Unit 2: Economic Indicators and the Business Cycle

a. Define (using the circular flow diagram as appropriate) how GDP is measured and its components. b. Calculate nominal GDP.

• GDP is a measure of final output of the economy.
• GDP as a total flow of income and expenditure can be represented by the circular flow diagram.
• There are three ways of measuring GDP: the expenditures approach, the income approach, and the value-added approach.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Define the limitations of GDP.

• GDP is a useful indicator of a nation’s economic performance, but it has some limitations, such as failing to account for nonmarket transactions.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

a. Define the labor force, the unemployment rate, and the labor force participation rate. b. Explain how changes in employment and the labor market affect the unemployment rate and the labor force participation rate. c. Calculate the unemployment rate and the labor force participation rate.

• The unemployment rate is the percentage of the labor force that is out of work.
• The labor force participation rate is another measure of the labor market activity in an economy. The labor force participation rate is the percentage of the adult population that is in the labor force.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Define the limitations of the unemployment rate.

• The measured unemployment rate is often criticized for understating the level of joblessness because it excludes groups such as discouraged workers and part-time workers.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

a. Define the types of unemployment and the natural rate of unemployment. b. Explain changes in the types of unemployment.

• Economists primarily focus on three types of unemployment: cyclical, frictional, and structural.
• The natural rate of unemployment is the unemployment rate that would exist when the economy produces full-employment real output. It is equal to the sum of frictional and structural unemployment.
• The deviation of the actual unemployment rate from the natural rate is cyclical unemployment.
• The natural rate of unemployment can gradually change over time because of such things as changes in labor force characteristics.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

a. Define the consumer price index (CPI), inflation, deflation, disinflation, the inflation rate, and real variables. b. Explain how price indices can be used to calculate the inflation rate and to compare nominal variables over time periods. c. Calculate the CPI, the inflation rate, and changes in real variables.

• The consumer price index (CPI) measures the change in income a consumer would need in order to maintain the same standard of living over time under a new set of prices as under the original set of prices.
• The CPI measures the cost of a fixed basket of goods and services in a given year relative to the base year. Calculating the producer price index (PPI) is beyond the scope of the course and AP Exam.
• The inflation rate is determined by calculating the percentage change in a price index, such as CPI or the GDP deflator.
• Real variables, such as real wages, are the nominal variables deflated by the price level.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Define the shortcomings of the CPI as a true measure of inflation.

• The CPI as a measure of inflation has some shortcomings, such as substitution bias, causing it to overstate the true inflation rate.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Explain the costs that unexpected inflation (deflation) imposes on individuals and the economy.

• Unexpected inflation arbitrarily redistributes wealth from one group of individuals to another group, such as lenders to borrowers.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Define nominal GDP and real GDP.

• Nominal GDP is a measure of how much is spent on output. Real GDP is a measure of how much is produced.
• Nominal GDP measures aggregate output using current prices. Real GDP measures aggregate output using constant prices, thus removing the effect of changes in the overall price level.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Calculate real GDP and the GDP deflator.

• One way of measuring real GDP is to weigh final goods and services by their prices in a base year. Because this can lead to overstatement of real GDP growth, statistical agencies actually use different methods.
• Nominal GDP can be converted to real GDP by using the GDP deflator.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

a. Define (using graphs and data as appropriate) turning points and phases of the business cycle. b. Explain (using graphs and data as appropriate) turning points and phases of the business cycle.

• Business cycles are fluctuations in aggregate output and employment because of changes in aggregate supply and/or aggregate demand.
• The phases of a business cycle are recession and expansion.
• The turning points of a business cycle are peak and trough.
• The difference between actual output and potential output is the output gap.
• Potential output is also called full-employment output. It is the level of GDP where unemployment is equal to the natural rate of unemployment. [See EK MEA-1.E.2]
• Enduring understanding MEA-2: The economy fluctuates between periods of expansion and contraction in the short run, but economic growth can occur in the long run.