Chapter 2 Notes Econ

National income and product accounts were developed at the end of World War II as measures of aggregate output.
The measure of aggregate output is called Gross Domestic Product (GDP).

Consider an economy with two firms, Firm 1 and Firm 2.
- Is aggregate output the sum of the values of all goods produced, that is, $300? Or just the value of cars, that is, $200?
- Steel is defined as an intermediate good, a good used in the production of another good.

GDP is the value of the final goods and services produced in the economy during a given period.
- Only final goods are counted, excluding intermediate goods.
- If the two firms merge, total revenues equal $200.
GDP is the sum of value added in the economy during a given period.
- Value added by a firm equals the value of its production minus the value of the intermediate goods used.
- In the two-firm example, the value added equals $100 + $100 = $200.
GDP is the sum of incomes in the economy during a given period.
- Aggregate production equals aggregate income.
- Value added in the two-firm example equals the sum of labor income ($150) and capital or profit income ($50), which totals $200.

Nominal GDP is the sum of the quantities of final goods produced times their current prices.
- Nominal GDP increases for two reasons:
1. The production of most goods increases over time.
2. The price of most goods increases over time.
Real GDP is the sum of quantities of final goods times constant prices (not current prices).

Year	Quantity of Cars	Price of Cars	Nominal GDP	Real GDP (in 2012 dollars)
2011	10	$20,000	$200,000	$240,000
2012	12	$24,000	$288,000	$288,000
2013	13	$26,000	$338,000	$312,000

Relative prices are used as natural weights to construct a weighted average of the output of all final goods.
Real GDP in chained (2012) dollars reflects relative price changes over time.
The year used to construct relative prices is called the base year.

Employment: The number of people who have a job.
Unemployment: The number of people who do not have a job but are actively looking for one.
Labor Force: The sum of employment and unemployment.
- $L = N + U$

Most rich countries rely on large surveys of households for computing the unemployment rate.
The US Current Population Survey (CPS) interviews 60,000 households every month.
A person is classified as unemployed if they do not have a job and have been searching for a job in the last four weeks.
Individuals not looking for work are categorized as not in the labor force.
Discouraged Workers: Individuals who have stopped looking for a job and are not counted as unemployed.

Participation Rate Definition: The ratio of the labor force to the total population of working age. It means that a larger part of the population is either employed or actively looking for work.
A higher unemployment rate is often associated with a higher participation rate, particularly due to the presence of discouraged workers. A higher participation rate means most people are part of the labor force compared to those who are not.

Why Economists Care:
1. It directly affects the welfare of the unemployed, especially those unemployed for extended periods.
2. It is an indicator of how efficiently the economy utilizes human resources.
Low Unemployment Issues: Extremely low unemployment may lead to labor shortages.

Inflation: A sustained increase in the general level of prices, referred to as the price level.
Inflation Rate: The rate at which the price level increases.
Deflation: A sustained decrease in the price level (negative inflation rate).

GDP Deflator in year t (Pt): Nominal GDP/ Real GDP
The GDP deflator tells you the overall price of produced final goods and services.
- It is referred to as an index number (1 in 2017) with no direct economic interpretation but the rate of change is significant as it represents inflation.
- Rate of Inflation Formula:

Defining the price level as the GDP deflator leads to the relationship: $Y = P imes Y$
- Nominal GDP equals the GDP deflator times real GDP.
- Growth in nominal GDP results from inflation plus growth in real GDP.

Some goods produced are not purchased by consumers but are sold to firms, governments, or exported.
Consumer Price Index (CPI): Measures the cost of living. It tracks price changes paid by consumers for a basket of goods and services.

Pure Inflation: A proportional increase in all prices and wages.
- It causes minimal inconvenience as relative prices remain unaffected.
- Real wage would be unaffected.
- However, there is no actual occurrence of pure inflation in practice.

Why Economists Care About Inflation:
- It impacts income distribution when prices and wages do not rise uniformly.
- It leads to various distortions due to uncertainties, fixed prices regulated by law, and interactions with taxation (known as bracket creep).
Most economists regard the optimal inflation rate to be low and stable, between 1% and 4%.

Okun’s Law is a relation explored by US economist Arthur Okun.
- A plot of unemployment rates against output growth shows a downward slope, suggesting that higher GDP correlates with lower unemployment.
- As GDP increases, unemployment decreases. Vice versa.

The Phillips Curve was introduced by New Zealand economist A.W. Phillips in 1958.
- It illustrates the inverse relationship between unemployment rates and inflation rates.
- Generally, a low unemployment rate corresponds to higher inflation, and vice versa.
- Historical trends demonstrate that when unemployment surpassed 5%, inflation typically remained below 2%.

Short Run: Changes in output driven by demand fluctuations.
Medium Run: Adjustments to output based on supply factors, such as:
- Capital stock
- Level of technology
- Labor force size
Long Run: Economic outcomes influenced by innovation, technology, saving behaviors, educational quality, and government standards.