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Fall 2014 Macroeconomics Starring Erik Hurst 1. 2 Total U.S. Non Farm Employment Since 1990 Note: Up through July 2014 (Shaded Years are Recessions)

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Presentation on theme: "Fall 2014 Macroeconomics Starring Erik Hurst 1. 2 Total U.S. Non Farm Employment Since 1990 Note: Up through July 2014 (Shaded Years are Recessions)"— Presentation transcript:

1 Fall 2014 Macroeconomics Starring Erik Hurst 1

2 2 Total U.S. Non Farm Employment Since 1990 Note: Up through July 2014 (Shaded Years are Recessions)

3 3 Unemployment Rate: 1970M1 – 2014M7

4 4 Rapid Fall in Unemployment at Recession End

5 5 Unemployment Rate: 1970M1 – 2014M7 “Jobless” Recoveries

6 6 Unemployment Duration: 1970M1 – 2014M7

7 7 Increased Extension of Unemployment Benefits?

8 8 Broad Questions of Interest About Unemployment What is a recession? Why would unemployment increase at the end of a recession? Why has the nature of unemployment coming out of recessions changed over time? Why does unemployment exist? Can policymakers affect the unemployment rate?

9 9 How is Unemployment Measured? Standardized Definition of the Unemployment Rate: Unemployed= jobless but looking for a job Labor Force = #Employed + #Unemployed Unemployment Rate = (# Unemployed) / (Labor Force) This is the definition used in most countries, including the U.S. U.S. data: U.S. measurement details: Issues: Discouraged Workers, Underemployed, Measurement Issues Readings: #23, 24 from Reading List

10 10 Components of Unemployment Flow of people into the unemployment pool o Flow into unemployment from employment (job loss) o Flow into unemployment from out of labor force (stop being discouraged) Flow of people out of the unemployment pool o Flow out of unemployment into employment (job finding) o Flow out of unemployment out of labor force (discouraged workers)

11 11 Labor Force Participation Rate: Men Labor force participation rate = Labor Force/Population

12 12 Labor Force Participation Rate: Women Labor force participation rate = Labor Force/Population

13 13 Employment to Population Rate: Men

14 14 Employment to Population Rate: Women

15 15 Types of Unemployment Frictional Unemployment: Result of Matching Behavior between Firms and Workers. Structural Unemployment: Result of Mismatch of Skills and Employer Needs Cyclical Unemployment: Result of output being below full-employment. Individuals have the desire to work and the skills to work, yet cannot find a job. Is Zero Unemployment a Reasonable Policy Goal? –No! Frictional and Structural Unemployment may be desirable (unavoidable). Readings: Supplemental Notes 4 (pages 16-17); Reading List #6,7, 29-30

16 16 Why is the Distinction Important? How much of the current unemployment is structural vs. cyclical? This is a current debate among policy makers (and a question I am trying to answer in my own research) Why could there be structural unemployment? o Some industries boomed inefficiently during the early 2000s (construction) and need to retrench. The jobs being created now are not in those industries (where unemployment is high). o Some industries were in secular decline during the 2000s (manufacturing). The jobs being created now are not in those industries. oWorkers in manufacturing and construction need to be reallocated to other sectors.

17 Some Other Labor Market Facts 17

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22 My Current Research Big decline in manufacturing employment during the early 2000s. This usually depresses wages and employment of non-college individuals. Housing boom during the early 2000s lifted the employment and wages of lower skilled individuals (by propping up construction and housing related services). Housing boom “masked” the structural decline in manufacturing. The manufacturing decline is “permanent” while the housing boom was temporary. This is the focus of a series of new papers with (with Kerwin Charles and Matt Notowidigdo). Preview some background patterns now. Will talk about the identification later in the course. About 40% of increase in non-employment during the period can be explained by declining manufacturing.

23 ~1 Million Jobs Lost During 1980s and 1990s

24 ~1 Million Jobs Lost During 1980s and 1990s ~4 Million Jobs Lost Between (Housing Boom Years)

25 ~1 Million Jobs Lost During 1980s and 1990s ~4 Million Jobs Lost Between (Housing Boom Years) ~1 Million Jobs Lost After 2007

26 U.S. Employment Trends for Non-College Men (age 21-55) Manufacturing + Construction Manufacturing Construction

27 U.S. Employment Trends for Non-College Men (age 21-55) Manufacturing + Construction Manufacturing Construction

28 Propensity to Have At Least One Year of College (Age: 18-29)

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30 30 A Side Question: Why Should We Care About Unemployment? Depreciation of Human Capital oIndividuals lose skills when they sit idle. Productive Externalities oWorking individuals mean fewer wasted resources. Social Externalities oIndividuals not working could increase crime, divorce, etc. Individual Self-Worth oIndividuals not working may have lower marginal utility of leisure or consumption.

31 31 Questions We Will Address In This Course 1.What causes recessions? What causes unemployment? 2.What caused this recession? Will there be a double dip? 3.What is the link between housing prices and “real” economic activity (consumption, production, unemployment, etc.)? 4.What is the link between the banking sector and “real” economic activity? 5.Should we be concerned with inflation? What about deflation? 6.What causes inflation/deflation? 7.How can policy makers (Fed/Congress/President) influence economic activity in the short run (fight inflation and recessions) and in the long run (promote economic growth)? 8.What are the pitfalls of government intervention? 9.What makes economies grow in the LONG RUN? 10.How worried should we be about long run government deficits? What about the “fiscal cliff”? 11.What are the costs/benefits of altering the nature of the Federal Reserve? 12.What is the influence of China and India on the U.S. economy?

32 32 Caveat #1 My course takes the perspective of analyzing any large macroeconomy (with respect to the models we build). The examples will come primarily from the U.S. (because that is what I study) However, the insights apply equally well to all large developed economies including: –The European Union –Japan –Canada, Australia, etc. (for the most part). The models you will learn in this class also explain consumer, business, and government behavior for all economies (China, India, etc.).

33 33 Caveat #2 The course takes time to build. Our goal is to construct and analyze the economy as a whole. To do that, we separately build the parts. After we build the parts, we put them together to see how they interact. At certain points in the class, you may feel that we are losing sight of the big picture and you may feel lost. That is common. But, I promise, by week 7 or 8 everything will come together (it always does).

34 34 Note I have so much material to cover in this course, that we will have a mandatory extra lecture. The course will be comprised of 11 lectures. The extra lecture for all sections: October 17th (from 6 pm – 9 pm) –in Gleacher Room 100 (this is a Friday night) All are expected to attend. See syllabus for full details.

35 TOPIC 1 A Introduction to Macro Data 35

36 36 Goals of the Lecture What is Gross Domestic Product (GDP)? Why do we care about it? How do we measure standard of living over time? What are the definitions of the major economic expenditure components? What are the trends in these components over time? What is the difference between ‘Real’ and ‘Nominal’ variables? How is Inflation measured? Why do we care about Inflation? What have been the predominant relationships between Inflation and GDP over the last four decades? NOTE: This lecture will likely go into next week. This is by design. It does not mean we will be short-changed on other material later in the class.

37 37 Gross Domestic Product (GDP) GDP is a measure of output. Why Do We Care? –Because output is highly correlated (at certain times) with other things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc…) Formal Definition: –GDP is the Market Value of all Final Goods and Services Newly Produced on Domestic Soil During a Given Time Period (different than GNP)

38 38 “Production” Equals “Expenditure” GDP is a measure of Market Production! GDP = Expenditure = Income = Y (the symbol we will use) (in macroeconomic equilibrium) What is produced in the market has to be show up as being purchased or held by some economic agent. Who are the economic agents we will consider on the expenditure side? –Consumers (refer to expenditure of consumers as “consumption”) –Businesses (refer to expenditure of firms as “investment”) –Governments (refer to expenditures of governments as “government spending”) –Foreign Sector (refer to expenditures of foreign sector as “exports”)

39 39 A Simple Example What is “produced” has to be “purchased” by someone (including the producer). Suppose I produce a cell phone. If so, I could: –sell it to some domestic customer (Consumption) –sell it some domestic business (Investment) –keep it in my stock room as inventory (Investment) –sell it to some domestic government (Government spending) –sell it to some foreign consumer, business or government (Export)

40 40 “Production” Equals “Income” What is Produced is Also a Measure of Income. If you pay a $1 for something, that $1 has to end up in someone’s pocket as: Wages/Salary (compensation for workers who make production) Profits (compensation for self employed) Rents (compensation for land owners) Interest (compensation for debt owners) Dividends (compensation for equity owners) Notice, wages are only one component of income (Y does not equal wages)! (Although, under certain production functions, they will be proportional to each other).

41 41 Stop and Pause By definition….. Production = Income = Expenditure = Y What is produced has to be purchased by someone (accounting for inventory changes). Value of what is purchased has to end up as income in somebody’s pocket! In our class, we realize that the terms are interchangeable in equilibrium.

42 42 Measuring GDP in Practice Production Method: Measure the Value Added summed Across Industries (value added = sale price - cost of raw materials) Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX) Income Method: Labor Income (wages/salary) + Capital Income (rent, interest, dividends, profits). In our class, we will model the production side of economy (supply side) and the expenditure side of the economy (demand side). Prices will always adjust to equate supply and demand such that Y (production) always equals Y (expenditure).

43 43 What GDP is NOT! GDP is not, or never claims to be, an absolute measure of well-being! –Size effects : But even GDP per capita is not a perfect measure of welfare “The gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud to be Americans.” –U.S. Senator Robert F. Kennedy, 1968

44 44 More on What GDP Is Not GDP Does Not Measure: –Non-Market Activity (home production, leisure, black market activity) –Environmental Quality/Natural Resource Depletion –Life Expectancy and Health –Income Distribution –Crime/Safety Remember how we measure GDP…(i.e., how does one measure “safety”). Ideally, what we would like to measure is quality of one’s life: –Present discounted value of utility from one’s own consumption and leisure and that of one’s loved ones. Readings: #17-22, 25-26

45 45 Defining the Expenditure Components (formally) Consumption (C): –The Sum of Durables, Non-Durables and Services Purchased Domestically by Non- Businesses and Non-Governments (ie, individual consumers). –Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables). –Does Not Include Purchases of New Housing. Investment (I): –The Sum of Durables, Non-Durables and Services Purchased Domestically by Businesses –Includes Business and Residential Structures, Equipment and Inventory Investment –Land purchases are NOT counted as part of GDP (land is not produced!!) –Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production – they are saving!) There is a difference between financial and economic investment!!!!!!!

46 46 More On Expenditure/Production Components Government Spending (G): Goods and Services Purchased by the domestic government. For the U.S., 2/3 of this is at the state level (police and fire protection, school teachers, snow plowing) and 1/3 is at the federal level (President, Post Office, Missiles). NOTE: Welfare and Social Security are NOT Government Spending. These are Transfer Payments. Nothing is Produced in this Case. Net Exports (NX): Exports (X) - Imports (IM); –Exports:The Amount of Domestically Produced Goods Sold on Foreign Soil –Imports:The Amount of Goods Produced on Foreign Soil Purchased Domestically.

47 47 Summary of the Demand Side of Economy Aggregate Expenditure: Y = C + I + G + X – IM (A key equation in our class) Only four economic agents can “spend” on domestic production Domestic consumers (C) Domestic firms (I) Domestic governments (G) Foreign consumers, firms, and governments (X) We will develop models for each sub component of the expenditure side of the economy (C, I, G, and NX).

48 48 Measuring Expenditure (Demand Side) Only include expenditures for goods that are “produced”. –If I give $10 to a movie theater to watch a movie, it is counted as expenditure. –If I give $10 to my nephew for a birthday present, it is not counted as expenditure. –If I give $10 to the ATM machine to put in my savings account, it is not counted as expenditure. The second example would be considered a “transfer” (once I give $10 to my nephew, he can go to the movies if he wanted to – once that $10 is spent, it will show up in GDP). –“Transfers” are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged. The third example is considered “saving” (I am delaying expenditure until the future). Once I spend the $10 in the future, it will show up in GDP. In the meantime, someone may borrow the $10 from the bank and spend it. –Interest rates will adjust to make sure savings equal investment.

49 49 Some Examples of GDP Measurement Thinking about imports Y = C + I + G + X – IM Thinking about inventories (storing production….) Y = C + I + G + X – IM Distinguishing between government spending and “transfers”. Y = C + I + G + X – IM

50 50 Preview of Supply Side of Economy Production: Y = f(A, N, K, other inputs like oil) A = technology, N = labor input, K = capital (machine) input We will develop models/intuition for A, N, K and other inputs (like oil) N will be determined in the labor market (labor demand and labor supply) K will be determined by past investment behavior (net of depreciation).

51 51 Where We are Headed

52 52 The role of “prices” “Prices” ensure that we are always in equilibrium 4 prices in our class Price of output (e.g., CPI)P Price of labor (real wages)W/P Price of money (loans – real interest rates)r Price of foreign currency (exchange rate)$ or e We will develop (from fundamentals) these 4 markets in our class. All are determined by “supply” forces and “demand” forces.

53 53 The 4 Markets 1)Labor Demand vs. Labor Supply (determines N and W/P) Necessary to compute the supply side of economy Key to where recessions come from (frictions in the labor market) 2)IS-LM market (determines r and Y (via I)) Interest rates determine firm investment Key to central bank policy (sets r) Key to understanding banking crises. 3)Aggregate Demand vs. Aggregate Supply (determines P and Y) Key to understanding where inflation comes from.

54 54 The 4 Markets (continued) 4)Foreign Exchange Market (determines value of currency and NX) We will focus on this market in last week of class. Key to understanding the interaction of macro link across countries. Notice: All markets help to pin down the level of Y in the economy These four markets (and their components) will determine everything we want to know about the macroeconomy (production, inflation, economic growth, unemployment, interest rates, budget deficits, trade deficits, etc.) For the next 7 weeks, we will build the underpinnings of these markets. In doing so, we will uncover how these markets work and what factors influence these markets.

55 55 An Important Equation

56 56 Defining Savings (Store this Away!) Y d = Disposable Income = Y - T + Tr (definition)(1) T = Taxes Tr = Transfers (ie, Welfare) Y d = C + S HH (Only can save or spend disposable income)(2) S HH = Personal (Household or Private) Saving S HH = Y - T + Tr – C >(3) Personal Savings Rate = S HH /Y d For simplicity, we are going to abstract from business saving (things like retained earnings and depreciation). For those interested in more of these accounting relationships, see the text.

57 57 A Look at Actual U.S. Household Saving Rates: 1970M1 – 2014M6 Remember: Shaded areas are recessions.

58 58 Saving Identities (continued) S govt = T - (G + Tr)(Definition of government surplus)(4) S govt = Government (Public) Saving Includes Federal, State and Local Saving What government collects (T) less what they pay out (G and Tr) S = S HH + S govt = Y - C - G = I + NX (combine (3) and (4))(5) S= National Savings Restate (5): S = Y - C – G >(6) S = I + NX >(7)

59 59 Summary S = I + NX We will use this equation for the rest of the class! National savings, goes into a “bank”. Firms looking to borrow, go to the “bank”. Firms can only borrow what is in the “bank” In a world where NX = 0, interest rates will adjust such that savings will always equal investment (I=S – this will be our IS curve later in the course). What is the role of NX? (International savings – discuss later in class)

60 60 Understanding Prices and Inflation

61 61 Prices and Inflation Why is it important to measure “prices” of goods and services? o Prices are a key metric of measurement (we measure GDP in prices). - The metric changes over time given that prices change over time. o Changes in prices (inflation) is of independent interest in the macroeconomy. - Inflation is just the percentage growth rate in prices.

62 62 Prices as Measurement Measures macro prices of goods and services through “price indices” Price Indices track the relative change in the prices for a “basket” of many goods (intended to representative of all goods) compared to the same basket of goods in a “base year”. The base year is the anchor for the price index and all subsequent price indices are relative to the base year. GDP Deflator (one prominent price index): Value of Current Output at Current Prices / Value of Current Output at Base Year Prices Another prominent price index is the CPI (consumer price index) – measures price changes of consumer goods. I will often use the CPI as our measure of a price index in this class.

63 63 Example of Price Index Calculation (Continued) Nominal GDP is output valued at Current Prices Comparing Nominal GDPs over time can become problematic. Confuse Changes in Output (production) with Changes in Prices Real GDP is output valued at some Constant Level of Prices (prices in a base year). Real GDP(t) = Nominal GDP(t) / Price Index (t) Growth in Real GDP: % Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)]/Real GDP (t) or (approximately) % Δ in Real GDP = % Δ in Nominal GDP - % Δ in P See Supplemental Notes 1 (Real vs. Nominal Variables) for examples.

64 64 Technical Notes on Price Indices Need to Pick a Basket of Goods (cannot measure all prices) ‘Ideal/Representative’ Basket of Goods Change Over Time –Invention (Computers, Cell Phones, VCRs, DVDs). –Quality Improvements (Anti-Lock Brakes) –Could differ by place or person? Criticism of Price Indices: Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time. How do we account for “sales”? Additionally - technology advances drive down the price of ‘same’ goods over time.

65 65 Technical Notes on Price Indices Boskin Report (1996) Concludes that CPI Overstates Inflation by 1.1% per year. Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure). Measures to Get Around Problems with CPI - Chain Weighting –Read Text to get a sense of chain weighting. Readings: #16, 27, 28

66 66 Technical Notes on Price Indices Which is better: Real or Nominal? –In this class, we will focus on the ‘Real’! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices. –From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told. ie, Y = Real GDP, C = Real Consumption, G = Real Government Purchases, etc...

67 67 Some More New Research Create price indices at state and local levels. Such series have never been systematically created within the U.S. Increased demand for such series (as more research is taking place exploiting cross U.S. variation – we will discuss this later in the course). Work in progress oScanner data which includes grocery goods and small durables. oHousing data oEnergy prices

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73 73 Recessions and Inflation in U.S. Over Last 40 Years

74 74 What is a Recession? “Official Rule of Thumb” - 2 or more quarters of negative real GDP growth Most Economies are usually not in recession –U.S. average postwar expansion: 50 months –U.S. average postwar recession: 11 months –Previous Recession: 19 months (December 2007 – June 2009) –Previous Expansion: 71 months (January November 2007) –The 1990s experienced the longest expansion since 1850 (the second longest was 106 months ; ) –For Information on Business Cycle Dates see:

75 75 A Look at U.S. Nominal GDP: 1970Q1 – 2014Q1

76 76 A Look at U.S. Inflation: 1970M1 – 2014M7

77 77 A Look at U.S. Real GDP: 1970Q1 – 2014Q1

78 78 Real GDP and Inflation Over the Last Three Decades? High or Rising Inflation: Low or Falling Inflation: (sustained) High Growth in GDP: (sustained) Negative Growth in GDP: ) Sometimes Negative Growth in GDP and Rising Inflation (70s) 2) Sometimes Negative Growth in GDP and Falling Inflation (80s and 90s) Need Theory to Explain Both Sets of Facts!!!!

79 79 More On Recessions Dates Length 2/ /69 Expansion 106 months 12/ /70 Recessions 11 months 11/ /73 Expansion 36 months 11/73 - 2/75 Recession 16 months 3/ /79 Expansion 58 months 1/80 - 6/80Recession 6 months 7/80 - 6/81Expansion 12 months 7/ /82Recession 16 months 11/82 - 6/90Expansion 92 months 7/90 - 2/91Recession 8 months 3/91 - 3/01Expansion 121 months 4/ /01Recession 8 months 1/ /07Expansion 71 months 12/07 - 6/09Recession 19 months 7/09 - currentExpansion 72 months

80 80 Great Moderation? Dates Length 2/ /69 Expansion 106 months 12/ /70 Recessions 11 months 11/ /73 Expansion 36 months 11/73 - 2/75 Recession 16 months 3/ /79 Expansion 58 months 1/80 - 6/80Recession 6 months 7/80 - 6/81Expansion 12 months 7/ /82Recession 16 months 11/82 - 6/90Expansion 92 months 7/90 - 2/91Recession 8 months 3/91 - 3/01Expansion 121 months 4/ /01Recession 8 months 1/ /07Expansion 71 months 12/07 - 6/09Recession 19 months 7/09 - currentExpansion 72 months 16 months of recession in 24 years ( ) 49 months of recession in 21 years ( ) The Great Moderation

81 81 Is the Great Moderation Dead? I do not think so…. My interpretation: Great Moderation refers to the fact that the economy is better at minimizing the impact of any given shock now relative to 30 years ago. It does not mean that: There will not be bad shocks There will not be “new” shocks Why? The economy is more flexible (inventory management, credit) We have gotten better at conducting macroeconomic policy!

82 82 Foreshadowing the rest of the course Assume aggregate demand (drawn in {Y,P} space) slopes down I will prove this to you later in the course Assume short run aggregate supply (drawn in {Y,P} space) slopes up I will prove this to you later in the course I will also distinguish between short run and long run aggregate supply

83 83 Foreshadowing the Rest of the Course: Demand Shocks The relationship between inflation and output when aggregate demand shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) Y Short Run AS AD Long Run AS Y* P AD’ a b Y’ P’ P If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y’). Prices will fall (from P to P’). Demand shocks cause prices and output to move in the same direction. (You should be able to illustrate a positive demand shock)

84 84 Foreshadowing the Rest of the Course: Supply Shocks The relationship between inflation and output when aggregate supply shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) Y Short Run AS AD Long Run AS Y* P AD’ AD’’ a Y’’ P’’ P Short Run AS’’ c If the economy receives a negative short run aggregate supply shock, short run equilibrium will move from point (a) to point (c). Output will fall (from Y* to Y’’). Prices will rise (from P to P’’). Supply shocks cause prices and output to move in opposite directions. (You should be able to illustrate a positive supply shock)

85 85 Business Cycles vs. Long Run Growth

86 86 Macroeconomic Goals Promote Economic Growth oMinimize uncertainty oMinimize distortions in the economy (create level playing field) oCreate incentives for efficient economic transactions oBottom line: Maximize “trend” growth Promote Economic Stability oKeep the unemployment rate low oKeep inflation in check oRefer to this as managing “business cycles” – minimize the deviations (cycles) around the trend. Note: Lower uncertainty leads to greater economic activity

87 87 Why We Care About Inflation

88 88 Interest Rates i 0,1 =the nominal interest rate between periods 0 and 1 (the nominal return on the asset) π e 0,1 =the expected inflation rate between periods 0 and 1 r e 0,1 =the expected real interest rate between periods 0 and 1 Definitions r e 0,1 = i 0,1 - π e 0,1 (or i 0,1 = π e 0,1 + r e 0,1 ) r a 0,1 = i 0,1 - π a 0,1 (or i 0,1 = π a 0,1 + r a 0,1 ) where r a and π a are the actual real interest rate and inflation

89 89 Interest Rate Notes The Formula given is approximate. The approximation is less accurate the higher the levels of inflation and nominal interest rates. The exact formula is r e = (1 + i) / (1 + л e ) - 1 Central Banks are very interested in r since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting i, but the Central Banks are really trying to set r. 3 easy ways of measuring expected inflation: –Recent actual inflation (see –Survey of forecasters (see –Interest rate spread on nominal vs. inflation-indexed securities (WSJ). See for other macro forecasts

90 90 Why We Care About Inflation Note: We will have a whole lecture on this later in the course Inflation is Unpredictable Indexing Costs (even if you know the inflation rate - you have to deal with it). Menu Costs (have have to go and re-price everything) Shoe-Leather Costs (you want to hold less cash - have to go to the bank more often). Caveat: There may be some benefits to small inflation rates - more on this later.

91 91 Why We Care About Inflation An Example of how inflation can affect real returns. Suppose we agree that a real rate of 0.05 over the next year is fair. –borrowing rate, salary growth rate, etc. Suppose we also agree that expected inflation over the next year is We should then set the nominal return equal to 0.12 (i = r e + л e ) Summary:i = 0.12 r e = 0.05 л e = 0.07

92 92 Why We Care About Inflation Suppose that actual inflation is 0.10 (л a > л e ) In this case, r a = 0.02 (r a = i - л a ) Borrowers/Firms are better off Lenders/Workers worse off Suppose that actual inflation is 0.03 (л a < л e ) In this case, r a = 0.09 (r a = i - л a ) Borrowers/Firms are worse off Lenders/Workers better off It has been shown that higher inflation rates are correlated with more variability. People/Firms Don’t Like the Uncertainty

93 93 Bonus: Understanding Housing Markets

94 Average Annual Real Price Growth By US State State State AK MT AL NC AR ND AZ NE CA NH CO NJ CT NM DC NV DE NY FL OH GA OK HI OR IA PA ID RI IL SC IN SD Average

95 Average Annual Real Price Growth By US State State State AK MT AL NC AR ND AZ NE CA NH CO NJ CT NM DC NV DE NY FL OH GA OK HI OR IA PA ID RI IL SC IN SD Average

96 Average Annual Real Price Growth By US State State State AK MT AL NC AR ND AZ NE CA NH CO NJ CT NM DC NV DE NY FL OH GA OK HI OR IA PA ID RI IL SC IN SD Average

97 Average Annual Real Price Growth By US State State State AK MT AL NC AR ND AZ NE CA NH CO NJ CT NM DC NV DE NY FL OH GA OK HI OR IA PA ID RI IL SC IN SD Average

98 Inflation Adjusted Housing Price Growth in the U.S. 98

99 Housing Market: New York 99

100 Typical “Local” Cycle: California 100

101 Typical “Local” Cycle: Nevada 101

102 Average Annual Real Price Growth Across Countries State Belgium Canada Germany Denmark Spain Finland France UK Ireland Italy Japan Luxembourg Norway Sweden S. Africa USA Average

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107 107 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply

108 108 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply PH’PH’

109 109 Equilibrium in Housing Markets Demand PHPH QHQH Fixed Supply PH’PH’ Supply Eventually Adjusts PH”PH”

110 How Does Supply Adjust? Build on Vacant Land Convert Rental or Commercial Property Build Up Build Out (Suburbs) Build Way Out (Create New Cities) Some of these adjustments can take consider amounts of time. Caveat: Gentrification/Agglomeration can lead to sustained increases in house prices. 110

111 Why Do House Prices Cycle? Supply and demand forces. When demand increases (increasing prices), supply eventually adjusts (build more houses). The increase in housing supply moderates price growth. Housing supply – in the long run – is very elastic (convert old properties, build on vacant land, create new cities, etc.). 111

112 U.S Quarterly Housing Starts (in 1,000s) 112

113 What We Should Expect oHousing prices have – for the most part - stabilizing in nominal terms. oWe should expect annual real housing price growth of somewhere in the range of 0% to 3% nominal in the medium run. oHousing market will not be “rebounding” toward 2006 levels anytime soon. - Have a glut of existing supply - No reason to expect a large housing demand shock


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