Chapter 2 The Measurement of Income Prices and

Chapter 2 The Measurement of Income, Prices, and Unemployment Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

The Measurement of Income, prices and Unemployment Why we care about income? • the key to understand the changes in unemployment is the changes in actual real GDP. • The growth rate of standards of living is measured by productivity, which requires understanding of real GDP. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -2

The circular flow of income and expenditures • The circular flow of income and expenditure model is a simple representation of the macro economy • Assume that households spend all their income, no savings and no government • There are two types of transactions between households and firms. Note: • Firms sell goods and services paid by households (consumption expenditures) • Households must work to earn income to pay for their consumption (income) Income and consumption are equal Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -3

Figure 2 -1 The Circular Flow of Income and Consumption Expenditures Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -4

The circular flow of income and expenditures • Income (Y) = labor services = consumption expenditures (C) = product • Each of the four elements in the figure is a flow magnitude. – The value of output produced by firms equals the value of expenditures by participants in the economy – The value of output produced by firms equals the total income generated in the economy Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -5

What GDP is and what GDP is not • GDP (Y) is the value of all final goods and services that are currently produced and sold (but not resold) through the market during the current time period • The GDP of a country is often referred to as the country’s output and/or income • There are 3 major rules for including items in the total final product. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -6

What GDP is and what GDP is not 1. Currently produced: a good must be currently produced, i. e. , exclude all used items. It also excludes any transaction in which money is transferred without any accompanying good or a service; transfer payments (gifts from one person to another, gifts from the government to persons; social security, medical care and unemployment benefits), it also excludes capital gains accruing to persons as the price of their assets change. 2. Sold in the market. Goods must be sold in the market and valued at market prices. The value of personal time spent in activities that are not sold in the market are excluded (self consumption). Pollution cost allowances are excluded. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -7

What GDP is and what GDP is not 3. But not resold. A good must not be resold in the current time period. i. e. , the good must be a final product not an intermediate product. Intermediate goods, Final goods and Value added. • Intermediate good, is resold by its purchaser either in its present form or in an altered form. • Final good, is sold to a final user rather than being resold. • Value added, is the value of firms output minus the value of the intermediate goods. It includes wages, rent, interest profit (it is equal to final product). Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -8

Table 2 -1 What’s In and What’s Out of GDP Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -9

What GDP is and what GDP is not What is the domestic in GDP? • GDP includes all final goods and services produced within the country regardless of whether they are sold in the country or exported. Imported goods are excluded. • Gross national product GNP. • It is GDP plus factor payments to citizens from abroad and subtracting payments to factor income to the rest of the world. GNP = GDP + Factor payments from the rest of the world – Factor payments to the rest of the world. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -10

What GDP is and what GDP is not What’s the Gross in GDP • GDP includes depreciation or part of the fixed capital stock used up due to obsolescence and physical wear (consumption of fixed capital. Net Domestic Product (NDP). = GDP - Depreciation. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -11

Components of Expenditure • Types of investment. Final goods that business firms keep for themselves are called private investments or capital formation. They add to nation’s stock of income-yielding assets. There are two types of private investments. • Inventory Investment is the change in the stock of raw materials, parts and finished products held by businesses. – Any goods that are unsold automatically are counted as part of unplanned inventory investment. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -12

• Fixed Investment includes all final goods (mainly structures and equipment) purchased by businesses not intended for resale. – Houses and condominiums owned by households are also counted as fixed investment. Relation of Investment and Saving • Personal Saving (S) is that part of personal income that is not consumed or paid out in taxes – Also referred to as Private Saving – Algebraically: S = (Y-T) - C (where T = Net Taxes) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -13

• Funds from savings are channeled to firms in two basis ways: – Households buy bonds and stocks issued by firms – Households deposit savings in banks and other financial institutions that in turn lend money to firms • Firms use the money channeled from savings to buy investment goods • Saving is a leakage from the income used for consumption expenditures. This leakage must be balanced by an injection on non-consumption spending in the form of private investment. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -14

Figure 2 -2 Introduction of Saving and Investment to the Circular Flow Diagram Leakage Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Injection 2 -15

Net Exports and Net Foreign Investment • Exports are goods produced within one country and shipped to another. Exports creates income in the country, but not part of the consumption and investment spending of residents • Imports are goods consumed within one country but produced in another country. Imports are expenditures of residents for goods ui 8/and services produced abroad and thus do not create domestic income • If income created from exports is greater than income spent on imports, the net effect is a higher level of domestic production and income. Thus, net exports is a component of a final product and GDP Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -16

Net Exports and Net Foreign Investment • Another name of net exports is net foreign investment, since net foreign investment (net exports) creates claims on foreigners. If Japanese exports to USA is greater than its imports from USA, US payments of the net exports will enable Japan to buy US assets including bank accounts in USA. • Net Exports (NX) are equal to the excess of exports over imports • Net Foreign Investment (NFI) is equal to purchases of foreign financial assets minus foreign purchases of financial assets Interesting connection: NX = NFI ! Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -17

The Government Sector • Government Purchases (G) is the value of goods and services purchased by the government. • Transfer Payments (F) are payments from the government to households that do not require the recipient to provide a service in return – Examples: Social Security, Medicare and Food Stamps • Government Spending = G + F • The Government pays for its spending by collecting Taxes (R) or by borrowing and/or printing money • Net Taxes (T) = R – F • Budget Surplus = T – G Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -18

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Global Ecolnomic Crisis and GDP • How long did the crisis last? – Business Cycle Peak: 2007: Q 4 – Business Cycle Trough: 2009: Q 2 • How did the components of GDP behave over this time? – – Real consumption by 0. 8% Real government spending by 6. 6% NX became significantly less negative But real investment by 31. 7%! Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -20

Deriving the “Magic” Equation and the Twin Deficits • The income accounting identity states that an economy’s income must equal its expenditures: (spending) Y≡E Y = C + I + G + NX (1) • Now, use the fact that household income must equal household outlays (and recall that T = R - F): (Income allocation) Y+F=C+S+R Y=C+S+T • Equating (1) and (2) yields the “Magic Equation” (2) C + S + T = C + I + G + NX S + T = I + G + NX • The technical name of this equation is “the leakages-injection) identity”. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -21

Interpreting the “Magic Equation” • Recall the “Magic Equation: ” S + T = I + G + NX • Leakages (S + T) describe the portion of total income that is not available for consumption • Injections (I + G + NX) is a term for non-consumption expenditures • The “Magic Equation” shows how leakages and injections are connected by definition! Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -22

“Magic Equation” Application: Twin Deficits Recall the “Magic Equation: ” S + T = I + G + NX • Rearranging (1) yields T - G = (I + NX) – S (1) – If T - G < 0 possibly NX < 0 – This suggests that a budget deficit and trade deficit might be observed at the same time! – Note that the “magic equation” only suggests the possible connections that may be observed in these variables. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -23

Interpreting the “Magic Equation” • • • The government budget and the twin deficits Rearrange eq. 4 to show the uses of a government budget surplus T – G = (I + NX) – S If T>G, there are 3 ways that a government budget surplus can be used 1. A budget surplus allows private savings to decline without a need for a decline of total investment (I+NX). 2. A budget surplus can stimulate domestic investment (I) 3. a budget surplus can boost foreign investment (NX) or if NX is negative, reduce borrowing from foreigners. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -24

• If T<G, the government is running a deficit, there are 3 implications • Budget deficit could make (I) smaller. • Budget deficit requires that (S) must rise to avoid any downward pressure on total investment (I+NX). • If S does not increase, to avoid a decline in (I+NX), there must be more borrowing from foreigners and a decline in lending to foreigners. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -25

The “Magic Equation” in Recent Years (as % of GDP) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -26

Where does household income from? income leakages and the circular flow • Expenditures on GDP (C+I+G+Nx) create income. • Income is to be spent on another round of expenditure. • Household receive only part of the GDP, the rest is leaks out in the form of tax and savings. • The most important portion of domestic income is compensations to employees. Different types of income (see the following figure) • US GDP data for Q 3 2010 Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -27

• Summarize the steps by which income travels from business firms to households. 1. Net Domestic Product = GDP – depreciation • Now you may notice that gross or net depends on whether depreciation is included or excluded 1. Domestic income = NDP – indirect business taxes 2. Personal income = DI – undistributed profits – corporate taxes + transfer payments 3. Personal disposable income = personal income – personal income taxes Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -28

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Nominal GDP, Real GDP and the GDP Deflator • Nominal GDP is the value of gross domestic product in current (actual) prices. • Real GDP is the measure of gross domestic product using prices of an arbitrarily chosen base year. • The GDP deflator is a price index that measures the aggregate economy’s price level. – Algebraically: GDP Def = Nominal GDP / Real GDP * 100 – The percentage change in the GDP deflator gives a measure of the economy’s inflation rate. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -30

Figure 2 -4 Nominal GDP, Real GDP, and the GDP Deflator, 1900– 2010 Source: Appendi x Table A-1. See explanat ion in Appendi x C-4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -31

Measuring Unemployment • The unemployed are those who either are on temporary layoff or have taken specific action to look for work • The total labor force is total of the civilian employed, the armed forces and the unemployed • The actual unemployment rate (U) is defined below: • Each month 1, 500 census workers interview a random sample of 60, 000 households to estimate unemployment Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -32

Flaws in the Definition of Unemployment • U is not a measure of social distress – Much worse for the head of a household to be unemployed compared to a 16 -year old teenage – Other common situations: • College graduates looking for first jobs • Women reentering the labor market after maternity leave • People who voluntarily quit jobs and are now looking again • U misses “forced part time workers” workers • U misses “discouraged workers” workers who are not actively seeking jobs and therefore are not in the labor force – See chart on next slide! Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -33

Millions Impacted by Recessions but Not Counted as Unemployed Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2 -34

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