1. O’Sullivan Sheffrin Perez © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez Measuring a Nation’sProduction and Income

2. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 2 of 27 macroeconomics The study of the nation’s economy as a whole; focuses on the issues of inflation, unemployment, and economic growth. inflation Sustained increases in the average prices of all goods and services. MEASURING A NATION’S PRODUCT AND INCOME

3. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 3 of 27 The Circular Flow of Production and Income THE “FLIP” SIDES OF MACROECONOMIC ACTIVITY: PRODUCTION AND INCOME 11.1  FIGURE 11.1 The Circular Flow of Production and Income

4. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 4 of 27 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT 11.2 gross domestic product (GDP) The total market value of final goods and services produced within an economy in a given year. intermediate goods Goods used in the production process that are not final goods and services.

5. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 5 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT real GDP A measure of GDP that controls for changes in prices. nominal GDP The value of GDP in current dollars.

6. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 6 of 27 THE ECONOMY HEATS UP One widely awaited economic indicator is the consumer sentiment index from the University of Michigan which provides a useful forecasting tool about future growth. Optimistic consumers spend money and pessimistic consumers reduce spending. Analysts are also waiting for the Fed’s press release later this week. Strong economic numbers may spell more rate increases in the near term. Reports indicate the economy is still going strong. Manufacturing and services are both showing growth as is personal income. Retail sales growth is up 0.6 %for April and chain store receipts grew by 3% for the month. In spite of the positive indicators some economists are worried about the ultimate impact of higher gasoline prices on consumer spending. Optimistic consumers fuel economic growth. As consumers feel better about the economy they will open their wallets and demand more goods and services. This increased optimism pushes the aggregate demand curve out and results in higher output as shown in the graph. Extra Application 4

7. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 7 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT  FIGURE 11.2 U.S. Real GDP, 1930–2005 economic growth Sustained increases in the real GDP of an economy over a long period of time.

8. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 8 of 27 The Components of GDP 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT Economists divide GDP into four broad categories, each corresponding to different types of purchases represented in GDP: 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 (domestic exports minus domestic imports)

9. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 9 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT CONSUMPTION EXPENDITURES The Components of GDP consumption expenditures Purchases of newly produced goods and services by households. PRIVATE INVESTMENT EXPENDITURES private investment expenditures Purchases of newly produced goods and services by firms.

10. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 10 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT The Components of GDP Private investment expenditures in GDP consist of three components: 1 First, there is spending on new plants and equipment during the year. 2 Second, newly produced housing is included in investment spending. 3 Finally, if firms add to their stock of inventories the increase in inventories during the current year is included in GDP. PRIVATE INVESTMENT EXPENDITURES gross investment Total new investment expenditures. depreciation Reduction in the value of capital goods over a one-year period due to physical wear and tear and also to obsolescence; also called capital consumption allowance. net investment Gross investment minus depreciation.

11. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 11 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT The Components of GDP GOVERNMENT PURCHASES government purchases Purchases of newly produced goods and services by local, state, and federal governments. transfer payments Payments from governments to individuals that do not correspond to the production of goods and services.

12. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 12 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT The Components of GDP NET EXPORTS import A good produced in a foreign country and purchased by residents of the home country (for example, the United States). export A good produced in the home country (for example, the United States) and sold in another country. net exports Exports minus imports.

13. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 13 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT The Components of GDP NET EXPORTS trade deficit The excess of imports over exports. trade surplus The excess of exports over imports.  FIGURE 11.3 U.S. Trade Balance as a Share of GDP, 1960–2005

14. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 14 of 27 11.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT Putting It All Together: The GDP Equation Y = C + I + G + NX Y = GDP C = Consumption I = Investment G = Government purchases NX = net exports GDP = consumption + investment + government purchases + net exports

15. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 15 of 27 11.3 THE INCOME APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING NATIONAL INCOME national income The total income earned by a nation’s residents both domestically and abroad in the production of goods and services. Measuring National Income gross national product GDP plus net income earned abroad.

16. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 16 of 27 11.3 THE INCOME APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING NATIONAL INCOME Measuring National Income personal disposable income Personal income that households retain after paying taxes. personal income Income, including transfer payments, received by households.

17. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 17 of 27 11.3 THE INCOME APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING NATIONAL INCOME Measuring National Income Through Value Added value added The sum of all the income—wages, interest, profits, and rent—generated by an organization. For a firm, we can measure value added by the dollar value of the firm’s sales minus the dollar value of the goods and services purchased from other firms.

18. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 18 of 27 11.3 THE INCOME APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING NATIONAL INCOME An Expanded Circular Flow  FIGURE 11.4 The Circular Flow with Government and the Foreign Sector

19. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 19 of 27 USING VALUE ADDED TO MEASURE THE TRUE SIZE OF WAL-MART APPLYING THE CONCEPTS #1: How can we use economic analysis to compare the size of a major corporation to a country? During 2004, Wal-Mart’s sales were approximately $285 billion, nearly 2.4 percent of U.S. GDP. Some social commentators might want to measure the impact of Wal-Mart just through its sales. But to produce those sales, Wal-Mart had to buy goods from many other companies. Based on Wal-Mart’s annual reports, its cost of sales was $219 billion, leaving approximately $66 billion in value added. If we used Wal-Mart’s sales to compare it to a country, it would have a GDP similar to Indonesia, which is ranked 23rd in the world. However, using the more appropriate measure of value added, Wal- Mart’s size is closer to the Ukraine, which is ranked 53rd in the world.

20. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 20 of 27 11.4 A CLOSER EXAMINATION OF NOMINAL AND REAL GDP Measuring Real Versus Nominal GDP  FIGURE 11.5 U.S. Nominal and Real GDP, 1950–2005

21. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 21 of 27 11.4 A CLOSER EXAMINATION OF NOMINAL AND REAL GDP How to Use the GDP Deflator GDP deflator An index that measures how the prices of goods and services included in GDP change over time. chain-weighted index A method for calculating changes in prices that uses an average of base years from neighboring years.

22. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 22 of 27  FIGURE 11.6 The 1990 Recession 11.5 FLUCTUATIONS IN GDP

23. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 23 of 27 11.5 FLUCTUATIONS IN GDP recession Commonly defined as six consecutive months of declining real GDP. peak The date at which a recession starts. trough The date at which output stops falling in a recession. expansion The period after a trough in the business cycle during which the economy recovers.

24. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 24 of 27 THE U.S. ECONOMY SLOWS BUT DOESN'T SHRINK The most recent numbers indicate that the U.S. economy has slowed to an annual growth rate of 1.6%. While that rate is the slowest rate in the past three years it still does not spell economic doom. Slowing growth is not all bad since it tends to dampen upward price movements or inflation. While slowing growth as measured by the change in gross domestic product (GDP) can be good, it also positions the economy to be susceptive to negative shocks such as additional weakness in consumer spending. Consumer spending typically accounts for about 70% of the total economy so slowing growth could make consumers more cautious and cause them to slow down on spending. The reduction in consumer spending could make negative growth (a recession) a self-fulfilling prophecy. The primary components of GDP are consumption, government spending, business investment, and net exports. Consumer spending is critical to continued growth hence the reason that consumer confidence is such a closely watched statistic. Extra Application 6

25. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 25 of 27 11.5 depression The common name for a severe recession. FLUCTUATIONS IN GDP

26. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 26 of 27 THE NBER AND THE 2001 RECESSION APPLYING THE CONCEPTS #2: How do we determine when a recession has occurred in the United States? Although the level of GDP is an extremely important indicator, the NBER committee also examines a full range of other data. This examination takes time, which is why the NBER often announces the beginning and end of a recession many months later. Example: On November 26, 2001, the NBER announced that the peak of the 2001 recession occurred in March 2001. Nearly two years later, on July 17, 2003, they dated the trough as occurring in November 2001. Although the common definition of a recession is a six-month consecutive period of negative economic growth, the NBER defines a recession as a “significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.”

27. chapter © 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan Sheffrin Perez 27 of 27 11.6 GDP AS A MEASURE OF WELFARE Shortcomings of GDP as a Measure of Welfare HOUSEWORK AND CHILDCARE LEISURE UNDERGROUND ECONOMY POLLUTION