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Macroeconomics Unit 2: Economic indicators and the business cycle

GDP, unemployment and inflation measure the economy's health, and the business cycle describes its ups and downs.

Covers: Circular flow, GDP and its components, real vs. nominal GDP, unemployment, price indices and inflation, costs of inflation, the business cycle

Study guide

The circular flow model shows households selling resources to firms in factor markets and buying goods and services from firms in product markets, with government and the foreign sector added in fuller versions. Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a year. Using the expenditure approach, GDP = C + I + G + Xn: consumption, investment (business spending on capital, new housing and inventories), government purchases and net exports. GDP excludes intermediate goods, used goods, financial transactions and transfer payments. Nominal GDP uses current prices; real GDP adjusts for inflation, and the GDP deflator = (nominal ÷ real) × 100. Real GDP per capita is a better measure of living standards.

Unemployment counts people in the labor force who are actively looking for work. The unemployment rate = unemployed ÷ labor force × 100, and the labor force participation rate compares the labor force to the adult population. Discouraged workers aren't counted. Types of unemployment are frictional (between jobs), structural (skills mismatch) and cyclical (from recessions). The natural rate of unemployment is frictional plus structural, reached at full employment.

Inflation is a rise in the general price level. The consumer price index (CPI) measures the cost of a fixed market basket: CPI = (cost this year ÷ cost in base year) × 100, and the inflation rate is the percent change in the CPI. The CPI may overstate inflation because of substitution and quality changes. Inflation hurts lenders and people on fixed incomes and helps borrowers when it's unexpected, and real values adjust nominal values for prices. Deflation is falling prices. The business cycle moves through expansion, peak, recession (contraction) and trough, around a long-run growth trend.

Real GDP values each year's output at the prices of a chosen base year: multiply current quantities by base-year prices and add them up. In the base year, real and nominal GDP are equal because the current and base prices are the same, so the GDP deflator is 100. The official rate doesn't count discouraged workers, and it treats part-time workers who want full-time jobs, or workers in jobs below their skill level, as employed. Both cause the official rate to understate labor-market weakness.

A real value is a nominal value adjusted for the price level. If prices rise faster than nominal wages, the real wage falls. The real interest rate is approximately the nominal rate minus inflation.

Key ideas

• GDP = C + I + G + Xn measures total output.
• Real GDP adjusts for inflation; nominal GDP doesn't.
• The natural rate of unemployment includes frictional and structural unemployment.
• The CPI measures inflation using a fixed basket of goods.
• Unexpected inflation helps borrowers and hurts lenders.

Formulas and rules

Common mistakes

• Counting used goods or stock purchases in GDP.
• Thinking discouraged workers are counted as unemployed.

Words to know

Circular flow model

Shows how money, goods and resources move between households and firms.

Gross domestic product (GDP)

Market value of all final goods and services produced in a country in a year.

Consumption (C)

Household spending on goods and services.

Investment (I)

Business spending on capital, new housing and inventories.

Government purchases (G)

Government spending on goods and services.

Net exports (Xn)

Exports minus imports.

Intermediate good

A good used to make another good; not counted separately in GDP.

Nominal GDP

GDP measured in current prices.

Real GDP

GDP adjusted for inflation.

GDP deflator

A price index: nominal GDP ÷ real GDP × 100.

Labor force

People who are employed or actively looking for work.

Unemployment rate

Unemployed ÷ labor force × 100.

Discouraged worker

Someone who stopped looking for work; not counted in the labor force.

Frictional unemployment

Between jobs or newly entering the workforce.

Structural unemployment

A mismatch between workers' skills and available jobs.

Cyclical unemployment

Unemployment caused by recessions.

Natural rate of unemployment

Frictional + structural unemployment.

Consumer price index (CPI)

Measures the cost of a fixed basket of consumer goods.

Inflation

A rise in the general price level.

Deflation

A fall in the general price level.

Business cycle

Expansion, peak, recession and trough.

Sample practice questions

33 more questions like these, from level 1 to 5, are in the practice set.