An Introduction to Macromeasurement

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1 An Introduction to Macromeasurement There are three kinds of economics: Greek-letter, up-and-down, and airport." Paul Krugman, The Age of Diminished Expectations Circular flow model The economy is an incredibly complex system and it is very easy to lose sight of the 'big picture' and get lost in the details, which is why economists tend to use models that allow us to see beyond the details. I suggest that the first step to understanding the macroeconomy is to visualize it. Plumbers and electricians use schematic diagrams all the time as a guide to how the electrical system or plumbing systems in a house work, and so do the architects who build those homes. We ll do the same, and we ll start by reducing the US economy with its billions of transactions to a simplified, small-scale model with four markets (output, labor, capital, and foreign exchange) and four groups of decision makers (households, firms, government, and foreigners) that interact with each other in these markets. In this diagram you can find the student loan you took out for the semester, the purchase of the computer that will be indispensible while you re here, your job that helps you pay your bills, and that flashy new shirt you bought that was made in China. We also need to know how those markets are functioning, so we have a number of indicators of activity / performance in these markets. You have probably heard of some - GDP, unemployment, interest rates, exchange rates ) - even if you have not spent any time thinking about what is being measured. All market transactions are registered in one of these markets, and the Classification Scheme below identifies the major actors in the macro economy, the markets in which they interact as buyers and sellers, and the primary measures of activity in each market. Classification Scheme Markets Demanders Suppliers Key Concepts Output Firms / Households / Government / Firms GDP / NI / CPI / Productivity Labor Firms / Government Households Employment / Earnings / Unemployment Domestic capital Capital Firms / Households / Government / Firms / Households / Fed / Firms / Households / Government Money supply / Interest Rates Trade balances / Exchange Rates You are part of the Household sector, so when you buy orange juice at the Emporium or gas at the Mobil station these transactions are recorded in the Output Market where firms are generally suppliers and individuals are demanders. You may also happen to have a weekend job as a waiter or retail clerk, in which case these transactions are recorded in the Labor Market where firms tend to be buyers and individuals are sellers. If you buy a DVD player made in Korea, khakis made in Indonesia, a sweater made in Ecuador, or a T-shirt made in China, then the transaction shows up in the Exchange Market because each purchase involves international transactions requiring the exchange of national currencies. And let's not forget that student loan or savings account that shows up in the Domestic Capital Market. Suppliers in the capital market are those firms, individuals, or governments with excess funds that come to the capital market with funds to lend. Included here would be your savings account and my pension contribution, since this is money we save now to be used at some future date. Demanders are those in need of funds - me 1

2 taking out a mortgage to buy a home, governments selling bonds to pay for a budget deficit, and you taking out those student loans. The interrelations between the markets can be seen in the Circular Flow Diagram that allows you to follow the flow of money through the economic system. You can start anywhere and then follow the flow through the system, and we'll start in the output market and keep it real simple and just "FOLLOW THE MONEY." Firms bring the "stuff" they produce to the output market and pay their workers wages and investors dividends equal to the value of what they bring to the market. The value of what firms produce and bring to the market is Gross Domestic Product (GDP), a term you will here used quite frequently. In a well functioning system, the income generated in production should generate enough demand to purchase all that is supplied, so inventories (unsold goods) would not pile up. We call this demand, Aggregate Demand (AD) for US "stuff," and we start with the households that received the wages and dividends as income. Households take some of the income and spend it on "stuff," which is called Consumption spending (C). Some of the income they receive will not be spent on stuff. Some will "leak" from the system when households pay Taxes (T) and some will leak out as Transfer payments (R) such as Social Security or unemployment benefits. Additional funds "leak" from the system when households Save (S), which supplies funds to the capital market, and when households buy Imports (M) by going to the foreign currency market to convert $s to foreign currencies to buy that French wine. We now have three leakages of $s from the economic system - savings, net taxes, and imports. For the system to "work" the amount of money the firms pay out as income must become demand for the "stuff" produced by those firms, and for this to be true "injections" must offset the leakages or there will not be enough money left in the system to buy all of the "stuff." This is where the other markets play a key role. 2

3 Do they recycle the money that leaks out of the system to sustain demand for the stuff? Do these other markets generate spending that is injected into the system? One injections is business spending on new factories and machines - Investment Spending (I). Firms go to the capital market to borrow funds to finance their buying of "stuff." The net taxes drained from the system will be recycled by the government and will emerge as Government Spending (G) on missiles, public school teachers, and judges. If the government spends more than it takes in, it needs to go to the capital market to borrow funds to cover the budget deficit. As for the funds leaking from the system to pay for imports, they would pass through the foreign currency market and reemerge as an injection of funds back into the system when the rest of the world bought our "stuff" what is called Export Spending (X). Any discrepancy between the level of imports and exports shows up in the balance of trade. There is a balance of trade deficit if (M>X) and a balance of trade surplus if (M<X). If all is well, these three injections - investment spending, government spending, and export spending - will offset the three leakages. We have now traced the flow of funds from the output market, through the complex system of aggregate markets, and an understanding of the interaction between these markets is a key to understanding macro economic theory and policy. For example, a crash in the price of stocks occurring in the US capital market is likely to have a negative impact on the output and labor market. As individuals' perception of their wealth is eroded they would reduce their consumption expenditures, which reduces aggregate demand in the output market. As firms cut back their output to bring production in line with demand there will be layoffs reflected in employment declines and a rise in the unemployment rate in the labor market. Similarly, the decision by OPEC to raise the price of oil, which directly affects the output market, will certainly have impacts felt in the labor and financial markets. i In the remainder of the course we will examine in detail these four markets and how they can be influenced by public policies. Before we look more deeply into the macroeconomy, however, we will need to look more closely in the macromeasurement unit at the macroeconomic variables you are familiar with from your reading of newspapers and magazines and from television news stories. We will start with a detailed treatment of two of these markets - the output and labor markets. Show Me the Data Where do you go if you need to track down some information on the macroeconomy? It turns out the circular flow diagram helps when you are tracking down information on the macro economy because there is a separate government agency primarily responsible for the collection and distribution of data on each of the markets. To help find information on the web, you should access Information Sources that contains an index of sources. If you want some time-series data, then check out Historical Data Series (US) where you will find some good all-purpose sites. Three of my favorites are the Statistical Tables from the Economic Report of the President, a great source of annual data, FRED Data, a data bank maintained by the Federal Reserve where you can find quarterly or monthly data and generate some professional graphs, and the Economic Time-Series Page where you can also generate Kool graphs online for many important economic variables. Here is a graph of the euro/us$ exchange rate from FRED. 3

4 If, on the other hand, you know you need current information, then check out Current / Outlook where you will find links to a variety of sites that contain the latest releases for data. Here you will find a number of sources including Economic Indicators. Below is a table from there that contains unemployment rate data for recent years. When you are not sure what you are looking for, then you might want to check out General Sources / Indexes where you will find my all-time favorite site, the annual Statistical Abstract. This is a wonderful source of data on a wide array of topics and often times it is a good place to start your data search. In the past I have found it useful to look at the bottom of the tables to find the source of the data since this is where I am likely to find more detailed information. If you were looking for data on the Labor Market, the best place to start would be with the Bureau of Labor Statistics where you will find a list of broad topics on which you can find reports and data. It is not the easiest site to navigate, but with a little hunting around you should be able to find information on employment, unemployment, and earnings. If you were looking for information on the official inflation rate based upon the Consumer Price Index (CPI), you would also find it at the BLS site. In the Data Analysis unit we talked about indexing data to account for price changes, and if you want to see how the inflation indexing works, you might want to check out the inflation calculators at Yahoo or the one at Bureau of Labor Statistics. For example, you can find that what you bought for $100 in 1955 would cost you $704 in To see how the adjustments can make a BIG difference, you can check out the site where the biggest movies of all times are listed - the actual gross sales and the inflation-adjusted sales. Box Office Hits: Adjusted and Unadjusted for Inflation. The largest box office hit has been Titanic released in 1997, but when adjusted an increase in the price level of 336 percent between 1939 and 1997 (based on the Fed's calculator), the largest grossing film was Gone With the Wind released in The primary source of data on the Output Market is the Bureau of Economic Analysis within the Commerce Department. This is where you would go to find all the information you wanted on GDP, productivity, or the GDP price deflator measure of the price level. The GDP data are published in a series of releases published in the Survey of Current Business. If you were interested in data on the Capital Market, the primary source would be the Federal Reserve Board of Governors that maintains the FRED database. For those interested in the foreign capital market that summarizes international transactions, you will need to check out a variety of sources. If you are interested in data on trade flows, then you will find this at the Bureau of Economic Analysis site, while if you are interested in historical data on the exchange rate, then you would probably want to check out the FRED database or Economic Report of the President. International data is a bit more difficult to find on-line, but there are a number of places where you might want to start your search. The International Monetary Fund (IMF) publishes the World Economic Outlook twice a year and at the end of these reports you will find a link to the Statistical Appendix where you will find about twenty years of data on most of the macro indicators for most of the world's countries. Another source for data would be the World Bank that publishes its annual World Development Reports that contain a link to selected indicators at the end of the document. You can also access World Development Indicators where you can quickly generate a table of data for any particular country in which you might be interested. 4

5 The United Nations also supplies information on its Social Indicator page that contains a wealth of data on an array of statistics, the World Trade Organization (WTO) provides access to current trade statistics in some spiffy excel tables, and the Organization for Economic Cooperation and Development (OECD) publishes data and information on the world's wealthiest countries. If you are looking for some data on international comparisons of labor markets, then you should check out BLS's foreign labor statistics.. As for the other links on the Information Sources page, if you need data on population check out the Demographics link, while any data on the federal budget can be found at Government Budget Data link. 5

6 6

7 Macro Intro i The distinction between the equilibrium equation and the national income identity can be seen by looking more closely at investment spending (I). Given the nature of the national income accounting, any changes in business inventories are included as part of investment spending. This means that a decision by an auto manufacturer to increase inventories will look the same on the national income "books" as a decrease in demand for autos that leaves more autos unsold. The best way to get past this is to think about decomposing total investment (I = I t ) demand into two components - desired (I d ) and undesired (I u ). [ (I t ) = (I d ) + (I u )]. The relationship between the two equations would be Equilibrium Q = C + I d + G + X - M >Identity Q = C + I t + G + X - M In this situation you will have equilibrium if (I t ) = (I d ) which happens when (I d ) = 0. This is why inventory investment data is so hard to interpret and important. By examining the inventory data you try to separate out the desired from the undesired components. If inventory investment is positive - inventories are building up then this could be an indicator of disequilibrium, of undesired investment and this would be expected to send a signal to producers to lower production. The identity holds because the undesired inventory investment is included in the recorded inventory change data. 7

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