ECONOMICS what is it and why study it?

1. ECONOMICSwhat is it andwhy study it? Social Science Efficiency

2. How to increase output Standard of Living = Income = Output • Economic Resources • Anything that can be used to produce output can be viewed as a resource (input, or factor of production) • Main categories of resources: • Land (inclusive of natural resources) • Physical Capital (productive capital) • Encouragement of saving (IRAs) • Labor • Immigration • Human Capital • Subsidized education • Entrepreneurship • Development of favorable business environment

3. efficiency Output can be increased through increases in the resource base, but it can also be increased or “improved” through efficiency • Fundamental Economic Questions: • What to Produce (allocative efficiency) • How to Produce (productive efficiency) • For Whom to Produce (allocative efficiency) • The Society answers these questions in large part through the choice of the economic system

4. Economic systems • Capitalism • Socialism • Communism These systems differ in the allocation of the ownership of productive resources The differences in these systems can also be formulated in terms of how they address the fundamental questions (e.g. command economy versus market economy) • Feudalism • Mercantilism

5. Capitalism • Natural emergence • Adam Smith’s “invisible hand” concept • Simplified role of the government • Institutional support for economic activity • Property rights laws • Stable political system • Well defined legal system • Transparent business regulations • System of checks and balances for gov’t officials

6. Socialism • Philosophical Foundation • Socialist Movement of the mid XIX century • Role of the government • Includes economic decisions in terms of allocation of resources and output, and possibly production

7. Modern Economies • Mixed system (capitalism + socialism) • EU versus US versus RU versus China Source: World Bank, WDI 2003

8. Unemployment rate comparison Source: World Bank, WDI 2003

9. The Concept of Cost in Economics • Every undertaken activity has a foregone sacrifice associated with it • Opportunity Cost • The value of the next BEST (highest valued) alternative (the value of the sacrifice that would have become the next choice) • E.g. opportunity cost of this class • E.g. Opportunity cost of the Colander’s book (relative price) • E.g. Opportunity cost of physical capital

10. The world of trade-offs • Budget Constraint and Relative Price • Production Possibilities Frontier

11. Gains from Trade • Specialization and increased output • Two-country two-product world • Absolute advantage principle • Why specialize in the production of something that is cheaper to purchase from abroad? • Comparative advantage principle • Specialize in the production of those products in which you have the lowest relative (opportunity) cost of production • Shape of PPF and lack of complete specialization • US trade data available on BEA website at: http://www.bea.gov/bea/di/home/trade.htm

12. For the US see BEA

13. Globalization and International Risks • Globalization = economic integration • Trade • Investment • Labor mobility • Economic union (EU) • Globalization and spread of economic recessions Correlation in economic growth (GDP growth rates: 1990-2005) between the US and some of its major trading partners)

14. Markets • Defining a market • Product definition (and competition) • Geographical boundaries (internet, shipping cost reduction – globalization and outsourcing) • Market forces: Buyers (demand) versus Sellers (supply) • Price and quantity as the outcome

15. demand • Quantity = f (price, other factors) • Price and the Law of Demand • Other factors • Income (normal versus inferior) • Related in consumption goods • Substitutes • Complements • Expectations about the future • OTHER FACTORS ………

16. supply • Quantity = f ( price, other factors) • Price and the Law of Supply • Other factors • Costs of Production (MC, and price as MB) • Goods related in production • Substitutes: (agricultural products) • Note, identical to costs of production since is based on opportunity cost concept • Complements: (like gold and silver) • Producer expectations of future prices • Other factors…

17. Market equilibrium • Qs = Qd • Shortage and surplus as unstable states and the stability property of the equilibrium • Market efficiency • Shifts in demand and supply • Is the equilibrium really efficient? • Productive and allocative efficiency

18. Market example: ForEx • How can the US run a trade deficit consistently? Or, differently put, can one live on credit forever?

19. Does Dollar Matter?

20. Should We Be Concerned With The Fluctuating Dollar? • TRADE and Currency Fluctuations • Price Changes • Standard of Living • Commodity Prices

21. The ForEx market • Supply of the USD • Imports to the US • Goods (trade) • Services (tourism) • US investment abroad • Foreign Financial Markets • Direct investment abroad • Central Banks • Speculation • Demand for the USD • US Exports • Goods • Services (tourism) • Foreign Investment into US • US Financial markets • Direct investment • Central Banks • Speculation

22. The Interesting 90’s • 1991-92: Collapse of the USSR Block, beginning of the Transitional Recession in Eastern Europe • 1994 Mexican Currency Crisis • 1991(2)-95 The Balkan Wars • 1998 Recession in Japan • 1997 (July) Beginning of the Asian Financial Crisis • 1998 major Rouble Crisis

23. The market for USD in the 90’s P of USD Influx of investment stimulated Demand D S Increase in imports stimulated Supply Demand Effect Dominated (thus positively effecting consumers’ standard of living)

24. The post 90’s era • United Europe • 10 New Countries Entered the Union on May 1st of 2004, bringing the total number of member states to 25, with combined population of over 430 million (US population is 293 million). • Strong Growth in Russia and China • Emerging Economies of Brazil and India • Threat of Terrorism to the US • Continuous Growth in US Trade Deficit • More Recently, the French and Dutch Referendums on the EU Constitution

25. The BIG picture • Rise in Imports  Increase in Supply  Depreciation • Rise in Exports  Increase in Demand  Appreciation • Influx of Investment  Increase in Demand  Appreciation • Outflow of Investment  Increase in Supply  Depreciation • BALANCE OF PAYMENTS – An Economy’s International Balance Sheet (www.bea.gov)

26. Demand for the dollar • different economic agents that purchase the dollar: • Foreigners who wish to purchase US goods or services, foreign • tourists who wish to travel to the US (US exports) • Foreigners who wish to invest in the US (higher US interest rate, attractive US stock market returns) • Supply of the dollar • different economic agents that sell the dollar: • US consumers/firms that want to purchase foreign goods or services, US tourists who wish to travel abroad (US imports) • US residents who wish to invest abroad (higher interest rates abroad, etc.) • The dollar will appreciate if demand exceeds supply at the current exchange rate. The increase in the demand creates a temporary shortage, but that shortage disappears due to the increase in the price. The price adjustment is the market’s correction mechanism to the changing conditions. • Note that when you purchase a foreign made product, the cost of the production of that product is paid in foreign currency, hence somewhere between the production process and your purchase someone would have to convert your currency into that foreign currency in order to pay for the production.

27. Measuring Economic Activity • OUTPUT • EMPLOYMENT • INFLATION

28. Gross Domestic Product the total market value of all final goods and services produced by factors of production located within a nation’s borders over a period of time (usually one year) • Gross National Product the total market value of all final goods and services produced by factors of production owned by a nation over a period of time (usually one year)

29. Output • Measuring production • Time period • Final goods and services (value added) • Market prices • Defining an economy (geographical boundaries versus resource ownership) • Gross Domestic Product • Gross National Product • www.bea.govTable 1.7.5 http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=43&FirstYear=2003&LastYear=2005&Freq=Qtr

31. GDP per capita in 2005 (using 2000 USD) Greater than $9910 (2445, 9910) (1172, 2445) (430, 1172) less than $430 no data available

32. The World Economy in 2004 Source: WDI: 2006, World Bank

33. Correlation between life expectancy and the standard of living as measured by the GDP per capita (PPP) is positive 0.65, see the stats table; correlation between GDP per capita and life expectancy is 0.57 (based on the 2005 data from WDI of 2007

34. The planet Earth in the darkness of the night* * Image source: NASA (http://antwrp.gsfc.nasa.gov/apod/ap001127.html)

35. Issues in GDP computation/comparison • Survey of economic activity • Self-employed/small businesses • Market prices and the government sector • Illegal activities • Underground economy (“shadow” sector) • Tax compliance • Defining legal vs illegal • Labor force participation/wages • Household vs market setting

36. Equivalence between expenditure and income approaches in GDP computation • Circular flaw concept • Production of output creates income • Income finances consumption of output Input markets Wages, interest, profits Labor, capital… Businesses Households prices output Output markets

37. Income = output • GDP = GNP – NET FOREIGN INCOME • NI = GNP – depreciation – indirect business taxes • PI = NI - (Transfer payments from Gov’t, net non-business interest income) + (Social Insurance tax, corporate retained earnings) • DI = PI – Personal Taxes • See Table 1.7.5 (www.bea.gov)

38. Income approach • Disposable Income (in 2004: 8,646.9 billion $) • Income that households actually receive • Available for consumption and saving • Personal Income (in 2004: 9,689.6 billion $) • Household income prior to personal taxes and transfers • PI= DI + Personal Taxes • National Income • Summation of factor payments • Employment compensation • Interest received from private business • Profits • Rental income • NI = PI + (Transfer payments from Gov’t, net non-business interest income) – (Social Insurance tax, corporate retained earnings) • Gross National Product • GNP = NI + Dep.Allowance + Indirect Business Taxes • GDP = GNP - Net Foreign Income

39. Expenditures Approach • Personal Consumption • Goods • Durable • Non-durable • Services • Gross Private Domestic Investment • Fixed Investment • Non-residential • Structure • Equipment and software • Residential • Business • Government Spending (all levels) • Exports of goods and services • Imports of goods and services • http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=35&FirstYear=2003&LastYear=2005&Freq=Qtr Table 1.5.5

40. employment • Labor force • Labor force participation rate • Unemployment • Unemployment rate BLS www.bls.gov US statistics Industry data: ftp://ftp.bls.gov/pub/suppl/empsit.ceseeb3.txt • Categorizing unemployment • Cyclical • Structural • Seasonal • Frictional

41. More on unemployment • Accuracy of unemployment statistics • Discouraged worker phenomenon • Two surveys Statistics for the US economy For March-July 2003 (seasonally adjusted). Source: BLS Discouraged Worker Phenomenon

42. Historical unemployment rate in the US

43. inflation • Rate of growth of the average of all prices • Average price: weighted price • Weight represents relative importance of the good • Average price converted into index: price index • Measuring inflation • Consumer Price Index (CPI) • www.bls.gov (http://www.bls.gov/news.release/cpi.t01.htm) • Producer Price Index (PPI) • www.bls.gov

44. Real versus Nominal Measures US Real and Nominal GDP. Source: BEA

45. Costs of (unanticipated) Inflation • Menu Cost • Redistribution of Wealth • Changes in Standard of Living • Inflation and relative prices • High inflation tends to be more volatile • Increased Uncertainty in Forward Looking Financial Arraignments • Impact on the Exchange Rate (Purchasing Price Parity for internationally traded goods)

46. Growth in Real GDP Recessions in Recent US history: 2000-2001: QIII:00 QI:01 QIII:01 1990-1991: QIV:90 QI:91 1981-1982: QIV:81 QI:82 (QIII:82) 1980: QII & QIII 1974-1975 QIII:74 QIV74 QI:75

47. Real Business Cycle - US Real GDP: 1974-2006

48. Unemployment Rate: 1974-2006 Source: BLS

49. Core Consumer Prices Source: BLS

50. The Business Cycle • Glut of goods and subsequent reduction in production Real GDP (per capita) time Recession – a period of two or more consecutive quarters of decline in real output