Chapters 6&7 Introduction to Macroeconomics McGraw-Hill/Irwin v

Economic Performance? How much “stuff” did our economy produce this year? –How do you add electricity+grapes+doctor’s visits+toothpaste+shoelaces+movies+….?

Economic Performance? How much “stuff” did our economy produce this year? –How do you add electricity+grapes+doctor’s visits+toothpaste+shoelaces+movies+….? –What do they all have in common?

Economic Performance? How much “stuff” did our economy produce this year? –How do you add electricity+grapes+doctor’s visits+toothpaste+shoelaces+movies+….? –What do they all have in common? –They can be bought/sold for $

Economic Performance? How much “stuff” did our economy produce this year? –How do you add electricity+grapes+doctor’s visits+toothpaste+shoelaces+movies+….? –What do they all have in common? –They can be bought/sold for $ So GDP=$PxQ of all final goods and services produced within the borders of an economy during a given year.

GDP=∑(PxQ) We want to measure REAL changes in the output (Q) of goods and services. $1x 100 cokes/year=$100 $100 $1x 200 cokes/year=$200 –$100  $200 correctly represents a 100% increase in coke production and sales BUT, what if the price of coke went up from $1  $2? Then, $2 x 100 cokes =$200: no real increase in coke production (Q)

GDP=∑(PxQ) Real GDP –Corrects for price changes Nominal GDP –Uses current prices Unemployment Inflation –Increase in overall level of prices 6-7

Business Cycle GDP=Employment? (PxQ) Unemployment? $Inflation? TIME (years)

Performance and Policy Can governments: –Promote economic growth? –Reduce severity of recession? Is monetary or fiscal policy more effective at mitigating recession? Is there a tradeoff between inflation and unemployment? 6-9

Economic Performance Output growth  +3.1% per year Unemployment rate  4.6% in 2007 Inflation rate  2.7% in

Economic Performance Output growth  +3.1% per year Unemployment rate  4.6% in 2007 Inflation rate  2.7% in GDP - 1% 2008 GDP - 1% Unemployment rate now = Inflation rate now = ? %

Economic Growth Standard of living measured by output per person (per capita) No growth in economic living standards prior to Industrial Revolution Modern economic growth –Output per person rises –Not experienced by all countries 6-12

Savings and Investment Saving –Tradeoff current for future consumption Investment –Financial investment –Economic investment Banks and financial institutions 6-13

Expectations The future is uncertain Expectations affect investment Shocks –What happens is not what you expected Demand shocks Supply shocks 6-14

Shocks Demand shocks and flexible prices –Price falls if demand low –Sales unchanged Demand shocks and sticky prices –Maintain inventory –Sales change –Business cycles-especially unemployment 6-15

Demand Shocks Cars per week Price DMDM DLDL DHDH 900 $40,000 $37,000 $35,000 Flexible Prices 6-16

Demand Shocks Cars per week DMDM DLDL DHDH $37,000 Fixed Prices Price 6-17

Sticky Prices Many prices sticky in short run –Consumers prefer stable prices –Firms want to avoid price wars All prices flexible in long run –Firms adjust to unexpected, but permanent changes in demand 6-18

Measuring Domestic Output and National Income Chapter 7 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Define and measure GDP GDP and income relationships The GDP price index Nominal GDP vs. real GDP Limitations of the GDP measure 7-20

Bureau of Economic Analysis compiles National Income and Product Accounts (GDP, NDP, NI,PI, DI) –Assess health of economy –Track long run course –Formulate policy National Income Accounting 7-21

Gross Domestic Product Measure of aggregate output (Q) Monetary measure ($) = PxQ Avoid multiple counting –Market value final goods –Ignore intermediate goods –Count value added 7-22

Gross Domestic Product Exclude financial transactions –Public transfer payments –Private transfer payments –Stock (and bond) market transactions –Excludes illegal activities Second hand sales –Sell used car to a friend –Garage/yard sales 7-23

GDP: Value Added Concept $0Iron ore

GDP: Value Added Concept $0Iron ore $1,000Mine ore

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill $10,000Make Steel

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill $10,000Make Steel $15,000Ship to Detroit

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill $10,000Make Steel $15,000Ship to Detroit $20,000Make Car

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill $10,000Make Steel $15,000Ship to Detroit $20,000Make Car $25,000Sell/Ship Car to Dealer

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill $10,000Make Steel $15,000Ship to Detroit $20,000Make Car $25,000Sell/Ship Car to Dealer What is added to the GDP ?

GDP: Value Added Concept $0Iron ore $1,000Mine ore $5,000Ship to Steel Mill $10,000Make Steel $15,000Ship to Detroit $20,000Make Car $25,000Sell/Ship Car to Dealer $30,000Consumer purchases Car What is added to the GDP ?

Two Approaches to GDP Income approach –Count income derived from production –Wages, rental income, interest income, profit Expenditure approach –Count sum of money spent buying the final goods –Who buys the goods? 7-33

Circular Flow Resource Market Product Market BusinessesHouseholds Both Flows Are Equal GDP

GDPGDP == + Consumption by Households Investment by Businesses Government Purchases Expenditures By Foreigners Wages Rents Interest Profits Statistical Adjustments + Two Approaches to GDP 7-35 Expenditure Income

Expenditures Approach GDP=C + Ig + G + Xn (X-M)

Expenditure Approach Personal consumption expenditures (C) –Durable consumer goods –Nondurable consumer goods –Consumer expenditures for services –Domestic plus foreign produced (within the borders of the USA) 7-37

Expenditure Approach Gross private domestic investment (I) –Machinery, equipment, and tools –All construction –Changes in inventories Creation of new capital asset Noninvestment transactions ( don’t include transfer of stocks, bonds, etc.) 7-38

Expenditure Approach January 1Year’s GDPDecember 31 Consumption & Government Spending Depreciation Net Investment Gross Investment Stock of Capital Increase Stock of Capital Gross Investment Depreciation (consumption of fixed capital) Net Investment - = 7-39

Yellow Bike Investment? Yellow Bikes Yellow Bikes

Yellow Bike Investment? Yellow Bikes Yellow Bikes Yellow Bikes Yellow Bikes 100 Yellow Bikes 100 Yellow Bikes Gross Investment =50 Bikes 2011

Yellow Bike Investment? Yellow Bikes Yellow Bikes Yellow Bikes Yellow Bikes 100 Yellow Bikes 100 Yellow Bikes 20 Bikes “Wear out” Gross Investment =50 Bikes 2011

Yellow Bike Investment? Yellow Bikes Yellow Bikes Yellow Bikes Yellow Bikes 100 Yellow Bikes 100 Yellow Bikes 20 Bikes “Wear out” Gross Investment =50 Bikes Net Investment= 30 bikes 100 Yellow Bikes 100 Yellow Bikes 130 Total Bikes 2011

Expenditure Approach Government purchases (G)  Expenditures for goods and services  Expenditures for social capital  Excludes transfer payments Net exports (X n )= exports - imports  Add exported goods ($’s spent in US)  Subtract imported goods($’s spent outside US) GDP = C+I g +G+X n 7-44

Compensation Rents Interest Proprietor’s Income Corporate Profits Taxes on Production and Imports National Income Net Foreign Factor Income (-) Statistical Discrepancy (+) Consumption of Fixed Capital (+) Gross Domestic Product $ $12, $ 13,841 Personal Consumption (C) Gross Private Domestic Investment (I g ) Government Purchases (G) Net Exports (X n ) Gross Domestic Product in Billions Receipts Expenditures Approach Allocations Income Approach $ $ 13,841 U.S. Economy

C omparative GDP Source: World Bank Selected Nations GDPs, 2007 United States Japan Germany China United Kingdom France Italy Canada Spain Brazil Russia India South Korea Mexico Australia GDP in Trillions of Dollars 7-46 China is now #2

Components of National Income Compensation of employees Rents Interest Proprietor’s income Corporate profits –Corporate income taxes –Dividends –Undistributed corporate profits –Taxes on production and imports 7-47

Income Approach From national income to GDP –Net foreign factor income –Statistical discrepancy –Consumption of fixed capital Other national accounts –Net domestic product (NDP) –National income (NI) –Personal income (PI) –Disposable income (DI) –DI = C + S 7-48

U.S. Income Relationships 2007 Gross Domestic Product (GDP) Less: Consumption of Fixed Capital Equals: Net Domestic Product (NDP) Less: Statistical Discrepancy Plus: Net Foreign Factor Income Equals: National Income (NI) Less: Taxes on Production and Imports Less: Social Security Contributions Less: Corporate Income Taxes Less: Undistributed Corporate Profits Plus: Transfer Payments Equals: Personal Income (PI) Less: Personal Taxes Equals: Disposable Income (DI) $ 13, $ 12, $ 12, $ 11, $ 10,

For Homework Problem #8 p. 143

GDP= C + Ig + G + (X-M) -depreciation NDP= C + In + G + Xn -statistical discrepancy + net foreign factor income NI=( comp. to employees)+(rent)+(interest)+(profit)+ (proprietor's income)+(taxes on production & imports) +transfer payments -social security taxes -undistributed corporate profits -corporate income taxes -taxes on production and imports PI= C + S + Tx -Tx DI= C + S

GDP= C + Ig + G + (X-M) = TOTAL PROD. -depreciation NDP= C + In + G + Xn = NET PRODUCTION -statistical discrepancy + net foreign factor income NI=( comp. to employees)+(rent)+(interest)+(profit)+ (proprietor's income)+(taxes on production & imports) = INCOME EARNED +transfer payments -social security taxes -undistributed corporate profits -corporate income taxes -taxes on production and imports PI= C + S + Tx = INCOME RECEIVED -Tx DI= C + S = INCOME AVAILABLE

Nominal vs. Real GDP GDP is a dollar measure of production Using dollar values creates problems Nominal GDP =∑ Pi X Qi –Use prevailing prices Real GDP –Reflect changes in prices –Use base year price 7-53

GDP=∑(PxQ) We want to measure REAL changes in the output (Q) of goods and services. $1x 100 cokes/year=$100 $100 $1x 200 cokes/year=$200 –$100  $200 correctly represents a 100% increase in coke production and sales BUT, what if the price of coke went up from $1  $2? Then, $2 x 100 cokes =$200: no real increase in coke production (Q)

GDP Price Index Use price index to determine real GDP Price Index In Given Year =x100 Price of Market Basket In Specific Year Price of Same Basket In Base Year Real GDP = Nominal GDP Price Index (in hundredths) 7-55

“Basket” “Basket”= typical goods and services purchased or produced in a year (apples, gasoline, clothes, electricity, rent, books, toothpaste, bagels, …)

1 st : determine the price index for each year (every year has its own price index). 2 nd : Divide the Nominal GDP for a year by that years price index to determine Real GDP

Prices in 1967= $100 (of a specified “basket” of goods & services). Prices in 1987= $300 for same “basket” Prices in 2010=$600 for same “basket” of goods and services

Price index= Pg/Pb Let 1967=base year P index 1967= Pg/Pb= $100/$100=1 or 100% (it is common to “drop the % sign) = 100 P index in 1987 P index in 2010

Price index= Pg/Pb Let 1967=base year P index 1967= Pg/Pb= $100/$100=1 or 100% P index in 1987= $300/$100=3 or 300% P index in 2010=

Price index= Pg/Pb Let 1967=base year P index 1967= Pg/Pb= $100/$100=1 or 100% P index in 1987= $300/$100=3 or 300% P index in 2010= $600/$100=6 or 600%

Nominal GDP 1967= $3,000 (current) Nominal GDP 1987= $9,000 (Current) Nominal GDP in 2010=$24,000 (Current) What is the REAL GDP in each year?

Real GDP= Nominal GDPt/PRICE INDEXt For 1967 $3,000/1=$3,000 For 1987 $9,000/3= For 2010 $24,000/6

Real GDP= Nominal GDPt/PRICE INDEXt For 1967 $3,000/1=$3,000 For 1987 $9,000/3= $3000 For 2010 $24,000/6

Real GDP= Nominal GDPt/PRICE INDEXt For 1967 $3,000/1=$3,000 For 1987 $9,000/3= $3000 For 2010 $24,000/6=$4,000

Year Nominal GDP RealGDP 19957,414.79, ,838.59, ,332.49, , , , , , , , , , , , , , ,263.8 Base year , , , , , , , , ,990.3 In Millions $ Actual BEA Data Actual BEA Data

Shortcomings of GDP Nonmarket activities Leisure Improved product quality The underground economy GDP and the environment Composition and distribution of the output Noneconomic sources of well-being 7-67

Und erground Economy Source: Open Assessment, E-Journal As a percentage of GDP, Selected Nations, 2007 Mexico South Korea India Italy Spain China Sweden Germany France United Kingdom Japan Switzerland United States Percentage of GDP 7-68

Sources of BEA Data Consumption –Census Bureau’s Retail Trade Survey –Census Bureau’s Survey of Manufacturers –Census Bureau’s Service Survey Investment –All Consumption data sources –Census Bureau’s Housing Starts Survey and Housing Sales Survey –Retail Trade Survey –Wholesale Trade Survey –Survey of Manufacturing 7-69

Government Purchases –Office of Personnel Management –Construction Surveys –Census Bureau’s Survey of Government Finance Net Exports –U.S. Customs Service –BEA Surveys and Analysis Sources of BEA Data 7-70

Key Terms national income accounting gross domestic product intermediate goods final goods multiple counting value added expenditures approach income approach personal consumption expenditures gross and net private domestic investment government purchases net exports taxes on production and imports national income consumption of fixed capital net domestic product personal income disposable income nominal GDP real GDP price index 7-71

Next Chapter Preview… Economic Growth 7-72