1

Introductionand

National Income and Product Accounting (NIPA)

MBA 774Macroeconomics

Class Notes - Part 1

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Syllabus

• Information about the class is on the course portal and my personal website:

http://public.kenan-flagler.unc.edu/faculty/browngr/macroweb/

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What is Macroeconomics?

• The biggest of “big pictures”

• How the whole (global) economy works

• Macroeconomics examines things like– economic growth– employment– inflation

4

Goals for Students

• To learn about the major economic factors– What they are...– How they are measured...– What they mean (and why we care) ...

• To begin developing intuition about how economic factors are integrated

• To get up-to-date with economic current events

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Course Road Map

• Part 1: The “Secret Language” of Macro– learn about specific economic factors (historically and in real

time)– Develop intuition for how factors are related

• Part 2: Money– What is money and why is it important?– How is monetary policy executed?– Why do markets care so much about monetary policy?– Develop a standard model of the money market.

• Part 3: Foreign Exchange– Understand currency trading and purchasing power parity– Develop a model for FX markets based on interest parity

• Part 4: Bring It All Together– Develop an integrated model for the product and financial

markets

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Why do we want this knowledge?

Answer: So we can make better business

decisions!

– To understand how macroeconomic conditions

affect individual companies

– To understand the “business cycle” and economic

risk

– To better understand financial markets and risk

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Goals for Me

• To provide key knowledge and understanding about how the macro economy affects you and your business.

• To teach you efficiently.

• To get you excited about macroeconomics.

• To have you strongly agree that this course is “excellent”.

8

Thinking Like an Economist

• As scary as it sounds, thinking like an economist is important for business decisions

• Let’s run through a common example that is important for our purposes:

– Comparative advantage & gains from trade

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Comparative Advantage & Gains from Trade (1)

• Assume a simple economy with only two goods:– Beer and Movies

• Let’s also assume for simplicity that there are only two countries– The US and Canada

• Now suppose that both countries can produce each good but the US is “better” at making movies and Canada is better at making beer.– It is pretty obvious that the countries would benefit

from trade. How and why?

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Comparative Advantage & Gains from Trade (2)

• Now let’s make the assumption that the US is better at making both beer and movies.

• Specifically, lets assume each country has 10 “units” of labor and for each unit of labor they can produce the following:

Country Beer MoviesUS 10 4Canada 3 3

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Comparative Advantage & Gains from Trade (3)

• Suppose there is no international trade and each country finds it optimal to devote 7 units of its labor to producing beer (and therefore 3 units of labor to producing movies). Then each country produces and consumes the following:

Country Beer MoviesUS 7*10=70 3*4=12Canada 7*3=21 3*3=9

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Comparative Advantage & Gains from Trade (4)

• Now let’s allow the countries to specialize at producing one good and trade with each other. The US should make only beer and Canada should only make movies (why?). National production will be:

Country Beer MoviesUS 100 0Canada 0 30

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Comparative Advantage & Gains from Trade (5)

• One possibility is that the US trades 25 beers for 15 movies and national consumption is then:

Country Beer MoviesUS 75 15Canada 25 15

• Recall that previouslyCountry Beer MoviesUS 70 12Canada 21 9

• What has happened? Is this realistic?

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Measuring Economic Activity

• To understand the economy we must measure the economy

• There are many economic indicators– What are some you hear about frequently?

• What we ultimately care most about are measures of overall economic activity

• The broadest measure is GNP = Gross National Product

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Gross National Product (GNP)

• GNP is:– the value of all final goods and services produced

and sold– a measure of a country’s economic output (size)– the sum of four components:

• Consumption (C)• Investment (I)• Government expenditures (G)• Net Exports (Exports - Imports = EX - IM)

• We will use this identity often:GNP = C + I + G + EX - IM

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GNP vs. GDP

• In 1991 the US joined the rest of the world by using Gross Domestic Product (GDP) as the measure of the economy– GDP = GNP – Net Receipts of Factor Income– Net Receipts of Factor Income =

income domestic residents earn on wealth held in other countries

– payments to foreign owners of domestic wealth – So, GDP does not correct for domestic output produced by foreign

owned capital • Example:

– The earnings of an Irish computer factory that is owned by Dell (US) are counted in Ireland’s GDP and in US’s GNP.

• Does not matter much in practice for US, for 2004– Receipts (329.0B) - payments (273.9B) = 55.1B (or 0.5% of GNP)

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GNP/GDP Component Detail

• C = Private Consumption Expenditures– Durable goods– Nondurable goods– Services

• I = Gross Private Domestic Investment– Fixed Investment

• Nonresidential structures• Nonresidential equipment and software• Residential

– Change in Private Inventories• EX-IM = Net Exports

– Goods– Services

• G = Government Consumption Expenditures and Gross Investment– Federal nondefense– Federal defense– State and local

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US GDP ($ billions, nominal)

1950 Percent 2000 PercentGross domestic product 294.3 100.0% 9872.9 100.0%Personal consumption expenditures 192.7 65.5% 6728.4 68.2% Durable goods 30.7 10.4% 819.6 8.3% Nondurable goods 98.2 33.4% 1989.6 20.2% Services 63.7 21.6% 3919.2 39.7%Gross private domestic investment 54.1 18.4% 1767.5 17.9% Fixed investment 48.3 16.4% 1718.1 17.4% Nonresidential 27.8 9.4% 1293.1 13.1% Structures 10 3.4% 313.6 3.2% Equipment and software 17.8 6.0% 979.5 9.9% Residential 20.5 7.0% 425.1 4.3% Change in private inventories 5.8 2.0% 49.4 0.5%Net exports of goods and services 0.7 0.2% -364.0 -3.7% Exports 12.3 4.2% 1102.9 11.2% Goods 10.2 3.5% 785.6 8.0% Services 2.1 0.7% 317.3 3.2% Imports 11.6 3.9% 1466.9 14.9% Goods 9.1 3.1% 1244.9 12.6% Services 2.5 0.8% 221.9 2.2%Government 46.9 15.9% 1741.0 17.6% Federal 26 8.8% 590.2 6.0% National defense 19.6 6.7% 375.4 3.8% Nondefense 6.4 2.2% 214.8 2.2% State and local 20.9 7.1% 1150.8 11.7%

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What Counts in GNP/GDP? (and Where?)

• Which of the following are included in GNP or GDP– You buy a box of Garden Burgers at the grocery store– A farmer sells soybeans to the local silo – A car dealer sells a 1998 Ford Escort to a college student– A car dealer sells a new panel van to a florist– Compaq adds a computer to inventory– You sell your house to a couple that just moved from FL– The Federal government builds a new bridge– Texas state government pays unemployment benefits to

former Enron employees– GM imports steel for use in a new car

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What Counts in GNP/GDP?

• Let’s track parts of a hypothetical product through its production and see how it enters into the NIPA accounts– GM imports 800 lbs. of steel from Korea for use in

manufacturing a Chevy Malibu at a cost of $1,300

– GM manufactures the Malibu and sells it to a dealer in Dallas for $12,700

– The dealer sells the new Malibu to a rodeo queen for $16,800

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Real vs. Nominal

• So far we have not adjusted for inflation• Why would we need to do this?

– Compare 8% growth in GDP in the US where inflation is about 3% with Venezuela where inflation is about 18%

• Unadjusted GDP is called Nominal GDP and Inflation adjusted GDP is called Real GDP

• There are two common ways of adjusting for inflation:– Simple base year comparison– Chain-weight comparison (latest and greatest

method)

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GDP Deflator

• GDP Deflator is an index (standardized to 2000=100) that changes nominal GDP to real GDP

Real GDP = Nominal GDP / (GDP Deflator/100)

• The percent change in the GDP Deflator is a measure of inflation

• The GDP Deflator is the broadest measure of inflation for an economy

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What is a Recession?

• National Bureau of Economic Research (NBER) determines official dates for the “business cycle”

• A committee of top economists called the “Business Cycle Dating Committee” makes the call: “A recession is a significant decline in activity spread

across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade. A recession begins just after the economy reaches a peak of output and employment and ends as the economy reaches its trough.”

• For details on the recent recession see:http://www.nber.org/cycles/recessions.html

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Real US GDP Growth(1929-2005, annual, purple indicates year with NBER recession)

-15%

-10%

-5%

0%

5%

10%

15%

20%

1929

1934

1939

1944

1949

1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

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Real US GDP Growth(1988-present, quarterly, purple indicates quarter with NBER recession)

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1988

:Q1

1989

:Q1

1990

:Q1

1991

:Q1

1992

:Q1

1993

:Q1

1994

:Q1

1995

:Q1

1996

:Q1

1997

:Q1

1998

:Q1

1999

:Q1

2000

:Q1

2001

:Q1

2002

:Q1

2003

:Q1

2004

:Q1

2005

:Q1

2006

:Q1

2007

:Q1

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Contributions to Real GDP %Change

2002 2003 2004 2005 2006 Gross domestic product 1.6 2.5 3.9 3.2 3.3 Personal consumption expenditures 1.9 1.9 2.7 2.4 2.2 Durable goods 0.6 0.5 0.5 0.5 0.4 Nondurable goods 0.5 0.6 0.7 0.9 0.8 Services 0.8 0.8 1.5 1.1 1.1

Gross private domestic investment -0.4 0.5 1.5 0.9 0.7 Fixed investment -0.8 0.5 1.1 1.2 0.5 Nonresidential -1.1 0.1 0.6 0.7 0.7 Structures -0.6 -0.1 0.1 0.0 0.3 Equipment and software -0.5 0.2 0.5 0.6 0.5 Residential 0.2 0.4 0.5 0.5 -0.3 Change in private inventories 0.4 0.0 0.4 -0.3 0.2

Net exports of goods and services -0.7 -0.4 -0.7 -0.3 0.0 Exports -0.2 0.1 0.9 0.7 0.9 Imports -0.5 -0.6 -1.5 -0.9 -1.0

Government 0.8 0.5 0.4 0.2 0.4 Federal 0.4 0.4 0.3 0.1 0.1 National defense 0.3 0.4 0.3 0.1 0.1 Nondefense 0.1 0.1 0.0 0.0 0.1 State and local 0.4 0.0 0.1 0.1 0.3

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Last Time Was Different(contributions to US GDP growth around 2001 recession)

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

C (incl Residential)

I (excl Residential)

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Global GDP in USD 2005 (most recent year with comprehensive data)

Rank Country GDP (bln) GDP/Capita1  United States 10,764 37,3232  Japan 4,933 38,8113  Germany 1,956 23,7104  China (Ex. Hong Kong) 1,715 1,3195  United Kingdom 1,578 26,7966  France 1,415 23,8187  Italy 1,114 19,2438  Canada 789 25,4649 Brazil 655 6,49510  Spain 655 15,898

All Countries 35,111 5,756European Monetary Union 6,476 17,114OECD (30 Rich Countries) 26,526 23,193Rest of World 8,585 1,732

(calculated using market exchange rates)

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Problems with Product Accounting

• NIPA accounting can be misleading and difficult in practice

• Problems include:– Black market– Household production– Fixed capital replacement (e.g., from a disaster)– Certain government services (e.g., national security)– Externalities (e.g., environmental impact)– Quality / technology adjustment (e.g., automobiles)

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Social Welfare

• We have talked about how to measure the economy but not how to directly measure the well-being of consumers– How might the two differ?

• We could use a “social welfare function”

• Examples– Add up the “utility level” of all consumers (called

‘classical utilitarian’)– Minimum of all consumers (Rawlsian)

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National Income

• We have defined GDP in terms of production of goods and services

• We can also think about GDP in terms of national income (Y). Why?

• Economists often assume Y=GDP but there is a slightly different precise definition of national income

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National Income

GNPless: Consumption of Fixed Capital (Depreciation)

= Net National Productless: Indirect Business Taxless: Business Transfer Paymentsless: Statistical Discrepancyplus: Subsidies less current surplus of

government = National Income

To keep things simple we will always assume GDP=GNP=National Income (unless otherwise stated).

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US National Income

Or looking at it the other way: USD (bln) Percent

National Income 9,707.8 100%Compensation of Employees 6,203.0 63.9%Proprietors' Income 846.9 8.7%Rental Income 164.2 1.7%Corporate Profits 1,069.9 11.0%Net Interest Income 583.2 6.0%Taxes on Imports and Production788.7 8.1%Net Subsidies & Other 52.0 0.5%

(percentages do not add to 100% because of rounding errors)

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Inflation Measures

• Price indexes are used to measure inflation • The three most common price indexes are

– GDP deflator – Consumer price index (CPI)

• Prices of finished or retail goods and services• Index set to 100 for base year(s), currently 1982-1984

average

– Producer price index (PPI) • Measures the cost of a given basket of crude goods (raw

materials), intermediate goods, or finished goods (3 indices)

• Constructed from prices at the level of the first significant commercial transaction

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U.S. CPI Percent Change(From 12 Months Prior, All Urban Consumers)

-2.5%

0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

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Recent CPI and CPI ex. Food & Energy

(Percent Change from 12 Months Prior)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

CPI- All Items

CPI Excluding Food and Energy

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Components of PPI(Index Levels—not percent change, Monthly)

80

100

120

140

160

180

200

220

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Finished Intermediate Crude

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Employment and Wages

• Another important measure of the economy is employment and labor income (wages + benefits)

• The most common measure of the number of jobs in the US is called “nonfarm payroll employment”

• Also frequently reported is the “unemployment rate”

number of people seeking jobs =

number of people in the labor force

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US Unemployment Rate(Percent)

0

2

4

6

8

10

12

1948

1952

1956

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

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US Non-Farm Payrolls (1,000s)

127,000

129,000

131,000

133,000

135,000

137,000

139,000Ja

n-99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

41

Civilian Labor Force Participation Rate

65.5

66.0

66.5

67.0

67.5Ja

n-99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

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What Happened Here?

129000

130000

131000

132000

133000

134000

135000

136000

129000

131000

133000

135000

137000

139000

141000

143000

145000Payroll Survey (left scale)

Household Survey (right scale)

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Current Account

• Current Account (CA) is defined as the difference between Exports (EX) and Imports (IM)

CA = EX - IM– CA < 0 is defined as current account deficit– CA > 0 is defined as current account surplus

• How does CA relate to – Foreign indebtedness? – Intertemporal consumption patterns?

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US Exports, Imports, & CA Deficit

(Quarterly, Percent of GDP, 2000 Dollars)

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Imports Exports CA

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Balance of Payments

• Three types of transactions are recorded in the balance of payments – Current Account Transactions: transactions that

involve the export or import of goods or services• Such as exporting computers or consulting services

– Financial Account Transactions: transactions that involve the purchase or sale of an asset

• Such as money, stocks, bonds, factories, government debt, land, or collectibles.

– Capital Account Transactions: everything else• acquisition or disposal of nonproduced, nonfinancial, and

some intangible assets (debt forgiveness, transfer of trademarks, etc)

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US Balance of Payments (2003)Credits Debits

Exports 1,314.9 Goods 713.1 Services 307.4 Income Receipts 294.4 Imports -1,778.1 Goods -1,260.7 Services -256.3 Income Payments -261.1 Net Unilateral Transfers -67.4Current Account Balance -530.7

Capital Account -3.1

US Assets Held Abroad -283.4 Official Reserve Assets 1.5 Other Assets -284.9 Foreign Assets Held in US 829.2 Official Reserve Assets 248.6 Other Assets 580.6Financial Account Balance 545.8

Statistical Discrepancy -12.0

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Current Account and Net Foreign Wealth

48

Current Account and National Savings

• National Savings (S) is defined as the portion of national income not devoted to consumption or government expenditures. So,

S = Y - C - G

S = (C + I + G +EX - IM) - C - G

S = I + EX – IM

S = I + CA