Foundation of Economic Analysis 3250:600

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Foundation of Economic Analysis 3250600

• Instructor Richard W. Stratton
• Meets Thursday 520 750 pm
• CAS 134

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Administration

• This Weeks Assignments
• Farnham Chapter 11 (NIPA)
• Homework 06 (due next week)
• Next Weeks Assignments
• Farnham Chapter 12 (Aggregate Expenditures)
• Homework 07 (review)

Decision Tree
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Decision Tree

• Review Circular Flow
• Economic Measurement
• Measuring price changes
• Measuring employment activity
• Policy Issues

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Circular flow

• Purpose To provide an overview of U.S.A.
  economic activity
• Focuses on transactions (flows) between groups of
  participants through markets.
• To simplify diagram, usually or monetary flows
  shown

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Circular flow

• List the main sectors
• Household, Firm, Government, Foreign
• List the markets
• Product and Factor markets
• Asset markets
• Flows with foreign sector deserve special
  attention

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The inner arrows represent the REAL flows
The outer arrows represent the MONEY flows
EQUAL
Product Markets
Revenues
Consumption
Goods and Services Sold
Goods and Services Purchased
House-holds
Firms
Factors Supplied (Labor, Land, Capital,
Entrepreneurship)
Factors Received (Labor, Land, Capital,
Entrepreneurship)
Income (Wages, Rent, Interest, Profits)
Factor Markets
Expenses (Wages, Rent, Interest, Profits)
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Foreign Sector detail
Product Markets
Revenues
Consumption
Export Receipts
Imported Goods and Services
Exported Goods and Services
Import Payments
Foreign Sector
House-holds
Firms
Borrowing
Loans
Borrowing
Financial Markets
Imported Production Factors
Exported Factors
Export Receipts
Import Payments
Factor Markets
Expenses
Income
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Foreign Sector
Exports
Imports
Product Markets
Revenues
Consumption
Investment
Government Expenditures
Net Personal Taxes
Net Business Taxes
House-holds
Governments
Firms
Borrowing
Borrowing
Borrowing
Financial Markets
Saving
Factor Markets
Expenses
Income
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Decision Tree

• Review Circular Flow
• Economic Measurement
• Measuring price changes
• Measuring employment activity
• Policy Issues

10
Economic measurements

• Introduction of concepts
• National Income and Product Accounts (NIPA)
• Finding the data

Decision Tree
11
Economic measurements

• Distinguishing Flow and Stock statistics
• Distinguishing Economic Activity and Social
  Well-being

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Economic measurements
Stock statistics examples Flow statistics examples
Volume of water in a pond
Inventory
Wealth
Rate of water in-flow and out-flow
Production and sales
Saving, Income and Consumption
Can you provide other economic examples?
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Economic measurements

• Remember the definition of each?
• Stock statistic
• Measurement of the quantity of an item at a point
  in time
• Flow statistic
• Measurement of the quantity of a rate or quantity
  per of time
• Unit of measure must include a unit of time

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Economic measurements

• Distinguishing Economic Activity and Social
  Well-being
• One purpose of economic systems (societies) is to
  provide for the well-being of its individuals
• Economic activity contributes to that well-being,
  but is not a complete picture of well-being

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Economic measurements

• We have seen that exchange and markets tend to
  provide for the needs and desires of individuals
• Well working competitive markets provides the
  highest valued output at the lowest opportunity
  cost
• Thus we can measure economic activity (and its
  contribution to well-being) by summing market
  activity

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Economic measurements

• Gross Domestic Product is a comprehensive measure
  of economic activity
• Individually
• Write a definition of Gross Domestic Product
• Groups
• Compare definitions, discuss differences
• Identify important components of the definition

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Economic measurements

• What are the important components of a definition
  of GDP?
• What
• How valued
• Where
• When
• Provide examples of included items.
• Provide examples of excluded items.

Final goods and services
market prices
within the country
during a given time period (1 year)
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Economic measurements

• Examples of excluded items
• Household Production
• Self-supplied goods and services
• Home care
• Child care

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Economic measurements

• Examples of excluded items
• Underground economy
• Non-market exchanges
• Imputed values for owner occupied housing
• Illegal activities

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Economic measurements

• Examples of excluded items
• Transfer payments
• Public
• Subsidies to individuals
• Subsidies to firms
• Private
• Voluntary transfers
• Involuntary transfers (theft)

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Economic measurements

• Other excluded items
• Environment
• Length of work day (leisure time)
• Health and Life expectancy
• Justice and Freedom

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Measuring Economic Activity

• National Income and Product Accounts
• Methodology for measuring economic activity
• Lets return to the circular flow diagram to
  guide our discussion
• Real flows Monetary flows
• Value of expenditures in the product market
  Revenues to firms Payments to households in the
  factor markets

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Foreign Sector
Exports
Imports
Product Markets
Revenues
Consumption
Investment
Government Expenditures
Net Personal Taxes
Net Business Taxes
House-holds
Governments
Firms
Borrowing
Borrowing
Borrowing
Financial Markets
Saving
Factor Markets
Expenses
Income
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Measuring Economic Activity

• Thus we can measure activity by summing
  expenditures in product markets
• Or summing income payments in the factor markets
• Measure activity by expenditures
• Household, Firm, Government, Foreign
• C I G (X M) C I G F

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Foreign Sector
Exports
Minus Imports
Net Exports
Product Markets
Consumption
Investment
Government Expenditures
House-holds
Governments
Firms
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Measuring Economic Activity

• Measure activity by expenditures
• Household, Firm, Government, Foreign
• C I G (X M) C I G F
• Sum the final sales
• Sum the value added at each stage in the
  production chain
• Sales Costs of materials

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Economic measurements

• Introduction of concepts
• National Income and Product Accounts (NIPA)
• Finding the data

Decision Tree
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NIPA Expenditures

• Consumption
• Durable goods
• Nondurable goods
• Service

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NIPA Expenditures

• Investment
• Business and nonresidential fixed investment
• Changes in business inventories
• Residential fixed investment
• NOT INVESTMENT
• Purchase bonds, equity stocks, mutual funds, etc.
  
• Portfolio allocations NOT investment

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NIPA Expenditures

• Government expenditures
• Consumption
• Investment
• Includes all levels of government
• Excludes transfer payments

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NIPA Expenditures

• Net Exports
• Exports spending by foreigners on domestically
  produced goods and services
• Imports spending by domestic residents on goods
  and services produced abroad

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Economic measurements

• Introduction of concepts
• National Income and Product Accounts (NIPA)
• Finding the data

Decision Tree
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NIPA Expenditures

• Bureau of Economic analysis
• Table 1.1.5 Gross Domestic Product
• Seasonally adjusted, annual rates
• Real GDP is found in Table 1.1.6

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NIPA Income

• Measure activity by incomes
• Payment for labor services
• Employee compensation
• Payment for land (natural resources)
• Rental income
• Payment to capital
• Net interest
• Payment for entrepreneurship
• Corporate profits

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What of the self-employed?
Labor
Land
Capital
Entrepreneurship
House-holds
Firms
Factor Markets
Rent
Proprietors Income
Employee Compensation
Interest
Profit
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Measuring Economic Activity

• Bureau of Economic analysis
• From GDP to Personal Income
• Table 1.7.5
• Personal Income to Consumption and Saving
• Table 2.1

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Economic measurements

• Introduction of concepts
• National Income and Product Accounts (NIPA)
• Finding the data

Decision Tree
38
Decision Tree

• Review Circular Flow
• Economic Measurement
• Measuring price changes
• Measuring employment activity
• Policy Issues

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Measuring Price Changes

• Measuring price changes
• Price Indexes
• Calculating Inflation
• Calculating Real values

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Measuring Price Changes

• NIPA uses current market prices to value (and
  weight) the real (physical) flows
• Thus, economic activity as measured by GDP can
  increase if
• Real (physical) flows increase
• The price weights increase

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Measuring Price Changes

• A thought experiment
• You are given 5000 to spend.
• The catch
• 1) you must spend all of it on items from Sears
• 2) you may choose either the 1903 OR the 2005
  catalog, BUT ONLY ONE!

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Measuring Price Changes

• You are given 5000 to spend.
• Which catalog (1903 or 2005) would you choose?
  Why?
• What would be the advantage of choosing the 1903
  catalog?
• What would be the advantage of choosing the 2005
  catalog?

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Measuring Price Changes
Product Markets
Revenues
Consumption
Goods and Services Sold
Goods and Services Purchased
The real (physical) flows (inner arrows) are
valued (and weighted) by current market prices
House-holds
Firms
Factors Supplied (Labor, Land, Capital,
Entrepreneurship)
Factors Received (Labor, Land, Capital,
Entrepreneurship)
Income (Wages, Rent, Interest, Profits)
Factor Markets
Expenses (Wages, Rent, Interest, Profits)
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Measuring Price Changes

• NIPA uses current market prices to value (and
  weight) the real (physical) flows
• Thus, economic activity as measured by GDP can
  increase if
• Real (physical) flows increase
• The price weights increase

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Measuring Price Changes

• For example
• Consider an economy with 3 goods
• In following table, determine total economic
  activity (GDP) in each year

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Measuring Price Changes
Item Quantity(2002) Price(2002) Quantity(2003) Price(2003)
Draft beer 400 5.00 450 5.00
Movie Ticket 50 6.00 75 6.00
Pizza 100 10.00 120 10.00
GDP
3300
3900
Increase real output gt increase in GDP
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Measuring Price Changes
Item Quantity(2002) Price(2002) Quantity(2003) Price(2003)
Draft beer 400 5.00 400 6.00
Movie Ticket 50 6.00 50 8.00
Pizza 100 10.00 100 10.50
GDP
3300
3850
Increase prices gt increase in GDP
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Measuring Price Changes
Item Quantity(2002) Price(2002) Quantity(2003) Price(2003)
Draft beer 400 5.00 450 4.50
Movie Ticket 50 6.00 40 8.00
Pizza 100 10.00 120 10.50
GDP
3300
3605
Has the economic activity increased?
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Measuring Price Changes

• So if we want to compare real (physical) output
  flows over time, we need to compensate for price
  changes
• This is the role of price Indexes
• Consumer price index (CPI)
• Producer price index (PPI)
• Gross domestic product deflator

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Measuring Price Changes

• Measuring price changes
• Price Indexes
• Calculating Inflation
• Calculating Real values

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Price Indexes

• A price index uses a fixed basket of goods
  (quantities) to allow measurement of the impact
  of changing prices
• General formula

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Price Indexes

• Consumer price index (CPI) uses a market basket
  of a typical urban familys purchasing patterns
  in the base year

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Price Indexes

• Producer price index (PPI) uses a market basket
  of goods used in production (raw materials,
  intermediate products, and wholesale goods) in
  the base year

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Price Indexes

• Gross domestic product deflator uses the entire
  production in the current year as the market
  basket of goods

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CPI (interpretation)

• Show graph of CPI
• What is being shown?
• Explain what you understand the graph to mean.
• How might this be used in an essay?
• Why the difference between the All items and
  the Core index?

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CPI All items and Core
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CPI (interpretation)

• Groups
• Do you agree on what is being shown? About how it
  might be used in an essay?
• Compare understandings of the graph
• Compare understanding of the difference between
  the All items and the Core index?
• Has there been a long term inflationary trend? If
  so, what is it?

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CPI (interpretation)

• Class
• Compare team responses and discuss
• Do we agree on what is being shown?
• Compare understanding of the difference between
  the All items and the Core index?
• How might this be used in an essay?

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CPI (interpretation)

• How does this help you understand the recent
  past?
• If this is all the information you have, what
  would be your inflation forecast?

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CPI All items and Core
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Measuring Price Changes

• Measuring price changes
• Price Indexes
• Calculating Inflation
• Calculating Real values

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Calculating Inflation

• Define Inflation
• General increase in prices
• Decline in the purchasing power of money
• Calculation

(Index period 2 / Index period 1) 1.0 100
(Index period 2 - Index period 1) / Index period
1 100
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Measuring Price Changes

• Measuring price changes
• Price Indexes
• Calculating Inflation
• Calculating Real values

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Calculating Real values

• So we can compare real (physical) output flows
  over time, by compensating for price changes
• Nominal values Output valued at current prices
• Real values Output valued at constant prices
• Adjusted for price changes

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Calculating Real values

• In general
• Real value (Nominal value / Index) 100
• (Real value Index) / 100 Nominal value
• Index (Nominal value / Real value) 100
• Real GDP (Nominal GDP / GDP deflator) 100

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Calculating Real Growth

• It is important to measure the growth in real
  economic activity
• Growth is usually measured by percentage increase
  in a value
• Growth of real GDP percentage increase
  (decrease) in real GDP

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Calculating Real Growth

• Calculating the percentage rate of growth

(Real GDP2 / Real GDP1) 1.0 100
(Real GDP2 Real GDP1) / Real GDP1 100
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Measuring Price Changes

• Measuring price changes
• Price Indexes
• Calculating Inflation
• Calculating Real values

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Decision Tree

• Review Circular Flow
• Economic Measurement
• Measuring price changes
• Measuring employment activity
• Policy Issues

70
Labor Markets

• Categorizing individuals by their participation
  in the economy
• From total population to the labor force
• Pop children institutional
• Non-institutionalized population

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Labor Markets

• Venn Diagram

1 Children Under age of 16
2 Institutionalized persons
3 Unemployed persons
4 Not in Labor Force
5 Employed persons
6 Military personnel
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Labor Markets

• Categorizing individuals by their participation
  in the economy
• Non-institutionalized population
• Employed if working for pay, etc
• Unemployed if not employed and looking for work
• Not in labor force if neither employed or
  unemployed

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Labor Markets

• The Current Population Survey (CPS) classifies
  all individuals in the non-institutionalized
  populations into 3 groups (categories)
• Employed
• Unemployed
• Not in Labor Force
• Labor Force Employed Unemployed

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Labor Markets

• Venn Diagram

1 Children Under age of 16
2 Institutionalized persons
3 Unemployed persons
4 Not in Labor Force
5 Employed persons
6 Military personnel
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Labor Markets
1
1.1
1.2
2.2
2.1
2
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Labor Markets

• Three measures
• Labor Force Participation Rate
• LF / Non-institutionalized Pop
• Employment rate
• Employed / Non-institutionalized Pop
• Unemployment Rate
• Unemployed / LF

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Labor Markets

• Four (4) primary types of unemployment based on
  the reasons for the unemployment and their
  duration.
• Frictional
• Seasonal
• Cyclical
• Structural

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Labor Markets

• Discouraged workers
• Individuals who stop looking for work but would
  accept a job if offered
• Natural rate of unemployment
• Non-inflationary level of unemployment
• LM in equilibrium
• No Cyclical unemployment
• Definition of full-employment

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Labor Markets
1
1.1
1.2
2.2
2.1
2
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Labor Markets

• Other measures of labor input
• Aggregate hours
• Aggregate earnings
• Labor Productivity

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Decision Tree

• Review Circular Flow
• Economic Measurement
• Measuring price changes
• Measuring employment activity
• Policy Issues

82
Policy Issues

• What determines spending levels
• How do changes in spending affect economic
  activity (GDP)?
• How do policy makers influence the economy?
• Can policy makers control the economy?
• Stable prices, full-employment, economic growth

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Decision Tree

• Review Circular Flow
• Economic Measurement
• Measuring price changes
• Measuring employment activity
• Policy Issues