Revised by khurram Shamim Khan Measuring the Economy Measure economic activity by –Output produced, or –Income earned Gross Domestic Product (GDP) –Final products from labor/property located in U.S. –At market prices National Income (NI) –Costs of production, plus –Profits earned

Revised by khurram Shamim Khan Measuring the Economy (cont.) GDP = C + I + G + (X - M) C =consumption I = gross private domestic investment G = government X = exports M = imports NI = GDP + NR - CC - IBT NR = net factor income from abroad CC = capital consumption (depreciation allowances) IBT = indirect business taxes (X - M) = net exports

Revised by khurram Shamim Khan Measuring the Economy (cont.) DI = NI + TR + INT - RE - Tp - Tc - INF DI = disposable income (available for spending by individuals) TR = transfer payments from government INT = interest paid on government debt RE = retained corporate earnings Tc = corporate tax payments Tp = personal tax payments INF = interest on government debt paid to foreigners

Revised by khurram Shamim Khan Measuring the Economy (cont.) DI = C + PS PS = personal savings I + NFI = PS + BS + GS NFI (net foreign investment) = X - M - INF + NR BS (business savings) = RE + CC GS (gov’t savings) = taxes - gov’t outlays Taxes = Tp + Tc + IBT Gov’t outlays = G + TR + INT

Revised by khurram Shamim Khan Indices Nominal GDP:  i Q it P it Real GDP (period 0 prices):  i Q it P i0 Implicit price deflator = ratio of real to nominal GDP Price index = weighted average of price relatives = I t =  i w it (P it / P io )

Revised by khurram Shamim Khan Indices (cont.) Paasche index: based on current period basket I t = {  i Q it P it } / {  i Q it P i0 } Laspeyres index: based on base period basket I t = {  i Q i0 P it } / {  i Q i0 P i0 } Paasche: may understate true inflation rate Laspeyres: overstates true inflation rate (because it neglects the fact that people search for cheaper substitutes over time in an inflationary environment)

Revised by khurram Shamim Khan Indices (cont.) Chain-linked index: mixture of Paasche and Laspeyres; quantity weights are from the immediate past period I t = I t-1 {  i Q i,t-1 P it } / {  i Q i,t-1 P i,t-1 } Chain-linked measure of rate of real GDP growth (from t-1 to t):  i Q it P i,t-1 } / {  i Q i,t-1 P i,t-1 }] - 1

Revised by khurram Shamim Khan Other Major Price Indices Consumer Price Index (CPI): representative basket of consumed goods –Laspeyres-type index –Issues: overstates true inflation (since Laspeyres); quality improvements, new products Producer Price Index (PPI): changes in costs of production –Laspeyres-type index

Revised by khurram Shamim Khan Data Sources and Presentation Sources of data –Product side: surveys and samples –Income side: tax collection system Presentation characteristics –Quarterly data usually shown as annual rates –Usually seasonal adjustments –Due to volatility, quarterly growth rates often not best measure with respect to trends in output or inflation

Revised by khurram Shamim Khan Balance of Payments Current account balance = receipts + payments + net transfers –Receipts (a positive entry): by U.S. residents from abroad –Payments (a negative entry): made abroad

Revised by khurram Shamim Khan Business Cycles Business cycle: recurring changes in economic activity –No fixed periodic pattern –Phases (e.g., expansion, recession) Peak: start of a recession Trough: end of a recession –Leading / coincident / lagging indicators (see lists for specific examples)

Revised by khurram Shamim Khan Interest Rates Yield curve: time to maturity versus yield to maturity –Expectations hypothesis: (1+r 2 ) 2 = (1+r 1 )(1+Er 1 ) r i = i-year spot rate (yield) Er 1 = expected future one-year yield Real rate of interest: (1+r) / (1+  ) = (1+r real ) where  is the inflation rate Fisher relationship: nominal rate = real rate + inflation rate

Revised by khurram Shamim Khan Exchange Rates Exchange rate: number of units of foreign currency per dollar Real exchange rate: e real = e nominal (P / P foreign ) P: domestic price level P foreign : foreign price level Appreciation of U.S. dollar: e (exchange rate) increases; U.S. dollar purchases more foreign currency Depreciation of U.S. dollar: e decreases

Revised by khurram Shamim Khan Growth (cont.) Elasticities can also be looked at in terms of total factor returns as shares of output c = return on capital w/p = real wage

Revised by khurram Shamim Khan Banks (cont.) Suppose R=kD, where R = banking system reserves D = demand deposits k = fraction of deposits held as reserves Money supply: M = C + D + T, where C = currency T = time (savings) deposits Total reserves: TR = RR + RE, where RR = required reserves RE = excess reserves

Revised by khurram Shamim Khan Banks (cont.) Central bank –Assets = Q + B Q = securities portfolio; B = loans to banks –Liabilities = TR + C TR = total reserves held by banks at central bank (assume banks do not hold cash reserves); C = currency in circulation –Balance sheet identity: Q+B = TR+C –Using prior definitions and defining free reserves as RF = RE - B, then money supply is M = (1/k){Q - (1-k)C - RF} + T –Note: RF = RF(r,r d ), where r d = Fed discount rate –Borrowing: increasing function of r, decreasing function of r d

Revised by khurram Shamim Khan Federal Reserve System Money supply increases when central bank –Increases its bond portfolio (Q increases) –Reduces its reserve requirements (k decreases) –Reduces the discount rate (r d decreases) (discount rate is interest rate on Fed loans) Structure of system –1913: Federal Reserve Act –12 regional banks (each owned by the member banks) –7-member Board of Governors –Profits of Federal Reserve banks go to Treasury

Revised by khurram Shamim Khan Federal Reserve System (cont.) Functions of Federal Reserve banks –Examine member banks –Review merger applications –Check-clearing and transfer services –Agent for sale of Treasury securities and distribution of new currency Policy functions –Set discount rate –Discount window (how much borrowing to allow) –Participate on Federal Open Market Committee

Revised by khurram Shamim Khan Federal Reserve System (cont.) Formal Board functions –Approve bank mergers –Set commercial banking activity regulations –Set reserve requirements, discount rate –Direct open market operations

Revised by khurram Shamim Khan Monetary Policy Tools Open market operations –Most actively used tool –Open market purchase of government securities ==> increases Fed’s portfolio of such securities; paid for by creating reserve deposits ==> increases public’s deposit balances –Fed Funds rate: rate at which reserve deposits are lent between financial institutions; a market- determined rate –Purchase securities ==> adds to banking system reserves ==> Fed Funds rate declines –Sell securities ==> decreases banking system reserves ==> Fed Funds rate increases

Revised by khurram Shamim Khan Monetary Policy Tools (cont.) Discount rate –Increase in rate reduces money supply (due to costly borrowing from Fed) –Typically, kept 1/4 point below the Fed Funds rate (allows small banks to use discount window) Reserve requirements –Increase in requirement reduces the money supply (forces banks to hold more in reserve ==> reduce loans, etc.) –Changes to requirements made infrequently

Revised by khurram Shamim Khan Fiscal Policy Fiscal policy tools –Tax policy Corporate Personal –Expenditure policies Problems with fiscal policies –Uncertain responses to policy changes –Lags / delays in implementation Recognition lag: between economic disturbance and policymaker recognition Decision lag: between recognition and policy decision Implementation lag: between decision and implementation Outside lag: between implementation and impact Inside lags