Finance 30220: Macroeconomics Introduction to The US Economy

Choose the “American” Product How do we measure a country’s size? Total production would be a good start, but the global economy complicates things…. Choose the “American” Product BMW X5 IPhone

Where do BMWs come from? Spartanburg, South Carolina 8,000 Employees Produces 300,000 vehicles annually Produces ALL X3, X4, X5, and X6 models (even for export to Europe) Germany China USA Canada Egypt South Africa India Munich, Germany Japan Mexico

Where does your IPhone come from? Imports of the iPhone in 2009 contributed $1.9 billion to the U.S. trade deficit with China.

VS Two measures of a country’s production Gross Domestic Product represents the total final goods produced within a country Gross National Product represents the total value of final goods produced by a country’s citizens VS By the Standard of GDP, a BMW X5 is an American car (The IPhone is a global product with most of the credit going to the US) By the Standard of GNP, a BMW X5 is (largely) a German car. (The IPhone is a global product with most of the credit going to the US) The Bureau of Economic Analysis officially made the switch from GNP to GDP as the standard benchmark in 1991

The Bureau of Economic Analysis (BEA) reports Gross Domestic Product (GDP) for the United States on a quarterly basis: For the first quarter of 2017, GDP in the United States was (on an annualized basis) was... $19,027,000,000,000.00 Gross National product (on an annualized basis was)… $19,264,000,000,000.00 ( +1.25%) * Source: www.bea.gov

The World Bank and other Development Agencies now use Gross National Income as the standard. Gross National Income is very similar to GNP. GNP = GDP + Income Receipts from assets/citizens abroad less income of foreign nationals within the country. GNI = GDP + Income earned by citizens/assets abroad that is spent in country less income of foreign nationals in country that is spent out of country. Income Earned by: GDP GNP GNI Residents in Country Includes  Includes Foreigners in Country Excludes Includes If Spent in Country  Residents Out of Country Includes If Remitted Back Foreigners Out of Country

For most countries, the differences between GDP and GNP are minor, but there are some extreme outliers! Number of Countries Luxembourg Kiribati Luxembourg GDP: $56.8B GNP: $40.1B Kiribati GDP: $160.1M GNP: $339.32M % Difference GDP > GNP GDP < GNP Percentage Difference between GDP and GNP (2015) * Source: World Bank

Let’s compare US GDP with some of our peers – different units! 140.7 5.9T 1.7T * Source: CIA Factbook *2016 Estimates

Using Market Exchange Rates to adjust GDP 1 Dollar equals 6.80 Chinese Yuan $10.5T 71.5T Foreign Currency GDP Dollar GDP Foreign Currency Per Dollar

Using Market Exchange Rates * Source: CIA Factbook World = $75.3T Pictured Above = $61T (81%) *2016 Estimates

Problem Using Market Exchange Rates 1 Dollar equals 2.80 Chinese Yuan 71.5T 1 Dollar equals 6.80 Chinese Yuan $10.5T 1 Dollar equals 10.80 Chinese Yuan $6.6T Foreign Currency GDP Exchange rates fluctuate a lot. How do we know when a country’s currency is “fairly” valued? Dollar GDP Foreign Currency Per Dollar

Example: Brazil Real Depreciates Real Appreciates Billions of Dollars Reals per Dollar Real Depreciates Real Appreciates

Purchasing Power Parity Example: Big Macs $2.44 16.60 $4.62 At the current exchange rate, you could buy Big Macs in China and Sell them in the US for a Profit! Foreign Currency Price Dollar Price Foreign Currency Per Dollar 1 Dollar equals 6.80 Chinese Yuan

“Purchasing Power Parity Exchange Rates” Eliminate Arbitrage Opportunities $4.62 $4.62 16.60 PPP Exchange Rate Foreign Currency Price PPP Exchange Rate (Foreign Currency Per Dollar) Dollar Price Yuan per dollar

Arbitrage Should Return the Exchange Rate to its PPP Value $4.62 16.60 Based off the Big Mac, the Yuan is undervalued by around 63%! Yuan per Dollar Buy in China, Sell in US (Yuan should appreciate) 6.80 Buy in US, Sell in China (Yuan should depreciate) Time

Using Purchasing Power Parity Conversions for GDP (Big Mac) For the time being, let’s assume that China only sells Big Macs 71.5T PPP Exchange Rate $19.9T (PPP) Market Exchange Rate An “undervalued” currency will make a country seem smaller than it is. $10.5T (ME) Side Note: Quantity of Big Macs produced in China By using the PPP exchange rate, you are revaluing Chinese production at prevailing US prices By the definition of the PPP exchange rate

Question? Should we expect goods prices to equalize across countries and does it matter? 16.60 Market Exchange Rate $4.62 PPP Market Exchange Rate Yuan per dollar PPP Exchange Rate Yuan per dollar

Valuing currencies using the Big Mac Standard * Source: The Economist

Arbitrage With Shipping Costs $4.62 16.60 Shipping Cost = $1 Sell Big Macs in China Buy Big Macs in the US Profit (Per Big Mac) Profitable if

Arbitrage With Shipping Costs $4.62 16.60 Shipping Cost = $1 Buy Big Macs in China Sell Big Macs in the US Profit (Per Big Mac) Profitable if

Arbitrage With Shipping Costs 16.60 $4.62 Shipping Cost = $1 Buy in China, Sell in the US (Yuan will appreciate) Yuan per Dollar 4.58 No Profitable Arbitrage 3.59 45% No Profitable Arbitrage 2.95 Buy in US, Sell in China (Yuan will depreciate) Buy in US, Sell in China (Yuan will depreciate) Time

Adding Non-Traded Goods - Haircuts $4.62 Haircut 50 Lets Assume the PPP exchange rate of 3.59 Yuan Per Dollar 16.60 $25 Big Macs Haircuts Big Mac prices are equalized, but haircut prices are not Chinese Expenditures Big Macs: 16,600 (1,000 Big Macs) Haircuts: 55,000 (1,000 Haircuts) GDP = 71,600 US Expenditures Big Macs: $4,620 (1,000 Big Macs) Haircuts: $25,000 (1,000 Haircuts) GDP = $29,620

$4.62 Haircut Haircut $25 50 16.60 We need to construct a price index that incorporates each good and its relative importance – let’s use expenditure shares as weights US Expenditures Big Macs: $4,620 (1,000 Big Macs) Haircuts: $25,000 (1,000 Haircuts) GDP = $29,620 Chinese Expenditures Big Macs: 16,600 (1,000 Big Macs) Haircuts: 55,000 (1,000 Haircuts) GDP = 71,600

$4.62 $25 50 16.60 Haircut Haircut GDP = $29,620 GDP = 71,600 PPP Exchange Rate $4.62 Haircut $25 50 Foreign Currency Price Index 16.60 PPP Exchange Rate (Foreign Currency Per Dollar) Dollar Price Index PPP Exchange Rate GDP = $29,620 GDP = 71,600 Yuan per dollar Market Exchange Approach Actual Exchange Rate PPP Approach The existence of non-traded goods makes the Yuan appear undervalued! Further, it makes the PPP approach overstate the size of the Chinese economy!

Now, suppose that China experiences a growth in haircuts (non-tradeable) and a decline in Big Macs (Tradeable). Did the Chinese economy grow or not? Haircut 50 16.60 PPP Exchange Rate Yuan per dollar Actual Exchange Rate Chinese Expenditures Big Macs: 13,280 (800 Big Macs) Haircuts: 60,000 (1,200 Haircuts) GDP = 73,280 Market Exchange Approach 2.3% Growth from previous year PPP Approach 1.7% decline from previous year

Example: Brazil Real Depreciates Real Depreciates Billions of Dollars Reals per Dollar Real Depreciates Real Appreciates

Nominal GDP around the world (PPP Method) World = $119.3T Pictured Above = $86.8T (73%) *Source: CIA Factbook

The method by which countries are evaluated sometimes greatly change the results! World = $119.3T World = $75.3T PPP Approach Market Exchange Rate Country GDP Rank China $21.2T #1 $10.7T #3 European Union $20.0T #2 $16.5T United States $18.6T India $8.7T #4 $2.3T #6 Japan $4.9T #5 $4.7T Russia $3.8T $1.3T #8 Brazil $3.1T #7 $1.8T Indonesia $3.0T $941B #13 United Kingdom $2.8T #9 $2.7T Mexico #10 $1.1T ** Source: CIA Factbook *2016 Estimate

Lets use the PPP method as a reasonable method for comparing countries Lets use the PPP method as a reasonable method for comparing countries. Per Capita GDP is calculated by dividing total GDP by the current population. This gives a better sense of average well being. $19T Per Capita GDP = 325M = $58,500 * Source: www.bea.gov

GDP Per Capita around the World $39,200 $26,100 $42,500 $57,300 $14,600 $38,900 $18,900 $6,700 $14,800 $48,800 *Source: CIA World Factbook

The World Bank classifies countries into four groups based on GNI per capita Maximum Minimum 2015 Luxembourg = $99,717 Burundi = $277 Country Type (# of Countries) (Average) GDP Per Capita (PPP) Average GNI Per Capita (PPP) Low Income (30) $600 $615 Low Middle Income (52) $2,364 $2,478 Upper Middle Income (56) $7,198 $7,329 High Income (78) $33,776 $35,644 Global Average (216) $13,155 $13,850

$20,000 is in the bottom 20% of the US income distribution Did you know that if you earn $20,000 or more per year, you are in the top 4% of the global income distribution 67% Are below $1,500 per year $20,000 is in the bottom 20% of the US income distribution * Source: World Bank

Side note: Calculating rates of growth 540 168% 100 t = 0 t = 1 t = 2 t = 3 t = 4 Suppose that we have the following data. How would you calculate the rate of growth between time 0 and time 4. Calculating a percentage change like this assumes that the growth takes place all at once Using natural logs allows the growth process to be a smooth, continual process

Side note: Calculating average annual rates of growth 42% 52% 42% 42% 52% 42% 52% 100 52% t = 0 t = 1 t = 2 t = 3 t = 4 Again, this assumes a discrete process (happening at regular intervals) Using natural logs allows the growth process to be a smooth, continual process

Period GDP (Billions) 2016Q1 18281.6 2016Q2 18450.1 2016Q3 18675.3 Another measure of economic performance would be the rate of growth in output rather than the level of output Period GDP (Billions) 2016Q1 18281.6 2016Q2 18450.1 2016Q3 18675.3 2016Q4 18869.4 2017Q1 19027.6 Year on Year Growth Annualized Growth Year on Year growth (2017Q1-2016Q1) Annualized Growth (2017Q1)

Period GDP (Billions) Price Level 2013Q3 18281.6 110.630 2013Q4 We can approximate real growth by subtracting the inflation rate Period GDP (Billions) Price Level 2013Q3 18281.6 110.630 2013Q4 18450.1 111.258 2014Q1 18675.3 111.648 2014Q2 18869.4 112.229 2014Q3 19027.6 112.846 Year on Year growth (2017Q1-2016Q1) Annualized Inflation (2017Q1) - Year on Year growth (2017Q1-2016Q1) - Annualized Inflation (2017Q1) * Source: www.bea.gov

Growth Rates of Real GDP around the world (PPP) – 2014 1.6% 0.7% 3.1% 2.4% 7.3% 0.0% 2.2% 7.2% 0.1% 2.7% *Source: CIA World Factbook

The World Bank classifies countries into four groups based on GNI per capita Maximum Minimum 2015 Ireland = 26.3% Yemen = -28.0% Country Type (# of Countries) GDP Growth (PPP) GDP Per Capita Growth (PPP) Low Income (30) 2.12% -.54% Low Middle Income (52) 3.52% 1.95% Upper Middle Income (56) 2.45% 1.43% High Income (78) 2.25% 1.35% Global Average (216) 2.63% 1.26%

Let’s look at longer term averages for the US… Year GDP Price 1947Q1 $243B 12.6 2017Q1 $19,027B 112.8 Price Growth (Inflation) Total Growth Average Annual Real Growth = 6.2% - 3.1% = 3.1%

Note that the US seems to be slowing…something happened in the 1970s Average (Pre 1970’s) = 4.2% 4.3% Average (Post 1970’s) = 2.4% 4.0% 3.1% 3.1% Average Real Growth = 3.1% 2.8% 2.0% 1.8% Real GDP Growth (%)

Technology happened in the 1970s…The Beginnings of what’s been dubbed “The Information Technologies Revolution”   Transistor count = 2,300 capable of executing 92,600 instructions per second  Transistor count = 2.27B capable of executing up to 317 Billion instructions per second Jack Kirby demonstrates the first working integrated circuit at Texas Instruments Intel Founded by Gordon Moore and Robert Noyce Intel Releases the 4004 CPU Intel Releases the 8008 CPU Core i7-6950X July 1958 July 1968 April 1971 April 1972 August 2016

Core i7-6950X Gordon Moore 1929 - Intel 4004 Moore's law refers to an observation made by Intel co-founder Gordon Moore in 1965. He noticed that the number of transistors per square inch on integrated circuits had doubled every year since their invention. Moore's law predicts that this trend will continue into the foreseeable future. Intel 4004

Technology leads to lower equipment costs for business…. Real Growth in Equipment Costs Pre 1977 Average = 5.6% Post 1977 Average = 1.7% 1972 1977

US Current Account Balance as a percentage of GDP Cheaper/Better equipment (among other things, leads to globalization)…. Pre-1977 Average = .5% Post -1977 Average = -2.4% 1972 1977 US Current Account Balance as a percentage of GDP

Union Membership in the US (% of Non-agricultural Labor Force) The pressure of global competition hurts labor unions Union Membership in the US (% of Non-agricultural Labor Force) 1964 29.3% 78% Decline 1972 26.6% 2014 11.1% *Source: Barry T. Hirsch, David A. Macpherson, and Wayne G. Vroman, “Estimates of Union Density by State,” Monthly Labor Review, Vol. 124, No. 7, July 2001.

The end result is the emergence of a “wage gap” The end result is the emergence of a “wage gap”. That is, we see a difference between productivity and wages Index: 1947 = 100 1972

So, how do families cope with stagnating wages? Historically, labor’s share of income has been constant at around 65%, but has decreased since the 1980s. Percent 65% This “wage gap” translates into a lower labor share of income 58% So, how do families cope with stagnating wages?

Phase #1: Women enter the workforce as a second household income Phase #2: Households begin borrowing 1972 - 1990 1985 - 2007 95% Labor Force Participation 67% Household Debt as a Percentage of GDP 45% 60%

Meanwhile, on Wall Street…. Dow Jones Industrial Average 1972

The top 20% of households collect 50% of all income earned (that’s 24 million households earning $9 Trillion – around $375,000 per household) Mean Household Income = $85,000 # of Households = 121M * Source: US Census Bureau

Average Income by Quintiles - 2015 dollars (2015) $117,002+ $72,001 - $117,002 $43,511 - $72,001 $22,800 - $43,511 $0 - $22,800 Source: US Census Bureau (www.census.gov)

Saez/Piketty Allow us to look at the top end of the distribution! Emmanuel Saez UC Berkeley Note: There are roughly 125 million households Thomas Piketty Paris School of Economics

Note the divergence of median income with mean income beginning in the late 1970’s in the United States 202.0 Real GDP Per Capita (1974 = 100) 176.3 Real Median Personal Income (1974 = 100) 130.7 128.0 100

Today, The top 10% of households ( 12 million) collect around 45% of all income earned ( $8 trillion) – that’s around $650,000 apiece. Emmanuel Saez UC Berkeley Thomas Piketty Paris School of Economics *Source: Thomas Piketty and Emmanuel Saez

Cumulative Growth in Average Inflation Adjusted After Tax Income by percentile: 1979 - 2011 * Source: Congressional Budget Office

The Lorenz curve plots the cumulative distribution of US income

The Gini Coefficient The US currently has a Gini coefficient of .45 0 = Perfect Equality 1 = Perfect inequality

Gini Coefficient in the US by County * Source: Census Bureau

Gini Coefficients around the world .310 .420 .324 .450 .465 .379 .482 .352 .597 .303 World = .379 * Source: CIA Fact book

Note that income inequality in the US was worse back in the 1920’s, but has grown dramatically since the 1970s Income inequality really accelerated in the 1990’s!

The Good Old Days: Economic Growth from 1947-1973

The Times, They are a Changin’: Economic growth from 1977-1989

Here we can see both the declining growth as well as the rising inequality.