Economic Indicators and the Business Cycle

The circular flow model shows households selling resources (land, labor, capital and entrepreneurship) to firms in the factor market, and firms selling goods and services to households in the product market, so every dollar spent becomes someone's income. Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period, usually a year. You can measure it by adding up spending (C + I + G + Xn: consumer spending, investment, government purchases and net exports), by adding up incomes, or by adding up the value added at each stage of production.

GDP is a useful measure of an economy's output, but it leaves a lot out. It doesn't count nonmarket work like cooking at home or volunteering, the underground economy, leisure time, pollution and other environmental damage, or how income is shared, so a higher GDP doesn't automatically mean people are better off.

The labor force is everyone who has a job or is actively looking for one. The unemployment rate is (unemployed ÷ labor force) × 100, and the labor force participation rate is (labor force ÷ adult population) × 100. The unemployment rate can understate joblessness: discouraged workers who stop looking aren't counted, and part-time workers who want full-time jobs count as employed. Unemployment can be frictional (between jobs), structural (skills or location don't match the jobs available) or cyclical (caused by a recession); the natural rate of unemployment is frictional plus structural.

The consumer price index (CPI) compares what a fixed market basket of goods and services costs now with what it cost in a base year: CPI = (cost of the basket this year ÷ cost in the base year) × 100. The inflation rate is the percent change in a price index: (new index − old index) ÷ old index × 100. To turn a nominal value into a real one, divide by the price index and multiply by 100. Deflation is a falling price level, and disinflation means inflation is slowing down. The CPI tends to overstate inflation because its basket stays fixed while people switch to cheaper substitutes (substitution bias).

When inflation turns out higher than people expected, it shifts wealth around: borrowers with fixed-rate loans gain because they repay with dollars that buy less, while lenders, savers and people on fixed incomes lose. Unexpected deflation does the reverse, and inflation that everyone expected is already built into loan rates and wage deals. Inflation also brings smaller costs, like businesses constantly changing their prices (menu costs) and people spending effort to avoid holding cash (shoe-leather costs).

Nominal GDP values output at the prices of the year it was produced, so it can rise just because prices rose; real GDP values output at constant base-year prices, so it tracks how much is actually produced. The GDP deflator links them: GDP deflator = (nominal GDP ÷ real GDP) × 100, so real GDP = nominal GDP ÷ (deflator ÷ 100), and in the base year nominal and real GDP are equal.

Business cycles are the short-run ups and downs in real output and employment, driven by shifts in aggregate demand or aggregate supply. On the business cycle graph (real GDP on the vertical axis, time on the horizontal axis), output rises during an expansion to a peak, then falls during a recession to a trough. It swings around an upward-sloping trend line of potential (full-employment) output, where unemployment equals the natural rate. How far actual output is from potential output is called the output gap.