five-percent raise per year, how long

would it take for your salary to double?


Rule of 70 (72)

DefinitionRule of 70 (72): the approximate amount of time (e.g. years) it takes for the

level of a variable growing at a constant rate to double.

T2 ≈ 70

R

where

T2: approximate time for variable to double

R: constant growth rate percent

Use 70 for numbers ending in 0, 2, 5, 7, and 10

Use 72 for numbers ending in 3, 4, 6, 8, and 9

Continuing from the previous slide it would take approximately70

5= 14

years for your salary to double.


Slope (of a Linear Line)

Definition

slope = rise

run= y2 −y1

x2 −x1= y1 −y2

x1 −x2= ∆y

∆x


Tangent Lines

Definitiontangent (line): A line that just touches a curve at one point, without cutting

across it.


Percentage Points vs. Percent Change

Percentage is relative, while percentage points are absolute.

Generally speaking, percentage points should be used to measure the difference between two

percentages, since it gives a clearer view of the differences than when percentages are used.Examples:

If we say that the number of female CEOs increase by 3%, we mean that the number increase with 3% of thecurrent number of female CEOs. If we say the number increases with 3 percentage points, we mean that thenumber of female CEOs increase with 3% of the total number of CEOs. So if 5% of all CEOs are female a 3%increase would not be noticeable, since it increased the number of female CEOs to 5.015% of the total numberof CEOs. However, if the number of female CEOs increases with 3 percentage points, this implies 8% of allCEOs would be female. Quite a difference.Let’s say that a poll in year 1 shows that 10% of the population supports consuming children for food (to take ahopefully absurd example). In year 2 the poll shows a 20% decrease in the support compared to year 1.However, in year 3, the same number has gone up by 25% compared to year 2.Many people would get the impression that the number of children as food supporters in year 3 is higher thanin year 1, but that’s actually not the case.In year one 10% supported eating children. The next year, the number fell by 20%. 20% of 10% is 2%, whichmeans that 8% supports consuming children. Then the number of supporters increased with 25%. 25% of 8%is 2%, so the total is back up to 10%.If we have used percentage points, we could just say that in year 2, the number of supporters fell by 2percentage points, and that the number of supporters increased by the same amount of percentage points inyear 3. Thus making it much clearer that the amount of supporters was the same in year 1 and year 3.Non Sequitor: See Jonathan Swift’s "A Modest Proposal"(https://andromeda.rutgers.edu/~jlynch/Texts/modest.html)


https://andromeda.rutgers.edu/~jlynch/Texts/modest.html

Basis Points

DefinitionA basis point is one hundredth of one per cent (0.01 per cent), so 100 basis

points (bps) is equal to 1 percentage point.

If a bond yield were to increase from 1 per cent to 2 per cent, it is said

to risen by 100 basis points (bps) or one percentage point.

Bond spreads, the difference between bonds of similar quality and

different maturities, or of different quality and the same maturity, are

usually expressed in basis points (bps). Basis points are also used to

express percentage changes in costs or prices of other securities, such

as mortgage loans.

See The Wall Street Journal "What Is a Basis Point and Why Is It So

Important?" by Constable 4th September 2013

http://online.wsj.com/news/articles/

SB10001424127887324823804579017141254359828


http://online.wsj.com/news/articles/SB10001424127887324823804579017141254359828

http://online.wsj.com/news/articles/SB10001424127887324823804579017141254359828

Outline



General Economics





Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) Economic Theory & Models Spring 2014 10 / 105


Definitioneconomic theory: a set of ideas about the economy, organized in a logical

framework

economic model: a simplified description of some aspect of the economy

or a representation of economic phenomenon that takes a mathematical

and/or, conceptual, and/or graphical form

Models embody assumptions about individual behavior, market

structure and what is taken as given (including policy regime).

Usefulness of economic theory or models depends on reasonableness

of assumptions, possibility of being applied to real problems,

empirically testable implications, theoretical results consistent with

real-world data.

A primary goal of developing models is to determine what policies can

produce better macroeconomic outcomes.



Definitionabstraction: means ignoring many details so as to focus on the most

important elements of a problem

Essentially, all models are wrong, but some are useful.

– George Box

Models are abstractions from reality and should be simplified to focus

on only the most crucial elements to explain economic phenomena.

Abstraction from unimportant details is necessary to understand the

functioning of anything as complex as the economy.

Models do not need to be “realistic”, but should be consistent with the

facts.

May need to switch between models according to context; no grand

“true” model.


Economic Theory & Models: Example

Suppose you are new to

UIC.

To navigate your way

around campus you

consult a map.

What makes a good map?

You can list numerous

attributes, but the most

important aspect of a good

map is that it helps you get

from point A to point B.



Definitionendogenous variable: a variable that is explained by an economic model

exogenous variable: a variable that is taken as given and is not explained

by an economic model

A solution to a model gives the endogenous variables in terms of the

exogenous variables.

Variables that are exogenous in some models might be endogenous inother models.

1 For example, in one macro model, we might take interest rates asexogenous.

2 But some economic models are designed exactly to explain interestrates.

3 In some cases, a variable is exogenous in the building block of a moregeneral model, but endogenous in the general model.


What Economics Is Not

Economics wants to be physics (or chemistry or biology, etc.). Why is

physics and the like enviable? They have controlled experiments.

There are very few controlled experiments in economics; e.g. the

RAND Health Insurance Experiment (HIE).

Why? Two main reasons:1 The costs for large social experiments, such as the RAND study cited

above, tend to be prohibitive.2 A more important concern is that many of the experiments economists

would like to perform, if they were even feasible, would likely beethically questionable.

For example, what if an economist wanted to determine how

Government spending would impact an economy experiencing a level

of unemployment like the peak level during the Great Depression

(approximately 25%). So, let’s randomly layoff/fire 15%–20% more of

the labor force. What do you think would happen?













(approximately 25%).

So, let’s randomly layoff/fire 15%–20% more of















the labor force.

What do you think would happen?
















Riots!


Ceteris Paribus

In the theoretical models, like the ones used in this class, economists

use ceteris paribus.

This Latin phrase acts along the lines of a thought experiment and

roughly translates to "if all other relevant things remain the same" or

"holding other things constant" or "all other things being equal".

To isolate the relationship of interest in a laboratory experiment, a

scientist holds everything constant except for the variable whose effect

is being studied. Economists use the same method to demonstrate a

relationship that has more than two variables.


Economic Theory & Models: Mathematical Functions

Functional notation is used to express the idea that one variable is

determined by other variables.

Macroeconomic Example1 Model aggregate consumption as depending on disposable income

(Y −T) and the real interest rate (r):

C = C(Y −T ,r)

2 In this model, income (Y ), taxes(T), and the interest rate (r) areexogenous; while consumption (C) is endogenous.

3 C = C(·) is functional notation indicating consumption (C) is a functionof what is inside the parentheses.



DefinitionPositive (direct) relationship: A relationship between two variables that

move in the same direction.; the relationship between two variables that

change in the same direction, for example, product price and quantity

supplied; positive relationship.

Negative (inverse) relationship: A relationship between variables that

move in opposite directions.



Question?1 The functional notation C = C(Y −T ,r) indicates consumption depends

on disposable income and the real interest rate, but how are theyrelated? In other words, how would consumption change with an inincrease in the real interest rate (↑ r) or disposable income (↑ (Y −T)),ceteris paribus? [Hint: positively, negatively, or both (depending oncontext)?]

2 ↑ rc.p.−→ ↓ C

3 ↑ (Y −T)c.p.−→ ↑ C





2 ↑ rc.p.−→

↓ C3 ↑ (Y −T)

c.p.−→ ↑ C





2 ↑ rc.p.−→ ↓ C

3 ↑ (Y −T)c.p.−→ ↑ C





2 ↑ rc.p.−→ ↓ C

3 ↑ (Y −T)c.p.−→

↑ C





2 ↑ rc.p.−→ ↓ C

3 ↑ (Y −T)c.p.−→ ↑ C


Consumption Example in Practice

In theory there is no difference between theory and practice. In practice there is.

– Yogi Berra

Real Interest Rate Consumption

2009 1.9 9077.3

2010 2.5

9334.0

↑ r −→↑ C ??

Did we break economics?

No, there is omitted variable bias.




– Yogi Berra


2009 1.9 9077.3

2010 2.5 9334.0

↑ r −→↑ C ??






– Yogi Berra


2009 1.9 9077.3

2010 2.5 9334.0

↑ r −→↑ C ??






– Yogi Berra


2009 1.9 9077.3

2010 2.5 9334.0

↑ r −→↑ C ??






– Yogi Berra


2009 1.9 9077.3

2010 2.5 9334.0

↑ r −→↑ C ??





Real Interest Rate Consumption Disposable Income

2009 1.9 9077.3 10,722.4

2010 2.5 9334.0 11,127.1

Do not forget about ceteris paribus!


Classical vs. Keynesian – Why MacroeconomistsDisagree (Fortune Cookie Version)

The Classical Approach

The economy works well on its ownWages and prices adjust rapidly to get to equilibrium

Equilibrium: a situation in which the quantities demanded and supplied are equal

Changes in wages and prices are signals that coordinate people’s actions

Result: Government should have only a limited role in the economy

The Keynesian Approach

The Great Depression: Classical theory failed because high unemployment was persistentKeynes: Persistent unemployment occurs because wages and prices adjust slowly, somarkets remain out of equilibrium for long periodsConclusion: Government should intervene to restore full employment

A Unified Approach

Model starts with microfoundations: individual behaviorLong-run: wages and prices are perfectly flexibleShort-run:

Classical case – flexible wages and prices

Keynesian case – wages and prices are slow to adjust


Outline



General Economics





Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) General Economics Spring 2014 24 / 105

Secondary (Tertiary) Effects

DefinitionSecondary effects: unintended consequences of economic actions that may develop

slowly over time as people react to events

Examples:1 In many cities, public officials have imposed rent controls on apartments. The primary

effect of this policy, the effect policy makers focus on (i.e. the one they sell to thepublic), is to keep rents from rising. Overtime, however, fewer apartments get builtbecause renting them becomes less profitable. Moreover, existing rental unitsdeteriorate because owners have plenty of tenants anyway. Thus, the quality andquantity of housing may decline as a result of what appears to be a reasonable measureto keep rents from rising. Another issue is ignoring how landlords would respond inlegally circumventing the policy; e.g., tacking on ’required’ extras to the apartmentsuch as curtains that the tenant must rent from the landlord for $250 a month inaddition to the rent.

2 A macro related example is Congress passing the Smoot-Hawley Tariff Act of 1930during the Great Depression. At first the tariff seemed successful. However, the UnitedStates’ trading partners retaliated. Overall, world trade decreased by approximately66% between 1929 and 1934!


Marginal Analysis

DefinitionMarginal analysis: an examination of the effects of additions to or

subtractions from a current situation

An example:


Diminishing (Marginal) Returns

Definition(law of ) diminishing (marginal) returns: The principle that as successive

increments of a variable resource are added to a fixed resource, the

marginal product of the variable resource will eventually decrease.

An example:


Positive vs. Normative

DefinitionNormative (questions) economic analysis: addresses questions that involve value judgments.

It concerns what ought to happen rather than what did, will, or would happen.

Positive (questions) economic analysis: addresses factual questions, usually concerning

choices or outcomes. It concerns what did, will, or would happen.

Economics could convince reasonable people of the truth of the "positive" ("what is")

predictions, but economics cannot end a "normative" ("what should be") disagreement.

Note: It is not always possible or at least easy to separate normative from positive

statements. That said, in this course the focus is nearly exclusively focused on positive

economic analysis; i.e. the did, will, or would. In answering any exam or problem set

question I do not care about my, your, or someone else’s opinion.

Note: The word positive does not mean that the answer admits no doubt. On the contrary,

all answers, particularly those involving predictions, involve some degree of uncertainty.

Rather, in this context, positive simply means that the prediction concerns a factual

matter.


Non Sequitur : Random Famous People Who Majoredin Economics

5. John Elway – Hall of Fame NFL quarterback (Stanford)

4. Bob Barker – TV Game Show host on The Price Is Right (Drury College)

3. Mick Jagger – Rolling Stones (London School of Economics)

2. William Shatner – "Khaaaan!" (McGill University)

https://www.youtube.com/watch?v=lul-Y8vSr0I

1. Arnold Schwarzenegger – Body Builder/Actor/Governor/Terminator

(University of Wisconsin)





















































Outline



General Economics





Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) Economic (Logical) Fallacies Spring 2014 30 / 105

Common Economic Fallacies

Definitionloaded terminology: terms that contain the prejudice and value judgments

of others; related terms include "appeal to emotion", "inflammatory

language", etc.

1 It is very difficult for a person to describe economic behavior without

letting their opinions about that behavior creep into their discussion.

The distinction between positive and normative statements is not

always clearly apparent.

2 Often, however, there is a deliberate attempt to sway opinion by using

loaded terminology (e.g. "greedy owners", "obscene profits",

"exploited workers", "mindless bureaucrats", "costly regulations",

"creeping socialism").



Definitionfallacy of composition: what is true for one individual or part of a whole is

necessarily true for a group of individuals or the whole; the false notion that

what is true for the individual (or part) is necessarily true for the group (or

whole).

Examples:

1 An individual stockholder’s sales of shares vs. a large number of

stockholders selling large numbers of shares.

2 At a football game the person in front of you obstructs your view, so

you stand up to get a better view vs. if everyone in the stadium stands

up to get a better view.



DefinitionCounterfactual: expressing what has not happened but could, would, or might

under differing conditions. Counterfactuals are what ifs, thought experiments,

alternatives to actual history; they imagine what would have happened to an

economy if, contrary to fact, some present condition were changed.

1 When you want to know the causal effect of an intervention (policy change,medical treatment, whatever) on something, you need to compare two states ofthe world: the world in which the intervention occurred and the world in which itdid not. The latter is the counterfactual world. Since most of us only get to live inone world (most of the time), observing the counterfactual is a rather tricky thingto do.

2 Example: The stimulus was predicted to hold unemployment below 8.5%; it didnot. Did the stimulus fail? It depends on the counterfactual of what wouldunemployment have been without the stimulus? The prediction was wrong, butthat doesn’t tell you what would have happened without the stimulus.


Schrödinger’s Cat (A Thought Experiment)



Definitionpost hoc, ergo propter hoc ["after this, therefore because of this"] fallacy:

The false belief that when one event precedes another, the first event must

have caused the second event; when two events occur in time sequence,

the first event is not necessarily the cause of the second event.

1 Example: The Republicans (Democrats) pass a new tax reform law that

benefits wealthly Americans. Shortly thereafter the economy takes a

nose dive. The Democrats (Republicans) claim that the the tax reform

caused the economic woes and they push to get rid of it.



Definitioncorrelation versus causation: events may be related without a causal

relationship

Correlation: A systematic and dependable association between two sets of

data (two kinds of events); does not necessarily indicate causation.

Causation: A relationship in which the occurrence of one or more events

brings about another event.

Causation vs. Correlation Example:1 The positive relationship between education and income does not tell

us which causes the increase in the other. (Which is the independentvariable and which is the dependent variable?)

2 It may be that the increased income that occurs with increasededucation is due to some other third factor (an omitted variable) that isnot under direct consideration.


Common Economic Fallacies: Causation vs.Correlation






The "Broken Window" Fallacy

In the essay "What Is Seen And What Is Not Seen", a 19th Centuryeconomist named Frederic Bastiat wrote a story about a boy who breaks ashopkeeper’s window. In replacing it, the shopkeeper gives money to theglassman, and the town observes that the broken window provided a boostto the local economy. However, Bastiat emphasizes that this fallacy ignoresthe unseen fact that, had the window not been broken, the shopkeeperwould have bought a new pair of shoes. Hence, there is no net gain for theeconomy.

Note: this a classic essay with an important point: if you look at only thebenefits of government programs, you miss the hidden costs – where the taxmoney would otherwise have been spent, money unspent due to tariffs, andso forth.However, Bastiat makes two hidden assumptions:

1 All money that is spent would have been spent elsewhere – call this Say’s Law.2 That the replacement for the proverbial broken window is not better in any way.

http://www.econlib.org/library/Bastiat/basEss1.html


http://www.econlib.org/library/Bastiat/basEss1.html

Common Causes of Fallacies

A 1987 study, published in the Journal of the American Veterinary Medical Association, of

132 cats that were brought into the New York Animal Medical Center after having fallen

from buildings found that cats falling from five stories or less and nine stories or more had

a much greater likelihood of surviving than cats who fell between five and nine stories.

Can you explain this? Note: I do not hate cats.

Bad data quality (narrow definition): data that are missing or incorrect (FYI: the word

"data" is a (Latin) plural)

In a survey of 200 children those with larger feet consistently scored more highly on a

spelling test.

Can you explain this?

Children with larger feet are likely to be older, and older children are generally better

spellers having had more exposure to words at school and at home.

Omitted variable (bias): when a valid or important variable is excluded from a modelReverse Causation: a reversal of cause and effect or the existence of a feedbackrelationship

Example: Is health a cause, effect, or both of higher incomes? Higher incomes are expectedon balance to lead to better health but better health may enhance productivity growth andhence lead to higher incomes.











spelling test.
















spelling test.







Outline



General Economics





Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) Understanding Behavioral Equations Spring 2014 42 / 105

Types of Data

DefinitionTime Series: Data collected over time on one or more variables.

Cross-Sectional: A data set collected from a population at a given point in

time.; observations of many different individuals (subjects, objects) at a

given time, each observation belonging to a different individual.

Panel: A data set constructed from repeated cross sections over time.

An example of time series data are the daily closing value of the Dow JonesIndustrial Average.

An example of cross-sectional data is the gross annual income for each of1000 randomly chosen households in New York City for the year 2011.

A famous example is the Panel Study of Income Dynamics (PSID) whichprimarily collects economic and demographic information from over 18,000individuals living in over 5,000 families in the United States.


Regression Analysis: Analyzing Theory

Economic theory specifies a set of relationships between variables; e.g.,

demand equations, production functions, consumption functions, etc.

Definitioneconometrics: empirically investigate economic theory using data to

provide estimates of key (unknown) parameters in economic models; e.g.,

estimates of elasticities, marginal propensity to consume, etc.


Example: Consumption Function

Theory: What kind of factors might influence household spendingbehavior?

1 Disposable Income (YD = Y −T)2 Real Interest rate (r)3 Expected Future Income (E[Y ] = Y e

f )4 Stock Market (STOCK )5 Weather (WEATHER)6 ... etc ...



How might we examine the effects of these different factors on

consumption?

Set consumption as a function of these variables; i.e., regress

consumption on a set of explanatory variables.

Thus the consumption function might look like:

C = c0 + c1YD + c2r+ c3Y ef + c4STOCK + c5WEATHER+εt



Dependent Variable: C

Parameters to be estimated: c0,c1,c2,c3,c4,c5

Independent variables: YD,r,Y ef ,Stock,Weather

Shocks: ε



Analysis in this Class


Given the consumption function above, we would wish to then

examine the impact that the independent variables have on the

dependent variable; e.g., what is the impact of a change in interest

rates on consumption?

Answer:

∆C = c2∆r

⇒ ∆C

∆r= c2

Question: Should the parameter c2 be positive or negative?

Answer: Negative (c2 < 0)









Answer:

∆C = c2∆r

⇒ ∆C

∆r= c2











Answer:

∆C = c2∆r

⇒ ∆C

∆r= c2




Outline



General Economics





Unemployment

The Business Cycle

Interest Rates

Plott (ECON 221) Measurement of the National Economy Spring 2014 49 / 105

Outline and Goals

1 How do we Measure Current Economic Activity? (Simon Kuznets,

Nobel 1971)

2 What is Gross Domestic Product (GDP)? Why do we care about it? How

do we measure standards of living over time?

3 What are the definitions of the major economic expenditure

components?

4 What is the difference between ’Real’ and ’Nominal’ variables?

5 How is Inflation measured? Why do we care about Inflation?

6 What have been the predominant relationships between

Unemployment, Inflation and GDP over the last four decades.

7 Nominal and Real Interest Rates.

8 How is Unemployment measured? Why do we care about

Unemployment?


Simon Kuznets (1901-1985) Nobel Prize 1971

1 Simon Kuznets provided the methodology for modern national-incomeaccounting and developed the first reliable national-income measures for theUnited States. Kuznets is often referred to as the "father of national-incomeaccounting". A native Russian, he immigrated to the United States at the ageof 21 and spent his academic career teaching at the University ofPennsylvania, Johns Hopkins University, and Harvard University.


Objective: Measuring the amount of Economic Activity

Three Approaches of Measuring the amount of Economic Activity:

1 Product approach: Add the market Value of Goods and Services

Produced Minus the Value of Intermediate Materials across all

industries. (VALUE ADDED)

2 Income approach: Add the Income Received by All Producers of

Output. (wages for workers and profits for owners of firms)

3 Expenditure approach: Add the Amount Spent by All Ultimate Users of

Output. (Final Consumers)

They are equivalent: Fundamental Identity of National Accounting

See Abel, Bernanke, and Croushore Chapter 2 Juice Example


"Production" Equals "Expenditure"

GDP is a measure of market Production

GDP = Expenditure = Income = Y (the symbol we will use) in

macroeconomic equilibrium

Because market value is equal to how much you have to spend to buy

What is produced in the market has to show up as being purchased or

held by some economic agent

Who are the economic agents we will consider on the expenditureside?

Consumers (refer to expenditure of consumers as "consumption")Businesses (refer to expenditure of firms as "investment")Governments (refer to expenditures of governments as "governmentspending")Foreign Sector (refer to expenditures of foreign sector as "exports")


A Simple Example

Suppose I produce Tablets. If so, I could:

sell it to some domestic customer (Consumption)sell it some business (Investment)keep it in my stock room as inventory (Investment)sell it to the city of Chicago to use in their offices (Governmentspending)sell it to some foreign customer (Export)


"Expenditure" Equals "Income": A Simple Example

What buyers spend (expenditure) equals what sellers receive (income)

Suppose I sell a glass of lemonade for $1.00I just use lemons, sugar, and water to make the lemonade. The watercosts $0.01 per glass, the sugar costs $0.09 per glass, and the lemonscosts $0.20 per glass.Income/Profit for me is $0.70The same procedure is used for the people who sell water ($0.01 ofincome), for the people who sell the sugar ($0.09 of income), and for thepeople who sell the lemons ($0.20 per glass).The $1.00 spent on a glass of lemonade resulted in $1.00 worth ofincome for various people (the $1.00 ended up in someone’s pocket).


Gross Domestic Product (GDP)

GDP is a measure of ProductionFormal Definition:

GDP is the Market Value of all Final Goods and Services Newly Produced onDomestic Soil During a Given Time Period (different than GNP)

Market Value: Goods and Services measured at the Prices at which they are sold.

Final Goods and Services: End Products of a process – Not Intermediate (avoid

double counting).

Newly Produced: Produced in the current period.

On Domestic Soil: We focus on this.

Why Do We Care?

Because output is highly correlated (at certain times) with things we care about(standard of living, wages, unemployment, inflation, budget and trade deficits,value of currency, etc.)

Who Measures GDP?

The Bureau of Economic Analysis (BEA) (www.bea.gov)GDP is reported quarterly and annually, although there are monthly revisionsas late as years after the initial reports.


www.bea.gov


A Look at U.S. Nominal & Real U.S. GDP: 1947–2013

http://research.stlouisfed.org/fred2/graph/?id=GDP


http://research.stlouisfed.org/fred2/graph/?id=GDP

What GDP is NOT

GDP is not, or never claims to be, an absolute measure of well-beingSize effects (Population): But even GDP per capita is not a perfectmeasure of welfare

Bill Gates’ remarks at Davos

(http://www.microsoft.com/en-us/news/exec/billg/

speeches/2008/01-24wefdavos.aspx)

"The gross national product does not allow for the health of our children,the quality of their education, or the joy of their play. It does not includethe beauty of our poetry or the strength of our marriages, the intelligenceof our public debate or the integrity of our public officials. It measuresneither our courage, nor our wisdom, nor our devotion to our country. Itmeasures everything, in short, except that which makes life worthwhile,and it can tell us everything about America except why we are proud to beAmericans."

– U.S. Senator Robert F. Kennedy, 1968Plott (ECON 221) Measurement of the National Economy Spring 2014 59 / 105

http://www.microsoft.com/en-us/news/exec/billg/speeches/2008/01-24wefdavos.aspx

http://www.microsoft.com/en-us/news/exec/billg/speeches/2008/01-24wefdavos.aspx

More on What GDP Is Not – GDP Shortcomings

GDP Does Not Measure:

Non-market Activity (e.g. homemakers’ services, parental child care, volunteer efforts, home improvementprojects)GDP doesn’t measure improved living conditions, improvements in product quality, or make allowances forincreased leisure timeThe Underground Economy

Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP).

Legal economic activity may also be part of the "underground", usually in an effort to avoid taxation.

GDP and the environment

Resource depletion and the harmful effects of pollution are not deducted from GDP (oil spills, increased

incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view).

GDP does include payments made for cleaning up the oil spills, and the cost of health care for the cancer victim.

Life Expectancy and Health (though highly correlated)GDP makes no value adjustments for changes in the composition of output or the distribution (inequality)of income.

Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the product is a

semi-automatic rifle or a jar of baby food.

Per capita GDP may give some hint as to the relative standard of living in the economy; but GDP figures do not

provide information about how the income is distributed.

Non-economic Sources of Well-Being like courtesy, safety, crime reduction, etc., are not covered in GDP.

Ideally, what economists would like to measure is quality of one’s life (See reading on Stiglitz’s report):

Present discounted value of utility from one’s own consumption and leisure and that of one’s loved ones.


Three Equivalent Approaches. Different Information

Production Method: Measure the Value Added summed Across

Industries (value added = sale price less cost of raw materials)

Expenditure Method: Spending by consumers (C) + Spending by

businesses (I) + Spending by government (G) + Net Spending by

foreign sector (NX = Net Exports = Exports − Imports)

Income Method: Labor Income (wages/salary) + Capital Income (rent,

interest, dividends, profits).

We will predominantly spend our time working with the Expenditure

Approach:

Y = C + I +G+NX


Measuring Expenditure

Only include expenditures for goods that are "newly produced".

If I give $10 to a movie theater to watch a movie, it is counted asexpenditure.If I give $10 to my nephew for a birthday present, it is not counted asexpenditure.If I give $10 to the ATM machine to put in my savings account, it is notcounted as expenditure.

The second example would be considered a "transfer" (once I give $10to my nephew, he can go to the movies if he wanted to – once that $10is spent, it will show up in GDP).

"Transfers" are defined as the exchange of economic resources from oneeconomic agent to another when no goods or services are exchanged.

The third example is considered "saving" (I am delaying expenditure

until the future) Once I spend the $10 future GDP in the future, it will

show up in GDP.


Defining the Expenditure Components (Formally)

Consumption (C):

The Sum of Durables (lasting three years or more), Non-Durables, andServices Purchased Domestically by Non-Businesses andNon-Governments (i.e. individual consumers).Includes Haircuts (services), Refrigerators (durables), and Apples(non-durables).Does Not Include Purchases of New Housing.


Defining the Expenditure Components (Formally)

Investment (I):

The Sum of Durables (lasting three years or more), Non-Durables, andServices Purchased Domestically by Businesses.Includes:

All final purchases of machinery, equipment, and tools by businesses.

All construction (including residential structures).

Changes in business inventory.

Excludes Intermediate Goods (i.e. goods used-up during production inthe same period that they themselves were produced–note thedifference with equipment/capital goods which last for several periods).Land purchases are NOT counted as part of GDP (land is not produced!)Stock purchases are NOT counted as part of GDP (stock transactions doNOT represent production – they are saving!)

Important: There is a difference between financial and economic

investment!


More On Expenditure Components

Government Spending (G): Goods and Services Purchased by the

domestic government.

For the U.S., 2/3 of this is at the state level (police and fire protection,

school teachers, snow plowing) and 1/3 is at the federal level

(President, Missiles).

Note: Welfare and Social Security are NOT Government Spending.

These are Transfer Payments. Nothing is Produced in this Case.

Net Exports (NX): Exports (EX) − Imports (IM);

Exports: The Amount of Domestically Produced Goods Sold on ForeignSoilImports: The Amount of Goods Produced on Foreign Soil PurchasedDomestically.


Some Examples of GDP Calculations

If the following transactions took place in 2014 which would count toward GDP for2014?

Social security payments received by a retired factory worker.

The purchase of an insurance policy.The sale of brand new tires.A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs testsflights before delivery as of 31st December 2014.A newly married couple purchases a newly constructed house.A house constructed in 2010 is sold again in January 2014.




Social security payments received by a retired factory worker.The purchase of an insurance policy.

The sale of brand new tires.A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs testsflights before delivery as of 31st December 2014.A newly married couple purchases a newly constructed house.A house constructed in 2010 is sold again in January 2014.




Social security payments received by a retired factory worker.The purchase of an insurance policy.The sale of brand new tires.

A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs testsflights before delivery as of 31st December 2014.A newly married couple purchases a newly constructed house.A house constructed in 2010 is sold again in January 2014.




Social security payments received by a retired factory worker.The purchase of an insurance policy.The sale of brand new tires.A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs testsflights before delivery as of 31st December 2014.

A newly married couple purchases a newly constructed house.A house constructed in 2010 is sold again in January 2014.




Social security payments received by a retired factory worker.The purchase of an insurance policy.The sale of brand new tires.A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs testsflights before delivery as of 31st December 2014.A newly married couple purchases a newly constructed house.

A house constructed in 2010 is sold again in January 2014.




Social security payments received by a retired factory worker.The purchase of an insurance policy.The sale of brand new tires.A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs testsflights before delivery as of 31st December 2014.A newly married couple purchases a newly constructed house.A house constructed in 2010 is sold again in January 2014.


GDP, GNP, and NFP

DefinitionGross National Product (GNP): output produced by domestically owned factors of

production

Gross Domestic Product (GDP): output produced within a nation

Net Factor Payments (NFP): net factor payments from abroad; payments to

domestically owned factors located abroad minus payments to foreign factors located

domestically

GDP = GNP−NFP

Example: A new Mercedes-Benz M-Class (SUV) made in Alabama is counted

toward U.S. GDP, but Germany’s GNP.

The difference between GNP and GDP is small for the United States, about 0.2%,

but higher for countries that have many citizens working abroad; e.g. the

Philippines


Stocks and Flows

A stock is often an accumulation of flows over time

Examples:

Inventory investment is a flow, which accumulates into the stock ofinventoriesSaving is a flow, which accumulates into a person’s wealth



Inflation rate = π = % change in P, where P is the level of Prices

π= Pt −Pt−1

Pt−1

How Are Prices Measured?

Price Indexes – a relative measure of a ’basket’ of many goods

GDP Deflator (one prominent price index):

GDP deflator = Value of Current Output at Current Prices

Value of Current Output at Base Year Prices

Another prominent price index is the Consumer Price Index (CPI): an average of

the prices of the goods and services purchased by the typical urban family of

four. I will often use the CPI as our measure of a price index in this class.

The Fed uses the (core) Personal Consumption Expenditures (PCE) price index:

a price index similar to the GDP deflator, except that it includes only the prices of

goods from the consumption category of GDP.


Question

Which headline would you prefer if you are planning on purchasing anew house several years in the future? Assume you currently do notown any property.

1 “Housing Prices Have Soared Doubling in the Last Decade”2 “The Market for Housing Grew Moderately at 7% Last Year, Consistent

with the Ten Year Average”

For simplicity, assume the relevant growth rate for these two respective

headlines remains constant.


CPI vs. PCE

http://research.stlouisfed.org/fred2/categories/9


http://research.stlouisfed.org/fred2/categories/9

Example of Price Index Calculations

Diana’s Basket of Goods (goods she produces in the fictional economy)

2013 2014

Quantity Price Y Quantity Price Y

Pizza 10 $1.00 $10.00 20 $2.00 $40.00

Swedish Meatballs 15 $3.00 $45.00 20 $4.00 $80.00

Scarves 50 $0.50 $25.00 40 $1.00 $40.00

Y2013 = 10 ·$1+15 ·$3+50 ·$0.5 = $80.00

Y2014 = 20 ·$2+20 ·$4+40 ·$1 = $160.00

Nominal GDP went up by 100%


Example of Price Index Calculation (Continued)

Compute GDP Deflator for Diana’s World (with 2013 as Base Year)

2013 2014

Quantity Price Y Quantity Price Y

Pizza 10 $1.00 $10.00 20 $2.00 $40.00

Swedish Meatballs 15 $3.00 $45.00 20 $4.00 $80.00

Scarves 50 $0.50 $25.00 40 $1.00 $40.00

Current Output at Current Prices: $160.00

Current Output at Base Year Prices:

$100.00($1.00 ·20+$3.00 ·20+$0.50 ·40)

GDP Deflator for 2014 = 160100 = 1.60

GDP Deflator for 2003 = 1.00 (Note: The base year price index is

ALWAYS = 1.00)

Inflation Rate Between 2013 and 2014 = 60%



Why are we doing this? Comparing Nominal GDPs over time canbecome problematic:

Confusing Changes in Output (production) with Changes in Prices

Real GDP is output valued at some Constant Level of Prices (prices in a

base year).

RealGDPt = NominalGDPt

Price Indext

Growth in Real GDP:

%∆ in Real GDP = RealGDPt −RealGDPt

RealGDPt

or approximately

%∆ in Real GDP = %∆ in Nominal GDP−%∆ inP



The exact relationship between nominal and real growth rates is:

%∆GDPnominal = %∆GDPreal +%∆P+%∆GDPreal ·%∆P

Can be derived easily by considering:

%∆GDPnominal =Yt+1

Yt−1 = Pt+1 ·Qt+1

Pt ·Qt−1

Prove it to yourself.

Check:

What is real GDP growth between 2013 and 2014 in Diana’s World? 40%(approximation)What is real GDP growth between 2013 and 2014 in Diana’s World? 25%(actual)


Consumer Price Index (CPI)

The consumer price index (CPI) is an average of the prices of goods and

services purchased by the typical urban family of four.

To compute the CPI, the U.S. Bureau of Labor Statistics (BLS) surveys

30,000 households nationwide on their spending habits.

The BLS uses the survey to construct a market basket of 211 types of goods

and services purchased by the typical urban family of four. Each month,

hundreds of BLS employees visit 23,000 stores in 87 cities and record

prices of goods and services in the market basket.

Each price in the CPI is given a weight equal to the fraction of the typical

family’s budget spent on that good or service. The CPI in a given year is

equal to the ratio of the dollar amount necessary to buy the market basket

of goods in that year divided by the amount necessary to buy the market

basket of goods in the base year, multiplied by 100.

The CPI is widely used for indexing, which involves increasing a dollar

value to protect against inflation.


Consumer Price Index (CPI) – Continued

Pros: Much faster than collecting all GDP dataCons: "Ideal/Representative" Basket of Goods Change Over Time

Invention (e.g. Computers, Cell Phones, VCRs, DVDs).Quality Improvements (e.g. Anti-Lock Brakes); the BLS attempts to lessen this withhedonic quality adjustment

Hedonic quality adjustment refers to a method of adjusting prices whenever the

characteristics of the products included in the CPI change due to innovation or the

introduction of completely new products.

Criticisms of CPI:1 The CPI suffers from substitution bias. Because the BLS assumes that consumers buy

fixed quantities of goods and services, the CPI will overstate the prices of goods andservices that increase the most, and understate the prices that increase the least.

2 The CPI suffers from a bias due to the introduction of new goods because the marketbasket is updated only every two years.

3 The quality of goods and services changes over time, and these changes are notcompletely reflected in the CPI.

4 There is an outlet bias in the CPI data. Many households shop at large discount storesand on the Internet; these sources are underrepresented in the sample of prices theBLS gathers.


Technical Notes on Price Indexes

Boskin Report (1996) Concludes that CPI Overstates Inflation by 1.1%

per year.

Overstating Inflation means understating Real GDP increases – makes

it appear that the economy has grown slower over time. (Same for

Stock Market, Housing Prices, Wages – any Nominal Measure).

Measures to (potentially) get around problems with base years – ChainWeighting

Read Abel, Bernanke, Croushore text to get a sense of chain weighting (away of solving the base year problem in Real GDP).

Despite the BLS’s attempts to improve the accuracy of the CPI, many

economists still believe that the CPI overstates the true inflation rate

by 0.5 to 1 percentage point. These differences can be large when

compounded over long periods of time.


Why We Care About Inflation

Inflation is Unpredictable

Indexing Costs (even if you know the inflation rate – you have to deal

with it).

Menu Costs (having to go and re-price everything on the shelves/on

the menu)

Shoe-Leather Costs (you want to hold less cash – have to go to the

bank more often).

Caveat: There may be some benefits to small inflation rates – more on

this later.


From Nominal to Real

The formula for turning dollar figures from year T into "today’s" dollars is

the following:

Amount in today’s dollars = Amount in year T dollars

(Price level today

Price level in year T

)Example: In 2005 dollars, what was the real wage in the U. S. in 1992 where

W1992 = $10.67, CPI1992 = 138.0, and CPI2005 = 191.3?

1992 Real Wage in 2005 dollars = Nominal Wage in 1992

(2005 CPI

1992 CPI

)1992 Real Wage in 2005 dollars = $10.67

(191.3

138.0

)1992 Real Wage in 2005 dollars = $14.79


Real vs. Nominal

Which is better: Real or Nominal?

In this class, we will focus on the real! We are trying to measure changesin production, expenditures, income, standard of livings, etc. We willseparately focus on the changes in prices.From now on, both in the analytical portions and the data portions ofthe course, we will assume everything is real unless otherwise told; i.e.,Y = Real GDP, C = Real Consumption, G = Real Government Purchases,etc.

DefinitionClassical dichotomy: the theoretical separation of real and nominal

variables in the classical model, which implies that nominal variables do

not influence real variables.


Measuring Unemployment

Definitionemployed (EMP): people who did any work at all for pay or profit during

the survey week.

unemployed (UNE): people who do not have a job, have actively looked for

work in the prior 4 weeks, and are currently available for work.

Labor force (LF): the sum of employed and unemployed workers in the

economy.

LF = EMP+UNE

Unemployment rate (u): the percentage of the labor force that is

unemployed.

u = UNE

LF

This is the definition used in most countries, including the U.S.

U.S. data: http://data.bls.gov/timeseries/LNS14000000


http://data.bls.gov/timeseries/LNS14000000

Types of Unemployment

DefinitionFrictional unemployment: short-term unemployment that arises from the process of

matching the job skills of workers to the requirements of jobs.

Structural unemployment: unemployment that arises from a persistent mismatch

between the job skills or attributes of workers and the requirements of jobs.

Cyclical Unemployment: unemployment caused by a recession; measured as the

difference between the actual level of unemployment and the level of unemployment

when the rate of unemployment equals the natural rate of unemployment.

Examples:

A financial analyst at Lehman Brothers is laid off in 2008 due to the financial crisis

would likely be classified as

A recent college graduate searching for their first job would likely be classified as

A well qualified high school teacher quits her job in Illinois and moves to Wisconsin,

but needs to be re-certified before she is able to teach would likely be classified as


Unemployment (Continued)

DefinitionFull employment: a situation in which the the unemployment rate equals

the natural unemployment rate. At full employment, there is no cyclical

unemployment; i.e., all unemployment is frictional and structural.

Natural unemployment rate: the unemployment rate when the economy

is at full employment – natural unemployment as a percentage of the labor

force.

Is zero unemployment a reasonable policy goal?No! Frictional and Structural Unemployment may bedesirable/unavoidable.

Who collects the U.S. unemployment data?The Bureau of Labor Statistics (BLS) uses monthly data collected by theBureau of the Census to measure the unemployment rate.The BLS also uses the establishment survey to measure totalemployment in the economy.


Criticisms of Unemployment Measures

Discouraged workers have given up looking for a job because they

believe finding a job is too difficult. These workers are not considered

to be in the labor force and are not counted as unemployed. Therefore,

the unemployment rate as measured by the BLS may understate the

true degree of joblessness in the economy.

Underemployment is defined as a situation where people are working

fewer hours than they wish; e.g., you would like to work 40 hours a

week, but the firm only gives you 30 hours. Underemployment may

also refer to the fact workers accept jobs that don’t utilise their skills;

e.g., a college graduate working at McDonalds.

Underemployment application to the Affordable Care Act:

http://economix.blogs.nytimes.com/2013/07/24/

the-new-economics-of-part-time-employment-continued/


http://economix.blogs.nytimes.com/2013/07/24/the-new-economics-of-part-time-employment-continued/

http://economix.blogs.nytimes.com/2013/07/24/the-new-economics-of-part-time-employment-continued/

Why Unemployment Is Important

Depreciation of human capital; i.e. loss of skills

Productive externalities; e.g. forgone output

Social externalities; e.g., Hitler’s ascent to power against a background

of unemployment in Germany.

Individual self worth or loss of self-respect


The Business Cycle

Economic activity typically follows a wavy line over time with fourphases:

TroughBusiness cycle expansion (boom)PeakBusiness cycle contraction (recession)


What is a Recession?

"Un-Official Rule of Thumb" – two or more quarters of negative real

GDP growth

Most Economies are usually not in recession

U.S. average postwar expansion: 50 monthsU.S. average postwar recession: 11 monthsPrevious Recession: 7–9 months (April 2001 – December 2001)Previous Expansion: 73 months (Jan 2002 – Nov 2007)The 1990s experienced the longest expansion since 1850, 121 months(more than 10 years; the second longest was 106 months; 1961-1969.

For U.S. Business Cycle dates see:

www.nber.org/cycles/cyclesmain.html


www.nber.org/cycles/cyclesmain.html

National Bureau of Economic Research (NBER)

The NBER is a private nonprofit research organization founded in 1920 and dedicated

to promoting a greater understanding of how the economy works. (www.nber.org)

The Business Cycle Dating Committee of the National Bureau of Economic Research

(NBER) determines when a recession begins and ends.

The NBER defines a recession as "a significant decline in economic activity [that]

spreads across the economy and can last from a few months to more than a year."

Government agencies collect most of the data the NBER uses to determine these

dates. There is a lag before the first estimates of these data are released, and the first

estimates are often revised several times as more complete information becomes

available. As a result, the NBER committee takes time to analyze the revised data

before announcing when a recession has begun or ended.

For example, the committee waited 15 months to announce that the recession that

began in 2007 ended in June 2009. Government and private decision makers are

typically unwilling to wait a year or more before taking action if they believe that a

recession has begun. Knowledge of key macroeconomic data is important to

determine business cycle dates as well as to make critical economic decisions.

measure the unemployment rate?


www.nber.org

Overview of Real GDP and Inflation – The Last ThreeDecades

The Great Moderation

Recessions seemed to have become less frequent until 2008.Recent recessions were much less severe than previous recessions.Even the expansions were more stable until 2008.This demonstrates how hard it is to identify structural breaks in themacroeconomy.

How are GDP and inflation related?

Sometimes Negative Growth in GDP and High Inflation (e.g. 1970s)Sometimes Negative Growth in GDP and NO High Inflation (1980s,1990s, and in 2008-09)


Here’s Our Theory: A Brief Overview

We want to learn how GDP, Inflation and Economic Growth aredetermined.

Economic growth is the change in GDP over time (usually long timeperiods, like decades or centuries).The level of GDP (as opposed to its growth) can determine the level ofunemployment.Why do we care about inflation and unemployment?

Questions we will ask:Is it possible to have low/stable inflation and high GDP at the sametime?Can too high of a level of GDP be a bad thing?How can policy makers use the tools available to them to manipulateinflation and GDP targets?How do we get sustainable increases in "standards of living" (i.e.,economic growth)?Specifically, how do workers, firms, consumers, and governmentagencies interact to determine macroeconomic outcomes?


Business Cycles vs. Economic Growth

Full-employment output = potential output = natural rate of output = Y = thelevel of output when labor market is in equilibrium = the level of economicactivity that an economy would attain when all prices and wages are flexibleand the factors of production are used at their full-capacity.

Note: Full-capacity does not mean that they are used for 24 hours a day. It means:People are working the ’right’ amount given labor market conditions (not workingtoo much, not working too little); Machines are working the right amount givenprofit maximizing conditions (not working too much, not working too little).

Business cycle analysis focuses on the movements around Y (why Y ′ differsfrom Y )

Why do we have recessions? Why do we have periods of economic expansions?Business cycle analysis tends to focus on ’high-frequency’ macroeconomicanalysis (quarters, years, maybe a decade)

Economic growth analysis focuses on the evolution of Y over time.

Focus is on low-frequency macroeconomic analysis (decades, centuries, etc.)


Business Cycles vs. Economic Growth

The Congressional Budget Office (CBO) (http://www.cbo.gov/) estimates

potential output.

Created by the Congressional Budget and Impoundment Control Act of 1974

the CBO produces independent, nonpartisan, analysis of economic and

budgetary issues to support the Congressional budget process.


http://www.cbo.gov/

Real GDP and Inflation Over the Last Five Decades

Recessions (negative growth) and inflation increases (Stagflation)

Recessions (negative growth) and inflation decreases.


Reinterpreting the Business Cycle Data 1970-2001

1970 recessions: Inflation increasing at start of recession! High

Increasing Inflation (supply shock) (cause: rapidly rising oil prices)

1981 recession: Dramatic decrease in inflation at start of recession No

inflation (demand shock) (cause: Fed induced recession)

1990 recession: Little increase in inflation,but low level of inflation

(demand shock) (cause: fall in consumer confidence/oil price

increase)

Rapid growth in mid-1990s: No inflation (supply shock) (cause: IT

revolution)

2001 recession: No inflation (demand shock) (cause: over confidence

by firms: inventory adjustment)


Movement of Business Cycle Variables: Co-Movementof Economic Variables

Many economic activities move together over the business cycle

DefinitionProcyclical: a variable moves up during expansions and down during

contractions

Countercylcial: a variable moves down during expansions and up during

contractions

Acyclical: a variable with ups and downs that do not coincide with those of

the business cycle


Movement of Business Cycle Variables: Timing

DefinitionLeading variable: reaches a peak or trough before the turning points of a business

cycle

Lagging variable: reaches a peak or trough after the turning points of a business

cycle

Coincident variable: reaches a peak or trough at the same time of a business cycle

Real consumer spending and investment: both are procyclical and

coincident, but investment is more volatile.

Unemployment: the unemployment rate is countercylical

Inflation: the inflation rate is procyclical and lagging the business cycle

Financial variables, such as stock and bond prices, are procyclical and tend to

be leading the business cycle

The interest rate paid on short-term U.S. government bonds, known as

Treasury bills, is both procyclical and lagging


Consumption & Investment Annual Percent Change

http://research.stlouisfed.org/fred2/graph/?id=GPDIPlott (ECON 221) Measurement of the National Economy Spring 2014 98 / 105

http://research.stlouisfed.org/fred2/graph/?id=GPDI

DefinitionNominal interest rate (i): the return to saving and the cost of borrowing

without adjustment for inflation.

Real interest rate (r): the return to saving and the cost of borrowing after

adjustment for inflation.

How are the nominal and real interest rates related? The Fisher

equation: i = r+π

The equation written in this way is called the Fisher equation, after

economist Irving Fisher. It shows that the nominal interest rate can

change for two reasons: because the real interest rate changes or

because the inflation rate changes.

There are two versions of the Fisher equation:

Ex ante ("before the fact"): i = re +πe; i.e. chosen before know, uncertainEx post ("after the fact"): i = r+π; i.e. no uncertainty, determined orknown


(Conditional Mathematical) Expectations

What are expectations? Think of them as the "best guess" given the

available information at the time.

The concept of mathematical expectations arose in connection with

games of chance (i.e. gambling).

Expectations cannot be observed directly, but they can be measured

roughly by surveys.

A better way is to observe implicit expectations from bond interest

rates. More on this later in the course.

Symbols (Notation)

πe ≡ E[π] ≡ Et [πt+1|Informationt−1]

How are expectations formed and modeled? This will be answered

later in the course as well.


Irving Fisher (1867–1947)

Fisher was an American (mathematical) economist with a well deserved reputation forclear exposition. He contributed a great deal to the field of economics includingmodernizing the quantity theory of money, the Fisher equation, Fisher effect, and hewas a pioneer in the construction and use of price indexes.


Interest Rate Notes

Note: the equation given is approximate. The approximation is less

accurate the higher the levels of inflation and nominal interest rates.

The exact formula is:

re = 1+ i

1+πe −1

Central Banks are very interested in r since it may affect the savings

decisions of households and definitely affects the investment

decisions of firms. The press talks about Central Banks setting i, but

the Central Banks are really trying to set r.Two relatively easy ways of measuring expected inflation:

Recent actual inflation and the interest rate spread on nominal vs.inflation-indexed securities (TIPS).http://www.clevelandfed.org/research/data/inflation_

expectations/.Survey of forecastershttp://www.phil.frb.org/econ/liv/welcom.html


http://www.clevelandfed.org/research/data/inflation_expectations/

http://www.clevelandfed.org/research/data/inflation_expectations/

http://www.phil.frb.org/econ/liv/welcom.html

Common Interest Rates of Interest

Federal funds rate: the interest rate that the banks charge each other on overnight

loans.http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

The London Interbank Offered Rate (LIBOR) is the most active interest rate market in theworld. It is determined by rates that banks participating in the London money market offereach other for short-term deposits.http://www.moneycafe.com/personal-finance/libor/

The prime interest rate is the interest rate charged by banks to their most creditworthycustomers (usually the most prominent and stable business customers). The prime rate is abenchmark that banks often use in quoting interest rates to all of their customers. Forexample, a less well-known firm might be quoted a rate of "prime plus three-fourths", whichmeans that if the prime rate is, say, 10%, the firm would have to pay interest of 10.75%. Theprime rate depends on the cost of funds to the bank; it moves up and down with changes inthe economy. http://www.moneycafe.com/personal-finance/prime-rate/The three-month U.S. Treasury bill (T-Bill) Rate is probably the most widely followedshort-term interest rate. The interest rate on U.S. Treasury bonds (T-Bond) with ten years tomaturity is probably the most widely followed long-term interest rate since it is a generalindicator of long-term interest rate movements.


http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

http://www.moneycafe.com/personal-finance/libor/

http://www.moneycafe.com/personal-finance/prime-rate/

Why We Care About Inflation (Continued)

An example of how inflation can affect real returns.

Suppose you and I agree that a real rate of 0.05 over the next year isfair.

borrowing rate, salary growth rate, etc.

Suppose we also agree that expected inflation over the next year is 0.07

We should then set the nominal return equal to 0.12 (i = re +πe)

Summary:

i = 0.12re = 0.05πe = 0.07


Why We Care About Inflation (Continued)

Suppose that actual inflation is 0.10 (π>πe)

In this case, r = 0.02 (r = i−π)

Borrowers/Firms are better-offLenders/Workers worse-off

Suppose that actual inflation is 0.03 (π<πe)

In this case, r = 0.09 (r = i−π)

Borrowers/Firms are worse offLenders/Workers better off

Research has also shown that higher inflation rates are correlated with

more variability. People/firms do NOT like the uncertainty; i.e. they

are risk adverse.


Documents

Macroeconomics in the World Economy: Theory and ...€¦ · General Economics Economic (Logical) Fallacies Understanding Behavioral Equations Measurement of the National Economy Gross