pic Economics for all: June 2009

Monday 29 June 2009

Macro notes

Macro notes week 9 source parkin ch.6 p.128

In the macroeconomy leakages equal injections. Leakages refer to the circular flow where money is not used for further investment, it comprises government expenditure, net imports, and savings. To see this, governments have to spend money on hospitals, roads, police, defence etc. households have to save money they don’t spend, the country buys products it cant produce cheaply from abroad. In each case the money goes out.

In the circular flow the output is equal to consumption + investment + government expenditure + net exports =Y. the inputs a firm receives equal the firms output, that is every money a firm receives it pays to people as wages.

The chapter is basically about how to calculate gdp, this is in the region of $7500 bn, nearly a tenth of a $tn. There are three approaches to measuring gdp, the expenditure approach (preference) , factor income approach, and the value added approach. I know about double counting, it’s counting the same value added twice. For example, a baker buys flour, the farmer has added value, a consumer buys a loaf of bread, if you add the value at each stage you count the farmers valued added twice.

Gdp is a big number, it is the aggregate of goods and services provision, actually two thirds of gdp is consumer expenditure on goods and services. A consumer expenditure on goods and services are food from the supermarket and a haircut from the barber.


Price level and inflation
Inflation is the average change in prices, it is an increase as deflation is the average fall in the price level.

Inflation is measured in two ways; the CPI (consumer price index) (preference) and the GDP deflator. Both measures give a very similar, but not exactly the same result. Both measures also suffer from upward bias, in the region of 2-3% a year. Upward bias happens for 3 reasons; new goods, increases in quality and substitution. To understand these three reasons it is first necessary to know the general idea behind calculating inflation. The method is to take the price and quantity of goods in one year, and the new price and new quantity of the same goods in the next year, by using a formula it’s possible to calculate the percentage change. Now it’s possible to explain the three reasons listed above. Firstly, new goods. In the time period of a year new goods are created, and so the original basked of goods used has to be updated to include the new goods, because the original basket might include for example a cd walkman and a tv (non flat screen), after a year there are new goods; the mp3 player and the flat screen tv. As mp3 players and flat screen tvs are more expensive this creates the upward bias. Second reason; increased quality of goods, during a year the quality of goods increases, for example a new, revised edition of a text book, a computer with faster components and more disk space, most often higher quality increases the price so there is an upward bias. Third; substitution, the basket of goods changes because consumers change where they shop to get more bargains, for example people go to discount shops and buy discount air plane tickets online. This overstates the effect of a price change.

GDP if far from being a perfect measure of the economy of a country. GDP doesn’t include the pleasure from taking time out of work to enjoy ourselves nor does it include the productive activities we do everyday in our homes, such as cooking, cleaning, teaching our family new things.

The gdp omits illegal activites such as drug selling, child slave labour, and this counts for between 9 and 30% of gdp, and even more in some countries.

The value of an hour spent in leisure must be higher than the value of the last hour I worked, otherwise I would continue working.

The way the imf and worldbank measure gdp presents a distorted picture of economies. How rich are countries really? If by changing the type of way to calculate gdp results in wealth per person becoming six times larger. Purchasing power parity takes into account how many good you can actually buy with your money.

Gdp fails to measure things that have an important effect on our wellbeing and lives in general. The right to vote, the freedom of speech and expression don’t get measured by gdp.

A stock is something that is built up and stored. A flow is something measured during a period of time that adds to the stock. Gdp is a stock and investment is a flow that contributes to the stock. Wealth is a stock and saving is a flow that increases wealth.

Aggregate expenditure is composed of consumption on goods and services, investment, government spending, and net exports.

Aggregate income is composed of wages paid by firms to households.

All expenditure goes to firms who pay it all out in wages to households.

Governments spend money on roads, police, nhs, defense, and government receives money through taxing people. Transfer payments from government to people in the form of unemployment benefit, child care benefit.

Injections equal leakages. Leakages are saving, taxes, imports, injections are investment, government expenditure and net exports.

Inflation

Inflation is the rise in the price level on average. If the price of one good rises and the price of another good falls by the same amount the other goods price rose then there is no inflation, inflation is an ongoing process and not a one time process, prices rise and keep rising through time and inflation is not when a price just rises but then the price rise is over. There are two types of inflation called demand pull and cost push inflation. Demand pull inflation is inflation stimulated by an increase in aggregate demand; aggregate demand can be increased by a rise in government expenditure, increase in exports, and an increase in money supply. Cost push inflation is started by an increase in costs for example a rise in wage rates or the increase in price of raw material inputs. Anticipated inflation is when people correctly predict that there will be inflation in the future and so people build this information into their behaviour by bidding for higher wages. Inflation has costs such as shoe leather costs, menu costs, and tax distortions. Shoe leather costs are the costs of going to the bank more often than usual because people want money to earn interest in times of inflation. Menu costs are the costs that firms face for having to continually change their price levels, the more customers the firm has the more price changes have to be notified to the customers and the more expensive it gets. Tax distortions are when taxes on goods like cigarettes, alcohol, and petrol stay the same even though the price level on average has gone up.
Unanticipated inflation has costs on the labour market. When people anticipate inflation they decide to get higher paying jobs and to re negotiate salaries to get higher salaries. The data must show a relationship between inflation in some period and an increase in the bids for higher wages in some period that is before the period. Redistribution of income is one cost; when unexpected aggregate demand creates inflation the employers gain over the workers. This is because the inflation has not been anticipated at all, wages are low but prices are high so the firms profits are high. On the other hand if aggregate demand is expected to rise but it doesn’t the employees gain over the employers from the redistribution of income. Wages are high but prices remain as they were so firms profits are low.
Anticipated inflation effects the level of employment through the real wage rate. The real wage rate is the wage rate that takes into account inflation. If firms don’t anticipate inflation but inflation occurs the real wage rate falls, firms try to hire more labourers to increase production to maximise profits but new workers aren’t attracted as the real wage rate is too low, the firm pays overtime to existing workers to increase production, at higher levels of production the firm incurs more costs of machine maintenance and repairs. Some workers leave the firm because the real wage rate has fallen and try to find jobs that offer the original wage they received before the inflation set in. the workers looking for new jobs thus incur job search costs as it takes some time to find new jobs.
What if people anticipate inflation but it does not occur? In this case the real wage rate is too high and the firm makes redundancies so the level of unemployment rises. The level of output of the firm and thus its profits fall.
The capital markets are affected by anticipated inflation. There are redistributions of income between lenders and borrowers of money. When unanticipated inflation occurs the interest rate is too low to sufficiently compensate lenders for the falling value of money, so borrowers can get money quite cheaply because interest rates are low hence borrowers gain at the expense of lenders; on the other hand when inflation is anticipated but it does not occur the rate of interest is set too high and lenders gain at the expense of the borrowers. Thus it is prudent to conclude that there are incentives for borrowers and lenders to anticipate inflation correctly.
Whether or not inflation is correctly anticipated has implications for the costs faced by lenders and borrowers. If the inflation turns out to be lower than expected the lenders will want to lend more and the borrowers will want to borrow less, on the other hand if inflation is higher than expected the borrowers wish they had borrowed more and the lenders wish they had borrowed less.
People use all available information to make forecasts of future inflation rates, people are assumed to form RATIONAL EXPECTATIONS that means that the expectations are correct on average, sometimes they are wrong, and the expectations take account of all available relevant information.

decision making

Economics is the science of decision making- its pretty cool that there is a science on decision making, because at first glance it appers as if a science on something in the mind that takes place without people seeing it could not exists because there would be want of a lack of data, but there are ways to measure and analyse how people make decisions. Take for example an unemployed person, we can infer from their status that they have made a choice not to work, so it is not necessary to delve into someones mind to have a science on decision making as the decisions people make from day to day, whether large, like going to university, or small, like buying a film, are respresented by consequent actions, for example people that decide to go to university move to campus and study something, or to take a more gruelling example people that decide to commit suicide end up killing themselves. So it must follow that before every action takes place a decision has to be made, so really if you think about it economics has more data to study than other sciences! Think of it this way, every person makes hundreds of decisions a day and there are 6,706,993,152 people in the world, that is a huge amount of decisions made and this fact cannot and should not be ignored.

People make around 221 food related decisions pe day according to a study by Brian Wansink in the January issue of Environment and Behavior. When people were asked how many decisions a day they made on food they said 15, but tests show it is more like 221 because of a large, wide range of decisions e.g. when to eat? How much to eat? What to eat? How much to spend on food? Where to get food? Where to eat? How to cook it? What not to eat? What cutlery to use? How to cook? What plate to use? How to clean up after eating? To eat with a knapkin or not? How many times to chew? What size to cut food to? The more you think about it the more mind boggling it becomes and the more detailed decisions you can think. Like, what colour plate to use? What position to sit in when eating? Whether to watch tv or listen to the radio or read a book whilst eating? Whether to count calories? The point is there a huge numbers of decisions being made, and in economics the most important decisions are analysed, for example to decision to work or not, the decision to spend money or not, how to pay for a new business? What policies to follow to help the poorest countries in the world come out of poverty? What to sell? How much to sell it for? Who to sell it to? The most famous text book in economics defines economics as the study of the choice of what, how and for whom to produce. (begg)

I think the way economics should be studied is to divide up the key decision areas into distinct groups and then focus on each group separately whilst studying possible links between the groups, for example decisions should be separated into areas like labour markets (getting jobs), business finance, decisions made by individuals (micro), decisions made by large groups of the same people (macro), economic growth, policies, and etc.

The next critical question to answer is how to go about studying economics- well first data needs to be collected which involves making observations of the real world and recording them using precise and effective methods. The data needs to be organised and any unreliable data needs to be discarded. The data needs to be analysed in relation to something else to find out relationships so theories can be formulated, for example data on decisions about how much to eat could be tested against the price of food to see if one effects the other, this is done by holding everything else constant, ceteris paribus, which means to ignore but not forget the important influence of other factors on a variable, variables are observations that change when another observation is changed, they vary, for example as food price goes up people eat less because they cannot afford as much food. When we know what causes the variable in question to change we can better understand how different decisions effect each other and from this we can make predictions about decisions. One could predict that a rise in food prices that leads people to eat less could eventually lead to starvation of people if the prices rise extremely high because no one can afford to eat, so there must be something that keeps prices from rising so high, like laws and institutions, because people do afford to eat as not everyone is dead from starvation. We also know that if food prices are too low people eat too much and get fat and become ill and go to hospital and the hospital becomes full and taxes are raised to pay for more beds and doctors. These predictions are very powerful. By knowing this the government can implement laws to stop food sellers from exploiting peoples need to eat and this prevents us from eating everything and us all starving. Maybe some readers believe this is not true but it is based on reliable data collected from the real world and the reasoning used has been correct so the conclusions drawn must be the truth, admittedly this is not perfection, we say ceteris paribus but what if other things do have an influence and we don’t know about them? This is a valid point but everything has its limitations and economics does the best with what it has, in fact it does a very good job, admittedly some economics is better than others but I believe the field of economist is strong and full of hard working researchers and students who are making the science of economics better as we speak.

What we have been talking about so far is positive economics as it is about “what is” but economics also uses value judgements “what ought to be” type statements. These types of judgements are not able to be proven, it is not like the price rise in food means people buy less food, these are value statements based on what society values, for example, the government should provide poor people with extra money so they don’t have to sleep outside without warm clothing. Indeed, many economists have made some very convincing arguments using normative economics. This may be because people make decisions on values of society, so in essence it is just as important as positive economics.

I think the best economics comes from studying relationships in as much detail as possible and by using data that is irrefutable as this proves to other people that it is the truth and that wild assertions can indeed be backed up by data. As long as economists keep in mind it is a science about decision making and don’t try to mix it up with other sciences then economics should progress as best as it possibly could. It is true that thoughts of unrelated things that enter into the study of economics only seek to cloud the economists judegement as two sciences shouldn’t be mixed as economics on its own is powerful enough. Its true that all sciences share some common methods, like analyzing data, using graphs, taking real world observations, making theories, studying other scientists in the same field, writing essays, a love of understanding of the world, wonder at the universe, and etc.

Sometimes you read an essay in economics and it is hard to understand and it is like reading another language, this is a pain for all economists as it makes studying the subject harder and it puts off some people from becoming economists. The problem stems from the fact that many authors in economics are indeed not English, their mother tongue is not English, and so they write in English as a second language and not a first language, they have learnt English for a limited time and their ability in it is limited, also the other point is that economists don’t want to keep writing about decision making but they have to so they write about decision making but re phrase it so they don’t use words like decisions all the time as this would make their essay rather repetitive, boring and not good, but rest assured they are meaning decisions even though it is not explicitly stated. One other thing is that mathematical models put people off but economics cam be studied just as effectively using verbal descriptive methods so descriptive essays can be read instead of mathematical papers without any loss in value.

Economics has its own language in the sense that it uses exotic sounding terms like credible threats, regret theory, expected utility theory, dominated strategy, capital deepening, capital intensity, certainty equivalent, choke price, collusion, conglomerate, cyclical unemployment, sales tax, speculative demand, spot market, future market, stock, strip financing, structural unemployment, stylised facts, sunk costs, supply,

Capital deepening- an increase in capital intensity

Capital intensity- the amount of capital input per labour input

Certainty equivalent- the amount (money or utility) a person is willing to receive in order to be indifferent between taking a gamble and accepting the sure thing

Choke price- the lowest quantity demanded for which the price is zero

Collusion- where parties refrain from partaking in an activity they usually would in order to reduce competition and raise prices

Conglomerate- a firm operating in several industries

Cournot duopoly- a pair of firms that split the market

Cyclical unemployment- when the unemployment rate moves in the opposite way to the gdp growth rate, for example the gdp growth rate is high and the unemployment rate is low

Sales tax- a tax levied on the sale of a good or service which is usually proportional to the price of the good or service

Sharpe ratio- it is the mean minus the risk free rate multiplied by the standard deviation for an asset portfolio. The nyse has a sharpe ratio of .3 to .4. standard deviation measures risk and mean measures return. Higher sharpe ratios are more desirable.

Speculative demand- the speculative demand for money is inversely related to the interest rate

Spot market- a market where good or services are traded for immediate delivery

Future market- a market where goods and services are traded for delivery in the future

Stock- a portion of ownership in a company that entitles the own to the companies profits (aka equity or share)

Strip financing- this is corporate finance where securities are sold in a stapled package and cannot be sold separately. This is useful because people with the same interest are all in one group so it is less likely there are conflicts of interest.

Structural unemployment- a form of unemployment that results from there being zero demand for workers that are available

Stylised facts- real world observations that have been made in so many contexts that they are considered economic truths, these are essential for theory building as the theory must fit the stylised facts, but stylised facts or of no use in economic history because context is required to be specific.

Irrevocable- incapable of being revoked

Sunk costs- costs that are not able to be revoked and should not influence current decisions

Supply- the total quantity of a good or service that is available at a particular price

Demand- the quantity of a good or service that a consumer is both willing and able to purchase at a particular price
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