A Tour of the
Book
Chapter 2
Chapter 2 Outline
A Tour of the Book
2-1 Aggregate Output
2-2 The Unemployment Rate
2-3 The Inflation Rate
2-4 Output, Unemployment, and the Inflation
Rate: Okun’s Law and the Phillips Curve
2-5 The Short Run, the Medium Run, and the
Long Run
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A Tour of the Book
• The words output, unemployment, and inflation
appear daily in newspapers and on the evening
news.
• In this chapter, we define these words more
precisely.
• The chapter also introduces concepts around which
the book is organized: the short run, the medium
ran, and the long run.
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2-1 Aggregate Output
• National income and product accounts were
developed at the end of World War II as measures of
aggregate output.
• The measure of aggregate output is called gross
domestic product (GDP).
• How would you define aggregate output in the
economy?
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2-1 Aggregate Output
• Consider an economy with two firms, Firm 1 and Firm 2.
• Is aggregate output the sum of the values of all goods produced, i.e.,
$300? Or just the value of cars, i.e., $200?
• Steel is an intermediate good, which is a good used in the
production of another good.
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2-1 Aggregate Output
1. GDP is the value of final goods and services
produced in the economy during a given
period.
– We want to count only final goods, not intermediate
goods.
– If we merge the two firms in the previous example, the
revenues of the new firm equal $200.
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2-1 Aggregate Output
2. GDP is the sum of value added in the
economy during a given period.
– The value added by a firm is the value of its production
minus the value of the intermediate goods used in
production.
– In the two-firm example, the value added equals $100 +
$100 = $200.
• So far, we have looked at GDP from the production
side.
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2-1 Aggregate Output
3. GDP is the sum of incomes in the economy
during a given period.
– Aggregate production and aggregate income are always
equal.
– From the income side, valued added in the two-firm
example is equal to the sum of labor income ($150) and
capital or profit income ($50), i.e., $200.
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2-1 Aggregate Output
• Nominal GDP is the sum of the quantities of final
goods produced times their current price.
• Nominal GDP increases for two reasons:
– The production of most goods increases
– The price of most goods increases
• Our goal is to measure production and its change
over time.
• Real GDP is the sum of quantities of final goods
times constant (not current) prices.
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2-1 Aggregate Output
• Example:
• Real GDP in 2008 (in 2009 dollars) = 10 cars x $24,000 per car =
$240,000.
• Real GDP in 2009 (in 2009 dollars) = 12 cars x $24,000 per car =
$288,000.
• Real GDP in 2010 (in 2009 dollars) = 13 cars x $24,000 per car =
$312,000.
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2-1 Aggregate Output
• For more than one good, relative prices of the goods
are natural weights for constructing the weighted
average of the output of all final goods.
• Real GDP in chained (2009) dollars reflects
relative prices that change over time.
• The year used to construct prices is called the base
year.
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2-1 Aggregate Output
Figure 2-1 Nominal and Real U.S. GDP, 1960–2014
From 1960 and 2014, nominal GDP increased by a factor of 32. Real GDP
increased by a factor of about 5.
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2-1 Aggregate Output
• Nominal GDP is also called dollar GDP, or GDP in
current dollars.
• Real GDP is also called GDP in terms of goods,
GDP in constant dollars, GDP adjusted for
inflation, or GDP in chained (2009) dollars, or
GDP in 2009 dollars.
• GDP will refer to real GDP.
• Yt will denote real GDP in year t.
• Nominal GDP and variables in current dollars will be
denoted by a dollar sign in front of them, e.g., $Yt.
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2-1 Aggregate Output
Figure 2-2 Growth Rate of U.S. GDP, 1960–2014
GDP growth in year t is (Yt − Yt-1)/Yt-1.
Since 1960, the U.S. economy has gone through a series of expansions,
interrupted by short recessions. The 2008−2009 recession was the most severe
recession in the period from 1960 to 2014.
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2-2 The Unemployment Rate
• Employment is the number of people who have a
job.
• Unemployment is the number of people who do
not have a job but are looking for one.
• The labor force is the sum of employment and
unemployment.
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2-2 The Unemployment Rate
• The unemployment rate is the ratio of the
number of people who are unemployed to the
number of people in the labor force.
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2-2 The Unemployment Rate
• Most rich countries rely on large surveys of
households to compute the unemployment rate.
• Countries rely on household surveys to obtain such
data (LFS by CAPMAS).
• A person is unemployed if he or she does not have
a job and has been looking for a job in the last four
weeks.
• Those who do not have a job and are not looking for
one are counted as not in the labor force.
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2-2 The Unemployment Rate
• Discouraged workers are those who give up looking
for a job and so no longer counted as unemployed.
• The participation rate is the ratio of the labor force to
the total population of working age.
Participation rate = labor force/population of working age
• Because of discouraged workers, a higher
unemployment rate is typically associated with a lower
participation rate.
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2-2 The Unemployment Rate
• Why Do Economists Care about Unemployment?
1. Direct effect on the welfare of the unemployed, especially
those remaining unemployed for long periods of time.
2. A signal that the economy is not using its human
resources efficiently.
• Very low unemployment can also be a problem as
the economy runs into labor shortages.
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2-2 The Unemployment Rate
Figure 2-3 U.S. Unemployment Rate, 1960−2014
• Since 1960, the U.S. unemployment rate has fluctuated between 3 and 10%,
going down during expansions and going up during recessions.
• The effect of the recent crisis is highly visible, with the unemployment rate
reaching close to 10% in 2010, the highest such rate since the early 1980s.
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2-3 The Inflation Rate
• Inflation is a sustained rise in the general level of
prices—the price level.
• The inflation rate is the rate at which the price
level increases.
• Deflation is a sustained decline in the price level
(negative inflation rate).
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2-3 The Inflation Rate
• The GDP deflator in year t (Pt) is the ratio of nominal
GDP to real GDP in year t:
• It is called an index number (1 in 2009), which has no
economic interpretation.
• The rate of change has a clear interpretation: the rate of
inflation.
πt = (Pt − Pt-1)/Pt-1
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2-3 The Inflation Rate
• Defining the price level as the GDP deflator implies a
simple relation between nominal GP, real GDP, and the
GDP deflator:
$Yt = PtYt
• Nominal GDP is equal to the GDP deflator times real
GDP.
• The rate of growth of nominal GDP is equal to the rate of
inflation plus the rate of growth of real GDP.
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2-3 The Inflation Rate
• The set of goods produced in the economy is not the
same as the set of goods purchased by consumers
because:
– Some of the goods in GDP are sold not to consumers but to firms,
to the government, or to foreigners.
– Some of the goods bought by consumers are not produced
domestically but are imported from abroad.
• The Consumer Price Index (CPI) is a measure of the
cost of living.
• The CPI is published monthly by the CAPMAS.
• The CPI gives the cost of a specific list of goods and
services over time.
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2-3 The Inflation Rate
Figure 2-4 Inflation Rate, Using the CPI and the GDP Deflator, 1960–
2014
The inflation rates,
computed using
either the CPI or
the GDP deflator,
are largely similar.
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2-3 The Inflation Rate
• The CPI and GDP deflator moved together most of
the time.
• Exception: In 1979 and 1980, the increase in the CPI
was significantly larger than the increase in the GDP
deflator due to the price of imported goods
increasing relative to the price of domestically
produced goods.
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2-3 The Inflation Rate
• Pure inflation is proportional increase in all prices
and wages.
– This type of inflation causes only a minor inconvenience as
relative prices are unaffected.
– Real wage (wage measured by goods rather than dollars)
would be unaffected.
– There is no such thing as pure inflation.
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2-3 The Inflation Rate
• Why Do Economists Care about Inflation?
– Inflation affects income distribution when not all prices and
wages rise proportionally.
– Inflation leads to distortions due to uncertainty, some
prices that are fixed by law or by regulation, and its
interaction with taxation (bracket creep in taxes*).
• Most economists believe the “best” rate of inflation
to be a low and stable rate of inflation between 1
and 4%.
* Bracket creep in taxes means that if tax brackets are not adjusted for
inflation, people move into higher and higher tax brackets as their
nominal income increases, even if their real income remains the same.
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2-4 Output, Unemployment, and the Inflation
Rate: Okun’s Law and the Phillips Curve
Figure 2-5 Changes in the Unemployment Rate versus Growth in the
United States, 1960–2014
Output growth that is
higher than usual is
associated with a
reduction in the
unemployment rate.
Output growth that is
lower than usual is
associated with an
increase in the
unemployment rate.
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2-4 Output, Unemployment, and the Inflation
Rate: Okun’s Law and the Phillips Curve
• Okun’s law is a relation first examined by U.S.
economist Arthur Okun.
• In Figure 2-5, the line that best fits the points is
downward sloping.
• The slope of the line is –0.4, which imples that, on
average, an increase in the growth rate of 1% decreases
the unemployment rate by –0.4%.
• The line crosses the horizontal axis where output growth
is 3%, meaning that it takes a growth rate of 3% to keep
unemployment constant.
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2-4 Output, Unemployment, and the Inflation
Rate: Okun’s Law and the Phillips Curve
Figure 2-6 Changes in the Inflation Rate versus the Unemployment
Rate in the United States, 1960–2014
A low unemployment rate
leads to an increase in
the inflation rate.
A high unemployment
rate leads to a decrease
in the inflation rate.
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2-4 Output, Unemployment, and the Inflation
Rate: Okun’s Law and the Phillips Curve
• The Phillips curve is a relation first explored in 1958 by
New Zealand economist A.W. Phillips.
• Figure 2-6 plots the change in the inflation rate against
the unemployment rate, along with the line that best fits
the points.
• The line is downward sloping, meaning that higher
unemployment leads, on average, to a decrease in
inflation, and vice versa.
• The line crosses the horizontal axis where the unemployment
rate is equal to about 6%. This means that inflation typically
increased when unemployment was below 6% (overheating
economy, operating above its potential). When
unemployment has been above 6%, inflation has typically
decreased (economy operating below potential).
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2-5 The Short Run, the Medium Run,
and the Long Run
• What determines the level of Aggregate Output in an
Economy?
Consider the following arguments !!!
• A newspaper quote,” Production and sales of automobiles were
higher last month due to a surge in consumer confidence, which
drove consumers to showrooms in record numbers.”
• Can Egyptian consumers rushing to Egyptian showrooms increase
Egypt’s output to the level of output in USA??????
• Why do some countries sustain a high level of growth for some time
(such as China that achieves high growth rate since 1980) while
others don't?????
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2-5 The Short Run, the Medium Run, and the
Long Run
• In the short run (e.g., a few years), year-to-year
movements in output are primarily driven by movements
in demand.
• In the medium run (e.g., a decade), the economy tends
to return to the level of output determined by supply
factors, such as the capital stock, the level of
technology, and the size and skills of the labor force.
• In the long run (e.g., a few decades or more), the
economy depends on its ability to innovate and
introduce new technologies, and how much people save,
the quality of the county’s education system, the quality
of the government, and so on.
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2-6 A Tour of the Book
• The Core
– Chapters 3 to 6: The short run and the role of demand
– Chapters 7 to 9: The medium run and the supply side
– Chapters 10 to 13: The long run
• Extensions
– Chapters 14 to 16: Expectations and implications for
fiscal and monetary policy
– Chapters 17 to 20: Open economy and implications for
fiscal and monetary policy
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2-6 A Tour of the Book
• Back to Policy
– Chapter 21: General issues of policy
– Chapters 22 & 23: The role of fiscal and monetary
policies.
• Epilogue
– Chapter 24: History of macroeconomics and how
macroeconomists have come to believe what they believe
today
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2-6 A Tour of the Book
Figure 2-7 The Organization of the Book
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