Prep for Intro to Microeconomics - Unit 2

What three ways can GDP be measured?

* the value added approach
* the income approach (how much is earned as income on resources used to make stuff)
* the expenditures approach (how much is spent on stuff)

Circular flow diagram

depicts how the expenditures approach and the income approach need to be equal to each other, with goods and services flowing in one direction and income flowing in the opposite direction.

Gross Domestic Product (GDP)

the **market value** of the final production of goods and services **within** the geographic borders of a country in a given period.

Expenditures approach to GDP

* one of the three approaches to calculating GDP
* **involves adding up all spending on final goods and services in an economy**
* 5 categories to expenditures approach:
* consumption
* investment
* government spending
* exports
* imports

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

5 categories to expenditures approach and it’s equation

* consumption
* investment
* government spending
* exports
* imports

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

Income approach to GDP

* one of the three approaches to calculating GDP
* **income earned within the borders of a country in a given year**
* income approach adds up wages, rents, interest, and profits

Value-added approach to GDP

* one of the three approaches to calculating GDP
* **this approach involves adding up all of the value added at different stages of production**
* EX) In the production of a cake that sells for $12, the value-added approach counts the value of the raw ingredients that a farmer sells to the baker ($4), which a baker then combines with her capital to create a cake, which adds $8 in value.

Final goods and services

the goods and services that are purchased by consumers, businesses, the government, or other countries in their final form for their intended final use

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like buying a laptop to be used as a laptop

Intermediate goods

goods that are used in the production of a final product

Consumption (C)

when using the expenditures approach, “C” is the category of GDP that is spent by households on final goods and services in a given year but excludes spending on new housing (buying a new house excluded)

Investment (I)

when using the expenditures approach, “I” is the category of GDP that’s spending businesses do in order to produce goods and services

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* this includes spending on capital goods (tools, equipment) and inventory

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EX) buying computers for accountants to use or building factories in order to build cars

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Government spending (G)

when using the expenditures approach, “G” is the spending by government entities, whether local or national governments, on goods and services

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* transfer payments are not included in “government spending” in GDP even though it’s something that’s part of money that the government might spend each year

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EX) building roads and national defense

Transfer payment

any payment by a government to a household that is not in exchange for a good or service

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EX) if government sends a retire person a pension check = they are not buying a good or service and therefore it’s not counted towards GDP

Exports (X)

goods that are produced in one country and sold to another country

Imports (M)

goods that are produced in a different country than where they were purchased

net exports (X-M)

spending on exports minus spending on imports’

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“exports” is the value of the goods that go out of the country

“imports” = value of goods that go into country

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trade deficit

when imports are higher than exports

trade surplus

when exports are higher than imports

Why are imported goods deducted from the calculation of GDP?

The goal of GDP is to capture what’s produced in your country.

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* one of the more straightforward ways of doing this is by adding up what is spent on goods and services by households, businesses, and government.
* since not everything that households, businesses, and government purchases each year is produced by their own country, imports must be subtracted in order to accurately capture what was produced in that country.

What does the circular flow diagram say about the relationship between expenditures approach and the income approach to calculating GDP?

the results are equal no matter what approach you choose to calculate GDP, the income and expenditure approach have to be equal to each other.

GDP calculating using income approach equation

Y = w + i + r + p

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* w = wages earned from labor
* i = interest earned on capital
* r = rent earned on land
* p = profits earned on entrepreneurial talent

Recession

a significant decline in economic activity, typically characterized by a decrease in GDP, income, employment, and trade.

Recessionary periods are often accompanied by increased unemployment rates and financial hardships for individuals and businesses.

deprication

a measure of the amount of value an asset loses from influential factors affecting its market value.

Quality of life

(sometimes called “well-being”)

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the standard of health, happiness, security, and material comfort of an individual, a group of people, or a nation

Non-market transactions

economic activity that takes place in the informal sector

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these are transactions that aren’t recorded, taxed, or officially monitored by the government.

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EX) babysitting and lawn mowing (within the household) or illegal drug sales (sometimes referred to as black market)

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Income inequality

when a disproportionate share of a nation’s income is earned by a small minority of households

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GDP doesn’t account for income distribution in any way

Sustainability

the ability of a system to endure indefinitely into the future

an increase in GDP will only be sustainable as long as it doesn’t deplete natural resources too rapidly nor exploit the environment in a way that diminishes the quality of life of the nation’s households over time

Economic bads

any outcome from economic activity that creates negative value for society

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EX) like air pollution from cars that harms human health and the environment; unsustainable economic growth may diminish the quality of life of a nation’s people

real GDP per capita

the real gross domestic product of a nation, divided by the nation’s population = this measure is an indication of the average income of a nation’s people

depreciation of capital

the decrease in the value of a nation’s capital stock over time

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GDP accounts for investment in new capital but doesn’t subtract the lost value of capital (like machines that are broken and need to be replaced)

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Therefore because of this, GDP may overstate the amount of economic activity in nations with rapidly depreciating capital stocks.

Human Development Index (HDI)

a composite measure of a nation’s social and economic development developed by the. United Nations that includes measures of health, wealth, and education.

Genuine Progress Indicator (GPI)

measure of a nation’s quality of life that includes the income and output measured by GDP.

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this measure subtracts the costs of **negative** effects related to economic growth

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GPI nets the positives and the negatives of economic activity to provide a more accurate measure of a nation’s quality of life than GDP alone.

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EX) subtracts negative costs like crime, resources depletion, or the costs of climate change

Happy Planet Index (HPI)

a measure of a nation’s quality of life that includes survey results on happiness, life expectancy at birth, the degree of inequality across society, and the ecological footprint.

Limitations of GDP

* exclusion of non-market transactions
* failure to account for or represent income inequality
* failure to indicate the nation’s rate of growth’s sustainability
* failure to account for costs imposted on human health and the environment of negative externalities arising from the production of consumption of the nation’s output
* treating the replacement of depreciated capital the same as the creation of new capital

Indicators that provide a more well-rounded measure of a nation’s quality of life by different national and international organizations

* the Human Development Index (HDI)
* the Genuine Progress Indicator (GPI)
* the Happy Planet Index (HPI)

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each of these indexes is a composite measure weighing both income and non-income variables

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takes into account things like literacy rates, environmental indicators, measures of inequality, etc.

Do higher incomes and more output always equal a higher quality of life for the people experiencing such growth?

No, because higher incomes and more output will not always equal a higher quality of life for the people experiencing such growth.

Under what circumstances would an increase in a nation's average income *not* lead to an increase in the income of the typical, median household?

It doesn’t consider things like the quality of life, environmental degradation, income inequality, etc. If a majority of the nation’s wealth is held by the top 5% earners, then the increase in the nation’s average income wouldn’t lead to the increase per person/per household

How does this affect the economy?

When adults who are willing and able to work cannot find a job, it may be a sign that the economy is producing less than it could. It represents the state of a nation’s workforce. 

What are the three types of unemployment that economists describe?

frictional, structural, and cyclical

unemployment

when people are not working, but they are actively looking for work

unemployment rate

percentage of the labor force that is unemployed

labor force

the number of people in a population who are either employed or unemployed

eligible population

these are the number of people deemed likely to be in the labor force

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EX) in the U.S., the eligible population in the US is anyone 16 years or older who isn’t institutionalized (not in prison) and not in the military

labor force participation rate

the percentage of the eligible population that is in the labor force

discouraged workers

people who DO NOT want a job, but will take a job if offered one.

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these people have given up looking for work so they’re not counted in the labor force.

underemployed

people who work part-time, but they really want to work full time if they could find a full-time job

full employment output

(also called full employment real output)

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the amount of output that is produced in an economy when the economy is using all of its resources efficiently

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the full employment output would be a combination of output that is on the country’s PPC

natural rate of unemployment

the unemployment rate that exists when an economy is producing the full employment output

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when an economy is in a recession, the current unemployment rate is higher than the natural rate

recession

period of temporary economic decline during which trade and industrial activity are reduce

frictional unemployment

comes with idea that there might be some friction when coming to getting a job, you are looking for a job, just out of college, you have to do interviews, etc. You have to go through a process in order to get a job. This is natural.

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this is the job search process

structural unemployment

unemployment that occurs as the result of a structural change in the economy

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EX) new technology causes less of a need for labor

cyclical unemployment

the unemployment associated with recessions and expansions

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the current unemployment rate will depend on both the natural rate of unemployment and the amount of cyclical unemployment at the time

What are the limitations of the unemployment rate?

It often excludes anyone working at all or people who aren’t looking for work. It leaves out the discouraged workers and the underemployed.

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Some people are counted as employed since they are part-time workers when in reality, they are looking for a full-time job.

Equation of Labor Force

Labor force = # unemployed + # employed

Labor force participation rate equation

Labor Force Participation Rate = (Labor force/Eligible population) x 100%

unemployment rate equation

unemployment rate = (# unemployed / # in labor force) x 100%

An inventor in Burginville developed a fantastic new dictation machine that perfectly records speech and turns it into a typed document. Unfortunately, that meant that unemployment increased among typists working in offices. Which type of unemployment is this? Explain.

structural unemployment

The nation of Fitlandia has 120,000120,000120, comma, 000 people. Of these, 20,00020,00020, comma, 000 are children under the age of 16, 72,00072,00072, comma, 000 have jobs, 8,0008,0008, comma, 000 don’t have jobs and are looking for work, and 20,00020,00020, comma, 000 people are retired. Assuming that these are all noninstitutionalized civilians, calculate the labor force participation rate and the unemployment rate.

(80,000/100,000) x 100%

LFPR = 80%

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(8,000/80,000) x 100%

UR = 10%

Substitution bias

can overstate how much the cost of living really has changed

inflation

a sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar

inflation rate

the pace at which the overall price level is increasing; the percentage increase in the price level from one period to the next

deflation

a sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative

disinflation

a slowing of the rate of inflation

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EX) if the rate of inflation is 5% in 2016 and 3% in 2017, there is still inflation in 2017. However, prices are not rising as fast as they were before.

aggregate

measures the total amount of demand for all finished goods and services produced in an economy.

aggregate price level

a single number that summarizes all prices in an economy; price indices are frequently used to represent the aggregate price level

price index

a measure that calculates the changing cost of purchasing a particular (and unchanging) combination of goods (called a “market basket”) each year; the consumer price index and the producer price index are examples

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consumer price index (CPI)

an index that calculates the cost of a market basket of goods purchased by a typical family that lives in an urban area; the purpose of the CPI is to track changes in the cost of living over time.

market basket

the combination of goods that are used to calculate a price index; the goods stay the same from year to year.

base year

a reference year to which variables are compared

real variables

variables that are adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, or real GDP)

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EX) if your boss gives you a 10% raise, but the purchasing power of your money has decreased by 8% because of inflation, your raise is only worth 2%

nominal variables

variables such as wages, income, or interest that have not been adjusted for the rate of inflation; you can think of nominal variables as the “sticker price.”

Purchasing power

what can actually be bought with money; if you walk into a store with $10 and want to buy apples that cost $1 each, the purchasing power of your $10 is 10 apples

If the next day, the price of apples increases to $2, you can only buy 5 apples, so the purchasing power of your $10 has decreased

real interest rate

the interest rate earned that reflects the actual purchasing power of that interest

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EX) if a bank pays 3% interest, but there is 2% inflation, you really have only gained 1% interest because the purchasing power of your interest has decreased

How to calculate the rate of inflation

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What are real variables?

nominal variables deflated by the price level

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EX) a real wage or a real interest rate

What is a shortcoming of CPI as a measure of the cost of living?

That can cause the CPI to overstate the true inflation rate.

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EX) substitution bias causes the CPI to overstate increases in the cost of living. When the price of goods go up, people will substitute other similar goods in place of the good that is now more expensive.

What are some reasons that the CPI might not capture the true rate of inflation?

Substitution bias - overstating the cost of living when in reality people just be substituting the things they can’t afford.

How might changes in spending habits of households over a 20 year period change? How does this impact CPI as a measure of the cost of living?

Households might substitute more expensive items for cheaper items. This does not impact CPI unless they change the basket of goods.

The CPI in the nation of Montrose was 220 in 2016 and 200 in 2015. What is the rate of inflation between 2015 and 2016?

what is the equation for rate of change?

unanticipated inflation

when the price level increases at a faster pace than expected

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EX) if you think the rate of inflation will be 5%, but it turns out to be 8%

unanticipated disinflation

when the price level increases at a slower pace than anticipated

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EX) if you think the rate of inflation will be 5%, but it turns out to be 2%

unanticipated deflation

when the price level decreases when it was expected to increase

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EX) if you think the rate of inflation will be 2% , but it turns out to be -2%

What is the difference between DISINflation and DEflation?

Disinflation refers to a **decrease** in the **rate of inflation**, meaning prices are still rising but at a slower pace.

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Deflation is a **sustained decrease** in the **general price level of goods and services**. In deflation, prices actually decline over time.

wealth redistribution

when the real value of wealth is transferred from one agent to another; when inflation is higher than borrowers and lenders expected, wealth is transferred from lenders to borrowers.

lender

an agent (usually a bank) or a person (like a holder of a bond) who makes money available to another agent, with the agreement that the money will be repaid (usually with interest)

borrower

an agent that has received money from another agent with the agreement that the money will be repaid (usually with interest)

saver

an agent that is not spending some of their income; usually if money is saved it is put in some sort of interest-earning asset (like a savings account or a bond) or purchasing some other financial asset (such as stocks and bonds).

bond

an asset that is a promise to pay a fixed amount at some point in the future

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EX) the government sells Tony a bond for $100 with the promise of paying him back $104 in one year, which allows Tony’s savings to earn interest.

What effect does unanticipated inflation have?

lenders are hurt and borrowers are hurt

what effect does unanticipated disinflation or deflation have?

lenders are helped and borrowers are hurt

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because money that lenders get paid back has more purchasing power than the money they expected it to be when they loaned it

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borrowers are hurt by deflation because they have to pay back their debts with money worth more than the money they borrowed in the first place (so the stuff costs even more now)

nominal GDP

the market value of the final production of goods and services within a country in a given period using that year’s prices (also called “current prices”)

real GDP

nominal GDP adjusted for changes in price level of goods and services, using prices from a base year (constant prices) instead of “current prices” used in nominal GDP; real GDP adjusts the level of output for any price changes that may have occurred over time

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this is constant, removes effect of changes in the overall price level

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how much is actually produced

GDP deflator

a price index used to adjust nominal GDP to find real GDP; the GDP deflator measures the average prices of all finished goods and services produced within a nation’s borders over time

base year

the year used for comparison in the determination of price changes using the GDP deflator price index

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deflator in base year is always 100

current prices

the prices at which goods are sold in a nation in a particular year; current prices are used when calculating nominal GDP.

constant prices

the prices at which goods are sold in a nation in a particular year; current prices are used when calculating nominal GDP.

Calculation for Real GDP

Calculation for nominal GDP

Why could calculating GDP each year using current prices overstate or understate changes in actual output year to year?

If current prices are higher than they were in previous years, then it will be inflated by higher prices and a country’s nominal GDP will overstate the actual change in output.

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On the other hand, if current prices are lower than in previous years, the value will be deflated by lower prices and nominal GDP will understate the actual change in output.