Basic Macroeconomic Concepts

Note: Only print out my notes for class. Do not print out all the links that you can explore here.

GDP

GDP (GROSS DOMESTIC PRODUCT): the money value of all final goods and services produced in a country's borders in a given year. GDP is not a perfect measure of the "health" of the economy because it fails to directly account for certain quality of life factors and makes arbitrary adjustments on others. For example, earthquakes and natural disasters can increase GDP because of the rebuilding that is necessary. Moreover, GDP does not reflect the state of the environment or the value of "leisure" time. Nevertheless, it is perhaps the single most important statistic that describes the economy.

If we divide GDP by the population, we calcuate GDP per capita. This tells us how wealthy our nation's citizens are on average. Note, however, that GDP only tells us about averages and tells us nothing about the distribution of the wealth. For that we need to look at statistics on income distribution.

Click here to see a table of GDP data from 1947 to the present, posted at the St. Louis Federal Reserve web site. GDP Data

GDP does not include:
  • sale of used goods (used cars)
  • sale of intermediate goods (raw materials)
  • illegal transactions (drugs, gambling)
  • purely financial transactions (stocks,bonds)
  • non-market transactions (do-it-yourself repairs, homemakers)
  • imports (goods made outside U.S. borders)

Gross National Product (GNP)

GNP was used in the US before 1991, then we switched to GDP. (Nominal) GNP is the money value of all final goods and services produced by a country's citizens in a given year.

Click here to see GNP data from 1947 to the present: GNP Data

GDP = GNP + production in US by foreign owned firms - production abroad by US firms

The Business Cycle

The cyclical behavior of economy's output is known as the business cycle. The downward periods of negative real growth in GDP are called recessions. The up-trends are periods of economic growth, or the boom of the cycle. A recession is defined as six consecutive months of negative growth in real GDP.

Stabilization Policy

Goals of Stabilization Policy:
  1. achieve stable prices (low inflation)
  2. achieve full employment (low unemployment)
  3. achieve robust economic growth (growth of GDP)

In other words, we are trying to smooth the business cycle. We will first examine price indices to see how inflation is calculated and then return to issues of inflation and unemployment.

Economy at a Glance

Click here to see major economic indicators published by the Bureau of Labor Statistics

PRICE INDICES

Constructing a Price Index

A price index is a device for measuring price level changes by tracking the price of a designated bundle of goods through time with respect to a base year.

A price index will allow us to measure inflation and convert nominals to reals.

To construct a price index:

  1. Select a base year. Price Index for base year = 100
  2. Select a bundle of goods, whose prices will be monitored over time.
  3. Compute the cost of the goods in your bundle in the base year.
  4. Compute the cost of the goods in your bundle in the year you wish to compare to the base year (year i).
  5. Apply the following formula:

PI(i) = (Cost of bundle in year I ) / (Cost of bundle in base year) x 100

where PI(i) is the price index in year i.

Example: 1. Base year = 1990. PI(1990) = 100. 2. Bundle = 1 shirt, 1 movie, 2 Cokes.

Year1 Shirt1 Movie1 Coke
1990$20$7$.50
1991$20$7.50$.50
1992$21$7.50$.75

3. Cost of bundle in 1991 is $28.50.

4. Cost of bundle in 1992 is $30.

5. PI(1991) = (28.50 / 28.00) × 100 = 101.8, PI(1992) = (30.00 / 28.00) × 100 = 107.1

Using the Price Index to Measure Inflation

The inflation rate is the percent change in the price index from one year to the next.

inflation rate(t) = [[P(t) - P(t-1)] / P(t-1)] × 100

This formula calculates the inflation rate in year t by taking the percent change in the price indices of year t (the current year) and year t-1 (i.e. last year).

Example:

Inflation rate in 1991 = (101.8 - 100)/100 × 100 = 1.8%

Inflation rate in 1992 = (107.1 - 101.8)/101.8×100 = 5.21%

Deflating Nominals to Reals

A nominal value is not corrected for the effects of inflation.

-A real value is corrected for the effects of inflation

Example: A coat costs $50 in 1991 and $57 in 1992. In real terms, in which year is the coat cheaper?

Part of the reason that the coat is more expensive in 1992 is because the price level has increased. To make a meaningful comparison, we have to remove this price effect. We must "deflate the nominal values."

Deflating is the process of deriving the real value of some nominal value by dividing by an appropriate price index. The formula is the following:

Real Value(i) = Nominal Value(i)/ Price Index(i) x 100

Example: The coat that cost $50 in 1991 is worth $50/101.8 × 100 = $49.12 in 1990 dollars, and the same coat in 1992 is worth $57/107.1 × 100 = $53.22 in 1990 dollars, so the coat is cheaper in real terms in 1991.

Example: Fill in the table below: the base year is 1992.

YearNominal GDPReal GDPPrice IndexInflation RateGrowth Rate
1991499597--------
19925014
199353153%

Inflation

Inflation is a sustained increase in the price level. The Price Level is the weighted average of all prices in the economy.

Click here to see a chart of inflation rates for the United States.

Click here to see inflation rates for the United States: Inflation Rates

Costs of Inflation

Myth of inflation: it erodes wages over the long-term. In fact, wages tend to keep pace with or surpass wages over the long term.

The costs of inflation depend on whether inflation is anticipated or unanticipated:

Costs of anticipated (completely expected) inflation:

  1. shoe-leather costs: costs of financial management
  2. menu costs: physical costs of changing prices (i.e. printing new menus).
  3. tax costs: even if inflation is anticipated, if the tax laws are not adjusted for inflation, inflation may cause the tax bill of an individual to rise. (ex. capital gains taxes, bracket creep)

Costs of unanticipated (unexpected) inflation:

  1. arbitrary redistribution of income. Example: mortgage borrowing.
  2. inflation uncertainty. It becomes more difficult to enter into transactions when future inflation is uncertain.
  3. Hyperinflation: Hyperinflation is inflation that proceeds at exceptionally high rates. Examples: Germany, Oct. 1923, inflation was 29,586%, in Nicaragua, 1988, inflation was 33,602%, and in Brazil, 1990, inflation was 2,360%. Hyperinflation is ultimately caused by creation of money that gets out of control (often to pay off debts).

Types of Inflation:

Demand-pull inflation: inflation is due to increases in demand for goods and services

Cost-Push Inflation: inflation is due to increases in production costs (ex. oil shocks)

UNEMPLOYMENT

Measuring Unemployment

For an elaborate discussion of how the BLS measures unemployment, visit the BLS site by clicking here:

How the BLS Measures Unemployment

Each month the BLS (Bureau of Labor Statistics) polls over 50,000 households either in person or by phone. The respondents of the survey are classified into one of three categories: not in labor force, unemployed, or employed. The Criteria for being counted in each group are clearly summarized in the link above.

The unemployment rate is the percentage of the labor force that is unemployed.

Unemployment Rate = unemployed/labor force × 100

Click here to see a chart of US unemployment.

To see historical US unemployment rates, click here: Unemployment Rates

Criticisms of the Unemployment Rate

  1. Does not include discouraged workers: those who have given up looking for work because they could not find a job. (understates unemployment)

  2. Does not account for the "hidden unemployment." "Hidden" unemployment includes those who are working part-time but wish to have a full-time job, and those who are grossly overqualified for their positions, the underemployed. (understates unemployment)

  3. To be unemployed, a person must only "say" he has actively sought work. (overstates unemployment)

Types of Unemployment

  1. Frictional unemployment: those unemployed due to the natural movements in and out of labor force. Short-term, voluntary.

  2. Structural unemployment: those unemployed due to changing technology and competitiveness. (Ex: laid off defense workers, those unemployed when a firm moves overseas.) Long-term, involuntary.

  3. Cyclical unemployment: those unemployed due to the downturn in the business cycle. Goal of stabilization policy is to achieve zero cyclical unemployment.

Frictional and structural unemployment are unavoidable in a dynamic economy. These two combined are called the Natural Rate of Unemployment, or the full-employment rate of unemployment. The Natural Rate of unemployment is estimated to be about 5.5%.

Costs of Unemployment

The costs of unemployment are the goods and services that might have been produced and consumed that are lost forever.

Cost of unemployment = Potential output - Actual output

where potential output is the level of GDP the economy would attain if all resources were fully employed. During recessions when unemployment is high, some labor is sitting idle and that lost work can not be made up.

There are also significant, noneconomic costs of unemployment such as individual and family stress.

This module contains a PowerPoint slide show.