Exam 2 - class @ Northeastern University, professor Martin Konan PDF

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Exam 2 (Chapter 8,9,10,11,12)

Chapter 8

GDP in relation to nation’s total income, output, production, spending GDP represents many different concepts 1. production/value of output 2. Income 3. Expenditure 4. Sum of all value added 5. Sales + Inventory invested

Definitions: 1. Business cycle: a cycle or series of cycles of economic expansions and contractions 2. Economic expansion: a phase of business cycle where production, employment, and income are increasing. Ends with business cycle peak 3. Economic contraction/recession: defined as two consecutive quarters of declining real GDP 4. Economic growth: --> Persistent increase in a nation's capacity to produce g/s --> Expanding PPF over time --> Process through which increases in productivity increase living standard 5. Inflation: Increase in price level/average price of g/s

GDP Def. the market value of all final good and services produced domestically during a period

Real GDP vs Nominal GDP

Components of GDP Final goods Inventory Rent Stock broking Not included → intermediates goods, imports, old goods...

Real

Nominal

Def. Value of GDP using constant prices, prices of a base year Increase in GDP, meaning it is an increase in production RGDP =

Def. Value of GDP using current prices of that period of time. RGDP =

GDP formula: the expenditure approach GDP = C + I + G + NX 1. Consumption 2. Investment: a. Business fixed investment b. Residential investment c. Inventory investment 3. Government spendings 4. Net export

Σ (Q x P)

Σ (Q x Pb ) b = base year Components of investment 1. Business fixed I (plants and equipment invested by firms) → I P+ E 2. Residential I (housing, offices invested by individuals and firms) →

IH

3. Inventory I →

I INV

How is GDP corrected for inflation? Inflation rate

GDP (2 nd yr )−GDP( prev GDP( prev yr) x100

Shortcoming of GDP GDP is not the most accurate measure of economic well being because it missed a number of factors because it does not take into account: - Home production (DIY) - laundry - Underground economy (buying and selling of goods and services that unreported, concealed from the government) avoid taxes or illegal goods and services (black market) GDP per capita misses not only home products and underground economy) but also: 1. Quantity changes 2. Leisure Time 3. Pollution and otters negative effect for production 4. Crimes and other social problem 5. Fair distribution of income GDP deflator Price index based on prices of goods and services purchased by the 4 sectors of the economy GDPD =

NGDP RGDP

x 100

GDP x circular flow GDP measures value of output sold to individuals; but also measures income received by individuals Government expenditure vs government spendings 1. Government spendings: taxes, transfer payments, government purchases 2. Government expenditure: transfer payment, government purchases [no taxes]

Other measurements of total production and total income 1. National income and product accounts (NIPA) 2. Gross national product (GNP) a. Def. Market value of all final goods and services produced by a nation’s factors of production, no matter where they happened to be. 3. National income a. NI = GDP - depreciation 4. Personal income a. PI = NI + transfer payment - RE (retained earnings) + interest on government bonds 5. Disposable personal income a. DI = PI - PI taxes = Consumption (C) + Saving (S)

Chapter 9

Unemployment Those who are in labor force, willing and available to look for a job, yet not working

Household survey measurements

Problems with measuring unemployment rate

Adult population rate

adult population entire population Labour force participation rate =

labour force adult population

Unemployment rate =

Unemployed Labour force

Sometimes UR overstate joblessness - people claim falsely that they are working/in the LF

Categories Employed→ working at least one hour during week of reference Unemployed→ available to work, looking for a job, but not working Labor force→ sum of employed and unemployed (a fraction of the adult population) Not in labor force→ adult population remaining (not in labor force)

LF = E + U LF = AP - LF

Prices indexes to adjust prices (Equivalent cost in year S in terms of year T) → Formula Cost in year t = cost in year S x

Sometimes UR understate joblessness - ignore discouraged workers - ignore intensity of work (part time/full time) - ignored underemployment

P( yr T ) P( yr S)

Labour union Def. Organizations that bargain for better working conditions for their members Bargain for higher wages→ wages will get stuck above equilibrium→ ↑ unemployment Types of unemployments 1. Frictional 2. Structural 3. Cyclical

Policies that reduce unemployment 1. Fiscal and monetary policies→ Ucyclical

Reasons for unemployment 1. Job losers 2. Job leavers/quitters 3. Re-entrants 4. New entrants Efficiency wage Some firms like to pay workers higher wages in order to increase productivity and profit Wages > equilibrium wage→ ↑ unemployment Policies that increase unemployment Minimum wage Unemployment insurance

Definition

Measuring unemployment - BLS uses 2 surveys to provide employment + unemployment measures

Two types of surveys 1. Household survey 2. Establishment survey

Alternative measures of unemployment rate - U6: including discouraged workers and underemployed workers into unemployment statistics

Trend in labour force participation?

Discouraged workers People from adult population available to work who gave up looking for work because they believe that there are no jobs available

The two major reasons why the LFPR for men has fallen over the last several decades are:

The labor force participation rate of adult men has declined gradually since 1948, but the labor force participation rate of adult women has increased significantly, making the overall labor force participation rate higher today than it was in 1948.

1.

2.

Men have been going to school for longer and retiring earlier than before; Increases in Social Security Disability Insurance availability have allowed people with disabilities to stop work

Whether these are good or bad is a value judgment.

Factors determine the unemployment rate? 1. Government policies a. Fiscal and monetary policies b. Gov subsidies to hiring firms c. Gov employment agencies d. Gov sponsored training program e. Relocation subsidies f. Unemployment insurance g. Minimum Wage laws 2. Job search 3. Seasonal unemployment 4. Sectoral shifts 5. Labour unions 6. Efficiency wages a. Worker health b. Worker quality c. Worker effort d. Worker turnover

Cyclical

Frictional

Structural

Unemployment that varies with business cycle; found among job losers

Unemployment that arises from time it takes to match workers and jobs ; found among new entrants, re-entrants, and job quitters

Unemployment that arises from severe mismatches between workers and jobs ; Found among job losers Mismatch: skills or geographic issue

2. 3. 4.

Gov employment agencies→ Ufrictional Gov training programs→ Ustructural Geographic/relocation subsidies→ Ustructural

Long term or short term unemployment? Causes

Mostly long term

Mostly short term

Mostly long term

1.

1. 2.

1.

2.

Inadequate (low) aggregate demand leading to recessions Sticky wages

Employer subsidies (encourage to hire more)--> Ufrictional

4 reasons for paying efficiency wages: 1. Workers’ health or nutrition 2. Workers’ quality→ usually higher wages will attract the best workers 3. Workers’ turnover→ reduce costs of training workers because workers do not leave/stay/new workers do not come in 4. Workers’ effort Inflation formula Def.

GDP (2 nd yr )−GDP ( prev GDP( prev yr)

Time Flow of information about the labour market is poor Seasonal changes

3.

Sensitive to business cycle? Solutions

2. 3. 4.

Yes

No

No

-

-

-

Improve flow of information about labour market → Government employment agencies → computerised job banks

Implement aggregate policy, to boost aggregate demand → fiscal policy → monetary policy

-

People have different preferences and skills Jobs have different skills requirement Geographic locations Sectoral shifts due to changes in consumers tastes and technology

Training workers Government training programme Location subsidies (solve geographic issue)

CPI Def. price index based on purchases of good and services by typical family of 4

Price level Def. ● Measured by a price index ● Reflects the average of prices of g/s

Price indexes 1. GDP deflator (price deflator) 2. CPI 3. PPI 4. PCE (personal consumption expenditure)

CPI formula

Limitations of CPI CPI tends to overstate cost of living and inflation, because: 1. Substitution bias 2. Quality increase bias 3. New product bias (introduction of new good) 4. Outlet bias Most of these problem associated with the CPI using a fixed basket

x100

CPI (2 nd yr )−CPI ( prev y CPI ( prev yr) x100 Uses of CPI 1. Measure inflation 2. Keep track of living cost 3. Make cost of living adjustments 4. Adjust prices over time

Cost of basket at (the asked Cost of basket at b (base y x100 Cost of basket =

Σ

(P x Q)

Substitution bias CPI ignores that consumers may substitute the purchases away from goods whose prices have increased

Quality increase bias Over time, some goods become more durable and have better quality Price increase can result from: Quality increase Pure inflation increase It’s hard to separate the pure inflation part of a price increase

New product bias - CPI ignores the introduction of new goods - CPI basket is updated every 10 years Outlet bias - CPI does not use prices from discount store in its computation

PPI (Producer Price Index) - Price index that represents the average of prices of goods and services received by producers - PPI gives early warning of future movement in consumer prices - Similar to CPI

Nominal Value vs Real Value - Nominal value → current prices - Real value → constant prices

Nominal interest rate vs Real interest rate

Nominal cash flow vs real cash flow - Nominal cash flow → not adjusted for inflation

Real interest rate

Nominal interest rate 1.

N

1.

A

PCE (Personal consumption expenditure) Price index measured by federal reserve, based on purchase of good and services by the typical consumer Similar to CPI → Uses basket of typical family

- PPI↑→ CPI↑

- Real cash flow → adjusted for inflation

2.

3.

o t a d j u st e d f o r i n fl at i o n O b s e r v a b le M e a s u r e s g r o w t h r at e o f t h e d o ll a r v al u e o f a n i n v

2.

3.

d j u st e d f o r i n fl at i o n N o t o b s e r v a b le , b u t m o r e i m p o rt a n t M e a s u r e s t h e g r o w t h o f t h e

p u r c h a si n g p o w e r o f a n i n v e st m e n t

e st m e n t

Inflation rate (Fisher equations) Links nominal and real interest rate

Fisher equation (inflation rate) Exact 1+i= (1 + r)(1 + π)

Cost of inflation Balanced vs Unbalanced inflation Balanced: prices are changing at the same rate Fully adjusted vs unadjusted inflation (indexed vs not indexed) Indexed or not indexed: All contrast are adjusted to the rate of inflation Anticipated vs unanticipated inflation

Approx

Notation i→ nominal interest rate r→ real interest rate π → inflation rate

i≈r+π

Problems with anticipated inflation a. Shoe leather cost of inflation: the cost and inconvenience of reducing money holdings in times of inflation b. Menu cost: cost of updating prices in catalogs and restaurant menus in terms of inflation c. Relative price distortion/ unfair tax treatment: With inflation, not all price changes at the same rate

Tax distortion Notations i→ before tax nominal interest rate r→ before tax real interest rate π→ inflation rate τ→ marginal tax rate -

Exact

Approximatio n

i = (1.06)(1.02) - 1 = 0.0812

i ≈ 6%+2% = 8%

iaτ = 0.812(1 0.30) = 0.568

iaτ ≈ 8%(10.30) = 5.6%

→ after tax nominal interest rate → after tax real interest rate (gov taxes nominal

incomes) -

Example r = 6% π = 2% Τ = 30%

ia τ ra τ

r a τ → after tax real interest rate (gov. taxes real incomes) TDI→ tax distortion of inflation

Real interest rate equations Exact Appr i = (1 + re) (1 + re) - i ≈ re+πe 1 a a i = (1+r )(1+π ) -1 i≈ ra+πa πa > πe → ra < re πa < πe→ ra > re πa = πe→ ra = re 2 types of real interest rate 1. Actual real interest rate (ex. Post real interest rate)

raτ = (1.0568/1.02) -1 = 0.0361

raτ ≈ 5.6%-2% = 3.6%

raτ* = 6%(1 0.30) = 0.0420

raτ* = 6%(10.30) = 4.2%

TDI = 0.0420 0.0361 = 0.059

TDI = 4.2%3.6% = 0.6%

2.

Calculate tax distortion, after tax real interest rate (nominal income taxed, real income taxed directly) Exact

Approximatio n

i = (1+r)(1+π) 1

i≈r+π

iaτ = i(1- τ)

iaτ ≈ i(1-τ)

Problems with unanticipated inflation rate Increase uncertainty and slower economic growth Arbitrary redistribution of wealth between lenders and borrowers a. Ex-ante real interest rate b. Ex-post real interest rate Relative price distortion formula

PA PB →

raτ ≈ iaτ-π

raτ =

1+ia τ 1+π raτ* = r(1- τ)

raτ* = r(1-τ)

TDI = raτ*- raτ

TDI ≈ raτ* raτ = r(1- τ) - [(r + π)(1- τ) - π)] = r(1- τ) - r(1τ) - π(1- τ) + π = -π + π(τ) + π = π(τ)

Chapter 10

Rules of 70 and 72: Approximate time it takes for an investment growing at G’% to double in value t ≈ 70/G (rule of 70) t ≈ 72/G (rule of 72) Ex. RGDP0 = 210 G’ = 7.30% Rule of 70

70 7.30

→

PA

=

$8 A

/

$4 B

$8 A =

;

❑

PB

=

$4 B

2B A

Tax distortion of inflation (unfair tax treatment) When inflation is higher and nominal income is higher, taxes are higher The government often taxes nominal income rather than real income

-

1

t=

Expected real interest rate (ex. Ante real interest rate)

Long run economic growth: Def: -Persistent increase in a nation’s capacity to produce g/s -Expanding PPF over time -Process through which increases in productivity increase living standards

Average growth rate: Arithmetic: (NORMAL AVG) G’A = (Σnt=1Gt)/n Ex. (5%+7.14%+19.05%+(-2%))/4 Geometric: G’G= [∏t=1n(1+Gt)]1/n-1 Ex. (1.05)(1.0714)(1.1905)(0.98) = 1.3124 → (1.3124)^¼ - 1= 7.03%

Proxies for economic growth: Variables for growth -Real GDP per capita -Mortality rates (infant) -Morbidity rates -Literacy rates -Cell phones per person Increases in living standard over time: ❑ RGDP = RGDP❑0

Determinants of long-run economic growth: -Increases in RGDP→ labor productivity = output produced per worker -Increases in labor productivity→ labor (talent, skills), capital, technology -Investment in human and physical capital→ KEY PART 2 in CH11 Potential (real) GDP:

t❑

(1+ g)❑ = 9.59 years (periods)

Increase in living standards over t

Growth rates over a long period of time: RGDPt = RGDP0(1+G’)t Ex. G’ = 7.3% RGDP0 = 210 t = 40 RGDP40= 210(1+0.0703)40 = 3517.29 Financial markets: -Markets where financial instruments/assets/securities -Funds are channeled from those with excess cash (savers) to those with a shortage of cash (investors or borrowers) Financial instruments/assets/securities: ex. Stocks, bonds Financial institutions/intermediaries: Ex. Commercial banks Financial system: -Collection of all regulations, laws

periods (years)

Def: Level of real GDP attained of all firms operate at full capacity Factors affecting potential (real) GDP: -Labor, capital, technology

under which funds are channeled from savings into investments

7 key functions of FS (know 3) 1. Saving function: The global system of financial markets and institutions provides a conduit for the public’s savings It provides potentially profitable, low-risk outlet for the public’s saving, which flow through the financial markets into investment, so that more goods and services can be produced, increasing the world’s standard of living 2. Wealth function: Providing a means to store purchasing power/wealth in financial assets until needed for future consumption

3.Liquidity function: -Providing a means of raising funds by converting financial assets (stocks, bonds, deposits) into cash balances -For wealth stored in financial instruments, the global financial marketplace provides a means of converting those instruments into cash with little risk of loss -Thus, the world’s financial markets provide liquidity (immediately spendable cash) for savers who hold financial instruments but are in need of money

Investment: Spending on now capital by firms purchases of new homes by individuals and firms, and changes in business inventories I = IP+E+IH+IIHV Saving (3 types) -Spersonal = GDP or National Income+Transfer Payments-TaxesConsumption-Retained earnings Y-(Tx-TR)-C-RE → Y-T-C-RE -Sprivate = Spersonal+Sbusiness -Spublic = Tx-TR-Government purchases = T-G (total or national s) S = Sprivate+Spublic Y-T-C+T-G = Y-C-G

Demand for loanable funds: -Comes from investment Determinants for DLF: -Real interest rate, r (-) (most important) ----Increase will lead to decrease in loans -Expected future profits (+) ----Profits higher, people invest more -Cash flows (+) -Taxes ---Corporate taxes (-) --Investment tax credit (+) -Technology (+) Crowding out: Def: reduction in private spending (consumption, investment) following an increase in gov expenditure G↑ → S↓ → r↑ → I↓ (important to mention in explanation)

Supply of loanable funds: -Comes from saving Determinants of saving: -Real interest rate (+) -Deficits, surplus, fiscal policy Fiscal policy -TX: TX↑ → DI↓ → C↓ → S↑ -TR: TR↑ → DI↑ → C↓ → S↑ -G: G↑ → S↓ Consumer preferences C↑ → S↓ Tax incentives Tax in consumption rather than income, promote savings.

Equilibrium in Market for LF Ex. Y = 4000, C = 250+0.75(Y-T) I = 2000-40r, G = 600 T = 1000 Sprivate? Spublic? S? I? Find r* Graph your answers Sprivate= Y-T-C = 4000-1000-[250+0.75(4000-1000)]= 500 Spublic= T-G = 1000-600 = 4000 S= 500+400= 900 Y-C-G = 4000-2500-600= 900 I = S = 900 r* = S=I 900 = 2000-40r 40r = 1100 r* = 1100/40 = 27.5 ← graph

Business cycles alternating periods of expansions and contractions (recessions) in real GDP over time

Effects on Business Cycles -On firms: Recession: demand for g/s ↓ due to expected incomes ------Output ↓ → firms will be

-On unemployment: R...