Unemployment

Unemployment is a macroeconomic phenomenon that directly affects people. When a member of a family is unemployed, the family feels it in lost income and a reduced standard of living. There is little in the realm of macroeconomics more feared by the average consumer than unemployment. Understanding what unemployment really is and how it works is important both for the economist and for the consumer, as it is often discussed.

The Costs of Unemployment 

Because most people rely on their income to maintain their standard of living, the loss of a job will often directly threaten to reduce that standard of living. This creates a number of emotional problems for the worker and the family. In terms of society, unemployment is harmful as well. Unemployed workers represent wasted production capability. This means that the economy is putting out less goods and services than it could be producing. It also means that there is less money being spent by consumers, which has the potential to lead to more unemployment, beginning a cycle. However, in general, while unemployment is harmful for individuals, there are some circumstances in which unemployment is both natural and beneficial for the economy as a whole.

Unexpected Inflation

If the rate of inflation from one year to the next differs from what economists and consumers expected, then unexpected inflation is said to have occurred. Unlike expected inflation, unexpected inflation can have serious consequences for consumers ranging well beyond inconvenience. The major effect of unexpected inflation is a redistribution of wealth either from lenders to borrowers, or vice versa. In order to understand how this works, it is important to remember that inflation reduces the real value of a dollar (the dollar will not buy as much as it once did). Thus, if a bank lends money to a consumer to purchase a home, and unexpected inflation is high, the money paid back to the bank by the consumer will have less purchasing power or real value than it did when it was originally borrowed because of the effects of inflation. If a bank lends money and inflation turns out to be lower than expected, then the shoe is on the other foot and the lender gains wealth, since the money paid back at interest is of more value than the borrower expected. In volatile circumstances, when inflation seems to be moving unexpectedly, neither lenders nor borrowers will want to risk the chance of hurting themselves financially, and this hesitancy to enter the market will hurt the entire economy.

The Effects of Inflation

There are two general categories of effects due to inflation. The first group of effects are caused by expected inflation. That is, these effects are a result of the inflation that economists and consumers plan on year to year. The second group of effects are caused by unexpected inflation. These effects are a result of inflation above and beyond what was expected by economics and consumers. In general, the effects of unexpected inflation are much more harmful than the effects of expected inflation.

Expected Inflation

The major effects of expected inflation are simply inconveniences. If inflation is expected, people are less likely to hold cash since, over time, this money looses value due to inflation. Instead, people will put cash into interest earning investments to combat the effects of inflation. This can be a bit of a nuisance, since people need money to take care of business. Thus, if consumers expect inflation, they are likely to hold less cash and travel more often to the bank to withdrawal a smaller amount of money. This phenomenon of changed consumer patterns is called the shoeleather cost of inflation, referring to the fact that more frequent trips to the bank will lessen the time it takes to wear out a pair of shoes. The second major inconvenient effect of expected inflation strikes companies that print the prices of their goods and services. If expected inflation makes the real value of the dollar fall over time, firms need to increase their nominal prices to combat the effects of inflation. Unfortunately, this is not always easy, as changing menus, catalogues, and price sheets takes both time and money. The problems of this sort are called the menu costs of inflation. Thus, the two major effects of expected inflation are merely inconveniences in the form of shoeleather costs and menu costs.

CPI vs. GDP Measures of Inflation

The inflation rate calculated from the CPI and GDP deflator are usually fairly similar in value. In theory, there is a significant difference between the abilities of each index to capture consumer's consumption choices when a change in price occurs. The CPI uses a fixed basked of goods from some base year, meaning that the quantities of goods and services consumed remains the same from year to year in the eyes of the CPI, whereas the price of goods and services changes. This type of index, where the basket of goods is fixed, is called a Laspeyres index.
The GDP deflator, on the other hand, uses a flexible basket of goods that depends on the quantities of goods and services produced within a given year, while the prices of the goods are fixed. This type of index, where the basket of goods is flexible, is called a Paasche index. While both of these indices work for the calculation of inflation, neither is perfect. The following example will help to illustrate why.
Let's say that a major disease spreads throughout the country and kills all of the cows. By dramatically limiting supply, this happenstance would cause the price of beef products to jump substantially. As a result, people would stop buying beef and purchase more chicken instead. However, given this situation, the GDP deflator would not reflect the increase in the price of beef products, because if very little beef was consumed, the flexible basket of goods used in the computation would simply change to not include beef. The CPI, on the other hand, would show a huge increase in cost of living because the quantities of beef and milk products consumed would not change even though the prices shot way up.
When the prices of goods change, consumers have the ability to substitute lower priced goods for more expensive ones. They also have the ability to continue buying the more expensive ones if they like them enough more than the less expensive ones. The GDP deflator takes into account an infinite amount of substitution. That is, because the index is a Paasche index where the basket of goods is flexible, the index reflects consumers substituting less expensive goods for more expensive ones. The CPI, on the other hand, takes into account zero substitution. That is, because the index is a Laspeyres index where the basket of goods is fixed, the index reflects consumers buying the more expensive goods regardless of the changes in prices. Thus, the
GDP deflator method underestimates the impact of a price change upon the consumer because it functions as if the consumer always substitutes a less expensive item for the more expensive one. On the other hand, the CPI method overestimates the impact of a price change upon the consumer because it functions as if the consumer never substitutes. While neither the CPI nor the GDP deflator fully captures consumers' actions resulting from a price change, each captures a unique portion of the change.

Calculating Inflation

Inflation is the change in the price level from one year to the next. The change in inflation can be calculated by using whatever price index is most applicable to the given situation. The two most common price indices used in calculating inflation are CPI and the GDP deflator. Know, though, that the inflation rates derived from different price indices will themselves be different.

Calculating Inflation Using CPI

The price level most commonly used in the United States is the CPI, or consumer price index. Thus, the simplest and most common method of calculating inflation is to calculate the percentage change in the CPI from one year to the next. The CPI is calculated using a fixed basket of goods and services; the percentage change in the CPI therefore tells how much more or less expensive the fixed basket of goods and services in the CPI is from one year to the next. The percentage change in the CPI is also known as the percentage change in the price level or as the inflation rate.
Fortunately, once the CPI has been calculated, the percentage change in the price level is very easy to find. Let us look at the following example of "Country B."

Figure %: Goods and Services Consumed in Country B 

Over time the CPI changes only as the prices associated with the items in the fixed basket of goods change. In the example from Country B, the CPI increased from 100 to 141 to 182 from time period 1 to time period 2 to time period 3. The percent change in the price level from the base year to the comparison year is calculated by subtracting 100 from the CPI. In this example, the percent change in the price level from time period 1 to time period 2 is 141 - 100 = 41%. The percent change in the price level from time period 1 to time period 3 is 182 - 100 = 82%. In this way, changes in the cost of living can be calculated across time. These changes are described by the inflation rate. That is, the rate of inflation from period 1 to period 2 was 41% and the rate of inflation from period 1 to period 3 was 82%. Notice that the inflation rate can only be calculated using this method when the same base year is used for all of the CPI's involved.
While it is simple to calculate the inflation rate between the base year and a comparison year, it is a bit more difficult to calculate the rate of inflation between two comparison years. To make this calculation, first check that both comparison years use the same base year. This is necessary to ensure that the same fixed basket of goods and services is used. Next, to calculate the percentage change in the level of the CPI, subtract the CPI for the later year from the CPI for the earlier year and then divide by the CPI for the earlier year.
In the example from Country B, the CPI for period 2 was 141 and the CPI for period 3 was 182. Since the base year for these CPI calculations was period 1, we must use the method of calculating inflation that takes into account the presence of two comparison years. We need to subtract the CPI for the later year from the CPI for the earlier year and then divide by the CPI for the earlier year. That gives (182 - 141) / 141 = 0.29 or 29%. Thus, the rate of inflation from period 2 to period 3 was 29%. Notice that this method works for calculating the rate of inflation between a base year and a comparison year as well. For instance, the CPI for period 1 was 100 and the CPI for period 2 was 141. Using the formula above gives (141 - 100) / 100 = 0.41 or 41%.

Calculating Inflation Using the GDP Deflator

The other major price index used to determine the price level is the GDP deflator, a price index that shows how much of the change in the GDP from a base year is reliant on changes in the price level.

For example, let's calculate, using the table above, the GDP deflator for Country B in period 3 using period 1 as the base year. In order to find the GDP deflator, we first must determine both nominal GDP and real GDP in period 3. Nominal GDP in period 3 is (10 X $2) + (9 X $6) = $74 and real GDP in period 3 using period 1 as the base year is (10 X $1) + (9 X $6) = $64. The ratio of nominal GDP to real GDP is ($74 / $64 ) - 1 = 16%. This means that the price level rose 16% from period 1, the base year, to period 3, the comparison year. Thus, the inflation rate from period 1 to period 3 was 16%. Notice that it is important to use the earlier year that you want to compare as the base year in the calculation of real GDP. 

Inflation

Things cost more today than they used to. In the 1920's, a loaf of bread cost about a nickel. Today it costs more than $1.50. In general, over the past 300 years in the United States the overall level of prices has risen from year to year. This phenomenon of rising prices is called inflation.

While small changes in the price level from year to year may not be that noticeable, over time, these small changes add up, leading to big effects. Over the past 70 years, the average rate of inflation in the United States from year to year has been a bit under 5 percent. This small year-to-year inflation level has led to a 30-fold increase in the overall price during that same period.

Inflation plays an important role in the macroeconomic economy by changing the value of a dollar across time. This section on inflation will deal with three
important aspects of inflation. First, it will cover how to calculate inflation. Second, it will cover the effects of inflation calculations using the CPI and GDP measures. Third, it will introduce the effects of inflation.

Problems with the CPI

While the CPI is a convenient way to compute the cost of living and the relative price level across time, because it is based on a fixed basket of goods, it does not provide a completely accurate estimate of the cost of living. Three problems with the CPI deserve mention: the substitution bias, the introduction of new items, and quality changes. Let's examine each of these in detail.

Substitution Bias 

The first problem with the CPI is the substitution bias. As the prices of goods and services change from one year to the next, they do not all change by the same amount. The number of specific items that consumers purchase changes depending upon the relative prices of items in the fixed basket. But since the basket is fixed, the CPI does not reflect consumer's preference for items that increase in price little from one year to the next. For example, if the price of backrubs in Country B jumped to $20 in time period 4 while the cost of bananas remained fixed at $3, consumer would likely purchase more bananas and fewer backrubs. This intuitive phenomenon of consumers substituting purchase of low priced items for higher priced items is not accounted for by the CPI. 

Introduction of New Items

The second problem with the CPI is the introduction of new items. As time goes on, new items enter into the basket of goods and services purchased by the typical consumer. For example, if in time period 4 consumers in Country B began to purchase books, this would need to be included in an accurate estimate of the cost of living. But since the CPI uses only a fixed basket of goods, the introduction of a new product cannot be reflected. Instead, the new items, books, are left out of the calculation in order to keep time period 4 comparable with the earlier time periods.

Quality Changes

The third problem with the CPI is that changes in the quality of goods and services are not well handled. When an item in the fixed basket of goods used to compute the CPI increases or decreases in quality, the value and desirability of the item changes. For example, if backrubs in time period 4 suddenly became much more satisfying than in earlier time periods, but the price of backrubs did not change, then the cost of living would remain the same while the standard of living would increase. This change would not be reflected in the CPI from one year to the next. While the Bureau of Labor Statistics attempts to correct this problem by adjusting the price of goods in the calculations, in reality this remains a major problem for the CPI.

Consumer Price Index (CPI)

The consumer price index or CPI is a more direct measure than per capita GDP of the standard of living in a country. It is based on the overall cost of a fixed basket of goods and services bought by a typical consumer, relative to price of the same basket in some base year. By including a broad range of thousands of goods and services with the fixed basket, the CPI can obtain an accurate estimate of the cost of living. It is important to remember that the CPI is not a dollar value like GDP, but instead an index number or a percentage change from the base year.

GDP Per Capita

GDP is the single most useful number when describing the size and growth of a country's economy. An important thing to consider, though, is how GDP is connected with standard of living. After all, to the citizens of a country, the economy itself is less important than the standard of living that it provides.
GDP per capita, the GDP divided by the size of the population, gives the amount of GDP that each individual gets, on average, and thereby provides an excellent measure of standard of living within an economy. Because GDP is equal to national income, the value of GDP per capita is therefore the income of a representative individual. This number is connected directly to standard of living. In general, the higher GDP per capita in a country, the higher the standard of living.
GDP per capita is a more useful measure than GDP for determining standard of living because of differences in population across countries. If a country has a large GDP and a very large population, each person in the country may have a low income and thus may live in poor conditions. On the other hand, a country may have a moderate GDP but a very small population and thus a high individual income. Using the GDP per capita measure to compare standard of living across countries avoids the problem of division of GDP among the inhabitants of a country.

GDP deflator

When comparing GDP between years, nominal GDP and real GDP capture different elements of the change. Nominal GDP captures both changes in quantity and changes in prices. Real GDP, on the other hand, captures only changes in quantity and is insensitive to the price level. Because of this difference, after computing nominal GDP and real GDP a third useful statistic can be computed. The GDP deflator is the ratio of nominal GDP to real GDP for a given year minus 1. In effect, the GDP deflator illustrates how much of the change in the GDP from a base year is reliant on changes in the price level.
For example, let's calculate, using , the GDP deflator for Country B in year 3, using year 1 as the base year. In order to find the GDP deflator, we first must determine both nominal GDP and real GDP in year 3.

Nominal GDP in year 3 = (10 X $2) + (9 X $6) = $74
Real GDP in year 3 (with year 1 as base year) = (10 X $1) + (9 X $6) = $64
The ratio of nominal GDP to real GDP is ( $74 / $64 ) - 1 = 16%.

This means that the price level rose 16% from year 1, the base year, to year 3, the comparison year. Rearranging the terms in the equation for the GDP deflator allows for the calculation of nominal GDP by multiplying real GDP and the GDP deflator. This equation demonstrates the unique information shown by each of these measures of output. Real GDP captures changes in quantities. The GDP deflator captures changes in the price level. Nominal GDP captures both changes in prices and changes in quantities. By using nominal GDP, real
GDP, and the GDP deflator you can look at a change in GDP and break it down into its component change in price level and change in quantities produced.

Growth Rate of GDP

GDP is an excellent index with which to compare the economy at two points in time. That comparison can then be used formulate the growth rate of total output within a nation.
In order to calculate the GDP growth rate, subtract 1 from the value received by dividing the GDP for the first year by the GDP for the second year.

GDP growth rate = [(GDP₁)/(GDP₂] - 1

For example, using , in year 1 Country B produced 5 bananas worth $1 each and 5 backrubs worth $6 each. In year 2 Country B produced 10 bananas worth $1 each and 7 backrubs worth $6 each. In this case the GDP growth rate from year 1 to year 2 would be:

[(10 X $1) + (7 X $6)] / [(5 X $1) + (5 X $6)] - 1 = 49%

There is an obvious problem with this method of computing growth in total output: both increases in the price of goods produced and increases in the quantity of goods produced lead to increases in GDP. From the GDP growth rate it is therefore difficult to determine if it is the amount of output that is changing or if it is the price of output undergoing change.
This limitation means that an increase in GDP does not necessarily imply
that an economy is growing. If, for example, Country B produced in one year 5 bananas each worth $1 and 5 backrubs each worth $6, then the GDP would be $35. If in the next year the price of bananas jumps to $2 and the quantities produced remain the same, then the GDP of Country B would be $40. While the market value of the goods and services produced by Country B increased, the amount of goods and services produced did not. This problem can make comparison of GDP from one year to the next difficult as changes in GDP are not necessarily due to economic growth.

GDP vs. GNP

GDP is just one way of measuring the total output of an economy. Gross National Product, or GNP, is another method. GDP, as said earlier, is the sum value of all goods and services produced within a country. GNP narrows this definition a bit: it is the sum value of all goods and services produced by permanent residents of a country regardless of their location. The important distinction between GDP and GNP rests on differences in counting production by foreigners in a country and by nationals outside of a country. For the GDP of a particular country, production by foreigners within that country is counted and production by nationals outside of that country is not counted. For GNP, production by foreigners within a particular country is not counted and production by nationals outside of that country is counted. Thus, while GDP is the value of goods and services produced within a country, GNP is the value of goods and services produced by citizens of a country.
For example, in Country B, represented in , bananas are produced by nationals and backrubs are produced by foreigners. Using figure 1, GDP for Country B in year 1 is (5 X $1) + (5 X $6) = $35. GNP for country B is (5 X $1) = $5, since the $30 from backrubs is added to the GNP of the foreigners' country of origin.
The distinction between GDP and GNP is theoretically important, but not often practically consequential. Since the majority of production within a country is by nationals within that country, GDP and GNP are usually very close together. In general, macroeconomists rely on GDP as the measure of a country's total output.

Measuring The GDP

We know that in an economy, GDP is the monetary value of all final goods and services produced. For example, let's say Country B only produces bananas and backrubs.

Figure %: Goods and Services Produced in Country B

In year 1 they produce 5 bananas that are worth $1 each and 5 backrubs that are worth $6 each. The GDP for the country in this year equals (quantity of bananas X price of bananas) + (quantity of backrubs X price of backrubs) or (5 X $1) + (5 X $6) = $35. As more goods and services are produced, the equation lengthens. In general, GDP = (quantity of A X price of A) + (quantity of B X price of B) + (quantity of whatever X price of whatever) for every good and service produced within the country. In the real world, the market values of many goods and services must be calculated to determine GDP. While the total output of GDP is important, the breakdown of this output into the large structures of the economy can often be just as important. In general, macroeconomists use a standard set of categories to breakdown an economy into its major constituent parts; in these instances, GDP is the sum of consumer spending, investment, government purchases, and net exports, as represented by the equation:

Y = C + I + G + NX

Because in this equation Y captures every segment of the national economy, Y represents both GDP and the national income. This because when money changes hands, it is expenditure for one party and income for the other, and Y, capturing all these values, thus represents the net of the entire economy. Let's briefly examine each of the components of GDP.
• Consumer spending, C, is the sum of expenditures by households
• on durable goods, nondurable goods, and services. Examples include clothing, food, and health care.
• Investment, I, is the sum of expenditures on capital equipment, inventories, and structures. Examples include machinery, unsold products, and housing.
• Government spending, G, is the sum of expenditures by all government bodies on goods and services. Examples include naval ships and salaries to government employees.
• Net exports, NX, equals the difference between spending on domestic goods by foreigners and spending on foreign goods by domestic residents. In other words, net exports describes the difference between exports and imports.

Gross Domestic Product (GDP)

The Gross Domestic Product measures the value of economic activity within a country. Strictly defined, GDP is the sum of the market values, or prices, of all final goods and services produced in an economy during a period of time. There are, however, three important distinctions within this seemingly simple definition:

1. GDP is a number that expresses the worth of the output of a country in local currency.
2. GDP tries to capture all final goods and services as long as they are produced within the country, thereby assuring that the final monetary value of everything that is created in a country is represented in the GDP.
3. GDP is calculated for a specific period of time, usually a year or a quarter of a year.

Taken together, these three aspects of GNP calculation provide a standard basis for the comparison of GDP across both time and distinct national economies.

Formulas

 

Gross Domestic Product

GDP = [(quantity of A X price of A) + (quantity of B X price of B) + ... + (quantity of N X price of N)] for every good and service produced within the country GDP = (national income) = Y = (C + I + G + NX)

 

GDP Growth Rate

GDP growth rate = [(GDP for year N) / (GDP for year N-1)] - 1

 

GDP Deflator

GDP deflator = [(nominal GDP) / (real GDP)] - 1

 

GDP Per Capita

GDP per capita = (GDP) / (population)

Terms Commonly Used In Economics

Base year  -  The year from which constant prices or quantities are taken in calculations of such indices as real GDP and CPI.

Bureau of Labor Statistics  -  The government organization responsible for regularly gathering data about the economic status of the population.

Consumer price index (CPI)  -  A cost of living index that measures the total cost of goods and services purchased by a typical consumer within a country.

Fixed basket  -  A set group of goods and services whose quantities do not change over time. This is used, for instance, in the calculation of the CPI.

Gross domestic product (GDP)  -  The sum of the market values of all final goods and services produced within a particular country during a period of time.

Gross domestic product deflator (GDP deflator)  -  The ratio of nominal GDP to real GDP for a given year minus 1. The GDP deflator shows how much of the change in the GDP from a base year is reliant on changes in the price level.

Gross domestic product per capita (GDP per capita)  -  GDP divided by the number of people in the population. This measure describes what portion of the GDP an average individual gets.

Gross national product (GNP)  -  An alternative measure of economic activity to GDP. GNP is the sum of the market values of all goods and services produced by the citizens of a country regardless of their physical location.

Nominal gross domestic product (nominal GDP)  -  The sum value of goods and services produced in a country and valued at current prices.

Real gross domestic product (real GDP)  -  The sum value of goods and services produced in a country and valued at constant prices, calibrated from some base year. Real GDP frees year-to-year comparisons of output from the effects of changes in the price level.

Measuring the Economy

Introduction and Summary 

Macro economists use a variety of different observational means in their effort to study and explain how the economy as a whole functions and changes over time. One such method relies on personal experience. It is relatively simple to notice that your company is producing more than it has in the past or that a paycheck does not go as far as it used to. Yet while personal observations do provide information about the economy, that information can often be localized rather than universal, and may not accurately reflect the state of the economy as a whole.

In order to move beyond the limitations inherent in personal experiences, macroeconomists begin by systematically measuring the basic elements of the economy in order to derive standard and comprehensiv
statistics. This data provides information about the entire economy rather than simply about a single household or firm. Two of the most fundamental elements macroeconomists study are the total output of an economy (GDP) and the cost of living within an economy (CPI). Gross domestic product, or GDP, is an indicator of economic performance that measures the market value of goods and services produced within a country. This measurement is of great importance to consumers since it also equals the total income within an economy. The consumer price index, or CPI, is a cost of living indicator; it measures the total cost of goods and services purchased by a typical consumer within a country. This index allows economists and consumers to see just how much purchasing power a dollar yields, and to compare that power between different years and eras. Together, GDP and CPI show how much income exists within an economy and how much this income can purchase.
The concepts of GDP and CPI open the door to a scientific understanding of the functioning of the economy on a large, or macro, level. These are the most basic tools of measurement used by macroeconomists, policy makers, and consumers to understand and describe the economy. In fact, GDP and CPI are published and discussed regularly in the media. Through understanding the concepts of GDP and CPI, the world of macroeconomics begins to unfold.