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Chapter Two
Introduction
Gross Domestic Product (GDP) tells us the nations total income and
the total expenditure of its output of goods and services
Consumer Price Index (CPI) measures the overall level of prices
Unemployment Rate tells us the fraction of workers who are
unemployed
How can GDP measure both the economys income and the
expenditure on its output?
The reason is that these two quantities are actually the same: for the
economy as a whole, income must equal expenditure.
Economy produces 1
good, bread, from 1
input, labor
What does the inner
loop represent?
What does the outer
loop represent?
GDP measures the flow
of dollars in this
economy and can be
computed 2 ways; GDP
is the total income from
the production of bread
= wages + profit = top
half of the circular flow;
GDP is the total
expenditure on
purchases of bread =
bottom half of the
circular flow chart
Income
($)
Labor
Households
Firms
Goods
(bread
)
Expenditure
($)
Suppose Hank purchases $25,000 worth of iron ore from Ken, uses
the ore to make steel and then sells the steel to Wyatt for $100,000;
should GDP include both the ore and the steel (a total of $125,000) or
just the steel ($100,000)?
Remember GDP includes only the value of final goods; why would
we not want to include the value of intermediate goods (iron ore)?
This suggests an alternative way to compute GDP:
A firms value added is the value of its output minus the value of the
intermediate goods the firm used to produce that output.
To compute GDP simply sum the value added at each stage of
production:
In our case, what is Kens value added (assuming he used no other
inputs)? What is Hanks value added? What is the total value added?
The sum of all value added must equal the value of all final goods and
services
Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)
Consumption (C)
def: the value of all
goods and services
bought by households.
Includes:
durable goods
last a long time
ex: cars, home
appliances
non-durable goods
last a short time
ex: food, clothing
services
work done for
consumers
ex: dry cleaning,
air travel.
Investment (I)
def1: spending on (the factor of production) capital.
def2: spending on goods bought for future use.
Includes:
1/1/2002:
economy has $500b worth of capital
during 2002:
investment = $37b
1/1/2003:
economy will have $537b worth of capital
Stock
Flow
More
examples:
stock
flow
a persons wealth
a persons saving
# of people with
college degrees
# of new college
graduates
$ billions
50
0
-50
-100
-150
-200
-250
-300
-350
-400
1960
1965
1970
1975
1980
1985
1990
1995
2000
An important identity
Y = C + I + G + NX
where
Y = GDP = the value of total output
C + I + G + NX = aggregate
expenditure
0.1%
3.3
-2.0
-3.2
-8.8
-16.2
20.8
-3.2
3.3
4.2
2002
2003
good A
$30
900
$31
1,000
$36
1,050
good B
$100
192
$102
200
$100
205
1970
1975
1980
NGDP (billions of $)
1985
1990
1995
2000
The GDP Deflator, or the implicit price deflator, is defined as the ratio of nominal GDP to real GDP:
Nominal GDP
GDP deflator = 100
Real GDP
The GDP Deflator indicates whats happening to the overall level of
prices.
Consider again the 1 good (bread) economy: GDP Deflator = ?
GDP Deflator = 100 (P Q)/(Pbase Q) = 100 (P/Pbase)
Writing it in this way we see that the GDP deflator is simply the ratio of
current to base year prices
What does it mean if the GDP deflator is > 100? < 100?
Real GDP
2001
$46,200
$46,200
2002
51,400
50,000
2003
58,300
52,000
GDP
deflator
inflation
rate
n.a.
Q2t
Q 3t
100
P1t
P2t
P3t
RGDP
RGDPt
RGDP
t
t
The
TheGDP
GDPdeflator
deflatorisisaaweighted
weightedaverage
averageof
ofprices.
prices.
The
Theweight
weighton
oneach
eachprice
pricereflects
reflects
that
thatgoods
goodsrelative
relativeimportance
importancein
inGDP.
GDP.
Note
Notethat
thatthe
theweights
weightschange
changeover
overtime.
time.
Just as GDP turns the quantities of many goods into a single number
measuring the value of production, the CPI turns the prices of many
goods into a single index measuring the overall level of prices.
The CPI is computed every month by the Bureau of Labor Statistics
The BLS constructs the CPI in the following way:
pizza
$10
$11
$12
$13
CDs
$15
$15
$16
$15
answers:
cost of
basket
2000
2001
2002
2003
CPI
inflation
rate
n.a.
Housing
5.9%
2.8%
Apparel
Transportation
5.8%
2.5%
4.5%
4.8%
Medical care
Recreation
16.2%
Education
Communication
Other goods and
services
40.0%
Et
CPI in month t 100
Eb
C1
C
2
C3
100 P1t P2t P3t
Eb
E
b
Eb
The CPI is a weighted average of prices.
The weight on each price reflects
that goods relative importance in the CPIs basket.
Note that the weights remain fixed over time.
1)
There are 3 key differences between the CPI and the GDP deflator as
measures of whats happening to the overall level of prices:
GDP deflator measures the prices of all goods produced, whereas the CPI
measures the prices of only the goods bought by consumers.
1)
2)
3)
The CPI assigns fixed weights to the prices of different goods, whereas the
GDP deflator assigns changing weights. The CPI is computed using a fixed
basket of goods, whereas the GDP deflator allows the basket of goods to
change over time as the composition of GDP changes.
1)
A drought causes the wheat crop to fail resulting in skyrocketing prices for
bread. Are both price indices greatly affected? Why or why not?
The unemployment rate is the statistic that measures the percentage of those people
wanting to work who do not have jobs.
To compute the official unemployment rate, the BLS places survey responders into
1 of 3 categories:
The labor force is the sum of the employed and unemployed persons
The unemployment rate is the percentage of the labor force that is unemployed
Employed the person spent some (part-time included) of the previous week working
at a paid job
Unemployed the person is not employed and has been actively seeking a job or is on
temporary layoff
Not in labor force a person who fits neither of the first 2 categories; full-time
student, retiree, discouraged worker
The labor-force participation rate is the percentage of the adult population that is
in the labor force
=
=
=
134.0 million
8.6 million
213.5 million
Answers:
labor force
L = E + U = __________
unemployment rate
(U/L) 100 = __________
Chapter Summary
1.
Gross Domestic Product (GDP) measures both total income and total
expenditure on the economys output of goods & services.
2.
Nominal GDP values output at current prices; real GDP values output at
constant prices. Changes in output affect both measures, but changes in
prices only affect nominal GDP.
3.
4.
the Consumer Price Index (CPI), the price of a fixed basket of goods
purchased by the typical consumer
5.
The unemployment rate is the fraction of the labor force that is not
employed.