1 Understanding Economics Chapter 9 The Economic Problem Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 3 rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 2 Learning Objectives  In this chapter you will: 1. learn about Gross Domestic Product (GDP) and the two approaches to calculating it 2. consider real GDP and per capita GDP and their possible uses and limitations when comparing living standards in different years or different countries 3. analyze other economic measures developed from the national income accounts

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 3 National Income Accounts  Canada’s national income accounts show the levels of total income and spending in the Canadian economy  Among other measures these accounts include Gross Domestic Product (GDP)

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 4 Gross Domestic Product (GDP)  GDP is the total dollar value of all final goods and services produced in an economy during a particular period  GDP is calculated using two approaches the income approach:a method of calculating GDP by adding together all incomes in the economy the expenditure approach:a method of calculating GDP by adding together all spending in the economy  The GDP identity states that GDP expressed as total income = GDP expressed as total spending

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 5 Calculating Gross Domestic Product Figure 9.1, Page 201 ProductCurrent Price (P) Annual Product (Q) Total Dollar Value (P x Q) Surgical lasers$10003$3000 Milkshakes GDP = $5000

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 6 Circular Flow in a Simple Economy Figure 9.2, Page 202 Economic Resources Expenditure Approach Businesses Households Household Incomes Consumer Spending Consumer Products Resource Markets Product Markets Income Approach

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 7 Circular Flow in a Simple Economy Figure 9.2, Page 202 The inner (clockwise) loop represents the flow of money. The outer ( counterclockwise) loop represents the flow of products and resources. The income approach to GDP measures the flow of incomes in the upper portion. The expenditure approach measures the flow of spending in the lower portion.

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 8 The Income Approach (a)  The income approach includes four classes of income wages and salaries corporate profits interest income proprietors’ incomes and rents

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 9 The Income Approach (b)  The income approach also includes three other categories to balance GDP calculated with the expenditure approach indirect taxes depreciation the statistical discrepancy, which is the difference between the GDP estimates using the two approaches with half added to the lower one and half deducted from the higher one

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 10 The Expenditure Approach  The expenditure approach is the sum of purchases in product markets  Final products: products that will not be processed further and will not be resold  Intermediate products:products that will be processed further or will be resold is based on value added at each production stage to avoid double counting  Double-counting: the problem of adding to GDP the same item at different stages in its production  Value added : the extra worth of a product at each stage in its production; a concept used to avoid double-counting in calculating GDP excludes financial exchanges and second-hand purchases

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 11 Value Added in Making Paper Figure 9.4, Page 205  The value added by each business at each production stage is the value of the business’s output, minus its cost of intermediate products.  The sum of the values added at all stages of production represents the price of the pad of paper when it is finally sold.

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 12 Value Added in Making Paper Figure 9.4, Page 205 Production Stage Total Value Paid/Received Value AddedBusiness That Adds Value 1.Wood is cut and transported to paper mill 2.Paper is processed and sold to retailer 3.Paper is sold by retailer to consumer $ $7.75 $ (2.75 – 1.00) 1.25(4.00 – 2.75) $4.00 logging company paper company retailer

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 13 Components of the Expenditure Approach (a)  There are four components of the expenditure approach personal consumption (C) consists of household purchases of services and nondurable and durable goods gross investment (I) represents business and government purchases of real capital (including added inventories) and is financed through retained earnings and personal saving

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 14 Components of the Expenditure Approach (b) government purchases (G) exclude transfer payments and are financed through taxes and borrowing net exports (X-M) equals exports (foreign purchases of Canadian products) minus imports (Canadian purchases of foreign products)

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 15 Canada’s Gross Domestic Product (2002) Figure 9.3, Page 204 Income Approach ($ billions) Expenditure Approach ($ billions) Wages and salaries597.3 Corporate profits143.4 Interest Income49.4 Proprietors’ incomes and rents71.1 Indirect taxes138.2 Depreciation155.0 Statistical discrepancy0.5 Gross Domestic Product Personal consumption (C)656.2 Gross investment (I)218.9 Government purchases (G)230.0 Net exports (X – M)50.3 Statistical Discrepancy0.5 Gross Domestic Product1154.9

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 16 Gross and Net Investment  Net investment is the annual change in an economy’s capital stock  Capital stock: the total value of productive assets that provides a flow of revenue equals gross investment – depreciation  Depreciation: the decrease in value of durable real assets over time is positive in a growing economy with an increasing capital stock is negative in a declining economy with a decreasing capital stock

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 17 Net Investment and Capital Stock Figure 9.5, Page 207 Capital Stock at Start of Year Depreciation Gross Investment Capital Stock at End of Year $200 billion $260 billion $100 billion$40 billion

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 18 Financial Market Flows  The sources of funds for investment come from businesses’ retained earnings personal saving (S)  These are inflows into financial markets, while investment is an outflow  Personal saving is transformed into investment funds for businesses by financial markets. Business then use these funds, plus their retained earning, to make investment.  Investment and personal consumption form part of total spending.

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 19 Financial Markets and the Circular flow Figure 9.6, Page 207 Resource Markets Financial Markets Households Product Markets Businesses Investment (I) Income Saving (S) Consumption (C) Spending Retained Earnings Investment Funds

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 20 Government Flows  Financial inflows to government include household taxes minus transfer payments business taxes minus subsidies Government borrowing  Government purchases are a financial outflow from government

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 21 Government and the Circular Flow Figure 9.7, Page 208 Income Consumption (C) Spending Government Borrowing Household Taxes (- Transfer Payments) Government Purchases (G) Resource Markets Financial Markets Households Government Businesses Product Markets Business Taxes (-Subsidies)

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 22 Connections with the Rest of the World  Net exports represent a net inflow into Canadian product markets  Lending by foreigners represents an inflow into Canadian financial markets  Borrowing by foreigners represents an outflow from Canadian financial markets

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 23 The Rest of the World and the Circular Flow Figure 9.8, Page 209 Income Consumption (C) Spending Foreign Lending (-Foreign Borrowing) Export (X) Resource Markets Financial Markets Households Rest of the World Businesses Product Markets Imports (M)

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 24 GDP and Living Standards  Per capita GDP is GDP per person. Per capita GDP = GDP/ population  Per capita real GDP is per capita GDP expressed in constant dollars from a given year is used to compare living standards in a given country over time Per capita real GDP = real GDP/ population  Per capita GDPs for various countries are measured in a single currency

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 25 Limitations of GDP (a)  GDP has limitations as an indicator of living standards because it does not include nonmarket activities and those that take place in the underground economy  Non-market activities: productive activities that take place outside the marketplace  Underground economy: all the market transactions that go unreported fully capture improvements in product quality indicate the composition of output indicate the distribution of income

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 26 Limitations of GDP (b) indicate how much leisure is enjoyed by a country’s citizens distinguish between activities that are and are not harmful to the environment

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 27 Other Economic Measures (a)  Gross National Product (GNP) is the total income acquired by Canadians both within Canada and elsewhere equals GDP - net investment income to the rest of the world

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 28 Deriving Gross National Product (2002) Figure 9.9, Page 214 ($ billions) Gross Domestic Product (GDP) Deduct: Net investment income to the rest of the world(-) 27.4 Gross National Product (GNP)1127.6

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 29 Other Economic Measures (b)  Disposable Income (DI) is personal income - personal taxes and other personal transfers to government

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 30 Other Income Measures (2000) Figure 9.10, Page 215 $ billions GDP GNP DI 695.9