SECTION 3 Review

Module 10

1. Economists keep track of the flows of money between sectors with the national income and product accounts, or national accounts. Households earn income via the factor markets from wages, interest on bonds, profit accruing to owners of stocks, and rent on land. In addition, they receive government transfers. Disposable income, total household income minus taxes plus government transfers, is allocated to consumer spending (C) in the product markets and private savings. Via the financial markets, private savings and foreign lending are channeled to investment spending (I), government borrowing, and foreign borrowing. Government purchases of goods and services (G) are paid for by tax revenues and government borrowing. Exports (X) generate an inflow of funds into the country from the rest of the world, but imports (IM) lead to an outflow of funds to the rest of the world. Foreigners can also buy stocks and bonds in the U.S. financial markets.

2. Gross domestic product, or GDP, measures the value of all final goods and services produced in the economy. It does not include the value of intermediate goods and services, but it does include inventories and net exports (X − IM). There are three approaches to calculating GDP: the value-added approach of adding up the value added by all producers; the expenditure approach of adding up all spending on domestically produced final goods and services, leading to the equation GDP = C + I + G + X − IM, also known as aggregate spending; and the income approach of adding up all the income paid by domestic firms to factors of production. These three methods are equivalent because in the economy as a whole, total income paid by domestic firms to factors of production must equal total spending on domestically produced final goods and services.

Module 11

3. Real GDP is the value of the final goods and services produced, calculated using the prices of a selected base year. Except in the base year, real GDP is not the same as nominal GDP, the value of aggregate output calculated using current prices. Analysis of the growth rate of aggregate output must use real GDP because doing so eliminates any change in the value of aggregate output due solely to price changes. Real GDP per capita is a measure of average aggregate output per person but is not in itself an appropriate policy goal. U.S. statistics on real GDP are always expressed in “chained dollars,” which means they are calculated with the chain-linking method of averaging the GDP growth rate found using an early base year and the GDP growth rate found using a late base year.

Module 12

4. Employed people currently hold a part-time or full-time job; unemployed people do not hold a job but are actively looking for work. Their sum is equal to the labor force; the labor force participation rate is the percentage of the population age 16 or older that is in the labor force.

5. The unemployment rate, the percentage of the labor force that is unemployed and actively looking for work, can overstate or understate the true level of unemployment. It can overstate because it counts as unemployed those who are continuing to search for a job despite having been offered one (that is, workers who are frictionally unemployed). It can understate because it ignores frustrated workers, such as discouraged workers, marginally attached workers, and the underemployed. In addition, the unemployment rate varies greatly among different groups in the population; it is typically higher for younger workers and for workers near retirement age than for workers in their prime working years.

6. The unemployment rate is affected by the business cycle. The unemployment rate generally falls when the growth rate of real GDP is above average and generally rises when the growth rate of real GDP is below average.

Module 13

7. Job creation and destruction, as well as voluntary job separations, lead to job search and frictional unemployment. In addition, a variety of factors, such as minimum wages, unions, and efficiency wages, result in a situation in which there is a surplus of labor at the market wage rate, creating structural unemployment. As a result, the natural rate of unemployment, the sum of frictional and structural unemployment, is well above zero, even when jobs are plentiful.

8. 154

   The actual unemployment rate is equal to the natural rate of unemployment, the share of unemployment that is independent of the business cycle, plus cyclical unemployment, the share of unemployment that depends on fluctuations in the business cycle.

9. The natural rate of unemployment changes over time, largely in response to changes in labor force characteristics, labor market institutions, and government policies.

Module 14

10. Inflation does not, as many assume, make everyone poorer by raising the level of prices. That’s because if wages and incomes are adjusted to take into account a rising price level, real wages and real income remain unchanged. However, a high inflation rate imposes overall costs on the economy: shoe-leather costs, menu costs, and unit-of-account costs.

11. Inflation can produce winners and losers within the economy, because long-term contracts are generally written in dollar terms. Loans typically specify a nominal interest rate, which differs from the real interest rate due to inflation. A higher-than-expected inflation rate is good for borrowers and bad for lenders. A lower-than-expected inflation rate is good for lenders and bad for borrowers.

12. Disinflation, the process of bringing the inflation rate down, usually comes at the cost of a higher unemployment rate. So policy makers try to prevent inflation from becoming excessive in the first place.

Module 15

13. To measure the aggregate price level, economists calculate the cost of purchasing a market basket. A price index is the ratio of the current cost of that market basket to the cost in a selected base year, multiplied by 100.

14. The inflation rate is calculated as the annual percentage change in a price index, typically based on the consumer price index, or CPI, the most common measure of the aggregate price level. A similar index for goods and services purchased by firms is the producer price index, or PPI. Finally, economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP times 100.