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Macroeconomics · AP Macroeconomics
measuring an economy
To steer an economy you first have to measure it: how much it produces, how many people want work and can’t find it, and how fast prices are rising.
The figure is the circular flow. Households own the factors of production and sell their services to firms; firms use them to make goods and services and sell them back to households. Money (red) goes round one way; goods, services and factors (blue) go round the other.
Every dollar spent on a final good is a dollar of some firm’s revenue, and every dollar of revenue is paid out as somebody’s income: wages, rent, interest or profit. So total spending, total income and the value of total output are three views of one number, gross domestic product.
This chapter measures output (GDP, nominal and real), the labor market (the unemployment rate) and prices (the consumer price index and inflation), and then follows all three through the business cycle. On the AP exam this unit is 12–17% of the multiple choice.
households, firms, government and the rest of the world
The circular flow model shows who pays whom in an economy, and in exchange for what.
There are two markets. In the product market households buy goods and services from firms. In the factor market (resource market) firms buy the services of labor, land, capital and entrepreneurship from households, paying wages, rent, interest and profit. Money flows opposite to the goods and factors it pays for.
Government joins the loop: it collects taxes, buys goods and services (G) in the product market, and pays transfer payments such as Social Security and unemployment benefits to households. Transfers are income for households but buy no output, so they are not part of G or of GDP.
The rest of the world buys our exports (X) and sells us imports (M). Spending by foreigners on goods made here is an injection into the flow; our spending on goods made abroad leaks out of it. Saving (through the financial sector) is a leakage too; investment spending an injection.
In a hypothetical economy, households spend $650 billion, firms invest $170 billion, government buys $140 billion, foreigners buy $150 billion of exports and the economy imports $110 billion. Its GDP is 650 + 170 + 140 + (150 − 110) = $1000 billion.
expenditure, income and value added
Gross domestic product is the market value of all final goods and services produced within a country in a given period.
Final means bought by the last user. A farmer sells wheat for $40, a miller turns it into flour and sells it for $100, and a baker turns that into bread sold for $250. Adding all three sales ($390) would count the wheat three times. The wheat and flour are intermediate goods, used up in making the bread.
Count only each firm’s value added, its sales minus what it bought from other firms: 40 + 60 + 150 = $250, exactly the price of the final good. That is the value-added (production) approach.
The expenditure approach adds spending on final goods and services: GDP = C + I + G + Xn, consumption plus gross private investment (new capital, new homes, and additions to inventories) plus government purchases plus net exports (exports − imports).
The income approach adds what that spending pays out: wages, rent, interest and profits, plus depreciation and taxes on production. For the hypothetical economy, both give $1000 billion. In the United States the Bureau of Economic Analysis (BEA) estimates GDP each quarter.
and what it cannot tell you
GDP counts only new, final goods and services sold in markets. Many transactions fail one of those tests.
GDP measures output, not well-being. It ignores leisure, the quality of the environment, and how output is shared. A larger population also raises GDP, so to compare living standards economists use real GDP per capita: real GDP divided by population.
the labor force and the unemployment rate
You are unemployed only if you have no job, are available for work, and have actively looked for work in the past four weeks (or are on temporary layoff, waiting to be recalled).
The Bureau of Labor Statistics (BLS) finds out each month from the Current Population Survey of about 60,000 households. It starts from the civilian noninstitutional population aged 16 and over (no one in the armed forces, prisons or nursing homes) and sorts each adult into one of three groups:
The labor force is the employed plus the unemployed. In a hypothetical country of 200 million adults (each figure is 2 million), 114 million are employed and 10 million unemployed:
unemployment rate = unemployed ÷ labor force = 5 ÷ 62 = 8.1%; labor-force participation rate = labor force ÷ adult population = 62%.
Then 4 million of the unemployed stop looking, believing no jobs are available. These discouraged workers leave the labor force, so the rate falls, to 3 ÷ 60 = 5.0%, though no one found a job. The official rate (BLS’s U-3) also counts underemployed part-timers who want full-time work as employed; the broader U-6 adds them back in, with the discouraged and other marginally attached workers.
frictional, structural, cyclical, and the natural rate
Some unemployment is always present, even in a healthy economy; the rest comes and goes with the business cycle.
Frictional unemployment: people between jobs or just entering the labor force, searching for a good match. A graduate looking for a first job, a worker who quit to find a better one.
Structural unemployment: a mismatch between workers’ skills or location and the jobs available, often after technology or trade changes an industry. It lasts longer, and retraining or moving is the cure.
Cyclical unemployment: caused by a fall in total spending in a recession. When output falls, firms need fewer workers.
The natural rate of unemployment is frictional plus structural: the rate when cyclical unemployment is zero. The economy is then at full employment, producing its potential output, even though the unemployment rate is not zero. In the hypothetical economy of the figure the natural rate is 1.6% + 2.4% = 4.0%.
In a recession the actual rate rises above the natural rate (cyclical unemployment is positive). In a boom it falls below it: cyclical unemployment is negative, because people find jobs faster than usual. The natural rate itself can change over time, with demographics, policies such as unemployment insurance, and how well workers and jobs are matched.
pricing a fixed market basket
A price index measures the cost of a fixed market basket of goods and services in a given year relative to its cost in a base year.
The base year’s index is 100 by definition. A hypothetical household’s monthly basket, priced in three years:
| item | year 1 | year 2 | year 3 |
|---|---|---|---|
| rent | $1,200 | $1,260 | $1,320 |
| groceries | $500 | $540 | $560 |
| gasoline | $140 | $160 | $150 |
| phone and internet | $160 | $160 | $170 |
| cost | $2,000 | $2,120 | $2,200 |
| CPI | 100 | 106 | 110 |
Year 2’s index is 2,120 ÷ 2,000 × 100 = 106: the basket costs 6% more than in the base year. Year 3’s is 110.
The consumer price index (CPI), published monthly by the BLS, prices the goods and services bought by urban consumers, a group making up over 90% of the US population. Its reference base is 1982–84 = 100, and its basket weights come from household spending surveys (updated every year since 2023).
The GDP deflator (2.6) is a different index: it covers everything in GDP, including investment and government purchases, and not imports.
the inflation rate, real wages, and the CPI’s biases
The inflation rate is the percentage change in a price index from one period to the next.
From year 2 to year 3: (110 − 106) ÷ 106 × 100 = 3.77%. Not 4%: the change is divided by the earlier year’s index, not the base year’s. Deflation is a falling price level (negative inflation); disinflation is inflation slowing but still positive.
A price index turns nominal dollars into real ones (dollars of base-year buying power): real value = nominal value ÷ price index × 100. A worker earning $40,000 in year 1 and $43,000 in year 3 got a 7.5% raise, but in year-1 dollars year 3’s pay is 43,000 ÷ 110 × 100 = $39,091: a real wage cut.
The CPI tends to overstate the rise in the cost of living:
The BLS works on each, for example by using, since 1999, a formula that allows substitution within item categories (between kinds of apples, say).
who wins and who loses
Inflation that people expect can be built into contracts; unexpected inflation moves buying power from some people to others.
The real interest rate is what a loan earns in buying power: real rate = nominal rate − inflation. A bank lends $1,000 at a nominal 6%, both sides expecting 2% inflation, so a real rate of 4%.
If inflation turns out at 8%, the real rate is −2%: the $1,060 repaid buys only $981 of today’s goods. The borrower gains and the lender loses. If inflation is 0%, the lender gains. The figure sweeps actual inflation from 0% to 8%.
So unexpected inflation hurts lenders, savers, and people on fixed incomes or with fixed wages, and helps borrowers and those whose incomes rise with prices. Unexpected deflation does the reverse, raising the real burden of debts. Social Security benefits and some bonds are indexed to a price index to protect against this.
Even expected inflation has costs: menu costs (changing prices), shoe-leather costs (effort spent holding less cash), and unit-of-account costs (money becomes a less reliable measure, which distorts contracts and taxes).
taking out the rise in prices
Nominal GDP values output at the prices of the year it was produced; real GDP values it at the prices of a base year, so it changes only when output does.
The GDP deflator is the price index linking them:
A hypothetical economy, base year 2 ($ billions):
| year | nominal GDP | deflator | real GDP |
|---|---|---|---|
| 1 | 795.4 | 97 | 820 |
| 2 | 850.0 | 100 | 850 |
| 3 | 915.2 | 104 | 880 |
| 4 | 930.9 | 107 | 870 |
| 5 | 999.0 | 111 | 900 |
In the base year the deflator is 100 and real equals nominal. Before it, prices were lower, so real GDP is above nominal; after it, below.
From year 3 to year 4 nominal GDP rose 1.7%, but real GDP fell 1.1%: all of the rise was higher prices. Growth is measured in real terms: the growth rate of real GDP = (this year − last year) ÷ last year. The inflation rate by the deflator in year 4 is 2.9%.
Divided by population, real GDP per capita went from $20,500 to $21,429 per person over the five years.
expansion, peak, recession, trough
Real GDP does not grow smoothly. It rises and falls around a long-run trend, potential output: what the economy produces at full employment.
A business cycle has four phases:
A common rule of thumb calls two consecutive quarters of falling real GDP a recession. The official US dates come instead from the National Bureau of Economic Research, which defines a recession as “a significant decline in economic activity that is spread across the economy” lasting more than a few months, and looks at jobs, income and spending as well as GDP. It dated the recession of 2007–09 from December 2007 to June 2009 (18 months) and the COVID-19 recession from February to April 2020 (two months).
In the hypothetical economy of the figure, potential output grows 2 a year; actual output swings around it. Recessions (shaded) are shorter than expansions, as they have been in the US since the Second World War.
below potential, above potential
The output gap is actual real GDP minus potential output. Its sign tells you where the economy is in the cycle.
Negative (recessionary) gap: output below potential, red in the figure. Resources sit idle: cyclical unemployment is positive and the unemployment rate is above the natural rate. At the trough here the gap is −4.3% of potential and unemployment 6.1%.
Positive (inflationary) gap: output above potential, blue. Workers and factories are used more intensively than can last; unemployment is below the natural rate (1.8% at the peak here, with a gap of +4.5%), and prices tend to rise faster.
At full employment the gap is zero and unemployment equals the natural rate. In the figure each percentage point of gap moves unemployment 0.5 point the other way, a rough rule of thumb known as Okun’s law.
On a production possibilities curve, an economy with a recessionary gap is inside the curve: it could produce more of both goods with what it already has. Growth in potential output, from more resources or better technology, shifts the curve outward (Chapter 1).
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