ECON 162 Macroeconomics

GDP

gross domestic product

the total market value of all final goods and services produced inside a country’s borders in a given time period

only counts final goods to avoid double counting. intermediate goods (like flour sold to a bakery) are already included in the price of the final good. If both the flour and the bread were counted, the flour would get counted twice

NOT counted in GDP:

• used goods (a used car was already counted when it was bought newly)

• intermediate goods (already in the final price)

• transfer payments (social security, unemployment benefits)

• financial transactions (buyings stocks or bonds just swaps ownership)

• household production (cooking, cleaning, childcare, home schooling done for yourself)

• underground economy (illegal activity, unreported cash work)

• leisure, environmental damage, inequality

circular flow model

a diagram showing how money and goods move between households and firms. households sell their labor, capital, and land to firms and get paid income (wages, rent, interest, profit). Households then spend that income buying goods and services from firms

total spending = total income = total output

3 ways to measure GDP

expenditure approach: add up all spending

• GDP (Y) = C + I + G + (X - M)

C: consumption (spending by households like food and clothes)

I: Investment (spending by business on new capital, new residential housing, and changes in inventories. does not include buying stocks or bonds as they are financial investments, not economic investments. economic investments = creating new physical stuff that produces things later)

G: government spending (government purchases of goods and services: roads, schools, military, etc.)

X: exports

M: imports

(X - M): net exports

income approach: add up all income earned

• wages + interest + rent + profits

value added (production) approach: add up the value each firm adds at each stage of production (its sales minus what it paid for inputs)

all three should give the same total because of the circular flow

nominal GDP

GDP measured using current year prices x current year quantities

changes in nominal GDP reflect both changes in output and changes in prices

real GDP

GDP measured using base year (constant) prices x current year quantities

holding prices fixed removes inflation, so changes in real GDP reflect only changes in output. this is a better measure of whether the economy actually grew. in base year, real GDP = nominal GDP

GDP price deflator

deflator = (nominal GDP / real GDP) x 100

measures the overall price level of everything produced in the country

chain type real GDP

g = √[(ΣQ₂P₁ / ΣQ₁P₁) x (ΣQ₂P₂ / ΣQ₁P₂)]

g is the growth factor. it averages (geometric mean) two growth rates: growth measured at year 1 prices and growth measured at year 2 prices

national income chain

GDP → GNP → NNP → NI → PI → DPI

GDP + NFIA = GNP

GNP - CCA = NNP

NNP - SD = NI

NI - income earned but not received + income received but not earned = PI

PI - personal taxes = DPI

GNP

gross national product

the market value of all final goods and services produced by a country’s citizens and companies, wherever they arei nthe world

NFIA: net factor income from abroad. income our citizens and firms earn in other countries - income foreigners and foreign firms earn in our country

NNP

net national product

GNP after subtracting the capital that wore out during production

CCA: capital consumption allowance = depreciation

NI

national income

the total income earned by all factors of production

NI = NNP - SD (from the expenditure side)

NI = w + i + R + profits (income approach: wages + interest rent + profits)

SD: statistical discrepancy. gap between GDP measured by spending and GDP measured by income

PI

personal income

the income households actually receive, whether they earned it this year or not

NI counts all income earned, but some of it never reaches households: companies keep some profit (retained earnings), pay corporate taxes, and pay into social security. meanwhile households receive money they didn’t earn through production (transfer payments) like social security checks, unemployment benefits. PI adjusts for both so it shows what actually lands in people’s hands

DPI

disposable personal income

what households have left after paying personal income taxes. this is the money they can actually spend (consumption) or save

DPI = PI - personal taxes

DPI = consumption + saving

simon kuznets

father of GDP

won the nobel prize in economics in 1971

warned congress that national income is not a measure of a nation’s welfare or wellbeing

kuznets curve

idea that income inequality rises and then falls as a country develops

mathis wackernagel

co created the ecological (global) footprint concept in the 1990s with william rees

founded the global footprint network, which calculates footprints for countries and publicizes “earth overshoot day” (the date each year when humanity has used up what the planet can regenerate that year)

ecological footprint: a way to measure sustainability that GDP completely ignores by looking at amount of land needed to produce everything a population consumes and absorb the waste they create

ecological footprint of a typical american

23.5 acres per year per person, far more than most other countries

lorenz curve

a graph of how evenly income is spread across a population

horizontal axis: cumulative % of population, poorest to richest (0 to 100)

vertical axis: cumulative % of total income (0 to 100)

45 degree straight line = perfect equality

the real lorenz curve sags below that line. the more it bows away, the more unequal income is

gini coefficient

a single number measuring inequality

0 = perfect equality

1 = perfect inequality (one person earns everything)

US gini = 0.489, one of the highest among rich countries

gini = (5000 - A) / 5000

5000 = area of the whole triangle under the equality line

A = area under the lorenz curve

foreign exchange market

the market where currencies are traded for each other. supply and demand for each currency set its price, which is the exchange rate

current account deficit

occurs when a country spends more on imported goods, services, primary income, and transfers than it earns from its exports and foreign receipts

trade deficit: imports > exports

trade surplus: exports > imports

balance of payments

the complete record of all transactions between a country and the rest of the world in a year

• current account (goods, services, income)

• capital and financial account (assets)

because of double entry bookkeeping, the overall balance always equals zero

PPP theory

purchasing power parity theory

the idea that currencies should have the same purchasing power in every country. after converting currencies, the same basket of goods should cost the same everywhere

P = P^f x E

P = domestic price

P^f = foreign price

E = exchange rate

international arbitrage

buying a good where it’s cheap and selling it where it’s expensive to profit from the price difference across countries. only profitable if the price gap is bigger than the shipping cost. arbitrage is the force that pushes prices toward PPP

labor force

everyone who either has a job or is actively looking for one. people who aren’t working AND aren’t looking are not in the labor force (e.g. retirees, students, prisoners are NOT in the labor force)

unemployment rate

unemployment rate = (unemployed / labor force) x 100

types of unemployment

frictional: short term unemployment from people search for or switching between jobs

seasonal: when the work only exists during part of the year

structural: workers’ skills or location no longer match the jobs available, caused by technology changes, industries declining, or jobs moving elsewhere

cyclical: caused by recession, when spending falls, firms produce less and lay off workers

natural rate of unemployment

natural rate = frictional + structural + seasonal (no cyclical)

measure of the unemployment rate when the economy is healthy and at full employment

full employment

when unemployment equals natural rate, meaning there’s no cyclical unemployment, does not mean 0% unemployment

potential GDP

the level of real GDP the economy produces when unemployment is at the natural rate. it’s the economy’s “normal capacity” output when resources are fully used.

GDP gap

GDP gap = actual GDP - potential GDP

actual GDP can be below it (recession or depression) or temporarily above it (boom, overtime, overheating)

underemployment

people who have a jjob but are working less than they want or below their skill level

business cycle

expansion: real GDP rising, unemployment falling

peak: the top, the economy at its highest point before turning down

contraction (recession): real GDP falling, unemployment rising

trough: the bottom, lowest point before recovery. then back to expansion

cycles are irregular, can differ in lengths and sizes

inflation

a sustained increase in the overall price level of the economy, not just one product getting more expensive

deflation is the opposite

disinflation

inflation rate is falling but still positive. prices are still rising, just more slowly

hyperinflation

extremely rapid inflation, often defined as over 50% per month

shrinkflation

price stays the same but the product gets smaller. like when a bag of chips has fewer chips but sells at the same price

shadow inflation

the price stays the same but the quality of service gets worse. like fewer workers in stores, longer wait times, self checkout instead of cashiers, worse customer service

price index

(cost of market basket in current year / cost of market basket in base year) x 100

base year is always 100, so index of 150 means prices are 50% higher than base year

CPI

consumer price index

measures the average price of a fixed market basket of goods and services by typical urban consumers

used for cost of living adjustments (COLAs) like social security payments

substitution bias

the CPI uses a fixed basket, so it assumes people keep buying the same things even when prices change. in reality, when beef gets expensive, people switch to chicken. because CPI ignores that switching, it overstates how much the cost of living actually rose

quality improvements is also another type of CPI bias that overstates inflation (a pricer phone that’s much better)

chain type CPI

a version of the CPI that updates the basket’s weights as people substitute between goods, instead of keepings them fixed. this fixes the substitution bias, so it usually shows slightly lower inflation than the regular CPI

PPI

producer price index

measures prices that producers/businesses receive for their output, including raw materials and wholesale goods (inputs)

considered an early warning sign for consumer inflation: when input costs rise for businesses, they usually pass them on to consumers later

PCE price index

personal consumption expenditures price index

covers everything households consume (broader than the CPI, including things paid for on their behalf, like employer provided health insurance). chain weighted, so it handles substitution. it’s the federal reserve’s preferred inflation measure. usually runs a bit lower than the CPI

nominal interest rate vs real interest rate

nominal interest rate (i): the rate stated on the loan or bank account

real interest rate (r): the rate after adjusting for inflation

fisher equation

i = r + π

i = nominal interest rate

r = real interest rate

π = expected inflation rate

shoe leather costs

the cost of resources spent keeping ahead of price changes: holding less cash (since it loses value), making more trips to the bank, moving money around constantly

name comes from wearing out shoes walking to the bank

menu costs

the cost of resources spent physically changing prices: reprinting menus, catalogs, price tags, updating websites and signs

classical model

the economy always returns to full employment on its own. prices, wages, and interest rates adjust quickly, so markets always clear and there’s no lasting unemployment or unsold goods. output depends only on real things (labor, capital, technology), not on money or spending. government doesn’t need to step in to fix recessions

4 assumptions of the classical model

• markets always clear (supply = demand, no lasting surpluses or shortages)

• prices, wages, and interest rates are flexible (if there are too many workers, wages drop until firms hire them all and vice versa)

• no money illusion (people only care about real values. if wages and prices both double, nobody works more or less, buys more or less. decisions are based on real variables, not nominal ones)

• rational self interest (people act to make themselves better off)

classical dichotomy

in the classical model, real variables are separable from nominal variables

real: output (Y), employment (L), real wage (W/P), real interest rate

nominal: price level (P), money supply, nominal wages, nominal interest rate

real variables are decided by real things (labor, capital, technology). money only affects nominal variables

say’s law

supply creates its own demand

when firms produce output, they pay out exactly that much income to the people who helped make it. that income is enough to buy all the output. if spending falls short, the price level adjusts until all outputs sell. so there’s never a general glut of unsold goods

named after french economist jean baptiste say

classical labor markets

vertical axis: real wage (W)

horizontal axis: quantity of labor (L)

labor demand (D_L): slopes down, firms hire more at lower wages

labor supply (S_L): slopes up, more people want to work at higher wages

intersection = equillibrium real wage W* and employment L*

production function

Y = F(K,L)

shows how much output (Y) the economy produces with a given amount of capital (K) and labor (L), using current technology

vertical axis: output (Y)
horizontal axis: labor (L)
shape: rises but bends over (gets flatter) because of diminishing marginal product: each extra worker adds less than the one before, with capital held fixed

classical AD/AS graph (product market graph)

vertical axis: price level (P)

horizontal axis: real output (Y)

AD (aggregate demand): slopes down in a curve like an L, at lower prices, the same money buys more goods

AS (aggregate supply): vertical at full employment output Y*

intersection = equilibrium price level P*