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03/29/2007 Econ 201: Principles of Economics Hakan TASCI

Where the telescope ends, the microscope begins. Which of the two has the

grander view? VICTOR HUGO

1. Today’s Outline • Aggregation and Macroeconomics • Supply and Demand in Macroeconomics • Gross Domestic Product • Growth • Unemployment • Inflation

2. Aggregation and Macroeconomics

In Microeconomics, the spotlight is on how individual decision-making units behave. For example farmer decides how much does he produce. Individuals decide how much they consume. On the other hand, macroeconomics concentrates on the behavior of the entire economies. Macroeconomics study the overall price level, unemployment rate, inflation, growth etc…of which we call economic aggregates. Economic Aggregates: is an abstraction that people use to describe some salient feature of economic life. Although we observe only price of electricity, rent, tickets, college everyday, we never see the price level economy wide. By putting some weight for each product in the market a price index can be found like Consumer Price Index Aggregation: The process by which real objects are combined into an abstraction like total domestic product etc is aggregation. The Foundations of Aggregation

• All goods in the market have some weight in aggregation • The composition of demand and supply in various markets is of little

consequence for the economy-wide issues of growth, inflation, and unemployment.

• During economic fluctuations, markets tend to move up or down together. Not individually. For example if market is going up, there is more demand for potatoes and tomatoes, pickles etc…

3. Supply and Demand in Macroeconomics

Aggregate Demand: shows the quantity of domestic product that is demanded at each possible value of the price level. Aggregate Supply: shows the quantity of domestic product that is supplied at each possible value of the price level.

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Recession: is a period of time which total output of economy declines. (Real GDP) There is also unemployment during recession. We faced this kind of recessions several times during the history. The most recent one is the recession in 2001 after the technology bubble busted

Economic Growth: is sustained improvement in total product of economy. During 90’s US observed a very stable growth period for years. When you look at the US economy on average the growth is around 4.5 percent in the last 40 years. Growth may occur because of both supply and demand shift. Here is an example where only demand shift brings the economic growth.

Stagflation: Inflation and recession together. Generally, a leftward shift in supply causes a stagflation. Oil Price shocks in 70’s is a very good example of this kind. (1973-80 Oil Price Shocks)

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4. Gross Domestic Product Gross domestic product is the most comprehensive measure of output of the economy. GDP: is the sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets during a specified period of time usually a year. Beware that if a good is produced and stored as an inventory. It is going to be a part of the inventory. So it is a part of the GDP although it is not sold in the market. Nominal GDP: is the value of total output at current prices. Real GDP: is the value of different years’ output at common prices. (Fix a price level of some year and calculate all GDPs by assuming this price level.) Example : Good Price(2003) Price(2004) Output

Bananas $0.5 $0.6 20 tons Oranges $1 $1.2 30 tons Apples $1.5 $1.4 50 tons Nominal GDP = Real GDP = Real GDP counts only the change in production. Nominal GDP counts not only the change in production but also change in prices How to calculate GDP? :

• GDP includes only goods and services produced within the year. Sales of items produced in previous years are explicitly excluded

• Only final goods and services count in GDP • No intermediate goods in GDP • Only production within the boundaries of a country is counted in GDP

Final goods: are those purchased by the ultimate users. Intermediate goods: is a good purchased for resale or for use in producing another good. Limitations of GDP:

• Is not a measure of the nation’s economic well being. Foreign production can be in it.

• Only market activity is included in GDP (House wives, farmers production for their own consumption)

• No value on Leisure. Developed country’s citizens take more leisure • Bads get counted in GDP (rebuilding after storms, earthquakes etc) • Ecological costs are not netted in GDP (pollution)

Per capita GDP = GDP/ population. Gross domestic product divided by population

5. Growth One of the main concerns of the nations is growth. The production of goods and

services should rise steadily in order to compensate the newborns, and extra consumption of individuals. Growth is slow but not automatic. Africa has negative growth in recent decades.

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Growth Policy: refers to government policies intended to make economy grow faster in the long run. Potential GDP: is the real GDP that the economy would produce if its labor and other resources were fully employed.

Growth of US Economy

Case Study: The Great Depression

The Great Depression was a worldwide economic downturn which started after the Stock Market Crash in October of 1929 and continued until 1941. It began in the United States and quickly spread to Europe and every part of the world, with devastating effects in both industrialized countries and those which export raw materials. International trade declined sharply, as did personal incomes, tax revenues, prices and profits. Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by 40 to 60 percent. Mining and logging areas had perhaps the most striking blow because the demand fell sharply and there were few employment alternatives. The Great Depression ended at different times in different countries;

for subsequent history see Home front during World War II. Most countries set up relief programs, and most underwent some sort of political upheaval, pushing them to the left or right. Democracy was weakened and on the defensive, as dictators such as Hitler, Stalin and Mussolini made major gains, which helped set the stage for World War II in 1939.

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Labor force: is the number of people holding or seeking jobs. The growth rate of potential GDP depends on

• The growth rate of the labor force • The growth rate of the nation’s capital stock • The rate of technical progress

Growth rate of potential GDP= growth of labor + growth of labor productivity How to measure Economic Growth:

• Real GDP: measure the size of expanding economy • Real GDP per capita: measures the change in country’s standard of living. • Labor productivity: measures how much more productive an economy is. 6. Unemployment

When an economy grows more slowly than its potential, it fails to generate enough jobs for ever-growing labor force. Hence unemployment rises. Conversely GDP growth faster than the economy’s potential leads to a falling unemployment. If a person is not willing to work, he is not counted as unemployed worker. Unemployment covers who are willing to work but cannot find a job. Unemployment Rate: is the number of unemployed people, expressed as a percentage of the labor force. Types of Unemployment:

• Frictional Unemployment: is unemployment that is due to normal turnover in the labor market. It includes people who are temporarily between jobs.

• Structural Unemployment: refers to workers who have lost their jobs because they have been displaced by automation. Their skill is no longer in demand.

• Cyclical unemployment: is the portion of unemployment that is attributable to a decline in the economy’s total activity. It rises in recession and falls in boom.

Full employment: is a situation in which everyone who is willing to and able to work can find a job. Measure unemployment rate is still positive.

7. Inflation and Interest Rates Inflation: is a sustained increase in the general price level. Negative inflation is deflation. Example : Good Price (2003) Price (2004) Weight (share in total product)

Bananas $0.5 $0.6 0.2 Oranges $1 $1.2 0.3 Apples $1.5 $1.4 0.5 Sum: 1 Price Level in 2003 = Price Level in 2004 = Inflation =

Inflation In US from 1870 to 2004

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Costs of Inflation:

• Inflation changes the income distribution. Lenders lose money and borrowers earn money. So there is a wealth transfer from lenders to borrowers. If there is deflation just the opposite is valid.

• Inflation redistributes the benefits of the economy. • High inflation can distort the economy as a whole. (German hyperinflation in

1930’s, Turkish cas in 1990s, Argentina, Brazil.. • Menu costs. Retailers have to change their prices frequently • Shoe Cost: Consumers in order to not to be affected from inflation, they go to

bank more frequently. • Inflation distorts measurements.

Nominal Interest Rate: The interest rate that we observe in real world. Federal funds rate, overnight rates etc… Real Interest Rate: Nominal Interest rate is adjusted to the prices (Nominal interest rate minus expected inflation ) How to measure inflation

• Consumer Price Index: the cost of living. Price index of a fixed basket of consumption goods essentially.

• Wholesale Price Index: price index of a fixed basket of goods in whole sales • GDP Deflator: Basket includes all goods that are in GDP.

8. Multiple Choice Questions:

1. A macroeconomist would concentrate on which of the following issues? a. the price of pizzas b. the profits of the IBM Corporation c. the unemployment rate in Germany d. the market for hot dogs

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2. In economics, aggregation refers to a. collecting sample specimens for reclassification. b. using small stones to pave an artistic walkway. c. combining many markets into one overall economy. d. using large computers to solve economic problems.

3. While their respective subject matters differ greatly, both microeconomists and macroeconomists rely on the same basic tools; that is, both rely on

a. government contracts to promote research and publications. b. demand-and-supply analysis. c. the economic theory of John Maynard Keynes. d. consumer protection laws and antitrust legislation.

4. The aggregate demand curve shows the quantity of domestic product a. produced at each possible price level. b. demanded and produced at each possible price level. c. that is exported at each possible price level. d. demanded at each possible price level.

5. In the aggregate demand-aggregate supply model, economic growth can be illustrated by an a. outward shift of the aggregate demand curve. b. inward shift of the aggregate demand curve. c. inward shift of the aggregate supply curve. d. outward shift of the aggregate supply curve.

6. The clearest sign of inflation would be a(n) a. increase in the price level. b. increase in the quantity of total final output. c. decrease in the quantity of total final output. d. simultaneous increase in both output and prices.

7. Real GDP a. is nominal GDP adjusted for changes in the price level. b. is also called nominal GDP. c. measures GDP minus depreciation of capital. d. will always change when prices change.

8. If the prices of all goods and services rise during the year, a. real GDP may fall. b. nominal GDP must rise. c. nominal GDP may increase. d. real GDP must rise.

9. A good produced in 2000 and held in inventory until it is sold in 2001 would be included in which measure of GDP?

a. Half the value in 2000 and half the value in 2001 b. In 2001 GDP c. In both 2000 and 2001 GDP d. In 2000 GDP

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10. General Motors Corporation (a U.S.-based firm) produces a Saab vehicle in Sweden, and sells it in the United States. In which country’s GDP is it included?

a. Sweden and the United States b. The United States because it was sold there c. The United States because GM is a U.S. company d. Sweden because it was produced there

11. Which of the following transactions would be included in GDP for 2001? a. On January 5, 2001, Chris Carter sold 100 shares of stock in IBM Corporation. b. Bonita Delgado purchases a new 2001 Oldsmobile on March 10, 2001. c. Nadav Daniel buys a used desk from the “Struggling Students Used Furniture” store on

May 9, 2001. d. Levi Lathan purchases a 75-year-old penthouse on Lake Shore Drive in Chicago,

Illinois, on June 23, 2001.

12. Which of the following is included in GDP? a. the value of illegally produced goods b. the value of housework by a stay-at-home dad c. the value of volunteer work done at a local homeless shelter d. the cost of government-provided social services

13. In 2001 severe floods hit the state of Texas causing extensive damage. What is the most likely effect of this natural disaster on GDP and well being?

a. Decreased GDP, decreased well being b. Increased GDP, decreased well being c. Decreased GDP, increased well being d. Increased GDP, increased well being e. Economists cannot predict these effects.

14. Large sport utility vehicles (SUVs) add significantly to air pollution because they do not have to meet passenger auto emission standards. The purchase of an SUV

a. adds less to GDP since the pollution costs are subtracted from GDP. b. adds to nominal but not real GDP because of the pollution costs. c. is a net loss to GDP because the pollution costs are so large. d. increases GDP.

15. The Great Depression of the 1930s led to a revolution in macroeconomic thinking, following the work of

a. Arthur Laffer. b. Milton Friedman. c. Adam Smith. d. John Maynard Keynes. e. David Ricardo.

16. When Keynes took the British civil service exam, his lowest score was on the _____________ section.

a. logic b. mathematics c. statistics d. economics e. history

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17. Faster economic growth in the United States may lead to the serious macroeconomic problem of higher

a. levels of unemployment. b. federal budget deficits. c. levels of inflation. d. levels of poverty.

18. Potential GDP is an estimate of the economy’s ability to produce goods and services if the a. labor force is fully employed. b. price level is stable. c. trade balance is zero. d. federal budget is balanced.

19. The growth rate of potential GDP depends, among other factors, on the a. rate of technological progress. b. unemployment rate. c. size of the labor force. d. rate of capital stock depreciation.

20. To measure how productive an economy is becoming, the best measure to use would be a. real GDP. b. GDP per capita. c. GDP per hours of work. d. GDP divided by population.

21. If the labor force grows faster than the number employed, the a. unemployment rate will fall. b. unemployment rate will rise. c. labor force rate will rise. d. employment rate will rise.

22. Someone who is out of work because they are between jobs is experiencing a. frictional unemployment. b. structural unemployment. c. seasonal unemployment. d. cyclical unemployment.

23. The use of automated teller machines (ATMs) has caused some bank tellers to lose their jobs. This is an example of

a. cyclical unemployment. b. seasonal unemployment. c. frictional unemployment. d. structural unemployment.