1. Measuring the Economy’s Performance
Chapter 8
Measuring the Economy’s
Performance

2. 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

3. 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

4. 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.

5. 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.

6. 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

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

8. The Simple Circular Flow (cont'd)
Product Markets
Transactions in which households buy goods

9. The Simple Circular Flow (cont'd)
Factor Markets
Transactions in which businesses buy resources

10. The Simple Circular Flow (cont'd)
Total Income
Wages, rent, interest, profits

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

12. National Income Accounting
A measurement system used to estimate national income and its components
Total Income
The yearly amount earned by the nation’s resources (factors of production)

13. National Income Accounting (cont'd)
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

14. 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.

15. 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

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

17. National Income Accounting (cont'd)
Numerous transactions occur that have nothing to do with final goods and services being produced:
Financial transactions
Transfer Payments
Secondhand Goods

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

19. National Income Accounting (cont'd)
Transfer of secondhand goods excluded
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

20. 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.

21. 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.
GDP is not a measure of a nation’s overall welfare.

22. 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

23. Two Main Methods of Measuring GDP (cont'd)
Expenditure Approach

24. 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

25. Two Main Methods of Measuring GDP (cont'd)
Income Approach

26. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Expenditure Approach
Consumption Expenditure (C)
Durable Consumer Goods
Life span of more than three years
Nondurable Consumer Goods
Goods that are used up in three years
Services
Mental or physical help

27. 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 included: changes in business inventories and repairs made to machines, buildings

28. 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

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

30. 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

31. 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

32. Figure 8-2 GDP and Its Components

33. Two Main Methods of Measuring GDP (cont'd)
Deriving GDP by the Income Approach

34. Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year)
Sources: U.S. Department of Commerce and author’s estimates.

35. 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

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

37. 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

38. 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.

39. Example: Correcting GDP for Price Index Changes
Nominal (current) dollars GDP
Real (constant) dollars GDP
Nominal GDP
Price index*
Real GDP =
x 100
*Price index: measured by the GDP deflator

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

41. Distinguishing Between Nominal and Real Values (cont'd)
Per capita GDP
Adjusting for population growth
Per capita real GDP =
Real GDP
Population

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

43. Comparing GDP Throughout the World
Foreign Exchange Rate
The price of one currency in terms of another

44. Comparing GDP Throughout the World (cont'd)
Foreign exchange rate
$1.50 = 1 euro, or $1 = .67 euros
French income per capita = 24,120 euros
French per capita income in terms of dollars equals 24,120 euros x $1.50 = $36,180

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

46. Table 8-4 Comparing GDP Internationally

47. 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

48. 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

49. 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.