Econ Week 3
AE Aggregate expenditure total spending on domestic products
Y national income
C consumer spending
I investing (by firms)
Mathematical relationship b/w GDP and Y
o GDP total wages total rent total interest= total profit
o Total wages, rent, interest, and profit= total income, so GDP= Y (income) o Y=C+S
o If you want to learn more check out How can you describe the international criminal justice law?
Govt affects this circular flow diagram by adding money and subtracting tax o Taxes+ Tx We also discuss several other topics like Who were the first hominids?
We also discuss several other topics like What is the meaning of computer forensics?
o Transfer payments (Tr) the govt makes to people who are not working for the govt (social security, for ex)
o Taxes net of transfers (T)
o Disposable income (Yd)
Yd= YT ( disposable income = income – taxes net of transfers
Tax cuts can therefore increase disposable income that then enters the economy. However, more disposable income enters the economy if you give tax cuts for (relatively) poorer people because they really feel the If you want to learn more check out How does society shape our individual experiences?
o these add to AE since it is foreign spending on domestic production Imports (IM)
o Subtract this from AE because Aggregate expenditure is total spending on domestic production, and imports are spending on foreign products
GDP defined the monetary value of all final goods and services produced within a country’s geographical borders within one year. Don't forget about the age old question of What is characterized by periods of irresistible sleep, cataplexy attacks, sleep paralysis, and hypnagogic hallucinations?
Intermediate good or service a good or service used to produce another good or service hat is sold to someone else.
o Flour bought for a bakery is intermediate, flour bought for a household is a final good
o Why does GDP include final goods but not intermediates? because you’ve already counted the value of the intermediates in the final good they are incorporated into.
Example: an economy produces jeans, entertainment systems, and hummus sandwiches (why. Of all sandwich types.) We also discuss several other topics like How many angels does a square have?
o If different amounts of goods are sold in Year 2 than in Year 1, but there is also price inflation , use prices from Year 1 for Year 2 goods sold and recalculate total GDP to calculate % change, or if the economy actually grew at all. (Or you can recalculate Year 1 with Year 2 prices. You just need a base year and a “consistent price yardstick.”)
To find growth rate of real GDP, take amount of change and divide by beginning level
Nominal GDP total value of all final goods and services valued in that year’s prices o If you’re not comparing across time, nominal works fine
Real GDP GDP value calculated at a base year’s prices. Usually used to compare GDP across time
Goods and services have to be traded on legal markets in order to be included in the GDP statistic
o Because we have to track what people are paying for it to figure out how much a product is actually worth
o GDP statistic may not accurately reflect total economic output because of this Ex.Bangladesh’s GPD per capita is not enough to live on, but that is because the GDP doesn’t reflect the food people are growing in their garden and consuming themselves because it’s not on the market
5 problems with GDP per capita as a measure of society’s wellbeing o 1. Nonmarket production is not included (see above, GDP understates how well off we are)
o 2. Does not reflect leisure time, or lack thereof. More GDP means less leisure time
o 3. Does not reflect how unevenly or unevenly output is distributed across population
if one guy has 99% of GDP, GPD per capita is the same, but wellbeing of the average person is significantly less
o 4. Military spending included in GDP
War isn’t always super helpful to people’s wellbeing (i.e. dying isn’t great)
o 5. More production means more environmental degradation; also, cost of pollution cleanup is included in GDP once pollution become unbearable Some items excluded from GDP:
o 1. Purchase of financial assets (money and legal documents entitling their holder to money. They aren’t products, so don’t count them)
o 2. Purchases of used goods, like cars. They have already been counted when they were initially sold. Counting the second sale would be recounting
o Value added in a stage of production= value of goods produced at the stage minus the value of goods used as inputs at that stage
o Think of valueadded as the value that is added to the produced intermediate goods by the firm that uses them. Bread has more value than flour + sugar + yeast. The difference is valueadded
Calculating GDP: Valueadded approach
o Imagine you raise cattle and produce $1 worth of milk, then sell it to a processing plant
o The processing plant adds a value of $1.50 by processing, sells to a distributor o Distributor adds value of $0.50 by making milk more accessible
o Total contribution to GDP: 1 + 1.50 + 0.50 = $3
Calculating GDP: Income approach
o Since the sum of value=added at each stage of production will equal total incomes generated in the economy, and since the sum of valueadded equals GDP, it follows sum of income equals GDP
o Total interest+ total wages and salaries+ total rent + total profit
Calculating GDP: Expenditures approach:
o Add output that does get sold to output that doesn’t get sold, and you get total output of the economy
Total change in inventories is the value of everything not sold
o Consumption spending (C ) total spending by households, both foreign and domestic, excluding purchases of new homes (that’s considered an investment) We would understate domestic consumption if excluded imported
consumption goods. Subtract imports at end of GDP equation so they
o Gross private domestic investment (I) total spending by firms on newly produced capital equipment (foreign and domestic), plus households purchases on new homes, plus total changes of economy’s inventory.
I= business fixed investment + residential construction + inventory investment
Or I= “planned investment” + “unplanned investment”
∙ Planned investment = business fixed investment and residential construction
∙ Unplanned= inventory investment. This is the leftover goods that a firm produces that doesn’t get sold. It is “unplanned” because the firm was planning on selling it. Technically this is not an
investment, but it has to be factored into GDP somewhere.
We include foreign produced goods in Investment because they improve the economy/ our overall efficiency and GDP, but we subtract off the original value of the good in Imports
Government spending (G) total spending by all levels of govt on newly purchased final goods and services, plus govt payroll
∙ Govt payroll doesn’t include transfer payments (like social security) because those people aren’t contributing to the economy like an employee is
∙ If G>T, then the govt budget deficit = govt borrowing = GT, assuming none of the deficit is monetized (we will cover later) ∙ Orrr: Govt outlays= (G+Tr), govt income=Tx. Budget deficit = (G+Tr) Tx, if Tx>(G+Tr)
∙ Note: If T>G, then govt budget surplus = govt paying down of its debt= (TG). Or, budget surplus= Tx (G+Tr), if Tx>(G+Tr) o Remember Tr=transfers
o T= TxTr
∙ All these equations are basically saying that the government makes money with taxes, and spends the on goods, services, and payroll (G) as well as Social Security and Medicaid and whatnot (Tr). If they spend more than they tax, they are in a deficit.
∙ Why include govt payroll in G? Because this is part of the cost of providing goods and services through the govt
Exports (X): Newly produced final and intermediate goods and services produced domestically but sold abroad
∙ There’s no problem with double counting by including intermediates in exports, because the final good made by the intermediate will be made and purchased overseas, therefore not part of our GDP
Imports (IM) Newly produced final and intermediate goods and services produced in foreign countries and sold domestically
∙ We include intermediates in Imports because the foreign content of final goods sold is not value that was produced domestically, so subtract this value out in our GDP calculation.
o Ie Canadian produced transmission imported into the U.S.
for $1000 that goes into a car assembled in US that sells for
$30,000. $30,000 goes into C, $1000 goes into IM, so the
net effect on GDP is $29,000
∙ This equation just says that GPD is the sum of expenditures in the economy, plus the changes in inventories (which is slipped into
Net Exports= XIM
Price Indices how the overall level of price is measured
A “price index” is used to measure the overall level of prices in the economy, or a subset of these prices.
Basic idea of how it works: It measures the relative cost of a representative bundle of goods and services (“market basket”) in the year in question to its cost in an arbitrarily chosen base year.
To get price index in a certain year, just take the cost of the market basket in that year, then divide by the cost of the same market basket in the base year.
Price index=(price of basket for year 1)÷ (price of basket for base year) = .765 (for example)
o Typically you move the decimal place in that number right two in the final representation: i.e. 0.765= 76.5
Price Indexes (3 types):
1) GDP Deflator measures the final prices of all final goods and services o Not exactly a price index. Its market basket consists of a sample of all final goods and services produced in the economy
o Also known as an implicit deflator
o GPD deflator in year i= (nominal GDP in year i)/ (real GDP in year i), then move the decimal point two places to the right
Remember real GDP is GDP of year i calculated at a base year’s prices o Also, %change of nominal GDP= % change of real GDP + %change of GDP Deflator
I.e. if real output grows by %2 and the GDP grows by 3%, then nominal GDP will rise by 5%
Also, real GDPi = (( nominal GDPi) * (100))/GDPDefi
2) Producer Price Index (PPI): A price index used to measure wholesale prices, compared to the base year. Its market basket consists of a representative sample of wholesale prices of goods.
o Wholesale prices going up should lead to market prices going up as well o Buttttt most of what we buy is services, and there’s only a wholesale price for goods. So PPI can rise rapidly, but it doesn’t tell us as much about the state of the economy (and the CPI) , because services aren’t included
3) The Consumer Price Index (CPI): The price index designed to measure the cost of living, compared to the base year. Market basket consists of a representative sample of consumption goods and services consumed by a typical household.
Unemployment unemployment means (in the most general sense) that a person is willing to work at a market wage commensurate with his/ her skills and experience, but is unable to find a job
Unemployment (3 types)
o 1) Frictional Unemployment unavoidable, usually shortterm unemployment that inevitably arises due to imperfect knowledge that workers have about where they will find their next job
o 2) Structural unemployment caused by mismatch b/w skills that workers have and that employers are seeking
Govt policies like minimum wage laws can also contribute to this
Natural rate of unemployment percent of workforce that is unemployed for frictional and structural reasons
o 3) Cyclical Unemployment unemployment over and above the unemployment that would exist if unemploymenet were at its “natural” rate, ie unemployment caused by a downturn in the economy
If there is no cyclical unemployment (ie at peak of business cycle) unemployment is at its natural rate
Actual Unemployment sum of all 3 previous unemployments (cyclical structural and frictional)
UNEMPLOYMENT PT 2
Causes of structural unemployment
o 1. Labor Unions
Force wage above mkt equilibrium with bargaining
o 2. Efficiency wages
o 3. Side effects of govt policies
In no rush to apply for a job if you’re getting unemployment payments (in theory)
o 4. Skills mismatch b/w employer and employees
o 5. Minimum wage laws
Remember, in the labor mkt, firms are on the demand side and households are the suppliers. Also, the price of labor is the hourly wage.
Minimum wage laws analysis essentially a price floor in the mkt for unskilled labor
In theory if you raise the minimum wage even higher, it simply raises the wage floor, increasing unemployment by 1) increasing the people willing to work 2) decreasing the firms willing to pay
o But the counter argument to that is low wage workers will then be spending more, stimulating the economy and allowing firms to spend more
If demand for labor is inelastic, and a minimum wage law is implemented, the total income of unskilled workers rises
o Blue box is basically the same or even bigger than the yellow box, so the minimum wage wasn’t harmful in this case
Efficiency wages (when firms willingly pay more to incentivize workers) have the same effect as minimum wage laws
Inflation rate is simply annual growth rate of relevant price index (so change in CPI between years over CPI of original year)
Converting a nominal economic variable to a real economic variable: o Real value of variable = [(nominal value of variable)*100]/(price index)