Welcome to macroeconomics! The web
notes are organized according to the date of the lectures. As you can see
above, the notes (and tests) are divided into four parts--part one is the
material on the first exam, part two is the stuff on the second exam and so on.
They expand the lecture outline and they include the
items. The notes are not a substitute for the lectures, but they will help
if you missed class or if your mind was wandering to things you perceive as more
interesting--which, I guess, could be a number of different things!
ECO 204--Part One Notes
NOTE: I am
not currently teaching this class, so much of the material
for ECO 204 is out of date. I have left the notes on
the web site,
however--at least for now.
Definitions of economics
It's a social science which studies human behavior and
employs a scientific method.
Formal definition: The allocation of
scarce and versatile resources among unlimited wants.
There are four classes
of productive resources: labor, land, capital and entrepreneurship.
(Entrepreneurship is sometimes not listed separately since it can be
considered part of the labor resource.)
not refer to money--it refers to
machines and tools used to produce other goods and services.
Economics may also be defined as the study of
The allocation problem is simple enough--how does an
economy determine its resource
allocation? How many
aspirin and how many
tractors and how many haircuts--and so on.
The production possibilities
designed to show the nature of the basic resource
along with some attendant features and
problems involved in allocating
scarce and versatile resources.
The production possibilities curve
Suppose an economy can
produce various combinations of widgets or gidgets and
that, initially, other
goods and services are not considered. This obviously is a
assumption but, as you saw in
class, a production possibilities curve
made more realistic later on. Following are five combinations
and gidgets that our hypothetical economy can produce per day, given the
quantity and quality
of its resources:
This data can be illustrated by a production possibilities
The curve (and the data)
show the maximum outputs of both goods. Our hypothetical
to produce some combination of widgets and gidgets that is on
curve. Producing a combination which
lies on the curve is called economic
An economy would have difficulty if it was only producing
quantities indicated by
point X. That would involve unemployed
resources. By doing something different,
economies could produce more
widgets and/or gidgets and ending up on the
curve. Point Y, on the other
hand, is unattainable. If the economy grows through
time, the curve
would shift outward and at a later
time point Y could become attainable.
A production possibilities curve may seem
awfully abstract but they can be useful if,
instead of using
about widgets and gidgets, you use defense goods on one axis and
nondefense goods on the other.
Or use manufacturing and services.
Opportunity cost is the cost of the best
If you want to purchase the latest Red Hot
Chili Peppers CD, you will have to forego
less pizza. The cost
of the CD is the pizza you forego.
(This is a very important concept which will come up over and
over throughout the course.)
Production possibilities and opportunity cost
Refer to the table above and suppose the hypothetical
economy is initially producing 9 widgets
and 1 gidget. (How the
economy would have arrived at this decision is explained in subsequent
discussions about how markets work.) Then suppose the economy decides
to produce 7 widgets
and 2 gidgets. What is the opportunity cost of
producing an additional gidget? It's the 2 widgets
they gave up to
secure the additional gidget. Make sure you understand this
Why is the production possibilities curve bowed
The reason is because of the law of
increasing opportunity cost. Go back to the
The economy had to give up 2 widgets to get 1 more widget.
What if the
economy now wants to
produce 3 gidgets. Notice from the table that
the opportunity cost of going from 2 to 3 gidgets is
3 widgets. So the
opportunity cost of additional gidgets gets larger as more gidgets are
If they want 4 gidgets, the opportunity cost of that is 4
widgets. All economies face this phenomenon
of increasing opportunity
The final question is why would there be
increasing opportunity costs--why would
you have to give up
of widgets to obtain an additional gidget? The reason is that to produce
gidgets, resources (land, labor, capital and entrepreneurship) have to be
moved out of widget production
and into gidget production. Resources are
not as good at producing gidgets as they were at producing
the United States resources, over time, have switched from farming to health
are not as good at being physicians as they were at
Four important concepts
Positive and normative economics
deals with scientific cause and effect (e.g. an increase in
will increase prices
other things equal), while normative economics
deals with opinions and value judgments (e.g. the
lower taxes). Normative economics is more important in macroeconomics
than it is
in microeconomics. There are lots of opinions in
This is a Latin phrase which means other
things equal. It is especially important in building theories.
make a statement like an increase in interest rates will lead to higher
household saving--ceteris paribus.
In fact, saving might not
increase if interest rates rise, but that's because other things don't always
equal. We analyze things one a time ceteris
paribus and then learn how to reason about several things
at a time.
Many events have effects quite different from what was
envisioned. A gun buy back program is a classic
the price of the guns is set too low, not many will be turned in. If
it's too high, guns will be
stolen and then turned in to fetch the nice high
price. Either outcome is an unintended effect.
economic events--especially government policy, involve
unintended effects. Learn to think critically so
you can discover
Common economic fallacies
There are two common fallacies involved in
economic reasoning. The first is a cause and effect
fallacy. Just because one event follows another chronologically does not
necessarily mean the first event
caused the second. If, for example,
stock market prices increase and subsequently unemployment in the
falls it is not necessarily true that the stock market caused
unemployment to fall. That has to be
empirically tested to be
The second is the
fallacy of composition,
which means that what is good for one isn't necessarily good
If minimum wages increase, some workers will in fact receive higher wages. But, as we
will see later, some workers will lose their jobs and have zero wages.
It is a fallacy to assume that
everyone is better off because minimum wages
Some facts about the U. S. economy.
Some, but not all, of this section is in
chapter 2 of your text. It is an overview of some of the economic
characteristics of the U. S. and introduces a few macro terms.
How big is it?
The U. S. produces $13,300 trillion (as of October, 2006).
Written out in full, that amounts to
To put that figure in some perspective, that's about 21
percent of total world output. We have a
population of only about 4.6
percent of the world's total population.
The most common measure of output is called gross domestic
product (GDP) and it is the total
dollar value of everything produced per
year. It's the market value in dollars of all final goods and
produced per year. More details on GDP will be explained later.
A good measure of a country's standard of living is GDP
per capita-that is GDP divided by total
population. Currently, GDP per
capita in the US is about $44,365. Your suggested text shows a
with the U.S. having the highest GDP per capita. Not quite. Some
and Luxemburg--have a slightly higher per
In the U.S., GDP has grown about 3.3 percent per year
since 1900 while population has grown
about 1.1 percent per year.
Obviously then per capita GDP has grown about 2.2 percent on average.
In the last several years, however, GDP and GDP per capita have grown at a
significantly higher rate
than the historical average.
Why have we done so well?
Because we have a huge amount of capital equipment and a
very productive labor force. Our labor
force can produce large amounts
of output per year because they have lots of capital, education
Even a simple fork lift goes a long way in making workers
more productive and in ensuring a high
standard of living in the United
States. (For those of you who took ECO 203 last semester--sorry--it's
the same stupid graphic!)
What kind of things do we produce?
Gross domestic product can be broken up into four
components. A brief description of these
components is set forth
below. The four components are studied in greater detail later on.
Consumption: all the stuff (goods and services)
households buy for their own use. This
is the largest component of
GDP--about 70 percent of it.
Investment: the production of capital
goods--machines and tools. Don't confuse this with
the financial use of the term investment, which
refers to the acquisition of stocks and bonds etc.
about 17 percent of GDP--and that's lower than some other advanced
will see later, the investment component also
includes business' unsold inventories
For investment to occur, households must engage in saving--
you a bit, saving means everything spent on stuff other than consumption.
Government: government purchases of goods and
services. This is about 19 percent of GDP,
but this does not include
transfer payments. Transfer payments are payments made to
individuals from other individuals--social security, unemployment
compensation and the like.
Transfer payments are about half of total
Net exports: the value of exports minus the
value of imports. Presently, U.S. net exports
are negative--about 6
percent of GDP. What does that mean? Imports, obviously, are
greater than exports. Is that a problem? Many think so, but it
isn't really. We'll learn more
about that in the last part of the
Changes in the mix of
Another way to categorize what we produce is to use a
listing frequently used by government
economists in analyzing the economy.
There are five such components--agriculture, construction
manufacturing (both consumption and investment goods), government and
If we look at the proportion of total output in each of
these five components in 1900 and at present,
there are some significant
changes. Agriculture, for example, was 37 percent of total output in
now it is only 2 percent. Services grew from 22 percent of the
total in 1900 to about 59 percent at
present. And government (of
course) also expanded rapidly from 10 to 19 percent of the total.
Manufacturing declined from 22 percent of the total to about
14 percent. So when someone says
"Well, we don't manufacture
anything any more," you can point out that they are
For whom is output produced?
Here we deal with how income is distributed--how rich are
the rich and how poor are the poor?
Income distribution is
controversial in any society and we will return to consider this in more
in the latter part of the course. Here we only want to provide
a simple overview of income
The following table shows
income distributed in the United States by quintiles:
Percent of total
lowest 20 %
second lowest 20 %
third lowest 20 %
fourth lowest 20 %
highest 20 %
As the table shows, the poorest 20 percent of households
earn only 4 percent of the nation's
total income. The richest 20
percent earn 50 percent of the income. Some think income
should be more equally distributed; others do not. Often times, poor
greater inequality than we do.
The data on income distribution do
not, however, include transfer payments.
So what are transfer
payments? Often called welfare, a transfer payment
government taxes some households or individuals and then
money to other households or individuals. If that is
account, income is not as unequally distributed as the table
Income distribution is always controversial. Some
think it should be more equally
distributed on grounds that the present
degree of inequality is not equitable.
Some think it should not be any
more equally distributed because those with higher
incomes are more likely
to save and invest and do other things that contribute to high
growth. Economic growth, they argue, benefits everyone. Society
debates the appropriate degree of inequality. Economics can not
solve the puzzle of
the optimum degree of inequality; that's one of
society's important value judgments.
The biggest problem associated with inequality is poverty.
Using the government's
official measure of poverty, about 12.6
percent of the population lives below the
poverty level. Government
has spent tons of money on anti-poverty (transfer payments)
poverty is still slightly higher than it was in 1978 which was the year of
lowest poverty level.
Finally, it should be noted that many other countries
often have greater inequality than does
the United States. Often
times, poor countries have much greater inequality than we do.
The market system
For the next three classes we review the basics of
microeconomics, learning how markets work and learning
about government and the
economy. Macroeconomics has microeconomic foundations and that's why we
to review them here.
Many of you (about two-thirds) have
so you may wonder why we review it here. The
reason is that
micro is not prerequisite for macro. Many
take one or the other of the principles courses, and we
them to be able to choose which one. So, if you've
relax and enjoy the review. Besides, you may
have forgotten some of
One of the basic objectives of microeconomics is to
understand how prices are determined. Prices
determine how resources are
allocated--where on a production possibilities curve society will be.
are determined by demand and supply. Consumers have
demands for various goods and services;
sense those demands and supply goods and services. The
interaction of demand and supply
the price of a good or service.
The demand for an item is defined as a desire plus a
willingness and an ability to pay for it.
How much of something will be
demanded depends on its price, consumers' incomes, the
prices of other items,
population, tastes and preferences and a bunch of other things.
proceed by looking at the relation between quantity demanded and price.
We do this
not because other determinants aren't important, but because price
is critical for understanding
resource allocation. Once we formulate the relation between quantity and price we can
discuss other determinants as well.
We developed the "law" of demand which simply
states that price and quantity demanded
(per some period of time) are
inversely related--ceteris paribus. When
we draw a graph of
a demand function it is negatively sloped. There can
be exceptions to the law of demand--
e.g. certain luxury goods--but we assume
for our purposes that all demand curves are
negatively sloped. The
negative slope is partially explained by the income effect,
which says that a lower price is tantamount to a larger income which, in turn,
suggest that people would be more at a lower price. There is also
a substitution effect,
which says that a lower
price causes people to substitute the good under consideration
goods. Our focus is on a market demand curve, not an individual
are interested in how many units of something will be demanded
at various prices by
everyone in the market--not just one individual.
in demand vs. changes in the amount demanded
This point is sometimes very confusing. An increase in
demand means the whole curve shift to the right--more is demanded at every
price. An increase in
the amount demanded refers to a movement along a demand curve.
The illustration below shows an increase and a decrease in demand.
Suppose the following was a true-false question
on a test: An increase in price will cause a decrease in demand.
The answer is false. It would be true if it said " .
. . a decrease in the quantity demanded."
Earlier I noted that many
things effect the quantity demanded of a good--not just price.
there was an increase in income, another of the things that bears on demand.
In most cases, an increase in income could be shows in the diagram above as an
in demand. With larger incomes, many people would likely
purchase more of this good.
So the diagram above--best called a price
demand curve--can be used to analyze changes
in other demand determinants.
Supply is defined as the number of units of
an item that will be offered at various prices
by all producers (per some
period of time). Supply depends on the cost of producing the
the number of suppliers, on the price of other goods, on expectations of
market conditions--and various other factors. We assume that the
quantity supplied as
a function of price for most goods is positively sloped;
that higher prices will call forth
a greater supply.
The same problem exists in talking about
changes in supply that we saw above in looking
at demand. An increase in
supply means the whole curve shifts to the right; an increase
in the quantity
supplied refers to a movement up a supply curve. Notice that in
of supply we often use the words "up" and "down"
to refer to shifts in the supply schedule.
Other supply determinants can be looked at in terms
of the supply curve which plots
quantity supplied as a function of price.
If wages increase, for example, the supply
curve would shift upward because,
for any given output, the higher wages would
require a higher price.
the terminology here. An increase in wages could
be described as the
supply curve shifting upward; it could be described as the supply
shifting to the left; or it could be described as a decrease in supply.
Equilibrium conditions for a good or service
A market is in equilibrium when the quantity demanded is exactly equal to
supplied. This equality determines both equilibrium price
and equilibrium quantity. Markets
are not always in equilibrium, but market
forces are always propelling the market toward
its equilibrium. In some
cases this adjustment is relatively quick; in other cases it takes
for the equilibrium to be achieved. To complicate this somewhat, a
may be finding its equilibrium only to be interrupted by a change in
demand or supply
which creates different equilibrium outcomes.
It is important to understand
why equilibrium is where demand intersects supply. Look
carefully at the diagram below:
The equilibrium price is Pe and the equilibrium quantity is Qe.
What if price is above
equilibrium at Pa? The quantity
supplied will be OF and the quantity demanded will be
only OC. Hence
there is an excess supply--producers are producing CF more than
buying. Firms would experience rising unsold inventories and would
to reduce price in order to sell them. Hence a price of Pa
not persist for
long--the market would force the price down. If
price was below equilibrium at Pb,
there would be excess demand.
Firms would find themselves with a back log of
unfilled orders and would raise
price to ration the shortage. At the equilibrium there
is neither a
surplus nor a shortage.
Shifts in demand and supply
It is very important for your to become skilled at figuring out
what happens to equilibrium
conditions when demand and/or supply change.
You will do a lot of this as the course proceeds.
A simple example was illustrated in class. We showed an increase in
that means the whole curve shifts to the right from D1
to D2). The result was that both
equilibrium price and
equilibrium quantity increase. An increase in supply resulted in a
decrease in price and an increase in quantity.
sure you can do these simple shifts!)
What happens if there is an increase in both demand and supply? Look
at the following diagram:
In this case we know that equilibrium quantity increases. An increase
in demand, by itself,
will increase quantity. An increase in supply, by
itself, will also increase quantity. But the
effect on price is
indeterminate. The increase in demand would, by itself, increase price;
the increase in supply, by itself, would reduce price. To know the effect on
that you know which increase was bigger. In the above
figure, the increase in demand is
bigger so the net effect on price is that it
increases. If the increase in supply had been
bigger than the increase
in demand, price would have fallen.
Some applications of demand and supply analysis
Sometimes governments impose price ceilings, or price controls,
establishing a price
below equilibrium. When this happens, the
quantity demanded exceeds the quantity
supplied and a shortage develops.
This leads to the development of so-called "black
people illegally sell at a price higher than the controlled price. In
cases, under the table payments may be made. Sometimes producers
reduce the quality
of the good to compensate for the below equilibrium
price. The market tries to find
its equilibrium in spite of
government. Historically, price controls have never worked well.
Pressures mount and sooner or later the attempt to mess with market outcomes
and is abandoned. The Roman Emperor Diocletian tried
price controls a couple of
thousand years ago. They didn't work then and
they haven't worked since then!
Sometimes government does the opposite of the above by instituting a
price floor, or
price support. This occurs when government sets a
minimum price above
This is done for some agricultural commodities.
When government does this, the result
is a surplus--quantity supplied
exceeds quantity demanded. What happens to the surplus?
price floor to work, government has to buy the surplus at the minimum price.
does government do with the surplus? They can store it, give it
away, sell it to another country--
or perhaps put it into orbit. The
cost of buying the surplus as well as the cost of disposing of
it places a
further burden on taxpayers--in addition to the higher price they pay for
Minimum wage laws
Demand and supply analysis can be used to analyze a labor market as well
as a product market.
Instead of labeling the vertical axis
"price," now label it as the "price of labor," more
called a wage rate. Instead of labeling the horizontal
axis as "quantity," now label it as the
labor" or the level of employment. There is a downward sloping
demand for labor
and an upward sloping supply of labor. The
equilibrium wage rate and the equilibrium level of
employment will be where
the demand and supply of labor curves intersect.
Suppose the particular labor market we are describing is for unskilled
labor. Now suppose
government comes along (as it has for years) and
mandates a minimum wage rate above
the equilibrium for unskilled labor.
It's just like a price floor we looked at earlier and
The equilibrium conditions are shown by the "e" subscripts.
With the minimum wage (shown by wm)
the quantity of unskilled
labor supplied exceeds the quantity demanded. Compared to the
conditions, fewer laborers will be employed with the minimum
wage. The quantity
supplied is Qs
while the quantity
demanded is only Qd. Hence minimum wages lead to an
in unemployment--a classical unintended effect. (Remember
earlier we noted that there are often unintended effects
government policies.) This will happen so long as the
minimum wage is
equilibrium. If the minimum wage is equal to or less than the
then minimum wage
laws would have no effect.
One final application of demand and supply analysis, and that is looking
at rent controls.
This may be a bit of overstatement, but a former chair of the Nobel economics
prize committee said that rent controls are the most effective way in the world to destroy
cities--more effective, said he, than a hydrogen bomb.
There are about 200 U. S. cities, and in many
European cities as well, where local governments
impose rent controls to
ensure "affordable" housing for low income families. These are
ceilings we looked at earlier. Typically a landlord can raise
rents ONLY when there is a new tenant.
In most locales, the rent
ceilings apply only to certain areas, not the whole city. What happens
with rent controls?
- A housing shortage
- Black markets develop--under the table payments,
rental, "key money" and other creative devices.
- Deterioration and abandonment occur because the rental
is not enough to ensure adequate maintenance.
- Overcrowding occurs.
- Discrimination may occur.
These are the kinds of effects the chair of the Nobel
economics committee looked at
when coming to his startling conclusion about
rent controls. There are also effects in
the nonregulated rental
properties market. Because there is a shortage in the rent
market, there will be an increase in demand for housing in the unregulated
areas. That leads to an increase in rent in those areas, which benefits
injures the residents in the unregulated areas. There's
another classic example of an
The public sector
Sometimes markets don't produce optimal outcomes.
That's called market failure. When that
happens, we expect government to
become involved. There are six sources of market failure
which lead to
the necessity for government intervention. These are briefly discussed
One of the obvious functions of government is to serve as a referee when
are disputes in the economy. That is essentially the justice system.
If you and I have a
contract and either of us thinks the other didnít
perform according to the contractís terms,
we can go to a civil court to
resolve the dispute. Everyone (or at least almost everyone)
agrees that we
must have a judicial system. There is, however, a lot of disagreement as
how government should discharge this function and as to the extent of
There certainly seem to be a large number of frivolous
2. Income redistribution
A market system produces inequality in the distribution of income. We looked
briefly at this
early in the course. Not everyone thinks that
government has any business altering the market
determined distribution of
income--but most do. There are those families and individuals who
poor, and become poor for a variety of reasons. Most of us have humanitarian
that lead us to conclude that government should redistribute
income. It should redistribute, put
simply, from the haves to the have nots.
Here again, however, there is huge disagreement as
to how government should
redistribute income and how much income should be redistributed.
government doesnít do enough while others think government has gone
and does too much redistribution. Then there are disagreements as
to what kinds of redistribution
programs work best. We will see later on
that many of our current programs donít seem to
3. Preserving competition
Some people just donít play by the rules as we would like them to. Some
firms will attempt to
stifle competition. The result will be higher prices
and diminished outputs. Certainly U. S.
economic history is full of firms
who attempted to abuse the system. Because of that, government
needs to play
a role in preserving competition.
Essentially there are two ways government can discharge this function.
One is by enforcing
anti-trust laws--laws which were written to ensure
fair play in the economy. Government has
undertaken a lot of trust busting
activities, breaking up large firms into smaller ones. Government
Standard Oil in the early 1900s; it broke up the aluminum industry
following World War II;
it broke up the long distance telephone industry
more recently. The other way government tries to
preserve competition is
through government regulations. There are about 128,000 federal
employees involved in administering a huge spectrum of government
expensive and imposes large costs on
businesses. Some think there is way too much government
regulation--especially the business community. There is disagreement as to
is better off emphasizing anti-trust or regulation.
Here again, as in the first two functions and the remaining three
functions, you see a common theme: Most agree on the basic
for government economic functions--but there is
as to how
government should discharge
them and as to how much
government intervention is appropriate.
4. Public goods
Some things just couldnít be provided in a private
market. The classic example is national
defense. It would be a little
difficult (!) for someone to open up a national defense store and
of us decides how much national defense we want. Another example is a:
(Thatís a lighthouse.) National defense and a lighthouse
are examples of pure public goods.
So is flood control.
Government provides many goods that are not pure public goods, but
look at the nature of pure public goods. Pure public goods have two
First, a pure public good is always consumed jointly.
With flood control, for example, either
the whole valley is protected or no
one is. Second, you can't charge consumers on the basis
Someone can benefit from the services of a lighthouse whether they are
pay for it or not. Those that don't want to pay are called
Well, government sure provides a Lot of goods
that that aren't really public goods. Some
examples include education, the post office, and the Tennessee Valley
about those examples. There may be good reasons for government
to provide them anyway,
but comparing what government provides with pure
public goods helps us form opinions as
to what government really
should provide. So here again the same theme is present--everyone
government should provide some goods and services, but there is disagreement
to what goods and how many of them.
An externality is a cost (or benefit) which accrues to someone external to a
One of the best examples of an external cost is air or
water pollution. The market doesnít force
producers or consumers to
include the cost of clean air or clean water in a market exchange.
Clean air or clean water is in the nature of a public good and government
must play a role in seeing
that our demand for a better environment is
satisfied. There is a lot of disagreement about how little
or how much
pollution we will tolerate, and there is a lot of disagreement as to how
accomplish this. More about environmental economics comes
up later on.
There are also external benefits. Education is an example of an external
benefit. If someone
an education and, as a result, all of us
benefit from having a more educated society we all benefit.
basic case for public funding of education.
The final function is the most important for macroeconomics
and that is stabilization. Government
is charged with the
responsibility to ensure that the society is on the production possibilities
meaning that all resources are to be employed. Government is
also charged with the responsibility
to prevent inflation, to smooth out
business cycles, and to foster economic growth. As we will see--
again--there is general agreement that these macroeconomic goals are
desirable but there is
a lot of disagreement as to how government should do
this. This is at the core of what we will
shortly be looking at in
How much does government spend?
The following table shows how much governments spend in the United States on
and services and what percent this is of gross domestic
Annual spending (in billions of dollars)
Percent of GDP
State and local
Note that total government purchases are $2,521 trillion
which is 19 percent of GDP. Many are
surprised to learn that state
and local governments spend far more then the federal government.
time, government spending has grown absolutely but has fallen very slightly
percentage of gross domestic product. In many other countries
government spending is an
even greater proportion of GDP than in the United
States--e.g. in Croatia government spending
is 30 percent of GDP; in Israel,
it's 29 percent; and in the United Kingdom, it's 21 percent.
These data, however, do not include transfer
payments. If transfer payments are included,
the proportion rises from
19 percent of GDP to about 30 percent of GDP. That too is low
relative to other countries. Many are surprised to learn that in counties like Italy and
government spending is more than half of GDP. Most of the
absolute increases in government
spending are because of increased spending on
transfer payments. In 1950, total government
transfer payments) was 22 percent of GDP, so there have been considerable
increases in the last half century.
The level of government expenditure is controversial.
Liberals often think the U. S. should
spend more than it does, chiefly on
additional transfer payment programs. Conservatives think
that a level
of 30 percent of GDP is too high, even if it is low relative to other
Conservatives think that level of spending is excessive and
diminishes economic freedom.
What do governments spend money for?
The federal government spends 16.2 percent of its total
budget (including transfer payments)
on defense--lower than many think. A total of 64.6
percent is spend on human services, of
which social security is the largest single component.
Interest on the public debt is 6.7 percent
of the total--an item that has significance for us later on.
State governments spend 31 percent of their total spending on welfare and 21
Local governments spend 43 percent on education.
Where do governments get their revenues?
Mostly from taxes and some from fees and some from
borrowing. We want to survey the main kinds of
taxes governments levy
because those are important for macro policy, as we will see later on.
The largest source of revenue for the federal government
is the personal income tax, which
about 45 percent of total federal
revenue. There are many controversies about this
tax; we look
at two of them. One is the definition of taxable income. There
is a big
the income an individual earns and the portion
of it which is taxable
income--the income against
which varying tax rates
are applied. The federal government
excludes some income from the
income tax. It allows people to take a number of deductions,
largest being interest on a
home mortgage. Then it allows some credits
amount of tax--e.g. certain child care
income tax regulations are very political
but the result is that
much smaller than total earned income.
The second controversy is that the tax is progressive.
That means that as one's taxable income
rises, so does the tax rate.
Currently, tax rates go from zero percent to 35 percent. Another way of
understanding progressive taxation is this:
you earn twice as much as I do, you will be more than
twice as much
income tax. It's controversial because some don't think it
should be progressive at
all and that it would be better if everyone paid
the same tax rate (the so-called flat tax). Others
think the tax
should be more (or less) progressive than it is.
The second largest federal revenue source is the social
security tax, which accounts for 40 percent
of federal revenues.
Social security is a
pay-as-you-go system. That means that those who are working
pay into the system, and those who are retired receive transfer
payments from those working. Social security is
like a private annuity--it's a transfer payment.
Social security, as noted above, is an entitlement but it
is not means tested. That means benefits
are not related to the
incomes (means) of the recipients. Many think it would be a lot better
was related to income.
The other major source of federal revenue is the
corporate income tax, which accounts for 7
percent of federal revenue. The corporate income
tax is exceedingly complex and is the source
of employment for thousands of
accountants and attorneys. Its complexity often means that
make decisions based on tax consequences and not on economic considerations.
The tax involves double taxation. Corporations pay taxes on their net
earnings, a portion of
which are distributed as dividends to shareholders.
Dividends are taxed a second time because
they are included in the federal
personal income tax. Many think this feature is inequitable.
State and local taxes
The largest source of revenue for state governments is the retail sales tax
almost half of the total. (Many states also have a
personal income tax.) You are familiar
with the retail sales tax.
For items covered by the tax, the amount of the tax is simply
added to the
sale. You buy a sweater for $50 and, if the sales tax rate is 6 percent,
an additional $3. Unfortunately the sales tax is regressive with
respect to income. That means
people with lower incomes pay a higher
their income on the sales tax than do
people with higher incomes.
Why? People with lower incomes spend a larger proportion of their
on goods subject to a sales tax than do wealthy people. Wealthy people
spend a lot on
stocks, bonds and real estate and those things aren't subject
to the sales tax.
Local governments rely on property taxes which constitute 72 percent of
their revenue. Property
taxes are also regressive because lower income
households spend a larger portion of their income
on housing. A
government study found that a household earning $50,000 pays 2.5 percent of
income on property taxes, but a household earning $10,000 pays 4.5 percent
of its income on
property taxes. Almost everyone thinks that regressive
taxes are a bad idea, but we have
Government decision making
Ideally government decisions would be made on the basis of benefits and
costs. For example, projects
would be evaluated by comparing benefits
with costs and those with the largest net benefits would be
That's an easy concept. Costs are relatively easy to measure, but
benefits are not. How
do you measure the benefits of longer life or a
local symphony? Although government attempts to use
analysis, many are made for purely political reasons. Government
intervenes, as we saw
earlier, in an effort to remedy market failure and
improve economic outcomes. Government does this,
but in some cases the
cure is worse than the disease. When government does not improve
outcomes, it's called government
failure. There is a lot of that and
that is important to remember
when we look at government macroeconomic
policy later on.
Here comes a bad joke about
A grade school teacher was
asking students what their parents did for a living. "Tim, you
be first. What does your mother do all day?"
"She's a physician," Tim replied.
"That's wonderful. How about you, Amy?"
Amy shyly stood up, scuffed her feet
and said, "My father is a mailman."
"Thank you, Amy" said the
teacher. "What does your parent do, Billy?"
stood up and announced, "My father plays piano in a whore house."
Quite distraught, the teacher went
to Billy's house and confronted his father with what
Billy had said. "Actually," the father said,
"I'm an economist--but how do you explain a thing
like that to a seven year old?"
Now we begin the heart of
macroeconomics. To understand the macro economy is as easy (or as
understanding the behavior of three important macroeconomic
variables. The three are income, employment
(or unemployment) and the
price level. We have to acquire a pretty thorough understanding of what
three mean, how they are measured, and some problems with each.
These three variables are, in turn,
determined by the behaviors of four economy
wide sectors: households, business firms, government,
and foreign participants.
We begin by exploring income beginning today.
Then we look at employment
and then the price level.
Gross domestic product (GDP)
The most common, but not only, measure of the
nation's income (or output) is called gross
domestic product. To
approach an understanding of this concept, we need to look at the circular
flow of economic activity. (There is a circular flow diagram in most
textbooks, but they are
sometimes needlessly confusing.) Below is a
simplified circular flow diagram which omits
government and the foreign
Gross domestic product measures the size of the dollars in
the diagram. It is possible to measure
the dollar flow either from the
expenditures side or the receipts side; the two values would be equal.
The commerce department does both, but the most common way is to measure from
side--the dollar value of expenditures on goods and services,
or the dollar value of output. The terms
"output" are synonymous. The diagram is simplified because it
omits government and
the foreign sector; that will come later. Note that
we measure GDP in dollars, not in physical terms.
Measuring in dollars
allows us to add together oranges, apples and rock concerts.
Here is a formal definition of GDP:
domestic product (GDP) is the final value of all
newly produced goods and
services within a nation's
borders, per year.
Now we have to dissect that definition to
understand what it means. First, why is the definition restricted
only newly produced goods and services? Why isn't a used car counted?
Why is a previously built
not included? The answer is to avoid
double counting. If I bought a new car in 2006, its value
included in the GDP for 2006. If I sell it to you in 2007, it would not
be counted again--it was
counted in 2006. Output is not higher
in 2007 just because I sold you my car. If we agree to
both better off--but society's output (or income) is not affected. The
used car is essentially
a transfer---I give you the car; you give me the
What does the "final value" part of
the definition mean? That also is to avoid double counting.
called a "value added" concept, meaning we count the value added at
each stage of
production. Shown below is a (very) simplified diagram
showing how wheat turns into bread
which consumers then purchase:
Look what's happening. If you looked at the total
expenditure of $2.26, you would have counted the
16Ę four different times!
Look at the last column which is the value added at each stage of production.
If you sum the value added column, you get $1.00--which is the final value.
So saying GDP measures the
final value is the same thing as saying that GDP is
a value added concept.
Gross domestic product vs. gross national product
Another older measure of output is gross national product
(GNP). Sometimes people still quote
GNP. It reports output using
factors of production owned by a country's residents, even if production
took place outside domestic borders. Gross domestic product says
"within a nation's borders,"
and does not include production in
other countries. GNP is about one percent higher than GDP--
so it's no
Real and nominal GDP
Hopefully you now understand what is meant by GDP and why
it is defined the way it is. Now we
need to make another adjustment to
the concept to improve its value as a measure of income
We need to adjust the yearly measure of GDP to account for inflation.
in a given year the value of GDP increased 10 percent.
Sounds pretty good. But suppose prices
also increased 10 percent.
Would we conclude that the economy is better off by 10 percent? No.
We would be no better of in terms of what we produced. The 10 percent
increase in GDP is
illusory because it merely reflects rising prices--not
real output. The term nominal
we are measuring in current dollars not adjusted for
inflation. The term real GDP
means we are
adjusting the measure for inflation.
How do we do that? First we have to have a price
index. That is a weighted average of a market
basket full of typical
goods and services purchased by households. There is a base year and
average price is given a value of 1. If the average price went up
5 percent in the next year, the
price index for that year would be 1.05.
(The government multiplies everything by 100 so published
price indexes are
100 in the base year. In the example above, the price index would be
as 105.) To get real income, we divide nominal
income by the price level. Nominal income is
also sometimes called
"income in current dollars." (A technical note: the commerce
doesn't use the price index in just one year. It uses a
moving average of several years and is
called a "chain weighted price
adjustment.") Here is the example done in class:
Over the four years, notice that nominal
increased 350 percent. But prices increased 250 percent,
income increased 40 percent. In most, but not all, subsequent
discussions of income
we will be talking in terms of real
This discussion has been pretty straight forward,
BUT--it's never as simple as it looks. Measuring
real GDP is
problematical. As we will see, there are also measurement problems
and the price level.
GDP does not account for nonmarket activities, although
they certainly add value. The services of
a homemaker are not
included. If I give you some fresh flowers from my garden, that isn't
The commerce department, however, does make estimates of two
important nonmarket activities.
One is the food grown by farmers for
their own consumption. The second is the rental value of
occupied by its owner.
There is a fair amount of unreported income. These
are participants in the so-called "underground
you pay a neighbor kid for mowing your lawn, that isn't included. If
you have a
person that cleans your house and you pay in cash, that isn't
included--unless the house cleaner
reports it, which almost never happens.
Drug dealers' income is not reported. The University
estimates that unreported income is about 9 percent of GDP.
In calculating real GDP we used a price index. As we
will see shortly, the price index also involves
Finally, there are various statistical problems involved. So our
of real GDP is not perfect, but it is still useful!
Other measures of income and output
GDP is the most common measure of income, but not the only
one. There are several other
derived from GDP, that are used for
various purposes. The following table shows
four are derived, and
also gives data for the third quarter of 2006 so you can see
Amount (in billions)
Net domestic product
indirect business taxes (any tax paid by business other than the
corporate income tax and employer's share of social security),
corporate income tax, employer's share of social
security tax, and corporate retained
earnings--and plus transfer payments
personal income taxes
Disposable personal income
So what's the importance of all this? For our
purposes, the net domestic product measure is not
Personal income is the income received by households.
Disposable personal income, as the name implies,
is what households have to spend on whatever they see fit.
Businesses are competing for shares of
disposable personal income. Aggregate consumption
depends on disposable personal income.
So, for us,
GDP and disposable personal
income are the significant measures. Note that
disposable income is
a little over 70 percent of GDP.
Components of income--expenditures side
Earlier we looked at the components of GDP when we defined
consumption, investment, government
and net exports. We revisit those
components, because the components will help us solve some of
about the macro economy. We begin with the following equation:
Y = C + I + G + (X - IM)
Y is the symbol we use for real output or
real income. (We don't use I, because that's for investment.)
stands for consumption, I for investment, G for government, X for exports and
IM for imports.
We review each of these, adding a little more fullness
to some of the definitions we did earlier.
to households' purchases of final goods and services. Goods are
things like bagels, sweaters and automobiles. Some goods are called
they last a long time. A washing machine is a durable
good. Services are intangibles, e.g.
investment advice, interior
decorators and so on. As we saw earlier, the U. S. produces a
proportion of services than it did a century ago.
to what business firms spend on new capital goods. Investment, as
in GDP accounting, actually refers to gross private domestic investment.
refers to the fact that depreciation is included. If depreciation
is excluded, the result
would be net investment and that would be consistent
with net domestic product. Private
means that no government investments
are included. Domestic means that international
investment is not
included. Two other things are included. One is the value of
unsold inventories. A car dealer has an inventory of new cars.
They are produced but not
yet sold to households. So they are included
in the investment category. The other thing
included is new housing.
Housing is certainly a durable good, but it lasts for so long and
is such a
high price item that it seems preferable to include it in investment. As
earlier, and as will be discussed again, investment can come about only
if households save
a portion of their incomes. By saving, we mean nonconsumption. So another macro
relationship is that Y = C + S, where S
stands for saving.
refers to what government (all levels added together) spends for goods
services--missiles, paper, asphalt and so on. Those transfer payments
are not included
in GDP because that would involve double counting.
Transfer payments are literally money
transferred from some individuals to
other individuals. But, if we want the total income
households (personal income) transfer payments are added in.
refers to the dollar value of things we produce and sell to parties in foreign
countries. These are added to GDP because they are a part of what we
subtracted from GDP because they represent money we spent on goods
we did not
produce. Net exports is simply (X - IM) and, as noted earlier, can be
and have been negative in recent years for the United States.
Components of income--receipts side
We can also split GDP into some components
by looking at the receipts side of the circular flow.
Although we don't
use this as often analytically as we do expenditure components, we need to
indicate briefly receipts components. The equation expressing these
components is as follows:
Y = w + r + i + p
Here the w stands for wages, the payments
made for the labor input. The r stands for rent, the
payments made for
the land input. The i stands for interest, the payments made for the
input. The p stands for profits, essentially the return for
entrepreneurship. These payments
correspond to the four factors of
production, or inputs, that we identified earlier.
The equation above is really one where Y
stands for national income, not GDP. If we add
indirect business taxes
and depreciation to the sum of w, r, i and p, then we have an expression
GDP and the quality of life
To complete our discussion of GDP, we need
to think about what it measures--and, equally as
important, what it does not
measure. GDP does not measure the quality of life. It doesn't
measure negative aspects of the quality of life such as pollution or crime.
Neither does it
measure some positive aspects--e.g. sitting in the sun or
attending church. In other words,
GDP measures economic
welfare but not social
welfare. We can't quantify many of the things
relevant to the quality of
Some attempts have been made to measure social welfare.
Your text briefly presents Fordham
University's index of
social health, which is based on sixteen indicators. Some items in
economic--e.g. unemployment and weekly earnings. Some are
sociological--e.g. child abuse,
teen suicides. That index concludes that
social health deteriorated in the 1970s and was
mostly flat in the 1980s and
1990s. I cannot vouch for whether the index is any good;
it's just an
example of measuring something broader than economic well being.
For measuring economic welfare, the best available is real
GDP per capita, although it is
far from a perfect measure.
Answers to Quiz #1--1/22/07--10:00
6. D or E
Answers to Quiz #1--1/22/07--1:00
7. D or E
8. B or E
We now look at the second of the three major macroeconomic
The labor force
We begin by inquiring as to how we define the labor force.
It is defined as all those over age 16 either
working for pay or seeking to
work for pay. Many individuals are not part of the labor force--those
retired, young children, homemakers, those in prison and others. All
together, about half of the total
population is in the labor force. Another interesting piece of data is the labor force
Since 1950, participation rates have increased for females and
decreased for males.
Unemployment and the unemployment rate
The definition of unemployment is simple--it's those
looking for work but unable to find it. The
unemployment rate then is
the number of people unemployed divided by the labor force, as defined
above. During the great depression of the early 1930s the unemployment
rate was about 25 percent.
Since the end of World War II, the highest
unemployment rate was 10.8 percent in 1982 and the lowest
was 3.4 percent in
1968. Currently (November, 2006) the rate stood at 4.6 percent.
and less educated people have higher rates of unemployment.
Teenagers, especially minorities,
have very high unemployment rates.
Black teenagers have an unemployment rate in excess of
Economists and policy makers are also interested in the
duration of unemployment. That is, at any
point in time, how many are
unemployed only briefly and how many are unemployed for long periods?
The duration statistics are as follows:
32 percent were unemployed less than 5
30 percent were unemployed between 5 and
16 percent were unemployed between 15 and 26 weeks.
22 percent were unemployed 27 weeks or more.
The median length of
unemployment in 2006 was 8.3 weeks.
The effects of unemployment
Why does unemployment matter? This
may be obvious, but there are both adverse macro and micro
unemployment. From a macro view, unemployment leaves the economy
inside its production
possibilities curve. (Remember that from very
early in the course?) Look below at a production
showing consumption goods on one axis and investment goods on the other:
If the economy is operating at point U, there
is unemployment. If we could move from point U to point X,
could produce more investment goods without giving up any consumption goods.
U to Z would mean more consumption goods without giving up any
investment goods. Hence the
important macro effect is that we have
less output than we are capable of producing. It is estimated by
economists that an increase in unemployment of 1 percent leads to a
reduction of 2 percent in
At the micro level, it's simple--people out of work have
no income and that's a big problem for any
obvious effects also occur. Sometimes disease increases because of the
stress of being out of
work. Sometimes suicides occur. Often,
crime rates rise when unemployment
How is unemployment measured? The Bureau of the
Census does it monthly using a sample of 60,000
households. It is a
telephone survey. They ask whether any member of the household is not
but is seeking work. If the answer is yes, that one counts as
being unemployed. They also obtain
demographic data--age, race, etc.
(Some of you may wonder
why I put these silly clip art things on the web site.
First, to brighten it up! Second, and more important, they may be
visual cues that will assist you in remembering important concepts and
There are, however, at least three problems with this
procedure. First, there is a response bias. Some
will say they
are looking for work even if they aren't really. Some on welfare are
required to be seeking a
job and they don't want to indicate that they
really aren't. So they say they are! This is called
unemployment. The extent of this is not
known, but it may mean the reported unemployment
rate is overstated.
Another problem has to do with
workers. These are people
who really do want to be
employed, but they aren't looking for work because
they don't think they will find a job anyway. They
may think they
don't have the skills, or are too old--or whatever. The existence of
might lead the reported unemployment rate to be too low.
A final concern involves the
This refers to one of two things. First are workers who
work part time
but really want to work full time. Even if someone is working only one
hour per week,
they are counted as employed when the census bureau calls.
Second are those working for incomes
less than their skills would
indicate--e.g. a college graduate working at burger world.
So how do we interpret the unemployment
rate? The absolute reported level may not be entirely reliable
reasons we just saw. Relative changes, however, are important.
An increase from 5 percent to
7 percent, even if the exact numbers are not
accurate, would be a cause for concern.
What is full employment?
When we say one macroeconomic goal is
"full employment," what does that mean? It doesn't mean an
unemployment rate of zero. There are reasons for believing that zero
is not attainable or even desirable.
To see that, we look at four
different types of unemployment.
Seasonal unemployment, as its name suggests, refers to those who are
unemployed during certain seasons of the year--e.g. construction workers,
workers at ski resorts.
These are typically not considered
problematical because they have earnings during the seasons
employed. In some cases, their annual earnings may be relatively high
they experienced some periods of unemployment.
Frictional unemployment occurs when someone is between jobs, often
for a better one. In part, frictional unemployment reflects a mobile
thought desirable by economists.
A more problematical type of unemployment is structural unemployment,
arises from structural changes within the economy. This occurs
when there is a mismatch
of either skills or location between unemployed
workers and available jobs. Technological
spawns structural unemployment. Many information technology related jobs
presently available, but some of the unemployed do not have the skills to
land those jobs.
Many talk about a skills gap. One government agency estimates
that 98 percent of all new
jobs created in the next decade will be service
sector jobs. The text and the government
see this as a source of structural unemployment. Over time, however, the U. S. labor force
been very resilient and has responded to many, many changes.
A final type of unemployment is cyclical unemployment. That occurs
when there is a lack of job vacancies during a period of recession. At
times, this has been a
problem; at present it is not.
What IS full employment?
We arbitrarily say that full employment is
some low rate of unemployment. We do this for the reasons
above--absolutely zero unemployment can not be attained and is not
desirable. Sometimes it is said
that full employment is the lowest level of
unemployment consistent with price stability. That's debatable--
will look more at the relation between prices and unemployment later on.
In the 1960s, government officials
proclaimed that full employment was an unemployment rate of 4 percent.
Reagan advisors in the 1980s said an unemployment rate of 6 or 7 percent was
full employment. Bush and
Clinton advisors said it's 5.5 percent.
Since the rate is now 4.6 percent, most think we are essentially at
Nature of inflation--and a few facts
Inflation is defined as an increase in the
prices of goods and services throughout the economy.
prices can change without there
being inflation. There can be instances in which some prices
while other prices decrease without there being any inflation. The
is simply the
annual percentage increase in average prices.
If we had inflation of 4 percent per year,
prices would double in 17.7 years. But if inflation was 10
year, prices would double in 7.3 years. That reflects the nature of
Historically inflation has always been
high following major wars. This is because of the transition
time to peace time production. During a war there is a shortage of
many consumer goods
and, when the war ends, there occur large increases in
demand for consumer goods. Following World
War I inflation was
about 20 percent and following World War II about 16 percent.
Inflation in the mid
1970s was over 11 percent and the highest inflation
rate since World War II was 13.5 percent in 1980.
In 1998 the inflation rate was a very low 1.6 percent and in
1999 it was 2.7 percent. Currently (in the
third quarter of 2006) inflation was 1.3 percent. Most of you cannot imagine an environment in which
prices rose more than 13 percent in a
single year! The subtitle in the syllabus for today's lecture asked
who had an inflation rate of 23,760 percent. The answer is Zaire in
1994. If inflation is over 200
percent it is called hyperinflation.
There was also hyperinflation in Germany following World War II.
It is possible to have deflation.
That would be a fall in average prices. That happened in the United
States in the 1930s, but has not happened since.
So what are the consequences of inflation?
Micro consequences of inflation
The chief micro effect of inflation is a redistribution
of income and wealth. This point may
be a little subtle, but it's
important. This redistribution can be explained through price
income effects and wealth effects.
First we consider
effects. When inflation occurs, some prices typically rise
than others. If a household purchases things whose price has
risen rapidly, they will suffer
a loss--the purchasing power of their
income falls. Households which purchase things
whose price has risen
slowly (or not at all) will gain. Hence there is a redistribution of
purchasing power (real income) from those who purchase things with rapidly
to those who purchase things with slowly rising prices.
effects. Some households experience an increase in their
income faster than the rate of inflation. (Remember what
nominal income is.) If I have
an increase in my nominal income of
eight percent and inflation is five percent, I come
out ahead in terms of
an increase in my real income. If you have an increase in nominal
income of three percent when inflation is five percent, you come out with
less real income.
Hence inflation redistributes real income from you
to me. Those on fixed incomes (
e.g. some retirees) are particularly
hard hit by inflation.
Finally there are
effects. Some kinds of assets typically increase in value
inflation--e.g. stocks and bonds. Some assets--e.g. farm land
or gold--typically lose value
during inflation. Here again inflation
redistributes. In this case, the real value of wealth is
redistributed dependent upon the type of assets a household holds.
Inflation really acts
like a tax--taking real income and wealth from some and giving it to
others. Typically these redistributions are "wrong
way" redistributions in that they take from lower income
households and transfer to richer households. That's the
opposite of what most think is desirable.
Macro effects of inflation
One of the chief macro effects of inflation is enormous
Consumers and businesses are
uncertain about how to plan. Some
consumers will delay purchases anticipating that prices will
fall. Others will buy more fearing that inflation will get worse.
Business don't know
what consumers will do in the aggregate.
This means that there is an effect on output, but it
isn't clear what kind of effect. If, in the
aggregate, people delay
purchases then output will fall. If inflation accelerates purchases,
rises--but only for a while.
Other effects may include social tension and perhaps
some despair. Hyperinflation is likely to
produce these kinds of
Anticipated vs. unanticipated inflation
If everyone fully and accurately anticipated inflation,
it might not do much harm. Wages and prices
anticipated inflation, and real output could continue to rise.
Unexpected inflation is
much more problematical. When it's
unexpected, debtors gain and creditors lose. If you borrow
inflation occurs, you repay it with dollars that are worth less.
That harms the lenders.
Almost no one, in fact, has enough information to
correctly anticipate inflation. It is further
complicated by the
difficulty of knowing which prices will increase and at what rate.
put simply, causes all kinds of distortions.
Consumer price index (CPI)
The most common, but not only, measure of inflation is
the consumer price index (CPI). The CPI is
constructed monthly by
the Bureau of Labor Statistics (BLS). It is based on a market basket
400 different goods and services. The market basket is based upon
periodic surveys of consumer
expenditure, the most recent being 1993-95.
The BLS sends teams to more than 50 urban centers
in the United States to
record the prices of these 400 items. It is calculated by valuing
at the current month's prices and expressing that value as a
percentage of the same basket in the
base period. The base period is
currently the three year period 1982-1984 and the index is assigned
value of 100 as the base value. (Statistically the base index is
given a value of one, but the
government always multiplies by 100
apparently thinking that makes it easier to see how the
A simplified calculation of the CPI is given in the
table which follows. It assumes a market basket
of three goods and
it assumes prices in the base year (year 1 in the table). Then it
happens in year 2 when the prices change. Note that the
calculation for year 2 is using the same
quantities as in year 1.
That, as we will see, is a problem. Here is the table with the
CPI in year 1 (base year)
The $295.00 total is given an index number of
CPI in year 2
TOTAL EXPENDITURE $325.00
The price index for year 2 is found by dividing
expenditure in year 2 by the total expenditure in year 1
and multiplying by 100:
325 x 100 = 110
The CPI went from 100 to 110 in year 2, so
year 2 were 10 percent higher than in year 1.
Problems with the CPI
Many think that the CPI overstates the
rate of inflation. This is for two reasons.
One is that
the market basket changes. Even the
current market basket will not include some newly
products or services. So this brings some error
into the published CPI. A second reason is that
the CPI doesn't do a good job of
accounting for quality changes. An ordinary
TV set costs more
it did thirty years ago, but it is a much higher quality product than it
was thirty years ago.
The BLS makes some adjustment for
quality changes, but many
experts still think the net result
is that the
CPI overstates the rate of inflation. Even though
it isn't a
perfect measure, many
contracts are indexed to the CPI so it is a very
Other price indexes
Producer price indexes
There are also producer price indexes which measure
inflation at the wholesale level. There
are actually three of
them--crude materials, intermediate goods and finished producer goods.
Over time, these move in tandem with the CPI but they are more unstable.
indexes fluctuate much more from month to month than the
CPI, and that's why producer
price indexes to not predict the CPI from
month to month--even though the media would
have you think so.
The CPI is not the index used to convert
nominal GDP to real GDP. That calculation uses a
called the GDP deflator. It includes all items in
GDP--consumption, investment and government expenditure. It does
allow the contents of the basket to differ as actual expenditure varies,
so it is not entirely a measure of price changes. It typically
registers a lower rate of
inflation than the CPI.
What is price stability
In 1978 Congress decreed that price stability is
inflation of three percent or less. We
have less inflation
than that. This is similar to thinking about what
We probably can't have--and would not want--zero
inflation because that would imply little or no
brings you to the end of the first part of macroeconomics. It
becomes more analytical in the second part.
To review last year's
first exam, click here: Part One Test