EC 202 Midterm 1 STUDY GUIDE
EC 202 Midterm 1 STUDY GUIDE Econ 202
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Date Created: 10/13/16
EC 202- Tim Duy: Midterm 1, Study Guide Terms and Definitions WEEK 1 (Chapter 4) Measuring Economic Growth GDP (Gross Domestic Product): GDP is the market value of the final goods and services produced within a country in a given time period Can be measured as either: 1. Total expenditure on goods and services (Expenditure method) 2. Income received from goods/services (Income method) (Circular) Flow of Expenditure and Income • Households: Consumption spending “C” Makes up roughly 70% of the economy Consumption spending is not volatile enough to make a sudden, drastic impact on the economy that would lead to inflation or a recession • Firms: Investment spending “I” The purchasing of products (intermediate goods, see below for definition) that are used to make other goods/services (final goods, see below for definition) Investment spending is volatile and can be cut off or increased very quickly • Governments: Government Spending “G” Federal, state, and local spending Governments can issue debt (primarily the federal government) to cover the cost of needs • Rest of the World: Exports “X” and Imports “M” Net Exports = Exports – Imports Usually negative for the U.S. We have more goods/services imported every year than what we export Trade Deficit: Imports > Exports The U.S. economy is consuming more goods and services than it is producing GDP is calculated using the equation: Y = C + I + G + (X-M) Where: • Y = Aggregate • C = Consumer • I = Investment • G = Government • X = Exports • M = Imports and Aggregate Income = Aggregate Expenditures (i.e. the same equation is used whether you’re counting GDP by the income or expenditure method) Final Goods: A good or service that is consumed by the final user, not in some other product Intermediate Goods: Part of another final good (i.e. wood used to build a new house) Not counted as a part of GDP, since the final product they are included in is counted. If they were included in GDP, they would be double counted and throw off the calculation. Does not include used goods *The same kind of good can sometimes be either a final good or an intermediate good, depending on its final destination (i.e. wood planks used to build a new house are intermediate goods, but buying a finished 2x4 from Jerry’s is a final good) 2 Transfer Payments: Cash payments to individuals (i.e. social security) are not included in government spending GDP because it is simply the transfer of money, not a newly produced good/service Services: (In terms of GDP) Examples include haircuts, movie tickets, college education. Essentially anything that does not provide a physical good, but an experience of some kind Inventory: Goods produced but not (yet) sold. If a product is produced in 2015, but sold in 2016, the GDP is included as part of 2015 Real vs. Nominal GDP Real: GDP valued at prices fixed a reference (or base) year (i.e. the cost of an orange in 2006) Nominal: GDP valued at current market prices. Nominal GDP is compared to the entire economy and is measured in large numbers (billions, trillions, etc.) The importance of nominal and real dollars are the same. They are used in different contexts (or the same context) but tell us different things *Real and nominal GDP can be the same if the set of numbers are identical and are calculated within a closed model PPP (Purchasing Power Parity): Approximates the total adjustment that must be made on the currency exchange rate between countries that allows the exchange to be equal to the purchasing power of each country’s currency Using GDP 1. GDP and the Standard of Living Two features of our expanding living standard: a. Growth of potential GDP per person b. Fluctuations of real GDP around potential GDP Potential GDP: The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed 3 *Real GDP can exceed potential GDP when the level of full employment is exceeded for a temporary amount of time. This is unsustainable in the economy, however, and leads to inflation Unemployment: Decreases economic output. Goods and services not produced in any given time frame can never be made up 2. Compare Standard of Living Across Countries Must compensate for different currency values (i.e. dollars to euros) Must account for different prices Limitations of GDP GDP does not quantify all factors that influence standard of living • Household Production: Any good or service produced at home (i.e. taking care of your kids at home, preparing your own meals) • Underground Economic Activity: Illegal activity, under-the-table transactions, barter/trade • Leisure Time: Reduces GDP, therefore reducing potential output, but (can) improve quality of living • Environmental Quality: Both producing and cleaning up garbage contributes to GDP, but the impact this has on the environment is not counted Measuring Output: Changes in quantity of goods and services Calculating real and nominal GDP in a closed economy model Q * P = E Where: • Q = Quantity • P = Price • E = Expenditure HDI (Human Development Index): A summary measure of average achievement in key dimensions of human development (i.e. living a long, healthy life, being knowledgeable, having a decent standard of living) 4 Labor Force Growth: How many resources you have to produce goods and services Rate of Growth: Percent change per quarter. Quarterly numbers are smaller and easier to understand WEEK 2 (CHAPTER 5) Employment and Unemployment Why do we care about unemployment? Unemployment leads to: • Lost incomes and lost production • Lost human capital: someone who is unemployed for a long period of time becomes undesirable to employers • Graduating college during a recession may lead to taking a job not related to your field, which in turn hurts you when you’re trying to get back into your field, since you’re no longer fresh in the subject *Unemployment feeds on itself. It gets worse for people who are unemployed for a long period of time Definition of unemployment and how we determine the unemployment rate Current Population Survey • 60,000 households are surveyed for 6 months, are out of the survey for 6 months, and are surveyed for an additional 6 • Participants are asked about their employment status Population is split into two broad groups 1. Working Age Population: The number of people 16+ and not in an institution (jail, hospital, the military) a. Labor Force: Everyone in the labor force is either employed or unemployed i. Without work but have to have looked in the last four weeks (includes documented and undocumented workers) 5 ii. Waiting to be called back to a job aft er a layoff, and expecting to return within 30 days iii. Waiting to start a new job within 30 days b. Not in the labor force 2. Young and Institutionalized: People not old enough to work, or who are in an institution Unemployment is calculated using the equation : U = 100(Number Unemployed/Labor Force) Labor Force = Employed + Unemployed Other types of unemployment • Marginally Attached Workers: Neither working nor looking for work, but are available for work and have looked in the recent past. These workers may take a job, should it come along, but are not actively searching for one • Discouraged Workers: Have stopped looking for work because of repeated failure. These workers are unable to find work after becoming unemployed, and eventually become discouraged and stop searching • Part-Time Workers for Economic Reasons: Can’t find full-time work, even though they would like to. These workers have the skillset and desire to work-full time, but their full-time employment isn’t justified due to a lack of economic activity Types of Unemployment Frictional Unemployment: Unemployment associated with people entering and leaving the labor force and natural job creation and destruction. Includes retirement, leaving for childcare reasons, or leaving because you simply don’t need to work, among other reasons Structural Unemployment: Unemployment that arises because of changes in skills, technology, international competition, or job location (i.e. your skillset is no longer relevant to your location, new technological advances 6 outdate your line of work, or international competition forces you to move in order to keep a job) Cyclical Unemployment: The temporary unemployment associated with the business cycle Natural Unemployment: The combination of structural and frictional unemployment, or when cyclical unemployment is zero Full Employment: Occurs when the actual unemployment rate is equal to the natural rate of unemployment Factors that influence the level of full employment 1. Age Distribution of the Population: Less frictional unemployment is associated with aging workers 2. Scale of Structural Change: More/rapid structural change leads to a higher rate of structural unemployment 3. Real Wage Rate: Unemployment can be caused by minimum wages or efficiency wages (i.e. higher wages for more productive workers. Firms higher fewer, more efficient workers at a higher wage, rather than more, less efficient workers at a low er wage) 4. Unemployment Benefits: The longer you can survive without a job, the less likely you are to put effort into finding one (i.e. surviving off social security or unemployment benefits). More benefits raise the natural rate of unemployment Full Employment and Potential GDP Output Gap When the gap is positive: Unemployment is less than the natural rate (actual GDP > potential GDP) When the gap is negative: Unemployment is more than the natural rate (actual GDP < potential GDP) Inflation Price Level: The average level of prices. The price level is calculated based on the millions of goods and services purchased yearly 7 Inflation: A persistent increase in the price level Deflation: A persistent decrease in the price level, also called negative inflation Disinflation: A decrease in the rate of inflation Why is inflation a problem? Redistributes Income: Unexpected inflation lowers real wages (real wages are adjusted for prices) • If your wage doubles, but the price of everything also doubles, you get no benefit. In these types of situations, we don ’t care about wage in nominal terms, only in real terms Redistributes Wealth: Unexpected inflation means debtors pay back creditors with money that is worth less than what it was originally worth when they borrowed it Lowers Real GDP and Employment: With deflation, firms and households with debt are worse off and consequently cut spending . Inflation might create a temporary boom in activity that pushes GDP above potential, but that often ends in a recession Diverts Resources from Production: People and firms spend time forecasting inflation, shoe leather costs, and menu costs • Shoe Leather Costs: “Running” around town, trying to find the lowest prices • Menu Costs: The cost to change prices (i.e. a restaurant purchasing new menus) CPI (Consumer Price Index): A measure of the average prices paid by consumers for a fixed basket of goods • The CPI is set to 100 during a period called the reference base period (base year). It is measured by items evaluated for price, size, and quality • The current base year is 1982-1984. The average of the 36 months is set to 100 8 The CPI for August 2015 was 237.703. Prices for the basket of CPI goods are more than twice the base year (138% higher) The CPI for August 2016 was 240.305. Prices for the basket of CPI goods are 1.1% higher than last year Constructing CPI 1. Selecting the CPI basket 2. Conducting a monthly survey of prices 3. Calculating the CPI *The CPI basket is not universal. People feel the effects of inflation differently based on how they spend their money, whether or not they have fixed payments, etc. The CPI is calculated using the formula: CPI = 100(Cost of basket at current-period prices/Cost of basket at base-period prices) Calculating Inflation • The main purpose of CPI is to measure inflation • The inflation rate is the percentage change in the price level from one year to the next Inflation is calculated using the formula: Inflation Rate = 100[(CPI this year – CPI last year)/CPI last year] Sources of Bias in CPI New Goods Bias: New goods are often more expensive than the old ones they replace. Inflation is then sometimes overstated by calculating it using a new, more expensive, item than with an old, less expensive one Quality Change Bias: Part of an increase in price might be for quality adjustment. This may or may not be fully accounted for, and lead to an overestimate of price change. Inflation may then be overstated by not accounting for better quality compared to price changes 9 Commodity Substitution Bias: Changing prices trigger changes in consumption patterns Outlet Substitution Bias: Higher prices may trigger shifts to lower priced discount stores *Magnitude of bias may be as high as 1.1 percentage points Alternate ways to calculate CPI to accommodate for biases • Chained CPI: Different measure of consumer price index. A measure of spending and taxes, including social security benefits, to the rate of inflation, or the rise in prices over time • PCE Deflator: Measures of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households. The data includes measures of durables, non-durables, and services • GDP Deflator: A measure of the level of prices of all new, domestically produced, final goods and services in an economy Core Inflation: Core inflation excludes volatile food and energy components to measure the underlying trend of inflation. It is a better prediction of where inflation is going to be Helps avoid overreaction to volatile prices a nd focuses on persistent prices If inflation passes through to core, it is persistent. If not, it is probably temporary Headline inflation will revert to core inflation over time. Headline inflation includes food and energy Real Variables Real Value at CPI Base Year = 100(Nominal Value/CPI) Real Wage = 100(Nominal Wage/CPI) *In nominal terms, wages have been improving, but to decide if workers are better off (can buy a bigger basket of goods and services), you have to look at wages in real terms 10 WEEK 3 (CHAPTER 6) Economic Growth Growth can be measured as: 1. The percentage change in real GDP per period 2. The percentage change in per capita real GDP per period - the amount of output per person in the economy (critical for standards of living!) Economic Growth vs. a Business Cycle Expansion Real GDP might be rising: 1. During the expansion phase of a business cycle: Coming out of a recession, the unemployment rate is falling We care about this as a standard of living 2. Due to rising potential GDP: Ability to produce goods and services (the supply side of the economy). This is the side of the economy that is critical for long-term economic growth. (The demand side is responsible for more short-term economic growth) We care about this as real economic growth The Rule of 70: The number of years it takes for the level of a variable to double is approximately 70 divided by the annual percentage growth rate of the variable (i.e. 1% growth doubles in 70 years, 2% growth doubles in 35 years, 7% growth doubles in 10 years) What determines potential GDP? Potential GDP is the quantity of real GDP produced when the amount of labor employed is the full-employment amount To determine potential GDP – Use a model with two components 1. Aggregate Production Function: The relationship between labor and output, ceteris paribus Increased labor hours = Increased real GDP 2. Aggregate Labor Market: Supply and demand in the labor market produce an equilibrium level of labor and real wages Labor surplus forces the real wage rate down 11 Labor Supply Growth Population Increase: More hours per worker, increase in labor force participation *Increased labor supply increases the equilibrium quantity of labor. This causes a right shift in the labor supply curve and raises potential GDP Growth of labor productivity = More output per unit of labor • Capital Deepening: More capital per worker- each worker is producing more goods and services. Capital can be physical or human capital (the amount of knowledge you have) • New Technology: Makes us more efficient than we were previously * If your nominal wage stays the same, but price level goes up, real wage is falling Higher labor productivity makes labor more valuable 1. Boosts the demand for labor 2. Raises real wages 3. Raises equilibrium quantity of labor and has a secondary positive impact on potential GDP *If output per worker is higher, labor becomes more valuable Policies for accelerating potential GDP growth 1. Stimulate Savings (to finance investment): The saving that we as households do, is essentially transferred through channels that allow firms to borrow that money. Discouraging savings could have a negative effect on the economy 2. Stimulate Research and Development: Increase research capacities at universities, grants for firms to do research 3. Improve Quality of Education: Education is reaching diminishing marginal returns. It is not as readily able to reach needs as before. 30- 40% of the population have a college education. Can that reach 50%? 4. Encourage International Trade: Allows nations and firms to focus on their specialties. If we didn’t have international trade, the number of 12 jobs we have in the U.S. would likely be the same, but would be comprised of different kinds of jobs. Transition costs to and from an economy that uses international trade also need to be taken into account 13
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