The economics of the US Economy

  • July 28, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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The economics of the US Economy

Subject: Economy

Section:  National income

Context:

Since March, the Fed has steadily pushed up the targeted  Federal Funds Rate (FFR) from zero to almost 2.5% now.

Implications:

  • Curb Inflation- 
    • by raising the cost of borrowing (the interest rate), the Fed hopes to reduce overall demand in the economy and related demand pull inflation.
  • Recession or hard landing of the economy-
    •  Aggressive monetary tightening — involves large increases in the interest rates in a relatively short period of time, and it runs the risk of creating a recession.
    • This is called a hard-landing of the economy as against a soft landing (which essentially refers to monetary tightening not leading to a recession).

US economy- mixed signals–

One the one hand, it faces an inflation rate that is at a four-decade high and, on the other, its unemployment rate is at five-decade low.

  • Higher Inflation-The US inflation rate is at over 9% and the Fed’s target inflation rate is 2%
  • Decline in the GDP (likely Recession)- 
    • For the first three months of the year, GDP contracted by 1.6% and estimated to be below 1% in the April-June quarter but it stays in the non-negative zone.
  • Rise in wages and employment-
    • Despite contraction in GDP, the US economy created around 2.7 million new jobs in the first half of 2022.
    • In the first quarter, GDI grew 1.8% — much better than the 1.6% decline in GDP.

Concept:

Federal Funds Rate (FFR):

  • The FFR is the interest rate at which commercial banks in the US borrow from each other overnight. 
  • The US Fed can’t directly specify the FFR but it tries to influence the rate by controlling the money supply
  • When the Fed wants to raise the prevailing interest rates in the US economy, it reduces the money supply, thus forcing every lender in the economy to charge higher interest rates.
  • This process starts with commercial banks charging higher to lend to each other for overnight loans.

Recession:

  • The most common definition of recession requires the GDP of a country to contract in two successive quarters. 
  • Contracting GDP typically results in job losses, reduced incomes, and reduced consumption.
  • In the US, it is the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee — that typically declares a recession. 
    • It defines recession—as a significant decline in economic activity that is spread across the economy and that lasts more than a few months.
    • It lays down 3 criteria —depth, diffusion, and duration—that needs to be met individually to some degree, where equal weight is given to GDP and GNI.
    • The NBER also studies many other data points in determining recessions, including measures of income, employment, inflation-adjusted spending, retail sales and factory output.

Indicators of onset of Recession:

  • Inversion of the bond yield curve-
    • Changes in the interest payments, or yields, on different bonds for a recession signal known as an “inverted yield curve.”
    • This occurs when the yield on the 10-year Treasury falls below the yield on a short-term Treasury, such as the 3-month T-bill.
    • Normally, longer-term bonds pay investors a richer yield in exchange for tying up their money for a longer period.
    • Inverted yield curves generally mean that investors foresee a recession that will compel the Fed to slash rates. Inverted curves often predate recessions. 
  • Surge in unemployment–
    • layoffs indicate slowing of manufacturing activities and lowering wages.

Gross Domestic Product (GDP) vs Gross Domestic Income (GDI):

  • The GDI refers to gross domestic income; this is also a measure of national income albeit from the income side of the economy as against the GDP, which looks at the expenditure side of the economy. Thus.
    • GDP calculates the value of the nation’s output of goods and services by adding up spending by consumers, businesses and governments. 
    • GDI  seeks to measure the same thing by assessing incomes of  consumers, businesses and governments.
  • Over time, the two measures should track each other. But they often diverge in the short run due to statistical errors.
    • According to NBER, the difference between GDP and GDI—called the ‘statistical discrepancy’
economy The economics of the US Economy