• Two-sector model (Households + Firms):
• Product market: Firms sell goods/services to households (clockwise flow)
• Factor market: Households supply labor, land, capital, entrepreneurship (counterclockwise flow)
• Real flows: Goods/services + factors of production
• Money flows: Expenditures/revenues + wages/rent/interest/profit
• Full model includes government and foreign sectors
• Shows interdependence between households and firms

• Market value of all final goods and services produced within a country's borders in a given period
• Final goods: Avoids double-counting intermediate goods
• Domestic: geographic-based, includes foreign firms producing in the country
• Flow variable: measured per time period (quarterly, annually)

Components of GDP: C+I+G+Xn: $GDP = C + I + G + NX$

• Transfer payments: Social Security, welfare, unemployment benefits (no production)
• Secondhand sales: Used cars, existing homes (already counted when new)
• Financial transactions: Stocks, bonds (transfer of ownership, not production)
• Non-market activities: Household work, volunteer work, barter
• Intermediate goods: Raw materials, components (to avoid double counting)
• Illegal activities: Underground economy
• Foreign-produced goods: Imports

• GDP excludes unpaid household work, volunteer services
• Childcare by parents vs. paid daycare: only paid daycare counted
• Underestimates economic activity in developing countries with large informal sectors

• GDP measures production, not well-being
• Excludes: leisure time, environmental quality, income distribution
• Externalities not counted: pollution, resource depletion
• Alternative measures: Human Development Index (HDI), Genuine Progress Indicator (GPI)

$\text{Unemployment Rate} = \frac{\text{Number of Unemployed}}{\text{Labor Force}} \times 100\%$

$\text{Labor Force Participation Rate} = \frac{\text{Labor Force}}{\text{Working-age Population}} \times 100\%$

• Labor Force: Employed + Unemployed (actively seeking work)
• Employed: Those with paid work, including part-time
• Unemployed: Those without work, available, and actively seeking
• Not in labor force: Students, retirees, discouraged workers, homemakers

• Temporary unemployment during job switching or initial job search
• New graduates entering labor market
• Seasonal workers between seasons
• Normal and healthy in a dynamic economy
• Example: Recent college graduate looking for first job

• Mismatch between skills workers have and skills employers need
• Caused by: technological change, international trade, industry decline
• Requires retraining or relocation to resolve
• Example: Factory worker replaced by automation, needs new skills

• Unemployment due to business cycle fluctuations
• Increases during recessions, decreases during expansions
• Caused by insufficient aggregate demand
• Target of macroeconomic stabilization policy
• Example: Workers laid off during 2008 financial crisis

= Frictional + Structural unemployment

• Typically 4-5% in the US
• The unemployment rate when economy at full employment
• No cyclical unemployment
• Also called NAIRU (Non-Accelerating Inflation Rate of Unemployment)
• Economy at potential GDP when unemployment = NRU

$CPI = \frac{\text{Cost of market basket in current year}}{\text{Cost of market basket in base year}} \times 100$

• Measures average price change of consumer goods and services
• Market basket: representative sample of urban consumer purchases
• Base year CPI = 100
• Most widely used measure of inflation

$\text{Inflation Rate} = \frac{CPI_{\text{current}} - CPI_{\text{previous}}}{CPI_{\text{previous}}} \times 100\%$

• Winners: Debtors (pay back with less valuable dollars), owners of real assets (real estate, commodities)
• Losers: Creditors (repaid with less valuable dollars), fixed-income recipients, cash holders
• Expected inflation: Both parties can adjust contracts, less distortion

• Costs of changing prices
• Printing new menus, catalogs, price tags
• Reduces efficiency when firms change prices less frequently
• Particularly important for small businesses

• Costs of effort to avoid holding money during inflation
• More frequent trips to bank, switching to interest-bearing assets
• Increases with inflation rate
• Reduces consumer convenience and shopping time

$\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

• Measures price level of all goods and services included in GDP
• Includes capital goods, government purchases, exports
• Excludes imports
• More comprehensive than CPI

$\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$

• Real GDP adjusts for price level changes
• Allows comparison of output across time periods
• Base year prices used for calculation
• Used to measure economic growth

• Period of declining real GDP
• Rising unemployment
• Falling income and output
• Typically lasts 6-18 months
• Official definition: two consecutive quarters of negative GDP growth

• Period of increasing real GDP
• Falling unemployment
• Rising income and output
• Average expansion lasts much longer than recession
• Can lead to inflationary pressures at peak

• Peak: Highest point before recession begins
• Economy at full employment or overfull employment
• Inflationary pressures may emerge
• Trough: Lowest point before expansion begins
• Unemployment at highest point
• Output at lowest level
• Business cycle measured peak to peak or trough to trough

• Level of GDP when economy at full employment (unemployment = NRU)
• Also called potential GDP or natural level of output
• Sustainable level of production
• Corresponds to LRAS (Long-Run Aggregate Supply)
• Actual GDP can be above or below potential output

GDP Deflator: $\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

• Measures price level of all goods and services included in GDP
• Includes capital goods, government purchases, exports
• Excludes imports
• More comprehensive than CPI

Calculating Real GDP: $\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$

• Real GDP adjusts for price level changes
• Allows comparison of output across time periods
• Base year prices used for calculation
• Used to measure economic growth