Macroeconomics

04/02/2014

Measures of Economic Performance

Gross Domestic Product (GDP)- the market value of final goods and
services produced within a country during a specific time period,
usually a year.
o GDP is the most commonly used output gauge.
Calculating GDP
o Only final goods and services count toward GDP
o Financial transactions and income transfers are excluded
because they do not reflect production.
o Only production within the geographic borders of the country
is counted.
o Only goods during the current period are counted.
Measurement Errors of GDP
o Does not count nonmarket or household production.
o Does not count the underground economy.
o No adjustment for leisure.
o Not adjusted for externalities or social problems.
o Does not consider income distribution.
o May understate gains in living standards because of the
problem of estimating improvements in the quality of
products.
Real vs. Nominal GDP
Real values are adjusted for the changing value or purchasing
power of the dollar (inflation or deflation).
Nominal values are not adjusted for inflation.
Price index- measures the cost of purchasing a market basket of
goods at a point in time relative to the cost of purchasing the
identical market basket during an earlier reference period.
Consumers Price Index (CPI)- measures the impact of price
changes on the cost of a typical bundle of goods and services
purchased by households.

GDP Deflator- designed to measure the change in the average price

of all the goods included in GDP (which makes it a broader index
then the CPI)
To correct for inflation to calculate a real value from a nominal
value, divide by the price index for that year, and then multiply by
100 to move decimal place over.
Real Value= (Nominal value/Price index) x100
Business Cycles
Phases
o Expansion
o Peak
o Contraction
o Trough
Unemployment
Unemployment is the highest ranked macroeconomic problem
Unemployment rate=(# of unemployed/Labor force) x100
Labor Force Participation Rate=(Labor Force/Working age pop)x100
Employment Population Ratio= (Employment/Working-age pop)100
There are no perfect ways to measure the unemployment rate
The Establishment Survey (Payroll Survey):
Provides information on the total number of persons who are
employed and on a company payroll.
The establishment survey has four drawbacks:
o It does not provide information on the total number of selfemployed persons because they are not on a company
payroll.
o It may fail to count some persons employed at newly opened
firms that are not included in the survey.
o It provides no information on unemployment.

o Its initial employment values can be significantly revised as

data from additional establishments become available.
However the establishment survey has the advantage of being
determined by actual payrolls rather than by unverified answers.
Types of Unemployment
Frictional
o Caused by imperfect information and search costs
o Occurs because employers are not aware of all available
workers and their qualifications.
o Also occurs because available workers are not fully aware of
all the jobs being offered by employers.
Structural
o Reflects an imperfect match of employee skills to skill
requirements of the available jobs
o Might be a function of the pace of technological change,
composition of labor force, or labor market regulations.
Cyclical
o Reflects business cycle conditions
o When there is a general downturn in business actively, cyclical
unemployment increases.
Full Employment
Full employment is the level of employment that results from
efficient use of resources; it allows for some unemployment that
results from:
o Search factors
Imperfect and costly information
o Structural factors
Dynamic changes in economy (technology,
demography)
Institutional factors (wage controls, ect.)
(But not cyclical factors, if there is no cyclical
unemployment, we say were at full employment)

Assertion: we are at full employment when unemployment is at

its natural rate (i.e. the unemployment rate not =0)
o E.g., for efficiency reasons, you wouldnt want a zero
unemployment rate any more than youd want a zero cab or
apartment vacancy rate
o UR = 0 inflexibility, inefficiency, mismatches, etc.
Natural rate of unemployment- the level of unemployment (>0)
that reflects frictional and structural conditions in labor markets
Deviations of actual unemployment from the natural rate thus
reflect cyclical conditions.
Over time, cyclical influences tend to wash out, so the long-run
average unemployment rate tends to be equal to the natural rate.
Institutions and Unemployment
Frictional and structural unemployment can be greatly affected by
government policies such as UI and social insurance, wage
controls, and labor cartels.
Inflation-increase in the general level of prices
Deflation- decrease in the general level of prices
Disinflation- deceleration of inflation
Calculating the rate of inflation
=(this years price index-last years/last years price index)x100
Two kinds of Inflation:
Unanticipated inflation- an increase in the price level that comes as
a surprise, at least for most individuals.
Anticipated inflation-a widely expected change in the price level
Unanticipated inflation and wealth transfers
When lending/borrowing, transactors will have to forecast the
future purchasing power of the dollars that will be repaid
Unanticipated inflation shifts wealth from lenders to borrowers.
Unanticipated disinflation or deflation shifts wealth from borrowers
to lenders.
Problems with unanticipated inflation:

Increases risk and reduces volume of many productive activities.

Distorts the signals sent by prices, leading to mistakes in resource
allocation.
It forces people to spend less time producing and more time trying
to protect their wealth and income from the uncertainty related to
price volatility.
Rapid expansion in the money supply is the primary cause of
inflation
Formula for growth of GDP, income, ect.
PV(1+g)n=FV
The Rule of 70
The number of years it takes to double your bank balance
o 70/interest
The loanable funds market
Stock of capital: goods used to produce other goods
Secure property rights, technological advance, and stock of capital
all influence growth rates
The rate of investment in stock of capital is a key factor that
influences growth rates
o The rate of investment depends on the interest rates (the
price in the loanable funds market)
Higher interest rates cause people to save more and defer present
consumption into the future i.e., will affect interest rates
o Greater present orientation higher i
o Greater future orientation lower i
Interest is a sum of real interest plus a premium for expected
inflation and risk of default.
Demand and Supply for Loanable Funds
Demand for loanable funds is determined by the willingness of firms
to borrow money to engage in new investment projects.
Supply of loanable funds is determined by the willingness of
households to save and by the extent of govt saving or dissaving.

Equilibrium in the loanable funds market determines the real

interest rate and the quantity of loanable funds exchanged.
The nominal interest rate is the stated interest rate on a loan.
The real interest rate corrects the nominal interest rate for the
effect of inflation and is equal to the nominal interest rate minus
the inflation rate.
To evaluate investments, the future benefits must be reduced to
their present value and then compared to the present costs
o PV=FV/(1+i)n
Formula for the present value for a stream of receipts:
o Written below

Only invest when the NPV>0

Secure property rights are often a necessary condition for
productive capital investments; if rights to the gains from such
investments are not secure, they wont be made
As capita stock declines, so does productivity and wages
The total output is the sum of spending from households, firms,
govt, and foreigners.
Keynesian Cross
Macro equilibrium does not= full employment equilibrium
Aggregate demand curve- shows the relationship b/w price level
and the total amount of domestically produced final goods and
services that purchasers are willing to buy
Three resources AD curve is negatively sloped:
o Wealth(or real balance)effect
Lower price increases purchasing power of money
o Interest Rate effect
Lower price reduces demand for money for day-to-day
transactions, increases supply of loanable funds, and
lowers the real interest rate, which stimulates
borrowing for additional purchasers.
o International Trade Effect

A lower domestic price level means that domestically

produced goods are less expensive relative to foreign
goods.
If price changes, you move along the AD curve
Three factors that shift the curve left or right:
o Changes in govt policies
o Changes in the expectations of households and firms
o Changes in foreign variables
Aggregate Supply Curve
Short run (SRAS)- a period in which some prices, particularly those
in resource markets, are set by prior contracts and agreements
Long Run (LRAS)- a period of sufficient duration that people have
the opportunity to modify their behavior in response to price
changes.
SRAS has a positive slope because:
o Resource price stickiness- in short run an unanticipated
increase in the aggregate price level while many input prices
remain fixed will mean that it will be profitable to produce
extra output.
LRAS indicates the relationship b/w the price level and quantity of
output after decision makers have had enough time to adjust their
prior commitments/contracts.
LRAS has a vertical slope at Potential GDP or Full Employment
Output because:
o LRAS is determined by an economys production possibilities,
In long run, a higher price doesnt loosen the constraints
imposed by the economys resource base, level of technology,
and the efficiency of its institutional arrangements.
An economys full employment rate of output, the maximum output
rate thats sustainable is determined by the supply of resources,
level of technology, and the structure of institutions, factors that
are insensitive to changes in price.
If price changes you move along the Aggregate supply curve.
There are 5 factors that can shift AS curve:
o Increase in labor force and/or capital stock=SRAS shifts
rightward
o Technological change= productivity increases= SRAS shifts
rightward
o Expected changes in future price level
o Adjustments of workers and firms to error in past

o Unexpected changes in the price of an important natural

resource
4 Components of Aggregate Expenditure or Demand
Consumption-spending by households on goods and services
Planned investment- planned spending by firms on capital goods
and by households on new homes.
Govt purchases- spending by local state, and federal govt on
goods and services
Net exports-spending by foreign firms and households on goods and
services produced in the United States, minus spending by U>S>
firms and households on goods and services produced in other
countries
Equilibrium
Equilibrium occurs when spending(AE)= output(GDP)
Disequilibrium
When AE>GDP :
o Inventories decline
o Firms increase production to replace inventories
o GDP and employment increase
When AE<GDP
o Inventories rise
o Firms cut production
o GDP and employment fall
What changes equilibrium?
Any changes in consumption, planned investments, government
purchases, or net exports can lead to changes in planned AE and a
new level of GDP and employment
5 key determinates of consumption
current disposable income (after taxes and transfers)

 household wealth
expected future income
the (aggregate) price level
the interest rate
4 keys determinants of planned investment:
expectations of future profitability
interest rate
taxes
(internal) cash flow
Key factors affecting government purchases:
Non-discretionary factors: shocks like the need to increase
defense spending to fight a war
Discretionary factors: stabilization factors
3 key determinates of net exports
the price level in the us relative to price levels in other countries
GDP growth in the us relative to GDP growth in other countries
The exchange rate between the dollar and other countries
Keynesian Cross
X-axis= real GDP (orY)
Y-axis= real AE
The economy will be in equilibrium on a 45 degree line because
thats when GDP =AE
Keynes said the economy will not heal itself, actions must be taken
to put the economy in equilibrium

Multiplier effect- the process through which a shift in spending

trickles through the economy and creates a multiple of that increase
in a new income and output
K= change in Y/change in autonomous spending
Paradox of thrift example: AE falls->economy goes into a recession>lower incomes->less saving
Variables that shift SRAS Curve
The labor force of the capital stock->more output can be produces
at every price level
Productivity->cost of producing output falls
Expected future price level->workers and firms increase wages and
prices
Workers and firms adjusting to having previously underestimated
the price levels->workers and firms increase wages and prices
The expected price of an important natural resource->cost of
producing output rises
o The short run equilibrium occurs when AD and SRAS curves
intersect
Variables that shift LRAS curve
Capital formation
Technological advances