Macroeconomics ECON 2301 May 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 8

Extra Credit Opportunity #7 4 Find out who won the Nobel Prize for Economics – announced Monday, Oct Find out what research strand(s) the prize is recognizing. 4 Send me that info in an , before class Wednesday, May. 4 points possible

Chapter 8: Measuring the Economy’s Performance

Learning Objectives 1. Describe the circular flow of income and output 2. Define gross domestic product (GDP) 3. Understand the limitations of using GDP as a measure of national welfare 4. Explain the expenditure approach to tabulating GDP 5. Explain the income approach to computing GDP 6. Distinguish between nominal GDP and real GDP

The Simple Circular Flow 4 Two observations 1.In every economic exchange, the seller receives exactly the same amount that the buyer spends. 2.Goods and services flow in one direction and money payments flow in the other.

8-6 The Simple Circular Flow (cont'd) 4 Final Goods and Services ÜGoods and services that are at their final stage of production and will not be transformed into yet other goods or services

8-7 The Simple Circular Flow (cont'd) 4 Product Markets ÜTransactions in which households buy goods

8-8 The Simple Circular Flow (cont'd) 4 Total Income ÜWages, rent, interest, profits

8-9 The Simple Circular Flow (cont'd) 4 Factor Markets ÜTransactions in which businesses buy resources

8-10 The Simple Circular Flow (cont'd)

8-11 National Income Accounting 4 National Income Accounting: A measurement system used to estimate national income and its components 4 Total Income: The yearly amount earned by the nation’s resources (factors of production)

8-12 National Income Accounting (cont'd) 4 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 ÜGDP measures the dollar value of final output. ÜGDP measures the dollar value of final goods and services produced per year by factors of production located within a nation’s borders.

8-13 National Income Accounting (cont'd) 4 Stress on final output ÜWhat is a final good? Wheat? Steel? Oil? Bread? Automobile? Gasoline?

8-14 National Income Accounting (cont'd) 4 Intermediate Goods: Goods used up entirely in the production of final goods 4 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

8-15 Table 8-1 Sales Value and Value Added at Each Stage of Donut Production

8-16 National Income Accounting (cont'd) 4 We exclude financial transactions, transfer payments, and secondhand goods ÜNumerous transactions occur that have nothing to do with final goods and services being produced.

8-17 National Income Accounting (cont'd) 4 Exclusion of financial transactions ÜSecurities – e.g., Stocks and bonds ÜGovernment transfer payments, e.g.: Social Security Unemployment compensation ÜPrivate transfer payments Individual gifts Corporate gifts

8-18 National Income Accounting (cont'd) 4 Transfer of secondhand goods excluded ÜWhy not count the sale of a used computer, guitar, or snowboard as part of GDP? 4 Other excluded transactions ÜHousehold production ÜLegal and illegal underground transactions

8-19 National Income Accounting (cont'd) 4 GDP’s limitations ÜExcludes non-market production ÜExcludes non-reported (illegal) market production ÜIt is not necessarily a good measure of the well-being of a nation. 4 GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity. 4 GDP is not a measure of a nation’s overall welfare.

8-20 National Income Accounting (cont'd) 4 GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity. 4 GDP is not a measure of a nation’s overall welfare.

Main Methods of Measuring GDP 1.Expenditure Approach to measuring GDP: Computing GDP by adding up the dollar value at current market prices of all final goods and services

Main Methods of Measuring GDP (cont'd) 2.Income Approach of measuring GDP: Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

Main Methods of Measuring GDP(cont'd) 1.Deriving GDP by the expenditure approach a.Consumption Expenditure (C) b.Gross Private Domestic Investment c.Government purchases of goods and services d.Net Exports

Main Methods of Measuring GDP (cont'd) 1.Deriving GDP by the expenditure approach a.Consumption Expenditure (C) Durable Consumer Goods –Life span of more than three years Nondurable Consumer Goods –Goods that are used up in three years Services –Mental or physical help

Main Methods of Measuring GDP (cont'd) 4 Deriving GDP by the expenditure approach b.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 included: changes in business inventories and repairs made to machines, buildings

2 Main Methods of Measuring GDP (cont'd) 4 Deriving GDP by the expenditure approach b.Gross Private Domestic Investment (I), cont’d 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

Main Methods of Measuring GDP (cont'd) 4 Deriving GDP by the expenditure approach c.Government Expenditures (G) State, local, and federal Valued at cost

Main Methods of Measuring GDP (cont'd) 4 Deriving GDP by the expenditure approach d.Net Exports (Foreign Expenditures) Net exports (X) = Total exports – Total imports

Main Methods of Measuring GDP (cont'd) 4 Presenting the expenditure approach ÜWhere a.C=consumption expenditures b.I=investment expenditures c.G=government expenditures d.X=net exports (exports – imports) GDP = C + I + G + X

8-30 Figure 8-2 GDP and 3 of Its Components

8-31 NDP = GDP – Depreciation 2 Main Methods of Measuring GDP (cont'd) 4 Depreciation and net domestic product ÜDeducting for depreciation (capital consumption allowance): Reduction in the value of capital goods over a one-year period due to physical wear and tear, and also to obsolescence

2 Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach

2 Main Methods of Measuring GDP (cont’d) Deriving GDP by the Income Approach 4 Gross Domestic Income (GDI): The sum of all income (wages, interest, rent, and profits) paid to the four factors of production.

2 Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach 2.Gross Domestic Income (GDI) a.Wages: salaries and labor income b.Rent: farms, houses, stores c.Interest: savings accounts d.Profits: sole proprietorships, partnerships, corporations

2 Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach 4 Gross domestic product equals gross domestic income plus indirect business taxes and depreciation 4 These last items are called non-income expense items

2 Main Methods of Measuring GDP (cont'd) Deriving GDP by the Income Approach 4 Indirect business taxes: All business taxes except the tax on corporate profits ÜInclude sales and business property taxes

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year) Sources: U.S. Department of Commerce and Miller’s estimates

8-38 Other Components of National Income Accounting 4 National Income (NI): The total of all factor payments to resource owners 4 Personal Income (PI): The amount of income that households actually receive before they pay personal income taxes 4 Disposable Personal Income (DPI): Personal income after personal income taxes have been paid

8-39 Table 8-2 Going from GDP to Disposable Income, 2007

GDP Measures Total Production, expenditure & Income Some Actual Values Go to a page of the Bureau of Economic Analysis Web site to look at each of these components: edTable=5&FirstYear=2007&LastYear=2008&Freq=Qtr edTable=1&FirstYear=2007&LastYear=2008&Freq=Qtr

8-41 Distinguishing Between Nominal and Real Values 4 Nominal Values ÜMeasurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values 4 Real Values ÜMeasurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars 4 Constant Dollars ÜDollars expressed in terms of real purchasing power

8-42 *Price level: measured by the GDP deflator Real GDP =  x 100 Nominal GDP Price level* Example: Correcting GDP for Price Index Changes 4 Correcting GDP for price index changes ÜNominal (current) dollars GDP ÜReal (constant) dollars GDP Go to and click on “Current Dollar & ‘Real’ GDP.”

8-43 Table 8-3 Correcting GDP for Price Index Changes

8-44 Source: U.S. Department of Commerce Figure 8-4 Nominal and Real GDP

8-45 Per capita real GDP = Real GDP Population 4 Per capita GDP ÜAdjusting for population growth Go to ftp://ftp.bls.gov/pub/special.requests/cpi/cp iai.txt for historical data. ftp://ftp.bls.gov/pub/special.requests/cpi/cp iai.txt

8-46 Comparing GDP Throughout the World 4 Foreign Exchange Rate ÜThe price of one currency in terms of another 4 Foreign exchange rate Suppose $1.50 = 1 euro, or $1 =.67 euros. French income per capita = 24,120 euros. French per capita income in terms of dollars equals 24,120 euros x $1.50 = $36,180.

8-47 Table 8-4 Comparing GDP Internationally

8-48 Issues and Applications: The Art of Estimating GDP Often Requires Touch-Ups 4 The Bureau of Economic Analysis gives an advance estimate of quarterly GDP. 4 The estimate receives considerable attention from the news media. 4 Nevertheless, the estimate is updated at least two times. 4 How different is the final result?

8-49 Figure 8-5 Effects of Revisions in GDP Estimates on Measured GDP Growth Rates

Unemployment Data from the Bureau of Labor Statistics Go to: and click on the table(s) of interest. Be sure to click on the tables for “Average Weeks Unemployed”.

Summary of Learning Objectives 4 The circular flow of income and output ÜIn every economic transaction, receipts exactly equal expenditures ÜGoods and services flow in one direction and money payments flow in the other 4 Gross domestic product (GDP) ÜThe 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 of Learning Objectives(cont'd) 4 The limitations of using GDP as a measure of national welfare ÜExcludes non-market transactions ÜDoes not measure national well-being 4 The expenditure approach to tabulating GDP GDP = C + I + G + X

Summary of Learning Objectives(cont'd) 4 The income approach to computing GDP ÜThe sum of wages, rent, interest, profits 4 Distinguishing between nominal GDP and real GDP ÜNominal GDP is the value of newly produced final output measured in current market prices. ÜReal GDP adjusts nominal GDP into constant dollars by correcting for price level changes.

Assignment to be completed before class May 24: 14 Pre-read Chapter 14 & also read these end- of-chapter Problems: 14 th ed: 14-1, 14-2, 14-4, 14-7, 14-9, 14-12, & on pp th ed: 14-1, 14-2, 14-4, 14-6, 14-8, 14-9, & on pp