Unit 2

Economic Indicators and the Business Cycle: the one-page sheet

2.1 The Circular Flow and GDP

The circular flow shows households selling factors of production to firms and buying their output, so spending on final goods equals income. GDP is the market value of final goods and services produced within a country in a year, measured by C + I + G + (X − M) . Intermediate goods, used goods, financial trades and transfer payments are left out.

GDP is the market value of all final goods and services produced within a country in a year.
The expenditure approach: $GDP$ $= C + I + G + (X - M)$ . Imports are subtracted because they are already inside C, I and G but were made abroad.
In GDP, investment means new capital, new homes and added inventory, not buying stocks.
Left out: intermediate goods (double counting), used goods, stocks and bonds, and transfer payments. Counting each stage's value added gives the same total as counting final goods.

firms receive that spending as revenue they pay wages, rent, interest and profit to households in the factor market they spend it again, so total spending on final output equals total income intermediate goods, used goods, financial trades and transfer payments are left out

circular flow model: A model of the economy in which households sell factors of production to firms for income and spend that income on firms' goods and services, so money and goods flow in opposite loops.
gross domestic product: Gross domestic product: the market value of all final goods and services produced within a country in a given year.
expenditure approach: Measuring GDP by adding spending on final goods and services: consumption + investment + government purchases + net exports, or $C + I + G + (X - M)$ .
final goods: Goods and services bought by their final users. Intermediate goods are used up to make other goods and are left out of GDP; value added is a firm's sales minus what it paid for intermediate goods.
exports: Exports are goods and services produced at home and sold abroad; imports are produced abroad and bought at home. Net exports are $X - M$ .
transfer payments: Payments from the government to people, such as pensions and other benefit checks, for which no good or service is produced in return. They are not part of GDP.

2.2 Limitations of GDP

GDP measures market production, so it leaves out nonmarket activity such as home production, the underground economy, the value of leisure and environmental damage, and it can miss quality gains. To compare living standards, use GDP per capita (GDP divided by population), keeping in mind that an average hides how income is shared.

Nonmarket activity (cooking for your family, volunteering) and the underground economy (unreported cash work) are left out, so GDP understates production.
GDP gives no value to leisure, does not subtract pollution, and can miss quality improvements.
GDP per capita = GDP divided by population: the better measure for comparing material living standards.
GDP per capita is an average: it says nothing about how income is shared, health or the environment.

unpaid home production, volunteer work and leisure are left out the underground economy is missed and measured GDP understates production cleaning up pollution raises GDP while the damage itself is not subtracted GDP per capita (output divided by population) is used to compare living standards, though it hides how income is shared

nonmarket activity: Production not sold in a market, such as cooking for your own family or volunteer work. The underground (informal) economy is market activity that goes unreported. Both are missing from measured GDP.
GDP per capita: GDP divided by population: output per person, the usual measure for comparing material living standards across countries or over time.

2.3 Unemployment

The labor force is the employed plus the unemployed; the unemployment rate divides the unemployed by the labor force, and the participation rate divides the labor force by the adult population. Frictional and structural unemployment make up the natural rate; cyclical unemployment is the actual rate minus the natural rate. Discouraged and underemployed workers make the official rate understate joblessness.

Labor force = employed + unemployed. Unemployment rate $= \frac{\text{unemployed}}{\text{labor force}} \times 100$ ; participation rate $= \frac{\text{labor force}}{\text{adult population}} \times 100$ .
Frictional: searching between jobs. Structural: skills or location do not match the jobs. Cyclical: caused by a downturn in spending.
Natural rate = frictional + structural; actual = natural + cyclical. Full employment does not mean zero unemployment.
Retirees and discouraged workers are outside the labor force; part-time workers who want full-time jobs count as employed.

they are counted as unemployed and are in the labor force they become a discouraged worker, outside the labor force, so the measured rate understates joblessness firms lay off workers and cyclical unemployment rises above zero the actual rate equals the natural rate (frictional + structural): full employment

labor force: Everyone who is employed or unemployed. The labor force participation rate is the labor force divided by the adult population, times 100.
unemployment rate: The percent of the labor force that is unemployed: unemployed divided by labor force, times 100. A person is unemployed if they have no job, are available and looked for work recently.
frictional unemployment: Unemployment while people search between jobs or enter the labor force, such as a nurse who moved and is applying for nursing jobs.
structural unemployment: Unemployment when workers' skills or locations do not match the jobs available, often after technology or the pattern of demand changes.
cyclical unemployment: Unemployment caused by a fall in total spending and output during a downturn; it equals the actual unemployment rate minus the natural rate.
natural rate of unemployment: The unemployment rate when cyclical unemployment is zero: frictional plus structural unemployment. When the actual rate equals it, the economy is at full employment.
discouraged worker: A person who wants a job but has stopped looking because they believe none is available. Discouraged workers are not in the labor force; underemployed workers have part-time jobs but want full-time ones.

2.4 Price Indices and Inflation

A price index compares the cost of a fixed basket with its cost in the base year (index 100). The consumer price index uses a basket households buy; the inflation rate is the percent change in the index. Dividing a nominal value by the index and multiplying by 100 gives a real value. Substitution bias, new goods and quality gains make the CPI overstate inflation.

CPI $= \frac{\text{cost of basket this year}}{\text{cost in base year}} \times 100$ . The base year is 100.
Inflation rate $= \frac{\text{new index} - \text{old index}}{\text{old index}} \times 100$ . Divide by the old index, not 100.
Real value $= \frac{\text{nominal value}}{\text{price index}} \times 100$ : what money buys in base-year dollars.
Deflation: prices fall. Disinflation: inflation slows but prices still rise. Substitution bias and quality gains make the CPI overstate inflation.

its cost this year divided by its cost in the base year, times 100, is the consumer price index the percent change in the index is the inflation rate their real wage (nominal wage divided by the index, times 100) falls the fixed basket overstates the rise in the cost of living (substitution bias)

price index: A number that compares the cost of a fixed market basket of goods in one year with its cost in a base year, where the index equals 100.
consumer price index: Consumer price index: the cost of a basket of goods and services that typical households buy, divided by its cost in the base year, times 100.
inflation: A rise in prices in general across the economy. The inflation rate is the percent change in a price index from one period to the next.
deflation: A fall in prices in general, so the inflation rate is negative. Disinflation is different: inflation slows, but prices are still rising.
substitution bias: The overstatement of inflation by a fixed-basket index when people switch from goods whose prices rose to cheaper substitutes.
real value: A nominal value (in dollars of the day) adjusted for prices: nominal value divided by a price index, times 100. A real wage is what a nominal wage buys in base-year dollars.

2.5 Costs of Inflation

When inflation is higher than people anticipated, fixed-rate borrowers repay in dollars that buy less, so they gain while lenders, savers and people on fixed incomes lose; lower-than-anticipated inflation reverses this. Anticipated inflation is built into contracts. Any inflation brings menu costs and shoe-leather costs, and unpredictable inflation makes long-term planning harder.

Unanticipated inflation helps fixed-rate borrowers and hurts lenders, savers and people on fixed incomes. Lower-than-anticipated inflation, or deflation, does the reverse.
Anticipated inflation is built into interest rates and contracts, so it moves much less purchasing power.
Menu costs (changing prices) and shoe-leather costs (holding less cash) come with any inflation.
Indexing pay or pensions to the CPI protects people from inflation; uncertainty about inflation makes long-term plans riskier.

the dollars repaid on a fixed-rate loan buy less than both sides planned the borrower gains purchasing power and the lender loses it people on fixed incomes can buy less firms pay menu costs and households pay shoe-leather costs

unanticipated inflation: Inflation different from what people anticipated when they signed loans, wage contracts or pensions. Unanticipated inflation redistributes purchasing power; anticipated inflation is built into those agreements.
fixed income: An income set in dollars that does not rise with prices, such as a pension that pays the same amount each month. Unanticipated inflation hurts people on fixed incomes and lenders and helps fixed-rate borrowers.
menu costs: The costs to firms of changing prices often, such as reprinting menus and updating price tags. Shoe-leather costs are the time and effort people spend holding less cash when inflation erodes its value.

2.6 Real v. Nominal GDP

Nominal GDP values output at current prices; real GDP values it at base-year prices, so only real GDP changes with production. The GDP deflator is nominal GDP divided by real GDP times 100, and real GDP is nominal GDP divided by the deflator times 100. The growth rate of real GDP is its percent change, and real GDP per capita measures living standards.

Nominal GDP uses current prices; real GDP uses base-year prices, so it measures output.
GDP deflator $= \frac{\text{nominal GDP}}{\text{real GDP}} \times 100$ ; real GDP $= \frac{\text{nominal GDP}}{\text{deflator}} \times 100$ . Divide by the deflator, never multiply.
The deflator is an index (base year 100), not a percent or dollars. Below 100 means prices were lower than in the base year.
Growth rate of real GDP $= \frac{\text{new} - \text{old}}{\text{old}} \times 100$ , using real values. Real GDP per capita measures living standards.

it can rise because prices rose, because output rose, or both it changes only when quantities produced change the GDP deflator, a price index for everything produced real GDP, whose percent change is the growth rate of output

nominal GDP: GDP measured at the prices of the year the output is produced, so it rises when prices rise even if output does not.
real GDP: GDP measured at base-year prices, so it changes only when the quantity of goods and services produced changes. Real GDP = nominal GDP divided by the GDP deflator, times 100.
GDP deflator: A price index for all final goods and services produced in a country: nominal GDP divided by real GDP, times 100. It is 100 in the base year.
growth rate of real GDP: The percent change in real GDP from one period to the next: (new minus old) divided by old, times 100.

2.7 Business Cycles

Real GDP rises in expansions and falls in contractions around potential output, the full-employment level that grows over time. The output gap is real GDP minus potential: a negative (recessionary) gap brings cyclical unemployment, and a positive (inflationary) gap brings unemployment below the natural rate and rising inflation. Peak and trough are the turning points between the phases.

The business cycle has two phases, expansion (real GDP rising) and contraction (real GDP falling). The peak and trough are the turning points.
Potential output is real GDP at full employment (the natural rate of unemployment). It grows over time.
Output gap = real GDP - potential output. Negative (recessionary): cyclical unemployment. Positive (inflationary): unemployment below the natural rate and rising inflation.
A recession is a severe, lasting contraction. On a PPC, a recession is a point inside the curve; potential output is a point on it.

firms sell less, cut production and real GDP falls: a contraction there is a negative (recessionary) output gap cyclical unemployment rises and the unemployment rate goes above the natural rate unemployment falls below the natural rate and inflation tends to rise

business cycle: The repeated rise and fall of real GDP around its trend: an expansion (rising output) and a contraction (falling output), with a peak and a trough as the turning points. A severe, lasting contraction is a recession.
potential output: The real GDP an economy produces when unemployment is at its natural rate: full-employment output. It grows over time.
output gap: Real GDP minus potential output. A negative (recessionary) gap means output is below potential and there is cyclical unemployment; a positive (inflationary) gap means output is above potential.