1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 William A. McEachern Macro 3 ECON 1

2. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Product of a Nation 17 th and 18 th century –Mercantilism Economic prosperity: stock of precious metals 1758 –Circular flow of output and income National income accounting system 2

3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts GDP –Market value –All final goods and services –Produced during a year –By resources located in US One person’s spending –Another person’s income 3

4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Expenditure approach –Spending on all final goods and services Produced in the nation Within the year Income approach –Earnings by those who produce all output In the nation During the year 4

5. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Final goods and services –Sold to the final user Intermediate goods and services –Purchased by firms –For further processing and resale 5

6. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Expenditure Approach Consumption, C –Household purchases of final goods and services Except for new residences (investment) –Personal consumption expenditures –Households Services, nondurable goods, durable goods –70% of GDP 6

7. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Expenditure Approach Investment, I –Gross private domestic investment –New capital goods Physical capital New residential construction –Net additions to inventories –16% of GDP 7

8. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Expenditure Approach Physical capital –Manufactured items used to produce goods and services New plants, new equipment Residential construction –Building new homes or dwelling places Inventories –Producers’ stocks of finished and in- process goods 8

9. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Expenditure Approach Government purchases, G –Spending for goods and services By all levels of government –Government outlays minus transfer payments –19% of GDP 9

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Expenditure Approach Net exports, X-M –Exports (X) minus imports (M) Physical items Invisibles (intangibles) –Negative Imports > Exports –5% of GDP for last decade C+I+G+(X-M)=Aggregate expenditure=GDP 10

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Income Approach Aggregate income –All earnings of resource suppliers in an economy –During a given period, usually a year Wages Interest Rent Profit Aggregate expenditure = GDP = Aggregate income 11

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. GDP: Income Approach Value added at each stage of production –Selling price of a product Minus the cost of intermediate goods purchased from other firms –Income earned 12

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 1 13 Computing Value Added for a New Desk The value added at each stage of production is the sale price at that stage minus the cost of intermediate goods, or column (1) minus column (2). The values added at each stage sum to the market value of the final good, shown at the bottom of column (3). Stage of Production (1) Sale Value (2) Cost of Intermediate Goods (3) Value Added (3)=(1)-(2) Logger Miller Manufacturer Retailer $20 50 120 200 - $20 50 120 $20 30 70 80 Market value of final good$200

14. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Circular Flow Circular flow –Of income and spending in the economy Assumptions –Capital – doesn’t wear out –Firms – pay out all profits 14

15. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 2 15 Circular Flow of Income and Expenditure The circular-flow model captures important relationships in the economy. The bottom half depicts the income arising from production. At juncture (1), GDP equals aggregate income. Taxes leak from the flow at (2), but transfer payments enter the flow at (3). Taxes minus transfers equals net taxes, NT. Aggregate income minus net taxes equals disposable income, DI, which flows to households at juncture (4). The top half of the model shows the flow of expenditure. At (5), households either spend disposable income or save it. Consumption enters the spending flow directly. Saving leaks from the spending flow into financial markets, where it is channeled to borrowers. At (6), investment enters the spending flow. At (7), government purchases enter the spending flow. At (8), imports leak from the spending flow, and at (9), exports enter the spending flow. Consumption plus investment plus government purchases plus net exports add up to the aggregate expenditure on GDP received by firms at (10).

16. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Circular Flow Income flow –Income arising from production –GDP = Aggregate income –Net taxes, NT = Taxes - Transfer payments –Disposable income, DI = GDP - NT GDP=DI+NT 16

17. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Circular Flow Disposable income (DI) –Income households have available to spend or to save –After paying taxes and receiving transfer payments Net taxes (NT) –Taxes minus transfer payments 17

18. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Circular Flow Expenditure flow –DI = C + S Consumption, C Savings, S, to financial markets –Investments, I (borrowed) Firms – on capital Households – residential construction –Government spending, G –Net exports = X – M 18

19. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Circular Flow C+I+G+(X-M) = Aggregate Expenditure = GDP Financial markets –Banks and other financial institutions –Facilitate the flow of funds from savers to borrowers 19

20. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Leakages = Injections C+I+G+(X-M)=DI+NT C+I+G+(X-M)=C+S+NT I+G+X=S+NT+M Injections –I, G, X Leakages –S, NT, M 20

21. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Leakages = Injections Injection –Any spending other than by households –Any income other than from resource earnings –Investment, government purchases, exports, and transfer payments Leakage –Any diversion of income from the domestic spending stream –Saving, taxes, and imports 21

22. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Limitations Some production – not included in GDP –Do-it-yourself production –Underground economy Underground economy –Market transactions that go unreported Illegal People involved want to evade taxes –10% of GDP –$1.5 trillion 22

23. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Limitations Leisure, quality, and variety –More leisure –Better quality –Greater variety Net domestic product –GDP minus depreciation Net investment = I – depreciation 23

24. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Limitations Depreciation –Value of capital stock used up to produce GDP or that becomes obsolete during the year GDP – doesn’t reflect all costs –Negative externalities Air pollution, water pollution –Depletion of natural resources Soil depletion, loss of other natural resources 24

25. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Price Changes Nominal GDP –GDP based on prices prevailing at the time of production Price index –Average price of products –In base year = 100 –(Price in current year / Price in base year)*100 25

26. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Price Changes Changes in a price index over time –Chow changes in the economy’s average price level Consumer price index, or CPI –Measure of inflation –Based on the cost of a fixed market basket of goods and services 26

27. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 3 27 Hypothetical Example of a Price Index (base year 2009) Year (1) Price of Bread in Current Year (2) Price of Bread in Base Year (3) Price index (3)=[(1)/(2)]×100 2006 2007 2008 $1.25 1.30 1.40 $1.25 1.25 100 104 112 The price index equals the price in the current year divided by the price in the base year, all multiplied by 100.

28. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Price Changes Consumer price index, CPI –Market basket –(Cost of basket in current year / Cost in base year)*100 –Overstates inflation, 1% per year Quality bias Substitution Discount stores Widely used products 28

29. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 4 29 Product (1) Quantity in market basket (2) Prices in base year (3) Cost of basket in base year (3)=(1)×(2) (4) Prices in current year (5) Cost of basket in current year (5)=(1)×(4) Twinkies Fuel oil Cable TV 365 packages 500 gallons 12 months $0.89/package 1.00/gallon 30.00/month $324.85 500.00 360.00 $0.79 1.50 30.00 $288.35 750.00 360.00 $1,184.85$1,398.35 The cost of a market basket in the current year, shown at the bottom of column (5), sums the quantities of each item in the basket, shown in column (1), times the price of each item in the current year, shown in column (4). Hypothetical Market Basket Used to Develop the Consumer Price Index

30. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounting for Price Changes GDP price index –Comprehensive inflation measure Of all goods and services included in GDP –(Nominal GDP/Real GDP)*100 –Before 1995 Fixed-weighted system; base year 1987 –Chain-weighted system; base year 2000 30

31. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5 31 Real GDP, the red line, shows the value of output measured in chained (2005) dollars. The blue line measures GDP in nominal dollars of each year shown. The two lines intersect in 2005, when real GDP equaled nominal GDP. Year-to-year changes in nominal-dollar GDP reflect changes in both real GDP and in the price level. Year-to-year changes in chained-dollar GDP reflect changes in real GDP only. Nominal-dollar GDP grows faster than chained-dollar GDP. Prior to 2005, nominal-dollar prices are less than chained-dollar prices, so nominal-dollar GDP is less than chained-dollar GDP. U.S. Gross Domestic Product in Nominal Dollars and Chained (2005) Dollars

32. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts National income –Earned by American-owned resources –Net domestic product –Plus net earnings from American resources abroad –Minus the statistical discrepancy 32

33. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deriving Net Domestic Product and National Income in 2009 (trillions) 33 Gross domestic product (GDP) Minus depreciation Net domestic product Plus net earnings of American resources abroad Statistical discrepancy National income $14.26 -1.86 12.40 + 0.11 - 0.23 $12.28

34. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Personal income –National income –Plus income received but not earned –Minus income earned but not received Income earned but not received Employer’s share of Social Security taxes Taxes on production Net of subsidies Corporate income taxes Undistributed corporate profits 34

35. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Income received but not earned –Government transfer payments –Receipts from private pension plans –Interest paid by government and by consumers Disposable income –Personal income minus taxes –Spend or save 35

36. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 7 36 National income Income received but not earned minus income earned but not received Personal income Minus personal taxes and nontax charges Disposable income $12.28 -0.26 12.02 -1.10 $10.92 Deriving Personal Income and Disposable Income in 2009 (trillions)

37. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Summary income statement of the economy –Aggregate expenditure Consumption Gross investment Government purchases Net exports 37

38. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Summary income statement of the economy –Aggregate income Employee compensation Proprietors’ income Corporate profits Net interest Rental income of persons 38

39. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Employee compensation –Money wages –Employer contributions Social Security taxes, medical insurance, and other fringe benefits Proprietors’ income –Earnings of unincorporated businesses 39

40. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Corporate profits –Net revenues received by incorporated businesses Before subtracting corporate income taxes Net interest –Interest received by individuals –Excludes Interest paid by consumers to businesses Interest paid by government 40

41. Appendix © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. National Income Accounts Rental income of persons –Imputed rental value of owner-occupied housing –Minus the cost of owning that property Property taxes, insurance, depreciation Interest paid on the mortgage 41

42. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 8 42 Aggregate Expenditure Consumption (C) Gross investment (I) Government purchases (G) Net exports (X-M) GDP $10.09 1.63 2.93 -0.39 $14.26 Aggregate Income Depreciation Net taxes on production Statistical discrepancy Compensation of employees Proprietors’ income Corporate profits Net interest Rental income of persons GDP $1.86 1.10 0.23 7.77 1.04 1.31 0.68 0.27 $14.26 Expenditure and Income Statement for the US Economy in 2009 (trillions)