Chapter 8 Powerpoint

Chapter 8

Measuring the Economy’s

Performance

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-2

Introduction

Some commentators are already referring to the twenty-first century as the “Asian century.” It has been suggested that China’s economy will be larger than the U.S. economy by 2020.

How do we go about measuring the size of an economy? And how do we make international comparisons with regard to this measure?

The concept of gross domestic product, which is a key concept of Chapter 8, is the starting point for contemplating these questions.


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


Learning Objectives (cont'd)

• Explain the expenditure approach to tabulating GDP

• Explain the income approach to computing GDP

• Distinguish between nominal GDP and real GDP


Chapter Outline

• The Simple Circular Flow• National Income Accounting• Two Main Methods of Measuring GDP• Other Components of National Income

Accounting• Distinguishing Between Nominal and Real

Values• Comparing GDP Throughout the World


Did You Know That ...

• The flow of U.S. economic activity since 2009 has been more dampened than during any other comparable post-recession period since the Great Depression of the 1930’s?

• To measure the nation’s overall economic performance, the government utilizes the concept of national income accounting.


The Simple Circular Flow

The concept of the circular flow of income involves two principles:

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


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


Figure 8-1 The Circular Flow of Income and Product



• Product Markets– Transactions in which households buy goods

• Factor Markets– Transactions in which businesses buy resources



• Total Income– The yearly amount earned by the nation’s

resources (factors of production) – Includes wages, rent, interest payments, and

profits received by workers, landowners, capital owners, and entrepreneurs, respectively



• 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



• Question– Why must the dollar value of total output equal

total income?

• Answer– Every transaction simultaneously involves an

expenditure and a business receipt


National Income Accounting

• National Income Accounting– A measurement system used to estimate

national income and its components• 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


National Income Accounting (cont'd)

• Observations– 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



• Stress on final output– What is a final good?

• Wheat?• Steel?• Crude oil?• Bread?• Automobile?• Gasoline?



• Intermediate Goods– Goods used up entirely in the production of final

goods

• Value Added– The dollar value of an industry’s sales minus the

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


Table 8-1 Sales Value and Value Added at Each Stage of Donut Production



• Numerous transactions occur that have nothing to do with final goods and services being produced:– Financial transactions– Transfer of secondhand goods– Others excluded transactions


What If . . . Market prices of house cleaning, child care, and lawn care services were valued for inclusion in GDP?• Even if market prices of household services

were used to place a value on household production, national income accountants still would not know the volume of such activity.

• Therefore, they would have to estimate the amount of household activity, and this would introduce measurement errors into the calculation of GDP.



• Financial transactions– Securities

• Stocks and bonds

– Government transfer payments• Social Security• Unemployment compensation

– Private transfer payments• Individual gifts• Corporate gifts



• Transfer of secondhand goods– Why not count the sale of a used computer,

guitar, or snowboard as part of GDP?

• Other excluded transactions– Household production– Legal and illegal underground transactions



• GDP’s limitations– Excludes non-market production– It is not necessarily a good measure of the well-

being of a nation



• GDP:– Is a measure of the value of production in terms

of market prices, and an indicator of economic activity

– Is not a measure of a nation’s overall welfare


Policy Example: Developed Nations Look for a “Happier” Alternative to GDP

• The 34 member nations of the Organization for Economic Cooperation and Development are aiming to supplement or even replace GDP with a measure called the “Your Better Life Index.”

• This measure of well-being includes scores in 11 areas such as community, education, health, housing, life satisfaction, and safety.

• Initial results of the Your Better Life Index yield high rankings for Denmark, Canada, and Norway, with Hungary, Portugal, and Estonia ranking lowest among the OECD nations.


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


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


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

– Consumption Expenditure (C)• Durable Consumer Goods

– Items that last more than three years (automobiles, furniture)

• Nondurable Consumer Goods– Goods that are used up in three years (gasoline, food)

• Services– Mental or physical help



– 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 includes changes in business inventories and repairs made to machines, buildings



– 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


Example: Imputing Part of the Government’s Contribution to GDP

• Some items included in GDP do not have explicit market prices. – Examples include public education, fire protection, and

national defense.• National income accountants have reasoned that

government expenditures on these items understate the market prices that would prevail if they were provided by private firms.

• Therefore, the values are determined by using prices for education, fire protection, and security services provided in private markets.


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

– Government Expenditures (G)• State, local, and federal• Valued at cost


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

– Net Exports (Foreign Expenditures)

Net exports (X) = Total exports – Total imports


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

whereC = consumption expendituresI = investment expendituresG= government expendituresX = net exports

GDP = C + I + G + X


Figure 8-2 GDP and Its Components


NDP = GDP – Depreciation

Two Main Methods of Measuring GDP (cont'd)• Net Domestic Product (NDP)

– Allowing for depreciation (capital consumption allowance)

• The amount that businesses would have to save in order to take care of deteriorating machines and other equipment


Two Main Methods of Measuring GDP (cont'd)• Because NDP = GDP – Depreciation, and GDP = C + I + G + X• NDP = C + I + G + X – Depreciation• NDP = C + net I + G + X where net I (net investment ) = I – Depreciation

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

– The change in the capital stock over a one-year period


Two Main Methods of Measuring GDP (cont’d)• 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


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

– Gross Domestic Income (GDI)• Wages: salaries and labor income• Rent: farms, houses, stores• Interest: savings accounts• Profits: sole proprietorships, partnerships, corporations



– 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


Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013(in billions of 2005 dollars per year)


Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year) (cont’d)


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


Example: Sources of U.S. Personal Income Exhibit Unsustainable Trends

• Since early 2010, the share of personal income derived from private payrolls has dropped to levels that are the lowest in U.S. history.

• At the same time, the portion of personal income derived from government-provided benefits has risen to its highest level.

• These trends are unsustainable because government benefits are financed through taxes on private income.


Other Components of National Income Accounting (cont'd)• Disposable Personal Income (DPI)

– Personal income after personal income taxes have been paid


Table 8-2 Going from GDP to Disposable Income, 2013


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


Distinguishing Between Nominal and Real Values (cont'd)• Constant Dollars

– Dollars expressed in terms of real purchasing power

– This price-corrected GDP is the real GDP


Example: Correcting GDP for Price Index Changes, 2003 - 2013• Let’s use a numerical example to show how

we can adjust GDP for changes in the price index.

• In this example shown on the next slide, the GDP deflator is used to calculate values for real GDP from 2003 to 2013.


Table 8-3 Correcting GDP for Price Index Changes


Figure 8-4 Nominal and Real GDP

Source: U.S. Department of Commerce.


Per capita real GDP =Real GDPPopulation

Distinguishing Between Nominal and Real Values (cont'd)• Per capita real GDP

– Real GDP divided by total population


Comparing GDP Throughout the World • Foreign Exchange Rate

– The price of one currency in terms of another

• Example:– $1.25 = 1 euro, or $1 = .80 euros– French income per capita = 28,944 euros– French per capita income in terms of dollars

equals 28,944 euros x $1.25 = $36,180


Comparing GDP Throughout the World (cont'd)• Purchasing Power Parity

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


International Example: Purchasing Power Parity Comparisons of World Incomes

• The International Monetary Fund accepted the purchasing power parity approach a few years ago

• It started presenting the statistics on each country’s GDP relative to others and based on the purchasing power parity relative to the dollar

• Why is China’s per capita GDP higher based on purchasing power parity?


Table 8-4 Comparing GDP Internationally


You Are There: Has the Economy Grown More than Official GDP Data Suggest?

• Economists Bart Hobijin and Charles Steindel at the Federal Reserve Bank of New York are considering how to include three additional items in GDP:– Intangible investment– Real capital investment undertaken by government– Shift away from non-market home production as more

women enter the labor force.

• Hobijin and Steindel conclude that the net effect of these three items is to boost the GDP growth rate by about 0.5 percentage points per year.


Issues & Applications: Asia’s “Economic Size” Depends on How It Is Measured

• The figure on the next slide shows the combined real GDP of Asia as a percentage of real GDP of the entire world.

• The calculation was done according to two different measures.

• One used prevailing exchange rates in foreign currency markets.

• The other used purchasing power parity adjustments.


Figure 8-5 Asia’s Share of Global Real GDP

Source: International Monetary Fund.


Issues & Applications: Asia’s “Economic Size” Depends on How It Is Measured (cont’d)

• Of the two methods, the purchasing power parity measure gives a larger estimate for Asia’s share of the world economy.

• Another measure of Asia’s economic presence is per capita real GDP.– When comparisons are based on foreign

exchange rates, Asian per capita real GDP is 11 percent of global per capita real GDP.

– Using a purchasing power parity comparison, the figure rises to 26 percent.


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


Summary Discussion of Learning Objectives (cont'd)• The limitations of using GDP as a measure

of national welfare– Excludes non-market transactions– Does not measure national well-being

• The expenditure approach to tabulating GDP– GDP = C + I + G + X


Summary Discussion of Learning Objectives (cont'd)• The income approach to computing GDP

– The sum of wages, rent, interest, profits

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

final output measured in current market prices.– Real GDP adjusts nominal GDP into constant

dollars by correcting for price level changes