Inflation, Unemployment, and National Income: The Abridged Version Because we never know when disaster will strike…

GDP Gap and Okun’s Law When the economy fails to create enough jobs for all who are able and willing to work, potential production of goods and services is irretrievably lost. GDP Gap- The amount by which actual GDP falls short of potential GDP

How do we solve for the GDP Gap? Okun’s Law indicates for every 1% unemployment exceeds the natural rate (6%) a gap of about 2% occurs Real Unemployment Rate (%) x Okun’s 2

NDP- Net Domestic Product GDP does not take into account the consumption of fixed capital (depreciation) To determine how much new output was available consumption and for additions to the stock of capital we subtract the capital that is consumed through production from GDP and that had to be replaced NDP= GDP – Consumption of fixed capital (depreciation)

National Income We can then use NDP to determine National Income (NI) by making two adjustments Subtract Net foreign factor income Subtract indirect business taxes Billions NDP $8709 Net foreign factor income -9 Indirect business taxes -682 National Income $8018

Personal Income Includes all income received whether earned or not When moving from NI to PI we must subtract what is earned but not received (taxes/undistributed corp. profits) and add the income that is received but not earned (SS payments, unemployment, welfare)

Disposable Income Personal Income- personal taxes (income tax, property tax, inheritance tax) Disposable income is the amount of income that households have left over after paying taxes

Inflation Rise in the general level of prices This does not mean that all prices are rising Ex. The U.S. experienced high rates of inflation in the 70’s and 80’s but the prices of video recorders, digital watches, and personal computers declined. This is why we use CPI to determine the rate of inflation for a given good

Inflation Rate of inflation= current CPI-base CPI X 100 base CPI Rule of 70: we can find the number of years it will take for some measure to double; given its annual percentage increase by dividing it into 70 So how long will it take a 3 percent annual rate of inflation to double the price level?

Demand-Pull & Cost-Push Inflation Demand-Pull Inflation – increase in AD. [“Too many dollars chasing too few goods”] Originates from “buyers side of the market”. Cost-Push Inflation – 3 things may cause “cost-push” inflation. 1. Wage-push – strong labor unions 2. Profit-push – companies increase prices when their costs increase. 3. Supply-side cost shocks – unanticipated increase in COSTS of raw materials such as oil.

Nominal and Real Income Nominal Income is the number of dollars received as wages, rents, interest, or profits Real income is a measure of the amount of goods and services nominal income can buy; it is the purchasing power of nominal income, or income adjusted for inflation Real Income= Nominal Income Price Index

[During deflation, the $ buys more but during inflation, it buys less]

Who is hurt by inflation? Fixed-income receivers Private pensions for elderly Landlords receive fixed lease payments Savers the value of savings will decline if the rate of inflation exceeds the interest rate Creditors The borrower is lent “dear” dollars, but because of inflation, pays back “cheap” dollars

Who is helped by inflation? Flexible-income receivers Social security Cost-of-living adjustments Debtors Business When the price of goods rises faster than the price of resources