ECON 101- midterm 2

circular flow diagram

model showing how households and businesses in the economy are linked

Green - flow of real resources

Purple - flow of money

Flows must be going opposite directions

the price of total output = total spending

total we spend = total income we recieve

GDP

the market value of all final goods and services produced within a country in a given year

GDP per capita

how much money would each person have?

GDP per capita = GDP / total population

What does GDP really measure

1. total spending —> how much did everyone spend?

2. total output —> how much did everyone produce?

3. total income —> how much did everyone earn?

Expenditure equation

Consumption

house hold spending on final goods and services

ex: rent, food, gas, doctors visits, durable goods (cars/stoves/etc)

Investment

spending on things that improve the economy ability to produce

Ex: office buildings and factories, buying airplanes and office computers. spending money on research, buying a new home

***NOT STOCKS

Government purchases

Gov buys goods or assets

Ex: maintaining roads, spending on schools, paying teachers

Transfer payment

payments that transfer income from one person to another

Ex: social security, unemployment insurance

they spend that money and THEN it gets counted into GDP

Net exports

spending on exports MINUS imports

exports: produced domestically, purchased by foreign buyers

Imports: produced in another country, purchased by domestic buyers

***imports not included because we just want to know what we are making

value added

amount by which the value of an item increased at each stage of production

VA = total sales - cost of intermediate inputs

Ex: Apple bought components for iphone for $400, makes and sells it for $900 —> Apple added $500 of value

Income

what we buy stuff with

Profits- income that we spend on businesses

Wages- the income workers receive

Problem with GDP

meant to capture the value of everything we produce in a country through prices

BUT prices change over time

Real GDP

GDP measured in constant prices (accounts for inflation)

how much real stuff we have (as opposed to money) so we can see if our economy has grown in value

Calculating real GDP

1. find average price between 2 years

2. compute GDP for both years using average prices

Growth calculation

Growth = 100 x (Real GDP this year - Real GDP last year) / Real GDP last year

Short term (year or two) growth calculation

% change in real GDP = % change in nominal GDP - % change in prices

Rule of 70

How long it takes the economy to double if that growth rate persist

Time to double = 70 / growth rate

production function

methods by which inputs are transformed into output

ex: how labor and parts turn into a car

aggregate production function

how much of everything a country can produce

labor

more labor a country has, the more stuff it can make

***population growth boosts GDP, but not GDP per capita

human capital

the accumulated knowledge and skills that make workers more productive

ex: educated workers

leads to GDP and GDP per capita growth

physical capital

the physical tools, machinery, and structures that are used in the production process

more computers, machines, etc means that one worker can produce more stuff

technological progress

new methods for using existing resources

aka growth is possible, even if we don’t increase population, education level, or capital stock

aggregate production function has constant returns to scale

double all three inputs and we get twice as much output

capital (by itself) has diminishing returns:

if you add more capital to the economy, holding the population constant, the growth in output will get smaller

EX: giving every worker a computer increases GDP by a lot, but a 2nd computer wont

poor countries can catch up

countries that havent yet invested in capital have much more potential growth to unlock'

Solow model

1. capital stock can only grow up to a certain point- every year, some of our capital stock stops working; must replace and then add even more for it to grow

2. physical capital per workers cant grow forever- the more capital we have, the more capital depreciates each year

3. Capital accumulation cannot sustain long-term growth- the economy reaches a steady state and the capital per person will reach equilibrium

What leads to technological innovations that drive growth

effective property rights

efficient regulation

government stability

encouraged innovation

working age population

those 16 and older who are not in the military or institutionalized

aka the potential labor force

employed

working age people who work for money

part time and full time

unemployed

working age people who are trying to get a job

some people are neither employed nor unemployed

retired people

teenagers finishing highschool

lottery winners

stay at home parents

labor force

the unemployed and the employed together

Labor force participation rate

percentage of the working age population that is employed or unemployed

tells us how many potential workers are active in the labor market

LFPR = 100 x (employed + unemployed) / working age population

high LFPR = more labor available to make stuff with

unemployment rate (Ur)

the percentage o the labor force that is unemployed

Ur = 100 x unemployed / labor force

the employment situation

monthly update on how the labor market in the US has chnaged since last month

found through household survey (asks some households if anyone lost/found a job) and establishment survey (ask 12,000 businesses about their payroll)

Explain the labor market

it is dynamic! —> in constant change

unemployment is never 0%

tight vs loose labor market

loose = high unemployment —> if there are a lot of unemployed people, you cant really negotiate or a big raise

tight = low unemployment —> hard to replace your workers, so they have more negotiating power

frictional unemployment

caused by the time it tkae for employers to searcg for the right worker and workers to search for the right job

needed to find quality matches between employers and workers

structural unemployment

unemployment that occurs because wages do not or cannot fall to bring labor supply and demand into equilibrium

the structure of the labor market makes it hard for someone to find a job

ex: jobs that are no longer needed —> girls who put you on the right call line

efficiency wages

causes structural unemployment

when employers pay workers exra in order to induce workers to be more productive

ex: McDonalds workers who are paid min wage don’t really care how good they do

job protections

causes structural unemployment

regulations that make it harder for firms to fire workers —> firms hire less workers, more slowly

labor market disrcimination

causes structural unemployment

when individual workers with identical productivity are treated inferior because of their demographics

Minimum wage

a price floor setting a minimum price for selling labor

price floor = persistent surplus —> persistent unemployment

Why won’t unemployment ever be 0%?

because of structural and frictional unemployment

both create the natural rate of unemployment- typical rate of unemployment when the economy is growing normally

cyclical unemployment

unemployment due to a temporary downturn in the economy

worker and business are the right match, but the economy isn’t strong enough for businesses to hire —→ workers face the most damage

Costs of unemployment

lower wages and worse career opportunities

longer unemployed = more likely to be permanently unemployed

imposes negative externalities: more gov spending, increased partner violence, etc

inflation

a generalized rise in the overall level of price

inflation ≠ high prices —> high prices are a result of inflation

typically measured on a yearly basis

Inflation rate

annual percentage increase in the average price level

inflation = 100 x (price level this year - price level last year) / price level last year

consumer price index (CPI)

an index that tracks the average price consumers pay over time for a “basket” of goods and services

finding CPI

1. construct basket: include groceries, rent, medical expenses, durables, services, etc

2. find the prices: ask thousands of stores how much the basket costs

3. tally the cost of the basket: add up the costs, accounting for the amount each thing is pruchase (rent takes up larger part than car)

4. Index: turn these numbers into an index by choosing a base year and seeing on much the cost has changed (100 x basket cost this year / cost during base year)

use CPI to calculate inflation between two years

(new year - old year) / old year x 100

deflation

a generalized fall in the overall level of price

what doesnt CPI tell us

1. can only measure price changes for existing goods (people in 1985 didnt have smart phones, so how do we compare?)

2. Quality improvements hide price increases: prices go up, not because of inflation, but because of improvements

3. people change their baskets when prices rise: a lot of people substitute away from goods that experience the most inflation

indexing

adjusting wages, social sercurity, taxes, etc, to compensate for inflation

GDP deflator

a price index that includes everything the economy produces

used to calculate real GDP between years

calculating GDP deflator

1. pick a base year

2. use prices from the base year to calculate real GDP in another year

3. take nominal GDP in that other year, divide by the real GDP from step 2

4. multiply by 100

calculating real GDP

real GDP = 100 x (nominal GDP / GDP deflator)

Money illusion

the mistaken tendency to focus on nominal dollar amounts instead of inflation adjusted amounts

if the price of everything goes up (including wages), inflation doesnt really hurt anyone

Purposes of money

1. is a medium for exchange: makes transactions simple

2. a unit of account: can easily measure relative values (a car is worth X amount of eggs)

3. is a store value: can turn production today into savings for the future

consequences of persistently high inflation

1. creates menu costs for businesses: the marginal cost of adjusting prices (adjusting signs, reprinting menus, changing software, etc); if inflation is high, businesses need to do this more often

2. creates shoe-leather costs for buyers: costs incurred to avoid holding cash (banks raising interest rates to discourage saving)

3. confuses price signals: does increased spending mean that a item is more valuable? —> businesses increases production and lose money

4. it redistributes between lenders and borrowers: loans change

hyperinlation

extremely high rates of inflation

erodes all functions of money —> society loses trust for transactions, savings, etc

business cycle

short-term fluctuations in economic activity

parts of business cycle

peak- high point of economic activity

recession- a period of falling in economic activity

trough- a low point in economic activity

expansion- a period of rising economic activity

when do new business cycles start

when expansion ends and the economy peaks, and then a new recession begins

potential output

the level of output that occurs when all resources are fully employed

economy is operating at a healthy limit (unemployment at a natural limit, no resources being wasted, capital is used productively)

output gap

the difference between actual and potential output, measured as a percentage of potential output

output gap = 100 x (actual - potential) / potential

negative vs positive output gap

neg- economy is producing less than potential (under using resources)

pos- economy is producing more than its potential (resources are over used)

Boom

economy is operating above sustainable potential

ex: workers pulling overtime, factories putting off repairs, etc

Bust

economy us operating below sustainable potential

ex: excess unemployment, unused factories/machinery

Business cycles aren’t natural cycles

we cannot predict recessions (or expansions) based on how long the current business cycle has lated

causes of recssion

typically caused by adverse shock to the economy —> a negative event that temporarily pushes us off the path of growth

ex: pandemics, government policy, bank runs, etc

characteristics of business cycles

recessions are shorts and sharp; expansions are long and gradual

business cycle is persistent: economic conditions today are closely tied to economic conditions in the near future

the impact is widespread: impacts the whole economy, not just isolated parts (when GDP falls, employments typically falls too)

leading vs lagging indicator

leading- variables that tend to predict the future path of the economy (stock market, confidence indicators, etc)

lagging- variables that tend to follow the business cycle with delay

how to look at macroeconomic data

focus on real (not nominal) data

always try to compare apples to apples: DON’T compare nominal and real variable

pay attention to revisions (changes)

be aware of seasonally adjusted data: employment always rise in December, so it will fall in January

Nominal exchange rate

the price of currency, in terms of another country’s currency

how many of my dollars do i need to give to you to get one euro

How to calculate nominal exchange rate

Nominal exchange rate of euros (in dollars) = number of dollars going one way / number of euros coming back the other way

aka: dollar per euro

Quantity in AD-AS model

total quantity of output produced in the economy as a whole

measured by real GDP

apprecaition

when the price of a currency rises

if you have that currency, it is more valuable / more expensive

it makes it easier to import (your dollars buy more from other countries)

exports are more expensive for other countries (their dollars buys less of your stuff)

depreaction

when the price of a currency falls

ex: euros are less expensive

price in AS-AD model

the average price level of all the output produced in the economy

measured by GDP deflator

macroeconomic equilibrium

occurs when the quantity of output that buyers plan to purchase equals the quantity of output that suppliers collectively produce at a given price level

where AS meets AD

Aggregate demand curve

the relationship between price level and total quantity of output that buyers collectively plan to purchase

slopes downwards due to decisions about spending today vs spending tomorrow

if components that make up GDP increase in price, people do them less, and decrease GDP

wealth effects

when price levels rise, wealth loses value and consumption falls (more money to buy the same thing)

when price levels fall, wealth gains value and consumption today rises

interest rate effects

when price level rises, interest rates rise —> investment becomes more costly, less money in economy

exchange rate effects

when price levels rise, other countries don’t want to buy those higher priced goods and will buy them from other countries

effects of price level on AD

changes in price level causes movement along AD curve, NOT SHIFTS

Shifts in AD line

caused by anything that changes components of GDP

consumption and investment change when business/consumer confidence changes

government spending rises whenever policymakers decide to spend more

the federal reserve can change interest rates to make spending today more/less attractive

exports change whenever global forces change the competitiveness of American products

increase vs decrease to shifts in AD

increase in GDP = shift right/up

decrease in GDP = left/down

aggregate supply curve

relationship between the price level and the total quantity o output that suppliers collectively plan to produce

slopes upwards

high price level leads sellers to produce larger quantity of output

sticky prices

cause AS to slope upwards

prices tend to adjust sporadically and sluggishly to changing market conditions

sticky wages- wages tend to adjust sporadically and with delay; no one demands a raise when the price of eggs went up by 0.1%

menu costs- business have a marginal cost to change output prices, making output prices sticky; some businesses cannot afford to raise their prices instantly

how price level changes effect AS

they do not shift AS

cause movement along the AS curve

direction of shifts in AS

shift right/down- create more output at the same price

shift left/up- sell the same output at a lower price

what causes shifts in AS curve

higher input prices raise production costs

higher import prices raise production costs

weaker productivity raises production costs

when currency depreciates, import costs and production costs rise

monetary policy

setting interest rates in an effort to influence economic conditions, usually done by central banks

by changing rates = influencing AD curve

The Fed’s job

1. maintain stable prices: influences prices so inflation doesnt overly influence peoples economic decision making

2. promote maximum (sustainable) employment: can increase real GDP = more employment

AD shifts with the Fed

raises interest rates = AD shifts left (spend less now and more later; dampens inflation, but lower output)

What is the federal reserve

made up of 12 district banks spread across the country

makes decisions independently (gov does not dictate policy to the Fed)

is subject to government oversight (gov has big-picture control over fed)

FOMC (federal open market committee)

committee that decides US interest rates, made up of 7 Fed governors and the Fed bank presidents

durning meeting, they debate their forecasts of the economy and vote on monetary policy

hawks: tighter monetary policy to temper inflation

doves: looser monetary policy to support growth

shares their agreements to the public clearly, to prevent any miscommunication