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AP/ Honors Unit 2 Notes: Measuring the Economy 1. 3 Goals of an Economy and the Major Economic Measurements A. Full Employment 1. Unemployment Rate- 4-6% 2. Employment Rate 3. Employment Population Ratio B. Stable Prices- Low or No inflation 1. Consumer Price Index (CPI)- Retail; 2-3% 2. Producer Price Index (PPI)- Wholesale 3. GDP Price Deflator- Broadest measure 1. 3 Goals of an Economy and the Major Economic measurements C. Economic Growth 1. Gross Domestic Product (RGDP)- Nominal vs. Real 2. Real GDP Growth Rate- 3-5% 3. Real GDP per capita- widely used measure to compare countries 4. Index of Leading Economic Indicators- predictive, 6 months out 1. 3 Goals of an Economy and the Major Economic measurements D. Misery Index- A blend of A and B 1. Inflation Rate (CPI) + Unemployment Rate a. Last 10 years- 3% Inflation + 5% unemployment = Misery Index of 8; not so miserable b. Late 1970’s- 12% Inflation + 7% unemployment = Misery Index of 19; very miserable! c. Today- 1% Inflation + 9.6% unemployment = Misery Index of 10.6; more miserable and getting worse??? + = 2. Gross Domestic Product (GDP)- total value($) of final goods and services(G&S) produced within a country in one year. GDP= Consumer Spending (C) + Business Investment (I) + Government Spending (G) + Net Exports (x - m or Nx) C + I + G + Nx = GDP The Paradox of Thrift Just when the government wants people to be spending the money they earn from government projects or from tax cuts they actually cut their spending. Why? People are worried about the economy and begin saving more instead. 3. Real vs. Nominal- Measurement in Nominal terms does not take into account changes in price while Real does. Real more accurately reflects the growth of GDP, changes in people's wages, or when measuring the value of anything over a period of time. Real rate = Nominal rate - inflation rate. Nominal rate = Real rate + inflation rate. Is the top film of all time REALLY Titanic? No! Adjusting for Inflation, Gone with the Wind is the top film. 3. Real vs. Nominal- Earning Interest Nominal interest rate - inflation rate = Real interest rate Real interest rate + inflation rate = Nominal interest rate If you earn 1% in a bank savings account how much do you make in real terms if the inflation rate is 3%? Nominal Interest Rate = 1% Inflation Rate = 3% 1% - 3% = -2% real rate Inflation Anticipated Inflation Nominal Interest Rate Real Interest Rate Inflation Premium 6% 11% = + 5% Nominal Interest Rate Real Interest Rate Inflation Premium O 7.2 3. Real vs. Nominal- Wage increase Nominal raise - inflation rate = Real raise Real raise + inflation rate = Nominal raise If you get a 3% raise how much do you make in real terms if the inflation rate is 3%? Nominal Raise = 3% Inflation Rate = 3% 3% - 3% = 0% real ∆ wage 3. Real vs. Nominal- GDP Growth Nominal GDP Growth rate - inflation rate = Real GDP Growth rate Real GDP Growth rate + inflation rate = Nominal GDP Growth rate If the GDP grows by 4% in 2008 how much did it grow in real terms if the inflation rate is 3%? Nominal GDP Growth Rate = 4% Inflation Rate = 3% 4% - 3% = 1% real GDP Growth Nominal Versus Real GDP • Nominal GDP • Real GDP • Price Index • GDP Price Index W 6.2 O 6.1 Price Index In Given Year Real GDP = = Price of Market Basket In Specific Year Price of Same Basket In Base Year x 100 Nominal GDP Price Index (in hundredths) Were gas prices during the summer of 2008 really at record highs of ≈ $4.00/gallon? Yes. In the summer of 2008 they were. Previous high was 1980 when they were $3.25 in current dollars. No, currently (2010) they are not. Even though in nominal terms gasoline prices have trended up, gasoline’s long term real trend has been downward, but with dramatic short term increases. Gasoline currently appears to be back to “normal” in real terms. Gasoline in real terms (2008 dollars) is near it’s 15 year average of $2.00/ gallon. 4. Real GDP per capita- Economic output per person; the best measure of economic well being of the citizen’s of one country compared with those of another country. 5. Gross National Product (GNP)- total value($) of final goods and services (G&S) owned by the citizens of a country in one year. Real Gross Domestic Product 1940- January, 2009; bil. of 2000 dollars Real Gross Domestic Product 1940- January 2009; % change from year ago GDP per Capita (2005) Japan has had a long slow slide Two ways to Count GDP Expenditure Approach Money is used to purchase/ buy goods and services in the Product Market. GDP= Consumer Spending (C) + Business Investment (I) + Government Spending (G) + Net Exports (x - m or Nx) C + I + G + Nx = GDP Two ways to Count GDP Income Approach Productive resources are sold for money in the Resource Market. Human Resources = Wages, Salaries, Tips, and Commissions Capital Resources = Interest Natural Resources = Rent Entrepreneurship resources = Profit W + I + R + P = National Income (NI) plus Indirect Taxes (sales taxes) and Depreciation = GDP Two Approaches to GDP Expenditure Approach Income Approach Consumption by Households Wages Investment by Businesses Interest + + Government Purchases + Expenditures By Foreigners G = D= P + + + + Rents Profits Statistical Adjustments Expenditure Approach Personal Consumption Expenditures C • Durable Consumer Goods • Nondurable Consumer Goods • Consumer Expenditures for Services Gross Private Domestic Investment Ig • Machinery, Equipment, and Tools • All Construction • Changes in Inventories • Noninvestment Transactions Households as Spenders Household Uses of Income-2005 Income Group (Households) 0 Household Income Expended (Percent) 10 20 30 40 50 60 70 80 Personal Taxes Personal Saving 90 12% 0% Personal Consumption 88% Consumption Divided Between… Composition of Consumption 59% 29% 12% Services Nondurable Goods Durable Goods Source: Bureau of Economic Analysis Expenditure Approach Gross Investment Depreciation = Net Investment - Gross Investment Net Investment Depreciation Increased Stock of Capital Consumption & Government Spending Stock of Capital January 1 Year’s GDP December 31 Expenditure Approach G Government Purchases • Expenditures for Goods and Services • Expenditures for Social Capital Net Exports Xn = Exports (X) – Imports (M) Xn Putting It All Together: GDP = C + I + G + Xn GDP= $8,746 + 2,105 + 2,363 727 = $12,487 in 2005 GDP Approaches Compared Accounting Statement for the U.S. Economy, 2005 in Billions Receipts Expenditures Approach Allocations Income Approach Personal Consumption (C) $ 8746 Compensation Gross Private Domestic Rents $ 7125 73 Investment (Ig) 2105 Interest 498 Government Purchases (G) 2363 Proprietor’s Income 939 Net Exports (Xn) -727 Corporate Profits Taxes on Production and 1352 917 Imports National Income Net Foreign Factor Income Statistical Discrepancy $10,904 -34 43 Consumption of Fixed Capital Gross Domestic Product $ 12,487 Gross Domestic Product 1574 $ 12,487 Comparative GDPs GLOBAL PERSPECTIVE Select Nations GDPs - 2005 GDP in Trillions of Dollars 0 United States Japan Germany China United Kingdom France Italy Spain Canada Brazil Korea, Rep. India Mexico Russian Fed. Australia 1 2 3 4 5 6 7 8 9 10 12 $12.4 $4.5 $2.8 $2.2 $2.2 $2.1 $1.7 $1.1 $1.1 $.79 $.79 $.78 $.77 $.76 $.70 Source: World Bank The Income Approach • Compensation of Employees • Rents • Interest • Proprietor’s Income • Corporate Profits – Corporate Income Taxes – Dividends – Undistributed Corporate Profits – Taxes on Production and Imports The Income Approach • From National Income to GDP – Net Foreign Factor Income – Statistical Discrepancy – Consumption of Fixed Capital • Other National Accounts – Net Domestic Product (NDP) – National Income (NI) – Personal Income (PI) – Disposable Income (DI) – DI = C + S W 6.1 The Income Approach Income Relationships – United States, 2005 Gross Domestic Product (GDP) Consumption of Fixed Capital Net Domestic Profit (NDP) Statistical Discrepancy Net Foreign Factor Income National Income (NI) Taxes on Production and Imports Social Security Contributions Corporate Income Taxes Undistributed Corporate Profits Transfer Payments Personal Income (PI) Personal Taxes Disposable Income (DI) $ 12,487 -1,574 $ 10,913 -43 34 $ 10,904 -917 -871 -378 -460 +1,970 $ 10,248 -1,210 $ 9,038 Legal Forms of Business •Sole Proprietorship •Partnership •Corporation Domestic Output by Business Type 20% Corporations 8% Partnerships Corporations 84% Partnerships 11% 72% Sole Proprietorships Sole Proprietorships Percentage of Firms 5% Percentage of Sales Source: U. S. Census Bureau HOUSEHOLDS AS INCOME RECEIVERS FUNCTIONAL DISTRIBUTION WAGES $5,977 Billion 72% PROPRIETOR’S 757 Billion INCOME 9% CORPORATE PROFITS 787 Billion 9% INTEREST 684 Billion 8% RENTS 142 Billion 2% 2002 DATA Households as Income Receivers Functional Distribution of Income-2005 Income By Function Performed 0 National Income Received (Percent) 10 20 30 40 50 60 Wages & Salaries 71% Rents 1% Interest Proprietor’s Income Corporate Profits 70 5% 9% 14% Source: Bureau of Economic Analysis Shortcomings of GDP • Nonmarket Activities • Leisure • Improved Product Quality • The Underground Economy • GDP and the Environment • Composition and Distribution of the Output • Noneconomic Sources of Well-Being Households as Income Receivers Personal Distribution of Income-2004 Income Group (Households) 0 Lowest 20% Second 20% Middle 20% Fourth 20% Highest 20% Personal Income Received (Percent) 10 20 30 40 50 60 3.4% 8.7% 14.7% 23.2% 50.1% Source: Bureau of the Census Shortcomings of GDP GLOBAL PERSPECTIVE Underground Economy as a Percentage of GDP - Select Nations Percentage of GDP 0 Greece Italy Spain Portugal Belgium Sweden Germany France Holland United Kingdom Japan United States Switzerland 5 10 15 20 25 30 Source: Journal of Economic Literature Income Inequality • Average Household Income $60,258 in 2004 - Among the Highest in the World Distribution of U.S. Income by Households, 2004 (1) Personal Income Category Under $10,000 $10,000 - $14,999 $15,000 - $24,999 $25,000 - $34,999 $35,000 - $49,999 $50,000 - $74,999 $75,000 - $99,999 $100,000 and Above (2) Percentage of All Households in this Category 8.7 6.7 12.9 11.9 14.8 18.3 11.0 15.7 100.0 Source: Bureau of the Census • Division Into 5 Equal Groups Distribution by Quintiles, 2004 (1) Quintile (2) Percentage of Total Income (3) Upper Income Limit Lowest 20% 3.4 $18,500 Second 20% 8.7 34,738 Third 20% 14.7 55,331 Fourth 20% 22.2 88,029 Highest 20% 50.1 No Limit Total 100.0 Source: Bureau of the Census Income Mobility: The Time Dimension Causes of Income Inequality Percentage of Total Income Received by the Top One-Tenth of Income Receivers, Selected Nations GLOBAL PERSPECTIVE 0 Guatemala Brazil South Africa Mexico United States Italy Sweden Germany 10 20 30 40 50 48.3 46.9 44.7 43.1 29.9 26.8 22.2 22.1 Source: World Bank, World Development Indicators, 2005 What is Included in GDP Money is exchanged for g and s. Consumer Spending (C)- Spending by consumers on goods and services Business Investment (I)- Tools, Equipment and Machinery; New Houses and Inventory too Government Spending (G)- Purchase of g and s. Net Exports (x - m or NX)- Exports ↑ NX ($ flows into U.S.), Imports ↓NX ($ flows out of U.S.), What is Excluded from GDP Reason #1 Money is not exchanged Non-Market Activities- G or S are produced but no $ is exchanged. Unpaid work or labor; housewife, volunteer, work you perform for yourself; What is Excluded from GDP Reason #2 A Good or Service is not exchanged Financial Transaction/ Transfer PaymentsMoney is exchanged but no G or S is produced. Depositing or withdrawing money from a bank, buying/ selling stock, receiving a loan, Social Security, Food Stamps, student loans. What is Excluded from GDP Reason #3 To avoid counting something twice Used Products – Not counted because they were counted when they were new. What is Excluded from GDP Reason #3 To avoid counting something twice Intermediate Goods- Parts or raw materials that are produced to be used to produce another product. Glass, Rubber, Steel, Aluminum, Plastic all used to make a Car (the final product). We do NOT want to count them twice, once when they are first produced and then AGAIN when they are added to the car. A value-added approach is used. We only count the value they add to the final product, the car. No! Intermediate Good Yes! Final Good Value-added approach is used with intermediate goods to avoid double counting Economics Unit 4 Notes and Terms Taxes, Spending, and Economic Measurement 6. Business Cycle- A periodic change in the GDP; includes recessions, expansions, peaks, troughs. GDP Growth Rate (%) Peak Peak Peak Trough Trough Trough Time in Quarters (3 months) The Business Cycle Phases of the Business Cycle O 7.1 Peak Level of Real Output Peak Peak Trough Trough Time Cyclical Impact: Durables and Nondurables Selected Growth Rates GLOBAL PERSPECTIVE Percentage Change (annual rate) 6 U.S. 4 2 0 France Germany U.K. Italy Japan -2 -4 1997 1999 2001 2003 2005 Source: Economic Report of the President, 2006 7. Recession/ Contraction- A phase of the business cycle where GDP declines. 8. Expansion/ Recovery- A phase of the business cycle where GDP increases. 9. Trough- A turnaround point; economy starts to grow again. 518 Days = 1 year and 5 months 10. Peak/ Prosperity/ Boom- A turnaround point; economy may be here for a long time before the economy starts to shrink into recession. 11. Depression- A very deep, long recession. 12. Index of Leading Economic Indicators- (TB p.258-259) An economic measurement which tries to predict what will occur to economic growth 6-9 months in the future. Consists of the following economic measurements: A. B. C. D. E. F. G. H. I. Average Workweek Initial Claims for Unemployment New Orders for Consumer Goods Vendor Performance- On-time delivery of inputs New Orders of Capital Goods Building Permits for New Houses Stock Prices Money Supply Interest Rate Spread (High v. Low) Dec. 2008 2009 Stimulus Package by category- Link to larger graphic 2009 Stimulus Package by year in which money is spent- Link to larger graphic. Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad 13. Net Domestic Product (NDP) - GDP minus that part of output needed to replace the capital goods worn out in producing the output. 14. National Income (NI) - Total income earned by resource (N, H, C, E) suppliers (households) for their contribution to the production of the GDP. 15. Personal Income (PI) - The income available to resource owners (households) before taxes. 16. Disposable Income (DI) - Personal income minus taxes. The money you have available to spend or save. 17. Unemployment- Over 16, being out of work, and actively seeking a job. 18. Unemployment rate- # unemployed divided by the total # of people in the labor force. 19. Employment Rate- # employed divided by civilian population. Civilian Unemployment Rate 1940- August 2010 Unemployment Rate by County Since January 2007 20. Labor force- # employed plus # unemployed 21. Labor force participation rate- the civilian labor force divided by the total noninstitutionalized civilian population 16 years of age and over. Unemployment Labor Force, Employment, and Unemployment, 2005 Under 16 And/or Institutionalized (70.5 Million) Not in Labor Force (76.8 Million) Total Population (296.6 Million) Employed (141.7 Million) Unemployed (7.6 Million) Labor Force (149.3 Million) Unemployment • Unequal Burdens –Occupation –Age –Race and Ethnicity –Gender –Education –Duration • Noneconomic Costs Unemployment Rate for Someone Like Me 22. Types of Unemployment 1. Structural- Changes in the structure of the economy caused by changing technology or consumer demands throw segments of workers out of work. Workers lack the right skills. Examples: Changing Consumer Tastes- Japanese v. American Cars Technology- iPods instead of CD’s Mergers- Smitty’sSmith’sKroger (Fry’s) Instead of Instead of 22. Types of Unemployment 2. Cyclical- Caused by swings in the business cycle. Examples: Housing, Cars, Appliances, Furniture, Sit-Down Restaurants all lay off in a recession. 22. Types of Unemployment 3. Frictional- Caused by workers who are "between jobs“ or are reentering the labor force. Examples: Quitting a job to look for a better one, Homemakers, Students graduating, Leaving the military 22. Types of Unemployment 4. Seasonal- Caused by changes in season or weather. Examples: Agriculture, Tourism, Sports 23. Natural Rate of Unemployment- The unemployment rate when the economy is at full employment, i.e. when the number of people looking for jobs equals the job vacancies. Defined as being between 4-6% unemployment because of frictional and structural unemployment, the 2 types of unemployment we will always have and can’t (and don’t want to) completely eliminate. 24. Discouraged Workers- Workers who have given up looking for work but would like to work. They are not considered to be unemployed because they are not actively seeking employment. 25. Underemployment- Occurs when workers are forced to take jobs that they are overqualified for. Example: Cleaning houses instead of managing an office even though you have the education and experience to manage the office. Unemployment GLOBAL PERSPECTIVE Unemployment Rates in Five Industrial Nations, 1995-2005 Unemployment Rate (percent) 15 France 10 Italy Germany U.S. 5 Japan 0 1995 2000 2005 26. Inflation- An increase in the level of prices. Ex: The CPI (see below) last year increased at an annual rate of 4%. Inflation Rate (percent) 15 10 5 0 1960 1970 1980 1990 Annual Inflation Rates in the United States,1960-2005 2000 28. Deflation- A decrease in the level of prices. Ex: The CPI decreased 2 % last year. Deflation may sound great but the only time in the last 100 years that the U.S has had deflation was during the Great Depression of the 1930’s. Japan also had a bad recession in the late 1990’s and experienced deflation. If there is deflation why would people not wanted to buy something today? If they wait until tomorrow the price will be cheaper! But… Then that puts downward pressure on prices because people are not buying things! College and medical care costs are 2 categories that have gone up much faster than the average rate of inflation. 27. Disinflation- A decrease in the rate of inflation. The CPI increased at only a 2% annual rate instead of last year's 5% rate. Example: Increased competition from China, India, and illegal immigration has put downward pressure on wages. Wages are a large cost for business so this has helped keep prices down. 1998-2008 Example: Technological change has helped push the price of some products down which has helped keep inflation relatively modest over the last 20 years. 29. Stagflation- High unemployment and high inflation at the same time. The worst possible economic condition to experience. 30. Misery Index = Inflation rate (CPI) + Unemployment Rate. A good measure of stagflation. A pretty good predictor of Presidential Elections. If the Misery Index increases in the year prior to the election then the incumbent party usually loses. Hyperinflation- When inflation gets out of control and increases at very large rates. Examples: Hungary (post WWII)- 12,950,000,000,000,000 % per year, with prices doubling every 15.6 hours. Weimar Germany (1923)- 29,525% per month with prices doubling every 3.7 days. Zimbabwean inflation rates (official) since independence Date Rate Date Rate Date Rate Date Rate Date Rate Date Rate 1980 7% 1981 14% 1982 15% 1983 19% 1984 10% 1985 10% 1986 15% 1987 10% 1988 8% 1989 14% 1990 17% 1991 48% 1992 40% 1993 20% 1994 25% 1995 28% 1996 16% 1997 20% 1998 48% 1999 56% 2000 55% 2001 112% 2002 198% 2003 598% 2004 132% 2005 585% 2006 1,281% 2007 66,212% 2008 231,000,000% (July) Zimbabwe (2008)- Actual exchange rate: 516 quintillion % per year (516 followed by 18 zeros). Zimbabwean prices are currently doubling every 1.3 days. Zimbabwe $10,000,000 Bill Zimbabwe Bills: $10 to $100,000,000,000 Hyperinflation- When inflation gets out of control and increases at very large rates. Sign in a Zimbabwe Toilet, 2008 31. Consumer Price Index (CPI ) -Most common measure of the change in prices. Measured from some BASE year which starts at 100. Economists check prices on a many different products (a "market basket" of goods) and then check those prices periodically and record the change in price. Measures changes at the retail level. 32. Producer Price Index (PPI)- Measures the change in the price of gods and services at the wholesale level. 33. GDP Price Deflator- Broadest price index because it measures changes to prices across the economy. Consumer Price Index 1940- August 2010; % change from 1 year ago Consumer Price Index Components A different way to look at inflation Inflation GLOBAL PERSPECTIVE Inflation Rates in Five Industrial Nations, 1995-2005 Inflation Rate (percent) 6 5 Italy 4 3 2 U.S. France 1 0 Germany Japan -1 1995 2000 2005 Source: Bureau of Labor Statistics Aggregate Demand and Aggregate Supply Graph PL = Price Level PL RGDP = Real Gross Domestic Product AS AD = Aggregate/ Total Demand PL0 AD 0 Y0 AS = Aggregate/ Total Supply RGDP=Y 35. Types or Causes of Inflation 1. Demand-Pull- Consumers and private businesses increase their spending faster than production(demand increases). This pulls prices up. PL Aggregate/ Total Demand (AD) ↑ from AD0 to AD1. AS PL ↑ from PL0 to PL1. PL1 PL0 AD1 AD0 0 Y0 Y1 RGDP=Y RGDP ↑ from Y0 to Y1. U Rate ↓ because RGDP ↑. 34. Types or Causes of Inflation 2. Cost-Push- The cost of productive resources (Natural, Human, Capital, Entrepreneurship) increases and this forces producers to push prices up. AS1 PL AS0 Aggregate/ Total Supply (AS) ↓ from AS0 to AS1. PL ↑ from PL0 to PL1. PL1 RGDP ↓ from Y0 to Y1. PL0 AD 0 Y1 Y0 RGDP=Y U Rate ↑ because RGDP ↓. 34. Types or Causes of Inflation 3. Wage-Price Spiral- High prices cause workers to ask for raises but this increases costs for producers who then raise prices on the products they sell. These higher prices then force workers to ask for..... (very similar to costpush inflation) 4. Excessive Monetary Growth- The supply of money increases at a rate that is greater than the increase in the production (supply) of G & S. People have more money and pull prices up. TOO MANY DOLLARS CHASING TOO FEW GOODS. Very closely related to demand-pull inflation. 35. Who benefits and who is hurt by inflation 1. Borrowers- Helped; paying back loans in dollars that are worth less than when they were borrowed. 2. Lenders- Hurt; being paid in dollars that are worth less than when they were loaned out. Real vs. Nominal and Inflation- Lending Nominal raise - inflation rate = Real raise Real raise + inflation rate = Nominal raise If a bank loans money at 6% and the inflation rate is 3% how much is the bank making in real terms? Nominal interest Rate = 6% Inflation Rate = 3% 6% - 3% = 3% real interest rate The bank is making a 3% real profit. Real vs. Nominal and Inflation- Lending Nominal raise - inflation rate = Real raise Real raise + inflation rate = Nominal raise If a bank loans money at 6% and the inflation rate increases to 8% how much is the bank making in real terms? Nominal interest Rate = 6% Inflation Rate = 8% 6% - 8% = -2% real interest rate! If this goes on for too long what is going to happen to the bank? The bank will go bankrupt! This is what happened to the savings and loans in the 1970’s and 1980’s. 35. Who benefits and who is hurt by inflation 3. Fixed income- Income stays the same while everything gets more expensive. Income decreases in real terms. Your purchasing power decreases. 4. Individuals with Cost-of-Living Adjustment (COLA) in wage contract.Helped or at least not affected. As inflation increases so does your pay . Ex: If inflation increases by 3% your hourly wage automatically increases by 3%. 35. Who benefits and who is hurt by inflation 5. Employees- Hurt; get paychecks that are worth less as inflation increases 6. Employers- Helped; give paychecks that are worth less as inflation increases Real vs. Nominal and Inflation- Wage increase Nominal raise - inflation rate = Real raise Real raise + inflation rate = Nominal raise If you get a 3% raise how much do you make in real terms if the inflation rate is 3%? Nominal Raise = 3% Inflation Rate = 3% 3% - 3% = 0% real ∆ wage Who gains? Employers get to give ZERO real wage increase. Who loses? Employees get a ZERO real wage increase. Inflation •Who is Hurt by Inflation? –Employees/ Fixed-Income Receivers –Savers –Creditors/ Lenders W 7.4 Inflation •Who is Unaffected or Helped by Inflation? –Flexible-Income Receivers •Cost-of-Living Adjustments (COLAs) –Debtors/ Borrowers –Employers W 7.4