Unit 2: Economic Indicators and the Business Cycle

 is a graphical representation of how goods, services, and money flow through our economy between consumers and firms.  There are two markets illustrated in the circular flow diagram: the 

 is where factors of production (resources) are exchanged.  The 

 is where economic goods (products) and services are exchanged.

 the act of firms and consumers gathering freely in economic markets to achieve beneficial exchange in order to maximize their economic incentives. In the factor (resource) market, firms are demanding and consumers are supplying.  In the product market, the consumers are demanding and firms are supplying.

Below is a drawing of the circular flow diagram:

GDP is the dollar value of all final goods and services produced within a country's borders in one year.  We use GDP to compare ourselves to other countries, to see the impact of policy changes, and to compare our growth from year to year.

The two main methods of calculating GDP are the expenditures approach and the income approach.  The 

 is the sum of all aggregate spending on all final goods and services within a country's borders in one year.

Using the data above and the expenditures approach we would calculate GDP by using the formula C + I + G + Xn.   GDP equals $400 + $175 + $120 + ($80 - $110) which is $665.

 is the sum of aggregate income earned on all inputs used in the product market to make goods and services in one year.

When using the expenditures approach, we calculate the money spent by a consumer on a particular good or service.  For example, if a consumer walks into a Subway restaurant and purchases a sandwich for $5 then that $5 would be added to the overall GDP.  When using the income approach, instead of adding what the consumer paid for the sandwich we would use the value of the pay the worker who made the sandwich receives.

The third way of calculating GDP is known as the 

 which involves calculating the value-added of any good or service by simply calculating the difference between the cost of inputs to production and the price of output at any particular stage in the overall production process.

To calculate GDP, economists use four main components:

There are several things that are not included in GDP: intermediate goods, non-production transactions (financial investments and used goods), and illegal or non-market activities.

Intermediate goods include goods that are used in the production of a good or service. For example, flour, cheese, and sauce purchased by a pizzeria is an intermediate good. We would only count the value of the final pizza in GDP and not the purchase of the intermediate goods used to make it.

Non-production transactions include financial transactions (i.e. personal investments) and used goods (those goods produced outside of the year we are calculating).

Illegal goods and services include anything not allowed by current laws and regulations (i.e. illegal drugs).

Non-market activities include types of services that are done but that do not receive payment.  For example, a plumber who fixes his own leak at his own home would not be counted in GDP.

Nominal GDP is the total value of goods and services produced within a given time period, used to measure output at current prices.

In the table above, there is information on four different products produced by a particular country and the prices that they sell each unit of these products for.  When you multiply the price of each product by the amount sold you get the total revenue earned.

When you add up the value of all the total revenues that gives us 

.  The nominal GDP in this particular example is $380,000 ($45,000 + $120,000 + $175,000 + $40,000).

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Circular Flow and GDP

There are several limitation of GDP.  In order to remember these we use the acronym P-I-E-S.

When populations are different from country to country and the countries are producing a similar amount of a product than it gives us an inaccurate picture of the standard of living because one country is taking the same amount of production and distributing it amongst a larger population.  For example, if one country is producing 15 million computers but has a population of 15 million than each person only has access to 1 computer but if another country produces the same amount of computers but has a population of 3 million than each person in that country has access to potentially 5 computers.  This is why economists use GDP per capita as a better measure of standard of living.

Inequality is also a limit to the use of GDP to measure the standard of living.  Two countries can have the same GDP per capita but if income is not evenly distributed to all families than it is not an accurate measure of production and economic stability.

Another limitation regarding using GDP as a measure of the health of our economy is with regard to the various environmental situations.  For example, if a factory is polluting during production they are still adding to GDP but GDP does not separate out the costs of this pollution from the actual production.

The final limitation has to do with the shadow economy.  The shadow economy involves the production of items that are not reported so they are not counted in GDP.  This shows us that GDP is not always accurate because there are some things not counted.

Limitations of GDP

Germany's unemployment rate in 2017 would be 10%.  That is determined by dividing the 5 million that are unemployed by the 50 million that are in the labor force.  Germany's unemployment rate in 2018 is 15%.  That is determined by dividing the 15 million that are unemployed by the 100 million that are in the labor force.

Italy's unemployment rate in 2017 is 5%.  That is determined by dividing the 8 million unemployed by the 160 million in the labor force.  Italy's unemployment rate in 2018 is 7%.  That is determined by dividing the 7 million unemployed by the 100 million in the labor force.

Below are some examples of different scenarios related to different types of unemployment:

Unemployment

—a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. (Source: 

).  The basket of consumer goods that we are talking about is a sample of goods and services that are typically bought by your average household.

—the general rising of prices in a market or aggregate economy over time.

—the general decrease of prices in a market or aggregate economy over time.

—the percent change in aggregate price level across an entire economy in one year.

—variables where the effects of inflation have been factored out.

The first step in calculating either the CPI or the inflation rate is to figure out the value of each market basket.  Once you have calculated the market basket, then you can figure out both the CPI for each year and the inflation rate from year to year.

To find the value of the market basket for each year, you simply multiply Price x Quantity for each good and then add all those amounts together. Let's use 2016 as the base year in this example.

 = ($3 x 10) + ($2 x 10) + ($5 x 10) = $100

 = ($3.25 x 10) + ($3.50 x 10) + ($5.25 x 10) = $120

 = ($3.50 x 10) + (3.50 x 10) + (5.50 x 10) = $125

💡When calculating the CPI for the base year, you are always going to get a 100 as the answer.  The reason for this is because you divide the value of the market basket for the base year by itself.

Price Indices and Inflation

There are a variety of costs associated with unanticipated inflation. Remember that inflation is a general rise in prices.  Economists will make predictions about possible inflation rates based on the current state of our economy however there are times when their predictions are not accurate.  As a result of the change between predictions and what the inflation rate actually is there are costs that result.  These costs include menu costs, shoe-leather costs, loss of purchasing power, and redistribution of wealth.

 result from a firm having to change prices. As inflation occurs within our economy, businesses are forced to change any business-related materials that have prices on them like a menu as a result. An example of this would be Walmart having to hire additional workers to replace all the price tags on their products every week.  Another example is the owner of a restaurant having to spend an extra three hours a week creating and updating coupons.

 refer to the cost of time and effort that people end up spending to counteract the effects of inflation.  For example, businesses may hold less cash or have to make additional trips to the bank during inflation.   A good example of this is each month your rent increases so you can't set up an online automatic payment and as a result, have to pay cash and deliver the rent in-person to your landlord.

 occurs because inflation causes the value of the individual dollar to decrease over time. For example, individuals who have the same wage next year as they do currently will not be able to purchase as much. For example, if an individual earns a salary of $60,000 and the inflation rate rises from 3% to 5% from 2018 to 2019 than that salary will not be able to purchase as much in 2019 as it was in 2018.

 involves the real value of wealth being transferred from one group to another. (i.e. borrowers and lenders).  When people are considering lending or borrowing money, they will take into consideration the expected inflation rate. If that inflation rate turns out to be different than anticipated, that affects the amount of interest that is repaid or earned.

Lenders will be hurt by unanticipated inflation because the money they get paid back with has less purchasing power. Borrowers, on the other hand, benefit from unanticipated inflation because the money they payback is worth less than the money they borrowed.

Costs of Inflation

—the dollar value of all final goods and services produced within a country's borders in one year, expressed in current dollar value (unadjusted for inflation).

—the dollar value of all finals goods and services produced within a country's borders in one year, expressed in constant dollar value (adjusted for inflation).

Steps to Calculate both Nominal GDP and Real GDP

 = Steel Production ($4,000,000) + Wheat Production ($600,000) + Corn Production ($600,000) + Sugar Production ($100,000) = 

 = Steel Production ($5,500,000) + Wheat Product ($900,000) + Corn Production ($1,200,000) + Sugar Production (400,000) = 

 = Steel Production (550,000 x $8) + Wheat Production (300,000 x $3) + Corn Production (400,000 x $2) + Sugar Production (200,000 x $1) = 

 = Iron Production ($1,500,000) + Coal Production ($2,000,000) + Wheat Production ($500,000) + Granite Production ($1,500,000) = 

 = Iron Production ($1,500,000) + Coal Production ($3,500,000) + Wheat Production ($900,000) + Granite Production ($2,000,000) = 

 = Iron Production (100,000 x $10) + Coal Production (500,000 x $4) + Wheat Production (300,000 x $2) + Granite Production (100,000 x $15) = 

This is another index that is used to measure the effects of inflation.

💡Remember in the base year the nominal GDP and real GDP are the same number.

Since 2017 is the base year, the nominal GDP and real GDP are the same.  When calculating the GDP Deflator for the base year you will find that it is always equal to 100.

Real vs Nominal GDP

—the highest rate of Real GDP expansion before Real GDP begins to contract.

—the highest rate of Real GDP contraction before Real GDP begins to expand.

—two straight fiscal quarters (6 months) of Real GDP contraction.

—an extreme or severe recession with excessive unemployment and Real GDP contraction

—any period of real GDP growth, accompanied by a decrease in the unemployment rate

—any period of real GDP reduction, accompanied by an increase in the unemployment rate.

—represents the natural rate of real GDP growth over time that the economy hopes to maintain.  It also represents a natural and healthy rate of inflation over time.  At the growth trend line, the economy is experiencing full employment and meeting each of its goals which include promoting economic growth, preventing unemployment, and limiting inflation (keeping prices stable).

Business cycles are fluctuations in aggregate output and employment because of changes in aggregate supply and/or aggregate demand.  Prior to March of this year, our country was one of the longest expansions it has experienced in history.  Due to the economic effects of the pandemic, we are now experiencing a contraction in our economy.  The Great Depression was seen as quite a long contraction in the history of the United States.  We typically see expansion take place during the onset of a way as countries mobilize to prepare for this type of conflict.

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Unit 2: Economic Indicators and the Business Cycle

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