Principle #8: Fiscal and monetary influence people’s decisions
Objectives:
List the four major components of aggregate spending.
Define recession.
Use the Federal Reserve Economic Data (FRED) to make some observations about different recessions.
Why do you want to learn this?
There is probably no economic statistic that is more quoted in the news than the rate of economic growth. As mentioned in the previous summary, economic growth is defined as the rate of change of real Gross Domestic Product (GDP). That’s a mouthful. The question is what has happened to the production of goods and services over the quarter or year? How does our production of razor blades, missiles, funerals, computer software, apples and oranges, insurance policies, homes, automobiles, and many other goods and services compare to the production of this stuff in the previous period?
One way to measure economic growth is to measure the amount that four groups have spent on goods and services: consumers (households, you and me) investors (businesses as they purchase buildings and capital goods and increase their inventories), government, and foreigners. Let’s examine the things that determine each of these four types of spending.
Consumption
Consumption (spending by households) is the largest component of spending, making up about 2/3 of total spending in the economy. The most obvious determinant of consumer spending is household income. Short-term interest rates affect consumer spending on interest sensitive items such as the car you are hoping to buy or your parents’ new washing machine where you and your folks are planning to finance the purchases on credit. Long-term interest rates affect household decisions concerning housing. Lower interest rates encourage greater consumption.
Investment
Remember when discussing investment, we are not talking about buying stocks, bonds, and mutual funds. The discussion includes purchase of plant (not living things, factories, office buildings, etc.), capital equipment (machines), and changes in inventories by businesses. Business managers will explore possible investments, attempt to estimate their rate of return on different investments, compare those rates of return to the interest rates they will pay to finance the investments, and use a decision-making grid to determine, based on their best estimates, which investments make sense and which do not. All other things being equal, the lower the interest rates, the more investment we will see.
Government
Government spending is fairly easy to predict since most government spending is done with long term contracts. In addition, government budgets detail expected government spending. Surprises can come with changes in the health of the economy as receipts and expenditures automatically change.
Exports and Imports
Exports are US products that are sold to people in other countries and imports are foreign products that are bought by Americans. The major determinant of both of these variables is income in the respective countries. If GDP in the U.S. in growing, it can be expected that expenditures on many types of products including imports will grow. If one of our major trading partners experiences slow growth or recession, it can be expected that exports to the nation from the U.S. will decrease. The exchange rate (the price of US dollars in relation to other currencies) also influences the trade deficit or surplus.
So you know the four types of spending and their major determinants. Summing up these four types of spending is one way of measuring GDP. As mentioned, the rate of change of real GDP is the rate of economic growth. The greater the rate of growth, the more goods and services that are produced. Since it takes workers to produce goods and services, a higher rate of growth means greater employment and, obviously, a slower rate of growth means fewer workers hired.
The Business Cycle
The rate of growth fluctuates somewhat unpredictably. The Depression of the 1930’s was one of the worst downturns in the history of our economy and the 2007 recession was particularly bad due to its length. The Covid pandemic beginning in 2020 continues to affect economic growth. Business cycles have upturns which are periods of economic growth and downturns which are periods of contraction or declining real GDP. During contractions (or recessions), businesses lose customers and employees lose jobs. A recession is generally thought of as two consecutive months of declining real GDP but is actually identified by the Business Cycle Dating Committee of the National Bureau of Economic Research. The NBER is a national private non-profit, non-partisan organization that conducts economic research…thus the name! Business cycles are identified by their peaks (greatest growth of real GDP) and their troughs (lowest decline of real GDP).
Your assignment
This and the next few summaries are going to use a tool that’s powerful and easy to use. It is called FRED (Federal Reserve Economic Data). FRED places numerous economic data series at your fingertips.
Go to the Federal Reserve Economic Data. https://fred.stlouisfed.org/
In the “search” bar, type in annual rate of change real GDP.
FRED can display 1261 series. The good news is that we only want the first one. Click on Gross Domestic Product.
You will see a graph for annual GDP growth rate from 1930 to the most recent data. The shaded areas represent recessions. Drag the mouse along in the picture. You will see a vertical line giving you a value for the rate of economic growth (rate of change of real GDP) at each of the time points. What time intervals are the periods changing by? (YEARS)
What was the rate of growth in 1930? (-8.5%) This was the beginning of the Depression; we will see that one quarter of the labor force was out of work during the Depression. The economy began to pull out of the Depression but then turned down again from 1942 to 1946.
What do you notice about the volatility in the period 1930 to 1955 compared to the volatility from 1956 to the latest data? Can you think of historical events that explain the difference?
At the bottom of the graph, see a bar that indicates the years that are being displayed, from 1930 to the most recent data. Place your cursor on the far left of the bar, hold it down, and slide it along the bar to the year 2000. The graph will display the rate of economic growth from 2000 to the present. What do you notice about the 2008-2009 recession compared to the other two?
Given the latest GDP growth data, what is your diagnosis of the state of the economy?