Macroeconomics Chapter 5

Real wage (omega)

which is the nominal wage divided by the price level

Price indexes that employ fixed market baskets are likely to overstate inflation (and understate deflation) for four reasons:

1. Because the components of the market basket are fixed, the index does not incorporate consumer responses to changing relative prices. 2. A fixed basket excludes new goods and services. 3. Quality changes may not be completely accounted for in computing price-level changes. 4.The type of store in which consumers choose to shop can affect the prices they pay, and the price indexes do not reflect changes consumers have made in where they shop.

Four steps to computing a price index:

1. Select the kinds and quantities of goods and services to be included in the index. A list of these goods and services, and the quantities of each, is the "market basket" for the index. 2. Determine what it would cost to buy the goods and services in the market basket in some period that is the base period for the index. A base period is a time period against which costs of the market basket in other periods will be compared in computing a price index. Most often, the base period for an index is a single year. 3. Compute the cost of the market basket in the current period. 4. Compute the price index. It equals the current cost divided by the base-period cost of the market basket.

Economists generally agree that the CPI and other price indexes that employ fixed market baskets of goods and services do not accurately measure price-level changes. Biases include the substitution bias, the new-product bias, the quality-change bias, and the outlet bias.

1. substitution bias 2. the new-product bias 3. the quality-change bias 4. the outlet bias.

Current base period for the CPI

1982-1984

8. If the consumer price index had a value of 1.25 last year but a value of 1.5 this year, what was the rate of inflation?

20% The rate of inflation gives the percentage change in the price level from one year to the next. It is calculated by dividing the change in the price index from year to year by the initial year's value. In this case, inflation = (1.5 - 1.25)/1.25 = 0.25/1.25 = 20%.

1. If the consumer price index for an economy is 0.80 in 1997, 0.90 in 1998, and 1.08 in 1999, the rate of inflation for 1999 is _____%.

20% The rate of inflation is calculated by dividing the change in the price index from year to year by the initial price index value. In this case, the price index = (1.08 - 0.9) / 0.90 = 0.18 / 0.90 = 20%.

Base period

A base period is a time period against which costs of the market basket in other periods will be compared in computing a price index. Most often, the base period for an index is a single year.

Price index

A price index is a number whose movement reflects movement in the average level of prices. If a price index rises 10%, it means the average level of prices has risen 10%.

Expansion

A sustained period in which real GDP is rising is an expansion

Real value vs. Nominal value

A value expressed in units of constant purchasing power is a real value. A value expressed in dollars of the current period is called a nominal value.

2. Which of the following would NOT explain how a price index may overstate the level of inflation? A. During periods of unanticipated inflation, people tend to be reluctant to lend money. B. The fixed basket used to develop a price index excludes new goods and services. C. The components of the fixed basked are fixed, so the index does not incorporate consumer responses to changing relative prices. D. Quality changes may not be completely accounted for in computing price-level changes.

A. During periods of unanticipated inflation, people tend to be reluctant to lend money. The fact that unanticipated inflation hurts lenders and makes them reluctant to lend money is a cost of inflation. This does not reflect how a price index can overstate inflation.

2. Which of the following is NOT true? A. When the economy is operating at the natural rate of unemployment, everyone who wants a job has a job. B. A change in technology may increase the amount of structural unemployment in an economy. C. During an economic expansion, the rate of unemployment tends to fall. D. Lower real wages make it more attractive for employers to hire more workers.

A. When the economy is operating at the natural rate of unemployment, everyone who wants a job has a job. An economy operating at the natural rate of unemployment still has structural and frictional unemployment, although the cyclical unemployment is zero.

6. Which of the following goods would you NOT expect to be included in the market basket of goods that is used to determine the consumer price index? A. Plywood B. Steel beams C. Cellular phones D. Oranges

B. Steel beams The market basket of goods used to calculate the consumer price index is designed to reflect the consumption of the typical consumer. The typical consumer is less likely to purchase steel beams than plywood, cellular phones, or oranges.

6. What is nominal GDP? A. The total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices. B. The total value of final goods and services for a particular period valued in terms of prices for that period. C. The total value of the factors of productions available in a particular year or period, adjusted to eliminate the effects of changes in prices. D. The total value of the factors of production available for a particular period valued in terms of prices for that period.

B. The total value of final goods and services for a particular period valued in terms of prices for that period. Nominal Gross Domestic Product (GDP), which is usually referred to as gross domestic product, is the total value of final goods and services for a particular period valued in terms of prices for that period.

5. The quality-change bias in a price index comes from: A. people substituting cheaper goods to minimize the effect of price changes on their well-being. B. improvements in the quality of goods and services. price indices undercounting C. the number of goods purchased at outlet stores. D. new products being left out of the calculation of a price index.

B. improvements in the quality of goods and services. price indices undercounting The quality-change bias in a price index comes from improvements in the quality of goods and services which are not accounted for by the index. Economists at the Bureau of Labor Statistics try to adjust for quality changes to overcome this bias.

5. Which of the following is the best example of a cyclically unemployed worker? A. A recent high school graduate waiting to enter community college B. A retired rail conductor looking for part-time employment C. A construction worker laid off during a downturn in new home construction D. A skilled computer punch-card operator who has been replaced by an automated computer operation system

C. A construction worker laid off during a downturn in new home construction Cyclical unemployment arises with fluctuations in the business cycle. In this case, the economic downturn caused the construction worker to be cyclically unemployed.

3. What is real GDP? A. A measure of total imports B. A combined measure of inputs and outputs C. A measure of an economy's total output D. The total value of the factors of production

C. A measure of an economy's total output Real GDP, or real Gross Domestic Product, is the total value of all final goods and services produced during a particular year or period, and adjusted to eliminate the effects of changes in prices.

3. Who among the following would be identified as a discouraged worker? A. An electrical engineer employed as a cook while he looks for a better job B. A self-employed attorney who works with a client only once every two weeks and who is looking for a full-time job with a legal firm C. A metal worker without work who would like to find work but no longer looks for employment D. A father returning to the labor market after taking leave to help raise his children

C. A metal worker without work who would like to find work but no longer looks for employment A discouraged worker is someone who is currently not working, would like to be employed, but is no longer looking for work. Only the metal worker meets all these conditions.

1. Who among the following will be counted as unemployed by the Bureau of Labor Statistics? A. A 17-year-old high school student working part-time at McDonald's B. An 80-year-old retired grandparent with no income other than Social Security C. A recent college graduate just beginning to look for a job but currently without work D. A parent who decides to stop working to begin looking after his or her children

C. A recent college graduate just beginning to look for a job but currently without work

4. Which of the following is an example of a structurally unemployed worker? A. A new college graduate seeking her first job as a management trainee B. A stockbroker fired by his firm during an economic downturn C. An unemployed electrical engineer living in New Mexico when suitable job openings exist in Massachusetts D. A recently retired janitor living in Los Angeles

C. An unemployed electrical engineer living in New Mexico when suitable job openings exist in Massachusetts A structurally unemployed worker is one whose skills do not match the skills required by employers or who lives in an area where the skills are not needed, resulting in a geographical mismatch of requirements and abilities. The electrical engineer meets the second requirement.

Cyclical unemployment

Cyclical unemployment is unemployment in excess of the unemployment that exists at the natural level of employment. For example, in a country with a demographic "bulge" of new entrants into the labor force, frictional unemployment is likely to be high, because it takes the new entrants some time to find their first jobs. This factor alone would raise the natural rate of unemployment. A demographic shift toward more mature workers would lower the natural rate. During recessions, highlighted in Figure 5.6, the part of unemployment that is cyclical unemployment grows.

3. Which of the following is NOT true? A. An increasing number of discouraged workers in an economy will tend to reduce the unemployment rate. B. Increasing the level of government purchases during a recession may help end the contraction. C. The trough of recession marks the beginning of an expansion. D. The consumer price index provides the perfect measure of the average level of prices in an economy.

D. The consumer price index provides the perfect measure of the average level of prices in an economy. The statement that the consumer price index provides a perfect measure of the average level of prices in an economy is false on two counts. The consumer price index provides a good but not perfect measure of the average prices of goods and services purchased by consumers. It does not measure the average level of all prices in the economy. Furthermore, the CPI does have flaws like the substitution bias, the outlet bias, and the quality bias.

10. Which of the following is NOT a cost of inflation? A. Purchasing power is eroded for those on fixed incomes. B. People are discouraged from saving money. C. Uncertainty attached to unanticipated inflation can reduce economic growth. D. The purchasing power of indexed payments is eroded.

D. The purchasing power of indexed payments is eroded. Indexing is designed to prevent the erosion of purchasing power and is therefore an attempt to avoid the cost of inflation. Note that if inflation is unanticipated or underestimated, however, indexing for it accurately is almost impossible, so unanticipated inflation would erode the purchasing power of payments that were indexed at a lower rate than actually occurred.

9. Which of the following is true? A. If the current cost of buying a market basket of goods is $1,500 while the base year cost is $2,000, the value of the price index is 1.33. B. The consumer price index reflects the level of prices throughout the economy. C. Inflation is the same as high prices. D. Unanticipated inflation harms savers.

D. Unanticipated inflation harms savers. Inflation lowers the purchasing power of savings unless the interest payments attached to savings are indexed to the rate of inflation. However, it is difficult to index unanticipated inflation so unanticipated inflation tends to harm savers.

4. Indexed payments can be used to protect purchasing power by: A. giving recipients of the payments more money regardless of the level of inflation. B. raising the level of payments to recipients as the rate of unemployment increases. C. adjusting the payments by the rate of growth of real GDP. D. adjusting the payments by the rate of inflation in the economy.

D. adjusting the payments by the rate of inflation in the economy. Indexing attempts to adjust payments by the rate of inflation to protect individuals' purchasing power from the effects of inflation.

The Business Cycle Dating Committee always dates the peaks and troughs in the business cycle at the time they actually occur. True/False?

False The Business Cycle Dating Committee relies on a variety of data sources when conducting their analyses. For example, GDP is estinopemated on a quarterly basis by the Bureau of Economic Analysis, and other measures like real personal income and employment are published monthly. Since all of these measures contribute to the committee's analysis of the dates of the peaks and troughs in the business cycle, it is not possible for the committee to identify the peaks and troughs as they occur. The data are analyzed retrospectively, meaning that the beginning date of a recession may not even be identified until the recession is actually over.

Hyperinflation

Hyperinflation is generally defined as an inflation rate in excess of 200% per year. It is always caused by the rapid printing of money.

Inflation

Inflation is an increase in the average level of prices In an economy experiencing inflation, most prices are likely to be rising

Although government programs may reduce frictional and structural unemployment, they cannot eliminate it. Information in the labor market will always have a cost, and that cost creates frictional unemployment. An economy with changing demands for goods and services, changing technology, and changing production costs will always have some sectors expanding and others contracting—structural unemployment is inevitable. An economy at its natural level of employment will therefore have frictional and structural unemployment.

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Even if employment is at the natural level, the economy will experience frictional and structural unemployment. Cyclical unemployment is unemployment in excess of that associated with the natural level of employment.

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Inflation and deflation affect the real value of money, of future obligations measured in money, and of fixed incomes. Unanticipated inflation and deflation create uncertainty about the future.

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Inflation and deflation refer to changes in the average level of prices, not to changes in particular prices. An increase in medical costs is not inflation. A decrease in gasoline prices is not deflation. Inflation means the average level of prices is rising, and deflation means the average level of prices is falling.

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Inflation and deflation refer to rising prices and falling prices, respectively; therefore, they do not have anything to do with the level of prices at any one time. "High" prices do not imply the presence of inflation, nor do "low" prices imply deflation. Inflation means a positive rate of change in average prices, and deflation means a negative rate of change in average prices.`

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Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. The rate of inflation or deflation is the percentage rate of change in a price index.

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Nominal values can be converted to real values by dividing by a price index.

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Over time, the general trend for most economies is one of rising real GDP. On average, real GDP in the United States has grown at a rate of over 3% per year since 1960.

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People who are not working but are looking and available for work at any one time are considered unemployed. The unemployment rate is the percentage of the labor force that is unemployed.

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Price-level change is measured as the percentage rate of change in the level of prices

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Real gross domestic product (real GDP) is a measure of the value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of price changes.

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The Bureau of Labor Statistics defines a person as unemployed if he or she is not working but is looking for and available for work.

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The consumer price index (CPI) is the most widely used price index in the United States.

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To convert nominal values to real values, divide by a price index

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Typically, an economy is said to be in a recession when real GDP drops for two consecutive quarters, but in the United States, the responsibility of defining precisely when the economy is in recession is left to the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The committee defines a recession as a "significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

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Whatever any particular person's situation may be, inflation always produces the following effects on the economy: it reduces the value of money and it reduces the value of future monetary obligations. It can also create uncertainty about the future

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When the labor market is in equilibrium, employment is at the natural level and the unemployment rate equals the natural rate of unemployment.

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Computing the rate of inflation or deflation

Rate of inflation or deflation = percentage change in index/ initial value of index

Chapter 5 Summary

Summary In this chapter we examined growth in real GDP and business cycles, price-level changes, and unemployment. We saw how these phenomena are defined and looked at their consequences. Examining real GDP, rather than nominal GDP, over time tells us whether the economy is expanding or contracting. Real GDP in the United States shows a long upward trend, but with the economy going through phases of expansion and recession around that trend. These phases make up the business cycle. An expansion reaches a peak, and the economy falls into a recession. The recession reaches a trough and begins an expansion again. Inflation is an increase in the price level and deflation is a decrease in the price level. The rate of inflation or deflation is the percentage rate of change in a price index. We looked at the calculation of the consumer price index (CPI) and the implicit price deflator. The CPI is widely used in the calculation of price-level changes. There are, however, biases in its calculation: the substitution bias, the new-product bias, the quality-change bias, and the outlet bias. Inflation and deflation affect economic activity in several ways. They change the value of money and of claims on money. Unexpected inflation benefits borrowers and hurts lenders. Unexpected deflation benefits lenders and hurts borrowers. Both inflation and deflation create uncertainty and make it difficult for individuals and firms to enter into long-term financial commitments. The unemployment rate is measured as the percentage of the labor force not working but seeking work. Frictional unemployment occurs because information about the labor market is costly; it takes time for firms seeking workers and workers seeking firms to find each other. Structural unemployment occurs when there is a mismatch between the skills offered by potential workers and the skills sought by firms. Both frictional and structural unemployment occur even if employment and the unemployment rate are at their natural levels. Cyclical unemployment is unemployment that is in excess of that associated with the natural level of employment.

Natural level of employment

The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment. It is sometimes referred to as full employment.

Labor force

The labor force is the total number of people working or unemployed.

Trough

The point at which a recession ends and an expansion begins is called the trough of the business cycle.

Peak

The point at which an expansion ends and a recession begins is called the peak of the business cycle.

Natural rate of employment

The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment. Business cycles may generate additional unemployment.

Unemployment rate

The unemployment rate is the percentage of the labor force that is unemployed.

Frictional unemployment

Unemployment that occurs because it takes time for employers and workers to find each other is called frictional unemployment. Ex: Recent graduates looking for work

Structural unemployment

Unemployment that results from a mismatch between worker qualifications and the characteristics employers require is called structural unemployment. Reasons: Technological change, geographical mismatches, too many or too few workers seek training or education that matches job requirements.

Implicit price deflator

a price index for all final goods and services produced, is the ratio of nominal GDP to real GDP. economists define the market basket quite simply: it includes all the final goods and services produced during that period. The nominal GDP gives the current cost of that basket; the real GDP adjusts the nominal GDP for changes in prices. nominal GDP/ real GDP

Consumer price index (CPI)

a price index whose movement reflects changes in the prices of goods and services typically purchased by consumers.

Recession

a sustained period in which real GDP is falling is a recession.

Deflation

deflation is a decrease in the average level of prices in an economy experiencing deflation, most prices are likely to be falling.

Personal consumption expenditures price index (PCE price index)

includes durable goods, nondurable goods, and services and is provided along with estimates for prices of each component of consumption spending. the price measure that excludes food and energy is often used as a measure of underlying, or "core," inflation. Note that the PCE price index differs substantially from the consumer price index, primarily because it is not a "fixed basket" index.[] The PCE price index has become a politically important measure of inflation since the Federal Reserve (discussed in detail in later chapters) uses it as its primary measure of price levels in the United States.

Real GDP

short for real gross domestic product, is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices.

Business cycle

the economy's pattern of expansion, then contraction, then expansion again

Nominal GDP

usually just referred to as gross domestic product (GDP), is the total value of final goods and services for a particular period valued in terms of prices for that period. For example, real GDP fell in the third quarter of 2008. But, because the price level in the United States was rising, nominal GDP rose 3.6%.