Ten Principles of Economics and the Data of Macroeconomics

ECO 372

Principles of Macroeconomics

The goal of this document is to ensure members of the strategic planning committee are familiar with current economic thoughts and principles. This document will explore and properly inform the planning committee regarding the following:

How economists are both scientists and policymakers and what principles society uses to allocate its scarce resources.

Using the circular flow model, explain the flow of money and goods in an economy.

How the economy coordinates society’s independent economic actors.

A country’s gross domestic product (GDP) and how it is defined and calculated.

How the consumer price index (CPI) is constructed and why it is an imperfect measurement of the cost of living. 

Economists as both Scientists and Policymakers

Economics and economic principles are an important part of our daily lives. Like a household, a society faces many decisions. It must decide what jobs will be done, who will do them and delegate those jobs. Someone will need to grow food, someone to make clothing, and others to design computer software and move forward the technology generation. Once the society has been established and the people allocated to various jobs, it must also allocate the goods and services they produce.

Economists can be seen as both scientists and policymakers as they are both able to develop and test their theories in an objective way. They do this through the scientific method of observation while using and testing their theories. This allows them to understand and predict the movement of the economy over time (Mankiw, 2015, p.20). Economists are like policymakers in that they help in the development of policies that will assist and improve the economy of a given country (p. 27).

Principles Used by Society to Allocate Scarce Resources

Economics is the analysis of how society determines how it will allocate, its scarce goods and resources to a population. Each economy has an infinite desire for more. Oftentimes, there is a scarcity of almost anything (good/resources) that brings people happiness. Therefore, it is essential that a society accomplishes its allocation through market system or/and command system: market systems use prices as signals to allocate its resources; command systems make use of political choice to allocate its resources.

Additionally, people may use tradeoffs among other alternatives to allocate the scarce resources and ensure the circular flow of money and goods in the economy. There are two major players in the economy: the households and the firms. The firms produce goods and services while the households are the major consumers of the goods and services as well as the supplier of the factors of production. Through these means, society strives to achieve both productive efficiency and allocative efficiency. https://en.wikibooks.org/wiki/Principles_of_Economics/Allocation

Circular Flow Model – Flow of Money and Goods in an Economy

Every economy consists of millions of people engaged in many activities doing various things on a daily basis: buying, selling, working, hiring, and manufacturing. This keeps the economy running and functioning. To understand how the economy works, all these activities must be condensed. Firms produce goods and services using inputs, such as labor, land, and capital; the factors of production. Households own the factors of production and consume all the goods and services that the firms produce. The circular flow model offers a simple way of organizing the economic transactions that occur between households and firms within the economy.

Households spend money to buy goods and services from the firms. The firms then use a portion of their revenue to pay for the cost of production, such as the wages of their workers. Any monies left over is profit for the firm owners, who are themselves members of households. It all eventually comes full circle.

How the Economy Coordinates Society’s Independent Economic Actors

According to Macroeconomics (Mankiw, 2015, pg. 196-197), the way the economy coordinates society’s independent economic actors is by using a method called, “Gross Domestic Product”. Gross Domestic Product or GDP, “is the market value of all final goods and services produced within a country in a given period of time” (Mankiw, 2015, pg. 199). The households, firms, and government are economic actors that interact with each other. Households demand goods and services, the firms employ the producing of goods and services, and governments set prices of the goods and services with taxation and incentives. Just as the circular flow model starts and ends in the same place because each factor interacts with the other, it is the same with how the economy coordinates society’s independent economic actors.

Gross domestic product (GDP) – How it is Defined and Calculated

Gross domestic product is the way economists measure how the economy is doing during a given time, either very well or poorly. GDP measures the total income of all individuals and the “total expenditure on the economy’s output of goods and services” (Mankiw, 2015). This can include items such as food, land, cars and clothing. What GDP does not measure is anything sold illicitly, such as illegal drugs. The formula for gross domestic product is GDP = C + G + I + NX.

C = household consumption

G = government purchase

I = gross private investment

NX = net exports

In order for the gross domestic product to be calculated the household consumption, government purchases, gross private investment, and net exports need to be used to measure how well the economy is performing.

Gross Domestic Product (GDP) – Imperfect Measurement of the Cost of Living

Although GDP can measure living standards to a certain extent that scope is very limited; living standards cannot be measured only through monetary terms. Real GDP, per capita, does not acknowledge aggregate labor productivity in terms of unpaid labor. This could include the value of housework, child care, elder care, volunteer work, and community service that cannot be factored into GDP per capita because those forms of labor are unpaid, even though such labor does have varying influence on living standards.

Additionally, GDP doesn’t give an accurate picture of wealth distribution. Now that small number of people at the top are worth more than the bottom billion, that tremendously skewed distribution is an important indicator of living standards. This means that average individuals are not as well off as the data would otherwise suggest.

CPI – How the Consumer Price Index is constructed

The Consumer Price Index is a monthly measurement of U.S. prices for goods and services a typical consumer has purchased by households. It is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. https://en.wikipedia.org/wiki/Consumer_price_index. The CPI reports inflation (rising prices) as well as deflation (falling prices.). The Bureau of Labor Statistics surveys the prices of 80,000 consumer items to create the index. To construct the CPI, two types of data are needed: price data and weighting data. Using these, a four-step process is used for constructing the CPI:

CPI – An Imperfect Measurement of the Cost of Living

• The BLS surveys consumers on different goods and services along with their prices.
  • Since the consumer buys the goods or services at a different point of time, the BLS must find every price for a specific point of time.
• The BLS then calculates for each point of time by multiplying the quantity for each item times its price.
• The BLS then divides the price by the year to find the base year.
• The BLS then multiplies this by 100 to find the price between the base year and other years.

The Consumer Price Index is definitely an imperfect measurement system for the cost of living. This is due to its many inaccuracies. Some of these include:

References

• Unmeasured changes in quality of new living spaces. By the time they have enough information for the cost of living, there are already new living spaces with updated systems, which would bring the original cost of living down.
• CPI does not include sales price of homes. Rather, it calculates the monthly equivalent of owning a home, which is derived from those who rent. Rental prices usually drop when there is a high vacancy rate. This typically occurs when interest rates are low, and housing prices are rising.
• On the other hand, home prices fall when interest rates rise. As the housing market deteriorates, people move into apartments, thus, making rent increase. As a result, the CPI gives a false low reading when home prices are high and rents are low. https://www.mruniversity.com/courses/principles-economics-macroeconomics/gdp-per-capita-standard-of-living

Mankiw, N. Gregory (2015). Principles of Macroeconomics (7th ed.). Stamford, CT: Cengage Learning.

https://en.wikibooks.org/wiki/Principles_of_Economics/Allocation

https://www.thebalance.com/consumer-price-index-cpi-index-definition-and-calculation-3305735

https://www.quora.com/Is-GDP-a-good-measure-for-the-standard-of-living

http://www.nber.org/