Comprehensive Study Notes: GDP, Unemployment, Inflation, and Aggregate Models in Macroeconomics

Macroeconomics Overview

Macroeconomics examines the behavior of the economy as a whole, focusing on broad aggregates such as GDP, unemployment, and inflation, and their interactions.

Gross Domestic Product (GDP)

Definition and Components

• Gross Domestic Product (GDP) is the total market value of all final goods and services produced within a country in a given period.

• GDP includes only final goods, not intermediate goods.

GDP Formula:

$GDP = C + I + G + NX$

• C: Consumer spending

• I: Business investment

• G: Government purchases

• NX: Net exports ($NX = X - M$), where X = exports and M = imports

GDP does NOT include:

• Intermediate goods

• Household production (e.g., cooking, cleaning at home)

• Underground economy (illegal activities, unreported income)

• Leisure time or quality of life

Nominal vs. Real GDP

• Nominal GDP: Measured at current prices; does not account for inflation.

• Real GDP: Measured at constant prices; adjusts for inflation to reflect true production.

GDP vs. GNP

• GDP: Measures production within a country's borders.

• GNP: Measures production by a country's citizens, regardless of location.

• Example: U.S. company in Japan counts toward Japan's GDP, but U.S. GNP.

What GDP Does NOT Measure

• Leisure time

• Environmental quality

• Household production

• Illegal or unreported market transactions

Unemployment

Definition and Measurement

• The labor force consists of all employed and unemployed individuals actively seeking work.

• Full employment does not mean 0% unemployment; frictional and structural unemployment always exist.

Unemployment Rate Formula:

$\text{Unemployment Rate} = \frac{\text{Unemployed}}{\text{Labor Force}} \times 100$

Types of Unemployment

• Frictional: Between jobs or new graduates entering the workforce.

• Structural: Skills no longer needed due to technological change or shifts in demand.

• Cyclical: Caused by economic downturns (recessions).

• Seasonal: Predictable timing (e.g., holidays, weather).

Price Level & CPI

Consumer Price Index (CPI)

• CPI measures the average change in prices paid by consumers for a basket of goods and services.

CPI Formula:

$\text{CPI} = \frac{\text{Cost of basket in current year}}{\text{Cost of basket in base year}} \times 100$

Inflation and Deflation

• Inflation: Increase in the general price level.

• Deflation: Decrease in the general price level.

Inflation Rate Formula:

$\text{Inflation} = \frac{\text{CPI}_{\text{new}} - \text{CPI}_{\text{old}}}{\text{CPI}_{\text{old}}} \times 100$

Purchasing Power

• When inflation rises faster than wages, purchasing power falls.

Aggregate Expenditure (AE) Model

Definition and Equilibrium

• AE Model shows the relationship between aggregate spending and total output at different price levels.

AE Formula:

$AE = C + I + G + NX$

Equilibrium: $AE = GDP$

• If $AE > GDP$: Unplanned inventories fall, production rises, GDP and jobs go up.

• If $AE < GDP$: Unplanned inventories rise, production falls, GDP and jobs go down.

Aggregate Demand (AD)

Definition and Movement

• AD shows total spending at each price level.

• Movement along AD: Caused by price changes.

• Shifts in AD: Caused by changes in consumer confidence, government policies, interest rates, exchange rates, and net exports.

Aggregate Supply (AS)

Short-Run and Long-Run Aggregate Supply

• SRAS (Short-Run Aggregate Supply): Upward sloping due to sticky wages and prices.

• LRAS (Long-Run Aggregate Supply): Vertical at potential GDP (full employment output).

SRAS Increases When:

• Input costs fall

• Technology improves

SRAS Decreases When:

• Wages rise

• Oil prices rise

• Negative supply shocks (e.g., natural disasters)

Long-Run Self-Correction

• In the long run, the economy self-corrects through wage adjustments.

• If equilibrium is left of LRAS: Recession gap (output below potential, high unemployment, SRAS shifts right over time).

• If equilibrium is right of LRAS: Inflation gap (tight labor market, wages rise, SRAS shifts left, economy returns to LRAS).

Interest Rates and Aggregate Demand

• When real interest rates fall: Borrowing becomes cheaper, consumer and business spending increases, AD shifts right.

• When real interest rates rise: Borrowing becomes more expensive, spending and investment fall, AD shifts left.

Net Exports (NX) and Inflation Differences

• If U.S. inflation is lower than foreign inflation: U.S. exports rise, imports fall, AD shifts right.

• If U.S. inflation is higher: U.S. exports fall, imports rise, AD shifts left.

Leading Economic Indicators

• Indicators that predict future economic activity, such as new building permits, stock market trends, orders of durable goods, and consumer confidence index.

• Examples: FedEx and UPS shipping volume.

Business Cycle Phases

• Expansion: GDP rising, unemployment falling.

• Peak: Highest point.

• Recession: GDP falling, unemployment rising.

• Trough: Lowest point.

Inventory Adjustment and Equilibrium Movement

• When firms sell more than expected: Inventories fall, production increases, GDP rises.

• When firms sell less than expected: Inventories rise, production decreases, GDP falls.

45° AE-GDP Diagram

• Shows all points where $AE = GDP$.

• Where AE line crosses 45° line is equilibrium real GDP.

• If AE shifts, equilibrium changes.

AD-AS Movement vs. Shift

• Movement along AD happens only when the price level changes.

• Shifts of AD happen when spending changes, not price level (e.g., interest rates, consumer expectations, government spending, net exports).

Household Production and Market Production

• When household work moves to paid market activity, GDP increases (because GDP only counts paid production).

Minimum Wage and SRAS

• If minimum wage > market wage, labor surplus occurs, unemployment rises, and the economy returns to LRAS.

• Minimum wage increases labor costs, causing SRAS to shift left.

Aggregate Supply Curve Shape

• SRAS slopes upward because wages and prices are sticky in the short run.

• LRAS is vertical because long-run output depends on resources, capital, and technology, not price level.

Inflation and AD

• When the price level increases, the quantity of real GDP demanded falls (movement up along the same AD curve, not a shift).

Exports & Imports Rule

• If foreign price levels fall relative to U.S. price levels, U.S. goods become more expensive, exports fall, and AD shifts left.

Economic Growth

• Occurs when capital stock increases, labor force increases, or technology improves.