FIN 30220: Macroeconomic Analysis

FIN 30220: Macroeconomic Analysis Measuring the U.S. Economy

U.S. GDP of $17 Trillion represents approximately one fifth of total worldwide production ($85 Trillion) and makes the United States the largest single country economy on the planet!! Note: 2006 GDP estimates measured on a Purchasing Power Parity Basis * Source: CIA Factbook

Principle #1: What exactly are you trying to measure? Is your definition consistent with what you are trying to measure? GDP is the standard benchmark for economic well being. Is it a good indicator of well being? VS 1950: $275B 2010: $14,600B Ratio 1950: $1,696B 2010: $12,973B 1950: $10,941 2010: $42,120 1950: $20,000 2010: $50,233 2005 Dollars 2005 Dollars 2008 Dollars

GDP is the standard benchmark for economic well being VS Annual defense spending has grown from $35B in 1950 to $795B in 2009. Should this be subtracted out? The service industry has grown from 30M employees in 1950 to 113M in 2009. Is this really “new activity”? Should we count things like pollution as economic “bads”? How do we account for the added quality and convenience of new products and technologies?

The Genuine Progress indicator corrects for social “bads” VS GDP = $15T GPI = $5T

Principle #2: How is your variable measured? Gross Domestic Product measures the current market value of all goods and services produced within a country’s borders over a certain time period (usually a quarter) Farmer A produces 1,000 bushels of Apples (Apples cost $10/bushel) Farmer B produces 2,000 bushels of Corn (Corn costs $15/bushel) GDP = ($10)(1,000) + ($15)(2,000) = $40,000

Suppose that Intel produces 1,000 computer chips (P = $100) 100 Chips sold to consumers Value Added Approach 900 Chips sold to Dell $100,000 Sales - $0 Materials Expenses $100,000 $500,000 Sales - $90,000 Materials Expenses $40,000 Change in Inventories Dell produces 500 computers (P = $1,000) $450,000 Total = $550,000 (The remaining 400 chips were added to Dell’s inventories)

Example: Microsoft Sales: $600,000 • Expenses: $420,000 • Labor Costs: $200,000 • R&D Costs: $50,000 • Materials: $100,000 • Lease: $20,000 • Utilities: $10,000 • Equipment Purchase: $40,000 • Value Added: • $600,000 • - $220,000 (Non-Labor Exp) • + $40,000 (Equipment Inv) • + $20,000 (Inv. Investment) • + $50,000 (R&D) – NEW • $490,000 • Inventories: • BOY: $620,000 • EOY: $640,000

Goods & Services (GDP) Product Markets Expenditures Income Factor Markets Factor Services

The Circular Flow of Payments suggests that we could also calculate GDP by measuring total expenditures on the goods and services produced Government Purchases (Federal, State, and Local) GDP • Gross Business Investment • Structures • Equipment • Inventories • Residential Investment • Consumer Expenditures • Durables • Non-Durables • Services

Suppose that Intel produces 1,000 computer chips (P = $100) 100 Chips sold to consumers Expenditure Approach 900 Chips sold to Dell $0 $40,000 Inventory Investment $510,000 Consumer Durables Dell produces 500 computers (P = $1,000) (The remaining 400 chips were added to Dell’s inventories) Total = $550,000

What’s so Gross about GDP? Suppose that we have the following information from GM’s financial statements $300,000 Sales (000s) - $150,000 Materials Expenses (000s) Sales: $300M $20,000 Change in Inventories (000s) Change in Inventories: $20M Total = $170,000 Materials Costs: $150M Depreciation: $5M Strictly speaking, depreciation should be counted as a cost of production. GDP calculations do not include depreciation expenses!

Exports of Goods and Services • US Citizens Working Abroad US Acquisition of Foreign Assets Foreign Acquisition of US Assets • Imports of Goods and Services • Foreign Citizens Working in the US

BMW operates a manufacturing facility in Spartanburg South Carolina. Meanwhile, Nike operates 73 production facilities in Thailand. How should we count this production? $130,000 Value Added (000s) $400,000 Value Added (000s) - $70,000 Labor Costs (000s) - $50,000 Labor Costs (000s) $60,000 Profits (000s) $350,000 Profits (000s) Gross Domestic Product = Total Production within US borders Gross National Product = Total Production by US Citizens The $60,000 in profits from BMW accrue to foreign nationals and should not be counted in US GNP. However, GNP would need to include the profits from Nike’s Thailand plants.

BMW operates a manufacturing facility in Spartanburg South Carolina. Meanwhile, Nike operates 73 production facilities in Thailand. How should we count this production? $130,000 Value Added (000s) $400,000 Value Added (000s) - $70,000 Labor Costs (000s) - $50,000 Labor Costs (000s) $60,000 Profits (000s) $350,000 Profits (000s) GDP = $130,000 GNP = $70,000 + $350,000 = $420,000 $420,000 = $130,000 +($350,000 - $60,000) GNP GDP Net Factor Payments

With the global economy, we need to keep track of expenditures between the US and the rest of the world as well as domestic expenditures GDP Government Purchases Consumer Expenditures Gross Investment Net Exports = Exports - Imports

GDP is calculated using a method of double entry accounting – each dollar of production should have a corresponding expenditure. GDP: 2014Q1

Recall that total income (national income) in the US should accrue from the production undertaken by American citizens First, we need to correct for income earned abroad as well as domestic production accruing to foreign nationals Gross Domestic Product = $17,101B + Net Factor Payments = $235B Gross National Product = $17,336B Now, recall that depreciation is an expense that should be deducted as a production cost - Depreciation Expense = $2,721B Net National Product = $14,615B - Indirect Taxes = $198B Finally, we need to correct for indirect taxes/transfers (essentially, sales taxes) National Income = $14,417B

National Income by Source: 2014Q1

To get to the flow of funds accounts, begin with GDP equals aggregate expenditures Now, add net factor payments to both sides Current Account = NX + NFP Lastly subtract depreciation and indirect taxes from both sides Net Investment (Gross Investment minus depreciation) National Income Consumer Outlays (Net of Indirect Taxes)

The flow of funds measures how net investment is financed National Income = Personal Income + Undistributed Corporate Profits Subtract taxes from both sides…. Now, Subtract Consumption from both sides… Net Private Saving = Personal Saving + Undistributed Profits

Last year, the US current account was -$380B. What does this mean? Net lending abroad Total US Outlays Total US Income In other words, the US is borrowing $1B per day from abroad! Should we be worried about this? This number continues to grow as the US government overspends!!! This number continues to shrink as US consumers overspend!!

Think of the current account as the savings of the entire economy. We have become a debtor nation! Billions of Dollars

What a wacky world we live in! Currently, China is running s $30B trade surplus with the world Currently, the US is running s $380B trade deficit with the world What’s wrong with this picture?

Principle #3:Is your variable in terms of current prices or fixed prices (Real vs. Nominal) Nominal Variables are in terms of a current year’s prices. For example, you’re starting salary after college might be $50,000 per year. VS. Real variables are in terms of some tangible commodity or some constant year’s prices. Real variables measure purchasing power.

When nominal GDP rises, its impossible to distinguish between an increase in production and an increase in prices! We need to separate the price changes from the quantity changes. Economy A: Zero growth, high inflation. Both have (approximately) 25% annual growth in Nominal GDP!!! Economy B: Rapid growth, no inflation. How do we measure price?

The objective of a price index is to measure cost of living. To state this precisely, a price index measures the dollar cost of obtaining a fixed level of utility (happiness). Suppose at the current prices, you elect to buy 3 slices of pizza and 2 beers Example: $3.50 $2.00 The absolute dollar cost of your current happiness is (2)($3.50) + (3)($2.00) = $13 If beer increases in price to $4.50 (25% increase) and pizza increases to $2.20 (10% increase), this level of happiness now costs (2)($4.50) + (3)($2.20) = $15.60

Alternatively, we could write the price index in terms of relative dollars (relative to a base year) instead of absolute dollars (this is how its actually calculated). Base Year Expenditure: (2)($3.50) + (3)($2.00) = $13 Beer Expenditure Share: (2)($3.50)/$13 =.54 Pizza Expenditure Share: (3)($2)/$13 = .46 (Or, 100) (Or, 120)

The CPI is calculated by the Bureau of Labor Statistics (BLS) on a monthly basis Consumer Price Index The CPI is composed of 211 individual products over 38 geographic areas.

Calculating the CPI Household Budget ( or, 100 ) ( or, 443 ) Average CPI inflation

If I choose a different year, the weights stay the same! Household Budget Or, 425 ( or, 443 ) CPI inflation (2013 – 2014)

The Consumer Price Index (1948 – 2014) Average Inflation = 3.54% CPI CPI CPI Inflation Rate 1983 = 100

Note That expenditure shares do change over time, so the weights need to be updated periodically

Potential Problem: Suppose at the current prices, you elect to buy 3 slices of pizza and two beers $3.50 $2.00 The cost of your current happiness is (2)($3.50) + (3)($2.00) = $13 If beer increases in price to $4.50 (25% increase) and pizza increases to $2.20 (10% increase), suppose you alter your decision and buy 1 beer and 4 slices of pizza (1)($4.50) + (4)($2.20) = $13.30

Original Expenditure: (2)($3.50) + (3)($2.00) = $13 Substitution: No Substitution: (2)($4.50) + (3)($2.20) = $15.60 (1)($4.50) + (4)($2.20) = $13.30 Which measure of inflation is more realistic?

In 2000, the BLS introduced a “chain weighted CPI” that allows for this substitution between different goods. It’s thought to be a better gauge of inflation CCPI Chained CPI Inflation Rate

It is, however, very controversial… Average Inflation Rate CPI: 2.31% CCPI: 2.06% Inflation Rate

Suppose that you are a social security recipient. Let’s calculate your total payments received in social security payments under the different inflation measures from 2000 to 2014. (Assume you received $1,000 per month in 2000) CPI Inflation Rate (2.31% per year) CCPI Inflation Rate (2.06% Per Year) Difference = $3,790 (1.8%) Now, consider that there are approximately 65 million social security recipients: $3,790*65M = $246B

Another potential problem: Products change over time. Suppose you observe the following TV Prices 2004 2003 Price: $250 Features: 27 inch Cathode Ray Tube Enhanced Definition TV S-Video Input Universal Remote Price: $1,250 Features: 42 inch Plasma High Definition TV S-Video Input Universal Remote Is this a fair assessment of inflation? Note: The first plasma TV was released by Fijitsu 1n 1995. The 42’’ TV cost $14,999

Solution: Hedonic price adjusting What do we value in a TV? (At least, what is reflected by price) Natural log of retail price Television Features

What do we value in a TV? (At least, what is reflected by price) Plasma TVs sell for 73% more that CRT TVs Each 1’’ increase in screen size raises the price by 8% HDTV is priced 22% more than EDTV

First, value all the features on the old TV Price: $250 Features: 27 inch Cathode Ray Tube Enhanced Definition TV S-Video Input Universal Remote

Now value all the features on a new TV Price: $1,250 Features: 42 inch Plasma High Definition TV S-Video Input Universal Remote

Now, we can add the extra features to the old TV 2003 2003 Price: $250 Features: 27 inch Cathode Ray Tube Enhanced Definition TV S-Video Input Universal Remote Price: $1,537 Features: 42 inch Plasma High Definition TV S-Video Input Universal Remote (Hedonically adjusted)

Potential Problem: What about housing? Consider the following examples Option #2: Buy a $240,000 house with an interest only mortgage (5% per year) Option #1: Rent a $240,000 house Option #3: Buy a $240,000 house with a 30 year mortgage (5% per year) $240,000(.05) = $12,000/yr. = $1,000/mo. $1,000/mo. $1,288/mo. One of these things is not like the other!

Potential Problem: What about housing? Consider the following examples Option #3: Buy a $240,000 house with a 30 year mortgage (5% per year) $1,288/mo. Option #1: Rent a $240,000 house OR $1,000/mo. Option #2: Buy a $240,000 house with an interest only mortgage (5% per year) What if you put $288/mo. and put it in a savings account that earns 5% per year? Difference = $288/mo.

What if you put $288/mo. and put it in a savings account that earns 5% per year? 5%/yr = (5/12) = .41%/mo. What do you think your balance would be after 30 years? $240,000 Cool, huh!?

Potential Problem: What about housing? Consider the following examples Option #1: Rent a $240,000 house OR $1,000/mo. Option #2: Buy a $240,000 house with an interest only mortgage (5% per year) (This is pure cost of living) Option #3: Buy a $240,000 house with a 30 year mortgage (5% per year) $1,288/mo. (This is cost of living plus investment in an asset)

In 1983, the BLS decided to focus entirely on rental markets for housing. Housing Prices Housing Inflation Average Inflation Rate Home Price Index: 4.40% Rental Index: 4.01% Can you spot the housing bubble?

An alternative to the consumer price index is the GDP Deflator. Suppose we have the following Data Now, Suppose we revalue current GDP at, say, prices in 2009 (Call this the base year)

FIN 30220: Macroeconomic Analysis