HE5091 Principles of Economics Lecture 7 Quiz

Measuring Economic Output

• Gross Domestic Product (GDP): the market value of final goods and services produced in a country in a given period of time
• Components of GDP: consumer goods and services, investment, government purchases, and net exports

Final Goods and Services

• Final goods: consumed by the ultimate user, e.g. a haircut
• Intermediate goods: used up in the production of final goods, e.g. flour for baking bread
• Value Added: the market value of a product minus the cost of inputs purchased from other firms

Expenditure Method

• Users of final goods: households, government, firms, and foreigners
• GDP can be measured by: the total spending for final goods and services less the value of imports
• Expenditure categories: consumption, investment, government purchases, and net exports

Income Approach

• GDP can be calculated by: the sum of labor income and capital income
• Labor income: wages, salaries, benefits, and incomes of the self-employed
• Capital income: profits, interest, rent, and royalties

Adjusting for Price Changes

• Nominal GDP: values output in the current year using current prices
• Real GDP: values output in the current year using base year prices
• Real GDP measures: the physical volume of output

Real and Nominal GDP

• Nominal GDP will exceed real GDP: when prices are increasing (inflation)
• Nominal GDP will be smaller than real GDP: when prices are decreasing (deflation)

Real GDP and Economic Well-being

• Real GDP is a flawed measure of well-being: it values only market transactions and omits nonmarket economic activities
• GDP does not account for: intangibles like crime rates, traffic congestion, and open space

Nonmarket Economic Activities

• Examples of nonmarket activities: household production, volunteer services, and illegal activities
• These activities are important: especially in poor countries where they are a significant part of economic activity

Underground Economy

• Unreported transactions: legal and illegal, e.g. casual labor, baby-sitting, home repair
• Estimates suggest the underground economy is large: regardless of national income level

Environmental Quality

• Production of more output: requires more factories, extraction of mineral resources, and contributes to environmental degradation
• Depletion of resources: may damage the environment permanently

Inflation

• Price level: the average price of a given class of goods and services relative to the price of the same goods and services in a base year
• Consumer Price Index (CPI): a measure of the cost of living during a particular period
• Rate of inflation: the annual percentage change in the price level

Adjusting for Inflation

• Nominal quantity: measured in terms of its current dollar value
• Real quantity: measured in physical terms
• Deflating a nominal quantity: converts it to a real quantity by dividing by the price index

Real Wages

• Real wage: the wage paid to the worker measured in terms of purchasing power
• Real wage is calculated by: dividing the nominal wage by the CPI

Indexing

• Indexing: increases a nominal quantity each period by the percentage increase in a specified price index
• Indexing prevents the purchasing power: of the nominal quantity from being eroded by inflation

The Costs of Inflation

• Prices transmit information: about the cost of production and the value buyers place on buying an additional unit

• Inflation creates static: in the communication between buyers and sellers, making it difficult to distinguish between relative price changes and inflation

• Indexing avoids distortions: by matching tax rates to the real income level### Inflation and Economic Growth

• High inflation rates lead to lower savings and investment, resulting in lower economic growth.

• Non-indexed taxes distort tax incentives for work, save, and invest, further hindering economic growth.

Shoe Leather and Menu Cost

• High inflation causes cash to lose value over time, prompting consumers and businesses to manage cash balances to limit losses.
• Frequent, smaller withdrawals increase costs for consumers and businesses, including "shoe leather" costs and bank processing fees.
• Sellers must frequently adjust price lists (menu cost) to account for inflation, consuming resources.

Unexpected Redistribution of Wealth

• Unexpected inflation redistributes wealth, benefiting borrowers at the expense of lenders when salaries and interest rates are not indexed.
• Employers gain at the expense of workers when salaries are not indexed and inflation is higher than anticipated.

Interference with Long-Term Planning

• Erratic inflation makes long-term planning risky, as unexpected changes in purchasing power can affect retirement planning and lived standards.

Inflation and Interest Rates

• Unanticipated inflation helps borrowers and hurts lenders, as real interest rates are affected by inflation.
• The real interest rate is the nominal interest rate minus inflation (r = i - p).
• Nominal interest rates vary with inflation, ranging from 3.2% to 11.4%, while inflation rates range from 1.6% to 13.5%.

Historical Inflation and Interest Rates

• The real interest rate was highest in 1985 (7.0%) and lowest in 1980 (-2.1%).
• Nominal interest rates and inflation rates have varied over the years, with a general trend of decreasing rates since the 1980s.

Fisher Effect and Inflation-Protected Bonds

• The Fisher effect describes the tendency for nominal interest rates to be high when inflation is high and low when inflation is low.
• Inflation-protected bonds pay a real rate of interest plus the inflation rate, protecting lenders from unexpected inflation.