AP Macro Unit 2

Core CPI

*The 'core' CPI is often used to assist in monetary policy as it takes out energy and food prices as they tend to be more volatile (change more often both up and down) than other components of the CPI.

Three Types of Unemployment

1. Frictional 2. Structural 3. Cyclical

Does the CPI overstate Inflation?

A few reasons why it might: The CPI uses a fixed basket of goods. If the price of a good in the basket rises, the CPI rises. In reality, if the price of a good rises consumers typically substitute in a cheaper good. (substitution bias) The CPI does not really take into account the value of innovation in technology we enjoy. A $2000 computer from 1990 is not the same as a $2000 computer today. The CPI does not really take into account product improvements, like a detergent that smells better and gets rid of more stains.

price indexes

A price index is a measurement of how the average price of a standard group of goods changes over time. Price indexes are the way we adjust nominal GDP (the value of GDP in current dollars) to real GDP (the value of GDP in constant dollars)

Real GDP per Capita (per person)

All other things being equal, a country with a greater population will have a higher GDP than a country with a lower population. To compare productivity or GDP across countries while eliminating the effect of differences in population, we use GDP per capita. GDP per capita is GDP divided by the size of the population. It is equivalent to the average GDP per person.

What GDP Tells Us

By measuring the size of an economy, GDP lets us compare the aggregate output of a country across years or against other countries. Because prices change over time, measuring actual changes in aggregate output requires a modified version of GDP that is adjusted for price changes. This is called real GDP.

What is CPI used for?

CPI is the most widely used measure of the overall price level in the US. Used by economists to make predictions about future prices Labor agreements (think unions) use the CPI for wage increases Used to index payments for social security 61 million people receive checks from social security for retirement or disability. Indexed to CPI Tax brackets are indexed to the CPI Other government programs are indexed to the CPI

Changes in Natural Rate of Unemployment

Changes in Labor Force Characteristics Change in Labor Market Institutions Labor unions Temp agencies Internet job searching Changes in Government Policies High minimum wage Generous government unemployment benefits Job training Employment subsidies

#1. Frictional Unemployment

Due to workers looking for jobs. Temporarily unemployed Qualified workers with transferable skills seeking better jobs or 'new' jobs. Examples: High school or college graduates looking for jobs. Individuals that quit or were fired and are looking for a better 'fit' job. Always Exists Limited amount is GOOD Need to educate people with skills and then they look for relevant jobs Want people to find right 'fit' jobs and that might require some level of unemployment

Employment varies by demographics

Easier to find in prime working years (25-54) Varies by gender Varies by race Varies by education obtained

Employed / unemployed

Employed people are currently holding a job in the economy, either full time or part time. Unemployed people are actively looking for work but aren't currently employed.

Phases of the Business Cycle

Expansion (Growing) Peak (Top) Contraction (Shrinking) Trough (Bottom)

How the CPI is calculated

Fix the Basket: Determine what prices are most important to the typical consumer. Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. Compute the Basket's Cost: Use the data on prices to calculate the cost of the basket of goods and services Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

CPI: Market basket using 200 categories, within 8 major groups:

Food and beverages, Housing (they use rent or rental equivalent of a house, not the cost of house on the market) Apparel, Transportation, Medical care, Recreation, Education and communications, Other goods and services Includes SALES tax and user fees (garbage, sewers, tolls, licensing fees etc.) Does NOT include investments (stocks/bonds/life insurance) Doe NOT include state or federal income tax, unemployment tax, social security tax etc., any tax that is not included in the price of a good/service

Real GDP: A Measure of Aggregate Output

GDP measures aggregate output, the total value of final goods and services produced within an economy. It is also known as economic output, or simply output. Tracking real GDP avoids the problem of price changes distorting the value of changes in output over time.

Gross Domestic Product

Gross domestic product or GDP is the total value of all final goods and services an economy produces in a given year. The U.S. is a net importer of goods and services, such as the toys made on this Chinese production line.

Growth and Unemployment

In a recession (shown here by the shaded bars), GDP falls and unemployment rises. The reverse—unemployment falls when GDP rises—is usually the case but not always during an expansion. Here, unemployment briefly continued to rise even though GDP was rising. 2

There are also two markets in the diagram: product and factor markets. factor markets:

In product markets, households buy what they want from firms. Their payments are consumer spending. Consumer spending produces a flow of goods and services to households and a return flow of money to firms.

GDP: What's In and What's Out?

Included in GDP •Domestically produced final goods and services •Capital goods •New construction of structures •Changes to inventories Not included in GDP •Intermediate goods and services •Inputs •Used goods •Financial assets such as stocks and bonds •Foreign-produced goods and services

inflation

Inflation is a rise in prices, which can be translated as the decline of purchasing power over time. Deflation is a decrease in prices Goals: How do we measure changes in price? How do we use price indexes? A price index helps us calculate the rate of change in prices (inflation) FED: intro to inflation video

Two other components of financial markets are investment spending and inventories.

Investment spending includes all spending by firms on new productive physical capital (like machinery and facilities) and on changes in inventories. Inventories are stocks of goods and raw materials held to facilitate business operations.

Demand shifters-Demand pulls inflation up

Market-the number of buyers becomes greater Income-income levels increase Taste-desirable goods change Expectations-consumers think there might be shortage! Related goods-substitutes and compliments If demand increases but supply stays the same, the result is a shortage driving prices up. An overheated economy with excessive spending but same amount of goods, will drive prices up.

Adjustments-substitutions

Must figure out adjustment if good from last month is changed or no longer available. Since 1999, the prices within most item categories (for example, apples) are averaged with the use of a geometric mean formula. This improvement moves the CPI closer to a cost-of-living measure, because the geometric mean formula allows for a modest amount of consumer substitution as relative prices within item categories change. (Substitution might be a different type of apple, but it would not substitute strawberries for apples)

Creating the National Accounts

National income accounting arose in the Great Depression when government officials needed accurate measurements of the economy in order to address the crisis. National accounts were also important for policy makers measuring economic performance during World War II.

national accounts

National income and product accounts, or national accounts, track the flows of money among different sectors of the economy. These numbers are calculated in the U.S. by the Bureau of Economic Analysis, part of the U.S. government's Department of Commerce.

#2. Structural Unemployment

Persistent surplus of job-seekers Causes JOB LOSS: Changes in the structure of the labor force makes the worker's skills obsolete and the jobs will not be coming back. Workers must learn new skills to get a job. The permanent loss of these jobs is called "creative destruction." Examples: VCR repairmen Carriage makers Technological Unemployment Type of structural unemployment where automation and machinery replace workers causing unemployment Examples: Auto assemblers fired as robots take over production Producers of Capital Goods (tractors) fire the assembly Fewer jobs than the labor pool in a given area Geographic migration of people (immigration into a city) Geographic migration of jobs (businesses relocate) Mismatch between workers' skills and job requirements. (not tech related) Persistent surplus of job-seekers Causes-More willing to work than available jobs Wage rate in excess of the equilibrium wage rate. Minimum wage (but not if wage is below equilibrium) Government mandated floor on the price of labor Labor unions-collective bargaining for higher wages Efficiency wages-set high wages so ee don't want to lose job. Tech companies do this!

Calculating a Price Index

Price Index in given year = Cost of market basket in a given year Cost of market basket in base year. x 100 We use the Consumer Price Index to calculate the inflation rate. Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period. inflation y2: (CPI year 2-year1)/CPI Year 1 x 100=

real vs nominal GDP

Real GDP is the valueof final goods and services produced in an economy during a given year, calculated relative to a selected base year to remove the effects of price changes. vs Nominal GDP is the total value of final goods and services produced in an economy during a given year, calculated in current prices for the year in question.

The natural rate in France and Germany is around 8-10% higher than America. Why?

Some economists attribute difference to more generous unemployment benefits in European countries U.S. unemployment benefits usually last for 6 months Unemployment benefits in some European countries are indefinite Generous benefits reduce incentives to search for a job, increase frictional unemployment Full employment means NO Cyclical unemployment! Economists generally agree that unemployment rate of around 4 to 6 % is full employment. 4-6% Unemployment = NRU Okun's Law: When unemployment rises 1 percent above the natural rate, GDP falls by about 2 percent

Seasonal Unemployment

Specific type of frictional unemployment due to time of year and the nature of the job. These jobs will come back Examples: Professional Santa Claus Impersonators

Supply shifters: Cost-Push inflation

T-Technology (efficiency of operations) E-Expectations N-Natural disaster N-Number of suppliers (producers) I-Input costs S-Subsidies T-Taxes O-Other goods (substitutes/compliments) P-Productivity (negative changes, like strikes) Higher production costs increase prices A negative supply shock increases the costs of production and forces producers to increase their prices.

Other price indices

The BLS calculates other prices indexes: The producer price index (PPI), which measures the cost of a basket of goods and services bought by firms rather than consumers. This index is a leading indicator of future price increases for consumers. (Early warning signal, more volatile than others) Personal consumption expenditures: similar to CPI but some view it as more accurate as the calculations appear more complex and a greater breadth of goods and services are included. Usually lower than CPI The GDP deflator

Other price indices

The GDP deflator distinguishes between nominal GDP, prices and quantities when the output was produced , and real GDP, deflated or inflated to reflect changes in the price level. Calculate 'real' GDP using the prices from the chosen base year.

The GDP Deflator versus the Consumer Price Index

The GDP deflator reflects the prices of all goods and services produced domestically, whereas... ...the consumer price index reflects the prices of all goods and services bought by consumers.

The circular-flow diagram

The circular-flow diagram is a simplified representation of the macroeconomy. It shows the flow of money, goods and services, and factors of production through an economy.

CPI

The consumer price index (CPI) is based on the overall cost of the goods and services bought by a typical consumer. The consumer price index uses a "fixed basket of goods" and evaluates changes in the basket's costs each month.

The Expanded Circular-Flow Diagram

The expanded circular-flow diagram adds flows to and from government to the flows between households and firms. Taxes are required payments to the government. Tax revenue is the total amount the government receives from taxes. Disposable income (income plus transfers minus taxes) is the total amount of income households can spend on consumption. Government transfers are payments the government makes to individuals without expecting a good or service in return. The expanded circular flow diagram shows how money flows through the three sectors of the economy: households, firms, and government (with financial system support)

Adding the Rest of the World to the Circular Flow

The rest of the world participates in a domestic economy through exports, imports, and financial markets. Exports are domestically-produced goods and services that are sold to other countries. Imports are goods and services purchased from other countries. Financial market transactions (foreign lending and borrowing) also generate flows into and out of a country.

The Simple Circular-Flow Diagram

The simplest circular-flow diagram shows an economy that contains two groups: households and firms. A household consists of either an individual or a group of people who share their income A firm is an organization that produces goods and services for sale—and that employs members of households.

The Significance of the Unemployment Rate

The unemployment rate is a good indicator of how hard it is to find work given the state of the economy, but it isn't a perfect measure.Most issues probably understate it. Discouraged workers are those who could work but who have given up seeking employment due to the state of the job market. The unemployment rate does not count discouraged workers, so it may understate the percentage of people who want to work but are unable to find jobs.

The Natural Rate of Unemployment (NRU)

Two of the three types of unemployment are unavoidable: Frictional unemployment (TEMPORARY) Structural unemployment (OBSOLETE) Together they make up the natural rate of unemployment America is at full employment if we have NRU. This is the normal amount of unemployment that is present and expected.

unemployed

Unemployed are those who are •jobless, •looking for work during the past 4 weeks and •available to work. IF NOT SEEKING WORK THEN NOT COUNTED AS UNEMPLOYED

#3 Cyclical Unemployment

Unemployment that results from economic downturns (recessions). As demand for goods and services falls, demand for labor falls and workers are laid off. Examples: Steel workers laid off during recessions. Restaurant owners fire waiters after months of poor sales due to recession. All the COVID-related layoffs

winners/losers of inflation

Who wins and who loses under inflation revolves around the interests rates on loans—the percentage of the loan that the borrower must pay to the lender in addition to the repayment of the loan amount itself. If inflation is higher than expected, borrowers win, and lenders lose: Borrowers repay loans with money that has a lower real value than had been expected. That money buys less due to the unexpectedly high rate of inflation. If inflation is lower than expected, lenders win, and borrowers lose: Borrowers repay loans with money that has a higher real value than had been expected. That money buys more due to the unexpectedly low rate of inflation. Borrowers are helped by inflation because it decreases the real value of what they must repay. Lenders, savers, and people with fixed incomes are hurt by inflation because it decreases the real value of the money available to them in the future. The reverse is true for deflation: borrowers are hurt, and lenders, savers, and people with fixed incomes are helped.

Intermediate goods and services

are bought from one firm by another firm as inputs in the production of other final goods and services. Final goods and services are sold directly to the end user.

Menu costs

are the real costs of changing listed prices. The faster prices change, the more menu costs go up. Under low inflation, businesses might update their prices only sporadically—and technology has lowered menu costs; prices are often changed electronically with little to no expense.

The underemployed

are those who would like to work more hours than they do or those who are overqualified for their jobs. race is impacted

Unit-of-account costs

arise from the way inflation makes money a less reliable unit of economic measurement. Households and firms make contracts, budgets, estimates, and pay taxes with the dollar as the unit of account. The faster price levels change, the less accurate and reliable these accounting measures become. For example, with 10% inflation, if a firm sells an asset for 10% more than it costs, the real value of the asset remains the same. The firm is still taxed, however, on its 10% "gain" as if it is a real gain—incurring a net loss.

Financial markets

channel private savings into investment spending and government borrowing.

GDP can be calculated in one of three ways:

expenditure approach income value added The expenditure approach adds aggregate spending on all domestically produced final goods and services in the economy. GDP = Consumer spending + Investment spending + Government purchases + (eXports - Imports) Note that exports minus imports, or (X - M) in the equation above, is also known as net exports.

In factor markets/ resource market

firms buy factors of production that they need to produce goods and services from households. In exchange, households earn income from wages rent, interest, and profit. Overall, households buy from firms in product markets, and firms buy from households in factor markets. human resources, natural resources, capital

Private savings

include all households' disposable income that is not spent on consumption.

disinflation

inflation rate down . Difficult to do because you must temporarily slow growth or even depress the economy. In disinflation, price increases still occur, just at a slower rate

Economic growth

is an increase in the maximum amount of goods and services an economy can produce. Due to economic growth, products that were considered luxuries in the 1950s are commonplace today.

Government borrowing

is the amount of funds borrowed by the government in the financial markets.

The nominal interest rate

is the interest rate actually paid for a loan.

The real interest rate

is the nominal interest rate minus the rate of inflation. For example, if a loan has a nominal interest rate of 8%, but the inflation rate is 5%, the real interest rate is 8% - 5% = 3%.

The labor force participation rate

is the percentage of the population aged 16 or older that is in the labor force.

The unemployment rate

is the percentage of the total number of people in the labor force who are unemployed. The unemployment rate has fluctuated widely over time. It always rises in recessions, shown here by the shaded bars... ...and it usually falls during economic expansions. Broader measures count discouraged workers, marginally attached workers, and the underemployed—but they move in close parallel with each other.

Disinflation

is the process of bringing the inflation rate down. Many economists believe the only way to reduce the inflation rate is through policies that temporarily depress the economy. Because inflation can be so costly and hard to get rid of, even when inflation is relatively low, governments may take disinflationary measures which temporarily depress the economy as a form of preventative medicine.

The labor force

is the sum of the employed and the unemployed.

real

real means comparing to nominal The real wage is the wage rate divided by the price level to account for inflation or deflation. Real income is income divided by the price level. The inflation rate is the percent increase in the overall level of prices per year.

The income approach

to calculating GDP adds all the income earned by factors of production in the economy. These include: •Wages earned by labor. •Interest earned by those who lend their savings to firms and the government. •Rent earned by those who lease their land or structures to firms. •Profits (money not paid to wages, interest, or rent) earned by the owners of the firms' physical capital.

The value-added approach

to calculating GDP adds the contribution of each firm along the way to the total value of the final good or service. The value added by a producer is the value of its sales minus the value of its purchases of inputs. For example, the value added by a steel producer is the dollar value of the steel it produces minus the cost of the ore it buys.

Marginally attached workers

would like to be employed, and they have looked for a job in the recent past, but they are not currently looking for work.

By comparing aggregate values

—like GDP, unemployment, or inflation.

What keeps the Business Cycle Going?

•4 variables cause changes in the Business Cycle: 1.Business Investment When the economy is expanding, sales and profit keep rising, so companies invest in new plants and equipment, creating new jobs and more expansion. In contraction, the opposite is true 2.Interest Rates and Credit Low interest rates, companies make new investments, adding jobs. When interest rates climb, investment dries up and less job growth 3.Consumer Expectations Forecasts of an expanding economy fuels more spending, while fear of a recession decreases consumer spending 4.External Shocks External Shocks, such as disruptions of the oil supply, wars, or natural disasters greatly influence the output of the economy Ex. 1992-2000 was a long period of expansion. Early in 2001, signs of contraction appeared. The Sept. 11th 2001 terrorist attacks quickly caused the business cycle to shift into a more pronounced contraction.

Recession/Depression

•A prolonged contraction is called a recession (contraction for 6 months or more, assessed on a quarterly basis, so 2 consecutive quarters). (But can be exceptions.) A recession of more than one year is called a depression.

What is an output gap?

•An output gap is the difference between potential output (efficient use of resources, full employment, on the PPC!) and actual output. •Actual output can be less than the PPC. This means resources are not deployed efficiently and there is unemployment above the natural rate (cyclical!) •Actual output can be temporarily above the PPC if workers are working overtime etc. •When the output gap is zero, workers are at the natural rate of employment and the economy is producing 'on' the PPC

Contraction

•During a period of contraction: -Businesses cut back production and layoff people -Unemployment increases -Number of jobs decline -People are pessimistic (negative) and stop spending money -Banks stop lending money

EXPANISION

•During a period of expansion: -Wages increase -Low unemployment -People are optimistic and spending money -High demand for goods -Businesses start -Easy to get a bank loan -Businesses make profits and stock prices increase

measuring health

•Fordham Index of Social Health (FISH) •Genuine Progress Indicator •United Nations Human Development Index •Gross Sustainable Development Product

What does the GDP tell us?

•If real GDP is larger than last year the economy is expanding (getting bigger) •If real GDP is smaller, the economy is shrinking (getting smaller)

why should we care? : "Don't quit that job!""Should I make a big purchase?"

•If the economy is going into a contraction, jobs will become more scarce. If you quit, you may not find another job! • •But, if the economy is in a period of expansion, jobs are readily available. It may be a good time to switch careers. •Only if you know that you won't lose your job in a contraction. So, buy your house during an expansion. HOWEVER, •When the economy starts to slow down (contraction), interest rates will decrease. Wait to buy a house until the rates drop to a low point, if you are sure you won't lose your job.

Business Cycle

•The Business Cycle allows people to understand the direction the economy (GDP) is going (growing or shrinking) and plan accordingly. • •Take out the percentage changes, our GDP plugs along!

peak

•When the economic cycle peaks: -The economy stops growing (reached the top) -GDP reaches maximum -Businesses can't produce any more or hire more people -Cycle begins to contract

trough

•When the economic cycle reaches a trough: -Economy "bottoms-out" (reaches lowest point) -High unemployment and low spending -Stock prices drop - But, when we hit bottom, no where to go but up! UNLESS....

Can the unemployment rate be overstated?

•lying: To obtain unemployment benefits you must state you are looking for work. People may not be actually looking. •People may have job offers and are waiting for the job to start