Economics

Problems with CPI

1. Changes in product quality − Technology has resulted in quality improvements 2. Substitution − If the price of one good increases, consumers can substitute other products or change their habits 3. Introduction of new products − Basket can be adjusted to include new products, but this takes time 1 and 2 above cause the CPI to overstate the actual change in prices, or how much they affect us.

The multiplier effect

1/1-MPC increase in final income arising from any new injection of spending

The value of a price index in the base year is equal to

100

If a price index is 50 in 1998 and 70 in 1999, the rate of inflation between the two years is ___ percent.

40

If the MPC is 0.80, the multiplier will be equal to

5

In a small country, the adult population is 5,000. There are 4,000 people in the labor force and 3,000 people are employed. The labor force participation rate is

80 percent.

Aggregate Supply

A curve that shows the relationship between the level of prices and the quantity of output supplied. These curves are different in the long-run (when prices have fully adjusted) vs. the short-run (when prices are still sticky)

Short run aggregate supply curve

A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand. In the short run, output is determined by demand, not prices.

Consumer Price Index

A statistical measure of a weighted average of prices of a specified set of goods and services purchased by a typical urban consumer Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.

Deflation

A sustained decrease in the average of all prices of goods and services in the industry.

Inflation

A sustained increase in the average of all prices of goods and services in the industry.

Per capita GDP

Adjusts for population growth Real GDP/Population

Gross public debt

All federal government debt irrespective of who owns it

What shifts AD?

Anything that increases or decreases demand for CIGX will shift the Aggregate Demand curve. − A change household spending (C) Change in real wealth, expected income, expected prices − A change in living standards abroad (X) − A change in exchange rates (X) − Firms' expectations of the future (I) − Government policy can affect AD

Unanticipated inflation

Arbitrary redistribution of income − As long as inflation differs from expected, there will be winners and losers Creditors lose and debtors gain − Easier to repay loans with inflated dollars. Protecting against inflation: − Adjustable-rate mortgages − Cost of living adjustments (COLAs)

C

C = Personal Consumption Expenditures (consumer spending by households) − Durable consumer goods Life span of more than 3 years (cars, clothes) − Nondurable consumer goods Goods that are used up in 3 years (food) − Services Mental or physical help (accountant, lawn service)

What shifts AD? Changes in government policy?

CHANGES IN THE SUPPLY OF MONEY − An increase in the supply of money in the economy will increase aggregate demand and shift the aggregate demand curve to the right. CHANGES IN TAXES − A decrease in taxes will increase aggregate demand and shift the aggregate demand curve to the right. CHANGES IN GOVERNMENT SPENDING − At any given price level, an increase in government spending will increase aggregate demand and shift the aggregate demand curve to the right.

Fiscal Policy

Changes in government taxes and spending at the federal level in order to affect the economy.

Sides of economists in today's politics

Classical economics aligns with today's political right(Republican), while Keynesian economics aligns more closely with the political left(Democrat).

Stances of classical economists vs. Keynesian economists on fiscal policy

Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Classical theory is the basis for Monetarism, which only concentrates on managing money supply, through monetary policy. Keynesian economics suggests governments need to use fiscal policy, especially in a recession.

Expenditure approach to measuring GDP

Computing GDP by adding up the dollar value at current market prices of all final goods and services.

Contractionary Fiscal Policy

Contractionary policy is used to slow down the economy by shifting AD to the left. Decrease government spending − decreases G component of CIGX Increase taxes (income and corporate taxes, tariffs) − decrease C, I, and X components of CIGX

Consumers in Country A have an MPS of 0.2 while consumers in Country B have an MPS of 0.1. Which country has the higher value for the multiplier?

Country B

The great recession

Dec 2007: Peak June 2009: Trough

Economic Growth

Economic growth can be shown graphically by shifting the production possibilities curve outward. Economic growth reflects the fact that more of all goods can be produced within the economy.

LRAS and Growth

Economic growth is represented by a rightward shift of the LRAS curve. What causes growth? − Increase in population or labor force participation rate − Capital accumulation/deepening − Technology improvements

Which of the following people would be considered unemployed?

Edna, who lost her job as a teacher and is looking for a new job.

What are the limitations of GDP?

Excludes non-market production − Household production, illegal and underground production Leisure Improved product quality Environment

Expansionary Fiscal Policy

Expansionary policy is used to stimulate the economy by shifting AD to the right. Increase government spending − increases G component of CIGX Decrease taxes (income and corporate taxes, tariffs) − increase C, I, and X components of CIGX

Classical economists believe prices do not adjust quickly to changes in the economy

False

For the last few years, the unemployment rate has been at about 2-4 percent.

False

Economists believe that the CPI tends to underestimate the increase in the cost of living over time

False;Economists actually think that the CPI overestimates inflation for two reasons: 1. As prices increase, we can "substitute away" from the good. In other words, if the price of bacon increases we will eat turkey bacon instead. Therefore the price increase doesn't hurt us too much. But because the goods that make up the CPI's market basket are unchanging, the high bacon prices will be reflected in the CPI in a way that we don't feel in our budgets. 2. The CPI doesn't always reflect changes in quality of the goods in the basket. For instance, computers we buy today are much more powerful than 30 years ago, but prices of computers haven't increased dramatically (in fact they have decreased). So we're getting a much better product for the money.

When the economy is at full employment, there is only cyclical unemployment

False;When the economy is at full employment, only frictional and structural unemployment exist because these two types of unemployment never go away. At full employment (when the economy is doing well) cyclical employment will be zero.

Full Employment = Natural Rate of Unemployment

Frictional and structural unemployment are unavoidable. So "full employment" is less than 100%. Natural rate of unemployment = no cyclical unemployment (no recession) = frictional + structural unemployment

Major types of unemployment

Frictional, structural, cyclical, and seasonal

Classical Economics

From Adam Smith until the 1930s, economists believed that prices and wages adjust freely and quickly to changes in demand and supply. Classical economists believe that over a relatively short period of time, wages and prices adjust quickly and naturally to bring the economy to full employment.

G

G = Government Purchases − Includes federal, state, and local governments − Does not include transfer payments because these do not generate production − Expenditures for goods and services that government consumes in providing public services − Expenditures for social capital such as schools and highways − Consumption and Investment

C+I+G+X

GDP = C (Consumption spending by households) + I (Investment spending by businesses)+ G (Gov't purchases of goods and services)+ X (net exports = exports - imports)

Net Public Debt

Gross public debt minus all government interagency borrowing To arrive at the net public debt, we subtract interagency borrowings from the gross public debt.

What shifts SRAS?

Higher costs will shift the curve up/left because firms will need to increase prices or reduce quantity supplied at each price point. Key changes that shift SRAS: 1. Input prices (wages and materials) 2. State of technology 3. Taxes, subsidies, or economic regulations

I

I = Gross Private Domestic Investment (investment spending by businesses) − Business fixed investment All final purchases of machinery, equipment, and tools (capital) by business enterprises Half is high technology equipment and software Half is transportation equipment, buildings, factories − Residential fixed investment All residential construction, remodeling − Changes in stock of inventories (unconsumed output is considered capital)

Long run aggregate supply

In the long run, the AS curve is vertical at the economy's full employment output level. This means that in the long run, we will produce at full employment output regardless of price level. Output is determined by factors of production and technology

Measuring Economic Growth

Increase in real GDP (percentage increase per year) or Increase in per capita real GDP (percentage increase per year

Capital Deepening

Increases in the stock of physical and human capital per workers − Increasing the amount of capital per worker will increase the productivity of each worker, leading to economic growth. − We increase our stock of capital per worker through saving and investment. Saving (instead of consuming) becomes investment in capital. Spending on capital must outpace depreciation, or capital stock will decrease over time.

Labor force

Individuals aged 16 or older who either have jobs or who are looking and available for work; the number of employed plus the number of unemployed.

Discouraged Worker

Individuals who have stopped looking for a job because they are convinced they will not find a suitable one.

Keynesian model

Keynes and his followers argued prices, including wages, (the price of labor) are "sticky". − Keynes' 1936 book "The General Theory of Employment, Interest, and Money" revolutionized the way economists think. The Great Depression validated his ideas that the Classical Model did not hold.

Growth theory over time

Malthusians − Limited resources support limited population Solow model − Physical capital is key to growth − convergence because of diminishing returns New Growth Theory − Incentives create constant technology/innovation, so no diminishing returns

MPC/MPS

Marginal Propensity to Consume/Save Every additional dollar of income will be spent or saved. The proportion spent or saved gives us our marginal propensity to consume and save MPC=additional consumption/additional income MPS=additional savings/additional income MPC+MPS=1

Suppose in Nation A, people consume 75% of every additional dollar of income. In Nation B, people consume 90% of every additional dollar of income. Will an increase in Aggregate Demand had a greater effect on the economy of Nation A or Nation B (all else being equal)?

Nation B, because increased spending will have a bigger multiplier effect.

During the Great Depression, real GDP and average prices both decreased significantly. In this situation, how much does nominal GDP change relative to real GDP?

Nominal GDP decreased by more than real GDP.

Real Values

Nominal Value/Price index x 100 Example: Real GDP= Nominal GDP/Price index x 100

What is the difference between real and nominal values of GDP?

Nominal values is the measure of the GDP in actual market prices at which the goods are sold. Real GDP is measurement of GDP after adjusting for price change

Which of the following is not included in the labor force?

People who do not have jobs, and do not want one

Which of the following is a problem with the price system that can lead to a break down in the coordination of economic activity?

Prices can be slow to adjust

When GDP is adjusted for price changes over time it is known as

Real GDP

What causes recessions?

Recessions can be caused by a leftwards shift of AD or SRAS

Market basket

Representative bundle of goods and service

Structural Unemployment

Results from a poor match of workers' abilities and skills with current requirements of employers. Innovation and technological change can cause structural unemployment.

Cyclical Unemployment

Results from fluctuations of real GDP (recessions)

Frictional Unemployment

Results from the fact that workers must search for appropriate job offers This takes time, so they remain temporarily unemployed. Frictional unemployment cannot be eliminated.

Seasonal Unemployment

Results from the seasonal pattern of work in specific industries. Unemployment statistics are usually "seasonally adjusted" to remove the pattern of seasonal unemployment.

Suppose the economy experiences a negative supply shock, such as a spike in oil prices. What happens to the AS/AD model?

SRAS shifts to the left

When MP3 players emerged and cassette players declined in popularity, what type of unemployment was created?

Structural

Aggregate Demand

The AD curve shows the relationship between the level of prices and the quantity of real GDP demanded. Downward sloping

What will happen to the equilibrium price level and the equilibrium quantity of output in the short run if the aggregate demand curve shifts to the right? (short run, so use SRAS)

The equilibrium price level and the equilibrium quantity of output increase.

Main sources of economic growth

The key to per capita economic growth is increased productivity - more output with the same resources. Society can increase productivity in two fundamental ways. − Capital deepening (more capital per person) • Physical capital (1/4 of growth) • Human capital (1/4 of growth) − Technological Progress (1/2 of growth)

Full-employment output

The level of output (GDP) that results at full employment. − cyclical unemployment = 0 − unemployment rate = natural rate of unemployment − labor market in equilibrium Also known as "potential output" or "potential GDP" Full-employment output is not the maximum level of output an economy can produce - an economy could produce more with higher levels of labor input - but reflects the level of labor input that workers wish to supply.

Natural rate of Unemployment

The level of unemployment at which there is no cyclical unemployment. It consists of only frictional and structural unemploymen

Full employment

The level of unemployment that occurs when the unemployment rate is at the natural rate.

Base Year

The point of reference for comparison of prices in other years. − The price index for the base year is always 100. − When calculating real values, we are using prices from the base year. − Real and nominal values are equal to each other in the base year (they are the same time period, so there is no inflation

Labor force participation rate

The proportion of non-institutionalized working age individuals who are employed or seeking employment. This excludes: children, active duty military, institutionalized population, seniors Labor Force/Labor force+ Not in labor force

Business Fluctuations

The relationship between unemployment and inflation What do inflation and unemployment generally look like during the different phases of the business cycle? There is generally a trade-off between inflation and unemployment. Keeping these two things in check is the balancing act of macroeconomics. − At low unemployment rates firms find it hard to recruit workers, and competition among firms will lead to wage increases. As wages increase, increases in prices (inflation) will soon follow.

Gross Domestic Product

The total market value of final goods and services produced within an economy in a given year.

How to calculate GDP

To calculate GDP we take the quantity of goods produced multiplied by their respective prices and add up the totals.

Unemployment

Total number of adults (aged 16 and older) willing and able to work and who are actively looking for work but have not found a job. − To be considered unemployed, a person cannot have a job (even part time), and must be actively looking for work.

Public Debt

Total value of all outstanding federal government securities (bonds) Total amount owed by the federal government from cumulative past deficits − surpluses reduce the debt, deficits add to it − interest adds further to debt

Creditors lose from unanticipated inflation.

True

Individuals who have stopped looking for work because they became discouraged are not counted as unemployed in the traditional unemployment statistics.

True

The highest unemployment rate the US has ever experienced was about 25%

True

Sticky Prices

Wages are sticky becasue Lower productivity − Minimum wage − Labor contracts Prices are sticky because Long term contracts-Menu prices-Sticky input prices lead to sticky product prices

X

X = Net Exports (Exports minus imports) − GDP includes all production within the US, so consumption of our goods by other nations (exports) must be included. − C includes all consumer spending, including what we spend on foreign made goods (imports). We must subtract imports because they were not made in the US.

The long-run supply curve is

a vertical line at potential output (full employment GDP).

Which of the following would NOT shift the AD curve?

an improvement in production technology

The full employment level of output can

be surpassed only in the short run

Which of the following would shift the aggregate demand curve to the left?

business firms expect lower sales in the future

Which of the following is not a component of aggregate demand?

business taxes

Discouraged workers are

considered not in labor force, so the reported unemployment rate is biased downward.

Price Index

cost of market basket today/cost of markey basked in base year x 100

___________________ unemployment is most closely associated with periods of falling GDP.

cyclical

The three key types of unemployment are

cyclical, frictional, and structural.

The aggregate demand curve is

downward sloping

Productivity

economic measure of output per unit of input. Inputs include labor and capital, while output is typically measured in revenues and other gross domestic product (GDP) components such as business inventories.

Hector voluntarily left his job to search for a job in accounting, the field in which he has his bachelor's degree. Hector is considered

fictionally unemployed

The natural rate of unemployment consists solely of

frictional and structural unemployment.

It is unlikely that the unemployment rate will ever fall to zero because of

frictional unemployment

Intermediate goods

goods used in the production process that are not final goods and services

Balanced Budget

government spending is equal to the total taxes and revenues it collects during a given period of time

Budget Deficit

government spending is greater than taxes and revenues during a given period of time − financed by issuing of new government bonds by US Treasury

Budget Surplus

government spending is less than taxes and revenues during a given period of time

The labor force participation rate shows

he percentage of the relevant population that is in the labor force

Classical economists believe that

he role of government should be limited, since the economy is self-correcting

Suppose a foreign country, which originally prevented the US from exporting to them, opens their market and buys a lot of American goods. In this case, aggregate demand wil

increase because increased exports shift aggregate demand to the right

When an inflationary gap exists (in the AS-AD model), then unemployment rate is

lower than the natural rate of unemployment

Transfer payments are excluded from government purchases in GDP because

nothing is being produced in return for the payment.

Unemployment rate

number of employed persons/labor force

When products improve in quality the CPI will

overestimate the inflation rate.

Role of institutions

political stability and rule of law − private property rights − markets, incentives − education − technology/innovation

The CPI relies on the calculation of

prices of a fixed basket of goods that does not change often.

The unemployment rate

rises during recessions and falls during booms

Frank recently lost his job as a bank teller when he was replaced by an ATM machine. Frank is

structurally unemployed

Which of the following is an example of a consumption expenditure?

the purchase of a ticket to a pro football game

Purchasing Power

the value of money for buying goods and services

Suppose medical care makes up 5% of CPI's market basket, and that prices of medical care are rising faster than the rest of the economy. If 15% of an elderly couple's spending is on medical care, for this couple the CPI

understates the effect of inflation on this couple

The short-run supply curve is

upward sloping

If you negotiated a salary based on an anticipated inflation rate of 4 percent, and the actual inflation rate turned out to be 6 percent

your nominal wages are unchanged but your real wages have decreased.

Who is not in the labor force?

− Full-time students, housewives, independently wealthy

Real GDP

− Measurements after adjusting for price changes (inflation) across years; expressed in constant dollars − Real GDP is a relative term - it needs a base year to measure agains

Nominal GDP

− Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars − If 2012's GDP is expressed using 2012's prices, it is nominal GDP.

What is not counted as GDP?

− Sales of intermediate goods − Purely financial transactions Public transfer payments (social security, welfare) Private transfer payments (cash gifts within family) Stock market transactions (buying and selling of stocks and bonds) − Secondhand sales − Underground economy