Economics Unit 2 Test

Gross Domestic Product

• Aggregate output of an economy

• How we measure growth in the economy

• Measure of the market value of the output of final goods and services in the economy in a given period

How do we grow the economy?

the net investment needs to be postive (more gross investment than depreciation)

How to calculate GDP?

• expenditures method: add up aggregate spending on all domestically produced goods and services in the economy (Y=C+I+G+(X-M)) *rent is counted as consumption

• income method: add up the total factor income earned by households from firms in the economy, every dollar spent become a dollar of income for someone, total value of market income = total value of GDP (income = wages, profits, interest, rent)

• value-add method: add total value of all final goods and services produced, used to avoid double counting by excluding intermediate goods

intermediate good

goods and services used as input to create a final good/service ex. leather in shoes

final good

final product counted in GDP

GDP v. GNP (Gross National Product)

GDP measures the market value of the output of final goods and services in the economy versus GNP which measures the market value of the output produced by residents and citizens of a country

Real GDP v. Nominal GDP

Real GDP is the value of final output produced adjusting for changing prices (accounts for inflation) (year t = nominal GDP in year t / price index) versus nominal GDP is the value of final output produced measured in the prices during that period of time (year t = 0)

price index

price level percentage change from a base of 100

purchasing power parity

the nominal exchange rate between two countries at which a given basket of goods would cost the same amount in each country (COLA) - exchange rates differ

What is counted in GDP?

• investment spending

• capital spending

• domestically produced G&S

What is not counted in GDP?

• spending on intermediate G&S

• used goods

• financial assets like stocks and bonds

• import spending

• black market economy

What are som shortcomings of GDP as a measure of economic growth?

• Does not account for: externalities ex. environmental damages, quality changes ex. free software updates, intangibles ex. political freedom, and non-market activities ex. money laundering

• does not show wealth distribution or accurately reflect the quality of life

labor force

all people 16 or older employed or actively seeking work (not included are those not employed or actively seeking work)

how to calculate labor force participation rate?

participation rate = (labor force / population 16 and older) x 100

way in which labor force increases?

• aging of the younger population (out of school)

• population increase

• immigration

*growth expands PPC

unemployment

inability of people in labor force to find a job

how to calculate unemployment rate

unemployment rate = number of people unemployed / labor force

okuns law

1% more unemployment = 2% less output

how does the government measure unemployment?

US census bureau surveys 60,000 households every month

how do unemployment rates understate the labor market

it does not count discouraged workers

how do unemployment rates overstate the labor market?

it includes people in between jobs (frictional unemployment) or gig workers

discouraged worker

individuals who have given up on looking for work because they cannot find a job (not counted in unemployment rate)

underemployed

workers who want full-time jobs but are working part-time or below their capacity

federal minumum wage

$7.25 per hour

labor supply curve

shows number of workers willing and able to work in an occupation at different wages

labor demand curve

shows number of workers firms are willing to hire at different wages

unemployment graphically

when minimum wage (price floor) is above equilibrium = surplus of labor = people unemployed

seasonal unemployment

unemployment due to seasonal changes ex. summer job

frictional unemployment

brief unemployment due to people moving between jobs or entering the labor market ex. college student

structural unemployment

unemployment caused by mismatch in skills ex. new technology puts factory workers out of work

cyclical unemployment

unemployment due to lack of job vacancies ex. market crash, depression

what does not count as unemployment?

vacation, strike, parental leave

full employment

not 0% unemployment because always people moving in between jobs, will cause inflation if at 0% unemployment, stays at natural unemployment

0% unemployment

unachievable because there is always frictional and seasonal unemployment

what is the relationship between unemployment and inflation?

when low unemployment (below 4-6% - natural rate), workers will demand higher wages, prices then increase, people buying more, wage pressure, inflation

stagflation

when both unemployment rate and inflation are high

inflation

increase in average price level

causes of inflation

• demand-pull inflation: consumers willing and able to buy more goods than economy can produce, producers raise prices, driven by high demand

• cost-push inflation: producers raising output prices to cover high costs when production gets expensive

inflationary spiral

when demand-pull and cost-push cause each other to grow, goes round and round (consequence of inflation)

deflation

decrease in average price levels

macroeconomic effects of inflation

• price of goods and services go up

• can affect people if nominal income does not rise with the rate of inflation

• affect wealth if assets are declining in real value

• social tensions, loose faith in government

• psychological affects: money illusion - the use of nominal dollars rather than real dollars to gauge income or wealth

consequences of deflation

• avg price level falling

microeconomic effects of inflation

• speculation

• uncertainty makes it hard to make long term decisions (investments)

• bracket creep: higher tax brackets = higher taxes but real income may not have increased

hyperinflation

200% inflation for at least one year

how do you measure inflation?

• market baskets: economist track prices of typical consumer goods

• inflation rate = ((price index in year 1 - price index in year 0)/price index in year 0)x100

• price indexes: (cost of market basket in given year / cost of market basket in base year) x 100

real interest rate

nominal - inflation

inflation rate

((consumer price index in year 1 - consumer price index in year 0)/consumer price index in year 0)x100

what are the economic cost of unstable prices?

• shoe-leather costs: everyone is running around with their money because loosing value if in savings

• menu costs: restaurants keep changing menu prices due to unstable prices, have to pay for printing new menus

• unit-of-account costs: money becomes unreliable unit of measurement

what indicates aggregate price level?

• consumer price index

• producer price index

• GDP deflator

• employment cost index

• import/export price indicators

what are limitations of consumer price index?

• avg bundle of goods isn’t necessarily what avg consumers purchase

• consumer habit change

• people substitute goods when prices change

CPI

consumer price index: measures price level of consumer goods

PPI

production price index: measures price level of production goods (includes material, intermediate goods, and final goods) - more accurate in measuring

what can the government do to control inflation?

• price stability

• allow some unemployment

What can happen when there is low inflation?

• high unemployment

• slower economic growth

• more demand from people anticipating inflation

What are some measures to reduce the effects of inflation?

• COLAs: cost of living adjustments, auto adjusts nominal income to rate of inflation

• ARMs: adjustable rate mortgages, protects banks

business cycle

1. peak - max gdp

2. recession - gdp declines

3. trough - gdp minimizes

4. recovery - gdp increases

*the business cycle is unpredictable

What causes economic recovery?

• stimulating aggregate demand or supply

• printing more money

• lowering interest rates

• tax relief/subsidies

• stimulus check

what causes recession?

• supply shocks ex. covid restricting resources

• demand shocks ex. gov stimulus everyone buying stuff

aggregate demand

total quantity of output (real GDP) demanded at alternative price levels

why does the aggregate demand curve slope downward?

people will buy more goods and services at lower price levels and vice cersa

real-balances effect

real value of money measure by how many goods/services dollars can buy us, therefore more money = more output

foreign-trade effect

as price levels rise, americans substitute away from american products, use cheaper foreign ones

interest-rate effect

at lower price levels, money is cheaper because interest rates go down at lower price levels

aggregate supply

total quantity of output (real GDP) producers are willing and able to supply at alternative prices

why is the aggregate supply curve sloping upward?

suppliers will bring more goods and services to the market at higher prices and vice versa

profit-effect

when price levels decline, profits drop, producers are stick with fixed costs ex. rent output will increase when price level rises

cost effect

costs are minimal at low rates of output but economy approaches capacity so suppliers raise prices to keep pace w costs

What causes shifts in aggregate demand?

changes in wealth, expectations, size of existing stock of physical capital, fiscal policy (congress, state, and local), monetary policy (the fed)

what causes shifts in aggregate supply?

changes in commodity prices, nominal wages, and productivity

the fed

the central bank of the united states

What are the results from shifts in aggregate demand and supply

• AD shift left = recession, reduces output and price levels

• AD shift right = recovery

• AS shift left = stagflation, reduced GDP and raises prices, too much = overheat

• AS shift right = lower inflation, reduces prices of key inputs

supply side theories

• failure to achieve full employment may result from unwillingness of producers to provide more goods and services at current prices

• solution = use tax incentives, deregulation, etc.

keynesian theory

• deficiency in spending depresses economy

• inadequate aggregate demand would lead to unemployment

• increasing money supply or lowering interest rates could move AD curve to the right

recessionary gap

• between theoretical LRAS and current equilibrium

• bottom of business cycle

• not achieving natural output

• real GDP is less than GDP at full employment

inflationary gap

peak in business cycle

inflationary flashpoint

aggregate demand stimulated to inflation, at the start of the inflationary spiral where inflation accelerates faster than output

why is the LRAS curve vertical?

• natural rate of output does not change with market structure, tech, demographics, etc.

• institutional infrastructure of economy is fixed (neoclassical)

• natural rate is immune to short-run fluctuations in AD

• shifts in AD in long run do not change quantity of output demanded, in the long run costs will catch up with prices, workers will demand higher wages, interest rates go up, etc.

classical economists

laissez-faire - let market mechanism, invisible hand do its thing, assumes nothing goes wrong

Say’s law

whatever is produced will be sold, unsold goods and unemployed labor only last until prices and wages are adjusted - supply creates its own demand

keynesian economics

• market-driven economies are unstable and take gov intervention to stimulate demand

• gov should spend money they don’t have (debt) to stimulate projects, more jobs, more economic activity, more supply, leads to more demand, out of great depression

keynesian multiplier

extra government spending can trigger private spending and investment

monetarist economist

• amt of money the fed prints is what circles around the economy

• concerned w reducing taxes and regulations to reach full productive capacity

• stimulate or cool AD

inflation winners

stockholders, owners of appreciating assets, fixed rate debt holders, gov with public sector debt

inflation losers

bondholders, renters, savers, some debt holders (ARMs), people with fixed income, banks with fix-interest loans, politicians