Unit Two

A. Circular Flow of Income

external image 300px-Standard_Circular_Flow_Model.gif
( From http://www.eoearth.org/article/Macroeconomics_and_the_environment )

This is an example of the most simple form of the Circular Flow of Income model. As stated earlier this diagram shows how Firms supply goods and services to households through the "product markets," and that households pay for these goods and services with money earned from supplying the firms with labor and resources. In this model, all income earned by the households is spent on goods or consumption, there is no savings. Likewise, all output earned by firms or companies is purchased by households through their consumption. So in essence the income follows a circular flow that never ends, as illustrated by the model.

The problem with this model is that not everything ends up as perfect as how this circular relationship is theorized to predict. In the real market leakages and injections to the economy occur such as savings and investments, taxes and government spending, and imports and exports. Thus the more realistic model used to predict this relationship is the five sector model of income flow as shown below. This model adds in three sectors to the flow of income, the Financial Sector, the Government Sector, and the Overseas Sector. These sectors provide what is known as Injections and Leakages to the circular flow of income. In other words, leakages such as the saving of money in the Financial sector is replaced by injections know as investments by banks into businesses. In the Government sector, leakages are the taxes that the government collects and injections is the spending that the government provides to the economy. Finally, Imports are leakages where money is flowing out in the Overseas sector and Exports or injections where money is flowing into the circular flow. In the end all things are equal when the sum of all the leakages equals the sum of all the injections. Unfortunately, this does not always happen in today's modern economy, as we all know.

external image Circular_flow_of_income.JPG
( From http://en.wikipedia.org/wiki/Image:Circular_flow_of_income.JPG )

B. Macro Economic Goals . . . are

1. Full Employment
With an economy at full employment there is lower rate of unemployment and a greater amount of goods and services being produced. All of this contributes to a growing economy and GDP
2. Price Stability
Price stability reduces the chances for inflation or unanticipated inflation, which could in turn upset the economy. It also prevents wealth redistribution.
3. Economic Growth
This occurs, when an economy's real GDP increases

source ( http://www.ncee.net/resources/lessons/ap_resources/AP-Macroeconomics-Visual-2-4.pdf )

C. Macroeconomic Measurement

1. Gross Domestic Product (GDP) – The most closely watched statistic, GDP is the aggregate output (the total market value of all final goods and services produces in a nation in a year). GDP is not a measure of the number of goods and services produces, but rather the market value. It measures (depending on the calculation method used) either the total income of everyone in the United States or the total expenditures of everyone in he United States. Both values should be equal.
The total expenditures of the U.S. can be calculated using the formula:
C + I + G + NX = GDP
Where C is consumption, I is investment, G is government spending, and NX is net exports. Consumption measures households’ contribution to GDP. It includes spending on goods and services, taxes (income, ad valorem, property, etc), and savings. Investment measures to contribution of businesses and firms to GDP. This value includes salaries, resources, capital goods (equipment), profit, and interest. Government spending describes the government’s spending, and encompasses all government purchases. Net exports measures the portion of GDP attained from the foreign sector. This figure is determined by subtracting what we buy (import) from what we sell (export). Therefore, if the U.S. imports more than she exports, the net exports value will be negative.
The total income of everyone in the U.S. can be calculated using the formula:
Compensation of employees (wages, pensions, etc.) + rents (any use of buildings) + interest + proprietor’s income (profit) + corporate profits + indirect business taxes (tariffs) + consumption of fixed capital (depreciation) + net foreign factor (overseas business) = GDP
Either way GDP is calculated, it does not include illegal purchases, transfer payments (Social Security checks, welfare payments, veterans payments, disability), the stock market, or second hand sales (used cars and used houses).
GDP should not be the ultimate measure of success because it does not include nonmarket activities (subsistence farming), leisure hours vs. work hours, quality improvements, underground activities, the effect on the environment, composition and distribution of output, and noneconomic sources of well-being (the crime rate, birth rate, etc.).

2. Economic Growth – economic growth is measured as the percent increase in real GDP (GDPr). Real GDP is not the same as nominal GDP, which is the named GDP. Real GDP is nominal GDP after it has been adjusted for inflation. Real GDP can be calculated using the formula: Real GDP = Nominal GDP/Price Index

3. Price Level – Price Level is also known as price index. Price index measures the cost of goods and services in an area at a certain time. Various price indexes can be used to compare how prices change over time and regions. This value can be calculated using the formula:
Price Index = (Cost in Target Year/Cost in Base Year) x 100

4. Employment – Employment is measured using the civilian unemployment rate, which is derived from a national survey. The survey encompasses some 60,000 households and the monthly employment status of its inhabitants over age 16 (the adult population). The survey consists of three categories: employed, unemployed, and not in the labor force. One might be classified as unable “not in the labor force” because of old age, inability to work, or choosing to not work. The unemployed and employed constitute the labor force.

D. Inflation and Price Indexes

1. Difference between price level and inflation - When inflation occurs, a rise in the overall level of prices takes place. During this time, the dollar will lose value and fewer goods and services can be purchased by the consumer. Inflation lowers the “purchasing power” of money. However, this drop in the value of the dollar does not mean that all prices are rising at the same time and rate. While some price levels could be increasing at alarming rates, others may decrease gradually or even remain constant.

external image personalitieshoward1.gif

2. Different price indexes- Inflation is most commonly measured by the Consumer Price Index (CPI). This index is created by the Bureau of Labor Statistics (BLS) each month and year. The government then reports the CPI rates to adjust income tax brackets and Social Security benefits. The CPI takes the top 300 goods and services purchased by the common urban consumer in American to find the current general price level. These goods and services are know as the “market basket.” The expense pattern of the common consumer is measured over the course of one year. As price levels and inflation percentages fluctuate from year to year, different price indexes are reported.
Price indexes are measured with this formula.

Price index = (Cost of Market Basket in Target Year / Cost in Base Year) x 100
The total cost is calculated by multiplying the number of units of the goods and services in the market basket by the price of each good or service.
Below is the United States Consumer Price Index from September 2006 to March 2007. Note the types of goods and services that make up the market basket.
external image US-Consumer-Price-Index-in-March-2007_img46260f8fed2f3.jpg


3. Nominal vs. real quantities- Nominal income is the amount of dollars received by a consumer through wages, rent, profits, or interest. Real income is expressed as the amount of goods or services that can be bought with the amount of nominal income obtained. Due to different prices levels, real income is forced to be adjusted by inflation. The quantity of goods or services received is a direct example of the purchasing power of the dollar in an economy.

Real income = [nominal income] / [price index (in hundredths)]
Real income will remain the same while nominal income and the price index rise together at same rate.

In the Graph below, the Real and Nominal Price Indexes from 1862 to 1992 are shown. The darker/thicker line represents the Real. The lighter/skinnier line represents the Nominal.
[[Unit Two|]]
external image nominal_vs_real_price_18621999_1.jpg


Economics: Principles, Problems, and Policies (McConnell & Brue)

E. Unemployment

1. Unemployment rate

The unemployment rate is the percentage determined by dividing the total number of employable people looking for jobs by the total number of employable people. This percentage is determined monthly in a survey by the Bureau of Labor Statistics. The current rate of unemployment for the United States is 4.7%, which means that about 7.2 million people in our country are unemployed of a possible 146.7 million. Below is a graph of the change in U.S. unemployment since 1948.

external image unemplrt.jpg

2. Labor force participation rate

The labor force participation rate measures how active economically a population is. It measures how many people who are able to work are willing. To calculate this ratio you divide the number of people who are in the labor force (a sum of both employed and unemployed) by the entire population of people who are able to work (typically between the ages of 16 and 64). This ratio is also determined monthly by the Bureau of Labor Statistics. Our current labor force is almost 154 million people and the U.S. labor force participation rate is at 66.1%.

external image labor_force_participation.gif

3. Types of unemployment

Unemployment is when a person has no job, is available to work, and is actively searching for a new job.

There are three main types of unemployment:
1. Frictional Unemployment - Frictional unemployment is when a person is in between jobs and is searching for a new job. An example is a law school graduate who is looking for a private firm to join.
2. Structural Unemployment - This type of unemployment occurs when a person does not have the correct skill set for a job. An example is a pizza delivery person who is laid off when a teleporter is invented (hopefully soon). This person cannot get another job if his/her only skill is to deliver pizza.
3. Cyclical Unemployment - A person is laid off or cannot get a job due to a downturn in the economic cycle (hence the name). The employer cannot afford the employee because there is not enough demand for a good or service. An example is a laid off auto worker when the economy is in a recession.

For more information on the latest unemployment rate or rate of labor force participation visit the Bureau of Labor Statistics at: http://www.bls.gov/news.release/empsit.nr0.htm

Are you unemployed and on the hunt for a job? Maybe you could use a few tips!

F. Business Cycles

Business cycles are also referred to as economic cycles and they help explain the fluctuations in the economy. Economists can also use business cycles to predict the future economic conditions by analyzing trends. Periods of economic prosperity and growth are displayed by a peak on the business cycle and periods of economic stagnation or recession are displayed by a trough.


1. Phases of the business cycle - the business cycle really has 4 phases: the contractionary phase, the trough, the expansionary phase, and the peak. As displayed in the picture, when real GDP declines, the economy experiences a contraction (or recession). At the lowest point of the economy, the business cycle hits a trough. The economy then starts to recover and grow, which is referred to as expansion. The peak of expansion is when the economy is at it's greatest strength and this is called the peak. these cycles repeat in varying ways due to varying variables.

2. Definition of recession - A recession is often mixed up with a depression and the terms are very similar. A recession is two consecutive periods of decline in real GDP. A depression is a drawn out recession with severe decline.