Ranjit S. Dighe
Fall 1999

[These notes were last revised on Sun., Sept. 26, at 8:30 pm.]

Tues., Sept. 20, 1999

* Today: Economic institutions
I.    The distribution of income and production
II.   Government
III.  International trade (begin)

[This lecture was done mostly with overheads from McConnell's 5th and 6th chapters. To get the most out of these lecture notes, you'll want to look at them with an open copy of McConnell's book by your side.]


We left off last week with the circular-flow model, a diagram that shows how the main players in the economy -- households, firms, government, and the international sector -- relate to each other. Today we will look at all of those players individually, to get a sense of how our economy is structured.

U.S. national income is paid out in wages and salaries (71%), as the "proprietors' income" of small-business owner-operators (8%), as corporate profits (12%), and as interest (7%) and rent (2%).
-- [Refer to Figure 5-1 of McConnell.]
-- Note that wages and salaries are by far the largest component of national income, and that their share of national income has been fairly steady at about 70% for most of this century.

Incomes in the U.S. are very unevenly distributed and in the past two decades have become even more skewed in favor of the rich.
-- [Refer to Figure 5-2 of McConnell.]
-- The richest 20% (the richest quintile) of households receive almost half of all personal income in the U.S., and the next 20% receives slightly more than proportional share (23%). The bottom 60% of households receive much less than their share -- the bottom quintile gets only 4% of U.S. income, the next quintile gets 10%, and the next (the middle quintile, or people in the 40th to 60th percentile of U.S. households) gets 16%.
-- In the 1980s, it was literally true that "the rich were getting richer and the poor were getting poorer." In the 1990s, people in the bottom 20% have seen a slight improvement in their real (inflation-adjusted) incomes, but the incomes of the rich have gotten vastly larger, so income inequality has increased.

Americans consume most of their income -- fully 80% of household income goes to personal consumption expenditures.
-- [Refer to Figure 5-3 of McConnell.]
-- The majority of American families "live from paycheck to paycheck," either saving nothing or devoting their non-consumption spending to paying down their debts. Personal savings account for 6% of personal income, with most of the saving being done by richer households. The U.S. national saving rate, including businesses and the government as well as households, has traditionally been one of the lowest among industrialized countries, and has lately turned negative -- we are spending more than we earn.
-- Taxes and government spending are a much smaller share of personal income in the U.S. than in most industrialized countries, with personal taxes taking up just 14% of U.S. personal income.

Turning our attention toward the production side of the economy, most U.S. business firms are small businesses -- sole proprietorships (owner-operated businesses) or partnerships -- but larger, incorporated businesses account for the overwhelming percentage of production and sales.
-- [Refer to Figure 5-4 of McConnell.]
-- Some 75% of all U.S. firms are sole proprietorships, and 82% of U.S. firms are small businesses. There are over 16 million proprietorships and about 1.5 million partnerships and about 4 million corporations in America.
-- Corporations, however, account for 89% of U.S. sales.


The government is another vital player in modern society, collecting taxes from households and firms and providing them with various services, and at the same time providing jobs to many Americans (about one American in 7 works for the government).
-- [Refer to Figure 6-3 of McConnell, the circular-flow diagram, with government in the middle.]

The U.S. government is "big" in comparison with the U.S. government of the 1920s or 1930s, but small in comparison with those of other industrialized countries, notably those of Western Europe, where government purchases of goods and services are typically more than half of GDP. In the U.S., government purchases of goods and services were about 22-23% of GDP in the 1960s and have gradually been shrinking as a share of GDP, to about 20% of GDP in the 1980s to 18% of GDP in 1997. On the other hand, total government spending in the U.S. rose in the 1960s to about 30% of GDP and has had a slight upward trend, to about 32% of GDP in 1997, because government transfer payments, such as Social Security and Medicare, have become increasingly large.

Defn. GOVERNMENT TRANSFER PAYMENTS: government programs into which people pay taxes and those taxes get redistributed as benefits to other people. Examples include Social Security (old-age pensions), unemployment insurance, and welfare (Temporary Assistance to Needy Families).

Government transfer payments have ballooned because of the rapid aging of the U.S. population, which means more people receiving Social Security pensions and Medicare health insurance coverage, and because of the rapid inflation of medical costs, which has raised the costs of Medicare and Medicaid (health insurance for poor people). Government transfer payments were about 5% of GDP in 1960, about 10% of GDP in 1980, and were about 15% of GDP in 1997.

The U.S.A. has long prided itself on its federalist system of government, by which power is shared among three levels of government -- federal (national), state, and local. Since the 1930s, the federal government's share of total government spending has grown substantially; the federal government, with a budget of roughly $1.5 trillion, now accounts for about two-thirds of total government spending.

The three levels of government get their revenues from very different sources. All three rely mostly on taxes (which wasn't always the case. Until World War I, the federal government depended mostly on tariffs -- duties on foreign imports -- for its financing).
-- [Refer to Figure 5-7 of McConnell.]
---- Today the federal government gets a bit more than half its revenue from the income tax, which applies both to individuals and to corporations. The personal income tax accounts for 45% of federal revenues and the corporate income tax (or corporate profits tax) accounts for 12%. Payroll taxes, which mostly go into the Social Security system and partly into Medicare, have risen in relative importance and now make up 35% of federal revenue. In fact, the majority of U.S. households (those in the working and middle classes) pay more in payroll taxes than they do in income taxes. The payroll tax is divided equally between workers and their employers, with each kicking in about 7.5% of the worker's income up to a certain limit (around $70,000). The payroll tax is regressive in that it takes a much smaller bite out of rich people's incomes than it does out of poor people's incomes, since income about that limit is not subject to the payroll tax at all. Excise taxes (sales taxes on specific commodities like cigarettes, alcohol, and gasoline) account for 4% of federal revenues, and "all other" sources, including tariffs, account for the remaining 4% of federal revenues.
---- Federal spending goes mostly toward pensions and income security programs (38%) like Social Security and health security programs (20%) like Medicare and Medicaid. National defense takes up a large share of the budget (18%), but that share has been rapidly declining since the collapse of the Soviet Union in 1989. Interest on the national debt (15%) is another large item that has exploded since about 1980, thanks to the stream of large federal budget deficits in the 1980s and early 1990s. (The national debt is roughly the sum of all past deficits minus all past surpluses.) All other federal spending totals 9% of the federal budget.
-- [Refer to Figure 5-8 of McConnell.]
---- State governments are somewhat less dependent on income taxes -- several states do not even have an income tax, and the payroll tax is strictly a federal tax. Sales and excise taxes account for nearly half of state revenues, with personal income taxes a distant second (32%), followed by corporate income taxes (7%), property taxes (2%), and inheritance and gift taxes (1%). "All other" taxes, which includes things like fees for marriage and driver's licenses but does not include lottery revenues (which are an increasingly large share of state revenues but are not technically taxes), come to 9% of state tax revenues.
---- The largest items in the states' budgets are "public welfare" (32%, mostly medical care and welfare), education (21%), health and hospitals (10%), highways (10%), and public safety (6%).
-- [Refer to Figure 5-9 of McConnell.]
---- Local governments are a story unto themselves -- they are almost completely dependent on property taxes, which make up 75% of their revenues. Some large cities have sales and excise taxes (15%) or income taxes (6%), but property taxes equal destiny for most localities. Poorer communities, especially poor cities, will tend to find themselves stretched to the breaking point, because the property values will be low, making for a low tax bases, and the needs of their populations, especially in crowded cities, will be great.
---- The biggest budget item by far for local governments is education (42%), which points to what one writer called the "savage inequalities" in American schools. Rich counties and suburbs, with many valuable properties, are able to generate a lot of property tax revenue and can lavishly support their public schools; poorer areas, especially cities, cannot easily generate nearly as much property tax revenue, so their school facilities are often dismal. Other major budget items for local governments are public safety, health and hospitals, welfare, housing, and sewerage.


The U.S. economy has become increasingly international, with our foreign trade now totaling in the trillions of dollars and many multinational corporations operating in both the U.S. and in other countries. Many of the items that are manufactured in the U.S. are not truly "American-made," because many of the parts often come from other countries, and parts of the product may be assembled in other countries as well.
-- [Refer to Figure 6-1 of McConnell, which shows a Boeing airplane and notes where all the different parts came from.] Although Boeing is an American company and final assembly of the plane was probably done near Boeing's Seattle headquarters, most of the body of the plane was made by "international suppliers," i.e. in other countries. The same is often true of "American-made" cars. Likewise, many foreign firms get many of their parts from U.S. plants.

EXPORTS: goods and services produced in the home country and sold to other countries.
IMPORTS: goods and services produced in other countries and sold to the home countries.

[We saw McConnell's overheads of exports as a percentage of GDP (Table 6-1, of exports/GDP for selected countries) and Figure 6-2 (imports and exports as percentages of GDP for the U.S., 1965-present.]
-- Exports are a relatively small share of the U.S. economy. The same is true in Japan as well. Exports are a much larger share of GDP for most countries in Western Europe (e.g., Holland, where exports totaled 56% of GDP in 1996), as well as Canada (38%) and New Zealand (30%).
-- Exports as share of GDP and imports as a share of GDP have both increased greatly in the U.S. in the past several decades, from about 3% of GDP in 1965 to 12-14% of GDP now.
-- U.S. imports have been more than U.S. exports in all but two of the years since 1965, so the U.S. has persistently run trade deficits.


Wed., Sept. 22, 1999

I.    International trade (finish)
II.   National income and national product
III.  GDP accounting (begin)


Last time we noted how the U.S. economy has become increasingly international in the past half-century. An increasing proportion of what we consume is produced abroad, and foreigners are among the biggest investors in the U.S. stock, bond, and real estate markets. Since the mid-1930s, the U.S., like most of the world's other leading economies, has greatly reduced its barriers to foreign imports.
-- [Refer to Figure 6-6 of McConnell.]
---- For most of our early history, the U.S. had very high tariffs (taxes on imports), in the area of 40-50% of the value of imports. The tariffs were seen as a way to protect new and growing "infant industries" in our then-young country from competition with established foreign producers who had the advantage of getting a much earlier start. They were also the government's main source of revenue.
---- U.S. tariffs reached an all-time high in 1930, when Congress passed the infamous Smoot-Hawley Tariff, which raised the average tariff to 60% of the value of imports and helped feed a worldwide trade war that made the Great Depression even worse. Imports and exports plummeted even more than the world economy did. The Smoot-Hawley tariff was reversed in 1934, and U.S. tariffs began a gradual decline.
---- After World War II, the U.S., by now the industrial world's economic and political leader, drastically reduced its tariffs to about 12%, as part of the General Agreement on Trade and Tariffs (GATT) in 1947. Successive rounds of the GATT talks have reduced tariffs even further --> the average U.S. tariff is now just 5%.

Nevertheless, despite our relative lack of barriers to foreign trade and despite the growing internationalization of our economy, international trade remains a fairly small part of the U.S. economy, at least in comparison with the economies of other countries around the world. The U.S., with a large and diverse population and geography, is able to produce the vast majority of what it consumes, and we consume the vast majority of what produce.


CLOSED ECONOMY ("autarky") -- no trade with the outside world
OPEN ECONOMY -- lots of trade with the outside world

"OPENNESS" = a measure of how "open" a country's economy is, i.e. how important its foreign trade is relative to the size of its economy
-- "openness" = (Exports + Imports) / GDP
-- By this measure, the U.S. economy is relatively closed, because so much of what we consume is produced here in the U.S.
-- In 1993, U.S. imports and exports summed to 27% of U.S. GDP
-- The corresponding "openness" measures of some other countries were:

Country Openness
Switzerland  81%
Germany  59%
Mozambique  56%
Canada  48%
Britain  45%
France  44%
Japan  23%
Mexico  19%
India  19%

[We also saw Tables 6-2 and 6-3 from McConnell, showing the principal goods that the U.S. exports and imports and also our principal trading partners.]
-- Computers, chemicals, and semiconductors are our biggest exports; other big U.S. exports are aircraft, grains, and automobiles.
-- Many of those same goods are among our biggest imports. Our top three categories of imports are petroleum (mainly Middle Eastern oil), automobiles, and computers. Semiconductors and chemicals are also in the top seven.
---- Q: Why do we import so many of the same goods that we export? The Theory of Comparative Advantage (which we learned in micro) tells us that countries should export the goods they produce relatively well, and import the goods they produce relatively badly. What's going on here?
---- A: These are very broad industrial groupings, that include things like computer and automobile parts that are produced in one country and then used in the assembly of a final good in another country (like that Boeing airplane in Figure 6-1 of McConnell). Also, in a category like automobiles, the type of cars we import (e.g., energy-efficient Honda Civics and all-wheel-drive Subarus) are likely to be different from the type of cars we export (e.g., trucks, jeeps).
-- The U.S. trades mostly with the world's other large industrial economies -- Canada, Japan, and Western Europe. Canada is our single largest trading partner, accounting for 22% of our exports and 20% of our imports in 1996. Japan is our next largest trading partner, accounting for 11% of our exports and 14% of our imports. Mexico is our third-largest trading partner, accounting for 9% of U.S. exports and 9% of U.S. imports; our trade with Mexico has skyrocketed in the past decade or so, thanks in part to the North American Free Trade Agreement (NAFTA) among the U.S., Canada, and Mexico in 1993. China has also emerged as a key U.S. export market and even more prominently as a key importer into the U.S.


"National income" and "national output" are roughly the same thing. They reflect the two different approaches to calculating GDP. They are:
* the product, or expenditure, approach: add up the values of everything that is produced
* the income approach: add up everybody's wages, salaries, interest income, company profits, etc.
-- The two approaches are both valid because every expenditure by a buyer is at the same time income for the seller. We see this in the circular-flow diagram, where the flow of households' consumption spending equals the flow of firms' revenues from that consumption.
-- [At this point, we saw an overhead of the circular-flow diagram (Figure 6-3 of McConnell) one more time.]

National product: total output of goods and services.
National income: total payments to factors of production.

Say's Law: Supply creates its own demand.
-- This law, named for the 19th century French economist Jean Baptiste Say, notes that the act of producing goods and services, in the aggregate, generates income sufficient to buy those goods and services.
-- The logic behind Say's Law is roughly the same logic behind the circular-flow model.


U.S. GDP in 1997, by these two computation methods.

Personal consumption (C) 68% Wages and salaries  58%
Gross private investment (Ig) 15% Proprietors' income 7%
Government purchases of goods and services (G) 18% Corporate profits and corporate taxes 10%
Net Exports (Xn) -1% Net interest 6%
Rental income (includes "imputed rent" on owned-occupied housing) 2%
Depreciation 11%
Indirect business taxes minus subsidies 7%
TOTAL GDP ($8 billion) 100% TOTAL GDP ($8 billion) 100%

-- [Refer to Table 7-3 in McConnell, which contains the same information but with a bit more detail.]

We can summarize the expenditure approach to GDP as

GDP = C + I + G + (EX-IM)

Defn. Gross investment: Additions to the capital stock (plant and equipment) and the housing stock by the private (nongovernmental) sector.

Defn. Depreciation ("capital consumption allowance," or "consumption of fixed capital"): The amount by which the value of the existing capital stock declines in a given period, because of rust, wear and tear, and destruction.
-- Note: It may seem puzzling that the income approach to GDP includes depreciation, which is clearly not a form of income. Depreciation is only added onto the income side so that the two sides will be equal. The logic of including indirect taxes and (-) subsidies is similar.

Defn. Net exports = Exports minus Imports. Net exports are the same thing as a country's overall trade surplus. If net exports are negative, as in the U.S. today, then the country is running a trade deficit. Currently U.S. exports are about 13% of U.S. GDP and U.S. imports are about 14% of U.S. GDP, hence the trade deficit, or net exports, is -1% of GDP.

Defn. Net investment = Gross investment - Depreciation. Net investment is the net increase in the value of a country's physical capital stock (K, for change in the capital stock) from the previous year.


Fri., Sept. 24, 1999

Today: GDP accounting (finish)

By national income accounting, we mean the process by which national output is officially calculated. Here are two more precise definitions of national output:

Defn. GDP (gross domestic product): the total market value of all final goods and services produced in a given year by factors of production located within a country, regardless of who owns the factors of production.

Defn. GNP (gross national product): the total market value of all final goods and services produced in a given year by factors of production owned by a country's citizens.

Let's dissect the above definitions:
* "market"-- i.e., the good has to be bought and sold (or available for sale) in an "above-ground" market. The market must be legal, and the income or transaction must be reported to the government (for tax purposes).
-- Ex.: I get a haircut. If a barber cut it and reported the income to the government, my payment for it would be counted in GDP. If my wife cut it and didn't report the income, my payment would not be counted in GDP.
* "final goods"-- as opposed to intermediate goods, resold goods.
-- Ex.: Production of a new car counts toward GDP. Production of the tires, dashboard, CD player, etc. that come with the car are not part of GDP, because they are intermediate goods used in production of another good. Likewise, if I sold my car, we would not count the sale in GDP.
-- Crucial to avoid double-counting.
* "services"-- everything from medical/legal/financial services to plumbing to flipping burgers to teaching economics.
* "produced"-- as opposed to "sold"
-- unsold inventories, even apples rotting on supermarket shelves, are part of GDP. If they're sold next year, they're still only part of this year's, but not next year's, GDP.
* "factors of production"-- What are they? Labor (L) and physical capital (K).
* "owned by a country's citizens" vs. "located within a country": this is the difference between GNP and GDP.
-- Exs.:
---- my teaching services in this classroom: counted in U.S. GNP, because I'm an American citizen, and U.S. GDP.
---- the teaching services of a visiting faculty member from Holland: not in GNP, because he's not a U.S. citizen, but it is in GDP.
---- A car produced at a Subaru plant in Indiana, owned by Japanese but using American labor: some of its output is in GNP; all of its output is in GDP.
---- A car produced at a Subaru plant in Japan: none of its output is in U.S. GNP or GDP.

Until about 1990, GNP was the standard measure of national output. Now we use GDP instead.
---- Q: Why do you suppose we've switched our standard measure from GNP to GDP?
---- A: Because of the growing internationalization of the U.S. economy. TV newscasters sometimes warn that "foreigners are buying up America," and it's partly true. That Subaru plant in Indiana provides a lot more jobs for Americans than does a Chrysler plant in Mexico, so seems logical to include most of its output in our national output, rather than vice versa. In 1990, U.S. GDP > GNP by $37 billion-- there were a lot more foreign-owned businesses in U.S. than U.S.-owned businesses in rest of world. (In recent years, by contrast, GNP has been slightly larger than GDP in the U.S.) Foreign direct investment in the U.S. jumped from $54.5 billion in 1979 to over $400 billion in 1989.

Def. Per capita GDP: GDP per person
= GDP/population
-- (Closely related to productivity, which is output/worker.)

U.S. GDP in 1998: ~ $8 trillion, world's largest by far.
-- U.S. per-capita GDP in 1995 = ~$27,000, world's 6th-largest
---- top five: Switzerland ($40,600); Japan ($39,600); Norway ($31,200); Denmark ($29,900); Germany ($27,510)

Q: Why should you care about what the level of GDP is?
* GDP has been called a country's "economic report card."
* Per-capita GDP is a reasonable measure of a country's standard of living. In fact, "standard of living" and "per capita GDP" have come to be virtually synonymous. Higher per capita GDP means that, on average, people will be eating better, living in better dwellings, healthier, better clothed, better educated, consuming more luxuries, etc.
* A large absolute GDP ==> a powerful country.
-- The U.S., with the world's largest GDP by far, is also "the world's only remaining superpower." Like the 900-pound gorilla that sits wherever it wants, an economic powerhouse like the U.S. wields enormous influence in world politics.

Also, you should care because it's an essential part of macro. Economics is about measuring social data as well as interpreting it. Most people would agree that interpreting the data is a lot more fun-- e.g., arguing over whether Reagan's supply-side policies worked or didn't work -- and we'll get to that soon in this course. But for now, let's learn a bit about what the data looks like and where it comes from.

National income accounting, like macro, itself is a relatively new phenomenon:
-- Recall that John Maynard Keynes published The General Theory in 1936, during and largely as an answer to the Great Depression.
-- Simon Kuznets, the father of national income accounting (and later a recipient of the Nobel Prize in economics), published his first estimates of U.S. national output in 1934 and continued to do so through the 1940s. Kuznets estimated U.S. output retroactively to 1869.
---- Historical note: In the 1940s, during World War II, the U.S. and England had national income accounting, and Hitler's Germany did not. That knowledge about national production capabilities made a tremendous contribution to the Allies' military victory.

Calculating the level of GNP or GDP is not easy -- the U.S. Commerce Department employs huge teams of economists and accountants to crunch out the "National Income and Product Accounts" (NIPA).