AP Exam ReviewAP Exam Review

AP MacroeconomicsAP MacroeconomicsMR. GRAHAMMR. GRAHAM

2

Unit 2:Measurement of Economic Performance

(12-16%)

Unit 2:Measurement of Economic Performance

(12-16%)

National Income Accounting• Measures the flows of income and expenditures in

the economy over time.

• Serves the same purpose for the economy as a whole as does the income statement of a firm.

• The most simplified representation of the macroeconomy and national income accounting is the Circular-Flow Model.

The Circular-Flow Diagram• The model involves the following principles:

– There are two groups of decision-makers in a private economy: households and businesses

– In every economic exchange, the seller receives exactly the same amount that the buyer spends

– Goods and services flow in one direction and money payments flow in the other

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FIGURE 2 The circular flow diagram expresses the linkages between businesses and

households through the goods and factor markets, as well as through government.

The Circular-Flow Diagram

Gross Domestic Product (GDP)• The most commonly presented statistic of national

income accounting is the GDP.• Represents the total market value of all final goods

and services produced within a country in one year.– It avoids double or multiple counting by eliminating any

intermediate goods (goods used up entirely in the production of final goods).

• The GDP at the end of FY12 = $15.85 trillion.

Gross Domestic Product (GDP)3 Ways for Calculating GDP

1.Production Approach:

• Survey firms and add up the total value of their production of final goods and services.

• In order to avoid counting intermediate goods, only the value added by each manufacturer is counted.

Gross Domestic Product (GDP)3 Ways for Calculating GDP

2.Income Approach:

• Sum the total factor income earned by households from firms in the economy.

• Adding up all components of national income, including wages, interest, rent, and profits.

Gross Domestic Product (GDP)3 Ways for Calculating GDP

3.Expenditure Approach:

• Add up aggregate spending on domestically produced final goods and services in economy.

• Adding up the dollar value of all final goods and services purchased by consumers, businesses, government, and buyers from outside the country.

• GDP = C + I + G + (X – M)

GDP = C + I + G + (X – M)1.Consumption (C): Households’ purchases of final goods and services during the year.2.Gross Private Domestic Investment (I): Households’ savings that businesses can borrow to invest in equipment, factories, or inventories.3.Government Expenditures (G): consumption and investment for all government branches.4.Net Exports (X - M): the value of exports (X) less the value of imports (M).

The Components of GDP

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Nominal GDP and Real GDP

• Nominal GDP: GDP calculated at existing prices.

• Real GDP: Nominal GDP adjusted for inflation.

Real GDP = Nominal GDPGDP Deflator

x 100

• Provides us with a scale against which to compare our current economy with

• Economic performance of other years (Real GDP)

• Economic performance of other countries (Real GDP per capita)

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• Unemployment Rate– The percentage of the labor force that is unemployed.

The Unemployment Rate

Unemployment Rate = UnemployedLabor Force

x 100

• Labor Force

– Those people in the economy who are over 16, not in the armed forces, and willing and able to work.

– 155.5 million people (February 2013)

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Problems with the Unemployment Rate

• Excludes discouraged workers• individuals who have stopped looking for a job because they

are convinced they will not find a suitable one.

• Excludes underemployed workers• individuals working beneath their skill level or only able to

find part-time jobs.

• Varies greatly among (and therefore misrepresents) certain demographic groups

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Categories of Unemployment• Frictional Unemployment

– Results from workers moving from one job to another seeking appropriate offers

• Structural Unemployment

– Results from a poor match of workers’ abilities and skills with current requirements of employers

• Cyclical Unemployment

– Results from business recessions and economic downturns that occur when aggregate (total) demand is insufficient to create full employment

Natural Rate of Unemployment• When cyclical unemployment is zero, the

unemployment rate is called the natural rate of unemployment, because it reflects unemployment that arises from natural features of a market society.

• It changes over time and is generally thought to be around 5% in the U.S. today.

Inflation• Inflation

– The situation in which the average of all prices of goods and services (i.e. “price level”) in an economy is rising.

– Measured through the use of price indexes

• Inflation Rate– The percentage increase in overall level of prices per year.

Inflation Rate = Price Index in Year 2

Price Index in Year 1- 1

• Price Index

– Summarizes what happens to the prices in a constant “market basket” of goods and services.

• Inflation is decline in purchasing power of money

– Nominal value: price expressed in today’s dollars

– Real value: value expressed in purchasing power (i.e. adjusted for inflation)

– For example, a $100 bill from your grandparents this year will have a nominal value of $100 next year but a real value of less, assuming a decrease in the purchasing power after a year of inflation.

Nominal and Real Values

"Costs" of Inflation• Shoe-Leather Costs

– A high inflation rate discourages people from holding money and encourages them to search out ways to combat inflation.

• Menu Costs

– A high inflation rate forces firms to change prices more often than they would if the price level was more or less stable.

• Unit-of-Account Costs

– A high inflation rate causes a dollar next year to be worth less than a dollar this year.

Winners and Losers from Inflation• Economists summarize the effect of inflation on

borrowers and lenders by distinguishing between nominal and real interest rates.

– Nominal Interest Rate• The market rate of interest expressed in today’s dollars

– Real Interest Rate• The nominal interest rate adjusted for inflation

(i.e. minus the inflation rate)

• When inflation is higher than anticipated…– Creditors lose

– Debtors gain

– Creditors lose because the debtor is charged an interest rate that does not cover the actual inflation rate

• When inflation is lower than anticipated…– Debtors lose

– Creditors gain

– Debtors lose because they are charged an interest rate that is higher than the actual inflation rate

Winners and Losers from Inflation

Protecting Against Inflation• Banks attempt to protect themselves by raising nominal

interest rates to reflect anticipated inflation (i.e. ARMs)

• Workers attempt to protect themselves with Cost of Living Adjustments (COLAs)

– Clauses in contracts that allow for increases in specified nominal values to take account of changes in the cost of living

• Individuals attempt to protect themselves by placing their savings into interest-bearing accounts

– Often pay nominal rates of interest that reflect anticipated inflation

• Consumer Price Index (CPI)

– A measure of the price of a fixed basket of consumer goods designed to represent the average consumer’s expenditures

– Reported monthly by BLS; most commonly used measure.

• Producer Price Index (PPI)

– A measure of the price of a fixed basket of goods common to industrial production.

– Used as a short-run leading indicator (before CPI)

• GDP Deflator

– A price index measuring the changes in prices of all new goods and services produced in the economy.

Price Indexes