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

Economic ReasoningModels: a model or theory is a

framework that helps us to understand relationships between cause and effect. They are a simplification of reality.

Economics

Basic Questions: Micro

Microeconomic QuestionsWhat should we produce?How should we produce?For whom should we produce?

Macroeconomic QuestionsHow 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?

Basic Questions: Macro

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

Savings and Investment

Firms Households

Income

Expenditures

Financial Markets SavingsBorrowings

Investment

SaversIndividualsBusinesses

Government

BorrowersIndividualsBusinesses

Government

Financial IntermediariesBanks

Pension fundsMutual funds

Financial Markets

Financial Intermediaries Financial intermediaries include banks,

insurance companies, investment companies, etc

Financial intermediaries act as the go-between 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 SectorBusiness SectorForeign SectorGovernment Sector

The demanders of credit or loanable funds:Government SectorBusiness SectorForeign SectorHousehold Sector

Financial Market: Participants

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

SavingsBorrowing

Investment

Government

HouseholdsFirms

Financial Markets

Income

Expenditures

Government Salaries and Transfers

Government Purchases ofGoods and Services Subsidies

Taxes Taxes

Government BorrowingGovernment Saving

The Role of Government: Market FailureInequity

Standards of fairness are determined by society and may not be met by the market’s distribution of benefits.

Failure of CompetitionMarkets may not be competitive.

• Regulation• Anti-trust

Public GoodsSome goods cannot be produced

profitably by the private market and as a result must be provided by government.

• Free Rider Problem

ExternalitiesSome activities provide benefits or impose

costs on others that are not captured by the the price system.

The Role of Government: Market Failure

The Role of Government: Market Failure

Underutilized ResourcesMacroeconomic stabilization

• Fiscal Policy• Monetary Policy

Circular Flow with Government and the Rest of the World

SavingsBorrowing

Investment

Foreign Borrowing Foreign Savings

Foreign Countries

Government

HouseholdsFirms

Financial Markets

Income

Expenditures

ExportsImports

Government Salaries and Transfers

Government Purchases ofGoods and Services Subsidies

Taxes Taxes

Government BorrowingGovernment Saving

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

servicesBuying and selling assets.

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.

The Rest of the World

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.

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.

What Is GDP?

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 GDPAn 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

ConsumptionNon-durable Goods (last less than 3 years)Durable Goods (last more than 3 years)Services

Gross Domestic InvestmentNon-residential lnvestment (plant and

equipment)Inventory ChangeResidential Investment

Government SpendingLocal and StateFederal

Net ExportsExports Minus Imports

Components of GDP: Expenditure Viewpoint

Components of GDP: Income ViewpointEmployee Compensation

Income 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.

Net InterestThe 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

Components of GDP: Income ViewpointRental 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.

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: Income Viewpoint

Components of GDP: Expenditure and IncomeExpenditure

GDP = C + I + G + (X-M)Income

NI (Y) = W + i + R + profitsSince NI and GDP measure

aggregate production, they must be equal.

GDP = NI 2001

Consumption 6,987.1 Durable Goods 835.9 Nondurables 2,041.3 Services 4,109.9

Investment 1,586.0 Nonresidential 1,201.6 Residential 444.7

Inventory Change -60.3 Government 1,858.0 Federal 628.1 State & Local 1,229.9

Net Exports -348.9 Exports 1,034.1 Imports 1,383.0

GDP 10,082.2

Employee Compensation 5,874.9Corporate Profits 731.6 Proprietors’ Income 727.9Net Interest 649.8Rental Income 137.9National Income 8,122.1+ CCA 1,329.3+ Indirect Business Taxes 774.8+ Business Transfers 42.5 - Subsidies 47.3+Statistical Discrepancy -117.3 GNP 10,104.1+Net Foreign Payments -21.9GDP 10,082.2

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

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 leisureSome expenditures are hidden from

data collectors

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.

What GDP Is Not

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 non-

institutional 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

Labor Force Participation Rate = Labor Force Adult Population X 100

X 100

Types of Unemployment Frictional Unemployment

Occurs due to normal turnover in the labor market. People changing jobs.

Structural UnemploymentRefers to workers who are not employed

because their skills are not in demand. Cyclical Unemployment

Occurs due to changes in the business cycle.

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.

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%

Inflation

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.

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.

The Costs of Inflation

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.

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.

Purchasing Power and Inflation

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.

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.

Inflation and Capital Gains

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.

GDP DeflatorThe 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

Price Indexes

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 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.

The GDP Deflator and the CPI

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. $357.77 Jurassic Park $354.16 Forrest Gump $336.38 Star Wars $273.30 Empire Strikes Back $200.50 The Sting $128.67 Gone with the Wind $ 76.35

Movies: Year Released

The Empire Strikes Back 1980 Gone with the Wind 1939 Forrest Gump 1994 The Sting 1973 Jurassic Park 1993 E.T. 1982 Star Wars 1977

Movies: Adjusted for Inflation

Gone with the Wind $859 Star Wars $628 E.T. $552 The Sting $397 Jurassic Park $375 The Empire Strikes Back $361 Forrest Gump $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

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