Winter 2012 Macroeconomics Starring Erik Hurst 1

Winter 2012Winter 2012

Macroeconomics

Starring Erik Hurst

1

2

Total U.S. Non Farm Employment Since 1990

Note: Up through November 2011

3

Unemployment Rate: 1970M1 – 2011M11

4

Unemployment Rate: 1970M1 – 2011M11

Civilian Unemployment Rate ~8.6%

5

Unemployment Rate: 1970M1 – 2011M11

Unemployment Falls As Recession Ends

6

Unemployment Rate: 1970M1 – 2011M11

Unemployment Does Not Fall As Recession Ends

7

Unemployment Rate: Historical

8

Broad Questions of Interest About Unemployment

• What is a recession?

• Why would unemployment increase at the end of a recession?

• Why has the nature of unemployment coming out of recessions changed over time?

• Why does unemployment exist?

• Can policymakers affect the unemployment rate?

9

How is Unemployment Measured?

• Standardized Definition of the Unemployment Rate:

Unemployed = jobless but looking for a job

Labor Force = #Employed + #Unemployed

Unemployment Rate = (# Unemployed) / (Labor Force)

This is the definition used in most countries, including the U.S.

U.S. data: http://stats.bls.gov/eag.table.html

U.S. measurement details: http://stats.bls.gov/cps_htgm.htm

Issues: Discouraged Workers, Underemployed, Measurement Issues

• Reading: #22 from the reading list

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Components of Unemployment

• Flow of people into the unemployment pool

o Flow into unemployment from employment (job loss)

o Flow into unemployment from out of labor force (stop being discouraged)

• Flow of people out of the unemployment pool

o Flow out of unemployment into employment (job finding)

o Flow out of unemployment out of labor force (discouraged workers)

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Unemployment Duration

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Unemployment Duration

Role of Unemployment Benefit Extensions?

13

Labor Force Participation Rate: Men

Labor force participation rate = Labor Force/Population

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Labor Force Participation Rate: Women

Labor force participation rate = Labor Force/Population

15

Labor Force Participation Rate: Women

Labor force participation rate = Labor Force/Population

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Types of Unemployment

• Frictional Unemployment: Result of Matching Behavior between Firms and Workers.

• Structural Unemployment: Result of Mismatch of Skills and Employer Needs

• Cyclical Unemployment: Result of output being below full-employment. Individuals have the desire to work and the skills to work, yet cannot find a job.

• Is Zero Unemployment a Reasonable Policy Goal?– No! Frictional and Structural Unemployment may be desirable (unavoidable).

Readings: Supplemental Notes 4 (pages 16-17); Reading List #25-28, 64

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Why is the Distinction Important?

• How much of the current unemployment is structural vs. cyclical?

• This is a current debate among policy makers (and a question I am trying to answer in my own research)

• Why could there be structural unemployment?

o Some industries boomed inefficiently during the early 2000s (construction) and need to retrench. The jobs being created now

are not in those industries (where unemployment is high).

o Some states boomed inefficiently during the early 2000s (Nevada, Florida, California, Arizona, etc.) and need to retrench. The jobs being created now are not in those states (where

unemployment is high)

Some Other Labor Market Facts

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19

Spatial Variation in Unemployment Rate (November 2011)

2

4

6

8

10

12

1990 1993 1996 1999 2002 2005 2008 2011

2

4

6

8

10

12

Unemployment Rate by Gender

Source: Bureau of Labor Statistics

Women

Men

Unemployment Rate Unemployment Rate

Seasonally Adjusted

Oct

200

9

2.7

1.1

0.1

0.15

0.2

0.25

0.3

1990 1994 1998 2002 2006 2010

0.1

0.2

0.3

0.4

Unemployment to Non-Participation by Gender

Source: Bureau of Labor Statistics

Men

Percent Men

Seasonally Adjusted

Percent Women

Women

The Unemployment Rate By Skills: All (20-45)

Education2007

UnempRate

2011Unemp

Rate

Change in

Rate

Share of

Pop.

Share Weighted

Change

Percent of Total

Unemp Rate

Explained

High School or Less

7.1% 15.2% 8.2% 41% 3.3% ~65%

Some College 4.2% 8.9% 4.7% 30% 1.5% ~25%

College or More

1.9% 4.5% 2.6% 29% 0.7% ~10%

All 4.6% 9.9% 5.3%

The Unemployment Rate By Skills: All (20-45)

Education2007

UnempRate

2011Unemp

Rate

Change in

Rate

Share of

Pop.

Share Weighted

Change

Percent of Total

Unemp Rate

Explained

High School or Less

7.1% 15.2% 8.2% 41% 3.3% ~65%

Some College 4.2% 8.9% 4.7% 30% 1.5% ~25%

College or More

1.9% 4.5% 2.6% 29% 0.7% ~10%

All 4.6% 9.9% 5.3%

The Unemployment Rate By Skills: All (20-45)

Education2007

UnempRate

2011Unemp

Rate

Change in

Rate

Share of

Pop.

Share Weighted

Change

Percent of Total

Unemp Rate

Explained

High School or Less

7.1% 15.2% 8.2% 41% 3.3% ~65%

Some College 4.2% 8.9% 4.7% 30% 1.5% ~25%

College or More

1.9% 4.5% 2.6% 29% 0.7% ~10%

All 4.6% 9.9% 5.3%

Share of Prime Age Lower Educated Men Working in Manufacturing

Rise of China: Autor et al. (2011)

Share of Prime Age Lower Educated Men Out of the Labor Force

Interaction Between the Construction and Manufacturing: Low Educated Men

Labor Market Break Down of Younger, Low Educated (<= 12)Men

Labor Market Status 1997 2007 2010

Out of Labor Force 10.7 12.5 13.9

Unemployed 7.3 6.6 16.0

Construction 13.6 18.8 13.1

Manufacturing 15.5 11.0 8.8

Other 52.1 51.1 48.2

Incarceration Rate about 5% in 2010.

Labor Market Break Down of Younger, High Educated (>= 16) Men

Labor Market Status 1997 2007 2010

Out of Labor Force 4.2 5.0 5.6

Unemployed 1.9 1.6 4.7

Construction 1.9 2.4 1.5

Manufacturing 2.1 1.9 1.7

Other 89.9 89.1 86.8

Wages of Lower Educated Men

A Potential Hypothesis About Current Unemployment

• The decline of manufacturing would have gradually caused an exodus of low skilled men from the labor market.

• During previous two decades, such forces were associated with an exodus of low skilled men out of the labor force (as wages fell).

• During the past decade, the housing (construction) boom may have delayed the inevitable (giving low skill men another employment option).

• As construction returns to “normal” and manufacturing has disappeared, what will low skill men do?

• May transition through unemployment before exiting the labor force.

• This is the focus of my new research project: “Construction Booms, Construction Busts and the Labor Supply of Low Skilled Men”

Trillion Dollar Question

• How do we get low skilled men back to work?

• How many of these unemployed men will transition out of the labor force given the decade long decline in manufacturing now that construction has returned to “normal”?

• Will any of the policies currently discussed in Washington to promote jobs solve this problem?

• Are any policies worth exploring?

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A Side Question: Why Should We Care About Unemployment?

• Depreciation of Human Capital

o Individuals lose skills when they sit idle.

• Productive Externalities

o Working individuals mean fewer wasted resources.

• Social Externalities

o Individuals not working could increase crime, divorce, etc.

• Individual Self-Worth

o Individuals not working may have lower marginal utility of leisure or consumption.

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Questions We Will Address In This Course

1. What causes recessions? What causes unemployment?

2. What caused this recession? Will there be a double dip?

3. What is the link between housing prices and “real” economic activity (consumption, production, unemployment, etc.)?

4. What is the link between the banking sector and “real” economic activity?

5. Should we be concerned with inflation? What about deflation?

6. What causes inflation/deflation?

7. How can policy makers (Fed/Congress/President) influence economic activity in the short run (fight inflation and recessions) and in the long run (promote economic growth)?

8. What are the pitfalls of government intervention?

9. What makes economies grow in the LONG RUN?!

10. How worried should we be about long run government deficits?

11. What are the costs/benefits of altering the nature of the Federal Reserve?

12. What is the influence of China and India on the U.S. economy?

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Caveat #1

• My course takes the perspective of analyzing any large macroeconomy (with respect to the models we build).

• The examples will come from the U.S. (because that is what I study)

• However, the insights apply equally well to all large developed economies including:

– The European Union

– Japan

– Canada, Australia, etc. (for the most part).

• The models you will learn in this class also explain consumer, business, and government behavior for all economies (China, India, etc.).

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Caveat #2

• The course takes time to build.

• Our goal is to construct and analyze the economy as a whole.

• To do that, we separately build the parts.

• After we build the parts, we put them together to see how they interact.

• At certain points in the class, you may feel that we are losing sight of the big picture and you may feel lost. That is common.

• But, I promise, by week 7 or 8 everything will come together (it always does).

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Note

• I have so much material to cover in this course, that we will have a mandatory extra lecture.

• The course will be comprised of 11 lectures.

• The extra lecture is January 1/21 at the Gleacher Center (from 9 am – 12 pm)

• See syllabus for full details.

TOPIC 1TOPIC 1

A Introduction to Macro Data

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Goals of the Lecture

• What is Gross Domestic Product (GDP)? Why do we care about it?

• How do we measure standard of living over time?

• What are the definitions of the major economic expenditure components?

• What are the trends in these components over time?

• What is the difference between ‘Real’ and ‘Nominal’ variables?

• How is Inflation measured? Why do we care about Inflation?

• What have been the predominant relationships between Inflation and GDP

over the last four decades?

NOTE: This lecture will likely go into next week. This is by design. It does not mean we will be short-changed on other material later in the class.

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Gross Domestic Product (GDP)

• GDP is a measure of output!

• Why Do We Care?

– Because output is highly correlated (at certain times) with things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc…)

• Formal Definition:

– GDP is the Market Value of all Final Goods and Services Newly Produced on Domestic Soil During a Given Time Period (different than GNP)

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“Production” Equals “Expenditure”

• GDP is a measure of Market Production!

• GDP = Expenditure = Income = Y (the symbol we will use)

(in macroeconomic equilibrium)

• What is produced in the market has to be show up as being purchased or held by some economic agent;

• Who are the economic agents we will consider on the expenditure side?

– Consumers (refer to expenditure of consumers as “consumption”)

– Businesses (refer to expenditure of firms as “investment”)

– Governments (refer to expenditures of governments as “government spending”)

– Foreign Sector (refer to expenditures of foreign sector as “exports”)

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A Simple Example

• What is “produced” has to be “purchased” by someone (including the producer).

• Suppose I produce silverware (forks, spoons, etc.). If so, I could:

– sell it to some domestic customer (Consumption)

– sell it some business (Investment)

– keep it in my stock room as inventory (Investment)

– sell it to the city of Chicago to use in their shelters (Government spending)

– sell it to some foreign customer (Export)

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“Production” Equals “Income”

• What is Produced is Also a Measure of Income.

• If you pay a $1 for something, that $1 has to end up in someone’s pocket as:

Wages/Salary (compensation for workers who make production)

Profits (compensation for self employed)

Rents (compensation for land owners)

Interest (compensation for debt owners)

Dividends (compensation for equity owners)

• Notice, wages are only one component of income (Y does not equal wages)! (Although, under certain production functions, they will be proportional to each other).

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Stop and Pause

• By definition…..

Production = Income = Expenditure = Y

• What is produced has to be purchased by someone (accounting for inventory changes).

• What is purchased has to end up as income in somebody’s pocket!

• In our class, we realize that the terms are interchangeable in equilibrium.

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Measuring GDP in Practice

• Production Method: Measure the Value Added summed Across Industries

(value added = sale price - cost of raw materials)

• Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX)

• Income Method: Labor Income (wages/salary) +

Capital Income (rent, interest, dividends, profits).

• In our class, we will model the production side of economy (supply side) and the expenditure side of the economy (demand side).

• Prices will always adjust to equate supply and demand such that Y (production) always equals Y (expenditure).

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What GDP is NOT!

• GDP is not, or never claims to be, an absolute measure of well-being!

– Size effects : But even GDP per capita is not a perfect measure of welfare

• “The gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud to be Americans.”

– U.S. Senator Robert F. Kennedy, 1968

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More on What GDP Is Not

• GDP Does Not Measure:

– Non-Market Activity (home production, leisure, black market activity)– Environmental Quality/Natural Resource Depletion– Life Expectancy and Health– Income Distribution– Crime/Safety

• Remember how we measure GDP…(i.e., how does one measure “safety”).

• Ideally, what we would like to measure is quality of one’s life:

– Present discounted value of utility from one’s own consumption and leisure and that of one’s loved ones.

• Read: Course Pack Readings 19-21 and 23

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Defining the Expenditure Components (formally)

• Consumption (C):

– The Sum of Durables, Non-Durables and Services Purchased Domestically by Non-Businesses and Non-Governments (ie, individual consumers).

– Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables).– Does Not Include Purchases of New Housing.

• Investment (I):

– The Sum of Durables, Non-Durables and Services Purchased Domestically by Businesses

– Includes Business and Residential Structures, Equipment and Inventory Investment– Land purchases are NOT counted as part of GDP (land is not produced!!)– Stock purchases are NOT counted as part of GDP (stock transactions do NOT

represent production – they are saving!)

There is a difference between financial and economic investment!!!!!!!

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More On Expenditure/Production Components

• Government Spending (G): Goods and Services Purchased by the domestic government.

• For the U.S., 2/3 of this is at the state level (police and fire protection, school teachers, snow plowing) and 1/3 is at the federal level (President, Post Office, Missiles).

• NOTE: Welfare and Social Security are NOT Government Spending. These are Transfer Payments. Nothing is Produced in this Case.

• Net Exports (NX): Exports (X) - Imports (IM); – Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil – Imports: The Amount of Goods Produced on Foreign Soil Purchased

Domestically.

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Summary of the Demand Side of Economy

• Expenditures:

Y = C + I + G + X - IM

• Only four economic agents can “spend” on domestic production

Domestic consumers (C)

Domestic firms (I)

Domestic governments (G)

Foreign consumers, firms, and governments (X)

• We will develop models for each sub component of the expenditure side of the economy (C, I, G, and NX).

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Measuring Expenditure (Demand Side)

• Only include expenditures for goods that are “produced”.

– If I give $10 to a movie theater to watch a movie, it is counted as expenditure.– If I give $10 to my nephew for a birthday present, it is not counted as expenditure.– If I give $10 to the ATM machine to put in my savings account, it is not counted as

expenditure.

• The second example would be considered a “transfer” (once I give $10 to my nephew, he can go to the movies if he wanted to – once that $10 is spent, it will show up in GDP).

– “Transfers” are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged.

• The third example is considered “saving” (I am delaying expenditure until the future). Once I spend the $10 in the future, it will show up in GDP.

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Some Examples of GDP Calculations

• Thinking about imports

Y = C + I + G + X – IM

• Thinking about inventories (storing production….)

Y = C + I + G + X – IM

• Distinguishing between government spending and “transfers”.

Y = C + I + G + X – IM

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Summary of Supply Side of Economy

• Production:

Y = f(A, N, K, other inputs like oil)

where A = technology, N = labor input, K = capital (machine) input

• We will develop models/intuition for A, N, K and oil

• N will be determined in the labor market (labor demand and labor supply)

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Where We are Headed

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The role of “prices”

• “Prices” ensure that we are always in equilibrium

• 4 prices in our class

Price of output (CPI) P

Price of labor (real wages) W/P

Price of money (loans – real interest rates) r

Price of foreign currency (exchange rate) $ or e

• We will develop (from fundamentals) 4 markets in our class

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The 4 Markets

1) Labor Demand vs. Labor Supply (determines N and W/P)

Necessary to compute the supply side of economy

Key to where recessions come from (frictions in the labor market)

2) IS-LM market (determines r and Y (via I))

Interest rates determine firm investment

Key to federal reserve policy (sets r)

Key to understanding banking crises.

3) Aggregate Demand vs. Aggregate Supply (determines P and Y)

Key to understanding where inflation comes from!

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The 4 Markets (continued)

4) Foreign Exchange Market (determines value of currency and NX)

We will focus on this market in week 10

Notice, markets 1-3 help to pin down the level of Y in the economy

These four markets (and their components) will determine everything we want to know about the macroeconomy (production, inflation, economic growth, unemployment, interest rates, budget deficits, trade deficits, etc.)

For the next 7 weeks, we will build the underpinnings of these markets. In doing so, we will uncover how these markets work and what factors influence those markets!

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An Important Equation

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Defining Savings (Store this Away!)

Yd = Disposable Income = Y - T + Tr (1)

• T = Taxes

• Tr = Transfers (ie, Welfare)

Yd = C + SHH (2)

• SHH = Personal (Household or Private) Saving

SHH = Y - T + Tr – C <<Combine (1) and (2)>> (3)

• Personal Savings Rate = SHH/Yd

For simplicity, we are going to abstract from business saving (things like retained earnings and depreciation). For those interested in more of these accounting relationships, see the text.

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A Look at Actual U.S. Household Saving Rates: 1970M1 – 2011M10

Note: Shaded areas are recessions.

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Saving Identities (continued)

Sgovt = T - (G + Tr) (4)

• Sgovt = Government (Public) Saving

• Includes Federal, State and Local Saving

• What government collects (T) less what they pay out (G and Tr)

S = SHH + Sgovt = Y - C - G = I + NX (5)

• S = National Savings

so,

S = Y - C – G <<Combine (3) and (5)>> (6)

S = I + NX <<Combine (6) and Y = C+I+G+NX>> (7)

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Summary

S = I + NX

We will use this equation for the rest of the class!

National savings, goes into a “bank”.

Firms looking to borrow, go to the “bank”.

Firms can only borrow what is in the “bank”

In a world where NX = 0, interest rates will adjust such that savings will always equal investment (I=S – this will be our IS curve later in the course).

What is the role of NX? (International savings)

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Understanding Prices and Inflation

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Prices and Inflation

• Why is it important to measure “prices” of goods and services?

o Prices are a key metric of measurement (we measure GDP in prices).

- The metric changes over time!

o Changes in prices (inflation) is of independent interest in the macroeconomy.

- Inflation is just the percentage growth rate in prices.

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Prices as Measurement

• Measures macro prices of goods and services through “price indices”

• Price Indices track the relative change in the prices for a “basket” of many goods (intended to representative of all goods) compared to the same basket of goods in a “base year”.

• The base year is the anchor for the price index and all subsequent price indices are relative to the base year.

• GDP Deflator (one prominent price index):

Value of Current Output at Current Prices / Value of Current Output at Base Year Prices

• Another prominent price index is the CPI (consumer price index) – measures price changes of consumer goods. I will often use the CPI as our measure of a price index in this class.

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Example of Price Index Calculation (Continued)

• Nominal GDP is output valued at Current Prices

• Comparing Nominal GDPs over time can become problematic. Confuse Changes in Output (production) with Changes in Prices

• Real GDP is output valued at some Constant Level of Prices (prices in a base year).

Real GDP(t) = Nominal GDP(t) / Price Index (t)

• Growth in Real GDP:

% Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)]/Real GDP (t)

or (approximately)

% Δ in Real GDP = % Δ in Nominal GDP - % Δ in P

• See Supplemental Notes 1 (Real vs. Nominal Variables) for examples.

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Technical Notes on Price Indices

• Need to Pick a Basket of Goods (cannot measure all prices)

• ‘Ideal/Representative’ Basket of Goods Change Over Time

– Invention (Computers, Cell Phones, VCRs, DVDs).

– Quality Improvements (Anti-Lock Brakes)

• Criticism of Price Indices: Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time.

• How do we account for “sales”?

• Additionally - technology advances drive down the price of ‘same’ goods over time.

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Technical Notes on Price Indices

• Boskin Report (1996) Concludes that CPI Overstates Inflation by 1.1% per year.

• Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure).

• Measures to Get Around Problems with CPI - Chain Weighting – Read Text to get a sense of chain weighting.

• Read Course Pack Readings: 18 (difficulty measuring prices)

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Technical Notes on Price Indices

• Which is better: Real or Nominal?

– In this class, we will focus on the ‘Real’! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices.

– From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told.

• ie, Y = Real GDP, C = Real Consumption, G = Real Government Purchases, etc...

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Recessions and Inflation in U.S. Over Last 40 Years

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What is a Recession?

• “Official Rule of Thumb” - 2 or more quarters of negative real GDP growth

• Most Economies are usually not in recession

– U.S. average postwar expansion: 50 months

– U.S. average postwar recession: 11 months

– Previous Recession: 19 months (December 2007 – June 2009)

– Previous Expansion: 71 months (January 2002 - November 2007)

– The 1990s experienced the longest expansion since 1850 (the second longest was 106 months ; 1961-1969)

– For Information on Business Cycle Dates see: http://www.nber.org/cycles.html

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A Look at U.S. Nominal GDP: 1970Q1 – 2011Q3

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A Look at U.S. Inflation: 1970Q1 – 2011Q11

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A Look at U.S. Real GDP: 1970Q1 – 2011Q3

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Real GDP and Inflation Over the Last Three Decades?

High or Rising Inflation: 73-75 07-0879-80

Low or Falling Inflation: 81-83 96-00 (sustained) 08-09

90-91 01-02

High Growth in GDP: 83-8696-00 (sustained)

Negative Growth in GDP: 74-75 90-9179-80 01-0281-83 08-09

1) Sometimes Negative Growth in GDP and Rising Inflation (70s)2) Sometimes Negative Growth in GDP and Falling Inflation (80s and 90s)

Need Theory to Explain Both Sets of Facts!!!!

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More On Recessions

Dates Length

2/61 - 11/69 Expansion 106 months

12/69 - 10/70 Recessions 11 months

11/70 - 10/73 Expansion 36 months

11/73 - 2/75 Recession 16 months

3/75 - 12/79 Expansion 58 months

1/80 - 6/80 Recession 6 months

7/80 - 6/81 Expansion 12 months

7/81 - 10/82 Recession 16 months

11/82 - 6/90 Expansion 92 months

7/90 - 2/91 Recession 8 months

3/91 - 3/01 Expansion 121 months

4/01 - 12/01 Recession 8 months

1/02 - 11/07 Expansion 71 months

12/07 - 6/09 Recession 19 months

7/09 - current Expansion 30 months

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Great Moderation?

Dates Length

2/61 - 11/69 Expansion 106 months

12/69 - 10/70 Recessions 11 months

11/70 - 10/73 Expansion 36 months

11/73 - 2/75 Recession 16 months

3/75 - 12/79 Expansion 58 months

1/80 - 6/80 Recession 6 months

7/80 - 6/81 Expansion 12 months

7/81 - 10/82 Recession 16 months

11/82 - 6/90 Expansion 92 months

7/90 - 2/91 Recession 8 months

3/91 - 3/01 Expansion 121 months

4/01 - 12/01 Recession 8 months

1/02 - 11/07 Expansion 71 months

12/07 - 6/09 Recession 19 months

7/09 - current Expansion 30 months

16 months of recession in24 years (1982-2007)

49 months of recession in 21 years (1961-1982)

The Great Moderation

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Great Moderation! - Analysis of Real GDP (Up Through 2007)

• Recessions have become less frequent • Recent recessions are much less severe than previous recessions • Even the expansions are more stable

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Is the Great Moderation Dead?

• I do not think so….

My interpretation:

Great Moderation refers to the fact that the economy is better at minimizing the impact of any given shock now relative to 30 years ago.

It does not mean that:

There will not be bad shocksThere will not be “new” shocks

Why? The economy is more flexible (inventory management, credit)We have gotten better at conducting macroeconomic policy!

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Foreshadowing the rest of the course

• Assume aggregate demand (drawn in {Y,P} space) slopes down

I will prove this to you later in the course

• Assume short run aggregate supply (drawn in {Y,P} space) slopes up

I will prove this to you later in the courseI will also distinguish between short run and long run aggregate supply

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Foreshadowing the Rest of the Course: Demand Shocks

The relationship between inflation and output when aggregate demand shifts:

Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS)

Y

Short Run AS

AD

Long Run AS

Y*

P

AD’

a

b

Y’

P’P

If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y’). Prices will fall (from P to P’).

Demand shocks cause prices and output to move in the same direction.(You should be able to illustrate a positive demand shock)

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Foreshadowing the Rest of the Course: Supply Shocks

The relationship between inflation and output when aggregate supply shifts:

Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS)

Y

Short Run AS

AD

Long Run AS

Y*

P

AD’AD’’

a

Y’’

P’’

P

Short Run AS’’

c

If the economy receives a negative short run aggregate supply shock, short run equilibrium will move from point (a) to point (c). Output will fall (from Y* to Y’’). Prices will rise (from P to P’’).

Supply shocks cause prices and output to move in opposite directions.(You should be able to illustrate a positive supply shock)

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Business Cycles vs. Long Run Growth

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Macroeconomic Goals

Promote Economic Growth

Minimize uncertainty

Minimize distortions in the economy (create level playing field)

Create incentives for efficient economic transactions

Maximize “trend” growth

Promote Economic Stability

Keep the unemployment rate low

Keep inflation in check

Refer to this as managing “business cycles” – minimize the deviations (cycles) around the trend.

Lower uncertainty leads to greater economic activity

87

Why We Care About Inflation

88

Interest Rates

i0,1 = the nominal interest rate between periods 0 and 1

(the nominal return on the asset)

πe0,1 = the expected inflation rate between periods 0 and 1

re0,1 = the expected real interest rate between periods 0 and 1

Definitions

re0,1 = i0,1 - πe

0,1 (or i0,1 = πe0,1 + re

0,1)

ra0,1 = i0,1 - πa

0,1 (or i0,1 = πa0,1 + ra

0,1)

where ra and πa are the actual real interest rate and inflation

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Interest Rate Notes

• The Formula given is approximate. The approximation is less accurate the higher the levels of inflation and nominal interest rates. The exact formula is re = (1 + i) / (1 + лe) - 1

• Central Banks are very interested in r since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting i, but the Central Banks are really trying to set r.

• 3 easy ways of measuring expected inflation:– Recent actual inflation (see http://www.clev.frb.org).

– Survey of forecasters (see http://www.phil.frb.org/econ/liv/welcom.html).

– Interest rate spread on nominal vs. inflation-indexed securities (WSJ).

• See http://www.phil.frb.org/econ/spf/spfpage.html for other macro forecasts

90

Why We Care About Inflation

• Note: We will have a whole lecture on this later in the course

• Inflation is Unpredictable

• Indexing Costs (even if you know the inflation rate - you have to deal with it).

• Menu Costs (have have to go and re-price everything)

• Shoe-Leather Costs (you want to hold less cash - have to go to the bank more often).

• Caveat: There may be some benefits to small inflation rates - more on this later.

91

Why We Care About Inflation

• An Example of how inflation can affect real returns.

• Suppose we agree that a real rate of 0.05 over the next year is fair. – borrowing rate, salary growth rate, etc.

• Suppose we also agree that expected inflation over the next year is 0.07.

• We should then set the nominal return equal to 0.12 (i = re + лe)

Summary: i = 0.12

re = 0.05

лe = 0.07

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Why We Care About Inflation

• Suppose that actual inflation is 0.10 (лa > лe)

In this case, ra = 0.02 (ra = i - лa)

Borrowers/Firms are better off

Lenders/Workers worse off

• Suppose that actual inflation is 0.03 (лa < лe)

In this case, ra = 0.09 (ra = i - лa)

Borrowers/Firms are worse off

Lenders/Workers better off

It has been shown that higher inflation rates are correlated with more variability. People/Firms Don’t Like the Uncertainty

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Bonus: Understanding Housing Markets

Average Annual Real Price Growth By US State

State 1980-2000 2000-2007 2000-10 State 1980-2000 2000-2007 2000-2010AK -0.001 0.041 0.021 MT 0.003 0.049 0.024AL 0.000 0.024 0.012 NC 0.008 0.022 0.004AR -0.009 0.023 0.006 ND -0.010 0.033 0.018AZ -0.002 0.061 0.008 NE -0.002 0.007 -0.004CA 0.012 0.066 0.021 NH 0.014 0.041 0.015CO 0.012 0.012 0.002 NJ 0.015 0.058 0.027CT 0.012 0.044 0.018 NM -0.002 0.043 0.016DC 0.010 0.081 0.045 NV -0.005 0.060 -0.006DE 0.011 0.053 0.022 NY 0.020 0.051 0.024FL -0.002 0.068 0.016 OH 0.003 -0.001 -0.013GA 0.008 0.019 -0.003 OK -0.019 0.019 0.007HI 0.004 0.074 0.036 OR 0.009 0.051 0.016IA -0.001 0.012 0.001 PA 0.008 0.042 0.018ID -0.001 0.047 0.012 RI 0.017 0.059 0.027IL 0.010 0.030 0.004 SC 0.007 0.025 0.014IN 0.002 0.020 -0.010 SD 0.002 0.025 0.010

Average 0.011 0.036 0.01294

Average Annual Real Price Growth By US State

State 1980-2000 2000-2007 2000-10 State 1980-2000 2000-2007 2000-2010AK -0.001 0.041 0.021 MT 0.003 0.049 0.024AL 0.000 0.024 0.012 NC 0.008 0.022 0.004AR -0.009 0.023 0.006 ND -0.010 0.033 0.018AZ -0.002 0.061 0.008 NE -0.002 0.007 -0.004CA 0.012 0.066 0.021 NH 0.014 0.041 0.015CO 0.012 0.012 0.002 NJ 0.015 0.058 0.027CT 0.012 0.044 0.018 NM -0.002 0.043 0.016DC 0.010 0.081 0.045 NV -0.005 0.060 -0.006DE 0.011 0.053 0.022 NY 0.020 0.051 0.024FL -0.002 0.068 0.016 OH 0.003 -0.001 -0.013GA 0.008 0.019 -0.003 OK -0.019 0.019 0.007HI 0.004 0.074 0.036 OR 0.009 0.051 0.016IA -0.001 0.012 0.001 PA 0.008 0.042 0.018ID -0.001 0.047 0.012 RI 0.017 0.059 0.027IL 0.010 0.030 0.004 SC 0.007 0.025 0.014IN 0.002 0.020 -0.010 SD 0.002 0.025 0.010

Average 0.011 0.036 0.01295

Average Annual Real Price Growth By US State

State 1980-2000 2000-2007 2000-10 State 1980-2000 2000-2007 2000-2010AK -0.001 0.041 0.021 MT 0.003 0.049 0.024AL 0.000 0.024 0.012 NC 0.008 0.022 0.004AR -0.009 0.023 0.006 ND -0.010 0.033 0.018AZ -0.002 0.061 0.008 NE -0.002 0.007 -0.004CA 0.012 0.066 0.021 NH 0.014 0.041 0.015CO 0.012 0.012 0.002 NJ 0.015 0.058 0.027CT 0.012 0.044 0.018 NM -0.002 0.043 0.016DC 0.010 0.081 0.045 NV -0.005 0.060 -0.006DE 0.011 0.053 0.022 NY 0.020 0.051 0.024FL -0.002 0.068 0.016 OH 0.003 -0.001 -0.013GA 0.008 0.019 -0.003 OK -0.019 0.019 0.007HI 0.004 0.074 0.036 OR 0.009 0.051 0.016IA -0.001 0.012 0.001 PA 0.008 0.042 0.018ID -0.001 0.047 0.012 RI 0.017 0.059 0.027IL 0.010 0.030 0.004 SC 0.007 0.025 0.014IN 0.002 0.020 -0.010 SD 0.002 0.025 0.010

Average 0.011 0.036 0.01296

Average Annual Real Price Growth By US State

State 1980-2000 2000-2007 2000-10 State 1980-2000 2000-2007 2000-2010AK -0.001 0.041 0.021 MT 0.003 0.049 0.024AL 0.000 0.024 0.012 NC 0.008 0.022 0.004AR -0.009 0.023 0.006 ND -0.010 0.033 0.018AZ -0.002 0.061 0.008 NE -0.002 0.007 -0.004CA 0.012 0.066 0.021 NH 0.014 0.041 0.015CO 0.012 0.012 0.002 NJ 0.015 0.058 0.027CT 0.012 0.044 0.018 NM -0.002 0.043 0.016DC 0.010 0.081 0.045 NV -0.005 0.060 -0.006DE 0.011 0.053 0.022 NY 0.020 0.051 0.024FL -0.002 0.068 0.016 OH 0.003 -0.001 -0.013GA 0.008 0.019 -0.003 OK -0.019 0.019 0.007HI 0.004 0.074 0.036 OR 0.009 0.051 0.016IA -0.001 0.012 0.001 PA 0.008 0.042 0.018ID -0.001 0.047 0.012 RI 0.017 0.059 0.027IL 0.010 0.030 0.004 SC 0.007 0.025 0.014IN 0.002 0.020 -0.010 SD 0.002 0.025 0.010

Average 0.011 0.036 0.01297

Typical “Country” Cycle (US – FHFA Data)

U.S. Real House Price Appreciation: 1976Q1 – 2010Q2

98

Typical “Local” Cycle: New York

99

Typical “Local” Cycle: California

100

Country 1970-1999 2000-2006 Country 1970-1999 2000-2006

U.S. 0.012 0.055 Netherlands 0.023 0.027Japan 0.010 -0.045 Belgium 0.019 0.064

Germany 0.001 -0.029 Sweden -0.002 0.059France 0.010 0.075 Switzerland 0.000 0.019

Great Britain 0.022 0.068 Denmark 0.011 0.065Italy 0.012 0.051 Norway 0.012 0.047

Canada 0.013 0.060 Finland 0.009 0.040Spain 0.019 0.081 New Zealand 0.014 0.080

Australia 0.015 0.065 Ireland 0.022 0.059

Average 1970-1999 0.0122000-2006 0.046

Average Annual Real Price Growth By OECD Country

101

Country Cycles – The U.S. is Not Alone

102

Country Cycles – The U.S. is Not Alone

103

104

Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply (Short Run)

105

Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply (Short Run)

PH’

106

Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply (Short Run)

PH’

Demand shocks cause large price increases when supply is fixed

107

Equilibrium in Housing Markets

Demand

PH

QH

Fixed Supply

PH’Supply Eventually Adjusts

PH”

Why Do House Prices Cycle?

• Supply and demand forces.

• When demand increases (increasing prices), supply eventually adjusts (build more houses).

• The increase in housing supply moderates price growth.

• Housing supply – in the long run – is very elastic (convert old properties, build on vacant land, create new cities, etc.).

108

U.S Quarterly Housing Starts (in 1,000s)

109

Housing Market: U.S.

FHFA Index Starting in 1997: Actual Data vs 1% Growth Trend

110