Thinking Like an Economist Economics  Economics is a social science which attempts to explain the behavior and interactions of economic actors in terms of the items of value they exchange  Actors = individuals, households, firms, industries, governments or countries Economics  Economic  Models: Reasoning a model or theory is a framework that helps us to understand relationships between cause and effect They are a simplification of reality Basic Questions: Micro  Microeconomic  What Questions should we produce?  How should we produce?  For whom should we produce? Basic Questions: Macro  Macroeconomic  How Questions can sufficient growth be attained so that the well being of society increases?  How should productive capacity be utilized so that there will be full employment with stable prices? The Economy as a Circular Flow Resources Income Firms Households Expenditures Goods and Services Savings and Investment Income Firms Investment Households Expenditures Borrowings Financial Markets Savings Financial Markets Savers Individuals Businesses Government Financial Intermediaries Banks Pension funds Mutual funds Borrowers Individuals Businesses Government Financial Intermediaries Financial intermediaries include banks, insurance companies, investment companies, etc  Financial intermediaries act as the gobetween in arrangements between savers and borrowers  They reduce the uncertainty facing individual households or businesses through diversification  Financial Market: Participants  The suppliers of credit or loanable funds:  Household Sector  Business Sector  Foreign Sector  Government Sector Purchasing Power and Inflation  Inflation erodes the purchasing power of a given sum of money  Assume you have $10,000 and the price level is • In current dollars, you have $10,000, and in constant dollars you have $10,000 Purchasing Power and Inflation  Now let the price level rise to • In current dollars, you still have $10,000, but in constant dollars you now have ??? ?  The rise in the price level has decreased the purchasing power of your money Inflation and Capital Gains A capital gain is the difference between the price at which an asset is sold and the price at which it was bought  Capital gains are not indexed for inflation People pay taxes on nominal gains even if the real gains are zero Inflation and Capital Gains  Example: Between 1979 and 1993, the price level doubled If you bought stock in 1979 for $5,000 and sold it for $7,500 in 1993, you would have received a nominal capital gain of $2,500  What was the real gain?   Solution: Adjust capital gains for inflation just as we income earned by working Price Indexes  Consumer Price Index (CPI)  The CPI is calculated by observing changes in the cost of purchasing a typical bundle of consumer goods and services • The CPI is a weighted average of all prices, with the weights given by the relative importance of different goods or services in the typical bundle of purchases Price Indexes  GDP Deflator  The GDP deflator is the ratio of GDP valued at current prices and GDP valued at base year prices For example, if 1992 is the base year, the GDP deflator is: • (GDP valued in 1999 prices/GDP valued in 1992 prices)100 The GDP Deflator and the CPI  There are major differences between the GDP deflator and the CPI The CPI reflects prices of only consumer goods and services: The GDP deflator includes prices of all output  The CPI incorporates prices of imports: The GDP deflator does not  The GDP Deflator and the CPI The CPI is calculated by tracking over time the cost of a fixed basket of goods and services: The GDP deflator allows the output basket to change  Once published, the CPI is never revised: The GDP deflator changes with GDP revisions  Which Movies Were Most Profitable? E.T  Gone with the Wind  Forrest Gump  Star Wars  Jurassic Park  Empire Strikes Back  The Sting  Movies: Receipts in Current Dollars        E.T Jurassic Park Forrest Gump Star Wars Empire Strikes Back The Sting Gone with the Wind $357.77 $354.16 $336.38 $273.30 $200.50 $128.67 $ 76.35 Movies: Year Released        The Empire Strikes Back Gone with the Wind Forrest Gump The Sting Jurassic Park E.T Star Wars 1980 1939 1994 1973 1993 1982 1977 Movies: Adjusted for Inflation        Gone with the Wind Star Wars E.T The Sting Jurassic Park The Empire Strikes Back Forrest Gump $859 $628 $552 $397 $375 $361 $343 Millions of 1996 Dollars Movies: Receipts in Constant Dollars         Receipts in $1996 = Nominal receipts x (1996 price level/Year movie released price level) Gone with the Wind $76.35 x 108/9.61 = $859 Star Wars $273.3 x 108/47 = $628 E.T $357.77 x 108/70 = $552 The Sting $128.67 x 108/35 = $397 Jurassic Park $354.16 x 108/102= $375 Empire Strikes Back $200.5 x 108/60 = $361 Forrest Gump $333 x 108/105 = $343 Movies: Receipts in Current Dollars         Nominal Receipts = Inflation adjusted receipts x (Year movie released price level/1996 or base price level) E.T $552 x 70/108 = $357.77 Jurassic Park $375 x 102/108 = $354.16 Forrest Gump $346 x 105/108 = $336.38 Star Wars $628 x 47/108 = $273.30 Empire Strikes Back $361 x 60/108 = $200.55 The Sting $397 x 35/108 = $128.67 Gone with the Wind $859 x 9.6/108 = $ 76.35 The End ... production Real and Nominal Rates  Nominal interest rates are rates unadjusted for the effect of inflation or deflation  Real rates are adjusted for price level changes Inflation and Interest... Salaries and Transfers Savings The Rest of the World  An economy has two basic kinds of economic interactions with the rest of the world  Buying and selling goods and services  Buying and selling... also lend to the rest of the world and borrow from them Measuring GDP What Is GDP?  GDP, Gross Domestic Product, is the total dollar value of all final goods and services produced in a country