What is an Economy?A Primer on Macroeconomics

Prof. Miles Cahill

College of the Holy Cross

Key Terms and Concepts

Opportunity cost Real vs. nominal GDP Inflation Unemployment Productivity Interest rates Business cycles

Opportunity cost

The value of the next-best alternativeExamples:

Value of leisure time Cost of college education Cost of buying a factory

Real vs. nominal

Nominal Measured with changing units Useful for actual transactions Not useful for comparisons over time, space

Real vs. nominal

Real Measured with “fixed” units of measure Useful for comparisons

Economics measurement Nominal: current prices (“dollars”) Real: base year prices

measure of quantity only

Real vs. nominal

Turning nominal into real Choose “yardstick” (usually an index) Make yardstick relative to some benchmark

(usually a base year) Real values: divide yardstick into nominal

value

Real = Nominal / index (base = 1)

Real vs. nominal

Most common usage Use price index, e.g. CPI

CPI = 100 in “base year” CPI = 110 prices 10% higher than base year Real = nominal / (CPI/100)

Real vs. nominal

Example Aug 1990: Regular gas price $1.20 Mar 2007: Regular gas price $2.54

Was gas ‘really’ 212% more expensive than 1990 in 2007?

CPI = 205 in March 2007 CPI = 132 in August 1990 CPI = 100 in July 1983

Real vs. nominal

Example Answers Real price 8/90: $1.20/(132/100)

= $0.91 in 1983 “dollars” Real price 3/07: $2.54/(205/100)

=$1.24 in 1983 “dollars”

Gas 36% more expensive in real terms

Gross Domestic Product

The market value of all marketable goods and services produced within the borders of a country in one year

Production = Expenditures = Income All the money has to go somewhere!

Fundamental measure of economic health, income, well-being

GDP issues

Annual Used goods Intermediate goods Unfinished/unsold goods Non-marketed goods

Home production Illegal activities

Home country of production firm

GDP: by spending

Consumption (households) Durable and non-durable; not housing

Investment (businesses) Plant, equipment (fixed capital), housing Inventories

Net exports (exports – imports) Government

GDP: by Income

Compensation (“wages”) Proprietor’s income

privately-owned businesses Rental income

Includes imputed income of owned property Corporate Profits Net interest Technical terms

GDP: value added

Value added of each industry Value of product sold to next stage or

consumer – cost of materials

Globalization

Is it new? No…not even in 1492!

What would Italian food be without pasta (from China), tomatoes (from South America), and garlic (from Egypt)?

What is extent today? Will see on assignment

Globalization

Gains from trade Lower prices, more choices for consumers Higher prices/wages for producers/workers

Costs Structural changes

Workers change jobs, etc. Not new – shift from agriculture, sailing ships, etc.

Loss of cultural identity Is it imperialism or consumer choice? Do we want society to remain stagnant?

GDP assignment

Make group calculations

Inflation calculation

Change in average prices Inflation rate: annual percentage change in

price index (e.g. CPI) Example

CPI = 206.7 in 4/07, 201.5 in 4/06 Inflation rate =

= 2.6%

Inflation measurement

Consumer Price Index (CPI) All urban consumers

Subgroup data available Index computed for individual products

Common: “core”, less food & energy Producer’s Price Index (PPI)

Prices as pre-retail level of production Used to predict CPI

PCEPI Consumption part of GDP Used by Federal Reserve

Inflation costs

Not necessarily worse off! Wages keep up with inflation

Unanticipated (high) Those paid by fixed contract receive less than expected in

real terms, so lose; those who pay gain Anticipated

Money management “shoe leather” Tax consequences

Volatile (unpredictable) Risk, reluctance to enter into contracts Higher real interest rates, slower growth

Policy goal: 2-3%, stable

Unemployment

Unemployment rate= # unemployed .

(# unemployed + # employed) Discouraged workers, others not looking for

job don’t count Part time = full time

Official rate is understatement Normal rate: approx. 5-5.5%

Productivity

Output per unit of input Labor productivity

GDP / total hours worked Total factor productivity

GDP / 1 unit of each input

Productivity

Key indicator of economic health Higher productivity = more produced with same

inputs Everyone is richer!

Wages grow with labor productivity Inflation, foreign wages less important

Long run GDP gains because of productivity Long run GDP per person growth rate = productivity growth

rate 3% growth rate is really good!

Productivity

Two sources “Technology” gains: most important

Faster computers, new inventions Better/smarter workers Better management

Work intensity: not true gain Firms often spread out work during slow times,

require extra work when busy

Interest rates

What is “interest”? Funds paid back above initial loan Compensate for time value of money, risk, costs,

etc. Opportunity cost of holding asset

Interest rate concepts Annual As percentage of original loan / investment Can be used to compare any two loans /

investments

Interest rates and present valueExample Suppose have $100 in bank, i=10% How much in 1 year?

=$110

Interest rates and present valueExample Have PV = $100 in bank, i=10% How much in 1 year (FV)?

$100 + $100 × 10% = $110 = FV PV + PV×i = PV×(1+i) = FV

How much in 2 years? $110 + $110 × 10% = $121 [PV×(1+i)]×(1+i) = PV×(1+i)2

Interest rates and present valueGeneral principles PV×(1+i)n=FV PV = FV/(1+i)n

PV of stream of cash flows (FVs) is sum of PV of each cash flow

This is the fundamental way all loans, stocks, bonds, etc. are valued

Assignment: calculate PV

G1: $200 in 3 years, i=9% G2: $200 in 3 years, i=10% G3: $200 in 4 years, i=9% G4: $200 in 4 years, i=10% G5: $200 in 4 years, i=5% G6: $200 in 4 years, i=20% G7: $200 in 8 years, i=10%

Assignment: calculate PV

G1: $200/3/9%$154.44

G2: $200/3/10%$150.26

G3: $200/4/9%$141.69

G4: $200/4/10%$136.60

G5: $200/4/5%$164.54

G6: $200/4/20%$96.45

G7: $200/8/10%$93.30

Key interest rates

Federal Funds Overnight loans between banks Used as Federal Reserve target Primary credit rate (discount rate) is interest rate for Fed

loans Treasury Bill (T-bill)

Interest rate on < 1 yr. (e.g. 3-mo.) government bond Considered safest investment Used as benchmark to compare other rates

Prime Benchmark rate for standard commercial loans NOT lowest interest rate “sub-prime”: risk greater than prime (high risk)

Key interest rates

Interest rate “building”

Nominal = real + inflation rate Inflation rate: compensate for higher prices when

funds paid back Real: compensate for time value of money, risk,

costs, etc. Benchmark

U.S. gov’t bond with same term (due date) Take into account expected rate changes

Add “premiums” Risk, liquidity, costs, etc.

Interest rate assignment

Find int. rates: Google “Fed H15 release”, use 5/29 release, 5/24 data

G1: federal funds G2: 3-month T-bill G3: 10 year T-bond G4: Aaa bond G5: Baa bond G6: prime G7: conventional mortgage

Interest rate assignment

G1: federal funds 5.24%

G2: 3-month T-bill 4.91%

G3: 10 year T-bond 4.86%

G4: Aaa bond 5.56%

G5: Baa bond 6.49%

G6: prime 8.25%

G7: Conventional mortgage 6.37%

Overview of Federal Reserve

Roles Distribute currency Regulate banks/provide services Bank for U.S., world governments Economic policy

Keep economy growing at “potential” Keep inflation low, steady

Independence Created by Congress “Makes own money” Appointed for long terms

Where does money come from? Fed buys bonds from banks for “reserves” Banks loan reserves out as money Money spent, deposited Most of deposit (>90%) loaned out Money spent, deposited (again) Most of new deposit loaned out Money spent, deposited again… Money multiplies itself!

Money facts

Most money does not exist in tangible form Bank accounts

Money multiplies itself Reserves, bonds, small fraction of dep’s

U.S. currency circulates on demand Most used abroad Most domestic used for illegal activities

Overview of Federal Reserve

Board of Governors Appointed by President 7 members, 14-year terms Chair has 4 year term

Federal Reserve Banks 12 banks NY most important

Conducts monetary policy Acts as banker, sells bonds, foreign currency

Fed monetary policy

Federal Open Market Committee (FOMC) 7 members of Board + Fed-NY + 4 Feds Decide monetary policy

Federal funds rate is current target Sets primary credit rate

May act in secret; chooses to be open Press release after meetings Minutes soon after

Policy choices

Expansionary: speed up economy Lower fed funds target (us. 0.25%) Buy bonds from banks (give reserves) Cause other interest rates to cascade Stimulate lending / borrowing

More spending more jobs• Long run impact: inflation

Policy choices

Contractionary: slow down economy to reduce inflation Raise fed funds target (us. 0.25%) Sell bonds to banks (get reserves) Cause other interest rates to cascade Decrease lending / borrowing

less spending fewer jobs• Long run impact: lower inflation

Expectations matter

Expected inflation can lead to actual inflation Fed goal: keep inflation expectations low

Fed talks tough But fighting inflation is costly

Must cause slowdown / recession Examples: 1981-82, 1990-91 (?)

Recent policy

Go to http://www.federalreserve.gov/fomc/ and read release. What did it do?

G1: 5/9/07 G2: 6/29/06 G3: 6/30/04 G4: 6/25/03 G5: 12/11/01 G6: 1/3/01 G7: 5/15/00

Recent policy

G7: 5/15/00 Raise 0.50% to 6.5%; worried about inflation

G6: 1/3/01 Lower 0.50% to 6%; new news on slowing economy

G5: 12/11/01 Lower 0.25% to 1.75%; slow growth

G4: 6/25/03 Lower 0.25% to 1%; economy growing slowly

G3: 6/30/04 Raise 0.25% to 1.25%; still expans., growing

G2: 6/29/06 Raise 0.25% to 5.25%; inflation worries

G1: 5/9/07 Keep same at 5.25%; uncertain outlook

Recent policy

Responses to crises

Roles: Keep markets operating Keep payments system operating Keep economy stable

Business cycles

Boom: GDP rising Unemployment falls Interest rates rise (more borrowing) If GDP grows faster than true productivity, inflation

rises Fed tries to keep economy from growing too

quickly: contractionary

Business cycles

Recession/bust: GDP falling Unemployment rises Interest rates fall (less borrowing) Inflation falls Fed tries to stimulate economy with expansionary

policy

Summary

Keep it “real” U.S. economy is diverse GDP fundamental measure of production and

income Inflation mostly bad if unpredictable Interest rates have key role Money is abstract