Winter 2010

1. Winter 2010 Macroeconomics Starring Erik Hurst

2. Some Perspective: Major Historical Recessions

3. Economic Recoveries The question at hand: When will we return to “normal growth?” Note: Out of a recession does not mean normal growth • “V” shape recoveries (rapid growth out of a recession) • “U” shape recoveries (sluggish growth before recovery) • “W” shape recoveries (slip back into another recession) • “Reverse J” shape recoveries (sluggish growth to lower level)

4. Symptom of a Recovery (Part 1)

5. Symptom of a Recovery (Part 2) Real Gross Domestic Product: Quarterly, 1970Q1 – 2009Q3 Note: The black line is the level of real GDP (left axis) Note: The red line is quarter over quarter growth rates of real GDP (right axis)

6. Symptom of Recession (Part 3) U.S. Consumption Expenditures: Quarterly, 1970Q1 – 2009Q3

7. Symptom of Recession (Part 4) Consumer Sentiment: Monthly, 1978M1 – 2009M10

8. Symptoms of a Recovery (Part 5) Unemployment Rate: Monthly 1970M1 – 2009M10

9. Consensus of State of the Economy • The recession likely over. • The million dollar question: what will the recovery look like? • Has the U.S. macroeconomic landscape changed? • What will economic growth look like going forward.

10. What We Will Do In This Course! Answer the following questions: • What causes recessions? • What caused this recession? • What is the link between housing prices and “real” economic activity (consumption, production, unemployment, etc.). • What is the link between the banking sector and “real” economic activity. • Should we be concerned with inflation? What about deflation? • What causes inflation/deflation? • How can policy makers (Fed/Congress/President) influence economic activity in the short run (fight inflation and recessions) and in the long run (promote economic growth)? • What are the pitfalls of government intervention? • What makes economies grow in the LONG RUN!

11. What We Will Do In This Course! Some additional topics we will cover along the way….: • What makes consumers “consume”? • Do consumers save too little? • Why are banks currently hoarding cash? • What is the role of “uncertainty” on economic activity? • What issues must we confront with Social Security? • Why can government budget deficits be bad? • Should the Federal Reserve be abolished (or changed)? • Does it make sense to put controls on labor markets (minimum wage laws, maximum wage laws (salary caps), etc.)? • What effect do taxes have on the U.S. economy in the short run and the long run? • What is the link between the world economy and the U.S. economy?

12. A Caveat • My course takes the perspective of analyzing any large macroeconomy (with respect to the models we build). • The examples will come from the U.S. (because that is what I study) • However, the insights apply equally well to all large developed economies including: • The European Union • Japan • Canada, Australia, etc. (for the most part). • The models also explains well consumer, business, and government behavior for all economies (China, India, etc.).

13. Course Preliminaries • Course Schedule We have 11 sessions this quarter (see syllabus) • Quizzes: 8 quizzes (see syllabus) Drop 2 lowest quizzes. All quizzes will take place at the start of class. NEVER – EVER – Give Makeup Quizzes/Midterm • Midterm: Midterm during week 5 (session 6). It is optional.

14. Course Preliminaries • Grading Policy: 30% quizzes, 70% midterm and final. • Readings/Must Reads: Assigned (encouraged). I will try to link to lectures. • “Readings are Fair Game For All Quizzes and Tests” • Each week, I will send out a weekly email update stating what readings you will be responsible for during the subsequent quiz. • Be patient – this is a course that builds a model of the macroeconomy – the payoff comes once the model is built (lecture 7ish).

15. TOPIC 1 A Introduction to Macro Data

16. Goals of the Lecture What is Gross Domestic Product (GDP)? Why do we care about it? How do we measure standard of livings over time? What are the definitions of the major economic expenditure components? What are the trends in these components over time? What is the difference between ‘Real’ and ‘Nominal’ variables? How is Inflation measured? Why do we care about Inflation? How is Unemployment measured? Why do we care about Unemployment? What have been the predominant relationships between Unemployment, Inflation and GDP over the last four decades. NOTE: This lecture will likely go into next week. This is by design. It does not mean we will be short changed on other material later in the class.

17. Gross Domestic Product (GDP) • GDP is a measure of output! • Why Do We Care? • Because output is highly correlated (at certain times) with things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc…) • Formal Definition: • GDP is the MarketValue of all FinalGoods and Services Newly Produced on DomesticSoil During a Given TimePeriod (different than GNP)

18. “Production” Equals “Expenditure” • GDP is a measure of Market Production! • GDP = Expenditure = Income = Y (the symbol we will use) (in macroeconomic equilibrium) • What is produced in the market has to be show up as being purchased or held by some economic agent; • Who are the economic agents we will consider on the expenditure side? • Consumers (refer to expenditure of consumers as “consumption”) • Businesses (refer to expenditure of firms as “investment”) • Governments (refer to expenditures of governments as “government spending”) • Foreign Sector (refer to expenditures of foreign sector as “exports”)

19. A Simple Example • What is “produced” has to be “purchased” by someone (including the producer). • Suppose I produce silverware (forks, spoons, etc.). If so, I could: • sell it to some domestic customer (Consumption) • sell it some business (Investment) • keep it in my stock room as inventory (Investment) • sell it to the city of Chicago to use in their shelters (Government spending) • sell it to some foreign customer (Export)

20. “Production” Equals “Income” • What is Produced is Also a Measure of Income. • If you pay a $1 for something, that $1 has to end up in someone’s pocket as: Wages/Salary (compensation for workers who make production) Profits (compensation for self employed) Rents (compensation for land owners) Interest (compensation for debt owners) Dividends (compensation for equity owners) • Notice, wages are only one component of income (Y does not equal wages)! (Although, under certain production functions, they will be proportional to each other).

21. Stop and Pause • By definition….. Production = Income = Expenditure = Y • What is produced has to be purchased by someone (accounting for inventory changes). • What is purchased has to end up as income in somebody’s pocket! • In our class, we realize that the terms are interchangeable in equilibrium.

22. Measuring GDP in Practice • Production Method: Measure the Value Added summed Across Industries (value added = sale price less cost of raw materials) • Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX) • Income Method: Labor Income (wages/salary) + Capital Income (rent, interest, dividends, profits). • In our class, we will model the production side of economy (supply side) and the expenditure side of the economy (demand side). • Prices will always adjust to equate supply and demand such that Y (production) always equals Y (expenditure).

23. What GDP is NOT! • GDP is not, or never claims to be, an absolute measure of well-being! • Size effects : But even GDP per capita is not a perfect measure of welfare • “The gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud to be Americans.” • U.S. Senator Robert F. Kennedy, 1968

24. More on What GDP Is Not • GDP Does Not Measure: • Non-Market Activity (home production, leisure, black market activity) • Environmental Quality/Natural Resource Depletion • Life Expectancy and Health • Income Distribution • Crime/Safety • Remember how we measure GDP…(i.e., how does one measure “safety”). • Ideally, what we would like to measure is quality of one’s life: • Present discounted value of utility from one’s own consumption and leisure and that of one’s loved ones. • Read: Course Pack Readings 21-23 and 25

25. Defining the Expenditure Components (formally) • Consumption (C): • The Sum of Durables, Non-Durables and Services Purchased Domestically by Non-Businesses and Non-Governments (ie, individual consumers). • Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables). • Does Not Include Purchases of New Housing. • Investment (I): • The Sum of Durables, Non-Durables and Services Purchased Domestically by Businesses • Includes Business and ResidentialStructures, Equipment and Inventory Investment • Land purchases are NOT counted as part of GDP (land is not produced!!) • Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production – they are saving!) There is a difference between financial and economic investment!!!!!!!

26. More On Expenditure/Production Components • Government Spending (G): Goods and Services Purchased by the domestic government. • For the U.S., 2/3 of this is at the state level (police and fire protection, school teachers, snow plowing) and 1/3 is at the federal level (President, Post Office, Missiles). • NOTE: Welfare and Social Security are NOT Government Spending. These are Transfer Payments. Nothing is Produced in this Case. • Net Exports (NX): Exports (X) - Imports (IM); • Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil • Imports: The Amount of Goods Produced on Foreign Soil Purchased Domestically.

27. Summary of the Demand Side of Economy • Expenditures: Y = C + I + G + X - IM • Only four economic agents can “spend” on domestic production Domestic consumers (C) Domestic firms (I) Domestic governments (G) Foreign consumers, firms, and governments (X) • We will develop models for each sub component of the expenditure side of the economy (C, I, G, and NX).

28. Measuring Expenditure (Demand Side) • Only include expenditures for goods that are “produced”. • If I give $10 to a movie theater to watch a movie, it is counted as expenditure. • If I give $10 to my nephew for a birthday present, it is not counted as expenditure. • If I give $10 to the ATM machine to put in my savings account, it is not counted as expenditure. • The second example would be considered a “transfer” (once I give $10 to my nephew, he can go to the movies if he wanted to – once that $10 is spent, it will show up in GDP). • “Transfers” are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged. • The third example is considered “saving” (I am delaying expenditure until the future). Once I spend the $10 in the future, it will show up in GDP.

29. Some Examples of GDP Calculations • Thinking about imports Y = C + I + G + X – IM • Thinking about inventories (storing production….) Y = C + I + G + X – IM • Distinguishing between government spending and “transfers”. Y = C + I + G + X – IM

30. Summary of Supply Side of Economy • Production: Y = f(A, N, K, other inputs like oil) where A = technology, N = labor input, K = capital (machine) input • We will develop models/intuition for A, N, K and oil • N will be determined in the labor market (labor demand and labor supply)

31. Where We are Headed

32. The role of “prices” • “Prices” ensure that we are always in equilibrium • 4 prices in our class Price of output (CPI) P Price of labor (real wages) W/P Price of money (loans – real interest rates) r Price of foreign currency (exchange rate) $ or e • We will develop (from fundamentals) 4 markets in our class

33. The 4 Markets 1) Labor Demand vs. Labor Supply (determines N and W/P) Necessary to compute the supply side of economy Key to where recessions come from (frictions in the labor market) 2) IS-LM market (determines r and Y (via I)) Interest rates determine firm investment Key to federal reserve policy (sets r) Key to understanding banking crises. 3) Aggregate Demand vs. Aggregate Supply (determines P and Y) Key to understanding where inflation comes from!

34. The 4 Markets (continued) 4) Foreign Exchange Market (determines value of currency and NX) We will focus on this market in week 10 Notice, markets 1-3 help to pin down the level of Y in the economy These four markets (and their components) will determine everything we want to know about the macroeconomy (production, inflation, economic growth, unemployment, interest rates, budget deficits, trade deficits, etc.) For the next 7 weeks, we will build the underpinnings of these markets. In doing so, we will uncover how these markets work and what factors influence those markets!

35. An Important Equation

36. Defining Savings (Store this Away!) Yd = Disposable Income = Y - T + Tr (1) • T = Taxes • Tr = Transfers (ie, Welfare) Yd = C + SHH (2) • SHH = Personal (Household or Private) Saving SHH = Y - T + Tr – C <<Combine (1) and (2)>> (3) • Personal Savings Rate = SHH/Yd For simplicity, we are going to abstract from business saving (things like retained earnings and depreciation). For those interested in more of these accounting relationships, see the text.

37. A Look at Actual U.S. Household Saving Rates: 1970Q1 – 2009Q3 Note: Shaded areas are recessions.

38. Saving Identities (continued) Sgovt = T - (G + Tr) (4) • Sgovt = Government (Public) Saving • Includes Federal, State and Local Saving • What government collects (T) less what they pay out (G and Tr) S = SHH + Sgovt = Y - C - G = I + NX (5) • S = National Savings so, S = Y - C – G <<Combine (3) and (5)>> (6) S = I + NX <<Combine (6) and Y = C+I+G+NX>> (7)

39. Summary S = I + NX We will use this equation for the rest of the class! National savings, goes into a “bank”. Firms looking to borrow, go to the “bank”. Firms can only borrow what is in the “bank” In a world where NX = 0, interest rates will adjust such that savings will always equal investment (I=S – this will be our IS curve later in the course). What is the role of NX? (International savings)

40. Understanding Prices and Inflation

41. Prices and Inflation • Inflation rate = % change in P, where P is the level of Prices • [P(t+1) - P(t)] / P(t) • How Are Prices Measured? • Price Indexes – a relative measure of a ‘basket’ of many goods • GDP Deflator (one prominent price index): Value of Current Output at Current Prices / Value of Current Output at Base Year Prices • Another prominent price index is the CPI (consumer price index) – measures price changes of consumer goods. I will often use the CPI as our measure of a price index in this class.

42. Example of Price Index Calculations • Erik’s Basket of Goods (goods I produce in my world) 2000 2006 Q P Y Q P Y Pizza 10 1.00 10.00 20 2.00 40.00 Diet Mountain Dew 15 3.00 45.00 20 4.00 80.00 Animal Crackers 50 0.50 25.00 40 1.00 40.00 Y(2000) = 80.00 (10 + 45 + 25) Y(2006) = 160.00 (40 + 80 + 40) GDP (Nominal) Went up by 100%

43. Example of Price Index Calculation (Continued) • Nominal GDP is output valued at Current Prices • Comparing Nominal GDPs over time can become problematic • Confuse Changes in Output (production) with Changes in Prices • Real GDP is output valued at some Constant Level of Prices (prices in a base year). Real GDP(t) = Nominal GDP(t) / Price Index (t) • Growth in Real GDP: % Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)]/Real GDP (t) or (approximately) % Δ in Real GDP = % Δ in Nominal GDP - % Δ in P

44. Example of Price Index Calculation (Continued) Compute GDP Deflator for Erik’s World (with 2000 as Base Year) 2000 2006 Q P Y Q P Y Pizza 10 1.00 10.00 20 2.00 40.00 Diet Mountain Dew 15 3.00 45.00 20 4.00 80.00 Animal Crackers 50 0.50 25.00 40 1.00 40.00 Current Output at Current Prices: 160.00 Current Output at Base Year Prices: 100.00 (1*20 + 3*20 +0.50*40) GDP Deflator for 2000 = 1.00 (Price Index in the Base Year ALWAYS = 1) GDP Deflator for 2006 = 1.60 Inflation Rate Between 2000, 2006 = 60% What is real GDP growth between 2000 and 2006 in Erik’s World? 40% (approximation) What is real GDP growth between 2000 and 2006 in Erik’s World? 25% (actual)

45. Technical Notes on Price Indexes • Need to Pick a Basket of Goods (cannot measure all prices) • ‘Ideal/Representative’ Basket of Goods Change Over Time • Invention (Computers, Cell Phones, VCRs, DVDs). • Quality Improvements (Anti-Lock Brakes) • Criticism of Price Indices: Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time. • How do we account for “sales”? • Additionally - technology advances drive down the price of ‘same’ goods over time.

46. Technical Notes on Price Indexes • Boskin Report (1996) Concludes that CPI Overstates Inflation by 1.1% per year. • Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure). • Measures to Get Around Problems with CPI - Chain Weighting • Read Text to get a sense of chain weighting. • Read Course Pack Readings: 20 (difficulty measuring prices)

47. Technical Notes on Price Indexes • Which is better: Real or Nominal? • In this class, we will focus on the ‘Real’! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices. • From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told. • ie, Y = Real GDP, C = Real Consumption, G = Real Government Purchases, etc...

48. A Look at U.S. Nominal GDP: 1970Q1 – 2009Q3 Black line - trend in nominal GDP over time (left axis) Red line - trend in nominal GDP growth (percentage change in nominal GDP) over time (right axis) (growth measured year over year) Shaded areas represent “official” recession dates (as calculated by National Bureau of Economic Research)

49. A Look at U.S. Inflation 1970M1 - 2009M11 Black line - trend in CPI over time (left axis) Red line - trend in CPI inflation rate (percentage change in CPI) over time (right axis) (growth measured year over year) Shaded areas represent “official” recession dates (as calculated by National Bureau of Economic Research)

50. A Look at U.S. Real GDP 1970Q1 – 2009Q3 Black line - trend in real GDP over time (left axis) Red line - trend in real GDP growth (percentage change in real GDP) over time (right axis) (growth measured year over year) Shaded areas represent “official” recession dates (as calculated by National Bureau of Economic Research)