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Thinking Like an Economist
Economics Economics is a social science which
attempts to explain the behavior and interactions of economic actors in terms of the items of value they exchange.
Actors = individuals, households, firms, industries, governments or countries
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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