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UNIT TWO Measurement of Economic Performance

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Page 1: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

UNIT TWO Measurement of Economic Performance

Page 2: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

P.S. Supply and Demand:Four events that will shift demand (determinants):(Fads, population, change of income levels across

society, price of other goods)Four events that will shift supply (determinants):(New technology, weather, price of inputs, and

government regulation)

Page 3: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Government Regulation•Subsidies▫A payment from the government to a producer for

each unit of good produced▫Lowers costs of production▫Increases supply▫Subsidies for farmers in United States

•Taxes▫Mandatory payment from the producer to the

government for each unit produced▫Adds to costs of production▫Lowers supply

Page 4: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Unit Outline: Key Measures of Economic Performance

• A. National Income Accounts▫Circular Flow▫Gross Domestic Product▫Components of Gross Domestic Product▫Real vs. Nominal GDP

• B. Inflation Measurement and Adjustment▫Price Indices▫Nominal and real values▫Costs of Inflation

• C. Unemployment▫Definition and Measurement▫Types of Unemployment▫Natural Rate of Employment

Page 5: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts• I. The Circular Flow of the Economy▫Significance of the circular flow

Illustrates the interactions of the modern market economy

Page 6: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts•The Five Contributors to the economic activity of a

nation▫Households▫Firms▫Government Sector▫Foreign Sector▫Banking Sector

•The Two Markets▫Product Market▫Resource Market

Page 7: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts•Households▫Demand goods and services in the product

market▫Supply land, labor, capital in the resource market▫Pay taxes to the government▫Receive transfer payments and the provision of

public goods from the government▫Demand imported goods from foreign nations

Page 8: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts•Firms▫Produce many goods and services to households in

the product market▫Demand productive resources from households in

the factor (resource) market▫Pay taxes to the government▫Enjoy public goods and services provided by the

government▫Sell output to foreign markets▫Demand resources from foreign households

Page 9: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts•Government Sector▫Collects taxes from households and firms▫Redistributes income through transfer payments

and the provision of public goods Transfer Payments

Welfare Social Security Subsidies

▫Provides infrastructure and legal structure to protect private property rights (which creates an environment for the economy to function)

Page 10: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts•The Foreign Sector▫Domestic households and firms demand goods,

services, and productive resources from foreign markets

▫Foreigners demand output from domestic markets Imports from abroad are LEAKAGES because money

leaves the domestic economy in order to purchase foreign goods

Exports to foreign markets are INJECTIONS into the domestic economy since money enters the economy for exports.

Page 11: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts•The Banking Sector▫Facilitates the flow of capital from households to

firms Money saved by households in banks is a LEAKAGE

from the circular flow because it is not money being spent on goods and services

Money lent to firms or households for investment is an injection into the circular flow because firms are spending on new capital which equals more employment and output

Bank as intermediary

Page 12: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Five Sector Model

Page 13: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts• Injections▫Government – government spending more than

collecting: education, infrastructure, legal system, judicial system

▫Foreign – Exports▫Banking – Money borrowed from banks by

households and firms•Leakages▫Government - Taxes paid by households and firms▫Foreign – Imports▫Banking – Savings – not spent on output

Page 14: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

National Income Accounts

•The Five Sector Model▫More realistic▫Illustrates leakages and injections

Page 15: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

There are three key measures of economic performance:•GDP

• Inflation

•Unemployment

Page 16: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

GDP

•How it is measured•What are its components•Real vs. Nominal GDP

Page 17: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Measuring GDP•GDP is the international standard for measuring

the economic output and growth of countries. ▫It is the market value of all final goods and services

produced within a nation in a year▫“Final goods and services” are goods and services

ready for consumption▫Intermediate goods – require further processing

before they are counted as a final good You count a car (final good), not steel (intermediate

good) You count a house (final good), not lumber

(intermediate good)

Page 18: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

NOT COUNTED IN GDP•Second-hand sales ▫You buy a new x-box from GameStop (YES)▫You buy a used x-box from GameStop (NO)

•Nonmarket Transactions▫Clogged drain

Call a plumber (YES) Get a neighbor to help (NO)

•Underground Economy▫Pharmaceutical sales (YES)▫Drug trafficking (NO)

Page 19: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

THREE METHODS FOR CALCULATING GDP

•The Expenditure Approach▫Adds up spending by households, firms,

government, and foreign trade•The Income Approach ▫Expenditures on GDP ultimately become income and

can thus be used to figure out the GDP•Output Approach▫Measures value of total output

Page 20: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Expenditure ApproachGDP = Aggregate Spending, spending across the

economy on output

Spending on production is done in four sectors:Consumer Spending (C)Investment Spending (I)Government Spending (G)Net Exports (X – M)

Exports minus imports

AGGREGATE SPENDING (GDP)= C + I + G + (X-M)

Page 21: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Consumer Spending (C)•Largest component of GDP•Spending done by consumers•Purchase services▫Lawn mowing companies▫College degrees▫Haircuts

•Purchase goods▫Durable – Boat (Expected to last a year or more)▫Non-durable – Pasta (Goods consumed in under a

year)

Page 22: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Investment Spending (I)•Current spending in order to increase output or

productivity later•Three kinds▫New capital machinery purchased by firms

Fleet of U-Haul trucks▫New construction for firms or consumers

A new Banana Republic store New residential houses

▫Market value of the change in unsold inventories New FORD in 2012, not bought by 2012 – appear in I

as unsold inventory. If it is sold in 2014, it is added into C and deducted

from I

Page 23: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Government Spending (G)•At all levels, the government purchases final goods

and services and invests in infrastructure▫Police cars▫Social workers▫Computers for the Pentagon▫Interpreters for visiting diplomats

•Government cash transfers do not count toward GDP

Page 24: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Net Exports (X-M)

•Add all domestically produced goods purchased by foreign consumers (exports –X) but subtract any spending by our citizens on purchases of goods made within other nations (imports – M)

• Include dollars flowing into our economy minus dollars flowing out

Page 25: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Second Approach: The Income Approach

•Measures GDP by recording the income of households on the resource side of the circular flow.

• If all spending on goods and services creates revenue to the firms providing products, and the revenue earned goes toward paying households for the land, labor, and capital employed in production, then you can arrive at an accurate measurement of GDP by counting the income received by households during one year.

Page 26: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Income Approach•Makes use of the fact that expenditures on GDP

ultimately become income•National Income: Sum of the income earned by the

factors of production owned by a country’s citizens.▫Includes

Wages, salaries, and fringe benefits paid for labor services (largest component)

Rent paid for the use of land and buildings Interest paid for the use of money Profits received for the use of capital resources. W + R + I + P = GDP

Page 27: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Output Approach

•Measures total value of all final goods and services by calculating the value of the total output produced in different sectors of the economy

•The sectors include:▫Agriculture, forest, fishing, mining, utilities,

construction, manufacturing, transportation, warehousing, wholesale, retail, information, education, professional and business services, healthcare, arts and entertainment, government, other services plus rest of the world plus national income plus capital consumption plus statistical adjustment = GDP

Page 28: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Before we move on . . . •Personal Income (PI)▫Money income received by households before

personal income taxes are subtracted•Disposable Income (DI)▫Personal income less personal income taxes

•National income = National output

Page 29: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Other measurements . . . •Gross National Product (GNP)▫which is a measure of the final output of the citizens

and businesses of a country, regardless of where in the world the output is produced.

▫GDP = GNP + net foreign factor income (the income from foreign sources located domestically minus the income of domestic sources located internationally)

•Net Domestic Product (NDP)▫GDP – depreciation; where depreciation accounts

for the gradual wearing out of factories and equipment

Page 30: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Components of GDP1. Consumer Spending (C)2. Investment Spending (I)3. Government Spending (G)4. Net Exports (X – M)

Exports minus imports

Page 31: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Components of GDPTotal (billions)

Per person in dollars

Percent of total

GDP 10,082 35375 100

C 6987 24516 69

I 1586 5565 16

G 1858 6519 18

(X-M) -349 -1225 -3

Page 32: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

GDP and its Components

Sales

InvestmentGovernment PurchasesNet ExportsConsumption

Page 33: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Quick Review•A. National Income Accounts▫Circular Flow▫Gross Domestic Product

- FINAL goods and services- Expenditure Approach C+I+G+ (X-M) = GDP- Income Approach W + R + I + P = GDP- Output Approach

▫Components of Gross Domestic Product▫Real vs. Nominal GDP

Page 34: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Real vs. Nominal GDP•Nominal: Values the production of goods and

services at current prices•Real: Values the production of goods and services

at constant prices

Page 35: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Real vs. Nominal•Nominal GDP measures the value of a nation’s

output produced in a year, expressed in the value of the prices charged for that year.

• If the average price level of a nation’s output increases in a year, the nominal GDP could increase even if the actual amount of output does not change.

• It would appear that GDP has increased when, in fact, the same number of goods and services were produced.

Page 36: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Nominal•Price increases from inflation could cause GDP to

be overestimated, causing us to think the economy is doing better than it actually is.

•How do economists fix this?

Page 37: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Measuring Real GDP•To determine the change in the real GDP,

economists must adjust the nominal value of the nation’s output in a year based on any changes in the average price level of goods and services during that year. ▫In the case of price level increasing (inflation):

nominal GDP exaggerates the value of output compared to actual output.

▫In the case of the price level decreasing (deflation): nominal GDP underestimates the value of real output.

Page 38: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Nominal becoming Real GDPGDP deflator (Price Index): Price of selected goods in

current year/Price of selected goods in base year X 100

This measures the average price of a good. It is also known as the GDP Price Index.

Real GDP = nominal GDP/deflator or price index X 100

Called “deflator” because the nominal GDP is usually overstated because of inflation.

Page 39: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Converting Nominal to Real

•Real GDP = nominal 20xx/GDP deflator x 100

Page 40: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Converting nominal to realYear Nominal GDP GDP Deflator Real GDP

2005 12, 683.4 100 12,638.4

2006 13, 398.9 103.25 12,977.1

2007 14, 061.8 106.29 13, 229.6

2008 14, 369.1 108.61 13,229.9

2009 14, 119.0 109.61 12, 881.1

Page 41: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

GDP Application•GDP is 10 million, consumer spending is 6 million,

government spending is 3 million, exports are 2 million, and imports are 3 million. How much was spent for investments?

•0 million•1 million•2 million•3 million•4 million•5 million

Page 42: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

GDP Application• If Real GDP = 200 billion and the price index = 200,

Nominal GDP is •4 billion•400 billion•200 billion•2 billion• Impossible to determine since the base year is not

given Real GDP = nominal GDP/price index X 100

Page 43: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Per Capita GDP•Real GDP adjusts for price changes, what adjusts

for population changes?•To account for the average income of a nation, real

GDP is divided by the population to find the per capita GDP.

•Per capita GDP = real GDP/population

Page 44: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

GDP does not Equal the Standard of Living

•GDP 2011▫US 15,090,000▫China 7,298, 000▫Italy 2,199, 000

•What is the population?▫US 311,800,000▫China 1,347,350,000▫Italy 59,464,000

Page 45: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Real GDP per capita•Gives us a better picture of how productive a

nation is on a per capita basis.•But it does not tell us anything about the income

distribution within a nation.

Page 46: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

How do we measure growth?•You calculate the rate of change . . .

•Growth rate = •Real GDP in period 2 – Real GDP in period 1/Real

GDP in period 1 X 100

Page 47: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Economic Downturn: The Final Number Illustrates Stagnation (2008) and Recession (2009)

Year Real GDP Real GDP Growth Rate

2006 12, 976.2

2007 13,228.9 13,228.9-12,976.2/12,976.2 X 100 = 1.95%

2008 13,228.8 13,228.8-13,228.9/13,228.9 X 100 = 0.0%

2009 12, 880.6 12,880.6-13,228.8/13,228.8 X 100 = -2.63%

Page 48: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Before we leave GDP• National economies suffer leakages and enjoy injections• Tally of FINAL goods and services produced in a nation in a

year• GNP = Tally of all final goods and services produced by a

nation’s citizens in a year. • GDP = C + I + G + (x-m)• GDP deflator = price of good current year/ price of good

base year X 100• Real GDP = Nominal GDP/Price Index X 100• GDP Growth = REAL GDP P2 – REAL GDP P1/Real GDP P1

X 100• You must focus on real, not nominal, GDP• GDP does not necessarily determine the standard of living.

Page 49: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Unit Outline: Key Measures of Economic Performance

• A. National Income Accounts▫Circular Flow▫Gross Domestic Product▫Components of Gross Domestic Product▫Real vs. Nominal GDP

• B. Inflation Measurement and Adjustment▫Price Indices▫Nominal and real values▫Costs of Inflation

• C. Unemployment▫Definition and Measurement▫Types of Unemployment▫Natural Rate of Employment

Page 50: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Inflation Measurement and Adjustment

• Inflation – an increase in the average price level of a nation’s output over time.

• Inflation rate can be determined using a price index

•Deflation – a decrease in the average price level of a nation’s output over time

Page 51: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Why measure inflation????•To keep track of the overall cost of living for a

nation.

Page 52: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

How is it measured?•The Consumer Price Index (CPI) – a measure of

the overall cost of the goods and services bought by typical consumer

Page 53: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

How do you establish the CPI?•1. Fix the basket. (Labor Department)

•2. Find the prices over time (2010, 2011, 2012).

•3. Compute the basket’s cost (Count prices, keep quantities constant)

•4. Choose a base year and compute the index.

•5. Compute inflation rate.

Page 54: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Fix Basket•Establish the basket of goods to be calculated

•Our example: a loaf of bread

Page 55: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Find the price over time•A loaf of bread▫2010 – $1▫2011 - $2▫2012 - $3

Page 56: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Compute the cost of the basket•2010 •$1 X 10 = $10•2011•$1.50 X 10 = $15.00•2012•$ 2.50 X 10 = $25.00

• **** The quantity needs to be fixed because we are focused on PRICE changes

Page 57: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Choose One Year as a Base Year to compute Consumer Price Index•2010 can be our base year•CPI = (Price in Period X/Period 1) x 100

•2010 (10/10) x 100 = 100•2011 (15/10) x 100 = 150•2012 (25/10) x 100 = 250

Page 58: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Use the CPI to compute the Inflation rate from previous year• Inflation rate in year 2 =

• (CPI in Year 2 - CPI in Year 1/CPI Year 1) x 100

•2011 = (150 – 100/100) x 100 = 50%•2012 = (250-150/150) x 100 = 66%

• In this example, inflation rate is 50% in 2011 and 66% in 2012.

Page 59: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Application •What is the inflation rate in 2012 if:

Your basket of goods cost $200 in 2010, $225 in 2011, and $230 in 2012 (2012 is your base year)?a. 112.5%b. 115%c. 2.2%d. 3%e. 23%

Page 60: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Goal of the Consumer Price Index•To measure changes in the cost of living•How much incomes must rise to maintain a

constant standard of living

Page 61: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Three Problems with the CPI•Substitution Bias▫If an item becomes more expensive, most of us will

substitute with another item (BLS looks at fixed basket from a base year)

• Introduction of new goods▫CPI does not catch these the first or even first few

years out (VCR – 3 years)•Unmeasured quality change▫A good is often measured against itself even if the

newer model is of higher/lower quality

Page 62: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Another example . . . What is the inflation rate for August? September?

Good or Service Price in July Price in Aug Price in Sept

Pizza $10 $10.50 $10.50

Haircuts $20 $19 $18

Wine $8 $10 $10

Total Basket Price $38 39.50 $38.50

C. Price Index (38/38) x 100 = 100

(39.5/38) x 100 = 104

(38.5/38) x 100 = 101.3

Page 63: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Dollar Figures from Different Times•CPI = 15.2 for 1931•CPI = 177 for 2001•Babe Ruth made $80,000 in 1931

• (CPI 2001/CPI 1931) x 80,000 = $931,579

Page 64: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Real and Nominal Interest Rates•Nominal Interest Rate▫Interest rate as usually reported without a

correction for the effects of inflation

•Real Interest Rate▫The interest rate corrected for the price of inflation

▫`

Page 65: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Example • I deposit $1000 in my bank account that pays an

annual interest rate of 10%.

•After one year, I have $100 in interest

• I withdraw my $1100. Am I $100 dollars richer?

•Yes – I do have $100 more dollars. (Nominal)•No – In that year, inflation rose 4%. My purchasing

power increased by 6, not 10, percent. (Real)

Page 66: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Relationship between Nominal and Real . . . •Real interest rate = nominal interest rate –

inflation rate.

Page 67: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Application •Henry Ford paid his workers $5 a day in 1914. If

the CPI was 10 in 1914 and 177 in 2001, how much is the paycheck worth? $88.50

•You deposit $1000 in bank with annual interest rate of 10%. At the end of the year, you have $1100. If the inflation rate increased by 3% that year. What are your nominal and real interest rates?

Page 68: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Consumer Price Index (Our basket)•Weighted categories▫Must add up to 100▫The weight of the category reflects relative

importance▫This is to reflect real life

Imagine the prices of feathers and milk fluctuates

Which one will affect you more?

Page 69: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Category Weight

Food and beverages 14.795

Housing 41.96

Apparel 3.695

Transportation 16.685

Medical care 6.513

Recreation 6.437

Education and communication 6.434

Other goods and services 3.483

Total 100

Page 70: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of
Page 71: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Unit Outline: Key Measures of Economic Performance

• A. National Income Accounts▫Circular Flow▫Gross Domestic Product▫Components of Gross Domestic Product▫Real vs. Nominal GDP

• B. Inflation Measurement and Adjustment▫Price Indices▫Nominal and real values▫Costs of Inflation

• C. Unemployment▫Definition and Measurement▫Types of Unemployment▫Natural Rate of Employment

Page 72: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

The Costs of Inflation 1. Shoeleather Costs2. Menu Costs3. Relative-Price Variability and the

Misallocation of Resources4. Inflation-Induced Tax Distortions5. Confusion and Inconvenience6. Arbitrary Redistributions of Wealth

* Large costs during hyperinflation but the size of these costs during times of moderate inflation is not clear.

Page 73: UNIT TWO Measurement of Economic Performance. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of

Shoeleather Costs

•Resources wasted when inflation encourages people to reduce their money holdings▫By pulling money out of the bank to purchase goods▫By converting their currency into another currency

• “Shoeleather” because of the leather worn out going back and forth from the bank.

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Menu Costs•The cost of changing prices▫Typical firm changes prices annually

Infrequent because it costs money to change prices Deciding Lists and catalogs Advertising new prices Dealing with annoyed customers

▫Low inflation Infrequent menu costs

▫Hyperinflation Prices change weekly or daily Menu costs increase

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Relative-Price Variability and Misallocation of Resources•Market economies rely on relative price to allocate

scarce resources•When inflation distorts relative prices▫ consumer decisions are distorted ▫ markets are less able to allocate resources to

their best use

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Inflation-Induced Tax Distortions• Inflation tends to raise the tax burden on income earned

from savings▫CAPITAL GAINS

PROFITS MADE BY SELLING AN ASSET FOR MORE THAN ITS PURCHASE PRICE 1980 – BOUGHT APPLE STOCK FOR $10 2000 – SOLD FOR $50 Capital gain equals $40 which is included in your 2000 income The $10 you invested in 1980 is equal to $20 in 2000 so when you

sell your stock, you have a REAL gain of only $30 dollars, not $40 – you are still taxed on the $40

▫INTEREST INCOME TAXED ON NOMINAL INTEREST RATE ON YOUR SAVINGS

•HIGHER INFLATION DISCOURAGES PEOPLE FROM SAVING

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Confusion and Inconvenience•It is difficult to calculate the costs of

confusion and inconvenience due to inflation •One way that inflation causes

confusion. . . ▫Inflation makes investors less able to

discern successful firms from unsuccessful firms

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Unexpected Inflation: Arbitrary Redistribution of Wealth•Sudden inflation can redistribute wealth in a way

that has nothing to do with merit or need▫Sally takes out a student loan for $20,000 at a 7%

interest rate to attend UF▫After her debt has compounded for 10 years, Sally

will owe $40,000▫Hyperinflation – the debt is not burdensome▫Deflation – the debt feels like much more than

$40,000• Inflation can redistribute wealth between debtors

and creditors

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Before we leave GDP + Inflation . . . •Remember . . . ▫GDP is the best single measure of a nation’s

economy▫The expenditure approach is used more than any

other GDP measurement▫CPI is a fixed number for every year▫Inflation rate is calculated using the previous period▫Real GDP = Nominal GDP/Price Index X 100▫Real interest rate = nominal interest rate –

inflation rate.▫There are 6 major costs of inflation

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Inflationary Spiral

•High inflation – firms and households will spend, rather than save, their money▫Why?

•More spending contributes to more inflation•Over time, this will lead to workers wanting higher

wages ▫Which further contributes to inflation

•An inflationary spiral takes shape

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Higher prices = more spending= higher wages = higher prices

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Keeping Inflation Under Control•Banks and governments want inflation to be about

2 – 3 percent•You do not want deflation or risk an inflationary

spiral

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Macroeconomic Policy

Goals Tools

•Economic Growth•Low Inflation •Low

Unemployment•Sustainable

Trade Balance

•Fiscal Policy▫Taxing and spending

of government•Monetary Policy▫Control of the

Federal Reserve over interest rates and the money supply

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UnemploymentA Third Way to Measure Economic Well Being

GDP (most accurate)Inflation (Cost of Living)Unemployment

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Key Terms•Unemployment – actively seeking, but unable to

find, a job•Employment – to have a paid job, either part time

or full time, of any type•Unemployment rate – the percentage of the labor

force that is unemployed

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How does the Dept. of Labor classify the Labor Force?

•Labor Force – non-institutionalized population of a nation between 16 – 64 that are either employed or unemployed▫A senior in high school who works at Publix 10

hours a week▫A full-time teacher▫A factory worker whose plant closed and who is

applying for jobs at other factories▫A recent college grad who is applying for jobs▫A family farm worker▫A custodian whose school is closed down

temporarily because of a hurricane

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Not in the Labor Force

•Stay-at-home mom•Stay-at-home dad•College grad who volunteers at the homeless shelter•A discouraged worker who has given up looking for a

job•A businessman who quits his job to return to school•Prisoners•Deployed military forces

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Measuring Unemployment

Unemployment rate = (# of unemployed/# in labor force ) X 100

In U.S. – there are 14 million people who are unemployed- there are 126 million people who have a part or full-time

job

What is the unemployment rate?

Rate = (14 million/140 million) x 100

Unemployment rate would be 10%

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Unemployment•Rises during recessions in the business cycle

•Falls during periods of economic growth in the business cycle

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Unemployment rate• Indicates economic well-being ▫Illustrates how a society uses its available labor

resources▫Reveals how closely society is approaching its

potential output (PPC)

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Shortcomings of Unemployment Rate as a Measuring Stick

•Does not include discouraged workers▫Workers who have given up looking for a job▫Rate will understate how bad things are, especially during

a long recession•Labor Force Participation Rate (LFPR) falls during a

recession▫LFPR measures the percentage of the adult population in a

country that is either employed or unemployed

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LFPRLFPR = Labor force

# of people between 16 and 64

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Question of the Day, October 29 + 30If a worker’s nominal wage rate increases from $10 to $12 per

hour and at the same time the general price level increases by 10 percent, the worker’s real wage has

a. Approximately decreased by 10%b. Approximately decreased by 20%c. Approximately increased by 10%d. Approximately increased by 20%e. Not changedWhich of the following would cause the official unemployment

rate to understate the problem of unemployment?f. Workers receiving unemployment compensationg. Cyclically unemployed workersh. Discouraged workersi. Recent college graduates looking for workj. Retirees

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Quick ReviewLabor Force =

Number of Employed + Number of Unemployed

Unemployment rate = (number of employed/labor force) X 100

LFPR = (labor force/adult population) X 100

Discouraged Workers = individuals who would like to work but have given up looking for a job

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Natural Rate of Unemployment•The normal rate of unemployment around which

the unemployment rate fluctuates

•Healthy rate

• In U.S., the natural rate is around 5.5%

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Types of Unemployment

Frictional

Structural

Cyclical

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Frictional Unemployment•Someone who is “in between jobs” or looking for his/her

first job but has employable skills- Lawyer who moved from Miami to Orlando and is looking

for a job- College grad looking for a job in her discipline- Nurse who quits his job to find better pay at another

hospital*Worker and firm have yet to find one another *Individuals possess skills that are in demand*Considered natural unemployment because it is evidence

of a healthy economy (usually short term unemployment)

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Structural Unemployment•Workers lose their job to the changing structure of the

economy- Their skills are no longer needed

- Factory worker laid off because a machine has taken the job- Manufacturer whose job has moved to China

- Often due to improvements in technology or globalization of workforce

- Usually long-term unemployment

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Ways to reduce structural unemployment

•Re-training of unemployed workers•Education•Wage flexibility

•Structural Unemployment▫Like frictional unemployment, structural unemployment is

considered natural unemployment since it is evidence of a healthy economy wherein the economy is expanding

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Cyclical Unemployment•Results from a fall in total demand for a nation’s output•Associated with a recession or a contraction phase of a

nation’s business cycle

- Store clerk who is laid off because of a drop in sales- Hairstylist whose business fails because incomes across the economy are down

Caused because of a larger decrease in demand

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Ways to Reduce Cyclical Unemployment•Cutting Taxes for Households▫Increase consumption which increases demand for labor

• Increase G spending▫Creates demand for g + s, putting workers back to work

•Lowering interest rates▫Stimulates new investment in capital by firms, increasing

demand for labor•Depreciate the nation’s currency▫Increase demand for exports from abroad and for workers

to produce those exports

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Natural Rate of Unemployment (NRU)•NRU prevails when an economy is producing at

its full-employment level

•Full employment when the economy experiences only frictional and structural

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October 31 + November 1An industry historically used employees with specific skills. If this

industry experiences technological advances that require new skills, there will most likely be

a. Cyclical unemploymentb. Frictional unemploymentc. Seasonal unemploymentd. Structural unemploymente. No change in unemploymentGross domestic product has been criticized as a measure of well-being

because it fails to take into account which of the followingf. The distribution of incomeg. The value of servicesh. The value of intermediate goodsi. The value of financial transactions and sales of used itemsj. The value of government services

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Natural Rate of Unemployment (NRU)•NRU prevails when an economy is producing at its full-

employment level

• Government intervention to reduce cyclical unemployment

▫Cutting taxes, government spending, lower inflation rates, and depreciating nation’s currency▫Examples of expansionary policies

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Which types of unemployment affect the unemployment rate? •All three types of unemployment

•An economy producing at full employment experiences only frictional and structural unemployment.

•When the U.S. economy is healthy, somewhere around 5% of the labor force should be unemployed.

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Unemployment in a Recession•Unemployment includes frictional, structural, and

cyclical

•Greater unemployment rate than the natural rate of unemployment

•Between 2009 and 2010, U.S. unemployment rate hit 10% - double the natural rate▫INDICATED THAT 5% OF UNEMPLOYED WERE

CYCLICALLY UNEMPLOYED

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The NRU•Stable within a nation within a set period of time

•Can vary from nation to nation and from time period to time period

•Exists when a nation is at full employment

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Reducing Unemployment•Training programs that match skilled workers

with jobs• Job training programs to help the structurally

unemployed•Reducing unemployment benefits•Reducing trade union power •Reducing the minimum wage

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Why is any rate of unemployment a good thing?•Unemployed workers (frictional and structural)

shows that the economy has room to grow or is in the midst of growth.

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The Costs of Unemployment• Individual Costs▫Decreased household income▫Decreased purchasing power▫Increased levels of psychological and physical illness▫Unemployment leads to more mental illness and

increased suicide rates

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The Costs of Unemployment•Social Costs▫Downward pressure on wages for the employed▫Pay cuts or risk of losing job▫Increased poverty and crime▫Transformation of traditional societies

Migration out of smaller towns and agricultural communities

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The Costs of Unemployment• Economic Costs▫Lower level of aggregate demand

Unemployed buy less leading to more unemployment▫Underutilization of nation’s resources

Increased gap between output and potential output▫ “Brain drain”

Workers may choose to emigrate from nation’s with high unemployment

▫Turn toward protectionism and isolation To preserve jobs Inhibit trade

▫ Increased budget deficits Lower taxes + Government spending

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The Costs•Because of the individual, social, and economic

costs, governments focus on keeping the unemployment levels in their nation at the natural rate.

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Question of the Day: 11.2 + 11.5The NRU for the nation of Orbot is 3.5 percent. Their labor force is 1000 people and 60 of those are currently unemployed. Which of the following is most likely true?a. The unemployment rate is 6 percent, all of which

are structurally or frictionally unemployed.b. The unemployment rate is 9.5 percent.c. The unemployment rate is 6 percent and 2.5

percent of these are cyclically unemployed.d. Orbot is at the trough of a recession.

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The Roller Coaster•The Four Phases of the Business Cycle▫Trough▫Expansion▫Peak▫Recession

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PPI•A Producer Price Index (PPI) measures average

changes in prices received by domestic producers for their output.