© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 5 Measuring a Nation’s Production and Income

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Macroeconomics Macroeconomics is the branch of economics that deals with any nation’s economy as a whole.Macroeconomics is the branch of economics that deals with any nation’s economy as a whole. Macroeconomics focuses on issues such as unemployment, inflation, growth, trade, and the gross domestic product.Macroeconomics focuses on issues such as unemployment, inflation, growth, trade, and the gross domestic product.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Macroeconomics Macroeconomics focuses on two basic issues:Macroeconomics focuses on two basic issues: Understanding economic growth in the long run and the factors behind the rise in living standards in modern economies.Understanding economic growth in the long run and the factors behind the rise in living standards in modern economies. Understanding economic fluctuations—the ups and downs of the economy over time.Understanding economic fluctuations—the ups and downs of the economy over time.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production, Income, and the Circular Flow The most fundamental concepts in macroeconomics are production and income.The most fundamental concepts in macroeconomics are production and income. The circular flow diagram makes a simple but fundamental point: Production generates income.The circular flow diagram makes a simple but fundamental point: Production generates income.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production, Income, and the Circular Flow The circular flow diagram shows how production of goods and services generates income for households and how households purchase goods and services produced by firms.The circular flow diagram shows how production of goods and services generates income for households and how households purchase goods and services produced by firms.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production, Income, and the Circular Flow In factor markets, households supply inputs to production.In factor markets, households supply inputs to production. Households are paid wages for their work, and interest, dividends and rents for supplying capital.Households are paid wages for their work, and interest, dividends and rents for supplying capital.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production, Income, and the Circular Flow Households use their income to purchase goods and services in product markets.Households use their income to purchase goods and services in product markets. The payments received by firms are used to pay for factors of production.The payments received by firms are used to pay for factors of production.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Production, Income, and the Circular Flow In sum, corresponding to the production of goods and services in the economy are flows of income to households.In sum, corresponding to the production of goods and services in the economy are flows of income to households.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Measuring Gross Domestic Product The most common measure of the total output of an economy is gross domestic product (GDP), the total market value of all the final goods and services produced within an economy in a given year.The most common measure of the total output of an economy is gross domestic product (GDP), the total market value of all the final goods and services produced within an economy in a given year.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Measuring Gross Domestic Product “Total market value” refers to the quantity of goods multiplied by their respective prices. Using prices allows us to express the value of everything in a common unit of measurement.“Total market value” refers to the quantity of goods multiplied by their respective prices. Using prices allows us to express the value of everything in a common unit of measurement.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Measuring Gross Domestic Product “Final goods and services” refers to the goods and services that are sold to the ultimate, or final, purchasers.“Final goods and services” refers to the goods and services that are sold to the ultimate, or final, purchasers. In order to avoid double counting, we do not count intermediate goods, or goods used in the production process that are not final goods or services. The value of the final good already reflects the price of the intermediate goods contained in it.In order to avoid double counting, we do not count intermediate goods, or goods used in the production process that are not final goods or services. The value of the final good already reflects the price of the intermediate goods contained in it.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Measuring Gross Domestic Product “In a given year” means that the sale of goods produced in prior years, for example, used cars, are not included in GDP this year.“In a given year” means that the sale of goods produced in prior years, for example, used cars, are not included in GDP this year. Since we use the prices times the quantities of goods to measure the value of GDP, GDP will increase when prices increase, even if the physical quantities of the goods produced remain the same.Since we use the prices times the quantities of goods to measure the value of GDP, GDP will increase when prices increase, even if the physical quantities of the goods produced remain the same.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Measuring Gross Domestic Product A measure of total output that does not increase just because prices increase is called real GDP. Real GDP takes into account price changes by using the same prices for both years.A measure of total output that does not increase just because prices increase is called real GDP. Real GDP takes into account price changes by using the same prices for both years. Reality PRINCIPLE What matters to people is the real value of money or income–its purchasing power–not the face value of money or income.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Measuring Gross Domestic Product Nominal GDP is the value of GDP in current dollars. Nominal GDP can increase for one of two reasons:Nominal GDP is the value of GDP in current dollars. Nominal GDP can increase for one of two reasons: The production of goods and services has increased, orThe production of goods and services has increased, or The prices of those goods and services has increased.The prices of those goods and services has increased.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin U.S. Real GDP Real GDP has grown substantially over this period.Real GDP has grown substantially over this period.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin U.S. Real GDP Sustained increases in the real production of an economy over a period of time is what economists call economic growth.Sustained increases in the real production of an economy over a period of time is what economists call economic growth.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Purchases GDP? Economists divide GDP into four broad expenditure categories:Economists divide GDP into four broad expenditure categories: Consumption expenditures: purchases by consumers.Consumption expenditures: purchases by consumers. Private investment expenditures: purchases by firms.Private investment expenditures: purchases by firms. Government purchases: purchases by federal, state, and local governments.Government purchases: purchases by federal, state, and local governments. Net exports: net purchases by the foreign sector, or domestic exports minus domestic imports.Net exports: net purchases by the foreign sector, or domestic exports minus domestic imports.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Purchases GDP? Composition of U.S. GDP, Second Quarter 2000 (billions of dollars expressed at annual rates) GDP Consumption Expenditures Private Investment Expenditures Government Purchases Net Exports 9,9456,7061,8521, A quarter is a 3-month period with the second quarter running from April through June.A quarter is a 3-month period with the second quarter running from April through June. GDP was approximately $9.9 trillion. U.S. population is approximately 281 million people, making GDP per person about $35,342.GDP was approximately $9.9 trillion. U.S. population is approximately 281 million people, making GDP per person about $35,342.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Consumption Expenditures Consumption expenditures are purchases of newly produced goods and services by households. Consumption is broken down into:Consumption expenditures are purchases of newly produced goods and services by households. Consumption is broken down into: Durable goods that last for a long time.Durable goods that last for a long time. Nondurable goods that last for a short time.Nondurable goods that last for a short time. Services that reflect work done in which people play a prominent role in the delivery.Services that reflect work done in which people play a prominent role in the delivery. Consumption comprises 67% of total purchases.Consumption comprises 67% of total purchases.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Private Investment Expenditures Private investment expenditures include:Private investment expenditures include: Spending on new plants and equipment.Spending on new plants and equipment. Newly produced housing.Newly produced housing. Increase in inventories during the current year.Increase in inventories during the current year.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Private Investment Expenditures New investment expenditures are called gross investment. The true addition to the stock of capital of the economy is net investment. Net investment equals gross investment minus depreciation.New investment expenditures are called gross investment. The true addition to the stock of capital of the economy is net investment. Net investment equals gross investment minus depreciation. Depreciation is the deterioration of plants, equipment, and housing in a given year.Depreciation is the deterioration of plants, equipment, and housing in a given year.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Private Investment Expenditures Note: Investment in everyday talk refers to the purchase of an existing financial asset. Investment in GDP accounts refers to the purchase of new final goods and services by firms. Don’t confuse the two.Note: Investment in everyday talk refers to the purchase of an existing financial asset. Investment in GDP accounts refers to the purchase of new final goods and services by firms. Don’t confuse the two.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Government Purchases Government purchases refer to purchases of newly produced goods and services by all levels of government.Government purchases refer to purchases of newly produced goods and services by all levels of government. Transfer payments are funds paid to individuals from governments (for example, Social Security, welfare, interest on government debt) and are not associated with the production of goods and services.Transfer payments are funds paid to individuals from governments (for example, Social Security, welfare, interest on government debt) and are not associated with the production of goods and services. A large part of the federal government budget is not part of GDP.A large part of the federal government budget is not part of GDP.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Net Exports Net exports are total exports minus total imports.Net exports are total exports minus total imports. Net exports are included in GDP to correctly measure U.S. production.Net exports are included in GDP to correctly measure U.S. production. When we buy more goods from abroad than we sell, we have a trade deficit.When we buy more goods from abroad than we sell, we have a trade deficit. A trade surplus occurs when our exports exceed our imports.A trade surplus occurs when our exports exceed our imports.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin U.S. Trade Balance as a Share of GDP,

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Net Exports When the U.S. runs a trade deficit, we are forced to sell some of our assets to individuals or governments in foreign countries.When the U.S. runs a trade deficit, we are forced to sell some of our assets to individuals or governments in foreign countries. We give up more dollars from exports than we receive from imports. Excess dollars in the hands of foreigners are used to buy U.S. assets.We give up more dollars from exports than we receive from imports. Excess dollars in the hands of foreigners are used to buy U.S. assets. If a country runs a trade surplus with one country and an equally large deficit with another, it does not add to its stock of foreign assets.If a country runs a trade surplus with one country and an equally large deficit with another, it does not add to its stock of foreign assets.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Trade Balance as a Percent of GDP, 2000

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Gets the Income? The income that flows to the private sector is the national income which is the net national product less indirect taxes.The income that flows to the private sector is the national income which is the net national product less indirect taxes. To measure national income, economists must make three adjustments to gross domestic product (GDP).To measure national income, economists must make three adjustments to gross domestic product (GDP).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Gets the Income? The three adjustments to GDP are as follows:The three adjustments to GDP are as follows: Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at gross national product (GNP).Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at gross national product (GNP). Subtract depreciation from GNP to arrive at net national product (NNP).Subtract depreciation from GNP to arrive at net national product (NNP). Subtract indirect taxes, which are sales taxes or excise taxes on products.Subtract indirect taxes, which are sales taxes or excise taxes on products.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Gets the Income? After making all three adjustments, we reach national income.After making all three adjustments, we reach national income. From GDP to National Income, Second Quarter 2000 (billions of dollars) Gross domestic product plus net income from abroad = 9,945 Gross national product minus depreciation = 9,937 Net national product minus indirect taxes (and other adjustments) = 8,693 From GDP to National Income, Second Quarter 2000 (billions of dollars) Gross domestic product plus net income from abroad = 9,945 Gross national product minus depreciation = 9,937 Net national product minus indirect taxes (and other adjustments) = 8,693 National income 7,983

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Gets the Income? Approximately 70% of all national income goes to workers in the form of wages and benefits.Approximately 70% of all national income goes to workers in the form of wages and benefits. Composition of U.S. National Income, Second Quarter 2000 (billions of dollars) National income 7,983 Compensation of employees 5,603 Corporate profits 964 Rental income 141 Proprietor’s income 709 Net interest 566

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Who Gets the Income? The sum of all the income (wages, interest, profits, and rent) generated by an organization is value added.The sum of all the income (wages, interest, profits, and rent) generated by an organization is value added. National income is calculated by adding the value added for all the firms, plus nonprofit and government organizations.National income is calculated by adding the value added for all the firms, plus nonprofit and government organizations. Personal income is income received by households (including transfer payments).Personal income is income received by households (including transfer payments). Personal disposable income is the income that households keep after paying taxes.Personal disposable income is the income that households keep after paying taxes.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Versus Nominal GDP GDP Data for a Simple Economy Quantity Produced Price YearCarsComputersCarsComputers Nominal GDP $10,000$5,000$45, $12,000$5,000$75,000 Differences between nominal GDP and real GDP arise only because of changes in prices.Differences between nominal GDP and real GDP arise only because of changes in prices.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Versus Nominal GDP Quantity Produced Price YearCarsComputersCarsComputers Real GDP $10,000$5,000$45, $10,000$5,000$65,000 GDP Data for a Simple Economy Quantity Produced Price YearCarsComputersCarsComputers Nominal GDP $10,000$5,000$45, $12,000$5,000$75,000 To calculate real GDP we use constant prices.To calculate real GDP we use constant prices.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Versus Nominal GDP Quantity Produced Price YearCarsComputersCarsComputers Real GDP $10,000$5,000$45, $10,000$5,000$65,000 Using the information on the table, we can calculate the growth of real GDP:Using the information on the table, we can calculate the growth of real GDP: We can also measure the change in prices over time using an index number called the GDP deflator.We can also measure the change in prices over time using an index number called the GDP deflator.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Versus Nominal GDP An index is set at 100 in a given year, say the year 2004, called the base year. Prices in other years are compared to prices in 2004:An index is set at 100 in a given year, say the year 2004, called the base year. Prices in other years are compared to prices in 2004: The value 115 means that prices rose by 15% ([ )/100] between the two years.The value 115 means that prices rose by 15% ([ )/100] between the two years.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Versus Nominal GDP The Commerce Department uses a chain index to calculate changes in prices that includes an average of price changes using base years from neighboring years.The Commerce Department uses a chain index to calculate changes in prices that includes an average of price changes using base years from neighboring years. Data produced by the Commerce Department measures real GDP in chained-dollars and a chain-type price index for GDP.Data produced by the Commerce Department measures real GDP in chained-dollars and a chain-type price index for GDP.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin GDP as a Measure of Welfare GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP:GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP: 1)GDP ignores transactions that do not take place in organized markets, such as the work we perform at home. 2)GDP ignores leisure time, along with other non-market activities.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin GDP as a Measure of Welfare GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP:GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP: 3)GDP ignores the underground economy, where transactions are not reported to official authorities. 4)Finally, GDP does not value changes in the environment that arise from the production of output.