Measuring and Modeling the Macro Economy
1.
Prices and Unemployment
Macro Problems
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High inflation rate
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High unemployment rate
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Low economic growth
Macro Theories
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The economy is self-regulating.
n
OR
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The economy cannot self-regulate.
n
OR
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Self-regulation is too slow:
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Government must step in and “fix” it.
Macro Policies
n
Laissez faire
n
Fiscal Policy
n
Supply-side Policy
n
Monetary Policy
Macro Measurements
n
Price Index
n
Consumer Price
Index (CPI)
n
Inflation rate
n
Employment Data
n
Unemployment rate
n
Gross Domestic
Product (GDP)
n
Economic growth
n
Business Cycle
n
Peak,
contraction/recession, trough, recovery/expansion, peak
Price Index
n
A measure of the price level in one year in
comparison to a price index of 100 in the base year.
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Consumer Price Index (CPI)
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Producer’s Price Index
n
GDP Deflator
Price Index
n
Basket of Goods –
each month, teams collect the prices for a standardized basket of goods
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Base Year –
identify one particular year to be the reference year.
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Price Index in
the Base Year – arbitrarily set to equal 100.
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The teams
measured prices for the basket in the current year and in the base year.
Price Index
n
Compute the Price Index:
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PIcurrent/PIbaseyear=Basketcurrent/Basketbaseyear
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Example:
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X/100 = $3300/$3000
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X = (3300 x 100)/3000
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X = 110
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PI in the current year is 110.
Price Index
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A PI of 110 indicates that prices in the current
year are 10% higher than prices in the base year.
Consumer Price Index: 1983-2006
Consumer Price Index:
1983-2006
Exercise
n
Data table, p.117:
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In 2006, CPI was about 200
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When was CPI close to 100?
Exercise
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Data table, p.117:
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In 2006, CPI was 201.6 (about 200)
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When was CPI close to 100? 1983
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These two CPI tell us that prices doubled
between 1983 and 2006.
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When was CPI close to 50?
Exercise
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Data table,
p.117:
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In 2006, CPI was
201.6 (about 200)
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When was CPI
close to 100? 1983
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These two CPI
tell us that prices doubled between 1983 and 2006.
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When was CPI
close to 50? 1974
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So, prices
doubled between 1974 and 1983.
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If a good was
priced at $10 in 1974, what would you expect the price to be in 2006?
Exercise
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Data table,
p.117:
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In 2006, CPI was
198.6 (nearly 200)
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When was CPI
close to 100? 1983
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These two CPI
tell us that prices doubled between 1983 and 2006.
n
When was CPI
close to 50? 1974
n
So, prices
doubled between 1974 and 1983.
n
If a good was
priced at $10 in 1974, what would you expect the price to be in 2006? $40
Inflation Rate
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% Change Calculation:
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inflation rate = (PIyear2-PIyear1)x100/(PIyear1)
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Example:
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PI in 2006 was 201.6; PI in 2005 was 195.3.
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Thus, for 2006:
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inflation rate = (201.6-195.3)x100/195.3
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= 3.23%
Exercise
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% Change Calculation:
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inflation rate = (PIyear2-PIyear1)x100/(PIyear1)
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Data table, p. 117:
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PI in 1979 was 72.6; PI in 1980 was 82.4.
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Thus, for 1980:
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inflation rate = (82.4-72.6)x100/72.6
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= ?
Exercise
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% Change Calculation:
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inflation rate = (PIyear2-PIyear1)x100/(PIyear1)
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Data table, p. 117:
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PI in 1979 was 72.6; PI in 1980 was 82.4.
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Thus, for 1980:
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inflation rate = (82.4-72.6)x100/72.6
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= 13.5%
Exercise
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The inflation rate in 1980 was 13.5%.
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In 1979, your income was $10,000.
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In 1980, your income was $11,000.
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Did your purchasing power increase? decrease?
Stay the same?
Exercise
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The inflation rate in 1980 was 13.5%.
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In 1979, your income was $10,000.
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In 1980, your income was $11,000.
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Did your purchasing power increase? decrease?
Stay the same?
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Decrease! Your income went up 10% while prices
went up 13.5%.
Exercise
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Gasoline was $1.15 per gallon in 1980. Is
gasoline cheaper or more expensive today?
Exercise
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Gasoline was $1.20 per gallon in 1983. Is
gasoline cheaper or more expensive today?
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CPI in 1983 was about 100.
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CPI at the end of 2006 was about 200.
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Price of gasoline is _______.
Inflation
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An increase in the general level of prices.
n
Price Index rises.
n
Purchasing power of money decreases.
Definitions
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Inflation – rising general level of prices
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Deflation – falling general level of prices
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Disinflation – prices are rising but slower than
before
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Hyperinflation – out of control inflation
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Stagflation – simultaneous rising inflation,
rising unemployment, and a stagnant GDP (no economic growth)
Impact of Inflation
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Borrowers are able to pay back loans in lower
valued dollars.
n
Lenders add an inflation premium to the interest
rate, so interest rates rise.
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People on fixed income suffer a decreased
standard of living.
n
Savings lose value.
Employment Definitions
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Employed – people working.
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Unemployed – people not working but actively
seeking work.
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Labor Force – employed + unemployed
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Not in the Labor Force – people not working and
NOT looking for work.
Who are the Unemployed?
Unemployment Rate
n
U% =
n
(#unemployed)x100/(#labor force)
n
Example:
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#in labor force =
20,000
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#unemployed =
1000
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U% = 1000 x 100 / 20,000 = 5%
Unemployment Rate
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Unemployment rate
(in %) =
n
#unemployed x 100
/# in labor force
n
Calculate the
unemployment rate.
Unemployment Rate
n
Unemployment rate
(in %) =
n
#unemployed x 100
/# in labor force
n
Calculate the
unemployment rate.
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U%=8.3x100/142.5
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=5.82%
Types of Unemployment
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Frictional
n
Structural
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Cyclical
Frictional Unemployment
n
People voluntarily leaving a job for the
purposes of seeking better opportunity elsewhere
Structural Unemployment
n
Employers, reacting to changing market
conditions and changes in technology, eliminate jobs.
n
Results in skilled workers with no job to match
that skill.
Cyclical Unemployment
n
Caused by layoffs as the economy enters into a
recession.
Full Employment
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This is the macroeconomic goal.
n
Only frictional unemployment and structural
unemployment exist.
n
Cyclical unemployment is zero.
n
Also called:
n
Natural Rate of Unemployment
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NAIRU (non-accelerating inflation rate of
unemployment)
Measuring and Modeling the Macro Economy
2.
Nominal GDP and Real GDP
Gross Domestic Product (GDP)
n
The total market value of all final goods and
services produced annually in the country.
Gross Domestic Product (GDP)
n
The total market
value of all final goods and services produced annually in the country.
n
measured in $
n
intermediate
goods not included
n
only American
production
n
non-market
activity not included
n
work done by
family members not included
n
used goods not
included
n
illegal activity
not included
The Underground
Economy
n
Illegal and legal
activities that are not reported make up the underground economy.
Expenditures Approach
n
GDP = C + I + G +
(X – M)
n
GDP can be
measured by adding up all purchases of American-made goods and services:
GDP = Consumption spending (C)
+ Business Investment spending (I)
+ Government spending (G)
+ Exports (X)
- Imports (M)
Income Approach
n
Households receive Income as payment for the
resource they own.
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What do households do with their Income?
Income Approach
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Households receive Income as payment for the
resource they own.
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What do households do with their Income?
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They spend: Consumption (C)
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They save: Saving (S)
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They pay taxes: Taxes (T)
Income Approach
n
GDP measured by the income approach equals GDP
measured by the expenditures approach.
n
So: GDP = C + I + G + (X – M)
n
And: GDP = Y = C + S + T
Basic Circular Flow
n
Business revenues (GDP) become business costs.
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Business costs become household income (Y).
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Household income is spent (C and M), saved (S),
and paid in taxes (T).
n
Business revenues come from C, I, G, and X.
Basic Circular Flow
Consumption Spending (C)
n
Largest category
n
Durable goods (most volatile)
n
Non-durable goods
n
Services
Business Investment Spending (I)
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New capital goods
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for expansion
n
to replace worn out capital goods
n
(heavily dependent upon interest rates and
projected return on investment (ROI))
n
New residential housing
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Investment in inventories (most volatile)
Government Spending (G)
n
All levels: federal, state, and local
n
Includes purchases of goods and services
n
Includes wages for government workers
n
Does not include transfer payments
Exports (X) and Imports (M)
n
Exports (X) - Foreign spending on American-made
goods and services
n
added to GDP
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Imports (M) – American spending on foreign-made
goods and services
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subtracted from GDP
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Net Exports = (X – M)
GDP (2006 data)
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C = $ 9.3 trillion 70.5% of GDP
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I = $ 2.2 trillion 16.6%
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G = $ 2.5 trillion 18.9%
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X = $ 1.1 trillion 8.3%
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M = $ 1.9 trillion 14.4%
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X – M = -$ 0.8 trillion 6.0%
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GDP = $13.2 trillion
Nominal GDP
n
Nominal means:
n
“as measured”.
n
“the effects of
inflation are included”.
n
Each year GDP is
measured by adding up all expenditures at the prices that existed in that year.
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Nominal GDP
cannot be used to compare production from year to year, since prices change.
Real GDP
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Real means:
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“with the effects
of inflation removed.”
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Real GDP data can
be used to compare production year to year, since the effects of changing
prices have been eliminated.
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For each year, we
recalculate Nominal GDP from current
year $ into base year $ to get Real GDP for that year.
Real GDP
n
To convert Nominal GDP (NGDP) to Real GDP
(RGDP):
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RGDPyear x/NGDPyear x
= PIbaseyear/PIyear x
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Example (for 1991):
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NGDP = 5677.5; PI = 117.8, therefore:
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RGDP/5677.5 = 100/117.8
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RGDP = 4819.9
Exercise
RGDPyear x/NGDPyear x = PIbaseyear/PIyear
x
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In year x: NGDP = $15 trillion.
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In year x: PI = 200.
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What is RGDP for year x?
Exercise
RGDPyear x/NGDPyear x = PIbaseyear/PIyear
x
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In year x: NGDP = $15 trillion.
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In year x: PI = 200.
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What is RGDP for year x?
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RGDP/$15 = 100/200
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RGDP = $7.5 trillion
Economic Growth
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If Real GDP increases from year to year, there
is economic growth.
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Use the % change formula to calculate economic
growth:
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= (RGDPyear2–RGDPyear1)x100/RGDPyear1
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Example:
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growth = (3090 – 3000)x100/3000
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= 90x100/3000 = 3%
Exercise
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Economic growth
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= (RGDPyear2–RGDPyear1)x100/RGDPyear1
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Year 2 RGDP = $12,480 billion
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Year 1 RGDP = $12,000 billion
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Calculate economic growth.
Exercise
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Economic growth
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= (RGDPyear2–RGDPyear1)x100/RGDPyear1
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Year 2 RGDP = $12,480 billion
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Year 1 RGDP = $12,000 billion
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Calculate economic growth.
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growth = (12,480 – 12,000)x100/12,000
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= 480x100/12,000 = 4%
Standard of Living
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One measure of our standard of living is Real
GDP/population, or per capita GDP.
n
This is the average amount of things produced
per person in a year.
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To raise the standard of living, Real GDP must
grow faster than the population growth.
Standard of Living
n
Data table, p.
134.
n
Compare the per
capita GDP for the countries listed.
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Can you see any
correlation between economic freedom and standard of living?
Standard of Living
n
Data table, p. 140.
n
What can you say about changes in standard of
living from 1820 to 1900 to 1950?
Measuring and Modeling the Macro Economy
3.
The Business Cycle
Business Cycle
n
The long-run
trend is up for economic growth.
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Short-run
fluctuations occur and cause problems due to rises in unemployment or in
inflation. We call this the business cycle.
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The sequence:
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Peak, contraction
(recession), trough, expansion (recovery), peak.
Business Cycle
Business Cycle, 1982-2002
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In the orange
areas, the economy is underperforming.
n
In the blue
areas, the economy is overheated.
n
Note that the
recession phase is short and the recovery/expansion phase is long.
Peak
n
Highest real GDP in the cycle
n
Unemployment low
n
Inflation may be a problem
Contraction/Recession
n
Real GDP decreases quickly
n
Unemployment rises rapidly
n
Inflation lessens
n
Production falls
Recessions since 1950
Note that the recessions of the 50s, 70s and
early 80s were much more significant than those of the 60s and the last two.
Trough
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Lowest real GDP in the cycle
n
Unemployment high
n
Inflation usually not a problem
Expansion/Recovery
n
Real GDP increases slowly
n
Production rises
n
Unemployment falls slowly
n
Inflation may begin to increase at the end of
this phase
Prosperity
n
GDP rises above the previous peak
n
Unemployment nears full-employment
n
Inflation may become a problem
n
Economy is “booming”
Unemployment Rate:
1982-2002
n
The unemployment
rises fast going into recession, but falls more slowly as we come out of a
recession. This is because employers are reluctant to add workers until business
picks up.
Inflation Rate, 1960-2002
In 1969, inflation was due to excessive
government spending. The peaks in 1974 and 1980 were due to the rising oil
prices.
Summary: Relationships
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GDP = Y
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GDP = C + I + G + X – M
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Y = C + S + T
n
Yd = Y – T = C + S
Measuring and Modeling the Macro Economy
4.
Creating the AD-AS Model
The AD - AS Model of the Economy
n
Consists of:
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Aggregate Demand (AD)
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Short-Run Aggregate Supply (SRAS)
n
Long-Run Aggregate Supply (LRAS)
n
The vertical axis is Price Level (P)
n
The horizontal axis is Real GDP (Q)
Aggregate Demand (AD)
n
This is the collective behavior of all buyers of
all products in the economy.
n
As Price level (P) increases, Real GDP (Q)
decreases, and vice versa.
Aggregate Demand (AD)
n
AD is a downward
sloping line.
n
As price level
rises, the purchasing power of income and wealth falls, so buyers must buy
less, and vice versa.
Aggregate Demand (AD)
n
AD increases
(shifts right) if:
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C increases
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I increases
n
G increases
n
X increases
n
M decreases
n
money supply
increases
n
interest rates
decrease
Aggregate Demand (AD)
n
AD decreases
(shifts left) if:
n
C decreases
n
I decreases
n
G decreases
n
X decreases
n
M increases
n
money supply
decreases
n
interest rates
increase
Short-Run Aggregate Supply (SRAS)
n
This is the collective behavior of all sellers
(producers) of all products in the economy.