Topic 4: Unemployment and Potential GDP

4.1 Understanding Potential GDP

Potential GDP is the maximum output an economy can produce when all resources are fully employed, without causing inflation. It represents the economy's sustainable productive capacity.

• Actual GDP may fluctuate above or below potential GDP due to business cycles.

• When actual GDP equals potential GDP, the economy is at full employment.

4.2 Key Labor Market Terms

• Working-age population: All individuals aged 16 and over, not in institutions (e.g., prison, military).

• Employed: People with paid jobs (full-time or part-time).

• Unemployed: People without jobs who are actively seeking work.

• Labor force: The sum of employed and unemployed individuals.

• Marginally attached worker: Not working, not actively seeking work recently, but wants a job.

• Discouraged worker: A marginally attached worker who has stopped looking for work due to belief that no jobs are available.

4.3 Classifying Labor Force Status

• Employed: Has a job (full or part-time).

• Unemployed: No job, actively seeking work.

• Discouraged worker: Not seeking work due to job market conditions.

• Marginally attached: Wants work, not actively seeking recently.

• Outside labor force: Not employed, not seeking work (includes students, retirees, homemakers).

• Outside working-age population: Under 16 or institutionalized.

Example: A college student not seeking work is outside the labor force; a laid-off worker seeking jobs is unemployed.

4.4 Calculating the Unemployment Rate

• Formula:

Example: If 10 people are unemployed and the labor force is 100, unemployment rate = 10%.

4.5 Calculating the Labor Force Participation Rate

• Formula:

Example: If labor force is 150 and working-age population is 200, participation rate = 75%.

4.6 Types of Unemployment

• Frictional Unemployment: Short-term, due to normal job search (e.g., recent graduates).

• Structural Unemployment: Mismatch between skills and jobs (e.g., technological change).

• Cyclical Unemployment: Caused by economic downturns (recessions).

4.7 Full Employment, Potential GDP, and Natural Rate of Unemployment

• Full Employment: When all unemployment is frictional or structural; cyclical unemployment is zero.

• Natural Rate of Unemployment: The sum of frictional and structural unemployment.

• Relationship: At full employment, actual unemployment = natural rate; actual GDP = potential GDP.

4.8 GDP and Unemployment Fluctuations

• During expansions, real GDP rises above potential GDP, and unemployment falls below the natural rate.

• During recessions, real GDP falls below potential GDP, and unemployment rises above the natural rate.

Topic 5: Inflation, CPI, and Real vs. Nominal Values

5.1 Calculating the Consumer Price Index (CPI)

• CPI measures the average price level of a fixed basket of goods and services purchased by households.

• Formula:

Example: If basket costs $200 in base year and $220 in current year, CPI = 110.

5.2 CPI of Base Year

• By definition, the CPI in the base year is always 100.

5.3 Calculating the Inflation Rate

• Formula:

Example: If CPI rises from 110 to 121, inflation rate = 10%.

5.4 Comparing Dollar Values Across Years

• To compare the value of money across years, adjust for inflation using CPI.

• Formula:

Example: $100 in 2000 (CPI=172) is equivalent to $100 \times (260/172) = $151.16 in 2020 (CPI=260).

5.5 GDP Deflator

• GDP Deflator measures the price level of all new, domestically produced, final goods and services in an economy.

• Formula:

Difference from CPI: CPI focuses on consumer goods; GDP deflator includes all goods and services.

5.6 Nominal vs. Real Wage

• Nominal wage: Wage measured in current dollars.

• Real wage: Wage adjusted for inflation (purchasing power).

5.7 Calculating Real Wage Rate

• Formula:

Example: Nominal wage = $20/hr, CPI = 125; Real wage = $16/hr.

5.8 Nominal vs. Real Interest Rate

• Nominal interest rate: Stated interest rate, not adjusted for inflation.

• Real interest rate: Interest rate adjusted for inflation.

5.9 Calculating Real Interest Rate

• Formula (Fisher Equation):

Example: Nominal rate = 5%, inflation = 2%; real rate = 3%.

5.10 Impact of Real Interest Rate on Lenders and Borrowers

• Positive real interest rate: Lenders gain purchasing power; borrowers pay more in real terms.

• Negative real interest rate: Lenders lose purchasing power; borrowers repay less in real terms.

Topic 6: Savings, Investment, and Government Budgets

6.1 Factors Affecting Household Savings

• Income: Higher income generally increases savings.

• Interest rates: Higher rates can incentivize saving.

• Expectations: Future uncertainty may increase savings.

• Government policies: Tax incentives or social security affect saving behavior.

6.2 Factors Affecting Firm Investment

• Expected profitability: Higher expected returns increase investment.

• Interest rates: Lower rates reduce cost of borrowing, encouraging investment.

• Business taxes: Higher taxes can discourage investment.

• Technological change: New technology can spur investment.

6.3 Government Budget Surplus and Deficit

• Budget surplus: Government revenues exceed expenditures.

• Budget deficit: Government expenditures exceed revenues.

6.4 Effects on National Saving and Investment

• Surplus: Increases national saving, potentially lowering interest rates and boosting investment.

• Deficit: Reduces national saving, may raise interest rates and crowd out private investment.

6.5 Crowding Out

• Crowding out: When government borrowing raises interest rates, reducing private investment.

Topic 7: Money, Banking, and the Federal Reserve

7.1 Functions of Money

• Medium of exchange: Used to buy goods and services.

• Unit of account: Standard measure of value.

• Store of value: Retains value over time.

Example: Cash is used to buy groceries (medium of exchange), prices are quoted in dollars (unit of account), and money can be saved for future use (store of value).

7.2 What Is Considered Money?

• Money: Currency, coins, checking account deposits.

• Not money: Credit cards, stocks, bonds (not directly used for transactions).

7.3 M1 and M2 Definitions of Money

7.4 Assets and Liabilities of Commercial Banks

• Assets: Loans, reserves, securities.

• Liabilities: Deposits, borrowings.

7.5 Key Banking Terms

• Deposits: Money placed in banks by customers.

• Reserves: Cash held by banks (in vault or at central bank).

• Reserve ratio: Fraction of deposits banks must hold as reserves.

• Loans: Money lent out to borrowers.

7.6 Reserve Calculations

• Target reserves: Required reserves = Reserve ratio × Deposits.

• Excess reserves: Actual reserves - Required reserves.

• Loans banks can make: Equal to excess reserves.

Example: If deposits = $1,000, reserve ratio = 10%, required reserves = $100. If actual reserves = $150, excess reserves = $50, so bank can lend $50 more.

7.7 Structure of the Federal Reserve System

• Ownership: Owned by member banks; overseen by Board of Governors.

• President of the Fed: The Chair of the Board of Governors (e.g., Jerome Powell as of 2024).

7.8 Main Functions of the Federal Reserve

• Conduct monetary policy (control money supply and interest rates).

• Supervise and regulate banks.

• Maintain financial system stability.

• Provide financial services to banks and government.

7.9 IORB (Interest on Reserve Balances)

• IORB: Interest paid by the Federal Reserve on reserves held by banks at the Fed.

• Purpose: Helps control short-term interest rates and influence monetary policy.

Additional info: Where the study guide only listed terms or formulas, academic context and examples have been added for clarity and completeness.