Business, Government, and the World Economy

1. Business, Government, and the World Economy Introduction

2. Economic Quiz • What is the current US unemployment rate? • How many people are currently employed in US? • What is the size of US nominal GDP? • What was the rate of growth of US Real GDP in 2nd quarter? • What is the yield on 10 year Treasury Bonds? • What is the amount of debt owed by US as a % of GDP?

3. Economics The study of the allocation of scarce resources

4. Macroeconomics • Interrelationship of Aggregate Economic Variables • Output (Gross Domestic Product) • Productivity • The level of prices (Inflation) • Interest rates • Employment (& Unemployment) • Value of currency (Foreign Exchange)

5. Macroeconomic Goals • Providing Jobs • Economic Growth • Increasing Productivity • Increasing Standard of Living • Stable Prices • Others?

6. Basic Assumptions • Markets work in the long-run • “Equilibrium” prices and quantities can be achieved. • Short-run constraints can inhibit long-run equilibrium • Speed of Market Adjustment • Government Policy • Exogenous Shocks

7. Government Policy • Monetary Policy • Controlled by Federal Reserve Board • Fiscal Policy • Federal and State • Taxes, Government Spending etc. • Trade Policy • Tariffs, quotas, etc. • Regulatory Policy • Environmental, occupational safety, equal opportunity laws, minimum wage etc..

8. Microeconomics vs. Macroeconomics • Microeconomics - economic decisions faced by individual firms and individual consumers. • Microeconomic decisions are based upon macroeconomic data as are macroeconomic policy decisions. There are the same underlying variables impacting both types of decision making – there has to be a link.

9. Common Questions Microeconomics Macroeconomics How much R&D will a firm undertake What is the level of interest rates? How can productivity be increased? How many I-Pods should Apple produce? How much leisure time do individuals desire? How can Output (GDP) be increased? Will consumers save or spend? How much will the country save in aggregate? What is the current price level? What is the current level of Unemployment?

10. Aggregating Micro? • Macroeconomics is not simply the aggregation of individual results • Fallacy of composition - not every individual acts the same way and even if they did the aggregate result may not reflect the individual result. For example, increasing nominal level of wages in an attempt to increase income…

11. Factors impacting the link between micro and macro • Rigidities – Macroeconomic relationships are often slower to respond to changes than individual markets • Liquidity – Short run decisions may not be based on long run expectations • Knowledge – Information is asymmetric • Expectations - Assumed relationships may be impacted by expected changes, as opposed to current events.

12. Positive vs. NormativeEconomics • Positive – What does occur under a given set of conditions – As prices rise demand falls. • Normative – what should occur – includes judgment – how should income be distributed?

13. Basic Economic Assumptions • Laws of Supply and Demand • Utility Maximization • Markets Forces Work in the Long Run

14. Ceterius Paribus“Other things being equal” • Multiple economic variables often change at any given time. • Most economic models keep the variables not under consideration constant. Therefore looking at only the relationship between two variables will often produce inaccurate analysis.

15. Economic Theory Changes • Economic theory can change over time – even theory that is supported by empirical evidence • Example: The Phillips Curve

16. 1960’s Philips Curve

17. Monetary Policy 1960’s • Focus on money market conditions. • Use of Free reserves as indicator resulting in procyclical monetary policy.

18. 1970’s Phillips Curve ?

19. 1996-2005 Phillips Curve?

20. The Phillips Curve • Has been modified to look at expectations of inflation as opposed to the level of inflation • Tradeoff between inflation and unemployment is still a common discussion / stylized fact in the media and economic debates.

21. Measuring Economic OutputThe Key Variable: GDP • Gross Domestic Product • The market value of all final goods and services produced in a country during a given time frame.

22. Components of GDPY = C + I + G + NX • Personal Consumption Expenditure (C) • Items purchased by consumers • Gross Private Domestic Investment (I) • Spending by business, construction, and inventory investment • Government Purchases (G) • Total federal state and local government purchases • Net Exports (F or NX) • Exports minus Imports

23. Personal Consumption Expenditures Approximately 72% of GDP* www.bea.gov 1st qtr2012

24. Gross Private Domestic Investment Approximately 12% of GDP: • Fixed Investment • Nonresidential (Structures and Equipment) • Residential • Inventories • GDP should account for everything produced • Change in inventories, is an important number to watch (not the level).

25. Government Spending and Net Exports • Government Spending: About 18% of GDP • Federal - 7%: Defense vs. Non defense • State and Local 11% • Net Exports (Exports - Imports) • Exports 11.6% • Imports 14.3%.

26. Trends in GDP Components

27. Current Values2nd Quarter 2012 Gross Domestic Product $15,595.9 Billion Real Gross Domestic Product $13,558.0 Billion Percentage change from previous quarter (annual rate) 2012 Qtr 2 1.5% 2012 Qtr 1 2.0% 2011 Qtr 4 4.1%

28. Contributors to GDP2ndQtr 2012 • Positive • Consumption +1.05% • Goods +.18% • Services +.87% • Business Investment +1.08% • Inventories +.32% • Negative • Government -.28% (State and local -.26%) • Net Exports -.31%

29. Three Markets • Good Markets • Consumption, Business Investment, and Saving. • Asset Market • Financial Assets • Money • Labor Market • Level of Employment and Wages

30. General Equilibrium • Adjustment of Interest Rates and Prices result in the Simultaneous Equilibrium of the Goods, Asset, and Labor Markets (general equilibrium). • Interest rates and prices impact the amount of Government Purchases and Net Exports as well (and they also influence the equilibrium in each market) • Therefore changes in any of the three markets can impact the level of GDP and the components of GDP.

31. Macro Interactions Goods Market Consumption, Saving, and Investment Interest Rates & Prices GDP C+I+G+NX Government Purchases Asset Market Labor Market Wages and Employment Net Exports / Interaction with Global Economy

32. Outline of the Class • Introduction (current state of the economy and the language of economics) • Useful Mathematical Tools • Labor, Goods, and Asset Markets • General Equilibrium (combining the three markets into one model of the economy) • Applying and using the model to understand the economic environment and make better business decisions.

33. Goals of the Class • Students should improve their understanding of: • Basic theoretical macroeconomic models and the issues surrounding their usefulness. • How macroeconomic performance is measured by commonly used economic indicators. • How changes in macroeconomic performance relates to the theoretical models and therefore impacts decision making in the business world.

34. Some Basic Economic Language • Annual Rates • Rates of Change • Business Cycles • Consensus Survey • Moving Average • Nominal vs. Real Dollars • Revisions and Benchmarks • Seasonal Adjustments

35. Economic Indicators • Leading Indicators that move ahead of the total economy (ahead of GDP). • Coincident Indicators that move with the level of GDP. • Lagging Indicators that move following GDP.

36. 4 Week Moving Average of Unemployment Claims1967-2012 FRED Economic Data http://research.stlouisfed.org/fred2/series/IC4WSA?cid=32240

37. The Current State of the Economy • The lingering effect of the financial crisis • Causes of the Crisis • The Great Recession • Current conditions • Pace of US Recovery (& housing market) • US Deficit Debate (& The Fiscal Cliff) • European Debt Crisis • Slowdown in China

38. The Big Picture Problems in Mortgage Market Global Credit Crisis / Bank failures / Equity Losses Declining Consumer Spending Decreased Business Investment

39. Who’s to Blame?

40. How Financial Markets Enabled“Keeping up with the Joneses” • New Products • Poor Underwriting • Public Policies Unintended Consequences • Low Rates and International Capital Flows

41. Average Size of Subprime Loans Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime

42. Credit Quality of Subprime Loans Originated each year Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime

43. Impact of Subprime Loans on Home Ownership "SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007

44. Fannie Mae’sGuarantee of Alt A Loans NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"

45. Blaming Fannie and Freddie? • No - Fannie and Freddie were small relative to the entire market. • Combined Subprime Purchases (% of Market)** • Consumer demand created rapid prince increase • Yes – Overall Size put them at risk for any Mortgage Market problem • Securitizing more risky loans opened door for Private securitization Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed the Crisis", Washington Post June 10, 2008

46. International Capital Flows Consumer Spending On Exports Increased Foreign Holdings of $ Increased Inflow of Dollars Helps Keep Long Term Rates Low

47. “The Perfect Storm” 2004 - 2007 • Domestic and global institutions buy MBS in attempt to increase margins on “safe” securities, incorrectly rated. • Institutions use higher debt levels for securitization. • Underwriting standards deteriorate. • Increased interest rate environment makes loans more likely to default • Increasing Home Prices encourage consumers to overextend and speculate in housing market

48. Non Agency Mortgage Foreclosure Rates

50. Response of Consumers • Increased access to credit and delusional optimism resulted in: • Short-Term Speculative Focus • Borrowing More and Saving Less