THE BUSINESS CYCLE ILLUSTRATED: Indicators of the Business Cycle [“The leading indicators have predicted 11 of the last 15 recessions”] Coincident Indicators “Where we are now” Payroll employment Personal income Factory orders Lagging Indicators “Where we have been” Labor cost, unempl. duration prime interest rates, etc. Leading Indicators Ave work week Unempl claims New orders New businesses Stock prices New orders Building permits Delivery times Inventories Materials prices Money supply Credit Had a recession in 2001 • Peak • temporary maximum in Real GDP. At this point the unemployment rate (u%) is probably below the natural rate of unemployment, and the inflation rate (π%) is probably increasing. • Recession/Contractionary • The contractionary phase of the business cycle. A period of decline in Real GDP accompanied by an increase in u%. To be classified as a recession, the economic decline must be at least 6 months long. • Trough • The bottom of the business cycle. The u% is probably high and π% is probably low. • Recovery/Expansionary • The phase of the business cycle where the economy is returning to full employment. FOUR PHASES OF BUSINESS CYCLE • Productivity refers to the amount of goods and services produced from each unit of labor input. • A nation’s standard of living is determined largely by the productivity of its workers. PRODUCTION FUNCTION • Y = A F(L, K, H, N) • Y = quantity of output • A = available production technology • L = quantity of labor • K = quantity of physical capital • H = quantity of human capital • N = quantity of natural resources • F( ) is a function that shows how the inputs are combined. PRODUCTION FUNCTION • Setting x = 1/L, • Y/ L = A F(1, K/L, H/L, N/L) • Where: • Y/L = output per worker • K/L = physical capital per worker • H/L = human capital per worker • N/L = natural resources per worker PRODUCTION FUNCTION • Productivity (Y/L) depends on: • physical capital per worker (K/L), • human capital per worker (H/L), • and natural resources per worker (N/L), • as well as the state of technology (A). DIMINISHING RETURNS AND THE CATCH-UP EFFECT • As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns. • Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. • In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these areas. SECTORS: B. Business Firms D. Consumer Households C. Where goods and services are supplied and demanded (bought and sold) A. Where factors of production (LLCE) are supplied and demanded (bought and sold). • Payments for goods and services (expenditures) • Payments for factors of production (income) • Goods and services • Factors of Production LEAKAGES AND INJECTIONS FROM INCOME/EXPENDITURE FLOWS: • Government • Leakage – Taxes (T) • Injection – Government Expenditures (G) • Financial Institutions • Leakage – Saving (S) (income not spent) • Injection – Business Investment (I) • Foreign Sector • Leakage – Expenditures for Imports (M) • Injection– Expenditures for Exports (X) Aggregate (total) Expenditures = C + I + G + X-M (AE) = GDP = AD THE MEASUREMENT OF GDP • Gross domestic product (GDP) is a measure of the income and expenditures of an economy. • GDP is the total market value of all final goods and services produced within a country in a given period of time. THE MEASUREMENT OF GDP • “GDP is the Market Value . . .” • Output is valued at market prices. • “. . . Of All. . .” • Includes all items produced in the economy and legally sold in markets • “. . . Final . . .” • It records only the value of final goods, not intermediate goods (the value is counted only once). • “. . . Goods and Services . . .” • It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). THE MEASUREMENT OF GDP • “. . . Produced . . .” • It includes goods and services currently produced, not transactions involving goods produced in the past. • “ . . . Within a Country . . .” • It measures the value of production within the geographic confines of a country. • “. . . In a Given Period of Time.” • It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). THE COMPONENTS OF GDP GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Y = C + I + G + NX CONSUMER HOUSEHOLDS • Symbol • Name • Significance C Consumption • Other Data Durable goods Nondurable goods Services Largest sector/ Significant impact BUSINESS FIRMS • Symbol • Name • Significance Very important. • Other Data Total Ig Gross Private Domestic Investment Affects productive potential of economy Capital goods All construction (houses, etc.) Changes in inventory HOW DOES BUSINESS INVESTMENT AFFECT THE PRODUCTIVE CAPACITY OF THE ECONOMY? • IG = Depreciation + Net Investment replacement capital additions to the stock (amount) of capital in the economy Machines worn out / used up while producing the nation’s output. Consumption of fixed capital Depreciation is also called: Capital consumption allowance (CCA) GOVERNMENT (PUBLIC) SECTOR • Symbol • Name • Significance G Government Expenditures Significantly large Includes gov. purchases • Other Data of goods and services TRANSFER PAYMENT: • Money that is transferred from one person to another (or group or business). Usually government is doing the redistribution. • Key characteristic --- no good or service or factor of production is exchanged in return (purely financial transaction) • Examples of transfer payments: • Private: Aunt Suzie gives you a check for your birthday. • Public: subsidies to businesses, social security payments, veteran’s benefits, welfare payments, unemployment compensation. • Note: work may have been done in the past for which the recipient is receiving the payment (social security, unemployment compensation, veteran’s benefits); however, no CURRENT PRODUCTION is taking place for receipt of the money NOW. FINANCIAL MARKETS The Bond Market • A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. • Characteristics of a Bond • Term: The length of time until the bond matures. • Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. • Tax Treatment: The way in which the tax laws treat the interest on the bond. • Municipal bonds are federal tax exempt. • Bond Prices react to interest rates. • If a bond is paying 10% and interest rates go to 5% is the bonds price going to go up or down? • What if interest rates go to 15% what is that bond going to be worth? • So if interest rates go up bond prices go down and vice versa. FINANCIAL MARKETS • The Stock Market • Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. • The sale of stock to raise money is called equity financing. • Compared to bonds, stocks offer both higher risk and potentially higher returns. • The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ. THE IMPORTANCE OF SAVING AND INVESTMENT • • As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns. Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. GDP AND ECONOMIC WELL-BEING • Some things that contribute to well-being are not included in GDP. • The value of leisure. • The value of a clean environment. • The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. 1. Second Hand Sales[no production] 2. Public/Private Transfer Payments 3. Purely Financial Transactions 4. Intermediate Goods 5. U.S. Corporations producing overseas 6. Non-market transactions [household or volunteer work] Underground Economy 7. Illegal business activity 8. Unreported legal business activity HOUSING WEIRDservices is somewhat The value of IS housing difficult to measure. a. If housing is rented, the value of the rent is used to measure the value of the housing services. b. For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services. C ___ Y 1. You buy a purple “Tinky Winky” from Wal-Mart. ___ ___ 6 ___ N 2. You and your family paint your house. [labor involved] N 3. You marry your housemaid. [“working-for-love”] [her services] ___ 6 ___ 3 ___ N 4. You buy 100 shares of Microsoft Corporation. ___ N 5. You volunteer to babysit your little sister to help your parents while 6 ___ ___ they work. 1 ___ N 6. Bob buys a 1965 ford Mustang convertible, in 2010, which is in mint ___ condition. C ___ Y 7. The salesman gets a commission [pay] for selling that 1965 Ford ___ Mustang in 2010. N 8. You and your friend volunteer to cook at the senior class picnic. ___ 6 ___ ___ 8 ___ N 9. Dr. Payne does $1,000 worth of dental work but reports only $500 of it. Does the $500 the dentist keeps and doesn’t report count? 7 ___ ___ N 10. You are given s suitcase full of $100 bills from the sale of smuggled drugs. ___ N 11. Your mother is teaching you to read 6 ___ 1. 2nd Hd sales 2. Transfers ___ N 12. Your dad bakes you a home-baked loaf of bread. 6 ___ 3. 4. 5. 6. 7. 8. Financial Intermediate Overseas Non-market Illegal Unreported ___ C ___ Y 13. You buy a loaf of bread from Kroger’s Grocery Store. G ___ Y 14. The U.S. government purchases 5 B-2 Bombers for $2 B each. ___ 4 ___ N 15. Ford buys a ton of sheet metal used in making car doors. ___ ___ Y 16. You buy a new “iPad” from the Apple store. C ___ C ___ Y 17. You send in a $90 check to your dentist for cleaning your teeth. ___ Ig ___ Y 18. Your family buys a new house next to the mansion of Bill Gates. ___ ___ G ___ Y 19. 100 additional teachers are hired by the Frisco ISD. Ig ___ Y 20. GM invest in $500 million worth of robots to assemble their cars. ___ 6 ___ N 21. You volunteer 10 hours a week of your time to work for senior ___ citizens. Ig ___ ___ Y 22. Ford produces 25,000 F150s in Denver which are not sold by the end of the year. ___ X ___ Y 23. Russia buys 3,000 Dell computers, produced in NY, as they become Rusky Dell Dudes. 6 ___ N 24. A man’s wife does all his cooking and sewing, working for him 16 ___ hours per day. 1. 2nd Hd sales 5 ___ N 25. Nike produces $10 million worth of Nike’s in Vietnam. ___ 2. Transfers 3. 4. 5. 6. 7. 8. Financial Intermediate Overseas Non-market Illegal Unreported Lets’ take a look at some “Is It Included In GDP” questions on the 2007 FRQ. 3. [8 pts] Indicate whether each of the following is counted in the U.S. GDP for the year 2006. Explain each of your answers. (a) The value of used textbook sold through online auction in 2006. Answer: No, it was counted the year it was produced. Because it was not produced again, it would not be counted. That would be double counting. [2 pts: 1 pt for saying not included and 1 pt for saying not produced in 2006] b. Rent paid in 2006 by residents in an apartment building built in 2000 Answer: Yes, rents consist of the income received by the households and businesses that supply property resources. The properties have to be maintained or “serviced” each year. It is included in the income approach to GDP. [2 pts: 1 pt for “yes” and 1 pt for saying this is the payment for services] c. Commissions earned in 2006 by a stockbroker Answer: Yes, payment is being made for productive services of the broker. So the purchase of stocks would not count but his work would. [2 pts: 1 pt for “yes” and 1 pt for saying this is the payment for services] d. The value of autos produced in 2006 entirely in South Korea by a firm fully owned by U.S. citizens Answer: No, GDP measures production inside the U.S. regardless of ownership. These autos were produced in South Korea. [2 pts: 1 pt for “not included” and 1 pt for saying produced in Korea] REAL VERSUS NOMINAL GDP • Nominal GDP values the production of goods and services at current prices. • Real GDP values the production of goods and services at constant prices. NOMINAL [MONEY] GDP V. REAL GDP An increase in prices and/or output will increase nominal GDP. Only an increase in output will increase real GDP. Nominal GDP could increase even if output falls. Real GDP = Nominal Y/GDP deflator x 100 So, nominal GDP measures output & prices. Real measures only output [actual production] Constant (real) GDP v. current (money) GDP GROSS DOMESTIC PRODUCT – MARKET VALUE OF ALL FINAL LEGAL OUTPUT PRODUCED IN A COUNTRY IN ONE YEAR. Nominal (money) GDP =$6.00 Year one $2.00 $2.00 $2.00 The base year is the benchmark year to which other years are compared. Nominal GDP measures “current” output valued at current prices. Nominal (money) GDP =$6.10 Year Two [Recession - decrease in real output] $3.05 $3.05 Real GDP – measures only output. [measures current output at base-year prices ($4), not current prices ($6.10)]. [“Real” or “constant-dollar” GDP] GDP DEFLATOR – MORE BROAD GDP Deflator includes prices for all goods that we produce: 1.What householders are buying 2.What businesses are buying 3.What the government is buying 4.What foreigners are buying [does not include imports because we don’t produce imports] GDP DEFLATOR The GDP deflator is calculated as follows: Nominal GDP GDP deflator = 100 Real GDP THE “GDP” BALLOON $6,736.9/126.1 x 100 = $5,342.5 takes Nominal – measured in terms of money. Real – measured in terms of goods/services. $4,839 $3,492 $4,848 THE INCOME APPROACH W+I+R+P • W=COMPENSATION OF EMPLOYEES • I=NET INTEREST=INTEREST YOU RECEIVE FROM INVESTMENTS(CDS, AND STOCKS) • R= RENTAL INCOME-RENTING OF HOUSES, etc • P=PROFITS-PROFITS EARNED BY BUSINESSES • SA= STATISTICAL ADJUSTMENTS (Corporate Income Taxes, Dividends, Undistributed Corporate Profits) Expenditure Approach Gross Domestic Production Income Approach Gross Domestic Sales Consumption by Households Rents + Investment by Businesses + Government Purchases + Expenditures By Foreigners + + + Interest G = D= P Profits Statistical Adjustments [corporate income taxes, Dividends, undistributed Corporate profits] + Wages OTHER MEASURES OF INCOME • • • • • Gross National Product (GNP) Net National Product (NNP) National Income Personal Income Disposable Personal Income • • GROSS NATIONAL PRODUCT Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals). It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here. NET NATIONAL PRODUCT (NNP) • Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation. NATIONAL INCOME • National Income is the total income earned by a nation’s residents in the production of goods and services. • It differs from NNP by excluding indirect business taxes (such as sales taxes) and including business subsidies. PERSONAL INCOME • Personal income is the income that households and noncorporate businesses receive. • Unlike national income, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners. • In addition, it includes household’s interest income and government transfers. DISPOSABLE PERSONAL INCOME • Disposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government. • It equals personal income minus personal taxes and certain nontax payments. BREAKING DOWN NATIONAL SAVINGS NS=(Y-T-C) + •Private Savings-is the amount of income that households have left after paying their taxes and paying for their consumption (TR-G) Public Savings-is the amount of tax revenue that the government has left after paying for it spending COMPOUNDING AND THE RULE OF 70 ACCORDING TO THE RULE OF 70, IF SOME VARIABLE GROWS AT A RATE OF X PERCENT PER YEAR, THEN THAT VARIABLE DOUBLES IN APPROXIMATELY 70/X =YEARS. AN EXAMPLE OF THE RULE OF 70 • $5,000 invested at 7 percent interest per year, will double in size in 10 years 70/ 7 = 10 THE IMPORTANCE OF SAVING AND INVESTMENT THE CATCH-UP EFFECT REFERS TO THE CONDITION THAT, OTHER THINGS BEING EQUAL, IT IS EASIER FOR A COUNTRY TO GROW FAST IF IT STARTS OUT RELATIVELY POOR. Poor countries devote more resources to consumer production than rich countries do. As more resources flow into capital production, the rate of economic growth in rich countries increases, and so does the gap between rich and poor countries. Rich Countries Favor Future Goods Poor Countries Favor Present Goods 2009 2019 CURRENT CURVE FUTURE CURVE CONSUMPTION Goods for the Present Goods for the Future Goods for the Future 2019 CONSUMPTION 2009 FUTURE CURVE CURRENT CURVE Goods for the Present Yes, if there is Full Employment. The speed limit for GDP growth is 4%. But, if the economy is in recession, There is no speed limit for GDP growth. increased Expanding Productive Capacity No change Maintaining our production possibilities Static Productive Capacity decreased Declining Productive Capacity CHECK FOR UNDERSTANDING WHAT’S INCLUDED / EXCLUDED IN GDP AND HOW IS IT CLASSIFIED? Year Price of Hot dogs Quantity of Hot dogs Price of Hamburgers Quantity of Hamburgers 2001 $1 100 $2 50 2002 $2 150 $3 100 2003 $3 200 $4 150 Calculating Nominal GDP: 2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200 2002 ($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600 2003 ($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200 Calculating Real GDP (base year 2001): 2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200 2002 ($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350 2003 ($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500 REAL AND NOMINAL GDP Year Price of Hot dogs Quantity of Hot dogs Price of Hamburgers Quantity of Hamburgers 2001 $1 100 $2 50 2002 $2 150 $3 100 2003 $3 200 $4 150 Calculating the GDP Deflator: 2001 ($200/$200) x 100 = 100 2002 ($600/$350) x 100 = 171 2003 ($1200/$500) x 100 = 240 Year PL Footballs Year 1 Year 2 Year 3 $10 12 14 Q Footballs 120 200 180 PL Basketballs $12 15 18 Q Basketballs 200 300 275 Nominal GDP year 1? Nominal GDP Year 2? Nominal GDP year 3? nGDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 nGDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900 nGDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470 Year PL Footballs Year 1 Year 2 Year 3 $10 12 14 Q Footballs 120 200 180 PL Basketballs $12 15 18 Q Basketballs 200 300 275 • Using Year 1 asGDP the Base Real yearYear: 1? • Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600 Real GDP Year 2? • Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600 Real GDP year 3? • Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100 • (Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.) 1. YOU SPEND $5 TO ATTEND A MOVIE. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) 2. YOU PAY A CONTRACTOR $100,000 FOR A NEW HOUSE. I • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) 3. YOU PAY $60,000 TO THE OWNER TO PURCHASE A TEN YEAR OLD HOME. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) 4. THE GOVERNMENT INCREASES ITS MILITARY EXPENDITURES BY $1 BILLION. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) 5. THE GOVERNMENT SENDS A $600 SOCIAL SECURITY CHECK TO A RETIRED PERSON. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) 6. YOU PURCHASE $2000 OF MICROSOFT STOCK ON THE STOCK MARKET. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Security (stock) transaction / nonproduction or purely financial transaction 7. AT THE END OF THE YEAR, A CAR DEALER FINDS THAT ITS INVENTORIES OF CARS ARE $300,000 HIGHER THAN THE BEGINNING OF THE YEAR. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Additions to inventories are unsold output. They are counted as Ig. Even though they are not sold, they must be counted because they were produced. 8. A HOUSEWIFE DOES A LOT OF WORK CARING FOR HER HUSBAND AND KIDS. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Nonmarket Transaction (underground economy) 9. GENERAL MOTORS BUYS NEW ROBOTS FOR ITS ASSEMBLY-LINE. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Robots are new capital goods. 10. APPLE BUILDS A NEW IPOD FACTORY. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) All new construction is counted as business investment. Building a factory is also adding to the economy’s capital stock. 11. R.J. REYNOLDS COMPANY BUYS CONTROL OF NABISCO. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Security (stock) transaction / nonproduction or purely financial transaction 12. YOU BUY A NEW TOYOTA MADE IN JAPAN. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Imports must be subtracted because the expenditure by Americans is for a car produced in another country (Japan). 13. YOU PAY TUITION TO ATTEND AN ECONOMICS COURSE AT THE LOCAL COLLEGE. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) 14. IBM PAYS YOU THE INTEREST ON YOUR IBM BOND. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Tricky question: Although stock and bond sales ARE NOT counted, dividends from stock and interest from corporate (but not government) bonds are counted because they represent income currently earned from the production of the current year’s output. This is tricky because no answer is correct. Interest payments would be part of the income approach – not the expenditures approach to GDP calculation. 15. A NEW TRUCK IS PRODUCED BUT NOT SOLD IN 2005. IN 2006, THE TRUCK IS SOLD. . truck is counted as negative change in inventory in A. The 2005 and a positive change in inventory in 2006. B. The truck is counted as a positive change in inventory in 2005 and as consumption and a negative change in inventory in 2006. C. The truck is counted as consumption in 2005. D. Because it was not sold in the year it was produced, the truck is not counted in the GDP of either year. The truck, although unsold in 2005, must be counted in 2005 because that was the year it was produced; therefore, in 2005 it is counted as part of Ig. In 2006 it was purchased (increase in C) but also the purchase reduced Ig by the same amount the C increased; therefore, the net effect for 2006 is zero. 16. A PAINTER PAINTS HIS OWN HOME. • C counted as consumption • Ig counted as business investment • G counted as government expenditures • Xn added or subtracted in the foreign sector •N NOT COUNTED (WHY?) Nonmarket Transaction – underground economy.