CIRCULAR FLOW OF INCOME

What assumptions does make? -Businesses sell whole output immediately to households -Households spend entire income immediately on consumer products What are the markets? What do these entail? -Factor Market: Households sell factors of production, Businesses pay in rent, wages, interests, and profits. -Product Market: Businesses give households final goods and services, households pay businesses with money (profits)

What are the market flows?

-Outermost flow= cash -Innermost flow= products, goods, and services

WHAT THE CIRCULAR FLOW LOOKS LIKE

GROSS DOMESTIC PRODUCT

What is it? -Total annual market value of a nations final output -With domestic factors of production

What does it exclude?

-Financial transactions, such as securities, government transfer payments, and private transfer payments -Transfer of Secondhand Goods, including homes, cars, & other consumer products -Household Production, such as housekeeping and child care -Legal, unreported transactions, otherwise deemed under-the-table -Illegal, underground activities, including prostitution and drug dealing -Intermediate Goods & Services, which are fully used up in the production of final goods and services

WHAT ARE THE TWO TYPES OF GDP? HOW DO WE CALCULATE THEM?

Real: -GDP which takes into account price changes -Nominal GDP x 100

Price Index or price level

Nominal: -GDP which does not account for price level changes over time!

FORMULA FOR OUTPUT GROWTH

(Real GDP in Year 2- Real GDP in Year 1) Real GDP in Year 1

Take that decimal and multiply it by 100

REAL PER CAPITA GDP

What? -Calculation of GDP per person if money distribution were equal.

Formula?
Year X real GDP Population in Year X How is it helpful?

-Allows economists to determine the degree to which GDP change compensates for population change.
What are its shortcomings? -Does not account for the true well-being of a nation -Though real GDP may rise, when population increases, PCGDP decreases -Does not account for changes in leisure time, increased crime, housework, etc

GROSS DOMESTIC PRODUCT

An EXPENDITURE approach of calculating economic activity.

I+C+G+X
A Breakdown.
I= Investment C= Consumption G= Government Spending X= Net Exports (total exports-total imports)

GROSS DOMESTIC INCOME

Sum of all incomes paid to the four factors of production..

W+I+R+P
A Breakdown.
W=Wages I=Interest R=Rent

P=Profits

NET DOMESTIC PRODUCT

Two ways to calculate.. GDP Depreciation OR Consumption + Net Investment + Government Spending + Net Exports What is Net Investment? Investment - Depreciation What is Depreciation? -Reduced value of capital goods over one year because of wear & tear or obsolescence. What is Capital Consumption Allowance? -Also known as depreciation -Amount businesses must save to repair & replace deteriorating machines

WHAT ARE THE TYPES OF INCOMES?

National -Total of all factor payments to resource owners -NDP indirect business taxes Personal -Income households receive before payment of taxes -National Income + government transfer payments income earned but not received Disposable Personal Income -Personal Income following income tax payment (what one can save or consume) -Personal Income Personal Income Taxes

EMPLOYMENT TECHNICALITIES
-Full Employment: -Most individuals willing to work at prevailing wages are employed -Average price level is stable -Some temporary unemployment -Frictional Unemployment: -Its okay, its temporary! -Workers change jobs; new workers look for first jobs -Structural Unemployment: -Mismatch between skills of job seekers & skills required for available jobs -E.g. typewriter-repairmens jobs became obsolete

-Cyclical Unemployment
-BAD for society & individuals -Downturns in business cycle -Seasonal Unemployment -Occurs when people work certain jobs for part of a year -e.g. Mall Santas, Lifeguards, Amusement Park Ride Operators

THE BALANCE OF PRICES

-Price Stability -Condition present when avg. level of prices is neither increasing nor decreasing

-Inflation
-Sustained increase in average price level -Deflation -Sustained decrease in average price level

ECONOMIC GROWTH
-Economy produces increasing amounts of goods & services over long term -Increase greater than increase in population?

-Amount of goods & services available per person will increase

-Overall standard of living will improve -Full Employment and Balanced Growth (Humphrey-Hawkins) Act -1978 Congressional Act- Very important! -Est. goals: -Unemployment rate of 4% -Inflation rate of 0%

HOW WE MEASURE EMPLOYMENT

-Civilian Unemployment Rate -Measure of how well we are achieving full employment -Derived from a national survey of 60,000 households -What age do people have to be in order to be considered adults in the workforce? -Sixteen -What are the three categories of the adult population? -Employed

-Unemployed
-Not in labor force Which categories comprise the labor force? -Employed and Unemployed

-Much smaller than total adult population b/c many are too old, some are unable to work, and others do not want to work.

FORMULA FOR UNEMPLOYMENT RATE

#Unemployed UR = *100 LaborForce

FORMULA FOR LABOR FORCE PARTICIPATION RATE

#inLaborForce LFPR = *100 AdultPopulation

INFLATION & DEFLATION

Inflation -Occurs when the average of all prices of goods and services rises -Decreases purchasing power, causes the real value of a good to vary

-Expression:
-To what degree has the price of an item increased? -By how many times (e.g. 1.5) has the price increased? -By what percent has the price of an item increased?

Deflation
-Occurs when the average of all prices of goods and services falls

WHAT TYPES OF INFLATION EXIST?

Anticipated: -Exactly that; what we believe will occur. -Enables consumers to protect themselves with precautionary measures. Unanticipated: -Inflation we do not expect -Can be damaging to lenders who give out fixed-rate loans, people who save money in fixed-rate accounts, and people with fixed incomes.

MEASURING INFLATION WITH A PRICE INDEX

What? Cost of a market basket of goods today How is it expressed?

Percentage of the cost of goods in the base year

How do we calculate it? PI= Current-year cost Base- year cost

WHAT ARE THE PRICE INDICES USED IN INFLATION CALCULATION?

-Consumer Price Index -Producer Price Index -GDP Deflator

CONSUMER PRICE INDEX THE BASICS

-What kind of indicator is this? -COINCIDENT! -What is it, specifically??

-Measure of price changes of goods and services bought by consumers

-How are things weighted? -Things on which consumers spend more money are given a greater weight. -41% Housing

- 17% Transportation
-16% Food - 6% each Education, Communication, Medical Care, Recreation -4% each Apparel and Other g&s

HOW DO YOU CALCULATE THE CPI?

!) Choose a market basket of g&s (about 400 in real life). 2) Choose a year as the base year -Benchmark against which we can compare prices in other years

3) Compute the Index using this formula..

Mkt.Basket$inDesiredYear CPI = *100 Mkt.Basket$inBaseYear

HOW DO YOU CALCULATE INFLATION RATE BASED ON CPI?

Year x Inflation Rate= Year X CPI Base Year CPI x 100 Base Year CPI

WHAT ARE THE ISSUES WITH CPI?

-Substitution Bias -Basket does not change to reflect consumers reactions to price changes. -Will not account for instances when consumers substitute less-expensive goods. -Index overstates increased cost of living. -Introduction of New Goods -Basket does not reflect purchasing power change brought on by new products -New products-> Greater variety-> Each dollar more valuable -Need less $ to maintain given standard of living -Unmeasured Quality Changes -If quality rises from year to year, value of $ rises even if price stays the same.

-If quality of good falls, value of $ falls even if price stays the same

PRODUCER PRICE INDEX

Weighted average of all prices and commodities -Involves firms purchasing from other firms -Cost of factors and resources
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GDP DEFLATOR
What does it measure?? Measures changes in prices of all goods and services produced domestically What does it include?? Includes Investment, Consumption, Government Spending, and Net Exports How do we calculate it? Nominal GDP *100 Real GDP

HOW DO WE TRY TO PROTECT AGAINST INFLATION?

Cost of Living Adjustments: -Contractual clauses which allow increases in specific nominal values to take account of cost-of-living changes

-Try to reduce cost of holding cash by putting into interest-bearing accounts

Resource Cost: -Opportunity cost of resources used to protect against inflation; distorted because firms try to plan for the long term -We spend resources in attempt to protect ourselves against unanticipated inflation, but we strain the economy.

THE BUSINESS CYCLE

Expansion or Recovery Phase -Real output increases, unemployment rate declines. Inflation, however, may begin to accelerate. Peak -GDP reaches its highest point Contractionary or Recession Phase -Real output decreases, unemployment rate rises. Inflation decelerates, and may eventually turn into deflation if prices fall. Trough -Lowest point of real GDP

-If output levels fall and unemployment rises to a great enough degree, this may be called a recession.
External Shocks to the Economy -War, Weather changes, and an increase in oil prices