Key Concepts in Macroeconomics: GDP, Unemployment, and Money

Posted on Dec 10, 2025 in Economy

Gross Domestic Product (GDP) and Economic Health

Gross Domestic Product (GDP) is a measure of the value of all goods and services produced within a country’s borders in a given period of time, typically a year. It is used to measure the size and health of a country’s economy.

Calculating GDP: Three Approaches

GDP can be calculated in three ways:

  1. The Output Approach: Adding up the value of all goods and services produced in a given period.
  2. The Income Approach: Adding up the income generated by those goods and services (wages, salaries, profits).
  3. The Expenditure Approach: Adding up the spending on those goods and services (consumers, businesses, government, and foreign buyers).

U.S. GDP is measured by the Bureau of Economic Analysis (BEA), which releases quarterly and annual estimates. The BEA primarily uses the expenditure approach but also calculates GDP using the income approach.

Real GDP and Its Importance

Real GDP is a measure of GDP that is adjusted for inflation. This means it shows the value of goods and services produced in a given year in constant prices. Real GDP is useful for comparing economic growth over time and across countries, as it provides a more accurate picture of changes in the economy when inflation is taken into account.

Limitations of GDP as a Well-being Measure

However, GDP has some limitations as a measure of economic well-being:

  • It does not take into account the distribution of income, meaning a country with high GDP per capita may still have widespread poverty.
  • It does not account for the value of non-market activities, such as unpaid work in the home, volunteer work, or the value of a clean environment.
  • GDP per capita is not a perfect measure of the standard of living, as it fails to account for differences in the cost of living across countries or how much of the GDP is spent on necessities versus luxuries.

Understanding Unemployment and the Labor Force

Unemployment is a measure of the number of people who are willing and able to work but are unable to find employment. There are several different types of unemployment, each caused by different factors.

Types of Unemployment

  1. Frictional Unemployment

    Refers to the natural turnover in the labor market as workers leave one job to look for another. This type is usually short-term and represents the time it takes for workers to find new jobs that match their skills and preferences.

  2. Structural Unemployment

    Caused by changes in the economy (e.g., technology shifts) that create a mismatch between the skills of available workers and the skills required for available jobs. This type is usually long-term and more difficult to address.

  3. Cyclical Unemployment

    Caused by fluctuations in the business cycle. It increases during recessions (when demand decreases and businesses lay off workers) and decreases during economic growth. This type moves in the same direction as the business cycle.

It is important to note that there is often overlap between these types of unemployment; for instance, a single individual may experience frictional and structural unemployment simultaneously. The sum of all types of unemployment yields the total unemployment rate, and the sum of employed people plus unemployed people defines the labor force of a country.

The Functions of Money and Banking Systems

The Four Functions of Money

Money serves several critical functions in an economy:

  • Medium of Exchange: Money is a widely accepted means of payment for goods and services, eliminating the need for barter and increasing transaction efficiency.
  • Unit of Account: Money is used to measure the value of goods and services and express prices, allowing for easy comparison of relative values.
  • Store of Value: Money allows individuals and businesses to save for future purchases and accumulate wealth over time.
  • Standard of Deferred Payment: Money is used to make payments at a later date, facilitating the smooth functioning of credit markets.

Fractional Reserve Banking and Money Creation

Banks create money primarily by issuing loans. When a bank grants a loan, it creates a deposit in the borrower’s account. This process is possible because of fractional reserve banking, where only a fraction of the money deposited with banks is held in reserve to meet withdrawal requests; the rest can be loaned out.

The Money Market and Quantity Theory

The Money Market refers to the market for short-term borrowing and lending of funds (periods up to one year). It is characterized by low-risk, low-return investments and is used by entities to manage short-term cash flow needs.

The Quantity Theory of Money is an economic theory stating that the overall level of prices in an economy is directly determined by the amount of money in circulation. If the money supply increases without a corresponding increase in the output of goods and services, the result will be inflation. Conversely, if the money supply decreases without a corresponding decrease in output, the result will be deflation.

The Collapse of the Bretton Woods System

The Bretton Woods system was an international monetary system established in 1944. Under this system, the value of the U.S. dollar was fixed to gold, and other currencies were pegged to the dollar. Although the system operated for nearly three decades, it ultimately collapsed in the 1970s.

Key Reasons for the End of Bretton Woods

  1. The U.S. Balance of Payments Deficit: Deficits resulting from the Vietnam War and Great Society programs led to an outflow of dollars, pressuring the U.S. to potentially devalue the dollar.
  2. The Gold Outflow: As the U.S. printed more dollars to finance the deficit, other countries began exchanging their dollars for gold, depleting U.S. gold reserves and further pressuring the dollar.
  3. Global Inflation: The 1970s saw high worldwide inflation, partly caused by the oil price shocks of 1973 and 1979. This made it difficult for countries to maintain their exchange rate peg to the dollar.
  4. Shift to Floating Exchange Rates: Many policymakers favored a floating exchange rate system, believing it would be more flexible and adaptable to changing economic conditions.

In 1971, the U.S. suspended the convertibility of the dollar into gold, effectively ending the Bretton Woods system. This led to the adoption of a floating exchange rate system, where currency values fluctuate based on supply and demand in the foreign exchange market.

Economic Cycles and Key Relationships

Inflation Cycles: Patterns of Price Change

Inflation cycles refer to the repetitive pattern of inflation (sustained increase in the overall price level) and deflation (sustained decrease in the overall price level) that occurs over time. These cycles, which typically last several years, are caused by factors such as changes in the money supply, government fiscal policy, and global commodity prices.

The Phillips Curve: Inflation vs. Unemployment

The Phillips Curve is a graphical representation illustrating the short-run trade-off between inflation and unemployment: when unemployment is low, inflation tends to be high, and vice versa. However, this relationship is not stable in the long run, as the Phillips curve tends to shift, indicating that the correlation between inflation and unemployment is not constant over extended periods.

The Business Cycle

The Business Cycle (or economic cycle) is the fluctuation of economic activity around its long-term growth path. It is characterized by periods of expansion (growth, low unemployment) and periods of contraction (shrinking economy, high unemployment). These cycles are driven by changes in consumer spending, business investment, government policy, and global economic conditions.

Four Phases of the Business Cycle

The Business Cycle, also known as the economic cycle or trade cycle, is composed of four main phases:

  1. Expansion: Characterized by a growing economy, increasing employment, and rising prices.
  2. Peak: The point where the economy reaches its highest level of growth before starting to decline.
  3. Contraction: Characterized by a shrinking economy, decreasing employment, and falling prices (or slowing inflation).
  4. Trough: Marks the end of the contraction phase and the beginning of a new expansion.

Fiat Money: Definition, Advantages, and Risks

Fiat money is a form of currency designated as legal tender by a government, but it is not backed by a physical commodity such as gold or silver. Its value is derived entirely from the faith and credit of the issuer, typically a central government or central bank.

Advantages of Fiat Money

  • It can be easily distributed and exchanged, as it does not require physical mining or minting like commodity-backed money.
  • It can be used to stabilize a country’s economy by controlling the money supply through monetary policy.
  • It is generally more durable than commodity-backed money, which can be subject to wear and tear.

Disadvantages and Risks of Fiat Money

  • Because it lacks physical backing, its value is highly susceptible to inflation if the money supply is excessively increased.
  • Its stability depends entirely on the public’s trust in the central authority to manage the money supply responsibly.
  • In the case of hyperinflation, where fiat money loses its value rapidly, restoring that value can be nearly impossible.

Historically, countries have abused the printing of money, leading to hyperinflationary conditions. Thus, the monetary policies of the government and central bank are key to maintaining the stability of fiat money.