Chapter 8 Measuring the Economy’s Performance

Introduction Some commentators are already referring to the twenty- first century as the “Asian century.” It has been suggested that China’s economy will be larger than the U.S. economy by 2020. How do we go about measuring the size of an economy? And how do we make international comparisons with regard to this measure? The concept of gross domestic product, which is a key concept of Chapter 8, is the starting point for contemplating these questions.

Learning Objectives Describe the circular flow of income and output Define gross domestic product (GDP) Understand the limitations of using GDP as a measure of national welfare

Learning Objectives (cont'd) Explain the expenditure approach to tabulating GDP Explain the income approach to computing GDP Distinguish between nominal GDP and real GDP

Chapter Outline The Simple Circular Flow National Income Accounting Two Main Methods of Measuring GDP Other Components of National Income Accounting Distinguishing Between Nominal and Real Values Comparing GDP Throughout the World

Did You Know That ... The flow of U.S. economic activity since 2009 has been more dampened than during any other comparable post-recession period since the Great Depression of the 1930’s? To measure the nation’s overall economic performance, the government utilizes the concept of national income accounting.

The Simple Circular Flow The concept of the circular flow of income involves two principles: In every economic exchange, the seller receives exactly the same amount that the buyer spends Goods and services flow in one direction and money payments flow in the other

The Simple Circular Flow (cont'd) Profits explained Question Why is profit a cost of production? Answer Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities

Figure 8-1 The Circular Flow of Income and Product

The Simple Circular Flow (cont'd) Product Markets Transactions in which households buy goods Factor Markets Transactions in which businesses buy resources

The Simple Circular Flow (cont'd) Total Income The yearly amount earned by the nation’s resources (factors of production) Includes wages, rent, interest payments, and profits received by workers, landowners, capital owners, and entrepreneurs, respectively

The Simple Circular Flow (cont'd) Final Goods and Services Goods and services that are at their final stage of production and will not be transformed into yet other goods or services

The Simple Circular Flow (cont'd) Question Why must the dollar value of total output equal total income? Answer Every transaction simultaneously involves an expenditure and a business receipt

National Income Accounting A measurement system used to estimate national income and its components Gross Domestic Product (GDP) The total market value of all final goods and services produced by factors of production located within a nation’s borders

National Income Accounting (cont'd) Observations GDP measures the dollar value of final output GDP measures the dollar value of final goods and services produced per year by factors of production located within a nation’s borders

National Income Accounting (cont'd) Stress on final output What is a final good? Wheat? Steel? Crude oil? Bread? Automobile? Gasoline?

National Income Accounting (cont'd) Intermediate Goods Goods used up entirely in the production of final goods Value Added The dollar value of an industry’s sales minus the value of intermediate goods (for example, raw materials and parts) used in production

Table 8-1 Sales Value and Value Added at Each Stage of Donut Production

National Income Accounting (cont'd) Numerous transactions occur that have nothing to do with final goods and services being produced: Financial transactions Transfer of secondhand goods Others excluded transactions

What If . . . Market prices of house cleaning, child care, and lawn care services were valued for inclusion in GDP? Even if market prices of household services were used to place a value on household production, national income accountants still would not know the volume of such activity. Therefore, they would have to estimate the amount of household activity, and this would introduce measurement errors into the calculation of GDP.

National Income Accounting (cont'd) Financial transactions Securities Stocks and bonds Government transfer payments Social Security Unemployment compensation Private transfer payments Individual gifts Corporate gifts

National Income Accounting (cont'd) Transfer of secondhand goods Why not count the sale of a used computer, guitar, or snowboard as part of GDP? Other excluded transactions Household production Legal and illegal underground transactions

National Income Accounting (cont'd) GDP’s limitations Excludes non-market production It is not necessarily a good measure of the well- being of a nation

National Income Accounting (cont'd) GDP: Is a measure of the value of production in terms of market prices, and an indicator of economic activity Is not a measure of a nation’s overall welfare

Policy Example: Developed Nations Look for a “Happier” Alternative to GDP The 34 member nations of the Organization for Economic Cooperation and Development are aiming to supplement or even replace GDP with a measure called the “Your Better Life Index.” This measure of well-being includes scores in 11 areas such as community, education, health, housing, life satisfaction, and safety. Initial results of the Your Better Life Index yield high rankings for Denmark, Canada, and Norway, with Hungary, Portugal, and Estonia ranking lowest among the OECD nations.

Two Main Methods of Measuring GDP Expenditure Approach Computing GDP by adding up the dollar value at current market prices of all final goods and services

Two Main Methods of Measuring GDP (cont'd) Income Approach Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach Consumption Expenditure (C) Durable Consumer Goods Items that last more than three years (automobiles, furniture) Nondurable Consumer Goods Goods that are used up in three years (gasoline, food) Services Mental or physical help

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach Gross Private Domestic Investment (I) The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future Also includes changes in business inventories and repairs made to machines, buildings

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach Gross Private Domestic Investment (I) Producer Durables or Capital Goods Life span of more than three years Fixed Investment Purchases by business of newly produced producer durables or capital goods Inventory Investment Changes in stocks of finished goods and goods in process, as well as changes in raw materials

Example: Imputing Part of the Government’s Contribution to GDP Some items included in GDP do not have explicit market prices. Examples include public education, fire protection, and national defense. National income accountants have reasoned that government expenditures on these items understate the market prices that would prevail if they were provided by private firms. Therefore, the values are determined by using prices for education, fire protection, and security services provided in private markets. 31

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the Expenditure Approach Government Expenditures (G) State, local, and federal Valued at cost

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the Expenditure Approach Net Exports (Foreign Expenditures) Net exports (X) = Total exports – Total imports

Two Main Methods of Measuring GDP (cont'd) Presenting the expenditure approach where C = consumption expenditures I = investment expenditures G = government expenditures X = net exports GDP = C + I + G + X

Figure 8-2 GDP and Its Components

Two Main Methods of Measuring GDP (cont'd) Net Domestic Product (NDP) Allowing for depreciation (capital consumption allowance) The amount that businesses would have to save in order to take care of deteriorating machines and other equipment NDP = GDP – Depreciation

Two Main Methods of Measuring GDP (cont'd) Because NDP = GDP – Depreciation, and GDP = C + I + G + X NDP = C + I + G + X – Depreciation NDP = C + net I + G + X where net I (net investment ) = I – Depreciation Domestic investment minus an estimate of the wear and tear on the existing capital stock The change in the capital stock over a one-year period

Two Main Methods of Measuring GDP (cont’d) Deriving GDP by the Income Approach Gross Domestic Income (GDI) The sum of all income (wages, interest, rent, and profits) paid to the four factors of production

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach Gross Domestic Income (GDI) Wages: salaries and labor income Rent: farms, houses, stores Interest: savings accounts Profits: sole proprietorships, partnerships, corporations

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach Gross domestic product equals gross domestic income plus indirect business taxes and depreciation These last items are called non-income expense items

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach Indirect business taxes All business taxes except the tax on corporate profits Include sales and business property taxes

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year)

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year) (cont’d)

Other Components of National Income Accounting National Income (NI) The total of all factor payments to resource owners Personal Income (PI) The amount of income that households actually receive before they pay personal income taxes

Example: Sources of U.S. Personal Income Exhibit Unsustainable Trends Since early 2010, the share of personal income derived from private payrolls has dropped to levels that are the lowest in U.S. history. At the same time, the portion of personal income derived from government-provided benefits has risen to its highest level. These trends are unsustainable because government benefits are financed through taxes on private income.

Other Components of National Income Accounting (cont'd) Disposable Personal Income (DPI) Personal income after personal income taxes have been paid

Table 8-2 Going from GDP to Disposable Income, 2013

Distinguishing Between Nominal and Real Values Nominal Values Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values Real Values Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars

Distinguishing Between Nominal and Real Values (cont'd) Constant Dollars Dollars expressed in terms of real purchasing power This price-corrected GDP is the real GDP

Example: Correcting GDP for Price Index Changes, 2003 - 2013 Let’s use a numerical example to show how we can adjust GDP for changes in the price index. In this example shown on the next slide, the GDP deflator is used to calculate values for real GDP from 2003 to 2013.

Table 8-3 Correcting GDP for Price Index Changes

Figure 8-4 Nominal and Real GDP Source: U.S. Department of Commerce.

Distinguishing Between Nominal and Real Values (cont'd) Per capita real GDP Real GDP divided by total population Per capita real GDP = Real GDP Population

Comparing GDP Throughout the World Foreign Exchange Rate The price of one currency in terms of another Example: $1.25 = 1 euro, or $1 = .80 euros French income per capita = 28,944 euros French per capita income in terms of dollars equals 28,944 euros x $1.25 = $36,180

Comparing GDP Throughout the World (cont'd) Purchasing Power Parity Adjustment in exchange rate conversions that takes into account differences in the true cost of living across countries

International Example: Purchasing Power Parity Comparisons of World Incomes The International Monetary Fund accepted the purchasing power parity approach a few years ago It started presenting the statistics on each country’s GDP relative to others and based on the purchasing power parity relative to the dollar Why is China’s per capita GDP higher based on purchasing power parity?

Table 8-4 Comparing GDP Internationally

You Are There: Has the Economy Grown More than Official GDP Data Suggest? Economists Bart Hobijin and Charles Steindel at the Federal Reserve Bank of New York are considering how to include three additional items in GDP: Intangible investment Real capital investment undertaken by government Shift away from non-market home production as more women enter the labor force. Hobijin and Steindel conclude that the net effect of these three items is to boost the GDP growth rate by about 0.5 percentage points per year.

Issues & Applications: Asia’s “Economic Size” Depends on How It Is Measured The figure on the next slide shows the combined real GDP of Asia as a percentage of real GDP of the entire world. The calculation was done according to two different measures. One used prevailing exchange rates in foreign currency markets. The other used purchasing power parity adjustments.

Figure 8-5 Asia’s Share of Global Real GDP Source: International Monetary Fund.

Another measure of Asia’s economic presence is per capita real GDP. Issues & Applications: Asia’s “Economic Size” Depends on How It Is Measured (cont’d) Of the two methods, the purchasing power parity measure gives a larger estimate for Asia’s share of the world economy. Another measure of Asia’s economic presence is per capita real GDP. When comparisons are based on foreign exchange rates, Asian per capita real GDP is 11 percent of global per capita real GDP. Using a purchasing power parity comparison, the figure rises to 26 percent.

Summary Discussion of Learning Objectives The circular flow of income and output In every economic transaction, receipts exactly equal expenditures Goods and services flow in one direction and money payments flow in the other Gross domestic product (GDP) The total market value of a nation’s final output of goods and services produced in a year using factors of production located within its borders

Summary Discussion of Learning Objectives (cont'd) The limitations of using GDP as a measure of national welfare Excludes non-market transactions Does not measure national well-being The expenditure approach to tabulating GDP GDP = C + I + G + X

Summary Discussion of Learning Objectives (cont'd) The income approach to computing GDP The sum of wages, rent, interest, profits Distinguishing between nominal GDP and real GDP Nominal GDP is the value of newly produced final output measured in current market prices. Real GDP adjusts nominal GDP into constant dollars by correcting for price level changes