Chapter 2 Measuring the Economy

Introduction Closed and Open Economies Sectors of a Economy Stocks and Flows GDP and its components National Wealth Wealth Accounting

Dividing Up the World Economy Open and Closed Economies We call the economy of the country that we are interested the domestic economy. The collection of all other economies is referred as the “rest of the world”.

Dividing Up the World Economy Open and Closed Economies When a domestic economy is studies in isolation from the rest of the world, it is called a closed economy. When we explicitly consider interactions with other countries, it is called a open economy. There are no real closed economies in the modern world. BOX 2-1

Dividing Up the World Economy Sectors of the Domestic Economy The domestic economy is divided into different sectors for different research purposes. When we want to know how the economy allocates its resources between consumption and investment  single decision maker. how the government policy affects the allocations  public and private sectors

Dividing Up the World Economy Sectors of the Domestic Economy The private sector is usually divided into households and firms income determination Firms are owned by Households.

Measuring Gross Domestic Product Income, Expenditure, and Product A comprehensive set of data on GDP and its components is recorded in the system of National Income and Product Account (NIPA). Three approaches to measure GDP 1. the income method 2. the expenditure method 3. the product (value-added) method

Measuring Gross Domestic Product Income, Expenditure, and Product Three concepts need to introduced first GDP is the value of all final goods and services produced within the domestic economy in a year. Final goods are those sold directly to end users. Intermediate goods are used as input by firms which may be produced by other firms. The value added is the difference between the value of the output that a firm sells and the value of the intermediate goods used to produce it.

Measuring Gross Domestic Product The Circular Flow of Income See Figure 2-1 For simplicity, we divide all the production factors into two type: labor and capital. The income earned by labor and capital are labor income (wage) and rent, respectively.

The Circular Flow of Income Figure 2.1 ©2002 South-Western College Publishing

Measuring Gross Domestic Product Income method: adding up all of the income earned by the factors of production. Expenditure: adding up all the expenditure on final goods and services. Product (Value-added): sum up the values added over all firms in the economy. Example: BOX 2-2

Measuring Gross Domestic Product Consumption and Investment Closed economy : GDP (Y) = private consumption expenditure (C) + private investment expenditure (I) + government expenditure (G)

Measuring Gross Domestic Product Consumption and Investment Open economy : GDP (Y) = private consumption expenditure (C) + private investment expenditure (I) + government expenditure (G) + the value of exports (X) - the value of imports (M)

Measuring Gross Domestic Product Consumption and Investment Consumption goods are commodities like beer, pizza, movies and etc., which meet our immediate needs. Capital goods are commodities like tractors, power plants, and etc., which help us to produce more goods in the future. Trade off relationship

Measuring Gross Domestic Product The Capital Market Financial institutions that channel savings from households to firms are collectively referred to as the “capital market”. banks, the stock market, pension fund, saving and loan institutions.

Measuring Gross Domestic Product Saving Saving is the act of abstaining from consumption. Households save by putting money in the bank or by lend it to the government or firms. Saving does not constitute investment.

Measuring Gross Domestic Product Investment Investment is the result of purchasing a new capital good. Example: A household buys a new house. A company buy a machine, a factory, a building. The government builds a new school or a hospital.

Saving and Investment in the Circular Flow Figure 2.2 ©2002 South-Western College Publishing

Measuring Gross Domestic Product Wage and Rent In a closed economy, the GDP is equal to the income earned by its residents. The income earned by the factor of production is broken into several components: - the largest component represents payments to the services of labor. Other categories include net interest, rent, corporate profit and proprietor’s income.

Measuring Gross Domestic Product Wage and Rent For simplicity, we distinguish only two types of income: labor income (wage) and capital income (rent). In U.S., labor share of GDP is approximately 60% and capital share is approximately 40%. BOX 2-3

FOCUS ON THE FACTS How Big are the Components of the U.S. Economy? Box 2.3

The Components of GDP In a closed economy, saving and investment are always equal. In open economies, the idea extends to relationships among the government budget deficit, the trade surplus and private saving.

Saving and Investment in a Closed Economy Expenditure can be divided into three categories: private consumption expenditure private investment expenditure government expenditure

Saving and Investment in a Closed Economy

Saving and Investment in an Open Economy Countries can invest more than they save by borrowing from abroad. When a Gov. spends more than it earns, the excess expenditure is the Gov.’s budget deficit. When a nation as a whole spends more on foreign goods and services than it earns by selling exports, the excess of expenditures over income is the nation’s trade deficit. Budget deficit has a significant impact on trade deficit.

Saving and Investment in an Open Economy

Government and the Private Sector Disposal income (YD) is the income that is available to the private sector after the government takes out taxes and put back transfer payments to individuals and firms.

Government and the Private Sector Two sources of government deficit S - I NX

Government and the Foreign Sector in the Circular Flow Figure 2.3 ©2002 South-Western College Publishing

The Twin Deficits Figure 2.4 ©2002 South-Western College Publishing

Measuring Wealth The concepts used to measure GDP and its component parts are examples of flows. Wealth is a stock and is measured by a system of balance sheet accounting.

Stocks and Flows with an Individual Example A stock is a variable measured at a point in time. Ex. Government debt, capital A flow is a variable measured per unit of time. A flow is often the rate of change of a stock. - Ex. Government budget deficit, investment

U.S. Government Debt Since 1890 - Stock

Real and Financial Assets The wealth of an individual can consist of real assets (capital goods) and financial assets. Real asset: the capital owned by an individual or firm. house, car, land, etc. Financial assets: promises to deliver resources in the future. - a mortgage on a house, bank account, etc.

Real and Financial Assets In a closed economy, every financial asset is someone else’s financial liability  the sum total of all financial assets and liabilities is zero. In a open economy, financial assets and liabilities may not equal zero since individuals and firms can borrow or lend abroad.

Balance Sheet Accounting The total wealth (net worth) of an agent is the sum total of his assets (both real and financial) minus the sum of his financial liabilities - This is called “balance sheet accounting”. TABLE 2.3

Table 2.3

The Link between GDP and Wealth Wealth accounting measures stocks and income accounting measures flows. The NIPA can be used to show how the stocks of real and financial assets for different sectors of the economy change from one year to the next.

Gross versus Net Domestic Product Not all investment creates new capital; Some investment is necessary each year to offset the deterioration through normal wear and tear of the existing stock of capital-depreciation. The portion of gross investment that contributes to increases in the stock of capital is called “net investment”.

Stocks and Flows Figure 2.6

Gross versus Domestic Product Net domestic product (NDP) is a measure of the maximum output of the economy that is available for consumption without running down the stock of capital. GDP = NDP + depreciation

Table 2.4

Growth Rates and Percentage Changes Growth rate of GDP in year t :

Table 2.6

Homework Question 3, 5, 6, 9

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