Team Quiz 2
negative output gap
A negative output gap occurs when actual output is below its potential: there are idle resources, and it typically corresponds with high unemployment.
positive output gap
A positive output gap means actual output is above potential output: the economy is using its resources with intensity.
basket: Personal Consumption Expenditures Price Index (PCE)
All goods and services included in "C" - personal consumption expenditures
basket: (GDP Implicit Price) Deflator
All goods and services produced by the domestic economy
Nominal interest rates example
Suppose you put $100 into your savings account, where the bank will pay you 5.50% nominal interest at the end of the year. - At the end of the year, you will have $105.50 - Check: interest rate = growth rate in an amount of money
Rule of 70
says that you can figure out approximately how many years it will take something to double if you divide 70 by its annual growth rate
efficiency wage
▪ An efficiency wage is a higher wage paid to encourage greater worker productivity. ▪ Efficiency wages cause structural unemployment but can also lower total labor costs.
rate of inflation
growth rate in the deflator-based measure of the average price level
Economic Costs of Unemployment
- Hysteresis occurs when a period of high unemployment leads to a higher equilibrium unemployment rate. - High unemployment means that the government receives lower tax revenues but spends more. - The unemployed often end up with lower wages and worse career opportunities. - More unemployment means that fewer goods and services are produced, and less income is generated in the macroeconomy. - Okun's Rule of Thumb for a rough measure of lost output
frictional unemployment: three main factors time
- The efficiency of the resources employers and workers use to find each other. - The alignment of the skills workers have and the skills employers desire. - There is more search (and longer unemployment spells) due to unemployment insurance and other income support during unemployment.
Interest Rate Determination (from the lender's perspective)
- The key to understanding the economic function of interest rates is to recognize that receiving $100 in the future has less economic value than having $100 today. - The basic lending rate as if you were lending at zero risk; this is referred to as the risk-free rate, and we'll express it in real terms. - Risk premium - an extra amount (also expressed in real terms) to compensate for all the risks of lending: default risk; liquidity risk; interest rate risk; risk aversion - Expected Inflation - an (expected) increase in the overall level of prices (Goal: maintain purchasing power)
Other reasons for nominal wage rigidity
- Unions keep wages high for some workers. - Minimum wage laws prevent wages from falling to the market-clearing wage. - Money illusion: (ch. 12, p. 307) People hate it when their employer cuts their wage. Managers know this, so even when business is struggling, managers will try to get by w/o cutting wages. Money illusion leads (many) workers to feel okay because their wage isn't being cut...but that's a NOMINAL wage. If there is inflation, real wages are falling.
What is an average price level (or, "price index")?
- just what it sounds like- several - ways of "averaging" - the GDP Deflator - the CPI - the consumer price index - the PPI - the producer price index - the PCE - the Personal Consumption Expenditures price index
Inflation imposes costs on societies
1. Because inflation undermines the productive benefit of money, it - inflation - imposes costs on society. - The costs arise because money isn't able to perform its functions well when inflation is present. • The higher the rate of inflation, the less well money performs its functions and the higher are the societal costs. - Extreme case: hyperinflationThose costs exist even if inflation is correctly (perfectly) anticipated: 𝜋 = 𝜋𝑒3. Societies face additional costs when inflation isn't correctly anticipated. 2. Those costs exist even if inflation is correctly (perfectly) anticipated: 𝜋 = 𝜋𝑒 3. Societies face additional costs when inflation isn't correctly anticipated.
Cyclical Unemployment & total unemployment
Cyclical Unemployment - The extra unemployment that occurs during periods of recession. • Due to shifts in the demand for labor & compounded by (downward) wage rigidity - Total unemployment (u) = the sum of frictional, structural and cyclical unemployment - Key idea: Unlike cyclical unemployment - present only during recessions - frictional and structural unemployment are always present in the labor market, even when the economy is operating 'normally.'
The societal "costs" of inflation
Even if inflation is fully and correctly anticipated: - Menu costs: The costs associated with changing prices and printing new price lists when there is inflation. - Menu costs arise because inflation renders money an unstable unit of account: prices are marked (for example) in US$, but those dollars are worth less - and so last year's price isn't suitable this year. - Businesses devote valuable resources to price adjustments. - Shoe-leather costs: Costs of inflation that arise from trying to reduce holdings of cash. - Shoe-leather costs arise because inflation undermines money's store of value function. - People have to take costly measures to keep their wealth in assets that better maintain their value (other than cash).
basket: Producer Price Index (PPI)
Fixed basket of goods and services purchased by a firms as inputs to production of final goods & services
basket: Consumer Price Index (CPI)
Fixed basket of goods and services purchased by a typical family (e.g., urban, 4)
Okun's rule of thumb
For every percentage point that actual output falls below potential output, the unemployment rate increases around half a percentage point.
nominal gdp formula
GDP=C+I+G+(X-M), nom GDP = (real GDP) (P)
CPI as cost of living measurement, limitation 1
Limitation #1 is based on the definition of the market basket. ▪ The most widely reported measure of the CPI is based on measuring prices of a "basket" of goods and services purchased by a typical urban family of four. ▪ Are you in that family? Am I? ▪ The prices we actually face are attached to the goods and services we actually purchase. ▪ If you buy these goods and services in the same proportion as they're represented in the "typical basket," then the CPI accurately reflects the cost of living that you actually face. ▪ Or: if all prices change by the same amount, then this is not a concern
CPI as cost of living measurement, limitation 2
Limitation #2 arises because the market basket is fixed. - New product introduction: Because the CPI only tracks changes in the prices of existing goods, the CPI-based rate of inflation doesn't account for any decrease in the cost of living associated with the introduction of new goods. - Substitution bias: if the price of an item in the market basket rises, people might substitute toward a less-expensive item (not in the market basket). In that case, the actual cost of living is less than that suggested by the CPI-based rate of inflation. - Quality improvements: Some part of a measured rise in prices could be due to unmeasured quality improvements, rather than a true rise in the cost of living (e.g., mobile phones, health care...)
Why does money have value, and how do we measure that value?
Money's value comes from its ability to be used in transactions, to buy "stuff" today or in the future.
How accurately do changes in the CPI measure "cost of living"?
One goal of the CPI is to measure changes in the cost of living. ▪ As we'll see next, the CPI is used for indexation, meaning that it's used to make "cost of living" adjustments in, for instance, employment contracts. ▪ But there are some limitations to interpreting the CPI as a "cost of living" measure. ▪ The first limitation stems from the use of a "typical" market basket. ▪ The second limitation is that there are measurement issues related to using a fixed market basket of goods and services. ▪ Upshot: the CPI-based inflation rate overstates the true cost of living faced by a typical household.
Real interest rates example
Suppose you put $100 into your savings account, where the bank will pay you 5.50% nominal interest at the end of the year. During this time, the inflation rate was 3%. - A 3% rate of inflation means that you need $103 at the end of the year to maintain your purchasing power ⬄ to be able to buy the same set of goods and services that you could purchase at the start of the year with $100. - At year's end, you get $105.50 - This means that you obtain a $2.50 increase in your purchasing power (as a result of saving in the bank), or a 2.5% increase in your purchasing power.
money illusion
The (mistaken) tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts
Cyclical Unemployment
The extra unemployment that occurs during periods of recession. • Due to shifts in the demand for labor & compounded by (downward) wage rigidity
structural unemployment
The long-term and chronic unemployment that occurs even when the economy is producing at its "normal" rate. It arises from many possible factors, including: - Language barriers - Income-related barriers to employment (e.g., transportation or inconsistent child-care or inconsistent employer scheduling) - Discrimination - Lack of skills, coupled with an inability to acquire required skills - Industry structural shifts, coupled with worker immobility - Other structural features of the labor market: Government regulations? - (downward) wage rigidity: money illusion, minimum wage, unionization, "efficiency wages"...
The Output Gap
The output gap is the difference between actual and potential output (or, GDP), measured as a percentage of potential output:
frictional unemployment
The short-term unemployment that is associated with the matching of workers and jobs. • Some amount of frictional unemployment is necessary for the labor market to function efficiently in a dynamic, changing economy.
average price level - Different measures but similar approach
These measures are all similar in that they involve a comparison of the value of a "basket of good & services" in the current-dollar terms and in constant-dollar terms.
If we want to use GDP to compare economic activity at different points in time, we need some method of excluding the effects of price changes.
This is why we focus on REAL GDP (and real GDP per capita), when describing growth in the economy - it's a measure of the change in the physical production in the economy.
consumer price index
a measure of the average change over time in the prices a typical urban family of four pays for the goods and services they purchase.
Growth rate approximation
formula useful approximation for comparing nominal and real GDP growth rates, but also for any nominal and real pairs (ie. real and nominal interest rates)
Real interest rate
the interest rate in terms of changes in your purchasing power.
Real GDP
the market value of production is calculated using a common, constant set of prices. This is also called constant dollar GDP.
Nominal GDP
the market value of production is calculated using current market prices; also called current dollar GDP.
Interest rate
the price per $100 (which is why an interest rate is expressed as a percent) - Equivalently, you can think of an interest rate as a growth rate in an amount of money from one time period to the next.
Interest
the price you pay (earn) for financial capital (e.g., money)
Inflation
the rate of change (the growth rate) of the average price level (or, of the "price index").
Nominal interest rate
the stated interest rate without a correction for the effects of inflation.
"real basket" calculation
we can move beyond "market baskets of goods" and generalize this to say that we can "deflate" a nominal monetary value (ie. dollar valye) by a price index to calculate a real monetary value (this is useful for comparing nominal valyes across time when we know, or suspect, that prices haven't been constant)
