FIN 30220: Macroeconomic Analysis

1. FIN 30220: Macroeconomic Analysis Measuring the U.S. Economy

2. U.S. GDP of $17 Trillion represents approximately one fifth of total worldwide production ($85 Trillion) and makes the United States the largest single country economy on the planet!! Note: 2006 GDP estimates measured on a Purchasing Power Parity Basis * Source: CIA Factbook

3. Principle #1: What exactly are you trying to measure? Is your definition consistent with what you are trying to measure? GDP is the standard benchmark for economic well being. Is it a good indicator of well being? VS 1950: $275B 2010: $14,600B Ratio 1950: $1,696B 2010: $12,973B 1950: $10,941 2010: $42,120 1950: $20,000 2010: $50,233 2005 Dollars 2005 Dollars 2008 Dollars

4. GDP is the standard benchmark for economic well being VS Annual defense spending has grown from $35B in 1950 to $795B in 2009. Should this be subtracted out? The service industry has grown from 30M employees in 1950 to 113M in 2009. Is this really “new activity”? Should we count things like pollution as economic “bads”? How do we account for the added quality and convenience of new products and technologies?

5. The Genuine Progress indicator corrects for social “bads” VS GDP = $15T GPI = $5T

6. Principle #2: How is your variable measured? Gross Domestic Product measures the current market value of all goods and services produced within a country’s borders over a certain time period (usually a quarter) Farmer A produces 1,000 bushels of Apples (Apples cost $10/bushel) Farmer B produces 2,000 bushels of Corn (Corn costs $15/bushel) GDP = ($10)(1,000) + ($15)(2,000) = $40,000

7. Suppose that Intel produces 1,000 computer chips (P = $100) 100 Chips sold to consumers Value Added Approach 900 Chips sold to Dell $100,000 Sales - $0 Materials Expenses $100,000 $500,000 Sales - $90,000 Materials Expenses $40,000 Change in Inventories Dell produces 500 computers (P = $1,000) $450,000 Total = $550,000 (The remaining 400 chips were added to Dell’s inventories)

8. Example: Microsoft Sales: $600,000 • Expenses: $420,000 • Labor Costs: $200,000 • R&D Costs: $50,000 • Materials: $100,000 • Lease: $20,000 • Utilities: $10,000 • Equipment Purchase: $40,000 • Value Added: • $600,000 • - $220,000 (Non-Labor Exp) • + $40,000 (Equipment Inv) • + $20,000 (Inv. Investment) • + $50,000 (R&D) – NEW • $490,000 • Inventories: • BOY: $620,000 • EOY: $640,000

9. Goods & Services (GDP) Product Markets Expenditures Income Factor Markets Factor Services

10. The Circular Flow of Payments suggests that we could also calculate GDP by measuring total expenditures on the goods and services produced Government Purchases (Federal, State, and Local) GDP • Gross Business Investment • Structures • Equipment • Inventories • Residential Investment • Consumer Expenditures • Durables • Non-Durables • Services

11. Suppose that Intel produces 1,000 computer chips (P = $100) 100 Chips sold to consumers Expenditure Approach 900 Chips sold to Dell $0 $40,000 Inventory Investment $510,000 Consumer Durables Dell produces 500 computers (P = $1,000) (The remaining 400 chips were added to Dell’s inventories) Total = $550,000

12. What’s so Gross about GDP? Suppose that we have the following information from GM’s financial statements $300,000 Sales (000s) - $150,000 Materials Expenses (000s) Sales: $300M $20,000 Change in Inventories (000s) Change in Inventories: $20M Total = $170,000 Materials Costs: $150M Depreciation: $5M Strictly speaking, depreciation should be counted as a cost of production. GDP calculations do not include depreciation expenses!

13. Exports of Goods and Services • US Citizens Working Abroad US Acquisition of Foreign Assets Foreign Acquisition of US Assets • Imports of Goods and Services • Foreign Citizens Working in the US

14. BMW operates a manufacturing facility in Spartanburg South Carolina. Meanwhile, Nike operates 73 production facilities in Thailand. How should we count this production? $130,000 Value Added (000s) $400,000 Value Added (000s) - $70,000 Labor Costs (000s) - $50,000 Labor Costs (000s) $60,000 Profits (000s) $350,000 Profits (000s) Gross Domestic Product = Total Production within US borders Gross National Product = Total Production by US Citizens The $60,000 in profits from BMW accrue to foreign nationals and should not be counted in US GNP. However, GNP would need to include the profits from Nike’s Thailand plants.

15. BMW operates a manufacturing facility in Spartanburg South Carolina. Meanwhile, Nike operates 73 production facilities in Thailand. How should we count this production? $130,000 Value Added (000s) $400,000 Value Added (000s) - $70,000 Labor Costs (000s) - $50,000 Labor Costs (000s) $60,000 Profits (000s) $350,000 Profits (000s) GDP = $130,000 GNP = $70,000 + $350,000 = $420,000 $420,000 = $130,000 +($350,000 - $60,000) GNP GDP Net Factor Payments

16. With the global economy, we need to keep track of expenditures between the US and the rest of the world as well as domestic expenditures GDP Government Purchases Consumer Expenditures Gross Investment Net Exports = Exports - Imports

17. GDP is calculated using a method of double entry accounting – each dollar of production should have a corresponding expenditure. GDP: 2011Q1

18. Recall that total income (national income) in the US should accrue from the production undertaken by American citizens First, we need to correct for income earned abroad as well as domestic production accruing to foreign nationals Gross Domestic Product = $15,010B + Net Factor Payments = $227B Gross National Product = $15,237B Now, recall that depreciation is an expense that should be deducted as a production cost - Depreciation Expense = $1,913B Net National Product = $13,324B - Indirect Taxes = $394B Finally, we need to correct for indirect taxes/transfers (essentially, sales taxes) National Income = $12,930B

19. National Income by Source: 2011Q1

20. To get to the flow of funds accounts, begin with GDP equals aggregate expenditures Now, add net factor payments to both sides Current Account = NX + NFP Lastly subtract depreciation and indirect taxes from both sides Net Investment (Gross Investment minus depreciation) National Income Consumer Outlays (Net of Indirect Taxes)

21. The flow of funds measures how net investment is financed National Income = Personal Income + Undistributed Corporate Profits Subtract taxes from both sides…. Now, Subtract Consumption from both sides… Net Private Saving = Personal Saving + Undistributed Profits

22. Last year, the US current account was -$570B. What does this mean? Net lending abroad Total US Outlays Total US Income In other words, the US is borrowing $1.5B per day from abroad! Should we be worried about this? This number continues to grow as the US government overspends!!! This number continues to shrink as US consumers overspend!!

23. Think of Net Exports as the savings of the entire economy. We have become a debtor nation! % of GDP

24. What a wacky world we live in! Currently, China is running s $30B trade surplus with the world Currently, the US is running s $570B trade deficit with the world What’s wrong with this picture?

25. Principle #3:Is your variable in terms of current prices or fixed prices (Real vs. Nominal) Nominal Variables are in terms of a current year’s prices. For example, you’re starting salary after college might be $50,000 per year. Real variables are in terms of some tangible commodity or some constant year’s prices. Real variables measure purchasing power. Nominal Real = Price What should we use as a price?

26. A fixed weight index defines a “basket” of goods. The value of the index is the cost of that basket. This basket should approximate the average American's spending patterns. Year 2005 P =$350 Year 2006 P =$399 Be sure to keep the weights constant!!

27. Usually, price indices are expressed as “relative to a base year”. Suppose we choose 2005 as the “base year Year 2005 P =$350 Year 2006 P =$399 Year 2005 P = 100 Year 2006 $399 P = 100 = 114 $350 Inflation adjusting with a fixed weight index Target Year Price Real Income = Nominal Income Current Year Price Year 2005 Year 2006 100 100 Real Income = $50,000 Real Income = $50,000 100 114 = $50,000 2005 dollars = $43,860

28. Suppose that we calculate inflation rates for each individual good. The overall inflation rate is a weighted average of the individual rates!

29. The CPI is calculated by the Bureau of Labor Statistics (BLS) on a monthly basis

30. General Problems with Price Indices How do we account for the differences in prices at places like Sam's club and outlet malls? How do we account for new products that replace old products? How should we account for quality improvements over time? How do we measure housing costs (some people rent while some people own)

31. Problems with the CPI Suppose that your personal weights are different than the actual weights in the CPI (Formula Bias) Food is a significantly higher portion of your budget. Therefore, when food prices rise, the CPI understates the effect of inflation on you!

32. Problems with the CPI Generally speaking, consumers substitute out of goods that are becoming more expensive. This causes the CPI to overstate inflation! As food and apparel became cheaper relative to housing and transportation, you bought more food and apparel relative to housing and transportation – the CPI can’t account for this!!!

33. Why should we care? • Cost of living adjustments for social security as well as government pension plans are indexed to the CPI • All federal assistance programs are based on the official poverty line, which is indexed to the CPI • Tax Brackets are indexed to the CPI A 1% overstatement in inflation amounts to a $50-$60 billion loss to the federal government!!! In 1996, the Boskin commission determined that the CPI systematically overstates inflation by 1 – 2.5% per year!!!

34. Nominal GDP measures current dollar value of all goods and services produced. When nominal GDP rises, its impossible to distinguish between an increase in production and an increase in prices!! Economy A: Zero growth, high inflation. Both have (approximately) 25% annual growth in Nominal GDP!!! Economy B: Rapid growth, no inflation.

35. Suppose that we have production totals for GDP in 2006. Further, we know prices in 2005 and 2006. We can calculate the nominal value of that production using 2006 prices and the “real” value using 2005 prices. Nominal GDP Real GDP = Real GDP (2006) Nominal GDP (2006) Price Nominal GDP $410,000 Price = = = 1.14 (GDP Deflator) Real GDP $360,000 Note: By definition, the GDP Deflator in the base year is always 1!!

36. Variable weights in the GDP Deflator Using this method, the weights are allowed to change each year and are determined by actual production patterns. This is why the GDP deflator is called a variable weight index.

37. Fixed Weight vs. Variable Weight Index Example Apples Oranges Fixed Weight: 50% Apples, 50% Oranges (Base year = 2012) 2012: (.5)(5) + (.5)(2) = $3.50 2013: (.5)(6) + (.5)(3) = $4.50 2012 = 100 2013 = 128 (Base year = 2013) 2012 = 77 2013 = 100

38. Fixed Weight vs. Variable Weight Index Example Apples Oranges Variable Weight Index (Use 2012 as base year) Nominal GDP: 2012: (5)(100) + (2)(250) = 1,000 2013: (6)(125) + (3)(270) = 1,560 Price Index 2012: 100 2013: 136 Real GDP (2012 prices): 2012: (5)(100) + (2)(250) = 1,000 2013: (5)(125) + (2)(270) = 1,140

39. Base Year = 2005 2005 GDP = $2000 Real GDP = $2000 P = 1 2006 GDP = $2000 Real GDP = $2500 P = .8 Its important to note that choosing a base year is no trivial matter. Consider the following example. There is no aggregate growth in the economy from 2005 to 2006, but there is a “sectoral shift”. Base Year = 2006 2005 GDP = $2000 Real GDP = $2500 P = .8 2006 GDP = $2000 Real GDP = $2000 P = 1 Inflation = -20% Real GDP Growth = 25% Inflation = 25% Real GDP Growth = -20%

40. Initially, it looked as if information technologies really took hold in the early 90’s – dramatically increasing the rate of productivity growth

41. However, in the mid 1990’s, the BLS changed its method of calculating prices (from a base year to chain weighting). All the productivity gains disappeared!

42. Out with the old….. On February 3, 2014, Ben Bernanke left his position as Chairman of the Federal Reserve. In with the new…..

43. Say hello to the new chairman of the federal reserve system… Janet Yellen • Born in Brooklyn, NY in 1946 • Graduated summa cum laude from Brown University in 1967 (Economics) • PhD. In Economics from Yale in 1971 • Assistant Professor at Harvard (1971-76) • Economist at Federal Reserve Board (1977-78) • Lecturer, London School of Economics (1978-80) • Assistant Professor, UC Berkeley (1980-82) • Associate Professor, UC Berkeley (1982-1985) • Professor, UC Berkeley (1985-Present) • Member, Board of Governors of Federal Reserve (1994-97) • Chairman of Council of Economic Advisors (1997-99) • President, Federal Reserve Bank of San Francisco (2004-10) • Vice Chair of Federal Reserve (2010 – Present) Note: Janet Yellen is married to George Akerlof (Nobel Prize in Economics, 2001)

44. “If the current, elevated rate of unemployment is largely cyclical, then the straightforward solution is to take action to raise aggregate demand. If unemployment is instead substantially structural, some worry that attempts to raise aggregate demand will have little effect on unemployment and serve only to stoke inflation” “I see the evidence as consistent with the view that the increase in unemployment since the onset of the Great Recession has been largely cyclical and not structural” Speech to labor unions, Feb. 2013 What does this mean?

45. Monetary policy in a nutshell… If unemployment is above NAIRU, keep interest rates low “Natural rate of unemployment” otherwise known as NAIRU (Non-Accelerating Inflation Rate of Unemployment) If unemployment is below NAIRU, raise interest rates up (INFLATION IS A CONCERN)

46. Since the recession, the Federal Reserve has been purchasing US Treasuries in an effort to keep interest rates low: The Fed is currently purchasing securities at the rate of around $75B per month. (Down from $85B)

47. The Fed has committed itself to the following policy: Tapering quantitative easing (bond purchases) to zero once the unemployment rate reaches 7% and raise interest rates once it hits 6.5% (or even lower) The question is “Is the unemployment in the economy cyclical or structural?”

48. Janet believes the unemployment we have is cyclical … No fear of inflation You are here 6.7% NAIRU = 5-6% Inflation becomes a worry here

49. Suppose that it is structural… No fear of inflation NAIRU = 7-8% Inflation a concern You are here 6.7% Janet’s Target = 5-6% Inflation a BIG concern

50. Lets plot out GDP over a few years. Notice the “saw tooth” pattern?