Chapter 19: GDP, Unemployment & Inflation

GDP, Income, Unemployment, Causes of Unemployment, Inflation, Consumer Price Index

Gross Domestic Product: Meaning & Components

What is the Gross Domestic Product (GDP)?

The value of all the final products produced in a year. Economists use a variety of GDP measures to indicate economic progress. GDP figures are often used to define standards of living.

The prices of each product is multiplied by the quantities of each good produced. All spending on every good is added up together.

To avoid duplicate calculations, statisticians use only the value of the final products (products received by final users). Changes in business inventories of goods are also included, although inventories are not strictly purchased by the product’s final users.

GDP does not include items sold in this year but produced in another. Used items aren’t counted.

It’s gross domestic product because we count all products that are replacing ones that have worn out or are no longer used. This does tend to overstate actual well-being because some of the production simply replaces already existing goods that are wearing out or depreciating. Net domestic product is total production minus the depreciation of existing machines & factories.

It’s gross domestic product because it only looks at production within the border of the country.

4 Components of GDP

GDP is divided into production of products in 4 categories.

  • Consumption: Spending by households, including durable goods (washing machines & cars), non-durable goods (food & gas) & services (haircuts).
  • Investment: Any spending intended to increase future output. For example, it consists of fixed investment (new factories) & inventory investment (change in inventories at business firms).
  • GDP statistics count all of education spending as consumption, though parts of it are very much an investment. Stuff like this causes the data to be a bit misleading.
  • Statisticians treat almost all individual spending as consumption, except the production of a new house & factories, tools, machines & inventories.
  • Though a lot of government spending (such as on infrastructure) are investments, it’s part of government spending in the GDP accounts.
  • Government: Local, state & federal governments purchase products (such as schools, roads, security, etc).
  • However, ~40% of government budgets aren’t included as they are transfer payments (any payment where income is transferred from one group to another via taxation, such as social security, unemployment compensation & welfare benefits). The reason they’re not included is because no products are being produced.
  • Net Exports: Products produced domestically & sold abroad.
  • Imports: Good produced abroad & purchased domestically.
  • If net exports (Exports – Imports) are positive, it’s known as a surplus in the balance of trade. If it’s negative, it’s known as a deficit in the balance of trade.

GDP = Consumption + Investment + Government Spending (– Welfare) + Exports (– Imports)

Spending Equals Production

The sum of spending for final products plus changes in businesses’ inventories is equal to the market value of production.​

When planned spending (the spending intended to occur) is less than production, the leftover production goes into inventories of businesses & is counted as part of investment spending. Thus, if planned spending is less than production, actual spending equals planned spending plus the unplanned spending. Overall, spending still equals total production.

Sometimes planned spending is greater than production. In this case, businesses are able to satisfy that spending by using goods already produced that are part of inventories. Investment in inventories decreases. This is counted as a negative investment & actual spending falls to equal actual production.


Spending equals income. However, then the statisticians add all of the numbers together, there is one other part of spending that is not included in income. Sales & excise taxes are part of spending, but do not provide income directly to any individuals.

Types of Income

Wages & Benefits

Wages, salaries & fringe benefits make up, by far, the largest portion of total income.

Corporate Profits

Revenues to corporations minus expenses are corporate profits. Regardless of status of dividends, it’s treated as incomes to the stockholders.

Other Types of Income

  • Proprietors’ Income: Includes earnings of small businesses & professionals (like lawyers).
  • Rental Income: Includes rental receipts & artists’ royalties on books & CDs.
  • Net Interest: Interest payments earned by individuals (the gross) minus the interest paid by individuals.

Standards of Living

GDP is not a good measure of the standard of living or overall well-being. This is because as products get more expensive, GDP increases, even if there’s no increase in production. In order to fix this, real GDP is introduced.

What is Real GDP?

The value of all the final products produced in a year using prices that don’t change from year to year.

But this also has weaknesses. If real GDP rises but population increases even more so, then on average each person is worse off. Thus, real GDP per person is introduced. Also known as real GDP per capita. This allows for country-to-country comparisons.

What is Gross National Happiness?

An alternative measurement of standard of living, though unpopular.

Income Inequality

Incomes might be remaining constant or perhaps declining even though real GDP per capita is rising. Economists typically track the distribution of income by fifths.

Limitations of GDP

​It’s difficult to measure all productive activity in an economy. Certain products are included, while others are unfairly excluded. As total income increases, individuals tend to reduce the number of hours they work. The amount of leisure enjoyed increases. If leisure increases, real GDP per capita is reduced. Unpaid household work is not included, If a person mows her own lawn, the service is not counted. However, if she hires someone to do it for her, real GDP per capita increases. But there has been no change in the amount produced. There has been only an increase in market activity.

Expenditures on crime prevention & national defense, for example, may not always represent an increase in a nation’s well-being.

An expanding economy often creates significant pollution. Real GDP per capita will increase, but it is conceivable that individuals would actually be worse off.

Caveat on comparing countries based upon GDP

Differing measurement techniques and data availability make accurate cross-country comparisons difficult. We should be careful about using these figures to compare standards of living of different societies or even between different time periods in the same country.


What Does the Unemployment Rate Measure?

The rate of unemployment describes the percentage of the labor force that is looking for, but cannot find a job. To be included in the labor force an individual must be a non-institutionalized civilian above the age of 16 who is either working or looking for work.

If someone has a job, they’re counted as employed. The labour force is all people who are either looking for or who have work. The labour force participation rate is the percentage of the population who are in the labour force.

How can Unemployment Rates be deceiving?

The unemployment rate is a national average & it doesn’t paint a picture of specific regions & demographics.

It is also important to couple the unemployment rate with the labour force participation rate to get a richer picture of the economic reality in a country.

Also, simply having employment is not always an indicator that all is well for individuals. Another consideration is underemployment (looking at part time workers who want a full time job).

What are the Personal Costs of Unemployment?

It becomes difficult to support yourself or your family. Bankruptcy increases, poverty increases. The likelihood of suicide, crime & marital problems increases.

What are the Societal Costs of Unemployment?

Society is not producing as much as we could. This means we are wasting resources.

What is Okun’s law?

It states for every 1% increase in unemployment, real GDP decreases by ~2%.

The 4 Primary Causes of Unemployment

  • Seasonal Unemployment: Unemployment occurs with changes in seasons, due to school schedules, weather, major holidays, etc.
  • Structural Unemployment: Unemployment caused by a mismatch of skills & job opportunities. Sometimes a lack of skills is the cause, but it could be because skilled workers don’t have opportunities (ex: due to automation).
  • The solution to such shifting sectoral demand for labour is retraining, relocating or developing a willingness to learn new skills.
  • Frictional Unemployment: Unemployment caused by the normal process of leaving jobs, getting fired, graduating from school & searching for new jobs. Sometimes people want to look around at a number of jobs to try to find the one best suited for their skills and interests.
  • Cyclical Unemployment: Unemployment caused by business cycles & fluctuations in the rate of growth in spending. Every year, more people enter the work force than leave it. Sometimes, the economy doesn’t grow fast enough to provide jobs to new entrants.

What is Full Employment?

Full employment level of unemployment is when there is zero cyclical unemployment. The lowest unemployment can be without causing an increase in the rate of inflation.

We will use this concept to identify the level of real GDP that can be produced when we’re at “full employment”. We will label that as the full-employment level of real GDP. This is the amount of output that can be produced if we are at a level of full employment. Sometimes also called the potential level of real GDP. Basically, it is the amount of output we can produce at full employment.

Alternative Terms for Full Employment

  • Natural Rate of Unemployment: The economy will “naturally” return to this level of unemployment, given sufficient time. Same as full employment.
  • NAIRU: Non-accelerating inflation rate of unemployment. Same as full employment.

Consumer Price Index

What is a Price Index?

A price index is used to track changes in the prices of products over time. In order to ensure that an index captures only the changes in the prices of products, rather than changes in consumption over time, the items being consumed in an index are held fixed over time. This is called the basket of goods. As long as the basket remains unchanged, any change in the cost of purchasing the basket over time can be attributed solely to changes in the average prices of products.

In order to measure how prices have changed between two years, we can ask, “How much would it cost us to buy the same amount of products that we purchased in 2016 in 2017?”.

Common indices used to measure inflation are the consumer price index (CPI), the producer price index (PPI) & the GDP deflator (also known as the GDP implicit price deflator). Something similar to the GDP deflator, yet calculated differently, is the GDP price index.

What is the Consumer Price Index (CPI)?

The most widely used price index. Many wage contracts are indexed to changes in the CPI (wages will increase by the same percentage as the CPI).

The CPI is the ratio of the average prices paid by consumers in one period to the average prices paid in what is called a base year. The base year is set equal to 100. Prices for more than 100,000 items each month are gathered from stores throughout the country. The basket of goods is updated to account for obsolescence of items due to technological innovation.

Weaknesses of Price Indexes

The market basket applies to a typical consumer. If an individual happens to match those patterns exactly, the CPI will be accurate. However, for most of us the CPI will be misleading. To account for prices that are subject to volatility, some items, such as gasoline, are omitted to calculate Core CPI.

There is considerable concern that the CPI consistently overstates inflation for the vast majority of the population. 2 of the most important reasons are the changing quality of products & changes in the basket in response to changes in prices.


If the price of a car increases by 5% in a year & the estimated quality of that car has increased by 5%, what has happened to the price? There really has not been an increase in the price. This is especially the case for computers, software & financial services.


The CPI has a fixed market basket. As prices change or stay the same, consumers will shift spending from more expensive goods to less expensive ones. Thus, the effects of the increased prices are smaller. The CPI will overstate that effective rate of inflation because it doesn’t change the basket.


What is Inflation?

A continual increase in average price levels. Thus, inflation is more than a one-time increase in prices.

What are Some Undesirable Effects of Inflation?

The expected rate of inflation is an important factor in the interest paid on loans. If inflation turns out to be different than what is expected, someone in that long-term financial transaction is going to be losing out in real terms.

Inflation can also affect taxes for various types of income such as interest income, capital gains & potentially the bracket that determines the marginal rate you pay.

If you are thinking ahead, individuals who may be living on fixed incomes will not be able to afford to buy as many products as they did last year.

Are real wages lowered by inflation?

On average, wage increases are not affected by inflation. In fact, due to increases in worker productivity, wages increase more rapidly than inflation. That means real wages tend to rise. Nominal wages tend to increase more rapidly with higher inflation & more slowly when inflation is low.

However, for those on fixed incomes, inflation does lower the value of that income. If one has a wage that adjusts very slowly, then that individual will be hurt by inflation.

How are lenders & borrowers affected by inflation?

With inflation, money a lender gives to a borrower is worth more than the money returned when the loan is paid off. However, lenders will normally raise interest rates in order to compensate themselves for the expected inflation. Only when the inflation is unexpected, will the lenders be hurt by inflation.​

Is the tax system distorted?

Inflation & the tax system create results that do not tax the same real incomes in the same fashion. The first example is one of capital gains. Capital gains are the appreciation in the value of an asset, such as a stock or a house, over time. A tax is owed on the gain in the value of the asset when the asset is sold. With inflation, the gain is not all a real gain. Some of it is due to inflation.

The second example is a tax on interest income. Interest income normally includes a portion that in essence compensates lenders or depositors for inflation. Because a portion of that compensation is taxed away, the lender is not fully compensated for inflation.

What are ‘Shoe Leather Costs’?

If interest rates are high, businesses will visit the bank to deposit their money more frequently. Thus, crossing the street will worn out their shoe leather. This means that high interest rates cause increased resources to be devoted to managing money. These resources could be used to produce useful products, thus causing a failure to be economically efficient.

What are Menu Costs?

​Increased rates of inflation mean that the menus in restaurants must be changed more often, and catalogue companies have to rewrite their catalogues.


There is an increase in uncertainty because it becomes harder to predict prices. As a result, less business may be done. Fewer long-term contracts are signed.

Others Costs

Many observers would add a general dislike and unhappiness with rapidly changing prices as part of inflation’s costs.

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