FIN 30220: Macroeconomic Analysis

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

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### FIN 30220: Macroeconomic Analysis

Measuring the U.S. Economy

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

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

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?

VS

GDP = \$15T

GPI = \$5T

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

Suppose that Intel produces 1,000 computer chips (P = \$100)

100 Chips sold to consumers

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)

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
• \$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

Goods & Services (GDP)

Product Markets

Expenditures

Income

Factor Markets

Factor Services

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

• Structures
• Equipment
• Inventories
• Residential Investment
• Consumer Expenditures
• Durables
• Non-Durables
• Services

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

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!

Exports of Goods and Services

US Acquisition of Foreign Assets

Foreign Acquisition of US Assets

• Imports of Goods and Services
• Foreign Citizens Working in the US

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

\$400,000

- \$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.

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

\$400,000

- \$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

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

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

GDP: 2011Q1

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

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)

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

Total US Outlays

Total US Income

This number continues to grow as the US government overspends!!!

This number continues to shrink as US consumers overspend!!

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?

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?

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!!

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

Suppose that we calculate inflation rates for each individual good.

The overall inflation rate is a weighted average of the individual rates!

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)

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!

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!!!

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!!!

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.

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!!

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.

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

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

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%

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

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!

Out with the old…..

On February 3, 2014, Ben Bernanke left his position as Chairman of the Federal Reserve.

In with the new…..

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)

“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?

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)

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)

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?”

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

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

Retail sales follows a seasonal cycle with lows in January/February and September/October and Highs in May/June and December. This seasonality in sales creates seasonal cycles in most macro series.

Lets take a look at the US economy from 1957 to 2008 …

GDP (Billions of Dollars)

\$14.2T (2008Q1)

\$457.2B (1957Q1)

Comparing GDP in 1957 and 2008 is like comparing apples and oranges. Prices were much different 51 years ago!!

Let’s “scale up” GDP in 1957 and “scale down” GDP in 2008 to reflect year 2000 prices…

\$457.2B (1957Q1)

180

=\$2,743.2B

30

Now, these numbers are comparable!

\$14,200B (2008Q1)

180

=\$11,983.12B

213

We have now converted GDP to real GDP (2000 prices)

GDP (Billions of 2000 Dollars)

\$14,200B (2008Q1)

\$11,983B

\$2,743.2B

\$457.2B (1957Q1)

Lets convert all the years…

We have now converted GDP to real GDP (2000 prices)

Real GDP (Billions of 2000 Dollars)

\$14,200B (2008Q1)

\$11,983B

\$2,743.2B

\$457.2B (1957Q1)

Note that “Real” GDP crosses GDP at the year 2000

Now that we have real GDP, let’s think about the trend…

Real GDP (Billions of 2000 Dollars)

\$11,983B

\$2,743B

Would a linear trend fit this data (constant dollar growth in GDP)

Exponential growth is constant annual percentage growth

Average quarterly growth rate

Real GDP (Billions of 2000 Dollars)

\$11,983B

\$2,743B

The previous slide uses an exponential trend. This assumes that the US has some constant annual rate of real economic growth (3.2% per year). Note that actual growth varies even over long time periods.

Notice the downward trend in growth…we’ll talk about that later!

Over five year periods, we see that growth seems to have a cyclical pattern rather than a constant annual rate.

The Hodrick-Prescott (HP) filter allows us to calculate a trend rate of growth that is not constant.

The HP filter applies a minimization problem…pretty ugly, huh?!

Smoothness of trend

Squared deviations between series and trend

Smoothing parameter (bigger numbers create smoother trends) – usual value = 1600

Here we have annualized growth rates of the HP trend and the Exponential trend

Why is getting the trend right so important?

Lets imagine enlarging a portion of our GDP graph with a trend. We can see a distinct set of stages…

Trend Growth

Negative growth

Trend

GDP

Time

Above trend growth

Below Trend Growth

This is what we mean by the business cycle

Recession

Expansion

Peak

Trough

The recessions are pretty easy to spot!