Macroeconomic Exam #2

Gross Domestic Product (GDP)

• = the market value of all final goods and services produced within a country during a given period of time, typically one year

• measures production

• (Adding up the prices of goods/services let's you compare value of differing things)

Intermediate Goods

• = are goods that are used to produce other final goods of which they are a component

• we do NOT directly include their value in GDP calculations because it would lead to double counting

Physical Capital

• = refers to the factories, machines, tools, etc. that are used to produce other final goods and services, of which they are NOT a component

• we do directly include the value of physical capital in GDP calculations

Net Investment (formula)

Gross Investment - Depreciation

Aggregate expenditure (AE) (formula)

= consumer spending + private investment spending + government purchases  + net exports

= C + I + G + (X-M)

Consumer spending

all spending by consumers on final goods/services by households and individuals produced this year (does not include used goods or the value of new homes)

Private investment

investment in new physical capital by private firms plus the value of new homes

Government purchases

spendings on goods and services by the government, including state and local governments, does not include transfer payments

Net exports

exports minus imports, only one that can be negative

The income approach

Wages paid to labor + Net interest paid to capital + Rental income paid to land + Proprietors income + Corporate profits = net domestic income at factor prices

+ Depreciation + Taxes = GDP

Why is GDP not a perfect measure of production?

1. Household production

2. Underground economic activity

• Includes the black market

Even if we had a perfect measure of production, why would it not be a perfect measure of the standard of living?

1. Leisure time

2. Pollution

3. Crime

Rule of 70

If real GDP grows at, for example, 4.4% per year, then real GDP will double in approximately 70/4.4 years = 15.9 years

Working age population

1) labor force (wants a job)

1. Employed

2. Unemployed 

2) not in the labor force (does not want a job, but could have one)

Not in working age population

1. Younger than 16 years old

2. Incarcerated 

3. In a long term health care facility

An individual is unemployed if:

• They do not have paid work

AND one of the following is true:

• They have applied for a job in the last 4 weeks

• They are waiting to start a new job in the next 30 days

• They are waiting to hear back from an employer who recently laid them off

Unemployment rate (formula)

= [ (# of unemployed people)/(# of people in labor force) ] x100 = %

Labor force participation rate (formula)

= [ (# of people in labor force)/(# of people in working age population) ] x 100 = %

Employment to population ratio (formula)

= [ (# of people employed)/(# of people in working age population) ] x 100 = %

Unemployment rate

the percentage of individuals in the labor force (i.e., those with paid work or actively looking for it) who do not have a paid job

Labor force participation rate

the percentage of individuals in the working-age population, which is supposed to measure those who could potentially be available for work, who are either employed or actively looking for paid work

Why does the unemployment rate understate the true problem of joblessness in the economy?

• Underemployment 

• Marginally attached workers (includes “discouraged workers”)

Marginally attached workers

meaning they're not actively looking for work so they're not in the labor force but if they were offered a job they would take it

Discouraged workers

usually in a recession, people who gave up on applying for a job but could still want one

Price level

measures the average level of prices in the economy

Inflation

 an increase in the price level

Deflation

 a reduction in the price level

Hyperinflation

a monthly inflation rate of 50% or more per month

Inflation that is not moderate or unexpected: problems

1. Redistribute income from workers to employers 

2. Redistributes wealth from lenders to borrowers 

3. Reduce production and employment

4. Divert resources away from production 

Consumer price index (CPI)

• CPI basket includes the goods and services that the average urban family of 4 would consume each year

• Government then collects price data on the set goods and services

• Then sees how the prices go up over time

• It uses the same basket of goods each year and holds the basket fixed 

• Any higher increase is due to inflation

Natural Unemployment

The normal level of unemployment, even in a good economy, which includes people changing jobs and jobs changing over time.

Structural Unemployment

Happens when people’s skills don’t match the jobs available, often because of new technology or changes in the economy.

Cyclical unemployment

Unemployment that rises during bad economic times and falls when the economy gets better.

Frictional unemployment

Temporary unemployment when people are switching jobs or just starting to look for work.

Autonomous consumption

is the portion of total consumption that is independent of income ; what consumption would be in income were zero ; it is on the graph as the vertical intercept of the consumption function

Induced consumption

is the portion of total consumption that is directly attributable to positive disposable income ; it is total consumption minus autonomous consumption

Marginal Propensity to consume (mpc)

• Measures the fraction of additional disposable income that households allocate to consumption

• Change in consumption divided by change in disposable income

Marginal Propensity to same (mps)

• Measures the fraction of additional disposable income that households allocate to saving

• Change in saving divided by change in disposable income

Consumption function shifters

1. The price level (-)

2. The value of household wealth (+)

3. Expected future income (+)

4. Real interest rate (-)

Investment function shifters

1. Expected profitability of business (+)

2. Business taxes (-)

3. Real interest rate (-)

Net Exports shifters

1. Exchange rate (-)

2. Real interest rate (-)

3. GDP growth in close trading partner countries (+)

What if real GDP were less than its equilibrium value?

• AE is greater than real GDP

• Total spending in the economy exceeds production

• Firms’ inventories are shrinking

• Firms’ respond by increasing production and employment

• As a result, real GDP increases toward its equilibrium value

What if real GDP was greater than equilibrium real GDP?

• Real GDP exceeds aggregate expenditure

• Total production in the economy exceeds total spending

• Firms’ inventories are growing

• Firms’ respond by reducing production and employment

• As a result, real GDP decreases toward its equilibrium level

Shifting the AE line

Any factor that increases (decreases) any of the four components of aggregate expenditure increases (decreases) aggregate expenditure and the AE line shifts upward (downward)

The Multiplier Effect

Any increase (decrease) in autonomous spending results in an even larger increase (reduction) in equilibrium real GDP and aggregate expenditure

Spending multiplier is defined as…

Change in equilibrium real GDP divided by change in autonomous spending.

How to calculate spending multiplier

And it can always be calculated as…

1/(1-slope of AE line)

• If there are no imports or taxes: the multiplier equals 1/(1-mpc) or 1/mps 

• If there are taxes or imports, the slope of the AE line will be less than the mpc, so the multiplier will be less than 1/1-mpc.

Economic growth

an increase in the productive capacity of the economy which is measured by “Potential GDP” 

Government Policies that promote economic growth

1. Stimulate saving

2. Promote research and development

3. Improve access to high quality education

4. Improve access to high quality health care

5. Encourage international trade

6. Provide international development aid

income

the funds that an individual or household earns during a specific period of time

Disposable income

income minus taxes

Saving

the funds that remain after paying taxes and purchasing goods and services during a specific period of time

Wealth

the accumulated value of everything that the individual or household owns

Types of financial markets

1. Loan markets

2. Bond markets

3. Stock markets

Supply shifters

1. Disposable income (+)

2. Value of household wealth (-)

3. Expected future income (-)

4. Default risk (-)

Demand Shifters

1. Expected profitability of business (+)

2. Business taxes (-)

Budget deficit

when the government spends more than it collects in taxes

Budget surplus

when the government spends less than it collects in taxes

The aggregate demand curve is downward sloping due to..

1. Intertemporal substitution effect

2. Real wealth effect

The aggregate supply curve would be perfectly vertical.

If both output and input prices (including wages paid to labor) are on average moving with changes to the price level, then changes to the price level would not affect firms profitability or their production of goods and services.

The aggregate supply curve would be upward sloping.

But in the short run, the prices that firms pay for inputs (including wages paid to labor) are “sticky” and take time to adjust to changes in the price level. In this short run, increases in the price level increase firms profitability and production of goods and services. (Inflation is good for firms)

Long-run equilibrium

The value of real GDP equals the value of potential GDP.

Recessionary gap

The value of real GDP is less than the value of potential GDP.

• In the long run, the prices of input goods (including wages paid to labor) fall.

• In response, firms profitability increases and firms increase production.

• The SAS shifts rightwards.

• Real GDP increases towards potential GDP.

Expansionary/Inflationary Gap

The value of real GDP exceeds the value of potential GDP.

• In the long run, the prices of input goods (including wages paid to labor) will rise.

• Firms experience reduced profitability and reduced production.

• The SAS shifts leftward.

• Real GDP decreases toward potential GDP.

GDP (gross domestic product) vs. GNP (gross national product)

• GDP includes final goods produced within a country, regardless of by which firm

• GNP includes final goods produced by firms from a country, regardless of where

What is Nominal GDP?

the market value of all final goods and services produced within a country in a specific period, measured using current prices, not adjusted for inflation.

GDP per person growth rate (formula)

GDP growth rate - population growth rate