© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R Measuring a Nation’s Income E conomics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 10

In this chapter, look for the answers to these questions:  What is Gross Domestic Product (GDP)?  How is GDP related to a nation’s total income and spending?  What are the components of GDP?  How is GDP corrected for inflation?  Does GDP measure society’s well-being? 1

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 2 Micro vs. Macro  Microeconomics: The study of how individual households and firms make decisions, interact with one another in markets.  Macroeconomics: The study of the economy as a whole.  We begin our study of macroeconomics with the country’s total income and expenditure.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 3 Macroeconomics studies the structure of aggregate economies and the impact of policies on their performance. What determines economic fluctuations? (business cycle) Why some countries grow faster than others ? (economic growth) What causes unemployment ? What drives prices changes? (inflation) What is the role of economic policies and the government? (monetary and fiscal policies) How being part of a global economic system affects the economy of a country?

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 4 (1) Income and Expenditure  Gross Domestic Product (GDP) measures total income of everyone in the economy. [later: more formal definition]  GDP also measures total expenditure on the economy’s output of goods and services (g&s). income equals expenditure For the economy as a whole, income equals expenditure because every dollar a buyer spends is a dollar of income for the seller.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 5 The Circular-Flow Diagram  a simple depiction of the macroeconomy  illustrates GDP as spending, revenue, factor payments, and income  Preliminaries:  Factors of production are inputs like labor, land, capital, and natural resources.  Factor payments are payments to the factors of production (e.g., wages, rent).

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 6 The Circular-Flow Diagram Households:  own the factors of production, sell/rent them to firms for income  buy and consume goods & services Households:  own the factors of production, sell/rent them to firms for income  buy and consume goods & services Households Firms Firms:  buy/hire factors of production, use them to produce goods and services  sell goods & services Firms:  buy/hire factors of production, use them to produce goods and services  sell goods & services

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 7 The Circular-Flow Diagram Markets for Factors of Production Households Firms Income (=GDP) Wages, rent, profit (=GDP) Factors of production Labor, land, capital Spending (=GDP) G & S bought G & S sold Revenue (=GDP) Markets for Goods & Services

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 8 What This Diagram Omits  The government  collects taxes, buys g&s  The financial system  matches savers’ supply of funds with borrowers’ demand for loans  The foreign sector  trades g&s, financial assets, and currencies with the country’s residents

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 9 (2) Gross Domestic Product One very important (may be most important) concept: Gross domestic product (GDP) Paul Samuelson and William Nordhaus: “GDP … among the great inventions of the twentieth century” (cited in Survey of Current Business, Jan 2000, 6-14) To understand macroeconomic issues, we first need information (data).

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 10 …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Goods are valued at their market prices, so:  All goods measured in the same units (e.g., Hong Kong dollars, U.S. dollars)  Things that don’t have a market value are excluded, e.g., housework you do for yourself.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 11 …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Final goods: intended for the end user Intermediate goods: used as components or ingredients in the production of other goods GDP only includes final goods – they already embody the value of the intermediate goods used in their production. e.g., General Motors (GM) does not produce tires for its cars; it buys them from tire companies (such as Goodyear) Tire: intermediate good; GM car: final good Prevent double counting

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 12 …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP includes tangible goods (like DVDs, mountain bikes, beer) and intangible services (dry cleaning, concerts, mobile phone service).

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 13 …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP includes currently produced goods, not goods produced in the past. e.g. If you bought a Toyota Prius on January 2005, the purchase (say, at $200,000) was included in GDP (of 2005). If you sold it on December 2010, that transaction was not included in GDP (of 2010). Why?

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 14 …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP measures the value of production that occurs within the borders of a country (an economy), whether done by its own citizens or by foreigners located there.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 15 …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Usually a year or a quarter (3 months)

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 16

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 17 Gross Domestic Product Iran nominal GDP (2007/1389): Rials 4,304,264 billions (US$ 391 billion) GDP per capita: Rials 59.8 million (US$ 5,435) USA nominal GDP (2007): US$14,077.6 billions population (est.): 301,290,332 (US Census Bureau) GDP per capita: US$ 46,724 nominal GDP: measured at current prices

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 18 Gross Domestic Product Data USA: Bureau of Economic Analysis (BEA), Department of Commerce ( Iran: Central Bank ( releases the information every quarter ?!!!

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 19 (3) The Components of GDP  Recall: GDP is total spending.  Four components:  Consumption ( C )  Investment ( I )  Government Purchases ( G )  Net Exports ( NX )  These components add up to GDP (denoted Y ): Y = C + I + G + NX

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 20 Consumption (C)  is total spending by households on g&s.  Note on housing costs:  For renters, consumption includes rent payments.  For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 21 Investment (I)  is total spending on goods that will be used in the future to produce more goods.  includes spending on  capital equipment (e.g., machines, tools)  structures (factories, office buildings, houses)  inventories (goods produced but not yet sold) “Investment” Note: “Investment” does not mean the purchase of financial assets like stocks and bonds.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 22 Government Purchases (G)  is all spending on the g&s purchased by govt. at the federal, state, and local levels.  G excludes transfer payments, such as Social Security or unemployment insurance benefits. They are not purchases of g&s.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 23 Net Exports (NX)  NX = exports – imports  Exports represent foreign spending on the economy’s g&s.  Imports are the portions of C, I, and G that are spent on g&s produced abroad.  If HK consumers buy $10 million worth of watches made in Switzerland, that spending is included in consumption expenditure. However, the imports do not represent domestic production. Thus, the value of these imports is subtracted from GDP (see the next equation).

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 24 GDP and Its Components  Adding up all the components of GDP gives: Y = C + I + G + NX

In each of the following cases, determine how much GDP and each of its components is affected (if at all). A.Debbie spends $200 to buy her husband dinner at the finest restaurant in the Central. B.Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in Japan. C.Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. D.A car company builds $500 million worth of cars, but consumers only buy $470 million worth of them. A C T I V E L E A R N I N G 1 GDP and its components

A. Debbie spends $200 to buy her husband dinner at the finest restaurant in the Central. Consumption and GDP rise by $200. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in Japan. Investment rises by $1800, net exports fall by $1800, GDP is unchanged. A C T I V E L E A R N I N G 1 Answers 26

C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. Current GDP and investment do not change, because the computer was built last year. D. A car company builds $500 million worth of cars, but consumers only buy $470 million of them. Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million. A C T I V E L E A R N I N G 1 Answers 27

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 28 U.S. GDP and Its Components, 2007 –2,344 8,905 7,037 32,228 $45,825 per capita – % of GDP –708 2,690 2,125 9,734 $13,841 billions NX G I C Y

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 29 Iran GDP and Its Components, 1389 Consumption= 1767 Trillion Rial(41%) Investment= 1785 T Rial(41%) - Gross domestic fixed capital formation = 1146 T Rial - Changes in inventories= 639 T Rial Government consumption= 481 T Rial(11%) Exports= 1194 T Rial Imports= 896 T Rial GDP = C + I + G + (X - M)= 4333 T Rial(100%)

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 30 GDP and Its Components USA vs. Iran (2007) Consumption: 70.3% in USA; 41% in Iran. Investment: 15.4% in USA; 41% in Iran. Government purchases: 19.4% in USA; 11% in Iran. Net exports: negative in USA; positive in Iran (7%).

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 31 (4) Real versus Nominal GDP  Inflation can distort economic variables like GDP, so we have two versions of GDP: One is corrected for inflation, the other is not.  Nominal GDP values output using current prices. It is not corrected for inflation.  Real GDP values output using the prices of a base year. Real GDP is corrected for inflation.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 32 Real versus Nominal GDP Nominal GDP of Iran, 1388 and 1389 Consumption1540 Trillion Rial 1767 Trillion Rial Investment1424 T Rial 1785 T Rial - Gross domestic fixed capital formation 949 T Rial 1146 T Rial - Changes in inventories475 T Rial 639 T Rial Government consumption445 T Rial 481 T Rial Exports923 T Rial 1194 T Rial Imports756 T Rial 896 T Rial GDP = C + I + G + (X - M)3577 T Rial (2006) 4333 T Rial (1389)

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 33 Real versus Nominal GDP When GDP increases from one year (1388) to the next (1389) by 21%, can we conclude that the quantity of production increases by 21%? Because GDP is measured in value terms, it can be changed by changes in prices, not quantities. We should be careful about interpreting changes over time. To separate price changes from quantity changes, we introduce a concept called real GDP. Reason for Introducing Real GDP

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 34 Real versus Nominal GDP Nominal GDP The value of final goods and services evaluated at current-year prices. = P 1 Q 1 + P 2 Q 2 +…+P n Q n Calculating Real GDP Real GDP The value of final goods and services evaluated at base-year prices.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 35 EXAMPLE: Compute nominal GDP in each year: 2005:$10 x $2 x 1000 = $6, :$11 x $2.50 x 1100 = $8, :$12 x $3 x 1200 = $10,800 PizzaLatte yearPQPQ 2005$10400$ $11500$ $12600$ % Increase: 30.9%

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 36 EXAMPLE: Compute real GDP in each year, using 2005 as the base year: PizzaLatte yearPQPQ 2005$10400$ $11500$ $12600$ % Increase: 16.7% $10 $ :$10 x $2 x 1000 = $6, :$10 x $2 x 1100 = $7, :$10 x $2 x 1200 = $8,400

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 37 EXAMPLE: In each year,  nominal GDP is measured using the (then) current prices.  real GDP is measured using constant prices from the base year (2005 in this example). year Nominal GDP Real GDP 2005$ $8250$ $10,800$8400

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 38 EXAMPLE:  The change in nominal GDP reflects both prices and quantities. year Nominal GDP Real GDP 2005$ $8250$ $10,800$ % 16.7% 37.5% 30.9%  The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). Hence, real GDP is corrected for inflation.

Nominal and Real GDP in the U.S., Real GDP (base year 2000) Nominal GDP 39

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 40 Which measure of GDP represents changes strictly in the quantity of goods and services produced in the economy, not the prices? a.Nominal GDP. b.Real GDP. c.The GDP measure that sums up the value of goods and services evaluated at current year prices. d.None of the above.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 41 Which measure of GDP represents changes strictly in the quantity of goods and services produced in the economy, not the prices? a.Nominal GDP. b.Real GDP. c.The GDP measure that sums up the value of goods and services evaluated at current year prices. d.None of the above.

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 42 The GDP Deflator  One by-product of real GDP calculation is to compute the general price level.  The GDP deflator is a measure of the overall level of prices.  Definition:  One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. GDP deflator = 100 x nominal GDP real GDP

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 43 EXAMPLE: Compute the GDP deflator in each year: year Nominal GDP Real GDP GDP Deflator 2005$ $8250$ $10,800$ :100 x (6000/6000) = :100 x (8250/7200) = :100 x (10,800/8400) = % 12.2%

A C T I V E L E A R N I N G 2 Computing GDP 44 Use the above data to solve these problems: A. Compute nominal GDP in B. Compute real GDP in C. Compute the GDP deflator in (base yr) PQPQPQ Good A$30900$311,000$ Good B$100192$102200$100205

A C T I V E L E A R N I N G 2 Answers 45 A. Compute nominal GDP in $30 x $100 x 192 = $46,200 B. Compute real GDP in $30 x $100 x 200 = $50, (base yr) PQPQPQ Good A$30900$311,000$ Good B$100192$102200$100205

A C T I V E L E A R N I N G 2 Answers 46 C. Compute the GDP deflator in Nom GDP = $36 x $100 x 205 = $58,300 Real GDP = $30 x $100 x 205 = $52,000 GDP deflator = 100 x (Nom GDP)/(Real GDP) = 100 x ($58,300)/($52,000) = (base yr) PQPQPQ Good A$30900$311,000$ Good B$100192$102200$100205

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 47 (5) GDP and Economic Well-Being  Real GDP per capita is the main indicator of the average person’s standard of living.  But GDP is not a perfect measure of well-being.  Robert Kennedy issued a very eloquent yet harsh criticism of GDP:

Gross Domestic Product… “… does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans.” - Senator Robert Kennedy,

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 49 GDP Does Not Value:  the quality of the environment  leisure time  non-market activity, such as the child care a parent provides his or her child at home  an equitable distribution of income

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 50 Then Why Do We Care About GDP?  Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc.  Many indicators of the quality of life are positively correlated with GDP. For example…

GDP and Life Expectancy in 12 countries 51 Life expectancy (years) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Pakistan Bangladesh Nigeria

GDP and Literacy in 12 countries 52 Adult Literacy (% of population) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Nigeria Pakistan Bangladesh

GDP and Internet Usage in 12 countries 53 Internet Usage (% of population) Real GDP per capita U.S. Germany Japan Mexico Russia Brazil China India Indonesia Nigeria Bangladesh Pakista n

CHAPTER SUMMARY  Gross Domestic Product (GDP) measures a country’s total income and expenditure.  The four spending components of GDP include: Consumption, Investment, Government Purchases, and Net Exports.  Nominal GDP is measured using current prices. Real GDP is measured using the prices of a constant base year and is corrected for inflation.  GDP is the main indicator of a country’s economic well-being, even though it is not perfect. 54

© South-Western Principles of Macroeconomics, by N. G. Mankiw. Growth around the World  Growth rates in developing countries (including China and India) are on average higher than those in developed countries. Does this mean convergence?  During the last decade of the 20th century 54 developing countries had negative average growth rates, and most of those with positive growth rates were growing slower than high-income countries  Even worse; due to much faster population, GDP per capita growth rates in most developing countries are relatively low or even negative ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 55

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 56

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 57

© South-Western Principles of Macroeconomics, by N. G. Mankiw. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 58

© South-Western Principles of Macroeconomics, by N. G. Mankiw. Iran GDP (current prices) ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 59

© South-Western Principles of Macroeconomics, by N. G. Mankiw. Iran GDP (fixed prices, 1376) ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 60

© South-Western Principles of Macroeconomics, by N. G. Mankiw. Iran Economic Growth ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME 61