Economics Final Term Lecture

Principles of Economics
Lecture 1
Objectives and Instruments of
Macroeconomics
◼ Objectives:
Output: High level and rapid growth of output
Employment: High level of employment with

involuntary unemployment
Price-level stability:
2
Instruments of Macroeconomics
◼ Instruments
◼ Monetary policy:
Controlling the money supply to determine
the interest rates
◼ Fiscal Policy:
Government expenditure
Taxation
3
Measuring National Income
◼ Three main statistics of macroeconomics:
1. GDP—Gross domestic product, which tells us
the nation’s total income and the total
expenditure on its output of goods and services
2. CPI—the Consumer Price Index, which
measures the level of prices (inflation)
3. Unemployment rate —this tells the fraction of
workers who are unemployed.
4
THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT
◼ Gross domestic product (GDP) is a measure
of the income and expenditures of an
economy.
THE MEASUREMENT OF
◼ GDP is the market value of all final goods and
services produced within a country in a given
period of time.
THE MEASUREMENT OF
◼ “GDP is the Market Value . . .”
◼ Output is valued at market prices.
◼ “. . . Of All Final . . .”
◼ It records only the value of final goods, not
intermediate goods (the value is counted only
once).
◼ Hallmark Card: Paper is an intermediate good.
◼ “. . . Goods and Services . . . “
◼ It includes both tangible goods (food, clothing,
cars) and intangible services (haircuts,
housecleaning, doctor visits).
THE MEASUREMENT OF
◼ “. . . Produced . . .”
◼ It includes goods and services currently
produced, not transactions involving goods
produced in the past.
◼ “ . . . Within a Country . . .”
◼ It measures the value of production within the
geographic confines of a country.
THE MEASUREMENT OF
◼ “. . . In a Given Period of Time.”
◼ It measures the value of production that takes
place within a specific interval of time, usually
a year or a quarter.
◼ GDP includes all items produced in the

economy and sold legally in markets.
REAL VERSUS NOMINAL GDP
◼ Nominal GDP values the production of goods
and services at current prices.
REAL VERSUS NOMINAL GDP
◼ Real GDP values the production of goods
and services at constant prices.
Base Year
Not Counted in GDP
◼ What Is Not Counted in GDP?
◼ GDP excludes most items that are produced
and consumed at home and that never enter
the marketplace.
◼ It excludes items produced and sold illicitly,
such as illegal drugs.
THE COMPONENTS OF GDP
◼ GDP (Y) is the sum of the following:
◼ Consumption (C)
◼ Investment (I)
◼ Government Purchases (G)
◼ Net Exports (NX)
Y = C + I + G + NX
◼ Consumption (C):
◼ The spending by households on goods and
services, with the exception of purchases of
new housing.
◼ Investment (I):
◼ The spending on capital equipment,
inventories, and structures, including new
housing.
◼ Government Purchases (G):
◼ The spending on goods and services by local,
state, and federal governments.
◼ Does not include transfer payments because
they are not made in exchange for currently
produced goods or services.
◼ Net Exports (NX):
◼ Exports minus imports.
GDP & Components of Expenditure
GDP Government
Consumption Purchases
Nondurable goods Defense
Durable goods Non-defense
Services Net Export
Investment Export
Nonresidential fixed Import
investment
Residential fixed
investment
16
GDP AND ECONOMIC WELL-
BEING
◼ GDP is the best single measure of the
economic well-being of a society.
◼ GDP per person tells us the income and

expenditure of the average person in the
economy.
GDP AND ECONOMIC WELL-
BEING
◼ Higher GDP per person indicates a higher
standard of living.
◼ GDP is not a perfect measure of the

happiness or quality of life, however.
GDP AND ECONOMIC
WELL-BEING
◼ Some things that contribute to well-being are
not included in GDP.
◼ The value of leisure.
◼ The value of a clean environment.
◼ The value of almost all activity that takes place
outside of markets, such as the value of the
time parents spend with their children and the
value of volunteer work.
Summary
◼ Because every transaction has a buyer and a
seller, the total expenditure in the economy
must equal the total income in the economy.
◼ Gross Domestic Product (GDP) measures an
economy’s total expenditure on newly
produced goods and services and the total
income earned from the production of these
goods and services.
Summary
◼ GDP is the market value of all final goods and
services produced within a country in a given
period of time.
◼ GDP is divided among four components of
expenditure: consumption, investment,
government purchases, and net exports.
Summary
◼ Nominal GDP uses current prices to value the
economy’s production. Real GDP uses
constant base-year prices to value the
economy’s production of goods and services.
Summary
◼ GDP is a good measure of economic well-
being because people prefer higher to lower
incomes.
◼ It is not a perfect measure of well-being
because some things, such as leisure time
and a clean environment, aren’t measured by
GDP.
Topic 2 (Chapter 24)

Measuring the Cost of Living – Consumer
Price Index (CPI)
Economic Models
◼ Economists use models to simplify reality in
order to improve our understanding of the
world.
◼ The most basic macroeconomic model

include:
◼ The Circular Flow Diagram
Figure 1 The Circular-Flow Diagram
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought
FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production
Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of money
Copyright © 2004 South-Western

The Circular-Flow Diagram
◼ The circular-flow diagram is a visual model of
the economy that shows how money flow
through markets among households and
firms.
THE CONSUMER PRICE INDEX
◼ The consumer price index (CPI) is a measure
of the overall cost of the goods and services
bought by a typical consumer.
◼ CPI is used to monitor changes in the cost of

living over time.
THE CONSUMER PRICE INDEX
◼ When the CPI rises, the typical family has to
spend more money to maintain the same
standard of living.
How the Consumer Price Index Is
Calculated
◼ Fix the Basket: Determine what prices are
most important to the typical consumer.
◼ The Economic Agency identifies a basket of
goods and services the typical consumer
buys.
Calculated
◼ Find the Prices: Find the prices of each of
the goods and services in the basket for each
point in time.
Calculated
◼ Compute the Basket’s Cost: Use the data
on prices to calculate the cost of the basket of
goods and services at different times.
Calculated
◼ Choose a Base Year and Compute the
Index:
◼ Designate one year as the base year, making
it the benchmark against which other years
are compared.
◼ Compute the index by dividing the price of the
basket in one year by the price in the base
year and multiplying by 100.
Calculated
◼ Compute the inflation rate: The inflation
rate is the percentage change in the price
index from the preceding period.
Calculated
◼ The Inflation Rate
◼ The inflation rate is calculated as follows:
CPI in Year 2 - CPI in Year 1

Inflation Rate in Year 2 =  100
CPI in Year 1
CPI Vs GDP deflator
 GDP deflator & CPI give some what different information
about what’s happening to the overall level of prices in the
economy.
 Three Key Differences:
1. GDP deflator measures the prices of all goods and services
produced
whereas CPI measures the prices of only the goods and
services bought by consumers
2. GDP deflator includes only those goods produced
domestically. Imported goods are not a part of GDP and do
not show up in the GDP deflator.
CPI include imported goods.
3. CPI is computed using a fixed basket of goods whereas GDP
deflator allows the basket of goods to change over time as
the composition of goods and services changed
13
Problems in Measuring the Cost of Living
◼ The CPI is an accurate measure of the

selected goods that make up the typical
bundle, but it is not a perfect measure of the
cost of living.
◼ Substitution bias
◼ Introduction of new goods
◼ Substitution Bias
◼ The basket does not change to reflect
consumer reaction to changes in relative
prices.
◼ Consumers substitute toward goods that
have become relatively less expensive.
◼ The index overstates the increase in
cost of living by not considering

consumer substitution.
◼ Introduction of New Goods

◼ The basket does not reflect the change in
purchasing power brought on by the
introduction of new products.
◼ New products result in greater variety,
which in turn makes each dollar more
valuable.
◼ Consumers need fewer dollars to
maintain any given standard of living.

◼ The substitution bias, introduction of new

goods, cause the CPI to overstate the true
cost of living.
◼ The issue is important because many
government programs use the CPI to adjust
for changes in the overall level of prices.
Summary
◼ The consumer price index shows the cost of a
basket of goods and services relative to the
cost of the same basket in the base year.
◼ The index is used to measure the overall
level of prices in the economy.
◼ The percentage change in the CPI measures
the inflation rate.
Summary
◼ The consumer price index is an imperfect
measure of the cost of living for the following
three reasons: substitution bias, and the
introduction of new goods.
Topic 3 (Chapter 28)

Unemployment
Macroeconomic Instability
⚫ Economic Growth
⚫ Business Cycle
⚫ Unemployment
⚫ Inflation
Economic Growth
⚫ Economists define and measure

economic growth as either:
→ An increase in real GDP occurring over
some time period
→ An increase in real GDP per capita
occurring over some time period.
Economic Growth
⚫ If real GDP was $ 200 billion in some

country last year and $ 210 billion this
year, the rate of growth would be 5
percent.
⚫Rule of 70:
Approximate number of years required to
double real GDP = (70 / annual
percentage rate of growth)
The Business Cycle
⚫ The term business cycle refers to

alternating rises and declines in the level
of economic activity.
⚫ Decline in real GDP leads to significant
increases in unemployment.
⚫ Rapid economic growth has been
marred by rapid inflation.
The Business Cycle
⚫ The term business cycle refers to

alternating rises and declines in the level
of economic activity.
⚫ Decline in real GDP leads to significant
increases in unemployment.
⚫ Rapid economic growth has been
marred by rapid inflation.
The Business Cycle
Growth Trend
Level of
real output Peak
Recovery
Recession
Trough
Time
Phases of the Business Cycle
⚫ Peak:
→ at a peak business activity has
reached a temporary maximum.
→ the economy is at full employment.
→ very close to full productivity.
⚫ The price level is likely to rise during this

phase.
⚫ Recession:
→ a period of decline in total output,
income, employment, and trade.
→ wide spread contraction of business
activity.
⚫ The price level is likely to fall.

⚫ Trough:
→ output and employment bottom out at
their lowest levels.
→ the trough phase may be either short
lived or quite long.
⚫ Recovery:
→ in the recovery phase, output and
employment rise toward full employment.
⚫ The price level may begin to rise before

full employment and full capacity
production return.
Unemployment
⚫ The labor force consists of people who

are able and willing to work.
⚫ Both those who are employed and those
who are unemployed but actively
seeking work are counted as being in the
labor force.
BLS divides population into 3 groups:
⚫ Employed: paid employees, self-employed,

and unpaid workers in a family business
⚫ Unemployed: people who were available and
not working but who have looked for work during
previous 4 weeks
⚫ Not in the labor force: those who do not fit
either any of the above two categories. i.e. full-
time student, homemaker, or retiree
The labor force is the total # of workers,

including the employed and unemployed.
Labor Force Statistics
⚫
Compute the labor force, u-rate, adult population,
and labor force participation rate using this data:
Answers
Labor force = employed + unemployed

= 145.9 + 8.5
= 154.4 million
U-rate = 100 x (unemployed)/(labor force)

= 100 x 8.5/154.4
= 5.5%
Answers
Population = labor force + not in labor force

= 154.4 + 79.2
= 233.6
LF partic. rate = 100 x (labor force)/(population)

= 100 x 154.4/233.6
= 66.1%
Unemployment
⚫ The unemployment rate is the percentage

of the labor force unemployed:
Unemployment rate= (unemployed / labor

force) X 100
Types of Unemployment
⚫ There are three types of unemployment:
→ Frictional Unemployment
→ Structural Unemployment
→ Cyclical Unemployment
Frictional Unemployment
⚫ Frictional unemployment consisting of

search unemployment and wait
unemployment.
⚫ The word frictional implies that the labor

market does not operate perfectly in
matching workers and jobs.
Structural Unemployment
⚫ Structural unemployment results

because the composition of the labor
force does not respond immediately or
completely to the new structure of job
opportunities.
⚫ Structurally unemployed workers find it
hard to obtain new jobs without
retraining, gaining additional education,
or relocating.
Cyclical Unemployment
⚫ Cyclical unemployment is caused by a

decline in total spending and is likely to
occur in the recession phase of the
business cycle.
Types of Inflation
⚫ Inflation: persisting rise in the price level

⚫ Two types of inflation:
→ Demand-Pull Inflation
→ Cost-Push Inflation
Demand-Pull & Cost-Push
Inflation
⚫ Demand Pull Inflation: Changes in the price
level are caused by an excess of total
spending beyond the economy’s capacity
to produce.
⚫ Cost-Push Inflation: Rising prices in terms

of factors that raise per-unit production cost
at each level of spending.
Final term :Topic 4

Money

THE MEANING OF MONEY
• Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.

The Functions of Money
• Money has three functions in the economy:

• Medium of exchange
• Unit of account
• Store of value

• Medium of Exchange
• A medium of exchange is an item that buyers give
to sellers when they want to purchase goods and
services.
• A medium of exchange is anything that is readily
acceptable as payment.

• Unit of Account
• A unit of account is the yardstick people use to post
prices.
• Store of Value
• A store of value is an item that people can use to
transfer purchasing power from the present to the
future.

• Liquidity
• Liquidity is the ease with which an asset can be
converted into the economy’s medium of exchange.

The Kinds of Money
• Commodity money takes the form of a

commodity with intrinsic value.
• Examples: Gold, silver
• Fiat money is used as money because of

government decree.
• It does not have intrinsic value.
• Examples: Coins, currency, check deposits.

Money in the Economy
• Currency is the paper bills and coins in the

hands of the public.
• Demand deposits are balances in bank accounts
that depositors can access on demand by
writing a check.

Figure 1 Money in the Economy
Billions
of Dollars
M2
$5,455
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($4,276 billion)
M1
$1,179
• Demand deposits
• Everything in M1
• Traveler ’s checks
($1,179 billion)
• Other checkable deposits
($599 billion)
• Currency
($580 billion)
0
Copyright
Copyright©2003 © 2004 South-Western
Southwestern/Thomson Learning
BANKS AND THE MONEY
SUPPLY
• Reserves are deposits that banks have received
but have not loaned out.
• In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.

BANKS AND THE MONEY
SUPPLY
• Reserve Ratio
• The reserve ratio is the fraction of deposits that
banks hold as reserves.

Money Creation with Fractional-Reserve
Banking
• When a bank makes a loan from its reserves, the
money supply increases.
• The money supply is affected by the amount
deposited in banks and the amount that banks loan.
• Deposits into a bank are recorded as both assets and
liabilities.
• The fraction of total deposits that a bank has to keep as
reserves is called the reserve ratio.
• Loans become an asset to the bank.

Banking
• This T-Account shows a bank that…
• accepts deposits, First National Bank
• keeps a portion Assets Liabilities
as reserves,
• and lends out Reserves Deposits
the rest. $10.00 $100.00
• It assumes a Loans
reserve ratio $90.00
of 10%.
Total Assets Total Liabilities
$100.00 $100.00
Banking
• When one bank loans money, that money is
generally deposited into another bank.
• This creates more deposits and more reserves to
be lent out.
• When a bank makes a loan from its reserves,
the money supply increases.

The Money Multiplier
• How much money is eventually created in this

economy?

• The money multiplier is the amount of money

the banking system generates with each dollar
of reserves.

First National Bank Second National Bank

Assets Liabilities Assets Liabilities
Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00
Loans Loans
$90.00 $81.00
Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00
Money Supply = $190.00!

• The money multiplier is the reciprocal of the

reserve ratio:
M = 1/R
• With a reserve requirement, R = 20% or 1/5,
• The multiplier is 5.
Inverse

The Central Bank’s Tools of Monetary
Control
• The Central Bank has three tools in its
monetary toolbox:
• Open-market operations
• Changing the reserve requirement
• Changing the discount rate

Control
• Open-Market Operations
• The Central Bank conducts open-market operations
when it buys government bonds from or sells
government bonds to the public:
• When the Central Bank buys government bonds,
the money supply increases.
• The money supply decreases when the Central
Bank sells government bonds.

Control
• Reserve Requirements
• The Central Bank also influences the money supply
with reserve requirements.
• Reserve requirements are regulations on the
minimum amount of reserves that banks must hold
against deposits.

Control
• Changing the Reserve Requirement
• The reserve requirement is the amount (%) of a
bank’s total reserves that may not be loaned out.
• Increasing the reserve requirement decreases the
money supply.
• Decreasing the reserve requirement increases the
money supply.

Control
• Changing the Discount Rate
• The discount rate is the interest rate the Central
Bank charges banks for loans.
• Increasing the discount rate decreases the money
supply.
• Decreasing the discount rate increases the money
supply.

Summary
• The term money refers to assets that people
regularly use to buy goods and services.
• Money serves three functions in an economy: as
a medium of exchange, a unit of account, and a
store of value.
• Commodity money is money that has intrinsic
value.
• Fiat money is money without intrinsic value.

Summary
• When banks loan out their deposits, they
increase the quantity of money in the economy.
• Because the Central Bank cannot control the
amount bankers choose to lend or the amount
households choose to deposit in banks, the
Central Bank control of the money supply is
imperfect.

Economics Final Term Lecture

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Economics Final Term Lecture

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Principles of Economics

Employment: High level of employment with

◼ GDP includes all items produced in the

◼ GDP per person tells us the income and

◼ GDP is not a perfect measure of the

Topic 2 (Chapter 24)

◼ The most basic macroeconomic model

Factors of MARKETS Labor, land,

Copyright © 2004 South-Western

◼ CPI is used to monitor changes in the cost of

CPI in Year 2 - CPI in Year 1

◼ The CPI is an accurate measure of the

cost of living by not considering

◼ Introduction of New Goods

maintain any given standard of living.

◼ The substitution bias, introduction of new

Topic 3 (Chapter 28)

⚫ Economists define and measure

⚫ If real GDP was $ 200 billion in some

⚫ The term business cycle refers to

⚫ The term business cycle refers to

⚫ The price level is likely to rise during this

⚫ The price level is likely to fall.

⚫ The price level may begin to rise before

⚫ The labor force consists of people who

⚫ Employed: paid employees, self-employed,

The labor force is the total # of workers,

Labor force = employed + unemployed

U-rate = 100 x (unemployed)/(labor force)

Population = labor force + not in labor force

LF partic. rate = 100 x (labor force)/(population)

⚫ The unemployment rate is the percentage

Unemployment rate= (unemployed / labor

⚫ There are three types of unemployment:

⚫ Frictional unemployment consisting of

⚫ The word frictional implies that the labor

⚫ Structural unemployment results

⚫ Cyclical unemployment is caused by a

⚫ Inflation: persisting rise in the price level

⚫ Cost-Push Inflation: Rising prices in terms

Final term :Topic 4

Copyright © 2004 South-Western

Copyright © 2004 South-Western

• Money has three functions in the economy:

Copyright © 2004 South-Western

Copyright © 2004 South-Western

Copyright © 2004 South-Western

Copyright © 2004 South-Western

• Commodity money takes the form of a

• Fiat money is used as money because of

Copyright © 2004 South-Western

• Currency is the paper bills and coins in the

Copyright © 2004 South-Western

Copyright © 2004 South-Western

Copyright © 2004 South-Western

Copyright © 2004 South-Western

Copyright © 2004 South-Western

• How much money is eventually created in this

Copyright © 2004 South-Western

• The money multiplier is the amount of money

Copyright © 2004 South-Western

First National Bank Second National Bank

Reserves Deposits Reserves Deposits

Total Assets Total Liabilities Total Assets Total Liabilities