Measuring The

Health of the Economy

Unit 4

Government actions affect economic activity.

Economic decisions require the government to evaluate the costs and benefits of actions.

Enduring Understandings

Essential QuestionsHow should the U.S. government carry out its economic roles? How healthy is the American economy

Terms

Gross Domestic Production Unemployment rate Inflation

Consumer Price Index Real and Nominal, per capita

Draw and identify phases of the business cycle Aggregate

Aggregate Supply- describe both the Keynesian and Classical models

Aggregate Demand Fiscal Policy Monetary Policy

Progressive Tax Rate Stagflation

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Circular Flow Model

Business Government Individuals

Investors Government Consumer

Product Markets

Resource Markets

Financial

Goods and Services Goods and Services

SpendingRevenue

Resources- factors of productionLand Labor capital entrepreneurship

Resources- factors of production

Cost

Income

Goods and Services

Gov’tSpending

Resources and labor

Gov’tSpending

Taxes and loansTaxes

Subsidies Transfer Payments

Public Goods/Services Public Goods/Services

Supply Demand

SupplyDemand

Marginal- additional, MB= Marginal Benefit, MC= Marginal Cost, MR- Marginal Revenue, MRP- Revenue product, MRC- Resource cost,MSB- Marginal Social Benefit, MSC- Marginal Social Cost

MB= MCUtility Maximization

MR= MCProfit Maximizing Rule

(MC) S= D (MB) or (MR)

Profit maximizing rule of hiring MRP= MRC

Loans

Interest

Consumers+

Investors+

Government+

Net Exports__________

Gross Domestic Production

MSB= MSC

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Identify Key terms and answer the associated questionsPart 1 (GDP)

G.D.P. (Gross Domestic Product)-

What factors contribute to the GDP? On another piece of paper chart the US GDP from 2000- 2011 (by year)

What does not contribute to the GDP? Next chart US real GDP from 2008-2011 by quarter

Explain:Nominal GDP

Real GDP

GDP per Capita

Explain how unemployment is it related to GDP?

Part 2 (Unemployment)

Explain the different types of unemployment and what is the natural rate of unemployment?

FrictionalStructuralCyclicalSeason

What is the natural rate of unemployment? Why is this ok?

If our current unemployment rate is 9% how much is the cyclical unemployment?

What portion of the population is not counted toward unemployment rates?

What is real unemployment?

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Part 3: The purchasing power of money

What is inflation?

What does higher inflation do the purchasing power of money?

How does this impact price?

What is CPI (Consumer Price Index)

How does the Consumer price index measure inflation?

What is monetary inflation?

Part 4: The Business Cycle

Diagram and Identify the different phases of the business cycle:

If the business cycle is natural and unavoidable should the government become involved? Explain your answer

To economist when is the business cycle officially in a recession?

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Part 5: Government Role and the Recession:

Aggregate Supply and Demand (AS/AD)

What is Aggregate Demand

What is LRAS?

What is Aggregate Supply

What is the difference between Classical vs Keynesian Approach to Aggregate Supply?

How would an economist who believed in the classical approach draw Aggregate Supply? Why?

What would Keynesian economists say the Aggregate Supply , Aggregate Demand, and Price?

How does the Aggregate Supply depending on what model you are looking at? What are the three different phases?

What is Keynesian economics and what does it say about the government’s role in getting the economy out of a recession?

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Part 8: Fiscal Policy and Monetary policy

Explain Fiscal Policy:

Explain Monetary policy:

How do both try to fix recessions and inflation?

Recession

Fiscal

Monetary

Inflation

Fiscal

Monetary

Part 7: Phillips Curve (inflation and unemployment) (Long and Short Run)

Explain the Phillips Curve and explain how we get short run and long run Phillip’s Curve

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Economic IndicatorsMeasure health of economy

Regardless of what you learn for the next two weeks

Remember these some important points:

1. Economics is the Allocation of scarce resources to their most useful purpose.

2. Remember the key lesson on economics- don’t look at policy in isolation, look at future phases, and measure policy by consequences and outcomes and not by intentions. This will come into play when we learn about “fixing” the health of the economy.

3. Regardless of statistics and numbers the most important thing to consider is standard of living. Very difficult to measure happiness.

4. Correlation does not mean Causation!!!!!!

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Gross Domestic ProductGross Domestic Product- the market value for all final goods and services produced within a country during a given period of time.

A steadily growing GDP is generally considered a sign of economic health.

The Department of Commerce’s Bureau of Economic Analysis determine the GDP.

Click here to find our current GDP. http://www.bea.gov/

Terms:

Final Good- a new good ready to be used by a consumer- cereal, cars, toys

Intermediate good- a good that is used in the production of a final good- not counted toward GDP. Example- grains, steel, rubber

Market Value- price buyers are willing to pay in the market place

Film on G.D.P. (Gross Domestic Product)

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Gross Domestic ProductHow do we calculate GDP?

CHousehold Consumption/Consumer spending

IBusiness Investment

GGovernment Spending

Imports

Exports

NXNet Exports

GDP

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Gross Domestic ProductTypes of GDP

Nominal GDP: Measuring GDP with today’s prices

Real GDP: Measuring GDP using a base year’s value of the dollar- this compensates for inflation

(Nominal GDP/GDP Price index) * 100

GDP per Capita:GDP per person, dividing GDP by the population

GDP Deflator= Nominal/Real *100

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Gross Domestic Product

GDP growth rate by nation 2011

http://www.tradingeconomics.com/gdp-growth-rates-list-by-country

Nominal GDP by nation 2011

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Gross Domestic ProductGross Domestic Product- maps

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Gross Domestic ProductGross Domestic Product- maps

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Gross Domestic Product

Real Growth rate

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Gross Domestic ProductDistribution of wealth 0 = total equality 1= total inequality

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Gross Domestic ProductThere are some important correlations (associations/relationships)

Remember correlation does not mean causation!!!

Nations with high GDP’s generally have the following. . .

High Literacy Rates

Improved health, nutrition, and high life expectancy

Lower infant mortality rates

Higher standards of living

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Gross Domestic ProductThere are some limitations to GDP

1. GDP leaves out unpaid work such as households and volunteer work

Volunteer firefighters, charity

2. GDP leaves out informal and illegal exchanges

Babysitting, working under the table, black markets, barter

3. GDP counts negatives as positives.

rebuilding after a hurricane, war efforts, over- exploiting resources

4. GDP does not reflect negative externalities

Pollution, people buying bottle water because of pollution

5. GDP places no value on leisure time or happiness

6. GDP says nothing about income distribution

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Gross Domestic ProductThere are other limitations to GDP

For example GDP measures things that were once done at home but now are considered work.

Housekeeping or gardening

Also it literally tries attempts to compare apples and oranges or more accurately bananas and oil.

It says nothing about the time it takes to create a product.

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Gross Domestic Product"The Gross National Product includes air pollution and advertising for cigarettes, and ambulance to clear our highways of carnage.

It counts special locks for our doors, and jails for the people who break them. GNP includes the destruction of the redwoods and the death of Lake Superior.

It grows with the production of napalm and missiles and nuclear warheads... And if GNP includes all this, there is much that it does not comprehend.

It does not allow for the health of our families, the quality of their education, or the joy of their play. It is indifferent to the decency of our factories and the safety of our streets alike.

It does not include the beauty of our poetry or the strength of our marriages, or the intelligence of our public debate or the integrity of our public officials...

GNP measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country.

It measures everything, in short, except that which makes life worthwhile; and it can tell us everything about America - except whether we are proud to be Americans."

- Senator Robert Kennedy. 1968

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Evaluate the following quote from Milton Friedman

“Spending isn’t good, what is good is producing. What we want to have is more goods and services. Government spending is ok for those things, those services that we believe that we can get more usefully and more effectively through government. If people are getting their money’s worth- fine. That’s why it is very desirable to have government expenditures occur as much at the local level as possible, because you as a citizen of a local community can judge if you are getting your money’s worth and you can decide if you want to spend it. But when it comes to the federal government you tend to think that you are spending someone else’s money. In a way you are, but he is spending yours.

The Broken Window Fallacy

Unemployment rateThe Bureau of Labor Statistics tracks the unemployment rate.

Click here to track our current unemployment rate. http://www.bls.gov/

The unemployment rate is used to measure the overall health of the economy.

In general a high unemployment rate indicates an unhealthy economy.

The BLS will conduct a random survey to determine the unemployment rate.

The are 3 classifications of people in the country.

1. Employed- members of the labor force who have jobs.

2. Unemployed- members of the labor force who don’t have jobs but are looking for work

3. Not in the labor force- those who are eligible to be in the labor force but don’t have jobs and are not looking for jobs. This includes full time students, disabled, retired, and those prevented by family responsibilities.

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Unemployment rateThe labor force is found by adding all employed and unemployed workers together.

To find the unemployment rate the BLS divides the unemployed by the labor force and multiples the number by 100.

number unemployedUnemployment rate = ______________________________ X 100

number in labor force

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Unemployment rateIn 2008, The Phillies won the World Series

Based on the data below and using the equation provided calculate the unemployment rate

U.S. Unemployment rate October 2008

Adult population (234.4 million)

Unemployment rate = ______________________ x 100 = 9.5 million

154.8 million

6.1%

Employed (145.3 million) Unemployed (9.5 million) Not in labor force (79.6 million)

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Unemployment rateTypes of Unemployment and Full employment

Frictional Unemployment- When a worker enters the workforce or quits a job to find a better job.

Structural/Technological Unemployment- when advances in technology eliminate jobs

Unemployment lesson

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Unemployment rateTypes of Unemployment and Full employment

Seasonal Unemployment- When a business shuts down during part of the year

Cyclical Unemployment- Occurs when there is a decline in business because of the economic downturn

Unemployment lesson

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Unemployment rateTypes of Unemployment and Full employment Unemployment lesson

There will always be Frictional, Structural, and Seasonal unemployment.

This is the natural rate of unemployment- NRU

The NRU is about 5%.

This is also considered Full Employment

It is Cyclical Unemployment that we need to be the most concerned with.

This happens during down periods of the economy. Currently we have a 9% unemployment rate.

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Unemployment rateUnemployment lesson

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Unemployment rate

1. Unemployment does not count discouraged workers or in other words those who have given up looking for work. Some say that if we counted these people in the unemployment calculations the our real unemployment rate is 17%.

2. Additionally, involuntary part-time workers are not counted as part of the unemployment rate. These are the people who would like full time jobs but can only get part-time hours. They are partially employed.

3. Does not count under the table workers or illegal activity.

Economic cost of Unemployment

1. Lost of potential output.

2. Loss of income by workers

3. The unemployed do not contribute to taxes and in fact usually collect unemployment insurance

4. If the number of unemployed becomes too large, money from other programs must be shifted to unemployment programs or taxes are raised on those who have jobs.

Problems with Unemployment rate as an indicator

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Inflation RateThe inflation rate is the percent of increase in the average price level of goods and services from one month or year to the next.

In other words inflation reduces the purchasing power of money.

It is tracked by the Bureau of Labor Statistics.

http://www.bls.gov/bls/inflation.htm

Imagine living in a country where if you ate breakfast at a café your second cup of coffee would cost more than the first or if you burned you cash because it was worth more as fuel than as currency.

Excessive Inflation can send a nation’s economy into a tailspin.

What is inflation?

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Inflation RateInflation is measured by using a price index.

A price index measures the average change in price of a type of good over time.

The Consumer Price index (CPI) is a price index for a “market basket” od consumer goods and services. Changes in the average prices of these items approximate the change in the cost of living.

Also know as the Cost of living index.

The CPI is determined by consumer and store surveys.

The current prices are compared to a base period. 1982-1984

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Inflation RateBase 100- 1982-1984TC

Inflation RateCPI is found by finding the total price of a consistent “market basket”

Item 2009 2010 2011

Hot Sausage 3.00 4.00 4.50

Pasta 1.00 1.50 2.00

Ice Cream 3.00 3.50 5.00

Eggs 1.00 1.50 2.00

Milk 3.00 3.00 4.50

Bread 1.00 1.50 2.00

Total: 12.00 15.00 20.00(Market Basket)

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Inflation Rate

Market basket price for year_____________________________ x 100= CPI

Market basket price for base year

What is CPI (Consumer Price Index)

Year Market Basket Base year 2009 Base year 2010 Base year 2011

2009 12

2010 15

2011 20

100

100

100

Base year is always 100Example

Market price for 2009 _______________________ x 100 = CPI

Base year 2009

Base year is always 100Example

12 _______________________ x 100 = 1

12

Now complete the chart

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Inflation Rate

Market basket price for year_____________________________ x 100= CPI

Market basket price for base year

What is CPI (Consumer Price Index)

Year Market Basket Base year 2009 Base year 2010 Base year 2011

2009 $ 12

2010 $ 15

2011 $ 20

100 %

100 %

100%

Example:

To find the increase in inflation from 2009 to 2010

15 ______ x 100= 125%

12

125%

167%

80

133%

60%

75%

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Inflation Rate

Limitations of CPI as a measure:

1. Substitution Bias- People buy substitutes if prices are too high. CPI doesn’t take this into consideration.

2. Outlet/Discount store bias- CPI doesn’t take into account that people may buy goods at a discount store.

Acme- average price of a chicken fryer (small whole Chicken)- $7.41Bottom Dollar – same item or similar item- $4.00

3. New Product biasMobile phones in 1983- $3995, 1998 $200- but mobile phones were not included in the CPI until 1998.

4. Quality change bias- technological improvements make items better and last longer.

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Inflation RateNominal cost of living- the cost in current dollars of the basic good and service that people need.

Real cost living- the nominal cost of basic goods and services, adjusted for inflation

Nominal wages- wages based on current prices

Real wages- nominal wages that have been adjust for inflation.

Wages need to keep up with the cost of living if the standard of living is to remain the same.

The cost of living is indeed going up—in money terms. What really matters, though, isn't what something costs in money; it's what it costs in time. Making money takes time, so when we shop, we're really spending time. The real cost of living isn't measured in dollars and cents but in the hours and minutes we must work to live.

American essayist Henry David Thoreau (1817-62) noted this in his famous book, Walden: "The cost of a thing is the amount of. . .life which is required to be exchanged for it, immediately or in the long run."

http://dallasfed.org/fed/annual/1999p/ar97.cfm

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Inflation Rate

In 2010, Sally started her new job making $40,000.

In 2011, Sally earned a $1,000 raise.

From 2010 to 2011 prices have increased 4%.

Should Sally be happy or disappointed? Why?

or

Sally received a 2.5% raise but her purchasing power dropped because inflation increased 4.

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Inflation Rate

Types of inflations

Creeping inflation- gradual inflation, in the United States the annual rate of inflation is 3.4 percent since 1914. The rate has varied widely but this is on average what we can expect.

Hyperinflation- when inflation goes into overdrive. Prices can double within days, the standard of living collapses.

Germany in the 1920’s

Zimbabwean 2008

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Inflation Rate

Types of inflations

Deflation- Inflation rate always rises. It either speeds up or slows down. It never drops.

If the rate becomes negative it is call Deflation. Deflation is caused when prices drop over time.

Sounds good for consumers and savers.

Every dollar saved will have an increased purchasing power in the future.

Who does this hurt?

This hurts borrowers- this hurts everybody because if people aren’t borrowing they aren’t investing and this slows down the economy.

Business will slow down production and there will be an decrease in wages and an increase in job cuts.

This is actually a very bad spiral – early days of the great depression saw deflation

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Inflation Rate

Causes of Inflation

1. Increase in money supply- too many dollars too few goods

2. Demand Pull- If the sectors of the economy try to buy more than the economy can produce. The extra demand pulls up prices

3. Cost-Push- according to the book the rising cost of labor, land, or capital pushes up the overall price.

Or course a company does not have to extend the cost to the buyer and the companies that don’t get the business

4. Wage-price spiral- higher wages result in higher prices and higher prices result in more people asking for higher wages.

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Inflation Rate

Economic cost of inflation

1. Loss of purchasing power

If the price of a guitar was $200 one year. A student saved his money for an entire year to buy the guitar. He came back to the store the following year to see that the price is now $220.

- Hurts those on fixed incomes the most.

- Wages have to keep up with inflation

2. Higher interest rates- real interest rate is the

nominal interest rate- the inflation rate= a real interest rate10% interest rate- 4% inflation rate= 6 % real interest rateDollars worth less tomorrow than today- slows lending

3. Loss of efficiency- many economist consider uncertainty about prices to be a bigger problem than the other. Buyers and sellers don’t have enough information to make the most efficient decisions.

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The Business CycleEconomies are always changing

There are periods of growth and decline. Booms and Bust

This is the business cycle.

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Movie The Business Cycle

The Business Cycle TC

The Business Cycle

The name business cycle makes it sound like the cycle is very predictable.

The opposite is true.

Peaks ad Trough are extremely difficult to predict.

The leading indicators are GDP, Unemployment, and Inflation.

Other leading indicators:

Housing construction- an increase signals confidence and a decrease slows a lack of confidence and an increase in savings.

Others:

Real GDP

Lagging indicators are indicators that lag behind or happen after contraction or expansion

Unemployment rate

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The Business Cycle

Other names.

Recession- a decline in GDP lasting 6 months or 2 quarters

Depression- Severe contraction

When GDP grows – there will be inflation and low unemployment- naturalWhen GDP shrinks- there will be less inflations and higher unemployment- natural

Stagflation – is the worst of both worlds- high unemployment and high inflation- unnatural

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The Business Cycle

What causes the dip?

1. Negative shock to the economy- rapidly rising oil prices, stock market crash, uncertainty with regards to government actions, terrorist attacks

2. Increase in interest rates making it more difficult to borrow money.

3. When supply is less than demand – natural or man-made

4. Some say an increase in savings leads to an increase in inventories. Increased inventories force firms to cut back production and layoff workers.

What causes Growth?

5. Confidence in market caused by knowledge- uncertainty is the worst enemy.

6. Increased production causes firms to hirm

7. New technology

8. Government??????- this is the question that needs to be answered for the unit.

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Now that we know how to measure the health

The Question is how do we fix the economy?

Just like doctors, economist will have different opinions

Some will say, “Do nothing it needs to run its course.” (Classical)

Other will say, “The Government needs to do something.”

While other may agree with doing “something” that “something” depends on the economist

Keynesians vs Monetarist

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