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Flashcards · AP® Macroeconomics · Unit 2

Unit 2: Economic Indicators and the Business Cycle flashcards

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2.1 The Circular Flow and GDP

What is GDP?
The market value of all final goods and services produced within a country in a given period.
What is the expenditure approach to GDP?
GDP = C + I + G + Xn, where Xn = exports − imports and can be negative. I = new capital goods + new housing + change in inventories. G is purchases of goods and services only.
What is left out of GDP, and why?
Intermediate goods (already in the final price), used goods (made in an earlier year), shares, bonds and bank deposits (financial, not production), transfer payments (nothing produced in return) and nonmarket activity.
Is buying shares counted as investment in GDP?
No. Shares and bonds are financial transactions. Investment is new capital goods, new housing and the change in inventories; a fall in inventories is a negative part of I.
C = 300, I = 80, G = 100, exports 40, imports 55 (VD billion). What is GDP?
300 + 80 + 100 + (40 − 55) = VD 465 billion. Imports are subtracted.
What is value added?
The value of a firm's output minus the intermediate goods it bought. A firm selling VD 90 of output after buying VD 35 of inputs adds VD 55. The sum of value added equals the price of the final good.
Diagram: describe the circular flow model.
Households sell resources to firms in the factor market and buy goods and services in the product market. Money flows one way; resources, goods and services flow the other. Total spending = total income = value of output. Leakages: saving, taxes, imports. Injections: investment, government purchases, exports.
What is the income approach to GDP?
GDP = wages + rent + interest + profit. Wages 400, rent 30, interest 50 and profit 120 (VD billion) give GDP of VD 600 billion.

2.2 Limitations of GDP

Why is GDP not a full measure of well-being?
It measures market production. It misses nonmarket work, most of the informal economy and leisure; it does not subtract pollution; and it ignores what is produced, quality changes and who receives the income.
Is leaving out intermediate goods or transfer payments a limitation of GDP?
No. Those exclusions are correct accounting by design. The limitations are things such as nonmarket activity, the informal economy, leisure and the environment.
How does clean-up spending after pollution affect GDP?
It raises GDP. Pollution and resource depletion are not subtracted, while clean-up and repair spending is added.
How should you compare living standards between countries?
Use GDP per person = GDP ÷ population, and real GDP to remove price changes. GDP of VD 240 billion with 8 million people is VD 30,000 per person.
Is a retired nurse's weekly volunteering at a clinic counted in GDP?
No. It is a nonmarket activity, so GDP understates output. Moving work from the home to the market inflates measured growth.
GDP and population both grow by 5%. What happens to GDP per person?
No change: % change in GDP per person ≈ % change in GDP − % change in population.

2.3 Unemployment

Who counts as unemployed?
An adult without a job who is available and actively looking for work. Retirees, students not seeking work and discouraged workers are not in the labor force.
How do you calculate the unemployment rate and the participation rate?
Unemployment rate = unemployed ÷ labor force × 100, where labor force = employed + unemployed. Participation rate = labor force ÷ adult population × 100.
What are frictional, structural and cyclical unemployment?
Frictional: searching between jobs or entering work. Structural: a mismatch of skills or location, often after technological change. Cyclical: caused by a downturn.
What does full employment mean?
No cyclical unemployment, not zero unemployment. Natural rate = frictional rate + structural rate; cyclical rate = actual rate − natural rate. A natural rate of 4.0% and an actual rate of 6.5% give 2.5% cyclical.
Why can the measured unemployment rate understate joblessness?
Discouraged workers are left out of the labor force, and part-time workers who want full-time work count as fully employed.
An unemployed worker becomes discouraged and stops looking. What happens to the rates?
The unemployment rate falls and the participation rate falls. A falling unemployment rate does not always mean more jobs.
Employed 9.0 million, unemployed 1.0 million. What is the unemployment rate?
1.0 ÷ (9.0 + 1.0) × 100 = 10%. Divide by the labor force, not the adult population.

2.4 Price Indices and Inflation

What is the CPI, and how is it calculated?
It compares the cost of a fixed market basket of consumer goods and services in a given year with its cost in the base year: CPI = (cost in year t ÷ cost in base year) × 100. VD 80 then and VD 92 now gives 115.
How do you calculate the inflation rate from a price index?
(new index − old index) ÷ old index × 100. A CPI rising from 150 to 156 gives 6 ÷ 150 = 4%. Index points equal percentages only when the earlier index is 100.
What are inflation, deflation and disinflation?
Inflation: the price level rises. Deflation: the price level falls. Disinflation: inflation is still positive but lower than before.
How do you turn a nominal value into a real value?
Real value = nominal value ÷ index × 100. A wage of VD 840 when the CPI is 120 is worth VD 700 in base-year valdas.
Why does the CPI tend to overstate inflation?
Substitution bias (the basket is fixed while consumers switch away from goods that become dearer), quality improvements and new goods.
What is the quick check for a real change?
Real % change ≈ nominal % change − inflation rate.

2.5 Costs of Inflation

Why does unexpected inflation matter more than expected inflation?
Expected inflation can be written into contracts: higher nominal interest rates, wage rises, indexed pensions. Unexpected inflation (actual − expected) cannot, because contracts already signed cannot adjust.
Who gains and who loses from unexpected inflation?
Gainers: borrowers with fixed-rate loans and employers paying fixed wages. Losers: lenders, savers holding cash, workers on fixed wage contracts and pensioners with fixed, non-indexed pensions. Unexpected deflation reverses this.
Does inflation make everyone poorer?
No. Unexpected inflation arbitrarily redistributes purchasing power: from lenders to borrowers, and from people receiving fixed nominal payments to those paying them.
What are the costs of inflation to the economy?
Unfair, luck-based redistribution; uncertainty that discourages long-term fixed-rate lending and investment; and resources spent protecting against inflation.
A fixed pension of VD 600 a month remains after prices rise by 20%. What is its purchasing power in old valdas?
600 × (100 ÷ 120) = VD 500.
A loan repayment of VD 1,050 is made after the CPI rose from 100 to 105. What is it worth in start-of-year valdas?
1,050 × (100 ÷ 105) = VD 1,000, so the lender earned nothing in real terms.

2.6 Real v. Nominal GDP

What is the difference between nominal and real GDP?
Nominal GDP values output at current prices and measures spending on final output. Real GDP values output at constant base-year prices and measures production. Real GDP rises only if output rises.
How do you calculate the GDP deflator and real GDP?
Deflator = (nominal GDP ÷ real GDP) × 100. Real GDP = (nominal GDP ÷ deflator) × 100. Nominal GDP of VD 540 billion with a deflator of 108 gives real GDP of VD 500 billion.
What does a GDP deflator of 112 mean?
The price level is 12% above the base year. It is a level, not an inflation rate; inflation is its % change, so 110 to 115.5 is 5%.
When is real GDP equal to nominal GDP?
In the base year, or whenever the deflator is 100. Real GDP is above nominal GDP when the deflator is below 100.
Why can valuing output at base-year prices overstate real growth?
Fast-growing goods often become relatively cheaper, so fixed base-year prices give them too much weight. Agencies use other methods (chain weighting) instead; you explain this but do not calculate it.
What is the quick link between nominal growth, real growth and inflation?
Real growth ≈ nominal growth − inflation. It is a quick check only.

2.7 Business Cycles

What is a business cycle?
The short-run rise and fall of real output and employment, caused by changes in aggregate demand and/or aggregate supply. Expansion: real GDP rises. Recession: real GDP falls. Peak and trough are the turning points.
What is potential output?
Full-employment output: the level at which unemployment equals the natural rate (frictional + structural).
What is the output gap?
Actual real GDP − potential real GDP. Negative: recessionary. Positive: inflationary. As a %: gap ÷ potential × 100. Actual VD 570 billion and potential VD 600 billion give −VD 30 billion, or −5%.
Graph: how do you read a business cycle graph?
Real GDP on the vertical axis, time on the horizontal. The straight upward line is potential output. High points are peaks and low points troughs; falling stretches are recessions and rising ones expansions. Above the line: positive gap, unemployment below the natural rate.
Is slower growth a recession?
No. In a recession real GDP must fall. Early in an expansion the output gap is often still negative.
Real GDP fell for two quarters and has just risen by 0.5%. Which phase is the economy in?
Expansion: the trough has passed. "Two quarters of falling real GDP" is only a rule of thumb.

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