AHS IB Economics Unit Measuring National Income

Microeconomic objectives firms aim to maximize profits consumers aim to maximize utility efficient resource allocation in competitive markets the correction of market failure through government intervention

Macroeconomic Objectives Full – employment Does NOT mean every single person has a job. Means that most people who want to work are working. Some unemployment will exist in a healthy economy. Stable prices – –This refers not to the prices of individual products, but to the price level in the economy as a whole. A rise in the overall price level is called inflation, a fall is called deflation Economic growth – –The most talked about macroeconomic goal, growth occurs when the total amount of goods and services an economy produces increases from year to year. Income distribution – –A nation's income should be somewhat equally distributed between the upper and lower "classes" in society. – –Some tax systems are designed to achieve more equitable income distribution.

The Product of A Nation: Measured historically by MercantilismMercantilism –The stock of precious metals in the country –17th & 18th centuries Francois Quesnay’s Circular Flow of IncomeFrancois Quesnay’s Circular Flow of Income –late 18th Century Kuznets National Income AccountingKuznets National Income Accounting –The detailed national income accounting system we use today –Developed in the 1930s

National Income Accounts Gross domestic product (GDP):Gross domestic product (GDP): –Measures the market value of all final goods and services produced during a year by resources located in the United States, regardless of who owns the resources. Gross vs. Net domestic productGross vs. Net domestic product –Gross is before subtracting capital consumption DepreciationDepreciation –Net is after subtracting capital consumption Domestic:Domestic: –Measures activities located in a country regardless of location of owners Product:Product: –Measures output produced rather than output absorbed by residents –Includes: Final goods and services:Final goods and services: –Sold to the ultimate (final) user. Intermediate goods and services:Intermediate goods and services: –Used as an input for production Oils, lubricants, fuels, parts Purchased for additional processing and resale.

Measurement Income model:Income model:W+I+R+P Expenditure ModelExpenditure Model C + I + G + (X-M)

FIRMS (suppliers of goods and services, demanders of factor services) HOUSEHOLDS (demanders of goods and services, suppliers of factor services) The interdependence of goods and factor markets

P Q £ £ D1D1 (1) Consumer demand demand O

The interdependence of goods and factor markets P Q £ £ Goods S (1) Consumer demand demand (2) Producer supply supply O D1D1

The interdependence of goods and factor markets P Q £ £ Goods (1) Consumer demand demand (2) Producer supply supply P1P1 O Q1Q1 D1D1 S

The interdependence of goods and factor markets P Q P Q £ £ ££ Goods (1) Consumer demand demand (3) Factor demand demand (2) Producer supply supply P1P1 O OQ1Q1 D1D1 S D1D1

The interdependence of goods and factor markets P Q P Q £ £ ££ Factor services Goods Factor services (1) Consumer demand demand (4) Factor supply supply (3) Factor demand demand (2) Producer supply supply P1P1 O Q1Q1 O D1D1 S D1D1 S

The interdependence of goods and factor markets P Q P Q £ £ ££ Factor services Goods Factor services (1) Consumer demand demand (4) Factor supply supply (3) Factor demand demand (2) Producer supply supply P1P1 Q1Q1 O PF1PF1 QF1QF1 O D1D1 S D1D1 S

The interdependence of goods and factor markets P Q P Q £ £ ££ Factor services Goods Factor services S S D1D1 D1D1 (1) Consumer demand demand (4) Factor supply supply (3) Factor demand demand (2) Producer supply supply P1P1 Q1Q1 O O D2D2 PF1PF1 QF1QF1

The interdependence of goods and factor markets P Q P Q £ £ ££ Factor services Goods Factor services S S D1D1 D1D1 (1) Consumer demand demand (4) Factor supply supply (3) Factor demand demand (2) Producer supply supply P1P1 Q1Q1 O O P2P2 Q2Q2 PF1PF1 QF1QF1 D2D2

The interdependence of goods and factor markets P Q P Q £ £ ££ Factor services Goods Factor services S S D1D1 D1D1 (1) Consumer demand demand (4) Factor supply supply (3) Factor demand demand (2) Producer supply supply P1P1 Q1Q1 O O P2P2 Q2Q2 D2D2 PF1PF1 QF1QF1 D2D2

The interdependence of goods and factor markets P Q P Q £ £ ££ Factor services Goods Factor services S S D1D1 D1D1 (1) Consumer demand demand (4) Factor supply supply (3) Factor demand demand (2) Producer supply supply P1P1 Q1Q1 O O P2P2 Q2Q2 PF1PF1 QF1QF1 PF2PF2 QF2QF2 D2D2 D2D2

The circular flow of income Injections, withdrawals and equilibrium Injections, withdrawals and equilibrium

Consumption of domestically produced goods and services (C d ) The circular flow of income

Factor Payments: Consumption of domestically produced goods and services (C d ) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc Net saving (S) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc Investment (I) Net saving (S) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc GOV. Investment (I) Net saving (S) Net taxes (T) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc GOV. Investment (I) Government expenditure (G) Net saving (S) Net taxes (T) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc GOV. ABROAD Investment (I) Government expenditure (G) Net saving (S) Net taxes (T) Import expenditure (M) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc GOV. ABROAD Investment (I) Government expenditure (G) Export expenditure (X) Net saving (S) Net taxes (T) Import expenditure (M) The circular flow of income

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc GOV. ABROAD Investment (I) Government expenditure (G) Export expenditure (X) Net saving (S) Net taxes (T) Import expenditure (M) The circular flow of income WITHDRAWALS

Factor payments Consumption of domestically produced goods and services (C d ) BANKS, etc GOV. ABROAD Investment (I) Government expenditure (G) Export expenditure (X) Net saving (S) Net taxes (T) Import expenditure (M) The circular flow of income WITHDRAWALS INJECTIONS

Gross Domestic Product: GDP is the monetary measure of the total market value of all final goods and services produced within a country in one year. Why is GDP important? >>It tells us something about the relative size of different countries' economies >>It is a monetary measure, so it tells us how much income a country earns in a year >>When we divide GDP by the population, we get GDP per capita, which tells us how many goods and services the average person consumes in a country. >>When real GDP grows more than the population, that tells us that people on average, have more stuff than they did before. >>If you believe that having more stuff makes people better off, then GDP per capita tells us how well off people in society are. IMPLICATIONS: GDP is the most important macroeconomic measurement! national income national output national expenditures GDP=W+R+I+P GDP= primary output + secondary output + tertiary output GDP=C+I+G+(X-M) Macroeconomics M easuring national income

National Income Net Domestic ProductNet Domestic Product NDP = GDP minus Depreciation

Limitations of National Income Accounting Some Production Is Not Included in GDP:Some Production Is Not Included in GDP: Do-it-yourself production Production in the parallel/shadow or underground economy. Some production that does not pass through markets is included in GDP:Some production that does not pass through markets is included in GDP: Imputed value of wages paid in kind. Imputed value of food produced on a farm for that farm family’s own consumption.

Aggregate Expenditure Model to calculate national income GDP = C + I + G + (X - M) Plus Net receipts of factor income from rest of world =GNPLessdepreciation= Net National product Less Indirect business taxes = National Income

National Income: WIRP Compensation + Net Interest + Rent + Profit + corporate income tax + dividends + retained earnings Plus Indirect business taxes = Net National Product Plus Depreciation (aka capital consumption) =GNPLess Net receipts of Factor income from rest of world =GDP

Accounting Identity Leakages = Injections S + NT + M = I + G + X

The Income Half of the Circular Flow Aggregate income: GDP = DI + NT Aggregate output equals aggregate income GDP = Aggregate income (assuming no depreciation and no retained earnings) DI = Aggregate income – (Taxes + Transfers) Disposable income (DI) is take-home pay. NT = Net Taxes.

GDP Based on the Income Approach Sum of : wagesinterestrentprofit arising from production Avoids double-counting calculates the value added at each stage of production. Aggregate expenditure = GDP = Aggregate income

GDP and Economic Welfare Accounting for Price Changes Accounting for Price Changes –Must deflate nominal GDP to Compare GDP over time and to focus on real changes in production. Nominal GDP (current $ GDP) Based on prices prevailing when the output is produced.Based on prices prevailing when the output is produced. –Real GDP Measured in terms of the goods and services produced.Measured in terms of the goods and services produced. After inflation is taken into accountAfter inflation is taken into account

How do we determine Real GDP? We will assume that we live in an economy that produces only one thing, Pizza.. 1. Find Nominal GDP for each year 2. Determine a price index for each year (using the price index formula), 3. Adjust the nominal GDP figures by dividing by the price index (in hundredths). Macroeconomics M easuring national income What is a price index? A price index is a measure of the price of a specified collection of goods and services called a, “ market basket ” in a given year as compared to the price of an identical basket of goods and services in a reference year. Price index for a given year = Price of a "market basket" of goods in a specific year Price of same "basket" in the base year X 100 Real GDP = Nominal GDP Price index (in hundredths)

Macroeconomics M easuring national income 2008: 10 $10/pizza. Nominal GDP = $ : 12 $12/pizza. Nominal GDP = $144 Example: Price index= P pizza 2008 = $10 P pizza 2009 = $12 =1.2 x 100 = 120 Nominal GDP in 2009 = 12 x $12 = $144 Real GDP in 2009 = $ = $120 Conclusions: Because the price of pizza's increased by 20% (inflation rate was 20%), the nominal GDP growth of 44% was over-stated. After adjusting for inflation, the nations' growth rate is only 20% What is the REAL GDP in 2009?

The Expenditure Half of the Circular Flow:  Consumption spending (C), investment spending (I) government purchases (G), and net exports (X –M) stay within the circular flow. C + I + G + (X  M) = Aggregate expenditure = GDP DI = C + S Households with disposable income must use it to consume or save. Net taxes, saving, and imports leak from the circular flow.

Price Indexes – –Used to compare the value of some variable in a particular year with its value in a base year – –A way to measure inflation Consumer Price Index – –Measures changes over time in the cost of buying a “market basket” of goods and services. Problems with the CPI – –By failing to reflect new products and improved quality, estimate the possibilities of substitution, and include shifts to discount outlets, the CPI is overstated. The GDP Price Index – –Nominal GDP divided by Real GDP)  by 100 – –measures level of prices of all output included in GDP.