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PART FIVE

Macroeconomic

Measurement, Models,and Fiscal Policy


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Chapter 12:

Introduction to GDP,Growth, and Instability


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Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Gross Domestic Product

Gross domestic product (GDP) is thetotal market value of all final goods and

services produced annually within theU.S., whether by U.S. or foreign-suppliedresources.

GDP is determined by the Bureau of

Economic Analysis (BEA), an agency of theCommerce Department, and is the primarymeasure of the economys performance.


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GDP is a monetary measure.

It compares the relative value of goods and

services produced in different year. To avoid counting components that are

bought and sold multiple times, GDPincludes on the market value of final goodsand ignores intermediate goodsaltogether.


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Secondhand goods are also excludedfrom GDP since they do not contribute to

current production. These goods were previously counted in the

year they were produced.


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Measuring GDP

The four categories of expenditures thatprovide a measure of the market value of

total output in a particular year include: Personal consumption expenditure (C)

Gross Private Domestic Investment (Ig)

Government Purchases (G)

Net Exports (Xn)


7/37Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Personal consumptionexpenditure (C)

All expenditures by households on durableconsumer goods, nondurable consumer

goods and consumer expenditure forservices are included in personalconsumption expenditure.



Gross Private DomesticInvestment (Ig)

Gross private domestic investmentincludes (1) all final purchases of

machinery, equipment, and tools bybusiness enterprises, (2) all construction,and (3) changes in inventories.



Measuring GDP

Government purchases includesspending for products that government

consumes in providing public services andexpenditure for social capital.

Net exports are exports minus imports.

Adding It Up: GDP = C+ Ig+ G+ NX



Nominal GDP versus Real GDP

It is difficult to compare values over timewithout correcting them for inflation ordeflation.

The monetary value of GDP changes fromyear to year either due to changes inprices and output.

Nominal GDP, or unadjusted GDP, is grossdomestic product in terms of the price level atthe time of measurement.




To compare the market value of thequantityof goods and services producedfrom year to year, an adjustment to inflateGDP when prices rise or deflate GDPwhen prices fall is required.




Real GDP, or adjusted GDP, is grossdomestic product measured in terms of theprice level in a base period (or referenceyear).

It is a GDP that has been deflated or inflatedto reflect changes in the price level.



Economic Growth

An expansion of real GDP (or real GDPper capita) over time is economic growth.

It is calculated as a percentage rate of growthper quarter or per year.

Real GDP per capita (or output per person) isfound by dividing real GDP by the size of the

population.



Economic Growth

Economic growth is an economic goal ofgovernment since it raises the standardsof living in society and lessens the burdenof scarcity.

Two fundamental ways society canincrease its real output and income are:

by increasing its inputs of resources

by increasing the productivity of those inputs



Business Cycles

Business cycles are recurring increasesand decreases in the level of economicactivity over periods of time.

The four phases of a business cycle arerecession, trough, expansion and peak.

Individual cycles vary substantially in duration

and intensity.



Business Cycles



Business Cycles

The two primary phases are recession andexpansion. A recession is a period of declining real GDP,

accompanied by lower income and higherunemployment.

An expansion is a generalized increase inoutput, income, and business activity.

The twin problems that arise from businesscycles are unemployment and inflation.



Unemployment

The Bureau of Labor Statistics (BLS) ischarged with reporting unemploymentfigures, such as the number of personsemployed, the unemployment rate, andthe number of persons in the labor force.

Data is based on a monthly nationwide

random survey of some 60,000 households.



Measurement ofUnemployment

The total U.S. population is divided intothree groups.

1) People under 16 years of age and those who

are institutionalized2) Adults that are not in the labor force; those

who are potential workers but are notemployed and not seeking work

3) Adults who are in the labor force; those whoare either employed or unemployed andseeking work




The unemployment rate is thepercentage of the labor force unemployed.

Unemployment rate = x 100unemployedlabor force


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Types of Unemployment

The three types of unemployment arefrictional, cyclical, and structural. Frictional Unemployment, consisting of

search unemployment and waitunemployment,is unemployment that isassociated with people searching for jobs orwaiting to take jobs in the near future.

Cyclical Unemployment is unemploymentthat is associated with the recessionary phaseof a business cycle.


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Types of Unemployment

Structural Unemployment is unemploymentthat is associated with a mismatch betweenavailable jobs and the skills or locations of

those unemployed. Changes over time in consumer demand and in

technology alter the structure of the total

demand for labor, causing this type of

unemployment.


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Definition of Full Employment

Full employment occurs when theeconomy experience only frictional andstructural unemployment; there is nocyclical unemployment.

The level of real GDP that would occur ifthere was full employment is calledpotential output.


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Economic Costof Unemployment

Forgone output is the basic economic costof unemployment.

If actual GDP is above or below potentialGDP, the result is a GDP gap.

When actual GDP is less than potential GDP,

there is a negative GDP gap accompaniedwith a higher unemployment rate andforegone income.

GDP gap = actual GDP potential GDP


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Inflation

Inflation is a rise in the general level ofprices in an economy.

When there is inflation, each dollar of incomebuys fewer goods and services; thepurchasing power of money declines.


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Inflation

On average, the prices of goods andservices are rising; however, not all pricesgo upthe prices of some productsremain fairly constant or decrease.


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Measurement of Inflation

CPI for any particular year equals:price of the most recent market basket in the particular year

price of the same market basket in 1982-1984

The composition of the market basket isupdated every two years.

The rate of inflation for a certain year is

found by comparing, in percentage terms,that years index with the index in theprevious year.


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Types of Inflation

Demand-pull inflation is increases in theprice level caused by excessive spendingbeyond the economys capacity to produce.

Excess demand from expanding output bids upthe prices of the limited output.

Cost-push inflation is increases in the pricelevel caused by sharp rises in the cost of key

resources. Supply shocks are the main source of cost-push

inflation.


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Redistribution Effectsof Inflation

Inflation redistributes real income fromsome people to others.

Nominal income is the number of dollarsreceived as wages, rent, interest, andprofits.

Real income is a measure of the amount

of goods and services nominal income canbuy; it is the purchasing power of nominalincome.


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Redistribution Effectsof Inflation

Real income =

When inflation occurs, some nominalincomes do not rise in proportion to the

price level. Thus, real income is affected.

Nominal incomePrice index (in hundredths)


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Who is Hurt by Inflation?

Fixed-income receivers, savers andcreditors are hurt by unanticipatedinflation.

Inflation redistributed income away fromthem and toward others. Fixed-income receivers real incomes fall, the

real value of accumulated savingsdeteriorates, and the value of the dollar goesdown when there is unanticipated inflation.


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Who is Unaffected orHelped by Inflation?

Flexible-income receivers are eitherunaffected or helped by inflation.

Some incomes are indexed for inflation whileother incomes rises faster than the priceindex, resulting in higher real incomes.

As inflation reduces the value of the dollar,

debtors (or borrowers) are helped.


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Does Inflation Affect Output?

Inflation may affect a nations level of realoutput and real income.

The direction and significance of this effect

on output depends on the type of inflationand its severity. Cost-push inflation reduces real output.

Demand-pull inflation causing mild inflation mayreduce real output, according to someeconomists, but can increase real output andlead to economic growth according to others.


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Hyperinflation

Another type of inflation is hyperinflation,an extraordinarily rapid inflation thatdisrupts normal economic relationships.

As average prices rise steeply andunpredictably, money eventually becomesworthless since its purchasing power erodes

and a state of barter may arise.

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