Unit 2: Economic Indicators and the Business Cycle

Macroeconomics

The branch of economics that studies the economy “as a whole,” focusing on overall output, income, prices, and employment.

Circular flow model

A model showing how households and firms interact by exchanging resources and goods/services, with money flowing in the opposite direction.

Households (consumers)

In the circular flow, households supply factors of production (especially labor) and demand goods and services.

Firms (producers)

In the circular flow, firms demand factors of production (hire labor, use land/capital) and supply goods and services.

Product market (goods and services market)

The market where firms sell goods and services and households buy them; determines prices and quantities of goods/services exchanged.

Factor market

The market where factors of production (labor, land, capital) are bought and sold; households supply factors and firms demand them.

Factors of production

Inputs used to produce goods and services, especially labor, land, and capital.

Real flows

Physical movements in the circular flow: resources (inputs) from households to firms and goods/services (output) from firms to households.

Money flows

Payments moving opposite real flows: households’ spending to firms and firms’ payments (wages, rent, interest, profit) to households.

Closed economy

An economy model with no foreign sector (no imports or exports).

Government sector (in circular flow)

An added sector that employs inputs and provides goods and services; also affects flows through taxes and transfers when included.

Foreign sector

An added sector that creates imports and exports, connecting domestic markets to the rest of the world.

Gross Domestic Product (GDP)

The total market value of all final goods and services produced within a country’s borders in a given period (usually a year or quarter).

Final good

A good or service bought by its end user; included in GDP to avoid double counting.

Intermediate good

A good or service used up as an input to produce another good; excluded from GDP to avoid double counting.

Double counting

Counting the value of intermediate goods and final goods together, which would count the same production more than once.

Value added

A firm’s contribution to output: value of its output minus the value of inputs purchased from other firms.

Value-added approach

A GDP measurement method that sums value added at each stage of production to avoid double counting.

GDP identity (expenditure components)

GDP measured by spending: GDP = C + I + G + (X − M).

Expenditure approach

A method of calculating GDP by adding spending on final goods and services: Y = C + I + G + (X − M).

Consumption (C)

Household spending on goods and services (durables, nondurables, and services); typically the largest GDP component in the U.S.

Investment (I) in GDP accounting

Current spending that increases future output/productivity (not purchases of stocks/bonds); includes fixed investment, new construction, and inventories.

Types of investment (components of I)

Business fixed investment (equipment/factories), residential investment (new housing), and change in inventories.

Government purchases (G)

Government spending on final goods and services and investment (e.g., salaries of public employees, infrastructure); excludes transfers.

Transfer payments

Payments like Social Security and unemployment benefits that redistribute income but do not represent current production, so they are excluded from GDP.

Net exports (X − M)

Exports minus imports; adds spending on domestically produced goods sold abroad and subtracts spending on foreign-produced goods.

Aggregate income (Y)

Total income earned from production (wages + rent + interest + profit); equals aggregate spending and total output (with accounting adjustments).

Gross National Product (GNP)

Total production by a country’s residents (ownership-based), regardless of where production occurs; differs from GDP (location-based).

GDP exclusions

Items not counted in GDP because they aren’t current market production (e.g., used goods resales, most financial asset trades, unpaid work, many illegal/unreported activities, transfer payments).

GDP per capita

GDP divided by population; used as a rough proxy for average material living standards (especially when using real GDP per capita).

P-I-E-S (limitations of GDP for living standards)

A checklist of what GDP misses/complicates: Population differences, Inequality, Environment, and Shadow economy.

Nominal GDP

GDP measured using current-year prices (current-dollar or money GDP); can rise due to higher prices even if output doesn’t rise.

Real GDP

GDP measured using prices from a fixed base year (constant-dollar GDP); better reflects changes in quantities/production.

Base year

The reference year for an index (set to 100), used to compare price levels over time.

Price index

A measure of the average price level relative to a base year; interpretable as current prices as a percentage of base-year prices.

GDP deflator

A price index for all final goods and services in GDP: (Nominal GDP / Real GDP) × 100.

Inflation

A sustained increase in the overall price level (a general rise in prices across the economy).

Consumer Price Index (CPI)

An index measuring the average change over time in prices paid by urban consumers for a market basket of consumer goods and services (a main measure of consumer inflation).

Inflation rate (from CPI)

The percent change in CPI from one period to the next: ((CPIt − CPI{t−1}) / CPI_{t−1}) × 100.

Nominal vs. real income

Nominal income is measured in today’s dollars; real income is inflation-adjusted (measures purchasing power, often using CPI).

Nominal vs. real interest rates

Nominal interest is the stated rate in dollars; real interest reflects purchasing power. Relationship: Nominal ≈ Real + Expected Inflation; Real ≈ Nominal − Inflation.

Labor force statuses

Employed (worked for pay at least one hour per week), Unemployed (not working, available, actively seeking), or Out of the labor force (not working and not actively seeking).

Labor force

The number of people either employed or unemployed: Labor Force = Employed + Unemployed.

Unemployment rate

The share of the labor force that is unemployed: (Unemployed / Labor Force) × 100.

Labor force participation rate

The share of the adult population that is in the labor force: (Labor Force / Adult Population) × 100.

Discouraged workers

People who stop searching for work after a long jobless period; counted as out of the labor force, which can understate unemployment.

Types of unemployment

Frictional (short-term job search), Seasonal (calendar-based), Structural (skills/location mismatch), and Cyclical (due to business-cycle downturns).

Full employment (natural rate idea)

A situation with no cyclical unemployment (only frictional/structural/seasonal remain); associated with the natural rate of unemployment (often around 4–6% in the U.S.).

Business cycle

The periodic rise and fall of economic activity measured by real GDP, with phases: expansion, peak, contraction, and trough (recession commonly described as two consecutive quarters of falling real GDP).

Potential output and output gaps

Potential output (full-employment real GDP) is sustainable production at the natural rate. If actual < potential → recessionary gap; if actual > potential → inflationary gap. Output gap percent: ((Actual − Potential)/Potential) × 100.