Understanding the Circular Flow Model and GDP

Circular Flow Model

Illustrates flow of money and goods in economy.

Gross Domestic Product (GDP)

Total market value of all final goods and services produced in a country in one year

Final Goods

Products sold to consumers, not for resale.

Intermediate Goods

Inputs used to produce final goods.

GDP Measurement Methods

Production, income, and expenditure approaches.

what's not included in GDP?

-second hand goods, purely financial transactions, trasnfer payments, services provided for free, intermediates, foreign produced goods

-ilicit/undergrond exchanges

GDP Formula

GDP = C + I + G + Xn.

Consumption Spending (C)

Expenditure by households on goods and services.

Investment Spending (I)

Business spending on capital goods and inventory.

Government Spending (G)

Expenditure by all government levels.

Net Exports (Xn)

Exports minus imports, can be negative.

limitations of GDP

-PIES + such

P - population

I - INequality

E- Environment

S - shadow economy

+ such - things like leisure and housework

Nominal GDP

Value of output in current dollars.

Real GDP

Output value adjusted for inflation.

Consumer Price Index (CPI)

-Measures average price change over time in a fixed market basket of goods + services

-used to calc. inflation rate

-evaluate purchasing power of the average american family

-Market Basket Current Year/Market Basket Base Year * 100

whats in a market basket and why?

-refers to the g + s purchased by consumers

Inflation

Overall increase in prices, erodes purchasing power

-happens when CPI inc

-New - old/old * 100

GDP Def Cy - GDP Def By/GDP def Bf * 100

Deflation

Overall decrease in prices, increases purchasing power.

-cpi falls

employed

holding a job

unemployment

not currently employed but actively searching for a job

Unemployment Rate

Percentage of labor force that is unemployed.

labor force

the sum of those who are employed and unemployed

Labor Force Participation Rate

Percentage of population in the labor force. (Labor Force/Population ) * 100

unemployment rate

% of ppl in labor force who are unemployed

# unemployed workers.labor force * (100)

limits of unemployment rate

marginally attached workers, discouraged workers,underemployed workers

Frictional Unemployment

Temporary unemployment while searching for jobs.

Structural Unemployment

Mismatch of skills and job availability.

Cyclical Unemployment

Related to economic downturns.

Natural Rate of Unemployment

Frictional plus structural unemployment at full employment.

GDP Deflator

Price index measuring inflation for GDP components.

-measures changes in prices for all g + s produced in an economy in a give period which gives the aggregate price levels

-convert NGDP --> RGDP or VV

Nominal GDP/Real GDP * 100

Purchasing Power

Value of money in terms of goods/services.

Cost of Living Adjustments (COLA)

Adjustments based on CPI changes.

Nominal

not adjusted for inflation

nominal income

money one earns via wages or salary

nominal GDP

value of economy output in current dollard—measure of output produced in a given period

-value of aggregate output (Q) in current dollars

∑Pcy Qcy for all g + s counted in GDP. price stays constant and quantity changes

- Real GDP * (aggregate price level/100)

nominal interest rate

stated interest rate

real

values that have been adjusted for inflation

real income

purchasing power of wage or salary

real GDP

value of economy's output in inflation - adjusted dollars

-measure of output produced in a given period

-PbyQby for all G + S in GDP

-∑PBYQCy

-Nominal GDP/aggregate price level * 100

real interest rate

inflation-adjusted cost borrowed money

real value formula

nominal value/price index * 100

limits of price inex

substiution bias - peeople will buy the cheaper thing and market goods will shift price -does not account for this

Intro of new goods- MB does not account for changes in purchasing power from new goods; with new goods each dollar has more value and that consumers will need fewer dollars to keep standard of living

Unmeasured quality changes: if quality falls the value of the dollar changes accordingly

Price Variation: prices of some items in the CPI are more volatile than others

Substitution Bias

Fixed basket doesn't reflect consumer substitutions.

Why does CPI matter?

COLA - if CPI wrong, then COLA wrong

what are the costs of inflation?

scarsity, OC, expectation of future prices, stability = confidence, vv

-high infltion = lower purchasing power

low inflation - higher purchasing power

who does inflation benefit, who does it hurt?

those who are borrowing money because they ulitmately pay less and the lender recieve less

-also anyone receiving money at a fixed rate in getting payed less (SS recipient, multi-year wage agreements)

Business Cycle

Fluctuations in economic activity over time.

-order is ExPRT

Expansion Phase

Rising output and employment in economy.

Recession Phase

Declining output and rising unemployment.

Trough Phase

Lowest point of economic activity.

Peak Phase

Highest point of economic activity before decline.

Output Gap

Difference between actual and potential output.

CPI v GDP

CPI: purchase power, based on fixed MB, Quantity constat, price change, reflects prices of g+s bought

GDP: output, Price constant, Quantity change, reflects g+s domestically

potential output

operates at max efficiency + unemploymnt = NRU

actual output

operate under, at, or over max efficiency; employment differs based on the situation