Chapter 8 Measuring the Economy’s Performance 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.

The Simple Circular Flow Two observations 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

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

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

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

Figure 8-1 The Circular Flow of Income and Product

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 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.

National Income Accounting (cont'd) Stress on final output What is a final good? Wheat? Steel? Oil? Bread? Automobile? Gasoline?

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 of Donut Production

National Income Accounting Numerous transactions occur that have nothing to do with final goods and services being produced. 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 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 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.

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 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 Note unique scale on vertical axis.

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

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

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

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

Two Main Methods of Measuring GDP Gross domestic product equals gross domestic income plus indirect business taxes and depreciation These last items are called non-income expense items Indirect business taxes All business taxes except the tax on corporate profits Include sales and business property taxes

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.

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

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 Disposable Personal Income (DPI) Personal income after personal income taxes have been paid

Table 8-2 Going from GDP to Disposable Income, 2007

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

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 Constant Dollars Dollars expressed in terms of real purchasing power

Example: Correcting GDP for Price Index Changes Nominal (current) dollars GDP Real (constant) dollars GDP Nominal GDP Price level* Real GDP = x 100 *Price level: 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 Foreign exchange rate & comparing GDP $1.25 = 1 euro, or $1 = 0.80 euros French per capita income = 23,168.80 euros French per capita income in terms of dollars equals 23,168.80 euros x $1.25 = $28,961

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

Chapter 8 Measuring the Economy’s Performance 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.