Unit 2: Gross Domestic Product, Inflation, and Unemployment
In macroeconomics, we study the total output an economy generates. Economists use gross domestic product (GDP), the monetary value of all final goods and services produced within a country's borders in one year, to measure a country's total output. Macroeconomics tend to use real GDP, rather than nominal GDP, for their comparisons since real GDP removes the effect of inflation. Measuring growth in current dollars (which does not account for inflation) rather than constant dollars might indicate a false sense of economic growth or decline.
Governments focus on three key indicators of economic growth: an increase in real GDP over time, full employment, and price level stability. Unit 5 explores how governments form, implement, and evaluate their fiscal and monetary policies to achieve these three goals. In this unit, we uncover scenarios and philosophical debates about the government's role in a market-based economy. We examine whether GDP accurately measures societal well-being, quality of life, and standard of living.
Completing this unit should take you approximately 6 hours.
Upon successful completion of this unit, you will be able to:
- identify the components of the business cycle and track real GDP;
- compare real and nominal gross domestic product;
- define inflation, deflation, hyperinflation, and stagflation;
- compute inflation by calculating the price of a basket of goods and the corresponding price index;
- define the price index and compare real variables using the corresponding price index;
- define economic growth and explain the role it plays in a country's success and why;
- define unemployment, the three types of unemployment, and how economists measure it;
- compare frictional, structural, and cyclical unemployment and their impact on economic production;
- analyze and apply the natural unemployment rate and full employment;
- explain the GDP deflator and the four elements of GDP – consumption, investment, government purchases, and net exports; and
- analyze problems associated with using GDP as a measure of well-being.
2.1: Defining GDP
How large is the U.S. economy compared to other countries? Gross domestic product (GDP) measures a country's entire income. Gross means entire, domestic refers to a particular economy, and product refers to economic output or activity. GDP is the most widely recognized measure of a country's economic strength and performance. GDP measures two things: the country's total income and total spending. In an economy, income and expenditure equal each other.
Read this text, which introduces the macroeconomic perspective, the bird's eye overall view of how well or poorly the economy is going, based on three key measurements: the unemployment rate, inflation rate, and GDP.
Read this text, which identifies the components of gross domestic product (GDP) on the demand and supply side. What do economists mean by investment or business spending? What is consumption? How do statisticians measure GDP? GDP measures what a country produces according to five categories: durable goods, nondurable goods, services, structures, and changes in inventories. GDP can be overvalued when double-counting, a common error, arises. GDP can also be undervalued.
In their calculation of GDP, economists include consumption, business investment, government spending on goods and services, and net exports. They do not include intermediate goods, transfer payments, non-market activities, used goods, or illegal goods. Be sure you can differentiate two other economic measures: gross national product (GNP) and net national product (NNP).
Watch these videos to analyze the definition of gross domestic product (GDP) and how this definition avoids double-counting and the effects of price changes.
Study this text, which contrasts nominal and real GDP and reviews how to calculate real GDP based on nominal GDP values. What is the GDP deflator?
GDP is the broadest measure of an economy's performance – it is central to macroeconomics. Read this text, which explains the four phases of the business cycle: recession, depression, peaks, and troughs. The economy goes through naturally alternating periods of economic growth and recession. Economies are naturally prone to cycles of boom and bust. Markets fluctuate, swinging from confidence to pessimism, as consumers shift from greed to fear and back again. Major swings in economic activity are inevitable.
Read this text on how to compare the economic welfare of different nations. It reviews how to convert GDP to a common currency using exchange rates and GDP per capita using population data.
Read this text on how productivity influences the standard of living. What are the limitations of using GDP to measure the standard of living? What is the relationship between GDP data and fluctuations in the standard of living?
2.2: Defining Business Cycles
The business cycle refers to the movement of the economy from peak to trough and trough to peak. The trough is the lowest point of a recession before a recovery begins. The peak is the highest point of the economy before the recession begins. In other words, a recession lasts from peak to trough, and an economic upswing runs from trough to peak.
Watch these videos to explore the components of the business cycle. As you will see, the business cycle is largely driven by the emotions of the market participants. Optimism can spur demand and increase economic activity, whereas negative expectations can precipitate economic decline.
2.3: Economic Growth
Economic growth is when a nation's wealth increases over time, and we see an increase in the production of goods and services. Increases in capital goods, labor force, human capital, and technology contribute to economic growth, which is measured by an increase in the aggregate market value of additional goods and services produced, using estimates such as GDP.
Read this text on the conditions that prompted economic growth during the past two centuries. Economists believe that the rule of law and contractual rights play a significant role in creating a functioning economic system. How have public policies influenced long-run economic growth?
Labor productivity, the value each employed person creates per unit of their input, is another factor that promotes economic growth. "Human capital is the accumulated knowledge (from education and experience), skills, and expertise that the average worker in an economy possesses". Read this text, which explores the aggregate production function, how to measure an economy's rate of productivity growth, and the power of sustained growth.
Read this text on the factors that contribute to a healthy climate of economic growth, such as the deepening of physical capital (infrastructure), human capital, and technological improvements. What is capital deepening? To improve their economic outlook, many countries invest in education, savings and investment, infrastructure, special economic zones, and scientific research.
This text discusses arguments for and against economic convergence, when low- and middle-income economies grow faster than high-income countries.
Watch these videos, which discuss economic growth in more detail. The second video walks you through calculations of economic growth under different scenarios for growth rates.
2.4: Real GDP and Nominal GDP
Nominal GDP reflects the raw numbers in current dollars unadjusted for inflation, while real GDP accurately adjusts the numbers by fixing the currency value, thus eliminating any distortion caused by inflation or deflation. The difference between nominal and real GDP is that nominal GDP is not adjusted for inflation, while real GDP is. Therefore real GDP is the better measurement to consider.
Watch these videos, which show the distinction between real GDP and nominal GDP, and introduce the GDP deflator, which is the price index calculated on all goods and services included in GDP.
Watch this lecture on calculating real GDP with a deflator. This is one among many approaches to removing the effect of inflation from nominal or current values. Watch for other approaches, some of which draw from a base broader or narrower relative to that under current consideration.
2.5: Defining Inflation
Inflation is the general rise in prices. Therefore, inflation represents a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual price change for everyday goods and services such as food, clothing, furniture, and transportation.
Review this section which defines and discusses the concept of inflation. A basket of goods and services includes the items individuals, businesses, and organizations typically buy. Pay attention to the steps followed to calculate the annual rate of inflation. What are index numbers? What is a price index, and how is it used to calculate inflation and its limitations?
This video introduces inflation as an increase in the price level over time. It shows how we use the consumer price index (CPI) to calculate inflation.
The cost of living is a critical measurement of every economy. The U.S. Bureau of Labor Statistics calculates the consumer price index (CPI) based on a fixed basket of goods and services the average family of four purchases. The eight major categories of the CPI include food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. What is substitution bias? Other price indices include the producer price index (PPI), GDP deflator, international price index, and employment cost index.
Watch these videos to review inflation, the price indexes, and how real variables such as real income and real GDP are derived. These three indices measure how well or poorly the economy performs: unemployment, inflation, and GDP.
Read this text on patterns of inflation using the CPI. What are deflation and hyperinflation?
Watch this lecture on hyperinflation, defined as inflation rates above 200 percent for one year or longer.
Read this text on economic problems inflation causes, redistributions of purchasing power, ways inflation can blur the perception of supply and demand, and the economic benefits and challenges of inflation.
Read this text on the relationship between indexing and inflation. What is a cost of living adjustment (COLA)?
Governments often use macroeconomic policy to control inflation: through taxes, spending, and regulating interest rates and credit.
Read this article, which discusses how inflation can distort the allocation of resources and adversely affect economic efficiency.
2.6: Unemployment
The unemployment rate, another important economic indicator, measures how close an economy is to full employment. A key measure of the economy's health, unemployment is when someone actively searches for work but cannot find a job. There are three types of unemployment: frictional, structural, and cyclical. Cyclical unemployment is unavoidable because it results from the economy's reoccurring boom and bust cycles. Frictional and structural unemployment are avoidable and can be minimized.
Read this text on how we define and calculate unemployment. Those who have left the workforce and not actively seeking employment are not considered unemployed. Examples include retired workers, full-time students, and stay-at-home parents. Hidden unemployment includes underemployed and discouraged workers.
Read this text, which examines the historical unemployment rate in the United States. What are some unemployment trends based on demographic groups? Statisticians also examine new entrants, re-entrants, job leavers, and temporary and non-temporary job losers.
Read this text on cyclical unemployment, the variation in unemployment rates due to the business cycle – when the economy moves from expansion to recession and back again. Wages are not very flexible – although employees often receive salary increases, we rarely see decreases.
Economists describe this situation by saying wages are "sticky downward." There are many theories on why this occurs. It is illegal for employers to pay an hourly rate below the minimum wage; many employees have multi-year contracts, and employers offer wages higher than what market conditions would dictate to keep qualified workers. It is expensive to hire and train new workers. This reading offers additional arguments that explain the relationship between sticky wages and employment.
Read this text on frictional and structural employment. It also explores the relationship between the natural unemployment rate, potential GDP, productivity, and public policy.
Watch these videos for a different perspective on the meaning of unemployment and the main types of unemployment: frictional, structural, and cyclical.
Watch this video on the natural rate of unemployment. It argues that our goal is not to achieve zero percent unemployment – that is impossible. A certain low unemployment rate (the natural unemployment rate) is not only possible but desirable.
Unit 2 Assessment
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