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circular flow diagram

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illustrates GDP as spending, revenue, factor payments, and income.

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Factors of production

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inputs like labor, land, capital, and natural resources.

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Factor Payments

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payments to the factors of production (ex: wages and rent)

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households

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- own the factors of production, sell/rent them to firms for income. - buy and consume goods and services.

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firms

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- buy/have factors of production, use them to produce goods and services. - sell goods and services.

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GDP

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*total spending (gross domestic product) - the market value of all final goods and services produced within a country in a given period of time.

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What does the circular flow diagram omit?

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the govt. - collects taxes, buys g&s the financial system - matches savers' supply of funds with borrowers' demand for loans. the foreign sector - trades g&s, financial assets and currencies with the country's residents.

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Goods are values at their market price so... (gdp)

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- all goods measure in the same unit. ex: $ dollars in US - things that don't have a market value are excluded.

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GDP only includes...

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Final goods - they already embody the value of the intermediate goods used in their production. *GDP includes Tangible goods

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Intermediate goods

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used as components or ingredients in the production of other goods.

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Tangible

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mountain bikes

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Intangible

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concerts, cell phone services, dry cleaning.

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Does GDP include goods produced in the past?

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No, only good produced currently.

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GDP measure the value of production that occurs within a countries boarders, whether done by its own citizens or by foreigners located there.

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True

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***4 components of gdp

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1. consumption C (households) 2. investment I (firms) 3. government purchases G (government) 4. net exports NX (foreign/exports/imports) Y=C+I+G+NX

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New homes are considered... (gdp)

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Investments/firms

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What drives consumption?

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households

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What drives investment?

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firms

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Investment

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Total spending on goods that will be used in the future to produce more goods. - capital equipment (machines and tools) - structures (factories, office buildings) - inventories (goods produced but not yet sold)

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Govt. Purchases

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Spending on g&s purchased by govt. at the federal, state, and local levels. *EXCEPT transfer payments - social security or unemployment insurance benefits

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Nominal GDP

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- values output using current prices - reflects both prices and quantities *NOT corrected for inflation

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Real GDP

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- values output using the prices of a base year - the change in real gdp is the amount that gdp would change if prices were constant. *corrected for inflation

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GDP does NOT value...

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- the quality of environment - leisure time - non-market activity, such as child care provided at home. - an equitable distribution of income.

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The quality of life is positively correlated with GDP. (large=better)

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True

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More property rights means what?

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People are going to be more willing to invest because there is a greater chance that they will get their returns for their investment.

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CPI index

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Measures the typical consumers cost of living. The basis of cost of living adjustments (colas) in many contacts and in social security.

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Calculation of CPI

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1. FIX THE BASKET The bureau of labor statistics surveys consumers to determine what's in the typical consumer's "shopping basket". 2. FIND THE PRICES The BLS collects data on the prices of all the goods in the basket. 3. COMPUTE THE BASKETS COST Use the prices to compute the total cost of the basket.

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***CPI formula

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Choose the base year and compute the index: cpi in any year *100 x cost of basket in current year / cost of basket in base year Compute the inflation rate: percent change in the cpi from the proceeding period *inflation rate= CPI this year - CPI last year / CPI last year x 100

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What's included in CPI?

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- housing - transportation - food and bev. - medical care - recreation - edu. and communication - apparel

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Problems with CPI

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CPI can miss the substations of goods because it uses a fixed basket of goods. (some prices rise fast than others) - it overstates the increases in the cost of living. The introduction of new goods. - increases variety, allows consumers to find products that more closely meet their needs. - in effect, dollars become more valuable (there are more options) The CPI misses the effect because it uses a fixed basket of goods.

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CPI overstates inflation by 0.5 a year.

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True - this is important because social security payments and many contracts goals tied to them.

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imported consumer goods

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included in CPI and not in GDP deflator

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capital goods

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excluded from CPI and included in GDP deflator (if produced domestically)

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the basket

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- CPI uses fixed basket - GDP deflator uses basket of currently produced goods and services. - this matters if different prices are changing by different amounts.

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Starbucks raises the price of frappuccinos..

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CPI and GDP deflator both rise

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Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory..

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GDP deflator rises, CPI does not.

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Armani raids the price of the Italian jeans it sells in the U.S..

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CPI rises, the GDP deflator does not.

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Real interest rates

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Corrected for inflation; the rate of growth in the purchasing power of a deposit or debt. ***= nominal rate - inflation rate

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Nominal interest rates

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The interest rate is not corrected for inflation; the rate of growth in the $ value of a deposit or debt.

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Productivity

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*A country's standard of living depends on its ability to produce g&s. This ability depends on productivity; the average quantity of g&s produced per unit of labor input. Y = real gdp = quantity output produced L = quantity of labor Productivity = Y/L (output per worker)

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When a nation's workers are very productive,

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real gdp is large and incomes are high

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When productivity grows rapidly,

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so do standards of living

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physical capital per worker

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The stock of equipment and structures used to produce g&s is called (physical) capital, denoted K. K/L = capital per worker

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Productivity is higher when..

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the average worker has more capital (machines, equipment, ect.)

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An increase in K/L...

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will cause an increase in Y/L

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Human Capital (H)

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the knowledge and skills workers acquire through education, training, and experience. H/L = the average worker's capital

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Productivity is higher when..

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the average worker has more human capital (edu., skills, etc)

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An increase in H/L causes..

answer

an increase in Y/L

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Natural Resources (N)

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the inputs into production that nature provides ex: (land, mineral deposits) *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.

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Some countries are rich because they have abundant natural resources.

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True ex: Saudi Arabi has lots of oil

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Some don't need N to be rich.

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True ex: Japan imports everything it needs

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Technological Knowledge

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Societies understanding of the best ways to produce g&s. - technological progress does not only mean a faster computer, a higher-def TV, or a smaller cell phone. *It means, any advance in knowledge that boosts productivity (allows society to get more output from its resources). ex: Henry Ford and the assembly line.

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The production function

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A graph/equation showing the relation between outputs and inputs. Y = AF (L,K,H,N) F = function that shows how inputs are combined to produce output. A = level of technology - A multiplies F; so improvements in technology increases A. *allow more output (Y) to be produced from any given combination of inputs.

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Production Function has the property of constant returns to scale:

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Changing all inputs by the same percentage causes output to change by that percentage. ex: doubling all inputs (mult. each by 2) causes output to double as well. 2Y = AF (2L,2K,2H,2N)

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Increasing all inputs by 10% (multi. each by 1.1) causes output to increase by 10%.

answer

True

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multiply by 1/L

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Y/L = 1, K/L, H/L, N/L Shows that productivity (outputs per worker) depends on: - level of tech (A( - physical capital per worker - human capital per worker - natural resources per worker

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Saving and Investment

answer

We can boost productivity by increasing K, which requires investment.

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Since resources are scarce, producing more capital requires producing..

answer

fewer consumption goods.

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Reducing consumption =

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increasing saving - this extra saving funds the production of investment goods. Hence, a tradeoff between current and future consumption.

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Diminishing returns and the catch-up effect

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The govt. can implement policies that raise saving and investment. Then, K will rise, causing productivity and living standards to rise. *But this faster growth is temporary due to diminishing returns to capital: as K rises the extra output from an additional unit of K falls.

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If workers have little K,

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giving them more increases in productivity.

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If workers already have a lot of K,

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their productivity increases a little bit.

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Investment from abroad

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To raise K/L and hence productivity, wages, and living standards, the govt. can also encourage: Foreign direct investment: a capital investment (factory) that is owned and operated by a foreign entity. foreign portfolio investment: a capital investments financed w/ foreign $ but operated by domestic residents. *some of the returns from these investments flow back to foreign countries that supplied the funds. Helpful in poorer countries because they cannot generate enough funds to invest in themselves.

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Education

answer

govt. can increase productivity by promoting edu. (investment in human capital/H) ex: public schools or loans for college)

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Effects of education on productivity

answer

each year of schooling increases wage by 10%

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Property rights and Political Stability

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*Markets are usually a good way to organize economic activity. - the price system allocates resources to their most efficient uses. This requires, respect for property rights, the ability of people to exercise authority over the resources they own.

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In many countries the justice system does NOT work very well..

answer

- contracts aren't always enforced - fraud, corruption often go unpunished - in some, firms must bribe govt. officials for permits

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Public Instability

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Creates uncertainty over whether property rights will be protected in the future.

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When people fear their capital may be stolen by criminals or confiscated by a corrupt govt.

answer

There is less investment from abroad and economy functions less effectively. *result: lower living standards

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Economic stability, efficiency, and healthy growth require...

answer

law enforcement, effective courts, a stable constitution, and honest govt. officials.

macroeconomics chapter 10,11,12,13 – Flashcards

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