What is an Economy?A Primer on Macroeconomics: What is an Economy? A Primer on Macroeconomics Prof. Miles Cahill College of the Holy Cross


Key Terms and Concepts: Key Terms and Concepts Opportunity cost Real vs. nominal GDP Inflation Unemployment Productivity Interest rates Business cycles


Opportunity cost: Opportunity cost The value of the next-best alternative Examples: Value of leisure time Cost of college education Cost of buying a factory


Real vs. nominal: Real vs. nominal Nominal Measured with changing units Useful for actual transactions Not useful for comparisons over time, space


Real vs. nominal: 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: 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: 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: 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: 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: 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: 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: 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: 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: GDP: value added Value added of each industry Value of product sold to next stage or consumer – cost of materials


Globalization: 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: 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: GDP assignment Make group calculations


Inflation calculation: 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: 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: 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 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: Productivity Output per unit of input Labor productivity GDP / total hours worked Total factor productivity GDP / 1 unit of each input


Productivity: 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: 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: 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 value: Interest rates and present value Example Suppose have $100 in bank, i=10% How much in 1 year? =$110


Interest rates and present value: Interest rates and present value Example 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 value: Interest rates and present value General 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: 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: 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: 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: Key interest rates


Interest rate “building”: 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: 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: 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: 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?: 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: 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: 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: 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: 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: 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: 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: 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: 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: Recent policy


Responses to crises: Responses to crises Roles: Keep markets operating Keep payments system operating Keep economy stable


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


Summary: 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