Macro Unit 2 Study Guide: Circular Flow, GDP, Unemployment, and Inflation

Flashcards covering AP Macroeconomics Unit 2 topics: the Circular Flow model, GDP definitions, expenditure and income formulas, limitations of GDP, unemployment types, price indices (CPI and GDP deflator), costs of inflation, and the business cycle.

What is the definition of Gross Domestic Product (GDP)?

GDP is the total market value of all final goods and services produced within a country's borders in one year (measured in one year).

Based on the circular-flow diagram, what do households provide to firms through the markets for factors of production, and what do they receive in return?

Households provide the factors of production (labor, land, capital, and human capital) to firms, and in return receive income in the form of wages, rent, and profit.

How do households and firms interact differently in the resource market versus the product market?

In the resource market, households are sellers (providing labor, land, and capital) and firms are buyers. In the product market, the roles are reversed: firms are sellers of goods and services, and households are buyers.

How is the government incorporated into the circular flow model?

The government collects tax revenue from firms and households, uses that revenue to purchase in both the factor and product markets, and distributes funds via transfer payments to individuals and subsidies to firms.

What is the formula for calculating GDP using the expenditure approach?

$GDP = C + I + G + X_n$, where $C$ is consumer spending, $I$ is investment spending, $G$ is government spending, and $X_n$ is net exports ($\text{Exports} - \text{Imports}$).

What is the formula for calculating GDP using the income approach?

$$GDP = \text{Wages} + \text{Rent} + \text{Profits} + \text{Interest}$$

How does the value-added approach to measuring GDP differ from the expenditure and income approaches regarding intermediate goods?

The expenditure and income approaches only count final goods and services to prevent double counting, whereas the value-added approach includes intermediate and final goods and services by reporting the value added at each stage of production.

Why are financial transactions like buying stocks excluded from GDP calculations?

Buying stocks is a non-production transaction where nothing is actually produced. However, any fee charged by a broker is a productive service and is counted in GDP.

What are three non-market or non-production activities that GDP fails to account for?

1. Non-market or illegal activities (the government has no record of them).\n2. Household/domestic production (e.g., changing your own car oil or cleaning your house, where no money is exchanged).\n3. Sales of used goods (they were counted in the GDP of the year they were produced).

What three criteria must an individual meet to be officially counted as unemployed?

1. Actively looking for work.\n2. At least $16$ years of age and able to work (excludes prisoners, disabled individuals, etc.).\n3. Currently not working (part-time workers are counted as employed, though underemployed).

What are the formulas for the labor force and the unemployment rate?

$\text{Labor Force} = \text{Employed} + \text{Unemployed}$\n$\text{Unemployment Rate} = \left(\frac{\text{Unemployed}}{\text{Labor Force}}\right) \times 100$

Why does the official unemployment rate often understate the true level of joblessness?

It excludes discouraged workers (people who have stopped looking for work) and underemployed workers (part-time workers seeking full-time work who are counted as fully employed).

What are the characteristics of frictional, structural, and cyclical unemployment?

• Frictional: Temporary unemployment when workers are between jobs but possess transferable skills (includes seasonal unemployment).\n- Structural: Joblessness caused when workers' skills become obsolete due to technological advances, requiring retraining.\n- Cyclical: Unemployment caused by a downturn in the business cycle (recession) when aggregate demand declines.

What is the Natural Rate of Unemployment (NRU)?

The NRU is the normal level of unemployment in an economy, consisting exclusively of frictional and structural unemployment (no cyclical unemployment). In the United States, it typically ranges between $4\%$ and $6\%$.

What does positive versus negative cyclical unemployment indicate about the economy?

Positive cyclical unemployment means the actual unemployment rate exceeds the NRU, indicating a negative (recessionary) output gap. Negative cyclical unemployment means the actual unemployment rate is below the NRU, indicating a positive (inflationary) output gap.

What is the formula for calculating the Consumer Price Index (CPI)?

$$\text{CPI} = \left(\frac{\text{Current year cost of market basket}}{\text{Base year cost of market basket}}\right) \times 100$$

What is the key difference in coverage between the CPI and the GDP deflator?

The CPI measures the prices of a fixed basket of goods and services typically purchased by consumers, whereas the GDP deflator measures the price level of all goods and services produced domestically.

What is substitution bias and how does it affect the Consumer Price Index (CPI)?

When prices for goods in the fixed market basket increase, consumers substitute toward lower-cost alternatives not included in the basket. Because the CPI uses a fixed basket, it overstates the true cost of living and inflation rate.

What are the formulas relating nominal interest rates, real interest rates, and expected inflation?

$\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Expected Inflation}$\n$\text{Nominal Interest Rate} = \text{Real Interest Rate} + \text{Expected Inflation}$

Who benefits and who is hurt when actual inflation turns out to be higher than expected?

Borrowers win and lenders lose, because borrowers repay their loans with dollars of lower purchasing power, resulting in a lower real interest rate than expected.

What is the difference between Nominal GDP and Real GDP?

Nominal GDP measures aggregate output using current prices (unadjusted for inflation), whereas Real GDP measures aggregate output using constant base-year prices, isolating changes in physical output from price changes.

What is the formula for calculating the GDP Deflator?

$$\text{GDP Deflator} = \left(\frac{\text{Nominal GDP}}{\text{Real GDP}}\right) \times 100$$

According to this business cycle graph, what do the phases, turning points, and the straight upward-sloping line represent?

• Peaks: The highest points before a recession begins.\n- Troughs: The lowest points before an expansion begins.\n- Expansion: A phase where Real GDP increases.\n- Recession: A phase where Real GDP decreases.\n- Trendline: The long-run growth of Real GDP over time.

What is the difference between an inflationary gap and a recessionary gap on the business cycle graph?

An inflationary (positive) output gap occurs when actual output is above the trendline (near a peak), corresponding to negative cyclical unemployment. A recessionary (negative) output gap occurs when output falls below the trendline (near a trough), corresponding to positive cyclical unemployment.

What is potential output and how does it relate to the Natural Rate of Unemployment (NRU)?

Potential output (full-employment output or long-run equilibrium) is the level of Real GDP achieved when the economy operates at the Natural Rate of Unemployment, representing production directly on the Production Possibilities Curve (PPC).