7.1 The Circular Flow Model

The Circular Flow Model

• Circular flow of economic activity - A model that shows how households and firms circulate resources, goods, and incomes through the economy. This basic model is expanded to include the government and the foreign sector.

• Closed economy - A model that assumes there is no foreign sector (imports and exports).

  

7.2 Accounting for Output and Income

• When valuing production, it’s important to measure the value of the goods that are produced, not the amount of goods that are produced.

  

Gross Domestic Product (GDP)

• Aggregation - The process of summing the microeconomic activity of households and firms into a more macroeconomic measure of economic activity.

• Gross domestic product (GDP) - The market value of the final goods and services produced within a nation in a given period of time.

• Final goods - Goods that are ready for their final use by consumers and firms, for example, a new Harley-Davidson motorcycle.

• Intermediate goods - Goods that require further modification before they are ready for final use, e.g., steel used to produce the new Harley.

• Double counting - The mistake of including the value of intermediate stages of production in GDP on top of the value of the final good.

• Secondhand sales - Final goods and services that are resold. Even if they are resold many times, final goods and services are only counted once—in the year in which they were produced.

• Nonmarket transactions - Household work or do-it-yourself jobs are missed by GDP accounting. The same is true of government transfer payments and purely financial transactions like the purchase of a share of Amazon stock.

• Underground economy - These include unreported illegal activity, bartering, or informal exchange of cash.

• Aggregate spending (GDP) - The sum of all spending from four sectors of the economy. GDP = C + I + G + (X – M).

  • Consumer spending (C) - Spending done by customers.

  • Investment spending (I) - Investment is defined as current spending in order to increase output or productivity later.

    There are three general types of investment that are included in GDP:

    • New capital machinery purchased by firms.

    • New construction for firms or consumers.

    • Market value of the change in unsold inventories.

  • Government spending (G) - Purchases made by the govermnet for final goods and services and investments in infrastructure.

  • Net exports (X– M) - Exports → X, Imports → M.

National Income Concepts

• Aggregate income (AI) - The sum of all income—Wages + Rents + Interest + Profit—earned by suppliers of resources in the economy. With some accounting adjustments, aggregate spending equals aggregate income and also equals the sum of the value added.

• Value-added approach - A third approach to calculating GDP that considers all stages of production of a final good and the value that was added to the final good along the way.

  

K.I.S.S.: Keep It Simple, Silly

Real and Nominal GDP

• Nominal GDP - The value of current production at the current prices. Valuing 2015 production with 2015 prices creates nominal GDP in 2015. Also known as current-dollar GDP or money GDP.

• Real GDP - The value of current production, but using prices from a fixed point in time. Valuing 2015 production at 2014 prices creates real GDP in 2015 and allows us to compare it back to 2014. Also known as constant-dollar or real GDP.

• To deflate the nominal GDP or adjust it for inflation, this division should be made:

  

  

• Base year - The year that serves as a reference point for constructing a price index and comparing real values over time

• Price index - A measure of the average level of prices in a market basket for a given year, when compared to the prices in a reference (or base) year. You can interpret the price index as the current price level as a percentage of the level in the base year.

  • Latte price index (LPI) example → Suppose GDP is made up of just one product, cups of latte. We need a price index to calculate real GDP. Using 2012 as the base year, a latte index is created and used to adjust nominal GDP to real GDP for this good.

    

Using Percentages

• If nominal GDP increased by 5 percent and the price index increased by 1 percent, we could say that real GDP increased by approximately 4 percent.

The GDP Deflator

• GDP price deflator - The price index that measures the average price level of the goods and services that make up GDP.

Business cycles

• Business cycle - The periodic rise and fall in 4 phases present in economic activity. Can be measured by changes in real GDP.

  

• Expansion - A period where real GDP is growing.

• Peak - The top of a business cycle where an expansion has ended.

• Contraction - A period where real GDP is falling.

  • Recession - Unofficially defined as two consecutive quarters of falling real GDP.

  • Depression - A prolonged, deep contraction in the business cycle.

• Trough - The bottom of the cycle where a contraction has stopped.

7.3 Inflation and the Consumer Price Index

The Consumer Price Index (CPI)

• Consumer price index (CPI) - The price index that measures the average price level of the items in the base year market basket. This is the main measure of consumer inflation.

• Market basket - A collection of goods and services used to represent what is consumed in the economy.

  

Inflation

• Inflation - The percentage change in the CPI from one period to the next.

• Annual rate of inflation on goods consumed by the typical consumer - The percentage change in the CPI from one year to the next.

  • Ex. → In January 2000, the CPI was 169.30, and one year later in January 2001 it had risen to 175.60. We need to calculate the percentage change in the CPI to calculate inflation. Inflation = (175.60 — 169.30)/169.30 = .037 or 3.7%

Difference between CPI and GDP Deflator

• The CPI is based on a market basket of goods bought by consumers, including the ones produced abroad. It’s a measure of inflation of only consumer goods.

  

• The GDP deflator includes all items that make up domestic product. It includes more than just consumer goods, so its a broader measure of inflation.

Nominal and Real Income

• Nominal income - Today’s income measured in today’s dollars. These are dollars unadjusted by inflation.

• Real income - Today’s income measured in base year dollars. These inflation-adjusted dollars can be compared from year to year to determine whether purchasing power has increased or decreased.

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• Ex. →In 2014 Kelsey’s nominal income was $40,000, and it increases to $41,000 in 2015. Curious about her purchasing power, she looks up the CPI in 2014 and finds that at the end of that year it was 234.8; at the end of 2015 it was 236.5. This is compared to the base year value of 100 in 1984.

• Real income 2015 = $40,000/2.348 = $17,036

• Real income 2016 = $41,000/2.365 = $17,336

Expected Inflation

• When inflation is predictable, people can plan accordingly. The bank adds an inflation factor on the real rate of interest to create a nominal rate of interest that savers receive and borrowers pay.

  

• Real rate of interest - The percentage increase in purchasing power that a borrower pays a lender.

Unexpected inflation

• Some people gain and other lose since there’s no time to plan.

  • Rapid unexpected inflation usually hurts employees if real wages are falling, as well as fixed-income recipients, savers, and lenders.

  • Rapid unexpected inflation usually helps firms if real wages are falling, as well as borrowers. It might also increase the value of some assets like real estate or other properties.

Difficulties with CPI

• Consumer substitute - As the price of goods begins to rise, we know that consumers seek substitutes. This substitution might make the base year market basket a poor representation of the current consumption pattern.

• Goods evolve - The emergence of new products (smartphones) and extinction of others (manual typewriters) is understood by firms and consumers, but the market basket must reflect this or it risks becoming irrelevant.

• Quality differences - Some price increases are the result of improvements in quality. Prices that increase because the product is fundamentally better are not an indication of overall inflation. Since the BLS can’t tell the difference between quality improvements and actual inflation, the CPI can be overstated.

7.4 Unemployment

• Employed - A person is employed if they have worked for pay at least one hour per week.

• Unemployed - A person is unemployed if they are not currently working but are actively seeking work.

Measuring the Unemployment Rate

• Labor force - The sum of all individuals 16 years and older who are either currently employed (E) or unemployed (U). LF = E + U.

• Out of the labor force - A person is classified as out of the labor force if they have chosen to not seek employment.

• Labor force participation - The ratio of the size of the labor force to the size of the population 16 years and older. LFPR = (LF/Pop)*100.

• Unemployment rate - The percentage of the labor force that falls into the unemployed category. Sometimes called the jobless rate. UR = 100 × U/LF.

• Discouraged workers - Citizens who have been without work for so long that they become tired of looking for work and drop out of the labor force. Because these citizens are not counted in the ranks of the unemployed, the reported unemployment rate is understated.

Types of Unemployment

• Frictional unemployment - A type of unemployment that occurs when someone new enters the labor market or switches jobs. This is a relatively harmless form of unemployment and not expected to last long.

• Seasonal unemployment - A type of unemployment that is periodic, is predictable, and follows the calendar. Workers and employers alike anticipate these changes in employment and plan accordingly, thus the damage is minimal.

• Structural unemployment - A type of unemployment that is the result of fundamental, underlying changes in the economy such that some job skills are no longer in demand.

• Cyclical unemployment - A type of unemployment that rises and falls with the business cycle. This form of unemployment is felt economy-wide, which makes it the focus of macroeconomic policy.

Full Employment

• Full employment - Exists when the economy is experiencing no cyclical unemployment.

• Natural rate of unemployment - The unemployment rate associated with full employment, somewhere between 4 to 6 percent in the United States.