© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT Gross domestic product (GDP) is … –the total market value of all final goods and services produced within a country in one year.

© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “GDP is the Market Value...” –Output is valued at market prices. “... Of All...” –Includes all items produced in the economy and legally sold in markets “... Final...” –It records only the value of final goods, not intermediate goods (the value is counted only once). “... Goods and Services...” –It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “... Produced...” –It includes goods and services currently produced, not transactions involving goods produced in the past. “... Within a Country...” –It measures the value of production within the geographic confines of a country. “... In One Year.” –Sums the dollar value of what has been produced in the economy over the year.

© 2007 Thomson South-Western THE COMPONENTS OF GDP GDP includes all items produced in the economy and sold legally in markets. What Is Not Counted in GDP? –GDP excludes most items that are produced and consumed at home and that never enter the marketplace. –It excludes items produced and sold illicitly, such as illegal drugs.

© 2007 Thomson South-Western THE COMPONENTS OF GDP GDP (Y) is the sum of the following:  Personal Consumption (C)  Domestic Investment (I)  Government Purchases (G)  Net Exports (NX) Y = C + I + G + NX

© 2007 Thomson South-Western THE COMPONENTS OF GDP Personal Consumption (C): spending by households on … Durable goods Non durable goods services

© 2007 Thomson South-Western THE COMPONENTS OF GDP Domestic Investment (I): All final purchases of machinery, equipment, and tools by businesses. All construction Changes in business inventory

© 2007 Thomson South-Western THE COMPONENTS OF GDP Government Purchases (G): –Spending by local, state, and federal governments. –All direct purchases of resources (labor in particular)

© 2007 Thomson South-Western THE COMPONENTS OF GDP Net Exports (NX): –All spending on goods produced in the US Purchases both here and abroad (exports) –Goods purchases in the US which are produced elsewhere (imports) –Net Exports = exports - imports

© 2007 Thomson South-Western NOT INCLUDED IN GDP Second Hand Sales –Reselling a car Purely Financial Transactions –Public transfer payments Social security Sale of stocks and bonds

© 2007 Thomson South-Western REAL VERSUS NOMINAL GDP Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices.

© 2007 Thomson South-Western Calculating Nominal GDP (P (year) * Q (year) ) + (P (year) * Q (year) ) + …

© 2007 Thomson South-Western Real and Nominal GDP

© 2007 Thomson South-Western Real and Nominal GDP

© 2007 Thomson South-Western Calculating Real GDP (P (base year) * Q (real year) ) + (P (base year) * Q (real year) ) + … Base year = a designated year for the price

© 2007 Thomson South-Western Real and Nominal GDP

© 2007 Thomson South-Western Real and Nominal GDP

© 2007 Thomson South-Western Calculating Real GDP in % Terms Real GDP – Real GDP base year Real GDP base year) Base year = a designated year for the price

© 2007 Thomson South-Western IS GDP A GOOD MEASURE OF ECONOMIC WELL-BEING? GDP –best single measure of the economic well-being of a society. –per person the income and expenditure of the average person in the economy. –Higher GDP per person indicates a higher standard of living. –not a perfect measure of the happiness or quality of life

© 2007 Thomson South-Western GDP AND ECONOMIC WELL-BEING Some things that contribute to well-being are not included in GDP. –The value of leisure. –The value of a clean environment. –The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

© 2007 Thomson South-Western Table 3 GDP and the Quality of Life

© 2007 Thomson South-Western Bureau of Labor Statistics (BLS) Labor Categories An adult is over 16 years old is … –Employed - those who are working at least one hour/week at a paid job. –Unemployed – those who are not working at least one hour/week but seeking employment. –Not in the labor force - A person who fits neither of these categories.

© 2007 Thomson South-Western How Is Unemployment Measured? Labor force - the sum of employed and unemployed. Labor Force (LF) = Number of Employed (E) + Number of Unemployed (U)

© 2007 Thomson South-Western How Is Unemployment Measured? Labor-force participation rate - the percentage of the working-age population in the labor force. LFPR% = 100*(LF) / (civilian population >= 16)

© 2007 Thomson South-Western How Is Unemployment Measured? Unemployment rate - the percentage of the labor force that is not employed UR% = 100*(# unemployed)/(# LF)

© 2007 Thomson South-Western How is Unemployment Measured? Natural Rate of Unemployment –The amount of unemployment that the economy normally experiences –There is ALWAYS a level of unemployment Natural Unemployment = Frictional Unemployment + Structural Unemployment

© 2007 Thomson South-Western Why Are There Always Some People Unemployed? Frictional unemployment - –Those searching for jobs –Waiting to take jobs soon College student graduates and their job starts in a month

© 2007 Thomson South-Western Why Are There Always Some People Unemployed? Structural unemployment - more people are seeking jobs than there are jobs available –Skills –Geographic distribution

© 2007 Thomson South-Western Structural Unemployment We know that when D decreases, P (W) decrease. What if the wage does not adjust downward? What would cause this to happen?

© 2007 Thomson South-Western Structural Unemployment 1.Minimum Wage –Price floor –Surplus of labor Fast food 2.Labor Unions 1.Negotiate with employers on behalf of their workers. 1.Goal is to raise wages above market equilibrium 2.May be some unemployment

© 2007 Thomson South-Western Structural Unemployment 3. Efficiency Wages 1.Wages above equilibrium wage rate 1.Incentive for better performance 2.May create a surplus of workers 4. Side Effects of Public Policy 1.Benefits to laid off workers 1.Reduces the incentive to quickly find work

© 2007 Thomson South-Western Cyclical Unemployment Cyclical Unemployment – –the portion of unemployment which arises from the business cycle. Actual Unemployment = Natural Unemployment + Cyclical Unemployment

© 2007 Thomson South-Western Changes in the Natural Rate of Unemployment 1.Labor Force Characteristics 1.People are working longer. 1.Decline in Natural Rate of Unemployment 2.Labor Market Institutions 1.Decline in the role of labor unions. 1.Reduced Structural Unemployment

© 2007 Thomson South-Western Changes in the Natural Rate of Unemployment 3. Government Policies 1.Subsidies to employers to employ and/or retrain workers with obsolete skills. 1.Lessen the Natural Rate of Employment

© 2007 Thomson South-Western Inflation and Deflation Matthew has income of $20/week to spend on Gasoline ($2/gallon) or Venti Mochaccino Café Lattes ($4/cup). His purchasing possibilities are: Most GasMost LattesOC of one more latte 10 gallons5 cups2 gallons One gallon of gas uses up 10% of his income. One cup of latte uses up 20% of his income.

© 2007 Thomson South-Western Inflation and Deflation Now, the price of gas doubles - $4/gallon, and the price of a latte doubles - $8/cup. Most GasMost LattesOC of one more latte 5 gallons2.5 cups2 gallons One gallon of gas uses up 20% of his income. One cup of latte uses up 40% of his income.

© 2007 Thomson South-Western Inflation and Deflation What would Matthew do? What would the sellers of gas and café lattes do? Inflation creates costs for both groups of people.

© 2007 Thomson South-Western Inflation and Deflation Inflation is the over all rise in prices. Deflation is the overall decline in prices.

© 2007 Thomson South-Western Costs of Inflation Shoe Leather Costs Menu Costs Unit-of-Account Costs

© 2007 Thomson South-Western Shoe Leather Costs Shoe Leather costs - resources wasted when inflation encourages people to reduce their money holdings. –Inflation reduces the real value of money –People have an incentive to minimize their cash holdings. –Less cash requires more frequent trips to the bank

© 2007 Thomson South-Western Menu Costs Menu costs are the costs of adjusting prices.

© 2007 Thomson South-Western Inflation and Deflation Unit-of-Accounts Costs –These costs arise due to the way inflation affects the value of money. –Less reliable unit of measure.

© 2007 Thomson South-Western Winners and Losers from Inflation Inflation can often just redistribute money from one person to another. –Borrowers and lenders

© 2007 Thomson South-Western Winners and Losers from Inflation Suppose you lend a friend $100 and she promises to pay you back in a year. You decide to charge her interest on the $100. How do you determine how much to charge?

© 2007 Thomson South-Western Winners and Losers from Inflation Compensation for not having the money to use during the year. Inflation will have eroded the purchasing power of the original $100. How do you determine how much to charge?

© 2007 Thomson South-Western Winners and Losers from Inflation Interest Rate has two parts: 1.Service compensation 2.Inflation offset How do you determine how much to charge?

© 2007 Thomson South-Western Winners and Losers from Inflation Nominal Interest Rate = real interest rate + expected inflation How do you determine how much to charge?

© 2007 Thomson South-Western Winners and Losers from Inflation Inflation = 5% Lending services = 3% 3% + 5% = 8% Nominal Interest Rate = 8%

© 2007 Thomson South-Western Winners and Losers from Inflation Expected Inflation Actual Inflation EffectsWho Benefits 5% No changeEven 5%1%Purchasing power increased Lender gains 5%8%Purchasing power decreased Borrower gains

© 2007 Thomson South-Western Price Indices and the Aggregate Price Level Inflation Inflation - the economy’s overall price level is rising. –% change in the price level from the previous period.

© 2007 Thomson South-Western THE CONSUMER PRICE INDEX Consumer price index (CPI) –Measures the overall cost of the goods and services bought by a typical consumer. –The Bureau of Labor Statistics (BLS) reports the CPI each month. –Monitors changes in the cost of living over time. –Rising CPI - more dollars need to be spent to maintain the same standard of living.

© 2007 Thomson South-Western Market Baskets and Price Market Basket: –The typical basket of goods and services purchased by a consumer.

© 2007 Thomson South-Western Our Economy of Four Foods Item in the Market Basket Q Consumed in a Typical Year (pounds) 2008 prices (per pound) 2009 prices (per pound) Salami300$4$6 Corned Beef200$5$7 Bologna100$2$1.50 Cheese500$3$2.50 Prices changed between 2008 and Calculate the 2008 and 2009 Market Basket Costs. (Q * P)+ (Q * P) + … 2008 cost = 300x x x x3 = $ cost = 300x x x1.5o + 500x2.50 = $4600

© 2007 Thomson South-Western Our Economy of Four Foods Item in the Market Basket Q Consumed in a Typical Year (pounds) 2008 prices (per pound) 2009 prices (per pound) Salami300$4$6 Corned Beef200$5$7 Bologna100$2$1.50 Cheese500$3$2.50 We look at these answers as a ration. Most recent year Other year 4600/3900 = What does this ratio tell us? 18% increase.

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated Compute the price index: Price index in year t = 100x(Cost of the market basket in year t) (Cost of the market basket in the base year) Base year is the benchmark year.

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated Use 2008 as the base year. Compute the price index: PI 2008 = 100x(3900/3900) = 100 PI 2009 = 100x(4600/3900) = 117.9

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated Inflation Rate = % change between any two price index values. Inflation Rate from 2009 – 2008 = 100x(PI 2009 – PI 2008 )/(PI 2008 ) 100(117.9 – 100/100) = 17.9%

© 2007 Thomson South-Western A C T I V E L E A R N I N G 1 : Calculate the CPI 57 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2004, the base year. A. Compute the CPI in B. What was the CPI inflation rate from ? price of beef price of chicken 2004$4 2005$5 2006$9$6

© 2007 Thomson South-Western A C T I V E L E A R N I N G 1 : Answers 58 beefchicken 2004$4 2005$5 2006$9$6 A. Compute the CPI in 2005: Cost of CPI basket in 2005 = ($5 x 10) + ($5 x 20) = $150 CPI in 2005 = 100 x ($150/$120) = 125 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2004, the base year.

© 2007 Thomson South-Western A C T I V E L E A R N I N G 1 : Answers 59 beefchicken 2004$4 2005$5 2006$9$6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2004, the base year. B. What was the inflation rate from ? Cost of CPI basket in 2006 = ($9 x 10) + ($6 x 20) = $210 CPI in 2006 = 100 x ($210/$120) = 175 CPI inflation rate = (175 – 125)/125 = 40%