Download Chapter 5: Production, Income, and Employment

Chapter 5: Production, Income, and Employment

Gross Domestic Product (GDP) and the unemployment rate are important
because they describe aspects of the economy that dramatically affect each of us
individually and our society as a whole. This chapter describes what these
statistics tell us about the economy, how the government obtains them, and how
they are sometimes misused.

GDP is the total value of all final goods and services produced for the
marketplace during a given year, within the nation’s borders. Three ways to
measure GDP are the expenditure approach, the value-added approach, and
the factor payments approach. Understanding these approaches tells us much
about the structure of our economy.
 Definition of GDP: the money value of all final goods and services produced in a
country over a given time period. GDP is typically measured for a country for a period
of a quarter or a year (though one could theoretically measure the GDP of California for
a month).

An intermediate good is: a good purchased for resale or for use in producing another
good; goods used in producing final goods. Purchase for resale purposes.

A final good (or service): is a good sold to its final user; goods ready to be consumed
(shelved goods are a good example of final goods)

Transfer payment: any payment that is not compensation for supplying goods and
services. Transfer payments represent money redistributed from one group of citizens
(taxpayer) to another (the poor, the unemployed, and the elderly). While transfers are
included in government budgets and spending, they are not purchases of currently
produced goods and services, and so are not included in government purchases or in
GDP. Government transfers account for 37 percent of all government spending. A
transfer payment is a payment made with no expectation of something in exchange.
o In the expenditure approach to measuring GDP, we add up the value of the
goods and services purchased by each type of final user: households,
businesses, government, and foreigners.
1. The Expenditure Approach:
This is based on the value of the goods and services sold in the economy for a given
period:
Consumption Goods and Services: purchases by households. Consumption is the
part of GDP purchased by households as final users. We traditionally use the letter
(C) to designate such expenditures.
Private Investment Goods and Services: purchases by businesses. Private investment
has three components: (1) business purchases of plant and equipment (2) new home
equipment; and (3) changes in business firms’ inventory stocks (stocks of unsold
goods). The traditional term applied to the accumulation of capital goods (including
construction), this also includes the accumulation of inventories; which, as unconsumed
goods or services, are generally viewed as accumulations of capital. We use the letter (I)
to designate such expenditures or accumulations.
Government Goods and Services: purchases by government agencies. Spending by
federal, state, and local governments on goods and services. The government makes
up a huge proportion of the total expenditures in modern American society. All public
works projects, military expenditures, and construction of public buildings contribute to
the total government participation in the demand for final goods and services (G).
Net Exports: purchased by foreigners (NX). Either negative or positive, this represents
the total quantity of goods and services we produce domestically relative to the quantity
sold abroad. If positive, we are selling more abroad than domestically, and visa versa.
The components of GDP:
GDP= c + i +g +nx
(Supply side) (Demand side)
C = Consumer spending
I = Investment
G = Government spending (federal, state, local)
NX = net export (export-import)
-If export greater than import=Trade surplus
-If import greater than export=Trade deficit
C = Consumer spending is usually 70% of a nations GDP (USA)
I = Investments usually consists of about 18% of the US GDP
G = Governmental spending usually makes up 15% of GDP
NX = The US trade deficit is -3%
Is the 3% trade deficit a big deal?
Relatively speaking, NO! How do we find out if the same is not true for another country?
We divide the “deficit” by the GDP or 300 Billion (trade deficit, United States) divided
by the GDP which is 10 Trillion dollars, and we see that is a small number considering
the whole.
On the other hand, there are countries who owe three times their GDP.
Foreign debt/GDP gives the percent of the GDP is comprised in debt.
GDP = C + I + G + NX
Net Investment = Investment – depreciation
o The GDP is NOT the sum total of all transactions in the economy. That
would be redundant. If we included every transaction for the purposes of
evaluating economic performance, we would capture a lot of transactions that
didn't reflect the real value of the product of society. As an example, the price
of the loaf of bread you buy in the supermarket would be added to the cost of
the ingredients sold to the bakery. Used car sales do not contribute to the
overall production of society. Once the original car is bought and sold, that
represents the last transaction of interest for measuring the production of the
economy.

If there were intermediary agents involved in the transaction,
the total amount of exchange could be quite considerable. The
real value of production rests in the opportunity cost of
producing the loaf of bread, but the final measure of the value
of that bread is found at the point of sale. GDP is traditionally
measured as the final value of all goods and services produced
in the economy, or the Value-Added from each component of
the productive process.
2. The Value Added Approach: GDP = Sum of Value added by all firms:
measuring GDP by summing the value added by all firms in the economy.
 A firm’s value added is the revenue it receives for its output, minus the
cost of all the intermediate goods that it buys
 In the value added approach, GDP is the sum of the values added by all
firms in the economy.
3. The Factor Payments Approach: In any year, the value added by a firm is
equal to the total factor payments made by that firm.

Factor payments: payments to the owners of resources that
are used in production.
= Sum of factor payments made by all firms
= Wages and salaries + interest + rent + profit
= Total household income

Households own the economy's resources (factors of production; land labor and
capital) whose services they rent or sell to firms through factor markets in exchange for
factor payments (rental payments, wage payments, interest payments, and profits).
Households use their factor income to purchase goods and services in the goods and
services markets: consumption goods and services, capital goods. They also use part of
their factor income to pay government taxes.
Real versus Nominal GDP

When a variable is measured over time with no adjustment for the dollar’s
changing value, it is called a nominal variable. When a variable is adjusted for
the dollar’s changing value it is called a real variable.
 Since our economic well-being depends, in large part, on the goods and
services we can buy, it is important to translate nominal GDP, which is
measured in current dollars, to real GDP, which is measured in purchasing
power. In general, all nominal variables must be translated into real variables
to make meaningful statements about the economy.
 The unemployment rate is defined as the percentage of the
labor force that is unemployed, and is calculated each month.
This measure understates unemployment because it fails to
account for involuntary part-time employment and
discouraged workers. On the other hand, it also overstates
unemployment by including as unemployed some people who
are not in the labor force. Regardless of these problems, the
unemployment rate provides valuable information about
conditions in the macroeconomy.
The Limitations of GDP
GDP is not perfect. Why?
1. It ignores non-market activities. (Mother watching children)
2. It ignores the underground economy. (Illegal market)
3. It ignores the environment. (Damage to the environment should be subtracted
from GDP).
To calculate the percentage of the economy that is illegal divide the size of the
underground economy/GDP.
Economic Well Being
GDP/population
GDP per person
Standard of Living
The size of the economy

GDP is used to guide the economy in two ways. In the short run,
changes in real GDP alert us to recessions, and give us a chance to
stabilize the economy. In the long run, changes in real GDP tell us
whether our economy is growing fast enough to raise output per capita
and our standard of living, and fast enough to generate sufficient jobs
for a growing population. Although GDP is extremely useful, it
suffers from measurement problems. It doesn’t take quality changes
into account, it can’t accurately measure underground production, and
it does not include nonmarket production. Because of these problems,
we must be careful when interpreting long-run changes in GDP.
 There are four types of unemployment: frictional, seasonal, structural,
and cyclical. Our economy is at full employment when there is no cyclical
unemployment. Unemployment is costly for individuals and for our
society. The purely economic cost of unemployment can be measured as
the difference between potential GDP (the amount of GDP that can be
produced at full employment) and actual GDP. There are also broader
costs of unemployment, both to individuals (psychological and physical
effects) and to society (the unemployment burden is not shared equally
among different groups).
Types of Unemployment:
1. Frictional unemployment is that unemployment caused by information or
search costs. Usually when a person quits, is fired, or enters the labor market,
there are jobs available for which that person is qualified. The person will be
frictionally unemployed because it takes time (and effort) to find the jobs that are
available.
2. Seasonal Unemployment: Unemployment is caused by relatively regular and
predictable declines in particular industries or occupations over the course of a
year, often corresponding with the seasons. Unlike cyclical unemployment, which
could occur at any time, seasonal unemployment is an essential part of many jobs.
For example, your regular, run-of-the-mill, department store Santa Clause can
count on 11 months of unemployment each year.



Hotel and catering
Tourism
Fruit picking
3. Structural Unemployment: Structural unemployment exists when a person is not
qualified for any job because the amount he can contribute to any job (his
marginal revenue product) is less than the minimum wage payable for that job.
The minimum wage can be set legally, by union negotiations, or by the force of
public opinion. Structural unemployment can exist even if the minimum wage
was zero. Structural unemployment is associated with those that are displaced due
to changes in technology or structure of the economy. Here labor must be
restrained so their skills match the new technologies.
4. Cyclical Unemployment: is associated with downturns in the economy.
Cyclical unemployment is caused by short-term economic changes, whereas
structural unemployment covers a range of situations including a mismatch
between the skills of the labor force and the available jobs. Cyclical
unemployment is associated with an economic recession or a sharp economic
slowdown. It occurs due to a fall in the level of national output in the economy
causing firms to lay-off workers to reduce costs and protect profits.
 Frictional and structural unemployment are unavoidable in a dynamic
economy. These two combined are called the Natural Rate of
Unemployment, or the full-employment rate of unemployment. The
Natural Rate of unemployment is estimated to be about 5.5%.
How unemployment is measured:

Early each month, the Bureau of Labor Statistics (BLS) of the
U.S. Department of Labor announces the total number of
employed and unemployed persons in the United States for the
previous month, along with many characteristics of such persons.
These figures, particularly the unemployment rate--which tells
you the percent of the labor force that is unemployed--receive
wide coverage in the press, on radio, and on television.

Unemployment is measured by the Bureau of Labor Statistics
(BLS).
It surveys 60,000 randomly selected households every month.
The survey is called the Current Population Survey.
Labor Force: those people who have a job or who are looking for a job.
Unemployment rate: the fraction of the labor force that is without a job.
The unemployment rate is calculated by dividing the people who want jobs but don't have
them by the labor force.
Unemployment/Labor Force = Unemployed/(Unemployed + employed)
Criticisms of the Unemployment Rate
 Does not include discouraged workers: those who have given up looking for work
because they could not find a job. (understates unemployment)
 Does not account for the "hidden unemployment." "Hidden" unemployment
includes those who are working part-time but wish to have a full-time job, and
those who are grossly overqualified for their positions, the underemployed.
(understates unemployment)
 To be unemployed, a person must only "say" he has actively sought work.
(overstates unemployment)
The Costs of Unemployment:
 Economic costs: The costs of unemployment are the goods and
services that might have been produced and consumed that are lost
forever. The costs of unemployment are generally viewed by the
society as those related to unemployment insurance and social
assistance programs for those who are able to work.
Cost of unemployment = Potential output - Actual output
 Where potential output is the level of GDP the economy would attain if all
resources were fully employed. During recessions when unemployment is
high, some labor is sitting idle and that lost work can not be made up.
 There are also significant, noneconomic costs of unemployment such as
individual and family stress.
Potential Output: the level of output the economy could produce if operating at
full employment.
Chapter 6:The Monetary System, Prices, and Inflation
The Monetary System:
 A monetary system establishes two different types of standardization in the
economy:
1. A monetary system establishes a unit of value. A unit of value is a common unit
for measuring how much something is worth. With a standard monetary unit,
like the dollar, we can easily price individual goods and services, putting a
single price on each item instead of having to compute a different exchange price
for every different pair of commodities (e.g., 1 cup of coffee = 2 newspapers = 6
minutes of office work as a temp = 3 minutes of my teaching services).
2. A monetary system concerns the means of payment—the things we can use as
payment when we buy goods and services. Means of payment is anything
acceptable as payment for goods and services. -- you can use it to buy whatever
you want. Money makes it much easier for people to exchange the goods and
services they produce for the goods and services that they want. Money "greases
the wheels of commerce," by making it much easier for people to exchange the
goods and services they produce for the goods and services that they want.
Having a generally accepted currency eliminates the need for barter (trading
goods and services for each other), and makes the volume of transactions a lot
larger than it would otherwise be.
Also: 3. Store of value -- money has some use as an asset, because it holds its
nominal value over time and, unlike stocks or bonds, its value does not fluctuate
from day to day. Unlike stocks or bonds, there is no risk that dollars will suddenly
become worthless. In sum, money is a virtually riskless asset. It is also a very liquid
(convertible into cash; spendable) asset, which is another desirable quality.
In 1913, the Federal Reserve System was created to be the national monetary
authority in the United States. The Federal Reserve was charged with creating and
regulating the nation’s supply of money, as it continues to do today. The earliest
forms of payment were precious metals and other valuable commodities. Eventually,
to make it easier to identify the value of precious metals and they were minted into
coins whose weight values were declared on their faces. Because gold and silver
coins could be melted down into pure metal and used in other ways, they were still
commodity money. Commodity money eventually gave way to paper currency.
Initially, paper currency was just a certificate representing a certain amount of gold or
silver held by a bank. But today, paper currency is no longer backed by gold or any
other physical commodity. This type of currency is called fiat money.
 Fiat money: anything that serves as a means of payment by government
declaration.
 Items designated as money that are intrinsically worthless.
-- Ex.: U.S. paper money - only other value is as paper
-- Fiat money has value only because the government declares it to
be legal tender and because people believe it has value.
---- LEGAL TENDER: money that a government has required
to be accepted as payment for debts.
Measuring the price level and inflation:
 The price level is the average level of dollar prices in an economy.
 Index numbers are a series of number used to track a variable’s
rise and fall over time.
 An index is a series of numbers, each one representing a different
period. Index numbers are only meaningful in a relative sense: we
compare one period’s index number with that of another period
and can quickly see which one is larger and by how much. The
actual number for a particular period has no meaning in and of
itself.
What are index numbers?
Value of measure in current period
*100
Value of measure in base period
Index numbers are values expressed as a percentage of a single base figure. For example,
if annual production of a particular chemical rose by 35%, output in the second year was
135% of that in the first year. In index terms, output in the two years was 100 and 135
respectively.
 An index will always equal 100 in the base period.
How to construct a price index:
A price index measures the cost of buying a certain "basket" of goods, so one must:
(1) total up the dollar cost of buying given quantities of all of the items in the basket,
for each of the years we are looking at.
Then, so that we may more easily compare price levels for different years, we index those
cost totals to the however much it costs to buy that basket of goods in the base year,
which is whatever year we choose to be our basis of comparison. Thus, we must
(2) choose a base year. Then, for each year, compute the price index by dividing the
total cost of the basket of goods in that year by the total cost of that basket of goods
in the base year, and then multiply by 100. So the price index for the base year is
always 100, because we're dividing a number by itself and then multiplying by 100. If the
same basket of goods costs 4% more (i.e., 104% as much) in the next year, then the next
year's price index is 104.
price index for year t = 100 * (cost total for year t)/(cost total for base year)
Example of constructing a price index and calculating the inflation rate from it:
Imagine the same small island economy that we used in our nominal-vs.-real GDP
example from earlier. In 1995, which we will use as our base year, the average person
there consumed just three commodities -- beer, pretzels, and bicycles -- in the following
quantities:
1995
Commodity
p
q p*q
Case of beer
$20 1
Bag of pretzels
$1
$20
20 + $20
Bicycle
$200 1 +$200
TOTAL COST OF GOODS
$240
-- Since 1995 is the base year, the price index for 1995 is: {$240/$240} * 100 = 100
-- -- In 1996, the price of beer was still $20, and the price of a bag of pretzels rose to
$1.50 and the price of a bike rose to $210. Now that same basket of goods costs a bit
more:
Commodity
1996 1995
p
q
p*q
Case of beer
$20
Bag of pretzels
$1.50 20
+ $30
Bicycle
$210 1
+$210
1
TOTAL COST OF GOODS
$20
$260
: -- In 1996, the price index was: {$260/$240} * 100 = 1.0833 * 100 = 108.33
-- The 1996 inflation rate was just the difference between the two, or 8.33%. To verify:
1996 inflation rate = {(108.33/100) - 1} * 100
= (1.0833 - 1) * 100
= .0833 * 100
= 8.33%
Types of price indexes:
 GDP price index
 Consumer price index (CPI)
 Producer price index (PPI) (previously known as the wholesale price index)
Figure 1
The Rate of Infla tion Using the Consumer
Price Index
Annual
Inflation
14
Rate
(%)
12
10
8
6
4
2
0
–2
1950
1955 1960 1965 1970 1975 1980 1985 1990 1995 1999
Year
ECONOMICS 2e / HALL & LIEBERMAN
CHAPTER 19 / THE MONETARY SYSTEM, PRICES, AND INFLATION
© 2001 So uth-Western
2
The Consumer Price Index:
 Definition: Consumer Price Index: an index of the
cost, through time, of a fixed market basket of
goods purchased in some base period.
In recent years, the base year for the CPI has
been 1983, so following our general formula for
price indexes, the CPI is calculated as:
Cost of market basket in current year
*100
Cost in market basket of 1983
“The Consumer Price Index (CPI) is the ratio of the value of a basket of goods in the
current year to the value of that same basket of goods in an earlier year. It measures the
average level of prices of the goods and services typically consumed by an urban
American family. Parkin, 1990”
According to the BLS:
“The CPIs are based on prices of food, clothing, shelter, and fuels,
transportation fares, charges for doctors’ and dentists’ services, drugs,
and other goods and services that people buy for day-to-day living.
Prices are collected in 87 urban areas across the country from about
50,000 housing units and approximately 23,000 retail establishmentsdepartment stores, supermarkets, hospitals, filling stations, and other
types of stores and service establishments. All taxes directly associated
with the purchase and use of items are included in the index. Prices of
fuels and a few other items are obtained every month in all 87 locations.
Prices of most other commodities and services are collected every month in
the three largest geographic areas and every other month in other areas.
Prices of most goods and services are obtained by personal visits or
telephone calls of the Bureau’s trained representatives.”
Source: http://www.bls.gov/news.release/cpi.nr0.htm
How the CPI has performed, selected years, 1960-2001 base year 1983 not shown =
100:
Year
Consumer Price Index
1960
29.8
1965
31.8
1970
39.8
1975
55.5
1980
86.3
1985
109.3
1990
133.8
1995
153.5
2000
174.0
2001
176.7
 The CPI is a measure of price level in an economy
 The rate of inflation is determined and measured by the Consumer Price
Index (CPI). The (http://www.bls.gov/cpi/home.htm) CPI is comprised of
a “basket of goods” of 400 items that include housing (40%), food and
beverages (17%), transportation (17%), medical care (7%), apparel (6%),
entertainment (5%), other (8%). Each year, the prices of these 400 good
and services are added up and compared to the base that was determined
by averaging the years 1982-1984. Thus, the CPI for 1950 was 24.1 which
means that 1950’s CPI was 24.1% of the base. In other words, prices in
1950 were only 24.1% of the prices being paid in 1982-1984. The CPI for
2001 was 177.1, that is, prices in 2001 were 177.1% of the prices being
paid in the base years (77% higher).
To see the CPI since 1913 go to ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
 Inflation rate: the percent change in the price level from one period to the next.
 Deflation: a decrease in the price level from one period to the next. -- A major
deflation has not occurred in this country since the Great Depression of the 1930s.
A very minor one did occur in 1954, when the consumer price index fell 0.4%
(the inflation rate was -0.4%).
Rate of inflation =
New CPI – Old CPI
Old CPI
Let us suppose that the
 The Formula used to calculate the inflation rate:
Inflation = a percentage change in CPI
Inflation =
CPI year 2- CPI year 1
*100
CPI year 1
Q: What is the inflation rate between 2002 and 2001?
A:
175-100
*100 = 75% inflation
100
Constructing the CPI: step 1: compute the cost
of a market basket in each year (prices times
quantities), step 2: choose a base year. Step 3:
Calculate the CPI for the current year by: (Cost
current year)/(cost in base year)*100. Side
implication: in the base year the CPI = 100. With
inflation, CPI increases.
The inflation rate via the CPI: (CPI current year
– CPI previous year)/CPI previous year all times
100. Note that this is just a percentage change. The
inflation rate is the percentage change in the CPI
from one period to the next.
How the CPI is used: the CPI is one of the most important measures of the performance
of the economy: It is used as:
1) A policy target
2) To index payments;
Indexation: adjusting the value of some nominal payment in proportion to a price index,
in order to keep the real payment unchanged. A payment is indexed when it is set by a
formula so that it rises and falls proportionately with a price index. An indexed payment
makes up for the loss in purchasing power that occurs when the price level rises. Whose
benefits are indexed to the CPI? Social Security recipients and about ¼ of all union
members (5 million+ workers in the US) have labor contracts that index their wages to
the CPI. Since the 1980’s, the US income tax has been indexed as well—the threshold
income levels at which tax rates change automatically rise at the same rate as the CPI.
Real Variables and adjustment for inflation: You can monitor changes in purchasing
power by not focusing on the nominal wage—the number of dollars you earn—but on the
real purchasing power of your wage. To track real wage, we need to look at the number
of dollars you earn relative to the price level.
Calculating the real wage: Example from Hall/Liebermann (data above)
Real wage in any year =
Nominal wage in that year
*100
CPI in that year
$4.67
*100  $8.41
55.5
$14.64
Re al wage in 2001 =
*100  $8.29
176.7
Real wage in 1975 =
Thus, although the average worker earned more dollars in 2001 than in 1975, when we
use the CPI as our measure of prices, purchasing power seems to have fallen over those
years.
 Thus: When we measure changes in the macroeconomy, we usually
care not about the number of dollars we are counting, but the
purchasing power those dollars represent. Thus, we translate
nominal values into real values by using the formula:
Real Value =
nominal value
*100
price index
Inflation and the measurement of real GDP: a special index is used to translate nominal
GDP figures into real GDP figures: the GDP price index.
 Demand-pull inflation - spending increases faster than production 
 Cost-push inflation (or supply side inflation) - prices rise because of rise in per
unit cost of production - e.g. oil price, wage push by unions
 The GDP price index measures the prices of all goods and services
that are included in U.S. GDP, while the CPI measures the process of
all goods and services bought by U.S. households.
 The Costs of Inflation/The inflation myth: Most people
think that inflation—merely by making goods and services
more expensive—erodes the average purchasing power of
income in the economy. Because every market transaction
involves two parties—a buyer and a seller, the loss in the
buyers real income is matched by the rise is seller’s real
income. Inflation may redistribute purchasing power among
the population, but it does not change average purchasing
power, when we include both buyers and sellers in the picture.
 Inflation can redistribute purchasing power
from one group to another, but it cannot, by
itself, decrease the average real income in the
economy.
 $$The redistributive cost of inflation:
 If nominal income rises faster than prices, then your
real income will rise;
 fixed income groups will be hurt by inflation
 Savers will be hurt by unanticipated inflation
 Borrowers gain by unanticipated inflation - borrow
'dear' and pay back 'cheap'
 If inflation is anticipated, the effects will be less
severe
 One cost of inflation is that it often redistributes purchasing power
within society; “harming” the needy and helping those who are already
well off. Because some workers have nominal wage agreements that
span over long periods, even years, such as minimum wage inflation
can harm ordinary workers, since it erodes the purchasing power of
their pre-specified nominal wage. But the effect can also work the
other way; benefiting ordinary households and harming businesses: for
example, many homeowners sign a fixed dollar mortgage agreement
with a bank. These are promises to pay the bank back the same
nominal sum each month. Inflation can reduce the real value of these
payments, thus redistributing purchasing power away from the bank
and toward the average homeowner.
 In general, inflation can shift purchasing power away from those who
are awaiting future payments specified in dollars, and toward those
who are obligated to make such payments.
Inflation does not mean that prices of everything in the economy are
rising. Inflation means that prices on “average” are rising. Some goods
and services prices even fall during the inflation period.
For example: Computer prices have fallen.
 Expected inflation need not shift purchasing power: over any
period, the percentage change in a real value (%Real) is
approximately equal to the percentage change in the associated
nominal value (%Nominal) minus the rate of inflation:
%Real = %Nominal – Rate of Inflation
 If the inflation rate is 10 percent, and the real wage
is to rise by 3 percent, then the change in the
nominal wage must (approximately) satisfy the
equation:

3 % = %Nominal – 10%  %Nominal = 13%
Thus the required nominal wage hike is 13%
If inflation is fully anticipated, and if both parties take it into account, then inflation will
not redistribute purchasing power.
 Nominal interest rate: the annual percent increase in a lenders
dollars from making a loan.
 Real interest rate: the annual percent increase in a lender’s
purchasing power from making a loan.
 Unexpected inflation does shift purchasing power: when inflationary
expectations are inaccurate, purchasing power is shifted between
those obligated to make future payments and those waiting to be paid.
An inflation rate higher than expected harms those awaiting payment
and benefits the payers; an inflation rate lower than expected harms
the payers and benefits those awaiting payment.
The resource cost of inflation: When people must spend time and other resources
coping with inflation, they pay an opportunity cost—they sacrifice the goods and
services those resources could have produced instead.
“Using the Theory: Is the CPI accurate?”
Limitations of CPI: Problems in measuring the cost of living
In reality, the CPI overestimates the actual inflation by 0.5 – 1.5%
Reasons for over calculation:
1) Substitution bias: When the price of one good increases, consumers
often respond by substituting another good in its place.
a) A good example of substitution bias is often seen between
products like Pepsi and Coca-cola.
Pepsi
Coca-cola
Last Month
$2
$2
This month
$2.10
$2
CPI will include these substitutable products into the CPI even
though they might not be purchase. CPI price will go up because
of Pepsi. This will bias the cost of living.
2) CPI cannot capture unmeasured quality change: Let us presume that
we buy a car today for $15,000. A car could be purchased 10 years ago
for $15,000. But did a car 10 years ago have an airbag or a CD player.
This is another disadvantage of CPI—that it cannot measure if the quality
or standards of quality have decimated.
3) New Technologies: The CPI still counts as inflation many causes in
which prices rise because of improvements in quality, not because the cost
of living has risen. This causes the CPI to overstate the inflation rate.
Example: cars are more reliable now and require less routine
maintenance, and have features like airbags and antilock brakes. The
BLS struggles to substantiate these changes—although they note that cars
have become more expensive, some of these rises in prices are not really
inflation, but the consumer is getting more.
4) Growth in discounting: The CPI omits reductions in the prices people
pay from more frequent shopping at discount stores and so overstates the
inflation rate.
The substitution bias, introduction of new goods, and unmeasured quality changes cause
the CPI to overstate the true cost of living.
Keep in mind that the measure of CPI is used to see if the cost of living has gone
up in a given period.
What is CPI and how is CPI useful?
Many government transfer programs such as social security benefits are
tied to the CPI.
Indexation: the automatic correction of a dollar amount for the effect of inflation
on a contract.
Indexation is also used by the private sector. Many private labor contracts
include COLA (cost-of-living-allowances) + 5 or 7%
A retired person would see his SSI check increase by 5% in the CPI went up by
5%.
Another example:
President Hoover in 1931 = $75,000
President Bush in 2002 = $400,000
75,000*166
15.2
= $819,079
Nominal Interest Rate vs. Real Interest Rate
1) Nominal interest rate: the rate as usually reported without a correction for
the effects of inflation
2) Real interest rate: the rate corrected for inflation
Real interest rate = nominal interest rate – inflation
Example: Person A borrows $100 from person B. Person B charges 5%
interest on the loan for a year. Inflation is 7%. Who is better and worse
off?
o Answer: Verify, though, person A is better off.
Chapter 7: The Classical Long Run Model
Macroeconomic Models: Classical versus Keynesian

A Brief History of Macro-economic Thinking:
- Classical Economists and 'Say's Law' until the 1930's (Say's Law - Supply
Creates Its Own Demand
- Believed in a perfect market system that would self-correct if there were any
deviations from full employment
- Then the Great Depression came along, and J.M Keynes emerged to
revolutionize macroeconomic thinking
-
Disputed Say's Law and argued that in some periods not all income is spent
on the output produced
Producers may respond to unsold inventories by reducing output rather than
cutting prices and a recession or depression may follow
Since then Keynesian economics has dominated macroeconomic thinking
The Aggregate expenditure model is based on Keynesian beliefs and ideas
Based on the premise that Savings and Investment decisions may not be coordinated, and prices and wages are 'sticky' downwards
Therefore markets fail, causing recessions or depressions without any
external events!
Assumptions of the Model:
-
'Closed economy' - no trade
No Government
All saving is personal
Depreciation and net income earned abroad are zero
 The classical model: developed by economists in the nineteenth and
early twentieth centuries, was an attempt to explain a key observation
about the economy: business cycles may come and go, but the economy
always returns to full employment. In the classical view, this behavior is
no accident; powerful forces are at work that drives the economy towards
full employment. Many of the classical economists went even further,
arguing that these forces operated within a reasonably short period of time.
Until the Great Depression of the 1930’s, there was little reason to
question these classical ideas. True, output fluctuated around its trend,
and from time to time there were serious recessions, but output always
returned to its potential, full employment level within a few years or less,
just as the classical economists predicted. But during the Great
Depression, output was stuck far below its potential for many years. For
some reason, the economy was not working the way the classical
economists said it should.
 In 1936, in the midst of the Great Depression, the British economist John
Maynard Keynes offered an explanation for the economy’s poor
performance. Keynesian ideas became increasingly popular in universities
and government agencies during the 1940’s and 1950’s. By the mid1960’s, the entire profession had been won over: Macroeconomics was
Keynesian economics, and the classical model was removed from virtually
all introductory economics textbooks.
While Keynes’s ideas and their further development help us understand economic
fluctuations—movements in output around its long-run trend—the classical model
has proven more useful in explaining the long run trend.
 Hall/Lieberman use the terms “classical view” and “long run view”
interchangeably.
 Assumptions of the classical model: In a properly functioning,
competitive market, supply and demand should quickly reach an
equilibrium point where quantity supplied and quantity demanded are
equal. If the labor market worked that way, then there would be an
equilibrium wage that cleared the market and there would be no
unemployment.
1. A “critical assumption” in the classical model is that markets clear: the price in
every market will adjust until quantity supplied and quantity demanded are equal.
 When we look at the economy through the classical lens, we assume that the
forces of supply and demand work fairly well throughout the economy and that
markets do reach equilibrium. Thus, an excess supply of anything traded will
lead to a fall in its price; an excess demand will drive the price up.
The remainder of this chapter uses the classical model to answer the following
questions:
1. How is total employment determined?
2. How much output will we produce?
3. What role does total spending play in the economy?
4. What happens when things change?
 The focus = real variables (real GDP, the real wage, real saving, and so on).
These values are typically measured in the dollars of some base year, and their
numerical values change only when their purchasing power changes.
How much output will we produce?

In the classical view, all production arises from one source: our desires for
goods and services.

In order to earn income so we can buy goods and services, we must supply
labor and other resources to firms.
The Classical Labor Market:
This labor demand curve diagram represents graphically the behavior of potential
workers and of firms. On Figure One, the horizontal axis represents the level of labor
services (N). This can be measured in hours, number of workers, or however. The vertical
axis is the average level of wages (W) in the macroeconomy. The curve on the graph,
labeled Nd, is the demand for labor by firms. Its negative slope can be explained as
follows:
 Firms are rational, greedy, and
they like to trade. Their
primary goal is to produce just
enough output for sale to
maximize their profit given
demand (i.e., given the price
they can charge and the volume
of sales they will have). If they
produce too much (or sell at a
lower price), then the costs
they incurred in the production of those goods and services they did not sell have
reduced their profits needlessly. If they produce too little (or sell at a higher price)
then they have foregone profit opportunity because they could have sold more. To
avoid either of these unpleasant possibilities, firms try to set output at the level that
will maximize profits.
 The reason for the negative slope of the labor demand curve is this: given that the
production and hiring decision are the same, and given that firms' production decision is
based on their goal of profit maximization, as wages rise the potential for profit falls,
forcing firms to cut back on production and therefore employment. As wages rise,
the demand for employees falls, so the slope of the line is negative.
 The labor supply curve explains the behavior of potential labor force participants (those
who are employed and those who would work under different labor market conditions).
As you can see from Figure Two, the slope of this line is positive. The simplest way to
understand this is that as wages rise, the willingness of laborers to work rises. As the
wage rises, more and more people in
the economy are willing to work. So
the labor supply curve shows the
number of people willing to work at
each possible wage rate and the labor
demand curve shows the number of
people firms wish to hire at each
possible wage rate.
 Figure Three shows the complete
labor market. The interaction of the
labor supply and labor demand
determine the wage rate (W0) and the actual level of employment (N0). If the wage
were at a level lower than the intersection, then, at that wage, there would be fewer
people willing to work than the number demanded by firms.
 In the classical view, the economy achieves full employment on its own.
Determining the Economy’s Output: (classical model)
The economy’s level of output depends on:
1. The amount of other resources (land and capital)
available for labor to use
2. The state of technology, which determines how much
output we can produce with given inputs, as well as the
types of inputs available (horse-drawn wagons or trucks;
pencil and paper or a laptop computer).
 In the classical model, we hold one of two variables
constant to answer these questions:
i. What would be the long-run equilibrium of
the macroeconomy for a given state of
technology and a given capital stock?
ii. What happens to this equilibrium when
capital or technology changes?
The Production Function:

Aggregate production function: the relationship between the quantity of
labor employed in the economy and the total quantity of output produced.

In the labor market, the supply and demand curves intersect to determine
employment of 100 million workers (graph below).
The aggregate production function shows the total output the economy can produce
with different quantities of labor, given constant amounts of land and capital and the
current state of technology.
 The declining slope of the aggregate production function is the result of
diminishing returns to labor: output rises when another worker is added,
but the rise is smaller and smaller with each successive worker.
 In the classical, long run view, the economy reaches its potential output
automatically—output tends toward its potential, full employment level “on its own”
with no need for government to steer the economy toward it.
Example: Use a diagram similar to Figure 2 [page 154] to illustrate the effect—on
aggregate output and the real hourly wage—of (a) an increase in labor demand, and (b)
an increase in labor supply.
Solution: An increase in labor demand: Both the real wage and output increase.
An increase in labor supply: Now output still increases, but the real wage decreases.
The Role of Spending:



Circular Flow of Income
Is based on the premise we are dealing with a market system
Depicts the interaction between different parts (markets) of the economy
Economic agents:
1.
Households
2.
Firms
3.
Government
What happens in the factor market?
 Households supply resources directly (labor) or indirectly (through ownership of
companies)
 Businesses demand resources in order to produce goods and services

Flow of payments from businesses for resources constitutes business costs, and
resource owners' income
What happens in the product market?
 Households are on the demand side of these markets by purchasing goods and
services
 Businesses are on the supply side, offering products for sale
 The flow of consumer (HH) expenditures constitutes sales receipts for businesses
NOTE:
1. HH and businesses participate in both markets, but on different sides of each
2. There are two flows:
 Real flow
 Monetary flow
Limitations of the Model:



Does not depict transactions between HH and between businesses
Does not explain how prices of products and resources are actually determined
This simple model ignores government, and the "rest of the world."
 Circular flow diagram: The circular-flow diagram shows how households
supply labor and savings to firms, who use that labor and invest those savings
so as to produce goods and services, which they in turn sell back to those
households. In other words, resources flow from households to firms in the
form of labor services and savings, and they flow back from firms to
households in the form of goods and services. Or we could think of income
flowing from firms to households in the form of wages, interest, and
dividends, and then flowing back to firms in the form of revenues for the
goods they produce and sell.
 Factor payments: Wage, interest, rent, and profit payments for the services of scarce
resources, or the factors of production (labor, capital, land, and entrepreneurship), in
return for productive services. Factor payments are frequently categorized according
to the services of the productive resource. Wages are paid for the services of labor,
interest is the payment for the services of capital, rent is the services for land, and
profit is the factor payment to entrepreneurship. In the circular flow, these are
payments made by the business sector for factor services purchased from the
household sector through the financial markets.
 Say’s Law: In a simple economy with just households and
firms, in which households spend all of their income, total
spending must be equal to total output. Says Law states that
supply creates demand.
 Say’s Own words: “A product is no sooner created
than it, form that instant, affords a market for other
products to the full extent of the value…Thus, the mere
circumstance of the creation of one product
immediately opens a vent for other products.”(J.B. Say,
A Treatise on Political Economy, 4th Edition (London:
Longman, 1821), Vol. I, p.167.
Example: Say's Law can be illustrated with a three-person, three-commodity,
barter economy. Let our three persons be Crusoe, who is a fisherman, Friday, who
collects coconuts, and Saturday, who grows bananas. Crusoe will catch fish for
two reasons, either because he wants to eat them himself, or because he wants to
trade them for coconuts and bananas. Friday and Saturday also work either to
consume their own output or to trade it. If initially each banana and coconut are
worth one fish, Crusoe may plan to trade five fish for two coconuts and three
bananas. (These numbers are made up and have no special significance.) In the
table below these plans are shown with a positive number indicating that a person
plans to supply a commodity to the marketplace and a negative number indicating
that a person plans to demand a commodity from the marketplace. The numbers
show what each wants to do at the existing set of prices, not necessarily what each
actually does.
Total Spending in a More Realistic Economy: In the “real world”
[Hall/Lieberman]:
1. Households don’t spend all their income. Rather, some of their income is saved
or goes to pay taxes.
2. Households are not the only spenders in the economy. Rather, businesses and the
government buy some of the final goods and services produced by households.
3. In addition to markets for goods and resources, there is also a loanable funds
market where household saving is made available to borrowers in the business or
government sectors.
Net taxes and The Circular Flow With Government



Net taxes flow from both House-holds and Business sectors to government in
exchange for public goods and services
Government expenditures flow to Households and Business sectors in exchange
for resources (such as labor) or goods and services provided to the govt (such as
computers, office equipment, etc)
These flows to and from govt suggest ways that govt might stabilize the economy,
alter income distribution and re-allocate resources such as
 'Net taxes' include transfer payments to households and subsidies to
business - “taxes in reverse."
 Federal poverty statistics are based on a measure of total household
income that includes earnings and any cash transfers received by the
household. Transfer payments are defined as any payment for which
no good or service is provided in return. Examples of cash transfers
include social security benefits, unemployment compensation, and
disability payments. Transfer payments are the part of tax revenue that the
government takes from one set of households and gives right back to
another set of households.
Government tax revenues minus transfer payments = Net taxes
Let “T” represent net taxes:
T = Total Taxes – Transfer Payments
 Household saving: (saving) is the part of the household sector’s income
that is left after deducting what it pays to the government in taxes and
what it spends on consumption.
Let S = household saving
Let Y = total income
Let C = consumption spending
S=Y–T–C
Leakages and Injections:
“By definition, total output equals total income. Leakages—net taxes and saving—
reduce consumption spending below total income. Injections—government purchases
plus investment spending—contribute to total spending. When leakages equal injections,
total spending equals total output.” Hall/Liebermann
Table: Flows in the economy of Classica
Total Output
$7 Trillion
Total Income
$7 Trillion
Consumption Spending (C)
$4 Trillion
Planned Investment Spending (IP)
$1 Trillion
Government Spending (G)
$2 Trillion
Net Tax Revenue (T)
$1.25 Trillion
Household Savings (S)
$1.75 Trillion
  Leakages from the Circular Flow
  Leakages represent Income (Y) not spent by US consumers
on US goods
  Leakages are:
  S = saving
  T = taxes
  M = imports

Leakages are important because they seem to threaten
Say’s Law—the classical idea that total spending will
always equal output.
  Injections into the Circular Flow
  Injections are spending on US goods not done by US
consumers
  Injections are:
  I = business investment spending
  G = government spending
  X = exports

There are two types of injections in the
economy:
1. Government purchases of goods
and services.
2. Planned investment spending
represented with the symbol IP.
Planned investment spending: business purchases of plant and equipment (sometimes
called investment spending), represented with the symbol IP. Do not forget that actual
investment (I) consists not just of planned investment in new capital, but also the
unplanned changes in inventories.
 Example: If Calvin Klein produces $40 million in clothing during the year, but
actually ships and sells only $35 million, the $5 million in unsold output will be
an unplanned increase in inventories. But if the company sells $45 million one
year—more than it had previously produced—it must have had some goods out of
the inventories it had previously built up.
  Macro Equilibrium
  Leakages = Injections
  GDP = Y at equilibrium
  GDP = C + I + G + (X – M)
 Y=C+S+T
  So, cancel C on each side:
 I+G+X–M=S+T
  Or, I + G + X = S + T + M
  Which is leakages = injections
“Total spending will equal total output if and only if total leakages in the economy are
equal to total injections—that is, only if the sum of saving and net taxes is equal to the
sum of investment spending and government purchases.” Hall/Lieberman
The Loanable Funds Market: “Is where households make their saving available to
those who need additional funds.”
 Definition: Arrangements through which households make their saving
available to borrowers.
o A simple supply-demand model of
the financial system.

One asset: “loanable funds”

Demand for funds: investment
o
Supply of funds: saving

“Price” of funds: real interest rate
“When government purchases of goods and services (G) are greater than net taxes
(T), the government runs a budget deficit equal to G – T. When government
purchases of goods and services (G) are less than net taxes (T), the government runs
a budget surplus equal to T – G.” Hall/Liberman
 Budget deficit: the excess of government purchases over net taxes
 Budget surplus: the excess of net taxes over government purchases
Classica is running a budget deficit:
Table: Flows in the economy of Classica
Total Output
$7 Trillion
Total Income
$7 Trillion
Consumption Spending (C)
$4 Trillion
Planned Investment Spending (IP)
$1 Trillion
Government Spending (G)
$2 Trillion
Net Tax Revenue (T)
$1.25 Trillion
Household Savings (S)
$1.75 Trillion
G = $2 Trillion
T = $1.25 trillion
Thus, G – T = $0.75 Trillion
This deficit is financed by borrowing in the loanable funds market. “When the
government runs a budget deficit, it demands loanable funds equal to its deficit. When
the government runs a budget surplus, it supplies loanable funds equal to its surplus”
Definition: National Debt: The total amount of government debt outstanding.
The Supply of Funds Curve: indicates the level of household saving at various interest
rates. As the interest rate rises, saving or the quantity of loanable funds supplied
increases.
“The quantity of funds supplied to the financial market depends positively on the interest
rate. This is why the saving, or supply of funds, curve slopes upward.”
The Demand for Funds Curve: When the interest rate falls, investment spending and
the businesses borrowing needed to finance it rise. The investment demand curve slopes
downward. As the interest rate falls, business firms demand more loanable funds for
investment projects.
Definition: Investment demand curve: indicates the level of investment spending firms
plan at various interest rates.
Example: What is the source of funds supplied to the loanable funds market? Explain
why the supply of funds curve slopes upward, and why the curve depicting business
demand for funds slopes downward.
Solution: Savings is the source of funds supplied to the loanable funds market. The
savings curve slopes upward because an increase in the real interest rate means there is a
higher opportunity cost for consumption, so people will save more and consume less (the
income from savings is higher hence the price of consumption is higher). The investment
curve slopes downward because the opportunity cost of investing increases as the interest
rate increases so a firm will invest less at higher interest rates.
Definition: Government demand for funds curve: indicates the amount of government
borrowing at various interest rates.
Definition: Total demand for funds curve: indicates the total amount of borrowing at
various interest rates.
a. Summing the governments demand for loanable funds
b. And business firms’ demand for loanable funds at each interest rate
c. Gives us the economy’s total demand for loanable funds at each interest rate
 “The government sector’s deficit and, therefore, its demand for funds are
independent of the interest rate”
 As the interest rate decreases, the quantity of funds demanded by business
firms increases, while the quantity demanded by the government remains
unchanged. Therefore, the total quantity of funds demanded rises.”
Example: How will the slope of the demand for funds curve be affected if the
government runs a budget deficit? Why?
Solution: If the government runs a budget deficit the demand for funds curve will shift
outwards, but we generally assume that the slope will not be affected because the
government does not base its decisions to run a deficit based on the interest rate
(as firms do for their investment decisions). The government requires a certain amount of
funds to pay for the deficit and will borrow the same amount at any interest rate. By
adding a set amount to the x-value of each point on the demand curve, it shifts outwards
without changing the slope (play with it in Excel if you want to see this happening).
Slope = change in Y/change in X. If you add the same amount to X1 and X2, the change
remains the same so the slope is unchanged.
Equilibrium in the Loanable Funds Market:
Suppliers and demanders of funds interact to determine the interest rate in the loanable
funds market. At an interest rate of 5%, quantity supplied and quantity demanded are
both equal to $1.75 trillion.”
Table: Flows in the economy of Classica
Total Output
$7 Trillion
Total Income
$7 Trillion
Consumption Spending (C)
$4 Trillion
Planned Investment Spending (IP)
$1 Trillion
Government Spending (G)
$2 Trillion
Net Tax Revenue (T)
$1.25 Trillion
Household Savings (S)
$1.75 Trillion
The Loanable Funds Market and Say’s Law

Remember that total spending will equal total output if and only if total leakages
(saving plus net taxes) are equal to total injections (planned investment plus
government purchases).
 Classical theory believes in the flexible market clearing mechanism, long
run full employment equilibrium, Say's Law (supply creates its own
demand) and savings being an engine of growth. Savings will be equated
with investment in the loanable funds market according to classical theory.
 Loanable funds:



S = supply of loanable funds
I+(G-T) = private + public borrowing = demand for loanable funds
Interest rate adjustments ensure that loanable funds market clears.
Therefore Say's Law must hold.
Let S = Saving
IP = Planned Investment
G – T (Deficit)
Quantity of funds supplied = S
Quantity of funds demanded = IP + G – T
Thus,
S = IP+ G – T
Move T to the left side and:
S + T = IP + G
 In other words, market clearing in the loanable funds market assures us that total
leakages in the economy will equal total injections, which in turn assures us that
there will be enough spending in the economy to purchase whatever output level is
produced.
o As long as the loanable funds market clears, Say’s law holds—total
spending equals total output—even in a more realistic economy with
saving, taxes, investment, and a government deficit.
Example: Show that Say’s law still holds when the government is running a surplus,
rather than a deficit.
 Solution: If the government is running a surplus rather than a deficit, then
G – T is negative rather than positive. When the loanable funds market
clears, then demand for funds, which now only includes private
investment since the government does not need any funds, must equal
supply of funds, which now includes both private savings and government
savings (the amount of the surplus). In the classical model it is assumed
that the interest rate will adjust to make the loanable funds market clear,
hence: S + T – G = I. We can rearrange the equation to see that leakages
(S + T) then equals injections (I + G) so that Say’s Law holds.
 “Saving is transformed into business and government spending in the loanable
funds market. The interest rate adjusts to guarantee that saving plus net taxes
will equal government spending purchases plus investment. As a result, total
income will equal total spending Say’s law shows that the total value of spending
in the economy will equal the total value of the output, which rules out a general
overproduction or underproduction of goods in the economy. It does not promise
that each firm will be able to sell all of its output…but don’t forget about the
market clearing assumption. In each market, prices adjust until quantities
supplied and demanded are equal. For this reason, the classical, long-run view
rules out over or under production in individual markets, as well as the
generalized overproduction ruled out by Say’s Law.
Summary of The Classical Model:

The economy will achieve and sustain output on its own.

We need never worry about there being too little or too much spending; Say’s law
assures us that total spending is always just right to purchase the economy’s total
output.
Fiscal Policy in the Classical Model:

G or
T, used to stabilize the economy.
Fiscal policy the spending and taxing policies used by the government to
influence the economy; a change in government purchases or in net taxes
designed to change total spending in the economy and thereby influence the levels
of employment and output. When the government either increases taxes in order
to influence the level of economic activity, it is engaging in fiscal policy.

In the classical view, fiscal policy is both ineffective and unnecessary because the
classical view holds that the economy achieves and sustains full employment on
its own.
1. The higher interest rate will retard private investment and
consumption. This is called the crowding-out effect.
 As a result of the increase in government purchases, both investment
spending and consumption spending decline. The government’s purchases
have crowded out the spending of households (C) and businesses (IP).
 Definition: “Crowding out is a decline in one
sector’s spending caused by an increase in some
other sector’s spending” Hall/Lieberman
 “In the classical model, a rise in government purchases completely
crowds out private sector spending, so total spending remains
unchanged.” Hall/Lieberman
 Definition: Complete crowding out: a dollar for
dollar decline in one sector’s spending caused by an
increase in some other sector’s spending.