ECON102 Study Guide

Unit 2: Gross Domestic Product, Inflation, and Unemployment

2a. Identify the components of the business cycle and track real GDP

What are business cycles?
What are economic contraction, recession, and trough?
What are economic expansion, boom, and peak?
What is real GDP, and what is the difference between real and nominal values?
How do economists calculate real values?
What is the GDP deflator, and how do economists use it to calculate real GDP?

Business cycles describe the periodic natural fluctuations in the economy, where recessions, economic expansions, and economic booms alternate. The phases of a business cycle include peak, contraction, recession, trough, recovery, and expansion.

Figure 5.2 Expansions and Recessions, 1960–2011

Economists use real GDP to evaluate and compare economic activity over time. Economists say the economy is in recession when GDP falls for two successive quarters. A depression describes a severe or prolonged economic downturn, specifically a recession that lasts more than two years.

Consider the measure of gross domestic product (GDP) we studied in the previous section as nominal GDP because it describes total spending in the economy: we measure the prices for goods and services at the time of the calculation.

While nominal GDP measures overall spending, it may not accurately portray whether the economy has really grown or has been more productive from one year to the next. We need to eliminate the effect of inflation when making these types of comparisons to get a more accurate reading of how well the economy is really doing.

For example, when we compare nominal GDP in 2017 ($18 trillion dollars) to nominal GDP in 2018 ($20 trillion dollars), we do not know if the $2 trillion increase was due to higher production levels or higher prices (inflation). The economy grew if the increase was due to higher production levels – a great outcome. However, if the $2 trillion increase was due to a price rise, we attribute the increase in nominal GDP to inflation, not production. A large increase in inflation could hide the fact that production levels may have held stagnant or even dropped.

The concept of real GDP removes the effect prices and inflation have on GDP. An increase in real GDP always means the economy is growing; a drop in real GDP always means the economy is contracting.

Note that while GDP measures economic activity, it is not an accurate measurement of the true standard of living in a country. An example of this limitation is that while GDP includes "what a country spends on environmental protection, healthcare, and education, it does not include the actual levels of environmental cleanliness, health, and learning".

To review, see:

2b. Compare real and nominal gross domestic product

How does including intermediate goods and services or inputs to production when calculating GDP reflect double counting?
Does the calculation for GDP include the value of goods and services that foreign nationals (residents who are not citizens) produce?
Does the calculation for GDP include the value of goods and services that all nationals (citizens who live in foreign countries) produce?

The concept of gross domestic product (GDP) is central to macroeconomics. The media and government officials and the media use it to document the health of a country's economy.

A country's overall economy can be measured by its gross domestic product (GDP): the value of all final goods and services produced within the country in a given year.

Remember four central elements economists use to calculate gross domestic product (GDP) from this definition:

market value of
final goods and services
within one country
in one given year

Gross domestic product (GDP) tallies up the services, durable goods, nondurable goods, structures, and changes in inventories a country produces. GDP measures domestic economic activity.

When we calculate gross domestic product (GDP) or economic activity from this supply-side or output-driven perspective, we tend to focus on the physical objects an economy produces, such as cars, machines, or computers. However, the services comprise the largest part of today's gross domestic product (GDP) by far.

In today's economy, most jobs involve working behind a computer screen, coordinating activities, creating plans, and meeting with our co-workers, customers, and suppliers to cater to the needs of our individual customers and clients. Today's leading service industries include healthcare, education, and legal and financial services. Do not forget to include these major producers when you think of GDP.

Economists assign five categories to the goods and services they include in GDP: services, durable goods, nondurable goods, structures, and changes in inventories.

We just explored services.
Durable goods include long-lasting items, such as cars and refrigerators.
Nondurable goods include short-lived items that last less than a year, such as food and clothing (this category includes clothing even though many clothes last longer than a year!).
Structures include homes, office buildings, shopping malls, and factories.
Inventories refer to the goods a business has already produced but not yet sold to consumers. They are sitting in warehouses and on shelves.

To review, see:

2c. Define inflation, deflation, hyperinflation, and stagflation

Why can an economy experience a period of inflation while some prices are falling?
Does an economy experience inflation when prices have been high for a long time?
Explain how inflation, deflation, and hyperinflation can negatively impact borrowers, lenders, retirees, and the general economy.

Inflation refers to a rise in the average price level. Deflation describes a fall in the average level of prices. Governments aim to steer their economies toward a steady, one or two percent inflation rate rather than zero percent.

Stagflation occurs when a recession and inflation coincide – a highly undesirable situation.

Aggregate demand (AD) is the total demand for all finished goods and services produced domestically in an economy. If consumer consumption rises because many people are employed and spending more, aggregate demand for goods and services will increase. Additionally, if investment increases due to decreased interest rates, production and output will increase. Therefore, aggregate demand will rise.

Aggregate supply (AS) is the total quantity of output firms produce and sell (in other words, real GDP). The aggregate supply (AS) curve shows the total quantity of output firms produce and sell at each price level.

To review, see:

2d. Compute inflation by calculating the price of a basket of goods and the corresponding price index.

What specific baskets of goods do various price indexes measure?
What is the base period and the value of an index in the base period?

Economists use various price indexes to calculate and compare price fluctuations for specific baskets of goods and services during specific time periods. The three primary price indexes economists in the United States use include the consumer price index (CPI), the producer price index (PPI), and the GDP deflator (or implicit price deflator).

Review these steps for calculating the inflation rate.

Identify the basket of goods you want to use to calculate the inflation rate. For example, for the consumer price index (CPI), you need to identify the specific goods and services a typical consumer buys, such as specific foods, gas, or clothes.
To calculate the cost of the basket of goods and services for the base and current years, multiply the price of each good by its quantity and add all of the goods and services in the basket.
To calculate the price index, divide the cost of the basket in the current year by the cost of the basket in the base year.
To calculate the inflation rate, take the percentage change in the cost of the basket or the percentage change in the price index.

In this section, we learn more about how the CPI has historically been used to measure inflation, deflation, and hyperinflation in the United States and other countries. One downside of indexing is that it tends to be partial. Some people are indexed against inflation, and some are not. It falls to the potential victims of inflation to seek out ways to protect themselves.

Review "Indexing and Its Limitations" for a discussion on the pros and cons of indexing. The discussion of the Federal Open Market Committee's (FOMC) challenge to create price stability while juggling inflation and economic growth tells us that good monetary policy is necessary to reach acceptable economic targets.

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2e. Define the price index and compare real variables using the corresponding price index

What is a price index, and what variables make up a price index?

While a consumer price index (CPI) provides a useful measure of inflation, as with all economic variables, it has some limitations. Think about the following sources of bias for the consumer price index.

Since economists calculate indexes based on a fixed basket of goods and services, they do not account for substitutions consumers use when prices change.

Companies frequently offer consumers new goods, services, and innovations that are not included in the baskets the economists study.

Price increases could reflect quality improvements manufacturers make to their goods and services, which we should attribute to economic growth, not inflation.

Price decreases could reflect a choice consumers make to shop at different locations (such as online) to obtain lower prices, which should not be attributed to deflation.

To review, see:

2f. Define economic growth and explain the role it plays in a country's success and why

How does a small difference in growth rates among countries lead to large differences in total production over an extended period of time?

Economic growth is the national increase in potential output, which is often determined by the country's available resources: labor, capital, raw materials (land), and entrepreneurship.

Labor productivity is the value each employed person creates per unit of their input.

Human capital is the skills and knowledge that make workers productive.

Physical capital includes the plant and equipment that firms use and things like roads (infrastructure).

Production function is the technical relationship by which economic inputs like labor, machinery, and raw materials are turned into outputs like goods and services that consumers use.

Entrepreneurship is the process of setting up a business by anticipating needs and turning new ideas to market. Entrepreneurs accept the risks of a startup and are rewarded with profits and growth opportunities. Newly created firms use capital and labor to produce goods and services, thereby contributing to economic growth.

How does an increase in savings contribute to increased investment?
Will a household decision to consume less and save more (increase total investment) enhance a country's long-term economic growth?

Countries often generate long-term economic growth by increasing investment in physical and human capital. Worker productivity can increase via improvements in technology and education, which lead to higher output.

Consider a typical household decision regarding dividing income between spending and saving.

Two key factors in a country's economic growth are whether it has a strong rule of law with a government that protects property rights and contractual rights. Can you give an example of a contractual right?

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2g. Define unemployment, the three types of unemployment, and how economists measure it

What are some examples of the types of people who are part of and outside the labor force?

According to the U.S. Bureau of Labor Statistics, individuals are unemployed if they are not working, but they are available and actively looking for a job. For economists, the unemployment rate provides a key measure of how well the economy is doing. The unemployment rate details the percentage of adults who are part of the labor force who do not have a job, not the percentage of everyone who is not officially employed. So, for example, the unemployment rate does not include retirees, full-time students, people who work from home and do not earn a salary, children, volunteers, and people who are not actively seeking employment.

You need to calculate the total labor force to calculate the unemployment rate.

Unemployment rate = Unemployed people / Total labor force × 100

Unemployment rate = Unemployed people / Total labor force × 100

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2h. Compare frictional, structural, and cyclical unemployment and their impact on economic production.

Are frictional, structural, and cyclical unemployment good, acceptable, or undesirable?
Which type of unemployment indicates the economy is performing poorly and may need a correction?
Can an economy achieve a zero unemployment rate?
What factors cause the unemployment rate to overstate the true level of unemployment?
What factors cause the unemployment rate to understand the true level of unemployment?

Economists distinguish three types of unemployment: frictional, structural, and cyclical unemployment. In the long run, the unemployment that results from a combination of income, social, and political factors that exist at a time, assuming the economy is not booming or in recession, is called the natural rate of unemployment.

These factors account for the fact that an economy will always have an unemployment rate above zero. Because it takes time for workers to find appropriate new employment or to relocate to a new job, workers remain unemployed during this period. This is called frictional unemployment. Structural unemployment includes individuals who are unemployed because they lack skills valued by the labor market. Cyclical unemployment is a short-term problem because it is caused by an economy that is in recession.

As with many policy calculations, the unemployment rate provides an imperfect measure of the economy. The unemployment rate may understate or overstate real unemployment in the economy.

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2i. Analyze and apply the natural unemployment rate and full employment

What are natural employment and full employment?

The "natural" rate of unemployment includes frictional and structural unemployment. Structural unemployment is impacted by people finding their skills are not a match for current hiring needs. Think of industries that have changed over time, for example, cars replacing horse-drawn carriages. Over time, these people can retrain to meet current skill demands.

Frictional unemployment reflects the people who are looking for a job and have skills that are in demand. Employers are searching for appropriate candidates. These people, in all likelihood, will eventually find jobs with their current skills. Theoretically, the closer the unemployment rate is to the natural rate of unemployment, the less need there is for the government to intervene with monetary and fiscal policies.

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2j. Explain the GDP deflator and the four elements of GDP – consumption, investment, government purchases, and net exports

Which component reflects new home purchases?
What common unit of measurement do economists use to measure GDP?
Which of the components of GDI is the largest?

In national income accounting, we calculate the GDP to identify economic activity in a given country. Economists use two primary methods to calculate GDP: the income and expenditure methods. Note that these GDP calculations should produce the same result: every transaction has a seller who receives income from the sale proceeds and a buyer who spends money to purchase goods and services. The nationally reported numbers for income and expenditures frequently differ slightly due to errors and omissions in measurement and reporting.

Seller receives income from the sale of the product or service (income approach)
↓
Product or Service (market value)
↓
Buyer spends money to purchase the product or services (expenditure approach)

Until now, we calculated GDP in terms of the supply side, business income, and total production of domestically produced goods and services. This task is straightforward: take the quantity of everything a country produces and multiply this quantity by the price of each product sold. This calculation describes an income-based approach.

To calculate GDP, the expenditure approach focuses on consumer demand or the total amount households, businesses, governments, and foreign sectors spend to purchase domestic goods and services.

Demand or Expenditure Side of GDP

From the demand or expenditure perspective, GDP includes four main components:

Consumption – consumer spending or expenditures on final goods and services;
Investment – business spending or expenditures on new capital equipment, inventory, structures, and consumer spending or expenditures on new homes;
Government – expenditures;
Spending or expenditures on net exports – the trade balance.

Note that we need to remove imported goods from our equation of gross domestic product (GDP). As its name suggests, GDP should only reflect domestic goods and services. Imports describe goods and services produced in a foreign country. In our equation for GDP from the demand side, we must subtract imports (M) because consumption (C) includes ALL consumption spending, including the purchase of imported goods.

GDP = Consumption + Investment + Government + Trade balance (exports – imports)

GDP = C + I + G + (X – M)

Measuring Total National and Domestic Income

National income includes all wages or employee compensation, profits, rental income, net interest, depreciation, and indirect taxes. Gross domestic income (GDI) restricts national income to the income residents earn within a country's borders.

In economics, investment refers to investment in physical capital, not investment in financial capital. Consumption refers to household spending on new final goods and services, except for new home purchases, which we consider investment.

For example, economic investment includes spending on machinery and equipment, factories, inventories, and new houses. Investments in financial assets, such as stocks and bonds, are not economic investments for the purposes of economic theory.

Savings and consumption are linked to disposable income. We spend disposable income (after-tax income) in two ways: for consumption and savings. Saved income is a funding source for investment.

For example, we consider the money we deposit into a savings account "savings". However, the bank where we deposit our money will loan our savings to other individuals and businesses, who may use the money to expand or start a new business (investment).

Consumption + Savings = Disposable Income

Savings = Investment

To review, see GDP Deflator and Calculating Real GDP with a Deflator Example.

2k. Analyze problems associated with using GDP as a measure of well-being

What are some measurement problems that exist with GDP calculations, such as when we measure production from the service sector, household production, the underground economy, and leisure?
How can GDP present a misleading measure of economic well-being, such as toxic elements of production, or negative byproducts, such as crime, disease, and pollution?

While gross domestic product (GDP) provides a good overall measure of economic well-being, it is not a perfect measure. Certain measurement problems reduce its accuracy. For example, the true productivity of a country can be overstated or understated. Statisticians may double-count goods as they flow through the production stages. Therefore, only final goods and services are counted. Intermediate goods are excluded from GDP calculations.

An underground economy of services paid "under the table" and illegal sales are not counted because they are impossible to track. Goods that are not sold in the marketplace are also not counted in GDP.

While GDP measures a country's economic activity, it does not capture unpaid work or leisure time. A country's standard of living is not necessarily reflected in its GDP. For example, the measurement of productivity may be equal in two countries, but a comparison may show that the standard of living is better in a country with a lower GDP.

To review, see How Well GDP Measures the Well-Being of Society.

Unit 2 Vocabulary

aggregate demand
aggregate supply
business cycle
consumption
cyclical unemployment
deflation
depression
durable good
economic growth
entrepreneurship
frictional unemployment
government
gross domestic income (GDI)
human capital
inflation
infrastructure
inventory
investment
labor force
labor productivity
leisure
market value
national income
nondurable good
physical capital
price index
production function
real GDP
recession
service
stagflation
standard of living
structural unemployment
structure
substitution
trade balance
underground economy
unemployment rate