Question

1. In theory, what conditions must exist for a company to build a new factory? That is, what hurdles must a firm overcome in order to build a factory?  

2. What are the five areas, or categories, of Total Spending? How large is each area, in terms of total dollars spent, and in percentage terms--- as a percent of Total Spending?  

3. What are the four events that may cause a recession, in theory? What IS a recession, exactly? Are we in one right now? What has happened to Total Spending in 2020, as compared to 2019? Why?

4. Please list and discuss three features of business spending that make it unique--that set it apart form the other areas of total spending. Why is business spending so important to our economy?

here is the lecture:

THE TOTAL SPENDING EQUATION AND THE IMPORTANCE OF “I”--- INVESTMENT --- BUSINESS SPENDING: An introduction into the entire field of Macroeconomics, in theory, may be expressed by the following equation: Total Spending (as measured by the GDP) = C + I + G + (X -M), that is, the concept of the total amount of money spent on U.S. goods and services in any given year may be measured by examining various areas of our economy: C, consumption, also known as household spending, I, Investment, which is more accurately described as business spending, G, government spending, X, exports, and M, imports. We have examined C, consumption, in earlier modules. We will now examine the concept of I, Investment, business spending. Later in the course we will examine G, government spending, along with tax collection, and the deficit and the debt, along with X and M. Before March 2020, total spending was cruising along at a level of about $21.5 trillion for the year---on an annual basis. Owing to the recession of 2020, total spending will probably drop to somewhere in the area of $20 trillion for the year---or lower. In terms of a percentage breakdown, C, total household spending, makes up about 68% of total spending, I, Business Spending, comes in at a historical average of about 17%, though it had been dropping for several months prior to March 2020, G comes in at about 22% of the total--- much higher than just a few years ago, while (exports minus imports) may vary between minus 3% and minus 5% of total spending. We track exports and imports in relationship to one another, which we call the ‘trade deficit”. Prior to March 2020, exports tended to represent about 12% of the U.S. economy, in terms of total spending, and imports represented about 15% of total spending. Here, a little humility is in order: WE DO NOT KNOW with any degree of precision what will happen to these numbers--- exports and imports--- in the next year or two. We have a global recession on our hands, and estimates are changing week to week. It is a very daunting time to come up with the next edition of an Econ text! Obviously, it is my job to present you with the latest numbers and the latest news in all matters involving the study of macroeconomics. As you may imagine, I am very busy these days! The category of total spending known as “I”, which stands for Investment, also known as Business Spending (sorry about all the terms!) is particularly compelling. I believe it is safe to say that the area of the economy known as “I” is MUCH MORE IMPORTANT THAN JUST 17% OF OUR ECONOMY. This sounds a little odd, since an area representing 17% of our economy should be worth 17% of our time---right? Well… it is ‘worth more than that’, one may argue. WHY? WHAT IS SO DARN SPECIAL ABOUT BUSINESS SPENDING??? Well, it is the only category of the ‘big three’--- C, I, and G --- that can rise or fall by 20% in one year. In fact, it would not surprise me if business spending DID IN FACT DROP BY 20%----OR MORE --- IN THE YEAR 2020. C will not drop 20% (THANK GOODNESS), and G SURELY WILL NOT DROP THIS YEAR---IN FACT, IT IS RISING AT A RATE NOT SEEN SINCE WORLD WAR TWO--- this rise in G will be studied for decades, if not centuries. The EXTRA $2.2 trillion in stimulus spending so far in 2020 is just the start. MUCH MORE ON THIS LATER! We may describe the area of business spending as follows: “businesses… spending money… hiring workers… to BUILD”---what we are really talking about here is CONSTRUCTION VOLUME, or CONSTRUCTION ACTIVITY! So… why not just call it CONSTRUCTION spending?? I do not know. That is what I would call it. It is more descriptive. A warning: the word “Investment” means something distinct and different inside this course: it is used to represent this area of the economy. Outside this course, this very slippery, malleable word means something else. The phrase: “we ‘invested’ $10,000 by buying Apple stock today” has a different meaning--- related to our definition, but not the same. Let me explain: “investment” in this course stands for the construction of new factories, (new plant and equipment and office buildings), the construction of new housing units (homes, condos, apartment units, ADUs, mobile homes) and the addition of new inventories—more on this later. What is so special and unique about Investment, also known as business spending? It involves BUILDING SOMETHING NEW: in 1932, it was zero for the year. C and G would NEVER be zero for the year. In 1932, we were three years in to the Great Depression. Unemployment (U) reached 25% AND STAYED THERE. U may hit 20 or 25% later in 2020, but IT WILL NOT STAY THERE. In 1932, there was no demand for new factories, or new homes, and businesses were busy drawing down inventories—not adding to them. Let’s look at one selfish firm deciding whether or not to build a new factory on U.S. soil in the next 12 months . This is the essence of business spending. It must proceed through four steps, or see four “green lights’, before it will start down this path. STEP #1: GREAT EXPECTATIONS! The decision to build this new factory is an ALL OR NOTHING decision. Let’s say it is April, 2019, and we are deciding whether or not to build the new factory. If we build the factory, we will start construction in Jan, 2020 and finish in Dec, 2020. The factory will cost $100 million to build in calendar year 2020 if we build it, and $0 if we do not build it. All or nothing. This is a small factory! The Tesla – Panasonic battery plant outside Sparks, Nevada may end up with a cost of about $5 billion when it is finally completed. Regardless of the size of the factory, a firm must have ‘the green light’ in order to build a new factory---an “all or nothing” decision. IT MUST GET EXCITED ABOUT THIS PROJECT! THIS IS THE MOST IMPORTANT DECISION THIS FIRM WILL MAKE IN THE NEXT THREE YEARS! This project will most likely have to ‘beat out’ other projects inside the firm competing for scarce resources. I want you to visualize a healthy firm that is doing so well THAT IT WANTS TO EXPAND. It has MORE IDEAS THAN MONEY. Thus, there is a ‘competition’ inside the firm for which project to pursue and which factory to build. Jobs and careers are at stake. ONCE WE HAVE THE GREEN LIGHT, then we have to line up FINANCING—whether it is generated in equity markers or in debt markets. More on this later, but let me introduce you to the idea that THERE IS A FINITE AMOUNT OF MONEY available for projects such as this one. We will have to ‘beat out’ other firms who are competing for the same pot of money. Our government does not help all of this by BORROWING A TREMENDOUS AMOUNT OF MONEY EACH YEAR. This is known as the deficit. Obviously, the deficit is skyrocketing this year as our government is borrowing over $2.2 trillion MORE THAN BEFORE in its efforts to save our economy and reduce the scale of human misery that comes with tens of millions of workers losing their jobs. Every major economist I have seen and heard this year has said “let’s not worry about the debt and the deficit right now”---and that is fine. We MUST worry about it LATER! MUCH more on this later! If the firm can secure financing, it must also clear regulatory hurdles: it must apply for, and be granted BUILDING PERMITS --- from local, state and federal government agencies. Thus, this area of spending in our economy is no “slam dunk”--- many pieces must fall into place in order for a construction project to move forward. Looking at the equation Total Spending = C + I + G + (X – M) we may ask this question: what possible events may occur that would start a recession? Now, there is a very precise definition of a recession, but an introductory look at this suggests that a recession occurs when total spending drops for two business quarters in a row—six months. In fact, there is a commission that “calls” recessions. There is NO doubt that we are in one right now. Recessions have occurred in: 1981-2, 1990-1, 2001, 2008-9, and, of course, 2020. WHAT FOUR EVENTS MAY CAUSE A RECESSION? In theory, we may see: 1. A drop in G 2. A drop in X 3. A drop in C 4. A drop in I. Let’s look at each possible event: in terms of the historical norm, a drop in G does not happen from year to year. I suppose that G, government spending, may well drop from its INCREDIBLY HIGH levels in 2020, back down to its ‘normal’ level in 2021---we certainly hope so. We hope and pray that the current recession is short. Normally, G rises by about 4% per year, for various reasons—much more on this later. If G must rise by 4% per year, or at least $160 billion per year, then SOME OTHER AREA of total spending must REALLY DROP in order to cause a recession. G does not drop from year to year in normal times. A drop in X may occur this year, but a once-in-a-century pandemic is not normal. In a normal year, export sales will rise as the global economy grows. Obama came in to the presidency in early 2009 promising to preside over a doubling of export sales--- and he just about got us there. The global economy tends to rise about 2 to 3% per year. Not so this year, obviously. We have a great record of producing products and services that are sold to households, businesses and governments in other countries: planes with weapons on them, planes without weapons on them, food, entertainment products and services, financial services, and MANY other products and services. Prior to March 2020, export sales accounted for over ten percent of our economy, and our jobs. In theory, let’s say that one of our trading partners is suffering a drop in total spending, and thus will be cutting back on the volume of products and services that they may buy from U.S. businesses. We have some of our best and brightest people in positions of power to try to make sure this does not happen: our trade representatives, the IMF, the World Bank, and many other institutions may act so to help that country’s economy. We also have “foreign aid”. While foreign aid represents a TINY portion of overall government spending, there is a false impression of it among many Americans. Many people believe that we just ‘hand out’ money to other countries. Let’s take Egypt as an example. As the most populous Arab nation, Egypt is just INCREDIBLY important in terms of U.S. interests. Ever since they signed a peace agreement with Israel--- President Carter’s greatest foreign policy achievement---our government has been ‘giving’ them a lot of money each year--- but it is NOT a ‘handout”. We tell Egypt, for example: “here is $3 billion—now, WHAT U.S. PRODUCTS AND SERVICES ARE YOU BUYING WITH THIS MONEY? Food? Weapons?” If we drill down more deeply, we see that this is a U.S. JOBS PROGRAM. Why does Turkey receive so much aid from the U.S.? Could it be that we have a military base on their soil? That they are a member of NATO? Our nation has a very good record of preventing event #2 from occurring. A once-in-a-century pandemic does not change this fact. EVENT #3: a drop in C. Now, obviously, it was a drop in C that caused this recession. Well, that is a bit simplistic… when many of our 30.2 million small business CLOSED SHOP, NEVER TO REOPEN, and over 20 million workers LOST THEIR JOBS OVERNIGHT… we will see a drop In C. Let’s say this is unusual. The events of 2020 will be studied 100 years from now. In normal times, obviously, a drop in C may cause a recession--- but that is not normally how it works, in terms of the ‘timing’---the initial cause of a recession. C, household spending, drops DURING a recession (usually) as a ‘fifth-in-time’ event. We may recall the story of Tom Green: he lost his job, and yes, as a direct result, his family will cut back on household spending. Here is how the sequence may transpire: 1. FOR SOME REASON, total spending drops. 2. Businesses see a drop in sales volume. 3. Businesses react by cutting back on production volume. 3. In doing so, they cut the hours of some workers and terminate the employment of others (when I get fired, my hours get cut, obviously, to zero) 4. Workers see a drop in wage income. 5. In response to the drop in income, most workers will cut back on household spending levels --- as income drops, household spending drops, albeit not dollar-for-dollar. YET… WHAT WAS THE INITIAL CAUSE OF THE DROP IN TOTAL SPENDING! What event “started’ the recession? In most cases, it is a drop in I, business spending. Not all cases, but most. Leading up to March 2020, economists were getting more and more concerned that this area of the economy was ALREADY DROPPING, partly in part to Trump’s erratic trade policies. Businesses need ‘GREAT EXPECTATIONS’ to build that new factory on U.S. soil ---(at least in theory)--- and Trump is not good at creating and maintaining great expectations. Then, the pandemic invaded our country, and both C and I dropped in a dramatic fashion. In the months leading up to the recession of 1981-1982, the volume of business spending dropped… and dropped… and dropped more… and more…. And, finally, the drop in business spending “dragged down” total spending. The drop I--- business spending---- OVERWHELMED the rise in government spending, and, as a result, the recession was inevitable. The recession started in Jan. 1981 – just as Reagan came in to office. By the time he was running for reelection in November, 1984, the economy had completely rebounded. Nice timing! The Fed had pursued ‘contractionary monetary policy’ from March 1979 to March 1980, in order to battle high rates of inflation, raising interest rates to a modern-day high. A home loan cost about 18% interest. VERY few homes were purchased, or sold, or BUILT during this time. Sellers of homes often had to PERSONALLY LEND buyers some of the money! If the new home buyers could not pay the monthly mortgage, the home seller, in theory, would have to hire an attorney and foreclose on the house. Thus, even though C and G are LARGER AREAS of total spending, I, that is, business spending, is by far THE MOST VOLATILE --- THE QUICKEST TO CHANGE, and BY A GREAT MAGNITUDE. Home construction and sales volume DROPPED BY HALF during the Great Recession which ran from Dec. 2007 to June 2009. The entire category of business spending can drop by 20% in one year. It may be doing just that right now in 2020. Our government is AGGRESSIVELY trying to minimize the drop in C, household spending, during this turbulent time. We will study some of the programs involved later in the course. Yet, business spending continues to drop this year as MANY firms delay planned construction projects. Thus, it is clear to see that business spending is quite unique and special, and deserves ‘more than 17%’ of our time. Later in the course, we will examine the role of our government in attempting to cause a rise in business spending—not just for one year, but for the next 20 years.

Answer 1

1. In theory, there should be great expectations about the future as the decision to build a new factory is all or nothing. Thus the economy should be essentially growing for a firm to build a new factory. It should have the green light within the firm regarding whether the project is worth pursuing. There is the issue of financing, whether it is easily available. One will have to beat out all other firms in order to pursue financing. Then it has to clear regulatory hurdles and be given building permits from various agencies. Thus many pieces have to be in place in order to build a new factory, even if one aspect goes missing, the entire project doesn't move ahead.

2. Five areas or categories of Total spending are Consumption, Investment, Government spending, Exports and Imports.

Now Consumption is the largest making 68% of the total spending. Now for example Total spending was $21.5 trillion for a year. Thus Consumption in dollar terms was 0.68 * 21.5 = $15 trillion approximately.

Investment holds third largest share at 17% of total spending. 0.17* 21.5 = $4 trillion

Government spending holds the second largest share at 22% of total spending. 0.22 * 21.5 = $5 trillion.

Exports 12% of spending. 0.12 * 21.5 = $3 trillion.

Imports 15% of total spending. 0.15 * 21.5 = $3 trillion.

3. Four events that may cause a recession in theory are

i. Drop in government expenditure.

ii.Drop in exports.

iii. Drop in consumption.

iv. Drop in Investment

Recession is when the total spending which is the GDP falls for two consecutive quarters which makes up six months.

The economy is in one right now as the US GDP has fallen for two consecutive quarters.

Total spending in 2020 has declined as compared to that in 2019, led by the recession as output has declined.

4. Three features of business spending that make it unique are that it involves building something new, it can go zero in times of recession, other components of spending can never go zero. Investment spending is also very volatile as it is the quickest to change by a great magnitude. It can drop drastically during times of recession, others can't fall by 20% in one year.

It is important to the economy because it drives future growth over several years as capacity is built, it is also important because a drop in business spending in most cases causes recession. And if it grows it causes cumulative growth in all other parameters.