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Unit 4 MACROECONOMICS Measuring a Nation’s Income Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once. Measuring a Nation’s Income Macroeconomics answers questions like the following: Why is average income high in some countries and low in others? Why do prices rise rapidly in some time periods while they are more stable in others? Why do production and employment expand in some years and contract in others? THE ECONOMY’S INCOME AND EXPENDITURE • When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. THE ECONOMY’S INCOME AND EXPENDITURE • For an economy as a whole, income must equal expenditure because: – Every transaction has a buyer and a seller. – Every dollar of spending by some buyer is a dollar of income for some seller. Figure 1 The Circular-Flow Diagram Revenue Goods and services sold MARKETS FOR GOODS AND SERVICES •Firms sell •Households buy Wages, rent, and profit Goods and services bought HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production FIRMS •Produce and sell goods and services •Hire and use factors of production Factors of production Spending MARKETS FOR FACTORS OF PRODUCTION •Households sell •Firms buy Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Warm up question… What’s the difference between Microeconomics and Macroeconomics? THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • Gross domestic product (GDP) is a measure of the income and expenditures of an economy. • GDP is the total market value of all final goods and services produced within a country in a given period of time. THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • “GDP is the Market Value . . .” – Output is valued at market prices. • “. . . Of All. . .” – Includes all items produced in the economy and legally sold in markets • “. . . Final . . .” – It records only the value of final goods, not intermediate goods (the value is counted only once). • “. . . Goods and Services . . .” – It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • “. . . Produced . . .” – It includes goods and services currently produced, not transactions involving goods produced in the past. • “ . . . Within a Country . . .” – It measures the value of production within the geographic confines of a country. • “. . . In a Given Period of Time.” – It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). THE COMPONENTS OF GDP • GDP includes all items produced in the economy and sold legally in markets. • What Is Not Counted in GDP? – GDP excludes most items that are produced and consumed at home and that never enter the marketplace. – It excludes items produced and sold illicitly, such as illegal drugs. THE COMPONENTS OF GDP GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Y = C + I + G + NX THE COMPONENTS OF GDP • Consumption (C): • The spending by households on goods and services, with the exception of purchases of new housing. • Investment (I): • The spending on capital equipment, inventories, and structures, including new housing. THE COMPONENTS OF GDP • Government Purchases (G): – The spending on goods and services by local, state, and federal governments. – Does not include transfer payments because they are not made in exchange for currently produced goods or services. • Net Exports (NX): – Exports minus imports. GDP Review! Is it counted? Where? • A painter purchases new paintbrushes for his business. • The services of an accountant. • A purchase of a used automobile. • A Social Security check paid to a retired worker. • The sale of a new home. • An increase in business inventories. • The government’s purchase of a new fighter plane. • Unemployment paid to a laid-off worker. Gross National Product (GNP) • An economic statistic that includes GDP, plus any income earned by residents from overseas investments, minus income earned within the domestic economy by overseas residents. REAL VERSUS NOMINAL GDP • Nominal GDP values the production of goods and services at current prices. • Real GDP values the production of goods and services at constant prices. Table 2 Real and Nominal GDP Table 2 Real and Nominal GDP Table 2 Real and Nominal GDP REAL VERSUS NOMINAL GDP • An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator. The GDP Deflator • The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. • It tells us what portion of the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. The GDP Deflator • The GDP deflator is calculated as follows: Nominal GDP GDP deflator = 100 Real GDP The GDP Deflator • Nominal GDP is converted to real GDP as follows: Real GDP20XX Nominal GDP20XX 100 GDP deflator20XX Table 2 Real and Nominal GDP Figure 2 Real GDP in the United States Billions of 2000 Dollars $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1970 1975 1980 1985 1990 1995 2000 2005 IS GDP A GOOD MEASURE OF ECONOMIC WELL-BEING? • GDP is the best single measure of the economic wellbeing of a society. • GDP per person tells us the income and expenditure of the average person in the economy. • Higher GDP per person indicates a higher standard of living. • GDP is not a perfect measure of the happiness or quality of life, however. GDP AND ECONOMIC WELL-BEING • Some things that contribute to well-being are not included in GDP. – The value of leisure. – The value of a clean environment. – The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. Table 3 GDP and the Quality of Life Unemployment How many of you are unemployed? Identifying Unemployment • How Is Unemployment Measured? – Categories of Unemployment • The problem of unemployment is usually divided into two categories. • The natural rate of unemployment • The cyclical rate of unemployment How is Unemployment Measured? • Natural Rate of Unemployment – The natural rate of unemployment that does not go away on its own even in the long run. – It is the amount of unemployment that the economy normally experiences. How is Unemployment Measured? • Cyclical Unemployment – Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. – It is associated with short-term ups and downs of the business cycle. Why Are There Always Some People Unemployed? • Frictional unemployment refers to the unemployment that results from the time that it takes to match workers with jobs. – In other words, it takes time for workers to search for the jobs that best suit their tastes and skills. • Structural Unemployment is the unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. How is Unemployment Measured? • Describing Unemployment: Three Basic Questions: – How does government measure the economy's rate of unemployment? – What problems arise in interpreting the unemployment data? – How long are the unemployed typically without work? Aggregate Supply and Demand Practice Aggregate Demand • The Aggregate Demand Curve shows the total amount of goods and services that consumers, businesses, governments and people in other countries will purchase at each and every price level. • Represents all the demand in the economy. Aggregate Demand • Why downward sloping? – The wealth effect – The income effect – The foreign purchases effect Aggregate Demand • Factors causing a shift in the Aggregate Demand Curve are changes in… 1. 2. 3. 4. Consumer spending Investment spending Government spending Net export spending • Increases in AD increase real GDP and the price level. • Decreases in AD decrease real GDP and the price level. Aggregate Supply • The Aggregate Supply Curve shows the total amounts of goods and services that suppliers will produce at each and every price level. • A higher price level increases the quantity of goods and services supplied • A decrease in the price level decreases the quantity supplied Aggregate Supply • Anything that changes production costs shifts AS. – – – – Price of inputs Productivity Technology Government taxes, subsidies, and regulations • Increases in AS increase real GDP and lower price level • Decreases in AS decreases real GDP and raise the price level Inflation What is inflation? • Inflation refers to a situation in which the economy’s overall price level is rising. – Money supply grows faster than the supply of goods and services. • The inflation rate is the percentage change in the price level from the previous period. Cost Push inflation • Increased production costs for a large section of the market create an increase in prices Demand Pull inflation • Demand exceeds production capacity thus creating an increase in prices The inflation rate is calculated as follows: Inflation Rate in Year 2= CPI in Year 2 CPI in Year 1 100 CPI in Year 1 Understanding Inflation and the CPI – Research Activity • Your job is to figure out what the CPI is, how it’s calculated, and ultimately how it is used. THE CONSUMER PRICE INDEX • The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. – It is used to monitor changes in the cost of living over time. – When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. How the Consumer Price Index Is Calculated Price of basket of goods and services Consumer price index 100 Price of basket in base year How the Consumer Price Index Is Calculated • Calculating the Consumer Price Index and the Inflation Rate: Another Example – Base Year is 2002. – Basket of goods in 2002 costs $1,200. – The same basket in 2004 costs $1,236. – CPI = ($1,236/$1,200) 100 = 103. • What is the inflation rate? – Prices increased 3 percent between 2002 and 2004. Unanticipated Inflation: Helped or Hurt? • Remember: Unexpected inflation hurts savers and people on fixed incomes, or being paid fixed amount; it helps people who have borrowed money at a fixed rate of interest. Aggregate Supply & Demand cont.… Aggregate Demand • Why downward sloping? – The wealth effect • When prices fall, people can buy more with the money they currently have. – The Interest Rate Effect • As price levels rise, demand for money rises and investment spending reduces. – The foreign purchases effect • When price level rises for a good it becomes more expensive in comparison. • Decrease in Net Exports Aggregate Supply • Long run curve is vertical – Nation is producing as efficiently as possible. • Short run curve has upward slope – Mixture of wages and prices Fiscal Policy • Use of the federal government’s power to tax and spend to regulate economic activity. Who’s to blame for lack of growth? • The People? • The Government? • Businesses? • The Government is often blamed when the economy experiences UNEMPLOYMENT, DECREASE IN GROSS DOMESTIC PRODUCT OR INFLATION. – Why? Can the government do anything about it? ECONOMIST POINT OF VIEW • Many economist believe that the federal government can, and should, help alleviate these problems at times by using traditional discretionary fiscal policy. – “Expansion” Traditional Expansionary Fiscal Policy… • The increase spending on goods and services and/or reduce taxes to increase aggregate demand • Multiplier Effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. – Applies to anything that alters GDP – Used during recessions or times of high unemployment Does Traditional Fiscal Policy Work? • It has critics for several reasons. • Why….? • Economist do not know with certainty how large the multiplier effects are or how long it takes fiscal policy to work. Therefore by the time expansionary policy takes effect, the economy may no longer be in a recession and the policy may lead to inflation. Hard Times…? • Contractionary Fiscal Policy calls for reduced governmental spending and/or increases in taxes to decrease aggregate demand. – Reductions in aggregate demand should then lead to decreased prices. – Used during times of high inflation The Crowding Out Effect • Stimulating aggregate demand can cause interest rates to rise, which lowers investment spending (too expensive for consumers/businesses). – When more money is demanded, it increases interest rates and shifts AD curve to the right to maintain balance between supply and demand. – Eventually shifts AD curve to the left when demand drops. – Amount of increase in aggregate demand depends on whether multiplier or crowding out effect is larger. Taxes • When government cuts taxes, it shifts aggregate demand to the right – Consumers will usually save more and spend more – Influenced by multiplier and crowding out effects Fiscal Policy: Two Act Play • Demand-Side Fiscal Policy – Traditional “Expansionary Fiscal Policy” • Supply-Side Fiscal Policy – Tax cuts for businesses to give them more income to spend as they choose – Increase production, investment, and supply of goods – Attempt to lower unemployment and inflation Money Supply is Key • There is a direct relationship between the money supply and the level of business activity. • More Money = More Activity • Less Money = Less Activity Monetary Policy • Use of the Federal Reserve’s power to control the money supply in an effort to limit inflation and/or stimulate economic growth. – “The Fed” – Nation’s Bank – Lends to member banks Automatic Stabilizers • Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. – Tax System (automatic reduction in taxes from decreased income) – Government spending • Increase in unemployment spending & other aide services