Macroeconomic Review

GDP

The market value of all final goods and services produced within a country in a year.

GDP formula (as total spending)

Y= C+I+G+NX

“Value Added” Formula for GDP

Sum of value added + Total sales - Cost of intermediate outputs

Gross Domestic Income Formula for GDP

Total wages + Total profits

Limitations of GDP

1. Prices are not values

2 Nonmarket activities are excluded

3. The shadow economy is missing

4. Environmental degradation isn't counted

5. Leisure doesn't count

6. GDP ignores distribution

Nominal GDP

Adds up the market value of total production in a year using the current prices prevailing in that year.

Real GDP

Excludes the effects of price changes, so it isolates economic growth that's due to changes in the quantity of output produced.

Change in real GDP formula (percent)

Percent change in nominal GDP - percent change in prices

Four Strategies for Scaling Big Numbers

1. Evaluate what it means per person

2. Compare big numbers to the size of the economy

3. Compare big numbers to their own history

4. Use the Rule of 70 to evaluate long-run growth rates

Rule of 70

Years it takes something to double = 70/Annual growth rate

Inflation

A generalized rise in the overall level of prices.

• can also be described as a rise in the cost of living.

• also a decline in the purchasing power of money.

Consumer Price Index (CPI)

tracks the average price consumers pay over time for a

representative "basket" of goods and services.

Steps to measure inflation

1. Find out what people buy and construct a representative basket of goods and services.

2. Collect prices from the stores where people do their shopping.

3. Tally up the cost of the basket of goods and services.

4. Calculate rate

Inflation rate formula

=price level this year-price level last year/ price level last year X 100

Real Variable

A variable that has been adjusted to account for inflation

Nominal Variable

A variable measured in dollars (whose value may fluctuate over time)

Inflation Adjustment Formula

Todays Dollars = Another times dollars X Price level today/Price level in another time

Inflation Adjustment: Formulas for relatively small percentage changes

Percent change in real value = Percent change in nominal value - Percent change in prices

Real interest rate = Nominal interest rate - Inflation rate

Money illusion

The (mistaken) tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts.

• creates nominal wage rigidity (reluctance to cut nominal wages).

Different Measures of Inflation: Consumer Prices

1. Cost of living adjustments -> Consumer Price Index (CPI)

2. A less-volatile inflation measure -> CPI-Median

3. Forecasting underlying inflation trends -> Core inflation (excluding food and energy)

Different Measures of Inflation: Business Prices

1. Cost of input—→ Producer Price Index (PPI)

2. Estimating the price of all output and hence real GDP → GDP deflator

Inflation Overstates the Cost of Living Because of ...

• Unmeasured quality improvements

• New products

• Substitution bias

Money

Any asset regularly used in transactions

• Medium of exchange

• Unit of account

• Store of value

Costs of (expected) Inflation

• Menu costs for sellers

• Shoe-leather costs for buyers

Costs of (unexpected) Inflation

• Confuses the signals that prices send

• Redistribution

Menu Costs

the expenses and resources companies incur when changing their nominal prices

(such as reprinting menus)

Shoe Leather Costs

the time, effort, and resources people waste managing their money to combat high inflation,

The Inflation Fallacy

The (mistaken) belief that inflation destroys purchasing power

Economic Growth

Increased production of goods and services, leading to rising living standards.

Ingredients of Economic Growth

• labour input

• human capital

• physical capital

Labour input

Number of workers to transform raw materials into products and services that people want to buy.

Human capital

The skills and knowledge of people developed through education, practice, and training.

Physical capital

The total amount of tools, machinery, and structures that

can be used in the production of goods and services.

Technological progress

New methods for using existing resources to produce more valuable output.

• increases GDP per person for any level of capital per person

• relies on new ideas

Production function

The methods for transforming labour input, human capital, and physical capital into goods and services (outputs).

Constant returns to scale

Doubling all inputs (labour input, human capital, and physical capital) leads to a doubling of all the outputs.

Diminishing returns

When one input (labour input, human capital, or physical capital) is held constant, increases in the other inputs will, at some point, begin to yield smaller and smaller increases in output

Why ideas generate unlimited growth

1. can be freely shared

2. don’t depreciate with use

3. may promote other ideas

Catch-up growth

The rapid growth that occurs when a relatively poor country (with low capital stock) invests in its physical capital

Why institutions matter for economic growth

They provide the framework that creates the right incentives for people to invest in physical and human capital and generate new ideas and products.

Property rights

Without this and a trusted enforcement system, no one creates wealth.

Government policy to encourage innovation

can support development of new ideas by:

1. Increasing the marginal benefit through intellectual property laws

2 Decreasing the marginal cost by subsidizing research and development

Income inequality

The difference in annual income between people.

Alternative measures of inequality

• Permanent income

• Inequality of opportunity

• Wealth

• Consumption

Permanent income

Your average lifetime income

Inequality of opportunity

Lack of intergenerational mobility

Poverty line

An income level, below which a family is defined to be in poverty.

Absolute poverty

Judges the adequacy of resources relative to an absolute standard of living.

Relative poverty

Judges poverty relative to the material living standards of your contemporary society.

Government Redistribution: Social Safety Net

The cash assistance, goods, and services given to those at the bottom of the income distribution.

• Means-tested -- > Eligibility is based on income and sometimes wealth.

• Minimal support -> lifts about a third of people living in poverty out of poverty. Increased child benefits have cut child poverty in half.

Government Redistribution: Social Insurance

Government-provided assistance against bad outcomes such as unemployment, illness, disability, or outliving your savings.

• Benefits are based on uncertain outcomes

• Everyone pays into social insurances

• Benefits are based on past earnings

Government Redistribution: Taxes

Pay for the safety net and social insurance.

Progressive taxes

those with more income tend to pay a higher share of their income in taxes.

Ex. Federal income taxes, however

• Investment gains are taxed at a lower rate

• Higher income people get bigger tax breaks

Investment

Spending on new capital assets that increase the economy's productive capacity

the flow of new purchases of capital that add to stock.

Capital Stock

The total quantity of capital at a point in time.

• declines over time due to depreciation, which includes wear and tear, obsolescence, accidental damage, and aging

Tools to Analyze Investment

1. Compounding: Helps you calculate how money grows over time when you leave it to accumulate interest in the bank.

2. Discounting: how much money in the future is worth today.

Compounding formula

Future value in t years = Present value × (1 + r)^t

Discounting Formula

Present value = Future value in t years X 1/(1 + r)^t

Interest rate

The rate of r cents per dollar (use the real r for real values and nominal r for nominal values).

• *the rate of return you could get from investing your funds in your next best alternative

Rational Rule for Investors

Pursue investment opportunity if:

Depreciation Rate (d)

The proportion of an investment's remaining productive capacity you lose each year due to ___.

Market for Loanable Funds

the market for the funds used to buy, rent, or build capital

Supply Shifters in the Market for Loanable Funds

• changes in personal saving rates

• government saving

• foreign savings

Demand Shifters in the Market for Loanable Funds

• technological advances

• expectations

• corporate taxes

• lending standards and cash reserves

Consumption

Household spending on final goods and services.

Marginal propensity to consume (MPC)

The fraction of each extra dollar of income that households spend on consumption.

MPC formula

Slope = change in consumption / change in income

Saving

The portion of income that you set aside, rather than spending on consumption.

= Income - Consumption

The Rational Rule for Consumers

Consume more today if:

the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar-plus-interest in the future.

Permanent Income Hypothesis

The idea that you choose how much to consume based on your permanent income (your best estimate of your long-term average income) rather than current income.

Consumption smoothing

The idea that you should maintain a steady or smooth path for your consumption spending over time.

Hand to Mouth Consumers

households that spend all their available income in every pay period, holding little to no liquid wealth (cash, savings)

Changing income

Causes a movement along consumption function

Shifters for consumption function

1. real interest rates

2. expectations of future income

3. taxes

4. wealth

Working age population

Noninstitutionalized civilians age 16 and over

Not in labour force

Neither employed nor unemployed

• included in working age population

Labour force

working age population that either has a job or would like a job

• included in working age population

• made up of employed and unemployed people

Labour force participation rate

the share of the working-age population that is either employed or unemployed

Labour force participation rate formula

Labour force/Working age population X 100

Unemployment rate

The share of the labour force thats unemployed

Unemployment rate formula

unemployed/labour force X 100

Equilibrium unemployment rate

the unemployment rate to which the economy tends to return in the long run

Underemployed

Someone who has some work but wants more hours or whose job isn't adequately using their skills.

Discouraged searcher

Someone who wants a job but isn't counted as unemployed because they arent currently searching for work since they don't believe theyll find anything suitable.

Involuntarily part time

Someone who wants full-time work and is working part-time because they haven't found a full-time job.

Frictional Unemployment

Unemployment due to the time it takes for employers to search for workers and for workers to search for jobs.

Sources:

1. Job search resources

2 Skills mismatch

3. Employment Insurance and other income support

Structural Unemployment

Unemployment that occurs because wages don't fall to bring labour demand and supply into equilibrium.

Sources:

1. Efficiency wages: Higher wages paid to encourage greater worker productivity

2. Institutional causes:

• Unions

• Job protection regulations

• Minimum wage law

Cyclical Unemployment

Unemployment that is due to a temporary downturn in the economy

Business cycle

Short-term fluctuations in economic activity. reflects the tendency for actual output to deviate from potential output (measured using the output gap)

Output gap

Actual output - Potential output/ Potential output X 100

Expansion

A period of rising economic activity

Recession

A period of falling economic activity

Features of business cycles

1. Business cycles are not cycles.

2. Recessions vary in their causes, their duration, and their depth.

3. Some variables lead recessions, while others lag.

4. The business cycle is persistent.

5. A typical business cycle involves a short, sharp

recession, followed by a long and gradual expansion.

6. Many economic variables comove up and down together over the business cycle.

Okun’s Rule of Thumb

For every percentage point that actual output falls below potential output, the unemployment rate is around one-third a percentage point higher.

Seasonally adjusted

Data stripped of predictable seasonal patterns.

Annualized rate

Data converted to the rate that would occur if the same rate had continued throughout the year.

Nominal variables

Variables expressed in dollars, using the prices of that year's data.

Real variables

Variables adjusted for inflation so you're comparing quantities, holding prices constant