© 2007 Thomson South-Western

Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator

© 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. 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 MEASURING A NATION’S INCOME 4 What This Diagram Omits The government –collects taxes, buys g&s The financial system –matches savers’ supply of funds with borrowers’ demand for loans The foreign sector –trades g&s, financial assets, and currencies with the country’s residents

© 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 “ 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 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 13

© 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 15

© 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 16

© 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 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 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): $1.574 trillion (2011 est.) GDP (official exchange rate): $1.116 trillion (2011 est.) GDP - real growth rate: 3.6% (2011 est.) GDP - per capita (PPP): $32,100 (2011 est.) GDP - composition by sector: agriculture: 2.6% industry: 39.2% services: 58.2% (2011 est.) For Comparison – US GDP - per capita (PPP): $49,000 (2011 est.) GDP - composition by sector: agriculture: 1.2% industry: 19.2% services: 79.6% (2011 est.)

© 2007 Thomson South-Western THE CONSUMER PRICE INDEX The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. The US Bureau of Labor Statistics reports the CPI each month. It is used to monitor changes in the cost of living over time.

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated 1. Fix the basket. Determine what prices are most important to the typical consumer. –The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated 2. Find the prices. Find the prices of each of the goods and services in the basket for each point in time. 3. Compute the basket ’ s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times.

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated 4. Choose a base year and compute the index. –Designate one year as the base year, making it the benchmark against which other years are compared. –Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

© 2007 Thomson South-Western How the Consumer Price Index Is Calculated 5. Compute the inflation rate. The inflation rate is the percentage change in the price index from the preceding period.

© 2007 Thomson South-Western MEASURING THE COST OF LIVING 37 What’s in the CPI’s Basket?

© 2007 Thomson South-Western MEASURING THE COST OF LIVING 38 Problems with the CPI: Substitution Bias Over time, some prices rise faster than others. Consumers substitute toward goods that become relatively cheaper. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

© 2007 Thomson South-Western MEASURING THE COST OF LIVING 39 Problems with the CPI: Introduction of New Goods The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

© 2007 Thomson South-Western MEASURING THE COST OF LIVING 40 Problems with the CPI: Unmeasured Quality Change Improvements in the quality of goods in the basket increase the value of each dollar. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. Thus, the CPI overstates increases in the cost of living.

© 2007 Thomson South-Western Problems in Measuring the Cost of Living The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. The CPI overstates inflation by about 1 percentage point per year.

© 2007 Thomson South-Western The GDP Deflator versus the Consumer Price Index Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are two important differences between the indexes that can cause them to diverge.

© 2007 Thomson South-Western MEASURING THE COST OF LIVING 43 Imported consumer goods: – included in CPI – excluded from GDP deflator Imported consumer goods: – included in CPI – excluded from GDP deflator The basket:  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. The basket:  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. Capital goods:  excluded from CPI  included in GDP deflator (if produced domestically) Capital goods:  excluded from CPI  included in GDP deflator (if produced domestically) Contrasting the CPI and GDP Deflator

© 2007 Thomson South-Western In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. C. Armani raises the price of the Italian jeans it sells in the U.S. A C T I V E L E A R N I N G 3 CPI vs. GDP deflator 44

© 2007 Thomson South-Western A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. A C T I V E L E A R N I N G 3 Answers 45

© 2007 Thomson South-Western What ’ s up in Korea with CPI? Korean CPI (Sources: IMF-IFS and EconStats. )EconStats What is the base year for the given CPI? 10,000 won in 2004 would have been worth how much in 1990?

© 2007 Thomson South-Western What ’ s up in Korea with CPI? CPI Info… (2/08) –By the end of the year, the office will add items that account for more than one-10,000th of monthly household expenditures; those falling short of the standard will be excluded. –The statistics agency revises the index, currently comprising 516 items, every five years. New Additions This Year –Bidets, Olive oil, Saunas, Substitute drivers, Medical expenses for pets Items Removed This Year –Briquettes, table clocks and artificial seasonings Source: