© 2007 Thomson South-Western

Macro vs. Micro Economics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. –Prices and selection of products 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. –Inflation –Unemployment –Economic Growth

© 2007 Thomson South-Western Macroeconomics Macroeconomics answers questions like the following:  Why is average income high in some countries and low in others?  Why do prices rise rapidly in some time periods while they are more stable in others?  Why do production and employment expand in some years and contract in others?

© 2007 Thomson South-Western Macro, Micro … or Neither!

© 2007 Thomson South-Western THE ECONOMY ’ S INCOME AND EXPENDITURE When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

© 2007 Thomson South-Western THE ECONOMY ’ S INCOME AND EXPENDITURE For an economy as a whole, income must equal expenditure because: –Every transaction has a buyer and a seller. –Every dollar of spending by some buyer is a dollar of income for some seller.

© 2007 Thomson South-Western Figure 1 The Circular-Flow Diagram Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES

© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT Gross domestic product (GDP) is a measure of the income and expenditures of an economy. GDP is the total market value of all final goods and services produced within a country in a given period of time.

© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT The equality of income and expenditure can be illustrated with the circular-flow diagram. Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES

© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “ GDP is the Market Value... ” –Output is valued at market prices. “... Of All... ” –Includes all items produced in the economy and legally sold in markets (not counted within households or for illegal sales). “... Final... ” –It records only the value of final goods, not intermediate goods (the value is counted only once and inventory is temporary). “... Goods and Services... ” –It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

© 2007 Thomson South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “... Produced... ” –It includes goods and services currently produced, not transactions involving goods produced in the past. “... Within a Country... ” –It measures the value of production within the geographic confines of a country. “... In a Given Period of Time. ” –It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

© 2007 Thomson South-Western THE COMPONENTS OF GDP GDP includes all items produced in the economy and sold legally in markets. What Is Not Counted in GDP? –GDP excludes most items that are produced and consumed at home and that never enter the marketplace. –It excludes items produced and sold illicitly, such as illegal drugs, gambling or prostitution. (AKA Grey or Black economies)

© 2007 Thomson South-Western THE COMPONENTS OF GDP Question. –Which contributes more to GDP – the production of a pound of hamburger or the production of a pound of caviar? Why?

© 2007 Thomson South-Western THE COMPONENTS OF GDP GDP (Y) is the sum of the following:  Consumption (C)  Investment (I)  Government Purchases (G)  Net Exports (NX) Y = C + I + G + NX

© 2007 Thomson South-Western THE COMPONENTS OF GDP Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing. This includes education. Investment (I): The spending on capital equipment (used in the future to produce more goods/services), inventories, and structures, including new housing. Many people think education should be included here. What do you think?

© 2007 Thomson South-Western THE COMPONENTS OF GDP Government Purchases (G): –The spending on goods and services by local, state, and federal governments. Example? –Does not include transfer payments because they are not made in exchange for currently produced goods or services. Example? Net Exports (NX): –Exports minus imports. –Can this be negative?

© 2007 Thomson South-Western THE COMPONENTS OF GDP Which component of the GDP is the largest?

© 2007 Thomson South-Western 2007, GDP of the United States = $14 trillion GDP per person = $45,838 –Consumption = $32,225 per person –Investment = $7,061 per person –Government purchases = $8,912 per person –Net exports = –$2,360 per person The components of U.S. GDP 17

© 2007 Thomson South-Western GDP and its components 1 18 Total (in billions of dollars) Per person (in dollars) Percent of total Gross domestic product, Y Consumption, C Investment, I Government purchases, G Net exports, NX $13,843 9,732 2,132 2,691 –712 $45,838 32,225 7,061 8,912 –2, % This table shows total GDP for the U.S. economy in 2007 and the breakdown of GDP among its four components. When reading this table, recall the identity Y = C + I + G + NX.

© 2007 Thomson South-Western In each of the following cases, determine how much GDP and each of its components is affected (if at all). A.Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston. B.Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. C.Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. D.General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them. A C T I V E L E A R N I N G 1 GDP and its components

© 2007 Thomson South-Western A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston. Consumption and GDP rise by $200. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. Investment rises by $1800, net exports fall by $1800, GDP is unchanged. A C T I V E L E A R N I N G 1 Answers 20

© 2007 Thomson South-Western C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. Current GDP and investment do not change, because the computer was built last year. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million of them. Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million. A C T I V E L E A R N I N G 1 Answers 21

© 2007 Thomson South-Western REAL VERSUS NOMINAL GDP Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices.

© 2007 Thomson South-Western REAL VERSUS NOMINAL GDP An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

© 2007 Thomson South-Western Table 2 Real and Nominal GDP

© 2007 Thomson South-Western Table 2 Real and Nominal GDP

© 2007 Thomson South-Western Table 2 Real and Nominal GDP Again….what is the difference between the Real and the Nominal GDP? Why is the Real GDP helpful to know?

© 2007 Thomson South-Western Real GDP Real GDP is a measure of the economy ’ s production of goods and services. This will reflect the economy ’ s ability to satisfy people ’ s needs and desires. Comparing different periods of Nominal GDP will show the growth/decline but how much of it was due to price changes will not be known. Comparing the same for Real GDP will show the change in actual production.

© 2007 Thomson South-Western Real vs. Nominal GDP In the Weimar years in Germany, when inflation went up thousands of percent, what was happening with Nominal GDP? Real GDP? Which measure is more useful?

© 2007 Thomson South-Western The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us what portion of the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

© 2007 Thomson South-Western The GDP Deflator The GDP deflator is calculated as follows:

© 2007 Thomson South-Western The GDP Deflator Nominal GDP is converted to real GDP as follows:

© 2007 Thomson South-Western Table 2 Real and Nominal GDP

© 2007 Thomson South-Western The GDP Deflator So if the GDP Deflator was 171 in 2006, that means that the price level increased by 71 percent as compared to the base year of the index.

© 2007 Thomson South-Western Figure 2 Real GDP in the United States Billions of 2000 Dollars $10,000 9,000 8,000 7,000 6,000 5,000 4,00 0 3, ,000

© 2007 Thomson South-Western IS GDP A GOOD MEASURE OF 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 the happiness or quality of life, however.

© 2007 Thomson South-Western GDP AND ECONOMIC WELL-BEING Some things that contribute to well-being are not included in GDP. –The value of leisure. –The value of a clean environment. –The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. –Does these have value?

© 2007 Thomson South-Western Rich countries - Higher GDP per person –Better Life expectancy Literacy Internet usage Poor countries - Lower GDP per person –Worse Life expectancy Literacy Internet usage International differences in GDP and the quality of life 37

© 2007 Thomson South-Western Low GDP per person –Higher rates of infant mortality –Higher rates of maternal mortality –Higher rates of child malnutrition –Less common access to safe drinking water –Fewer school-age children are actually in school –Fewer teachers per student –Fewer televisions; Fewer telephones –Fewer paved roads –Fewer households with electricity International differences in GDP and the quality of life 38

© 2007 Thomson South-Western GDP and the quality of life 3 39 Country Real GDP per person (2005) Life expectancy Adult literacy (% of population) Internet usage (% of population) United States Japan Germany Russia Mexico Brazil China Indonesia India Pakistan Bangladesh Nigeria $41,890 31,267 29,461 10,845 10,751 8,402 6,757 3,843 3,452 2,370 2,053 1, years % % The table shows GDP per person and three other measures of the quality of life for twelve major countries.

© 2007 Thomson South-Western GDP and Life Expectancy in 12 countries 40 Life expectancy (years) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Pakistan Bangladesh Nigeria

© 2007 Thomson South-Western GDP and Literacy in 12 countries 41 Adult Literacy (% of population) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Nigeria Pakistan Bangladesh

© 2007 Thomson South-Western GDP and Internet Usage in 12 countries 42 Internet Usage (% of population) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Nigeria Bangladesh Pakista n

© 2007 Thomson South-Western More issues with GDP GDP can vary depending upon the “ market basket ” used to calculate prices. Ie. Prices of potatoes vs. eggs. Black market, bartering, etc. Externalities such as the environment, subsistence production and domestic work Volunteer work Counts work that produces no net change or that results from repairing harm, ie. Natural disasters Sustainable growth…bubbles. Economic surplus

© 2007 Thomson South-Western Alternatives Gross National Product Net National Product Personal Income Genuine Progress Indicator Gross National Happiness (Bhutan)Gross National Happiness

© 2007 Thomson South-Western What is happening in Korea? GDP (purchasing power parity): $1.278 trillion (2008 est.) GDP (official exchange rate): $857.5 billion (2008 est.) GDP - real growth rate: 2.5% (2008 est.) GDP - per capita (PPP): $26,000 (2008 est.) GDP - composition by sector: agriculture: 3% industry: 39.5% services: 57.6% (2008 est.) For Comparison – US GDP - per capita (PPP): $14.29 tril. (2008 est.) GDP - composition by sector: agriculture: 1.2% industry: 19.6% services: 79.2% (2008 est.)

© 2007 Thomson South-Western What is happening in Korea? Rank Order - GDP (purchasing power parity) - #15 Rank Order - GDP - per capita (PPP) - #52

© 2007 Thomson South-Western Does the study of the GNP mean anything? Is this information actually useful beyond coffee table discussions and this class?

Summary © 2007 Thomson South-Western Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross domestic product (GDP) measures an economy ’ s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.

Summary © 2007 Thomson South-Western GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

Summary © 2007 Thomson South-Western Nominal GDP uses current prices to value the economy ’ s production. Real GDP uses constant base-year prices to value the economy ’ s production of goods and services. The GDP deflator — calculated from the ratio of nominal to real GDP — measures the level of prices in the economy.

Summary © 2007 Thomson South-Western GDP is a good measure of economic well- being because people prefer higher to lower incomes. It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, are not measured by GDP.