Economic Rulers

GDP, Deflator, CPI, Unemployment Rate

Simple (Closed) Circular-Flow Diagram

The Expanded Circular-Flow Diagram

What is GDP?

• The total value of all final goods and services produced within a country in a given period of time

GDP formula

GDP =

C + I + G + (X – M)

Income (Y) =

C + I + G + (X – M)

AD (Aggregate Demand) =

C + I + G + (X – M)

Components of GDP

What’s included in GDP

• End Module 10

Nominal, Real, & per capita GDP

Nominal GDP (nGDP) uses current year prices. There are 2 reasons it could increase

-- more goods & services are produced by the economy

-- there is an increase in the price level (a.k.a. inflation)

-- ex: GDP is currently raising in the US, some economists think this is due to rise in price of oil.

Nominal, Real, & per capita GDP

Real GDP (rGDP) uses base year prices. This means that one year (e.g. 2000) is randomly picked and the prices for that year are used when totaling the RGDP for all the other years too. There is only 1 reason it could increase

-- more goods & services are produced by the economy

Nominal, Real, & per capita GDP

Per capita GDP:GDP divided by the size of the population; it is equivalent to the average GDP per person

-- the greater inequality that exists in income distribution, the less likely that per capita GDP will correspond to the “typical” person’s share of GDP (still standard and best measurement of standard of living within a nation)

Important:

• Real GDP = Nominal GDP – inflation

• Real interest rates = Nominal interest rates – inflation

• In Econ, NOMINAL stuff = REAL stuff but with inflation added!

This graph shows that while output at constant prices rose about four-fold, at current prices it rose about nineteen-fold or over four times as much.

Still important:

• The GDP Deflator is an instrument that measures the change in the price level of products but not changes in production (broadest price index)

The green line is inflation calculated from the quarterly GDP deflator numbers (% change from 4 quarters earlier).

The purple line is calculated from the monthly CPI-U index (% change from 12 months earlier).

FORMULAS (you know you love them)

Deflator = Nominal GDP x 100

Real GDP

Real GDP = Nominal GDP x 100

GDP Deflator

PRACTICEAssume the following:

Consumer Expenditures $600Business Expenditures $150Government Expenditures $200Imports $75Exports $65Transfer Payments $50Depreciation $25

1. Calculate the GDP for this economy.C + I + G + (X - M)

$940

PRACTICE2. The GDP figure that you calculated above is for Year 1

& is comprised of:90 econ texts @ $10 each40 econ workbooks @ $1 each

In Year 2 this same economy produced:90 econ texts @ $15 each40 econ worksheets @ $2 each

Calculate Nominal GDP for Years 1 & 2.(90 x $10) + (40 x $1)Year 1 GDP $940

(90 x $15) + (40 x $2)Year 2 GDP $1430

PRACTICE

3. Calculate the GDP deflator for this economy from Year 1 to Year 2 using the figures provided.

Nominal GDP/Real GDP x 100 $1430/$940 x 100 = 152.13

4. Calculate the real GDP for Year 2 for this economy.Nominal GDP/Deflator x 100

$1430/152.13 x 100 = $940.00

5. Calculate real GDP if in 2002 nominal GDP is $1000 and the deflator is 200.

Nominal GDP/Deflator x 100$1000/200 x 100 = 500

2B Friday 9.19

Breaking News…

GDP changes

Sometimes it goes up

Sometimes it goes down

This is called the business cycle

Parts of the Cycle

Peak – top of the cycle, prelude to recessionRecession – 2 consecutive quarters of negative growthTrough – bottom of the cycle (prob not a depression)Recovery – growth below the trend line (~3%)Expansion – growth above the trend lineBoom – an unusually sharp period of growth; steep slope

EXTREME Cycling:Hyperinflation

• Extreme, rapid, pervasive inflation

• Leads to the breakdown of the economic system

• Spend, don’t lend• Encourages speculation,

hoarding, and investment in nonproductive wealth

• Inflation arbitrarily redistributes income

e.g. Argentina’s coupon barter system

e.g. African entrepreneur’s refrigerator wealth

EXTREME Cycling:Hyperinflation

EXTREME Cycling:Depression

• A severe and prolonged recession

• Not seen in the U.S. since the 1930s

• Unlikely to recur due to automatic stabilizers and more activist fiscal and monetary policies

EXTREME Cycling:Depression

• Unemployment wastes resources & drains the economy

• Long-term unemployment has been associated with increased homicides, suicides, heart disease, and mental illness

Extremes are Yucky!

Employment Act of 1946 has stated it is the “responsibility of the U.S. government to promote full employment and production.” (i.e. stable growth and full employment)

Stable growth: increasing GDP without ruinous inflation; growth achieved either through an increase in inputs or an increase in productivity

*productivity is the best key to long term growth

Full Employment

• Everyone able and willing to work has a job

OR• No cyclical

unemployment• 3 – 6%• a.k.a. “the natural

rate of unemployment”

Limitations of GDP as an Economic Indicator

• Doesn’t count illegal activity• Doesn’t count legal activity which goes unreported

to evade taxes• Doesn’t count production outside of the market

economy

Limitations of GDP as an Economic Indicator

• Doesn’t indicate income distribution• Doesn’t count environmental effects

Limitations of GDP as an Economic Indicator

• Doesn’t count the value of leisure• Doesn’t count improved product quality

The Economic Supervillian:

Inflation and Unemployment

Inflation Bc

• Inflation is a sustained & widespread rise in prices

• Measured by a change in some price level index

• All indexes express the cost of a market basket of goods relative to its cost in some base year

• Base year = 100

The Consumer Price Index

• The Consumer Price Index (CPI) is the most popularly used measure of inflation

• The CPI measures the overall cost of goods and services bought by the “typical” consumer

• The CPI is a weighted index

The Consumer Price Index

“A tsk-it, a tas-kit: the CPI (weighted) basket”

Housing (includes rent,

insurance, maintenance,

utilities, etc.)

41%

Food & Beverages

17%

Transportation

17%

The Consumer Price Index

“A tsk-it, a tas-kit: the CPI (weighted) basket”

Medical Expenses

7%

Clothing

6%

Entertainment

4%

“Other”

7%

Calculate Inflation with the CPI by…

1. Fixing the basket (fixed items, fixed quantity

2. Identifying prices at various points in time

3. Totaling the basket’s cost

4. Choosing a base year & computing the index

Calculate Inflation with the CPI by…

4b. CPI Formula:

Current basket amount

Base basket amount

5. Computing the Inflation Rate

CPI Yr 2 – CPI Yr 1

CPI Yr 1

X 100 = CPI

X 100 = inflation rate

Practice

The only things Logan citizens ever consume are bananas and laffy taffy. Each year consumers purchase 3 laffy taffy and 2 bananas.

LTLT BananaBananass

20022002 $6.00$6.00 $1.00$1.00

20032003 $6.50$6.50 $1.25$1.25

20042004 $6.75$6.75 $1.40$1.40

20052005 $7.15$7.15 $1.50$1.50

Practice

LTLT BananBananasas

20020022

$6.0$6.000

$1.00$1.00

20020033

$6.5$6.500

$1.25$1.25

20020044

$6.7$6.755

$1.40$1.40

20020055

$7.1$7.155

$1.50$1.50

1. Calculate the total cost of what a typical consumer purchases in Logan in each of the years listed.

2002 ($6 x 3) + ($1 x 2) = $18 + $2 = $20

2003 ($6.50 x 3) + ($1.25 x 2) = $19.50 + $2.50 = $22

2004 ($6.75 x 3) + ($1.40 x 2) = $20.25 + $2.80 = $23.05

2005 ($7.15 x 3) + ($1.50 x 2) = $21.45 + $3 = $24.45

Practice

2. Using 2003 as the base year, calculate the consumer price index for each year.

2002 $20/$22 x 100

90.9

2003 $22/$22 x 100

100

2004 $23.05/$22 x 100

104.8

2005 $24.45/$22 x 100

111.1

LTLT BananBananasas

20020022

$6.0$6.000

$1.00$1.00

20020033

$6.5$6.500

$1.25$1.25

20020044

$6.7$6.755

$1.40$1.40

20020055

$7.1$7.155

$1.50$1.50

Practice

LTLT BananaBananass

20022002 $6.00$6.00 $1.00$1.00

20032003 $6.50$6.50 $1.25$1.25

20042004 $6.75$6.75 $1.40$1.40

20052005 $7.15$7.15 $1.50$1.50

3. Use the consumer price index figures from question 2 to calculate the rate of inflation from 2002 to 2003, 2003 to 2004, and 2004 to 2005.

2002-2003 (100 – 90.9) / 90.9 x 100

= 10%

2003-2004 (104.8 – 100) / 100 x 100

= 4.8%

2004-2005 (111.1 – 104.8) / 104.8 x 100

= 6.01%

Application: Real Wage Example

Knowing the inflation rate with the CPI allows economists to compare the prices of things across time (e.g. P of labor)

19701970 19801980 19901990 20002000

Average Average Hourly Hourly WageWage

$3.23$3.23 $6.66$6.66 $10.01$10.01 $13.75$13.75

CPICPI 38.838.8 82.482.4 130.7130.7 172.2172.2

Application: Real Wage Example

Find the decade with the highest real wage using the following formula:

Real Wage Yr X = Nominal Wage Yr X x 100 CPI Yr X

19701970 19801980 19901990 20002000Average Average Hourly Hourly WageWage

$3.23$3.23 $6.66$6.66 $10.01$10.01 $13.75$13.75

CPICPI 38.838.8 82.482.4 130.7130.7 172.2172.2

Application: Real Wage Example

Answer: $3.23 / 38.8 =

Base Year 1983 ($8.02); 2001 Av. Nom. Hrly Wage is $14.33 (CPI 177.1) By what % did real wages change ’83 to ’01?

*less than 1% increase in real wages

19701970 19801980 19901990 20002000Average Average Hourly Hourly WageWage

$3.23$3.23 $6.66$6.66 $10.01$10.01 $13.75$13.75

CPICPI 38.838.8 82.482.4 130.7130.7 172.2172.2Real Real

WageWage$8.32$8.32 $8.08$8.08 $7.66$7.66 $7.99$7.99

The Other Indexes

Producer Price Index (PPI)

-- broader index than the CPI and measures the cost of goods (intermediate / capital) and services (intermediate) bought by firms

Useful as a leading economic indicator – predicts changes in CPI 6 to 9 months prior to the occurance

The Other Indexes

GDP Deflator

-- broadest price index

-- NOT weighted

-- measures price level changes of the same quantity of GDP across time

Why Evil? Inflation’s WMD

Because money is earned and purchases are made through time, inflation has the potential to redistribute income.

Inflation decreases the purchasing power of dollars-- 1/price level = purchasing power

Lenders seek a “fair” return for the loan of their money:

Nominal i rate – real i rate = anticipated rate of inflation

Inflation Redistributes Income (Y)

• Net Debtors – amount borrowed > the amount saved / lent; GAINS

with unanticipated inflation because borrows dollars with a higher purchasing power than the dollars used to repay debt

• Net Creditors – amount saved / lent > the amount borrowed (e.g.

retirees); HURT with unanticipated inflation because the value of their assets decreases due to cheaper dollars (less purchasing power)

Inflation Redistributes Income (Y)

• Employers – GAIN if output prices rise

faster than wages (most common type of inflation); HURT if wages outpace output prices

• Employees – HURT if real wages are

decreased due to faster rising prices (usual case); GAIN if reverse is true (and do not lose job)

Inflation Redistributes Income (Y)

• Producers – GAIN if output

prices rise faster than costs (wages, machinery, inputs)

• Consumers – likely HURT

because of eroding real income (less purchasing power)

Inflation’s WMD

• Adds uncertainty to the economy (new ventures may be tabled due to the uncertain rate of return)

• Inflation distorts the economy by encouraging people to buy more (before the price goes up)

• Deflation – people buy less while waiting for further price decreases

Two Types of Inflation

• Cost-Push Inflation– Costs of production

increase forcing an increase in the price level

• Demand-Pull Inflation– Aggregate demand equals

total spending; “too many dollars chasing too few goods” bids up the price for goods and services

‘lation Review• Inflation

– General increases in all prices across the country (rule of thumb: keep under 3%)

• Disinflation– Inflation occurring but at a decreasing rate (lower rate

of inflation than before)• Deflation

– General decrease in prices across the country (Japan in 1990s; U.S. in 1930s)

• Hyperinflation– Collapse of the monetary system due to government

overprinting of money• Stagflation

– Supply shocks; both unemployment & inflation increase at the same time

Confessions: Index # Problem

• There is no perfect cost of living index because no two families buy the exact same bundle of goods (retirees v. teenagers)

• Substitution bias: prices change unevenly; consumers substitute toward less expensive goods

Confessions: Index # Problem

• Introduction of new goods: there is a time lag before new products are added to the basket

• Unmeasured quality changes: computers may cost slightly more but are more powerful, etc.

CPI v. GDP Deflator

Specialized (C only) broader (all production)

Includes imports (M) solely domestic production

Fixed basket (weighted) varied basket (unweighted)

Varied prices fixed dollars (prices)

*GDP Deflator tends to show slightly higher inflation compared to the CPI

UNEMPLOYMENT

Unemployment Rate:

# of unemployed people expressed as a % of the labor force

Unemployment Rate =

# unemployed Total Civilian Labor Force

X 100

Calculating Unemployment Rate Solutions

The following formulas should be used to answer the questions in this problem set:

Labor Force = # of employed + # of unemployed

Unemployment Rate = [(# of unemployed/labor force) x 100] %

Labor Force Participation Rate = [(Labor force/adult population) x 100] %

Adult population 200 million

Employed 125 million

Unemployed 8 million

Not in labor force 67 million

1. Calculate the size of the labor force.

Calculating Unemployment Rate Solutions1. Calculate the size of the labor force.

# employed + # of unemployed = (125 million + 8 million) =133 million in labor force

2. Calculate the unemployment rate.# of unemployed / labor force x 100 =

8 million / 133 million x 100 =6%

3. Calculate the labor-force participation rate.Labor Force / Adult Population x 100 =

133 million / 200 million x 100 =66.5%

Unemployment

• When actual GDP grows more slowly than potential GDP then unemployment rises

• When actual GDP grows faster than potential GDP then unemployment falls

Who Counts?U.S. population 280m (everyone in U.S.)

-70m (children & institutionalized)

Potential Labor Force 210m (out of labor force: retired, unpaid

-70m rich, students, discouraged)

Labor Force 140m

-2m (military)

Civilian Labor Force 138 million

Labor Force = labor force x 100

Participation Rate adult population

Who Counts?

*approximately 1/3 of adults are not in the labor force

Employment Definitions

Employed:anyone with a job – even part-time or over qualified

Unemployed:temporarily laid off or have actively looked for work in the past 4 weeks

Types of UnemploymentFrictional Unemployment

voluntarily left to improve job, short time off, or improve skills

Structural Unemployment

needs of the economy have shifted; no further demand for these workers; workers tend to be older, difficult to retrain, unable to find work near previous salary; fairly intractable problem

Types of Unemployment

Seasonal Unemployment:

temporary & due to the time of year; self-correcting

Cyclical Unemployment:

due to the business cycle (recession, etc.); focus of government policy

Tape Measure Problems: the unemployment rate

• Does not indicate underemployed workers• Doesn’t count discouraged workers (no longer

looking for a job)

Tape Measure Problems: the unemployment rate

• Does not indicate length of unemployment• Doesn’t count disguised unemployment

(involuntarily part-time work, loss of overtime, shortened hours, etc.)

The Axis of Evil: the connection

• Generally there is a negative correlation between inflation & unemployment

• Phillips Curve: a curve that shows the tradeoff between inflation and unemployment

The Axis of Evil: the connection

• Phillips Curve is downward sloping

• Higher inflation rates are associated with lower unemployment rates

Effects

• High unemployment wastes resources (lost output)

• “full” employment varies (3 – 6% unemployment)

2 Solutions

Governments seek to mitigate the effect of the business cycle (inflation & unemployment) in pursuit of growth, price stability, and full employment by using two strategies…

2 Solutions

Fiscal Policy –

manipulation of government money flows (spending & taxation)

Monetary Policy –

manipulation of the money supply (& interest rates) by the Federal Reserve