Measuring Economic Health: National Income and Price Determination

Circular Flow Model

Visualizes the interdependence of different economic sectors and how resources, goods, and money move through an economy.

Households

Owners of factors of production who sell these factors to firms and buy goods/services.

Firms

Entities that produce goods and services, buying factors of production and selling finished products.

Government

Collects taxes, buys goods/services, and provides transfer payments and public goods.

Foreign Sector

Represents trade with other countries, including imports and exports.

Product Market

Market where goods and services are sold; households demand, and firms supply.

Factor (Resource) Market

Market where factors of production are sold; households supply, and firms demand.

Gross Domestic Product (GDP)

Total market value of all final goods and services produced within a country's borders in a specific time period.

Expenditure Approach

Method of calculating GDP by adding up all spending on final goods and services.

Consumption (C)

Spending by households on goods and services, the largest component of US GDP (approx. 70%).

Gross Private Domestic Investment (Ig)

Investment in new machinery, equipment, construction, and change in inventories.

Government Spending (G)

Expenditure on goods/services by the government, excluding transfer payments.

Net Exports (Xn)

Exports minus imports; indicates trade balance.

Income Approach

Calculates GDP by summing all income earned by factors of production.

National Income

Sum of wages, rent, interest, and profit earned in producing output.

Value-Added Approach

Calculates GDP by summing the value added at each stage of production.

Intermediate Goods

Goods used to produce other goods, not counted in GDP to avoid double counting.

Used Goods

Second-hand items not included in GDP calculation due to lack of new production.

Financial Transactions

Transfers of ownership like stocks and bonds, not counted in GDP as they do not represent production.

Transfer Payments

Government payments such as welfare, not included in GDP as no goods/services are produced.

Shadow Economy

Economic activities not captured by official measurements, including underground activities.

GDP per Capita

Adjusts GDP for population size to measure standard of living.

Frictional Unemployment

Temporary unemployment experienced by individuals changing jobs or entering the labor force.

Structural Unemployment

Unemployment caused by a mismatch in skills needed by employers and those possessed by workers.

Cyclical Unemployment

Unemployment that rises during economic downturns and falls during times of economic growth.

Natural Rate of Unemployment (NRU)

The unemployment level that exists when the economy is at full employment, typically around 4-6%.

Labor Force (LF)

The sum of employed and unemployed individuals who are actively looking for work.

Unemployment Rate (UR)

Percentage of the labor force that is unemployed.

Labor Force Participation Rate (LFPR)

Percentage of the adult population that is in the labor force.

Consumer Price Index (CPI)

Common measure of inflation based on a fixed market basket of goods and services.

Calculating CPI

CPI = (Cost of Basket in Current Year / Cost of Basket in Base Year) x 100.

Inflation Rate

The percentage change in the price index over time.

CPI vs GDP Deflator

CPI measures the cost of living; GDP Deflator measures prices of all domestic production.

Substitution Bias

CPI's failure to account for consumers switching to cheaper alternatives when prices change.

Nominal GDP

Value of GDP measured at current year prices, not adjusted for inflation.

Real GDP

Value of GDP adjusted for inflation, using base year prices.

GDP Deflator Formula

Real GDP = (Nominal GDP / GDP Deflator) x 100.

Expansion (Recovery) Phase

Phase of the business cycle where real GDP is rising and unemployment is typically falling.

Recession

Economic contraction marked by falling real GDP and rising unemployment.

Trough

The lowest phase of the business cycle, signaling the end of economic decline.

Potential GDP (Yp)

Real GDP produced when the economy is operating at full employment.

Output Gap

The difference between actual GDP and potential GDP.