Week4-5_Study_Material

Course- Economics GM545 Week 4: Introduction to Macroeconomics Introduction Basics of Macroeconomics Macroeconomic Cycles Introduction | | As groundwork for the study of economic cycles, we will concentrate this week on some basic macroeconomic variables: gross domestic product (GDP), unemployment, and inflation. These variables are all related in important ways. For example, business firms will produce the volume of goods and services they plan to be able to sell in the next period.  GDP measures this flow of output of goods and services.  However, if consumers do not choose to purchase all output that is produced, inventories of unsold goods will accumulate and business firms will cut back on output for the next period. This will result in an increase in the unemployment rate or even a recession. Conversely, consumers may desire to purchase more goods and services than the business sector is able to produce in a given period, and this excessive demand will lead to inflation. Basics of Macroeconomics | | Macroeconomics is the study of the aggregate economy; e.g., the entire U.S., German, or Indian economy. Normally, a nation adopts a set of accounts through which to measure its economy. In the U.S.'s case, the national income and product accounts (NIPA's) constitute the accounting system used to measure the U.S. economy. GDP is a measure of the value of all final goods and services produced on U.S. domestic soil during a specified period—normally, one year. Please note that the following equation is usually used to denote the GDP equivalence: GDP = C + I + G + NX where C is consumption, I is investment, G is for government consumption and investment, and NX is net exports (exports less imports). GDP is a measure of the economy using the goods that are produced. Yet there is another measure of the economy using the incomes that are generated by the production processes, gross domestic income (GDI). A slightly more familiar income-side measure of economic activity is national income.   It is very important to understand the difference between nominal and real GDP. Nominal GDP is the value of the economy's output of final goods and services valued in dollars of the year being measured. Real GDP, on the other hand, is the value of the economy's output of final goods valued in a base year—the latter being accomplished by deflating the current dollar or nominal dollar value of output using price indexes having a particular base year equal to 100. On another note, the formula used to deflate a nominal value (i.e. to convert it to a real value) is: Real value = [Nominal value / Price Index ] * 100  As a bonus for reading these lecture highlights, visit the U.S. Department of Commerce, Bureau of Economic Analysis (BEA) website and identify the real GDP estimate of growth for the most recent past quarter. Visit the BEA Website . Macroeconomic Cycles | | What are business cycles—what causes their peaks and troughs' The economy is like a living organism. It may chug along for extended periods without the hint of a problem; then suddenly it seems to contract a virus and slumps for awhile before recovering and starting off on a path of growth for another extended period. Business cycles are these fluctuations in the economy; peaks coming at the top of a growth cycle and troughs occurring at the bottom of a slump. Note that a recession is defined as the occurrence of two consecutive quarters of negative real growth. Unemployment is a product of business cycles. If the economy grows at a rate that requires all available persons to work, then there would be no unemployment. However, the economy does not always operate at such a rate. Therefore, it is important that we define and comprehend unemployment and the unemployment rate. An unemployed person is an individual over 16 years of age who has actively sought work during the past four weeks but has been unable to find employment. In other words, an unemployed person must be in the labor or work force—at least 16 years of age, eligible to work, and seeking work. Once we have identified who is in the labor force and who is unemployed, it is a simple task to calculate the unemployment rate.  It is the ratio of the number of unemployed to the number in the labor force. There are two main types of unemployment: frictional and structural. Frictional unemployment is characterized by spells of unemployment that are of short duration—as one is unemployed between jobs. Frictional unemployment can be voluntary or imposed. An unemployed person may leave a job to search for a different and better job, or the unemployed person may be laid off. Structural unemployment, on the other hand, is usually long in duration as the economy adjusts to eliminate obsolete industries and technology and to add new industries and technologies. Structurally unemployed persons normally must be retrained before they are able to find new work. The U.S. Department of Labor, Bureau of Labor Statistics is the official keeper of unemployment statistics. Feel free to visit their site: http://www.bls.gov . Thinking about the changing economy begs the question of why the economy grows or fails to grow. Usually, economies grow when there is an abundance of cheap resources, when productivity is increasing, when new technology is being introduced, and when efficiency increases. When these events are not occurring, economies tend to not grow. Price is nothing more than the dollar value we assign to a particular product. Inflation is the rate of price change. Usually, one measures inflation by developing a price index using a time series of prices for particular products. You develop an index by stringing together prices in a time series, selecting a base period, then dividing every entry in the price series by the price in the base period. For example, suppose we had the following prices for bottled water over the period of 1995 through 1999: $1.05, $1.15, $ 1.28, $1.39, and $1.50. We can construct a price index for bottled water having 1995 as the base period by dividing each entry by the price of bottled water in 1995, then multiplying by 100; e.g., 100.0, 109.5, 121.9, 132.3, and 142.9. Note that any period can be the base period. As an example, let us assume that 1999 is the base period, then our price index (using the original prices) becomes: 70.0, 76.7, 85.3, 92.7, and 100.0. Visit the U.S. Department of Labor's Bureau of Labor Statistics website: http://www.bls.gov to become familiar with some of the most often used prices indexes: consumer price indexes and producer price indexes. BEA's GDP Deflator is another important index to account for price change. (Consult the BEA website if you would like to find the value of the GDP Deflator for recent periods).  Know how to calculate growth or the rate of change in indexes.  Week 5: International Issues Introduction International Trade Foreign Exchange Rate Introduction | | We will begin the discussion of international economics with a brief outline of world trade patterns, and introduce a number of important trade concepts: the meaning of comparative advantage as the justification for trade, the meaning of exchange rates, and finally, some institutional aspects of trade.  In particular, we want to focus on exchange rates and their effect on the domestic economy.  In short, we are going to view foreign exchange as just another form of a market subject to supply and demand forces. International Trade | | Let's consider international economics. When we mention the term international economics, we often mean international trade. As a fledgling economist, your first question should be: "Why do nations trade'" A great business person/economist from the first part of the 19th century, David Ricardo, answered this question well. He answered the question in terms of absolute and comparative advantage. Absolute advantage in trade is when one nation can produce more of a good over a specified period of time than another nation, given the same amount of inputs (resources). A nation has a comparative advantage over a trading partner if it can produce a good at a lower opportunity cost than its partner. There are gains to be had from trade if nations specialize in the production of goods for which they have a comparative advantage, then trade those goods for other goods for which they do not have a comparative advantage. Remember not to confuse absolute and comparative advantage and completely comprehend the differences between them. This leads to a pretty powerful result, namely, that one nation can have an absolute advantage in terms of all products under consideration (we usually just look at two products, as this gets complicated enough), and still trade is beneficial with the trading partner because that other trading partner will have a comparative advantage in one of the two products.  This is a very powerful result in that it highly supports trade between countries to benefit the overall standard of living for everyone.  It might surprise you again to realize that we have known this fact for over 200 years, yet continue to place trade embargos and restriction on trade with other countries.  Why do we do this'  Well, the simple answer is that political pressures make it essential at times for our legislators to take this "anti-trade" position when public opinion seems to warrant it.  The theory that we are studying in this course is very solid and not debated by any economist, but politics is still certainly an important factor in economic decisions. Nations decide to trade by assessing the real terms of trade (RTT). The RTT is the actual market exchange rate of one good for another in international trade. Nations will trade if the RTT for a good is below the opportunity cost for producing the good domestically. Economies are dynamic, and one nation's RTT can change over time. Usually, lagging productivity (i.e. not increasing the amount produced given the same resources over time as a result of a failure to experience technological improvements, etc.) is a key reason for swings in the RTT from one nation to another. Given the above information, it might seem appropriate to always be open to trade. Generally speaking, this is true. However, the following arguments have been put forth as reasons to not trade: preserving national security, producing at home instead of importing to decrease structural unemployment; putting up barriers to imports to protect an infant industry that is weak in the beginning stages of its development, and putting up barriers for imports to protect domestic industries from unfair trade practices such as subsidized production or dumping. Foreign Exchange Rate | | Let's assume that nations decide to trade. In this case, they don't just move goods back and forth across borders; there is a payment process—money is exchanged. How do purchasers in country A obtain currency to buy goods from the country B' To purchase country B's products, don't country A's consumers need country B's currency' Yes, and they obtain the currency directly or indirectly from foreign exchange markets which are ruled by simple supply and demand concepts that we have discussed earlier. Foreign exchange rates are nothing more than the price of one currency in terms of another currency, with the price being determined by demand and supply principles.  What determines a nation's foreign exchange rate' There are six determinants: 1. foreign demand for exports; 2. domestic demand for imports; 3. domestic real interest rates relative to the interest rates in other countries; 4. the profitability of investments in the domestic economy; 5. expectations concerning the future foreign exchange rate of the currency; and 6. prices in the domestic economy relative to prices elsewhere in the world.