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Measuring National Output ECON 704 Module 5, Part 1 Measuring National Output ECON 704 Module 5, Part 1

Agenda • Define Gross Domestic Product • Understand link between income and spending • Agenda • Define Gross Domestic Product • Understand link between income and spending • Distinguish major components of income and spending • Understand distinction between real and nominal measures of income

What is GDP? • GDP is the market value of all final goods and What is GDP? • GDP is the market value of all final goods and services produced within a country in given time period • Excludes intermediate goods (those not “consumed” by the final user) – avoid double counting – intermediate: transformed before final use, or meant for resale • furniture manuf: wood is intermediate; delivery vehicle is not; factory is not

GDP Details • Incomplete? – non-market output or consumption? – adequate measure of national GDP Details • Incomplete? – non-market output or consumption? – adequate measure of national welfare? – impact of market failures, where “the price is wrong”? • Captures production within the country, not use of a country’s resources

Measuring GDP: Spending = Income • Every dollar spent creates a dollar of income Measuring GDP: Spending = Income • Every dollar spent creates a dollar of income (in total) somewhere else in the economy • Thus, 2 ways to measure National Income: – add up all spending – add up all income

The Circular Flow Revenue Goods & Services sold Market for Goods and Services Firms The Circular Flow Revenue Goods & Services sold Market for Goods and Services Firms Inputs for production Wages, rent, and profit Spending Goods & Services bought Resources flow one way (red) Households Market for Factors of Production Labor, land, and capital Income Money flows the other (dark)

From National Income (GNP)… • GNP = Gross National Product; a measure of income From National Income (GNP)… • GNP = Gross National Product; a measure of income received – Profits from GM factory in Mexico adds to Mexican GDP, but U. S. GNP – Mexican national working in U. S. adds to U. S. GDP, but Mexican GNP – Difference between GDP and GNP • not important for U. S. ($13. 194 t vs. $13. 252 t) • more important for small open economies; GDP good measure of output, GNP of income

…to Disposable Personal Income • GNP… – less depreciation (capital consumption allowance) and net …to Disposable Personal Income • GNP… – less depreciation (capital consumption allowance) and net factor payments abroad; – less net indirect business taxes (tax – subsidies) – less retained earnings, corporate income tax, and net transfer payments; – less personal taxes equals Disposable Personal Income (DPI)

National Spending (GDP) • Y = C+I+G+NX ($13, 194. 7 b 2006) – Consumption National Spending (GDP) • Y = C+I+G+NX ($13, 194. 7 b 2006) – Consumption ($9, 224. 5 b) • durables, non-durables, and services – Gross Private Dom. Investment ($2, 209. 2 b) • residential vs. non; inventory changes – Government Purchases ($2, 523 b) • excludes transfers! – Net EXports ($1, 467. 6 b – $2, 229. 6 b = -$762 b)

GDP Tidbits • Consumption largest component • Gross Private Investment is most variable component GDP Tidbits • Consumption largest component • Gross Private Investment is most variable component • Very Large Trade Deficit – U. S. has to borrow large sums from rest-of-world to cover this ~ effect on dollar? • Government Deficit ($220 b in 2006) – gone until 9/11 (spending increase) and tax revenue decline (economy, rich-rebate); War in Iraq; recently, revenue increase

GDP and Inflation • Inflation: a general rise in the overall average price level GDP and Inflation • Inflation: a general rise in the overall average price level • Results in increased Nominal (i. e. , current) GDP even if Real output is unchanged • Real GDP better measure of change in real economic output – GDP Deflator Index = (Nominal / Real) 100 – 2006 Real GDP = $11, 319 (2000 benchmark); GDP deflator = 116. 56

Changes in GDP • Economic Growth – increase in amount of economy’s resources – Changes in GDP • Economic Growth – increase in amount of economy’s resources – increase in productivity of economy • The Business Cycle – cyclical changes in Aggregate Demand Aggregate Supply (last module) – recessions and expansions – Obviously, the business cycle is not dead

Conclusion • Next Time: Inflation and The Cost of Living Conclusion • Next Time: Inflation and The Cost of Living

Inflation and the Cost of Living ECON 704 Module 5, Part 2 Inflation and the Cost of Living ECON 704 Module 5, Part 2

Agenda • Explain the construction, meaning, and use of most common price indices • Agenda • Explain the construction, meaning, and use of most common price indices • Apply indices to correct for inflation • Identify some of the important economic consequences of inflation and deflation

Dealing with the “Cost of Living” • If the minimum wage had kept up Dealing with the “Cost of Living” • If the minimum wage had kept up with inflation, would currently be around $12 • Are Social Security payments keeping up with inflation? Or racing ahead? • The Japanese economy is experiencing falling prices (deflation). Isn’t this good?

What is a price index? • A time-relative measure of average, overall prices for What is a price index? • A time-relative measure of average, overall prices for a given selection of goods during a given period – relative to a base year • Inflation & Deflation – increases & decreases in price indices – not the same as some goods or services becoming more or less expensive relative to other goods and services

Some Common Price Indices • Consumer Price Index (CPI) – includes prices of goods Some Common Price Indices • Consumer Price Index (CPI) – includes prices of goods and services most often bought by consumers – Core CPI: excl. volatile food & energy • Producer Price Index (PPI) – goods and services bought by producers • GDP Deflator – all output produced domestically

Constructing a Price Index (PI) • Compare the total dollar price of a basket Constructing a Price Index (PI) • Compare the total dollar price of a basket of goods to the base year – PI in a year is (Price / Pricebase) 100 • if 1999 total price is $1200, and 2000 price is $1278, then PI 2000 = (1278/1200) 100 = 106. 5 – PI in base year is 100 – % change in PI is the inflation rate between two periods • if PI 2001 = 108. 9, 2001 infl. = (108. 9 -106. 5)/106. 5 100 = 2. 25%

Choosing the “Basket” • GDP Deflator – the basket is all goods currently produced Choosing the “Basket” • GDP Deflator – the basket is all goods currently produced • CPI – the basket is “fixed” and changes infrequently – Limits: consumers substitute across goods; ignores changes in product quality or the introduction of new goods – may not reflect purchasing habits well – individual item prices may differ from CPI

Application: Interest Rates • Nominal interest rate vs. Real interest rate – real = Application: Interest Rates • Nominal interest rate vs. Real interest rate – real = nominal – inflation – unexpected inflation: • real interest rate will differ from expected • inflation too high; real rate too low: bad for lenders, good for borrowers • inflation too low; real rate too high • deflation: even 0 nominal rate gives positive real rate ~ impact on Central Bank policy discretion?

Using indices • Many government payments automatically indexed to inflation (e. g. , COLA) Using indices • Many government payments automatically indexed to inflation (e. g. , COLA) • Finding “real” costs of living, wages – say salary in 2001 is $40 k, and CPI is 177. 5 (1983 base year) – $40 k is equivalent to (40 k/177. 5) 100 = $22, 535 in 1982 dollars • Can compare indices across locations – if cost of living in NYC is 121 and in Chicago is 114, cost of living is 6. 14% higher in NYC

Problems with Inflation If expected, should be no problem, but: • Money Illusion • Problems with Inflation If expected, should be no problem, but: • Money Illusion • Fixed payments vs. fixed income • Price Regulation • Tax System based on nominal values • Confuses business decisions • High inflation increases uncertainty, reduces bank lending

1990 s Deflation in Japan • Effects of Japanese Deflation – related to bursting 1990 s Deflation in Japan • Effects of Japanese Deflation – related to bursting of Japanese asset “bubble” – real debt burdens increase • prices, revenues fall; debt burden nominally fixed – bank financing collapse – Negative impact on wages and consumer sentiment

Other Inflation Stories • China: keeps currency low? – Has to buy up $, Other Inflation Stories • China: keeps currency low? – Has to buy up $, sell yuan – Injects yuan into economy, increases inflationary pressure of high growth • US – Low total inflation, but significant relative price movements – Price bubble in US real estate

The Financial System ECON 704 Module 6, Part 1 The Financial System ECON 704 Module 6, Part 1

Agenda • Understand role of Financial Markets, and problems therein • Analyze role of Agenda • Understand role of Financial Markets, and problems therein • Analyze role of Saving and Investment in the economy • Analyze impact of government policy on saving and investment decisions

Defining Savings and Investment • Saving = deferred consumption – borrowing is dis-saving • Defining Savings and Investment • Saving = deferred consumption – borrowing is dis-saving • Investing = purchase of productive resources – different from colloquial “investment” – gross vs. net investment and depreciation – is “I” in spending approach to GDP • Financial markets/intermediaries bring savers and borrowers together

Interest, Discounting, and Yields • Deferred consumption requires compensation ~ $1 tomorrow worth less Interest, Discounting, and Yields • Deferred consumption requires compensation ~ $1 tomorrow worth less than $1 today • Interest payments to savers are this compensation; this is also the yield on their savings (a. k. a, rate of return) • Discount rate, present value, and future value – FV = PV / (1+i); PV = FV (1+i)

Bonds are Debt • Bonds are debt instruments providing fixed nominal income stream • Bonds are Debt • Bonds are debt instruments providing fixed nominal income stream • Yield on a bond = rate of return – Maturity; principal/face value; coupon – risk premium (compensation for default risk) – tax distortions – price and yield are inversely related! • yield = coupon rate when price = principal

Stocks are Equity • Ownership in firm: entitled to share of profits (the dividend, Stocks are Equity • Ownership in firm: entitled to share of profits (the dividend, a variable stream) • Higher risk than bonds • Price should reflect present value of expected future dividends, plus expected appreciation by time of sale, plus “risk premium” – Microsoft ~ old no-dividend policy?

America’s Financial Bubble of late 1990 s • Global Context ~ strong US economy America’s Financial Bubble of late 1990 s • Global Context ~ strong US economy • “New Economy” hype ~ focus on appreciation rather than profits (speculation) • Integrity of Corporate Financial Statements and Perception of Risk – share options and management incentives – regulatory framework (or lack thereof) • 2007: securitized debt, housing bubble, and the sub-prime mess?

Saving, Investment, and National Income • GDP – C – G – NX = Saving, Investment, and National Income • GDP – C – G – NX = I • GDP – C – Taxes = Saving • (S – I) + (T – G) = NX – private net saving + public net saving = net lending to rest of world – 80 s and twin deficits: govt. deficit created trade deficit? – 90 s: private net borrowing (S , I ) aggravated trade deficit though govt. borrowing fell

U. S. as an International Debtor • Trade deficit requires us to “borrow” from U. S. as an International Debtor • Trade deficit requires us to “borrow” from rest of world – foreigners purchase US assets • Pessimism over US markets – – foreigners sell their US assets then sell $ foreign exchange then dollar loses value then trade deficit declines? • Federal Deficit and Asian Currency Intervention

Market for Loanable Funds • Supply of loanable funds: national saving – “price” of Market for Loanable Funds • Supply of loanable funds: national saving – “price” of LF is an interest rate; increase in interest rate increases qty of LF supplied • Demand for LF from investors – decreases in interest rate increases qty of LF demanded (more projects profitable) • Equilibrium real interest rate • Investment important for economic growth!

Affecting Incentives • Policies to increase demand: – investment tax credits; increased depreciation allowance Affecting Incentives • Policies to increase demand: – investment tax credits; increased depreciation allowance – Effect: Higher investment at a higher interest rate – increase in quantity of loanable funds supplied • Policies that affect national saving: – corporate income tax; capital gains tax; “supplyside” economics – supply shifts out; more investment at a lower interest rate – quantity of LF demanded increases • Other policies may have indirect effects

Government Borrowing and Crowding Out • Increased government borrowing reduces national net saving • Government Borrowing and Crowding Out • Increased government borrowing reduces national net saving • Interest rates increase, lower qty of private investment undertaken • Is this bad (for growth)? Depends – is deficit due to increased spending or lower taxes? – is the effect more consumption, or more physical investment?

Unemployment ECON 704 Module 6, Part 2 Unemployment ECON 704 Module 6, Part 2

Agenda • Show unemployment rates are calculated and mis-calculated • Differentiate types of unemployment Agenda • Show unemployment rates are calculated and mis-calculated • Differentiate types of unemployment • Describe types and effects of government policy towards unemployment • Discuss labor and unemployment issues in the global context

Calculating Unemployment • Unemployment Rate = % of labor force not working • Labor Calculating Unemployment • Unemployment Rate = % of labor force not working • Labor Force Defined – Those working or looking for work – Labor Force Participation Rate = % adult population (>16 yrs) in the labor force • excludes institutionalized and those not looking for work • based on self-reported survey data

Mis-calculating Unemployment • Ideal: measure of use of labor resources • Bureau of Labor Mis-calculating Unemployment • Ideal: measure of use of labor resources • Bureau of Labor Statistics Survey Data – “Are you working, or have you looked for work in past 4 weeks? ” – Does not count underemployed ~ those not employed as productively as possible – Discouraged Workers ~ do not self-report as looking for work (so not part of labor force), but would want to – Underground Economy

Types of Unemployment: The Natural Rate… • Structural ~ excess supply of workers – Types of Unemployment: The Natural Rate… • Structural ~ excess supply of workers – skill mis-match; minimum wage; unions? • Frictional ~ job search • Seasonal ~ e. g. , some farm workers; Christmas âAdded together, these are the Natural Rate of Unemployment (4 -5%? )

…and Cyclical Unemployment • Cyclical Unemployment – that which varies with the ups and …and Cyclical Unemployment • Cyclical Unemployment – that which varies with the ups and downs of the economy – GDP recession: cyclical unempl. positive; total unempl. above the natural rate – GDP expansion: cyclical unempl. negative; total unempl. below the natural rate • Unemployment is a lagging indicator of GDP changes

Policies and Institutions Increasing Unemployment • minimum wages • union limits on supply of Policies and Institutions Increasing Unemployment • minimum wages • union limits on supply of labor • high unemployment/welfare benefits – lower opportunity cost of not working • which type of unemployment is affected by each phenomenon?

Policies Decreasing Unempl. • Job/Skill Training and Retraining • Low employment taxes – tend Policies Decreasing Unempl. • Job/Skill Training and Retraining • Low employment taxes – tend to be on a “per-worker” basis; high taxes encourage employers to work fewer employees harder • Low severance pay requirements • Role of Small Business in Job Creation

Global Context • “Lump of Labor” Fallacy – idea that there a fixed number Global Context • “Lump of Labor” Fallacy – idea that there a fixed number of jobs to go around – French 35 -hour week – Immigration Fears – Trade

Is Globalization a Threat? • Increased Income Inequality – In US, due to technological Is Globalization a Threat? • Increased Income Inequality – In US, due to technological change • Trade – import-competing jobs lost while exporting jobs gained – but they aren’t the “same” – need to deal with the losers! • “Fair” Labor Standards

Money and the Banking System ECON 704 Module 7, Part 1 Money and the Banking System ECON 704 Module 7, Part 1

Agenda • Define money, its functions, and measurement • Explain how banks create money Agenda • Define money, its functions, and measurement • Explain how banks create money

What is Money? • Money is assets used to buy or sell in lieu What is Money? • Money is assets used to buy or sell in lieu of barter – related to the liquidity of the asset; money is most liquid asset • Partly defined by its functions – unit of account – store of value – medium of exchange

Money Then and Now • Then: precious metals – also called commodity money – Money Then and Now • Then: precious metals – also called commodity money – enclosed communities develop own forms – old-style inflation: doping “gold” coins • Now: currency, coinage, demand deposits (not credit) – also called fiat money ~ only has value because an arm of government says it does – used to be backed by precious metals

Money Measures • Money Measures distinguished by liquidity Measure Amount in 6/05 M 1 Money Measures • Money Measures distinguished by liquidity Measure Amount in 6/05 M 1 $1, 365 billion M 2 $6, 503 billion What’s Included Currency Traveler’s checks Demand deposits Other checkable deposits Everything in M 1 Saving deposits Small time deposits Money market mutual funds A few minor categories

Making Money • Currency: issued by Federal Reserve • Coinage: issued by Dept. Treasury Making Money • Currency: issued by Federal Reserve • Coinage: issued by Dept. Treasury • Deposits: who creates deposits? – Banking System!! – Origins in banking lie with goldsmiths

Banking • Banks take deposits to make loans • Deposits are a liability – Banking • Banks take deposits to make loans • Deposits are a liability – short-term: can be withdrawn on demand – other liabilities: equity, capital requirement • Loans are an asset – long-term: can only be called in according to contract – other assets: securities, bonds, cash reserves (held in vault or account at Fed)

Fractional Reserve System • Banks make no money on reserves, have incentive to lend Fractional Reserve System • Banks make no money on reserves, have incentive to lend • Fractional Reserve System – Banks must hold a fraction of deposits as reserves that cannot be lent out – Required Reserve Ratio (R) is the fraction • currently 10% in US – Makes banks vulnerable to “runs” without deposit insurance (i. e. , FDIC)

Banking System Creates (and Destroys) Money • Suppose deposit $100 (cash to deposit) – Banking System Creates (and Destroys) Money • Suppose deposit $100 (cash to deposit) – money has changed form, but not amount • Suppose bank now lends out $50 – $100 deposit still there, – plus $50 that was just lent money supply has increased! – Lending injects new currency in circulation or deposits and thus more money is created

Money Expansion Multiplier • Deposit (D) creates excess reserves (ER) of lesser amount – Money Expansion Multiplier • Deposit (D) creates excess reserves (ER) of lesser amount – ER = (1 – R) D • Excess Reserves determine lending potential • Maximum Expansion in Money Supply is a multiple (M) of new deposit: – M = 1 / R (e. g. , if R =. 1, M = 10)

Some Factors Affecting Money Expansion • Some currency is not deposited, cannot be loaned Some Factors Affecting Money Expansion • Some currency is not deposited, cannot be loaned out • Banks hold excess reserves – desire to take on risk of new lending – excess reserves can be loaned out to banks with insufficient reserves on federal funds market • Fed cannot “control” these decisions • Actual US Money Multiplier appx. 2. 5

The Federal Reserve and Monetary Policy ECON 704 Module 7, Part 2 The Federal Reserve and Monetary Policy ECON 704 Module 7, Part 2

Agenda • Describe some of the central features of the Federal Reserve System • Agenda • Describe some of the central features of the Federal Reserve System • Explain the goals of the Fed • Understand the tools available to the Fed in achieving its goals (and their limits), and their impact on the Money Supply and the economy as a whole • Briefly examine Central Bank recent policy in the US

The Federal Reserve System • A system of 12 regional banks created to stabilize The Federal Reserve System • A system of 12 regional banks created to stabilize nation’s banking system • Fed is an independent arm of government, with 3 primary functions – regulate U. S. banks – banker’s bank, and lender of last resort – determines monetary policy by influencing the nation’s money supply

Notable Parts of the Fed • The Board of Governors – current chairman is? Notable Parts of the Fed • The Board of Governors – current chairman is? • The Federal Open Market Committee (FOMC) – determines monetary policy • The New York Regional Fed Bank – closest to bond markets in NYC; actually executes monetary policy

Fed’s Goals • To balance the needs for low and stable inflation; economic growth Fed’s Goals • To balance the needs for low and stable inflation; economic growth (rising GDP); and low unemployment • Unusual compared to other Central Banks – European Central Bank (ECB): strict inflation targeting – Some central banks under control of government ~ political implications?

Fed and the Economy • Goal: sustainable GDP growth • Tool Available: Money Supply Fed and the Economy • Goal: sustainable GDP growth • Tool Available: Money Supply • Primary channel of influence: nominal interest rates – most Investment is via borrowing, so is very sensitive to interest rates, especially housing – some Consumption also sensitive to same – nominal interest rates determined by money supply and money demand

Money Supply and Interest Rates (short run) • Higher Money Supply lower nominal interest Money Supply and Interest Rates (short run) • Higher Money Supply lower nominal interest rates (& vis-versa) MS 1 MS 2 2. . decreases the interest rate. . . Interest Rate (i) 1. An increase in the money supply. . . A i 1 B i 2 Money demand 0 M 1 M 2 Quantity of Money

Money, Inflation, and Interest Rates ~ the Long Run • In the long run, Money, Inflation, and Interest Rates ~ the Long Run • In the long run, money growth in excess of output growth leads to inflation – more dollars chasing each unit of output • Inflation leads to higher nominal interest rates (Fisher Effect)

Fed Tools of Money Control • Required Reserve Ratio – negative relation to MS Fed Tools of Money Control • Required Reserve Ratio – negative relation to MS – only used in response to structural issues • Discount Rate and Federal Funds Rate – negative relation to MS – Fed Funds Rate is the “headline” rate; cost of having insufficient reserves (& thus too many loans) – Discount Rate less important ~ banks borrowing at discount window perceived to be in trouble

Fed Tools, cont. • Open Market Operations – buying and selling government securities (bonds) Fed Tools, cont. • Open Market Operations – buying and selling government securities (bonds) on open market – Open Market Purchase buys bonds from public, in exchange for deposits or excess reserves increases MS – Used to keep interest rates at target level – Sometimes used to increase market liquidity (S&L crisis, Y 2 K, LTCM collapse, sub-prime mortgage fiasco)

Recent Fed Policy • End of 90 s: rates kept too low too long? Recent Fed Policy • End of 90 s: rates kept too low too long? – contribute to asset price bubble? – lag effect: takes a full quarter or two for monetary policy to trickle down to real economy must be pre-emptive! • End of the Greenspan era • Housing Price Bubble? • Rates steady for a while…is it safe and effective to lower rates to ensure liquidity?