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AP Macroeconomics MR. GRAHAM AP Exam Review Unit 2: Measurement of Economic Performance (12-16%) 2 National Income Accounting • Measures the flows of income and expenditures in the economy over time. • Serves the same purpose for the economy as a whole as does the income statement of a firm. • The most simplified representation of the macroeconomy and national income accounting is the Circular-Flow Model. The Circular-Flow Diagram • The model involves the following principles: – There are two groups of decision-makers in a private economy: households and businesses – In every economic exchange, the seller receives exactly the same amount that the buyer spends – Goods and services flow in one direction and money payments flow in the other The Circular-Flow Diagram FIGURE 2 The circular flow diagram expresses the linkages between businesses and households through the goods and factor markets, as well as through government. 5 Gross Domestic Product (GDP) • The most commonly presented statistic of national income accounting is the GDP. • Represents the total market value of all final goods and services produced within a country in one year. – It avoids double or multiple counting by eliminating any intermediate goods (goods used up entirely in the production of final goods). • The GDP at the end of FY12 = $15.85 trillion. Gross Domestic Product (GDP) 3 Ways for Calculating GDP 1. Production Approach: • Survey firms and add up the total value of their production of final goods and services. • In order to avoid counting intermediate goods, only the value added by each manufacturer is counted. Gross Domestic Product (GDP) 3 Ways for Calculating GDP 2. Income Approach: • Sum the total factor income earned by households from firms in the economy. • Adding up all components of national income, including wages, interest, rent, and profits. Gross Domestic Product (GDP) 3 Ways for Calculating GDP 3. Expenditure Approach: • Add up aggregate spending on domestically produced final goods and services in economy. • Adding up the dollar value of all final goods and services purchased by consumers, businesses, government, and buyers from outside the country. • GDP = C + I + G + (X – M) The Components of GDP GDP = C + I + G + (X – M) 1. Consumption (C): Households’ purchases of final goods and services during the year. 2. Gross Private Domestic Investment (I): Households’ savings that businesses can borrow to invest in equipment, factories, or inventories. 3. Government Expenditures (G): consumption and investment for all government branches. 4. Net Exports (X - M): the value of exports (X) less the value of imports (M). Nominal GDP and Real GDP • Nominal GDP: GDP calculated at existing prices. • Real GDP: Nominal GDP adjusted for inflation. Nominal GDP Real GDP = x 100 GDP Deflator • Provides us with a scale against which to compare our current economy with • Economic performance of other years (Real GDP) • Economic performance of other countries (Real GDP per capita) 8-11 The Unemployment Rate • Unemployment Rate – The percentage of the labor force that is unemployed. Unemployed Unemployment Rate = x 100 Labor Force • Labor Force – Those people in the economy who are over 16, not in the armed forces, and willing and able to work. – 155.5 million people (February 2013) 7-12 Problems with the Unemployment Rate • Excludes discouraged workers • • Excludes underemployed workers • • individuals who have stopped looking for a job because they are convinced they will not find a suitable one. individuals working beneath their skill level or only able to find part-time jobs. Varies greatly among (and therefore misrepresents) certain demographic groups 7-13 Categories of Unemployment • Frictional Unemployment – Results from workers moving from one job to another seeking appropriate offers • Structural Unemployment – Results from a poor match of workers’ abilities and skills with current requirements of employers • Cyclical Unemployment – Results from business recessions and economic downturns that occur when aggregate (total) demand is insufficient to create full employment 7-14 Natural Rate of Unemployment • When cyclical unemployment is zero, the unemployment rate is called the natural rate of unemployment, because it reflects unemployment that arises from natural features of a market society. • It changes over time and is generally thought to be around 5% in the U.S. today. Inflation • Inflation – The situation in which the average of all prices of goods and services (i.e. “price level”) in an economy is rising. – Measured through the use of price indexes • Inflation Rate – The percentage increase in overall level of prices per year. Inflation Rate = Price Index in Year 2 Price Index in Year 1 -1 • Price Index – Summarizes what happens to the prices in a constant “market basket” of goods and services. Nominal and Real Values • Inflation is decline in purchasing power of money – Nominal value: price expressed in today’s dollars – Real value: value expressed in purchasing power (i.e. adjusted for inflation) – For example, a $100 bill from your grandparents this year will have a nominal value of $100 next year but a real value of less, assuming a decrease in the purchasing power after a year of inflation. "Costs" of Inflation • Shoe-Leather Costs – A high inflation rate discourages people from holding money and encourages them to search out ways to combat inflation. • Menu Costs – A high inflation rate forces firms to change prices more often than they would if the price level was more or less stable. • Unit-of-Account Costs – A high inflation rate causes a dollar next year to be worth less than a dollar this year. Winners and Losers from Inflation • Economists summarize the effect of inflation on borrowers and lenders by distinguishing between nominal and real interest rates. – Nominal Interest Rate • The market rate of interest expressed in today’s dollars – Real Interest Rate • The nominal interest rate adjusted for inflation (i.e. minus the inflation rate) Winners and Losers from Inflation • When inflation is higher than anticipated… – Creditors lose – Debtors gain – Creditors lose because the debtor is charged an interest rate that does not cover the actual inflation rate • When inflation is lower than anticipated… – Debtors lose – Creditors gain – Debtors lose because they are charged an interest rate that is higher than the actual inflation rate Protecting Against Inflation • Banks attempt to protect themselves by raising nominal interest rates to reflect anticipated inflation (i.e. ARMs) • Workers attempt to protect themselves with Cost of Living Adjustments (COLAs) – Clauses in contracts that allow for increases in specified nominal values to take account of changes in the cost of living • Individuals attempt to protect themselves by placing their savings into interest-bearing accounts – Often pay nominal rates of interest that reflect anticipated inflation Price Indexes • Consumer Price Index (CPI) – A measure of the price of a fixed basket of consumer goods designed to represent the average consumer’s expenditures – Reported monthly by BLS; most commonly used measure. • Producer Price Index (PPI) – A measure of the price of a fixed basket of goods common to industrial production. – Used as a short-run leading indicator (before CPI) • GDP Deflator – A price index measuring the changes in prices of all new goods and services produced in the economy.