Lecture 4 - Saving, Investment and Trade Balance in an Open Economy

Output in an Open Economy
Recall the national economy equation in an open economy (including net exports):
Y = C+I+G+NX

Derivation
Y (output) = total expenditure on domestic goods and services
= C^d + I^d + G ^d + Exports
where d denotes domestic consumption, investment or gov't purchases

= C-C^f+ I - I^f + G - G^f + EX
=C + I + G + EX - (C^f+I^f+G^f)
that last term is all the imports
= C + I + G + EX - IM
= C + I + G + NX

NX = EX-IM = net exports = trade balance

NX = Y - C - I - G
NX > 0 indicates a trade surplus
NX < 0 indicates a trade deficit
NX = 0 balanced trade

(ii) Y-C-G-I=NX
(Y-T-C) + (T-G) - I = NX
S^p + S^g - I = NX
S - I = NX

We run a trade surplus if NX > 0, which means S > I
We run a trade deficit if NX < 0, which means S < I

Savings, Investment and Trade Balance

S - I = Net foreign lending
= amount of money we lend abroad - amount of money foreigners lend to us
NX = Net exports = Trade balance
Thus, S-I=NX implies that international flow of capital and international flow of goods & services are two sides of the same coin

Trade deficit: NX < 0
Import more than export
Someone needs to pay for the gap
Pay by borrowing form abroad (S-I < 0)

When running a trade deficit, we finance the deficit by borrowing the equivalent amount from abroad, and vice versa.

The borrowing can take many different forms: straight loans, gov't bonds, corporate bonds, etc. There was a brief discussion of foreign investment limits, particularly real estate and the Chicago Skyway leased to Macquarie.

Twin Deficits
(see Mankiw page 129)

Gov't deficit and trade deficit.
Mechanism:
Consider the savings-investment (S-I) model in a small open economy, under free capital mobility.

(i) Ybar = AxF(Kbar, Lbar)
(ii) S - I(r) = NX (investment is a fxn of the interest rate)
(iii) r = r^world
since we're assuming it is a small open economy the domestic interest rate (and banana prices) will be dictated by the world interest rate (and worldwide price of bananas).

If the equilibrium interest rate is the same as the world interest rate, there will be a trade balance. If the world interest rate is higher, there will be a trade surplus (NX>0). If the world interest rate is lower, there will be a trade deficit (NX<0).

Model:
(see packet page 15)
Assume that initially the economy is at equilibrium and that the govt has a balanced budget. Then assume that the govt pursues fiscal expansion (G up or T down). Then the saving (S) curve will shift to the left. But the interest rate can't go up since it's dictated by the world interest rate!
This will create a gap between domestic savings and investment. We will end up with NX < 0 - a trade deficit!

Data:
(see packet page 17)
In the 60s and 70s, we had mostly a trade surplus, and the federal budget deficit was kept to 3% or less. In the mid 80s, the trade deficit jumped up to 2-3%. At the same time, it was matched by an increase in the federal budget deficit of about 2-3%. Decline in budget deficit in the late 80s was matched by a decline in the trade deficit.

But in the late 90s when Clinton cut the federal deficit and actually created a surplus, it was not matched by a similar movement of the trade deficit. Rather, the trade deficit continued to increase.

Explanation of the model break down
Why did the twin deficit mechanism break down in the 1990s? Because the model assumes "other things being equal". Private savings, private investment were factors.
(i) the twin deficit mechanism tells us that if S^g goes up (govt budget deficit reduction), then S overall increases and NX increases. But that didn't happen!
(ii) Instead, S^p went way down, i.e. household savings plummeted. I (investment) increased due to the IT investment boom. As a result, S overall went down, I increased. Therefore, S-I=NX went down and we saw increasing trade deficits.

Why did private savings go down? Because of the stock market boom and low interest rates.

(See Whatever Happened to the "Twin Deficits" - Chapter 2 of Is the US Trade Deficit Sustainable by Catherine L Mann)

Balance of Payments System (BOP)

The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time.

BOP consists of subaccounts:
current account: accounts for flows of goods and services (imports and exports) sometimes called "above the line items"
capital account: accounts for flows of financial assets (financial capital)

(See BEA, Survey of Current Business, March 2008 data for 2007)

Current Account
2007 US trade deficit was -708 billion. Current account deficit was -738 billion.
Current account deficit = Trade balance+Net Foreign Receipts+Unilateral current transfers (international charity)

In the US, current account and trade deficit are used interchangeably. But in some countries like Czech Republic and Ireland (the "Celtic Tiger"), they have a trade surplus, but because of the Net Foreign Receipts they end up with a current account deficit.

Capital Account

Increase in US holdings of foreign assets = 1206 B
Increase in Foreign holdings of US assets = 1863 B
Net = 657 B

There's a 81B$ statistical discrepancy between the current account balance and the capital account balance. This is due to various different measurement errors that go into these enormous calculations which are really estimates, not exact accountings. It may also be explained by the underground economy. The statistical discrepancy is growing from year to year.

Exchange Rates

When the capital account measures the foreign holdings of US assets, the transactions are in dollars. Fine. US holdings in foreign assets, the transactions are in foreign currencies and must be converted to dollars using the exchange rates. Dollar depreciation impacts this accounting. There is a question as to how long the foreign investors will continue to finance our trade deficit with their investments since they often lose money on the transactions due to the falling dollar.

Consumption and the Balance of Trade

Trade deficits could be worrisome, if C is the main cause.

(i) In a closed economy, if C goes up, S goes down. Since S=I, I goes down, leading to K (capital stock) going down, which will cause C to go down in the future.

(ii) In an open economy, if C goes up, S goes down. Since S-I=NX, NX will go down. Then we will pile up foreign liabilities which will need to be paid back eventually.

Australia and Canada have run a big trade deficit for many years and financed it through foreign investment (not loans). In other countries, like Argentina, the investors have panicked and pulled out. 8% of GDP for a trade deficit is the threshold beyond which investors consider it a big risk to continue investing.

Researching Social Security

Now that you've seen how to use the Depaul Online Research Library in the previous post, I'll show you how to use it to research a particular topic, Social Security. (I chose this example because my group's project has to do with Social Security.)

Finding and Using the CCH Human Resources Database
One of the best resources for information on Social Security is the CCH Social Security Reporter. (Full Disclosure: I work for Wolters Kluwer, the parent company of CCH.)

1. Bring up the main DePaul web site by browsing to http://www.depaul.edu.
2. At the top of the page, click on the "Libraries" link.
3. On the Libraries page, in the Research section (top left), click A-Z library list.
4. Scroll down to library 43 - CCH Human Resources. Click the link. You will be prompted to log in with your Depaul student ID and password and then be forwarded to the CCH HR Library. Since CCH doesn't get your Depaul ID info, they will prompt you for an email address so they can identify you the next time you visit and maintain your site preferences if you set any.
5. On the CCH HR Library page (the CCH Internet Research Network), select the Payroll tab and then scroll down to the Social Security Reporter section.
6. The Social Security Reporter has over 14000 cases in the case table. The Benefits Explained section has a paper on Financing Social Security. The Benefits Explained subsection within the Benefits Explained section has a section on Retirement and Survivor Benefits which has details on the Old-Age Insurance Benefit, which is what I think most people think of when they think of Social Security benefits.

How to Use the Depaul Online Library for Research

span style="font-weight: bold;">DePaul Online Research Library
One of the really nice perks that we have as students at DePaul is the online research library. The library subscribes to many databases of academic journals and magazines which are searchable. Many of these databases allow you to access and download full text versions of the journal articles, usually available in PDF format. To access the online research library, all you need is your Depaul student ID.

Here's how to access the DePaul online research library:
1. Bring up the main DePaul web site by browsing to http://www.depaul.edu.
2. At the top of the page, click on the "Libraries" link.

3. This will bring you to the Library page. There are lots of links to follow here. Focus on the "Research" section. The way this works is that you need to identify the database in which you want to conduct your search. Once you do that, you can use the database's internal search function to find your article. So, how do you find a database? There are a couple ways:

Method 1:
Use this method if you're just starting out and don't know which database or journal you're going to search
4. Click the "Journals and newspaper articles" link. That will bring you to the subject page.
5. Since we're studying statistics, a good choice for subject would be Mathematical Sciences. Click that link.
6. You get the database list. For mathematical sciences, we subscribe to 7 databases. The database list gives you a short description of the database and the dates covered by the database. Some of the databases indicate whether we subscribe to full text of articles with a FT icon:

7. Choose your database and click on its link. You'll be prompted for your DePaul username and password. Enter those and click Login.

Method 2:
Use this method if you know the database you want to search
4. In the Research section of the Library page you can click on the A-Z Database List to see all the databases. If you already know the database that you want to search, you can skip by the "subject" steps 4-5 above in method 1 by just using the A-Z list.

Method 3:
Use this method if you know the name of the journal that you want to search
4. Click the "Journals and newspaper articles" link.
5. On the left hand margin, enter the name of the journal and click Search.
6. The results page will show you which databases contain that journal and for which years

Each database has its own interface and it would be impossible for me to cover all of them, but most of them are self explanatory and user-friendly. You can usually search by author, article title or keyword. Several databases also allow you to browse the issues of the journals in the database.

How to Write a Group Paper

Writing a paper as a group can be a difficult task. Here's the process that we're using to write our group paper. You may find this helpful in managing your own group project. If you have any suggestions or recommendations, feel free to comment or send an email.

1. Form a good group. Look for people who are at the top of their game intellectually and seem interested in the class. The gal in the front row with her hand up all the time is a a better choice than the slouching guy in the back of the room who's nodding off during the lecture.

2. Pick an interesting topic. At least one person in the group should have some significant passion behind your topic. It would be best to have at least one person who works in that industry. So, if you're going to write about the Fed, try to find someone who works there! Even if he's not directly or even indirectly involved with setting interest rates, chances are good that he can get some good information from the people he works with.

3. Narrow the topic to something very specific. Getting as specific as you can will help you focus your efforts. Of course, don't get so specific that you're unable to find material on the subject. Choosing something timely and popular will make material easier to find.

4. Write an outline with the entire group. You're gonna need your standard introduction, body and conclusion, of course. Break out the body into 3-5 sections. Most topics will have a history section where you review the history of the issue at hand. Then you might review different views of experts on the current issue. Lastly, you'll probably want to assess each of those views in your own opinion. Draw some conclusions and set it up for your concluding section.

5. Assign the sections of the outline to the members of your team. If anyone has a preference, try to honor it. It's always better to have someone writing on something that they feel comfortable with and that they're interested in. Each person should have ownership and responsibility for their section. That said, everyone should be willing to help out with any section, as needed.

6. Pick a collaboration tool. I prefer GoogleDocs. There's also Microsoft Office Live. You could also use any web-based tool/site that allows you to upload and share a document. You want to be able to share a common document so there's visibility into the progress of the entire progress. You don't want to find out that one section isn't progressing at the last minute. In addition, you'll be easily able to help each other out with content and form as well as double-checking spelling and grammar.

7. Gather source materials and cut/paste them (or links to them) into the project doc at the bottom. This should take at least a week. Don't worry about writing anything during this time. Just gather information.

8. Refine the outline and cull the information that you've gathered. You probably won't use all of the information that you gathered. Despite how interesting some material may be, resist the temptation of including it unless it fits clearly into your topic and the outline.

9. Each member should begin writing a draft of his/her section. Go through a write/review/refine feedback loop until you get the draft to a point that it looks polished.

10. The group should meet at least once a week to review the progress of each section. Even if you have good email communication and you're using a collaborative tool to work on the paper, it's best to have a face-to-face discussion where everyone is together, you review progress, talk about any issues/problems that you're having and assign actions to team members to resolve the problems.

11. Polish it, finalize it and turn it in!

Good luck!

Lecture 3 - National Income

Terminology

Y = A x F(K,L)

Y: Output, real GDP
A: Technology
K: Capital
L: Labor

By nature of the definition of GDP, Y (output) = total income = labor income + capital income

Labor income is salaries, benefits, etc given as compensation to laborers.
Capital income is corporate profits and rental income. Also includes depreciation. Shouldn't this be subtracted from capital income??

Labor income share is the percent of Y that is labor income = total labor income/Y = 0.7
Capital income share is 0.3.

Paul Douglas found that the labor income share is very consistent at 0.7.

If Z=X/Y, how does the growth rate of one of the factor, X or Y, impact the growth rate of the ratio, Z? The answer is: %ΔZ = %ΔX - %ΔY

Let total labor income = (W/p) L, where (W/p) is real wage (i.e. wage/price index) and L is the # of workers.

Let labor productivity = Y/L; i.e. output per worker

Then labor income share = [(W/p)L]/Y = (W/p)/(Y/L) = 0.7

Since Douglas observed that this ratio doesn't change,
%δlabor income share = 0 = %Δ(W/p) - %Δ(Y/L)
and therefore,
%Δ(W/p) = %Δ(Y/L)

Income inequality. Look at the labor market.

You can increase production by adding labor, adding machinery or adding factories. When adding labor, you need to look at the marginal productivity curve.

MP_L = marginal productivity of labor = ΔY / ΔL
All things being equal, how much additional output with be produced by adding one more worker.

Examples: Adding more and more computers eventually gives you less and less benefit per computer added. Adding workers at a crowded ice cream shop eventually cuts down the line to a point where adding additional workers does not provide any faster service.

If you hire one more worker, the benefit to the owner is more cheese. By how much? By MP_L. In terms of $, this is MP_L x P, where P is the unit price of the product. This is the marginal revenue product.

Labor Demand Curve

Why is there wage inequality between skilled and unskilled labor workers?
Supply-side factor explanation. There are two different markets. There were a large number of unskilled immigrants, women and teenagers who entered the US job market in the 1970s. The rightward shift in the labor supply curve of unskilled workers was much greater than the shift in the labor supply curve of skilled workers.

The rightward shift for skilled laborers should have caused their real wages to go down. Why didn't we see that?

For that, we need to look at the demand-side factor explanation. Technological advances favor the skilled workers more than it did the unskilled workers. This skill-biased technological progress raised the real wages of skilled workers to increase and those of unskilled workers to decrease.

Some argue that the international trade has caused the income inequality. At the same time, US companies relocated outside the US, causing loss of jobs. The bargaining power of companies increased and they were able to keep the wages in the US low.

Observation: Even those companies that were not effected by international trade have experienced depressed wages for unskilled labors. This indicates that although int'l trade may be a factor, it is not the primary factor. Remember also that int'l trade is only 30% of US GDP. Skill-based technological progress is a more important factor.

Refer to table (5) Widening Wage Inequality in the US by Autor, Katz and Kearney. Their study found that nearly 2/3 of the relative increase in demand for college or more educated workers can be explained by rising workplace computer use.

Readings

Full class on April 30. Half class on June 4th.

The richest 1% of the population has dramatically increased. Bill Gates, David Beckham. There's a huge gap between #1 and #2.

Who benefitted from the Black Death? Common workers.

Technology replaced routine jobs, but it created many many other jobs.

We find rising income inequality even in developing nations.

When Bush came into office, he imposed a 30% tariff on steel. It saved 5000 US jobs. What was the cost to the whole economy? According to some, the increase cost 50,000 jobs in other areas.

National Income: Expenditure Side

How can we possibly finance the trade deficit? How do tax cuts work?

Saving-Investment model (closed economy)

Y = C + I + G (no NX factor because it's a closed economy)

Consumption: C = C((Y-T), (Y-T)f,wealth, r)

where
Y-T = disposable income = income-taxes = C+Sp (private savings)

naturally, if you increase disposable income, consumption will increase

MP_c = marginal propensity to consume = ΔC/Δ(Y-T)
i.e. if you have one more dollar in your pocket, how much more will you spend?
0 < MP_c < 1

This is almost a linear relationship and the slope is about 0.96.

Consumption is affected by future expected income. That's the (Y-T)f factor.

One-time tax rebates (like the recent one) are more comparable to a bonus than a salary increase. We don't expect a large increase in consumption based on this one-time event.

The Wealth factor is accumulated savings. There was a strong correlation between the housing boom and consumption.

Real Interest Rate, r = i - π
where i = nominal interest rate and π = inflation
This is known as the Fisher equation and is based on an arbitrage argument.

When the real interest rate goes up, the real cost of borrowing goes up, which reduces consumption. And vice-versa. Ex: When mortgage interest rates went down, people had more money in their pockets and consumption increased.

Investment

I = I (r, Y, Yf, tax policy)
Factor correlations: -, +, +, ?

Example:
r = 10%
rate of return = 8%
don't invest!

But if rate of return > r, then companies will invest. Therefore, when interest rates are low, there are more profitable opportunities.

When output level, Y, is high, it's a good time to invest.

Tax policy can impact investment in either direction.

Total Savings-Investment Model:

Y = C+I+G
C = C(Y-T)
I = I(r)
Therefore Y-C-G = I
(Y-T-C)+(T-G) = I
private savings Sp + govt savings Sg (approximate) = I

call it national savings, S. S=I

Asumme full employment and level of output
Ybar = AxF(Kbar, Lbar)

S = Sp+Sg
S = Ybar - Tbar - C(Ybar-Tbar) + (Tbar-Gbar)

Everything is constant so S is constant (verticle).

S can be viewed as the supply of loanable funds and I is the demand for loanable funds. The equilibrium interest rate is where the two curves meet.

Lecture 3 - Foreign Exchange Rates

Continued from lecture 2

Nominal exchange rate (symbolized by e) is the relative exchange rate of two currencies. You need to make sure which one you're using as numerator and which is denominator.

By convention, we always put the US$ in the denominator.

Euro/$ = 0.74 in April 2007; but in April 2008, it's 0.63 Euro/$! This drop indicates that dollar has become "cheaper" (or weaker) relative to the Euro, and euros have become more expensive relative to the US$. We call this US$ depreciation against Euros. Euros have appreciated against the US$.

Some currencies have actually depreciated against the US$, but they're hard to find.

At home, confirm that depreciated dollar makes Japanese exports in the US more expensive (in dollars).

Other things being equal - ceteris paribus. Ignores the chain reactions in the economy.

Robert Rubin, Larry Sommers - "Strong dollar is in the interest of the US." But, why?

The Economic Week in Review

Just a few observations and links

John McCain laid out his economic plan.
Obama's plan to strengthen the economy is on his web page.
Hillary Clinton's web page on strengthening the middle class links to several of her plans. Her policy director, Neera Tanden, issued a statement in response to the McCain plan.

The World Bank warned of the severe effects of rising food prices around the world. It makes you stop and appreciate all you have when you realize that 100 million people are worried about where their next meal may come from. I was happy to hear that President Bush ordered $200 million in emergency aid to alleviate the food shortages in Africa and other parts of the world.

Lecture 2 - The Data of Macroeconomics

THE DATA OF MACROECONOMICS

This lecture was highly correlated with the material in Mankiw Chapter 2. See my reading notes on that chapter.

Gross Domestic Product (GDP)

Measure of total production. We also use the GDP as a yardstick against which to measure other indicators.

Only final products are included. Not intermediary products. This prevents double counting. Alternatively, GDP could be calculated by summing all the "value added" amounts. Value-added = value of output - value of intermediary goods.

Determining what is a final product and what is an intermediate good is tricky. An intermediate good is complete used up in producing something else. See Intermediate Consumption in Wikipedia.

Only goods and services that have a market value are included in GDP. Except housing services and govt services. Those are included in GDP. For those, GDP adds an imputed value.

Only new products are included. Not used. That's merely exchange of ownership. However, services provided by car dealerships or other agents to facilitate the sale of used items is included in GDP.

Only domestic products are included in GDP.

Income, Expenditure and Circular Flow

Advanced, preliminary and then revised data is published (by BEA). This is because there are three ways to calculate GDP which are crosschecked against each other.

In the model of a simplified single-item economy, output must equal expenditures.

The components of GDP are:
Private Consumption (C): In US this is 72%. China it's 38%. In Europe it's 50-60%.
Private Investment (I): Not the commonly used term. It means acquisition of physical capital stock like buildings, plants, factories, machinery.
Government Purchases of Goods and Services (G): Deficit means govt spending > tax revenues. The total govt spending includes more than G. It also includes transfer payments like Social Security. It's just redistribution, so it's not included in GDP.
Net Exports (NX): Exports-imports. This takes out the foreign products that were included in C, I, and G.

Imports and Exports (trade volume) are only 30% total of GDP. This contradicts those economists who say that job losses are caused by foreign competition.

Nominal vs Real GDP

Nominal is at current prices. But it can change based on either output or price change.

Question: How do they account for different prices charged by different firms for the same product. Answer: It could be calculated precisely with enough data, but practically speaking it's estimated and crosschecked. Precision is not required because we're just using it to compare to our own other GDP estimates from year to year. See the Methodologies page at BEA for more info.

Real GDP applies constant prices to all years' quantities to get a comparable GDP. For new products, use the current price even for Real GDP.

Chain-weighted method: uses a geometric average to calculate the weighted average for prices. See the article from Miles Cahill of Indiana University on Teaching Chain-Weight Real GDP Measures for a good explanation.

GDP Deflator = Nominal GDP / Real GDP

GDP Deflator is a measure of inflation, but it includes many items that the average consumer doesn't buy.

Consumer Price Index (CPI)

Therefore, the CPI was created to only look at a "basket" of goods purchased by an average consumer.

Inflation Rate

Inflation rate = (CPI_current - CPI_previous)/CPI_previous

(multiply by 100 to get a percentage)

CPI vs GDP Deflator

GDP deflator includes more g&s than CPI.
CPI includes imports, GDP deflator doesn't.
CPI basket is fixed, GDP deflator varies.

CPI tends to overstate inflation. GDP deflator tends to understate it.
Why?
In reality, consumers change their buying habits based on prices. Their basket varies.

In 1973 and 1978 the CPIrose more sharply than the GDP Deflator due to oil price shock.

Fed looks more at the "core" CPI = CPI-food-energy. For policymaking, they want to look at fundamental items and not at the more volatile items like food and energy.

Social Security benefits are also linked to the CPI.

CPI biases:
Substitution bias (mentioned above)
New products
Change in quality
Outlet mall bias (real consumers may purchase products cheaper from outlet malls)

Research indicated that CPI overstatement is about 1% and recommended that Soc Security be adjusted by CPI-1%. But the recommendation was not implemented.

Many nations target 2% inflation rate. It's because of these biases. If we got anything less than 2%, it might actually be deflation.

Unemployment Rate

Current Population Survey of 60,000 households, monthly. Ages 15-65.

3 categories: Employed, Unemployed, Not in Labor Force

Discouraged workers - They wanted a job, but weren't able to find one and have stopped looking. If they would find a job, they would take it. They're categorized as Not in the Labor Force.

You need to consider these discouraged workers and how they move from one category to another when evaluating the unemployment numbers. When economic conditions improve, discouraged workers often move to the unemployed category, leading to a higher inflation rate.

Military is considered employed.

Okun's Law

Unemployed workers don't contribute to production. Therefore there should be a negative correlation between unemployment and GDP.

Normal GDP growth is 3.3%. For every 1% of increase in the unemployment rate, the real GDP growth falls by 1.86 percentage points.

Reading for next week: Chapter 3.

Lecture 2 - End of Overview of US Economy

Business cycles

We'll talk about these in the last 3 weeks of the course.

Create a model to explain boom and bust cycles. What can gov'ts do to smooth out the cycles? And are those actions effective. What can we learn from history - great depression, japan? What is similar, what is different? We don't have a lot of experience dealing with situations of deflation.

Fiscal policy vs. monetary policy - we will discuss later.

Ben Bernanke is much quicker to respond with fiscal policy changes. He learned a lesson from the Japanese who responded with "too little, too late".

In the modern period, cycles are much more moderate. Benign business cycles. Investors have become complacent.

Inflation and unemployment typically move in opposite direction of the business cycle.

Recently, the typical recession typically lasts less than one year. This makes it difficult for monetary policy makers because their policy changes don't have an effect for about a year. Therefore, they need to be predictive in their policies, which of course is very difficult to do.

There's a narrow time window to react and a long time lapse before policy changes have and effect.

New, more direct approaches are being tried now - not just cutting interest rates. Direct borrowing from the Fed. 28 days instead of overnight.

Lessons from 18 past banking crises
We'll talk about these at the end of the course

5 big crises and 13 more benign crises, including the 1984 Savings and Loan crisis in the US.

The 1984 S&L crisis was caused, in part, by high inflation rates because no one would deposit in the S&L unless they got interest higher than inflation. But long-term mortgage loans had already been written at relatively low rates.

Each crisis is different, but they tend to take similar paths.

What will happen with this current crisis? We seem to be following the path of a minor crisis.

Closing Remarks on the US Economy

This recession may be more serious than the 2001 stock market bubble burst because of multiple bad things happening simultaneously: housing, banks, inflation

We can learn from the Japanese experience and not make the same mistakes. If we're successful, we can avoid a prolonged slump.

Fed can't keep cutting interest rate. It would cause inflation and devaluing of the dollar.

If house prices fall much further, the Fed may not be in a position to help to stabilize losses.

Reading Notes - Chapter 2

The reading assignment for lecture 2 was chapter 2 of Mankiw. The chapter focuses on 3 economic indicators:

Gross Domestic Product (GDP) - reported by the Bureau of Economic Analysis (BEA)
Consumer Price Index (CPI) - reported by the Bureau of Labor Statistics (BLS)
Unemployment Rate - also reported by the BLS

Gross Domestic Product (GDP)

The GDP is the total income of everyone in the economy or, equivalently, the total expenditure on the economy's output of goods and services. For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in the economy.

There are two types of quantities: stocks and flows. A stock is a quantity measured at a given point in time (e.g. amount of water in a bathtub). A flow is a quantity measured per unit time (e.g. amount of water coming out of a faucet).

More precisely, the GDP is the market value of all final goods and services produced within an economy in a given period of time.

Parse that definition:
Market value - to calculate the GDP, don't count the number of apples or oranges produced. Rather, calculate their market value according to the price of each and compute the sum.
Produced - the sale of used goods is not included in the GDP.
Final Goods and Services - the sale of intermediate goods is not included in the GDP; only final goods.
Produced - Even if not sold. If the product goes into inventory, it is still considered as part of the GDP. When goods are sold from inventory, the sale is added to the GDP, but the reduction in inventory is subtracted.
Produced - The GDP includes some "imputations". These are approximations include services which are not sold on the regular market place. These include housing "services" to homeowners, government services such as police and fire departments. No imputation is made for services for the use of goods other than housing. No imputation is made for household goods and services such as home-made meals. No imputation is made for the underground economy.

Nominal vs Real GDP

The GDP measured at current prices is called nominal GDP. The GDP adjusted for inflation is called the real GDP. In computing Real GDP, a base-year for prices is usually chosen and indicated when reporting.

The Nominal GDP divided by the Real GDP is called the GDP Deflator.

A better way to calculate Real GDP is with a chain-weighted measure. To measure real growth from year X to year X+1, the average prices for those two years are used.
Components of GDP

The four basic components of the GDP are:
Consumption - nondurable goods, durable goods, services
Investment - business fixed investment, residential fixed investment, inventories
Government Purchases - Federal military, Federal non-military, state and local (but not transfer payments like Social Security and welfare)
Net Exports - exports minus imports

GDP is often reported on a per capita basis.

Other Measures

Gross National Product
GNP = GDP + Factor Payments from Abroad - Factor Payments to Abroad

A factor payment from abroad is a payment from someone outside of the economy to someone within the economy. For example, if a US citizen owns a building in London and collects rent on it, those payments are factor payments from abroad. And similarly for factor payments to abroad.

Net National Product
NNP = GNP - Depreciation

(Net) National Income
NNI = NNP - Indirect Business Taxes

Personal Income
Personal Income = National Income
- Corporate Profits
- Social Insurance Contributions
- Net Interest
+ Dividends
+ Government Transfers to Individuals
+ Personal Interest Income

Disposable Personal Income
DPI = Personal Income - Personal Tax - NonTax Gov't Payments

GDP and other economic indicators are usually seasonally adjusted to eliminate the fluctuations due to predictable seasonal changes.

Consumer Price Index (CPI)

Inflation is the increase in the overall level of prices and is measured by the Consumer Price Index (CPI). The CPI is calculated by the "basket of goods and services purchased by a typical consumer" model. Chicken has a higher weight than caviar since people buy more chicken than they do caviar.

There's also a PPI - Producer Price Index - which measures the price of the basket of goods and services purchases by a typical firm.

CPI vs. GDP Deflator

GDP Deflator has all types of goods and services. CPI only has consumer goods and services.
GDP Deflator only has domestic goods and services. CPI has domestic and imported goods and services.
The GDP Deflator "basket" changes as the GDP changes. It's a Paasche index. The CPI "basket" is fixed. It's a Laspeyres index.

A Fisher index is an index that takes the average of a Paasche index and a Laspeyres index.

Problems with the CPI

Many economists believe that the CPI overstates inflation. Some of the problems are:

1. Substitution bias. Consumers may shift and their buying habits based on prices. The fixed basket of the CPI does not take this into account.
2. New goods don't come into the CPI quickly.
3. The quality of the goods is not measured by the CPI.

A 1995 congressional panel concluded that the CPI overstates inflation by 0.8 - 1.6 percent.

Unemployment Rate

The unemployment rate is calculated based on two surveys: The Household Survey and the Establishment Survey.

The Household Survey surveys 60,000 households and gathers responses on the number of people in each household who are employed (anyone with a job), unemployed (anyone without a job but looking for one) and "not in the labor force" (anyone without a job and not looking - students, retirees, homemakers).

Labor Force = Employed + Unemployed

Unemployment Rate = Unemployed/Labor Force

Labor-Force Participation Rate = Labor Force / Total Adult Population

The Establishment Survey comes from the responses of 160,000 businesses about their payroll numbers.

Greenspan's Policies Questioned

Finding a Scapegoat

Now that Ben Bernanke has told us that a recession is imminent, this week's hot economy topic is finding a scapegoat. The most likely candidate: Alan Greenspan. Did Greenspan, who was praised at the time for growing the US economy during the 1990s, get us into this mess?

Former Fed chairman Alan Greenspan's policies were questioned in a front page WSJ article yesterday. Mr. Greenspan responded in an interview and strongly defended his actioins as head of the Fed.

The primary criticisms were:

• The Fed lowered interest rates in 2001-2003 and kept those rates low for too long. This encouraged mortgage borrowing, leading to escalating housing prices and eventually to the housing market collapse. This criticism was mentioned by Prof Woo in last week's lecture.
• The Fed was not aggressive enough in regulating banks and their mortgage lending practices, specifically subprime lending, and their subsequent risk exposure.

One comment (by the writer of the article) that I found particularly interesting was the Greenspan "has long maintained that bubbles are an unavoidable feature of a dynamic economy."

For more criticism of Greenspan, you may want to read Greenspan's Fraud: How Two Decades of His Policies Have Undermined the Global Economy by Ravi Batra.

I'd be interested in finding a more positive (or at least balanced) retrospective view of Greenspan's policies... if one exists!

On the WSJ blog entry related to this article, there's an informal, unscientific survey that asks the question: How has your opinion of Alan Greenspan changed since he left the Fed? Ask of this writing, the results have been:
3% It has risen
45% It has fallen
27% It has remained low
21% It has remained high
4% Something else

It doesn't surprise me that the results of a survey embedded within a negative article about Greenspan and his policies would be skewed in this way.

See Greenspan's article in the Financial Times (April 6, 2008) entitled The Fed is Blameless on the Property Bubble. See also his article (March 16, 2008) We Will Never Have a Perfect Model of Risk.

Lecture 1 - Overview of US and World Economies

My notes from Lecture 1 are below. They're still in pretty raw form - as I took them during class. I brushed them up a bit and added some links that you may find helpful or interesting reading.

The lecture was (to me) a fast-paced overview of lots of economic topics. It sounds like we're going to go into more depth on each of them in future lectures.

The US Economy

US GDP growth rate has historically hovered around 3-4%. Lower than 3% generally indicates that economy is shrinking and slowing down. Over the past 3 years, GDP growth has been 3.1, 2.9 and 2.2%. Anticipated growth in 2008 is expected to be in the 1.3-2% range.

CPI inflation has also been lessening over the last 3 years. Unemployment (4.8% last month) is lower than historical average. Some ppl question whether there's a recession or not due to this.

The US govt is currently running a federal budget deficit of 3% (of GDP).

US Current account balance = trade deficit = about -6% of GDP (double the govt deficit) = about $800 billion! This is about 2/3 of combined trade deficits of all other countries. $$ are needed from foreigners to balance this deficit. Borrowing from foreigners finances the trade deficit.

In Euro Area: Real GDP growth is about 2% constant.

China: real GDP growth is 10%! By the rule of 70, this means that their GDP doubles in size every 7 years! If you do the math, the Chinese GDP will be equal to that of the US in about 2036. We can't ignore these developing nations. They have an 11% trade surplus. 2008 inflation rate is 8.7%!

US Economy - Background

When IT investment collapsed in 2000, the Fed lowered interest rates, but Greenspan kept the interest rates too low for too long. Policies caused rapid economic recovery. Increased consumption caused a huge trade deficit to develop. 6% was never heard of in the past. It was historically more like 3%. More recently, housing bubble burst, subprime loan losses and credit crisis caused economic activity to slow down because banks didn't have money to lend.

GDP growth rate per capita is relatively stable for US and W European nations. 1950-1973 saw tremendous growth as European countries rebuilt and rebounded from WWII.

Labor Productivity

How has the US economy been doing for the last 15 yrs? Living standard depends on the labor productivity. Labor productivity jumped to 2.5% (from 1.3%) beginning in 1995. Many economists called this a miracle! It was closely related to the technology revolution. Lately (since 2006), productivity growth is slowing down to 1-1.6%. The higher rate couldn't last forever.

Question: How is productivity measured?

When productivity is high, inflation tends to be low. Prof Woo will make a case for the mechanism in week 5 or 6.

Mankiw questioned how much we owe to Greenspan and how much was his luck. His answer (in an article) is that Greenspan was very fortunate and less prophetic.

Income Inequality

Bottom 99% have not gained much, while the top 1% have grown substantially. What is the cause? Which arguments have stronger evidence? Most economists believe it's due to the IT revolution, not due to international trade and job outsourcing. We'll talk about this in more detail in 2 weeks.

Globalization

Global stock markets experience a "synchronization" nowadays because they aren't isolated, because there are many multinational companies and many companies are listed on several exchanges.

Some economists suggest a decoupling between US and other economies.

Since 1992, there has been a tremendous increase in foreign investment (assets and liabilities). How big? Big! We'll get back to this in week 5.

Benefits of Globalization

Everyone gains from Globalization. We achieve economies of scale due to larger markets (exports). Cheaper imports. Risk diversification through international investment. Access to international financial markets. Increased competition boosts efficiency.

Costs of Globalization

Displaced labor due to outsourcing. Greater exposure to external shocks due to financial crises in foreign markets. (Eliezer asks: Does this offset the risk diversification that is gained?)

Current Issues in the US Economy

Trade Deficit (both govt and personal)
Housing Bubble Burst

Why did we go into such a big consumption boom? Stock market and housing market were booming (until they both burst) and the Fed had a very low interest rate policy. Americans took out a lot of home equity loans based on the housing market boom and low interest rates.

Eliezer's personal take on this: I believe both technological innovation and consumerism were a major driver of the consumption boom. My observation is that there was a sudden and tremendous increase in the popularity in consumer electronics like pagers, cell phones, mp3 players, ipods, iphones, large screen tvs, cable tv, high-speed internet access, cd and dvd players, etc etc. All these items suddenly became part of the popular culture and items that every household must have - whether or not they could practically afford them or not. There was a similar change in the availability of larger automobiles. Low interest rate policy made credit card companys more liberal in their issuance of consumer credit and allowed consumers to make these "essential" purchases. Although housing costs are a large portion of household spending, the addition of these new items, some of which involve recurring monthly charges, have increased the financial burden on the average consumer.

US Trade Deficits: Unsustainable?

The current trade deficit is about $800 billion - about 6% of GDP. It's financed by borrowing from foreigners. Who are these mysterious foreigners? Primarily Middle Eastern oil (They are following the example of Norway - depositing into a national "sovereign" fund and then investing in foreign economies.)

EA Note: Congress recently held a joint subcommittee hearing on Foreign Government Investment in the US Economy and Financial Sector.

Chinese and Japanese wanted to keep their currencies cheap, so they bought a lot of US Treasury Bonds in order to keep the US$ relatively strong. But they could have made more investing outside the US. So why did they do it? We'll talk about that later in the class.

Bernanke referred to a "global saving glut" - "it's not our problem".

Subprime Loan Losses and Financial Crisis

We had strong economic growth with little risk (since Argentina 2002) and low cost of borrowing (due to Fed interest rate policy). This caused a huge credit boom.

Financial innovation

Banks didn't keep the mortgage loans. Rather, they repackaged them as CDOs which standardized all the loans together (with a wide variety of risk level) and sold the package to other financial institutions. The financial institutions only invested into these instruments because interest rates were low and they couldn't make $$ elsewhere. SIV = structured investment vehicle.

March Employment Statistics Released by BLS

The US Bureau of Labor Statistics released its latest employment report this morning. Non-farm payroll employment lost 80,000 jobs and the unemployment rate rose from 4.8 to 5.1 per cent. Not good!

You can get the latest report in HTML or PDF format from the BLS web site.

If you're interested in how these statistics are collected and calculated, you can see a summary on my GSB420 blog post or in the BLS technical note.

Lecture 1 - Introduction

Introduction
Professor Woo introduced himself to us. Most of the introductory information is on the course web page/syllabus which is linked from his home page. Here are some miscellaneous notes that I took:

Professor Woo received his PhD from Harvard and worked at the OECD in Paris.

The course will focus on macroeconomics, including productivity growth, employment, the boom/bust cycle, international trade and the flow of capital. We'll be discussing very relevant issues such as the impending recession, the banking crisis and policy setting.

We'll start each class with a discussion of a theoretical model in a highly analytical way. Examining the theoretical model will be an intellectual exercise, but with a purpose. We'll look at real data and interpret current events and apply/compare them to the model to see if the model adequately explains the data and events.

Class Goals

This class will not make you an economist. However, one of the high-level goals of the class is to get you to a level at which you can read the Financial Times, Wall Street Journal, The Economist, etc and understand them.

A note about economics articles: They're not always right! Reporters often get things wrong, so don't take anything you read, especially in the popular press, as absolutely true.

Textbook, Readings and Lectures

Our textbook is Mankiw's Macroeconomics Sixth Edition. (Mankiw is a Harvard economics professor and has a popular blog.) The textbook is written very clearly and simplifies complex concepts. Be aware, though, that you sometimes lose some of the detail through abstraction and simplification.

The textbook will be supplemented by outside readings which are either posted on the class web site or will be provided in hardcopy in class. Readings can be read either before or after the topic has been covered in class - your choice. As a suggestion, Prof Woo mentioned that it may be easier to read the articles after learning about the model in class first.

The lectures don't follow the chapters of the textbook strictly. For example, there isn't much discussion in the textbook on financial markets. We will be covering that topic in the lecture though.

Exams and Group Project

Readings are great, but the lectures are the most important in terms of preparing for the exams.

Midterm and Final are each worth 40% of grade.

Midterm is take-home. The exam will be emailed to us and you will turn it in via email as well. The timing of the exam wasn't totally clear to me. It sounded like Prof Woo will email it out on the day of the 5th week of class (no lecture that day) and that it's due by the day of the 6th week of class. Expect to spend half a day preparing the answers if you've kept up with the readings. (Is that half of a work day - 4 hours? Half of normal waking hours - 8 hours? Half of a full day - 12 hours?)

There will be 2 parts to the midterm:
1. Economic statements. Answer whether they are true or false and explain. Explanation is very important, of course.
2. I didn't catch exactly what the second type of question will be. Maybe someone else can fill me in on that.

The Final Exam will be in-class, closed-book and not cumulative. It will consist of multiple choice questions and an analysis (short essay) section.

There is a group project that is 20% of the final grade. Groups are limited to 4 people max. All members receive the same grade - it's hard to evaluate individual effort in a group project. The paper should be about 15 pages. He's not concerned with format (don't bother making it fancy and look pretty), but he is concerned with the content. You don't need to think about a topic until about the 3rd or 4th week of the class, so you have a better idea of the type of things we'll be covering. (Personally, I'd like to get a jump on this.)

Although it's not formally worked into the final grade 40-40-20 formula, contributing to class will merit consideration when a grade is on the borderline.

No Blackboard.

One of the best assessments of the US economy is the Monetary Policy Report to Congress which is prepared to by the Federal Reserve Board and delivered in February and July of each year. (Feb and July are only 5 months apart. Not a very even split of the year. I wonder why they chose those months specifically...) It's pretty heavy reading, but its contents are supported by both theoretical model and empirical evidence. Take it to bed with you. (It's sure to help you fall asleep.)

Virtual Economies

In my first post, I mentioned the analysis of virtual economies as a possible subject for a group project. Today, I found this post at 26econ.com which references an article in Scientific American on Eyjólfur Guðmundsson, whom they call "the first virtual-world economist".

All the major virtual economies have different operating rules. Some allow real-world trading, others are entirely self-enclosed and have no real-world interaction. Some work with a free market economy, others are highly regulated. The most interesting aspect for study is what we can learn from the virtual economies and apply to the real world. Although some economists, like Tyler Cowen, doubt whether there is anything we can apply, Guðmundsson himself views the virtual economy as another computer simulation that economists already regularly use.

If you're interested in this as a group project, I hope these links will be of some help.

Bernanke Warns of Possible Recession

Federal Reserve Board chairman Ben Bernanke testified before congress today and warned of a possible recession in the first half of 2008.

How is a "recession" defined?

It's primarily sustained, declining GDP.

Mankiw, pg 252, says "When the economy experiences a period of falling output and rising unemployment, the economy is said to be in recession." Mankiw does not specify the length of the period of decline required to constitute a recession. He then refers to the recession of 2001 in which during the first and third quarters of the year real GDP fell from the previous quarter. It seems that Mankiw does not require two consecutive quarters to define a recession.

Others, however, do require at least two consecutive quarters of declining GDP to define an economic recession. The National Bureau of Economic Research (NBER) has a Business Cycle Dating Committee which monitors economic indicators and has defined standards for defining recessions and other business cycles. Here's a link to NBER's Recession Dating Procedure.

According to NBER:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Who determines the GDP?

It's primarily the Bureau of Economic Analysis, which is part of the US Department of Commerce. Unfortunately, the BEA issues its GDP numbers on a quarterly, not monthly basis. You can download all the historic GDP numbers (since 1929 annually and since 1947 quarterly) in Excel format from the BEA site.

NBER makes reference to a group known as Macroeconomic Advisers (sic) which calculates a monthly GDP. I'm unable to find much information about this group and their web site (www.macroadvisers.com) is not currently up.

Mankiw Writes on Inequality

We won't be discussing income inequality for a few weeks in class, but I'm linking to Greg Mankiw's blog where he posted some thoughts on inequality back in 2006: Greg Mankiw's Blog: On Inequality

Blueprint for a Modernized Financial Regulatory Structure

Here are some quick links to "hot off the presses" information on Treasury Secretary Henry Paulson's announcement this morning of a restructuring of the financial regulatory system.

The complete Blueprint (PDF format - 200 pages)
Summary Fact Sheet (PDF - 7 pages)

Main Regulatory Blueprint Initiative page

Transcript of Secretary Paulson's remarks

I'll have more to say after I review and digest the announcement.

For those in the class already thinking about a group project, a review and assessment of this blueprint sounds like an interesting one to pursue.

Paulson to make major announcement tomorrow

We've barely begun the new quarter and already there's major news on the US economic front. Tomorrow at 10am EDT, US Treasury Secretary Henry Paulson will "discuss issues relating to financial institutions and financial markets" according to the Treasury web site. The event will be webcast at www.treas.gov.

While details won't be released until tomorrow, analysts are already discussing the outline of Paulson's plan to restructure the banking and insurance regulatory agencies. Both the Times Online and BusinessWeek are calling the proposed changes "the biggest overhaul of the supervision of America's banks and insurers since the Great Depression."

The current system of oversight was the result of piecemeal additions of supervisory agencies and departments since the Civil War. The proposed system will consolidate much of the supervisory responsibilities in the Federal Reserve. Some agencies will be consolidated or possibly entirely scrapped and new ones may emerge.

The plan is generating a lot of controversy among economists and those involved in the regulatory agencies. Opinions are also developing along Democrat and Republican party lines. Most analysts agree that the plan is a long-range plan and that only a few, if any, of its recommendations could be implemented in 2008. Which parts of the plan are actually implemented may also be affected by the results of the presidential elections this fall.

Here's a link to the WSJ article.

Pre-Class Post 1

This is the blog of my class notes for ECO 509 - Business Conditions Analysis. The course focuses on Macroeconomics and is taught by Professor Jaejoon Woo. I added links to the official class web site on the side bar.

Course Outline
The course is divided into 3 units:
Unit 1. Overview of the World Economy and Macroeconomic Indicators

Unit 2. The Economy in the Long Run
I. National Income Accounts and the Balance of Payments System
II. Productivity and Growth
III. Money, Inflation, Interest Rates, Exchange Rates and Asset Prices

Unit 3. The Economy in the Short Run
I. AD-AS Model
II. Aggregate Demand
III. The Open Economy in the Short Run (time permitting)
IV. Monetary and Fiscal Policies, Budget Deficits and Government Debt

The text is Mankiw's Macroeconomics. Bookstore price is $150 new, $122 used. Amazon price is $103 new, about $60 used. Kind of a no-brainer, huh? There's also a Study Guide and Workbook available. The textbook has a companion web site with self tests, flashcards, a tutorial (set of powerpoint slides), a data plotter, macro models and a simulation game. You need to register (free).

There are also many outside readings, most of which are available for download online.

We'll have the Depaul usual:
4 lectures
Midterm (40%)
5 lectures
Final (40%)

The one unusual thing I noticed on the syllabus is that the midterm is a take-home test. A take-home exam is generally favored by students, but it may mean that it'll require more time, thought and analysis. The final is in-class, closed-book as usual.

Group Project
There's also a group project (20% of final grade) due on the day of the final. I'm interested in getting started on the project right away. It sounds like we can choose our own topic. It just needs to be approved by the professor. Here are a few of the things I'm interested in:

• The macroeconomic effect of raising the eligibility age for tax-payer financed benefits for the elderly (Social Security, Medicare, etc). This is my preferred topic. It's a hot topic and there's plenty of literature to work with.
  
• How macroeconomic indicators can be used effectively. (There's already plenty of discussion of their shortcomings)
• Counterfactual assessment of a 90/10 Social Security system
  
• How macroeconomic indicators influence US presidential elections
• Microcredit (Grameen Bank) and how it influences the macroeconomy
• Macroeconomics in online virtual environments (Second Life, WoW, Runescape, etc)
  

If you're interested in working with me in a serious way on one of these or any other topic for the group project, drop me an email and we can talk. I'm very interested in trying to use collaboration technology such as GoogleDocs to do the group project. If you're into that too, we'll work well together.