Macroeconomics Unit 2 Summary: Economic Indicators and the Business Cycle

Economic Indicators and the Business Cycle

Overview of Key Concepts

• Economists assess the economy's health using indicators like:

  • Gross Domestic Product (GDP)

  • Unemployment rate

  • Consumer Price Index (CPI) for inflation

• The circular flow model illustrates interactions between:

  • Households

  • Businesses

  • Government

• GDP is the total dollar value of final goods and services produced within a country in a year.

• Three types of unemployment exist:

  • Frictional

  • Structural

  • Cyclical

  • Full employment occurs when there is no cyclical unemployment.

• Real GDP is adjusted for inflation, while nominal GDP is not.

2.1: Circular Flow Model

• The circular flow model explains the interactions between households and businesses.

  • Households own factors of production and sell them to businesses in the factor market.

  • Businesses use these factors to produce goods and services, selling them to households in the product market.

• Households pay for goods and services, while businesses pay for factors of production (factor payments).

  • Labor: wages

  • Land: rent

  • Capital: interest

  • Entrepreneurship: profit

• Mixed economies include government, which taxes individuals and businesses.

  • Government buys goods/services (e.g., fire engines) and pays for resources (e.g., firefighters).

  • The government provides public goods/services (e.g., fire protection, schools) and transfer payments like subsidies or public assistance (welfare, unemployment).

• Financial sector: money is saved and lent out to businesses, households, and the government.

• International trade: other countries buy goods/services, resources, and financial assets.

• Every economy has three economic goals:

  • Economic growth

  • Low unemployment

  • Price stability

2.2: Gross Domestic Product (GDP)

• GDP measures economic activity and growth.

  • GDP is the dollar value of all final goods and services produced in a country in one year.

• Three ways to measure GDP:

  • Expenditures approach (most important)

  • Income approach

  • Value-added approach

• Expenditures Approach: GDP = C + I + G + X where:

  • C = Consumer spending

  • I = Investment (business spending on physical capital)

  • G = Government spending

  • X = Net exports (exports minus imports)

• Investment is business spending on physical capital (tools, machines, and factories). It does not include stocks and bonds or retirement accounts.

• Government spending includes public goods (infrastructure) and services (national defense, education), excluding transfer payments (subsidies, welfare).

• Net Exports: Exports less imports.

• The US imports more than it exports, resulting in a negative net export value.

• Income approach: calculates GDP by summing all income earned (factor payments).

  • wages + rent + interest + profit = total income = GDP

• Value-added approach: Sums the value added at each production stage.

2.2: Limitations of GDP

• GDP doesn't include all transactions.

• Transactions must occur in the current year.

  • Buying/selling used items doesn't count.

• GDP excludes intermediate goods.

  • Only the final good's price is included (e.g., the price of a car, not the radio or tires used to make the car).

• Non-production transactions are excluded.

  • Buying/selling stocks and bonds doesn't count.

• Illegal or non-market transactions don't count.

2.3: Unemployment

• Labor force: individuals 16+ who have a job or are actively seeking one, excluding military and incarcerated individuals.

• Labor force participation rate = \frac{\text{Number in labor force}}{\text{Working-age population}} \times 100

• Unemployment rate = \frac{\text{Number of unemployed}}{\text{Number in labor force}} \times 100

• Discouraged workers: Out-of-work individuals who have stopped seeking employment and are no longer counted as unemployed.

• Part-time workers: Considered fully employed, even if seeking full-time work.

• Three types of unemployment:

  • Frictional : individuals between jobs.

  • Structural: skills mismatch or obsolete skills due to changes in the labor market (e.g., VCR repairmen).

  • Cyclical: unemployment due to economic recession.

• Natural rate of unemployment: the sum of frictional and structural unemployment when the economy is at full employment (no cyclical unemployment).

  • In the US, the natural rate is around 4-5%.

• At the production possibilities curve (PPC):

  • Inside the curve: all three types of unemployment.

  • On the curve: full employment; frictional and structural unemployment.

  • Beyond full employment: very low frictional and structural unemployment; overheating economy.

2.4: Measuring Inflation

• CPI (Consumer Price Index): measures inflation by tracking a market basket of commonly purchased goods and services over time.

• CPI = \frac{\text{Value of market basket in current year}}{\text{Value of market basket in base year}} \times 100

• CPI Outputs:

  • If the CPI is 125, prices increased by 25% since the base year.

  • If the CPI is 90, prices decreased by 10% since the base year.

  • The base year is always 100.

• Inflation: prices are going up.

• Deflation: prices are going down.

• Disinflation: prices are going up, but at a slower rate.

• Substitution bias: The CPI might overestimate inflation because consumers substitute goods when prices increase.

2.5: Problems with Inflation

• Unanticipated inflation:

  • Hurts: lenders (fixed interest rates) and individuals who earn a fixed income (retirees).

  • Benefits: Borrowers (fixed interest rates).

• It is important to understand inflation to negotiate salary increases.

2.6: GDP Deflator

• The GDP deflator compares nominal GDP to real GDP and reflects the prices of all goods and services in the economy.

• GDP \ Deflator = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100

• The GDP deflator removes inflation from nominal GDP to get real GDP.

2.7: Business Cycles

• The economy goes up and down over time, following a business cycle.

• Four phases of the business cycle:

  • Trough: the lowest point of the economy.

  • Expansion (recovery): the economy grows.

  • Peak: the highest point of the economy.

  • Recession (contraction): the economy declines.

• The trend line represents full employment or potential GDP.

• The actual GDP may be higher or lower than the potential GDP.

• Three possible economic states:

  • Recession (negative output gap): all three types of unemployment, actual GDP less than the potential GDP.

  • Full employment: frictional and structural unemployment only, actual GDP equals potential GDP; natural rate of unemployment.

  • Inflationary gap (positive output gap): low frictional and structural unemployment, the actual GDP is greater than the potential GDP, leads to higher inflation.