economics what does it mean to me? unit 2: unit 2: measuring the macroeconomy business cycle...
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ECONOMICSWhat Does It Mean To Me?
Unit 2: Unit 2: MEASURING THE MACROECONOMY
•Business Cycle
•Unemployment
•GDP Equation (nominal/real)
•Marginal Propensity to Consume/Save
•Price Deflator
•CPI
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READ: Krugman Chapters 23, 24
OR Mankiw, Chapters 23, 24, 28
OR, here’s an idea!!
READ THEM ALL!!
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Copyright © 2004 South-Western
*Mankiw
Websites for government agencies that collect economic data:
Bureau of Labor Statistics www.bls.gov
Federal Reserve www.federalreserve.gov
Congressional Budget Office www.cbo.gov
Department of Commerce www.commerce.gov
You have a handout for collecting economic data. It’s due tomorrow.
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Ten Propositions about Which Most Economists Agree
Copyright © 2004 South-Western
*Mankiw
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BUSINESS CYCLE
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The Business Cycle is the short-run alternation between economic downturns and economic upturns.
Depression is a very deep and prolonged downturn. (over 3 reporting periods)
Recessions are periods of economic downturns when output and employment are falling. (2 reporting periods)
Expansions, sometimes called recoveries, are periods of economic upturns when output and employment are rising.
*Krugman
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The Circular-Flow Diagram
Spending
Goods andservicesbought
Revenue
Goodsand servicessold
Labor, land,and capital
Income
= Flow of inputs and outputs
= Flow of dollars
Factors ofproduction
Wages, rent,and profit
FIRMS•Produce and sellgoods and services
•Hire and use factorsof production
•Buy and consumegoods and services
•Own and sell factorsof production
HOUSEHOLDS
•Households sell•Firms buy
MARKETSFOR
FACTORS OF PRODUCTION
•Firms sell•Households buy
MARKETSFOR
GOODS AND SERVICES
Copyright © 2004 South-Western*Mankiw
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An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
*Krugman
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What happens during a business cycle, and what can be done about it?
the effects of recessions and expansions on unemployment;
the effects on aggregate output; and
the possible role of government policy.
QUESTIONS TO ANSWER:
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Policy efforts undertaken to reduce the severity of recessions are called stabilization policy.
One type of stabilization policy is monetary policy, changes in the quantity of money or the interest rate. (raise/lower interest rate, raise/lower reserve requirement, buy/sell T-bills)
The second type of stabilization policy is fiscal policy, changes in tax policy or government spending, or both. (raise/lower taxes, raise/lower spending)
*Krugman
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Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades.
A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth.
*Krugman
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UNEMPLOYMENT
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*Mankiw
How Is Unemployment Measured?–Categories of Unemployment
•The problem of unemployment is usually divided into two categories, the long-run problem and the short-run problem.•Natural rate of unemployment does not go away on its own even in the long run.
•Cyclical rate of unemployment year-to-year fluctuations in unemployment around its natural rate.
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*Mankiw
•Unemployment is measured by the Bureau of Labor Statistics (BLS).•It surveys 60,000 randomly selected households every month.•The survey is called the Current Population Survey
•Based on the answers to the survey questions, the BLS places each adult into one
of three categories:
**Employed
**Unemployed
**Not in the labor force
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Employment is the number of people working in the economy.
Unemployment is the number of people who are actively looking for work but aren’t currently employed.
The labor force is equal to the sum of employment and unemployment.
*Krugman
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*Mankiw
•Employed vs. unemployed–The BLS considers a person an adult if he or she is over 16 years old.–A person is considered employed if he or she has spent some of the previous week working at a paid job.–A person is unemployed if he or she is on temporary layoff, is looking for a job, or is waiting for the start date of a new job.–A person who fits neither of these categories, such as a full-time student, homemaker, or retiree, is not in the labor force.
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*Mankiw
AdultPopulation
(223.4 million)
Labor Force(147.4 million)
Employed(139.3 million)
Not in labor force(76.0 million)
Unemployed (8.1 million)
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Discouraged workers are non-working people who are capable of working but are not actively looking for a job. They would like to work but have given up looking for jobs after an unsuccessful search, don’t show up in unemployment statistics.
Underemployment is the number of people who work during a recession but receive lower wages than they would during an expansion due to smaller number of hours worked, lower-paying jobs, or both.
The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force, either currently working
*Krugman
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History of the unemployment rate since 1948
*Krugman
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*Mankiw
• The unemployment rate is calculated as the percentage of the labor force that is unemployed.
Unemployment rate =Number unemployed
Labor force×100
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*Mankiw
• The labor-force participation rate is the percentage of the adult population that is in the labor force.
Labor force
Adult population 100X
Labor Force Participation Rate
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*Mankiw
10
8
6
4
2
01970 19751960 1965 1980 1985 1990 2005
Percent ofLabor Force
1995 2000
Natural rate ofunemployment
Unemployment rate
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*Mankiw
Demographic Groups
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*Mankiw
100
80
60
40
20
01950 1955 1960 1965 1970 1975 1980 1985 1990 2000
Labor-ForceParticipation
Rate (in percent)
Women
Men
1995 2005
1950
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*Mankiw
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*Mankiw
• In an ideal labor market, wages would adjust to balance the supply and demand for labor, ensuring that all workers
would be fully employed.
Why Are There Always Some People
Unemployed?
Quantity of labor
Wage Labor Supply
Labor Demand
WE
QE
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*Mankiw
•Frictional unemployment refers to the unemployment that results from the time that it takes to match workers with jobs.
–In other words, it takes time for workers to search for the jobs that are best suit their tastes and skills.
•Structural unemployment is the unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one.
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*Mankiw
•Unemployment insurance is a government program that partially protects workers’ incomes when they become unemployed.
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*Mankiw
•Structural unemployment occurs when the quantity of labor supplied exceeds the quantity demanded. •Structural unemployment is often thought to explain longer spells of unemployment.•Why is there Structural Unemployment?
–Minimum-wage laws–Unions–Efficiency wages
•When the minimum wage is set above the level that balances supply and demand, it creates unemployment.
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*Mankiw
Unemployment from a Wage Above the Equilibrium Level
Quantity ofLabor
0
Surplus of labor =Unemployment
Laborsupply
Labordemand
Wage
Minimumwage
LD LS
WE
LE
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•A union is a worker association that bargains with employers over wages, benefits and working conditions. •In the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor force was unionized.•A union is a type of cartel attempting to exert its market power.•The process by which unions and firms agree on the terms of employment is called collective bargaining.
•A strike will be organized if the union and the firm cannot reach an agreement.
–A strike occurs when the union organizes a withdrawal of labor from the firm.
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•A strike makes some workers better off and other workers worse off.•Workers in unions (insiders) reap the benefits of collective bargaining, while workers not in the union (outsiders) bear some of the costs.•By acting as a cartel with ability to strike or otherwise impose high costs on employers, unions usually achieve above-equilibrium wages for their members.•Union workers earn 10 to 20 percent more than nonunion workers.•Critics argue that unions cause the allocation of labor to be inefficient and inequitable.•Wages above the competitive level reduce the quantity of labor demanded and cause unemployment.•Some workers benefit at the expense of other workers.
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•Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity. •A firm may prefer higher than equilibrium wages for the following reasons:
–Worker health: Better paid workers eat a better diet and thus are more productive.–Worker turnover: A higher paid worker is less likely to look for another job.–Worker quality: Higher wages attract a better pool of workers to apply for jobs.–Worker effort: Higher wages motivate workers to put forward their best effort.
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*Krugman
Unemployment Rate
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GROSS DOMESTIC PRODUCT
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GROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCT is defined as:
The market value of all final goods and services produced within a country in a
given period of time. It does NOT include the value of intermediate goods.
Intermediate goods and services are inputs for production of final goods and services, such as the purchase of glass or steel to build an automobile
*Krugman
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GDP can be calculated in one of 3 ways:
1) Measuring GDP as the Value of Production of Final Goods and Services.
2) Measuring GDP as Spending on Domestically Produced Final Goods and Services.
3) Measuring GDP as Factor Income Earned from Firms in the Economy.
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Calculating GDP
*Krugman
2
3
13 ways to calculate
GDP
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U.S. GDP in 2004: Two Methods of Calculating GDP
*Krugman
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The four major components or determinants of Gross Domestic Product are:
•Consumption (C)
•Investment (I)
•Government Spending (G)
•Net Exports (X-M)
GDP (Y) is equal to:
C + I + G + (X - M)
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Consumption 69%
Government Purchases
18% Net Exports -3 %
Investment16%
GDP and Its Components (2001)
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The most important factor in aggregate demand is
CONSUMPTION (C)CONSUMPTION (C)
Therefore, understanding consumption is of vital importance, as it will eventually
affect total output and income.
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Is it true that the higher the national income, the more it spends on consumer items?
The answer is YES.
However, it is also true that what matters most is not the total income but the after-tax income
called DISPOSABLE INCOMEDISPOSABLE INCOME.
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Milton Friedman, economist, observed that consumption is related to permanent income rather than current income levels. This is called the PERMANENT INCOME PERMANENT INCOME HYPOTHESISHYPOTHESIS.
For example, it has been shown that college students and very old persons tend to spend more than their total income. These
groups DISSAVEDISSAVE.
On the other hand, people in their 30s and 40s tend to save quite a bit and consume relatively less of their income.
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WHY IS THIS?
College students expect to make the bulk of their earnings after graduation and, thusly, base consumption on future earnings.
Middle age persons expect to retire in the future and tend to save for that eventuality.
Older people expect to die in the future and feel withdrawal of their savings is justified.
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Additionally, the consumption rate Additionally, the consumption rate may be based on occupation.may be based on occupation.
Farmers have “good” years and “bad” years. They save more in
the good years to maintain consumption in the bad years.
A professional football player may save more and consume less during his playing years because he knows that his professional life is limited.
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WHAT IS THE AVERAGE WHAT IS THE AVERAGE AND MARGINAL AND MARGINAL PROPENSITY TO PROPENSITY TO CONSUME?CONSUME?
Households will generally spend the majority of their total income and save the remainder.
The portion of total income consumed is called the AVERAGE PROPENSITY TO AVERAGE PROPENSITY TO
CONSUME (APC)CONSUME (APC).
(i.e.) If a family spends $1350 out of $1500 total income, it has an APC of 0.9
(1350/1500).
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So, how would an increase in income affect the consumption of this family?
That depends on the MARGINAL MARGINAL PROPENSITY TO CONSUME (MPC)PROPENSITY TO CONSUME (MPC).
MPC is the additional consumption that results from an additional dollar of
disposable income.
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If consumption goes from $1350 to $1800 while disposable income goes from $1500 to
$2100, what is the MPC?
Firstly, calculate change ( ) in consumption:
1800 - 1350 = 450
Secondly, calculate change ( ) in income:
2100 - 1500 = 600
MPC = consumption/disposable income
450/600 = 3/4 = 0.75
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We interpret this by saying
…..for each additional for each additional dollar in after-tax dollar in after-tax
income, this family will income, this family will consume an additional consume an additional
0.75 or 75 cents0.75 or 75 cents.
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Examples of changes in CONSUMPTION (C) might
include:
•Increase/decrease in consumer confidence or consumer expectations of the future. (i.e. raise in salary)
•Increase/decrease in wealth. (i.e. land, stocks, homes)
•Increase/decrease in taxes.
•Increase/decrease in population.
•Increase/decrease in savings or debt.
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The next determinant in determining aggregate demand is:
INVESTMENT (I)INVESTMENT (I)Investment expenditures are an important
part of aggregate demand, as well as GDP; therefore, changes in investment spending will also be responsible for changes in the
level of economic activity.
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If you will recall, spending on investments is the most unstable portion
of GDP because of its sensitivity to changes in political, social, and
economic conditions…..
First, we need to determine the difference between INDUCED INDUCED
INVESTMENTINVESTMENT and AUTONOMOUS AUTONOMOUS INVESTMENTINVESTMENT.
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INDUCED INVESTMENT INDUCED INVESTMENT occurs when occurs when good good business climatebusiness climate “induces” firms to invest, as “induces” firms to invest, as
an increasing growth in future demand is likely.an increasing growth in future demand is likely.
The elements which impact Induced Investment include:
OPTIMISM: Investment is greater when people are more optimistic.
LEVEL OF AND RATE OF CHANGE in PROFITS: When economic growth is high,profits are high and rising. If total revenue is high, the resulting profit enables businesses to invest more.
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AUTONOMOUS INVESTMENT AUTONOMOUS INVESTMENT is investment is investment that is not determined by the level of income.that is not determined by the level of income.
The elements which impact Autonomous Investment include:
INTEREST RATES: The higher the interest rate, the higher the opportunity cost in capital; fewer investments will now have benefits greater than the new higher costs.
RATE of CAPITAL UTILIZATION: When output is relative to the ability of business capital to produce goods, capital utilization rates are also low, and new investment will be lower.
INVENTORIES: High inventories occur when sales are less than expected.. Inventory investment will be high, causing a reduction in planned investment.
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Examples of changes in INVESTMENT (I) might
include:
•Increase/decrease in interest rates.
•Increase/decrease in business confidence or expected returns on investment projects.
•Increase/decrease in business taxes.
•New and improved technology will stimulate investment.
•Degree in excess capacity (unused existing capital) will retard demand for new capital goods and reduce aggregate demand.
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A third determinant of aggregate demand is:
GOVERNMENT SPENDING (G)
Government spending can vary over time for a variety of reasons. While volatile shifts may occur at the
beginning or end of wars, for example, the tendency is that spending will increase with rising income because of the decrease in welfare payments and
unemployment compensation.
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An increase in GOVERNMENT SPENDING (G)
would also shift the aggregate demand curve to the right,
while a decrease in spending would shift the curve to
the left.
An example would be a decision by
government to expand the interstate highway system. In contrast, a reduction in spending, such as a cutback in orders for the military, will reduce aggregate
demand.
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The fourth determinant of aggregate demand is:
NET EXPORTS (X - M)
The impact of international trade effects has become increasingly important. Exports (X) must be added to the demand side of the equation to realize the effect
of foreign buyers on our economy. Additionally, Import (M) must be subtracted from the equation to
realize purchases made which have no direct impact on our economy.
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Exports minus imports (X - M) is what we call NET EXPORTSNET EXPORTS.
It represents BALANCE OF TRADE.It represents BALANCE OF TRADE.
A higher level of U.S. exports constitutes an increased foreign demand for U.S. goods.
A reduction of U.S. imports implies an increased domestic demand for U.S.-
produced products.
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Positive net exports (X - M), as a result of greater demand for U.S. goods will create a
higher level of aggregate demand.
This might explain why a country in a This might explain why a country in a recession might like to run a trade recession might like to run a trade
surplus by increasing exports.surplus by increasing exports.
The non-price-level factors which alter net exports are primarily NATIONAL INCOME ABROAD and
EXCHANGE RATES.
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NATIONAL INCOME ABROAD
Rising national income in a foreign nation increases the foreign demand for U.S. goods, increasing aggregate demand in the United
States.
Declines in national income abroad have the opposite effect: U.S. net exports decline, shifting the U.S. aggregate demand curve
leftward.
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EXCHANGE RATESA change in the exchange rate between the dollar and other
currencies also affects net exports and hence aggregate demand.
Suppose the dollar price of yen rises, meaning the dollar depreciates in terms of the yen. This is the same as saying
the yen price of dollar falls--the yen appreciates.
The new relative values of dollars and yen means consumers in Japan can obtain more dollars with any particular number of
yen. Consumers in the U.S. can obtain fewer yen for each dollar.
Japanese consumers therefore discover that U.S. goods are cheaper in terms of yen……they buy more U.S. goods.
Consumers in the U.S. find that fewer Japanese products can be purchased with a set number of dollars…..they buy fewer
Japanese goods.
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With respect the U.S. exports, a $30 pair of U.S.-made blue jeans now
might be brought for 2880 yen compared to 3600 yen. In terms of
U.S. imports, a Japanese watch might now cost $225 rather than $180.
Under these circumstances, U.S. exports will rise and imports will fall. This increase in NET This increase in NET EXPORTS translates into a rightward shift in EXPORTS translates into a rightward shift in
U.S. aggregate demand.U.S. aggregate demand.
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A closed economy is an economy that does not trade goods, services, and assets.
The United States has become increasingly open, so that open-economy macroeconomics has become increasingly important.
Open-economy macroeconomics is the study of those aspects of macroeconomics that are affected by movements of goods, services, and assets across national boundaries.
*Krugman
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One of the main concerns introduced by open-economy macroeconomics is the exchange rate, the price of one currency in terms of another.
Exchange rates can affect the aggregate price level.
They can also affect aggregate output through their effect on the trade balance, the difference between the value of the goods and services a country sells to other countries and the value of the goods and services it buys in return.
Economists are also concerned about capital flows, movements of financial assets across borders. *Krugman
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Movements of the exchange rate between the U.S. dollar and the euro
*Krugman
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•When major trading partners are experiencing economic slowdowns, causing the demand for exports to fall, shifting the curve to the left.
•When major trading partners are experiencing economic booms, causing the demand for exports to rise, shifting the curve to the right.
Examples of changes in NET EXPORTS (X - M) might include:
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The Consumer Consumer Confidence SurveyConfidence Survey measures the level of confidence individual
households have in the performance of the
economy.
Questionnaires are sent to 5,000
households; about 3,500 are returned.
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The five questions include:
•A rating of current business conditions in the household’s area.
•Rating of expected business conditions in six months.
•Current job availability in the area.
•Expected job availability in six months.
•Expected family income in six months.
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The results are compiled into indexes for the present and expected future economic situations.
The Consumer Confidence index has the potential to reflect important aggregate
demand shifters.
•Will expected stock market wealth increase their spending?
•Will inflation on the horizon increase saving?
•Will expected joblessness decrease spending?
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We can conclude, therefore, the PERCEPTIONS of consumers and
businesses on the state of the economy are important aggregate demand shifters
and can have a significant impact on price level, real output, and employment.
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NOMINAL GDP vs.
REAL GDP
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Real GDP: the value of the final goods and services produced calculated using the prices of some base year.
Nominal GDP: output valued at current prices.
Real GDP per capita is a measure of average output per person, but is not by itself an appropriate policy goal.
*Krugman
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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.
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*Krugman
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*Krugman
Real vs. Nominal GDP
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*Krugman
Real vs. Nominal GDP
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*Krugman
The Relationship between Real GDP and Unemployment, 1949-2004
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To calculate REAL GDP, we must choose a base year.
The current base year used for federal statistics is 2001.Therefore 2001 prices are used to calculate REAL GDP.
Because REAL GDP uses a constant base year, changes in REAL GDP measure only the amounts being produced.
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In the year 2001, the economy produces 100 loaves of bread that sell for $2 each. In the year 2002, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP and the GDP price deflator for each year.
(use 2001 as the base year) by what percentage does each of these three statistics rise from one year to the next?
Year 2001 100 x $2 = 200 nominal GDP
100 x $2 = 200 real GDP
($200/$200) x 100 = 100 GDP deflator
Year 2002 200 x $3 = 600 nominal GDP
200 x $2 = $400 real GDP
($600/$400) x 100 = 150 GDP deflator
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In the year 2001, the economy produces 100 loaves of bread that sell for $2 each. In the year 2002, the economy produces 200 loaves of bread
that sell for $3 each. Calculate nominal GDP, real GDP and the GDP price
deflator for each year. (use 2001 as the base year) By what percentage does each of these three statistics rise from
one year to the next?
Year 2001 100 x $2 = 200 nominal GDP
100 x $2 = 200 real GDP
($200/$200) x 100 = 100 GDP deflator
Year 2002 200 x $3 = 600 nominal GDP
200 x $2 = $400 real GDP
($600/$400) x 100 = 150 GDP deflator
Percentage change in nominal GDP is (600 - 200)/200 x 100 = 200%
Percentage change in real GDP is (400 - 200)/200 x 100 = 100%
Percentage change in the deflator is (150 - 100/100 x 100 = 50%
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• You borrowed $1,000 for one year.
• Nominal interest rate was 15%.
• During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
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The GDP Price Deflator measures the current level of prices relative to the level of prices in the base year.
GDP DEFLATOR = X 100Nominal GDP
Real GDP
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*Krugman
Calculating GDP and Real GDP in a Simple Economy
What is the total value of sales in the 1st year?
What is the total value of sales in the 2nd year?
(2000b x .25) + (1000b x .50) = $1000b
(2200b x .30) + (1200b x .70) = $1500b
Notice Notice the 2nd the 2nd year is year is 50% 50%
larger.larger.
Although the Although the quantities of both quantities of both
apples and oranges apples and oranges increased the prices increased the prices of both apples and of both apples and oranges also rose.oranges also rose.
So part of the 50% increase in So part of the 50% increase in the dollar value of GDP the dollar value of GDP
simply reflects higher prices, simply reflects higher prices, not higher production of not higher production of
output.output.
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*Krugman
Calculating GDP and Real GDP in a Simple Economy
What is the total value of sales in the 1st year?
What is the total value of sales in the 2nd year?
(2000b x .25) + (1000b x .50) = $1000b
(2200b x .30) + (1200b x .70) = $1500b
So, how much would GDP have gone up if price had NOT changed?
To do this, simply calculate Q at year 1 prices.
.25) .50) $1150B
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Now, we can define REAL GDP as the total value of final goods and
services produced in the economy during a year, calculated as if prices had stayed constant at the level of
some given base year.
*Krugman
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U.S. real gross domestic product per person from 1900 to 2004
*Krugman
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INFLATION and the INFLATION and the Consumer Price Index Consumer Price Index
(CPI)(CPI)
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The aggregate price level is the overall level of prices in the economy.
A rising aggregate price level is inflation.
A falling aggregate price level is deflation.
The inflation rate is the annual percent change in the aggregate price level.
The economy has price stability when the aggregate price level is changing only slowly.
*Krugman
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Inflation and deflation since 1929
*Krugman
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Consumer price index from 1913 to 2004
*Krugman
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CPI CPI -- prime indicator of inflation and recession
• Comprised of a market basket of goods and services.
• Measures current cost of living against base year (2000)
INFLATIONINFLATION: when the economy’s overall price level is rising.
INFLATION RATE: INFLATION RATE: percentage change in the price level from the previous period
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*Krugman
Price Indexes and the Aggregate Price Level
A price index is the ratio of the current cost of that market basket to the cost in a base year, multiplied by 100.
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Calculating the Cost of a Market Basket
Suppose a frost in Florida destroys most of the citrus crop. As a result, the price of oranges go from $.20 to $.40 and the price of grapefruit rises from
$.60 to $1.00 and lemons rise from $.25 to $.45.
We could recite three prices OR calculate an overall measure of the AVERAGE price increase.
Economists measure average price changes by comparing a consumer’s
consumption bundleconsumption bundle from year to year. This is also called the MARKET BASKETMARKET BASKET.
*Krugman
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*Krugman
Calculating the Cost of a Market Basket
In the example above, the MARKET BASKET cost $95 before the frost.
After the frost, it cost $175.
Since 175/95 = 1.842, the post-frost basket costs 1.842 times the cost of the pre-frost basket, an increase of 84.2%.
In this case, we would say that the average price of citrus fruit increased 84.2% as a result of the frost.
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*Krugman
The Makeup of the Consumer Price Index in 2004
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FYI: What’s in the CPI’s Basket?FYI: What’s in the CPI’s Basket?
16%Food andbeverages
17%Transportation
Medical care
6%
Recreation
6%
Apparel
4%
Other goodsand services
4%
41%Housing
6%Education and communication
Copyright©2004 South-Western
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*Krugman
The CPI, the PPI, and the GDP Deflator
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Problems in Measuring the Cost of LivingProblems in Measuring the Cost of Living
Substitution bias*Consumers substitute toward goods that have become relatively less expensive.
*The index overstates the increase in cost of living by not considering consumer substitution
Introduction of new goods*New products result in greater variety, which in turn makes each dollar more valuable.
*Consumers need fewer dollars to maintain any given standard of living.
Unmeasured quality changes*If the quality of a good rises from one year to the next, the value of a dollar
rises, even if the price of the good stays the same.
*If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.
*The BLS tries to adjust the price for constant quality, but such differences are hard to measure.
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To calculate CPI:
1) Choose what goes into your market basket. The Bureau of Labor Statistics conducts surveys to determine the consumption of the typical consumer.
For example: 2 pizzas,3 sodas
When the CPI rises, a family will have to spend more money to make the same
purchases.
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To calculate CPI:
2)Determine the prices of the market basket for each point in time.
Year PricePizza(2) PriceSoda(3)
2001 $5 $1
2002 $8 $2
2003 $10 $3
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To calculate CPI:
3)Determine the total cost of the market basket.
Year PricePizza(2) PriceSoda(3)
2001 $5 $1
2002 $8 $2
2003 $10 $3
2001: (2x5) + (3x1) = $13
2002: (2x8) + (3x2) = $22
2003: (2x10) + (3x3) = $29
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To calculate CPI:
4)Select a base year and compute the CPI in each year
2001: (2x5) + (3x1) = $13
2002: (2x8) + (3x2) = $22
2003: (2x10) + (3x3) = $29
2001: (13/13) x 100 = 100
2002: (22/13) x 100 = 169
2003: (29/13) x 100 = 223
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To calculate CPI:
2002: (169-100)/100 x 100 = 69%
2003: (223-169)/169 x 100 = 32%
IR:yr2 = x 100
CPI:yr2 - CPI:yr1
CPI:yr1
5)Compute the Inflation Rate.
2001: (13/13) x 100 = 100
2002: (22/13) x 100 = 169
2003: (29/13) x 100 = 223
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The CPI is used to calculate how prices have changed over
the years.
Let’s say you have $7 in your pocket to purchase some goods and services today. How much
money would you have needed in 1950 to buy the same amount of
goods and services?
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The CPI for 1950 = 24.1
The CPI for 1999 (based on first 5 months of 1999 = 166.2
Use the following formula to compute the calculation:
1950 price = 1999 Price * (1950 CPI / 1999 CPI)
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THE ANSWER:
$7.00 * 24.1 / 166.2 = $1.02
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Let’s say your parents told you that in 1950 a movie cost
25 cents. How could you tell if movies have increased in price faster or slower than
most goods and services? To convert that price into today’s
dollars, use the CPI.
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The CPI for 1950 = 24.1
The CPI for 1999 (based on first 5 months of 1999 = 166.2
Use the following formula to compute the calculation:
1999 price = 1950 Price * (1999 CPI / 1950 CPI)
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THE ANSWER:
$0.25 * 166.2 / 24.1 = $1.72
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In 1999, a full priced movie in South Florida cost
between $5.00 and $7.00. It looks like movies have
increased in price faster than most other goods and
services.
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• Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001:
Salary SalaryPrice level in 2001
Price level in 19312001 1931= ×
= ×
=
$80,.
$931,
000177152
579
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Two Measures of InflationTwo Measures of Inflation
1965
Percentper Year
15
CPI
GDP deflator
10
5
01970 1975 1980 1985 1990 20001995
Copyright©2004 South-Western
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QUESTIONS FOR REVIEW
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Price Quantity Price Quantity
Year Hot Dogs Hot Dogs Hamburgers Hamburgers
2005 $1 100 $2 50
2006 $2 150 $3 100
2007 $3 200 $4 150
Two goods are produced: hot dogs and hamburgers:
What is the NOMINAL GDP for each year?
Nominal GDP for 2005 = ($1 x100) + ($2 x50) = $200
Nominal GDP for 2006 = ($2 x150) + ($3 x100) = $600
Nominal GDP for 2007 = ($3 x200) + ($4 x150) = $1,200
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Price Quantity Price Quantity
Year Hot Dogs Hot Dogs Hamburgers Hamburgers
2005 $1 100 $2 50
2006 $2 150 $3 100
2007 $3 200 $4 150
Two goods are produced: hot dogs and hamburgers:
What is the REAL GDP for each year assuming a base year of 2005?
Real GDP for 2005 = ($1 x100) + ($2 x50) = $200
Real GDP for 2006 = ($1 x150) + ($2 x100) = $350
Real GDP for 2007 = ($1 x 200) + ($2 x150) = $500
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Price Quantity Price Quantity
Year Footballs Footballs Basketballs Basketballs
Year 1 $10 120 $12 200
Year 2 $12 200 $15 300
Year 3 $14 180 $18 275
The country of Coltsville produces two goods: footballs and basketballs.
What is the nominal GDP for each year?
Nominal GDP for year 1 = ($10 x120) + ($12 x200) = $3,600
Nominal GDP for year 2 = ($12 x200) + ($15 x300) = $6,900
Nominal GDP for year 3 = ($14 x 180) + ($18 x275) = $7,470
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Price Quantity Price Quantity
Year Footballs Footballs Basketballs Basketballs
Year 1 $10 120 $12 200
Year 2 $12 200 $15 300
Year 3 $14 180 $18 275
The country of Coltsville produces two goods: footballs and basketballs.
What is the real GDP for each year using year 1 as the base year?Real GDP for year 1 = ($10 x120) + ($12 x200) = $3,600
Real GDP for year 2 = ($10 x200) + ($12 x300) = $5,600
Real GDP for year 3 = ($10 x 180) + ($12 x275) = $5,100
NOTE that nominal GDP rises from Year 2 to Year 3, but real GDP falls.
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Price Quantity Price Quantity
Year Footballs Footballs Basketballs Basketballs
Year 1 $10 120 $12 200
Year 2 $12 200 $15 300
Year 3 $14 180 $18 275
The country of Coltsville produces two goods: footballs and basketballs.
What is the GDP deflator for each year?
GDP deflator for year 1 = (3600/3600) x 100 = 1 x 100 = 100GDP deflator for year 2 = (6900/5600) x 100 = 1.2321 x 100 = 123.21
GDP deflator for year 3 = (7470/5100) x 100 = 1.4647 x 100 = 146.71
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During 2009, the country of Meachotopia recorded a GDP of $65b, interest payments of $15b, imports of $13b, profits of $7b, exports
of $15b, and rent of $7b. This would mean wages during 2009 in Meachotopia were:
$36b
65b -15b -7b - 7b =
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In the US, consumer spending accounts for what percentage of GDP?
70%
In the US, investment spending accounts for what percentage of GDP?
16%
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GDP tends to understate our economic well being because it:
excludes the value of leisure
If real GDP rises while nominal GDP falls, then prices on average have
fallen
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GDP tends to understate our economic well being because it:
excludes the value of leisure
If real GDP rises while nominal GDP falls, then prices on average have
fallen
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Compiled by:Compiled by:Virginia H. Meachum, Economics TeacherVirginia H. Meachum, Economics Teacher
Coral Springs High SchoolCoral Springs High School
Sources:Sources:Principles, Problems, and Policies, by Campbell McConnell
& Stanley Brue
Exploring Economics, by Robert Sexton
Principles of Economics, by N. Gregory Mankiw
Economics, by Paul Krugman & Robin Wells
Notes by Florida Council on Economic Education and FAU Center for Economic Education
Notes by Foundation for Teaching Economics