Download II. Measurement of Economic Performance (12

II. Measurement of Economic Performance (12-16%)
A.
National Income Accounts
Simple Circular Flow Diagram (no
government or foreign sector)
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Only two decision-makers in private
economy: households and businesses.
Product Market. A product market is where
goods and services are bought and sold.
o Households are on the demand side
of these markets, purchasing goods
and services.
o Businesses are on the supply side of
these markets, offering products for
sale.
o Interaction of this demand and
supply determines the price of each
product.
o Flow of consumer expenditures
constitutes sales receipts for
businesses.
Resource Market. A resource market is
where resources (labor, capital, land) are
offered for hire and employed.
o Households supply resources
directly (workers) or indirectly
(through ownership of
corporations).
o Businesses demand resources in
order to produce goods and services.
o Interaction of this supply and
demand determines the price of each
resource, which in turn is income for
the owner of that resource.
o Flow of payments from businesses
for resources constitutes business
costs and resource owners’ incomes.
Expanded Circular-Flow Diagram
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Factor Market
o Funds flow from firms to
households through wages, profit,
interest and rent.
o After paying taxes to government
and receiving government transfers,
households put remaining disposable
income to private savings and
consumer spending.
Financial Market.
o Private savings and funds from the
rest of the world are channeled into
investment spending by firms,
government borrowing, foreign
borrowing and lending and foreign
transactions of stocks.
o Funds flow from government and
households to firms to pay for
purchases of goods and services.
Market for Goods and Services
o Exports to the rest of the world
generate a flow of funds into the
economy and imports lead to a flow
of funds out of the economy.
GDP. The total flow of funds is calculated by
adding all spending and then subtracting the
value of imports.
o Spending. Consumer spending on
g/s, investment spending,
government purchases of g/s,
exports.
Gross Domestic Product. The total market value of all final goods and services produced within a
country in one year.
Value-Added Method—Measuring GDP as Value of Production of Final Goods and
Services. Must compute the value of production, not just production.
Example 1. Monthly production of a coffee shop. Suppose you need to track the monthly
production of a small coffee shop. A first attempt might be to sum up all of the cappuccinos, café
lattes and scones that were purchased. This would be FAIL. Remember, GDP is the total market
value, NOT production. You must calculate what the production was worth.
January
Cappucino
Café au lait
Donut
Total
Quantity
25
25
50
100
Prices
$3.00
$2.50
$1.50
Value of Production
$75.00
$62.50
$75
$212.50
February
Cappucino
Café au lait
Donut
Total
Quantity
30
30
40
100
Price
$3.00
$2.50
$1.50
Value of Production
$90
$75
$60
$225
The total value of production in February was higher than January. If you go by simply adding up
the total production both months would be equal and this would be FAIL.
GDP includes only final products and services. Calculation of GDP avoids double or multiple
counting, by eliminating any intermediate goods.
 Final goods are those that are ready for consumption.
 Intermediate goods are those that require further processing before counted as a final good.
Example 2. Ketchup, oftentimes classified as a vegetable for children. Tomatoes can be
bought and sold several times before appearing as a final product (unless, of course, the tomato
itself is the final product in a market). By counting the dollars added at every stage of the process,
you avoid double counting. Double-counting BAD.
Transaction
1 lb tomatoes from farm to Heinz
Bottle of ketchup from Heinz to Publix
Publix sells ketchup to consumer
Total Value
Cost
$0.50
$1.50
$3.00
$5.00
Value is added at each stage to the final product: the bottle of ketchup. The total price of ketchup
includes all of these values, so we only count the final transaction price of $3.00. If you added all
of these transactions, you come up with $5, which overstates the value of the good in its final use.
GDP only adds the final transaction as the value of the final good produced and consumed.
GDP is calculated as the production done within the borders of a country. If it was produced
in the U.S., it belongs in U.S. GDP. It doesn’t matter where it is actually consumed, or where
the actual company is headquartered.
Example 3. General Motors Counts Krugerand. General Motors, an American company, has a
factory producing trucks in South Africa. The value of these trucks is counted in South Africa’s
GDP.
GDP sums the dollar value of what has been produced in the economy over the year, NOT
what was actually sold.
Example 4. A Honda Civic produced in Kentucky in 2009, but not sold until January 2010 is
counted in 2009 production and 2009 GDP.
Expenditure Method—Measuring GDP as Spending on Domestically Produced Final G/S.
GDP  C  I  G  ( X  IM )
C—Consumer Spending—includes durable goods, non-durable goods and services.
I—Investment Spending
 All final purchases of machinery, equipment, and tools by businesses.
 All construction (including residential).
 Changes in business inventory.
o If total output exceeds current sales, unsold inventories build up.
o If businesses are able to sell more than they currently produce, this entry will be a
negative number.
G—Government Spending
 Includes spending by all levels of government (federal, state and local).
 Includes all direct purchases of resources (labor in particular).
(X – IM) or NX--Net Exports
 All spending on goods produced in U.S. must be included in GDP, whether purchase made
here or abroad (Exports).
 Net exports, (X - IM) is the difference (exports minus imports) and can be either a positive
or negative number depending on which is the larger amount.
Income Method—Measuring GDP as Factor Income Earned from Firms in the Economy
NI  Wages  Re nts  Interest  Pr ofits
National Income is all income earned by American supplied resources, whether here or abroad.
 Compensation of employees: wages, salaries, fringe benefits, salary and supplements, social
security, health and pension plans
 Rents: payments for supplying property resources (adjusted for depreciation it is net rent)
 Interest: payments from private business to suppliers of money capital
 Proprietors’ income: income of unincorporated businesses, sole proprietorships, partnerships,
and cooperatives.
 Corporate profits: After corporate income taxes are paid to government, dividends are
distributed to shareholders, and remainder is left as undistributed corporate profits.
FYI: In the circular flow model, top (spending) and bottom (income) parts of model are equal.
FYI: Rarely shows up on AP Exam, but doesn’t hurt to be familiar with it.
Other Things NOT Counted in GDP
 Second Hand Sales. GDP is designed to measure what is newly produced or created over the time
period. Previously existing assets or property that is sold or transferred is excluded. Otherwise,
it would be double-counted. Final g/s are only counted once, in the year in which they
were produced.
 Purely financial transactions are excluded.
o Public transfer payments: social security, welfare benefits
o Private transfer payments: allowance, alimony
 Excluded: Sales of stocks and bonds represent a transfer of existing assets.
 Included: Brokers’ fee included for services rendered.
Nominal GDP ultimately is the value of current production at current prices. Valuing 2012
production with 2012 prices creates nominal GDP in 2012. Nominal GDP is used to gauge the size
of the overall economy because it does value the total output of final goods and services over that
period of time.
Real GDP—Measure of Aggregate Output. Real GDP calculates the value of current
production, but
using prices from a fixed point in time. This fixed point in time is called the base year. Ultimately,
this is to adjust for changing price. For example, if we were to figure 2012 production at 2011
prices, then this creates real GDP in 2012, allowing us to compare it back to the base year 2011.
Calculating Real GDP
Example 1. Apples and Oranges.
Nominal GDP in each year multiplies current prices by current levels of output. In this economy,
nominal GDP has risen by $500. Nominal GDP Year 1 = real GDP Year 1 because Year 1 is the
base year.
Compute the value of real GDP using Year 1 as the base year, multiplying Year 2 output by Year 1
prices.
(2200  $0.25)  (1200  $0.50)  $1150
Real GDP Year 2 = $1150, so in real terms the value of the economic output has only risen by $150.
In percentage terms: (1150 – 1000)/1000 = .15 or 15%.
Example 2. Corn and Soybeans.
Year
Tons
of
Corn
Price
per
Ton
Tons of
Soybeans
Price
per
Ton
2010
100
$100
80
$50
(100 x $100) + (80 x $50) =
$14,000
$14,000
$100
(110 x $110) + (80 x $100) =
$20,100
(110 x
$100) + (80
x $50) =
$15,000
2011
110
$110
80
Nominal GDP
Real GDP
(base year
2010)
Nominal GDP in each year multiplies current prices by current levels of output. In this economy,
nominal GDP has risen by $6,100. Nominal GDP 2010 = real GDP 2010 because 2010 is the base
year.
Compute the value of real GDP using 2010 as the base year, multiplying 2011 output by 2010 prices.
(110  $100)  (80  $50)  $15,000
Real GDP 2011 = $15,000, so in real terms the value of the economic output has only risen by
$1000. In percentage terms: (15,000 – 14,000)/14,000 = .071 or 7.1%.
GDP is a statistical measure. It does not measure happiness or national mood or touchyfeely crap.
B. Inflation Measurement and Adjustment.
The level of prices doesn’t matter, but the rate of change does.
Shoe leather costs. Allusion to the wear and tear caused by the extra running around that takes
place when people are trying to avoid holding money, or increased costs of transactions caused by
inflation. All of this extra time and effort comes at a cost to the consumer.
Menu Costs. Costs incurred by the sellers just to update the posted prices. Changing signs,
printing new menus, etc.
Unit-of-Account Costs. The costs arising from the way inflation makes money a less reliable unit
of measurement. These costs can emerge from the way in which we tax certain assets.
Example 1. Suppose you owned a house that was worth $100,000 and Florida levies a property tax
of 1% on that house. Each year, you expected to pay $1000 in property taxes. Over the course of a
short period of time, maybe two years, real estate prices increase exponentially. Now your house, on
paper, is worth $200,000, but it’s the very same house. It’s not a better house. Florida reassesses
property taxes and now claims that you owe $2000 every year.
Assuming your income didn’t double as your house was doubling in value, you are worse off
because the property tax system didn’t take into account that inflation caused your house to increase
in value.
Nominal Interest Rate. The nominal interest rate is the interest rate actually paid for a loan.
Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate
Real Interest Rate. The real interest rate is the nominal interest rate adjusted for inflation.
Real Interest rate = Nominal Interest Rate – Inflation Rate
Disinflation is the process of reducing rapid inflation to a smaller, less damaging, amount of
inflation.
 Inflation is the overall rise in prices.
 Deflation is the overall decline in prices.
Problems with disinflation. Often a high rate of inflation is caused by “too much” money being
circulated and spent in the economy. The obvious way to reduce the inflation is to act in ways to
reduce the amount of money being circulated and spent. This can be painful because this will often
reduce demand for goods and services and put some workers out of work.
Market Baskets and Price Indices. We need to figure out what consumers are buying in their
market basket, and then determine the prices of those goods, and then compile this information into
one statistic: a price index.
 Market basket is a hypothetical set of consumer purchases of goods and services.
 Price index measures the cost of purchasing a given market basket in a given year. The index
value is normalized so that it is equal to 100 in the selected base year.
 Aggregate price level is a measure of the overall level of prices in the economy.
Price Index (PI) Formula
PI in given year = Cost of market basket in given year/Cost of market basket in base year x 100
Inflation Rate Formula
Inflation rate = (PI in year 2 – PI in year 1)/PI in year 1 x 100%
Example 1. Delicatessia. The economy of Delicatessia revolves around the following foods:
Market Basket Item
Salami
Corned beef
Bologna
Cheese
Quantity Consumed
in Typical Year
300
200
100
500
2008 Prices
$4
$5
$2
$3
2009 Prices
$6
$7
$1.50
$2.50
We need to determine the cost of the market baskets for 2008 and 2009.
2008 Cost = 300($4) + 200($5) + 100($2) + 500($3) = $3900
2009 Cost = 300($6) + 200($7) + 100($1.50) + 500($2.50) = $4600
The base year is the benchmark year. All other years will be compared to the base year to see if the
market basket was more or less expensive than it was in that year.
To create the price index, we place the cost of the market basket in a given year over the cost of the
market basket in the base year times 100. Note that any price index will always be 100 in the base
year. In this case, 2008 is the base year.
PI 2008 = ($3900/$3900) x 100 = 100
PI 2009 = ($4600/$3900) x 100 = 117.9
To calculating the inflation rate, we calculate the percentage change between any two values of the
price index.
Inflation rate from 2009 to 2008 = (117.9 – 100/100) x 100% = 17.9%
Example 2. Florida Citrus.
We need to determine the cost of the market baskets for pre-frost and post-frost. For convenience,
let’s call pre-frost 2010 and post-frost 2011.
2010 Cost = 200($0.20) + 50($0.60) + 100($0.25) = $95
2011 Cost = 200($0.40) + 50($1) + 100($0.45) = $175
The base year is the benchmark year. All other years will be compared to the base year to see if the
market basket was more or less expensive than it was in that year.
To create the price index, we place the cost of the market basket in a given year over the cost of the
market basket in the base year times 100. Note that any price index will always be 100 in the base
year. In this case, 2010 is the base year. Note that the PI is NOT a percentage.
PI 2010 = ($95/$95) x 100 = 100
PI 2009 = ($175/$95) x 100 = 184.2
To calculating the inflation rate, we calculate the percentage change between any two values of the
price index.
Inflation rate from 2010 to 2011 = (184.2 – 100/100) x 100% = 84.2% (no wonder orange juice is
so expensive lately).
Consumer Price Index (CPI). When talking about inflation, the CPI is usually used to measure.
CPI computed every month and uses prices for a market basket of about 80,000 goods and services
that a typical urban family of four consumes.
Producer Price Index (PPI) measures the cost of a typical basket of goods and services—
containing raw commodities such as steel, electricity, coal, and so on—purchased by producers.
GDP deflator
GDP deflator = (Nominal GDP/Real GDP) x 100
For a given year the GDP deflator is equal to 100 times the ratio of nominal GDP for that year to
real GDP for that year expressed in prices of a selected base year.
Since real GDP is currently expressed in 2005 dollars, the GDP deflator for 2005 is equal to 100. If
nominal GDP were to increase by 5%, but real GDP does not change, the GDP deflator indicates
that the aggregate price level increased by 5%.
C. Unemployment
Defining and Measuring Unemployment
 Labor force = Employed + Unemployed
o Employed people are currently holding a job in the economy either full-time or
part-time.
o Unemployed people are actively looking for work but aren’t currently employed.
 Labor force participation rate is the percentage of the working-age population (age 16 or
older) that is in the labor force
LFPR = (labor force/population age 16+) x 100%

Unemployment rate is the percentage of the labor force that is not employed.
UR = (number unemployed/labor force) x 100%
Unemployment and Recession. Firms are producing less output because consumers are buying
fewer products. With fewer customers, firms need fewer workers. As workers are laid off, the
unemployment rate begins to rise. A weakening economy shows up as a rising unemployment rate.
Issues with Unemployment Rate
 Discouraged workers are non-working people who are capable of working but have given
up looking for a job due to the state of the job market. NOT UNEMPLOYED.
 Marginally attached workers are interested in employment, and have looked for a job in
the past, but are not currently looking for work. NOT UNEMPLOYED.
 Underemployed are people who work part-time because they can not find full-time jobs.
EMPLOYED.
 Causes official unemployment rate to appear lower (better) than actual labor market
conditions.
The Natural Rate of Unemployment. Unemployment rates cannot be negative. Unemployment
rates cannot be zero. Even when there are lots of jobs, unemployment exists because jobs are
constantly being created and destroyed.
Frictional unemployment consists of those searching for jobs or waiting to take jobs soon.
Frictional unemployment is regarded as somewhat desirable, because it indicates that there is
mobility as people change or seek jobs. If workers are seeking new jobs that better fit their skills or
lifestyle, this increases productivity and efficiency in the labor markets.
Structural unemployment occurs when there are more people seeking jobs in a labor market than
there are jobs available at the current wage rate. This may be due to changes in the structural
demand for labor; e.g., when certain skills become obsolete or geographic distribution of jobs
changes.
Example 1. I’m a lumberjack and I’m okay. Back in the 1980s, loggers and sawmill workers lost
their jobs when environmental restrictions were placed on old-growth forests and endangered
species. This job loss can be graphed out through supply and demand.
SL is the supply of labor, comes from workers
wanting to work more for higher wages. DL is
the demand for labor, comes from employers
who want to employ fewer workers at higher
wages.
W80 was the wage in 1980. L80 was the
employment rate. As regulations were
introduced, the DL decreased permanently as
more and more forests were protected.
At W80, the number of workers seeking to supply
their labor (L80) exceeded the quantity of labor
demanded at the end of the decade (LD). The difference between L80 and LD is structural
employment.
Sources of Structural Unemployment
Minimum Wage is a price floor. In some industries,
there may always be structural unemployment because
there may always be a surplus of labor.
Labor unions will negotiate with employers on behalf
of the workers. The goal is usually to raise wages
above market equilibrium. As a result, there may be
some structural unemployment. The members and
leadership of the unions usually are willing to make this
tradeoff of higher wages for lower employment.
Efficiency Wages are wages that employers set above
the equilibrium wage rate as an incentive for their workers to deliver better performance. If the
efficiency wage creates a surplus of workers, it has created structural unemployment.
Side Effects of Public Policy. Most economically advanced countries provide benefits to laid off
workers as a way to tide them over until they find a new job. The drawback is that it reduces the
incentive to quickly find a new job, and by keeping more people searching for longer, the benefits
increase structural and frictional unemployment.
Natural Rate of Unemployment. Frictional unemployment is inevitable and many factors create
some structural unemployment. Thus, a certain amount of unemployment is normal, or “natural”
and actual unemployment fluctuates around this normal level. The natural rate of unemployment
is the normal unemployment rate around which the actual unemployment rate fluctuates.
Natural unemployment = Frictional unemployment + Structural unemployment
When the economy goes through the business cycle, jobs are created and destroyed, and this can add
to, or subtract from, the natural rate.
Cyclical unemployment is the deviation of the actual rate of unemployment from the natural rate,
or the share of unemployment that arises from the business cycle.
Actual unemployment = Natural unemployment + Cyclical unemployment
Changes in the Natural Rate of Unemployment
 Changes in Labor Force Characteristics. Older, more experienced, workers are more likely to be
employed. As U.S. workforce has gradually ages, this contributes to a declining natural rate of
unemployment.
 Changes in Labor Market Institutions. Declining role of unions in U.S. labor market has weakened
ability to raise wages and some of that structural unemployment has been reduced.
o Technology in job search (on-line services) has lessened time a worker is in between jobs, lessening
the frictional unemployment.
o Changes in Government Policies. Government can offer subsidies to employers to employ
workers who are currently unemployed. Programs to retrain workers with obsolete skills can also
lessen the natural rate of unemployment.