Thinking Like an Economist

Macroeconomic QuestionsHow can sufficient growth be attained

so that the well being of society increases?

How should productive capacity be utilized so that there will be full employment with stable prices?

Basic Questions: Macro

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

Measuring GDP

What Is GDP?

GDP, Gross Domestic Product, is the total dollar value of all final goods and services produced in a country during a year.Current market prices are used to aggregate

different outputs to a dollar total. Government purchases, many of which do

not occur in markets, are valued at their cost of production.

Only final goods and services are included. Intermediate goods are not included to avoid double counting.

The measure is an annual flow, a rate of production. A GDP of $10 trillion implies that the economy is producing $10 trillion worth of goods and services per year.

GDP measures production by U.S. citizens and foreigners alike inside the geographic borders of the USA and thus unequivocally reflects economic activity in the USA.

What Is GDP?

Real and Nominal GDP Nominal GDP

The market value of a nation’s final output based on current prices for the goods and services produced during the year.

• Nominal GDP in 2001 = the sum of all the goods and services produced in 2001 multiplied by their 2001 prices

Real GDPAn estimate of the value of a nation’s final

products adjusted for changes in prices since some base year.

Components of GDP: Expenditure Viewpoint

ConsumptionNon-durable Goods (last less than 3 years)Durable Goods (last more than 3 years)Services

Gross Domestic InvestmentNon-residential Investment (plant and

equipment)Inventory ChangeResidential Investment

Government SpendingLocal and StateFederal

Net ExportsExports Minus Imports

Components of GDP: Expenditure Viewpoint

Components of GDP: Income ViewpointEmployee Compensation

Income from the sale of labor services during the year. • It includes wages, salaries, and fringe

benefits such as employer provided insurance and employer contributions to pension funds.

Net InterestThe portion of business receipts used to

pay for borrowed funds that finance investment purchases.

Rental IncomeRental income is earned by those who

supply the services of land, mineral rights, and buildings for use by others.

Components of GDP: Income Viewpoint

Profits.Profits of corporations and

unincorporated business• Profits = Total revenues - Indirect

business taxes - Capital consumption allowance - labor costs - net interest - rents paid

Components of GDP: Income Viewpoint

Components of GDP: Expenditure and IncomeExpenditure

GDP = C + I + G + (X-M)Income

NI = W + i + R + Since NI and GDP measure

aggregate production, they must be equal.

GDP = NI 2001

Consumption 6,987.1 Durable Goods 835.9 Nondurables 2,041.3 Services 4,109.9

Investment 1,586.0 Nonresidential 1,201.6 Residential 444.7

Inventory Change -60.3 Government 1,858.0 Federal 628.1 State & Local 1,229.9

Net Exports -348.9 Exports 1,034.1 Imports 1,383.0

GDP 10,082.2

Employee Compensation 5874.9Corporate Profits 731.6 Proprietors’ Income 727.9Net Interest 649.8Rental Income 137.9National Income 8,122.1+ CCA 1329.3+ Indirect Business Taxes 774.8+ Business Transfers 42.5 - Subsidies -47.3+Statistical Discrepancy -117.3 GNP 10,104.1+Net Foreign Payments -21.9GDP 10,082.2

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

What GDP Is Not It is not a measure of a nation’s

overall welfare. Why?Some things are produced but never

sold and so are not included in GDP.GDP places no value on leisureSome expenditures are hidden from

data collectors

Production of some goods and services while increasing GDP can have a negative effect on the environment

Some items are included that do not reflect net benefits to society.

• Environmental clean-ups bring us back to the pre-damage state. These expenditures are included with no offsetting reduction to reflect the cost of pollution.

What GDP Is Not

Macroeconomic Problems

Unemployment Inadequate Growth Inflation

Unemployment

The unemployment rate is the number of unemployed people, expressed as a percentage of the labor force.Labor Force = (Civilian non-

institutional population over age 16 minus people not in the labor force (students, homemakers, retirees, discouraged workers)

Definitions

Labor Force = Number of Employed + Number of Unemployed

Unemployment Rate = Number of Unemployed Labor Force

Labor Force Participation Rate = Labor Force Adult Population X 100

X 100

Types of Unemployment Frictional Unemployment

Occurs due to normal turnover in the labor market. People changing jobs.

Structural UnemploymentRefers to workers who are not employed

because their skills are not in demand. Cyclical Unemployment

Occurs due to changes in the business cycle.

Natural Rate of Unemployment

The natural rate of unemployment is the percentage of the labor force that can normally be expected to be unemployed for reasons other than cyclical fluctuations in real GDP.The natural rate of unemployment is related to the

willingness of workers to voluntarily separate from their jobs, job loss, the duration of unemployment periods, the rate of change in the pattern of demand, and changes in technology.

Costs of Unemployment

Loss in productivity is measured by the gap between potential GDP and actual GDP.A conservative estimate of the cumulative gap

between actual and potential GDP over the years 1974-1992 (evaluated in 1987 prices) is approximately $1300 billion.

At 1993 levels, this loss in output would be about 3 months’ worth of production.

Inflation

Inflation refers to a sustained rise in the average level of prices.Inflation does not mean that all prices

are rising. Some prices may be falling, but on average the overall level of prices is rising.

Creeping inflation is an inflation that proceeds for a long time at a moderate and fairly steady pace.

Galloping inflation is an inflation that proceeds at an exceptionally high rate, often for only a brief period.In 1993, Brazil experienced inflation rates

of 2,700%

Inflation

The Costs of Inflation

The main cost of inflation is the loss of efficiency that results because inflation distorts price signals. For example…People invest in assets designed to protect

them against inflation, such as real estate, rather than in productive investments that enhance the growth and efficiency of the economy.

Business collect bills more promptly, using resources that could otherwise have been used to produce goods and services.

Individuals reduce money holdings, which is inconvenient and misallocates the individual’s personal resources of time, energy , and leisure.

In the case of hyperinflation, inflation over 100%, the currency system breaks down and the economy reverts to barter.

The Costs of Inflation

Purchasing Power and Inflation Inflation erodes the purchasing

power of a given sum of money.Assume you have $10,000 and the

price level is 1.• In current dollars, you have $10,000,

and in constant dollars you have $10,000.

Now let the price level rise to 2.• In current dollars, you still have

$10,000, but in constant dollars you now have ??? ?

The rise in the price level has decreased the purchasing power of your money.

Purchasing Power and Inflation

Price Indexes

Consumer Price Index (CPI)The CPI is calculated by observing

changes in the cost of purchasing a typical bundle of consumer goods and services.

• The CPI is a weighted average of all prices, with the weights given by the relative importance of different goods or services in the typical bundle of purchases.

GDP DeflatorThe GDP deflator is the ratio of

GDP valued at current prices and GDP valued at base year prices. For example, if 1992 is the base year, the GDP deflator is:

• (GDP valued in 1999 prices/GDP valued in 1992 prices)100

Price Indexes

The GDP Deflator and the CPI There are 4 major differences between

the GDP deflator and the CPI.The CPI reflects prices of only consumer

goods and services: The GDP deflator includes prices of all output.

The CPI incorporates prices of imports: The GDP deflator does not.

The CPI is calculated by tracking over time the cost of a fixed basket of goods and services: The GDP deflator allows the output basket to change.

Once published, the CPI is never revised: The GDP deflator changes with GDP revisions.

The GDP Deflator and the CPI

Which Movies Were Most Profitable?

E.T. Gone with the Wind Forrest Gump Star Wars Jurassic Park Empire Strikes Back The Sting

Movies: Receipts in Current Dollars E.T. $357.77 Jurassic Park $354.16 Forrest Gump $336.38 Star Wars $273.30 Empire Strikes Back $200.50 The Sting $128.67 Gone with the Wind $ 76.35

Movies: Year Released

The Empire Strikes Back 1980 Gone with the Wind 1939 Forrest Gump 1994 The Sting 1973 Jurassic Park 1993 E.T. 1982 Star Wars 1977

Movies: Adjusted for Inflation

Gone with the Wind $859 Star Wars $628 E.T. $552 The Sting $397 Jurassic Park $375 The Empire Strikes Back $361 Forrest Gump $343

Millions of 1996 Dollars

Movies: Receipts in Constant Dollars

Receipts in $1996 = Nominal receipts x (1996 price level/Year movie released price level).

Gone with the Wind $76.35 x 108/9.61 = $859 Star Wars $273.3 x 108/47 = $628 E.T. $357.77 x 108/70 = $552 The Sting $128.67 x 108/35 = $397 Jurassic Park $354.16 x 108/102= $375 Empire Strikes Back $200.5 x 108/60 = $361 Forrest Gump $333 x 108/105 = $343

Movies: Receipts in Current Dollars

Nominal Receipts = Inflation adjusted receipts x (Year movie released price level/1996 or base price level).

E.T. $552 x 70/108 = $357.77 Jurassic Park $375 x 102/108 = $354.16 Forrest Gump $346 x 105/108 = $336.38 Star Wars $628 x 47/108 = $273.30 Empire Strikes Back $361 x 60/108 = $200.55 The Sting $397 x 35/108 = $128.67 Gone with the Wind $859 x 9.6/108 = $ 76.35

The

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