thinking like an economist. macroeconomic questions how can sufficient growth be attained so that...
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Thinking Like an Economist
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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
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The Economy as a Circular Flow
Resources
Firms Households
Goods and Services
Expenditures
Income
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Saving and Investment
Firms Households
Income
Expenditures
Financial Markets SavingsBorrowings
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SaversIndividualsBusinesses
Government
BorrowersIndividualsBusinesses
Government
Financial IntermediariesBanks
Pension fundsMutual funds
Financial Markets
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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.
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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.
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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.
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Inflation and Interest Rates
Nominal interest rates 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.
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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.
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Nominal Rates: The Fisher Effect
THE FISHER EFFECT:
NOMINAL RATE = REAL RATE + EXPECTED INFLATION
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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
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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
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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
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The Role of Government: Market Failure
Underutilized ResourcesMacroeconomic stabilization
• Fiscal Policy• Monetary Policy• Exchange Rate Policies
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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
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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.
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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
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Measuring GDP
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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.
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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?
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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.
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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
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Government SpendingLocal and StateFederal
Net ExportsExports Minus Imports
Components of GDP: Expenditure Viewpoint
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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.
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Net InterestThe portion of business receipts used
to pay for borrowed funds that finance investment purchases.
Components of GDP: Income Viewpoint
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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.
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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
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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.
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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 5874.9Corporate Profits 731.6 Proprietors’ Income 727.9Net Interest 649.8Rental Income 137.9National Income 8,122.1+ CCA 1329.3+ 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
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The Economy as a Circular Flow
Resources
Firms Households
Goods and Services
Expenditures
Income
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Saving and Investment
Economists make a clear distinction between saving and investment.Saving is the act of abstaining from
consumption.Investment is the result of purchasing a
new capital good.
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Saving and Investment: Closed Economy
Y = C + I + GG = IGOV + CGOV
Y = CNAT + INAT
CNAT = C + CGOV
INAT = I + IGOV
Y – CNAT = INAT
SNAT = INAT
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Savings = Investment: Closed Economy
In a closed economy, savings must just equal investment.If S > I, interest rates will fall and I will
rise.If S < I, interest rates will rise and I will
fall.
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Saving and Investment: Open Economy
Y = CNAT + INAT + NXNX = Exports – Imports
Y – CNAT – INAT = NX SNAT – INAT = NX
If SNAT = INAT, NX =0, trade balanceIf SNAT > INAT, NX >0, trade surplusIf SNAT < INAT, NX <0, trade deficit
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Looking at X - M
X represents the exports of a country.X is the income a country receives from
the rest of the world through exporting goods and services.
M represents the imports of a country.M is a country’s consumption of goods
and services produced by the rest of the world.
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Looking at X - M
X – M then is income minus consumption vis a vis the rest of the world.If X > M, a country has excess funds to
lend to the ROW, or S > I.If X < M, the country’s trading partner has
excess funds to lend to it or domestically S < I.
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S – I = NX
Net foreign investment (S - I) always equals the trade balance (NX).The international flow of funds to finance
capital accumulation and the international flow of goods and services are two sides of the same coin.
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Government and the Private Sector YD = Y + TR – T S = YD – C
YD = C + I + G + NX + TR – TYD = S + C
Set YD = YD and solve for NXS + C = C + I + G + NX + TR – TS + C – C – I – G – TR + T = NX
(S – I) + (T – TR – G) = NX
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Government and the Private Sector
(S – I) + (T – TR – G) = NX(S – I) = Private saving(T – TR – G) = Government saving
There are two ways the government can raise funds if G +TR > TIt can borrow at home, if S > I orIt can borrow from the ROW, if S < I or
NX < 0.
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Twin Deficits Problem
T < G + TRFederal government budget deficit.If S <=I, we must borrow from abroad.This will be possible only if the ROW has
excess funds or a trade surplus with us.
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Twin Deficits Problem
T > G + TRFederal government budget surplus.If S >= I, we may lend to the ROW.This will be occur only if the ROW has
insufficient saving or a trade deficit with us.
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Macroeconomic Problems
Unemployment Inadequate Growth Inflation
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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)
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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
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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.
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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.
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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 $1300 billion.
At 1993 levels, this loss in output would be about 3 months’ worth of production.
It cannot be made up.
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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.
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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
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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.
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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
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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.
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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
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Price Indexes
Consumer Price Index (CPI)Producer Price Index (PPI)GDP DeflatorGDP Price IndexPCE Price Index
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Price Indexes: Use
GDP in 2000 = P2000 times Q2000
GDP in 2002 = P2002 times Q2002
If we wish to compare GDP in 2002 with GDP in 2000, we must remove any price changes that have occurred.
Why?
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Price Indexes: Use
GDP 2002 = P2002 x Q2002
Divide by a price index = P2002/P2000
P2002Q2002 P2002 = P2002Q2002 x P2000 = Q2002P2000
P2000 P2002
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The
End