Prepared by: Jamal Husein C H A P T E R 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring a Nation’s Production and Income

2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin MacroeconomicsMacroeconomics  Macroeconomics is the branch of economics that deals with any nation’s economy as a whole.  Macroeconomics focuses on issues such as unemployment, inflation, growth, trade, and the gross domestic product.

3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin MacroeconomicsMacroeconomics  Macroeconomics focuses on two key issues: Understanding economic growth in the long run and the factors behind the rise in living standards in modern economies Understanding economic fluctuations; the ups and downs of the economy over time

4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Production, Income and the Circular Flow  The most fundamental concepts in macroeconomics are production and income.  In factor markets, households supply inputs to production.  Households supply labor and capital to the firms.  Households are paid wages for their work, and interest, dividends and rents for supplying capital.

5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Production, Income and the Circular Flow  Households use their income to purchase goods and services in product markets.  The payments received by firms are used to pay for factors of production.  In sum, corresponding to the production of goods and services in the economy are flows of income to households.

6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring Gross Domestic Product (GDP)  The most common measure of the total output of an economy is gross domestic product (GDP) GDP is the total market value of all the final goods and services produced within an economy in a given year.

7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring Gross Domestic Product  “Total market value” refers to the quantity of goods multiplied by their respective prices. Using prices allows us to express the value of everything in a common unit of measurement. QuantityPriceValue 2 cars$15,000$30,000 3 computers$3,000$9,000 Gross domestic product$39,000

8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring Gross Domestic Product  “Final goods and services” refers to the goods and services that are sold to the ultimate, or final, purchasers.  In order to avoid double counting, we do not count intermediate goods, or goods used in the production process. The value of the final good already reflects the price of the intermediate goods contained in it.  “In a given year” means that the sale of goods produced in prior years, for example, used cars, are not included in GDP this year.

9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring Gross Domestic Product  Since we use the prices times the quantities of goods to measure the value of GDP, GDP will increase when prices increase, even if the physical quantities of the goods produced remain the same. Year 1Year 2 QuantityPriceValueQuantityPriceValue 2 cars$15,000$30,0002 cars$30,000$60,000 3 computers$3,000$9,0003 computers$6,000$18,000 GDP =$39,000GDP =$78,000

10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring Gross Domestic Product  A measure of total output that does not increase just because prices increase is called real GDP. Real GDP takes into account price changes by using the same prices for both years.  Nominal GDP is the value of GDP in current dollars

11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Measuring Gross Domestic Product  Using year 1 prices to compute GDP in year 2: Year 1Year 2 QuantityPriceValueQuantityPriceValue 10 computers$1,000$10,00012 computers$1,100$11,000 Nominal GDP$10,000Nominal GDP$11,000 Growth in nominal GDP ($13,200/$10,000) =1.32 QuantityPriceValueQuantityPriceValue 10 computers$1,000$10,00012 computers$1,000$12,000 Real GDP$10,000Real GDP$12,000 Growth in real GDP ($12,000/$10,000) =1.20

12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin U.S. Real GDP

13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Who Purchases GDP?  Economists divide GDP into four broad expenditure categories: 1.Consumption expenditures : purchases by consumers 2.Private investment expenditures : purchases by firms 3.Government purchases : purchases by federal, state, and local governments 4.Net exports : net purchases by the foreign sector, or domestic exports minus domestic imports

14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Composition of U.S. GDP  GDP figures are produced by the U.S. Department of Commerce. Composition of U.S. GDP, Third Quarter 2002 (billions of dollars expressed at annual rates) GDP Consumption Expenditures Private Investment Expenditures Government Purchases Net Exports 10,5067,3611,5971, In percentage terms: 100% =70.1% +15.2% +18.5%- 4.12%

15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Consumption Expenditures  Consumption expenditures comprise purchases of currently produced, domestic or foreign, goods and services.  Consumption is broken down into: Durable goods. Nondurable goods. Services, the fastest growing component of consumption.  Consumption comprises 70% of total purchases.

16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Private Investment Expenditures  Private investment expenditures include: Spending on new plants and equipment. Newly produced housing. Increase in inventories during the current year.  Note: investment in everyday talk refers to the purchase of an existing financial asset. Investment in GDP accounts refers to the purchase of new final goods and services by firms. Don’t confuse the two.

17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Private Investment Expenditures  New investment expenditures are called gross investment. The true addition to the stock of capital of the economy is net investment. Net investment equals gross investment minus depreciation.  Depreciation is the deterioration of plants, equipment, and housing in a given year. Third Quarter 2002 (billions $) Gross Investment Depreciation Net Investment $1,597$1,175$ %74%26%

18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Government Purchases  Includes any goods the government purchases plus the wages and benefits of all government employees; but does not include all the government spending.  Transfer payments, or government payments to individuals which are not associated with the production of any goods and services, are not included in government purchases.  This means that a large part of the federal government budget is not part of GDP.

19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Net Exports  Net exports are total exports minus total imports. By including net exports in GDP, we correctly measure U.S. production—by adding exports and subtracting imports. Purchases of foreign goods (imports) are subtracted from GDP because these goods were not produced in the U.S. Any goods that are produced in the U.S. and sold abroad (exports) are included in GDP.

20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Net Exports  Net exports for the U.S. in 3 rd quarter of 2002 were -$433. This means that the U.S. bought $433 billion more goods and services from abroad than it sold abroad.  The balance of trade: Trade deficit: imports > exports Trade surplus: imports < exports Trade balance: imports = exports

21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin U.S. Trade Balance As a Share of GDP

22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Meaning of Continued Trade Deficits  When the U.S. runs a trade deficit, we are forced to sell some of our assets to individuals or governments in foreign countries.  We give up more dollars from exports than we receive from imports. Excess dollars in the hands of foreigners are used to buy U.S. assets such as stocks, bonds or real estate.  If a country runs a trade surplus with one country and an equally large deficit with another, it does not add to its stock of foreign assets.

23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Who Gets the Income?  Three adjustments must be made to GDP in order to arrive at national income: 1.Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at GNP or gross national product. 2.Subtract depreciation from GNP to arrive at net national product, or NNP. 3.Subtract indirect taxes, which are sales taxes or excise taxes on products, because the part of sales revenue that goes to the government is not part of private sector income.

24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Who Gets the Income From GDP to National Income, Third Quarter 2002 (billions) Gross domestic product$ plus net income from abroad = Gross national product minus depreciation =10,495 Net national product minus indirect taxes (and other adjustments) 9,090 National income8,388 Composition of U.S. National Income, Third Quarter 2002 (billions) National income8,388 Compensation of employees $6,027 Corporate profits771 Rental Income144 Proprietor’s income759 Net interest687

25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Real Versus Nominal GDP  Differences between nominal GDP and real GDP arise only because of changes in prices. Quantity ProducedPrice Nominal GDP YearCarsComputersCarsComputers $10,000$5,000$45, ,0005,000$75,000  To calculate real GDP we use constant prices Quantity ProducedPrice Real GDP YearCarsComputersCarsComputers $10,000$5,000$45, ,0005,000$65,000

26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Calculating the Growth of Real GDP  Using the information on the table, we can calculate the growth of real GDP for this economy: ($65,000 - $45,000)/$45,000 =.444, or 44.4%  We can also measure the change in prices over time using an index number called the GDP deflator. Quantity ProducedPrice Real GDP YearCarsComputersCarsComputers $10,000$5,000$45, ,0005,000$65,000

27 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The GDP Deflator Value of GDP deflator in 2005 = 100 x [(Nominal GDP in 2005)/(Real GDP in 2005)] 100 x ($75,000/$65,000) = 100 x 1.15 = 115  The value 115 means that prices rose by 15% ([ )/100] between the two years.  The Commerce Department uses a chain index to calculate price changes which is based on an average of price changes using base years from neighboring years.  An index is set at 100 in a given year, say the year 2004, called the base year. Prices in other years are compared to prices in 2004:

28 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin GDP As a Measure of Welfare  GDP is our best measure of the value of output produced, but not a perfect measure: GDP ignores transactions that do not take place in organized markets, such as the work we perform at home. GDP ignores the underground economy, where transactions are not reported to official authorities.

29 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin GDP As a Measure of Welfare The Internal Revenue Service estimated that in the 1990s, about $100 billion in income from the underground economy escaped federal taxes each year. If the average tax rate is 20%, about $500 billion ($100/0.20) escaped the GDP accountants, or 7% of GDP. Finally, GDP does not value changes in the environment that arise from the production of output, such as pollution and depletion of nonrenewable resources.