Economics 121 Principles of Macroeconomics …...Gross Domestic Product (GDP) Inﬂation...

Gross DomesticProduct (GDP)

Inflation

Unemployment

Economics 121Principles of Macroeconomics

Foundations: Macroeconomic Fundamentals

Dennis C. Plott

University of Illinois at ChicagoDepartment of Economicswww.dennisplott.com

Summer 2015

Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 – Summer 2015 1 / 85

www.dennisplott.com


Definition

Calculating GDP

Nominal versus RealGDP

Limitations andCriticisms of GDP

Other Measures ofTotal Production andTotal Income

Inflation

Unemployment

Goals of This Section

Ï Over the course of the semester, we will explore many aspects of the economy,including how all of the elements relate to one another.

Ï For this section, we have a less lofty goal: to figure out how to measure the totaloutput of an economy.

Ï Being able to measure total output is incredibly important, since much ofmacroeconomics depends on our ability to measure and predict aggregateeconomic activity.



Definition

Calculating GDP




Inflation

Unemployment

Measuring Total Production: Gross Domestic Product (GDP)

Ï The most common measure used by economists of overall economic activity inan economy is gross domestic product, or GDP.

DefinitionGross domestic product (GDP): the market value of all final goods and servicesproduced in a country during a period of time, typically one year or quarter.

Ï We will examine each of the parts of this definition in turn.Ï Why Do We Care?

Ï 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.)

Ï Who Measures GDP?Ï The Bureau of Economic Analysis (BEA) (www.bea.gov)Ï GDP is reported quarterly and annually, although there are monthly revisions as

late as years after the initial reports.


www.bea.gov


Definition

Calculating GDP




Inflation

Unemployment

Gross Domestic Product (GDP)

Ï “. . . market value . . . ”Ï We cannot add together the number of cars, melons, haircuts, and all other goods

and services without agreeing on a common way to measure them.Ï The best practical way is to value each good and service in monetary terms; and

the best measure of this that we have is the price that each good or service is soldfor.

Ï “. . . final goods and services . . . ”Ï A final good or service is a good or service purchased by a final user. These are

what are used to calculate GDP.Ï Why? If we counted intermediate goods and services as well, ones that were inputs

into another good or service, then we would end up double-counting.

Ï Example: if we counted the value of the ice cream bought by a grocery store, andalso counted the value of that ice cream when it was sold to a consumer, wewould be double-counting the wholesale value of the ice cream.



Definition

Calculating GDP




Inflation

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Gross Domestic Product (GDP)

Ï “. . . during a period of time . . . ”Ï To measure total output in a given year (quarter), we measure the goods and

services produced only in that given year (quarter).Ï Again, this avoids double-counting: if you buy a DVD in 2014, that DVD counts in

2014’s GDP. If you resell it in 2015, it will not count again in 2015.Ï So GDP counts only new goods and services. Used items were previously produced

and counted, so don’t need to be counted again.



Definition

Calculating GDP




Inflation

Unemployment

Production and Income

Ï There are two main conceptual ways to measure the total economic activity inan economy: total production or total income.

Ï When we measure one, we are also measuring the other.Ï Why? Everything that is produced and sold constitutes income for someone; so

we have the choice of measuring the value of products produced and sold, or thevalue of incomes, and each is a valid way of measuring economic activity.



Definition

Calculating GDP




Inflation

Unemployment

Follow the Spending to Measure GDP

Ï To measure GDP, the Bureau of Economic Analysis (BEA) in the Department ofCommerce measures four major categories of expenditures:

Ï Personal Consumption Expenditures, or “Consumption” (C)Ï Gross Private Domestic Investment, or “Investment” (I)Ï Government Consumption and Gross Investment, or “Government Purchases”

(G)Ï Net Exports of Goods and Services, or “Net Exports” (NX)

Ï GDP can be expressed as the sum of these:

Y = C + I +G+NX

Ï We will examine each component of GDP in turn.



Definition

Calculating GDP




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Consumption

Ï Consumption is spending by households on goods and services, not includingspending on new houses (which are counted instead in investment).

Ï In BEA statistics, consumption is further divided into expenditure on services,durable goods, and non-durable goods.

Ï The Sum of Durables (lasting three years or more), Non-Durables, and ServicesPurchased Domestically by Non-Businesses and Non-Governments (i.e.,individual consumers).

Ï Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables).



Definition

Calculating GDP




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Investment

Ï Investment is spending by firms on new factories, office buildings, andadditions to inventories, plus spending by households and firms on newhouses.

Ï The BEA measures the following categories of investment: business fixedinvestment, residential investment, and changes in business inventories.

Ï This last category includes goods that have been produced but not yet sold.

Ï Includes:Ï All final purchases of machinery, equipment, and tools by businesses.Ï All construction (including residential structures).Ï Changes in business inventory.



Definition

Calculating GDP




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Investment (Continued)

Ï Excludes intermediate goods (i.e., goods used-up during production in thesame period that they themselves were produced–note the difference withequipment/capital goods which last for several periods).

Ï Land purchases are NOT counted as part of GDP (land is not produced!)

Ï Stock purchases are NOT counted as part of GDP (stock transactions do NOTrepresent production – they are saving. More on saving later.)

Ï Important: There is a difference between financial and economic investment!



Definition

Calculating GDP




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Unemployment

Adding More of Lady Gaga to GDP

Ï The BEA continually studies ways to improve its measurement of GDP.Ï In 2013, the BEA started counting R&D as investment, rather than an

intermediate good, so as to emphasize the importance of intellectual property.Ï A consequence is that money spent on development of, say, entertainment

products, now gets counted as investment.Ï So the money spent by Lady Gaga and her record company on writing and

recording her songs is now included in the investment component of GDP.



Definition

Calculating GDP




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Unemployment

Government Purchases

Ï Government purchases are spending by federal, state, and local governmentson goods and services, such as teachers’ salaries, highways, and aircraftcarriers.

Ï For the U.S., state and local levels (police and fire protection, school teachers,snow plowing) and the federal level (President, Missiles).

Ï This does not include transfer payments, since those do not result inimmediate production of new goods and services.

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

Ï Examples of transfer payments: Welfare and Social Security



Definition

Calculating GDP




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Net Exports

Ï Net exports are defined as the value of exports minus the value of imports. Thisdifference might be positive or negative; in recent years, this has been negativein the United States.

Ï Since we want to count domestic production (production in the United States),we add up the value of the goods and services sold to foreigners, and subtractoff the value of the goods and services sold to Americans by foreigners.

Ï Net Exports (NX): Exports (EX) − Imports (IM);Ï Exports: The Amount of Domestically Produced Goods Sold on Foreign SoilÏ Imports: The Amount of Goods Produced on Foreign Soil Purchased

Domestically.



Definition

Calculating GDP




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Simple Examples

Ï Suppose I produce tablets; e.g., an iWhatever. If so, I could:Ï sell it to some domestic customer (Consumption)Ï sell it some business (Investment)Ï keep it in my stock room as inventory (Investment)Ï sell it to the city of Chicago to use in their offices (Government spending)Ï sell it to some foreign customer (Export)

Ï Only include expenditures for goods that are “newly produced”.Ï If I give $10 to a movie theater to watch a movie, it is counted as expenditure.Ï If I give $10 to my nephew for a birthday present, it is not counted as expenditure.Ï If I give $10 to the ATM machine to put in my savings account, it is not counted as

expenditure.

Ï The second example would be considered a “transfer” (once I give $10 to mynephew, he can go to the movies if he wanted to – once that $10 is spent, it willshow up in GDP).

Ï The third example is considered “saving” (I am delaying expenditure until thefuture). Once I spend the $10 future GDP in the future, it will show up in GDP.



Definition

Calculating GDP




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Unemployment

Components of GDP in 2012

Ï Consumption is the largest component of GDP; within that, services are thelargest component – almost half of GDP.

Ï American net exports are negative, since the value of our imports exceeds thevalue of our exports.



Definition

Calculating GDP




Inflation

Unemployment



Definition

Calculating GDP




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Unemployment

Some Examples of GDP Calculations

Ï If the following transactions took place in 2015 which would count toward GDP for 2015?Ï Social security payments received by a retired factory worker.Ï The purchase of an insurance policy.Ï The sale of brand new tires.Ï A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs tests

flights before delivery as of 31st December 2015.Ï A newly married couple purchases a newly constructed house.Ï A house constructed in 2010 is sold again in January 2014.



Definition

Calculating GDP




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Unemployment

Measuring GDP Using the Value-Added Method

Ï An alternative method to measure GDP is to measure the value added: themarket value a firm adds to a product.

Ï The final selling price of a product must equal the sum of the values added tothe product at each stage of production.

Ï The table below illustrates this method for a shirt sold on L.L.Bean’s web site.



Definition

Calculating GDP




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Unemployment

Using Value Added to Measure the True Size of Wal-Mart

Ï How can we use economic analysis to compare the size of a major corporationto the size of a country?

Ï During 2008, Wal-Mart’s sales were approximately $374 billion, nearly 2.6percent of U.S. GDP. Some social commentators might want to measure theimpact of Wal-Mart just through its sales. But to produce those sales, Wal-Marthad to buy goods from many other companies.

Ï Based on Wal-Mart’s annual reports, its cost of sales was $286 billion, leavingapproximately $88 billion in value added.

Ï If we used Wal-Mart’s sales to compare it to a country, it would have a GDPsimilar to that of Belgium, which is ranked 28th in the world.

Ï However, using the more appropriate measure of value added, Wal-Mart’s sizeis closer to Bulgaria, ranked 56th in the world.



Definition

Calculating GDP




Inflation

Unemployment

“Expenditure” Equals “Income”: A Simple Example

Ï What buyers spend (expenditure) equals what sellers receive (income)Ï Suppose I sell a glass of lemonade for $1.00Ï I just use lemons, sugar, and water to make the lemonade. The water costs $0.01

per glass, the sugar costs $0.09 per glass, and the lemons costs $0.20 per glass.Ï Income/Profit for me is $0.70Ï The same procedure is used for the people who sell water ($0.01 of income), for

the people who sell the sugar ($0.09 of income), and for the people who sell thelemons ($0.20 per glass).

Ï The $1.00 spent on a glass of lemonade resulted in $1.00 worth of income forvarious people (the $1.00 ended up in someone’s pocket).



Definition

Calculating GDP




Inflation

Unemployment

Calculating Real GDP

Ï Since GDP is measured in “value” terms, we might have problems interpretingchanges over time if prices change. Is an increase in GDP due to productionincreasing, or due to prices increasing?

Ï To separate these effects, the BEA calculates both nominal GDP – the value offinal goods and services evaluated at current-year prices – and real GDP – thevalue of final goods and services evaluated at base-year prices.

Ï The choice of a base-year is arbitrary; we might use any year’s prices tocompare real GDP in each year. The current standard is 2009.

Ï Unfortunately, the relative prices also change from year to year, distorting realGDP calculations. Since 1996, the BEA has overcome this problem by usingchain-weighted prices, using previous-year prices to adjust current-yearproduction measure.



Definition

Calculating GDP




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Calculating Real GDP: An Example

Ï The table shows output and prices in 2009 and 2015.Ï Calculating the total value of output in 2009 gives:

$3200+$990+$1350 = $5540.Ï To calculate real GDP in 2015, we use the prices from 2009.

Ï This gives real 2015 GDP in 2009 dollars of $6680.Ï Most prices increased from 2009 to 2015, so using nominal GDP would have

yielded a higher figure: $7800.Ï This highlights the need to use real GDP to avoid exaggerating growth.



Definition

Calculating GDP




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Comparing Real GDP and Nominal GDP

Ï The current base year for calculating prices is 2009, so real and nominal GDPare equal in 2009.

Ï Growth figures reported in the media are the growth in real GDP.Ï Since prices have generally increased since 2009, real GDP is less than nominal

GDP, and the opposite is true before 2009.



Definition

Calculating GDP




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Unemployment

The GDP Deflator

Ï Economists and policy-makers are interested in the price level: a measure ofthe average prices of goods and services in the economy.

Ï Why? Stable prices are desirable because they allow households and firms to planfor the future appropriately.

Ï In order to know whether we are achieving price stability, we need to measurethe price level.

Ï One way to do this is using the GDP deflator: a measure of the price level,calculated by dividing nominal GDP by real GDP and multiplying by 100:

GDP deflator = Nominal GDP

Real GDP×100

Ï Since nominal and real GDP will be the same in the base year, the GDP deflatorwill be 100 in the base year.



Definition

Calculating GDP




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Calculating the GDP Deflator

Ï The table below gives the values of nominal and real GDP for 2011 and 2012.

Ï We can use this to calculate the GDP deflator in each year:

Ï The GDP deflator increased from 103 to 105 between the two years. This is a1.9% increase: (

105−103

103

)×100 = 1.9%

So we say the price level rose 1.9% over this period.



Definition

Calculating GDP




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Unemployment

Shortcomings of GDP – What GDP Is NOT

Ï GDP can be a useful tool to measure total output in an economy. Many peoplego further than this, interpreting GDP as a measure of the well-being ofcitizens.

Ï However GDP has shortcomings, both in its measure of total production, and inits usefulness as a measure of well-being.

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

“The gross national product does not allow for the health of our children, thequality of their education, or the joy of their play. It does not include the beauty ofour poetry or the strength of our marriages, the intelligence of our public debate orthe integrity of our public officials. It measures neither our courage, nor ourwisdom, nor our devotion to our country. It measures everything, in short, exceptthat which makes life worthwhile, and it can tell us everything about Americaexcept why we are proud to be Americans.”

– U.S. Senator Robert F. Kennedy, 1968Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 – Summer 2015 26 / 85


Definition

Calculating GDP




Inflation

Unemployment

Shortcomings of GDP as a Measure of Total Production

Ï Two important types of production are omitted from the BEA’s measurement ofGDP:

1. Household ProductionÏ Household production such as childcare, cleaning, and cooking is not typically paid

for with money. However such contributions are real – if they were performed by anon-household-member, they would be paid for and counted in GDP.

2. The Underground EconomyÏ Buying and selling of goods and services might be concealed from the government to

avoid taxes or regulations, or because the goods and services are illegal. Thisconstitutes the underground economy.

Ï This is estimated to be approximately 10% of the economy in America, andsubstantially more in low-income households.



Definition

Calculating GDP




Inflation

Unemployment

How Important Are These Shortcomings?

Ï If we are comparing GDP from year to year, the size of household productionand the underground economy is probably about the same from year to year,so GDP growth is a reasonable measure of the growth in total production.

Ï However over long periods of time, these shortcomings might be more serious.

Ï Example: As women have entered the workforce in larger numbers, somehousehold production has been replaced by paid childcare and restaurantmeals. So increases in GDP may exaggerate the increase in actual totalproduction.



Definition

Calculating GDP




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Underground Economies in Developing Countries

Ï In developing countries, the underground economy is often referred to as theinformal sector, as opposed to the formal sector, in which output of goods andservices is measured.

Ï In many developing countries, the informal sector is very large; often above 50%of total output.

Ï Economists studying economic development say this often reflects poorgovernment policies: high taxes and regulations and low confidence in thesecurity of private property from government seizure.



Definition

Calculating GDP




Inflation

Unemployment

Shortcomings of GDP as a Measure of Well-Being

Ï GDP per capita (i.e., GDP divided by population) is often used to representdifferences in standards of living from country to country. However, even if itaccurately measured total production, it would not reflect:

Ï The value of leisure or increased product qualityÏ GDP and the environment – pollution and other negative effects of production

Ï 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 ofa clear unobstructed view).

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

Ï Crime and other social problemsÏ The distribution of income

Ï In fact, improvements in many of these will result in lower GDP per capita.

Ï Example: Lower crime would allow lower spending on police, prisons, andprivate security. This would decrease GDP, but surely result in improvements ineconomic well-being.



Definition

Calculating GDP




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Did World War II Bring Prosperity?

Ï World War II was a period of extraordinary sacrifice and achievement by the“greatest generation”.

Ï But statistics on GDP may give a misleading indication of whether it was also aperiod of prosperity:

Ï Production was very high, but much of the production was of military goods – sopeople weren’t becoming more well-off.

Ï After the war, GDP fell; but the production of consumption goods rose rapidly.



Definition

Calculating GDP




Inflation

Unemployment

National Income and Product Accounts (NIPA)

Ï The BEA is charged with performing national income accounting for the UnitedStates. Each quarter, it publishes the National Income and Product Accountstables.

Ï These include GDP computations, but also:Ï Gross National Product (GNP): Production performed by citizens of a nation,

including overseas production (as opposed to GDP, which is performed withinnational borders)

Ï Example: A new Mercedes-Benz M-Class (SUV) made in Alabama is counted towardU.S. GDP, but Germany’s GNP.

Ï The difference between GNP and GDP is small for the United States, about 0.2%, buthigher for countries that have many citizens working abroad; e.g., the Philippines

Ï National Income: GDP minus the consumption of fixed capital; i.e., GDP minusdepreciation

Ï Personal Income: Income received by households; includes transfer payments,but excludes firms’ retained earnings

Ï Disposable Personal Income: Personal income minus personal tax payments; thismeasures the amount that households are able to spend or save



Definition

Calculating GDP




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NIPA Measurements

Ï The graph below shows the various measures of the national income accountsfor the United States in 2012.

Ï National income must be smaller than GDP, since it is just GDP minusdepreciation.

Ï Similarly, disposable personal income must be less than personal income, sinceit is just personal income minus taxes.

Ï Each measure is useful in different contexts.



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Calculating GDP




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Total Production = Total Income

Ï All production must be rewarded with income; so in theory, we could counteither in order to calculate GDP.

Ï In practice, data limitations make us unlikely to come up with the same number;there will always be some statistical discrepancy.

Ï The figure illustrates the division of income as measured by the BEA in 2012.



Definition

Calculating GDP




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Simon Kuznets (1901-1985) – Nobel Prize 1971

Simon Kuznets provided the methodology for modern national-income accounting anddeveloped the first reliable national-income measures for the United States. Kuznets is oftenreferred to as the "father of national-income accounting". A native Russian, he immigratedto the United States at the age of 21 and spent his academic career teaching at the Universityof Pennsylvania, Johns Hopkins University, and Harvard University.



Definition

Calculating GDP




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Common Misconceptions to Avoid

Ï “Investment” in reference to national income accounting has a very narrowdefinition: purchases of things like machines, factories, and houses. It refersonly to the purchase of new items, not trades in financial instruments based onthose items.

Ï We based statements about growth on GDP; but GDP has limitations, both as ameasure of total production, and as a measure of well-being.

Ï In order to make useful comparisons, concentrate on real GDP rather thannominal GDP.

Ï In calculating real GDP, the choice of base year is largely arbitrary; there is no“correct” base year.



Inflation

Measuring Inflation

Adjusting for Inflationusing Price Indexes

Nominal Interest Ratesversus Real InterestRates

The Costs of Inflation

Hyperinflation

Unemployment

Measuring Inflation

Ï Last section, we learned about how to measure total output – a critical first stepin understanding the economy.

Ï In this section, we continue along these lines, learning about how to measureinflation.

Ï This is a very important and commonly-used macroeconomic concept; wewant to solidify what it means, so that we can talk intelligently about it.



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Measuring Inflation




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Price Level and Inflation Rate

DefinitionPrice level: a measure of the average prices of goods and services in the economy.

Ï We refer to the percentage increase in the price level (P) from one year to thenext as the inflation rate (π).

π= Pt −Pt−1

Pt−1×100

Ï Last section we used the GDP deflator to measure changes in the price level. Bymeasuring changes in the prices of different baskets of goods, we would comeup with different measures.

Ï Two commonly-used measures are:1. The consumer price index (CPI)2. The producer price index (PPI)

Ï We will examine each in turn.



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Measuring Inflation




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Inflation, Deflation, and Disinflation

Ï Inflation is a rise in the general level of prices of goods and services in aneconomy over a period of time.

Ï Disinflation is a decrease in the rate of inflation – a slowdown in the rate ofincrease of the general price level of goods and services over a period of time.

Ï For example if the annual inflation rate for the month of January is 5% and it is 4%in the month of February, the prices disinflated by 1% but are still increasing at a4% annual rate.

Ï Deflation is a decrease in the general price level of goods and services.Ï Deflation occurs when the inflation rate falls below 0%.



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Measuring Inflation




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Consumer Price Index (CPI)

DefinitionConsumer price index (CPI): a measure of the average change over time in theprices a typical urban family of four pays for the goods and services they purchase.

Ï The chart shows the composition of the basket of goods used to create the CPI.This basket of goods derives from a survey of 14,000 households by the BLS.



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Calculating the CPI

Ï To calculate the CPI in a given year, we need:Ï A basket of goodsÏ The cost to purchase the basket of goods in a base yearÏ The prices in the current year

Ï The CPI in the current year is the cost to purchase the basket of goods this year,divided by the cost in the base year. By convention, we multiply this by 100, sothat the CPI in the base year is 100.



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A Simple CPI Calculation

Ï The table above gives the information we need to create the CPI in 2014 and2015, using the basket of goods from 1999.



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A Simple CPI Calculation (Continued)

Ï Based on these data, the inflation rate from 2014 to 2015 is the percentagechange in the CPI:

122−120

120×100 = 1.7%

Ï Since the CPI measures consumer prices, it is often referred to as thecost-of-living index. CPI-inflation is sometimes used to generate “fair”increases in wages for workers, and government benefits.



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Is the CPI an Accurate Measure of Inflation?

Ï Some potential problems with the CPI include:Ï Substitution bias: Consumers may change their purchasing habits away from

goods that have increased in price.Ï Increase in quality bias: Products like cars and computers have become more

durable and better quality over time. It is hard to isolate the pure-inflation part ofprice increases.

Ï New product bias: The basket of goods changes only every 10 years. There is adelay to including new goods like cell phones.

Ï Outlet bias: Increases in purchases from discount stores like Sam’s Club andCostco or the internet are not incorporated into the CPI; it still uses full-retailprice.

Ï For these reasons, economists believe the CPI overstates true inflation by 0.5 to1 percentage point.



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Producer Price Index (PPI)

DefinitionProducer price index (PPI): an average of the prices received by producers of goodsand services at all stages of the production process.

Ï It is conceptually similar to the CPI, in that it uses a basket of goods, but thegoods are those used by producers.

Ï The PPI can give early warning of future movements in consumer prices.



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Using Price Indexes to Adjust Prices

Ï Suppose your mother received a salary of $25,000 in 1987. This would havebought much more than a salary of $25,000 in 2012.

Ï We can use the CPI to estimate the purchasing power of that $25,000 in 2012dollars:

Value in 2012 Dollars = Value in 1987 Dollars× CPI in 2012

CPI in 1987

= $25,000×(

230

114

)≈ $50,000

Ï So $25,000 in 1987 would have bought about as much as $50,000 in 2012.



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Measuring Inflation




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Nominal and Real Values

Ï The current standard base “year” for the CPI is an average of 1982–1984 prices.

Ï Values like wages in current-year dollars are called nominal variables. When weadjust them for inflation, by dividing by the current year’s price index andmultiplying by 100, we convert them to real variables.

Ï Example: Caterpillar employees signed a contract freezing wages until 2018.How much less will their wages be worth then?

Ï If the CPI rises to 260, then Caterpillar employees will receive a real wagedecrease of: (

$10.38−$11.59

$11.59

)×100 =−10.4%



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Inflation and Interest Rates

Ï When you lend money to someone, they typically agree to pay you back withinterest. If the interest rate is 6%, for example, then a $1,000 loan paid back in ayear will be paid back with $1,060.

Ï This 6% is the nominal interest rate: the stated interest rate on a loan. But inthat year’s time, prices will have risen; so the $1,060 next year is not worth thesame as $1,060 this year.

Ï We can adjust for inflation by calculating the real interest rate, equal to thenominal interest rate minus the inflation rate. (Note: this is an approximation,but it is quite accurate for low interest and inflation rates.)

i ≈ r+π (Fisher Equation)

Ï If prices rise by 2% from this year to next, then your real interest rate on theloan is only 4%. This more accurately reflects the cost of borrowing and lendingmoney.



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DefinitionNominal interest rate (i): the return to saving and the cost of borrowing withoutadjustment for inflation.Real interest rate (r): the return to saving and the cost of borrowing afteradjustment for inflation.

Ï How are the nominal and real interest rates related? The Fisher equation:i = r+π

Ï The equation written in this way is called the Fisher equation, after economistIrving Fisher. It shows that the nominal interest rate can change for tworeasons: because the real interest rate changes or because the inflation ratechanges.

Ï There are two versions of the Fisher equation:Ï Ex ante (“before the fact”): i = re +πe; i.e. chosen before know, uncertainÏ Ex post (“after the fact”): i = r+π; i.e. no uncertainty, determined or known



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Irving Fisher (1867–1947)

Ï Fisher was an American (mathematical) economist with a well deserved reputation for clear exposition.He contributed a great deal to the field of economics including modernizing the quantity theory ofmoney, the Fisher equation, Fisher effect, and he was a pioneer in the construction and use of priceindexes.



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Common Interest Rates

Ï Federal funds rate: the interest rate that the banks charge each other onovernight loans.1

Ï The London Interbank Offered Rate (LIBOR) is the most active interest ratemarket in the world. It is determined by rates that banks participating in theLondon money market offer each other for short-term deposits.2

1http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm2http://www.moneycafe.com/personal-finance/libor/


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

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


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Common Interest Rates (Continued)

Ï The prime interest rate is the interest rate charged by banks to their mostcreditworthy customers (usually the most prominent and stable businesscustomers). The prime rate is a benchmark that banks often use in quotinginterest rates to all of their customers. For example, a less well-known firmmight be quoted a rate of "prime plus three-fourths", which means that if theprime 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 downwith changes in the economy.3

Ï The three-month U.S. Treasury bill (T-Bill) Rate is probably the most widelyfollowed short-term interest rate. The interest rate on U.S. Treasury bonds(T-Bond) with ten years to maturity is probably the most widely followedlong-term interest rate since it is a general indicator of long-term interest ratemovements.4

3http://www.moneycafe.com/personal-finance/prime-rate/4http://www.moneycafe.com/personal-finance/interest-rates-daily-updates/


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

http://www.moneycafe.com/personal-finance/interest-rates-daily-updates/


Inflation

Measuring Inflation




Hyperinflation

Unemployment

Why We Care About Inflation

Ï An example of how inflation can affect real returns.Ï Suppose you and I agree that a real rate of 0.05 over the next year is fair.

Ï borrowing rate, salary growth rate, etc.

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

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

Ï i = 0.12Ï re = 0.05Ï πe = 0.07



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Why We Care About Inflation (Continued)

Ï Suppose that actual inflation is 0.10 (π>πe)Ï In this case, r = 0.02 (r = i−π)

Ï Borrowers/Firms are better-offÏ Lenders/Workers worse-off

Ï Suppose that actual inflation is 0.03 (π<πe)Ï In this case, r = 0.09 (r = i−π)

Ï Borrowers/Firms are worse offÏ Lenders/Workers better off

Ï Research has also shown that higher inflation rates are correlated with morevariability. People/firms do NOT like the uncertainty; i.e. they are risk adverse.



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Measuring Inflation




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Unemployment

U.S. Nominal and Real Interest Rates

Ï The chart shows the interest rate on three-month treasury-bills, a goodmeasure of the nominal interest rate.

Ï The real interest rate adjusts them for changes in the CPI.Ï Notice that in 2009, the real interest rate was above the nominal interest rate.

This was because the change in the CPI was negative then, indicating a raredeflation, or decrease in the price level.



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Measuring Inflation




Hyperinflation

Unemployment

Is Inflation a Problem?

Ï Sometimes inflation seems unimportant. If all prices doubled overnight andwages followed suit, then you could afford exactly as much as before.

Ï But there are some less obvious problems with inflation. For example, inflationaffects the distribution of income and wealth.

Ï It is unlikely that everyone’s wages would increase at the same rate. Many peoplehave long-term contracts specifying their wage in nominal terms, for example.

Ï Also, nominal assets like cash decrease in value when there is significant inflation.If you hold much of your wealth in cash, then inflation causes a significantdecrease in real wealth for you.



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Measuring Inflation




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Unemployment

Problems with Anticipated Inflation

Ï Even if inflation is anticipated, it still causes problems.Ï People and firms have increased real costs of holding cash.Ï Firms have menu costs: the cost to firms of changing prices. Frequently

changing prices are inconvenient for firms (and consumers too) to deal with.Ï Investors are taxed on nominal returns, rather than real returns; so this can

increase the tax due. Some taxes are not adjusted to account for inflation, suchas the capital gains tax.

Ï Example:Ï 1 January: you buy $10,000 worth of Apple stockÏ 31 December: you sell the stock for $11,000, so your nominal capital gain is $1,000

(10%).Ï Suppose π= 10% during the year. Your real capital gain is $0.Ï But the government requires you to pay taxes on your $1,000 nominal gain!

Ï Shoeleather costsÏ General inconvenience

Ï Inflation makes it harder to compare nominal values from different time periods.



Inflation

Measuring Inflation




Hyperinflation

Unemployment

Problems with Unanticipated Inflation

Ï When people cannot predict the rate of inflation, they find it hard to make goodborrowing and lending decisions.

Ï For example, in 1980 banks were charging 18% or more on home loans becausethe rate of inflation was very high. People who bought homes were locked intohigh rates even when inflation subsided.

Ï On the other hand, if banks lend money at a low rate and then high inflationtakes place, the real interest rate they receive may be zero or negative; thus therisk of inflation makes banks wary of lending.

Ï Increased uncertaintyÏ Unpredictable inflation makes borrowing and lending risky.Ï Makes risk-averse people worse off.



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Measuring Inflation




Hyperinflation

Unemployment

One Benefit of Inflation

Ï Nominal wages (W ) are rarely reduced.

Ï Inflation allows the real wages

(W

P

)to be reduced without nominal wage cuts.

Ï Therefore, moderate inflation improves the functioning of labor markets.Ï Labor markets will be discussed in the section “The Supply Side”



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Measuring Inflation




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What’s So Bad about Falling Prices?

Ï Deflation is much more dangerous for an economy than inflation.Ï Why? Suppose you are considering buying a car. You know the car will be

cheaper next year, so you delay purchasing. But if everyone does the same, thenmany purchases are postponed, firms stop producing, people becomeunemployed, etc.

Ï This can create a dangerous downward-spiral, delaying economic recovery.Economists believe this occurred after the Great Depression of the 1930s, andalso in Japan in the 1990s.

Ï There were concerns that significant periods of deflation might have followedthe recession of 2007–2009. but fortunately that did not occur.



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Measuring Inflation




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Unemployment

Hyperinflation

Ï At its worst, inflation becomes hyperinflation – an inflation rate that is so rapidthat workers are paid multiple times a day because money loses its value soquickly.

Ï Common definition: π≥ 50% per month

Ï All the costs of moderate inflation described above become HUGE underhyperinflation.



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Measuring Inflation




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Unemployment



Inflation

Unemployment

MeasuringUnemployment

Types ofUnemployment

The Problem ofUnemployment

Measuring Unemployment

Ï There are more than 300 million people in the United States, and monitoringand reporting on their activities regularly would be very difficult and costly.

Ï Instead, the U.S. Department of Labor reports estimates of employment,unemployment, and other statistics related to the labor force each month.

DefinitionLabor force: The sum of employed and unemployed workers in the economy.

Ï Of these statistics, the most watched is known as the unemployment rate: thepercentage of the labor force that is unemployed.



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The Household Survey

Ï Each month, the U.S. Bureau of the Census conducts the Current PopulationSurvey (a.k.a. the household survey).

Ï ≈ 60,000 households selected to be “representative”Ï Household members of “working age” (16+ years old)Ï Asked about employment during “reference week”Ï Also asked about recent job-search activities

Ï People are then classified as:Ï Employed: Worked 1+ hours in reference week (or were temporarily away from

their jobs).Ï Unemployed: Someone who is not currently at work but who is available for work

and who has actively looked for work during the previous monthÏ Not in the labor force, if neither of the above apply



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Civilian Working-Age Population (August 2013)



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Unemployment Rate

Ï Based on the CPS estimates, we calculate several important macroeconomicindicators.

Ï The most-watched is the unemployment rate:

Number of unemployed

Labor force×100 = Unemployment rate

11.3 million

155.5 million×= 7.3%

Ï This most-common measure of unemployment is known formally as BLS seriesU-3.



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Unemployment




Labor Force Participation and Employment-Population

Ï Also important are the labor force participation rate (the percentage of theworking-age population in the labor force) . . .

Labor force

Working-age population×= Labor force participation rate

155.9 million

249.9 million×= 63.2%

. . . and the employment-population ratio (the percentage of the working-agepopulation that is employed):

Employment

Working-age population×= Employment-population ratio

144.2 million

245.9 million×= 58.6%



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Problems with Measuring the Unemployment Rate

Ï The unemployment rate measured by the BLS is not a perfect measure ofjoblessness. Why?

DefinitionDiscouraged workers: People who are available for work, but have not looked for ajob during the previous four weeks because they believe no jobs are available forthem.

Ï It may understate unemployment:Ï Distinguishing between people who are unemployed and not in the labor force

requires judgment (should we exclude “discouraged workers”?)Ï Only measures employment, not intensity of employment (full-time vs.

part-time; some people are underemployed)

Ï It may overstate unemployment:Ï People might claim falsely to be actively looking for workÏ May claim not to be working to evade taxes or keep criminal activity unnoticed



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Alternative Measures of Unemployment: U-6

Ï Some people suggest that we should include discouraged workers andunderemployed workers in the unemployment statistics, to create a broadermeasure of unemployment.

Ï The BLS measures this, calling it BLS series U-6.



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Trends in Labor Force Participation

Ï The labor force participation rate of adult men has declined gradually since1948, but it has increased significantly for adult women, making the overall ratehigher today than it was then.



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Unemployment




Is Falling Labor Force Participation Bad?

Ï Politicians often like to point to a “falling labor force participation rate” as astrongly negative sign for the economy.

Ï Is this necessarily true?

Ï The two major reasons why the LFPR for men has fallen over the last severaldecades are:

Ï Men have been going to school for longer and retiring earlier than beforeÏ Increases in Social Security Disability Insurance availability have allowed people

with disabilities to stop work

Ï Whether these are good or bad is a value judgment.



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Unemployment Rates for Different Groups

Ï Unemployment rates vary by ethnic group and by education level.Ï These two observations are statistically related.



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How Long Are People Typically Unemployed?

Ï Long periods of unemployment are bad for workers, as their skills decay andthey risk becoming discouraged and depressed.

Ï During the Great Depression of the 1930s, some people were unemployed foryears at a time.

Ï Since World War II, average lengths of unemployment have been relatively low;but that changed dramatically with the 2007–2009 recession.



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The Employment Situation Following the 2007-2009Recession

Ï The fall of the employment-population ratio may give an even better indicationof how weak the U.S. labor market was during and after the 2007–2009recession.

Ï Explaining these changes is a top priority for labor economists.



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Unemployment




The Establishment Survey

Ï In addition to the household survey, the BLS also uses the establishmentsurvey, (a.k.a. the payroll survey).

Ï This survey samples ≈ 300,000 establishments, or places of employment, abouttheir employees. Disadvantages include:

Ï Self-employed people not surveyed (not on a company payroll)Ï Newly-opened firms often omittedÏ Information on employment only, not unemploymentÏ Numbers fluctuate depending on establishments included, often requiring large

revisions

Ï However, a big advantage is that the data are determined by real payrolls, notself-reporting like the household survey.



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Comparing the Household and Establishment Surveys

Ï The table below gives the data from the July and August 2013 household andestablishment surveys:

Ï Even if all surveys are truthfully and accurately answered, we do not expect thenumbers to be identical between the two surveys:

Ï Different groups are measuredÏ All surveys have measurement errors

Ï But we get a more complete picture by considering both surveys.



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Revisions to Employment Numbers

Ï Over time, the BLS adjusts its estimates of employment and unemployment forprevious months. Revisions sometimes take place years later.

Ï The large negative revisions were because the BLS underestimated the severityof the 2007–2009 recession.



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Unemployment




Job Creation and Destruction

Ï Jobs are continually being created and destroyed in the U.S. economy. In 2012,about 27.8 million jobs were created, while about 25.5 million jobs weredestroyed.

Ï This is a natural and normal process for the economy.

Ï The table shows jobs created and destroyed over a three-month period fromSeptember to December 2012.



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U.S. Annual Unemployment Rate over Time

Ï Unemployment rates rise when the economy is faltering, and fall when theeconomy is doing well. But they never fall to zero.

Ï To understand why, we will examine the types of unemployment.



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Unemployment




Three Types of Unemployment

Ï The three types of unemployment are:Ï Frictional unemploymentÏ Structural unemploymentÏ Cyclical unemployment

Ï We will examine each in turn over the coming slides.



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Frictional Unemployment

DefinitionFrictional unemployment: Short-term unemployment that arises from the processof matching workers with jobs.

Ï Frictional unemployment occurs mostly because of job search: entering orre-entering the labor force, or being between jobs.

Ï It also occurs because of seasonal unemployment: some jobs fluctuate inavailability due to seasonal demand, like ski-instructor or farm-work.

Ï To control for this, the BLS releases raw and seasonally-adjusted employmentfigures.

Ï Some frictional unemployment actually increases economic efficiency byallowing for better job matches.



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Structural Unemployment

DefinitionStructural unemployment: Unemployment that arises from a persistent mismatchbetween the skills and attributes of workers and the requirements of jobs.

Ï Structural unemployment is associated with longer unemployment spells.

Ï Workers who are structurally unemployed may require retraining in order toobtain “modern” jobs.



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Cyclical Unemployment

DefinitionCyclical unemployment: Unemployment causes by a business cycle recession.

Ï In normal recoveries after a recession, unemployment due to cyclical factorswill fall.

Ï When all unemployment is due to frictional and structural factors, we say thatthe economy is at full employment. This means there will always be someunemployment in the economy.

Ï Economists call this the natural rate of unemployment: The normal rate ofunemployment, consisting of frictional unemployment and structuralunemployment.

Ï The general consensus of economists is that the U.S. natural rate ofunemployment is somewhere between 5 and 6 percent.



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How Should We Categorize Unemployment at Caterpillar?

Ï In 2013, Caterpillar announced layoffs at its South Milwaukee plant.Ï Did this increase frictional, structural, or cyclical unemployment?

Ï This is generally a hard question to answer; we need to look closely at thisspecific plant:

Ï The South Milwaukee plant manufactured mining equipment.Ï Prices for mining products were in decline, decreasing demand for Caterpillar’s

mining machinery. But sales of other equipment remained strong.Ï The laid-off workers were likely specialists at making mining equipment; so they

are probably structurally unemployed.



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The Costs of Unemployment

Ï Loss in output from idle resourcesÏ Workers lose incomeÏ Society pays for unemployment benefits and makes up lost tax revenueÏ Using Okun’s Law (each percentage point of cyclical unemployment is associated

with a loss equal to 2% of full-employment output), if full-employment output is$17 trillion, each percentage point of unemployment sustained for one year costs$340 billion

Ï Personal or psychological cost to workers and their familiesÏ Especially important for those with long spells of unemployment

Ï There are some offsetting factorsÏ Unemployment leads to increased job search and acquiring new skills, which

may lead to increased future outputÏ Unemployed workers have increased leisure time, though most wouldn’t feel that

the increased leisure compensated them for being unemployed


Economics 121 Principles of Macroeconomics …...Gross Domestic Product (GDP) Inﬂation...

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