1. Chapter Five: Measuring The Economy's Performance

2. 5.1 Economic Activity and the Circular-Flow A measure of economic activity is called National Income Accounting The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle. Seller produces = Buyer spends Flow is in one direction

3. Circular-Flow of Economic Activities A household is a person or a group of people that share their income. A firm is an organization that produces goods and services for sale. Firms sell goods and services they produce to households in markets made for goods and services. Firms buy the resources they need to produce— factors of production—in factor markets.

4. The Circular-Flow Diagram

5. The Circular Flow Goods & Services Firms (production) Household Factor Services Total Income = wages, rents, interest, profits Personal Consumption $Value of all G&S = $Value of output

6. Total Income = $Value of output?? 1. Spending by one is income for another 2. Profit is a cost of production it is residual

7. The Enhanced Circular Flow Goods Other countries Financial markets Government Firms (production) Household Taxes Factor services Savings Imports Government Spending Wages, rents, interest, profits Exports Investment Personal consumption

8. The Enhanced Circular Flow Other countries -trade and FDI Financial Markets –show saving and borrowing Government -collect taxes and use money to purchase G&S, transfers Total (Aggregate) Expenditure = Consumer + Foreign + Government + Business

9. GDP is the nation’s expenditures on all FINAL goods and services produced during the year at market prices. 5.1 Measuring GDP

10. Avoid Double Counting 1.Intermediate goods $Value Added at each production stage 2.Transfer Payments

11. Two Things to Avoid when Compiling GDP Multiple counting –Only expenditures on final products – what consumers, businesses, and government units buy for their own use belong in GDP Intermediate goods are not counted Used goods are not counted

12. Two Things to Avoid when Compiling GDP Transfer payments –Transfer payments are not payments for currently produced goods and services When they are spent for final goods and services they will go into GDP as consumer spending Financial transactions don’t go into GDP

13. Why only Final Goods Counting the sale of final goods and intermediate products would result in double and triple counting.

14. What is counted? What is not? Only the value of the final sale is counted. The cost of the parts is included in the final sale price So they are not counted when the manufacturer buys them.

15. This is confusing! The tires that come with the car is not counted as a final good However if you get a flat and buy the same tire it is counted as a final good

16. No Problem! To correct for this problem economist have created the Value Added approach.

17. Value Added Approach Eliminates Double Counting

18. 5.3 Calculating GDP GDP can be calculated two ways:  Expenditure: add up all spending on domestically produced final goods and services, leading to the equation: GDP = C+I+G+(X-M)  Income: add up the all income paid to factors of production

19. Calculating GDP

20. Expenditure Approach Consumer – on G&S+ Investment – creation of capital goods+ Government – buying G&S and pays wages+ (X-M) – net exports, what we buy from other nations

21. The Flow, Not Stock With GDP we are measuring a Flow or a movement NOT a Stock –The store of wealth is a stock concept.

22. How GDP Is Measured? Households Firms Income (wages, salary, rent, interest, profits) Expenditures by Consumers, Investors, Government, and Net Exports

23. How GDP Is Measured? Households Firms Income (wages, salary, rent, interest, profits) Expenditures by Consumers, Investors, Government, and Net Exports Same As

24. How GDP Is Measured? Households Firms Income (wages, salary, rent, interest, profits) Expenditures by Consumers, Investors, Government, and Net Exports Same As Value of what is produced Value of what is spent

25. How GDP Is Measured? Households Firms Income (wages, salary, rent, interest, profits) Expenditures by Consumers, Investors, Government, and Net Exports Same As Value of what is produced Value of what is spent Flow of Income Approach Expenditures Approach

26. How GDP Is Measured? Households Firms Income (wages, salary, rent, interest, profits) Expenditures by Consumers, Investors, Government, and Net Exports Same As Value of what is produced Value of what is spent Flow of Income Approach Expenditures Approach (GDP = C + I + G + NX )

27. Consumption –Durable goods …………$ 820 –Nondurable goods …….. 2,010 –Services ……………….. 3,929 –Total C …………………………….$6,759 Investment –Plant & Equipment …….$ 1,361 –Residential Housing …… 416 –Inventory change ………. 57 –Total I ……………………………….1,834 Government Purchases –Federal ………………….$ 595 –State and Local …………..1,148 –Total G ……………………………..$1,743 Net Exports (Xn) –Exports ………………….$ 1,099 –Imports …………………..- 1,466 –NX …………………………………$ - 370 GDP …… …………………………$9,966 The Components of GDP, 2000 (in $ billions)

28. Consumption –Durable goods …………$ 820 –Nondurable goods …….. 2,010 –Services ……………….. 3,929 –Total C …………………………….$6,759 Investment –Plant & Equipment …….$ 1,361 –Residential Housing …… 416 –Inventory change ………. 57 –Total I ……………………………….1,834 Government Purchases –Federal ………………….$ 595 –State and Local …………..1,148 –Total G ……………………………..$1,743 Net Exports (Xn) –Exports ………………….$ 1,099 –Imports …………………..- 1,466 –Xn …………………………………$ - 370 GDP …… …………………………$9,966 The Components of GDP, 2000 (in $billions) GDP = C + I + G + NX GDP = 6,759+1,834+1,743+(-370) GDP = 9,966

29. What’s measured on the income side? Income received by Households Wages for use of Rent Interest Profit Factors of Production Labor Land Financial Capital Physical Capital

30. Net Domestic Income Payments to Owners of Factors of Production Wages + Rent + Interest + Profit

31. 5.4 Other Components of GDP and National Income Accounting GDP = NDI + Nonincome Expense Items (ind. Bus. taxes – (dep. + subs.)) NDP = GDP – Dep. Dep: amount of capital stock that has been used (to repair) Therefore, NDP = C + I + G + (X-M) – Dep Net I = I – Dep, changes in Cap Stock over time

32. Net National Income Accounting If, GDP = NDI + Nonincome Expense Items (ind. Bus. taxes– (dep + subs)) Then, NDP does not rep. income available to ppl. in that economy because of income paid to foreigners (NX) Therefore, Net National Income = all factor income of Canadian resource owners

33. Nominal Vs. Real Nominal GDP is GDP calculated at existing prices. Real GDP is nominal GDP adjusted for inflation. Real GDP is important to society because it measures what is really produced

34. Nominal GDP nominal GDP, is the value of all final output produced in an economy during a given year, calculated using the prices current in the year which the output is produced

35. Keeping it Real Comparing output over time is best done with real output which is nominal output adjusted for inflation Real GDP is the value of the final goods and services produced calculated using the prices of some base year

36. Real vs. Nominal GDP

37. GDP Versus Real GDP (RGDP) $8 $9 $10 $11 1998 1999 2000 2001 GDP is measured in current dollars. Therefore it appears as if GDP was larger in 2001 than in previous years. To make year-to- year GDP comparisons, we have to get rid of inflation

38. Deflating GDP to Get RGDP RGDP cy = GDP cy X -------------------------- GDP DEFLATORcy GDP DEFLATORby Nominal GPDcy = GDPcy X

39. Deflating GDP to Get RGDP RGDPcy = GDPcy X -------------------------- GDP DEFLATOR cy GDP DEFLATOR by RGDP 86 = 4422.2 X ------------------------------------ 100 80.6

40. Deflating GDP to Get RGDP RGDPcy = GDPcy X -------------------------- GDP DEFLATOR cy GDP DEFLATOR by RGDP 86 = 4422.2 X ------------------------------------ 100 80.6 RGDP 86 = 4422.2 X 1.2406948

41. Deflating GDP to Get RGDP RGDPcy = GDPcy X -------------------------- GDP DEFLATOR cy GDP DEFLATOR by RGDP 86 = 4422.2 X ------------------------------------ 100 80.6 RGDP 86 = 4422.2 X 1.2406948 RGDP 86 = 5486.6

42. Deflating GDP to Get RGDP RGDP 97 = GDP 97 X -------------------------- GDP DEFLATOR by GDP DEFLATOR 97

43. Deflating GDP to Get RGDP RGDP 97 = GDP 97 X -------------------------- GDP DEFLATOR by GDP DEFLATOR 97 RGDP 97 = 8083.4 X ----------------------------------------` 100 115.2

44. Deflating GDP to Get RGDP RGDP 97 = GDP 97 X -------------------------- GDP DEFLATOR by GDP DEFLATOR 97 RGDP 97 = 8083.4 X ----------------------------------------` 100 115.2 RGDP 97 = 8083.4 X.8680556

45. Deflating GDP to Get RGDP RGDP 97 = GDP 97 X -------------------------- GDP DEFLATOR by GDP DEFLATOR 97 RGDP 97 = 8083.4 X ----------------------------------------` 100 115.2 RGDP 97 = 8083.4 X 8680556 RGDP 97 = 7016.8

46. Calculating Percentage Changes % change = ------------------------------------ Change Original Number

47. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5

48. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7

49. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7 % change = -------------------- 226.7 2557.5

50. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7 % change = -------------------- 226.7 2557.5 % change =.0886413 = 8.8%

51. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7 % change = --------------------- 226.7 2557.5 % change =.0886413 = 8.8% 1980 RGDP = 4611.9 1979 RGDP = 4624.0

52. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7 % change = --------------------- 226.7 2557.5 % change =.0886413 = 8.8% 1980 RGDP = 4611.9 1979 RGDP = 4624.0 Change ------> 12.9

53. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7 % change = --------------------- 226.7 2557.5 % change =.0886413 = 8.8% 1980 RGDP = 4611.9 1979 RGDP = 4624.0 Change ------> 12.9 % change = ------------------------- 12.9 4624.0

54. Calculating Percentage Changes % change = ------------------------------------ Change Original Number 1980 GDP = 2784.2 1979 GDP = 2557.5 Change -----> 226.7 % change = ------------------- 226.7 2557.5 % change =.0886413 = 8.8% 1980 RGDP = 4611.9 1979 RGDP = 4624.0 Change ------> 12.9 % change = ------------------------- 12.1 4624.0 % change =.0026168 =.26 %

55. GDP Measures Market Activity, Not Welfare GDP does not measure happiness, nor does it measure economic welfare. Welfare is a complicated idea, very difficult to measure.

56. 5.5 Limitations of GDP Production that is excluded –Household production –Illegal production –The underground economy Treatment of leisure time Human cost and benefits GDP gives us a ballpark idea of how much we produce, not necessarily how well off we are

57. GDP Per Capita GDP Per Capita is GDP divided by the size of the population: it is equal to the average GDP per person. Not an end in itself does not address how a country uses that output to affect living standards.

58. Per Capita GDP Per capita GDP = --------------------------------- GDP Population

59. Per Capita GDP Per capita GDP = -------------------------------- GDP Population 20000 2000 Per capita GDP = -------------------------------- $9,966,000,000,000 281,000,000 Per capita GDP = $35,466 20000

60. Foreign Exchange Rates: the price we pay for another country's currency Eg. 0.98CAD : 1.00USD Purchasing Power of Parity is an exchange rate where currency would have the same value Eg. Baseball Bats

61. PPP Eg. Baseball Bats 1.00USD : 10.00MXN United States wooden baseball bats sell for $40 Mexico they sell for 150 pesos then, the bat costs $40 USD if we buy it in the U.S. but only 15 USD if we buy it in Mexico *advantage to buying the bat in Mexico!

62. PPP Eg. Baseball Bats 1.00USD : 10.00MXN United States wooden baseball bats sell for $40 Mexico they sell for 150 pesos -Need Mexico Pesos in order to buy baseball bats in Mexico. -Sell American Dollars and buy Mexican Pesos -Mexican Peso to become more valuable relative to the USD. -The demand for baseball bats sold in the United States decreases, so the price American retailers charge goes down. -The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge goes up.

63. PPP Eg. Baseball Bats 1.00USD : 10.00MXN United States wooden baseball bats sell for $40 Mexico they sell for 150 pesos -The exchange rates and the prices in the two countries to change such that we have purchasing power parity. -If 1USD = 8MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos each, we will have PPP -This is because a consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off.