Chapter 8 ECON 151 PRINCIPLES OF MACROECONOMICS Chapter

Chapter 8 ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 8: Measuring the Economy’s Performance 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 n 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) n Profits explained ¨ Question n Why is profit a cost of production? ¨ Answer n Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities. 8 -3

The Simple Circular Flow (cont'd) n 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) n Product Markets ¨ Transactions in which households buy goods 8 -5

The Simple Circular Flow (cont'd) n Total Income ¨ Wages, rent, interest, profits 8 -6

The Simple Circular Flow (cont'd) n 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) n Question ¨ n 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 n National Income Accounting ¨A measurement system used to estimate national income and its components n Total Income ¨ The yearly amount earned by the nation’s resources (factors of production) 8 -10

National Income Accounting n 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) n Stress on final output ¨ What is a final good? n Wheat? n Steel? n Oil? n Bread? n Automobile? n Gasoline? 8 -12

National Income Accounting (cont'd) n Intermediate Goods ¨ Goods used up entirely in the production of final goods n 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 8 -13

Table 8 -1 Sales Value and Value Added of Donut Production 8 -14

National Income Accounting n n Numerous transactions occur that have nothing to do with final goods and services being produced. Exclusion of financial transactions ¨ Securities n Stocks and bonds ¨ Government transfer payments n Social Security n Unemployment compensation ¨ Private transfer payments n Individual gifts n Corporate gifts 8 -15

National Income Accounting n Transfer of secondhand goods excluded ¨ Why not count the sale of a used computer, guitar, or snowboard as part of GDP? n Other excluded transactions ¨ Household ¨ Legal production and illegal underground transactions 8 -16

National Income Accounting n 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 n 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) Expenditure Approach 8 -19

Two Main Methods of Measuring GDP (cont'd) n 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) Income Approach 8 -21

Two Main Methods of Measuring GDP (cont'd) n Deriving GDP by the expenditure approach ¨ Consumption n Durable Consumer Goods ¨ n Life span of more than three years Nondurable Consumer Goods ¨ n Expenditure (C) Goods that are used up in three years Services ¨ Mental or physical help 8 -22

Two Main Methods of Measuring GDP (cont'd) n Deriving GDP by the expenditure approach ¨ Gross n 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) n Deriving GDP by the expenditure approach ¨ Gross n Producer Durables or Capital Goods ¨ n Life span of more than three years Fixed Investment ¨ n Private Domestic Investment (I) 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) n Deriving GDP by the expenditure approach ¨ Government Expenditures (G) n State, local, and federal n Valued at cost ¨ Net Exports (Foreign Expenditures) Net exports (X) = Total exports – Total imports 8 -25

Two Main Methods of Measuring GDP (cont'd) n Presenting the expenditure approach ¨ Where n C = consumption expenditures n I n G = government expenditures n X = net exports = investment expenditures GDP = C + I + G + X 8 -26

Figure 8 -2 GDP and Its Components Note unique scale on vertical axis. 8 -27

Two Main Methods of Measuring GDP (cont'd) n Depreciation and net domestic product ¨ Deducting for depreciation (capital consumption allowance) n Reduction in the value of capital goods over a oneyear period due to physical wear and tear, and also to obsolescence NDP = GDP – Depreciation 8 -28

Two Main Methods of Measuring GDP (cont'd) n NDP = GDP – Depreciation n GDP = C + I + G + X n NDP = C + I + G + X – Depreciation n Net Investment = I – Depreciation ¨ Domestic investment minus an estimate of the wear and tear on the existing capital stock n NDP = C + Net I + G + X 8 -29

Two Main Methods of Measuring GDP (cont'd) n Deriving GDP by the income approach 8 -30

Deriving GDP by the Income Approach n Gross Domestic Income (GDI) ¨ The sum of all income—wages, interest, rent, and profits—paid to the four factors of production n Wages: salaries and labor income n Rent: farms, houses, stores n Interest: savings accounts n Profits: sole proprietorships, partnerships, corporations 8 -31

Two Main Methods of Measuring GDP n Gross domestic product equals gross domestic income plus indirect business taxes and depreciation n These last items are called non-income expense items n 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) Source: U. S. Department of Commerce. First quarter preliminary data annualized. 8 -33

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 n National Income (NI) ¨ The n 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 n 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 n 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 n Nominal Values ¨ Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values n Real Values ¨ Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars n Constant Dollars ¨ Dollars expressed in terms of real purchasing power 8 -38

Example: Correcting GDP for Price Index Changes n Correcting GDP for price index changes ¨ Nominal ¨ Real (current) dollars GDP (constant) dollars GDP Nominal GDP x 100 Real GDP = Price level* *Price level: measured by the GDP deflator 8 -39

Table 8 -3 Correcting GDP for Price Index Changes 8 -40

Distinguishing Between Nominal and Real Values (cont'd) n Per capita GDP ¨ Adjusting for population growth Real GDP Per capita real GDP = Population 8 -41

Figure 8 -4 Nominal and Real GDP Source: U. S. Department of Commerce 8 -42

Comparing GDP Throughout the World n Foreign Exchange Rate ¨ The price of one currency in terms of another n Foreign exchange rate & comparing GDP n $1. 25 = 1 euro, or $1 = 0. 80 euros n French per capita income = 23, 168. 80 euros n French per capita income in terms of dollars equals 23, 168. 80 euros x $1. 25 = $28, 961 8 -43

Comparing GDP Throughout the World (cont'd) n 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 8 ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 8: Measuring the Economy’s Performance Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved. 46