[MUSIC] In order to understand economic policymaking, we have to start back with the basic indicators, the basic numbers that tell us what's happening in a macroeconomy. Now you have to remember that a country's economy, a macroeconomy, is a dynamic, vibrant, immensely complex organism. It's moving all the time, it's not stable, and so we're going to concentrate in these first few minutes on three indicators that you surely have studied elsewhere in a different course. But, just to make sure that we understand them and the relationships among them, so that we can talk about what government should do when they look at the economy, and when they try to correct the problem. So, we're going to start with the, something we call the circular flow diagram to understand what GDP is, and also to see the dynamics of a macroeconomy. So we, the first picture we're going to make here is of a, an economy, that's very simple. It's got just households on one side. It's got businesses on the other side. And we have a relationship between the two of them, which is the households buy goods and services from businesses. And the businesses then pay income to households, in the form of wages, interest, rent whatever. Now, what households buy from businesses, is something we called consumption, and this is the biggest part of GDP, it's very stable what people tend to buy in order to live; it's not going to fluctuate a lot over time And, so if you look at this diagram and you think about that top arrow, which is the expenditures in the economy. So far, it's just consumption. That top arrow and its relationship with the bottom arrow, which is income in the economy, what you realize is that they're going to tend to be equal. In other words, if people are consuming 100, the businesses will then have 100 to pay back to the households in the form of profits, wages, interest, rents, whatever. But if people receive 100 and suddenly start to consume only 90, what's going to happen is that the next round, businesses will have only 90 to generate an income. So the whole economy will shrink. In other words, the idea is that the top arrows are spending, and whatever is spent will determine those bottom arrows, which are income. And the two will tend towards equality. It's an important thing for us to remember, because this is dynamic, right? And the top part is determining the bottom part. So, after people receive their income, we've seen that they consume. But something else they might do with their income is, they might save it. Okay, so we have an arrow coming out of here and that's savings. And it goes into the financial sector, which is a box up here. And once it's in the financial sector, it may come back into spending again in the form of investment. Okay? Now something we need to understand is that it's one group of people that does the saving, and another group of people that does the investing, so there's no reason for those two to be equal. In other words, I might be saving money because I'm thinking about my future. I'm thinking about getting my children through the university. I'm thinking about my pension, my house I want to buy. And investors might go and borrow the money I saved. Because they want to build a new building, because they think that the future is going to be really bright. or, they might [UNKNOWN] not want to borrow the money I saved, because they don't think the future looks very good, for the same reason I want to save a lot. So, there's a possibility that savings will be bigger than investment. Or, investment will be bigger than savings. All right. If this happens, I want you to just think for a minute, what is the effect on the economy? Imagine that we've got 100 on that bottom flow, 100 in income, and households receive it. They spend 90, and they save ten. Okay? So ten goes into the financial system. All right? Now imagine that investors go to the financial system and they want to borrow only five of that ten. Okay, so we've got ten going out and only five coming back in. This will cause the economy to shrink. In fact, we talk about, in the economy we talk about things that are injections, which is money that comes out of the income stream, and joins expenditure, all right? And then we have things that we call leakages. And that's money that was in that income stream and it leaves. So in this picture we're just drawing, a leakage is savings. Alright, it was generated, it went into household's pockets, and they took it out of the income stream. All right, and the injection is investment. This is money that is out of the system, it's in the financial sector, and investors go and get it, bring it back in. All right? So that's an injection, and what you realize if you think about this is, the economy will be stable at the place where injections equal leakages. All right? Now if leakages, savings in this case, are bigger than injections, which is investment, you can see that the economy is going to decline. All right? We took out 10 and only 5 come back in. The economy will decline. And in this respect, it's important to think about the financial crisis. What happened when the financial crisis started? Well, people became very afraid because they realized that their house wasn't worth what they thought it was, that their mortgage was a lot bigger than they thought it was, relative to the value of their house, that they might lose their job. They started saving more, leakages grew. At the same time, investors looked at the future and they said, Wow. This doesn't look good. I don't want to build that new factory, because I don't know if I'm going to sell what I would produce in it next year. So they started investing less. Okay? So the leakage became greater. The injection became smaller. The economy went straight down. Okay, and that's the beginning of the financial crisis. Now, there are some other things that happened in the economy. Just to go through them briefly, besides saving some of our money, we also pay taxes with some of it, all right? In fact, we pay taxes every place in this circular flow. We pay taxes when we get our money, while we're spending our money, businesses pay, right? All kinds of taxes coming out, and these flow into the public sector, all right? And, the public sector then puts the money back in, in the ter, in the form of government spending, or in the form of transfer payments to people: unemployment benefits, pensions and whatever. So, you see that we have a new leakage, which is tax, and a new injection, which is government spending. And again, now when we put all these together, we see that [COUGH] all leakages will need to equal all injections for the economy to be stable. All right? If all leakages are bigger than all injections, in other words, if savings and tax together are taking more out of the economy than government spending and investment are bringing in, the economy will shrink, all right? If all injections are bigger than all leakages, so investment plus government spending together are bigger. They're putting more into the economy than what savings and tax are taking out. The economy will grow. So again, going back to the financial crisis, we saw that in the first phase, in the first moment of the crisis, people began to save more, invest less. Okay, bigger leakages, smaller injections. How could the government offset this? This is our first insight onto the government. How could the government offset this? By spending more and taxing less. And that is in fact what the U.S. Government did in the first moment after the crisis started. So a new, a new bigger injection to compensate for smaller investment. A smaller leakage to compensate for bigger savings. This should have done the trick. All right? Now there's one other thing that happens in the economy, just to understand the whole picture of GDP, and that is, that we trade with foreign countries. So, we've got a foreign sector out there, and we import from them, which takes some of our income and puts it in foreign countries. That's a leakage. And we export to them, which takes some of their income and shoots it into our expenditure stream, that's an injection, okay? So if you look at this picture, you can see that one way for countries to come out of this crisis would be for this new injection we've just added, exports, to be very big, relative to the new leakage we've added, which is imports. Okay, so if a country manages to export a lot more than it imports, it can compensate for the extra savings that happened as the financial crisis hit, or for the low investment that happened as the financial crisis hit. Or, if you think of a country like Spain, which had savings going up, investment going down, government spending going down, taxes going up. So, leakage is way up, injection is way down. The only way a country like Spain could compensate for the downward effect that this exercises on the economy would be to export much more than it imports, and try to get some growth, and that's exactly what it's doing. So, this picture of the circular flow helps us to understand what GDP is. GDP is actually the top part of this flow in the analysis we're doing today. The top part of this flow, all of the spending in the economy. If you look at all of the arrows we've drawn, we've got consumption, investment, government spending, and net exports, or exports minus imports. In other words, we have a GDP equation C plus I plus G plus X minus M. The way to express this in, in words is that GDP is the total market value of all final goods and services produced in the economy in a given year. We add all of this up, all of our spending, on the things produced by the economy, and we get GDP. Now there are two other indicators that we need to talk about, and they're not the topic of this course, and so I just want to mention their definitions, because I'll be referring to them all the time in later episodes of this course. We're going to be interested in inflation. Inflation simply measures the increase, and sometimes the decrease, the increase in the prices of a basket of goods that the normal consumer buys, and we usually talk about how much those prices have gone up or have gone down in the last year. Unemployment is the percent of the labor force that is looking for work and can't find it. Okay? The percent of all of those who are either working or looking for work who cannot find work even though they're searching for it actively. So those are the three big indicators we're going to be talking about in this first session, and in later sessions. GDP, inflation, and unemployment. What we're going to do next is try to figure out what the right levels are, and how they interact with each other. [MUSIC]
