Investment Tools: Economics: Macroeconomic Analysis 1.A: Preliminary Reading: Taking the Nation's Economic Pulse a: Explain the two approaches to measuring gross domestic product (GDP) and calculate GDP using each approach. The expenditure approach is a demand-based concept measured by summing personal consumption, gross private investment, government consumption and gross investment, and net exports of goods and services. Resource cost/income approach:The resource cost/income approach is a supply or production oriented approach and measures GDP by summing the following components employee compensation, proprietors' income, rents, corporate profits, interest income, indirect business taxes, depreciation, and net income of foreigners. b: Distinguish between GDP and gross national product (GNP). GNPis the total market value of all final goods and services produced by the citizens of a country no matter where they are residing. Prior to 1991 GNP was used to measure US production. GNP and GDP are closely related concepts. GDP is a measure of the output that is produced domestically, while GNP is a measure of the output produced by the nationals of a country regardless of where they live. GNP is GDP PLUS income earned by citizens from their work and investments abroad, LESS the income earned by foreigners from their work and investments within the country. GDP measures output within the borders of a country regardless of the citizenship of the producer. GNP measures the output of the country’s nationals regardless of where they live. c: Explain the difference between real and nominal GDP. An important use of GDP is to compare the level of production over time. However, when nominal GDP (GDP measured in terms of current prices) changes from one period to the next, it reflects both changes in production and price changes. Therefore, economists attempt to filter out the impact of GDP by calculating GDP measured in terms of prices from some base year. This measure is called real GDP. Changes in real GDP correspond to real or actual changes in production. Since nominal GDP is measured with current prices and real GDP is measured relative to the price level in some base year, we need a price index to indicate the relative price change between periods. d: Distinguish between the GDP deflator and the consumer price index. The GDP Deflator is a general price index that corresponds to the price change exhibited by a very large market basket - all final goods and services produced. An important point to note is that the market basket of goods changes every year depending on current production. In other words, the market basket is not fixed. The GDP Deflator is useful for measuring economy-wide inflation. The current base year is 1992. The Consumer Price Index (CPI) is different than the GDP deflator. First, a relatively small market basket (364 items) is used. Second, the market basket is fixed from year-to-year. Finally, the CPI measures consumer price changes and does not directly measure the price changes of items purchased by businesses and government. The net result of all these differences is very small. However, the CPI tends to overstate the inflation rate because its market basket is fixed and does not consider that consumers will substitute away from goods that have risen dramatically in price . However, the CPI is useful for measuring inflation in the consumer goods sector. e: Calculate real GDP, using nominal GDP and the GDP deflator. Example:Nominal GDP was $2.5 billion in 1992 and $3.5 billion in 1998. If the GDP deflator was 100.0 in 1992 and 112.7 in 1998, what is the change in real GDP over the period both in dollars and in percentage terms? Answer: 1. Nominal GDPin 1992 = $2.5 billion. 2. 1998 GDP in 1992 dollars = $3.5 (100.0/112.7) = $3.1 billion. 3. Increase in dollars: $3.1 - 2.5 = $0.6 billion. Increase in percent: [(3.1 - 2.5) = .24 or 24%. Although nominal GDP rose by over 40% during the period, the real production of the economy only rose by 24%. Real GDP current period = nominal GDP current period x (GDP deflator base year / GDP deflator current period) f: Discuss the major limitations of GDP. Limitations with using GDP as a measure of economic activity: 1. GDP does not count non-market production--specifically, homemaker services. 2. GDP does not count the underground economy--illegal activities and tax evasion. 3. GDP does not measure the value of leisure activities, the standard of living accounted for by a shorter workweek, and changing working conditions. 4. GDP does not measure the changing quality of goods and services. 5. GDP does not measure the cost of pollution and damage to the ecology. g: Describe alternative measures of domestic output and income, including GDP, GNP, national income, personal income, and disposable income. · Gross domestic product = the total market value of all final goods produced within a country. · Gross national product = the total market value of all final goods produced by the citizens of a country. · National income = the total income payments to labor and capital during the year. It includes total earnings (domestic and foreign) of a nation’s citizens. · Personal income = the total income received by individuals. Note that transfer payments such as social security are included here. · Disposable Income = personal income - personal taxes. 1.B: Preliminary Reading: Economic Fluctuations, Unemployment, and Inflation a: Explain the phases of the business cycle. The business cycle is characterized by fluctuations in economic activity. Real GDP and the rate of unemployment are key variables used when determining the current phase of the cycle. The four phases of the business cycle are: 1. Peak, 2. Contraction, 3. Recessionary Trough, and 4. Expansion. As to the length of each phase, recent experience has shown that the contractionary periods are becoming shorter, and the expansionary periods are becoming longer in duration. A recession is defined as a period during which real GNP declines for two or more successive quarters. Both the contraction and recessionary trough comprise a recession. A depression is a prolonged and very severe recession. b: Describe unemployment statistics and discuss the problems in measuring unemployment. The labor force is defined as those people of working age (+16) who are either employed or seeking employment. The labor force participation rate is the number of persons 16 or older who are either employed or actively seeking employment as a percentage of the civilian population 16 or older. The rate of unemployment is the percent of people in the civilian labor force who are unemployed It is important to note that if a person is not working, he/she is not necessarily classified as unemployed. An individual must be actively seeking employment or waiting for another job to be considered unemployed. Household workers, students, and retirees are examples of individuals who have chosen to exit the labor force. Workers who have been laid off but are waiting for recall to their old jobs are counted as unemployed. An individual is said to be unemployed if he/she is actively seeking employment or waiting to begin or return to a job. Workers who have become discouraged and have given up looking for employment are not counted as unemployed. This problem accounts for the anomaly that occurs when the economy turns up and the unemployment rate jumps. Workers looking for full-time employment but settling for part-time work are considered as being employed. Because of these measurement problems, some economists feel the proper measure of employment would be the employment/population ratio rather than the rate of unemployment. c: Describe the three types of unemployment. Frictional unemploymentis unemployment due to constant changes in the economy that prevent qualified workers from being immediately matched with existing job openings. There are two causes of frictional unemployment: 1. Imperfect information. 2. The job searchconducted by both employees and employers. Structural unemploymentis unemployment due to structural changes in the economy that eliminate some jobs while generating job openings for which unemployed workers are not qualified. Structural unemployment differs from frictional unemployment in that workers do not currently have the skills needed to perform the newly created jobs. Cyclical unemploymentis unemployment caused by a change in the general level of economic productivity. When the economy is operating at less than full capacity, positive levels of cyclical unemployment will be present. At levels above full capacity, negative cyclical unemployment will exist. d: Define full employment. When cyclical unemployment is zero, the economy is said to be operating at full employment. However, at full employment, both structural and frictional unemployment still exist. Therefore, there is some level of unemployment, which is expected when the economy is at full employment. The natural rate of unemployment is that rate of unemployment present when the economy is at its full employment rate of production or output. In the recent past, the natural rate has risen due to changes in the composition of the labor force, namely, and increase in young workers entering the labor force. This rate of unemployment can persist for an indefinite period of time and is typically associated with the economy's maximum long-rate of output. e: Define inflation and calculate the inflation rate. Inflationis a protracted period of rising prices. As inflation rises, the purchasing power of each dollar held declines. Inflation = (this year's price index - last year's price index) / (last year's price index). Example: A price index is 113.5 for 2000 and 119.9 at the end of 2001. What was the inflation rate during 2001? Answer: Inflation rate = (119.9 – 113.5)/113.5 = 5.6% f: Discuss the effects of inflation. Unanticipated inflationis a change in prices that was not expected by rational decision makers. When inflation is unanticipated, the purchasing power of every dollar is unexpectedly eroded. Therefore, any income which is to be received in the future is now worth less in a present-value sense. Now, let’s think for a moment about potential winners and losers from a dose of unanticipated inflation. The definite losers would be people who are currently holding long-term contracts in which they are promised to receive a fixed dollar payment. The winners would obviously be the individuals or institutions which have made the promise to pay under those same fixed-rate contracts. Anticipated inflationis expected by decision makers. Therefore, all contracts will be written to accommodate for the inflation. With anticipated inflation, variable rate contracts will be the preferred contract by lenders, and anyone wishing to obtain a fixed-rate contract will have to pay a higher price for that contract. Once the anticipated inflation has been written into all contracts, no one will win or lose. 1.C: Preliminary Reading: Working with Our Basic Aggregate Demand/Aggregate Supply Model a: Discuss the factors that shift aggregate demand and aggregate supply. · An increase in real wealth will cause an increased demand for goods and services at each price level. · An increase in the real rate of interest or real cost of funds will decrease AD at all price levels and shift the AD curve to the left. The increased real cost of borrowing will make it more expensive for consumers to purchase goods and for businesses to invest. · Positive business expectation, or optimism, will shift AD to the right because the expectation of improved economic conditions will increase consumption and investment. · If people expect inflation in the future, spending will occur today in order to avoid the future inflation. · If income abroad increases, then AD will increase due to heightened demand for our export goods. · If exchange rates change causing the value of the dollar to decline relative to foreign currencies, net exports will increase, causing AD to shift to the right. b: Discuss the short- and long-run effects of unanticipated changes in aggregate demand and aggregate supply. An unexpected shift in ADwill disturb the prevailing long-run equilibrium (E) and eventually lead to a new long-run equilibrium. If consumers decide to consume less today, they necessarily have to save more (given some level of income). This reduction in consumption will temporarily shift the AD curve downward to the left (from AD1 to AD2). Inventories will accumulate on store shelves, production will be cut, and workers will be laid off. The economy will move from point E (full employment GDPf) to point A (under employment GDPu). The reduction in demand places downward pressure on wage rates and prices. As workers and suppliers begin to accept the lower wage rate, employment and output will rise due to the favorable shift in resource prices. Hence, SRAS1 will shift to the right (SRAS2) back to a point of long-run equilibrium (point B). While the long-run result is solely a reduction in prices, the short-run results are 1. Decline in output (higher unemployment) and 2. Reduction in prices. If consumers decide to consume more, it will cause a shift to the right in AD resulting in GDP moving above full employment GDPf. In the short run both output and prices rise (reducing unemployment). In the long run, the increased resource costs (higher wages and other inputs) will reduce SRAS leading solely to higher prices. (Note: as the SRAS curve moves upward to the left, supply is falling.) c: Discuss three self-correcting mechanisms that may help stabilize a market economy. Three primary mechanisms are responsible for self-correcting the economy after a shock. They are: · Consumption Demand - demand is relatively stable over the business cycle. · Real Interest Rates - changes in real interest rates will help to stabilize aggregate demand and redirect economic fluctuations. · Resource Prices - changes in real resource prices will redirect economic fluctuations. 1.D: Preliminary Reading: Keynesian Foundations of Modern Macroeconomics a: Distinguish between classical economics and Keynesian economics. John M. Keynes emphasized the importance of aggregate demand in determining the overall level of output in the economy. If spending decreases due to pessimism on the part of consumers and investors, business will respond by cutting output. At this point, the argument is precisely the same as that used in the classical AD/AS model. But the classical AD/AS model depends on a subsequent reduction in resource prices to restore long-run equilibrium, namely a reduction in wages. Keynes, however, felt that resource prices, especially wages, were highly inflexible in a downward direction. Hence, in Keynes' view, the economy would languish for an extended period of time with high unemployment. The Keynesian equilibrium occurs when spending is equal to output. Since extreme downward price rigidity is present, prices do not play a role in the Keynesian Aggregate Expenditure Model. Hence, if demand is slack, “there are no automatic forces capable of assuring full employment.” Instability in the Keynesian model is driven from the demand side of the economy. The main sources of economic instability are consumer spending, private investment, and government expenditures. b: Explain the major components of the Keynesian model. Planned consumptionis determined primarily by disposable income. As income rises, consumption will also rise. However, the rise in consumption will not be on a one-to-one basis with income since a portion of each additional dollar is saved. Planned investment (I) and government spending (G)are assumed to be autonomous or given in this model. They are not directly related to income. Therefore, a change in one of these variables will shift the aggregate expenditure (AE = C + I + G + NX) schedule up or down by the amount of the change. Planned net exports decrease as income increases. Planned expendituresmust be distinguished from actual expenditures. If actual consumer expenditures turn out to be less than planned (below the equilibrium level), actual inventory investment will be greater than planned (unplanned inventory investment is positive), employees will be laid-off and output will fall. Since inventories are considered investment, the above argument shows that investment is the primary source of economic instability. c: Explain Keynesian macroequilibrium. A key point to remember is that this equilibrium can occur away from the full employment rate of output and that it is spending which drives this equilibrium. Hence, if the economy is operating at less than full employment, only additional spending can drive the economy back to full employment. If equilibrium output is less than the economy's full employment capacity, how can the economy reach its full employment capacity? It can be reached only by an increase in aggregate expenditures. AE shifts from AE1 to AE2 as expenditures increase. d: Define and calculate the marginal propensity to consume and the expenditure multiplier. The proportion of each additional dollar of income spent on personal consumption is called the marginal propensity to consume (MPC). Mathematically: MPC = additional consumption divided by additional income. Assume you receive an additional $1,000 payment. You consume some of it ($1,000 x MPC) and save the rest. What happens to the amount you spent? It represents someone else's additional income ($1,000 x MPC). They will spend some [($1,000 x MPC) x MPC] and save the rest. This process continues indefinitely. You can see that the original $1,000 of income expands or is multiplied into more than $1,000 of total income for the economy. The amount of the expansion is called the expenditures multiplier and is equal to: M = 1/(1 - MPC) Therefore, if investment spending increases by $1,000, total spending will increase by M x $1,000. The multiplier shows why small changes in C, I, or G can cause large changes in output. This is the key to the multiplier concept. e: Explain the importance of the expenditure multiplier within the framework of the Keynesian model. The proportion of each additional dollar of income spent on personal consumption is called the marginal propensity to consume (MPC). Mathematically: MPC = additional consumption divided by additional income. Assume you receive an additional $1,000 payment. You consume some of it ($1,000 x MPC) and save the rest. What happens to the amount you spent? It represents someone else's additional income ($1,000 x MPC). They will spend some [($1,000 x MPC) x MPC] and save the rest. This process continues indefinitely. You can see that the original $1,000 of income expands or is multiplied into more than $1,000 of total income for the economy. The amount of the expansion is called the expenditures multiplier and is equal to: M = 1/(1 - MPC) Therefore, if investment spending increases by $1,000, total spending will increase by M x $1,000. The multiplier shows why small changes in C, I, or G can cause large changes in output. This is the key to the multiplier concept. f: Discuss the Keynesian view of the business cycle. Assume there is an increase in aggregate demand (perhaps from higher incomes abroad or an increase in consumer or business optimism). The multiplier magnifies the increased demand. The higher demand leads to income growth. The income growth leads to additional consumption and growing business sales. This leads to declining inventories, so businesses expand their output. Unemployment
