GDP
Gross Domestic Product. The total market value of all final goods and services produced in a country in a given year, equal to
total consumption, investment and government spending, plus the value of exports, minus the value of imports.
What is a good “growth rate” for GDP
GDP growth has historically averaged about 2.5-3% per year but with substantial deviations. Generally speaking economists want
GDP to grow fast enough (2-4%) to create enough jobs and ensure a strong economy but not too fast (above 4%) to cause the
economy to “over-heat” which leads to inflation. The economy needs to generate at least 150,000 new jobs every month just to
keep the unemployment rate the same! (this is because of our growing population) Slow GDP growth (below 2%), will leading to
rising unemployment.
The GDP numbers are reported in two forms: current dollar and constant dollar. Current dollar GDP is not adjusted for inflation
while constant dollar GDP solves this problem by converting the current information into some standard era dollar, such as 1997
dollars. This process factors out the effects of inflation and allows easy comparisons between periods. We will use constant
dollars numbers for all of our calculations.
The formula for GDP can be summarized in the following equation:
GDP = C + I + G + (X-M)
C
I
G
(X-M)
=
=
=
=
consumer spending
Investment spending
Government spending
Trade balance
GDP Percent Change By Year
Numbers are in a percentage (%) formula. In other words, 1.9 means the GDP expanded at a +1.9% rate. Try to find the recent
trend of GDP growth and locate any recessions OR periods of unusually slow economic growth that have occurred during the
last 15 years
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
4.1
3.5
3.4
4.1
3.5
1.9
-0.2
3.3
2.7
4.0
2.5
3.7
4.5
4.2
4.5
3.7
0.8
1.6
2.7
3.6
2005
2006
2007
2008
3.1%
3.0%
2.3% (4th qtr of 2007 was -0.2%)
1ST QUARTER +0.9%,
2nd Quarter +3.3% (why did it get better)
Employment and Unemployment
Each month, the U.S. Department of Labor surveys individuals and businesses to gather employment and unemployment data. The
unemployment rate is the percentage of people in the total labor force actively seeking jobs, including new entrants into the
workforce and people who have lost jobs and are looking for new ones.
The current labor force in the United States is 148,000,000 and there was approximately 7,500,000 Americans considered
unemployed in 2007:
7.5 million
= 5.0% Unemployment Rate
148 million
An increase unemployment generally signals a slowing economy; falling unemployment is generally good news. Investors
sometimes grow concerned that a very low unemployment rates will cause employers to bid up wages and benefits to attract
workers, resulting in higher costs and more rapid inflation.
What are the basic concepts of employment and unemployment?
The basic concepts involved in identifying the employed and unemployed are quite simple:
 People with jobs are employed.
 People who are jobless, looking for jobs, and available for work are unemployed.
 People who are neither employed nor unemployed are not in the labor force.
Who is not in the labor force?
All members of the civilian non-institutional population are eligible for inclusion in the labor force, and those 16 and over who
have a job or are actively looking for one are so classified. All others--those who have no job and are not looking for one--are
counted as "not in the labor force." Many who do not participate in the labor force are going to school or are retired. Family
responsibilities keep others out of the labor force. Still others have a physical or mental disability, which prevents them from
participating in labor force activities.
Effect on Circular Flow:
A rise in the unemployment rate means less people are working. As people lose their jobs, consumer spending (C) will decrease
and the circular flow will start to slow down. If producers become more pessimistic then they may hire less workers in the future
and produce less goods. This will slow the circular flow down further, thereby lowering GDP
Recent Unemployment Numbers
Year
Dec
1997
4.7
1998
4.4
1999
4.0
2000
3.9
2001 5.7
2002 6.0
2003
5.7
2004
5.4
2005
4.9
2006
4.5
2007
5.0
2008
5.7
Housing
Housing is perhaps the most interest-rate sensitive sector of the economy. It often experiences large swings in activity in response
to changes in the level of long-term interest rates such as those on mortgages. Policy makers monitor the housing sector very
carefully for clues about the near-term performance of the economy (GDP) and for the effects of changes in financial conditions.
Houses are the largest single investment most people will ever make. People buy houses when they fee confident about the
economy and the security of their employment. If consumers get concerned about the health of GDP and employment they are
more likely to delay the purchase of a new home.
When the housing market slows down, it affects all of GDP. When people buy a new home, they also buy new furniture and other
durable goods for their new home. Therefore, a dramatic slowdown in the housing market can lead to producers to make less
products which will slow down the entire circular flow of our economy.
Overall Housing Market Summary:
The housing market is currently the most fragile part of the U.S. economy. Foreclosures are rising on a monthly basis, consumers
are having difficulty getting mortgages from banks and, overall, there is concern that home prices will no longer rise quickly and
will fall in many areas of the country. Many of the problems are in the subprime market. How did this housing crisis happen?
Good question and we will answer that throughout the course; however,
a. the Federal Reserve’s decision to lower interest rates to 1% (the lowest rate in 45 years)
b. a large part of it were banks decision to make loans to people with no down deposit and an artificially low
monthly payment (this payment rate would adjust up in the future).
This led consumers to take loans for homes they really could not afford. When their low payments rose in the future, they no
longer had the ability to pay their mortgage and they lost the house through foreclosure
Because housing is such an important part of GDP, economists fear the housing problem will spread to other parts of the economy
leading to job loss and a possible economic recession. This is why the Federal Reserve may lower interest rates further in January.
(Isn’t that part of the reason we got in this mess?)
The graph below illustrates the rapid decline in new home sales over the past year. Home prices are falling throughout the
country. The bad news is that many people are losing their homes through foreclosures. The good news is builders are building
less new homes (less supply) and lower home prices are bringing new buyers (new demand) into the housing market. Over time,
the housing market will naturally “self-regulate” and home prices will stop falling.
NEW HOME SALES:
June 2007 - June 2008
Stock Market Indices
What are market indices:
There are over 5,000 stocks in the United States. Imagine trying to keep track of 5,000 stocks and to determine how the whole stock market is
performing. Indices are basically averages of a large number of stocks and they offer an easy way to quickly determine whether the OVERALL
market is going up or down.
The 2 most popular stock market indices are the Dow Jones Industrial Index (DOW) and the S&P 500 index (SP500)
Stock Indices are considered LEADING economic indicators and are used to help gauge how investors feel about the strength of the U.S.
economy and the outlook for future profits for US companies. When investors expect the economy to be very strong and companies to earn
higher profits, the overall stock market tends to rise. When the economy slows down the overall stock market tends to fall for the opposite
reason. Therefore, the stock market is often an excellent indicator (leading) on the future direction of the business cycle. Are we going into a
recession? Well, the stock market could be one of your best “clues” on the answer.
Dow Jones Industrial Average
One of the best-known market indicators, the Dow Jones Industrial Average, is comprised of 30 leading companies. These companies tend to be
the largest and most well-known companies in the United States. Over the past 5 years the Dow Jones has traded between 7,200 and 11,200.
Calculated by adding the prices of these 30 stocks, the Dow is now considered a figure that indicates the general state of the market. Originally,
the Dow divided the sum of the prices of the 30 stocks by 30, giving a true average. However, to be consistent every time a stock split or paid a
dividend, the number 30 had to be adjusted.
S & P 500 Index
Created in the 1920s by the Standard and Poor's Corporation (S & P), this index tracks 500 companies in leading industries. The major sectors of
the SP500 are: transportation, utilities, financial services, technology, health care, energy, communications, services, capital goods, basic
materials and consumer products. Over the past 5 years the SP500 has traded between 790 and 1,500. Many consider the SP500 the most
accurate reflection of the U.S. stock market today. This high regard has led many money managers and pension plan administrators to use it as a
benchmark for judging the overall performance of their fund against the stock market.
NASDAQ INDEX: a new index comprised mainly of technology stocks. The following charts list the TOTAL RETURN of the stock indices by
year. So far in 2008 the Dow Jones Index has declined -13.0%. The stock market has averaged over a +10.0% per year over the last 100 years!
2004
.
2008
Dow
-13.0%
SP 500 -12.0%
Nasdaq -9.0%
Dow
+ 3.1%
SP 500 + 9.0%
Nasdaq + 8.6%
2005
.
Dow
-0.6
SP 500 + 3.1%
Nasdaq +1.4%
2006
Dow
+16.0%
SP 500 + 13.6%
Nasdaq +9.5%
2007
Dow
+6.4%
SP 500 + 3.5%
Nasdaq +9.8%
.
Federal funds rate
What is the Fed and who is Greenspan?
The Federal Reserve (Fed) is the Central Bank of the United States and was founded by Congress in 1913 to provide the nation
with a safer, more flexible, and more stable monetary and financial system. The Fed has the ability regulate the U.S. money
supply and interest rates to influence economic outcomes (this is called Monetary Policy). The current head of the Federal
Reserve is Ben Bernanke, who replaced Alan Greenspan in 2005.
What is the Federal Funds Rate?
The Fed funds rate is the interest banks charge each other for overnight loans to help them satisfy the Fed's reserve requirements.
The rate plays a big part in determining banks' cost of capital and the growth of money in the U.S. economy. When the Federal
Reserve lowers interest rates consumer can borrow money to buy houses and cars at less expensive levels of interest rates. This
effectively reduces a consumer’s monthly payment on a loan. Therefore, this encourages consumers to spend more money and,
generally, helps improve the rate of economic growth. (GDP).
In the short run, When interest rates are low => consumers borrow more money => Circular Flow speeds up (higher GDP)
Recent Federal Reserve Interest Rate Changes
The Federal Reserve, led by Alan Greenspan, was very busy during both 2001 and 2002 lowering the federal funds rate. The
economic recession of 2001 led to increasing unemployment, a declining stock market and decreasing consumer confidence. The
Fed lowered the federal funds rate from 6% to 1.00%----the lowest level in over 45 years to help increase economic growth. (Did
this help our economy in the long run?)
2004 marked a sharp CHANGE IN FED POLICY, as the Federal Reserve began raising rates! From 2004-2006 the Fed increased
the Funds rate from 1.00% to 5.25%. 2006 represented the peak in the housing market (highest prices).
During 2007 & 2008 the U.S. Housing market has collapsed in many areas of the country. Home prices have fallen in the USA
for the first time in decades and many consumers a losing their homes (due to foreclosure) Economists began to fear the housing
market would drag the U.S. economy into an economic recession and Ben Bernanke has lowered rates from 5.25% to 2.0%. By
lowering interest rates the Fed has made it “cheaper” to borrow money.
This should leading consumers to be more likely to buy a new car or a home. In theory, the housing market should naturally selfregulate through a combination of lower home prices (to get rid of excess supply of homes) and less new building and an
increasing population. The question is: how low do home prices have to fall to correct the market?
Current Rate:
2.00%
Consumer Price Index (CPI)
For consumers and investors, one of the most important economic factors to watch is inflation, whose best-known indicator is the
Consumer Price Index. Inflation is basically the condition of rising prices. That is when the same good costs more than it did
last week or last month. For example, If you bought a T-shirt for $10 dollars and 1-year later the exact same T-shirt costs $12
dollars, then the price of the T-shirt rose 20%. This is inflation and it reduces the purchasing power of money. Hopefully, the
price of other goods did not rise so dramatically. Whenever the prices of the majority of good & services of an economy rise,
inflation becomes a major problem for the U.S. economy.
How do we measure inflation?
The CPI tracks the prices of some 80,000 goods and services—food, housing, transportation, health care, and clothing, among
others—purchased by consumers in a “market basket”. Then every month the Government re-prices this exact same market
basket of goods & services and compare prices with last month. This becomes the “actual” inflation rate. Changes in the CPI are
used to adjust some aspects of Social Security and the federal income tax as well as certain labor and rental contracts.
Why is inflation important?
Generally speaking, the U.S. wants to keep inflation very low, somewhere between 1% and 2%. Rising inflation is usually a signal
that the economy is heading for major trouble. The only real cure for rising inflation is to rapidly increase interest rates. In this
the short run, this will hurt the economy by leading to rising unemployment; however, in the long run this should lower inflation.
What goods and services does the CPI cover?








. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks);
HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture);
APPAREL (men's shirts and sweaters, women's dresses, jewelry);
TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance);
MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital
services);
RECREATION (televisions, cable television, pets and pet products, sports equipment, admissions);
EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and
accessories);
OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral
expenses).
Recent Consumer Price Index Numbers:
Year Annual
1997 2.3
1998 1.6
1999 2.2
2000 3.4
2001 2.8
2002 1.6
2003 2.3
2004 2.7
2005 3.4
2006 3.2
2007 3.6
2008 5.2