Macroeconomic Measurements

Study Questions

n 1. What is Gross Domestic Product (GDP)?

n 2. Why must Nominal GDP be corrected for inflation?

n 3. How is economic growth calculated?

n 4. What is the difference between growth, stagnation, and decline?

n 5. What are the phases of the business cycle?

n 6. What are the three types of inflation?

n 7. What are the four types of unemployment?

n 8. Which is the one of most concern to policy makers?

n 9. What is the full employment goal?

Macroeconomic Goals

n inflation: 3 percent

n unemployment: 4 percent

n economic growth: 4 percent

Gross Domestic Product (GDP)

n The dollar value of all final goods and services produced within the nation’s borders in one year.

¨ total production

¨ total expenditures

¨ total income

Transactions Not Included in GDP

n transfer payments

n unreported income

n work for which no money changed hands

Basic Circular Flow

n This shows the interactions between households (income earners and resource owners) and businesses (resource buyers)

Figure 8-1. Basic Circular Flow

Expenditures

n The components of total spending are:

¨ C – Consumption spending

¨ I – Investment spending

¨ G – Government spending

¨ X – Exports

n From which we subtract

¨ M - Imports

C – Consumption spending

n Three kinds:

¨ durable goods

¨ non-durable goods

¨ services

n Determining factors:

¨ income

¨ expectations about the future

I – Investment spending

n Three kinds:

¨ new or replacement capital goods

¨ inventory changes

¨ new housing construction

n Determining factors:

¨ interest rates

¨ expected return on investment

¨ expectations about the future

G – Government spending

n Three kinds:

¨ Federal

¨ state

¨ local

n Determining factors:

¨ politics

¨ unexpected external events

X – Exports and M - Imports

n Exports - Determining factors:

¨ income of foreign customers

¨ comparative advantage of American goods

n Imports – Determining factors:

¨ income of American customers

¨ comparative advantage of foreign goods

Macro Equilibrium

n Total spending = total output

n No unexpected changes in inventories

n Full-employment equilibrium is the goal:

¨ total spending = total production at the economy’s capacity to produce

Macro Equilibrium

n Equilibrium with high unemployment:

¨ total spending is less than the economy’s capacity to produce

¨ recession

¨ underperforming economy

¨ idle labor and capital goods

Macro Equilibrium

n Equilibrium with low unemployment:

¨ total spending is greater than the economy’s capacity to produce

¨ inflation

¨ overheated economy

¨ shortages of labor and capital goods

Leakages

n Households do not spend all of their income on American goods

¨ The following leak out of the circular flow:

n saving (S)

n taxes (T)

n imports (M)

Injections

n Not all American made products are bought by US households.

¨ The following are injected into the circular flow:

n investment spending (I)

n government spending (G)

n exports (X)

Basic Circular Flow

Leakages and Injections

n For equilibrium:

¨ leakages = injections

¨ S + T + M = I + G + X

n It is not necessary that S = I and T = G and M = X to have equilibrium

Recessions

n Usually caused by a decrease in total spending

¨ Spending < production

¨ Inventories rise

¨ Investment spending falls

¨ Unemployment rises

¨ Income falls

¨ Tax collections fall and transfer payments rise

Recessions

n Real GDP decreases

n To be called a recession, real GDP must decrease two quarters (six months) in a row.

Recessions

n Possible causes:

¨ Decreases in injections (I, G, X)

¨ Increases in leakages (S, T, M)

n Result:

¨ injections < leakages

¨ spending < production

¨ ultimately reach an equilibrium in an underperforming economy

Real GDP

n Terminology:

¨ “nominal” means as measured

¨ “real” means with the effects of inflation removed

Real GDP

n A change in Nominal GDP includes changes in both prices and quantities.

n Economic growth wants to consider only the change in quantities.

n Thus, the change in prices must be removed from the data.

¨ Convert Nominal GDP to Real GDP

GDP Deflator

n In addition to measuring Nominal GDP, prices of a standardized basket of goods and services are also measured.

n A price index – the GDP deflator – is created using the price measures.

GDP Deflator

n A reference point is established:

¨ one year is determined to be the base year

¨ the GDP deflator in the base year is set to be 100

¨ then the GDP deflator in any other year is found by the ratio formula:

¨ GDP deflator in year x = Basket price in year x

¨ GDP deflator in base year Basket price in base year

Finding Real GDP

n Now we have measured Nominal GDP and calculated GDP deflator for year x.

n Divide GDP deflator into Nominal GDP (then multiply by 100) and you get Real GDP for year x.

Using Real GDP

n Compare Real GDP for year x to Real GDP for year x+1.

¨ Use the %change formula:

n = (change in GDP) x 100 / (real GDP in year x)

n Growth economy – increases 3% or more

n Stagnant economy – grows less than 3%

n Declining economy – growth is negative

Business Cycle

n The long run trend in economic growth is positive, 3 to 3.5 percent per year

n Short run, there are periods of greater growth and of decline

¨ this variation is called the business cycle

Business Cycle

n Four phases:

¨ peak

¨ recession/contraction

¨ trough

¨ recovery/expansion/prosperity

Peak

n economic activity at its highest

n unemployment is low

n income is at its highest

¨ tax collections are high

¨ transfer payments are low

n danger of inflation

Recession/Contraction

n economic activity slows

n inventory levels rise unexpectedly

n sales fall off

n production decreases

n unemployment rises

n incomes fall

¨ tax collections fall and transfer payments rise

Trough

n economic activity is at its lowest

n unemployment is high

n incomes are at their lowest

¨ tax collections are low and transfer payments are high

Recovery/Expansion/Prosperity

n economic activity increases

n sales rise

n production rises

n unemployment falls

n income rises

¨ tax collections rise and transfer payments fall

n when real GDP increases beyond the previous peak, prosperity sets in

n in the late stages, inflation may become a problem

Inflation

n A rising general level of prices

n Measured monthly similar to the GDP deflator

¨ Special basket of goods consumers buy

¨ Consumer Price Index (CPI)

n Inflation then is the %change in the CPI from year to year

Inflation’s Harmful Effects

n Purchasing power falls

n Redistribution of income and wealth

n Savings rate falls

n Businesses plan only in very short time horizons

n Interest rates rise

Types of Inflation

n Monetary

n Demand-pull

n Cost-push

Unemployment

n Definitions:

¨ labor force = those at least 16 years old who are working or are actively seeking work

¨ employed = those in the labor force who are working

¨ unemployed = those in the labor force who are not working but are actively seeking work

Unemployment

n The unemployment rate is number unemployed divided by the labor force, expressed in a percent.

n Types:

¨ seasonal

¨ cyclical

¨ frictional

¨ structural

Full Employment

n No cyclical unemployment exists.

n Only frictional and structural unemployment exists.

¨ Full employment exists when the unemployment rate is 4 to 6 percent.

¨ Occurs at or near the peak of the business cycle.