How is the economy doing? Economists answer with three numbers: GDP, the unemployment rate and the inflation rate. This unit is about how each is measured, what each misses, why real and nominal values differ, and how output rises and falls through the business cycle.
GDP measures the market value of all final goods and services produced in a country in a year. The circular flow shows that spending by one sector is income for another, so GDP can be measured by expenditures, by income, or by adding up value added at each stage of production.
GDP is a useful measure of economic performance, but it leaves out nonmarket transactions and says little about well-being, how income is shared, leisure or the environment.
The unemployment rate is the share of the labor force out of work; the labor force participation rate is the share of adults in the labor force. The rate understates joblessness because it leaves out discouraged and underemployed workers. Unemployment is frictional, structural or cyclical; the natural rate is frictional plus structural.
The CPI compares the cost of a fixed basket of goods with its cost in a base year. The inflation rate is the percentage change in a price index. Real values remove the effect of prices. The CPI tends to overstate inflation, partly because of substitution bias.
Unexpected inflation redistributes wealth arbitrarily. Borrowers repay loans with dollars worth less than expected, so they gain and lenders lose. People on fixed incomes and savers also lose. Unexpected deflation does the reverse.
Nominal GDP values output at current prices and measures spending; real GDP uses constant base-year prices and measures production. The GDP deflator converts one to the other.
Business cycles are fluctuations in output and employment caused by changes in aggregate demand or aggregate supply. The phases are expansion and recession; the turning points are peak and trough. The output gap is actual output minus potential (full-employment) output.