AP Econ Unit II Notes part A

§Microeconomics: The study of how individual households and firms make decisions, interact with one another in markets.
§Macroeconomics: The study of the economy as a whole.
§We begin our study of macroeconomics with the country’s total income and expenditure.

§Gross Domestic Product (GDP) measures total income of everyone in the economy.
§GDP also measures total expenditure on the economy’s output of g&s.

For the economy as a whole, income equals expenditure, because every dollar a buyer spends is a dollar of income for the seller

The Circular-Flow Diagram

§a simple depiction of the macroeconomy
§illustrates GDP as spending, revenue, factor payments, and income
§Preliminaries:
•Factors of production are inputs like labor, land, capital, and natural resources.
•Factor payments are payments to the factors of production. (e.g., wages, rent)

What This Diagram Omits

§The government
•collects taxes
•purchases g&s
§The financial system
•matches savers’ supply of funds with borrowers’ demand for loans
§The foreign sector
•trades g&s, financial assets, and currencies with the country’s residents

Gross Domestic Product (GDP) Is

the market value of all final goods & services produced within a country in a given period of time.
Goods are valued at their market prices, so:

•all goods measured in the same units (e.g., dollars in the U.S.)
•Things that don’t have a market value are excluded, e.g., housework you do for yourself.

Gross Domestic Product (GDP) Is…

…the market value of all final goods & services produced within a country in a given period of time.

Final goods: intended for the end user

Intermediate goods: used as components or ingredients in the production of other goods
GDP only includes final goods – they already embody the value of the intermediate goods used in their production.

Gross Domestic Product (GDP) Is…

…the market value of all final goods & services produced within a country in a given period of time.

GDP includes tangible goods (like DVDs, mountain bikes, beer)

and intangible services (dry cleaning, concerts, cell phone service).

Gross Domestic Product (GDP) Is…

…the market value of all final goods & services produced within a country in a given period of time

GDP includes currently produced goods, not goods produced in the past.

Gross Domestic Product (GDP) Is…

…the market value of all final goods & services produced within a country in a given period of time.

GDP measures the value of production that occurs within a country’s borders, whether done by its own citizens or by foreigners located there.

Gross Domestic Product (GDP) Is…

…the market value of all final goods & services produced within a country in a given period of time.

usually a year or a quarter (3 months)

The Components of GDP

§Recall: GDP is total spending.
§Four components:
•Consumption (C)
•Investment (I)
•Government Purchases (G)
•Net Exports (NX)
§These components add up to GDP (denoted Y):

Y = C + I + G + NX

Consumption (C)

§is total spending by households on g&s.
§Note on housing costs:
•For renters, consumption includes rent payments.
•For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments.

Investment (I)

§is total spending on goods that will be used in the future to produce more goods.
§includes spending on
•capital equipment (e.g., machines, tools)
•structures (factories, office buildings, houses)
•inventories (goods produced but not yet sold

Note: “Investment” does not mean the purchase of financial assets like stocks and bonds.

Government Purchases (G)

§is all spending on the g&s purchased by govt at the federal, state, and local levels.
§G excludes transfer payments, such as Social Security or unemployment insurance benefits.
They are not purchases of g&s.

Net Exports (NX)

§NX = exports – imports
§Exports represent foreign spending on the economy’s g&s.
§Imports are the portions of C, I, and G that are spent on g&s produced abroad.
§Adding up all the components of GDP gives:

Y = C + I + G + NX

Real versus Nominal GDP

§Inflation can distort economic variables like GDP, so we have two versions of GDP: One is corrected for inflation, the other is not.
§Nominal GDP values output using current prices. It is not corrected for inflation.
§Real GDP values output using the prices of a base year. Real GDP is corrected for inflation.

The GDP Deflator


§The GDP deflator is a measure of the overall level of prices.


GDP deflator = 100 x nominal/real GDP

One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next


§Real GDP per capita is the main indicator of the average person’s standard of living.
§But GDP is not a perfect measure of well-being.