Measuring the Economy’s Performance Chapter 8 Measuring the Economy’s Performance

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

The Simple Circular Flow The concept of the circular flow of income involves two principles: 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.

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.

The Simple Circular Flow (cont'd) 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

Figure 8-1 The Circular Flow of Income and Product

The Simple Circular Flow (cont'd) Product Markets Transactions in which households buy goods

The Simple Circular Flow (cont'd) Factor Markets Transactions in which businesses buy resources

The Simple Circular Flow (cont'd) Total Income Wages, rent, interest, profits

The Simple Circular Flow (cont'd) Question Why must total income be identical to the dollar value of total output? Answer Every transaction simultaneously involves an expenditure and a receipt.

National Income Accounting A measurement system used to estimate national income and its components Total Income The yearly amount earned by the nation’s resources (factors of production)

National Income Accounting (cont'd) 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.

National Income Accounting (cont'd) 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

National Income Accounting (cont'd) Numerous transactions occur that have nothing to do with final goods and services being produced: Financial transactions Transfer Payments Secondhand Goods

National Income Accounting (cont'd) Exclusion of financial transactions Securities Stocks and bonds Government transfer payments Social Security Unemployment compensation Private transfer payments Individual gifts Corporate gifts

National Income Accounting (cont'd) Transfer of secondhand goods excluded 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

National Income Accounting (cont'd) GDP’s limitations Excludes non-market production It is not necessarily a good measure of the well- being of a nation.

National Income Accounting (cont'd) GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity. GDP is not a measure of a nation’s overall welfare.

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) Expenditure Approach

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) Income Approach

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

Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the Expenditure Approach 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 included: changes in business inventories and repairs made to machines, buildings

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

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 Where C = consumption expenditures I = investment expenditures G = government expenditures X = net exports GDP = C + I + G + X

Figure 8-2 GDP and Its Components

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

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year) Sources: U.S. Department of Commerce and author’s estimates.

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

Other Components of National Income Accounting (cont'd) Disposable Personal Income (DPI) Personal income after personal income taxes have been paid

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 Nominal (current) dollars GDP Real (constant) dollars GDP Nominal GDP Price index* Real GDP = x 100 *Price index: measured by the GDP deflator

Table 8-3 Correcting GDP for Price Index Changes

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

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

Comparing GDP Throughout the World Foreign Exchange Rate The price of one currency in terms of another

Comparing GDP Throughout the World (cont'd) Foreign exchange rate $1.50 = 1 euro, or $1 = .67 euros French income per capita = 24,120 euros French per capita income in terms of dollars equals 24,120 euros x $1.50 = $36,180

Comparing GDP Throughout the World (cont'd) Purchasing Power Parity Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries

Table 8-4 Comparing GDP Internationally

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.