Chapter 5 Macroeconomics The Big Picture 1 GROWTH

Chapter 5 Macroeconomics: The Big Picture

1. GROWTH OF REAL GDP AND BUSINESS CYCLES Learning Objectives 1. Define real gross domestic product and explain how its calculation avoids both double-counting and the effects of changes in the price level. 2. Identify the phases of a business cycle. 3. Relate business cycles to the overall long -run trend in real GDP in the United States.

1. GROWTH OF REAL GDP AND BUSINESS CYCLES • • • The Business cycle is the economy’s pattern of expansion, then contraction, then expansion again. Nominal GDP is the total value of final goods and services for a particular period valued in terms of prices for that period. Real GDP is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices.

1. 1 Phases of the Business Cycle • • An expansion is a sustained period in which real GDP is rising. A recession is a sustained period in which real GDP is falling. A peak is the point of the business cycle at which an expansion ends and a recession begins. A trough is the point of the business cycle at which a recession ends and an expansion begins.

Phases of the Business Cycle

1. 2 Business Cycles and the Growth of Real GDP in the United States

2 PRICE LEVEL CHANGES Learning Objectives 1. Define inflation and deflation, explain how their rates are determined, and articulate why pricelevel changes matter. 2. Explain what a price index is and outline the general steps in computing a price index. 3. Describe and compare different price indexes. 4. Explain how to convert nominal values to real values and explain why it is useful to make this calculation. 5. Discuss the biases that may arise from price indexes that employ fixed market baskets of goods and services.

2 PRICE LEVEL CHANGES • Inflation is an increase in the average level of prices. – – – • Deflation is a decrease in the average level of prices. – – – • • Redistributes wealth Creates uncertainty reduces lending hurts lenders and benefits borrowers Redistributes wealth Creates uncertainty hurts borrowers and benefits lenders Hyperinflation is an inflation rate in excess of 200% per year. Disinflation is a decrease in the level of inflation. e. g. inflation fell from 5% to just 3%.

2. 1 Why Do We Care?

2. 2 Price Indexes • • • A price index is a number whose movement reflects movement in the average level of prices. A base period is a time period against which costs of the market basket in other periods will be compared in computing a price index. The consumer price index (CPI) is a price index whose movement reflects changes in the prices of goods and services typically purchased by consumers.

2. 2 Price Indexes Item Quantity 2007 Cost in 2007 in Basket Price Basket 2008 Price Cost in 2008 Basket DVD rental 4 $2. 25 $9. 00 $2. 97 $11. 88 Movie admission 3 7. 75 23. 25 8. 00 24. 00 Popcorn 3 2. 25 6. 75 Soft drink 3 3. 00 9. 00 2. 75 8. 25 2007 $48. 00 2008 $50. 88 Total cost of basket Movie Price Index MPI 2008 = $50. 88/$48 = 1. 06 EQUATION 2. 1 CPI = current cost of basket /base-period cost of basket

2. 2 Price Indexes • The implicit price deflator is a price index for all final goods and services produced; it is the ratio of nominal GDP to real GDP. EQUATION 2. 3 Implicit price deflator = nominal GDP/real GDP • The personal consumption expenditures price index is a price index that includes durable goods, nondurable goods, and services and is provided along with estimates for prices of each component of consumption spending.

2. 3 Computing the Rate of Inflation or Deflation EQUATION 2. 4

2. 4 Computing Real Values Using Price Indexes • • The real value is a value expressed in units of constant purchasing power (adjusts for inflation). The nominal value is a value expressed in dollars of the current period. EQUATION 2. 5

2. 4 Computing Real Values Using Price Indexes • Are price indexes accurate measures of price-level changes? – Components of market basket are fixed. – New goods are excluded. – Quality changes may not be accounted for. – Indexes do not account for changes consumers make in terms of where they shop. Sources of Bias 1997 Estimate 2006 Estimate Substitution 0. 4 New products and quality change 0. 6 0. 3 Switching to new outlets 0. 1 Total 1. 1 0. 8 -1. 6 ------ Plausible range

3. UNEMPLOYMENT Learning Objectives 1. Explain how unemployment is measured in the United States. 2. Define three different types of unemployment. 3. Define and illustrate graphically what is meant by the natural level of employment. Relate the natural level of employment to the natural rate of unemployment.

3. 1 Measuring Unemployment • • The labor force is the total number of people (age 16 and over) working or unemployed. The unemployment rate is the % of the labor force that is unemployed. Is person working? Yes No Employed 144, 958 Is person looking and available for work? s Ye No Unemployed 10, 080 Not in labor force 79, 038 The unemployment rate in August 2008 was 6. 5 percent: Unemployment rate = 10, 080/(10, 080+144, 958) = 0. 065 = 6. 5 percent

3. 2 Types of Unemployment • • • The natural level of employment is the employment level at which the quantity of labor demanded equals the quantity supplied. The natural rate of unemployment is the rate of unemployment consistent with the natural level of employment. Frictional unemployment occurs because it takes time for employers and workers to find each other. Structural unemployment results from a mismatch between worker qualifications and the characteristics employers require. Cyclical unemployment is the excess of the unemployment that exists at the natural level of employment.

The Natural Level of Employment S 1 we D 1 Le

Unemployment Rate, 1960 -2008