8 THE DATA OF MACROECONOMICS

Copyright © 2004 South-Western 23 Measuring a Nation’s Income

Copyright © 2004 South-Western Objectives a. In National Income Accounting: Total income = total expenditure : why? b. Define and calculate Gross Domestic Product c. Identify components of GDP d. Distinguish between real and nominal GDP - constant $ vs. current $ e. Evaluate how well GDP measures economic well-being

Copyright © 2004 South-Western Essential Macro Growth and Fluctuations (business cycle) Four key macro variables a.Price level – inflation b.Unemployment/employment c.Interest rates – price of money d.Output (production of goods and services) and income – GDP a.GDP – Gross Domestic Product -Gross – total -Domestic – within a nation -Product – goods and services

Copyright © 2004 South-Western Macro Our interest is in the aggregate - all households - all firms From previous lecture (1 st chap) we know… Consumption = f (Production) How do we measure production/income?

Copyright © 2004 South-Western THE ECONOMY’S INCOME AND EXPENDITURE For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Example: Carpenter sells a bench to a dentist for $115 expenditure ($115) = income ($115) Dentist fixes teeth for $275 expenditure ($275) = income ($275)

Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT Gross domestic product (GDP) is a measure of the income and expenditures of an economy. The equality of income and expenditure can be illustrated with the circular-flow diagram (chapter 2). income = expenditures

Figure 1 The Circular-Flow Diagram Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES Copyright © 2004 South-Western

Definition: GROSS DOMESTIC PRODUCT GDP is the market value of all final goods and services produced within a country in a given period of time.

Copyright © 2004 South-Western Breakdown of Definition “GDP is the Market Value...” Output is valued at market prices. -The value of that chair… $115 -The value of that dental work… $275 … value is measured in $ … dollars

Copyright © 2004 South-Western Breakdown of Definition “... Of All Final...” It records only the value of final goods, not intermediate goods (the value is counted only once). Example: a. Farmer sells unit of wheat to refiner for $1.00 b. Refiner sells flour to wholesaler for $1.75 c. Wholesaler sells flour to Baker - $2.00 d. Baker sells bread to Customer - $3.00 What is counted? The sale of the bread!!!

Copyright © 2004 South-Western What is counted? The final good, bread, was sold for $3.00 Looked at another way… Farmer added $1.00 of value Refiner added $0.75 of value Wholesaler added $0.25 of value Baker added $1.00 of value Total Value (of production) in process = $3.00

Copyright © 2004 South-Western What is counted? If we counted intermediate goods that would be double counting (see previous slide) * Careful – An investment good is NOT an intermediate good. If Baker buys a stainless steel mixing bowl or display racks that would not be considered an intermediate good.

Copyright © 2004 South-Western Distinction It is difficult to make a distinction sometimes between what is a final good and what is an intermediate good. Examples: a. paint – used in new residential construction or on someone’s kitchen on a Saturday. b. flour purchased by a baker or purchased by a person to bake Oatmeal cookies on the weekend

Copyright © 2004 South-Western Breakdown of Definition “... Goods and Services... “ It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “... Produced...” It includes goods and services currently produced, not transactions involving goods produced in the past. (used cars v. new cars, homes, broker (stocks and bonds) “... Within a Country...” It measures the value of production within the geographic confines of a country.

Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “... In a Given Period of Time.” It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). Reports of GDP come out quarterly but are annualized: “… the economy grew in the second quarter at a rate of 3.6%...”

Copyright © 2004 South-Western GDP does not include GDP includes all items produced in the economy and sold legally in markets, but… Underground or black markets exist Drugs, babysitting, lawn cutting, “under the table”, many cash transactions

Copyright © 2004 South-Western GDP does not include Also, GDP excludes most items that are produced and consumed at home and that never enter the marketplace. This is noteworthy… a.Daycare is counted in GDP but not when parent cares for child b.Take out food counted but not a home-cooked meal (cost of food is counted) c.Teaching child to cast a fly rod, catch baseball etc d.Playing a board game at home is not counted but mini-golf is…

Copyright © 2004 South-Western THE COMPONENTS OF GDP GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Y = C + I + G + NX Where NX = exports - imports

Copyright © 2004 South-Western THE COMPONENTS OF GDP Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing. Investment (I): The spending on capital equipment, inventories, and structures, including new housing. (Example: Van purchased to make deliveries in not an intermediate good. Like stainless steel mixing bowl, it is an investment good) * Inventories – not all inventory is sold, but it has been produced so it must be counted.

Copyright © 2004 South-Western THE COMPONENTS OF GDP Government Purchases (G): The spending on goods and services by local, state, and federal governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services. Net Exports (NX): Exports minus imports.

Table 1 GDP and Its Components Copyright©2004 South-Western

GDP and Its Components (2001) Consumption 69% Government Purchases 18% Net Exports -3 % Investment 16%

Copyright © 2004 South-Western REAL VERSUS NOMINAL GDP Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices. Money flows vs. Real flows Suppose someone told you that Wendy’s in Alabama sold $300 million worth of hamburgers in 2004 and $325 million worth in 2005… what could you say? Just because money flows increase it does not mean that real flows have increased.

Copyright © 2004 South-Western REAL VERSUS NOMINAL GDP An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator. … or deflating

Table 2 Real and Nominal GDP Copyright©2004 South-Western

Table 2 Real and Nominal GDP Copyright©2004 South-Western

Table 2 Real and Nominal GDP Copyright©2004 South-Western

In constant dollars $ By using 2001 prices we can compare fairly the output (expenditures) over time. We have 2003 output in 2001 dollars, a fair comparison. That is to say that we, through controlling for changes in price, can compare real flows over time.

Copyright © 2004 South-Western Goal Suppose GDP increases from $100 to $200 Did it increase merely because prices increased or did it increase because more goods and services were produced and purchased? Or, was it a combination of the two – higher prices and more output?

Copyright © 2004 South-Western How? Use an index (indices are used in various areas; the periodic table - atomic weight, DJIA for example – The Dow) * This will be covered precisely when we discuss inflation (CPI – Consumer Price Index) in the next chapter

Copyright © 2004 South-Western The GDP Deflator Converting Nominal GDP to Real GDP Nominal GDP is converted to real GDP as follows:

Copyright © 2004 South-Western GDP deflator is not constant Notice the GDP deflator is not constant GDP deflator for 2002 is not the same as the deflator for 2003 See an index on the ensuing slide. A base year is chosen and any given index number has meaning relative to the other index numbers.

Table 2 Real and Nominal GDP Copyright©2004 South-Western

Notice The deflator was derived by taking the value for Nominal GDP and dividing by how much that same amount of goods (hamburgers and hotdogs) would have cost at base year values For example, for 2003 the numerator is how much the burgers and dogs cost in 2003 – nominal GDP. The denominator is how much that same amount would have cost using 2001 prices… Sooooo, we can get a sense, by using an index, of how much the increase was due to real change and how much a price change Problem – how do we get Real GDP without a deflator? We saw how to get the deflator GIVEN that we had real GDP, but where do we get the deflator to begin with?

Figure 2 Real GDP in the United States Billions of 1996 Dollars $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3, Copyright © 2004 South-Western

GDP AND ECONOMIC WELL- BEING GDP is the best single measure of the economic well- being of a society. GDP per person, or per capita, tells us the income and expenditure of the average person in the economy. (sort of… it does not reveal anything about distribution) Say country A and country B both have GDP of $1000 and have the same number of people… Say country C also has GDP of $1000 but has fewer people… MK observations : GDP is the broadest and most cite datum

Copyright © 2004 South-Western GDP AND ECONOMIC WELL- BEING Higher GDP per person indicates a higher standard of living… generally speaking. GDP is not a perfect measure of the happiness or quality of life however, therefore do not overestimate what GDP indicates

Copyright © 2004 South-Western GDP AND ECONOMIC WELL-BEING Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work. * (mk examples - Security example, respirator example)

Table 3 GDP, Life Expectancy, and Literacy Copyright©2004 South-Western

Summary Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross Domestic Product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.

Copyright © 2004 South-Western Summary GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

Copyright © 2004 South-Western Summary Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator is used to adjust – go from nominal GDP to real GDP

Copyright © 2004 South-Western Summary GDP is a good measure of economic well-being because people prefer higher to lower incomes. It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren’t captured by GDP. * Mk comment: GDP is a limited measure. Most people seem to exaggerate its importance.