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Real GDP, or real gross domestic product, measures the value of final goods and services
produced within the borders of a given country during a given period of time, typically a year.
Nominal GDP, or nominal gross domestic product, measures the dollar value of all goods and
services produced within the borders of a given country using their current during the year
that they were produced.
Real GDP is the appropriate measure one should use to determine changes in economic
activity across time. This is because nominal GDP captures BOTH changes in output and
changes in prices over time. Thus, Nominal GDP may increase without any change (or
even a decrease) in real economic activity.
Unemployment is the state a person is in if he or she cannot get a job despite willing to work and
actively seeking work.
1. High rates of unemployment are undesirable because they indicate that the nation is not
using a large fraction of its most important resource, the talents and skills of its people.
Inflation is an increase in the overall level of prices.
Macroeconomic models also clarify many important questions about the powers and limits of
government and economic policy. These include:
1. Can governments promote long-run economic growth?
2. Can governments reduce the severity of recessions by smoothing out short-run
3. Are certain government policy tools more effective at mitigating short-run fluctuations
than other government policy tools?
Savings, Investment, and Choosing Present and Future Consumption
At the heart of economic growth is the principle that in order to raise living standards over time,
an economy must devote at least some fraction of its current output to increasing future
output. This process requires both savings and investment.
1. Savings are generated when current consumption is less than current output.
2. Investment happens when resources are devoted to increasing future output.
a. Financial Investment captures what ordinary people mean when they say investment,
namely the purchase of assets like stocks, bonds, or real estate in the hope of reaping
a financial gain.
b. Economic Investment only includes money spent purchasing newly created capital
goods such as machinery, tools, factories, and warehouses. This what economists
mean when they refer to “Investment”.
Households are the principal source of savings and businesses are the main economic investors.
1. Financial institutions collect savings from households and lend these funds to businesses.
Thus, savings and investment are fundamentally linked together.
Uncertainty, Expectations, and Shocks
A. Decisions about savings and investment are complicated by the fact that the future is
uncertain. Investment projects sometimes produce disappointing results or even fail totally.
This implies that macroeconomics has to take into account expectations about the future.

Private transfer payments. by eliminating any intermediate goods used in production of these final goods or services. Public transfer payments. D. like student allowances or alimony payments. Secondhand sales are excluded. if businesses become pessimistic about the future of the economy they may reduce investment today. including used items. GDP is the monetary measure of the total market value of all final goods and services produced within a country in one year. 2. 2. This is an important identity and the foundation of the national accounting process. B. government. The sale of stocks and bonds represent a transfer of existing assets. Existing assets or property that sold or transferred. National income accounting measures the economy’s performance by measuring the flows of income and expenditures over a period of time. the brokers’ fees are included for services rendered. What is spent on a product is income to those who helped to produce and sell it. and foreign buyers. (However. GDP is the value of what has been produced in the economy over the year. The less obvious reason is that firms are often forced to cope with “shocks” to the economy. Gross Domestic Product A. were expecting one thing to happen but something else happened. GDP is designed to measure what is produced or created over the current time period. Expenditures Approach 1. National income accounts serve a similar purpose for the economy. a. 1. 3. Money valuation allows the summing of apples and oranges. not what was actually sold. GDP Excludes Nonproduction Transactions 1. money acts as the common denominator. For example. The more obvious reason involves the effect that changing expectations can have on current behavior. . are not counted. c. as do income statements for business firms. businesses. GDP is divided into the categories of buyers in the market. Two Ways to Look at GDP: Spending and Income. The national income accounts provide a basis for of appropriate public policies to improve economic performance. Consistent definition of terms and measurement techniques allows us to use the national accounts in comparing conditions over time and across countries. GDP includes only final products and services.B. b. 2. Expectations are important for two reasons. A “shock” is a situation in which firms. 1. a. like social security or cash welfare benefits. it avoids double or multiple counting. Purely financial transactions are excluded. 2. or businesses. they do not represent current output. 1.) 3. household consumers.

Income Approach to GDP Demonstrates how the expenditures on final products are allocated to resource suppliers. public capital (government buildings. nondurable goods and services. 4. The depreciation allowance is set aside to replace the machinery and equipment used up. Nominal GDP is the market value of all final goods and services produced in a year. license fees. All spending on final goods produced in the U. 7. equipment. and tools by businesses. Proprietors’ income: income of incorporated businesses. Net Exports—(X ) n a. F. Taxes on production and imports: general sales taxes. and customs duties. 3. net exports. In addition to the depreciation of private capital. etc. b. b. 2. must be included in GDP. salary and supplements. Interest: payments from private business to suppliers of money capital. 3. partnerships. excise taxes. fringe benefits. and payments made on behalf of workers like social security and other health and pension plans.). 5. Corporate profits: After corporate income taxes are paid to government. Depreciation/Consumption of Fixed Capital: The firm also regards the decline of its capital stock as a cost of production. Includes spending by all levels of government b. All construction (including residential). 6. c. 1.S. Government Purchases (of consumption goods and capital goods) – (G) a. . sole proprietorships. Compensation of employees includes wages. port facilities. Gross Private Domestic Investment—(I ) g a. whether the purchase is made here or abroad. and the remainder is left as undistributed corporate profits (also referred to as retained earnings). Rents: payments for supplying property resources (adjusted for depreciation it is net rent). Nominal versus Real GDP A. Summary: GDP = C + I + G + X g n E. (X ) is the difference: (exports minus imports) and can be either a n positive or negative number depending on which is the larger amount.2. salaries. Statistical discrepancy: NIPA accountants add a statistical discrepancy to national income to equalize the income and expenditures approaches. Disposable income (DI) is personal income less personal taxes. 5. 4. must be included in this entry. All final purchases of machinery. and cooperatives. Personal Consumption Expenditures—(C)—includes durable goods (lasting 3 years or more). The sum of the above entries equals national income: 8. Includes all direct purchases of resources (labor in particular). 6. dividends are distributed to the shareholders. business property taxes.

To make comparisons of real output. GDP is a (P x Q) figure including every item produced in the economy. are not covered in GDP. GDP and the environment. a yard must remain 36 inches. G. D.” usually in an effort to avoid taxation.1.. 1. Money is the common denominator that allows us to sum the total output. A recession is a decline in total output. The trough is the bottom of the recession period. Unemployment A. Measuring unemployment: . income. A peak is when business activity reaches a temporary maximum with full employment and near-capacity output. 2. we need a yardstick that stays the same size. GDP doesn’t measure improved living conditions as a result of more leisure. The harmful effects of pollution are not deducted from GDP (oil spills. GDP does not measure improvements in product quality or make allowances for increased leisure time. GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services. destruction of habitat for wildlife. and the cost of health care for the cancer victim. it makes no difference if the product is a semi-automatic rifle or a jar of baby food. The Underground Economy 1. 4. Noneconomic Sources of Well-Being like courtesy. 1 Per capita GDP may give some hint as to the relative standard of living in the economy. a dollar must keep the same purchasing power. Legal economic activity may also be part of the “underground. GDP does include payments made for cleaning up the oil spills. 1. 2. Shortcomings of GDP A. Illegal activities are not counted in GDP 2. 3. To make comparisons of length. Nominal GDP simply adds the dollar value of what is produced. but GDP figures do not provide information about how the income is distributed. employment. crime reduction. and trade lasting six months or more. GDP makes no value adjustments for changes in the composition of output or the distribution of income. volunteer efforts. B. Overview of the Business Cycle Four phases of the business cycle are identified over a severalyear period. the loss of a clear unobstructed view). Recovery is when output and employment are expanding toward fullemployment level. C. To measure changes in the quantity of output. E. 3. etc. increased incidence of cancer. Nominal GDP is calculated using the current prices prevailing when the output was produced but real GDP is a figure that has been adjusted for price level changes. 2. home improvement projects). 1. parental child care. F.

The unemployment rate is defined as the percentage of the labor force that is not employed. Economist Arthur Okun quantified the relationship between unemployment and GDP as follows: For every 1 percent of unemployment above the natural rate. GDP gap and Okun’s Law: GDP gap is the difference between potential and actual GDP. Economic cost of unemployment: 1. when certain skills become obsolete or geographic distribution of jobs changes. Cyclical unemployment is caused by the recession phase of the business cycle. since wage and pension contracts may have inflation clauses built in. 3. Frictional unemployment consists of those searching for jobs or waiting to take jobs soon. Causes and theories of inflation: 1. and some may fall). Fixedincome groups will be hurt because their real income suffers. . C. Unanticipated inflation has stronger impacts. This is known as “Okun’s law. Definition of “Full Employment” 1. 2. so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender. 3. because it indicates that there is mobility as people change or seek jobs. and interest rates will be high enough to cover the cost of inflation to savers and lenders. D. the number of job seekers equals the number of job vacancies.g. those expecting inflation may be able to adjust their work or spending activities to avoid or lessen the effects. then multiply by 100 to express as a percentage. C. To measure inflation. it is regarded as somewhat desirable. It is often described as “too much spending chasing too few goods. because interest rate returns may not cover the cost of inflation. Types of unemployment: 1.. Their savings will lose purchasing power. The natural rate is achieved when labor markets are in balance.” 2. Demandpull inflation: Spending increases faster than production. If inflation is anticipated. a negative GDP gap of about 2 percent occurs. e. Definition: Inflation is a rising general level of prices (not all prices rise at the same rate. Interest payments may be less than the inflation rate. B. subtract last year’s price index from this year’s price index and divide by last year’s index. Costpush or supplyside inflation: Prices rise because of rise in per-unit production costs (Unit cost = total input cost/units of output). Savers will be hurt by unanticipated inflation. 4. The main index used to measure inflation is the Consumer Price Index (CPI). Full employment does not mean zero unemployment. the effects of inflation may be less severe. The fullemployment unemployment rate is equal to the total frictional and structural unemployment. The fullemployment rate of unemployment is also referred to as the natural rate of unemployment. Their nominal income does not rise with prices. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. B.” Inflation: Defined and Measured A. 2. Structural unemployment: due to changes in the structure of demand for labor.

2. then the difference must represent the amount of income that is saved. If the actual graph of the relationship between consumption and income is below the 45degree line. and more inflation The Income-Consumption and Income-Saving Relationships A. Note that APC + APS = 1 and MPC + MPS = 1. etc.) S 5. 1. B. capital equipment. 2. (MPC = change in consumption/change in income. machinery. Define average propensity to save (APS) as a the fraction or % of income saved (APS = saving/income). The expected rate of return is the marginal benefit and the interest rate – the cost of borrowing funds – represents the marginal cost. other points represent actual C 2. could cause both output and employment to decline. D. Note that “dissaving” occurs at low levels of disposable income. A hypothetical consumption schedule shows that households spend a larger proportion of a small income than of a large income. 2. C. (MPS = change in saving/change in income.) 4. A 45-degree line represents all points where consumer spending is equal to disposable income. Marginal propensity to consume (MPC) is the fraction or proportion of any change in income that is consumed. What is not spent is called saving. Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action. Households consume a large portion of their disposable income. Disposable income is the most important determinant of consumer spending. reckless spending. B. Mild inflation (<3%) has uncertain effects. The Interest Rate – Investment Relationship A. C. inventories. construction. Marginal propensity to save (MPS) is the fraction or proportion of any change in income that is saved. Average and marginal propensities to consume and save: 1. The investment decision weighs marginal benefits and marginal costs. 3. 1.I Output Effects of Inflation A. Some conclusions can be drawn: a. . Costpush inflation. The consumption schedule: 1. Define average propensity to consume (APC) as the fraction or % of income consumed (APC = consumption/income). b. 5. It may be a healthy by-product of a prosperous economy. which can cause speculation. Both consumption and saving are directly related to the level of income. where resource prices rise unexpectedly. 3. Danger of creeping inflation turning into hyperinflation. where consumption exceeds income and households must borrow or use up some of their wealth. Real income falls. Investment consists of spending on new plants. or it may have an undesirable impact on real income.

Expected rate of return is found by comparing the expected economic profit (total revenue minus total cost) to cost of investment to get expected rate of return. In equation form Multiplier = 1 / MPS or 1 / (1MPC). Three points to remember about the multiplier: a. The initial change refers to an upshift or downshift in the aggregate expenditures schedule due to a change in one of its components. The Multiplier Effect Changes in spending ripple through the economy to generate event larger changes in real GDP. or curve. As long as expected return exceeds interest rate. net exports. 3. 1. a.B. the investment should not be made. and by a fraction of that change. like investment. I is more volatile than GDP 1. Profits vary considerably. The initial change in spending is usually associated with investment because it is so volatile. 2. which is income forgone. Alternatively. c. it can be rearranged to read Change in real GDP = initial change in spending x multiplier. The multiplier works in both directions (up or down). Expectations can be easily changed. i (nominal rate corrected for expected inflation). b. b. D. and government purchases also are subject to the multiplier effect. Any change in income will cause both consumption and saving to vary in the same direction as the initial change in income. The size of the MPC and the multiplier are directly related. T C. 1. so spending can be postponed or not. The interest rate represents either the cost of borrowed funds or the opportunity cost of investing your own funds. 2. Innovation occurs irregularly. Multiplier = change in real GDP / initial change in spending. the investment is expected to be profitable Investment is a very unstable type of spending. The real interest rate. C. 4. The fraction of the change in income that is saved is called the marginal propensity to save (MPS). determines the cost of investment. Investment demand schedule. If real interest rate exceeds the expected rate of return. 2. This is called the multiplier effect. shows an inverse relationship between the interest rate and amount of investment. the size of the MPS and the multiplier are inversely related. The significance of the multiplier is that a small change in investment plans or consumptionsaving plans can trigger a much larger change in the equilibrium level of GDP. Capital goods are durable. Fiscal Policy . The fraction of the change in income that is spent is called the marginal propensity to consume (MPC). but changes in consumption (unrelated to income). This is unpredictable. D.

2. “Tools” of Monetary Policy A. expansionary fiscal policy creates a budget deficit. The crowdingout effect may be caused by fiscal policy.. it is also argued that monetary authorities could counteract the crowdingout by increasing the money supply to accommodate the expansionary fiscal policy. It is less political. A decrease in taxes. c. Some economists argue that little crowding out will occur during a recession. 1. and stimulate economic growth. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession.If the budget was initially balanced. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy. including the prime rate. A Current thinking on fiscal policy 1. printing money The CB may use an expansionary monetary policy if the economy is experiencing a recession and rising rates of unemployment. Contractionary fiscal policy needed: Policy options: G or T? 1. It is speedier and more flexible than fiscal policy since the CB can buy and sell securities daily. and using monetary policy more for “fine tuning. a. 2. fiscal policy refers to the deliberate manipulation of taxes and government spending to alter real domestic output and employment. b. Expansionary Policy needed. Reserve Requirements C. Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient. believing that monetary policy is more effective or that the economy is sufficiently self-correcting. 3. CB Board members are isolated from political pressure. Openmarket operations refer to the buying and selling of government bonds. It is easier to make good. 2. Some economists oppose the use of fiscal policy. a. Strengths of monetary policy: 1. Contractionary monetary policy results in higher interest rates.E. An increase in government spending. “Crowdingout” may occur with government deficit spending. including the prime interest rate – the benchmark interest rate used by banks to set many other interest rates. Contractionary monetary policy is used to combat rising inflation.” . Most economists support the use of fiscal policy to help “push the economy” in a desired direction. but unpopular decisions. Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure. 2. B. control inflation. Expansionary monetary policy will put downward pressure on interest rates. B. Fiscal Policy and Monetary Policy: Evaluation and Issues A. A combination of increased spending and reduced taxes. Economists agree that government deficits should not occur at F.A.

3. along with the short-run cyclical effects. Economists agree that the potential impacts (positive and negative) of fiscal policy on long-term productivity growth should be evaluated and considered in the decisionmaking process. .