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Unit 3: Measuring Economic Performance Chapters 6-7 Revisit the Circular Flow Diagram • On board • What is “Income”? – Rent, profits to the entrepreneur, interest, wages Measuring Economic Activity • Three primary ways to measure – Gross Domestic Product – Unemployment – Inflation National Income Accounting • Measures the economy’s overall performance • Why measure? – Assess the health of the economy by comparing production to previous dates – Track long-run course of the economy – Formulate policies that will improve economy Gross Domestic Product • Gross Domestic Product (GDP) – Measure of aggregate output – Total market value of all final goods and services produced by either citizen or foreign supplied resources within the country – Includes everything made in the US for final use – It is a monetary measure ($ value) GDP cont. • What is included? – All final goods produced within the country – Goods purchased for final use by consumers, not for resale or further processing GDP cont. • What is not included? – Intermediate goods • Goods purchased for resale or further processing or manufacturing • Why exclude these? – Nonproduction transactions • Financial transactions – Public transfer payments » Welfare, unemployment, social security, subsidies – Private transfer payments » Birthday money from family – Stock market transactions • Secondhand sales GDP cont. • What else is not included? – Stuff made by American companies in other countries – Illegal activities – Non-market activities • Doing things yourself GDP cont. • How do you find the GDP value? • 2 ways – Expenditure VS Income Approach – Expenditure Approach (Super Easy) • Based on what people spend to purchase on the Product Market of the Circular Flow Diagram • C + Ig + G + Xn – – – – C = Personal Consumption Expenditures Ig = Gross Private Domestic Investment G = Government Purchases Xn = Net Exports GDP cont. – C = Personal consumption expenditure • All households expenditures • Largest portion – Ig = Gross Private Domestic Investment • All final purchases of machinery, equipment, and tools by business enterprises • All construction (houses, factories, warehouses, and stores) • Changes in business inventories – Negative and Positive GDP cont. • G = Government Purchases – Includes all government expenditures on final goods and services and purchases of resources, including labor • In other words…all government spending except transfer payments • G/S the government consumes to provide public services • “Social or Public Capital” like schools and roads • Xn = Net Exports – Exports (X) – Imports (M) GDP cont. • Income Approach (Super Complicated) – Add the following to get National Income (All income earned through the use of Americanowned resources) – Based on the income generated from purchasing FOP on the Factor Market of the circular flow diagram GDP cont. • Income Approach = Expenditure Approach – All income earned is “spent” as either expenditures or savings • Because expenditures equal income, if GDP rises income must also. (VERY IMPORTANT CONCEPT) Real VS Nominal • Nominal values change with prices and real values are adjusted for price changes – Why would this be an important difference? • Use price indices to adjust nominal values to create real values – A price index tells you what $100 worth of goods in a previous year would cost today. • Price Index = (current prices/base year prices)x100 • Real GDP = (nominal GDP/price index in hundredths) GDP cont. • Shortcomings – Nonmarket activities • Leads to understated number – Leisure time or job satisfaction • Adds to well-being but cannot be measured – Product quality – Underground economy • Also includes cash-only jobs not reported on taxes – Environment – Distribution of income – Noneconomic sources of well-being • Reductions in crime, civility, drug or alcohol abuse GDP and the Business Cycle Economic Growth • Growth occurs when… – Increase in real GDP – Increase in real GDP per Capita • GDP/population • Tells more about living standards • Growth leads to… – Rise in real wages – Decreases of the burden of scarcity Growth cont. • Rule of 70 – 70 divided by annual % growth rate tells us how long it will take to double GDP • Sources of growth – What shifts PPC? • Increases in resources • Increasing productivity – Real output per input – 2/3 of US growth comes from this Growth cont. • Again, what are the limitations of growth information? – What are the limitations of GDP? • • • • Improved products Added leisure Environment Gains in well-being Business Cycle and Growth • What causes the business cycle? – Really controversial • • • • • Innovations Changes in productivity Monetary phenomenon Changes in spending Government interference • Who is affected most/least? – Least • Non-durable good producers – Most • Durable good producers and capital good producers Enemies of the Economy • Inflation and unemployment – Usually don’t occur at the same time – High rates are either have negative effects on the economy • Therefore, societies want to avoid both Unemployment • Civilian Labor Force (CLF) – Men and women 16 and up not in the military, prison, or otherwise institutionalized who are working or actively looking for a job. • Who does this not include? (IMPORTANT!!!) – The number of people in the CLF is determined by the Bureau of Labor Statistics (BLS) Unemployment cont. • Unemployment rate – % of Civilian Labor Force without a job – Calculation? • On board – They also determine the unemployment rate • Current Rate? – http://www.bls.gov/cps/ – Limitations • Part-time employment • Underemployed • Discouraged workers Unemployment cont. • 4 types of unemployment – Frictional • Not necessarily bad • Labor market is not perfect and it takes time to match jobs to workers • Usually short term – Structural • Replaced by machines, changes in demand for products, movement of businesses • Longer term – Cyclical • Downturn in economy – Seasonal • Seasonal demand for employees Unemployment cont. • Is zero unemployment desirable? – Why or why not? • Full Employment rate of unemployment or natural rate of unemployment (NRU) – Economy is at potential output – Long-run equilibrium rate of unemployment – Job seekers=job vacancies – There is only frictional unemployment – Economy can be above potential output temporarily – NRU can change over time – In the 1980s it was around 6% – Today between 4-5% – Changes in population – Welfare laws – Internet job sites Unemployment cont. • GDP gap – Gap between PPC and point inside the curve due to unemployment • GDP Gap = actual GDP – potential GDP – Okun’s Law • For every 1% actual unemployment exceeds NRU, a negative GDP gap of about 2% occurs • We can use this to find how much loss of wealth unemployment causes Unemployment cont. • Unequal burdens – Low skilled or less educated – Teenagers – AA and Hispanics • Costs of unemployment – Loss of wealth (GDP) – Social costs • Poverty, racial and ethnic tensions, loss of hope and morale, sociopolitical unrest, family disintegration, loss of skills – Long term unemployed Inflation • What is inflation? – Rise in the general level of prices • Real income is declining • Does NOT mean all prices are rising – Inflation is monetary phenomenon!!! – Hyperinflation • Caused by inflating away government deficits/debt – Deflation Inflation cont. • How is it measured? – Consumer Price Index (CPI) • • • • Official price index used to measure inflation in the US “market basket” of 300 consumer goods and services Compiled by the BLS CPI = [(Price of most recent “basket”) / (Price estimate of same basket in 1982-1984)] X 100 – Inflation Rate = [(year 2 – year 1) / (year 1)] X 100 – Weakness? Only 300 goods… – Does not account for the face that you can substitute goods – GDP Deflator • Uses GDP instead of “market basket” • (Nominal / Real) X 100 Inflation cont. • Types – Demand Pull • Too much money chasing too few goods • Loans increasing at a rapid rate – Cost Push • Increasing in factor of production costs • Per-unit production costs rise – Per-unit cost = (total input cost) / unit of output • Supply shocks • Leads to increases in unemployment and inflation at the same time (stagflation) – Hard to know which is causing inflation Effects of Inflation • Nominal and real income changes – Real income = (nominal income) / (price index in hundredths) – Doesn’t necessarily change real income for everyone • Anticipated VS Unanticipated Inflation – If we expect it we can plan for it Effects cont. • Who is hurt? – Almost everyone, but in particular… • • • • • People on fixed incomes Savers Creditors People who hold cash (non-interest bearing accounts) People who are shifted into higher tax brackets • Who is helped or unaffected? – Flexible-income receivers • People who receive Cost-of-Living Adjustments – Borrowers AKA Debtors • Governments Effects cont. • Planning for inflation – Real VS Nominal Interest rates • Real is true cost to borrow the money • Nominal is real plus the extra cost of due to inflation – Nominal = Real + Expected Rate of Inflation • Effects on output – Cost-push reduces output – Demand-pull • Harder to know. Some say… – Costs associated with changing prices (menu costs) – Distinguishing between real and nominal interest rates – Costs of getting cash