Measuring the Economy’s Performance

National Income Accounting

 National Income Accounting : the measurement of the national economy’s performance  Five major statistics measure the national economy:  gross domestic product (GDP)  net domestic product (NDP)  national income (NI)  personal income (PI)  disposable personal income (DPI)

 Gross Domestic Product (GDP) : total dollar value of all final goods produced in a country during a year  This figure tells the amount of goods and services produced within the country’s borders and made available for purchase in that year.

 Simply adding up the quantities of different items produced would not mean much to measuring the economy.  It is important to know the value of items using some common metric.  The GDP value is always expressed in dollars.

 The GDP only accounts for final products so that parts are not double counted.  For example: GDP does not add the price of computers and motherboards and memory chips if those motherboards and memory chips are going to be installed in computers for sale.  Only new products are counted: used products are not because they are considered a transfer from one owner to another.

 GDP is computed by adding products purchased by consumers (C), by businesses (I), by the government (G), and net exports (X), which is the difference between exports and imports.  GDP= (C)+(I)+(G)+(X)

 Some of the figures used to compute GDP are estimates.  It omits some areas of the economy.  It only measures quantity not quality.

 Accounts for fact that some production is only due to depreciation.  Depreciation : loss of value because of wear and tear to durable goods and capital goods  Net Domestic Product (NDP) : value of the nation’s total output (GDP) minus the total value lost through depreciation on equipment  NDP is a better measure of productivity because it accounts for depreciation.

 Three measurements look at income:  National Income  Personal Income  Disposable Personal Income

 National Income (NI) : the total income earned by everyone in the economy.  NI is equal to the sum of all income resulting from 5 areas of the economy:  wages and salaries  income of self-employed people  rental income  corporate profits  interest on savings and other investments.

 Personal income (PI) : total income that individuals receive before paying personal taxes  PI is National Income minus transfer payments (assistance payments) and income that is not available to be spent.  Transfer Payments : welfare and other supplementary payments that a state or the federal government makes to individuals

 Disposable personal income (DI) : income left to purchase goods or put in savings after paying taxes.  DI is an important indicator of the economy’s health because it measures the actual amount of money income people have available to save and spend.

Correcting Statistics for Inflation

 When inflation occurs, the prices of goods and services rise, and the purchasing price of the dollar goes down.  Inflation : prolonged rise in the general price level of goods and services  Purchasing power of a dollar is equal to the real goods and services the dollar can buy.  Inflation can also be defined as the decline in the purchasing power of money.

 Faster the rate of inflation, greater the drop in purchasing power.  Inflation must be taken into account when calculating the GDP.  Deflation : a prolonged decline in the general price level of goods and services  Deflation rarely happens.

 The government measures inflation in several ways.  Three of the most commonly used measurements are:  Consumer Price Index (CPI)  Producer Price Index (PPI)  GDP Price Deflator

 The consumer price index (CPI) : measure of the change in price of a specific group of products and services used by the average household.  The group of items that are priced are referred to as a market basket.  Market Basket : representative group of goods and services used to compile the consumer price index  The list includes about 80,000 specific goods and services under general categories.

 The numbers are updated monthly and new items are added to the list every 10 years.  The Bureau of Labor Statistics is responsible for updating the list.  They start with prices from a base year to serve as a comparison.

 The Producer Price Index (PPI) : measures the average change in prices that companies charge the consumer for their goods and services  Most of the producer prices are in mining, manufacturing, and agriculture.  PPIs usually increase before the CPI and are used as an indicator that inflation is going to increase.

 GDP Price Deflator : price index that removes the effect of inflation from GDP so that the overall economy in one year can be compared to another year  When the price deflator is applied to the GDP in any year, the new figure is called the real GDP.  Real GDP : GDP that has been adjusted for inflation by applying the price deflator

Aggregate Demand and Supply

 The laws of supply and demand can be applied to the economy as a whole as well as to individual consumer decisions.  Economist are interested in the demand by all consumers for all goods and services and the supply by all producers of all goods and services.  This requires the use of aggregates.  Aggregate : summation of all the individual parts in the economy

 Aggregate Demand : total quantity of goods and services in the entire economy that all citizens will demand at any single time  Where consumer demand is related to the price of one product, aggregate demand is related to the price level or the average of all prices as measured by a price index.  Because there are millions of different prices for all products, aggregate demand cannot be related to one price.

 If the price level goes down, a larger quantity of real domestic output is demanded per year.  There are two reasons for this inverse relationship:  Purchasing power of money  Relative prices of goods and services sold to other countries.

 Purchasing Power  Inflation causes the purchasing power to decrease.  Deflation causes purchasing power to increase.  Therefore, when price level goes down, the purchasing power of any cash held will increase.  Relative Prices  When price level goes down in the United States, our goods become relatively better deals for foreigners who want to buy them.  Foreigners would them demand more of our goods and services.

 Aggregate Supply : real domestic output of producers based on the rise and fall of the price level  If the price level goes up and wages do not, overall profits will rise and producers will want to supply more.

 If you combine the aggregate supply curve and the aggregate demand curve, you can find the equilibrium price and quantity (where two curves meet).  If price levels and output remain the same, there will be neither inflation nor deflation.

Business Fluctuations

 Some years inflation, unemployment, world trade, or taxes are high; other years they are not.  There are fluctuations in virtually all aspects of our economy.  Business Fluctuations : ups and downs in an economy  Business Cycle : irregular changes in the level of total output measured by real GDP

 Begins with growth that leads to an economic peak, boom, or period of prosperity.  Peak/Boom : period of prosperity in a business cycle in which economic activity is at its highest point  Economies also experience contraction, where real GDP levels off and begins to decline, while business activity slows down.  Contraction : part of the business cycle during which economic activity is slowing down

 If real GDP doesn’t grow for at least 6 months, economy is in a recession.  If recession continues to get worse, economy goes into a depression.  Depression : major slowdown of economic activity

 The downward direction of economy levels off in a trough and real GDP stops going down.  Trough : lowest part of the business cycle in which the downward spiral of the economy levels off  Business activity increases and economy begins expansion or recovery.

 In real world economy, business cycles are not regular.  The largest drop in the U.S. economy was following the stock market crash of 1929, which resulted in a severe depression.  The rise climaxed after World War II.

 In the 1970s and 1980s the economy had small recessions.  The 1990s began with a recession but became a time of great economic growth.

Causes and Indicators of Business Fluctuations

 For many years economists believed that business fluctuations occurred in regular cycles.  Today economists tend to link business fluctuations to 4 main forces:  Business Investment  Government Activity  External Factors  Psychological Fators

 Some economists believe that business decisions are the key to business fluctuations.  Business investment involves companies expanding or scaling back, or companies using innovations in their business practices.  Innovation : inventions and new production techniques  When businesses anticipate a downturn in the economy, they cut back their investments and inventories.

 A number of economists believe that the changing policies of the federal government are a major reason for business cycles.  Government activity involves taxing and spending policies, and control of money supply in economy.

 Factors outside a nation's economy also influence the business cycle.  External factors are non-economy related factors, such as wars or raw material costs.  The impact of wars results from the increase in government spending during wartime.  New sources of raw materials may lower operating costs for certain industries.

 Psychological factors are people’s optimistic or pessimistic outlook on the future and the economy and can contribute to increased spending or more saving.

 Business leaders are faced with the dilemma of trying to predict what will happen to the economy in the coming months or years.  Economists and the government create forecasts to try and aid in predicting the future of the economy.  They are usually too broad to be helpful.

 Economists then turn to indicators to help predict the economy more accurately.  Economic Indicators : statistics that measure variables in the economy  Often different indicators within a group move in opposite directions.  It can take a long time before a change in an indicator is felt in the economy.

 Economic indicators can be placed into 3 groups:  Leading Indicators  Coincident Indicators  Lagging Indicators

 Leading Indicators : statistics that point to what will happen in the economy  They seem to lead to a change in overall business activity- whether it is an upward or a downward trend.  The Commerce Department keeps track of numerous leading indicators.  Example:  Weekly initial claims for unemployment insurance  New orders for consumer goods  Stock prices

 Coincident Indicators : economic indicators that usually change at the same time as changes in overall business activity  They indicate a downswing or upswing has begun.  Examples:  Personal income minus transfer payments  Rate of industrial production  Sales of manufacturers, wholesalers, and retailers

 Lagging Indicators : indicators that seem to lag behind changes in overall business activity  It could be months after the start of a downturn before businesses begin to reduce borrowing.  Lagging indicators give economists clues as to the duration of the phase of the business cycles  Examples:  Averate length of unemployment  Size of manufacturing and trade inventories  Change in CPI for services