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Econ 200 Summer 2012 • Microeconomics • Opportunity Cost and the Gains from Trade • Supply and Demand • Firms and Industries • Macroeconomics • The Data of Macroeconomics • Growth, Saving and Investment • Money and Exchange Rates REFERENCE: Chapters 23, 24 and 28 (pages 593 to 600 only) in your text. Copyright © 2010 Cengage Learning Measuring a Nation s Income • Microeconomics • Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. • Macroeconomics • 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. Copyright © 2010 Cengage Learning Measuring a Nation s Income • Macroeconomics answers questions such as 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? Copyright © 2010 Cengage Learning 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. Copyright © 2010 Cengage Learning 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. Copyright © 2010 Cengage Learning THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • Gross domestic product (GDP) is a measure of the income and expenditures of an economy. • It is the total market value of all final goods and services produced within a country in a given period of time. Copyright © 2010 Cengage Learning THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • The equality of income and expenditure can be illustrated with the circular-flow diagram. Copyright © 2010 Cengage Learning Figure 1 The Circular-Flow Diagram Copyright©2010 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • GDP is the market value of all final goods and services produced within a country in a given period of time. Copyright © 2010 Cengage Learning THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • GDP is the Market Value . . . • Output is valued at market prices. • . . . Of All 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, house cleaning, doctor visits). Copyright © 2010 Cengage Learning 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. Copyright © 2010 Cengage Learning THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • . . . 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). Copyright © 2010 Cengage Learning THE COMPONENTS OF GDP • GDP includes all items produced in the economy and sold legally in markets. Copyright © 2010 Cengage Learning THE COMPONENTS OF GDP • 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. Copyright © 2010 Cengage Learning 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 Copyright © 2010 Cengage Learning 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. Copyright © 2010 Cengage Learning THE COMPONENTS OF GDP • Government Purchases (G): • The spending on goods and services by local and central 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. Copyright © 2010 Cengage Learning Table 1 GDP and Its Components Copyright©2010 South-Western 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. Copyright © 2010 Cengage Learning REAL VERSUS NOMINAL GDP • An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator. Copyright © 2010 Cengage Learning Table 2 Real and Nominal GDP Copyright©2010 South-Western Table 2 Real and Nominal GDP Copyright©2010 South-Western Table 2 Real and Nominal GDP Copyright©2010 South-Western 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 the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. Copyright © 2010 Cengage Learning The GDP Deflator • The GDP deflator is calculated as follows: Nominal GDP GDP deflator = ×100 Real GDP Copyright © 2010 Cengage Learning The GDP Deflator • Converting Nominal GDP to Real GDP • Nominal GDP is converted to real GDP as follows: Nominal GDP20XX Real GDP20XX = ×100 GDP deflator20XX Copyright © 2010 Cengage Learning Table 2 Real and Nominal GDP Copyright©2010 South-Western Figure 2 Real GDP in the United Kingdom Copyright©2010 South-Western Potential and Actual Real GDP - Turkey 27000 25000 23000 21000 19000 17000 15000 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 GDPsa Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Potential GDP Copyright © 2010 Cengage Learning GDP AND ECONOMIC WELLBEING • GDP is the best single measure of the economic well-being of a society. • GDP per person tells us the mean income and expenditure of the people in the economy. Copyright © 2010 Cengage Learning GDP AND ECONOMIC WELLBEING • Higher GDP per person indicates a higher standard of living. • GDP is not a perfect measure of the happiness or quality of life, however. Copyright © 2010 Cengage Learning 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. Copyright © 2010 Cengage Learning Table 3 GDP, Life Expectancy, and Literacy Copyright©2010 South-Western Turkish Economy GDP Per capita growth rate, 1926-2005 (5-yr moving average, %) Annual growth rate of GDP per capital, 1926-2005 (5-year moving averages) 10 Annual growth rate (%) 5 0 1925 1935 1945 1955 1965 1975 1985 1995 2005 -5 Copyright © 2010 Cengage Learning 3 4 Review • Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. • Gross Domestic Product (GDP) measures an economy s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. Copyright © 2010 Cengage Learning Review • GDP is the market value of all final goods and services produced within a country in a given period of time. • GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Copyright © 2010 Cengage Learning Review • Nominal GDP uses current prices to value the economy s production. Real GDP uses constant base-year prices to value the economy s production of goods and services. • The GDP deflator—calculated from the ratio of nominal to real GDP—measures the level of prices in the economy. Copyright © 2010 Cengage Learning Review • GDP is a good measure of economic well-being because people prefer higher to lower incomes. • It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren t measured by GDP. Copyright © 2010 Cengage Learning Mini Quiz In the circular flow model, firms use the money they earn from selling their goods and services to pay for the a. goods and services they buy on the product market. b. resources they buy on the product market. c. goods and services they buy from government. d. resources they buy in the factor market. Which of the following would be counted in France s GDP? a. The purchase of an historic chateau b. The purchase of a haircut c. The purchase of a €1,000 government savings bond d. The value generated when Pierre washes his car in his garden Copyright © 2010 Cengage Learning Measuring the Cost of Living • Inflation refers to a situation in which the economy s overall price level is rising. • The inflation rate is the percentage change in the price level from the previous period. Copyright © 2010 Cengage Learning 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. • The Office of National Statistics reports the CPI each month. • It is used to monitor changes in the cost of living over time. Copyright © 2010 Cengage Learning THE CONSUMER PRICE INDEX • When the CPI rises, the typical family has to spend more money to maintain the same standard of living. Copyright © 2010 Cengage Learning How the Consumer Price Index Is Calculated • Fix the Basket: Determine what prices are most important to the typical consumer. • The Office of National Statistics (ONS) identifies a market basket of goods and services the typical consumer buys. • The ONS conducts regular consumer surveys to set the weights for the prices of those goods and services. Copyright © 2010 Cengage Learning How the Consumer Price Index Is Calculated • Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. Copyright © 2010 Cengage Learning How the Consumer Price Index Is Calculated • Compute the Basket s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. Copyright © 2010 Cengage Learning How the Consumer Price Index Is Calculated • Choose a Base Year and Compute the Index: • Designate one year as the base year, making it the benchmark against which other years are compared. • Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. Copyright © 2010 Cengage Learning How the Consumer Price Index Is Calculated • Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period. Copyright © 2010 Cengage Learning How the Consumer Price Index Is Calculated • The Inflation Rate • The inflation rate is calculated as follows: CPI in Year 2 - CPI in Year 1 Inflation Rate in Year 2 = ×100 CPI in Year 1 Copyright © 2010 Cengage Learning Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright Copyright©2010 © 2010 Cengage South-Western Learning Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright Copyright©2010 © 2010 Cengage South-Western Learning Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright Copyright©2010 © 2010 Cengage South-Western Learning Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright Copyright©2010 © 2010 Cengage South-Western Learning Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright Copyright©2010 © 2010 Cengage South-Western Learning 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. Prices increased 3 percent between 2002 and 2004. Copyright © 2010 Cengage Learning FYI: The Typical Basket of Goods and Services Copyright Copyright©2010 © 2010 Cengage South-Western Learning Consumer Price Index - Turkey 16000 14000 CPI (1994=100) 12000 10000 8000 6000 4000 2000 0 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Copyright © 2010 Cengage Learning Turkish Inflation 160 Rate of Inflation in CPI (%) 140 120 100 80 60 40 20 0 1969 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Copyright © 2010 Cengage Learning 5 7 Problems in Measuring the Cost of Living • The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. Copyright © 2010 Cengage Learning Problems in Measuring the Cost of Living • Substitution bias • Introduction of new goods • Unmeasured quality changes Copyright © 2010 Cengage Learning Problems in Measuring the Cost of Living • Substitution Bias • The basket does not change to reflect consumer reaction to changes in relative prices. • Consumers substitute toward goods that have become relatively less expensive. • The index overstates the increase in cost of living by not considering consumer substitution. Copyright © 2010 Cengage Learning Problems in Measuring the Cost of Living • Introduction of New Goods • The basket does not reflect the change in purchasing power brought on by the introduction of new products. • New products result in greater variety, which in turn makes each euro more valuable. • Consumers need less money to maintain any given standard of living. Copyright © 2010 Cengage Learning Problems in Measuring the Cost of Living • Unmeasured Quality Changes • If the quality of a good rises from one year to the next, the value of a euro rises, even if the price of the good stays the same. • If the quality of a good falls from one year to the next, the value of a euro falls, even if the price of the good stays the same. • The ONS tries to adjust the price for constant quality, but such differences are hard to measure. Copyright © 2010 Cengage Learning Problems in Measuring the Cost of Living • The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. • The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. Copyright © 2010 Cengage Learning The GDP Deflator versus the Consumer Price Index • The GDP deflator is calculated as follows: Nominal GDP GDP deflator = ×100 Real GDP Copyright © 2010 Cengage Learning The GDP Deflator versus the Consumer Price Index • The ONS calculates other prices indexes: • The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. Copyright © 2010 Cengage Learning The GDP Deflator versus the Consumer Price Index • Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. • There are two important differences between the indexes that can cause them to diverge. Copyright © 2010 Cengage Learning The GDP Deflator versus the Consumer Price Index • The GDP deflator reflects the prices of all goods and services produced domestically, whereas... • …the consumer price index reflects the prices of all goods and services bought by consumers. Copyright © 2010 Cengage Learning The GDP Deflator versus the Consumer Price Index • The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the ONS change the basket)... • …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. Copyright © 2010 Cengage Learning Figure 2 Two Measures of Inflation Copyright Copyright©2010 © 2010 Cengage South-Western Learning CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION • Price indexes are used to correct for the effects of inflation when comparing money figures from different times. Copyright © 2010 Cengage Learning Money Figures from Different Times • Do the following to convert (inflate) MPs salary in 1911 to a figure in 2004 pounds: Salary 2004 = Salary = £400 1911 × × Price leve l in 2004 Price leve l in 1911 5,040 100 = £20,160 Copyright © 2010 Cengage Learning Table 2 The Most Popular Movies of All Times, Inflation Adjusted Copyright Copyright©2010 © 2010 Cengage South-Western Learning Indexation • When some money amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. Copyright © 2010 Cengage Learning Real and Nominal Interest Rates • Interest represents a payment in the future for a transfer of money in the past. Copyright © 2010 Cengage Learning Real and Nominal Interest Rates • The nominal interest rate is the interest rate usually reported and not corrected for inflation. • It is the interest rate that a bank pays. • The real interest rate is the nominal interest rate that is corrected for the effects of inflation. Copyright © 2010 Cengage Learning Real and Nominal Interest Rates • You borrowed €1,000 for one year. • Nominal interest rate was 15%. • During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5% Copyright © 2010 Cengage Learning Figure 3 Real and Nominal Interest Rates Copyright Copyright©2010 © 2010 Cengage South-Western Learning The Costs of Inflation • May be difficult to determine • Wages are often partially or perfectly indexed to inflation. • Example: COLAs (cost of living adjustments) are included in many labor contracts and Social Security • Who suffers from inflation? • Lenders, who are paid back in dollars that have lower purchasing power • Taxpayers, since the tax code is only partially indexed • Holders of currency, since inflation is a tax on holding currency Copyright © 2010 Cengage Learning Social Costs of Inflation • Shoe-leather costs • The costs of managing cash balances and otherwise avoiding the inflation tax • Added variability in relative prices: • Not all prices rise by the same percentage during inflation. • This may make it difficult to determine whether the price of a good is increasing due to higher demand for that good or due to a rise in the general price level. • Increased uncertainty • Makes planning more difficult Copyright © 2010 Cengage Learning The Costs of Deflation • Hurts borrowers: • Failure to repay loans may lead to widespread bankruptcies and a banking and financial crisis. • Deflation puts a lower bound on the real interest rate. • Nominal interest rate = real interest rate + inflation • Nominal interest rate ≥ 0 so • Real interest rate + inflation ≥ 0, • Which means real interest rate ≥ - inflation. • Example: if inflation is -5% (a deflation) then the real interest rate ≥ 5% • This may discourage borrowing by businesses and consumers which would lead to lower investment and consumer spending. Copyright © 2010 Cengage Learning Review • The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. • The index is used to measure the overall level of prices in the economy. • The percentage change in the CPI measures the inflation rate. Copyright © 2010 Cengage Learning Review • The consumer price index is an imperfect measure of the cost of living for the following three reasons: • substitution bias, • the introduction of new goods, • and unmeasured changes in quality. Copyright © 2010 Cengage Learning Review • The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. • In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. Copyright © 2010 Cengage Learning Review • Money figures from different points in time do not represent a valid comparison of purchasing power. • Various laws and private contracts use price indexes to correct for the effects of inflation. • The real interest rate equals the nominal interest rate minus the rate of inflation. Copyright © 2010 Cengage Learning IDENTIFYING UNEMPLOYMENT • Categories of Unemployment • The problem of unemployment is usually divided into two categories. • The long-run problem and the short-run problem: • The natural rate of unemployment • The cyclical rate of unemployment Copyright © 2010 Cengage Learning IDENTIFYING UNEMPLOYMENT • Natural Rate of Unemployment • The natural rate of unemployment is 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. Copyright © 2010 Cengage Learning IDENTIFYING UNEMPLOYMENT • Cyclical Unemployment • Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. • It is associated with with short-term ups and downs of the business cycle. Copyright © 2010 Cengage Learning IDENTIFYING UNEMPLOYMENT • 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? Copyright © 2010 Cengage Learning How Is Unemployment Measured? • Unemployment may be measured in two ways. • A monthly survey of households – the Labour Force Survey in the UK. • The claimant count. Copyright © 2010 Cengage Learning How Is Unemployment Measured? • Each adult is placed into one of three categories: • Employed • Unemployed • Not in the labour force Copyright © 2010 Cengage Learning How Is Unemployment Measured? • Labour Force • The labour force is the total number of workers, including both the employed and the unemployed. Copyright © 2010 Cengage Learning Figure 1 The Breakdown of the UK Adult Population in 2004 Employed (28.4 million) Adult Population (47.4 million) Labour Force (29.8 million) Unemployed (1.4 million) Economically inactive (17.6 million) Copyright Copyright©2010 © 2010 Cengage South-Western Learning How Is Unemployment Measured? • The unemployment rate is calculated as the percentage of the labour force that is unemployed. Number unemployed× Unemployment rate= 100 Labour force Copyright © 2010 Cengage Learning How Is Unemployment Measured? • The labour force participation rate is the percentage of the adult population that is in the labour force. Labour force participation rate Labour force = × 100 Adult population Copyright © 2010 Cengage Learning International Comparisons of Unemployment Copyright © 2010 Cengage Learning International Labour Office Definitions • Employed: spent some of the previous week working at a paid job • Unemployed • Without a job • Willing to start work within the next two weeks • Either looking for a job or waiting for a job to start in the last four weeks • Out of the labour force: everyone else (full-time student, home-maker, retiree) Copyright © 2010 Cengage Learning Does the Unemployment Rate Measure What We Want It To? • It is difficult to distinguish between a person who is unemployed and a person who is not in the labour force. • Discouraged workers, people who would like to work but have given up looking for jobs after an unsuccessful search, don t show up in unemployment statistics. • Other people may claim to be unemployed in order to receive financial assistance, even though they aren t looking for work. Copyright © 2010 Cengage Learning How Long Are the Unemployed without Work? • Most spells of unemployment are short. • Most unemployment observed at any given time is long-term. • Most of the economy s unemployment problem is attributable to relatively few workers who are jobless for long periods of time. Copyright © 2010 Cengage Learning Why Are There Always Some People Unemployed? • In an ideal labour market, wages would adjust to balance the supply and demand for labour, ensuring that all workers would be fully employed. Copyright © 2010 Cengage Learning 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 are best suit their tastes and skills. Copyright © 2010 Cengage Learning Why Are There Always Some People Unemployed? • Structural unemployment is the unemployment that results because the number of jobs available in some labour markets is insufficient to provide a job for everyone who wants one. • For example, a minimum wage (a price floor) can give rise to a surplus of labour Copyright © 2010 Cengage Learning Review • The unemployment rate is the percentage of those who would like to work but don t have jobs. • The National Statistical agency calculates this statistic monthly in most countries (including Turkey). • The unemployment rate is an imperfect measure of joblessness. Copyright © 2010 Cengage Learning Mini Quiz If the price of the market basket of goods in the base year of 2004 was €20,000 and the price of the same basket had risen to €22,000 by 2005, the CPI for 2005 a. cannot be calculated. b. is €12,000. c. is 200. d. is 110. If a lender wants a real return of 6 per cent and she expects inflation to be 4 per cent, which of the following is the nominal interest rate to charge? a. 4 per cent b. 6 per cent c. 2 per cent d. 10 per cent Copyright © 2010 Cengage Learning Mini Quiz Suppose that a large number of men who used to work or seek work now no longer do either. Other things the same, this makes a. the number of people unemployed rise but does not change the labor force. b. the number of people unemployed rise but makes the labor force fall. c. both the number of people unemployed and the labor force fall. d. the number of people unemployed fall but does not change the labor force. Copyright © 2010 Cengage Learning