Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 5: Measuring A Nation’s Income

Econ 202 Dr. Ugur Aker 2 Why Measure A Nation’s Income To have a sense of an economy’s size. The well being of a citizen, on average, depends on the nation’s income and its population. As the income of the society increases, the average person will have a higher standard of living. –One can drown in a lake of 3-ft average depth. –Standard of living may not necessarily be the goods and services a household can consume.

Econ 202 Dr. Ugur Aker 3 Nation’s Income Has Connections to Other Macro Measures As nation’s income rises at a fast rate, unemployment drops. A fast, sustained increase in nation’s income may spur inflation. A drop in nation’s income will lower interest rates. A fast increase in nation’s income will raise trade deficit and depreciate its currency.

Econ 202 Dr. Ugur Aker 4 Definition of GDP Gross Domestic Product is the value of all the final goods and services produced within a country in a year. –How do you determine the value of child care? –How do you include the production of steel or plastics? –How do you include the sales of existing homes? –How do you account for $4 million paid at an auction for a Van Gogh painting? –How do you account for Mexican agricultural workers’ output when the workers send most of the income they earn to Mexico? Counts as US GDP and similar to US imports.

Econ 202 Dr. Ugur Aker 5 Why GDP Is Equal to Income? How is my contribution to the US economy calculated? –The amount of educational service I create is equal to my gross income. How is the income of a real estate agent calculated? –When she sells a 25-yr old house, she gets a percent of the price as a payment for her services.

Econ 202 Dr. Ugur Aker 6 Why GDP Is Equal to Income? How is the GDP contribution of the textbook company calculated? –After they pay the author, the paper company and the ink company, the amount of revenue they get from textbook sales plus the value of their book inventory (unsold books) is their contribution to the US GDP. –Their contribution is equal to wages, salaries, rent, interest and profits they pay.

Econ 202 Dr. Ugur Aker 7 Circular Flow Households Firms Consumption expenditures of households Income (wages, salaries, rent, interest, profit) earned by households

Econ 202 Dr. Ugur Aker 8 Circular Flow Upper flow is equal to GDP. Lower flow is equal to income. If GDP < Income, businesses will reduce production and create less income. If GDP > Income, businesses will want to expand production and create more income.

Econ 202 Dr. Ugur Aker 9

10 How Can We Measure GDP? Expenditure Approach: the upper flow. Y = C + I + G + NX Income Approach: the lower flow. Y = Sum of factor incomes Y = Wages + Salaries + Rent + Interest + Profits

Econ 202 Dr. Ugur Aker 11 Components of Expenditure Approach Consumption includes spending on food, entertainment, shelter, health care, transportation, clothing, household items, insurance, education.

Econ 202 Dr. Ugur Aker 12 Components of Expenditure Approach Investment includes purchases made by firms to generate future income. Machinery, tools, buildings, trucks and cars are part of investment if they are bought to generate future income. By convention, newly built houses and inventory are included under investment.

Econ 202 Dr. Ugur Aker 13 Components of Expenditure Approach Government purchases are expenditures of federal, state and local governments on goods and services plus their payrolls.

Econ 202 Dr. Ugur Aker 14 Components of Expenditure Approach Net exports is exports minus imports. Dell Computer sales in China are part of US exports. Dell Computer purchases of plastic molds for their computers from China are part of US imports.

Econ 202 Dr. Ugur Aker 15 How To Find US GDP Numbers? Go to Click on Library link on the left. You will get to On the top left of the page there is a link that says “Begin Research By Subject Area.” Click on it. You will get to Click on economics. You will get to Go to Stat-USA link towards the bottom of the page. Click on it. You will get to Click on the US Department of Commerce link. You will be at Click on the left frame on Bureau of Economic Analysis: Scroll all the way down and click on Survey of Current Business link. You will be at ready to choose the monthly publication.

Econ 202 Dr. Ugur Aker 16 A GDP Increase Always Increases The Size of the Economy WRONG! What if GDP in 1998 were 1000, in 1999 were 1500 but inflation was 50%? In this case, the increase in GDP is solely attributable to price increases, not improving the well being (standard of living) of the average citizen.

Econ 202 Dr. Ugur Aker 17 Nominal vs. Real Measures In macroeconomics, most variables are measured in real terms, not nominal terms. Real variable eliminates the effect of inflation. Nominal variable includes the effect of inflation. GDP comparisons are always made with real GDP. Nominal GDP uses current prices. Real GDP uses base year prices.

Econ 202 Dr. Ugur Aker 18 An Example of Real and Nominal GDP Nominal GDP is calculated by adding the amounts spent on each Product. Real GDP is calculated by using the prices of pizza and Soda from 1997 o calculate the amounts spent in future years. GDP Deflator is Nominal GDP/Real GDP.

Econ 202 Dr. Ugur Aker 19 Real and Nominal GDP

Econ 202 Dr. Ugur Aker 20 What Is Wrong With Real GDP? Real GDP increases if you sell your services rather than provide them free. If you build a house through Habitat for Humanity your work doesn’t count as part of GDP. If you get paid for the same work, it counts. If you pollute during production and someone pays to clean the environment, the GDP will be higher than if the producer tried to reduce pollution during production so no clean-up was necessary.

Econ 202 Dr. Ugur Aker 21 Underground Economy If market transactions cannot be tracked by data collectors, they may be ignored. Transactions with high cash usage and no paper trail can remain hidden from the government. GDP may actually be much higher than government statistics if there is a large underground economy.