Chapter 8: Measuring the Economy’s Performance ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which has

Chapter 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.

2

Learning Objectives

Describe the circular flow of income and output

Define gross domestic product (GDP) Understand the limitations of using GDP

as a measure of national welfare

3

Learning Objectives

Explain the expenditure approach to tabulating GDP

Explain the income approach to computing GDP

Distinguish between nominal GDP and real GDP

4

National Income Accounting

National Income AccountingA measurement system used to estimate

national income and its components

5

The Simple Circular Flow

Figure 8-1

6


Figure 8-1

7


Figure 8-1

8


Figure 8-1

9


Two observations In every economic exchange, the seller

receives exactly the same amount that the buyer spends.

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

10


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

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Product Markets Transactions in which

households buy goods

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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

13


Factor Markets Transactions in which

businesses buy resources

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Total Income The yearly amount

earned by the nation’s factors of production

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Question Why must total income be

identical to the dollar value of total output?

Answer Every transaction

simultaneously involves an expenditure and a receipt

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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

17


ObservationsGDP measures the dollar value of final outputGDP measures the dollar value of final goods

and services produced per year by factors of production located within a nation’s borders

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Intermediate GoodsGoods used up entirely in the production of

final goods

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Stage 1: Fertilizer and Seed $.03

Stage 2: Growing .06

Stage 3: Milling .12

Stage 4: Baking .30

Stage 5: Retailing .45

Total value added $.45

Stage of Production Dollar Value of Sales Value Added

$.03

$.03

$.06

$.18

$.15

Sales Value and Value Added at Each Stage of Donut Production

Total dollar value of all sales $.96

20


Exclusion of financial transactions, transfer payments, and secondhand goodsNumerous transactions occur that have

nothing to do with final goods and services being produced.

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Financial transactions Securities

Stocks and bonds

Government transfer payments Social Security Unemployment compensation

Private transfer payments Individual gifts Corporate gifts

22


Transfer of secondhand goodsWhy not count the sale of a used car, stereo,

or snowboard as part of GDP? Other excluded transactions

Household productionLegal underground transactions Illegal underground transactions

23

Recognizing GDP Limitations

GDP’s limitationsExcludes non-market productionDifferent countries have different legal versus

illegal activitiesQuality of life is not measuredGDP poorly measures a nation’s well-being

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Two Main Methodsof Measuring GDP

Expenditure ApproachA way of computing national income by

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

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Expenditure Approach

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Two Main Methods of Measuring GDP

Income ApproachA way of measuring national income by

adding up income received by all factors of production

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Income Approach

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Deriving GDP by the expenditure approachConsumption Expenditure (C)

Durables Life span of more than three years

Nondurables Life span of less than three years

Services Intangible commodities

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Deriving GDP by the expenditure approachGross Private Domestic Investment (I)

The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future

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Deriving GDP by the expenditure approachGovernment Expenditures (G)

State, local, and federal Valued at cost

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Deriving GDP by the expenditure approachNet Exports (Foreign Expenditures)

Net exports (X) = total exports - total imports

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Mathematical representation using the expenditure approach

GDP = C + I + G + X

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GDP and Its Components

Figure 8-4

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Depreciation and net domestic productDeducting 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

NDP = GDP - depreciation

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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

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Deriving GDP by the income approach

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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

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Gross Domestic Income (GDI)Wages InterestRentProfits

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

These last items are called nonincome expense items.

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Gross Domestic Product and Gross Domestic Income, 2005(in billions of 2005 dollars per year)

Figure 8-5 Source: U.S. Department of Commerce. First quarter preliminary data annualized.

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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

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Other Components of National Income Accounting

Disposable Personal Income (DPI)Personal income after personal income taxes

have been paid

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Source: U.S. Department of Commerce, and author’s estimates

Going from GDP to Disposable Income, 2005

Table 8-2

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Distinguishing Between Nominal and Real Values

Nominal ValuesMeasurements in terms of the actual market

prices at which goods are sold; expressed in current dollars

45


Real ValuesMeasurements after adjustments have been

made for changes in the average of prices between years; expressed in constant dollars

46

Example: Correcting GDP for Price Index Changes

Correcting GDP for price index changesNominal (current) dollars GDPReal (constant) dollars GDP

*Price level: measured by the GDP deflator

Real GDP = x 100nominal GDP

price level*

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Example: Correcting GDP for Price Index Changes

Source: U.S. Department of Commerce, Bureau of Economic Analysis, and author’s estimatesTable 8-3

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Nominal and Real GDP

Figure 8-6 Source: U.S. Department of Commerce

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Per capita GDPAdjusting for population growth

Per capita real GDP =real GDP

population

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Nominal and Real GDP

The Bureau of Economic Analysis now uses a chain-weighted measure of real GDP.

This means that changes in the prices and output levels of a certain good will contribute to overall changes in GDP to the extent that the good accounts for a significant share of overall economic activity.

51


Some issuesThe distribution of outputChanges in leisure time Increased traffic congestionAir pollutionCrimeHousework

52

Comparing GDPThroughout the World

ExampleFrance

$1.25 = 1 euro Per capita income = 23,168.80 euros

France per capita income in terms of dollars equals23,168.80 x 1.25 = $28,961.

53

Comparing GDPThroughout the World

True purchasing powerAccounting for goods and services that are

not traded in the world marketPurchasing Power Parity

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

54Source: World Bank

International Example:Purchasing Power Parity Comparisons of Incomes

Table 8-4

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Summary Discussion of Learning Objectives

The circular flow of income and output In every economic transaction, receipts exactly

equal expenditures Goods and services flow in one direction and

money payments flow in the other

Gross Domestic Product (GDP) The total market value of a nation’s final output of

goods and services produced in a year using factors of production located within its borders

56

Summary Discussion of Learning Objectives

The limitations of using GDP as a measure of national welfareExcludes non-market transactionsDoes not measure national well-being

The expenditure approach to tabulating GDPGDP = C + I + G + X

57

Summary Discussion of Learning Objectives The income approach to computing GDP

The sum of wages, rent, interest, profit, depreciation, and indirect business taxes

Distinguishing between nominal GDP and real GDP Nominal GDP is the value of newly produced final

output in the current year measured in current market prices.

Real GDP adjusts nominal GDP into constant dollars by correcting for price level changes.

Chapter 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.

Documents

Chapter 8: Measuring the Economy’s Performance ECON 151 – PRINCIPLES OF MACROECONOMICS Materials include content from Pearson Addison-Wesley which has