1. Chapter 8 Measuring the Economy’s Performance

2. Introduction
Some commentators are already referring to the twenty- first century as the “Asian century.” It has been suggested that China’s economy will be larger than the U.S. economy by 2020.
How do we go about measuring the size of an economy? And how do we make international comparisons with regard to this measure?
The concept of gross domestic product, which is a key concept of Chapter 8, is the starting point for contemplating these questions.

3. Learning Objectives Describe the circular flow of income and output
Define gross domestic product (GDP)
Understand the limitations of using GDP as a measure of national welfare

4. Learning Objectives (cont'd)
Explain the expenditure approach to tabulating GDP
Explain the income approach to computing GDP
Distinguish between nominal GDP and real GDP

5. Chapter Outline The Simple Circular Flow National Income Accounting
Two Main Methods of Measuring GDP
Other Components of National Income Accounting
Distinguishing Between Nominal and Real Values
Comparing GDP Throughout the World

6. Did You Know That ...
The flow of U.S. economic activity since has been more dampened than during any other comparable post-recession period since the Great Depression of the 1930’s?
To measure the nation’s overall economic performance, the government utilizes the concept of national income accounting.

7. The Simple Circular Flow
The concept of the circular flow of income involves two principles:
In every economic exchange, the seller receives exactly the same amount that the buyer spends
Goods and services flow in one direction and money payments flow in the other

8. The Simple Circular Flow (cont'd)
Profits explained
Question
Why is profit a cost of production?
Answer
Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities

9. Figure 8-1 The Circular Flow of Income and Product

10. The Simple Circular Flow (cont'd)
Product Markets
Transactions in which households buy goods
Factor Markets
Transactions in which businesses buy resources

11. The Simple Circular Flow (cont'd)
Total Income
The yearly amount earned by the nation’s resources (factors of production)
Includes wages, rent, interest payments, and profits received by workers, landowners, capital owners, and entrepreneurs, respectively

12. The Simple Circular Flow (cont'd)
Final Goods and Services
Goods and services that are at their final stage of production and will not be transformed into yet other goods or services

13. The Simple Circular Flow (cont'd)
Question
Why must the dollar value of total output equal total income?
Answer
Every transaction simultaneously involves an expenditure and a business receipt

14. National Income Accounting
A measurement system used to estimate national income and its components
Gross Domestic Product (GDP)
The total market value of all final goods and services produced by factors of production located within a nation’s borders

15. National Income Accounting (cont'd)
Observations
GDP measures the dollar value of final output
GDP measures the dollar value of final goods and services produced per year by factors of production located within a nation’s borders

16. National Income Accounting (cont'd)
Stress on final output
What is a final good?
Wheat?
Steel?
Crude oil?
Bread?
Automobile?
Gasoline?

17. National Income Accounting (cont'd)
Intermediate Goods
Goods used up entirely in the production of final goods
Value Added
The dollar value of an industry’s sales minus the value of intermediate goods (for example, raw materials and parts) used in production

18. Table 8-1 Sales Value and Value Added at Each Stage of Donut Production

19. National Income Accounting (cont'd)
Numerous transactions occur that have nothing to do with final goods and services being produced:
Financial transactions
Transfer of secondhand goods
Others excluded transactions

20. What If Market prices of house cleaning, child care, and lawn care services were valued for inclusion in GDP?
Even if market prices of household services were used to place a value on household production, national income accountants still would not know the volume of such activity.
Therefore, they would have to estimate the amount of household activity, and this would introduce measurement errors into the calculation of GDP.

21. National Income Accounting (cont'd)
Financial transactions
Securities
Stocks and bonds
Government transfer payments
Social Security
Unemployment compensation
Private transfer payments
Individual gifts
Corporate gifts

22. National Income Accounting (cont'd)
Transfer of secondhand goods
Why not count the sale of a used computer, guitar, or snowboard as part of GDP?
Other excluded transactions
Household production
Legal and illegal underground transactions

23. National Income Accounting (cont'd)
GDP’s limitations
Excludes non-market production
It is not necessarily a good measure of the well- being of a nation

24. National Income Accounting (cont'd)
GDP:
Is a measure of the value of production in terms of market prices, and an indicator of economic activity
Is not a measure of a nation’s overall welfare

25. Policy Example: Developed Nations Look for a “Happier” Alternative to GDP
The 34 member nations of the Organization for Economic Cooperation and Development are aiming to supplement or even replace GDP with a measure called the “Your Better Life Index.”
This measure of well-being includes scores in 11 areas such as community, education, health, housing, life satisfaction, and safety.
Initial results of the Your Better Life Index yield high rankings for Denmark, Canada, and Norway, with Hungary, Portugal, and Estonia ranking lowest among the OECD nations.

26. Two Main Methods of Measuring GDP
Expenditure Approach
Computing GDP by adding up the dollar value at current market prices of all final goods and services

27. Two Main Methods of Measuring GDP (cont'd)
Income Approach
Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

28. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the expenditure approach
Consumption Expenditure (C)
Durable Consumer Goods
Items that last more than three years (automobiles, furniture)
Nondurable Consumer Goods
Goods that are used up in three years (gasoline, food)
Services
Mental or physical help

29. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the expenditure approach
Gross Private Domestic Investment (I)
The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future
Also includes changes in business inventories and repairs made to machines, buildings

30. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the expenditure approach
Gross Private Domestic Investment (I)
Producer Durables or Capital Goods
Life span of more than three years
Fixed Investment
Purchases by business of newly produced producer durables or capital goods
Inventory Investment
Changes in stocks of finished goods and goods in process, as well as changes in raw materials

31. Example: Imputing Part of the Government’s Contribution to GDP
Some items included in GDP do not have explicit market prices.
Examples include public education, fire protection, and national defense.
National income accountants have reasoned that government expenditures on these items understate the market prices that would prevail if they were provided by private firms.
Therefore, the values are determined by using prices for education, fire protection, and security services provided in private markets. 31

32. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Expenditure Approach
Government Expenditures (G)
State, local, and federal
Valued at cost

33. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Expenditure Approach
Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports

34. Two Main Methods of Measuring GDP (cont'd)
Presenting the expenditure approach
where
C = consumption expenditures
I = investment expenditures
G = government expenditures
X = net exports
GDP = C + I + G + X

35. Figure 8-2 GDP and Its Components

36. Two Main Methods of Measuring GDP (cont'd)
Net Domestic Product (NDP)
Allowing for depreciation (capital consumption allowance)
The amount that businesses would have to save in order to take care of deteriorating machines and other equipment
NDP = GDP – Depreciation

37. Two Main Methods of Measuring GDP (cont'd)
Because NDP = GDP – Depreciation, and
GDP = C + I + G + X
NDP = C + I + G + X – Depreciation
NDP = C + net I + G + X
where net I (net investment ) = I – Depreciation
Domestic investment minus an estimate of the wear and tear on the existing capital stock
The change in the capital stock over a one-year period

38. Two Main Methods of Measuring GDP (cont’d)
Deriving GDP by the Income Approach
Gross Domestic Income (GDI)
The sum of all income (wages, interest, rent, and profits) paid to the four factors of production

39. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Income Approach
Gross Domestic Income (GDI)
Wages: salaries and labor income
Rent: farms, houses, stores
Interest: savings accounts
Profits: sole proprietorships, partnerships, corporations

40. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Income Approach
Gross domestic product equals gross domestic income plus indirect business taxes and depreciation
These last items are called non-income expense items

41. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Income Approach
Indirect business taxes
All business taxes except the tax on corporate profits
Include sales and business property taxes

42. Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year)

43. Figure 8-3 Gross Domestic Product and Gross Domestic Income, (in billions of 2005 dollars per year) (cont’d)

44. Other Components of National Income Accounting
National Income (NI)
The total of all factor payments to resource owners
Personal Income (PI)
The amount of income that households actually receive before they pay personal income taxes

45. Example: Sources of U.S. Personal Income Exhibit Unsustainable Trends
Since early 2010, the share of personal income derived from private payrolls has dropped to levels that are the lowest in U.S. history.
At the same time, the portion of personal income derived from government-provided benefits has risen to its highest level.
These trends are unsustainable because government benefits are financed through taxes on private income.

46. Other Components of National Income Accounting (cont'd)
Disposable Personal Income (DPI)
Personal income after personal income taxes have been paid

47. Table 8-2 Going from GDP to Disposable Income, 2013

48. Distinguishing Between Nominal and Real Values
Nominal Values
Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values
Real Values
Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars

49. Distinguishing Between Nominal and Real Values (cont'd)
Constant Dollars
Dollars expressed in terms of real purchasing power
This price-corrected GDP is the real GDP

50. Example: Correcting GDP for Price Index Changes, 2003 - 2013
Let’s use a numerical example to show how we can adjust GDP for changes in the price index.
In this example shown on the next slide, the GDP deflator is used to calculate values for real GDP from 2003 to 2013.

51. Table 8-3 Correcting GDP for Price Index Changes

52. Figure 8-4 Nominal and Real GDP
Source: U.S. Department of Commerce.

53. Distinguishing Between Nominal and Real Values (cont'd)
Per capita real GDP
Real GDP divided by total population
Per capita real GDP =
Real GDP
Population

54. Comparing GDP Throughout the World
Foreign Exchange Rate
The price of one currency in terms of another
Example:
$1.25 = 1 euro, or $1 = .80 euros
French income per capita = 28,944 euros
French per capita income in terms of dollars equals 28,944 euros x $1.25 = $36,180

55. Comparing GDP Throughout the World (cont'd)
Purchasing Power Parity
Adjustment in exchange rate conversions that takes into account differences in the true cost of living across countries

56. International Example: Purchasing Power Parity Comparisons of World Incomes
The International Monetary Fund accepted the purchasing power parity approach a few years ago
It started presenting the statistics on each country’s GDP relative to others and based on the purchasing power parity relative to the dollar
Why is China’s per capita GDP higher based on purchasing power parity?

57. Table 8-4 Comparing GDP Internationally

58. You Are There: Has the Economy Grown More than Official GDP Data Suggest?
Economists Bart Hobijin and Charles Steindel at the Federal Reserve Bank of New York are considering how to include three additional items in GDP:
Intangible investment
Real capital investment undertaken by government
Shift away from non-market home production as more women enter the labor force.
Hobijin and Steindel conclude that the net effect of these three items is to boost the GDP growth rate by about 0.5 percentage points per year.

59. Issues & Applications: Asia’s “Economic Size” Depends on How It Is Measured
The figure on the next slide shows the combined real GDP of Asia as a percentage of real GDP of the entire world.
The calculation was done according to two different measures.
One used prevailing exchange rates in foreign currency markets.
The other used purchasing power parity adjustments.

60. Figure 8-5 Asia’s Share of Global Real GDP
Source: International Monetary Fund.

61. Another measure of Asia’s economic presence is per capita real GDP.
Issues & Applications: Asia’s “Economic Size” Depends on How It Is Measured (cont’d)
Of the two methods, the purchasing power parity measure gives a larger estimate for Asia’s share of the world economy.
Another measure of Asia’s economic presence is per capita real GDP.
When comparisons are based on foreign exchange rates, Asian per capita real GDP is 11 percent of global per capita real GDP.
Using a purchasing power parity comparison, the figure rises to 26 percent.

62. Summary Discussion of Learning Objectives
The circular flow of income and output
In every economic transaction, receipts exactly equal expenditures
Goods and services flow in one direction and money payments flow in the other
Gross domestic product (GDP)
The total market value of a nation’s final output of goods and services produced in a year using factors of production located within its borders

63. Summary Discussion of Learning Objectives (cont'd)
The limitations of using GDP as a measure of national welfare
Excludes non-market transactions
Does not measure national well-being
The expenditure approach to tabulating GDP
GDP = C + I + G + X

64. Summary Discussion of Learning Objectives (cont'd)
The income approach to computing GDP
The sum of wages, rent, interest, profits
Distinguishing between nominal GDP and real GDP
Nominal GDP is the value of newly produced final output measured in current market prices.
Real GDP adjusts nominal GDP into constant dollars by correcting for price level changes