Econ 202: Principles of Macroeconomics Review Session: (Midterm 1) Chapters: 10,11,12,15 The exam is open book and open

notes. There are two sections: Multiple Choice and Short Answer questions. Chapter 10:

GDP
What is GDP? The market value of all final goods & services produced within a country in a given period of time. Market Value: Final goods & services Currently produced

What are the components of GDP?

Y = C + I + G + NX
Expenditure approach

Consumption (C): spending by households on goods and services, with the exception of purchases of new housing. Investment (I): spending on capital equipment, inventories, and structures, including household purchases of housing. Government Purchases (G): spending on goods and services by local, state and Federal governments, including salaries for government workers and spending on public works. G excludes transfer payments, such as

Social Security or unemployment insurance benefits.

 Net Exports (NX = Exports Imports) Exports: spending on domestically made goods and services by foreigners. Imports: spending on foreign goods and services by domestic residents. GDP growth rate: Growth rate for specific year t:
GDPt GDPt 1 100% GDPt 1

Average GDP growth rate over a period from year t1 to year t2:
( ) ( )

How is GDP corrected for inflation?

Nominal GDP: values output using current prices; not corrected for inflation Real GDP: values output using the prices of a base year; corrected for inflation GDP deflator: a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. GDP deflator = (Nominal GDP / Real GDP) * 100

How is inflation rate calculated based on GDP deflator? ( )

Does GDP measure societys well-being?

there are something left out of GDP

i. ii. iii. iv. v. vi. vii. Intermediate goods Second hand sales Nonproduction Transactions Transfer Payments Unreported income Illegal activity Non-market transactions

viii.

U.S. corporations produce goods overseas

Inflation

What is CPI? How is it calculated?

CPI is a measure of overall cost of the goods and services bought by a typical consumer. It is used to monitor changes in the cost of living over time.

How is CPI calculated? Fix the basket Find the prices Compute the baskets costs Choose a base year to compute the index cost of basket in current year ( ) 100 cost of basket in base year

How is inflation rate calculated based on CPI? The percentage change of the CPI from the preceding period.
( CPIYear 2 CPIYear 1 ) 100 CPIYear 1

Weakness of CPI Overstate the cost of living Substitution bias: Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. Not measure introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. Not measure quality improvements in the basket increase the value of each dollar

GDP deflator vs CPI

GDP deflator Measure the price of all goods and services Only includes domestically produced goods Assign changing weights to the prices of different goods Understate inflation

CPI Measure only consumer goods Includes imported consumer good

Assign fixed weights to the prices of different goods Overstate inflation

Correcting Economic Variables for the Effects of Inflation

Dollar value changes:

Dollar value in year 2 = Dollar value in year 1

Price level in year 2 Price level in year 1

Real and nominal interest rates Real interest rate = Nominal interest rate Inflation rate

Unemployment Rate

How to measure unemployment?

Unemployment rate

Number of employed 100% Labor force

Employed: A person is employed if they worked full time or part time during the past week or is on vacation or sick leave from a regular job Unemployed: A person is unemployed if they did not work during the preceding week but made some effort to find work in the last 4 weeks. Not in the Labor Force: A person is considered out of the work labor force if they did not work in the past week and did not look for a job in the last 4 weeks. Labor Force = Unemployed + Employed

Problems with unemployment rate Understates the true extent of unemployment Discouraged workers: People who would like to work but have given up looking for a job in the past 4 weeks. Involuntary part-time workers: People who would like to work full-time but are able to find only a part-time job.

Participation rate: It measures how many adult people willing to go to work. In other words, the percentage of the adult population that is in the labor force. Labor force Participation rate 100% Adult population

Why are there always some people unemployed?(natural rate of unemployment) Because there are two types of unemployment that always exist in the labor market. *Cyclical unemployment the deviation of unemployment from its natural rate associated with business cycles which well study in later chapters Frictional unemployment: The unemployment because it takes time for workers to search for the jobs that best suit their tastes and skills. Sectoral shifts are changes in the composition of demand across industries or regions of the country. Structural unemployment: The unemployment because the number of jobs available in some labor markets is insufficient (to provide a job for everyone who is job-seeking).

Why are workers structurally unemployed? Minimal wage law makes market wage level higher than the equilibrium level for the least skilled or experienced workers Unions negotiate above-equilibrium wages for union members (20%) Efficiency wage: Firms voluntarily pay above-equilibrium wages to boost worker productivity. - Attract high quality applicants - Induce workers to execute more effort - Reduce worker turnover

What is productivity? The average quantity of g&s produced per unit of (labor) input of production. Why productivity is the determinant of living standard?
Y Y Labor Population Labor Population

Production Funtion Y = AF(L, K, H, N) Y real GDP =quantity of output produced A level of Technological knowledge, societys understanding of the best way to produce g&s; Technological progress does not only mean a faster computer; Henry Ford and the assembly line. L Quantity of labor K the stock of equipment and structures used to produce g&s. [physical] Capital K. H Human capital, the knowledge and skills workers acquire through education, training, and experience N Natural resources, the input into production that nature provides Constant return to scale constant return to scale: : Changing all inputs by the same percentage causes output to change by that percentage. xY = AF(xL, xK, xH, xN) then we let x=1/L,

Y K H N AF (1, , , ) L L L L

Since 1 is a constant in function F, we can rewrite the function into Y/L output per worker

Y K H N AF ( , , ) L L L L

K/L capital per worker; productivity is higher when the average worker has more capital an increase in K/L causes an increase in Y/L. *diminishing return to capital, growth from investment eventually slows down; catch-up effect H/L average workers human capital; the average workers human capital; productivity is higher when the average worker has more human capital N/L natural resources per worker; Other things equal, more N allows a country to produce more Y in per-worker terms, an increase in N/L causes an increase in Y/L.

Policy to boost economic growth Patent laws or grants, to increase A; Research and Development to develop more advanced technology Saving, investment and capital stock K. Promotion of human capital - Provide better education system and encourage people to take a good advantage of it - Provide better health and nutrition program for people

Other things affect economic growth Population growth - Stretching natural resources - Diluting the capital stock; Bigger population = higher L = lower K/L; - Promoting tech. progress; more scientists, inventors, engineers; more frequent discoveries; faster tech. progress & economic growth