Mod 2 Flashcards
(156 cards)
1
Q
gross domestic product (GDP), can be measured in three different ways:
A
the value added approach, the income approach (how much is earned as income on resources used to make stuff), and the expenditures approach (how much is spent on stuff). However, you will likely run into the expenditures approach the most as you progress through this course.
2
Q
A model called the circular flow diagram illustrates
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how the expenditures approach and the income approach must equal each other, with goods and services flowing in one direction and income flowing in the opposite direction, in a closed loop.
3
Q
gross domestic product (GDP)
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the market value of the final production of goods and services within the geographic borders of a country in a given period; for example, if the GDP of India is $2.264\text{ trillion}$2.264 trilliondollar sign, 2, point, 264, start text, space, t, r, i, l, l, i, o, n, end text in 2016, this means that this is the value of all new goods and services that were produced inside the border of India, excluding intermediate goods, during 2016.
4
Q
expenditures approach to GDP
A
one of the three approaches to calculating GDP that involves adding up all spending on final goods and services in an economy; the expenditures approach categories this spending into five categories: consumption, investment, government spending, exports, and imports: Y=C+I+G+X-MY=C+I+G+X−MY, equals, C, plus, I
5
Q
Gross domestic product (GDP) is a measure of
A
the final output of a nation’s economy. GDP measures the total value of all new goods and services produced in an economy in a given year.
6
Q
For example, in 2016 GDP in Japan was $4.939\text{ trillion}$4.939 trilliondollar sign, 4, point, 939, start text, space, t, r, i, l, l, i, o, n, end text. This means that during 2016, Japan produced goods and services within its geographic borders that were sold for $4.939 \text{ trillion}$4.939 trilliondollar sign, 4, point, 939, start text, space, t, r, i, l, l, i, o, n, end text. GDP can be measured using
A
1) the expenditures approach, 2) the income approach, or 3) the value added approach. The three approaches are equivalent—regardless of which approach you use you should end up with the same value.
7
Q
GDP can be represented by the circular flow diagram as
A
a flow of income going in one direction and expenditures on goods, services, and resources going in the opposite direction. In this diagram, households buy goods and services from businesses and businesses buy resources from households.
8
Q
The circular flow diagram has a box representing
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households and another box representing firms. An arrow pointing from households to firms represents the flow of resources. An arrow pointing from firms to households represents the flow of goods and services. Collectively these two arrows represent the flow of goods, services, and resources in a clockwise way. An arrow pointing from households to firms represents spending by households on goods and firms revenues. An arrow pointing from firms to households represents payments made by firms to households. Collectively, these two arrows represent the flow of income in a counterclockwise way
9
Q
The circular flow diagram illustrates the equivalence of
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the income approach and expenditures approach to calculating national income. In this diagram, goods, services, and resources move clockwise, and money (income from the sale of the goods, services, and resources) moves counterclockwise.
Individuals purchase goods and services from businesses, and their expenditures (the money they spend) go to businesses. Firms purchases resources, such as labor from households, and the money they pay for these resources go to households.
10
Q
The expenditures approach
GDP can be calculated using the expenditures approach using the following equation:
A
Y=C+I+G+X-MY=C+I+G+X−MY, equals, C, plus, I, plus, G, plus, X, minus, M
11
Q
CCC
A
consumption: spending by households
12
Q
III
A
investment: spending by businesses on capital and inventory
13
Q
GGG
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government spending: spending by all government entities on goods and services (but not transfer payments)
14
Q
XXX
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exports: goods and services produced within a country that are purchased in other countries
15
Q
MMM
A
imports: goods and services that are produced in other countries but are purchased in your country.
16
Q
income approach to GDP
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an approach to calculating GDP that involves adding up all of the income earned within the borders of a country in a given year; the income approach adds up wages, rents, interest,
17
Q
value-added approach to GDP
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an approach to calculating GDP that involved adding up all of the value added at various stages of production; for example, in the production of a cake that sells for $12$12dollar sign, 12, the value-added approach counts the value of the raw ingredients that a farmer sells to the baker ($4$4dollar sign, 4), which a baker then combines with her capital to create a cake, which adds $8$8dollar sign
18
Q
final goods and services
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the goods and services that are purchased by consumers, businesses, the government, or other countries in their final form for their intended final use; for example, a car purchased by a household, a haircut, or a laptop bought by a student.
19
Q
intermediate goods
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goods that are used in the production of a final product; for example, tires are final goods when Katherine buys them at the tire store. But when Acme Motor Company buys tires to build a car that they plan on selling, those tires would be considered intermediate goods.
20
Q
consumption (C)
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when using the expenditures approach, “C” is the category of GDP that is spending by households on final goods and services in a given year but excludes spending on new housing
21
Q
investment (I)
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when using the expenditures approach, “I” is the category of GDP that is spending businesses do in order to produce goods and services (such as buy computers for accountants to use or build factories to build cars); investment includes spending on capital goods (tools, equipment) and invent
22
Q
government spending (G)
A
when using the expenditures approach, “G” is the spending by government entities, whether local or national governments, on goods and services such as building roads and national defense; note that transfer payments are not included in “government spending” in GDP even though it is something that is part of the money that a government might spend each year.
23
Q
transfer payment
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any payment by a government to a household that is not in exchange for a good or service; for example, if the government hires a contractor they are buying a service that is included in GDP, but if they send a retired person a pension check they are not buying a good or service and it is not co
24
Q
exports (X)
A
goods that are produced in one country and then sold within another country; for example, if a producer in the United States makes 400400400 Katnest Evergreen bobblehead dolls and sells them to a store in Japan, these dolls would be counted as Exports for the United States.
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imports (M)
goods that are produced in a different country than where they were purchased; for example, those bobblehead dolls made in the U.S. are purchased by Japanese consumers, so they would get counted initially as consumption (“C”) for Japan. Since they do not reflect something that was produced in Japan, they are subtracted from Japan’s GDP as an import (“M”).
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net exports X-M
spending on exports minus spending on imports’ “exports” is the value of goods that go out of a country, “imports” is the value of the goods that come into a country. There is a trade deficit when imports are higher than exports and there is a trade surplus and when exports are higher than imports
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Why are imported goods deducted from the calculation of GDP?
The objective of GDP is to capture what is produced in your country. One of the more straightforward ways of doing this is to add up what is spent on goods and services by households, businesses, and the government. The problem with this approach is that not everything that households, businesses, and the government purchases every year is actually produced in their country. This means imports (goods produced in another country) must be subtracted in order to accurately capture what was produced in your country.
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nothing is perfect. And GDP is no exception. As much as economists like to use GDP as a measure of output, or even as a measure of a country’s well being, GDP has some limitations when trying to answer those questions.
GDP leaves out some production in an economy, such as the squash your mom might grow in the backyard, or other non-marketed goods. Even though GDP is frequently used to capture the wellbeing of a society, it was never intended to do that, and as a result it leaves out important aspects of well-being like pollution or even happiness.
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quality of life
sometimes called “well-being”) the standard of health, happiness, security, and material comfort of an individual, a group of people, or a nation
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non-market transactions
economic activity that takes place in the informal sector (from babysitting, to lawn mowing, to illegal drug sales), sometimes called the gray market or the black market economy; non-market transactions are not recorded, taxed, or officially monitored by the government. Because of this, the output and income generated is not included in the calculation of a nation’s GDP.
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income inequality
when a disproportionate share of a nation’s income is earned by a small minority of households; for example, when the top 10\%10%10, percent of households earn 80\%80%80, percent of the total income in a country, there is a high degree of income inequality; GDP does not account for income distribution in any way.
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sustainability
the ability of a system to endure indefinitely into the future; an increase in GDP will only be sustainable as long as it does not deplete natural resources too rapidly nor exploit the environment in a way that diminishes the quality of life of the nation’s households over time.
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economic bads
any outcome from economic activity that creates negative value for society, such as air pollution from cars that harms human health and the environment; unsustainable economic growth may diminish the quality of life of a nation’s people.
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real GDP per capita
the real gross domestic product of a nation, divided by the nation’s population; this measure is an indication of the average income of a nation’s people
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depreciation of capital
the decrease in the value of a nation’s capital stock over time; GDP accounts for investment in new capital but does not subtract the lost value of depreciated capital. Because of this, GDP may overstate the amount of economic activity in nations with rapidly depreciating capital stocks.
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Human Development Index (HDI)
a composite measure of nation’s social and economic development developed by the United Nations that includes measures of health, wealth, and education
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Genuine Progress Indicator (GPI)
a measure of a nation’s quality of life that includes the income and output measured by gross domestic product. This measure subtracts out the costs of negative effects related to economic growth such as crime, environmental degradation, resource depletion, and the costs of climate change. GPI nets the positives and negatives of economic activity to provide a more accurate measure of a nation’s quality of life than GDP alone.
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Happy Planet Index (HPI)
a measure of a nation’s quality of life that includes survey results on happiness, life expectancy at birth, the degree of inequality across society, and the ecological footprint
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GDP is a useful indicator of a nation’s
economic performance, and it is the most commonly used measure of well-being.
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However, GDP has some important limitations, including:
The exclusion of non-market transactions
The failure to account for or represent the degree of income inequality in society
The failure to indicate whether the nation’s rate of growth is sustainable or not
The failure to account for the costs imposed on human health and the environment of negative externalities arising from the production or consumption of the nation’s output
Treating the replacement of depreciated capital the same as the creation of new capital
41
Alternative indicators have been developed to provide
a more well-rounded measure of a nation’s quality of life by different national and international organizations. These include:
The Human Development Index (HDI)
The Genuine Progress Indicator (GPI)
The Happy Planet Index (HPI)
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The Human Development Index (HDI)
The Genuine Progress Indicator (GPI)
The Happy Planet Index (HPI)
Each of these indexes is a composite measure weighing both income and non-income variables such as life expectancy, literacy rates, environmental indicators, measures of inequality and so on. By including these variables, they provide a measure of life quality that goes beyond the narrowness of a nation’s GDP value.
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Common misperceptions
Some people mistakenly think a higher income (and larger GDP) is correlated with a higher quality of life and more happiness, but only up to a certain income level. Some studies have actually found that beyond a certain income level, additional increases in income are no longer correlated with higher quality of life. Instead, other, non-income factors (such as the equity of income distribution and access to education and health-care) are more closely correlated with a happier, healthier society.
Some of the poorest countries in the world may actually appear poorer than they really are if we only consider their official GDP figures. If a large percentage of the workforce is employed in the informal sector, then their incomes will not be reflected in the nation’s GDP. As a result, the nation’s GDP will appear smaller than it would be if all economic activity were included.
44
A country’s economic performance is measured using three key indicators, one of which is the unemployment rate.
When adults who are willing and able to work cannot find a job, it may be a sign that an economy is producing less than it could. On the other hand, unemployment is also a natural phenomenon that even healthy economies experience. While the official unemployment rate is helpful in representing the state of a nation’s workforce, it does have some shortcomings that should be considered, such as excluding discouraged workers.
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There are three types of unemployment that economists describe:
frictional, structural, and cyclical. During recessions and expansions, the amount of cylical unemployment changes. Cyclical unemployment is closely related to the business cycle, and causes the deviations of the current rate of unemployment away from the natural rate of unemployment.
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unemployment
when people are not working, but they are actively looking for work; for example, Glenn did not work at all last week, though he tried to find a job, so he is considered unemployed.
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unemployed
a term that describes a person who could be working, and wants to work, but is not working; to be counted as unemployed you must be part of the eligible population, not working, and actively looking for work.
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unemployment rate
he percentage of the labor force that is unemployed
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labor force
the number of people in a population who are either employed or unemployed
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eligible population
these are the people deemed likely to be in the labor force; for example, in the United States, the eligible population in the US is anyone 16 years of age or older who is not institutionalized (i.e., not in prison) and not in the military.
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labor force participation rate
the percentage of the eligible population that is in the labor force
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discouraged workers
people who do not have a job, but they will take a job if offered one. However, they have given up looking for work, so they are not counted in the labor force; for example, if Carol gives up looking for work because she is having trouble finding a job, she is no longer in the labor force and therefore is not counted as unemployed.
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underemployed
people who work part-time, but they really want to work full time if they could find a full-time job; for example, Tyreese wants to work full time as an engineer, but he can only find a part-time job.
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full employment output
also called the full employment real output) the amount of output that is produced in an economy when that economy is using all of its resources efficiently; the full employment output would be a combination of output that is on that country’s PPC.
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natural rate of unemployment
the unemployment rate that exists when an economy is producing the full employment output; when an economy is in a recession, the current unemployment rate is higher than the natural rate. During expansions, the current unemployment rate is less than the natural rate.
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frictional unemployment
the component of the natural rate of unemployment that occurs because the job search process is not instantaneous; for example, after Rosita graduated from dental school, it took her a few weeks to find a job as a dentist. During this period she will be frictionally unemployed.
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structural unemployment
unemployment that occurs as a result of a structural change in the economy, such as the development of a new technology or industry; this is a part of the natural rate of unemployment. For example, Negan finds a cure for all dental diseases, and as a result, Rosita loses her job as a dentist and is now structurally unemployed.
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cyclical unemployment
the unemployment associated with the recessions and expansions; this can have a positive or negative value. The current unemployment rate will depend on both the natural rate of unemployment and the amount of cyclical unemployment at the time.
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The labor force participation rate (LFPR) is
another measure of labor market activity in the economy. The LFPR is the percentage of the adult population that is in the labor force. The labor force includes everyone who is either employed or unemployed. The adult population is defined as anyone who is over the age of 16 who potentially could be part of the labor force. Anyone who is less than 16 years old, is in the military, or is institutionalized is not considered to be potentially part of the labor force and is excluded from this calculation.
When people enter the labor force the LFPR increases, and when people exit the labor force the LFPR decreases. A decrease in the LFPR that occurs at the same time as a decrease in the unemployment rate can signal that there are more discouraged workers.
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The unemployment rate as it is measured officially is often criticized for understating the level of joblessness because
it excludes anyone working at all or people who aren’t looking for work. In particular, the official unemployment rate leaves out discouraged workers and the underemployed. People who have given up looking for work because they are convinced that they cannot find jobs are considered discouraged workers. Some people are counted as employed because they are working part-time, even though they really want full-time work.
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Economists primarily focus on three types of unemployment:
cyclical, frictional, and structural. Cyclical unemployment is the unemployment associated with the ups and downs of the business cycle. During recessions, cyclical unemployment increases and drives up the unemployment rate. During expansions, cyclical unemployment decreases and drives down the unemployment rate.
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The natural rate of unemployment (NRU) is
the unemployment rate that exists when the economy produces full-employment real output. NRU is equal to the sum of frictional and structural unemployment. When an economy is producing an efficient amount of output (meaning it is operating on its PPC), the unemployment rate will be equal to the natural rate of unemployment. Even though an economy may be operating efficiently, there will still be some unemployment. Because of that, the natural rate of unemployment is never equal to zero.
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The natural rate of unemployment (NRU) can gradually change over time due to events such as
changes in labor force characteristics. The NRU can change due to changes in structural and frictional unemployment. For example, a firm may want to hire fewer workers because the skills of those workers are not needed as much as they used to be. That will cause more structural unemployment, and the natural rate of unemployment will increase.
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The labor force is made up of
he number of people unemployed and the number of people employed:
LF=# Unemployed+# Employed
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To be employed you must have
worked at all (even just one hour) for pay in the “reference week” (the week that you are being asked about). To be counted as unemployed you must not have worked at all in the reference week and be actively looking for work.
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The LFPR is
the percentage of the eligible population that is in the labor force.
LFPR = \dfrac{LF}{\text{Eligible Population}}\times 100\%LFPR=
Eligible Population
LF
×100%L, F, P, R, equals, start fraction, L, F, divided by, start text, E, l, i, g, i, b, l, e, space, P, o, p, u, l, a, t, i, o, n, end text, end fraction, times, 100, percent
People are not considered part of the eligible population if they are not working age (defined as 161616 years or older), institutionalized (for example, in prison), or in the military.
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The unemployment rate is
the percentage the labor force that is unemployed.
| UR=# Unemployed# in Labor Force×100%
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The third of our three key macroeconomic indicators is
the inflation rate, can help you figure that out. Inflation is an increase in the overall price level.
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The official inflation rate is tracked by calculating changes in a measure called
the consumer price index (CPI). The CPI tracks changes in the cost of living over time. Like other economic measures it does a pretty good job of this. But it does have some limitations, such as substitution bias, which can overstate how much the cost of living really has changed.
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inflation
a sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar
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inflation rate
the pace at which the overall price level is increasing; this is the percentage increase in the price level from one period to the next.
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deflation
a sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative.
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inflation rate
the pace at which the overall price level is increasing; this is the percentage increase in the price level from one period to the next.
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deflation
a sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative.
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disinflation
a slowing of the rate of inflation; for example if the rate of inflation is 5\%5%5, percent in 2016 and 3\%3%3, percent in 2017, there is still inflation in 2017.Prices are just not rising as fast as they were before.
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aggregate price level
a single number that summarizes all prices in an economy; price indices are frequently used to represent the aggregate price level.
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price index
a measure that calculates the changing cost of purchasing a particular (and unchanging) combination of goods (called a “market basket”) each year; the consumer price index and the producer price index are examples.
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market basket
the combination of goods that are used to calculate a price index; the goods stay the same from year to year.
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base year
a reference year to which variables are compared; for example, the current CPI in the United States uses 1983 as its base year, so all values of the CPI compare the current to 1983.
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real variables
variables that are adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, or real GDP); for example if your boss gives you a 10\%10%10, percent raise, but the purchasing power of your money has decreased by 8\%8%8, percent because of inflation, your raise is really only worth 2\%2%2, percent.
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nominal variables
variables such as wages, income, or interest that have not been adjusted for the rate of inflation; you can think of nominal variables as the “sticker price.” The bank tells you they will pay you 3\%3%3, percent interest, but the real interest rate that tells you what you are actually earning.
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purchasing power
what can actually be bought with money; if you walk into a store with \$10$10dollar sign, 10 and want to buy apples that cost \$1$1dollar sign, 1 each, the purchasing power of your \$10$10dollar sign, 10 is 101010 apples; If the next day the price of apples increases to \$2$2dollar sign, 2, you can only buy 555 apples, so the purchasing power of your \$10$10dollar sign, 10 has decreased.
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real interest rate
the interest rate earned that reflects the actual purchasing power of that interest; for example if a bank pays 3\%3%3, percent interest, but there is 2\%2%2, percent inflation, you really have only gained 1\%1%1, percent interest because the purchasing power of your interest has decreased.
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The Consumer Price Index (CPI) measures
the change in income a consumer needs to maintain the same standard of living over time. The CPI is meant to reflect changes in the cost of living for a typical urban household.
For example, suppose every household buys 222 bottles of cod liver oil, 101010 loaves of bread, and 888 dog treats every week. A consumer price index tracks changes in the price of this unchanging collection of goods over time to measure changes in the cost of living for this household. Once the CPI is calculated for two years, we can to calculate the rate of inflation.
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How the CPI is calculated
To calculate the consumer price index we 1) calculate the price of the basket in the base year, 2) then the price of the basket in the year we want the CPI for, then finally 3) apply this formula:
CPI = \dfrac{\text{Price of goods in 2016}}{\text{Price of goods in 1995}} \times
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Inflation can get a bad rap because
some people think inflation makes everyone worse off. But it turns out that there are both winners and losers from inflation. In general, if you owe money that has to be paid back with a fixed amount of interest, you are going to benefit from unexpected inflation. On the other hand, if someone owes you money, when there is unexpected inflation the money you are paid back won’t be worth as much as the money you loaned out.
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unanticipated inflation
when the price level increases at a faster pace than expected; for example, if you think that the rate of inflation will be 5%, but it turns out to be 8%.
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unanticipated disinflation
when the price level increases at a slower pace than anticipated; for example, if you think the rate of inflation will be 5%, but it turns out to be 2%.
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unanticipated deflation
when the price level decreases when it was expected to increase; for example, if you think the rate of inflation will be 2%, but it turns out to be -2%.
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wealth redistribution
when the real value of wealth is transferred from one agent to another; when inflation is higher than borrowers and lenders expected, wealth is transferred from lenders to borrowers.
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lender
an agent (usually a bank) or a person (for example, a holder of a bond) who makes money available to another agent, with the agreement that the money will be repaid (usually with interest)
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borrower
an agent that has received money from another agent with the agreement that the money will be repaid (usually with interest)
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saver
an agent that is not spending some of their income; usually if money is saved it is put in some sort of interest-earning asset (like a savings account or a bond) or purchasing some other financial asset (such as stocks and bonds).
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bond
an asset that is a promise to pay a fixed amount at some point in the future; for example, the government sells Tony a bond for \$100$100dollar sign, 100 with the promise of paying him back \$104$104dollar sign, 104 in one year, which allows Tony’s savings to earn interest.
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Unexpected inflation arbitrarily
redistributes wealth from one group to another group, such as from borrowers to lenders. When people decide to borrow money or lend money, they often consider what they think the rate of inflation will be. When the rate of inflation is different than anticipated, the amount of interest repaid or earned will also be different than what they expected.
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Lenders are hurt by
unanticipated inflation because the money they get paid back has less purchasing power than the money they loaned out.
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Borrowers benefit from
unanticipated inflation because the money they pay back is worth less than the money they borrowed.[Thanks!]
For example, suppose Jerry borrows \$10$10dollar sign, 10 from Michonne and promises to pay her back \$11$11dollar sign, 11 next year. This year \$1$1dollar sign, 1 can buy one can of tuna, so in Jerry’s mind, he is promising to pay back 111111 cans of tuna next year in exchange for the ability to buy 101010 cans this year. Suppose over the course of that year there is inflation and the price of tuna doubles. This means that Jerry is paying back the value of only 5.55.55, point, 5 cans of tuna, so he benefits from this inflation. Michonne, on the other hand, is hurt because she thought she was getting more cans of tuna in exchange for her loan.
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The redistribution effects of disinflation and deflation
Unanticipated disinflation or deflation, when the inflation rate is lower than it was expected to be (or even negative), has the opposite effect as unanticipated inflation: lenders are helped and borrowers are hurt.
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Lenders are helped by
unanticipated disinflation or deflation because the money they get paid back has more purchasing power than the money they expected it to be when they loaned it out.
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Borrowers are hurt by
deflation in particular because they have to pay back their debts with money worth more than the money they borrowed in the first place!
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Most policies that target inflation are aimed at
maintaining small and predictable rates of inflation.
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Inflation that is too close to zero runs the risk of
becoming negative, and deflation becomes a possibility.
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Deflation has a very damaging impact on an economy and is associated with
particularly severe recessions and depressions. If you hear about policymakers talking about "lowering inflation," their objective is slowing down the rate of inflation (in other words, disinflation), not deflation.
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A common misperception is that inflation is bad for everyone (who likes more expensive stuff?). But this is not the case. because
nflation reduces the value of money. Because of that, people who have borrowed money benefit from a higher inflation rate when they pay the money back. The interest rate that a borrower pays is effectively lower thanks to inflation.
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Another common misperception is that disinflation and deflation are good for everyone (who doesn't enjoy cheaper stuff?). The problem is,
deflation increases the purchasing power of money. People who have borrowed money are paying back that loan with money that is effectively worth more than the money they borrowed. Deflation effectively increases the interest rate that a borrower pays.
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A very common misperception is that inflation
should always be avoided. Deflation has such a destructive impact on an economy that most policymakers agree that avoiding deflation is a far more important objective. As a result, the goal of policymakers is not zero inflation, but small and predictable inflation rates.
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1) Suppose you take out a \$50{,}000$50,000dollar sign, 50, comma, 000 loan from the Bank of Baloney to pay for college, and they give you five years to pay back the loan. If inflation unexpectedly increases over the next five years, who is helped by the inflation, you or the bank?
The unexpected inflation benefits you and hurts the bank. The value of the dollars you pay back to the bank is less than the value of the dollars the bank thought they would be getting because you are paying back the loan using dollars that are worth less.
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2) The Lady of Wintersfell has borrowed \$2.5$2.5dollar sign, 2, point, 5 million dollars from the Iron Bank of Bravodos which she promises to pay back in five years. During those five years there is unanticipated deflation across the kingdom. How does this deflation redistribute wealth between the borrowers and lenders? Explain.
Unanticipated deflation hurts the Lady of Wintersfell (the borrower) and benefits the Iron Bank (the lender). The Lady of Wintersfell will see a decrease in her wealth as she must pay back the Iron Bank with money that is now worth more than she borrowed. The Iron Bank, on the other hand, will see their wealth increase as a result of the unanticipated deflation.
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3) You inherit a fortune of \$100$100dollar sign, 100, which you place in a secure savings account that has a fixed interest rate. The inflation rate ends up being higher than you anticipated when you first placed your money in the bank. Does your expected wealth increase, decrease, or stay the same over time? Explain
The higher than anticipated inflation rate reduces your future wealth. Savers with fixed interest rates are worse off when inflation is higher than expected because effectively the value of interest income they earn is lower than what they thought it would have been based on expected inflation rates.
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Even GDP needs to keep it real. When we calculate GDP using today’s prices, we are creating a measure called
nominal GDP.
However, prices can change even if output doesn’t change. Because of that, our measure of output might get distorted by something like inflation.
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We account for this using real GDP, which is
a measure of GDP that has been adjusted for the price level. In this way, real GDP is a truer measure of output in an economy.
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There are two approaches to adjusting nominal GDP to get real GDP:
1) using the same prices every year or 2) using the GDP deflator.
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nominal GDP
the market value of the final production of goods and services within a country in a given period using that year’s prices (also called “current prices”)
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real GDP
nominal GDP adjusted for changes in the price level, using prices from a base year (constant prices) instead of “current prices” used in nominal GDP; real GDP adjusts the level of output for any price changes that may have occurred over time
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GDP deflator
a price index used to adjust nominal GDP to find real GDP; the GDP deflator measures the average prices of all finished goods and services produced within a nation’s borders over time.
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base year
the year used for comparison in the determination of price changes using the GDP deflator price index; the deflator in a base year is always equal to =100=100equals, 100.
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current prices
the prices at which goods are sold in a nation in a particular year; current prices are used when calculating nominal GDP.
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constant prices
the prices from a base year that are used to calculate real GDP in other years; this allows for a more accurate measure of how a country’s actual output changes over time, because using constant prices cancels out any changes in the price level between years.
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Nominal GDP is a measure of
how much is spent on output. For example, in Canada during 2015, \text{CAN }\$1{,}994.9\text{ billion}CAN $1,994.9 billionstart text, C, A, N, space, end text, dollar sign, 1, comma, 994, point, 9, start text, space, b, i, l, l, i, o, n, end text was spent on the goods and services produced in Canada. Nominal GDP measures aggregate output (meaning the value of all of the final goods and services produced) using current prices. In other words, these figures reflect the amount spent on Canada’s output in the country’s prices in 2015.
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Real GDP is a measure of
how much is actually produced. Real GDP measures aggregate output using constant prices, thus removing the effect of changes in the overall price level. For example, in 2015 the value of Canada’s output expressed in constant 2010 prices was \text{CAN }\$1{,}857\text{ bilion}CAN $1,857 bilionstart text, C, A, N, spac
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Another method of calculating real GDP involves
converting nominal GDP to real GDP by using the GDP deflator, which tracks price changes of a nation’s output over time. Canada’s GDP deflator for its base year of 2010 was 100100100 since this is the year against which prices are compared. By 2015 the deflator had increased to 107.4107.4107, point, 4, indicating that the average prices of Canada’s output had increased by 7.4\%7.4%7, point, 4, percent.
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By expressing 2015’s output in 2015 prices, therefore, Canada’s output would
ppear to have increased by 7.4%7.47, point, 4 more than it actually did. Canada’s nominal GDP, which has been “inflated” by higher prices, can be “deflated” by dividing the country’s nominal GDP of \text{CAN }\$1{,}994 \text{ billion}CAN $1,994 billionstart text, C, A, N, space, end text, dollar sign, 1, comma, 994, start text, space, b, i, l, l, i, o, n, end text by the deflator expressed in hundredths.
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Canada's real GDP can be calculated by
weighting final goods and services by their prices in a base year or by dividing nominal GDP by the GDP deflator price index in hundredths. Either method is considered valid, but the deflator method is more likely to account for price changes of particular goods produced by a nation between a base year and the current year.
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An increase in GDP does not necessarily mean a nation has produced more output because
it must be specified whether the GDP in question is nominal or real. An increase in nominal GDP may just mean prices have increased, while an increase in real GDP definitely means output increased.
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The GDP deflator is a price index, which means
it tracks the average prices of goods and services produced across all sectors of a nation's economy over time. With this index, changes in the average price level (inflation or deflation) can be calculated between years. However, this is not the most commonly used price index for tracking inflation and deflation. The consumer price index (CPI) is the most commonly used price index, which you'll learn more about later in this course.
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Every nation’s economy fluctuates between periods of expansion and contraction. These changes are caused by
levels of employment, productivity, and the total demand for and supply of the nation’s goods and services. In the short-run, these changes lead to periods of expansion and recession. But in the long-run, economic growth can occur, allowing a nation to increase its potential level of output over time.
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business cycle model
a model showing the increases and decreases in a nation’s real GDP over time; this model typically demonstrates an increase in real GDP over the long run, combined with short-run fluctuations in output.
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aggregate demand
the total demand for a nation’s output, including household consumption, government spending, business investment, and net exports
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aggregate supply
the total supply of goods and services produced by a nation’s businesses
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expansion
the phase of the business cycle during which output is increasing
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recession
the phase of the business cycle during which output is falling
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depression
a deep and prolonged recession
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peak
the turning point in the business cycle between an expansion and a contraction; during a peak in the business cycle, output has stopped increasing and begins to decrease.
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trough
the turning point in the business cycle between a recession and an expansion; during a trough in the business cycle, output that had been falling during the recession stage of the business cycle bottoms out and begins to increase again.
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recovery
when GDP begins to increase following a contraction and a trough in the business cycle; an economy is considered in recovery until real GDP returns to its long-run potential level.
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potential output
the level of output an economy can achieve when it is producing at full employment; when an economy is producing at its potential output, it experiences only its natural rate of unemployment, no more and no less.
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potential output
the level of output an economy can achieve when it is producing at full employment; when an economy is producing at its potential output, it experiences only its natural rate of unemployment, no more and no less.
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growth trend
the straight line in the business cycle model, which is usually upward sloping and shows the long-run pattern of change in real GDP over time
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positive output gap
the difference between actual output and potential output when an economy is producing more than full employment output; when there is a positive output gap, the rate of unemployment is less than the natural rate of unemployment and an economy is operating outside of its PPC.
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negative output gap
the difference between actual output and potential output when an economy is producing less than full employment output; when there is a negative output gap, the rate of unemployment is greater than the natural rate of unemployment and an economy is operating inside its PPC.
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The business cycle model shows
how a nation’s real GDP fluctuates over time, going through phases as aggregate output increases and decreases. Over the long-run, the business cycle shows a steady increase in potential output in a growing economy.
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The typical business cycle has four phases, which progress as follows:
Phase of cycle Description
Expansion When real GDP is increasing and unemployment is decreasing
Peak The turning point in the business cycle at which output stops increasing and starts decreasing
Recession When output is decreasing and unemployment is increasing
Trough The turning point at which a recession ends and output starts increasing again
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Expansion
When real GDP is increasing and unemployment is decreasing
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Peak
The turning point in the business cycle at which output stops increasing and starts decreasing
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Recession
When output is decreasing and unemployment is increasing
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Trough
The turning point at which a recession ends and output starts increasing again
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Output gaps in the business cycle is
the difference between actual output and potential output in the business cycle. Potential output is what a nation could be producing if all of its resources were being used efficiently. In the business cycle model, a nation’s potential output at any given time is represented as the long-run growth trend.
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Output gaps exist whenever
the current amount that a nation is producing is more or less than potential output. In the business cycle model, whenever the business cycle curve is above the growth trend that means an economy is experiencing a positive output gap. Whenever the business cycle curve is below the growth trend that means the economy is experiencing a negative output gap.
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When actual output is above the potential output then
aggregate demand has grown faster than aggregate supply, causing the economy to overheat. Overheating in this instance means output is occurring at an unsustainably high level, at which the unemployment rate is lower than the natural rate of unemployment. Eventually, the business cycle will reach a peak and enter a recession.
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When actual output is below the potential output, then
aggregate demand or aggregate supply have fallen, causing a fall in employment and output. When a negative output gap exists, the unemployment rate will be higher than the natural rate of unemployment. Eventually, the business cycle will reach a trough and enter a recovery and expansion.
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Potential output is also called
full-employment output
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Potential output is
the level of real GDP that would be produced if all resources are used efficiently. For example, if labor is used efficiently, the actual rate of unemployment will be equal to the natural rate of unemployment. When there is a positive output gap, an economy is producing beyond its long-run potential and the unemployment rate will be lower than the NRU. During a recession, real GDP falls below its potential and the unemployment rate is higher than the NRU.
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The actual unemployment rate is
different than the natural rate of unemployment, at different points along the business cycle, because cyclical unemployment changes along the business cycle. Cyclical unemployment increases due to reduced output during recessions, and cyclical unemployment decreases due to increased output during expansions.
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business cycle model shows the
fluctuations in a nation’s aggregate output and employment over time. The model shows the four phases an economy experiences over the long-run: expansion, peak, recession, and trough. The business cycle curve is represented by the solid line in the model shown in Figure 1, and the growth trend is represented by the dashed line in Figure 1.
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Output gaps are represented by
the difference between actual output. During an expansion, the business cycle line is above the growth trend. During a recession, the business cycle is below the growth trend.
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Fluctuations experienced in the business cycle can also be illustrated using
the production possibilities curve (PPC)
