Business Condition Analysis

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Business Conditions Analysis

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Dr. David A. DiltsDepartment of Economics

June 2006 first revisionMay 2005


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Business Conditions Analysis, E550

Dr. David A. Dilts

All rights reserved. No portion of this bookmay be reproduced, transmitted, or stored, byany process or technique, without the expresswritten consent of Dr. David A. Dilts

2006

Published by Indiana - Purdue University - Fort Waynefor use in classes offered by the Department of Economics,Richard T. Doermer School of Business and Management Sciences at IPFWby permission of Dr. David A. Dilts


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SYLLABUSE550, Business Conditions Analysis

Dr. David A. Dilts Office: Neff Hall 340DDepartment of Economics Office Phone: 481-6486

School of Business and Management Sciences Email Office: [email protected] University - Purdue University- Fort Wayne Home Phone: 486-8225Email Home:

[email protected]

Course Policies

1. This course is an intersession course. It meets from 5:30 p.m. to 10:20 p.m. forten straight weekdays beginning August 7, 2006.

2. Grades will be determined through take-home quizzes. A package of quizzes will

be distributed to class, and you will be expected to turn one in at the beginning ofclass on August 8, August 10, August 14, August 16 August 17, and August 18,2005. There are a total of six quizzes, each worth twenty points. The best fivequizzes will be used to calculate your final grade. The grade scale is:

89-100 A77-88 B65-76 C53-64 D52 and below F

3. Attendance will not be taken; however, it is strongly encouraged.

4. The quizzes may be turned-in early, but will not be accepted more than one classday late. Remember, as much as this is like taking a drink from a fireplug, it isworse for the instructor who has to grade the work you turn in, and you peopleoutnumber me. Im not trying to be officious, but I want to survive this too.

5. All other department, school, campus and university policies will be applicable tothis course and strictly observe.

Course Objectives:

This course has several objectives, which are very much intertwined. These objectivesinclude:

To solve problems innovatively, using the following tools, and concepts:


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1. A quick review of the essence of macroeconomics which is most important inunderstanding the environment of business both domestically and globally,including:

A. National Income Accounts, Price Indices, and Employment Data

B. Keynesian Model of Macroeconomic Activity1. Business Cycles2. Fiscal Policy

C. Monetary Aggregates1. Monetary Policy2. Exchange rates3. Interest Rates

2. Economic data sources and their interrelationsA. Economic Indicators

1. Leading indicators

2. Concurrent indicators3. Trailing indicatorsB. Understanding sector performance using economic aggregates

3. Forecasting models and their usesA. Simple internal modelsB. Correlative methodsC. Limitations and value

4. Putting together the notion of business environment within a strategic view of abusiness enterprise

With these issues mastered it is also the objective of this course to master thesetools to be able to integrate and synthesize business conditions information andanalysis for the purposes of planning and decision making.

Reading AssignmentsEconomics:Monday, August 7, 2006Dilts, Chapters 1-2

Tuesday, August 8, 2006Dilts, Chapters 3

Wednesday, August 9, 2006Dilts, Chapters 4-5

Thursday, August 10, 2006Dilts, Chapters 6-7


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Friday, August 12, 2006Dilts, Chapters 8-9

Monday, August 14 2006

Dilts, Chapter 10-11

Tuesday, August 15, 2006Dilts, Chapter 12

Data:

Wednesday, August 16, 2006Dilts, Chapter 13-14

Thursday, August 17, 2006

Dilts, Chapter 15

Friday, August 18, 2006Dilts, Chapter 16 -17 and Catch-up


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Chapter 1

Introduction to Economics

In general, the purpose of this chapter is to provide the basic definitions uponwhich the subsequent discussions of macroeconomics and business conditions will bebuilt. The specific purpose of this chapter is to define economics (and its majorcomponent fields of study), describe the relation between economic theory andempirical economics, and examine the role of objectivity in economic analysis, beforeexamining economic goals and their relations. For those of you who have had E201 orE202, Introduction to Microeconomics or Introduction to Macroeconomics much of thematerial contained in this chapter will be similar to the introductory material contained in

those courses. However, you will find that there is considerable expansion of thediscussions offered in the typical principle courses, as a matter of foundation for themore in depth discussions of business conditions that will occur in E550.

Definitions

Economics has been studied since sixteenth century and is the oldest of thesocial studies. Most of the business disciplines arose in attempt to fill some of theinstitutional and analytical gaps in the areas with which economics was particularly well

suited to examine. The subject matter examined in economics is the behavior ofconsumers, businesses, and other economic agents, including the government in theproduction and allocation processes. Therefore, any business discipline will have somedirect relation with the methods or at least the subject matter with which economistsdeal.

Economics is one of those words that seems to be constantly in the newspapersand on television news shows. Most people have some vague idea of what the wordeconomics means, but precise definitions generally require some academic exposure tothe subject. Economics is the study of the allocation of SCARCE resources tomeet UNLIMITED human wants. In other words, economics is the study of human

behavior as it pertains to the material well-being of people (as either individuals orsocieties).

Robert Heilbroner describes economics as a "Worldly Philosophy." It is theorganized examination of how, why and for what purposes people conduct their day-to-day activities, particularly as relates to the production of goods and services, theaccumulation of wealth, earning incomes, spending their resources, and saving for


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future consumption. This worldly philosophy has been used to explain most rationalhuman behavior. (Irrational behavior being the domain of specialties in sociology,psychology, history, and anthropology.)

Underlying all of economics is the base assumption that people act in their own

best interest (at least most of the time and in the aggregate). Without the assumptionof rational behavior, economics would be incapable of explaining the preponderance ofobserved economic activity. Consistent responses to stimuli are necessary for a modelof behavior to predict future behavior. If we assume people will always act in their besteconomic interests, then we can model their behavior so that the model will predict (withsome accuracy) future economic behavior. As limiting as this assumption may seem, itappears to be an accurate description of reality. Experimental economics, using rats inmazes, suggests that rats will act in their own best interest, therefore it appears to be areasonable assumption that humans are no less rational.

Most academic disciplines have evolved over the years to become collections of

closely associated scholarly endeavors of a specialized nature. Economics is noexception. An examination of one of the scholarly journals published by the AmericanEconomics Association, The Journal of Economic Literaturereveals a classificationscheme for the professional literature in economics. Several dozen specialties areidentified in that classification scheme, everything from national income accounting, tolabor economics, to international economics. In other words, the realm of economicshas expanded to such an extent over the centuries that it is nearly impossible foranyone to be an expert in all aspects of the discipline, so each economist generallyspecializes in some narrow portion of the discipline. The decline of the generalist is afunction of the explosion of knowledge in most disciplines, and is not limited toeconomists.

Economics can be classified into two general categories, these are (1)microeconomics and (2) macroeconomics. Microeconomics is concerned withdecision-making by individual economic agents such as firms and consumers. Inother words, microeconomics is concerned with the behavior of individuals or groupsorganized into firms, industries, unions, and other identifiable agents. Microeconomicsis the subject matter of E201 and E321 Microeconomics.

Macroeconomics is concerned with the aggregate performance of theentire economic system. Unemployment, inflation, growth, balance of trade, andbusiness cycles are the topics that occupy most of the attention of students ofmacroeconomics. In E202 and E321 the focus is on macroeconomic topics. Thesematters are the topics to be examined this course E550, Business Conditions Analysis.

Macroeconomics is a course that interfaces with several other academicdisciplines. A significant amount of the material covered in this course involves publicpolicy and has a significant historical foundation. The result is that much of what is


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currently in the news will be things that are being studied in this course as they happen.In many respects, that makes this course of current interest, if not fun.

Methods in Economics

Economists seek to understand the behavior of people and economic systemsusing scientific methods. These scientific endeavors can be classified into twocategories, (1) economic theory and (2) empirical economics. Economic theory reliesupon principles to analyze behavior of economic agents. These theories aretypically rigorous mathematical models (abstract representations) of behavior. A goodtheory is one that accurately predicts future behavior and is consistent with the availableevidence.

Empirical economics relies upon facts to present a description of

economic activity. Empirical economics is used to test and refine theoreticaleconomics, based on tests of economic theory. The tests that are typically applied toeconomic theories are statistically based, and is generally called econometric methods.Much of the material involved in forecasting techniques draws heavily from thesemethods. The regression-based forecasting models are very similar to the econometricmodels used to analyze the macroeconomy.

In Business Conditions analysis we will rely heavily on a sound theoretical basisto understand the macroeconomic framework in which business activity arises. Withinthis theoretical framework a range of empirical models, and data will be examined whichwill allow us to both formally and informally forecast economic conditions and what sortsof phenomenon are associated with these conditions for specific markets.

Theory concerning human behavior is generally constructed using one of twoforms of logic. Sociology, psychology and anthropology typically rely on inductive logicto create theory. Inductive logic creates principles from observation. In otherwords, the scientist will observe evidence and attempt to create a principle or a theorybased on any consistencies that may be observed in the evidence. Economics reliesprimarily on deductive logic to create theory. Deductive logic involves formulatingand testinghypotheses. Often the theory that will be tested comes form inductivelogic or sometime informed guess-work. The development of rigorous modelsexpressed as equations typically lend themselves to rigorous statistical methods todetermine whether the models are consistent with evidence from the real world. Thetests of hypotheses can only serve to reject or fail to reject a hypothesis. Therefore,empirical methods are focused on rejecting hypotheses and those that fail to be rejectedover large numbers of tests generally attain the status of principle.

However, examples of both types of logic can be found in each of the socialsciences. In each of the social sciences it is common to find that the basic theory is


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developed using inductive logic. With increasing regularity standard statistical methodsare being employed across all of the social sciences and business disciplines to test thevalidity of theories.

The usefulness of economics depends on how accurate economic theory

predicts behavior. Even so, economics provides an objective mode of analysis, withrigorous models that permit the discounting of the substantial bias that is usuallypresent with discussions of economic issues. The internal consistency brought toeconomic theory by mathematical models often fosters objectivity. However, no modelis any better than the assumptions that underpin that model. If the assumptions areeither unrealistic or formulated to introduce a specific bias, objective analysis ca still bethwarted (under the guise of scientific inquiry).

The purpose of economic theory is to describe behavior, but behavior isdescribed using models. Models are abstractions from reality - the best model is theone that best describes reality and is the simplest (the simplest requirement is called

Occam's Razor). Economic models of human behavior are built upon assumptions; orsimplifications that allow rigorous analysis of real world events, without irrelevantcomplications. Often (as will be pointed-out in this course) the assumptions underlyinga model are not accurate descriptions of reality. When the model's assumptions areinaccurate then the model will provide results that are consistently wrong (known asbias).

One assumption frequently used in economics is ceteris paribus which meansall other things equal (notice that economists, like lawyers and doctors will use Latin toexpress rather simple ideas). This assumption is used to eliminate all sources ofvariation in the model except for those sources under examination (not very realistic!).

Economic Goals, Policy, and Reality

Most people and organizations do, at least rudimentary planning, the purpose ofplanning is the establishment of an organized effort to accomplish some economicgoals. Planning to finish your education is an economic goal. Goals are, in a sense, anidea of what should be (what we would like to accomplish). However, goals must berealistic and within our means to accomplish, if they are to be effective guides to action.This brings another classification scheme to bear on economic thought. Economics canbe again classified into positive and normative economics.

Positive economics is concerned with what is; and normative economics isconcerned with what should be. Economic goals are examples of normativeeconomics. Evidence concerning economic performance or achievement of goals fallswithin the domain of positive economics.


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Most nations have established broad social goals that involve economic issues.The types of goals a society adopts depends very much on the stage of economicdevelopment, system of government, and societal norms. Most societies will adopt oneor more of the following goals: (1) economic efficiency, (2) economic growth, (3)economic freedom, (4) economic security, (5) an equitable distribution of income, (6)

full employment, (7) price level stability, and (8) a reasonable balance of trade.

Each goal (listed above) has obvious merit. However, goals are little more thanvalue statements in this broad context. For example, it is easy for the very wealthy tocite as their primary goal, economic freedom, but it is doubtful that anybody living inpoverty is going to get very excited about economic freedom; but equitable distributionsof income, full employment and economic security will probably find rather wide supportamong the poor. Notice, if you will, goals will also differ within a society, based onsocio-political views of the individuals that comprise that society.

Economics can hardly be separated from politics because the establishment of

national goals occurs through the political arena. Government policies, regulations, law,and public opinion will all effect goals and how goals are interpreted and whether theyhave been achieved. A word of warning, eCONomics can be, and has often been used,to further particular political agendas. The assumptions underlying a model used toanalyze a particular set of circumstances will often reflect a political agenda of theeconomist doing the analysis. For example, Ronald Reagan argued that governmentdeficits were inexcusable, and that the way to reduce the deficit was to lower peoples'taxes -- thereby spurring economic growth, therefore more income that could be taxedat a lower rate and yet produce more revenue. Mr. Reagan is often accused, by hisdetractors, of having a specific political agenda that was well-hidden in this analysis.His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric tomake his tax cuts for the rich acceptable to most of the voters. (Who really knows?)Most political commentators, both left and right, have mastered the use of assumptionsand high sounding goals to advance a specific agenda. This adds to the lack ofobjectivity that seems to increasingly dominate discourse on economic problems.

On the other hand, goals can be publicly spirited and accomplish a substantialamount of good. President Lincoln was convinced that the working classes should haveaccess to higher education. The Morrell Act was passed 1861 and created Land Grantinstitutions for educating the working masses (Purdue, Michigan State, Iowa State, andKansas State (the first land grant school) are all examples of these types of schools).By educating the working class, it was believed that several economic goals could beachieved, including growth, a more equitable distribution of income, economic securityand freedom. In other words, economic goals that are complementary are consistentand can often be accomplished together. Therefore, conflict need not be thecenterpiece of establishing economic goals.

Because any society's resources are limited there must be decisions about whichgoals should be most actively pursued. The process by which such decisions are madeis called prioritizing. Prioritizing is the rank ordering of goals, from the most important to


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the least important. Prioritizing of goals also involves value judgments, concerningwhich goals are the most important. In the public policy arena prioritizing of economicgoals is often the subject of politics.

Herein lies one of the greatest difficulties in macroeconomics. An individual can

easily prioritize goals. It is also a relatively easy task for a small organization or firm toprioritize goals. For the United States to establish national priorities is a far larger task.Adam Smith in the Wealth of Nations(1776) describes the basic characteristics ofcapitalism (this book marks the birth of capitalism). Smith suggests that there are threelegitimate functions of government in a free enterprise economy. These three functionsare (1) provide for the national defense, (2) provide for a system of justice, and (3)provides those goods and services that cannot be effectively provided by the privateeconomy because of the lack of a profit motive. There is little or no controversyconcerning the first two of these government functions. Where debate occurs is overthe third of these legitimate roles.

Often you hear that some non-profit organization or government agency shouldbe "run like a business." A business is operated to make a profit. If the capitalistmodel is correct, then the only reason for an entrepreneur to establish and operate abusiness is to make profits (otherwise the conduct of the business is irrational andcannot be explained as self-interested conduct). A church, charity, or school isestablished for purposes other than the making of a profit. For example, a church maybe established for the purposes of maximizing spiritual well-being of the congregation(the doing of good-works, giving testimony to one's religion, worship of God, and theother higher pursuits). The purpose of a college or a secondary/elementary schoolsystem, likewise is not to make profits, the purposes of educational institutions is toprovide access knowledge. A University is to increase the body of knowledge throughbasic and applied research, professional services, and (of primary importance to thestudents) to provide for the education of students. To argue that these public orcharitable organizations should be run like a business is to suggest that these matterscan be left to the private sector to operate for a profit. Inherent in this argument is theassumption (a fallacy) that the profit motive would suffice to assure that society receiveda quality product (spiritual or educational or both) and in the quantities necessary toaccomplish broad social objectives. Can you imagine what religion would become if itwas reduced to worldly profitability (some argue there's too much of that sort of thingnow), can you imagine what you would have to pay for your education if, instead of theState of Indiana subsidizing education, the student was asked to pay for the total cost ofa course plus some percentage of cost as a profit? Perhaps worse still, who would dothe basic research that has provided the scientific breakthroughs that result inthousands of new products each year? Would we have ever had computers without thebasic research done in universities, what would be missing from our medicaltechnology?

Priorities at a national level are rarely set without significant debate,disagreements, and even conflict. It is through our free, democratic processes that weestablish national, state and local priorities. In other words, the establishment of our


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economic priorities are accomplished through the political arena, and therefore it isoften impossible to separate the politics from the economics at the macro level.

Objective Thinking

Most people bring many misconceptions and biases to economics. After all,economics deals with people's material well-being. Because of political beliefs andother value system components rational, objective thinking concerning variouseconomic issues fail. Rational and objective thought requires approaching a subjectwith an open-mind and a willingness to accept what ever answer the evidence suggestsis correct. In turn, such objectivity requires the shedding of the most basicpreconceptions and biases -- not an easy assignment.

What conclusions an individual draws from an objective analysis using economic

principles, are not necessarily cast in stone. The appropriate decision based oneconomic principles may be inconsistent with other values. The respective evaluationof the economic and "other values" (i.e., ethics) may result in a conflict. If aninconsistency between economics and ethics is discovered in a particular application, arational person will normally select the option that is the least costly (i.e., the majorityview their integrity as priceless). An individual with a low value for ethics or morals mayfind that a criminal act, such as theft, as involving minimal costs. In other words,economics does not provide all of the answers, it provides only those answers capableof being analyzed within the framework of the rational behavior that forms the basis ofthe discipline.

Perhaps of greatest importance by modeling economic systems, it provide abasis of cold, calculation free from individual emotion and self-interest. Do not beconfused, anytime we deal with economic forecasts, there is always the problem ofhope versus whats next. By modeling economic activity, and empirically testing thatmodel, one may be able to produce forecasting models or even indicators that permitunbiased forecasts. To forecast is one thing, to hope is another.

There are several common pitfalls to objective thinking in economics. After all,few things excite more emotion than our material well-being. It should come as nosurprise that bias and less than objective reasoning is common when it comes toeconomic issues, particularly those involving public policy.. Among the most commonlogical pitfalls that affect economic thought are: (1) the fallacy of composition, and (2)post hoc, ergo prompter hoc. Each of these will be reviewed, in turn.

The fallacy of composition is the mistaken belief that what is true for theindividual must be true for the group. An individual or small group of individuals mayexhibit behavior that is not common to an entire population. In other words, this fallacyis simply assuming a small, unscientifically selected sample will predict the behavior,


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values, or characteristics of an entire population. For example, if one individual in thisclass is a I.U. fan then everyone in this class must be an I.U. fan is an obvious fallacy ofcomposition. Statistical inference can be drawn from a sample of individualobservations, but only within confidence intervals that provide information concerningthe likelihood of making an incorrect conclusion (E270, Introduction to Statistics,

provides a more in depth discussion of confidence intervals and inference).

Post hoc, ergo prompter hoc means after this, hence because of this, andis a fallacy in reasoning. Simply because one event follows another does notnecessarily imply there is a causal relation. One event can follow another and becompletely unrelated. All of us have, at one time or another, experienced a simplecoincidence. One event can follow another, but there may be something other than adirect causal relation that accounts for the timing of the two events.

For example, during the thirteenth century people noticed that the black plagueoccurred in a location when the population of cats increased. Unfortunately, some

people concluded that the plague was caused by cats so they killed the cats. In fact,the plague was carried by fleas on rats. When the rat population increased, cats wereattracted to the area because of the food supply (the rats). The people killed thepredatory cats, and therefore, rat populations increased, and so did the population offleas that carried the disease. This increase in the rat population also happened toattract cats, but cats did not cause the plague, if left alone they may have gotten rid ofthe real carriers (the rats, therefore the fleas). The idea that cats were observedincreasing in population gave rise to the conclusion that the cats brought the plague is apost hoc, ergo prompter hoc fallacy, but this example has an indirect relation betweencats in the real cause. Often, even this indirect relation is absent.

Many superstitions are classic examples of this type of fallacy. Broken mirrorscausing seven years bad luck, or walking under a ladder brining bad luck are nothingbut fallacies of the post hoc, ergo prompter hoc variety. There is no causal relationbetween breaking glass and bad luck or walking under ladder (unless something falls offthe ladder on the pedestrian). Deeper examination of the causal relations arenecessary for such events if the truth of the relations is to be discovered. However,more in depth analysis is often costly, and the cost has the potential of causingdecision-makers to skip the informed part and cut straight to the opinion.

Economic history has several examples of how uniformed opinion resulted invery significant difficulties for innocent third-parties, in addition, to those responsible forthe decisions. The following box presents a case where policy was implemented basedon the failure to recognize that there is a significant amount of interdependence in theU.S. economy.

This story shows fairly conclusively that private interests can damage society asa whole. While our economic freedom is one of the prime ingredients in making oureconomy the grandest in the world, such freedom requires that it be exercised in aresponsible fashion, lest the freedom we prize becomes a source of social harm. Like


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anything else, economic freedom for one group may mean disaster for another, throughno fault of the victims. Government and the exercise of our democratic responsibilitiesis suppose to provide the checks on the negative results of the type portrayed in theabove box.

Statistical Methods in Economics

The use of statistical methods in empirical economics can result in errors ininference. Most of the statistical methods used in econometrics (statistical examinationof economic data) rely on correlation. Correlation is the statistical association oftwo or more variables. This statistical association means that the two variables movepredictably with or against each other. To infer that there is a causal relation betweentwo variables that are correlated is an error. For example, a graduate student oncefound that Pete Rose's batting average was highly correlated with movement in GNP

during several baseball seasons. This spurious correlation cannot reasonably beconsidered path-breaking economic research.

On the other hand we can test for causation (where one variable actually causesanother). Granger causality states that the thing that causes another must occurfirst, that the explainer must add to the correlation, and must be sensible. As withmost statistical methods Granger causality models permit testing for the purpose ofrejecting that a causal relation exists, it cannot be used to prove causality exists. Thesetypes of statistical methods are rather sophisticated and are generally examined inupper division or graduate courses in statistics.

As is true with economics, statistics are simply a tool for analyzing evidence.Statistical models are also based on assumptions, and too often, statistical methods areused for purposes for which they were not intended. Caution is required in acceptingstatistical evidence. One must be satisfied that the data is properly gathered, andappropriate methods were applied before accepting statistical evidence. Statistics donot lie, but sometimes statisticians do!

A whole chapter will be dedicated to forecasting methods in this course. It is notso much that forecasting methods are the cognitive content of this course, as much as itis presented to provide the student with a menu of the types of forecasting techniquesthat are available to help get a handle on what to expect. BUFW H509 is ResearchMethods in Businesswhich focuses on data collection, statistical methods, andinference. Together with E550 these two courses should provide the student with adeep-dish approach to both subjects.


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Objectivity and Rationality

Objective thinking in economics also includes rational behavior. The underlyingassumptions with each of the concepts examined in this course assumes that people

will act in their perceived best interest. Acting in one's best interests is how rationality isdefined. The only way this can be done, logically and rigorously, is with the use ofmarginal analysis. This economic perspective involves weighing the costs against thebenefits of each additional action. In other words, if benefits of an additional action willbe greater than the costs, it is rational to do that thing, otherwise it is not.

Forecasting

Objectivity and rationality are critical in developing models and understanding

how business conditions arise. However, the forecaster is less interested in explaininghow the economy works, and more interested in what some series of numbers is goingto do over time, and in particular, in the near future. The end result is that forecastingand economic analyses are very often similar processes. If one is interested in theeconomic environment (business conditions), one must understand how the economyactually works. This is why much of the first half of this course is focused exclusively onthe macroeconomy.

Forecasting is like most other endeavors, you need to have a plan. The steps inforecasting provide an organized approach to permitting the best possible forecasts.The steps in forecasting involve the identification of the variable or variables you wish toforecast. Once these are identified, you need to determine the sophistication of theforecasting method, i.e., who is going to do the forecasting, and who is going to use theforecast will determine the sophistication. Once the sophistication level is determined,then the selection of the method, i.e., exponential smoothing, moving averages at thesimple end, at the more complex end, two-stage least squares, autoregressive models,etc. This, again, involves sophistication, but also the nature of the variable to beforecasted may have something to say about the method selected. Once themethodology is selected, predictor variables must be selected, tested, and incorporatedinto the model. Once the model is developed it will be subject to nearly constantevaluation, and re-specification. The efficacy, accuracy and usability of the results, andthe efficiency of the model in making the forecasts are the primary criteria used indetermining whether the model needs to be revised. Finally, forecasting reports willneed to be framed and circulated to the appropriate management officials for their use.These reports will also be subject to evaluation and re-specification.

In sum, the forecasting plan includes several, interrelated steps, which are:

1. Selection of variables to be forecast


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2. Determining the level of forecast sophistication3. Specification of the model to be used to forecast4. Specification of the variables to be used in the model5. Re-evaluation of the model, using the results, their efficiency and efficacy6. Creating the reports, and evaluating the effectiveness of the reports

One should never lose track of the fact that a forecast will never be perfectlyaccurate, realistic goals for the forecasts must be set. If one can pick up the direction ofmoves in aggregate economic data, the models is probably pretty good. Arriving atexact magnitudes of the changes in economic aggregates is probably more a function ofluck than of good modeling in most cases. In other words, be realistic in evaluating theefficiency and efficacy of the forecasting models selected.

Conclusion

Business Conditions Analysis is focused on macroeconomic topics and howthese topics result in various aspects of the business environment in which the modernenterprise operates. It is not simply a macroeconomics course, nor is it simply a datacollection, modeling and inference course. E550 is the managerial aspects ofmacroeconomics, together with a quick and dirty introduction to analysis of themacroeconomy.

This course is far different than what the typical MBA course of the same titlewould have been twenty-five years ago. Twenty-five years ago this course would havefocused on a closed economy, with very little foreign sector influences, and an economythat was far more reliant on the goods producing sectors. Today, the U.S. economy isstill losing manufacturing, fewer people are employed in mining and agriculture, and it istruly an economy searching for what it wants to be. This is in some ways a moreexciting economy to study because it is at a cross-roads. The U.S. economy was thedominate economy when it was a manufacturing based system. At this cross-roads,there is the potential to re-double that economic dominance, a system full ofopportunities and challenges. On the other hand, there is always the path the Britishfollowed in the 1960s and since, towards less satisfactory results. In U.S. economyhistory we have had many mis-steps, but in general the long-term trend has beentoward ever-increasing prosperity. That is no guarantee, but it is certainly cause foroptimism, particularly if everyone masters the ideas that comprise this course.


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KEY CONCEPTS

Economics

Microeconomics

Macroeconomics

Empirical economics v. Theoretical economics

Inductive logic v. Deductive logic

Model Building

Assumptions

Occams Razor

Normative economics v. Positive economics

Objective Thinking

Rationality

Fallacy of Composition

Cause and effect

Bias

Correlation v. causation

Cost-benefit analysis

Forecasting

Steps

Plan

Evaluation


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STUDY GUIDE

Food for Thought:

Most people are biased in their thinking particularly concerning economic issues. Whydo you suppose this is?

Sample Questions:

Multiple Choice:

Which of the following is not an economic goal?

A. Full EmploymentB. Price StabilityC. Economic SecurityD. All of the above are economic goals

Which of the following methods can be applied to test for the existence of statisticalassociation between two variables?

A. CorrelationB. Granger causalityC. Theoretical modelingD. None of the above

True - false:

Non-economists are no less or no more biased about economics than physics orchemistry {FALSE}.

Assumptions are used to simplify the real world so that it may be rigorously analyzed{TRUE}.


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Chapter 2

National Income Accounting

The aggregate performance of a large and complex economic system requiressome standards by which to measure that performance. Unfortunately our systems ofaccounting are imperfect and provide only rough guidelines, rather than crisp, clearmeasurements of the economic performance of large systems. As imperfect as thenational income accounting methods are, they are the best measures we have and theydo provide substantial useful information. The purpose of this chapter is to present themeasures we do have of aggregate economic performance.

Gross Domestic and Gross National Product

The most inclusive measures we have of aggregate economic activity are GrossDomestic Product and Gross National Product. These measures are used to describetotal output of the economy, by source. In the case of Gross Domestic Product we areconcerned with what is produced within our domestic economy. More precisely, GrossDomestic Product (GDP) is the total value of all goods and services producedwithin the borders of the United States (or country under analysis). On the otherhand, Gross National Product is concerned with American production (regardless ofwhether it was produced domestically). More precisely, Gross National Product(GNP) is the total value of all goods and services produced by Americansregardless of whether in the United States or overseas.

These measures (GDP and GNP) are the two most commonly discussed in thepopular press. The reason they garner such interest is that they measure all of theeconomy's output and are perhaps the least complicated of the national incomeaccounts. Often these data are presented as being overall measures of ourpopulation's economic well-being. There is some truth in the assertion that GDP andGNP are social welfare measures, however, there are significant limitations in suchinferences. To fully understand these limitations we must first understand how thesemeasures are constructed.

The national income accounts are constructed in such a manner as to avoid theproblem of double-counting. For example, if we count a finished automobile in thenational income accounts, what about the paint, steel, rubber, plastic, and othercomponents that go into making that car? To systematically eliminate double-counting,only value-added is counted for each firm in each industry. The value of the paint,used in producing a car, is value-added by the paint manufacturing company, the


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application of that paint by an automobile worker is value-added by the car company(but the value of the paint itself is not). By focusing only on value-added at each step ofthe production process in each industry national income accountants are thus able toavoid the problems of double-counting.

The above box presents the GDP accounts in the major expenditurescomponents. GDP is the summation of personal consumption expenditures , grossdomestic private investment (Ig), government expenditures (G) and net exports (Xn),

where net exports are total export minus total imports. Put in equation form:

GDP (Y) = C + Ig + G + Xn

GDP can also be calculated using the incomes approach. GDP can be found bysumming each of the income categories and deducting Net American Income EarnedAbroad. The following illustration shows how GNP and GDP are calculated using theincomes approach as follows:

GROSS DOMESTIC PRODUCT by COMPONENT 1940-2000(billions of current U.S. dollars)

YEAR PersonalConsumption

Gross DomesticInvestment

GovernmentExpenditures

Net Exports GDP

1940 71.1 13.4 14.2 1.4 100.11950 192.1 55.1 32.6 0.7 286.71960 332.4 78.7 99.8 -1.7 513.41970 646.5 150.3 212.7 1.2 1010.71980 1748.1 467.6 507.1 -14.7 2708.01990 3742.6 802.6 1042.9 -74.4 5513.82000 6257.8 1772.9 1572.6 -399.1 9224.02005 8745.7 2105.0 2362.9 -726.5 12487.1


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____________________________________________________________________________________________________________________________________________

Depreciation+

Indirect Business Taxes+Employee Compensation

+Rents

+Interest

+Proprietors' Income

+Corporate Income Taxes

+Dividends+

Undistributed Corporate Profits

= Gross National Product

- Net American Income Earned Abroad

= Gross Domestic Product

____________________________________________________________________________________________________________________________________________

In a practical sense, it makes little difference which approach to calculating GDPis used, the same result will be obtained either way. What is of interest is theinformation that each approach provides. The sub-accounts under each approachprovide useful information for purposes of understanding the aggregate performance ofthe economy and potentially formulating economic policy. Under the expendituresapproach we have information concerning the amount of foreign trade, governmentexpenditures, personal consumption and investment.

The following accounts illustrate how GDP is broken down into another useful setof sub-accounts. Each of these additional sub-accounts provides information that helpsus gain a more complete understanding of the aggregate economic system. Thefollowing illustration demonstrates how the sub-accounts are calculated:


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____________________________________________________________________________________________________________________________________________

Gross Domestic Product- Depreciation =

Net Domestic Product+ Net American Income Earned Abroad- Indirect Business Taxes =

National Income- Social Security Contributions- Corporate Income Taxes- Undistributed Corporate Profits+ Transfer Payments =

Personal Income- Personal Taxes =

Disposable Income____________________________________________________________________________________________________________________________________________

The expenditures approach provides information concerning from what sectorproportions of GDP come. Personal consumption, government expenditures, foreignsector, and investment all are useful in determining what is responsible for oureconomic well-being. Likewise, the incomes approach provides greater detail to ourunderstanding of the aggregate economic output. Net National Product is the outputthat we still have after accounting for what is used-up in producing, in other words, thecapital we used-up getting GDP is netted-out to provide a measure of the output wehave left. National Income takes out of Net National Product all ad valoremtaxes thatmust be paid during production and net American income originating from overseas.Appropriate adjustments are made to National Income to deduct those things that donot reach households (i.e., undistributed corporate profits) and adds in transferpayments to arrive at Personal Income. The amount of Personal Income thathouseholds are free to spend after paying their taxes is called Disposable Income.

So far, the national income accounts appear to provide a great deal ofinformation. However, we do know that this information fails to accurately measure ouraggregate economic well-being. There are many aspects of economic activity that donot lend themselves well to standard accounting techniques and these problems mustbe examined to gain a full appreciation for what this information really means.


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National Income Accounts as a Measure of Social Welfare

Accounting, whether it is financial, cost, corporate, nonprofit, public sector, oreven national income, provides images of transactions. The images that the accounting

process provides have value judgments implicit within the practices and procedures ofthe accountants. National income accounting, as do other accounting practices, alsohas significant limitations in the availability of data and the cost of gathering data. Inturn, the costs of data gathering may also substantially influence the images that theaccounts portray.

GDP and GNP are nothing more than measures of total output (or income).However, the total output measured is limited to legitimate market activities. Further,national income accountants make no pretense to measure only positive contributionsto total output that occur through markets. Both economic goods and economic badsare included in the accounts, which significantly limit any inference that GDP or any of

its sub-accounts are accurate images of social welfare. More information is necessarybefore conclusions can be drawn concerning social welfare.

Nonmarket transactions such as household-provided services or barter are notincluded in GDP. In other words, the services of a cook if employed are counted, butthe services of a man or woman doing the cooking for their own household is not. Thismakes comparisons across time within the United States suspect. In the earliestdecades of national income accounting, many of the more routine needs of thehousehold were served by the household members own labor. As society becamefaster paced, and two wage earners began to become the rule for Americanhouseholds, more laundry, housecleaning, child rearing, and maintenance worknecessary to maintain the household were accomplished by persons hired in themarketplace. In other words, the same level of service may have been provided, butmore of it is now a market activity, hence included in GNP. This is also the case incomparing U.S. households with households in less developed countries. Certainly,less market activity is in evidence in less developed countries that could becharacterized as household maintenance. Few people are hired outside of the familyunit to perform domestic labor in less developed countries, and if they are, they aretypically paid pennies per hour. Less developed countries' populations relypredominately on subsistence farming or fishing, and therefore even food and clothingmay be rarely obtained in the marketplace.

Leisure is an economic good but time away from work is not included in GNP.The only way leisure time could be included in GNP is to impute (estimate) a value forthe time and add it to GNP (the same method would be required for household servicesof family members). Because of the lack of consistency in the use of time for leisureactivities these imputation would be a very arbitrary, at best. However, commoditiesused in leisure activities are included in GNP. Such things as movie tickets, skis, and


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other commodities are purchased in the market and may serve as a rough guide to thebenefits received by people having time away from work.

Product quality is not reflected in GNP. There is no pretense made by nationalincome accountants that GDP can account for product or service quality. There is also

little information available upon which to base a sound conclusions concerning whetherthe qualitative aspects of our total output has increased. It is clear that domesticautomobiles have increased in quality since 1980, and this same experience is likelytrue of most of U.S. industry.

No attempt is made in GDP data to account for the composition output. We mustlook at the contributions of each sector of the economy to determine composition. TheU.S. Department of Commerce publishes information concerning output and classifiesthat output by industry groups. These industry groupings are called Standard IndustrialCodes (S.I.C.) and permits relatively easy tracking of total output by industry group, andby components of industry groups.

Over time, there are new products introduced and older products disappear astechnology advances. Whale oil lamps and horseshoes gave way to electric lights andautomobiles between the Nineteenth and Twentieth Centuries. As we moved into thelatter part of this century vinyl records gave way to cassettes, which, in turn, have beenreplaced by compact disks. In almost every aspect of life, the commodities that we usehave changed within our lifetimes. Therefore, comparisons of GNP in 1996 with GNP in1966 are really comparing apples and oranges because we did not have the sameproducts available in those two years.

As we move further back in time, the commodities change even more. However,it is interesting to note the relative stability of the composition of output before theindustrial revolution. For centuries, after the fall of the Roman Empire, the compositionof total output was very similar. Attila the Hun would have recognized most of what wasavailable to Mohammed and he would have recognized most of what Da Vinci couldhave found in the market place. Therefore, the rapid change in available commoditiesis a function of the advancement of knowledge, hence the advancement in technology.

Another shortcoming of national income accounting is that the accounts saynothing about how income is distributed. In the early centuries of this millennium, only aprivileged few had lifestyles that most of us would recognize as middle income orabove. With recent archaeological work at Imperial Roman sites, many scholars haveconcluded that over 95% of the population lived in poverty (the majority in life-threatening poverty), while a very few lived in extreme wealth. With the tremendousincreases in knowledge over the past two-hundred years, technology has increased ourproductivity so substantially that in the 28 industrialized nations of the world, themajority of people in those countries do not know poverty. However, the majority of theworld's population lives in less developed countries and the overwhelming majority ofthe people in those countries do know poverty, and a significant minority of these


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people knows life threatening poverty. In short, with the increase in output has come anincrease in the well-being of most people.

Per capita income is GDP divided by the population, and this is a very roughguide to individual income, which still fails to account for distribution. In the United

States, the largest economy in the world, there are still over 40 million people (about14 percent) that live in poverty, and only a very few these in life threatening poverty.Something just under four percent of the population (about 1 person in 26) is classifiedas wealthy. The other 81 percent experience a middle-income lifestyle in the UnitedStates. The distribution of poverty is not equal across the population of this country.Poverty disproportionately falls to youngest and oldest segments of our population.Minority group persons also experience a higher proportion of poverty than do themajority.

Environmental problems are not addressed in the national income accounts. Thedamage done to the environment in the production or consumption of commodities is

not counted in GDP data. The image created by the accounts is that pollution,deforestation, chemical poisoning, and poor quality air and water that give rise tocancer, birth defects and other health problems are economic goods, not economicbads. The cost of the gasoline burned in a car that creates pollution is included in GNP,however, the poisoning of the air, especially in places like Los Angeles, Denver, andLouisville is not deducted as an economic bad. The only time these economic bads areaccounted for in GNP is when market transactions occur to clean-up the damage, andthese transactions are added to GNP. The end result is that GNP is overstated by theamount of environmental damage done as a result of pollution and environmentaldamage.

The largest understatement of GNP comes from something called theunderground economy. The underground economy is very substantial in mostless developed countries and in the United States. It includes all illegitimate(mostly illegal) economic activities, whether market activities or not. In lessdeveloped countries, much of the underground economy is the "black market," but thereis also a significant amount of crime in many of these countries. Estimates aboundconcerning the actual size of the underground economy in the United States. Themiddle range of these estimates suggests the amount of underground economicactivities may be as much as one-third of total U.S. output.

The F.B.I. has, for years, tracked crime statistics in the United States andpublishes an annual report concerning crime. It is clear that drugs, organized theft,robberies, and other crimes against property are very substantial in the United States.However, when these crimes result in income for the offenders, there is also thesubstantial problem of income tax evasion from not reporting the income from thecriminal activity. After all, Al Capone never went to jail for all of the overt criminal actsinvolved in his various criminal enterprises, he went to jail for another crime, that is,because he did not pay income taxes on his ill-gotten gains.


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Drug trafficking in the United States is a very large business. The maximum

estimates place this industry someplace in the order of a $500 billion per year businessin the U.S. Few legitimate industries are its equal. Worse yet, the news media reportsthat nearly half of those incarcerated in this nation's prisons are there on drug charges.

The image that the national income accounts portrays is that the $100 billion, plus thatis spent on law enforcement and corrections because of drug trafficking is somehow aneconomic good, not a failure of our system. Drugs, however, are not the only problem.As almost any insurance company official can tell you, car theft is also another majorindustry. A couple of years ago CNN reported that a car theft ring operating in theSoutheast (and particularly Florida) was responsible for a large proportion of vehiclessold in certain Latin American countries. Further, that if this car theft ring were alegitimate business it would be the fourteenth largest in the United States (right aboveCoca-Cola in the Fortune 100).

In an economy with total output of $6 trillion, when nearly 10% of that is matched

by only one illegitimate industry - drugs - there is a serious undercounting problem. Ifestimates are anyplace close to correct, and $500 billion per year are the gross sales ofdrug dealers, and if the profits on this trade are only eighty percent (likely a lowestimate), and if the corporate income tax rate of forty-nine percent could be applied tothis sum, then instead of a $270 billion budget deficit, the Federal government would beexperiencing a surplus of something in the order of $130 billion, without any reduction inexpenditures for law enforcement and corrections (which could be re-allocated toeducation, health care or other good purposes). Maybe the best argument for thelegalization of drugs is its effect on the nation's finances (assuming, of course, drugswere only a national income accounting problem).

Price Indices

Changes in the price level pose some significant problems for national incomeaccountants. If we experience 10% inflation and a reduction of total output of 5% itwould appear that we had an increase in GNP. In fact, we had an increase in GNP, butonly in the current dollar value of that number. In real terms, we had a reduction inGNP. Comparisons between these two time periods means very little because the pricelevels were not the same. If we are to meaningfully compare output, we must have amethod by which we can compare output with from one period to another by controllingfor changes in the price levels.

Nominal GDP is the value of total output, at the prices that exist at that time. Byadjusting aggregate economic data for variations in price levels then we have data thatcan be compared across time periods with different price levels. Real GDP is the valueof total output using constant prices (variations in price levels being removed).


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Price indices are the way we attempt to measure inflation and adjust aggregateeconomic data to account for price level variations. There is a wide array of priceindices. We measure the prices wholesalers must pay, that consumers must pay (eitherurban consumers (CPI(U) or that wage earners must pay (CPI(W)), we measure pricesfor all goods and services (GNP Deflator) and we also have indices that focus on

particular regions of the country, generally large urban areas, called StandardMetropolitan Statistical Areas -- S.M.S.A.).

Price indices are far from perfect measures of variations in prices. These indicesare based on surveys of prices of a specific market basket of goods, at a particular pointin time. The accuracy of any inference that may be drawn from these indices dependson how well the market basket of commodities used to construct the index match ourown expenditures (or the expenditures of the people upon whom the analysis focuses).Further complicating matters, is the fact that the market basket of goods changesperiodically as researchers believe consumption patterns change. Every five to tenyears (generally seven years) the Commerce Department (Current Population Surveys)

changes the market basket of goods in an attempt to account for the currentexpenditure patterns of the group for which the index is constructed (total GNP,consumers, wholesalers, etc.).

For the consumer price indices, there is a standard set of assumptions used toguide the survey takers concerning what should be included in the market basket. Themarket basket for consumers assumes a family of four, with a male wage earner, anadult female not employed outside of the home, and two children (one male, onefemale). There are also assumptions concerning home ownership, gift giving, diet, andmost aspects of the hypothetical family's standard of living.

The cost of living and the standard of living are mirror images of one another. Ifsomeone has a fixed income and there is a two percent inflation rate per year, then theirstandard of living will decrease two percent per year (assuming the index used is anaccurate description of their consumption patterns). In other words, a standard of livingis eroded if there is inflation and no equal increase in wages (or other income, i.e.,pensions). Under the two percent annual inflation scenario, a household would need atwo percent increase in income each year simply to avoid a loss in purchasing power oftheir income (standard of living).

During most, if not all, of your lifetime this economy has experienced inflation.Prior to World War II, however, the majority of American economic history is marked bydeflation. That is, a general decrease in all prices. With a deflationary economy all onemust do to have a constant increase in their standard of living is to keep their incomeconstant while prices fall. However, deflation is a problem. Suppose you want to buy ahouse. Most of us have mortgages; we borrow to buy a house. If you purchase ahouse worth $50,000 and borrow eighty percent of the purchase price, $40,000 youmay have a problem. If we have five percent deflation per year, it only takes five yearsfor the market value of that house to reach $38689. In the sixth year, you owe more on


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your thirty-year mortgage than the market value of the house. Credit for consumerpurchases becomes an interesting problem in a deflationary economy.

On the other hand, if you owe a great deal of money, you have the opportunity topay back your loans with less valuable money the higher the rate of inflation. Therefore,

debtors benefit from inflation if they have fixed rate loans that do not adjust the rates forthe effects of inflation.

The inflationary experience of the post-World War II period has resulted in ourexpecting prices to increase each year. Because we have come to anticipate inflation,our behaviors change. One of the most notable changes in our economic behavior hasbeen the wide adoption of escalator provisions in collective bargaining agreements,executory contracts, and in entitlement laws (social security, veterans' benefits, etc.).Escalator arrangements (sometimes called Cost of Living Adjustments, C.O.L.A.)typically tie earnings or other payments to the rate of inflation, but only proportionally.For example, the escalator contained in the General Motors and United Auto Workers

contract provides for employees receiving 1 per hour for each .2 the CPI increases.This protects approximately $5.00 of the employees earnings from the erosive effectsof inflation (.01/.2)100, assuming a base CPI of 100. (There is no escalator thatprovides a greater benefit to income receivers than the GM-UAW national agreement).

There are other price indices that focus on geographic differences. (Price datathat measures changes over time are called time series, and those that measuredifferences within a time period but across people or regions are called cross sections).The American Chamber of Commerce Research Association (ACCRA) in Indianapolisdoes a cross sectional survey, for mid-sized to large communities across the UnitedStates. On this ACCRA index Fort Wayne generally ranges between about 96.0 and102.0, where 100 is the national average and the error of estimate is between 2 and 4percent.

There are also producer and wholesale price indices and several componentparts of the consumer price indices that are designed for specific purposes that focus onregions of the country or industries. For example, the components of the CPI are alsobroken down so that we have detailed price information for health care costs, housingcosts, and energy costs among others.

Paashe v. Laspeyres Indices

There are two different methods of calculating price indices; these are theLaspeyres Index and the Paashe Index. The Laspeyres Index uses a constant marketbasket of goods and services to represent the quantity portion of the ration Q0 so thatonly price changes are in the index.

L = PnQ0 / P0Q0 X 100


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This is the most widely used index in constructing price indices. It has the disadvantageof not reflecting changes in the quantities of the commodities purchased over time. ThePaasche index overcomes this problem by permitting the quantities to vary over time,which requires more extensive data grubbing. The Passche index is:

P = PnQn / P0Qn X 100

Measuring the Price Level

The discussion here will focus on the Consumer Price Index (CPI) but isgenerally applicable. The CPI is based on a market basket of goods and is expressedas a percentage of the value of the market baskets' value in a base year (the year withwhich all prices in the index are compared). Each year's index is constructed bydividing the current year market basket's value by the base year market basket's value

and then multiplying the result by 100. Note that the index number for the base year willbe 100.00 (or 1 X 100).

By using this index we can convert nominal values into real values (real value areexpressed in base year dollars). We can either inflate or deflate current values to obtainreal values. Inflating is the adjustment of prices to a higher level, for years when theindex is less than 100. Deflating is the adjustment of prices to a lower level, for yearswhen the index is more than 100.

The process whereby we inflate and deflate is relatively simple andstraightforward. To change nominal into real values the following equation is used:

Nominal value/ (price index/100)

For example, in 1989 the current base year the CPI is 100. By 1996 the CPI increasedto 110.0. If we want to know how much $1.00 of 1996 money is worth in 1989 we mustdeflate the 1996 dollar. We accomplish this by dividing 110 by 100 and obtaining 1.1;we then divided 1 by 1.1 and find .909, which is the value of a 1996 dollar in 1989. If wewant to know how much a 1989 dollar would buy in 1996 we must inflate. Weaccomplish this by dividing 100 by 110 and obtaining .909; we then divide 1 by .909 andfind 1.10, which is the value of a 1989 dollar in 1996.

Because the government changes base years it may be necessary to convertone or more indices with different base years to obtain a consistent time series if wewant to compare price levels between years decades apart. Changing base years is arelatively simple operation. If you wish to convert a 1982 base year index to beconsistent with a 1987 base year, then you use the index number for 1982 in the 1987series and divide all other observations for the 1982 series using the 1982 value in 1987index series. This results in a new index with 1987 as a base year. If inflation was


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experienced during the entire period then the index number for 1987 will be 100, for theyears prior to 1987 the indices will be less than 100 and for the years after 1987 thenumbers will be larger than 100.

The price index method has problems. The assumptions concerning the market

basket of goods to be surveyed causes specific results that are not descriptive of ageneral population. In the case of the consumer price index, families without children orwith more than two may find their cost of living differs from what the index suggests. Ifboth parents work, the indices may understand the cost of living. For families with tenyear old, fixed rate mortgages and high current mortgages rates, the CPI mayunderstate their current cost of living. Therefore, the CPI is only a rough measure, andits applicability differs from household to household.

The following boxes provide some recent information of the type to be found at

the Bureau of Labor Statistics site. The first box provides annual data for consumerprices for both All Urban Consumers (CPI-U), and Urban Wage Earners and ClericalEmployees (CPI-W).

Cost of Living Adjustments

David A. Dilts and Clarence R. Deitsch, Labor Relations, New York: Macmillan

Publishing Company, 1983, p. 167.

To the casual observer, COLA clauses may appear to be an excellent methodof protecting the real earnings of employees. This is not totally accurate. COLA isnot designed to protect the real wage of the employee but is simply to keep theemployee's nominal wage, within certain limits, close to its original purchasing power.With a 1 cent adjustment per .4 increase in the CPI (if no ceiling is present) the basewage which is being protected from the erosive effect of inflation is $2.50 per hour, 1cent per .3 increase in the CPI protects $3.33 per hour, and 1 cent per .2 increase inthe CPI protects $5.00 per hour. This is quite easy to see; since the CPI is an indexnumber computed against some base year (CPI = 100 in 1967) and the adjustment

factor normally required in escalator clauses is 1 cent per some increase x, in theCPI, the real wage which is protected by the escalator is the inverse of the CPIrequirement or 1/x.

The items, which go into the market basket of goods to construct the priceindices, and the proper inference, which can be drawn from these data, are publishedin several sources. Perhaps the easiest accessible location of this information is atthe Bureau of Labor Statistics site www.bls.gov, which also publishes a wealth ofinformation concerning employment, output, and prices.


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Notice that the trend of prices is upwards, and that the CPI (W) is always slightlylarger than the CPI (U). The difference between the two series is growing in 1996, thedifference was about 1.78% of CPI (U), whereby in 2005 the difference was 2.2 % ofCPI (U).

The market basket of goods and services that go into calculating the consumerprice index has been the subject of substantial controversy. For inference to beproperly drawn concerning the underlying prices in the CPI one must have some idea ofwhat goes into to the market basket and whether that mix of goods and service is of anyparticular significance for a consumer. The general categories of expenditures byconsumers which are represented by the CPI (U) are presented in the following table.The table presents the categories of expenditure, rather than each specific item that isincluded in the market basket. This category of expenditure is for the base period 1982-84 and is supposed to be representative of what the average urban consumerpurchased during this time frame.

Consider the consumer expenditure categories used in calculating the CPI (U)

which are presented in the following table:

Consumer Prices 1996-2005, Annual Averages

Year CPI-U CPI-W Difference (U-W)

1996 156.9 154.1 2.81997 160.5 157.6 2.91998 163.0 159.7 3.31999 166.6 1632. 3.42000 172.2 168.9 3.32001 177.1 173.5 3.62002 179.9 175.9 4.02003 184.0 179.8 4.22004 188.9 184.5 4.42005 195.3 191.0 4.3

Not seasonally adjusted1982-84 = 100.0Source: U.S. Department of Labor, Bureau of Labor Statistics


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This is an exercise in positive economics. These are NOT the percentages ofincomes that consumers spend. These are the percentages of incomes assumed to bespent by consumers in constructing the CPI (U). It is clear that there are value

judgments and biases included in these data, but is not so clear is whether the data isupwardly or downwardly biased. With the increases in health care costs and recentincreases in oil prices it is very likely that, in general, the CPI (U) is downwardly biased.However, there are those who argued that the CPI (U) is upwardly biased, and shouldbe adjusted downward. These economists, however, are those who also argue thatindexing government transfer payments and social security is a bad idea. Where thetruth actually lies is an empirical question.

CPI (U) Expenditure Categories 1982-84

Category Relative ImportanceDec. 2005

Food 13.942Alcoholic Beverage 1.109

Shelter 32.260Fuels & Utilities 5.371Furnishings & Operations 4.749

Apparel 3.786

Transportation 17.415

Medical Care 6.220

Recreation 5.637

Education 2.967

Communication 3.080

Other goods & services 3.463___________________________

All Categories 99.999

Source: Bureau of Labor Statistics


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Other Price Level Aggregates

The key price level measures are published data from the CommerceDepartment. Some simple relationship has been demonstrated in the economic

literature which is worth examining here. The consumer price index is divided into corecomponents and also includes things which are more volatile, these items are food andenergy. Housing, clothing, entertainment, etc. are less volatile are often referred to asthe core elements of the consumer price index.

Theoretically it is presumed that the Wholesale Price Index, an index of itemsthat wholesalers provide to retailers, and the Producer Price Index, an index ofintermediate goods are leading indicators of prices at the consumer level. In fact, thesetwo price indices, over the broad sweep of American economic history, have been prettyreasonable indicators of what to expect from consumer prices.

The Producer Price Index is a complex, but useful collection of numbers. ThePPI is divided into general categories, industry and commodity. The major groupingsunder each of these broad categories have a series of price data which has beencollected monthly for several years. The following two tables present simple examplesof the types of PPI data that are available. The first table presents industry data, thesecond box presents commodity data. There are also series on such specializedpricing information as import and export prices, and these are all available on thewww.bls.gov site.

Industry PPI data, 1996-2005

Petroleum Book Auto & Light GeneralYear Refineries Publishers Vehicle Mfg Hospitals

1996 85.3 224.7 140.4 112.51997 83.1 232.1 137.8 113.61998 62.3 238.8 136.8 114.61999 73.6 247.6 137.6 116.62000 111.6 255.0 138.7 119.82001 103.1 263.3 137.6 123.42002 96.3 273.0 134.9 127.92003 121.2 283.0 135.1 135.3

2004 151.5 293.7 136.5 141.92005 205.3 305.4 135.1 147.3%1996-05 140.7 35.9 -3.9 30.9



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As can be easily seen from the above table, there is wide variation in PPI by

industry. Oil refineries costs of operation have gone up more than 140% over theperiod, while the costs for automobile and light vehicle manufacturers have actuallydeclined over the period by nearly 4 percent. In keeping with the high costs of health

care, hospitals costs of operation have increased nearly as much as the costs to bookpublishers over the period. Remember, these are industry cost numbers. The followingtable present commodity cost statistics in the PPI series.

As can readily be seen in comparing the two series, there is a reason why oilrefineries costs of operations increased. The price of crude oil increase by just aboutwhat the costs to the refiners increased. However, book publishers need not look to theprice of paper to explain their cost increases. In sum, the costs of commodities went upover the nine year period by a rather small 23.3 percent or just over two and one-halfpercent.

Monetary aggregates have also been used as a rough gauge of what to expect inthe behavior price variables over time. Later in the course there will be substantialdiscussion of the Federal Reserve and monetary economics, but it is interesting to notehere that monetary aggregates have both a practical and theoretical relationship toaggregate price information in the economy. Monetary aggregates generally havesignificant influence over interest rates, which, in turn, will have both aggregate supply

Commodity PPI data, 1996-2005

All Petroleum Iron andYear Commodities Crude Paper Steel

1996 127.7 62.6 149.4 125.81997 127.6 57.5 143.9 126.5

1998 124.4 35.7 145.4 122.51999 125.5 50.3 141.8 114.02000 132.7 85.2 149.8 116.62001 134.2 69.2 150.6 109.72002 131.1 67.9 144.7 114.12003 138.1 83.0 146.1 121.52004 146.7 108.2 149.4 162.42005 157.4 150.1 159.6 171.1%1996-05 23.3 139.8 6.8 36.0



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and aggregate demand implications. A presentation and discussion of these economicstatistics is reserved for the monetary economics chapters in this course.

Employment and Output

Unemployment and employment data have implications for the business cycle,as will be discussed in detail later. However, it is important to note here thatemployment statistics are generally a lagging indicator, that is, they trail (or confirm)what is going on in the aggregate economy.

Forecasting can be as much a game of indications, more than precision. If wesee industrial output is on the rise, we can expect that unemployment rates will declineonce a trough in the business cycle has been reached. On the other hand, if industrialoutput is declining, we can expect future unemployment rates to be on the rise. Thispresumes that there has not been prolonged recession or structural changes in theeconomy. When there are structural changes or prolonged recession, then such

phenomenon as the discouraged worker hypothesis may operate to make theunemployment rates move in directions that would be otherwise inconsistent with whathad been recently observed in the aggregate economy.

In other words, even though the unemployment and employment statistics have agenerally predictable relationship with output, you can get fooled sometimes because ofunderlying phenomenon in the economy. These theoretical relationships are onlyindicative and can sometimes be overwhelmed by other economic pressures in theeconomy.

A discussion of the various economic statistics relevant to employment andoutput will be reserved for the following chapter where more discussion of the conceptswhich underpin these data is discussed.

KEY CONCEPTS

National Income Accounting

Social Welfare

Under-estimations

Over-estimations

Gross Domestic Product v. Gross National Product

Value added


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Expenditures Approach

Income Approach

Criticisms

Net Domestic Product v. Net National Product

Depreciation

National Income

Personal Income

Disposable Income

Inflation v. Deflation

Cost-Push Inflation v. Demand-Pull Inflation

Pure Inflation

Monetarist School

Quantity Theory of Money

Price Indices

CPI

PPI

Other Indices

Inflating v. Deflating

Paasche v. Laspeyres

Price aggregates

CPI and WPI and PPI relations

Monetary aggregatesEmployment and Unemployment


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Relations with output

Indicators, not hard and fast rules

STUDY GUIDE

Food for Thought:

Critically evaluate the use of national income accounts as measures of social welfare.

Using the following data construct the price indices indicated:

Year Market basket $

1989 3501990 4001991 4401992 4651993 500

Calculate a price index using 1989 as the base year

Calculate a price index using 1991 as the base year

If the nominal price of new house in 1993 is $100,000, how much is the house in 1989dollars? In 1991 dollars?

If the price of a new house in 1989 is $90,000 what is the price in 1991 dollars?


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Critically evaluate the use of price indices for comparison purpose across time.

Using the following data calculate GDP, NDP, NI, PI, and DI

Undistributed Corporate profits $40Personal consumption expenditures $1345Compensation of employees $841

Interest $142Gross exports $55Indirect business taxes $90Government expenditures $560Rents $115Personal taxes $500Gross imports $75Proprietors income $460Depreciation $80Corporate income taxes $100Net Investment $120Dividends $222Net American income earned abroad $5Social security contributions $70


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Sample Questions:

Multiple Choice:

If U.S. corporations paid out all of their undistributed corporate profits as dividends totheir stockholders then which of the following national income accountants would showan increase?

A. Gross Domestic ProductB. Net Domestic ProductC. Personal IncomeD. National Income

The following are costs of market baskets of goods and services for the years indicated:

1900 $1001910 $1021920 $1051930 $901940 $1001950 $1101960 $160

Using 1920 as a base year what is the price index for 1900 and for 1960?

A. 1900 is 105, 1960 is 160B. 1900 is 95.2, 1960 is 152.4C. 1900 is 111.1, 1960 is 177.8D. Cannot tell from the information given

True - False:

The GDP is overstated because of the relatively large amount of economic activity thatoccurs in the underground economy {TRUE}.

The difference between Personal Income and Disposable Income is personal taxes{TRUE}.


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Chapter 3

Unemployment and Inflation

When one thinks of business conditions, the first thing to come to mind, typically,is the recurrent cycles that the economy repeats with near regularity. Business cyclesare a fact of economic life with a market based economy. Recessions are generallyfollowed by recoveries which give a sort of up and down vibration to the long-termsecular growth trend in the U.S. economy. The way we track this vibration is throughthe two major economic phenomenons that are used to track business cycles, these areemployment and price level stability. The purpose of this chapter is to examine two ofthe most important and recurrent economic problems that have characterized modern

economic history throughout the industrialized world, including the United States.These two problems are unemployment (associated with recessions) and inflation(associated with the loss of purchasing power of our incomes). Most economic policyfocuses on mitigating these, most serious, of problems in the macroeconomy.

Mixed Economic System and Standard of Living

American capitalism is a mixed economic system. There are small elements ofcommand and tradition, and some socialism. However, our economic system is

predominately capitalist. The economic freedom and ability to pursue our individualself-interest provides for the American people a standard of living, in the main, that isunprecedented in world history. Perhaps more important, our high standards of livingare widely shared throughout American society (with fewer than 17.5% of Americansliving in poverty).

The accomplishments of American society ought not to be taken lightly, no otherepoch and no other nation, has seen a "golden" age as impressive as modern America.However, there are aspects of our freedom of enterprise that are not so positive. Freemarket systems have a troubling propensity to experience recessions (at the extremedepressions) periodically. As our freedom of inquiry develops new knowledge, new

products and new technologies, our freedom of enterprise also results in theabandonment of old industries (generally in favor of new industries). At times we alsoseem to lose faith in accelerating rates of growth or economic progress. At other times,we have experienced little growth in incomes (at the extreme declines in consumerincomes). All of these problems have resulted in down-turns in economic activity. Atother times, consumer's income have increased at accelerating rates, people havebecome enthusiastic about our economic future, and the growth of new industries have


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far outpaced the loss of old industries that have resulted in substantial expansions ofeconomic activity. Together these down-turns and expansions are referred to as thebusiness cycle.

Business Cycles

The business cycle is the recurrent ups and downs in economic activityobserved in market economies. Troughs, in the business cycle, are whereemployment and output bottom-out during a recession (downturn) or depression(serious recession). Peaks, in the business cycle, are where employment and outputtop-out during a recovery or expansionary period (upturn). These ups and downs(peaks and troughs) are generally short-run variations in economic activity. It isrelatively rare for a recession to last more than several months, two or three years

maximum. The Great Depression of the 1920s and 1930s was a rare exception. Infact, the 1981-85 recession was unusually long.

One of the most confusing aspects of the business cycle is the differencebetween a recession and depression. For the most part, recessionary trends aremarked by a downturn in output. This downturn in output is associated with increasedlevels of unemployment. Therefore, unemployment is what is typically keyed upon infollowing the course of a recession. In 1934, the U.S. economy experienced 24.9%unemployment, this is clearly a depression. The recession of 1958-61 reached only6.7% unemployment. This level of reduced economic activity is clearly only arecession. However, in the 1981 through 1986 downturn the unemployment ratereached a high of 12%, and in both 1982 and 1983 the annual average unemploymentrate was 10.7%. Probably the Reagan recession was close to, if not actually, a shortdepression, arguably a deep recession. This 1981-85 period was clearly the worstperforming economy since World War II, but it also was clearly nothing compared to theproblems in the decade before World War II.

The old story about the difference between a recession and depression probablyis as close to describing the difference between a recession and a depression asanything an economist can offer. That is, a recession is when your neighbor is out ofwork, a depression is when you are out of work!

In general, the peaks and troughs associated with the business cycle, are short-run variations around a long-term secular trend. Secular trends are generalmovements in a particular direction that are observed for decades (at least 25years in macroeconomic analyses).

Prior to World War II the secular trend started as relatively flat and limited growthperiod and then it took a sharp downward direction until the beginnings of the War in


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Europe (a period of about twenty years). Since the end of World War II we haveexperienced a long period of rather impressive economic growth (a period of over fiftyyears).

The following diagram shows a long-term secular trend that is substantially

positive (the straight, upward sloping line). About that secular trend is another curvedline, whose slope varies between positive and negative, this is much the same as thebusiness cycle variations about that long-term growth trend. If we map out economicactivity since World War II we would observe a positive long-term trend, with markedups and downs showing the effects of the business cycle.

There are other variations observed in macroeconomic data. These variations,called seasonal variations, last only weeks and are associated with the seasonsof the year. During the summer, unemployment generally increases due to studentsand teachers not having school in the summer and both groups seeking employmentduring the summer months. Throughout most of the Midwest agriculture andconstruction tend to be seasonal. Crops are harvested in

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Business Condition Analysis