Chapter 8Chapter 8:Measuring

the Economy’s Performance

ECON 151 – PRINCIPLES OF MACROECONOMICS

Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved .

1

The Simple Circular Flow

Two observations

1. In every economic exchange, the seller receives exactly the same amount that the buyer spends.

2. Goods and services flow in one direction and money payments flow in the other.

8-2

The Simple Circular Flow (cont'd) Profits explained

Question Why is profit a cost of production?

Answer Profits are the return entrepreneurs receive

for the risk they incur when organizing productive activities.

8-3

The Simple Circular Flow (cont'd) Final Goods and Services

Goods and services that are at their final stage of production and will not be transformed into yet other goods or services

8-4

The Simple Circular Flow (cont'd)

Product Markets

Transactions in which households buy goods

8-5

The Simple Circular Flow (cont'd) Total Income

Wages, rent, interest, profits

8-6

The Simple Circular Flow (cont'd) Factor Markets

Transactions in which businesses buy resources

8-7

Figure 8-1 The Circular Flow of Income and Product

8-8

The Simple Circular Flow (cont'd)

Question Why must total income

be identical to the dollar value of total output?

Answer Every transaction

simultaneously involves an expenditure and a receipt.

8-9

National Income Accounting

National Income AccountingA measurement system used to estimate

national income and its components

Total IncomeThe yearly amount earned by the nation’s

resources (factors of production)

8-10

National Income Accounting Gross Domestic Product (GDP)

The total market value of all final goods and services produced by factors of production located within a nation’s borders

GDP measures the dollar value of final output.

GDP measures the dollar value of final goods and services produced per year by factors of production located within a nation’s borders.

8-11

National Income Accounting (cont'd) Stress on final output

What is a final good? Wheat?

Steel?

Oil?

Bread?

Automobile?

Gasoline?

8-12

National Income Accounting (cont'd) Intermediate Goods

Goods used up entirely in the production of final goods

Value AddedThe dollar value of an industry’s sales minus the

value of intermediate goods (for example, raw materials and parts) used in production

8-13

Table 8-1 Sales Value and Value Added of Donut Production

8-14

National Income Accounting Numerous transactions occur that have nothing to do with final goods

and services being produced. Exclusion of financial transactions

Securities Stocks and bonds

Government transfer payments Social Security

Unemployment compensation

Private transfer payments Individual gifts

Corporate gifts

8-15

National Income Accounting

Transfer of secondhand goods excludedWhy not count the sale of a used computer, guitar,

or snowboard as part of GDP?

Other excluded transactionsHousehold production

Legal and illegal underground transactions

8-16

National Income Accounting

GDP’s limitations

Excludes non-market production

It is not necessarily a good measure of the well-being of a nation.

GDP is not a measure of a nation’s overall welfare.

GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity.

8-17

Two Main Methods of Measuring GDP Expenditure Approach

Computing GDP by adding up the dollar value at current market prices of all final goods and services

8-18

Two Main Methods of Measuring GDP (cont'd)

8-19

Expenditure Approach

Two Main Methods of Measuring GDP (cont'd) Income Approach

Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

8-20

Two Main Methods of Measuring GDP (cont'd)

8-21

Income Approach

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach

Consumption Expenditure (C) Durable Consumer Goods

Life span of more than three years

Nondurable Consumer Goods Goods that are used up in three years

Services Mental or physical help

8-22

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the

expenditure approach

Gross Private Domestic Investment (I) The creation of capital goods, such as factories

and machines, that can yield production and hence consumption in the future

Also included: changes in business inventories and repairs made to machines, buildings

8-23

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach

Gross Private Domestic Investment (I) Producer Durables or Capital Goods

Life span of more than three years

Fixed Investment Purchases by business of newly produced producer durables or

capital goods

Inventory Investment Changes in stocks of finished goods and goods in process, as well

as changes in raw materials

8-24

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the

expenditure approach

Government Expenditures (G) State, local, and federal

Valued at cost

Net Exports (Foreign Expenditures)

8-25

Net exports (X) = Total exports – Total imports

Two Main Methods of Measuring GDP (cont'd) Presenting the expenditure approach

Where C = consumption expenditures I = investment expenditures G = government expenditures X = net exports

8-26

GDP = C + I + G + X

Figure 8-2 GDP and Its Components

8-27

Note unique scale on vertical axis.

Two Main Methods of Measuring GDP (cont'd) Depreciation and net domestic product

Deducting for depreciation (capital consumption allowance)

Reduction in the value of capital goods over a one-year period due to physical wear and tear, and also to obsolescence

8-28

NDP = GDP – Depreciation

Two Main Methods of Measuring GDP (cont'd) NDP = GDP – Depreciation GDP = C + I + G + X NDP = C + I + G + X – Depreciation Net Investment = I – Depreciation

Domestic investment minus an estimate of the wear and tear on the existing capital stock

NDP = C + Net I + G + X

8-29

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the income approach

8-30

Deriving GDP by the Income Approach Gross Domestic Income (GDI)

The sum of all income—wages, interest, rent, and profits—paid to the four factors of production

Wages: salaries and labor income

Rent: farms, houses, stores

Interest: savings accounts

Profits: sole proprietorships, partnerships, corporations

8-31

Two Main Methods of Measuring GDP

Gross domestic product equals gross domestic income plus indirect business taxes and depreciation

These last items are called non-income expense items

Indirect business taxes

All business taxes except the tax on corporate profits

Include sales and business property taxes

8-32

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

8-33

Source: U.S. Department of Commerce. First quarter preliminary data annualized.

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

8-34

Other Components of National Income Accounting

National Income (NI) The total of all factor payments to resource owners

Personal Income (PI) The amount of income that households actually

receive before they pay personal income taxes

Disposable Personal Income (DPI)

Personal income after personal income taxes have been paid

8-35

Table 8-2 Going from GDP to Disposable Income, 2007

8-36

Distinguishing Between Nominal

and Real Values Nominal Values

Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values

8-37

Distinguishing Between Nominal and Real Values Nominal Values

Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values

Real Values Measurements after adjustments have been made for changes in

the average of prices between years; expressed in constant dollars

Constant Dollars Dollars expressed in terms of real purchasing power

8-38

Example: Correcting GDP for Price Index Changes Correcting GDP for price index changes

Nominal (current) dollars GDP

Real (constant) dollars GDP

8-39

*Price level: measured by the GDP deflator

Real GDP = x 100Nominal GDP

Price level*

Table 8-3 Correcting GDP for Price Index Changes

8-40

Distinguishing Between Nominal

and Real Values (cont'd) Per capita GDP

Adjusting for population growth

8-41

Per capita real GDP =Real GDP

Population

Figure 8-4 Nominal and Real GDP

8-42Source: U.S. Department of Commerce

Comparing GDP Throughout the World Foreign Exchange Rate

The price of one currency in terms of another

Foreign exchange rate & comparing GDP $1.25 = 1 euro, or $1 = 0.80 euros

French per capita income = 23,168.80 euros

French per capita income in terms of dollars equals 23,168.80 euros x $1.25 = $28,961

8-43

Comparing GDPThroughout the World (cont'd) Purchasing Power Parity

Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries

8-44

Table 8-4 Comparing GDP Internationally

8-45

Chapter 8Chapter 8:Measuring

the Economy’s Performance

ECON 151 – PRINCIPLES OF MACROECONOMICS

Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved .

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