Department of Economics Jayashree Sil

University of California, Berkeley Economics 1

Lecture 9 , July 23, 2003

Macroeconomics Potential Output & Output Gaps

Output Gaps, Unemployment & ! Potential Output: Output produced when

Inflation ! economy uses capital and labor at normal
! rates (near full capacity)
Measuring Unemployment Rate
! Think of it as the economy has some long
Measuring Inflation ! run rising path of potential output. In the
! short run there are deviations from potential

Potential Output & SR Output Gaps Recessions (Latest NBER Announcement)

Output Y, Y* Output
Y peak
Potential
Y > Y* or trend output
Y* peak trough

Y < Y*
trough
rec exp rec
ttime ttime
3/01 11/01

Calling Recessions SR Output Gaps: Why They Matter

! Last week National Bureau of Economic Research
announced that the recent recession ended in November
2001 (recession trough). Policy makers rely on NBER to
! Output Gap= Potential Output -Actual Output
make these judgments. »= Y* - Y

! Hard call since 1 million jobs have been lost since

November 2001 and unemployment rate risen from 5.6% ! Y* - Y > 0 positive output gap called
! to 6.4% recessionary gap

! Committee observes real GDP. It now is 3.3% above pre-

recession peak & 4% above trough. Personal income, ! Y* - Y < 0 negative output gap called
manufacturing, wholesale, retail sales also above pre- expansionary gap
recession peak.

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Output Gaps: Why They Matter Output Gaps: Why They Occur
! Y* - Y > 0 recessionary gap ! Main Reason: Fluctuations in Spending
! unemployment rate high (above normal)
! economy incurs costs of unemployment ! Tale of Al’s Ice Cream Parlor

! Y* - Y < 0 expansionary gap ! Hot day, demand increases, meet demand at

! inflation can be high set prices, increase output, use resources at
max or higher capacity
! economy incurs costs of inflation

! Eventually increase prices, quantity

!
demanded falls , output falls back to potential

Output Gaps: Why They Matter Okun’s Law

! Y* - Y > 0 recessionary gap, ! Cyclical Unemployment
unemployment more than “normal”
! Actual unemployment rate= u
! Natural (or normal) Unemployment ! Natural unemployment rate = u*
! Cyclical unemployment rate = u - u*
! Structural : outmoded skills, declining
industry ! Recessionary Gap: u - u* > 0 (extra high)
! Expansionary Gap: u - u* < 0 (extra low)
! Frictional: due to search process, right
match

Okun’s Law Okun’s Law

! (Based on Empirical Observation) ! Every 1 % rise in cyclical unemployment associated
with rise in output gap that is 2% of potential output

! Output Gap = Y* - Y
! eg. Y*=100B
! Cyclical unemployment rate = u - u*
! u-u* = 1.5% , then
! Y*-Y = 3% x Y* = 0.03x100B=3B, rec gap
! Every 1 % rise in cyclical unemployment
! associated with rise in output gap that is 2%
! u-u* = -2.5% , then
of potential output
! Y*- Y=5%xY* = -0.05x100B=-5B, exp gap

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Economic Costs of Gaps Unemployment

! Recessionary Gap: extra high unemployment, lost output ! Current U.S. Unemployment Situation

! Lost Output: eg from earlier example, output gap=3B.

Suppose population is 1M. Means loss of $3000 each.
! 2.5 Million jobs lost since March 2001 (peak)
! Additional costs: costs of unemployment
! ! 1 Millions Jobs lost since November 2001
! Expansionary Gap: “extra high inflation” (as opposed to (trough)
steady, expected inflation)

! Unemployment Rate = 6.4%

! costs of inflation (unexpected inflation, ie unexpectedly
high inflation) ! natural rate = 5.2%

! Situation varies by state

The U.S. Unemployment

Rate since 1960 Measuring Unemployment
! Working Age Population: Age 16 and over

! Labor Force: employed or unemployed

among working age population, exclude full-
time student, retirees, military

! Participation Rate = LF + Wkg Age Pop

Measuring Unemployment Unemployment

! Among age 16 and over in survey ! 1) Larry (age 26) was fired 2 months ago, looked for
job for 7 weeks, gave up 1 week ago.

! Unemployed = did not work past week & ! 2) Barry (age 45) was fired 5 weeks ago. Has not
actively sought work some time in past 4 wk looked for a job. Did consulting work during the past
week.

! Employed = worked full/partime in past wk ! 3) Data at www.bls.gov (1000s)

! Civilian Labor Force= 147,096
!
! Employed = 137,738
! Unemployment Rate = Unemployed + LF ! Unemployed = 9,358
! Not in Labor Force = 73,918
! PR = UR =

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Unemployment Measuring Inflation

! Imperfect Measure: ! Use Price Index

! does not count those who are discouraged (so ! Many price indexes available: CPI , PPI, CPI (excl
understates true rate) food/energy), WPI

! counts those who work part-time (so overstates ! We consider most commonly used: CPI
“employment” and understates true unemployment rate)
! CPI = Consumer Price Index
! Costs of Unemployment

! psychological damage and social stigma

! underutilized resource, so output could be more

Consumer Price Index CPI Measures Change in Cost of Living

Hypothetical CPI

! Bureau of Labor Statistics (BLS)

Item Cost (2000) Cost (1995)

" Base year Rent, two-bedroom apartment $630 $500

" Base-year basket of goods and services Hamburgers (60 at $2.00 each) 150 120
" Measure prices in current & base-year basket Movie tickets (10 at $6.00 each) 70 60
Total expenditure $850 $680

•Base year basket of goods = 2BR apt, 60 burgers, 10 tickets

Cost of base - year basket of goods and services in current year •CPI (2000) = $850/$680 = 1.25
CPI = •CPI (1995) = 1.00 (ALWAYS IN BASE YEAR)
Cost of base - year basket of goods and services in base year
•Cost of living increased by 25% from 1995 to 2000

Inflation Calculating Inflation Rates

1930-31 & 1973-74
Year CPI
! Price Index (like CPI) 1930 0.167
# Measures the average level of prices 1931 0.152
… ...
relative to prices in the base year 1973 0.444
1974 0.493

! Inflation Rate
# Rate of change in average price level over 0.152 - 0.167
Inflation rate : 1930 - '31 = = - 0.090 x 100 = - 9.0%
time 0 167

0.493 - 0.444
Inflation rate : 1973 - '74 = = 0.110 x 100 = 11.0%
# Deflation = negative inflation rate 0 444

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Adjusting for Inflation Adjusting for Inflation

! Example: Top Baseball Players
Why: to make comparisons over time
" 1930 Babe Ruth’s salary = $80,000
to set level of salary/payment adjustments
" 1998 Mark McGwire’s salary = $8.3 million
" CPI (1982 - 84 = 100)
o CPI 1930 = 0.167
! How: Deflate Nominal Quantity o CPI 1998 = 1.64

o Real Salary:
" Divide
nominal quantity by price index to o BR $ 80,000 / 0.167 = $479,000
express the quantity in real terms o MM $ 8,300,000 / 1.64 = $5,060,000

o Nominal Terms: about 100 times more

" eg. Income, wage, o Real Terms: Only about 10 times more!!

Adjusting for Inflation Adjusting for Inflation

Example: indexed labor contract , Year 1 wage = $12/hr

! Indexing CPI Year 1 = 1.00 & CPI Year 2 = 1.05

# Rule to increase nominal quantity each Method 1: Contract specifies real wage to increase
period by some percentage increase in a 2 percent each year
specified price index
Year 2 Real Wage = 1.02 x Year 1 Real Wage
# Enables stable purchasing power w / 1.05 = ( 12 / 1 ) x 1.02 = 12.24,
w = 1.05 x 12.24 = 12.85 is Year 2 wage

Method 2: Contract specifies wage to increase by 2% of CPI

Year 2 wage = 1.02 x 1.05 x 12 = 12.85

Adjusting for Inflation CPI: Imperfect Measure of Inflation

! Quality adjustment Bias
! Substitution Bias
# Every few years there is a well-publicized
battle in Congress over whether the minimum ! Boskin Commission: CPI overstates inflation
wage should be raised. by 1 to 2 percent/year
# Why do these heated debates recur so
regularly? ! 1) Excessive increase in indexed payments

! 2) Understates true rise in standard of living

! (from overstating rise in cost of living)

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Costs of Inflation Avoiding Costs of Inflation: Lenders & Borrowers

! Noise in price system
Lenders set nominal rates so as to avoid
unexpected costs of inflation
! Unexpected Redistribution of Wealth
# borrower & lender
They decide on an acceptable real rate r
# employer & employee
Set nominal interest rate so that
! Long run planning difficult (retirees, firms)
real rate = nominal rate - inflation rate
! Distorts tax system : nominal income tax r=i-!
brackets

Inflation and Interest Rates in the

Avoiding Costs of Inflation United States, 1960 - 2001

! Fisher-Effect: Tendency for nominal

interest rates to be high when inflation is
high and low when inflation is low

! Lenders try to set nominal interest rates

are being set to try to avoid unexpected
redistribution of wealth

Summary
Avoiding Costs of Inflation
Short run output gaps occur due to fluctuations in
! Cousin Martha lends $1000 to Pudge demand. Recessionary gaps are costly due to high
for 1 year unemployment and lost output. Expansionary gaps
can be costly due to high inflation
! Agree real interest = 2%
Measurement of unemployment and inflation rates
help to monitor state of macroeconomy
! Expect annual inflation rate = 10%
Indexing of labor contracts and transfer payments
! What interest rate does Martha ask for? and making decisions with real interest rates
helps to overcome costs of inflation

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

National Savings, Investment, Well-functioning Financial System

International Capital Inflows
Key to Rising Standard of Living (growth)
Standards of living rise with APL
1) High rates of national saving
2) National savings allocated to most productive
Physical capital increases APL investments

Financial Institutions mobilize Efficient financial system Improves the

saving so that firms can purchase allocation of savings
physical capital
1) Provides information
2) Helps savers share the risk

Savings & Investment

Savings & Investment
Investment Spending Decision
Saving = Current income minus spending
on current needs
Compare benefit or value of marginal product
to the cost of the investment
Saving Rate = Saving divided by income
Savings Decision
Investment = creation of new capital Life-cycle, Precautionary, Bequest motives,
goods and housing Demonstration effect, Self-control. See notes.

Saving, Investment, and National Saving

Financial Markets

Supply of Savings (S)

Quantity supplied (of saved funds) is Real income or expenditures (Y)
positively related to the real interest rate (r)
Y = C + I + G + NX
Demand for Saving (I)
Quantity demanded (for investment) is For now, take NX = 0
negatively related to r. Y=C+I+G
Saving = Y - spending on current needs

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

National Saving: Current Needs

National Saving

I = spending on capital goods and

residential housing
National Saving (S) = Y - C - G
Assume C and G are current need
expenditures National Saving Rate = S + Y

C includes durable goods which may be current

and future needs
G may also include current and future needs

U.S. National Saving Rate National Saving: Private & Public

1960 - 2001

S=Y-C-G
T (net taxes) = tax - (transfer + interest)

S=Y-C-G + T-T
S = (Y - T - C) + (T - G)
Private saving = Sprivate = Y - T - C
Public saving = Spublic = T - G

National Saving: Private & Public Public Saving:

Budget Deficit & Surplus
S = (Y - T - C) + (T - G)
S = Sprivate + Spublic Government Budget Deficit
excess of spending over tax revenue (G - T)
Sprivate =Y - T - C

Household (personal) saving

Government Budget Surplus
Business saving excess of tax revenue over spending (T - G)
budget surplus = public saving
Spublic = T - G

Includes Federal, State , Local

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

The Three Components of

Public Saving: 1995 & 2000
National Saving, 1960- 2001
Spublic= T - G

2000
Federal: 218.5 = 2,046.8 - 1,828.3
State & local: 32.8 = 1,222.6 - 1,189.8
Spublic = 251.3 = 3,269.4 - 2,018.1

1995
Federal: -174.4 = 1,460.3 - 1,634.7
State & local: 111.7 = 997.7 - 886.0
Spublic = -62.7 = 2,458.0 - 2520.7

What do you expect for 2003?

Investment Decision Saving, Investment, and

Financial Markets

Costs Supply of Savings (S)

Real interest rate r (opportunity cost) Quantity supplied (of saved funds) is
Price of capital goods positively related to the real interest rate (r)

Benefits Demand for Saving (I)

Value of marginal product
Influenced by the relative price of the good or
Quantity demanded (for investment) is
service produced by the capital negatively related to r.

Market for Savings Funds The Supply and Demand For Savings

Saving S
Real interest rate (%)

Market determines equilibrium r.

If r above equilibrium, get surplus of
savings r

If r below equilibrium, get shortage of

savings. Investment I

S, I
Saving and investment

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Effect of a New Technology Effects of An Increase in the

Government Budget Deficit
S’ S
S
Real interest rate (%)

Real interest rate (%)

F F Reduces Spublic
r’ r’ so national
E E
r r saving falls

I’ I
Crowding Out
I
S& I fall, r rises

Saving and investment Saving and investment

International Capital Flows International Capital Flows

International Capital Flows
Purchases or sales of real and financial
assets across international borders
A country with greater investment
opportunities than savings can fill the
savings gap by borrowing from abroad. Capital Inflows
Purchases of domestic assets by foreign
International capital flows allow countries households and firms
to run trade imbalances. Capital Outflows
Purchases of foreign assets by domestic
households and firms

The U.S. Trade Balance

International Capital Flows 1960 - 2001
Trade Balance (or net exports)
The value of a country’s exports less the value
of its imports in a particular time period

Trade Surplus : exports exceed imports

Trade Deficit: imports exceed exports,

Trade has become increasingly important

Since the 1970s, the U.S. has run trade deficits

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

International Capital Flows International Capital Flows

Net Capital Flows Capital Flows and the Balance of Trade

NX = trade balance (net exports)
Difference between purchases of domestic KI = net capital inflows
assets by foreigners and the purchase of NX + KI = 0
foreign assets by domestic residents
KI > 0 Net Capital Inflow
KI < 0 Net Capital Outflow

NX + KI = 0 International Capital Flows

U.S. resident buys a $20,000 Japanese The Japanese car manufacturer has
automobile $20,000 and can buy U.S. assets (land,
bond, etc.)
The Japanese car manufacturer receives
$20,000 and can buy $20,000 of U.S. NX = -$20,000
goods Capital inflow = KI = $20,000
NX (-$20,000) + KI ($20,000) = 0
U.S. exports = imports
NX = 20,000 - 20000 = 0 and KI = 0 Note: Japanese Manufacturer could have bought other
NX + KI = 0 country’s good or asset, get same result

Net Capital Inflows

International Capital Flows and The Real Interest Rate
Determinants Net capital inflows, KI
KI < 0
Net capital
Domestic real interest rate r

outflows
Real interest rate

High domestic real interest rates will cause net

capital inflows. KI > 0
Net capital
inflows
Low domestic real interest rates will cause net
capital outflows.
0
Net capital inflow KI

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

An Increase In Risk
International Capital Flows Reduces Net Capital Inflows
KI’
KI

Domestic real interest rate r

Risk
For a given real interest rate, an increase
foreign and
in riskiness in domestic assets will domestic
reduce net capital inflows and vice versa savers less
willing to hold
domestic
assets.

0
Net capital inflow KI

Saving, Investment, and Capital S + KI = I

Inflows
S + KI = I

Y = C + I + G + NX
Subtract C + G + NX from both sides The pool of saving available for domestic
Y - C - G - NX = I investment includes national savings and
National saving (S) = Y - C - G the funds from savers abroad.
NX + KI = 0; so, KI = -NX
Substitute S for Y - C - G & KI for -NX
S + KI = I

The Saving-Investment
Diagram For An Open Economy S & I & KI
S
S + KI
Real interest rate (%)

S + KI = total supply
of saving A country that attracts foreign capital will
E
r*
S = domestic supply have lower real interest and higher
of saving
investment.

I Countries with a stable political

environment and well defined property
rights will attract more foreign capital.
Saving and investment

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Saving Rate and the Trade Deficit Saving Rate and the Trade Deficit

Y = C + I + G + NX
A low rate of national saving is the primary Subtracting C + I + G from both sides
cause of trade deficits.
Y - C - I - G = NX
S =Y-C-G
S - I = NX

S - I = NX

Low national saving: high C & G

Low national saving will also increase
High rates of spending: NX low capital inflows.
High spending creates investment
Increase imports. opportunities
Decrease exports. Shortage of domestic saving will occur
Real interest rates will rise
Capital inflows will occur
(Likewise, high S means NX high)

National Saving, Investment, and the

International Capital Flows Trade Balance in the U.S., 1960 - 2001

Why is the U.S. trade deficit so large?

Is the U.S. trade deficit a problem?

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Department of Economics Jayashree Sil
University of California, Berkeley Economics 1
Lecture 9 , July 23, 2003

Summary

National savings (sum of business,

consumers & government) is necessary
for capital formation

Savings can be supplemented by

international capital flows

However, in the latter case the country

is ultimately obligated to pay return to
foreigners

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