Macroeconomics Unit II: Circular Flow Diagram, GDP, Business Cycle

Macroeconomics

branch of econ dealing with the performance, structure, behavior, and decision making of an economy as a WHOLE

What is using interest rates, taxes, and govt. spending to regulate an economy’s growth and stability an example of?

Macroeconomics

t/f regional, national, AND global economies are included in macroeconomics

true

Circular flow diagram

What are the two most important actors in the Circular Flow Model?

Households (buy products) and firms (create products)

what is the most basic model of how a large economy works?

the circular flow diagram

Macroeconomic indicators

measurements economists use to measure the health of a nation’s economy (ex. GDP)

Gross Domestic Product (GDP)

The total dollar value of all final goods and services produced within a country during one year

What is GDP considered a measure of?

“National income”

What does higher GDP typically mean?

Typically means the economy is doing well, but too high can mean inflation

What does a declining GDP mean?

Typically means the nation is in a recession and there are high unemployment rates (economy is at an inefficient point)

How is GDP Calculated?

Calculated by adding up the value of all FINAL products produced in ONE YEAR

expenditures approach to GDP (one of the methods/equations to calculate GDP)

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

• C = consumer spending (excluding spending on new housing)

• I = Investments (the spending businesses do to produce goods/services)

• G = Govt. spending (doesn’t include transfer payments)

• X = Exports

• M = Imports

Transfer Payments

A payment from govt. to household that is not in exchange for a product (ex: stimulus check)

• not included in GDP

Net exports

(X-M)

Trade deficit

when imports are higher than exports

Trade surplus

when exports are higher than imports

Income approach to GDP (one of the methods of calculating GDP)

Involves adding up all of the income earned within the borders of a country in a given year; adds up wages, rents, interests, and profits

Income Approach to GDP formula

National Income = wages + rent + interest + profit

Value-added approach to GDP (one of the methods of calculating GDP)

involves adding up all of the value added at various stages of production

What IS included in GDP?

• Consumer spending

• All capital equipment bought by a firm (investment)

• Exports - goods SOLD TO foreigners

What is NOT included in GDP?

• Intermediate goods and services/input resources

• Used goods

• Financial assets (stocks, bonds, etc.)

• Govt. transfers

• Goods made (but not sold) before the year measured

• Imports - goods BOUGHT FROM foreigners

  • These contribute to the other country’s GDP

Employed

includes those who worked as paid employees, own their own business, or worked as unpaid workers in a family member’s business (both full-time and part-time)

Unemployed

includes those who were not employed, unavailable to work, waiting to be recalled to a job they have been laid off from, and has tried to find employment in the previous four weeks

Not in the labor force

anyone who is 16 or under, uninstitutionalized, and does not fit in the first two categories

• Uninstitutionalized means not official work (like getting paid to mow your neighbor’s lawn)

What is a Starbucks part-time employee?

Employed

What is a home-maker?

Not in the labor force because they are not actively looking for employment

What is someone who just got out of college and is now looking for work?

Unemployed

What is a retiree?

Not in the labor force

Labor Force Equation

Employed + Unemployed

Unemployment Rate Equation

(Unemployed/Labor Force) x 100%

Labor Force Participation Rate Equation

[(Employed + Unemployed)/adult population] x 100%

OR: (Labor force/adult population) x 100%

Limits of UR as a Macroeconomic Indicator

• discouraged workers are considered not in the labor force —> not counted in UR

• Someone who is not working to their skill level is considered employed —> not counted in UR

• Someone who is working part-time but wants to work full time is considered employed —> not counted in UR

Discouraged workers

individuals who are not working, but want a job, but gave up; considered not in the labor force

Frictional Unemployement

unemployment from people entering or reentering the labor force

• due to job search

• the govt. should NOT try to eliminate thise

structural unemployment

unemployment due to changes in structure (ex. technology, wage)

cyclical unemployment

due to downturns/economic contractions in the business cycle

What unemployment is it when someone goes from being not in the labor force to being unemployed?

frictional

what type of unemployment is caused by minimum wage, union wage (workers threatening strike for higher wages), or efficiency wage above wage equilibrium?

structural

What type of unemployment is indicated by RGDP declining?

cyclical

What does unemployment insurance do to unemployment?

Increases FRICTIONAL unemployment

What is the main form of unemployment?

Structural Unemployment

• on the test if you don’t know the type of unemployment, its most likely to be structural

What type of unemployment does the govt. try to combat?

cyclical

What type of unemployment was high after the Great Depression?

cyclical

Natural Rate of Unemployment

an estimated number when no cyclical unemployment

• The goal - used by policy makers as a guide for where to move the economy

What is the Natural Rate of Unemployment also called?

“Full Employment”

Equation for the NRU

NRU = Structural Unemployment Rate + Frictional Unemployment Rate

T/F the government’s goal is to get the Natural Rate of Unemployment to 0%

F; it can never (and should never) be 0%

Purchasing power

how much you can buy with one unit of currency

Inflation

the rise in the GENERAL PRICE LEVEL in the economy

• NOT for a specific good or service

What does inflation do to the purchasing power of the dollar?

reduces; you can’t buy as much with each unit of currency as before

Inflation rate (IR)

the percent change in the general price level from the year before

Deflation

When the IR is NEGATIVE

What does deflation do to the purchasing power of the dollar?

increases; you can buy more with each unit of currency as the year before

T/F the IR is a YEARLY measure

True

Disinflation

Prices are still rising, but not as fast as the rate they were before

Hyperinflation

super high rates of inflation

What is hyperinflation caused by?

Printing too much money —> demand increases —> prices hyperinflate

What effect does hyperinflation have on the economy?

It erodes people’s savings severely —> people lose faith in economy

Nominal value

any value stated in current dollars — does NOT take into account changes in general price level

Real Value

a value adjusted to take account changes in the general price level/purchasing power of the dollar

What is the Business Cycle driven by?

Demand

How can inflation/deflation/disinflation be seen on the Business Cycle Model?

Business cycle in Contractions (below potential RGDP) means disinflation or deflation

Business cycle in Peaks (above potential RGDP) means inflation

What are the three costs of inflation?

Shoe leather costs

Menu Costs

Unit of Account costs

Shoe Leather Costs

people make more transactions to avoid holding cash due to inflation

• associated with very high rates of inflation

Menu Costs

the cost of changing prices sustained by a firm due to inflation

Unit of Account Costs

Money becomes a less reliable unit of measurement

What are some important Price Indexes?

• CPI

• PPI

Aggregate Price Level

The general price level in the economy

• can be used to calculate the inflation rate

Price Index

a tool used to track aggregate Price Level and Inflation

• measures the prices of a given market basket of goods in a given year

• the value is normalized so that it is equal to 100 in the selected base year

Consumer Price Index (CPI)

The most important Price index

What does CPI let us calculate and what are the equations?

• inflation rate = [(second CPI - first CPI)/first CPI] x 100

• Real Average Wage = (Nominal wage in a year/CPI in a year) x 100

• Real GDP = (GDP of a year/CPI of the same year) x 100%

“Market Basket”

a hypothetical set of goods and services purchased by a consumer

• used to create a price index to measure changes in aggregate price level

What takes up most of the CPI in America and why?

Housing — b/c it is a necessity and takes up a lot of the avg. consumer’s income

Producer Price Index (PPI)

a price index that contains the prices of goods and services produced by producers

• contains mostly raw materials

Does CPI or PPI respond quicker to inflationary pressure?

PPI; can be used as an early warning sign for upcoming inflation

GDP Deflator

for a given year, is 100 times the ratio of nominal GDP to Real GDP in that year

Equation for GDP Deflator

(Nominal GDP/Real GDP) x 100

What does it mean if GDP Deflator is over or under 100?

Over —> there has been inflation since base year

Under —> there has been deflation since the base year

Limits of using a price index

• substitution — people may substitute goods over the years (goods that are in a consumer’s market basket today would not be in the market basket in the past)

• introduction of new goods — new goods created would not have been part of the market basket in the past

• Unmeasured quality changes — goods in the market may have increased/decreased in quality over the years, but that’s not reflected in the index

What is the relationship between inflation and lending?

Borrowers prefer inflation

Lenders prefer deflation

Real Interest Rate Formula

Real r = Nominal r - inflation rate

• r = interest rate

Underemployment

when a worker is working less than full-time, or not up to their skill level

What is the relationship between CPI and Inflation?

CPI measures inflation; a higher CPI typically means inflation b/c consumer prices are rising and a lower CPI typically means the opposite

Potential Output

the level of RGDP associated with reaching unemployment