An Economic Barometer What exactly is GDP?

An Economic Barometer What exactly is GDP?
How do we use GDP to tell us whether our economy is in a recession or how rapidly our economy is expanding? How do we take the effects of inflation out of GDP to reveal the rate of growth of our economic well-being? And how to we compare economic well-being across countries?

Gross Domestic Product
GDP Defined GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period. This definition has four parts: Market value Final goods and services Produced within a country In a given time period The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. For such a measure is the basis of measurement of the standard of living, economic welfare, and making international comparisons. Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software. The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999. When the 1996 GDP was recalculated to include software, it increased by $115 billion, or 1.5 percent of GDP.

Market Value GDP is a market value—goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in dollars.

Final Goods and Services GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. Excluding intermediate goods and services avoids double counting.

Produced Within a Country GDP measures production within a country—domestic production. In a Given Time Period GDP measures production during a specific time period, normally a year or a quarter of a year.

GDP and the Circular Flow of Expenditure and Income GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and output shows the link between productivity and living standards. The circular flow diagram illustrates the equality of income, expenditure, and the value of production.

The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

These transactions take place in factor markets, goods markets, and financial markets.

Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

Households buy consumer goods and services. The red flow, C, shows consumption expenditure.

Households save, S, and pay net taxes, T. Firms borrow some of what households save to finance their investment.

Firms buy capital goods from other firms. The red flow I represents this investment by firms.

Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than net taxes.

The rest of the world buys goods and services from us, X, and sells us goods and services, M. Net exports are X – M.

And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

The blue and red flows are the circular flow of expenditure and income. The green flows are financial flows.

The sum of the red flows equals the blue flow.

That is: Y = C + I + G + X – M

The circular flow demonstrates how GDP can be measured in two ways. Aggregate expenditure Total expenditure on final goods and services, equals the value of output of final goods and services, which is GDP. Total expenditure = C + I + G + (X – M).

Aggregate income Aggregate income equals the total amount paid for the use of factors of production: wages, interest, rent, and profit. Firms pay out all their receipts from the sale of final goods, so income equals expenditure, Y = C + I + G + (X – M).

If G exceeds T, the government has a budget deficit (G –T) and the government borrows from the financial markets. If T exceeds G, the government has a budget surplus (T – G) and this surplus flows to the financial markets. If U.S. imports exceed U.S. exports, the United States borrows an amount equal to (M – X) from the rest of the world. Rest of world saving finances some investment in the United States. If U.S. exports exceed U.S. imports, the United States lends an amount equal to (X – M) to the rest of the world. U.S. saving finances some investment in other countries.

How Investment Is Financed Investment is financed from three sources: 1. Private saving, S 2. Government budget surplus, (T – G) 3. Borrowing from the rest of the world (M – X). How investment is financed. Don’t skimp on this topic. It provides the foundation for what the student will meet in Chapter 23 (Economics) Chapter 7 (Macroeconomics).

Gross and Net Domestic Product “Gross” means before deducting the depreciation of capital. The opposite of gross is net. To understand this distinction, we need to distinguish between flows and stocks. Flows and Stocks in Macroeconomics A flow is a quantity per unit of time. A stock is the quantity that exists at a point in time.

Wealth and Saving Wealth, the value of all the things that people own, is a stock. Saving is the flow that changes the stock of wealth. Wealth at the start of this year equals wealth at the start of last year plus saving during last year.

Capital and Investment Capital is the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods. Capital is a stock. Investment is the flow that changes the stock of capital.

Depreciation is the decrease in the capital stock that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Net investment is the change in the capital stock. Net investment = Gross investment  Depreciation.

Figure illustrates the relationships among the capital stock, gross investment, depreciation, and net investment.

The Short Run Meets the Long Run Capital and investment play a central role in the understanding the growth and fluctuations in real GDP. Investment adds to the capital stock, so investment is one source of real GDP growth. Investment fluctuates, so investment is one source of fluctuations in real GDP.

Measuring U.S. GDP The Bureau of Economic Analysis uses two approaches to measure GDP: The expenditure approach The income approach The low cost of economic data. You might like to tell your students that measuring real GDP is actually very cheap. The Bureau of Economic Analysis (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than a quarter to measure the value of US production. For some further perspective, the U.S. National Oceanic and Atmospheric Administration, whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion! Much of the income data used by the BEA comes from the Internal Revenue Service. Expenditure data comes from a variety of sources. Creative accounting and GDP measurement. In recent years, the first estimates of GDP, which are based on companies’ reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enron-style accounting has contaminated the initial estimates of GDP, but not the final estimates. You can make a nice point with one example of creative accounting. For some years, in its reports to stock holders AOL recorded its advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services by AOL and as a charge against AOL profit. The expenditure on AOL services is the value of AOL’s production. And AOL’s expenditure on advertising is part of the value of the production of the advertising agencies used by AOL. You can go on to explain that AOL accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOL’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But if when AOL files its tax returns it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts get adjusted appropriately.

Measuring U.S. GDP The Expenditure Approach
The expenditure approach measures GDP as the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. GDP = C + I + G + (X  M) Table in the textbook shows the expenditure approach with data for 2006. GDP = $9,079 + $2,215 + $2,479  $765 = $13,008

Measuring U.S. GDP The Income Approach
The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire.

Measuring U.S. GDP The National Income and Expenditure Accounts divide incomes into five categories: 1. Compensation of employees 2. Net interest 3. Rental income 4. Corporate profits 5. Proprietors’ income These five income components sum to net domestic income at factor cost.

Real GDP and the Price Level
Real GDP is the value of final goods and services produced in a given year when valued at constant prices. Calculating Real GDP The first step in calculating real GDP is to calculate nominal GDP. Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year.

Nominal GDP Calculations The table provides data for 2005 and 2006. In 2005, Expenditure on balls = $100 Expenditure on bats = $100 Nominal GDP = $200 Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

In 2006, Expenditure on balls = $80 Expenditure on bats = $495 Nominal GDP = $575 Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

Base-Year Prices Value of Real GDP This method of calculating real GDP is to value each year’s output at the prices of a base year. In the base year, real GDP equals nominal GDP. Suppose 2005 is the base year, then real GDP in 2005 is $200. This method is the traditional method. Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

Using the traditional base-year prices method to calculate real GDP in 2006: Expenditure on balls in 2006 valued at 2005 prices is $160. Expenditure on bats in 2006 valued at 2005 prices is $110. So real GDP in 2006 would be recorded as $270. Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

The new method of calculating real GDP, which is called the chain-weighted output index. The chain-weighted output index method, uses the prices of two adjacent years to calculate the real GDP growth rate. This calculation has four steps described on the next slide. Chain-weighted output index method. If you don’t want to bother with the chain-weighted output index method of calculating real GDP and prefer to limit your discussion to the traditional base-year prices method, you can draw a line half way down the first column of page 492 (Economics) page 120 (Macroeconomics) and define the number we compute in Table 5.5 as real GDP. The section on calculating the price level flows fine with this measure of real GDP. But I suggest that you do explain the chain-weighted method. The textbook has stripped the explanation down to the bare bones and makes the approach intelligible to any student willing to make a small amount of effort.

Step 1: Value last year’s production and this year’s production at last year’s prices and then calculate the growth rate of this number from last year to this year. Step 2: Value last year’s production and this year’s production at this year’s prices and then calculate the growth rate of this number from last year to this year. Step 3: Calculate the average of the two growth rates. This average growth rate is the growth rate of real GDP from last year to this year. Step 4: Apply the growth rate this year to last year’s real GDP to calculate this year’s real GDP.

We’ve done step 1. Value of 2005 quantities at 2005 prices (GDP in 2005) is $200. Value of 2006 quantities at 2005 prices is $270. At 2005 prices, the value of production increased from $200 to $270—an increase of 35 percent. Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

Step 2. Value of 2005 quantities at 2006 prices is $500. Value of 2006 quantities at 2006 prices (GDP in 2006) is $575. At 2006 prices, the value of production increased from $500 to $575—an increase of 15 percent. Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

Step 3. At 2005 prices, the 2006 growth rate is 35 percent. At 2006 prices, the 2006 growth rate is 15 percent. The average of these two growth rates is 25 percent. Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

Step 4. So with 2005 as the base year, real GDP in 2006 is $250—25 percent more that $200 in 2005. Real GDP in 2005 is $200 Real GDP in 2006 is $250 Item Quantity Price 2005 Balls 100 $1.00 Bats 20 $5.00 2006 160 $0.50 22 $22.50

Calculating the Price Level The average level of prices is called the price level. One measure of the price level is the GDP deflator, which is an average of the prices of the goods and services in GDP in the current year expressed as a percentage of the base-year prices. The GDP deflator is calculated in the table on the next slide.

Nominal GDP and real GDP are calculated in the way that you’ve just seen. GDP Deflator = (Nominal GDP ÷ Real GDP)  100. In 2005, the GDP deflator is ($200 ÷ $200)  100 = 100. In 2006, the GDP deflator is ($575 ÷ $250)  100 = 230. Year Nominal GDP Real GDP GDP deflator 2005 $200 100 2006 $575 $250 230

Deflating the GDP Balloon Nominal GDP increases because production—real GDP– increases.

Nominal GDP also increases because prices rise.

We use the GDP deflator to let the inflation air out of the nominal GDP balloon and reveal real GDP.

The Uses and Limitations of Real GDP
We use real GDP to calculate the economic growth rate. The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next. We measure economic growth so we can make Economic welfare comparisons across time International comparisons across countries Business cycle forecasts

Economic Welfare Comparisons Over Time Economic welfare measures the nation’s overall state of economic well-being. Real GDP is not a perfect measure of economic welfare for seven reasons: 1. Inflation rate tends to be overestimated because quality improvements are neglected, so real GDP is underestimated. 2. Real GDP does not include household production— productive activities done in and around the house by members of the household. Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Current Population Survey or the Family Expenditure Survey. The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

3. Real GDP, as measured, omits the underground economy, which is illegal economic activity or legal economic activity that goes unreported for tax avoidance reasons. 4. Health and life expectancy are not directly included in real GDP. 5. Leisure time, a valuable component of an individual’s welfare, is not included in real GDP. 6. Environmental damage is not deducted from real GDP. 7. Political freedom and social justice are not included in real GDP.

Economic Welfare Comparisons Across Countries Real GDP is used to compare economic welfare in one country with that in another. Two special problems arise in making these comparisons. Real GDP of one country must be converted into the same currency units as the real GDP of the other country, so an exchange rate must be used. The same prices should be used to value the goods and services in the countries being compared, but often are not.

Using the exchange rate to compare GDP in one country with GDP in another country is problematic because prices of particular products in one country may be much less or much more than in the other country. For example, using the market exchange rate to value Chinese GDP in dollars leads to an estimate that in 2006, U.S. real GDP per person was 28 times Chinese real GDP per person. International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes. Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.

Figure illustrates the problem. Using the market exchange rate and domestic prices leads to an estimate that China is very poor. U.S. GDP per person is 28 times that in China.

Using purchasing power parity prices leads to an estimate that U.S. GDP per person is (only) 12 times that in China. The difference in the two sets of numbers is astonishingly large and makes a dramatic difference to how we view the balance of economic power over the next 25 years. At current growth rates and market exchange rates, by 2020, China will have a GDP around a quarter that of the United States. At current growth rates and PPP exchange rates, China’s real GDP will exceed that of the United States before 2020. Per person, China in 2020 will still have a long way to go to catch the United States. But China’s economy will be the world’s largest.

Business Cycle Forecasts Real GDP is used to measure business cycle fluctuations. These fluctuations are probably accurately timed, but the changes in real GDP probably overstate the changes in total production and people’s welfare caused by business cycles.

Unemployment and Full Employment
Full employment occurs when there is no cyclical unemployment or, equivalently, when all unemployment is frictional and structural. The unemployment rate at full employment is called the natural unemployment rate. The natural unemployment rate was high during the early 1980s but has gradually decreased.

Real GDP and Unemployment Over the Cycle Potential GDP is the quantity of real GDP produced at full employment. Potential GDP corresponds to the capacity of the economy to produce output on a sustained basis. Over the business cycle, actual real GDP fluctuates around potential GDP and the unemployment rate fluctuates around the natural rate of unemployment.

Real GDP and Unemployment Over the Cycle Figure 6.10 shows real GDP, and the unemployment rate... …and estimates of potential GDP and the natural unemployment rate.

The Consumer Price Index
The BLS calculates the Consumer Price Index every month. The Consumer Price Index, or CPI, measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods and services. The CPI—an average. It is important for students to understand that the CPI is based on the average expenditure basket, not the expenditure pattern of any given household. Displaying the detailed press releases on the Statistics Canada Web site helps make this point very forcibly: students often do not realize until they see the numbers that the CPI must include both costs of owning a house and costs of renting one; costs of buying a car and costs of public transportation; and so on.

Reading the CPI Numbers The CPI is defined to equal 100 for the reference base period. Currently, the reference base period is 19821984. That is, for the average of the 36 months from January 1982 through December 1984, the CPI equals 100. In June 2006, the CPI was This number tells us that the average of the prices paid by urban consumers for a fixed basket of goods was percent higher in 2006 than it was during 19821984.

Constructing the CPI Constructing the CPI involves three stages: Selecting the CPI basket Conducting a monthly price survey Calculating the CPI

The CPI Basket The CPI basket is based on a Consumer Expenditure Survey, which is undertaken infrequently. The CPI basket today is based on data collected in the Consumer Expenditure Survey of 20012002. The CPI basket contains 80,000 goods.

Figure 6.11 illustrates the CPI basket. Housing is the largest component. Transportation and food and beverages are the next largest components. The remaining components account for 25 percent of the basket. Making the CPI personal. If you have time (or want to make time) you can get your students to construct their own CPI basket. Each student makes a statement of her/his expenditure in the same categories as the CPI basket in the figure on this slide. Students then compare their expenditure patterns to the average of the CPI basket.

The Monthly Price Survey Every month, BLS employees check the prices of 80,000 goods on 30 metropolitan areas. Calculating the CPI 1. Find the cost of the CPI basket at base-period prices. 2. Find the cost of the CPI basket at current-period prices. 3. Calculate the CPI for the current period.

Let’s work an example of the CPI calculation. In a simple economy, people consume only oranges and haircuts. The CPI basket is 10 oranges and 5 haircuts. The table also shows the prices in the base period. Item Quantity Price Oranges 10 $1.00 Haircuts 5 $8.00

The cost of the CPI basket in the base period was $50. Item Quantity Price Cost of CPI basket Oranges 10 $1.00 $10 Haircuts 5 $8.00 $40 Cost of CPI basket at base period prices $50

This table shows the prices in the current period. The cost of the CPI basket at current-period prices is $70. Item Quantity Price Cost of CPI basket Oranges 10 $2.00 $20 Haircuts 5 $10.00 $50 Cost of CPI basket at current-period prices $70

The CPI is calculated using the formula: CPI = (Cost of basket at current-period prices ÷ Cost of basket at base-period prices)  100. Using the numbers for the simple example, CPI = ($70 ÷ $50)  100 = 140. The CPI is 40 percent higher in the current period than it was in the base period.

Measuring Inflation The major purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The inflation formula is: Inflation rate = [(CPI this year – CPI last year) ÷ CPI last year]  100.

Figure shows the relationship between the price level and inflation. Figure (a) shows the CPI from1971 to 2006.

Figure (b) shows that the inflation rate is High when the price level is rising rapidly and Low when the price level is rising slowly.

The Biased CPI The CPI might overstate the true inflation for four reasons: New goods bias Quality change bias Commodity substitution bias Outlet substitution bias CPI biases—concrete illustrations. New goods bias can be illustrated with MP3 music rather than CDs; quality change with computers and cars; commodity substitution with movies versus videos; and outlet substitution by the growth of Wal-mart, Target, and shopping on the internet.

New Goods Bias New goods that were not available in the base year appear and, if they are more expensive than the goods they replace, they put an upward bias into the CPI. Quality Change Bias Quality improvements occur every year. Part of the rise in the price is payment for improved quality and is not inflation. The CPI counts all the price rise as inflation.

Commodity Substitution Bias The market basket of goods used in calculating the CPI is fixed and does not take into account consumers’ substitutions away from goods whose relative prices increase. Outlet Substitution Bias As the structure of retailing changes, people switch to buying from cheaper sources, but the CPI, as measured, does not take account of this outlet substitution.

Some Consequences of the Bias The bias in the CPI Distorts private contracts. Increases government outlays (close to a third of federal government outlays are linked to the CPI). Biases estimates of real earnings. Reducing the Bias The BLS now undertakes consumer spending surveys at more frequent intervals and is experimenting with a chained CPI.

What is Money? Official Measures of Money
The two main official measures of money in the United States are M1 and M2. M1 consists of currency and traveler’s checks and checking deposits owned by individuals and businesses. M2 consists of M1 plus time, saving deposits, money market mutual funds, and other deposits. Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you can poke fun at some of the suggestions. (Point out that students rarely pay for books by giving the bookstore shares of Bombardier stock and asking for change in BCE stock.) By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.

What is Money? Figure 9.1 illustrates the composition of M1 and M2 in June 2005 and shows the relative magnitudes of their components.

What is Money? Are M1 and M2 Really Money?
All the items in M1 are means of payment. Some saving deposits in M2 are not means of payments—they are called liquid assets. Liquidity is the property of being instantly convertible into a means of payment with little loss of value. Deposits are money, but checks are not–a check is an instruction to a bank to transfer money. Credit cards are not money. A credit card enables the holder to obtain a loan quickly, but the loan must be repaid with money.

Depository Institutions
A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms. The institutions in the banking system divide into Commercial banks Thrift institutions Money market mutual funds Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice chartered banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.

Many Monies! The dollar, the yen, and the euro are three of the world’s monies. But they are among more than 100 different monies that circulate in the global economy. The dollar and the yen have been around for a long time. The euro was created in the 1990s. In August 2002, 1 dollar bought 1.02 euros. In August 2006, 1 dollar bought 0.78 euros. Why do currency exchange rates fluctuate? The U.S. economy has become attractive to foreign investors. What determines the amount of international borrowing and lending?

Currencies and Exchange Rates
To buy goods and services produced in another country we need money of that country. Foreign bank notes, coins, and bank deposits are called foreign currency. We get foreign currency in the foreign exchange market.

The Foreign Exchange Market We get foreign currency and foreigners get U.S dollars in the foreign exchange market. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The data. You and your students can get up to the minute exchange rate data and useful historical exchange rate data at PACIFICA ( This site also has data on deviations from purchasing power parity. The strength of a nation’s currency matters, but it isn’t a sign of manhood or womanhood! A lot of silly ideas about the exchange rate find their way into the popular media. The most notable one is that the strength of a nation’s currency on the foreign exchange market is somehow a sign of the nation’s overall strength—its manhood/womanhood so to speak. Explain that the exchange rate is just a price. And it is the relative price of two currencies that ultimately depends on the price levels in two countries. A downward trend in an exchange rate means that a country is experiencing more rapid inflation than another country. That is all. The exchange rate trend tells us nothing—absolutely nothing—about productivity and real income growth in the two countries.

Foreign Exchange Rates The price at which one currency exchanges for another is called a foreign exchange rate. A fall in the value of one currency in terms of another currency is called currency depreciation. A rise in value of one currency in terms of another currency is called currency appreciation.

Figure 10.1 shows how the U.S. dollar has moved against other currencies from 1995 to 2005.

Nominal and Real Exchange Rates The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It is a measure of how much of one money exchanges for a unit of another currency. The real exchange rate is the relative price of foreign-produced goods and services. It is a measure of the quantity of real GDP of other countries that we get for a unit of U.S. real GDP.

Trade-Weighted Index The trade-weighted index is the average exchange rate of the U.S. dollar against other currencies, with individual currencies weighted by their importance in U.S. international trade.

The Foreign Exchange Market
The Demand for One Money Is the Supply of Another Money When people who are holding one money want to exchange it for U.S. dollars, they demand U.S. dollars and they supply that other country’s money. So the factors that influence the demand for U.S. dollars also influence the supply of Canadian dollars, E.U. euros, U.K. pounds, and Japanese yen. And the factors that influence the demand for another country’s money also influence the supply of U.S. dollars.

Demand in the Foreign Exchange Market The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given period depends on 1. The exchange rate 2. World demand for U.S. exports 3. Interest rates in the United States and other countries 4. The expected future exchange rate

The Law of Demand for Foreign Exchange The demand for dollars is a derived demand. People buy U.S. dollars so that they can buy U.S.-produced goods and services or U.S. assets. Other things remaining the same, the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market.

The exchange rate influences the quantity of U.S. dollars demanded for two reasons: Exports effect Expected profit effect Exports Effect The larger the value of U.S. exports, the greater is the quantity of U.S. dollars demanded on the foreign exchange market. And the lower the exchange rate, the greater is the value of U.S. exports, so the greater is the quantity of U.S. dollars demanded.

Expected Profit Effect The larger the expected profit from holding U.S. dollars, the greater is the quantity of U.S. dollars demanded today. But expected profit depends on the exchange rate. The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying U.S. dollars and the greater is the quantity of U.S. dollars demanded today.

Supply in the Foreign Exchange Market The quantity of U.S. dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. This quantity depends on many factors but the main ones are 1. The exchange rate 2. U.S. demand for imports 3. Interest rates in the United States and other countries 4. The expected future exchange rate

The Law of Supply of Foreign Exchange Other things remaining the same, the higher the exchange rate, the greater is the quantity of U.S. dollars supplied in the foreign exchange market. The exchange rate influences the quantity of U.S.dollars supplied for two reasons: Imports effect Expected profit effect

Imports Effect The larger the value of U.S. imports, the larger is the quantity of U.S. dollars supplied on the foreign exchange market. And the higher the exchange rate, the greater is the value of U.S. imports, so the greater is the quantity of U.S. dollars supplied.

Expected Profit Effect For a given expected future U.S. dollar exchange rate, the lower the exchange rate, the greater is the expected profit from holding U.S. dollars, and the smaller is the quantity of U.S. dollars supplied on the foreign exchange market.

Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars A change in any influence on the quantity of U.S.dollars that people plan to buy, other than the exchange rate, brings a change in the demand for U.S. dollars and a shift in the demand curve for U.S. dollars. These other influences are World demand for U.S. exports U.S. interest rate relative to the foreign interest rate The expected future interest rate

World Demand for U.S. Exports Increases At a given exchange rate, if world demand for U.S. exports increases, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate The U.S. interest rate minus the foreign interest rate is called the U.S. interest rate differential. If the U.S. interest differential rises, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward.

The Expected Future Exchange Rate At a given exchange rate, if the expected future exchange rate for U.S. dollars rises, the demand for U.S. dollars increases and the demand curve for dollars shifts rightward.

Changes in the Supply of Dollars A change in any influence on the quantity of U.S. dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars and a shift in the supply curve of dollars. These other influences are U.S. demand for imports U.S. interest rates relative to the foreign interest rate The expected future exchange rate

U.S. Demand for Imports At a given exchange rate, if the U.S. demand for imports increases, the supply of U.S. dollars on the foreign exchange market increases and the supply curve of U.S. dollars shifts rightward. U.S. Interest Rates Relative to the Foreign Interest Rate If the U.S. interest differential rises, the supply for U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward.

The Expected Future Exchange Rate At a given exchange rate, if the expected future exchange rate for U.S. dollars rises, the supply of U.S. dollars decreases and the demand curve for dollars shifts leftward.

Changes in the Exchange Rate Changes in demand and supply in the foreign exchange market change the exchange rate (just like they change the price in any market). If demand for U.S. dollars increases and supply does not change, the exchange rate rises. If demand for U.S. dollars decreases and supply does not change, the exchange rate falls. If supply of U.S. dollars increases and demand does not change, the exchange rate falls. If supply of U.S. dollars decreases and demand does not change, the exchange rate rises.

An Appreciating U.S. Dollar: 20002002 Between 2000 and 2002, the U.S. dollar appreciated against the yen. Investors expected higher profits in the United States than in Japan and the demand for U.S. dollars increased. Currency traders expected the U.S. dollar to appreciate and the supply of U.S. dollars decreased. The exchange rate rose from 108 yen per U.S. dollar to 127 yen per U.S. dollar.

A Depreciating Dollar: 20022004 Between 2000 and 2002, the U.S. dollar depreciated against the yen. Investors began to expect higher profits in Japan and the demand for U.S. dollars increased. Currency traders expected the U.S. dollar to depreciate and the supply of U.S. dollars increased. The exchange rate fell from 127 yen per U.S. dollar to 109 yen per U.S. dollar.

Exchange Rate Expectations The exchange rate changes when it is expected to change. But expectations about the exchange rate are driven by deeper forces. Two such forces are Interest rate parity Purchasing power parity

Interest Rate Parity A currency is worth what it can earn. The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the rates of returns on two currencies are equal, interest rate parity prevails. Interest rate parity means equal interest rates when exchange rate changes are taken into account. Market forces achieve interest rate parity very quickly. Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market.

Purchasing Power Parity A currency is worth the value of goods and services that it will buy. The quantity of goods and services that one unit of a particular currency will buy differs from the quantity of goods and services that one unit of another currency will buy. When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity, which means equal value of money. Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.ca, amazon.com, and at amazon.co.uk, get the latest exchange rate for the U.S. dollar against the U.S. dollar and the U.K. pound, and see whether it is cheaper to buy a given title in Canada, the United States, or the United Kingdom.

Instant Exchange Rate Response The exchange rate responds instantly to news about changes in the variables that influence demand and supply in the foreign exchange market. Suppose that the Bank of Japan is considering raising the interest rate next week. With this news, currency traders expect the demand for yen to increase and the demand for dollars to decrease—they expect the U.S. dollar to depreciate.

But to benefit from a yen appreciation, yen must be bought and dollars must be sold before the exchange rate changes. Each trader knows that all the other traders share the same information and have similar expectations. Each trader knows that when people begin to sell dollars and buy yen, the exchange rate will change. To transact before the exchange rate changes means transacting right away, as soon as the news is received.

Nominal and Real Exchange Rates in Short Run and the Long Run The equation that links the nominal exchange rate (E) and real exchange rate (RER) is RER = E x (P/P*) where P is the U.S. price level and P* is the Japanese price level. In the short run, this equation determines RER. In the short run, (P/P*) doesn’t change and a change in E brings an equivalent change in RER.

In the long run, RER is determined by the real forces of demand and supply in markets for goods and services. So in the long run E determined by RER and the price levels. That is E = RER x (P*/P) A rise in the Japanese price level P* brings an appreciation of the U.S. dollar in the long run. A rise in the U.S. price level P brings a depreciation of the U.S. dollar in the long run.

Financing International Trade
We’ve seen how the exchange rate is determined, but what is the effect of the exchange rate? How does currency appreciation or appreciation influence U.S. international trade? We record international transactions in the balance of payments accounts. Balance of Payments Accounts A country’s balance of payments accounts records its international trading, borrowing, and lending. Something new almost every day. This topic is one that is easily kept current. Today, the United States has a very large and persistent deficit. Pay attention to the development of this deficit in the New York Times, Wall Street Journal, and on the news Web sites. Herb Stein’s Dictum. Larry Summers remind me recently of Herb Stein’s dictum: “the unsustainable cannot be sustained and must surely end!” Ask your students what will happen to end the unsustainable current account deficit. They will want to say, a change in the exchange rate. And that is surely part of the answer. But fundamentally, unless Americans save more relative to U.S. investment, the current account will be in deficit no matter what the exchange rate does. Understanding this fundamental fact is a big lesson in this chapter.

There are three balance of payments accounts: 1. Current account 2. Capital account 3. Official settlements account The current account records receipts from exports of goods and services sold abroad, payments for imports of goods and services from abroad, net interest paid abroad, and net transfers (such as foreign aid payments). The current accounts balance equals the sum of: exports minus imports, net interest income, and net transfers.

The capital account records foreign investment in the United States minus U.S. investment abroad. The official settlements account records the change in U.S. official reserves. U.S. official reserves are the government’s holdings of foreign currency. If U.S. official reserves increase, the official settlements account is negative. The sum of the balances of the three accounts always equals zero.

Figure 10.9 shows the balance of payments (as a percentage of GDP) over the period 1980 to 2005.

Borrowers and Lenders A country that is borrowing more from the rest of the world than it is lending to it is called a net borrower. A country that is lending more to the rest of the world than it is borrowing from it is called a net lender. The United States is currently a net borrower but during the 1960s and 1970s, the United States was a net lender.

Debtors and Creditors A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. Since 1986, the United States has been a debtor nation. A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it. The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.

Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.

Current Account Balance The current account balance (CAB) is CAB = NX + Net interest income + Net transfers The main item in the current account balance is net exports (NX). The other two items are much smaller and don’t fluctuate much.

The government sector surplus or deficit is equal to net taxes, T, minus government expenditures on goods and services G. The private sector surplus or deficit is saving, S, minus investment, I. Net exports is equal to the sum of government sector balance and private sector balance: NX = (T – G) + (S – I)

For the United States in 2006, Net exports is a deficit of $784 billion, which equals the sum of the government sector deficit of $313 billion and the private sector deficit of $471 billion.

The Three Sector Balances Figure shows these three balances from 1980 through 2005. The private sector balance and the government sector balance tend to move in opposite directions. Net exports is the sum of the private sector and government sector balances.

Where is the Exchange Rate? In the short run, a fall in the nominal exchange rate lowers the real exchange rate, which makes our imports more costly and our exports more competitive. So in the short run, fall in the nominal exchange rate decreases the current account deficit. But in the long run, a change in the nominal exchange rate leaves the real exchange rate unchanged. So in the long run, the nominal exchange rate plays no role in influencing the current account balance.

Exchange Rate Policy Three possible exchange rate policies are
Flexible exchange rate Fixed exchange rate Crawling peg Flexible Exchange Rate A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.

Exchange Rate Policy Fixed Exchange Rate
A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market. A fixed exchange rate requires active intervention in the foreign exchange market.

Exchange Rate Policy Figure shows how the central bank can intervene in the foreign exchange market to keep the exchange rate close to a target rate. Suppose that the target is 100 yen per U.S. dollar. If demand increases, the central bank sells U.S. dollars to increase supply.

Exchange Rate Policy If demand decreases, the central bank buys U.S. dollars to decrease supply. Persistent intervention on one side of the foreign exchange market cannot be sustained.

Exchange Rate Policy Crawling Peg
A crawling peg exchange rate policy is one that selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. China is a country that operates a crawling peg. A crawling peg works like a fixed exchange rate except that the target value changes. The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

Exchange Rate Policy People’s Bank of China in the Foreign exchange Market Figure 10.12(a) shows the immediate effect of the fixed yuan exchange rate. China’s official foreign currency reserves are piling up.

Exchange Rate Policy Figure (b) illustrates what is happening in the market for U.S. dollars priced in terms of the yuan. The People’s bank buy U.S. dollars to maintain the target exchange rate. China’s official foreign reserves increase.

An Economic Barometer What exactly is GDP?

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