Business, Government, and the
World Economy
Introduction
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?
Economics
The study of the allocation of scarce resources
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)
Macroeconomic Goals
Providing Jobs
Economic Growth
Increasing Productivity
Increasing Standard of Living
Stable Prices
Others?
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
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..
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.
Common Questions
Microeconomics
Macroeconomics
How much R&D will a firm undertake
What is the level of interest rates?
How many I-Pods should Apple produce?
How can productivity be increased?
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?
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…
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.
Positive vs. Normative
Economics
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?
Basic Economic Assumptions
Laws of Supply and Demand
Utility Maximization
Markets Forces Work in the Long Run
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.
Economic Theory Changes
Economic theory can change over time – even
theory that is supported by empirical evidence
Example: The Phillips Curve
1960’s Philips Curve
6
1969
Inflation (Annual %)
5
1968
4
1967
3
1966
2
1964
1965
1
1963
1962
1961
0
2
2.5
3
3.5
4
4.5
5
Unemployment (Annual %)
5.5
6
6.5
7
Monetary Policy 1960’s
Focus on money market conditions.
Use of Free reserves as indicator resulting in
procyclical monetary policy.
1970’s Phillips Curve ?
16
14
1980
Inflation (Annual %)
12
1974
1979
10
1975
8
1978
1973
6
1977
1970
1976
1971
4
1972
2
0
3
4
5
6
7
Unemployment (Annual %)
8
9
1996-2005 Phillips Curve?
4
2000
3.5
2005
1996
Inflation (Annual %)
3
2001
2004
2.5
1997
1999
2003
2
1.5
1998
2002
1
0.5
0
3
3.5
4
4.5
5
Unemployment (Annual %)
5.5
6
6.5
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.
Measuring Economic Output
The Key Variable: GDP
Gross Domestic Product
The market value of all final goods and services
produced in a country during a given time
frame.
Components of GDP
Y = 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
Personal Consumption Expenditures
Approximately 72% of GDP*
Item
% of
GDP
Description
Durable Goods
10%
Goods that last > 3 years
Cars, appliances, furniture
Non-Durable
Goods
20%
Goods usable < 3 years
Fuel, food, clothes
Services
41%
Intangible tasks by specialists
Repairs, hair styling, cleaning
www.bea.gov 1st qtr 2012
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).
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%.
Trends in GDP Components
Current Values
2nd 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%
Contributors to GDP
2nd Qtr 2012
Positive
Consumption
Goods
Services
Business Investment
Inventories
+1.05%
+.18%
+.87%
+1.08%
+.32%
Negative
Government -.28% (State and local -.26%)
Net Exports -.31%
Three Markets
Good Markets
Consumption, Business Investment, and Saving.
Asset Market
Financial Assets
Money
Labor Market
Level of Employment and Wages
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.
Macro Interactions
Goods Market
Consumption, Saving, and
Investment
GDP
C+I+G+NX
Government
Purchases
Interest
Rates &
Prices
Asset
Market
Labor Market
Wages and Employment
Net Exports /
Interaction with Global Economy
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.
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.
Some Basic Economic Language
Annual Rates
Rates of Change
Business Cycles
Consensus Survey
Moving Average
Nominal vs. Real Dollars
Revisions and Benchmarks
Seasonal Adjustments
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.
4 Week Moving Average of Unemployment Claims
1967-2012
FRED Economic Data
http://research.stlouisfed.org/fred2/series/IC4WSA?cid=32240
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
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending
Decreased Business Investment
Who’s to Blame?
Economic
Environment
Congress
Consumers
Mortgage
Originators
Regulators
Wall Street
GSEs
Rating
Agencies
International
Flows
How Financial Markets Enabled
“Keeping up with the Joneses”
New Products
Poor Underwriting
Public Policies Unintended Consequences
Low Rates and International Capital Flows
Average Size of
Subprime Loans
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 200705, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime
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
Impact of Subprime Loans
on Home Ownership
"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007
Fannie Mae’s
Guarantee of Alt A Loans
$ Billions of Alt A Loans Guaranteed
300
2007
$79
Billion
Added
250
2006
$87
Billion
Added
200
150
2005
$58
Billion Added
100
50
2004 & Before
$77 Billion Total
0
NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"
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
International Capital Flows
Consumer Spending On Exports
Increased Foreign Holdings of $
Increased Inflow of Dollars
Helps Keep Long Term Rates Low
“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
Non Agency Mortgage
Foreclosure Rates
Response of Consumers
Increased access to credit and delusional
optimism resulted in:
Short-Term Speculative Focus
Borrowing More and Saving Less
Case Study: Natalie Brandon
1985 Buys $105,000 house
30 Year fixed rate loan
2000-2006
Payment = $770
Paid penalties to Refi 5 times in 5 years
Yearly income = $100,000
2006 New Loan $625,500 2/28 7.99% teaser
Payment = $4,585
Fall 2007
Home Value = $450,000
Attempt to Refi for 40 years at 6% Fails
Borrowing More & Saving Less
Equity Prices
Compared to Past Recessions
Precautionary Saving
If you were to lose your job, for how long could you afford to be out of
work and still meet your financial obligations including monthly expenses?
Less than 2 weeks
2 weeks to a month
2 to 3 months
4 to 6 months
7 months to a year
More than a year
All
28%
22%
22%
14%
5%
10%
Silents
11%
17%
23%
15%
7%
27%
Boomers
25%
21%
24%
11%
5%
14%
Gen X
31%
21%
19%
17%
6%
5%
The 2009 MetLife Study of the American Dream
Gen Y
32%
27%
22%
12%
2%
6%
Confidence in Having Enough Money to Live
Comfortably Throughout Retirement Years
Employee Benefits Research Institute – Retirement Confidence Survey
The Keys to Recovery – The Big Picture
Consumers
Precautionary or Long Term Savings?
Lost Faith in Investment Planning?
View of home ownership
Corporate Earnings
Financial Markets and Regulation
Regulatory Changes
Long Term Inflation Fears
Monetary and Fiscal Policy & Interest Rates
Global Concerns
Consumer Credit Outstanding
ISM Manufacturing Survey
Employment: Non Farm Payrolls
Employment: Non Farm Payrolls
Peak = 138 M
Jan 2009
Min = 129.2 M
Feb 2010
Current = 133.2 M
July 2012
Employment
Peak Employment Jan 2009 = 138.023 Million
Current Employment July 2012 = 133.245 Million
Average monthly gain needed in payrolls to
return to peak level in:
1 year 398,166
2 years 199,083
3 years 132,722
Feb 240,000
May 77,000
March 154,000
June 64,000
April 77,000
July 164,000
Labor Force Participation Rate
65.5%
Average 1980 – 2012 65.8%
Average 1948 – 2012 62.87%
Max (April 2000) = 67.3%
63.7%
Impact of Great Recession
Dec 07 to May 11
US economy
lost $7,300 per
person in
consumption
($175 per
month per
person)1
1. Gauging the Impact of the Great Recession, FRBSF Economic Letter July 11, 2011
Impact of Great Recession
Change in trend of
personal
consumption
expenditure from
2000 -2007 path
after the
recession1
1. Gauging the Impact of the Great Recession, FRBSF Economic Letter July 11, 2011
Impact of Great Recession
Figure 1 - When Will Residential Construction Rebound?, FRBSF Economic Letter July 25, 2011
Figure 4 - Gauging the Impact of the Great Recession, FRBSF Economic Letter July 11, 2011
Job Losses Mirrored House Price Decline
The Slow Recovery: It’s No Just Housing FRBSF Economic Letter April 9, 2012
Job Recovery
The Slow Recovery: It’s No Just Housing FRBSF Economic Letter April 9, 2012
The Output Gap
What is Potential GDP and Why Does It Matter? Economic Synopses, FRB St Louis 2012 Number 11
Other Forces
Government
Contraction
Tight Credit
Uncertainty
US, Europe, China
The Slow Recovery: It’s No Just Housing FRBSF Economic Letter April 9, 2012
History of EU 1950
The Schuman Declaration
Plan for France and Germany
to pool coal and steel
production.
European economic unity will
make war “Not merely
unthinkable but materially
impossible”
Robert Schuman
French Foreign Minister
1951
European Coal and Steel Community
France, Germany, Italy,
Netherlands, Belgium and
Luxembourg
High Authority (oversees coal and
steel production)
Common Assembly (future
European Parliament)
Council of Ministers
Changing Landscape
1980 1997 2006
% of GDP (PPP) produced by g-7
countries
54% 46% 40%
% OF GDP (PPP) produced by
other G-20 Countries
21% 30% 36%
The Group of Twenty a History www.g20.org
A Brief History of European Debt Crisis
January 2001 – Greece Joins Euro zone and adopts
Euro.
Nov 2004 – Greece admits its deficit has been
above the required EU limit (3% of GDP) since
1999
March 2005 – Trade Unions impose 24 hour strike
to protest austerity measures after cost of hosting
Olympics causes high deficits
Greek timeline on this and future slides from news.bbc.co.uk/2/hi/Europe/country_profiles/1014812.stm
2002
Germany’s Debt hits 60.7% in 2002 of GDP and is still
above 60%
Germany’s budget deficit hits 3.8% of GDP in 2002 and
remains above 3% until 2006
France’s debt hits 63.3% of GDP in 2003 and is still above
60%
France’s budget deficit hits 3.3%in 2002 and remains above
3% until 2006
Neither country receives penalties from the European Union
2005
The 1997 Growth and Stability Pact is altered to
allow “exceptional circumstances” and “other
relevant factors” to be considered when the
deficit and debt targets are missed.
Memebers are allowed two year to correct the
problem and could be given more time with an
exception.
Deficit as a % of GDP
ECB http://www.ecb.int/stats/gov/html/dashboard.en.html
Euro Area Debt
Long Term Borrowing Costs
(10 year debt) Jan 2010 – May 2012
Contagion
November 28, 2010
Ireland receives €67.5B in bailout loan
commitments
Given to 2015 to decrease deficit to 3% of GDP
May 2011
May 3 Portugal accepts €116B loan commitment
package
shttp://www.huffingtonpost.com/2010/11/28/ireland-bailout-european-union_n_788922.html
Public Debt Comparison
1999
2004
2010
Country
Unep
Rate
Debt
% of
GDP
Rev %
of GDP
Unep
Rate
Debt
% of
GDP
Rev %
of GDP
Unep
Rate
Debt
% of
GDP
Rev %
of GDP
(2009)
Japan
4.7%
97%
26.3%
4.7%
156%
26.3%
5.1%
183%*
28.1%
Greece
12.1%
103%
32.8%
10.5%
108%
31.1%
12.6%
147%
29.4%
Italy
11%
106%
42.5%
8.1%
96%
40.9%
8.4%
109%
43.5%
US
4.2%
38%
29.1%
5.5%
36%
25.7%
9.6%
61%
23.9%
Spain
15.6%
52%
34.1%
11%
39%
34.6%
10%
51%
30.7%
Treasury Bid to Cover Ratio
2 year
10 year
2005 Average
2.19
3.75
2012 Average
2.36
3.18
Average Interest Expense
Average Interest Rates
Title
June 30,
2012
June 30,
2011
Treasury Bills
0.115
0.129
Treasury Notes
2.077
2.385
Treasury Bonds
5.452
5.860
1.696
2.005
4.625
4.625
2.159*
2.380
Interest-bearing Debt:
Marketable:
Treasury InflationProtected Securities
Federal Financing Bank
Total Marketable
GAO Baseline
Revenues as a share of GDP increase and
discretionary spending as a share of GDP
decreases
GAO Baseline
GAO Alternative Scenario
Revenue and Discretionary Spending are at
historical averages over long term.
Soc Sec, Medicare, Medicaid and interest
exceed revenue by 2030
GAO Alternative Scenario
Fiscal Gap or
Current Value of Future Primary Deficits
The sum of the present values of the
difference, or gap, between revenue and
noninterest spending over the next 75 years.
Assumes the goal of having today’s debt to
GDP ratio at the end of the period
Cost of Closing the Gap
Federal Fiscal Gap under GAO’s Simulations Based upon Trustees
Assumptions, 2011-2085
Average % change required to close gap
If action is taken today
If action is taken in 2021
% of
GDP
Solely
through
increase in
revenue
Solely through
Solely
decreases in
through
noninterest
increases in
spending
revenue
Solely
through
decreases in
noninterest
spending
Baseline
1.8
8.4
8.0
9.9
9.4
Alternative
8.2
45.7
32.2
54.3
37.0
www.gao.gov The Federal Government's Long-Term Fiscal Outlook January 2012
The World in 2050
The G7 vs the E7 (Brazil, Russia, India, China,
Indonesia, Mexico and Turkey)
Emerging Middle Class in Developing Economies
2005 G7 is currently about 20% larger in
Purchasing power parity (PPP) and 75% larger in
terms of market exchange rates (MER)
E7 will be 75% larger than G7 in PPP and 25%
larger in terms of the (MER)
The World in 2050, Price Waterhouse Coopers, March 2006