Unit II

Unit II: 

I. Inflation- a rise in the general level of prices 

Standard Inflation Rate: 2-3%

II. Measuring Inflation 

A. Inflation Rate: measures the percentage increase in the price level over time. It is a key indicator of the economy's strength. 

- Deflation: decline in the general price level 

- Disinflation: occurs when the inflation rate itself declines. 

B. Consumer Price Index: (CPI): measures inflation by tracking the yearly price of a fixed basket of consumer goods and services. Indicates changes in the price level and cost of living. 

III. Solving Inflation Problems: 

A. Finding inflation rate using market basket data:

Current year market basket value - base year market basket value / base year market value X 100

B. Finding inflation rate using Price indexes:

Current year price index - base year price index / base year price index X 100. 

C. Estimating inflation using the rule of 70: 

Rule of 70- used to calculate the number of years it will take for the. Price level to double at any given rate of inflation.  

Years needed to double inflation = 70/annual inflation rate 

D. Determining real wages: 

Real Wages = nominal wages/ price level X 100

E. Finding real interest rate: 

Real interest rate = nominal interest rate - inflation premium 

A. Real interest rate: the cost of borrowing or lending money that is adjusted for expected inflation. 

B. Nominal interest rate: the unadjusted cost of borrowing or lending money.  

IV. Causes of Inflation:

A. Demand pull inflation: Caused by an excess of demand over output that pulls prices upward. 

B. Cost push inflation: caused by a rise in per unit production cost due to increasing resource cost. 

V. Effects of Inflation: 

Anticipated vs. Unanticipated inflation: anticipated is when you expect it and unanticipated is when you don't see it coming. 

Unemployment: Percentage of people who do not have a job but are part of the labor force. 

Labor Force: the number of people in a country that are classified as either employed or unemployed. 

Unemployment rate: # of unemployed/ # of unemployed + # of employed 

Not in the Labor Force: kids, retired people, military personal, mentally insane, incarcerated, full time students, stay at home parents, discouraged worker( someone who has been looking for work but haven't found anything) 

Full employment: Occurs when there is no cyclical unemployment present In the economy.  4-5%    (natural rate of unemployment NRU- achieved when labor markets are imbalanced) 

NRU= structural unemployment|frictional employment 

Unemployment is good because 1. there is less pressure to raise wages. 

2. There are more workers available for future expansions. 

Unemployment is bad because

1. Not enough for consumption (GDP) 

2. Too much poverty

3. Too much government assistance is needed. 

Okun'sc law- for every 1% of unemployment above the NRU causes a 2% decline in real GDP 

Aggregate Supply: the level of real GDP (GDPr) that firms will produce at each Price Level (PL) 

Long run v. Short Run: 

Long-Run: period of time where input prices are completely flexible and adjust to changes in the the price level. 

In the long run, The level of Real GDP supplied is independent of the price level.

Short-Run: period of time where input prices are sticky and do not adjust to changes in the price level. 

The level of real GDP supplied is directly related to the price of level. 

Long-Run Aggregate Supply: the long run aggregate supply or LRAS marks the level of full employment in the economy.(analogous to PPC) 

Because input prices are completely flexible in the long run, changes in price level do not change firms real profit and therefore do not change firms level of output. This means that the LRAS is vertical at the economy's level of full employment. 

Because input prices are sticky in the short run, the SRAS is upward sloping. 

Change in SRAS: 

An increase in SRAS is seen as a shift to the right. SRAS ➡️

A decrease in SRAS is seen as a shift to the left. SRAS ⬅️ 

The key to understanding sifts in SRAS is per unit cost of production. 

Per unit production cost= total input cost/total output cost

Determinants of SRAS: 

1. Input prices

Domestic resource prices:

-Wages(75% of all business cost)

-Raw materials 

-Cost of Capital 

Foreign resources prices:

-depends on the strength of the dollar. 

Strong $= lower foreign resource prices

Weak $=higher foreign resource prices 

Market Power: 

-Monopolies and cartels that control resources control the price of those resources. 

Increases in Resources- SRAS shifts to the right 

Decrease in Resources-SRAS shifts to the left 

2. Productivity

Productivity=total output/total inputs

More productivity= lower unit production cost= SRAS➡️

3. Legal-Institutional environment 

Taxes and Subsidies:

Taxes on business increase per unit production cost=SRAS ⬅️

Subsidies to business reduce per unit production cost=SRAS ➡️ 

Government Regulation: Government regulation creates a cost of compliance=SRAS ⬅️. 

Deregulation reduces compliance costs=SRAS➡️. 

Full employment:  Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point. 

A recessionary Gap: a recessionary gap exists when equilibrium occurs below full employment output 

- AD decreases shifts to the left: 

An inflationary Gap: exists when equilibrium occurs beyond full employment output. 

-AD increases Because it shifts to the right