1. © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney Prepared by: Fernando & Yvonn Quijano

2. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 2 of 31 With accurate economic data, Portugal was able to make the transition from revolution in 1975 to a prosperous democracy today. What you will learn in this chapter: ➤ How economists use aggregate measures to track the performance of the economy ➤ What gross domestic product, or GDP, is and the three ways of calculating it ➤ The difference between real GDP and nominal GDP and why real GDP is the appropriate measure of real economic activity ➤ The significance of the unemployment rate and how it moves over the business cycle ➤ What a price index is and how it is used to calculate the inflation rate

3. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 3 of 31 The National Accounts The national income and product accounts, or national accounts, keep track of the flows of money between different sectors of the economy.

4. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 4 of 31 The National Accounts The Circular-Flow Diagram, Revisited and Expanded

5. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 5 of 31 The National Accounts Consumer spending is household spending on goods and services. The Circular-Flow Diagram, Revisited and Expanded A stock is a share in the ownership of a company held by a shareholder. A bond is borrowing in the form of an IOU that pays interest.

6. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 6 of 31 The National Accounts Government transfers are payments by the government to individuals for which no good or service is provided in return. Disposable income, equal to income plus government transfers minus taxes, is the total amount of household income available to spend on consumption and to save. Private savings, equal to disposable income minus consumer spending, is disposable income that is not spent on consumption. The banking, stock, and bond markets, which channel private savings and foreign lending into investment spending, government borrowing, and foreign borrowing are known as the financial markets. The Circular-Flow Diagram, Revisited and Expanded

7. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 7 of 31 The National Accounts Government borrowing is the amount of funds borrowed by the government in the financial markets. Government purchases of goods and services are government expenditures on goods and services. The Circular-Flow Diagram, Revisited and Expanded

8. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 8 of 31 The National Accounts Goods and services sold to residents of other countries are exports; goods and services purchased from residents of other countries are imports. The Circular-Flow Diagram, Revisited and Expanded Investment spending is spending on productive physical capital, such as machinery and construction of structures, and on changes to inventories.

9. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 9 of 31 The National Accounts Final goods and services are goods and services sold to the final, or end, user. Intermediate goods and services are goods and services—bought from one firm by another firm— that are inputs for production of final goods and services. Gross domestic product, or GDP, is the total value of all final goods and services produced in the economy during a given year. Aggregate spending, the sum of consumer spending, investment spending, government purchases, and exports minus imports, is the total spending on domestically produced final goods and services in the economy. Gross Domestic Product

10. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 10 of 31 The National Accounts Calculating GDP

11. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 11 of 31 The National Accounts Calculating GDP Measuring GDP as the Value of Production of Final Goods and Services The value added of a producer is the value of its sales minus the value of its purchases of inputs.

12. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 12 of 31 The National Accounts Calculating GDP Measuring GDP as Spending on Domestically Produced Final Goods and Services Another way to calculate GDP is by adding up aggregate spending on domestically produced final goods and services. That is, GDP can be measured by the flow of funds into firms. The following equation breaks GDP down by the four sources of aggregate spending: (15-1)GDP = C + I + G + X - IM

13. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 13 of 31 The National Accounts Calculating GDP Measuring GDP as Factor Income Earned from Firms in the Economy Another way to calculate GDP is to add up all the income earned by factors of production from firms in the economy—the wages earned by labor; the interest earned by those who lend their savings to firms and the government; the rent earned by those who lease their land or structures to firms; and the profit earned by the shareholders, the owners of the firms’ physical capital.

14. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 14 of 31 The National Accounts Calculating GDP The Components of GDP

15. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 15 of 31 The National Accounts Calculating GDP The Components of GDP Net exports are the difference between the value of exports and the value of imports. What GDP Tells Us The most important use of GDP is as a measure of the size of the economy, providing us a scale against which to measure the economic performance of other years, or compare the economic performance of other countries.

16. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 16 of 31 Real GDP and Aggregate Output Calculating Real GDP TABLE 15-1 Calculating GDP and Real GDP in a Simple Economy Year 1Year 2 Quantity of apples (billions)2,0002,200 Price of apple$0.25$0.30 Quantity of oranges (billions)1,0001,200 Price of orange$0.50$0.70 GDP (billions of dollars)$1,000$1,500 Real GDP (billions of year 1 dollars)$1,000$1,150

17. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 17 of 31 Real GDP and Aggregate Output Calculating Real GDP Real GDP is the total value of all final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. Nominal GDP is the value of all final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced.

18. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 18 of 31 Real GDP and Aggregate Output Calculating Real GDP TABLE 15-2 Nominal versus Real GDP in 1996, 2000, and 2004 Nominal GDP (billions of current dollars) Real GDP (billions of 2000 dollars) 1996$7,817$8,329 20009,817 200411,73410,842

19. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 19 of 31 Real GDP and Aggregate Output What Real GDP Doesn’t Measure GDP per capita is GDP divided by the size of the population; it is equivalent to the average GDP per person.

20. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 20 of 31 economics in action Good Decades, Bad Decades

21. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 21 of 31 The Unemployment Rate Understanding the Unemployment Rate

22. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 22 of 31 The Unemployment Rate Growth and Unemployment

23. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 23 of 31 Price Indexes and the Aggregate Price Level Market Baskets and Price Indexes A market basket is a hypothetical set of consumer purchases of goods and services. TABLE 15-3 Calculating the Cost of a Market Basket Pre-frostPost-frost Price of orange$0.20$0.40 Price of grapefruit$0.60$1.00 Price of lemon$0.25$0.45 Cost of market basket (200 oranges, 50 grapefruit, 100 lemons) (200 × $0.20) + (50 × $0.60) + (100 × $0.25) = $95.00 (200 × $0.40) + (50 × $1.00) + (100 × $0.45) = $175.00

24. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 24 of 31 Price Indexes and the Aggregate Price Level Market Baskets and Price Indexes A price index measures the cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the selected base year. (15-2)

25. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 25 of 31 Price Indexes and the Aggregate Price Level Market Baskets and Price Indexes The inflation rate is the percent change per year in a price index—typically the consumer price index. (15-3)

26. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 26 of 31 Price Indexes and the Aggregate Price Level The Consumer Price Index The consumer price index, or CPI, measures the cost of the market basket of a typical urban American family.

27. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 27 of 31 Price Indexes and the Aggregate Price Level The Consumer Price Index

28. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 28 of 31 Price Indexes and the Aggregate Price Level The Consumer Price Index

29. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 29 of 31 Price Indexes and the Aggregate Price Level Other Price Measures The producer price index, or PPI, measures changes in the prices of goods purchased by producers. The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year.

30. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 30 of 31 Price Indexes and the Aggregate Price Level Other Price Measures

31. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 31 of 31 National income and product accounts (national accounts) Consumer spending Stock Bond Government transfers Disposable income Private savings Financial markets Government borrowing Government purchases of goods and services Exports Imports Investment spending Final goods and services Intermediate goods and services Gross domestic product (GDP) Aggregate spending Value added Net exports Real GDP Nominal GDP GDP per capita Market basket Price index Inflation rate Consumer price index (CPI) Producer price index (PPI) GDP deflator K E Y T E R M S