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Measuring a Nation’s Income Unit 5 The Production Possibilities Curve (PPC) Using Economic Models… Step 1: Explain concept in words Step 2: Use numbers as examples Step 3: Generate graphs from numbers Step 4: Make generalizations using graph What is the Production Possibilities Curve? • • A production possibilities graph (PPG) is a model that shows alternative ways that an economy can use its scarce resources This model graphically demonstrates scarcity, trade-offs, opportunity costs, and efficiency. 4 Key Assumptions • Only two goods can be produced • Full employment of resources • Fixed Resources (Ceteris Paribus) • Fixed Technology Production “Possibilities” Table a BIKES 14 GUNS 0 b 12 2 c 9 4 d 5 6 e 0 8 f 0 10 Each point represents a specific combination of goods that can be produced given full employment of resources. NOW GRAPH IT: Put bikes on y-axis and computers on x-axis Production Possibilities How does the PPG graphically demonstrates scarcity, trade-offs, opportunity costs, and efficiency? 14 Impossible/Unattainable A (given current resources) B 12 Bikes G C 10 8 Efficient D 6 Inefficient/ Unemployment 4 2 E 0 0 2 4 6 8 GUNS 10 Productive and Allocative Efficiency Which points are productively efficient? Which are allocatively efficient? 14 A B Bikes 12 G Productively Efficient combinations are A through D Allocative Efficient combinations depend on the wants of society 10 8 C E 6 (What if this represents a country with no electricity?) 4 F 2 D 0 0 2 4 6 8 GUNS 10 Economists look to answer these questions 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? Vocabulary Inflation Hyperinflation Rate at which the level of prices for goods and services is rising and, subsequently, purchasing power is falling Extremely rapid or out of control inflation Economic indicators A piece of economic data that is used by investors to interpret current or future investment possibilities Used to judge the overall health of an economy The Economy’s Income and Expenditure When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. The Economy’s Income and Expenditure For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. The Measurement of GDP GDP is the market value of all final goods and services produced within a country in a given period of time. The Measurement of GDP Output is valued at market prices. It records only the value of final goods, not intermediate goods (the value is counted only once). It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). The Measurement of GDP It includes goods and services currently produced, not transactions involving goods produced in the past. It measures the value of production within the geographic confines of a country. The Measurement of GDP It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). What Is Counted in GDP? GDP includes all items produced in the economy and sold legally in markets. What Is Not Counted in GDP? GDP excludes most items that are produced and consumed at home and that never enter the marketplace. Intermediate goods – Ford buys tires and batteries for their trucks Second hand goods – 1957 Chevy for sale Pure Financial sales – stock, bonds, etc.. Transfer Payments – Social Security, welfare, etc.. Unreported “Legal” activity – tips from waitress Illegal activities – drugs, prostitution Producing Goods overseas – Chevy in France Other Measures of Income Gross National Product (GNP) Net National Product (NNP) National Income Personal Income Disposable Personal Income Gross National Product Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals). It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here. Net National Product (NNP) Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation. Depreciation is the wear and tear on the economy’s stock of equipment and structures. National Income National Income is the total income earned by a nation’s residents in the production of goods and services. It differs from NNP by excluding indirect business taxes (such as sales taxes) and including business subsidies. Personal Income Personal income is the income that households and non-corporate businesses receive. Unlike national income, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners. In addition, it includes household’s interest income and government transfers. Disposable Personal Income Disposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government. It equals personal income minus personal taxes and certain nontax payments. The Components of GDP GDP (Y ) is the sum of the following: Consumption (C ) Investment (I ) Government Purchases (G ) Net Exports (NX ) Y = C + I + G + NX The Components of GDP Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing. Food, fuel, appliances, tickets, etc… Investment (I): The spending on capital equipment, inventories, and structures, including new housing. Buildings, machinery, etc… The Components of GDP Government Purchases (G): The spending on goods and services by local, state, and federal governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services. Police salaries, military jets, highways, etc… Net Exports (NX): Exports minus imports. 2012 – Transportation equipment top export GDP and Its Components (1998) Total (in billions of dollars) Per Person (in dollars) % of Total Gross domestic product, Y $8,511 $31,522 100 percent Consumption, C 5,808 21,511 68 Investment, I 1,367 5,063 16 Government purchases, G 1,487 5,507 18 Net exports, NX -151 -559 -2 GDP and Its Components (1998) GDP and Its Components (1998) Consumption 68 % GDP and Its Components (1998) Investment 16% Consumption 68 % GDP and Its Components (1998) Investment 16% Consumption 68 % Government Purchases 18% GDP and Its Components (1998) Government Purchases Investment Net Exports 18% 16% -2 % Consumption 68 % 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. GDP and Economic Well-Being GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy. GDP and Economic Well-Being Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life, however. GDP and Economic Well-Being Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. Adjusting for population Per capita GDP – nation’s GDP divided by its population Allows economists to compare nation’s GDP with other nation’s GDP Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life, however. http://www.youtube.com/watch?v=RrmY1ewwZV0&feature=player_embedded Limitations of GDP Leaves out unpaid household & volunteer work Ignores informal & illegal exchanges Counts some negatives as positives Consumption of cigarettes, traffic jams, ecological disasters that require major clean-up operations and war – all could be said to have an adverse effect on human wellbeing while being good for the economy Ignores negative externalities Places no value on leisure time Says nothing about income distribution Why is GDP important? GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy. High GDP’s also correspond with higher indicators in other areas: Literacy & education Health & life expectancy Rising standards of living GDP, Life Expectancy, and Literacy Country Real GDP per Person (1997) Life Expectancy United States $29,010 77 years 99% Japan 24,070 80 99 Germany 21,260 77 99 Mexico 8,370 72 90 Brazil 6,480 67 84 Russia 4,370 67 99 Indonesia 3,490 65 85 China 3,130 70 83 India 1,670 63 53 Pakistan 1,560 64 41 Bangladesh 1,050 58 39 920 50 59 Nigeria Adult Literacy Aggregate All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises. Aggregate Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. Aggregate Demand The aggregate-demand curve slopes downward for three reasons: wealth effect an interest rate effect an exchange rate effect. Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve. Aggregate Supply The long run Aggregate supply curve is vertical. The short-run Aggregate supply curve is upward sloping. There are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory the sticky-wage theory the sticky-price theory. Aggregate Supply Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. Short-run aggregate-supply curve depends on the expected price level. One possible cause of economic fluctuations is a shift in aggregate demand. Aggregate Supply A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices. Adverse shifts in aggregate supply cause stagflation a combination of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously. Stagflation Adverse shifts in aggregate supply cause stagflation—a combination of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously. Who is considered employed & unemployed? Employed Work for at least 1 hour for pay or profit during survey week Those who worked 15+ hours in a family owned business without pay Workers who were sick, on vacation, or excused from jobs Unemployed Are jobless, but looking for work must have actively looked for work for 4 weeks prior to survey Not in labor force Full-time students People who are retired, disabled, or prevented by family responsibilities from taking a paying job Frictional unemployment Leaving one job for a better job Seeking 1st job Usually going to a job more suited for your skills Structural unemployment Lost job because of change in the structure of the economy or technological change Seasonal unemployment Cyclical unemployment Goes with the Business Cycle Worst type of unemployment there is Full employment & natural rate of unemployment Natural rate of unemployment is a part of a healthy economy Full employment rate is considered 95% Problems with unemployment rate Discouraged workers people who are willing & able to work, but have given up looking for work because jobs are hard to find Involuntary part time workers people who take part time jobs even though they are better qualified for other jobs underemployed Underground economy people who earn income from gambling, drug dealing, or other illegal activities Economic costs of high unemployment Lost potential output decreasing GDP Loss of income leads to less purchasing by families and individuals Loss of income taxes to government that pay for various programs Tracking inflation with CPI Consumer price index – price index for “market basket” of consumer goods & services AKA - cost of living index Is the primary measure of inflation in the United States What’s in the CPI’s Basket? 5% 6% 6% 5% 5% 40% 17% 16% Housing Food/Beverages Transportation Medical Care Apparel Recreation Other Education and communication Nominal vs. Real Cost of Living Nominal cost of living – based on current prices Real cost of living – costs of products adjusted for inflation This is what is measured when Grandma tells you it was so much cheaper in the “good old days.” http://www.youtube.com/watch?v=caMRBGmja3w&list=PL7E8A774DA8435EEB&feature=player_detailpage Inflation Inflation is an increase in the overall level of prices. Inflation: Historical Aspects Over the past sixty years, prices have risen on average about 5 percent per year. Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s. Inflation: Historical Aspects In the 1970s prices rose by 7 percent per year. During the 1990s, prices rose at an average rate of 2 percent per year. The Classical Theory of Inflation The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. When the overall price level rises, the value of money falls. Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the Fed. Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. Creeping inflation, hyperinflation, deflation Creeping inflation – normal inflation; expected Hyperinflation – worst type; is out of control Deflation – prices go down over time Good news for consumers & savers Dollar buys more Bad news for businesses & borrowers Some consumers put off spending hoping for lower prices Forces businesses to cut production & spending Causes of inflation Demand-pull – increase in overall demand – extra demand causes prices to be “pulled” up Cost-push – higher production costs forces prices to go up on prices – Often triggered by higher energy & fuel costs (sound familiar) – Wage-price spiral is a form of cost-push where as wages increase it leads to increase in prices of products http://www.youtube.com/watch?v=-xCy6sDxnhs&feature=player_detailpage Limitations of CPI as a measure of inflation Substitution bias – buy chicken instead of beef if beef prices go up Outlet substitution bias – buying at Dollar General instead of Kroger New product bias – new products are not measured until they become common place Quality change bias – better technology leads to longer lifespan on some products Economic costs of inflation Loss of purchasing power Higher interest rates Loss of economic efficiency – sends mixed signals on whether to buy or not (sound familiar) Business Cycle 4 phases 1. 2. 3. 4. Expansion Peak Contraction Trough Economic indicators • • • Leading indicator • are used to forecast peaks/troughs • not always accurate • includes housing starts Coincident indicators • consistently rise/fall with business cycle • help track expansions/contractions as they occur • Real GDP is good example Lagging indicators • used to confirm that one phase of business cycle has ended and another has begun • consistently rise/fall months after expansion/contraction • includes unemployment rate Business cycle growth 1. Factors of growing economies a. b. c. d. increase in business investment discovery of new resources innovations in science/technology consumer confidence Recessions Depressions Recession - A decline in economic growth for at least 6 months Depression – recession that lasts longer than 6 months Possible causes: not one single factor negative shock to economy (rise in oil prices, terrorist attack, stock market crash) rise in interest rates shortage of raw materials Small group activity • Create a business cycle for one year using one of the following industries: – – – – – • floral industry candy industry kid's toys movies amusement parks Explain why you labeled each phase the way that you did.
