If you wish to make this more challenging, move the preceding slide so that it appears immediately after the answers to this exercise. If you are outside the U.S., please make the following changes: in (b), change the example to “A local manufacturer raises the price on industrial tractors it produces.” in (c), change “U.S.” to your country’s name, unless your country’s name is Italy. (If your country is Italy, then change the example to something involving an imported consumer good.)
Explanations: A. Frappuccinos are produced in the U.S., so their prices are part of the GDP deflator. They are purchased by consumers, so their prices are part of the CPI. Hence, an increase in the price of Frappuccinos causes both the CPI and GDP deflator to increase. B. Since the tractors are produced here in the U.S., the price increase causes the GDP deflator to rise. However, industrial tractors are a capital good, not a consumer good, so the CPI is unaffected. C. Italian jeans appear in the U.S. consumer’s shopping basket, and hence the increase in their price causes the CPI to rise. However, the GDP deflator is unchanged, because it only includes prices of domestically produced goods, and excludes the prices of imports.
Source of data: Bureau of Labor Statistics, www.bls.gov
These data are hypothetical. I can not be held responsible if students subliminally acquire the perception that majoring in economics is a good thing to do.
The figure is constructed using quarterly data from the U.S. Note: The nominal interest rate is the rate on a three-month Treasury Bill. The real interest rate is the same, minus the inflation rate as measured by the percentage change in the CPI. Notice that the nominal and real interest rates often do not move together, indicating that the real interest rate varies over time. Sources: CPI – Bureau of Labor Statistics Treasury bill rate – Board of Governors of the Federal Reserve System. I obtained both from the Federal Reserve Bank of St. Louis “Fred” database: http://research.stlouisfed.org/fred2/
The “definition” of capital shown on this slide (“buildings and machines”).
In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram). To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide. Changing the animation on this slide: If you wish, you can easily change the order in which the markets and arrows appear. From the “Slide Show” drop-down menu, choose “Custom Animation…” Then, a box will appear (maybe along the right-hand-side of your PowerPoint window) that allows you to modify the order in which things appear (as well as other aspects of the animation). For further information, open PowerPoint help and search on “change the sequence of animations.”
Econ 110A 1
The Big Picture 1
The Problem….. Fluctuations around the expected trend in economic growth
Business Cycles … a type of fluctuation found in the aggregate economic activity of nations who organize their work mainly in business enterprises : a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals and expansions . . .; business cycles vary from more than one year to ten or twelve years . . . - Arthur F. Burns and Wesley C. Mitchell, 1946
The Business Cycle Cyclical Expansion Begins The Recession becomes a Contraction Peak Trough Revival
The Business Cycle Cyclical Expansion Begins The Recession becomes a Contraction Peak Trough Revival
A Recession? Business Cycle Dating Committee “NBER” The Three “D’s” Duration Depth Diffusion Two Months % Change in Real GDP & Un/E Rate % Industries w/ Declining Emplmt http://www.econlib.org/library/Enc1/Recessions.html
Prediction “Conference Board” <ul><li>More than 250 series covering the most important aspects and sectors of the U.S. economy, such as: </li></ul><ul><li>Employment and unemployment; </li></ul><ul><li>Personal income and industrial production; </li></ul><ul><li>Interest rates and money supply; </li></ul><ul><li>Consumer price indexes </li></ul>
Prediction “Conference Board” <ul><li>The Index of </li></ul><ul><li>Leading, Lagging, and Coincident </li></ul><ul><li>Indicators </li></ul><ul><li>For most industrialized countries. </li></ul><ul><li>6-11 measures of economics activity </li></ul><ul><li>Published monthly. </li></ul>
Indicators “BCI” Of a change in the direction of economic growth. Leading - new orders, backlogs, permits Coincident - employment & consumption Lagging - labor costs, interest rates
Output The annual aggregate value of final goods & services produced and sold at current prices. GDP “D” domestic factors (any) of production GNP “N” domestically-owned factors of production (anywhere)
Data GDP GNP Per ca p ita Luxemburg $ 87,000 $ 45,000 USA $ 46,000 Liberia $ 16 Mozambique $ 80 USA (2009) $ 14 trillion (2.4%) over ‘08 USA Gov’t Debt $ 13 trillion rising $ 4B/day
Prices The goal is stable prices. Inflation and Deflation both distort economic behavior. The CPI 1971-77 + 47.4 percent 1999-08 + 17.2 percent 2008 + 3.8 percent 2009 - 0.4 percent * 2010 + 0.9 percent in the 1 st quarter * First decline in the CPI since 1955. GDP deflator + 1.36%.
The C.P.I. (BLS) A weighted (by portions) index of the average prices of a basket (about 159 items) of Good & Services purchased (CES survey data) by urban households. There are 7 product groups: Food & Bev 15%, Housing 42% , Apparel, Transportation 17% , Medical, Recreation, Education & Communications, Other. With sub-groups & strata. Revised periodically (last 1998): added - alcohol away, parking fees, car leases, cell phones (dropped long distance charges recently).
Substitution Bias <ul><li>Changes in relative prices causes consumers to substitute into relatively cheaper goods. </li></ul><ul><li>The CPI misses this substitution because it uses a fixed basket of goods. </li></ul>Thus, the CPI overstates increases in the cost of living.
Newer Goods <ul><li>New goods allow consumers to find products that more closely meet their needs, which makes each dollar more valuable. </li></ul><ul><li>The CPI misses this effect because it uses a fixed basket of goods. </li></ul>Thus, the CPI overstates increases in the cost of living.
Improvements – increases in Quality <ul><li>Improvements in the quality of goods in the basket increase the value of each dollar. </li></ul><ul><li>In particular, computing devices improve while computing costs decline. </li></ul>Thus, the CPI overstates increases in the cost of living.
<ul><li>Imported consumer goods: </li></ul><ul><ul><li>included in CPI </li></ul></ul><ul><ul><li>excluded from GDP deflator </li></ul></ul>The CPI and the GDP Deflator <ul><li>The basket: </li></ul><ul><ul><li>CPI uses fixed basket </li></ul></ul><ul><ul><li>GDP deflator uses basket of currently produced goods & services. </li></ul></ul><ul><li>This matters if different prices are changing by different amounts. </li></ul><ul><li>Capital goods: </li></ul><ul><ul><li>excluded from CPI </li></ul></ul><ul><ul><li>included in GDP deflator (if produced domestically ) </li></ul></ul>
CPI vs. GDP deflator <ul><li>The effects on the CPI and the GDP deflator. </li></ul><ul><ul><li>Starbucks raises the price of Frappuccinos. </li></ul></ul><ul><ul><li>Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. </li></ul></ul><ul><ul><li>C. Armani raises the price of the Italian jeans it sells in the U.S . </li></ul></ul>
Answers <ul><li>The CPI and GDP deflator both rise. </li></ul><ul><li>The GDP deflator rises, the CPI does not. </li></ul><ul><li>C. The CPI rises, the GDP deflator does not. </li></ul>
Comparing Dollar Figures from Different Times <ul><li>Inflation makes it difficult to compare dollar amounts from different times. </li></ul><ul><li>We can use the CPI to adjust figures so that they can be compared. </li></ul>
The Price of Gasoline <ul><li>Price of a gallon of regular unleaded gas: </li></ul><ul><ul><li>$1.42 in March 1981 </li></ul></ul><ul><ul><li>$2.50 in August 2005 </li></ul></ul><ul><li>To compare these figures, we will use the CPI to express the 1981 gas price in “2005 dollars.” Question: what gas in 1981 would have cost if the cost of living were the same then as in 2005. </li></ul>Answer: Multiply the 1981 gas price by the ratio of the CPI in 2005 to the CPI in 1981.
Solution: The Real Price of Gasoline <ul><li>1981 gas price in 2005 dollars </li></ul><ul><li>= $1.42 x [196.4/88.5] = $3.15 </li></ul><ul><li>After correcting for inflation, gas was more expensive in 1981. </li></ul>$2.50 $3.15 Gas price in 2005 dollars Ratio = 2.22 x 196.4 $2.50 2005 88.5 $1.42 1981 CPI Price per Gallon Date
Exercise <ul><li>2000: CPI = 152.4 </li></ul><ul><li>Starting salary for economic majors = $34,000 </li></ul><ul><li>Today: CPI = 195.3 </li></ul><ul><li>Starting salary for economic majors = $48,000 </li></ul><ul><li>Are economic majors better off today than in 2000? </li></ul>
Solution <ul><li>1980: CPI = 152.4 Starting salary for econ majors = $34,000 </li></ul><ul><li>Today: CPI = 195.3 Starting salary for econ majors = $48,000 </li></ul>Solution Convert 2000 salary of $34,000 “today’s dollars” $34,000 x (195.3/152.4) = 1.28 x $34,000 = $43,520. After adjusting for inflation, salary is higher today than in 2000.
Real vs. Nominal Interest Rates <ul><li>The nominal interest rate is: </li></ul><ul><ul><li>the interest rate which is not corrected for inflation. </li></ul></ul><ul><li>The real interest rate is: </li></ul><ul><ul><li>corrected for inflation. </li></ul></ul>Real interest rate = (nominal interest rate) – (inflation rate)
Real and Nominal Interest Rates EXAMPLE <ul><li>Suppose you deposited $1,000 for one year. </li></ul><ul><li>Suppose nominal interest rate in that year is 9%. </li></ul><ul><li>Suppose during that year, inflation is 3.5%. </li></ul><ul><li>Calculate the real interest rate. What happened to purchasing power of your $1000 ? </li></ul><ul><li>Real interest rate = Nominal interest rate – Inflation </li></ul><ul><li>= 0.09 – 0.035 = 0.055 = 5.5% </li></ul><ul><li>Thus, the purchasing power of the $1000 you deposited has grown by 5.5%. </li></ul>
Employment Population Population > 15 but < 66 Less the institutionalized (prisons, etc.), Armed Forces, stay at home parents, retired persons, some others. Labor Force includes the unemployed, discouraged, etc. Labor Force World 3 Billion USA 153 million 49% women 40% of employed women are in management or professional occupations.
Unemployment Rate Monthly labor force surveys. 60,000 households. U1: Percentage of labor force unemployed 15 weeks or longer. U2: Percentage of labor force who lost jobs or completed temporary work. U3: Official unemployment rate per ILO definition - currently not working but are willin g, able , and available to work for pay, and are activel y searchin g for work. U4: U3 + " discouraged workers “, U5: U4 + other "marginally attached workers“. U6: U5 + Part time workers who want to work full time.
Types of Unemployment Frictional – location & season, skill mismatch – informational inefficiencies in the labor market. Cyclical - due insufficient Aggregate Demand Structural – technological change and disruptions, globalization causing skill mismatch. Classical - due to rigidities in labor markets and institutional disincentives.
Unemployment At the end of 2009, the proportion of the unemployed who had been jobless for 27 weeks or longer was the highest since 1948 . On Saturday (July 3 rd ) the number of people cut from unemployment benefits will surge to 1.63 million. By mid-July, about 2 million unemployed Americans could lose their benefits.
Data “BLS” Q2 2010 Unemployment rates were higher in May than a year earlier in 222 of the 372 metropolitan areas, lower in 141 areas, and unchanged in 9 areas. In May, 270 metropolitan areas reported over-the-year decreases in nonfarm payroll employment, 95 reported increases, and 7 were unchanged. In May, employers took 1,412 mass layoff actions involving 135,789 workers .
Data “BLS” Quarterly Census of Employment and Wages (QCEW) Metropolitan Area Employment and Unemployment (Monthly) Mass Layoffs (Monthly)
History To 1776 Mercantilists vs Smith “ Wealth of Nations” 19 th Century Classical Economics Says’ Law some fundamental I/O work 20 th Century Great Depression 1936 Keynes “General Theory” later Neoclassical Economics Game Theory Significant advances in computing Today waiting for the revolution
The Classical View – Says’ Law <ul><li>Supply creates its own demand . </li></ul><ul><li>Production creates demand sufficient to purchase all goods and services produced. </li></ul><ul><li>Implies that there cannot be either </li></ul><ul><li>(1) a general overproduction of goods (where supply in the economy is greater than demand in the economy), or </li></ul><ul><li>(2) a general underproduction of goods (where demand in the economy is greater than supply in the economy). </li></ul>
A barter economy? <ul><li>You produce good X only so that you can use it to demand other goods. </li></ul><ul><li>The act of supplying is motivated by the desire to demand. </li></ul><ul><li>Supply and demand are opposite sides of the same coin. </li></ul>
Say’s Law in a Money Economy <ul><li>If consumption drops, then saving rises, and economic forces produce an equivalent increase in investment. </li></ul><ul><li>C↓ S↑ -> I↑ </li></ul>The classical economists argued that saving (S) is matched by an equal amount of investment (I) because of interest rate (i) flexibility in the credit market.
Savings and Investment are linked in the Loanable Funds market
If Saving rises and Consumption falls, will total spending in the economy decrease? <ul><li>No. </li></ul><ul><li>Total spending will not decrease. </li></ul><ul><li>For classical economists, an increase in saving (reflected by a decrease in consumption) will lower the interest rate and stimulate investment spending. </li></ul><ul><li>So one spending component (consumption) goes down, and another spending component (investment) goes up. </li></ul><ul><li>Moreover, according to classical economists, the decrease in one spending component will be completely offset by an increase in another spending component so that overall spending does not change. </li></ul>
What is the Classical position on prices and wages? <ul><li>Prices and wages are flexible ; they move up and down in response to market conditions. </li></ul>
Policy Implication of Believing the Economy is Self-Regulating Laissez-faire Classical, new classical, and monetarist economists believe that the economy is self-regulating. For these economists, full employment is the norm: The economy always moves back to Natural Real GDP .
Simple Model <ul><li>A 2-Sector Circular-Flow: A visual model of how dollars flow through markets among households and firms. </li></ul><ul><li>Two types of “actors”: </li></ul><ul><ul><li>households </li></ul></ul><ul><ul><li>firms </li></ul></ul><ul><li>Includes two markets: </li></ul><ul><ul><li>the market for goods and services </li></ul></ul><ul><ul><li>the market for “factors of production” </li></ul></ul>CHAPTER 2 THINKING LIKE AN ECONOMIST
Factors of Production <ul><li>The factors of production include: </li></ul><ul><ul><li>labor </li></ul></ul><ul><ul><li>land </li></ul></ul><ul><ul><li>capital (buildings & machines used in production) </li></ul></ul><ul><ul><li>entrepreneur </li></ul></ul>CHAPTER 2 THINKING LIKE AN ECONOMIST
The Circular-Flow Diagram Markets for Factors of Production Households Firms Income Wages, rent, profit Factors of production Labor, land, capital Spending G & S bought G & S sold Revenue Markets for Goods & Services