Gross Domestic Product (Measure of Economic Activity) Web: Monthly revisions, annual revisions in July, benchmark changes every 5 years. Gross domestic product (GDP) total value of all final goods and services produced in the U.S. Most important economic indicator, can identify economic strengths and weaknesses. It is used by forecasters to project future economic activity, by business leaders for business planning and sales forecasting, by money managers for investment strategies, and policymakers to alter macroeconomic policies. GDP = final sales +  Inventory Self-Sustaining Economic Expansion: Economic growth =>  employment =>  HH income =>  HH consumption =>  production =>  employment =>  HH income => self-generating growth cycle Cycle can be interrupted by an outside shock (war, oil embargo,... ) Nominal GDP values output in current dollars (PY) Real GDP describes output in constant dollars (chain weighted) Y = C + I + G + X – M Increase in Y leads to higher living standards. Increase in P leads to lower living standards.  PY) =  PY 1 +  YP 1 +  P  Y P 1 Y 1 P 1 Y 1 P 1 Y 1 P 1 Y 1  PY) =  P +  Y + 0 if  P and  Y are small P 1 Y 1 P 1 Y 1  Y =  PY) –  P Y 1 P 1 Y 1 P Market Analysis: Bonds: Compare GDP data to market expectations. If  Y/Y   P/P =>  D Bonds =>  i Bonds Stocks: If  Y/Y > expectations =>  future corporate sales =>  future profits =>  P Stocks Dollar: If  Y/Y > expectations =>  future corporate sales and interest rates =>  demand for U.S. stocks and bonds =>  Demand for dollars => dollar appreciates.

Recession Factors: Loose monetary policy Poor regulation Lax bank supervision Opaque derivatives Shadow banking system Lax investor diligence Poor governance Misaligned incentives fraud Below trend growth Falling stimulus spending Less inventory rebuilding Slowing Euro-Zone Financial crisis Deleveraging households Rising savings rates Falling Potential Growth Rate 3.5% to 2.5% Less investment spending Lower leverage in post-credit era Suppressed demand Negative demographic trends Lower total factory productivity growth

Components of GDP PERSONAL CONSUMPTION EXPENDITURES, OR “CONSUMPTION” Consumption Spending by households on goods and services, not including spending on new houses. GROSS PRIVATE DOMESTIC INVESTMENT, OR “INVESTMENT” Investment Spending by firms on new factories, office buildings, machinery, and inventories, and spending by households on new houses. GOVERNMENT CONSUMPTION AND GROSS INVESTMENT, OR “GOVERNMENT PURCHASES” Government purchases Spending by federal, state, and local governments on goods and services. NET EXPORTS OF GOODS AND SERVICES, OR “NET EXPORTS” Net exports Exports minus imports. Spending = C + I + G + X – M % of total = (70.6) (14.0) (18.5) (13.4) (-16.4) Growth rate = (2.2) (-0.6) (-6.6) (-5.7) (-3.2) Contribution = (1.5) + (-0.1) + (-1.3) + (-0.8) + (0.6) = -0.1% ( ) 1/4 -1 = = -0.1% 4th Quarter 2012 GDP

Domestic Production, Y =100 Sales, C + I + G + X Inventory Foreign Production, M=18

Equilibrium Condition Q.S. = Q.D. Y + M = C + I + G + X 2011 $ Trillion $ $2.7 = $ $1.9 + $3.0 + $2.1 Divide by Y (15.1 trillion) to get relative perspective 100% + 18% = 71% + 13% + 20% + 14% For heuristic reasons, multiply by = Or 100 = – 18 Y = C + I + G + X - M

Circular-Flow Diagram Government Firms Markets for goods and services Financial Markets Households Factor Markets Rest of the world Government purchases of goods and services Government borrowing Private savings Government transfers Wages, profit, interest, rent Borrowing and stock issues by firms Foreign borrowing and sales of stock Foreign lending and purchases of stock Exports Imports GDP Taxes Consumer spending Investment

Resource Cost-Income Approach Expenditure Approach The two methods of calculating GDP are summarized below: Personal consumption expenditures + Gross private domestic investment + Government consumption and gross investment + Net exports of goods and services Aggregate income: Employee Compensation Income of self-employed Rents Profits Interest + Non-income cost items: Indirect business taxes and depreciation Net income of foreigners + = GDP Two Ways of Measuring GDP: = GDP

GDP estimates include an imputation for the value of “owner-occupied housing.” If you buy the home you were formerly renting, GDP does not go down. Statisticians make an estimate of what you would have paid if you rented whatever you live in, whether it’s an apartment or a house. To be accurate, estimates of GDP must take into account the value of housing that is occupied by owners, as well as the value of rental housing. GDP: What’s In and What’s Out Included  domestically produced final goods and services (including capital goods)  new construction of structures  changes to inventories Not Included  intermediate goods and services  inputs  used goods  financial assets like stocks and bonds  foreign-produced goods and services

Real GDP versus Nominal GDP Calculating Real GDP Real GDP The value of final goods and services evaluated at base year prices. Nominal GDP The value of final goods and services evaluated at current year prices. The GDP Deflator Price level A measure of the average prices of goods and services in the economy. GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP, and multiplying by 100.

CPI Inflation Gauge (Measure of price inflation in retail goods and services) Web address: No monthly revision, annual revision in February. CPI: Inflation affects the following activities Costs of doing business Investment decisions Retirees quality of life Labor contracts & rental contracts Government macroeconomic policy Social security benefits, food stamps, alimony, child support payments CPI is an index number which leads to a historical perspective of inflation. ( =100) Inflation Explanations: Monetarist View – excessive money supply growth. Too many dollars, chasing to few goods. If  M/M >  Y/Y then  P/P > 0 Keynesian View – AD > AS => shortage =>  Prices inflation is a function of the state of the business cycle and level of production slack/idle capacity/resource scarcity Core-CPI - best measure of underlying inflation 2 Population Groups: CPI-W (wage earners & clerical workers) 32% of population benchmark for pay increases in collective bargaining agreements and for yearly cost-of-living adjustments on social security checks. CPI-U (all urban workers)

CPI Inflation Gauge (Measure of price inflation in retail goods and services) Deflationary Spiral:  prices =>  corporate profits => job layoffs =>  household income =>  consumption spending =>  inventories =>  prices Forecasting Tool: Business can anticipate future technology and medical costs Investors can reassess investment strategies Union leaders use inflation forecasts in pay negotiations CPI is a lagging economic indicator 6 Other Price Gauges: PCE, Producer Prices, Import Prices, Employment Cost Index, Unit Labor Costs, GDP deflator Unexpected increase in inflation Bond Market:  bond demand =>  bond price =>  nominal interest rates Stock Market:  nominal interest rates =>  borrowing costs =>  profits=>  stock prices Federal Reserve  nominal interest rates =>  borrowing costs =>  profits =>  stock prices Firms prefer an increase in output rather than an increase in prices to boost revenues FX Market: AD > AS => unexpected inflation  Y =>  r =>  exchange rate (good investment environment)   P/P =>  i =>  exchange rate (erodes dollar-based investments held by foreigners)

Price Indexes and the Aggregate Price Level The aggregate price level is a measure of the overall level of prices in the economy. To measure the aggregate price level, economists calculate the cost of purchasing a market basket. A price index is the ratio of the current cost of that market basket to the cost in a base year, multiplied by 100. The inflation rate is the yearly percentage change in a price index, typically based on the Consumer Price Index, or CPI, the most common measure of the aggregate price level. The consumer price index measures the cost of the market basket of a typical urban American family.

Consumer Price Index

Is the CPI biased? The U.S. government takes considerable care in measuring consumer prices. Nonetheless, many economists believe that the consumer price index systematically overstates the actual rate of inflation. One reason is the fact that the CPI measures the cost of buying a given market basket. Yet, consumers typically alter the mix of goods and services they buy (substitution effect), reducing purchases of products that have become relatively more expensive and increasing purchases of products that have become relatively cheaper. The second reason arises from innovation. By widening the range of consumer choice, innovation makes a given amount of money worth more.