Chapter 7



Chapter 6

Every Macroeconomic Word You Have Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession and Depression

Chapter Objectives

After reading this chapter you should be able to:

• Use the basic vocabulary of macroeconomics.

• Understand how the economy is measured.

• Understand that gross domestic product is our national measure of output and that inflation is calculated using a price index.

• See that real gross domestic product is adjusted for inflation and as such is the accepted measure of the economy’s health.

• Understand how unemployment is measured and be familiar with the types of unemployment that economists recognize.

• Use the vocabulary of the business cycle.

Microeconomics vs. Macroeconomics

• Microeconomics: that part of the discipline of economics that deals with individual markets and firms

• Macroeconomics: that part of the discipline of economics that deals with the economy as a whole

Gross Domestic Product

• Gross Domestic Product: the dollar value of all of the goods and services produced for final sale in the United States in a year

Measuring Prices and Inflation

Measuring Prices

• Market Basket: what average people buy and in what quantities they buy it

• Base Year: year in which the market basket is established and year to which all other prices are compared

• Price of the Market Basket in the Base Year: (PBYMB) national average of the total cost of the market basket for the first month in the first year.

• Price Index: a device that centers the price of the market basket around 100

• Consumer Price Index: the price index based on what average consumer’s buy

[pic]

Measuring Inflation

Inflation Rate: the percentage increase in the consumer price index

[pic]

Cost of Living Adjustment

or COLA: a device that compensates people for the fact that inflation makes the spending power of their income less

Table 1

CPI and Inflation in Selected Years

1920-1999

Base Years 1982-1984

Year |CPI at end of year |inflation rate |Year |CPI at end of year |inflation |Year |CPI at end of year |inflation rate | |1920 |19.4 | |1983 |101.3 |3.8 |1994 |149.7 |2.7 | |1930 |16.1 | |1984 |105.3 |3.9 |1995 |153.5 |2.5 | |1940 |14.1 | |1985 |109.3 |3.8 |1996 |158.6 |3.3 | |1950 |25.0 | |1986 |110.5 |1.1 |1997 |161.3 |1.7 | |1960 |29.8 | |1987 |115.4 |4.4 |1998 |163.9 |1.6 | |1970 |39.8 | |1988 |120.5 |4.4 |1999 |168.3 |2.7 | |1978 |67.7 | |1989 |126.1 |4.6 |2000 |174.0 |3.4 | |1979 |76.7 |13.3 |1990 |133.8 |6.1 |2001 |176.7 |1.6 | |1980 |86.3 |12.5 |1991 |137.9 |3.1 |2002 |180.9 |2.4 | |1981 |94.0 |8.9 |1992 |141.9 |2.9 | | | | |1982 |97.6 |3.8 |1993 |145.8 |2.7 | | | | |

Source:

Problems Measuring Inflation

• Changes in the Market Basket are too infrequent.

• The treatment of improvements in the quality of goods is inadequate.

• People have changed the places they buy frequently.

• No accounting for substitutions

The result is that economists estimate that CPI overstates the cost of living by approximately 1.1 percentage points annually.

Inflation’s Winners and Losers

Losers

• People on fixed incomes

• Lenders

Winners

Borrowers

Interest and Expected Inflation

If inflation exceeds expectations then borrowers win and lenders lose

If inflation is less expectations then borrowers lose and lenders win

Real Gross Domestic Product

• Real Gross Domestic Product: an inflation adjusted measure of GDP

• GDP Deflator: the price index used to adjust GDP for inflation, including all goods rather than a market basket

• current production of goods and services times their previous year prices and then adding these up across different goods and services.

• current production of new goods and services is then added to this figure.

• the process is different from that which creates the CPI in that the market basket changes from year to year so the choice of a base year is somewhat arbitrary.

• Still allows for a comparison of total production from one year to the next while eliminating the effects of inflation.

• economists feel more comfortable computing inflation using the GDP deflator approach (which is the annual percentage increase in the GDP deflator) than the CPI approach (which is the annual percentage increase in the CPI.)

Real GDP in Billions

1996 Dollars

[pic]

Problems with RGDP as a Measure of Social Welfare

• GDP only counts market sales so it ignores home production.

• GDP ignores the value of leisure

• GDP ignores the composition of output

• Should be a per capita measure

• GDP ignores environmental measures

• GDP ignores the “underground economy”

Measuring Unemployment

• Work Force: all those non-military personnel who are over 16 and are employed or are unemployed and actively seeking employment

• Unemployment Rate: the percentage of people in the work force who do not have jobs and are actively seeking them

Problems Measuring Unemployment

• Underemployed : the state of working significantly below skill level or working fewer hours than desired

• Discouraged worker effect: when bad news induces people to stop looking for work causing the unemployment rate to fall

• Encouraged worker effect: when good news induces people to start looking for work causing the unemployment rate to rise (until they succeed in finding work)

Annual Unemployment Rates since 1947

[pic]

Types of Unemployment

• Cyclically Unemployed: people lose their jobs because of a temporary downturn in the economy

• Seasonally Unemployed: (a subset of the cyclically unemployed) people who lose their jobs predictably every year at the same time

• Structurally Unemployed : people who lose their jobs because of a change in the economy that makes their particular skill obsolete

• Frictionally Unemployed: people who are unemployed for a short time in the transition to an equal or better job

The Business Cycle

• Business Cycle: regular pattern of ups and downs in the economy

• Trough: the lowest point in the business cycle

• Recovery: the part of the growth period of the business cycle from the trough to the previous peak

• Expansion: the part of the growth period of the business cycle from the previous peak to the new peak

• Peak: the highest point in the business cycle

• Recession: the declining period of at least two consecutive quarters in the business cycle

The 1982 to 2002 Business Cycles

[pic]

Depression

• Depression: There is no generally accepted standard but most are characterized by a severe recession that results in a financial panic and bank closures, unemployment rates exceeding 20%, prolonged retrenchment in RGDP on the magnitude of ten percent or more, and significant deflation.

If Inflation is Bad How can Deflation be Worse?

With deflation

• People delay buying big ticket items when they are certain it will be cheaper if they are patient.

• If they delay buying

o then demand for those those goods will fall.

o firms will cut costs by cutting wages and benefits, or by laying people off.

o when profits decline, the value of stocks decline. With less wealth, stockholders spend less on consumer goods.

o housing prices may decline. Purchases that are made using home equity decline.

Back of Chapter Questions

Question 1) One subject of study for macroeconomics is

a) inflation.

b) monopoly.

c) perfect competition.

d) the shape of an individual’s demand curve.

Question 2) One problem with measuring inflation is

a) the market basket does not change fast enough to keep up with trends.

b) it does not account for substitution to cheaper goods.

c) it is sometimes hard to control for quality of the product.

d) all of the above

Question 3) If a person is laid-off from a job his employer tells him that he will be brought back as soon as the economy picks up and demand for their product rises, then economists call this person

a) underemployed.

b) structurally unemployed.

c) frictionally unemployed.

d) cyclically unemployed.

Question 4) If people are unemployed because their industry has moved to another country economists refer to them as

a) underemployed.

b) structurally unemployed.

c) frictionally unemployed.

d) cyclically unemployed.

Question 5) A 15 year old who wants a job but can not find one is

a) underemployed.

b) unemployed.

c) not counted at all.

d) cyclically unemployed.

Question 6) If the military recruits 100,000 new soldiers and gets them from the ranks of the unemployed then the unemployment rate will

a) rise.

b) fall.

c) remain unchanged.

Question 7) If the military recruits 100,000 new soldiers and gets them from the ranks of those who had private sector jobs then the unemployment rate will

a) rise.

b) fall.

c) remain unchanged.

Question 8) If a market basket was defined in 1998, it cost $10,000 to purchase the items in that basket in 1998 and cost $11,000 to purchase those identical goods in 1999 then the price index for the base year is

a) 100.

b) (11000/10000)*100=110.

c) (10000/11000)*100=90.9.

d) none of these.

Question 9) Economists generally believe that relative to the true cost of living the CPI

a) is perfectly measured.

b) overstates it by a factor of 2 (meaning that inflation is really only half as bad as the government states).

c) overstates it by a difference of about 1.1% (meaning that an official inflation rate of 2.1% is really only about 1%).

d) understates it by a factor of 2 (meaning that inflation is actually twice as bad as the government states).

Question 10) One of the reasons that Real Gross Domestic Product is not synonymous with social welfare is

a) people substitute between goods.

b) things produced by people under 18 are not counted.

c) it ignores the value of leisure.

d) all of the above

-----------------------

Teaching Tips

1) Emphasize the prefixes “micro” and “macro” and their everyday uses.

2) Go through some issues in the news and let students discuss whether they are primarily “micro” or “macro”.

Teaching Tips

1) Note that “Final Sale” avoids double counting of intermediate production

2) Note that “Sale” implies exclusively market activities

3) Note that “produced..in the United States” implies that Honda’s produced in the US count but Fords produced in Mexico do not.

Teaching Tips

1) Have students imagine “the worlds largest Super Wal-Mart” where they could buy everything they buy in a year.

2) Mathematically challenged students will need you to spell out the sub- and superscripts so they know what they mean.

Teaching Tip

Do not be surprised if students have forgotten how to do percentage increases.

Teaching Tip

Students may be familiar with COLAs if they live in union households and have a parent with a COLA-tied contract. Refer to the Social Security COLAs

Teaching Tips

1) Do a few inflation rate calculations for a couple of years.

2) Demonstrate how the CPI can be used to compare 1920 prices with current prices.

Teaching Tips

1) Note that MP3players have not entered the CPI market basket and have fallen in price from more than $200 to less than $100.

2) Note that computer quality is indexed but food quality (especially meats, vegetables and fruits) has increased substantially over the last 40 years without any adjustments.

3) Ask students where they would buy a TV (they will likely answer Sam's, Wal-Mart, Circuit City etc.) If you are over 35 note where your family bought its first color TV (likely a relatively expensive electronics store.)

4) Note that there are many substitutes for goods and that an increase in the price of one good can have little impact of a family’s cost of living if a perfectly acceptable substitute does not increase in price.

5) Let students discuss the impact of reducing COLAs by 1.1 percentage points.

Teaching Tips

Note that the dips are recessions and that the trend is steadily higher.

Teaching Tips

1) Note that paying someone to clean you house counts in GDP but cleaning it yourself doesn’t.

2) Note that people who are forced to work involuntary overtime are, by definition, worse off with more money.

3) Note that money spent on socially unhealthy items counts the same as socially healthy items. (A dollar spent by an alcoholic at a bar counts the same as a dollar spent by a nun at a religious bookstore.)

4) Note that the population of the US has increased by almost 90% in the last half-century and that an increase of that amount in RGDP would be necessary to keep the per-capita figure constant.

5) Note that producing a good at a substantial environmental cost could make us worse off but RGDP would rise. Let students discuss the tradeoff.

6) Note that upwards of 10% of the economy is not measured because it is not reported. Note that the accounting is done via sale tax receipts and other government reports so a payment by an addict to a dealer doesn’t count and neither does the lawn-mowing money they earned as a kid.

Teaching Tip

Stress that the unemployment rate is civilian one.

Teaching Tips

1) Let students discuss the types of underemployment they have seen.

2) Use a numerical example for the discouraged and encouraged worker effect.

Teaching Tip

Let students discuss each type by having them provide examples.

Drawing Tip

Draw a sin wave with an upward trend

Teaching Tip

Label the parts of the cycle as you draw

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download