Macro Unit 2

Topic 2.1 & 2.2 - Circular Flow & Gross Domestic Product (GDP)
Macroeconomics - is the study of the of the ____________________, _____________________,
______________________, and _____________________ of an economy as a whole. It can be applied to regional, national,
or global economies.

Why Study Macro?

1.​ Measure the health of the whole economy.
2.​ Guide government policies to fix economic problems.

Main Measures of Macroeconomics (we will focus on these throughout the unit)
​ 1. Economic growth - The increase in the size of an economy over time, which is usually measured by the total production of
goods and services, or gross domestic product (GDP).
​ 2. Unemployment - The state of being without a job while actively looking for one. The unemployment rate is the percentage of
people in the labor force who are unemployed.
​ 3. Inflation - The gradual loss of purchasing power over time, which is reflected in a general increase in prices for goods and
services

The Circular Flow Model

The Product Market-
•​The “place” where goods and services produced by businesses are
sold to households.
The Resource (Factor) Market-
•​The “place” where resources (land, labor, capital, and
entrepreneurship) are sold to businesses.
Three Major Macroeconomics Goals
1.​ Promote Economic Growth - Growth is measured using changes in ______________________________ product. (2.1 & 2.2)
2.​ Limit Unemployment - ____________________ rate. (2.3)
3.​ Keep Prices Stable (Limit Inflation) - Inflation is measured using ____________________________ index or
______________________________ deflator. (2.4 - 2.6)

National Income Accounting - economist measure how much stuff is made or consumed in an economy in one year using (we focus
primarily on expenditures in AP Economics)
1.​ Income Approach - measure how much income everyone made in an economy in one year (income earned from goods &
services)
2.​ Expenditures Approach - measure how much everyone in an economy spent on goods and services in one year.
3.​ Value-Added Approach - adds up all the dollar value added at each stage of the production process.

Income = Expenditures = Value-Added

ALL must be equal!

The Expenditure Approach is our main focus to measuring output in an economy and is calculated using GDP.

Gross Domestic Product (GDP) - is the dollar value of all final goods and services produced within a country’s borders in one year.
●​ Dollar value - GDP is measured in dollars.
●​ Final Goods - GDP does not include the value of intermediate goods (goods used to make final goods)
●​ Within a Country - GDP measures production within the country’s borders
●​ One Year - GDP measures annual economic performance.

Measure Growth using

Percentage Change in GDP

Standard of Living is measured using GDP Per Capita, which is calculated by dividing GDP by a nation __________________ size.

Some countries with high GDP actually have low GDP per capita & vice-versa
Some countries have higher GDP or GDP Per Capita for the following reasons:
1. Economic System- Capitalism promotes innovation and provides incentives to improve productivity.
2. Rule of Law- Countries with solid institutions and political stability have historically had more economic growth.
3. Capital Stock- Countries that have more machines and tools are more productive.
4. Human Capital- Countries that have better education and training are more productive.
5. Natural Resources- In general, countries that have access to more natural resources are more productive.

* economics systems is one of the current hot topics in Macroeconomics research*

Expenditures Approach to National Income- Four Components of GDP - very important!

1. Consumer Spending- ≈ 70% of U.S. GDP Purchases of final goods and services by individuals.
Ex: $5 Sandwich at Subway
2. Business Investment- ≈ 16% of U.S. GDP. Businesses spending on tools and equipment.
​ Ex: Walmart buys self checkout machines.
3. Government Spending- ≈ 17% of U.S. GDP.
Ex: Schools, roads, tanks (NOT transfer payments or subsidies)
4. Net Exports- Exports (X) – Imports (M) ≈ -3%
Ex: Value of 3 Ford Focuses made in Michigan minus 2 Hondas made in Japan.

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

The Income Approach to National Income - adds up all the income earned from factors of production.
(land,labor,capital,entrepreneurship)
1. Labor Income - Wages earned from performing work.
2. Rental Income - Income earned from property owned by individuals.
3. Interest Income - Interest earned from loaning money to businesses.
4. Profit - Money businesses have after paying all their costs.

Value-Added Approach to National Income - adds up the value of intermediate all intermediate goods & services.

What is not Included in GDP?

1._______________________Goods​ 2. Non-_________________ Transactions ​ 3. Non-Market & ______________ Activities
​
Breaking Down GDP = C + I + G + Xn
Consumer Spending - private sector spending on goods & services
●​ Durable Goods - Goods that last a while (generally more than 3 years) ​
○​ Washing machine, refrigerator, cars, ovens, etc.
●​ Non-Durable Goods - goods that are consumed relatively quickly.
○​ Foods, clothes, toiletries, school supplies, etc.
●​ Services
○​ Dental work, repairs, tutoring, etc.
Investment Spending - when businesses buy capital goods like machines, tools, and factories
●​ Buying stocks and bonds is how the word “investment” is used in finance. When individuals invest in stocks and bonds,
businesses use this money to buy capital goods.
Government Spending - public sector/government spending on goods and services or capital
●​ transfer payments or subsidies are not included in G because that money will be spent by someone else
Net Exports - spending on exports to other countries minus spending imports from other countries.

EX1: Determine if each spending is included or not included in U.S. GDP. If included,
identify C,I,G, or Xn
1.​ $10.00 for movie tickets
2.​ $5M Increase in defense expenditures
3.​ $45 for used economics textbook
4.​ Ford makes new $2M factory
5.​ $20K Toyota made and sold in Mexico
6.​ $10K Profit from selling stocks
7.​ $15K car made in US, sold in Canada
8.​ $10K Tuition to attend college
9.​ $120 Social Security payment to Bob
10.​ Farmer purchases new $100K tractor
​
Topic 2.3 - Measures of Unemployment
Unemployment- Workers that are _______________ _____________for a job but aren’t working.

The Unemployment Rate- The _________________ of people in the labor force who want a job but are not working.​

Who is in the Labor Force?

●​ At least 16 years old
●​ Able and willing to work
●​ Not institutionalized (in jails or hospitals)
●​ Not in military, in school full time, or retired

Three Types of Unemployment

1.​ Frictional Unemployment - _________________ unemployment or being between jobs. Individuals are qualified workers with
transferable skills.
Examples:
●​ High school or college graduates looking for jobs.
●​ Individuals that were fired or quit to look for a better job.
●​ Seasonal Unemployment is a specific type of frictional unemployment, which is due to time of year and the nature of the
job.

2.​ Structural Unemployment - Changes in the labor force make some skills _________________. These workers DO NOT have
transferable skills and these jobs will never come back. Workers must learn new skills to get a job.
●​ The permanent loss of these jobs is called “creative destruction.”
○​ Examples: VCR repairman, Milkman, payphone operator
●​ Technological Unemployment- Type of structural unemployment where automation and machinery replace
workers.

3.​ Cyclical Unemployment - Unemployment caused by a ____________________. As demand for goods and services falls,
demand for labor falls and workers are laid off.
○​ This is sometimes called “demand ____________________ unemployment.”
○​ Steel workers laid off during recessions.
○​ Restaurant owners lay off waiters after months of poor sales due to recession.
The Natural Rate of Unemployment (NRU) - When only frictional and structural unemployment is present in the economy at any
given time. Frictional & Structural unemployment are considered “natural” in a healthy economy.

Natural Rate of Unemployment (NRU)- Frictional plus structural unemployment. The amount of unemployment that exists when the
economy is healthy and growing. The U.S. has a NRU of 4-6%.

Full Employment Output (Y)- The Real GDP created when there is no cyclical unemployment.
●​ The US is at full employment when it is experiencing only the NRU of 4-6% unemployment.

Example: The U.S. is currently at an unemployment rate of 9%. What must be true?

Question: The Natural Rate of Unemployment in France and Germany is 8-10%, but is only 4-6% in the United States. Why might this
be?

Critiques of the Unemployment Rate (why the unemployment rate may misrepresent actual employment rates)
Discouraged Workers-
•​Some people are no longer looking for a job because they have given up.
Labor Force Participation Rate
Percent of population in the labor force.
If people leave labor force the unemployment rate falls
Underemployed Workers-
•​Someone who wants more hours but can’t get them is still considered employed.
Race/Age Inequalities-
•​The overall unemployment rate doesn’t show disparity for minorities and teenagers

Example: Draw a PPC with consumer goods on the horizontal axis and capital goods on the vertical axis, then draw a business cycle
showing the same corresponding points.

Assume the natural rate of unemployment is between 4%-6%.

Add the following points to your graphs:

​ Point A - unemployment rate of 8%

​ Point B - unemployment rate of 5%
​ Point C - unemployment rate of 1%
Topic 2.4 - Measuring Inflation (Using the Consumer Price Index)

Inflation - rising general level of prices and it reduces the “purchasing power” of money.
●​ Examples:
○​ It takes $2 to buy what $1 bought in 1987.
○​ It takes $6 to buy what $1 bought in 1970.
○​ It takes $24 to buy what $1 bought in 1913.

When inflation occurs, each dollar of income will buy fewer goods than before. Some Inflation is necessary as a result of a growing
economy. However, unexpected inflation is what economists worry about and what causes economic damage.

The government tracks the prices of specific “market baskets” that include the same goods and services.
There are two ways to look at inflation over time:
The Inflation Rate- The percent change in prices from year to year.
Price Indices- Index numbers assigned to each year that show how prices have changed relative to a specific base year.
Examples:
•​The U.S. inflation rate in 2014 was 0.8%.
•​The Consumer Price Index for 2014 was 235 (base year 1982). This means that prices have increased 135% since 1982.

Consumer Price Index (CPI)

CPI is the most commonly used, but not the only, measurement of inflation for consumers.

Here is how it works:

•​ The base year is given an index of 100.
•​ To compare, each year is given an index # is computed as well.
•​ Use the percentage change formula calculate inflation
•​ If finding inflation since the base year, then the difference is the inflation rate.

Example:
1997 Market Basket: Movie is $6 & Pizza is $14
Total = $20 (Index of Base Year = 100)

2009 Market Basket: Movie is $8 & Pizza is $17

Total = $25 (Index of 125)

•​This means inflation increased 25% between ’97 & ‘09

•​Items that cost $100 in ’97 cost $125 in ‘09
Example:

Use Year 1 as the Base Year

Good Year 1 Year 2 Year 3
●​ What is the CPI for Year 1?
1 lb of Apples $1.00 $2.00 $2.50
●​ Calculate the CPI for Year 2?
1 lb of Bananas $.25 $.50 $.75
●​ What is the Inflation Rate in Year 2 since the base year?
1 Gallon Milk $1.75 $2.50 $2.75

●​ Calculate the CPI for Year 3? Cost of Market

Basket (COMB)
●​ What is the Inflation Rate in Year 3 since the base year?

●​ What is the Inflation Rate between Year 2 and Year 3?

Problems with Using CPI as a Measure of Inflation (over and underestimating inflation)
1.​ Substitution Bias - As prices increase for the fixed market basket, consumers buy less of these products and more substitutes
that may not be part of the market basket. (Result: CPI may be higher than what consumers are really paying.)

2.​ New Products - The CPI market basket may not include the newest consumer products. (Result: CPI measures prices but not
the increase in choices.)

3.​ Product Quality - The CPI ignores both improvements and decline in product quality. (Result: CPI may suggest that prices stay
the same though the economic well being has improved significantly.)
Topic 2.5 - Economic Costs of Unanticipated Inflation
Costs of Inflation
1. Menu Costs - the real cost of changing listed prices.
Businesses must update menus, signage, advertising, etc.
2. Shoe Leather Costs - the increased costs of transactions.
People reduce their real money holdings so they must spend time and effort making additional trips to the bank.
3. Unit of Account Costs - currency is no longer reliable as a way of measuring value.
Leads to less efficient use of resources because of uncertainty caused by changes in currency value.

Effects of Unanticipated Inflation on Borrowing & Saving

Identify which people are helped and which are hurt by unanticipated inflation.
1.​ A man who lent out $500 to his friend in 1960 and gets paid back in 2018.
2.​ A tenant who is charged $850 rent each year.
3.​ An elderly couple living off fixed retirement payments of $2000 a month.
4.​ A man that borrowed $1,000 in 1995 and paid it back in 2014.
5.​ A woman who saved $500 in 1950 by putting it under her mattress.
Topic 2.6 - Measuring Inflation: Real GDP vs. Nominal GDP
Using the GDP Deflator

Nominal GDP is GDP measured in current prices. It does not account for inflation from year to year.

Real GDP is GDP expressed in constant, or unchanging, dollars. Real GDP is adjusted for inflation.
●​ Aka Real GDP is deflated using the GDP Deflator
​
EX: If apples are the only thing being produced in an economy
​ Year 1: 10 apples at $1 each; GDP = $10
​ Year 2: 10 apples x $1.25; GDP = $12.50

Notice: Nominal GDP went up 25% ($2.50). However, nothing new was produced. If we use Year 1 prices we can see that Real GDP is still $10.
(nothing new was produced)

Calculating the GDP Deflator

​ ​

Nominal GDP = Quantity * Prices in a Year​ ​ Real GDP = Quantity * Prices in the Base Year

●​ The GDP deflator measures the prices of all goods

produced, whereas the CPI measures prices of only the
goods and services bought by consumers.
●​ An increase in the price of goods bought by firms or the
government will show up in the GDP deflator but not in
the CPI.
●​ The GDP deflator includes only those goods and
services produced domestically. Imported goods are not
a part of GDP and therefore don’t show up in the GDP
deflator.

Ex1:
Calculate the table to the right using year 1 as base

Calculate the table to the right using year 3 as base

Ex2:
1.​ In an economy, Real GDP (base year = 1996) is $100 billion and the Nominal GDP is $150 billion. Calculate the GDP deflator.

2.​ In an economy, Real GDP (base year = 1996) is $125 billion and the Nominal GDP is $150 billion. Calculate the GDP deflator.

3.​ In an economy, Real GDP for year 2002 (base year = 1996) is $200 billion and the GDP deflator 2002 (base year = 1996) is 120.
Calculate the Nominal GDP for 2002.

4.​ In an economy, Nominal GDP for year 2005 (base year = 1996) is $60 billion and the GDP deflator 2005 (base year = 1996) is 120.
Calculate the Real GDP for 2005.

Ex3:
Topic 2.7 - The Business Cycle
Causes of Inflation and The Quantity Theory of Money

The Business Cycle

Label the key features of the business cycle:

Inflationary/Positive Output Gap:

Recessionary/Negative Output Gap:

Recession:

Three Causes of Inflation

1)​ The Government Prints too Much Money
a)​ The Quantity Theory of Money states MV = PY
■​ M = Money Supply​ V = Velocity of Money​ P = Price Level Y = Quantity of Output
■​ Notice that PY = Nominal GDP
b)​ Ex: Assume money supply is $5 and it is being used to buy 10 products with a price of $2 each.
■​ How much is the velocity of money
■​ If the Velocity and Output stay the same, what will happen if the amount of money is increased to $10?
2)​ Demand-Pull Inflation (demand increases driven inflation)
a)​ DEMAND PULLS UP PRICES!!! “Too many dollars chasing too few goods”. An overheated economy with excessive spending but
same amount of goods.
3)​ Cost-Push Inflation (supply shortages drive inflation)
a)​ Higher production costs increase prices.
■​ A negative supply shock increases the costs of production and forces producers to increase prices.