Business, Government, and the
World Economy
Introduction
Economic Quiz
What is the current unemployment rate?
How many people are currently unemployed?
What is the size of US nominal GDP?
What was the rate of growth of US 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
What is 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 2011
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
1st Quarter 2010
Gross Domestic Product
$14,597.7 Billion
Real Gross Domestic Product $13,216.5 Billion
Percentage change from previous quarter
(annual rate)
2010 Qtr 2
2.4%
2010 Qtr 1
3.7%
2009 Qtr 1 5%
Contributors to GDP
1st qtr 2010
Positive
Consumption 1.15%
Business Investment 3.14%
Negative
Net Exports -2.78%
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.
Capacity Utilization vs. GDP
1967-2007
0.2
0.15
0.1
0.05
0
-0.05
-0.1
-0.15
-0.2
CU
GDP
The Current State of the Economy
The lingering effect of the financial crisis
Causes of the crisis
The Great Recession
Current conditions - slowdown or double dip?
European Debt
US deficit debate
US housing market
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
Products
How Financial Markets Enabled Underwriting
Policy
“Keeping up with the Joneses” Markets
New Products
Poor Underwriting
Public Policies Unintended Consequences
Low Rates and International Capital Flows
Mortgage Market
Developments
Products
Underwriting
Policy
Markets
Securitization and new participants
Graham Leach Bliley Financial Modernization Act
of 1999
Increased Use of Mortgage Brokers
2000 Commodity Futures Modernization Act
Increased Access to Credit
Subprime, Alt A, Option ARMs
Products
Underwriting
Securitization
Policy
Markets
Loan Bank A Loan Bank B
Loan Bank Z
Financial Intermediary
Buys Loans, Forms a “Pool”
and Issues MBS
Insurance Firm, Banks, Pension Funds etc.
Buy MBS – Cash Flows “Guaranteed” by Original Mortgages
Average Size of
Subprime Loans
Products
Underwriting
Policy
Markets
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
Products
Underwriting
Policy
Markets
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
Structure of Subprime
Loans Originated each year
Products
Underwriting
Policy
Markets
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
Products
Underwriting
"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007
Policy
Markets
Products
Fannie Mae’s
Guarantee of Alt A Loans
Underwriting
Policy
Markets
$ 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"
Products
Blaming Fannie and Freddie?
Underwriting
Policy
Markets
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
Products
International Capital Flows
Underwriting
Policy
Markets
Consumer Spending On Exports
Increased Foreign Holdings of $
Increased Inflow of Dollars
Helps Keep Long Term Rates Low
“The Perfect Storm”
2004 - 2007
Products
Underwriting
Policy
Markets
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
Home Sales and Home Prices
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
Consumer Credit Outstanding
Compared to Past Recessions
Impact of the Crisis
Increase in Precautionary Saving
Lost Wealth from Equity Declines
High Unemployment
Consumer Confidence hits Record Lows
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
30
% of Respondents
25
20
15
10
5
0
1993
1995
1997
1999
Very Confident
2001
2003
2005
Not at all Confident
2007
2009
“The Pressure I feel to buy more and better material
possessions is greater than ever” Metlife
Disagree
Agree
Gen
66%
Y
Gen
X
47%
53%
53%
47%
29%
Baby
Boom
Silent
34%
71%
39%
18%
61%
75%
10%
90%
All
46%
26%
54%
74%
09
06
09
06
09
06
09
82%
25%
06
06
09
Buyers Remorse
51%
I have no
regrets
about the
major
purchases
that I have
made over
the past
few years
54%
Gen Y
Gen X
66%
Boomers
79%
62%
49%
46%
34%
Silents
All
21%
38%
I regret
making
major
purchases
and wish I
would have
saved more
over the
past few
years
The Crystal Ball – The Big Picture
How will Consumers Respond?
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
The Current State of the Economy
Slowdown or Double Dip?
Federal Reserve Policy
Fiscal Policy
Global Headwinds
Some Troubling Signs
Manufacturing
Consumer Spending / Confidence
Housing
Unemployment
Employment: Non Farm Payrolls
Employment: Non Farm Payrolls
Consumer Credit Outstanding
Consumer Credit Outstanding