All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Answers for the Day
Macromeasurement

Output market

1. GDP is generally accepted as a measure of economic welfare-a higher GDP figure indicating a stronger economy. Please explain what impact the following will have on GDP: a devastating hurricane, higher crime rates, higher divorce rates.

There are no easy answers to these questions, but consider the following. After a devastating hurricane we are likely to see a boom in construction which is considered a part of GDP and therefore we can expect to see the hurricane increase GDP. Rising crime rates may raise the level of fear of crime which may result in increased expenses for both public and private security forces, once again raising GDP. If you want to try one more, what would be the impact of divorce on GDP?

2. What are the 'biggest' movies of all time?

What are the biggest movies of all time? If you listen to the media in March of 1998 you would be led to believe that Titanic had just passed Star Wars as the biggest box office smash of all times. The table below lists the top ten movies as of February 23, 1998 and we can see that Titanic is poised to take over the top spot. Others that have grossed over $300 million are E.T, Jurassic Park, Forest Gump, The Lion King, Return of the Jedi, and Independence Day – all movies that you can recognize.

Nominal Revenues

If you ask your parents about the biggest movies, however, they would probably have a very different list. Those who have been around for a longer time believe that their favorites – Gone With the Wind, ET, Ben Hur, Sound of Music, Doctor Zhivago, and Snow White - were bigger. As they see it, the problem is that these movies were released years ago when prices were lower and therefore the sales revenues would be lower. What they are talking about is the difference between real and nominal values. The table above gives you the real, or actual results and what they want is a table of real numbers. They would like you to account for the fact that prices have risen over time which gives current movies an unfair advantage. The results of the conversion to real are presented in the table below.

Real Revenues

The question is: How did we make these adjustments? How did we get from the real to nominal? The answer is with price indexes. The formula which you have seen elsewhere is:

R = N/PI

or

N = R * PI

If we know the change in the price level then we can convert the $ sales in the various years into a common denominator – sales in the base year $s. For more information, check out BIGGEST MOVIES

3. Jeremy has been doing some soul-searching on his life. He feels as though he has gotten nowhere financially in the past few years despite the fact that his current income in $35,000 and only 5 years ago he was making $30,000. Do you think he should lighten up? Is he actually better off today?

We need to calculate real earnings. The formula for real earnings is R = N/CPI. If we do that for 1992 we get $30,000/140.3 = $213.83. We the take this figure and multiply it by the CPI in the base year (whatever year we want the dollars expressed in term of) to obtain real earnings in base year dollars. [$213.83*158.6=$33,913]. If we do the same for 1997, the real earnings figure is $35,000. [$35,000/158.6*158.6]

3. In the mid 1990s the stock market was booming in the US as the price of stock rose rapidly. How much of an impact did this have on the inflation rate in those years?

One of the limitations of the CPI is that it does not include any measure of the price of assets.  All that is included in the CPI are the prices of goods and services that are purchased and therefore when the price of stock increases, as it did in the 1990s, this will not be reflected in a higher CPI. 

Labor market

1. What is the relationship between the labor force participation rate and GDP?

An increase in labor force participation rates means that a higher percentage of the population is in the work force - individuals that used to be at home are now either working or looking for work.  For example, the largest increase in participation rates has been among married women.  If these women now work in the labor market and hire others to take care of the children, GDP has been increased.  The new workers produce "Stuff" as do the children's care givers.

2. Who are the baby boomers and why do we care so much about them?

The baby boomers are a generation that was born between the years 1948-1964.  The leading edge of the baby boomers was reaching age 50 in 1998.   The reason this group gets so much press is the fact that they are a BIG generation - in fact they are the largest generation. As a result, they tend to have a pronounced influence on society and the economy. For example, when the boomers reached middle age in the 19990s, an age where people are investing, money poured into the stock market and this helped drive up the price of stock.  They also moved beyond tennis playing age and into golf, a development that could be seen in the decline in tennis and the resurgence in golf.  Finally, there was the housing boom in the late 1970s and early 1980s as the boomers bought their homes and the "echo" effect in the late 19990s - the boomers were finally having babies which gave us an entirely new line of baby stores.

3. Jeremy had been doing some soul-searching on his life. He felt as though he has gotten nowhere financially in the past few years despite the fact that his 1998 income was $50,000 and only 5 years ago he was making $60,000. Do you think he should lighten up? Is he actually better off today?  What do you need to know to answer that question?

The answer to the question depends upon what happened to prices over that period of time.  In that 5 year period, Jeremy's income rose 20 percent [(60,000-50,000)/50,000].  What matters is the change in the cost of living.   If prices rose more than 20 percent, Jeremy is likely to be worse off, while if prices rose slower than 20 percent, Jeremy would be better off.  You should keep in mind that other things could have happened that would influence your decision, but the adjustment for inflation ignores them.  For example, if Jeremy had a new family member to support, it may very well be true that his financial position would have deteriorated even if his wages had increased faster than prices.

4. The majority of American families live in their own homes so it is likely that someday you will be buying your own home. But how much will it cost? Let's assume that you will be buying your home in ten years. If the current average price is $155,000 and prices are expected to rise 5 percent per year, what can you expect to pay for that house in 10 years?

We need to calculate the cost of a home in ten years. Because it is a problem that involves time, we need to use present value analysis. The unknown in this problem is future value (FV) so we use the FV formula and plug in the appropriate numbers.

FV = PV*(1+g)^T

• where
• PV = $155,000
• g = .05
• T = 10

In the table below you will see the answer for each of the next ten years for two different growth rates-5 percent in the first column and 7 percent in the second column. By 2002, if prices continue to rise at 5 percent per year, the average price of the house will be $197,824. At a 7 percent growth rate, meanwhile, the price will be $217,396.

4. There has been much written about the price index which should be used for indexing social security. Economists generally agree that the existing CPI overstates inflation and suggest that Social security be indexed by something less than the inflation rate based on the CPI. How important is this debate? To see the magnitude of the issue, I would like you to estimate the savings in social security expenses by an adjustment. In 1995 social security expenses of the federal government were $336 billion. Let's assume that the CPI is expected to increase at a rate of 3 percent per year for the next decade. Please calculate what social security expenses will be in ten years if they are indexed to inflation. Then calculate the expenses if we use an adjustment that is 1 percentage point lower than the inflation rate as measured by the CPI (2 percent).

Once again this is a present value problem since we are dealing with numbers from two different years. We simply need to plug the information into the formula

FV = PV*(1+g)^T

and we can produce the following table. If the growth rate is 3 percent, expenses in 2005 will be $452 billion, but if we use a 2 percent growth rate the expenses will be $410 billion. With this 'small' adjustment, the government would save $42 billion in expenses.

6. What's happening with the economy? Just when I thought I was beginning to understand the measures we use to understand the economy I find the following headline: "Employment down, but so is the unemployment rate." How can this be? A decline in employment is taken as a sign that the economy is picking up steam since fewer people are working, while the falling unemployment rate indicates that a smaller percentage of the labor market is not finding jobs. How can the labor market be giving such mixed signals? [Hint: check out that definition of unemployment rate].

Let's follow the hint and look at the unemployment rate formula

Urate = unemployed/labor force

Because the unemployment rate is a ratio, there are a number of 'ways' that the rate could change. For example, the unemployment rate can decrease if:

• the number of unemployed falls
• the labor force expands
• the number of unemployed falls faster than the labor force
• the number of unemployed rises slower than the labor force
• the number of unemployed falls while the labor force rises

Once we look at the options, we can see that the third option will allow us to explain the reported figures. Employment could be falling because of a declining labor force, but the number of unemployed could be falling also. Maybe what we are seeing in the figures is an increase in the number of discouraged workers.

7. You have heard much about the baby boomers-probably enough so that you do not want to hear any more. But let's try one more boomer question. What would you expect to have been the impact of the boomers on the labor market in the 1970s? (Hint: think about how old they would have been].

The boomers are those born between the years 1948-1964. By the 1970s the oldest boomers were beginning to enter the labor market. In this situation we could expect to see downward pressure on wages and upward pressure on the unemployment rate.

Capital and foreign exchange markets?

1. What is a mutual fund and what are the similarities between it and a pension fund?

A mutual fund is a company that takes in money from individuals and uses the money to buy stock in companies.  This allows individuals to invest in the stock market without needing to do a lot of research on their own and it allows them to diversify their holdings across a lot of companies.  A pension fund also takes the money of individuals and invests it.  Your pension funds will own stock, bonds, and real estate.  In both instances the companies are financial intermediaries - they take the monies of individuals and invest them.

2. The government has a truth in lending law that "forces" lenders to give a "truthful" answer to the question: What is the interest rate?  Unfortunately, these laws do not protect consumers completely.   Can you explain when an increase in a scheduled interest rate is actually a decrease in rates?

The answer here is the same as the answer to the question posed by Jeremy.  An increase in interest rates could actually be a decline if at the same time there was an increase in the inflation rate.  For example, if the inflation rate is 0 and the interest rate is 5%, then you will need to pay $5 in interest on a loan of $100 and the $105 will allow the lender to buy more "stuff" - 5% more stuff.   But what if the interest rate rose to 10% at the same time prices rose 10%?   Now you would still pay back the $10 in interest, but now costs were up 10% so it would cost $110 to do what you did with $100.  The lender has seen no increase in buying power so the return is lower even though the stated rate is higher.  In this case, the nominal rate rose and the real rate declined. 

3. Interest rates are the price of funds so why are there so many rates?  What is the current mortgage rate?  What about a car loan rate and the rate on student loans?

A few phone calls or a simple search on the web will turn up these rates.  You should find that the mortgage rate varies with the duration of the loan - higher rates for longer mortgages.  You should also find that the rates on mortgages are lower than the rates on car loans and that the rates on new cars is lower than the rate on used cars. 

4. What will happen to the price of a bottle of French wine if the $/franc exchange rate falls from 5 francs to the $ to 4 francs to the dollar?   The wine now costs $20 a bottle.

The exchange rate allows us to make the conversion between currencies.  If the price is $20 and the exchange rate was 5 francs to the $, then the franc cost was 100 francs.  If the exchange rate falls to 4 francs to the $, then the $ price of the 100 franc wine will be $25.  The decline in the value of the $ has increased the price of imports.

5. What is happening to the flow of dollars if there is a current account deficit in the US?

A current account deficit means that the $ value of goods and services and investment income flowing into the US is lower than the flow going out from the US.  In this situation there is a net outflow of $s.  In effect the world is lending us money.

Additional Questions:

1. The following data has been reported for an economy. The CPI data is end of the year data.

a. In what year was there a recession?

A recession refers to a slowing of the economy which would be reflected in a decline in real (inflation adjusted)GNP. We can see from the table that the recession began in 1991.

b. How much did current dollar GNP increase (%) from 1985 to 1993?

To answer this question we need to first compute current dollar (nominal) GNP. To do this we use the formula R = N/P, but switch it around so we get the unknown on the left. N = R*P. Using this formula (and dividing by 100) we get:

1985 = 1231*125.8/100 = 1549

1993 = 1534*215.1/100 = 3299.6

Now all we need to do is calculate the percentage change in GNP using the formula (new-old)/old = (3299.6-1549)/1549 = 1.13 = 113% increase (it just more than doubled)

c. What was the inflation rate for 1992? for 1990?

The inflation rate is defined as the percentage change in the price level over a one year period. Because these are end of the year data, the inflation rate for 1990 would be calculated as:

i = (207.4-195.6)/195.6 = .06 = 6% for 1992

The inflation rate cannot be calculated for 1990 since we do not have the data for 1989.

2.The data below pertains to the Finlandia economy. The interest rates are yearly averages and the price level and wage data are for end of year.

a. Calculate real wages for 1994.

Real wages are inflation adjusted wages. The adjustment is made with the formula:

Real = nominal/price level

Plugging in these data we get 720/180 = 4. By itself this is not an useful number, but if we did the computation for two years we could see how the buying power of wages changed. If we do it for 1996 (830/210= 3.95), then we can see that over these years real wages fell from 4 to 3.95, a 1.25% fall [(3.95-4)/4].

b. Calculate the real interest rate for 1995.

The real interest rate is the rate after adjusting for inflation. If we pay back a lender 10 percent, but the price level has risen 8 percent, the lender is only getting 2 percent extra buying power - 8 percent of the 10 percent is 'eaten' by inflation. We therefore need to calculate the inflation rate for 1995 [(200-180)/180 = .11 (11%). If we subtract the inflation rate from the interest rate we get a real interest rate of -5% (6% -11% = -5%). People are actually being paid to borrow money.

3. The data below pertains to the U.S. economy. The figures are for end of year.

GDP

a. Fill in the missing numbers.

The key is to use some variation of the equation Real = Nominal/Price index. (We also must remember that the price indexes are in 100s so we need to divide out the 100). We can use this and reshuffle the terms until we get each term isolated on the left. The computations are:

• 1930 Real GNP = 285.2 = 90.7/31.8*100
• 1933 cannot estimate potential GNP from the data
• 1950 Price deflator = 53.65 = 286.2/533.6*100
• 1960 Real GDP = 506/68.67*100
• 1970 cannot do it since we are missing two pieces of information
• 1978 Real GDP = 2127.5/1431.1*100
• 1979 Price deflator = 2368.5/1431.1 = 165.5

b. In what year was the economy producing closest to capacity (where the unemployment rate would be lowest)? Which year was it operating furthest from capacity?

This would be the year where real output was closest to (in percentage terms) to potential output. This would be in 1978

c. What was the inflation rate in 1979?

I'll leave this one for you.

d. What is the base year used for data? If you cannot give me a specific figure, at least determine the narrowest possible range of years in which it would be.

The base year is the year that the price level = 100. It seems to be somewhere after 1960 and before 1978.

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