Understanding Economics: Core Principles

Posted on Mar 16, 2025 in Economy

Microeconomics and Macroeconomics

Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.

Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

Transactions and Spending

  • Every transaction has a buyer and a seller.
  • Every dollar of spending by some buyer is a dollar of income for some seller.

Gross Domestic Product (GDP)

GDP is the market value of all final goods and services produced within a country in a given period of time. It includes all items produced in the economy and sold legally in markets. GDP is the sum of the following:

  • Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing.
  • Investment (I): The spending on capital equipment, inventories, and structures, including new housing.
  • Government Purchases (G): The spending on goods and services by local, state, and federal governments. Does not include transfer payments.
  • Net Exports (NX): Exports minus imports.

Y = C + I + G + NX

Inflation and Consumer Price Index (CPI)

Inflation refers to a situation in which the economy’s overall price level is rising.

The inflation rate is the percentage change in the price level from the previous period.

The Consumer Price Index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. The Bureau of Labor Statistics (BLS) reports the CPI each month. It is used to monitor changes in the cost of living over time. When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

Problems with CPI

  • If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.
  • If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.
  • The BLS tries to adjust the price for constant quality, but such differences are hard to measure.
  • The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.

Real vs. Nominal GDP

  • Inflation can distort economic variables such as GDP. For this reason, we have two measures for GDP: one controls for the effects of inflation and the other does not.
  • Nominal GDP values the production of goods and services at current prices.
  • Real GDP values the production of goods and services at constant prices for a base year.

GDP and Economic Well-being

  • GDP is the best single measure of the economic well-being of a society.
  • GDP per person tells us the income and expenditure of the average person in the economy.
  • Higher GDP per person indicates a higher standard of living.
  • GDP is not a perfect measure of happiness or quality of life, however.

Human Development Index (HDI)

The HDI is built as a weighted aggregation of three main factors:

  • Life expectancy
  • Literacy and scholarship rate
  • Incomes per capita

Indexation and Interest Rates

Indexation: When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.

Nominal Interest vs. Real Interest Rate

Interest represents a payment in the future for a transfer of money in the past.

  • The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays.
  • The real interest rate is the nominal interest rate that is corrected for the effects of inflation.