1. Lecture 3: Basics of Macroeconomics Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class January 18, 2008

2. Basics of Macroeconomics Chapter 23

3. The Economy’s Income & Expenditure  For an economy as a whole, income must equal expenditure because: –Every transaction has a buyer and a seller. –Every dollar of spending by some buyer is a dollar of income for some seller.  Gross domestic product (GDP)  Gross domestic product (GDP) is a measure of the income and expenditures of an economy.  It is the total market value of all final goods and services produced within a country in a given period of time.

4. Definition of GDP  GDP is the market value of all final goods and services produced within a country in a given period of time.

5. Definition of GDP  “GDP is the Market Value...” –Output is valued at market prices.  “... Of All Final...” –It records only the value of final goods, not intermediate goods (the value is counted only once).  “... Goods and Services... “ –It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

6. Definition of GDP  “... Produced...” –It includes goods and services currently produced, not transactions involving goods produced in the past.  “... Within a Country...” –It measures the value of production within the geographic confines of a country. –  “... In a Given Period of Time.” –It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

7. Definition of GDP  What Is Not Counted in GDP? –GDP excludes most items that are produced and consumed at home and that never enter the marketplace. –It excludes items produced and sold illicitly, such as illegal drugs.

8. Simple GDP Example This simple economy has 2 people: Baker and Miller. Baker buys flour for $350. He also uses a worker and pays $200 in wages. He also pays a rent of $25. He makes a profit as $25 on the bread he sells for $600. The miller pays his worker $300, a rent of $25, and his profit is $25 on a sale of $350. The GDP of this economy is $600! Why? 2 sides of a coin, Income=Expenditures Expenditures=Value of final Goods sold=600 Income=wages+Rent+profits=300+200+25+25+25+25=600

9. NIPA Definition of GDP Y=C+I+G+NX Y = GDP C = Consumption I = Investment G = Government Purchases NX = Net Exports = Exports-Imports

10. GDP and Its Components

11. GDP Components (2005) Consumption 70% Government Purchases 19% Net Exports -6 % Investment 17%

13. NIPA Definition of GDP  Consumption (C): –The spending by households on goods and services, with the exception of purchases of new housing.  Investment (I): –The spending on capital equipment, inventories, and structures, including new housing.  Government Purchases (G): –The spending on goods and services by local, state, and federal governments. –Does not include transfer payments because they are not made in exchange for currently produced goods or services.  Net Exports (NX): –Exports minus imports.

14. Real vs. Nominal GDP  Nominal GDP values the production of goods and services at current prices.  Real GDP values the production of goods and services at constant prices. GDP Deflator deflates for Inflation! Inflation is rate of change of prices.

22. Recessions  A recession is a significant decline in activity lasting more than a few months and is visible in industrial production, employment, real income and wholesale- retail sales (NBER definition). NBER uses monthly data.  Rule of thumb is 2 consecutive quarters of negative Real GDP growth or GDP decline.

23. BUSINESS CYCLE REFERENCE DATES DURATION IN MONTHS PeakTroughContractionExpansionCycle Quarterly dates are in parentheses Peak to Trough Previous trough to this peak Trough from Previous Trough Peak from Previous Peak May 1937(II) February 1945(I) November 1948(IV) July 1953(II) August 1957(III) April 1960(II) December 1969(IV) November 1973(IV) January 1980(I) July 1981(III) July 1990(III) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991(I) 13 8 11 10 8 10 11 16 6 16 8 50 80 37 45 39 24 106 36 58 12 92 63 88 48 55 47 34 117 52 64 28 100 93 93 45 56 49 32 116 47 74 18 108 March 2001 (I)November 2001 (IV)8120128 NBER Report Cycle Dates 2003 Article: Business Cycles

26. Forecast of the Nation, 2003 Mar 01’ ~ Nov 01’9-0.1%-4.0%4.25.6

29. 2001 Recession vs. History For Details Refer: http://www.nber.org/

30. FRBSF Economic Letter, June 2003 Real GDP and Consumption

31. FRBSF Economic Letter, June 2003 Investment and Stock Market

32. Article: Article: NBER’s FAQs Q: The financial press often states the definition of a recession as two consecutive quarters of decline in real GDP. How does that relate to the NBER's recession dating procedure? –Most of the recessions identified by our procedures consist of two or more quarters of declining real GDP, but not all of them –We consider the depth as well as the duration of the decline in economic activity. –Second, we use a broader array of indicators than just real GDP –Third, we use monthly indicators to arrive at a monthly chronology Q: Could you give an example illustrating this point? –The two-quarter-decline rule of thumb would not have allowed the declaration of the recession until August 2002 Q: How does the NBER balance the differing behavior of employment and output? –There is no fixed rule for how the different indicators are weighted

33. Q. You emphasize the payroll survey as a source for data on economy-wide employment. What about the household survey? –Although the household survey is a large, well-designed probability sample of the U.S. population, its estimates of total employment appear to be noisier than those from the payroll survey Q. How do the movements of unemployment claims inform the Bureau's thinking? –A bulge in jobless claims would appear to forecast declining employment, but we do not use forecasts and the claims numbers have a lot of noise Q: What about the unemployment rate? –Unemployment is generally a lagging indicator. Its rise from a very low level to date is consistent with the employment data Article: Article: NBER’s FAQs

34. The November 2001 trough was announced July 17, 2003. The March 2001 peak was announced November 26, 2001. The March 1991 trough was announced December 22, 1992. The July 1990 peak was announced April 25, 1991. The November 1982 trough was announced July 8, 1983. The July 1981 peak was announced January 6, 1982. The July 1980 trough was announced July 8, 1981. The January 1980 peak was announced June 3, 1980. Peak & Trough Announcements

35. Chapter 24 Measuring the Cost of Living

37. Consumer Price Index & Inflation  Inflation refers to a situation in which the economy’s overall price level is rising.  The inflation rate is the percentage change in the price level from the previous period.  The Consumer Price Index (CPI) is a measure of the overall cost of goods and services bought by a typical consumer (produced by BLS).  Inflation rate is change in CPI.

38. Steps to Calculate CPI Index  Fix the Basket: Determine what prices are most important to the typical consumer. –The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. –The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.  Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.  Compute the Basket's Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.  Choose a Base Year and Compute the Index:

39. Steps to Calculate CPI Index  Choose a Base Year and Compute the Index: –Designate one year as the base year, making it the benchmark against which other years are compared. –Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

40. How the Inflation Rate Is Calculated  The Inflation Rate –The inflation rate is calculated as follows:

41. A Simple Example of CPI and Inflation Calculations  Calculating the Consumer Price Index and the Inflation Rate: –Base Year is 2002. –Basket of goods in 2002 costs $1,200. –The same basket in 2003 costs $1,236. –CPI = ($1,236/$1,200)  100 = 103. –Prices increased 3 percent between 2002 and 2003.

42. FYI: What Is in the CPI’s Basket? 17% Transportation 15% Food and beverages Medical care 6% Recreation 6% Apparel 4% Other goods and services 4% 42% Housing 6% Education and communication

43. Calculating the Consumer Price Index and the Inflation Rate: An Example

45. The GDP Deflator vs. CPI  The BLS calculates other prices indexes: –The index for different regions within the country. –The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

46. CPI and GDP Deflator 1965 Percent per Year 15 CPI GDP deflator 10 5 0 1970197519801985199020001995

49. Problems in Measuring CPI  Substitution bias  Introduction of new goods  Unmeasured quality changes

50. Use of Price Indexes  Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.  Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2005:

51. The Most Popular Movies of All Times, Inflation Adjusted

52. Real and Nominal Interest Rates  The nominal interest rate is the interest rate usually reported and not corrected for inflation. –This is the interest rate that a bank pays.  The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

53. Real and Nominal Interest Rates You borrow $1,000 for one year. Nominal interest rate is 15%. During the year inflation is 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5%

54. Real and Nominal Interest Rates 1965 Interest Rates (percent per year) 15% Real interest rate 10 5 0 -5 19701975198019851990199520002005 Nominal interest rate

55.  Bill claims that CPI inaccurately calculates Americans’ cost of living.  Example: Say you buy 1 bag of gumdrops for $1 which has 100 of those. Productivity makes it 110 gumdrops but for $1.10. Hedonic pricing says that CPI hasn’t gone up as per-capita cost is the same (1 cent). But you have to shelve out $1.10 to get the bag, which is an increase in cost of 10%. They must fork out an extra dime even though they’re getting more for their money.  We can’t buy individual pieces of memory in a computer-we have to buy the entire package! Article: Con Job Redux (PIMCO) by: Bill Gross