Topic 2: MacroeconomicsGDPUnemploymentInflation

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What are signs of a healthy economy?High output, high incomeLow unemploymentStability (output, prices, etc.)

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Measures of outputGross Domestic Product (GDP): market

value of all final goods & services produced within an economy in a given time period.

Gross National Product (GNP): market value of all final goods & services produced by a nation’s citizens in a given time period.

National Income (Y): total income earned in an economy in a given time period. Equivalent to GDP in equilibrium.

Net Domestic Product (NDP): GDP minus depreciation

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GDP and GNP

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GDP

GNP

citizens outside nation

citizens inside nation

non-citizens inside nation

GDP Only GDP & GNPGNP Only

What we care about, what we observe

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Most policy makers are more concerned with National Income (Y) or NDP, rather than GDP

GDP is easier to measure

We will refer to any these items as “output”, and treat them as approximate equals

How do we use GDP numbers?Provides a means of comparing standards

of living between countries and overtime

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Does the map imply that people in India and eastern China have a higher standard of living than people in Utah or most of Australia?

What’s missing?Population Size / Population DensityA better measure of well being is GDP Per

Capita

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GDP per capitaA better measure since

Adjusts for differences in populationOtherwise a big country can have higher GDP

than a small country even if the small country has a higher standard of living

Which country has the highest GDP per capita?

Which country has the lowest GDP per capita?

LINK

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Comments on GDP GDP does not account for income

inequality. Counties with high GDP might have high income inequality. That is, a few very rich people may pull up the GDP for an otherwise poor country.

Can be difficult to measure accurately, especially in developing countries and countries that do not collect or release data.

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Economic Growth

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Economic Growth = Sustained rise in real GDP per capita

Causes:Increased workforce participationIncrease output per worker hour

Better quality (education & skills) of the work forceMore capital Better capital (improved technology)Declining share in agriculture (can work year round)

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US economic growthUS GDP per capita over time

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Economic RecessionRecession = Negative economic growth

The US government defines a recession as a period of two or more consecutive quarters of negative growth (declines to real GDP)

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US economic growthUS GDP per capita over time

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GDP Changes During Recessions

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UK:

US:

Economic Growth

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Representing economic growth on the PPF

Macroeconomic policy is concerned withIncreasing economic growthLimiting the duration and severity of

recessions and periods of slow growth

Calculating GDP

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Gross Domestic Product (GDP)GDP is the market value

considering monetary value allows us to add apples to oranges

of FINAL goods and services if we count the value of the car, we shouldn’t

add to it the value of the steering wheel.produced IN an economy

by citizens and non-citizens within the boarders of a county

in a given time period.usually annually or quarterly

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Guidelines for calculating GDP

1. It must go through the market place. Otherwise, ignore it.

2. Should involve the 3 factors of production that year. Ignore payments towards future production, or things produced last year.

3. Don’t include transfers in ownership without production, or pure paper money transfers.

4. Nothing illegal.

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Would the following transactions be counted by this year’s US GDP?Hire neighbor teenager to babysit or cut your

grassNo–doesn’t go through the market place. Under-

the-table payments.Buy a pizza from the local pizza joint owned by

an Italian citizenYes

Do your own laundry when you would be willing to pay $10 for someone else to do it for youNo—no transaction takes place

Pay a laundry service to wash your dirty clothesYes

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Would the following transactions be counted by this year’s US GDP?Hire a limo driver to take you out for a night on a

townYes

Hire a get-a-way driver for your weekend bank heistNo—illegal transaction

Buy a bottle of French wine from the local wine storeMostly No—the wine production would not count, but

the value added by the wine shop and US importers would count

Use a stock broker to buy 100 shares of Google stockMostly No—buying stock does not involve production so

it doesn’t count, but the services provided by the broker do count

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Would the following transactions be counted by this year’s US GDP?Boeing builds a plane in Kansas which it

sells to the US governmentYes

Grow weed to sell to one’s roommateNo—illegal transaction & doesn’t go through

marketGo skiing at a Utah resort

YesBuy a 2007 Ford Mustang from someone on

Craig’s ListNo—production didn’t take place this year

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Would the following transactions be counted by this year’s US GDP?Firestone produces tires which it sells to Ford for

use on new trucksIndirectly—The production contributes to GDP by

adding to the value of the Ford trucks. But, they shouldn’t be double counted if we are already counting the trucks.

Ford builds a Mustang this year that sits on a dealer’s lot before being sold next JanuaryYes—All of the production (except some dealer

services) took place this year. That’s what counts.Brazilian citizen attends UM as a student, paying

tuitionYes—education is a service

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Calculating GDP: big pictureExpenditure approach

Add together how much households, the government, and investors spend on all final goods and services, adjust for net exports (i.e., exports minus imports)

Income approachAdd together total compensation, interest

payments, rental income, owner income, and profits in the economy

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Calculating GDPThe Income and Expenditure approaches

are equivalent

GDP = Y = C + I + G + (X – M)Y = Income, C = Consumption, I =

Investment, G = Government Spending, X = Exports, M = Imports

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Circular Flow Diagram

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Expenditure Approach, exampleNumbers in billions for US, year 2008C = $10,003I = $2,056G = $2,796X-M = -$706 (i.e., trade deficit)

GDP = Y = $14,151

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Practical Tools for Calculating GDPExpenditure Approach: Count only final

sales. (Works if all transactions happen in the same year.)

Income Approach: Count value added (VA) for each stage of production.

VA = final sales - intermediate goodsGDP = ΣVA

DON’T double count. Avoid counting Value Added and Final Sales.

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GDP ExampleIn an economy, there are three producers:

a grape farm, a winery, and a liquor store. All production goes towards the production of wine. What’s their Value Added?

Buys input at

Sells output at

VA

Vineyard 0 $75k

Winery $75k $200k

Liquor store

$200k $300k

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GDP ExampleIn an economy, there are three producers:

a grape farm, a winery, and a liquor store. All production goes towards the production of wine.

Buys input at

Sells output at

VA

Vineyard 0 $75k $75k

Winery $75k $200k $225k

Liquor store

$200k $300k $100k

Total: $300k

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GDP ExampleGDP = Total VA = Value of Final Goods

Buys input at

Sells output at

VA

Vineyard 0 $75k $75k

Winery $75k $200k $225k

Liquor store

$200k $300k $100k

Total VA: $300k

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Value of Final GoodsTotal Value Added

Liquor Store Value Added

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The liquor store bought inputs for $200K, sold outputs for $300K, and added value of $100K.

What did the liquor store produce?A retail service, which counts towards GDP

just like production itself

GDP Example

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The liquor store sells some of the wine during their annual closeout sale, and total sales fall to $250k…

The vineyard is located in a different country…

If the vineyard produced the grapes and sold them to the winery last year, but the winery and liquor store didn’t do anything themselves until this year…

GDP Example 2Consider an isolated island economy with only three industries: fish, wool, and cloth. There are no other inputs or production that is not listed here.

1. Commercial fishermen catch boatloads of fish per year, all of which is bought by consumers for a total of $25,000.

2. Sheep herders raise sheep which they use to produce wool, all of which is sold to cloth producers for a total price of $30,000.

3. The cloth producers use the wool to produce 11,000 yards of cloth per year, which they sell to households for $100,000 total. (Households use the cloth to make their own clothing.)

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GDP Example 2, continueda) Calculate value added by each industry: fish, wool, and

cloth.

b) What is the total value added in the economy?

c) What are the final goods sold in the economy? What is the total value of final goods sold?

d) What is the island’s GDP?

e) What happens if the wool was produced the year before?

f) What other changes would effect GDP?

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Unemployment

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Unemployment

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When there is unemployment, the economy isn’t utilizing all of its factors of production:

The economy is inside of its PPF.

By decreasing unemployment, we increase output.

By increasing output, we decrease unemployment.

(Also, unemployment can decrease human capital, which can cause the PPF to shift in…)

Unemployment Rate

Unemployment rate =

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# of people unemployedLabor force

Unemployment

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Who’s considered unemployed? :1. Must be eligible for the labor force:

• 16 or older and not in jail, hospital, or some other institutional care

2. Must not have a job3. Must meet one of the following descriptions

1. Without work but has made specific efforts to find a job within past 4 weeks

2. Waiting to be called back to a job from which he or she was laid off

3. Waiting to start a new job within 30 days

Dividing up the population

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Total Population

Dividing up the population

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Total Population

Labor force eligible population

Dividing up the population

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Total Population

Labor force eligible

Labor Force

Eligible but don’t participate

Dividing up the population

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Total Population

Labor force eligible

Labor force

Une

mpl

oyed

Em

ploy

ed

Dividing up the population

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Total Population

Labor force eligible

Labor force

Une

mpl

oyed

Em

ploy

ed

“Not in Labor Force”

3 types of unemployment

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1. Structural – comes from the rigidity of the labor market; minimum wages, lack of required skills; things that could be fixed through better policy, education, or training

2. Frictional – the natural flow of people between jobs or careers, or transition into the workforce

3. Cyclical – unemployment resulting from economic downturns

Natural Rate of Unemployment = Structural + Frictional

(Natural Rate exists even if a healthy economy)

Types of unemployment

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A mother returns to work after raising her children? Frictional

Graduate from college and must find a job?Frictional

Unemployment caused by a minimum wage law?Structural

Unemployment resulting from lack of information about available jobs? (i.e., bad matching)Structural

Types of unemployment

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Real estate brokerage lays off some of its agents in a bad economy?Cyclical

A steel plant lays off some of its works after the government eliminates steel tariffsStructural (skills don’t match the needs of employers)

GM lays off workers due to poor economic conditions?Cyclical

GM lays off workers due to changing production technology?Structural (skills don’t match the needs of employers)

Types of unemployment

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A college student decides they want to work on the side while taking classesFrictional

You move to NYC then start looking for a job?Frictional

A 15 year old is looking for a summer job?Not counted as unemployed (younger than

16)

Types of unemployment

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A laid off worker decides to return to school instead of searching for a jobNot in labor force

A laid off worker plays video games all day instead of looking for a job, since she doesn’t expect to find one in such a bad economyNot in labor force (“discouraged worker”)

A worker at a pizza joint is searching for a job as an engineerNot counted as unemployed (she is

“underemployed”)

54http://www.phdcomics.com/comics/archive/phd100108s.gif

Labor MarketSupply, determined by workersDemand, determined by employers

At Equilibrium, everyone looking for a job is employed

Unemployment is a surplus of workers in this model

If there is unemployment, then the wage rate should fall to the equilibrium wage. (But, “sticky” wages might delay the adjustment to equilibrium.)

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Labor market in a downturn

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Demand for workers decreases Wages are slow to respond (“Sticky” wages)

Why might wages be sticky?current employee happinesscontracts (unions)bills – have expenses that must be paid

This causes unemployment, until wages adjust, or economy recovers

Fighting unemploymentIf macroeconomic policy increases output

(GDP), this will increase the demand for workers, thus reducing unemployment.

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Inflation

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Inflation = “An increase in the overall price level”

Inflation

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If prices go up, wages will go up too. Why are we concerned with inflation?People on fixed incomeIncentives to save or investStability (how to set interest rates, etc.)

Types of InflationDemand-Pull Inflation

Caused by an increase in aggregate demande.g., consumers start spending a higher

portion of their income, or a jump in government spending

Cost-Push InflationCaused by an increase in costse.g., changes in the price of factors of

production; natural resources increase in price (supply-shock), wages increase annually which can push up the price (wage-price spiral)

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Measuring Inflation

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Consumer Price Index (CPI)

CPI = A price index computed each month by the Bureau of Labor Statistics using a pre-defined “market basket” purchased monthly by the typical family.

How is the CPI market basket determined? The CPI market basket is developed from detailed

expenditure information provided by families and individuals on what they actually bought.

Data from the Consumer Expenditure Surveys includes interviews with about 7,000 families from around the country, and another 7,000 families keeping diaries listing everything they bought during 2-week periods.

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What goods and services does the CPI market basket include? FOOD AND BEVERAGES (e.g., breakfast cereal, milk, coffee,

chicken, wine, full service meals, snacks) HOUSING (e.g., rent of primary residence, owners' equivalent rent,

fuel oil, bedroom furniture) APPAREL (e.g., men's shirts and sweaters, women's dresses,

jewelry) TRANSPORTATION (e.g., new vehicles, airline fares, gasoline,

motor vehicle insurance) MEDICAL CARE (e.g., prescription drugs and medical supplies,

physicians' services, eyeglasses and eye care, hospital services) RECREATION (e.g., televisions, toys, pets and pet products, sports

equipment, admissions); EDUCATION AND COMMUNICATION (e.g., college tuition, postage,

telephone services, computer software and accessories); OTHER GOODS AND SERVICES (e.g., tobacco and smoking

products, haircuts and other personal services, funeral expenses).

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How is the CPI price data collected? Each month, BLS data collectors visit or call thousands of

retail stores, service establishments, rental units, and doctors' offices, all over the United States, to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI.

These economic assistants record the prices of about 80,000 items each month, representing a scientifically selected sample of the prices paid by consumers for goods and services purchased.

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LinksSource for the previous three slides:

http://www.bls.gov/cpi/cpifaq.htm

Relative importance of different items in CPI:ftp://ftp.bls.gov/pub/special.requests/cpi/cpiri2010.txt

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Calculating Avg Inflation

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Using the CPI

Inflation = Percent Change in Prices = Percent Change in CPI

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Using the CPI (Example 1)Base Year CPI is always normalized to equal

100.

CPI in base year: 100CPI in year two: 105.1

Inflation between base year and year two =

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(Year two CPI) – (Base year CPI)

(Base year CPI)

Using the CPI (Example 1)Inflation between base year and year two =

If year two CPI was 107.4?If year two CPI was 97.2?If year two CPI was 159.8?

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(105.1) – (100)

(100)= 0.051 = 5.1%

Using the CPI (Example 2)

CPI in year one: 201.6CPI in year two: 207.3

Inflation between year one and year two =

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(Year two CPI) – (Year one CPI)

(Year one CPI)

Using the CPI (Example 2)Inflation between year one and year two =

71

(207.3) – (201.6)

(207.3)= 0.028 = 2.8%

Using the CPI (Example 3)

CPI in year one: 184.3CPI in year two: 170.0

Inflation between year one and year two =

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(170.0) – (184.3)

(184.3)= -0.078 = -7.8%

CPI by city

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City Miami Detroit New York San Francisco

1990 128 128.6 138.5 132.1

2000 167.8 169.8 182.5 184.1

2010 223.1 205.1 240.8 227.7

Inf. 90-00

Inf. 00-10

Avg Inf. 90-00

Avg Inf. 00-10

Avg Inf. 90-10

CPI by city

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City Miami Detroit New York San Francisco

1990 128.0 128.6 138.5 132.1

2000 167.8 169.8 182.5 184.1

2010 223.1 205.1 240.8 227.7

Inf. 90-00 31.1% 32.0% 31.8% 39.4%

Inf. 00-10 33.0% 20.8% 31.4% 23.7%

Avg Inf. 90-00

Avg Inf. 00-10

Avg Inf. 90-10

Using the CPI (Example 4)

CPI0 = value in initial year

CPIT = value T years laterAvgInf = Average inflation between year 0

and year T

Solving for AvgInf:

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CPI0 ( 1 + AvgInf )T = CPIT

AvgInf = ( CPIT / CPI0 )(1/T) - 1

Using the CPI (Example )

CPI in year one: 128.0CPI in 10 years later: 167.8

Average Inflation = ( CPIT / CPI0 )(1/T) – 1 = ( 167.8/ 128.0)(1/10) – 1

= 0.02744 = 2.7%

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CPI by city

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City Miami Detroit New York San Francisco

1990 128 128.6 138.5 132.1

2000 167.8 169.8 182.5 184.1

2010 223.1 205.1 240.8 227.7

Inf. 90-00 31.1% 32.0% 31.8% 39.4%

Inf. 00-10 33.0% 20.8% 31.4% 23.7%

Avg Inf. 90-00 2.7% 2.8% 2.8% 3.4%

Avg Inf. 00-10 2.9% 1.9% 2.8% 2.1%

Avg Inf. 90-10 2.8% 2.4% 2.8% 2.8%

http://www.bls.gov/cpi/

How to calculate the CPI1. Determine the “market basket” of goods2. Calculate inflation from the base year for

the market basket3. Multiply by 100 (e.g., 4.6% inflation

becomes 4.6) 4. Add to base year CPI which is always 100

(e.g., 100 + 4.6 = 104.6)

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Calculating CPI (Example 1)

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Good Market Basket Quantity

Price 1998

Price 1999

Expend. 1998

Expend. 1999

Gasoline

100 gal $1.40/gal $1.60/gal

Bread 150 loaves

$1.30/loaf

$1.20/loaf

Milk 300 quarts

$0.75/qrt $0.77/qrt

Total:

Calculating CPI (Example 1)

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Good Market Basket Quantity

Price 1998

Price 1999

Expend. 1998

Expend. 1999

Gasoline

100 gal $1.40/gal $1.60/gal

$140 $160

Bread 150 loaves

$1.30/loaf

$1.20/loaf

$195 $180

Milk 300 quarts

$0.75/qrt $0.77/qrt

$225 $231

Total: $560 $571Inflation between 1998 and 1999 ?

Calculating Inflation

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Price of market basket in 1998 = 560Price of market basket in 1999 = 571

Inflation between 1998 and 1999?

(Market Basket Price 1999) – (Market Basket Price 1998)

(Market Basket Price 1998)

(571) – (560)

(560)= 0.0196 = 1.96%

Calculating CPIIf 1998 is the base year and inflation is

1.96%, what is the CPI in 1999?

100 + 1.96 = 101.96

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Calculating CPI (Example 1)If a different year is the base year and

1998 has CPI 204.3, then what is the CPI in 1999?

CPI in 1999 must be 1.96% higher than the CPI in 1998.

CPI in 1999 = (CPI in 1998) x [1 + (1998 to 1999 inflation)]

CPI in 1999 = (204.3) (1.0196) = 208.3

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Calculating CPI (Example 2)Last year, a typical family spent $35 on

sandwiches and $27 on soda. Prices were $5/sandwhich and $3/soda.

What is the CPI market basket?7 sandwiches and 9 sodas

If last year was the base year, what is the base year CPI? 100 (it’s always 100 in the base year)

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Calculating CPI (Example 2)Last year, a typical family spent $35 on

sandwiches and $27 on soda. Prices were $5/sandwich and $3/soda. The market basket is therefore 7 sandwiches and 9 sodas.

This year, prices are $7/sandwich and $5/soda.

What was the market basket price last year?$35 + $27 = $62

What is the market basket price this year?$7 x 7 + $5 x 9 = $49 + $45 = $94

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Calculating CPI (Example 2)Last year, a typical family spent $35 on

sandwiches and $27 on soda. Prices were $5/sandwich and $3/soda. The market basket is therefore 7 sandwiches and 9 sodas.

This year, prices are $7/sandwich and $5/soda.

What was inflation this year?

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(Market basket price this year) – (Market basket price last year)

(Market basket price last year)

($94) – ($62)

($62)= 0.516 = 51.6%

Calculating CPI (Example 2)In the base year, a typical family spent $35

on sandwiches and $27 on soda. Prices were $5/sandwich and $3/soda. The market basket is therefore 7 sandwiches and 9 sodas.

This year, prices are $7/sandwich and $5/soda.

What is the CPI this year?151.6

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One last example

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Suppose thatThe CPI in 1980 equals 82.4The CPI in 1990 equals 130.7Inflation between 1990 and 2000 was 31.8%

Questions:What was inflation between 1980 and 1990?What is the CPI in 2000?What was inflation between 1980 and 2000?

One last example

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Suppose thatThe CPI in 1980 equals 82.4The CPI in 1990 equals 130.7Inflation between 1990 and 2000 was 31.8%

What was inflation between 1980 and 1990?(130.7 – 82.4) / 82.4 = 0.586 = 58.6%

One last example

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Suppose thatThe CPI in 1980 equals 82.4The CPI in 1990 equals 130.7Inflation between 1990 and 2000 was 31.8%

What is the CPI in 2000?Must be 31.8% higher than 1990 CPI(130.7)(1+0.318) = (130.7)(1.318) = 172.3

One last example

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Suppose thatThe CPI in 1980 equals 82.4The CPI in 1990 equals 130.7Inflation between 1990 and 2000 was 31.8%

What was inflation between 1980 and 2000?(172.3-82.4)/(82.4)= 1.091 = 109.1%

Why is this more than 58.6% + 31.8%?