Macroeconomics: Key Concepts, Models, and Applications – Study Guide

Business Cycles and GDP

Phases of the Business Cycle

The business cycle describes fluctuations in economic activity over time, including periods of expansion and contraction.

• Expansion: GDP rises, employment increases, and economic activity grows.

• Peak: The highest point of economic activity before a downturn.

• Contraction (Recession): GDP declines, unemployment rises, and economic activity slows.

• Trough: The lowest point of economic activity before recovery begins.

Example: GDP declines during a recession, which is the movement from peak to trough. Additional info: The movement from trough to peak is called recovery or expansion.

Potential vs. Actual GDP

• Potential GDP: The level of output an economy can produce at full employment.

• Actual GDP: The real output produced in a given period.

Formula: $GDP_{gap} = GDP_{actual} - GDP_{potential}$ Additional info: A negative GDP gap indicates underutilization of resources.

Unemployment

Types of Unemployment

Unemployment is classified into several types based on its causes:

• Frictional Unemployment: Short-term unemployment as people transition between jobs.

• Structural Unemployment: Mismatch between workers' skills and job requirements.

• Cyclical Unemployment: Caused by downturns in the business cycle.

• Natural Rate of Unemployment: The sum of frictional and structural unemployment; occurs when the economy is at full employment.

Example: A person who is actively seeking work but has not found a job in the past week is considered unemployed.

Calculating Unemployment Rate

• Labor Force: The sum of employed and unemployed persons actively seeking work.

• Unemployment Rate Formula: $Unemployment\ Rate = \frac{Number\ of\ Unemployed}{Labor\ Force} \times 100$

Example: If the labor force is 150 million and 8 million are unemployed, the unemployment rate is $\frac{8}{150} \times 100 = 5.33\%$.

Labor Market and Wage Determination

Labor Supply and Demand

The labor market equilibrium is determined by the intersection of labor supply and demand.

• Labor Supply: The number of people willing to work at different wage rates.

• Labor Demand: The number of workers firms are willing to hire at different wage rates.

• Equilibrium Wage: The wage rate at which labor supply equals labor demand.

Example: An increase in the real wage rate increases the quantity of labor supplied.

Marginal Product of Labor

• Marginal Product: The additional output produced by one more unit of labor.

• Formula: $MP_L = \frac{\Delta Output}{\Delta Labor}$

Example: If output increases from 9 to 16 when labor increases from 1 to 2 hours, $MP_L = 16 - 9 = 7$ units.

Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)

Aggregate demand represents the total demand for goods and services in an economy at different price levels.

• Downward Slope: As the price level rises, the quantity of real GDP demanded falls due to wealth, interest rate, and international trade effects.

• Shifts in AD: Caused by changes in government spending, consumer confidence, taxes, and investment.

Example: A decrease in personal income taxes shifts AD rightward.

Aggregate Supply (AS)

• Short-Run Aggregate Supply (SRAS): Shows the relationship between the price level and real GDP supplied in the short run.

• Long-Run Aggregate Supply (LRAS): Vertical at potential GDP; unaffected by price level.

• Shifts in AS: Caused by changes in resource prices, technology, and productivity.

Example: Advances in technology shift the production function upward and the demand for labor curve rightward.

Macroeconomic Equilibrium

Short-Run vs. Long-Run Equilibrium

• Short-Run Equilibrium: Where AD intersects SRAS; output may be above or below potential GDP.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS intersect; output equals potential GDP.

Example: An increase in government purchases shifts AD rightward, increasing real GDP and the price level in the short run.

Inflation, Interest Rates, and Investment

Real vs. Nominal Interest Rates

• Nominal Interest Rate: The stated interest rate without adjustment for inflation.

• Real Interest Rate Formula: $Real\ Interest\ Rate = Nominal\ Interest\ Rate - Inflation\ Rate$

Example: If the nominal rate is 11% and inflation is 9%, the real rate is 2%.

Investment and Saving

• Investment: Expenditure on capital goods to increase future production.

• Saving: Income not spent on consumption.

• Interest Rate Effect: Higher real interest rates decrease investment and increase saving.

Example: When the real interest rate increases, the saving supply curve shifts rightward.

Production Function and Diminishing Returns

Production Function

• Production Function: Shows the relationship between inputs (labor, capital) and output.

• Diminishing Returns: As more units of a variable input are added, the marginal product eventually decreases.

Example: The marginal product of the second hour of labor is 7 units (from 9 to 16 units of output).

Summary Table: Types of Unemployment

Type	Description	Example
Frictional	Short-term, between jobs	Recent graduate seeking first job
Structural	Mismatch of skills	Factory worker replaced by automation
Cyclical	Due to business cycle downturn	Worker laid off during recession

Summary Table: Shifts in Aggregate Demand and Supply

Factor	AD Shift	AS Shift
Government Purchases	Increase: Rightward	No effect
Technology	No effect	Improvement: Rightward
Taxes	Decrease: Rightward	No effect
Resource Prices	No effect	Increase: Leftward

Additional info: These tables summarize the main causes and effects of shifts in macroeconomic models.