A Tour of The book

Chapter 2
Chapter 2: A Tour of the Book

Q1: How do economists define output, the

unemployment rate and the inflation rate?
Q2: Why do economists care about these
variables?

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Macroeconomic Goals
Economic growth-growth rate
Full employment-unemployment rate

Chapter 2: A Tour of the Book

Price level stability-inflation rate

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2-1 Aggregate Output

National income and product accounts are an accounting

system used to measure aggregate economic activity.

GDP: Production and Income

Chapter 2: A Tour of the Book

The measure of aggregate output in the national income

accounts is gross domestic product, or GDP.
There are three ways of defining GDP:
1. The expenditure approach (final goods and services)
2. The product approach (value added)
3. The income approach

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2-1 Aggregate Output

GDP: Production and Income

There are three ways of defining GDP:

Chapter 2: A Tour of the Book

1. GDP is the value of the final goods and services

produced in the economy during a given period.

A final good is a good that is destined for final

consumption.

An intermediate good is a good used in the

production of another good.

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An Example

Chapter 2: A Tour of the Book

Business A:
Produces oranges. It sells to
public (consumers) and to
Business B.
Business A :
Revenue from sales = $35
Sold to public = $10
Sold to B = $25
Expenses($15):
Wages to workers = $15

Profit = $20

Business B:
Produces orange juice.

B:
Revenue from sale of OJ =
$40

Expenses($35):
Wages to workers=$10
Orange purchases=$25
Profit=$5

1st: Sum of value of the Final Goods and Services

GDP=$10(final goods from A)+$40(final goods from B)=$50
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2-1 Aggregate Output

GDP: Production and Income

There are three ways of defining GDP:
2. GDP is the sum of value added in the economy during
a given period.

Chapter 2: A Tour of the Book

Value added equals the value of a firms production

minus the value of the intermediate goods it uses in
production.

Value added of A=$35(revenue)-$0(cost on intermediates)=$35

Value added of B=$40(revenue)-$25(cost on intermediates)=$15
2nd : Sum of Value Added
GDP=$35 (value added of A)+$15 (value added of B)= $50
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2-1 Aggregate Output

GDP: Production and Income

There are three ways of defining GDP:

Chapter 2: A Tour of the Book

3. GDP is the sum of incomes in the economy during a

given period.
Households income: $15 (wages of A)+$10(wages of B)=$25
Firms income: $20 (profit of A)+ $5 (profit of B) =$25
3rd : Sum of Incomes
GDP=$25(households income)+$25(firms income)=$50

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Chapter 2: A Tour of the Book

GDP excludes:
Intermediate goods
Nonproduction transactions
Used goods
Financial transactions
Transfer payments
Nonmarket production
Underground production
Leisure
Economic bads

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Chapter 2: A Tour of the Book

How does each transaction affect Current years

GDP in Hong Kong?

On January 1, you purchase 10 gallons of gasoline at HKD $24 per gallon.

The gas station purchased the gasoline the previous week at HKD $20 per
gallons.

Li Ka-shing denotes $1 billion to the Faculty of Medicine, University of Hong

Kong.

A working mother receives HKD $ 300,000 salary, while spends HKD$

30,000 for hiring baby-sitter.

You spend HK$2 million for a brand new BMW M6 Convertible purchased
from Germany.

You sell your 2000 ford for HK$10,000 to your friend.

In 2005, Hurricane Katrina caused damage roughly estimated at $80 billion.

You purchased your house in 2007 for HK$ 1 million. The houses price is
HK$ 2 million in 2013.

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2-1 Aggregate Output

Nominal and Real GDP

Nominal GDP is the sum of the quantities of final goods
produced multiplied by their current price.
Nominal GDP increases over time because:

Chapter 2: A Tour of the Book

The production of most goods increases over time.

The prices of most goods also increase over time.
Real GDP is constructed as the sum of the quantities of
final goods multiplied by constant (rather than current)
prices.
Solely affected by the production

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2-1 Aggregate Output

Nominal and Real GDP

Quantity
of Cars

Price
of cars

Nominal
GDP

Real GDP
(in 2000 dollars)

1999

10

$20,000

$200,000

$240,000

2000

12

$24,000

$288,000

$288,000

2001

13

$26,000

$338,000

$312,000

Chapter 2: A Tour of the Book

Year

To construct real GDP, multiply the number of cars in

each year by a common price. Suppose we use the
price of the car in 2000 as the common price. This
approach gives us, in effect, real GDP in chained
(2000) dollars.

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2-1 Aggregate Output

Figure 2-1 Nominal and real U.S. GDP, 19602010

Figure 2 - 1
Nominal and Real U.S.
GDP, Since 1960

Chapter 2: A Tour of the Book

From 1960 to 2010, nominal

GDP increased by a factor of
28. Real GDP increased by a
factor of about 5.

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2-1 Aggregate Output

Nominal and Real GDP

Chapter 2: A Tour of the Book

The terms nominal GDP and real GDP each have many
synonyms:

Nominal GDP is also called dollar GDP or GDP in current

dollars.

Real GDP is also called GDP in terms of goods, GDP in

constant dollars, GDP adjusted for inflation, or GDP in
(chained)2000 dollars.

GDP will refer to real GDP, and Yt will denote real GDP in year t.

Nominal GDP and variables measured in current dollars will be

denoted by a dollar sign in front of themfor example, $Yt. for
nominal GDP in year t.

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Practice
1. Explain why it is necessary to compute Real GDP in order to get a
fair comparison of GDP number from different years.

Chapter 2: A Tour of the Book

2. Explain what an intermediate good is and why intermediate goods

are excluded from GDP.
3. Which of the following would directly affect GDP?
a) A refinery buys crude oil
b) A refinery takes out a large loan from a bank
c) A refinery emits pollution into the air
d) None of the above

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2-1 Aggregate Output

GDP: Level Versus Growth Rate

Real GDP per capita is the ratio of real GDP to the
population of the country.

Chapter 2: A Tour of the Book

GDP growth equals:

(Yt Yt 1 )
Yt 1

Periods of positive GDP growth are called expansions.

Periods of negative GDP growth are called recessions.

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2-1 Aggregate Output

Figure 2-2 Growth rate of U.S. GDP, 19602010
Figure 2 - 2

Chapter 2: A Tour of the Book

Growth Rate of U.S. GDP

Since 1960
Since 1960, the U.S. economy
has gone through a series of
expansions, interrupted by
short recessions. The most
recent recession was the most
severe recession in the period
from 1960 to 2010.

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2-2 The Unemployment Rate

The Unemployment Rate

Each people in households who is 16 years or older is placed into
three categories:
1.Employment(N) is the number of people who have a job.

Chapter 2: A Tour of the Book

2.Unemployment(U) is the number of people who do not

have a job but are looking for one.
3.Not in the labor force (or Out of the labor force): those
who do not have a job and are not looking for one.
-e.g. Full-time students, unpaid homeworkers, retirees, disables, etc.

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2-2 The Unemployment Rate

The Unemployment Rate

The labor force is the sum of employment and
unemployment:

Chapter 2: A Tour of the Book

L
=
N
+
U
Labor force = Employment + Unemployment
The unemployment rate is the ratio of the number of
people who are unemployed to the number of people
in the labor force:

U
u
L
Unemployment rate = Unemployment/Labor force
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2-2 The Unemployment Rate

The Unemployment Rate

The Current Population Survey (CPS) is used to
compute the unemployment rate.

Chapter 2: A Tour of the Book

In the United States, estimates based on the CPS

show that:

u2006

7.0

4.6%
144.4 7.0

u2010

14.8

9.6%
139.0 14.8

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2-2 The Unemployment Rate

The Unemployment Rate

Labor force + Out of the labor force

= Population of working age(16+)

Chapter 2: A Tour of the Book

la b o r fo r c e
Participation rate =
p o p u la tio n o f w o r k in g a g e
People without jobs who give up looking for work are known as
discouraged workers.

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2-2 The Unemployment Rate

Example:
U.S. Employment Data, March 2010(in millions)
Employed (N):

138.9

+
Unemployed (U):

15

=Labor Force (L=N+U)

153.9

Chapter 2: A Tour of the Book

+
Out of Labor Force

83.2

=Working-age(over16) population

237.2

Unemployment rate=unemployed/labor force=15.0/153.9=9.7%

Participation rate=labor force/working-age population=153.9/237.2=64.9%

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2-2 The Unemployment Rate

Practice:
African America Employment Data, March 2010(in millions)
Employed

14.920

Unemployed

2.951

Not in the labor force

10.720

Chapter 2: A Tour of the Book

Q:
Find the labor force, the working-age population, the unemployment rate, and the
participation rate for African Americans.

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2-2 The Unemployment Rate

The Unemployment Rate

Figure 2 - 3

Chapter 2: A Tour of the Book

U.S. Unemployment Rate

Since 1960
Since 1960, the U.S.
unemployment rate has
fluctuated between 3% and
10%, going down during
expansions and going up
during recessions. The effect of
the crisis is highly visible, with
the unemployment rate
reaching close to 10%, the
highest such rate since the
1980s.

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2-2 The Unemployment Rate

The Unemployment Rate

Why Do Economists Care About Unemployment?
The costs of unemployment:
Economic costs: the lost output because the workforce
is not fully utilized.

Chapter 2: A Tour of the Book

Psychological costs: loss of self-esteem, depression,

etc.
Social costs: increases in unemployment tend to be
associated with increases social problems, such as
crimes, drug abuse, alcoholism, etc.

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2-2 The Unemployment Rate

Full Employment
Types of Unemployment

Chapter 2: A Tour of the Book

Frictional unemployment :short-term unemployment due to the

time required to match workers.
Structural unemployment :long-term unemployment that exists
even when the economy is producing at a normal rate.
-lack of skills, language barriers, discrimination, technology
advances, etc.
-in this case, a person either goes out of the job or remains
unemployed till he acquires new skills.
Cyclical unemployment : due to downturns in the business cycle.

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2-2 The Unemployment Rate

Policy Goal: Unemployment Rate is Zero? (u=0 ?)

No

Chapter 2: A Tour of the Book

Instead:
Policy Goal: Full Employment (Natural Unemployment Rate)

Natural unemployment Rate=

Frictional unemployment rate + Structural unemployment rate

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2-2 The Unemployment Rate

Practice:
Q:
Assume that last month the frictional unemployment rate was 2.8% and the
structural unemployment rate was 2.3%. What was the natural unemployment rate?
If the actual unemployment rate is 5.8%, what is the cyclical unemployment rate?

Chapter 2: A Tour of the Book

A:
Natural unemployment rate=2.8%+2.3%=5.1%
Cyclical unemployment rate=5.8%-5.1%=0.7%

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2-3 The Inflation Rate

The Inflation Rate

Inflation is a sustained rise in the general level of prices
- the price level.

Chapter 2: A Tour of the Book

The inflation rate is the rate at which the price level

increases.
Two measurement of the price level:
The GDP Deflator
The Consumer Price Index(CPI)
Symmetrically, deflation is a sustained decline in the
price level. It corresponds to a negative inflation rate.

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2-3 The Inflation Rate

The Inflation Rate

The GDP Deflator
The GDP deflator in year t, Pt, is defined as the
ratio of nominal GDP to real GDP in year t:

P
t

NominalGDP

RealGDP

Chapter 2: A Tour of the Book

$Y

The GDP deflator is what is called an index

numberset equal to 100 in the base year.

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2-3 The Inflation Rate

The Inflation Rate

The GDP Deflator
The rate of change in the GDP deflator equals the
rate of inflation :

Chapter 2: A Tour of the Book

( P t P t1 )
P t1
Nominal GDP is equal to the GDP deflator
multiplied by real GDP:

$ Y t PtY t

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2-3 The Inflation Rate

The Inflation Rate

The Consumer Price Index
The GDP deflator gives the average price of the output in the
economy. But

Chapter 2: A Tour of the Book

Some of the goods are sold to firms, to the government, or to

foreigners.
Some of the goods are not produced domestically but are
imported from abroad.

Consumers only care about the goods they consume.

The consumer price index (CPI), measures the average
price of consumption, or equivalently, the cost of living.
-The CPI gives the cost in dollars of a specific list of goods
and services over time, which attempts to represent the
consumption basket of a typical urban consumer.
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2-3 The Inflation Rate

The Inflation Rate

Example: Construct the Consumer Price Index

Chapter 2: A Tour of the Book

Cost of Reproducing the 2005(Base-Year) Basket of Goods and

Services in Year 2011
Item

Cost(in 2011) Item

Cost(in 2005)

Rent, two-bedroom
apartment

$630

Rent, two-bedroom
apartment

$500

Hamburgers(60 at
$2.50 each)

150

Hamburgers(60 at
$2.00 each)

120

Movie tickets(10 at
$7.00 each)

70

Movie tickets(10 at
$6.00 each)

60

Total

$850

Total

$680

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2-3 The Inflation Rate

The Inflation Rate

The Consumer Price Index
The rate of change in the CPI equals the rate of inflation :

Chapter 2: A Tour of the Book

( P t P t1 )
P t1

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2-3 The Inflation Rate

The Inflation Rate

Figure 2 - 4

Chapter 2: A Tour of the Book

U.S. Inflation Rate,

Using the CPI and
the GDP Deflator,
1960-2010
The inflation rates,
computed using either
the CPI or the GDP
deflator, are largely
similar.

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2-3 The Inflation Rate

The Inflation Rate

The Consumer Price Index
Figure 2-4 yields two conclusions:

Chapter 2: A Tour of the Book

The CPI and the GDP deflator move together most of

the time. In most years, the two inflation rates differ by
less than 1%.
There are clear exceptions, however. In 1979 and
1980, the increase in the CPI was significantly larger
than the increase in the GDP deflator.

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2-3 The Inflation Rate

The Inflation Rate

Why Do Economists Care About Inflation?
Economists care about inflation for two reasons:

Chapter 2: A Tour of the Book

During periods of inflation, not all prices and wages

rise proportionately, inflation affects income
distribution.
Inflation leads to other distortions.
Noise in the price system
Distortions of the tax system
Shoe-Leather Costs
etc.

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2-5 The Short Run, the Medium Run, and the Long Run

The level of aggregate output in an economy is

determined by:
demand in the short run, say, a few years,

Chapter 2: A Tour of the Book

the level of technology, the capital stock, and the

labor force in the medium run, say, a decade or so,
factors such as education, research, saving, and the
quality of government in the long run, say, a half
century or more.

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2-6 A Tour of the Book

The book is organized into three parts:

A core which has three parts the short run, the
medium run, and the long run.

Chapter 2: A Tour of the Book

Three extensions which explore the role of

expectations, closed economies, and expansion and
recessions.
A deeper look at the role of microeconomic policy.

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