1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 2 The Measurement of Income, Prices, and Unemployment

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-2 The Circular Flow of Income and Expenditure The circular flow of income and expenditure model is a simple representation of the macro economy In the following graph, convince yourself that: –The value of output produced by firms equals the value of expenditures by participants in the economy –The value of output produced by firms equals the total income generated in the economy

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-3 Figure 2-1 The Circular Flow of Income and Consumption Expenditures

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-4 Defining GDP GDP (Y) is the value of all final goods and services that are currently produced and sold (but not resold) through the market during the current time period –The GDP of a country is often referred to as the country’s output and/or income

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-5 Table 2-1 What’s In and What’s Out of GDP

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-6 Keeping Track of GDP and other U.S. Data The National Income and Product Accounts (NIPA) is the official U.S. government accounting of all the U.S. flows of income and expenditures. The “Big Three” agencies for U.S. economic data –The Bureau of Economic Analysis (BEA)BEA –The Bureau of Labor Statistics (BLS)BLS –The Federal Reserve Board (Fed)Fed Other sources of data –The Bureau of the CensusBureau of the Census –International data: OECD, the World Bank and the IMFOECDWorld BankIMF

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-7 Types of Investment (I) Inventory Investment is the change in the stock of raw materials, parts and finished products held by businesses. –Any goods that are unsold automatically are counted as part of unplanned inventory investment. Fixed Investment includes all final goods (mainly structures and equipment) purchased by businesses not intended for resale. –Houses and condominiums owned by households are also counted as fixed investment.

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-8 Relation of Investment and Saving Personal Saving (S) is that part of personal income that is not consumed or paid out in taxes –Also referred to as Private Saving – Algebraically: S = (Y-T) - C (where T = Net Taxes) Funds from savings are channeled to firms in two basis ways: –Households buy bonds and stocks issued by firms –Households deposit savings in banks and other financial institutions that in turn lend money to firms Firms use the money channeled from savings to buy investment goods

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-9 Figure 2-2 Introduction of Saving and Investment to the Circular Flow Diagram

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-10 Net Exports and Net Foreign Investment Exports are goods produced within one country and shipped to another Imports are goods consumed within one country but produced in another country Net Exports (NX) are equal to the excess of exports over imports Net Foreign Investment (NFI) is equal to U.S. purchases of foreign financial assets minus foreign purchases of U.S. financial assets –Interesting connection: NX = NFI !

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-11 The Government Sector Government Purchases (G) is the value of goods and services purchased by the government at the federal, state and local levels Transfer Payments (F) are payments from the government to households that do not require the recipient to provide a service in return –Examples: Social Security, Medicare and Food Stamps Government Spending = G + F The Government pays for its spending by collecting Taxes (R) or by borrowing and/or printing money Net Taxes (T) = R – F Budget Surplus = T – G

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-12 Figure 2-3 Introduction of Taxation, Government Spending, and the Foreign Sector to the Circular Flow Diagram

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-13 Global Economic Crisis and GDP How long did the crisis last? –Business Cycle Peak: 2007:Q4 –Business Cycle Trough: 2009:Q2 How did the components of GDP behave over this time? –Real consumption by 0.8% –Real government spending by 6.6% –NX became significantly less negative –But real investment by 31.7%!

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-14 Deriving the “Magic” Equation The income accounting identity states that an economy’s income must equal its expenditures: Y ≡ E Y ≡ E  Now, use the fact that household income must equal household outlays (and recall that T = R - F): Y + F = C + S + R  Equating (1) and (2) yields the “Magic Equation” C + S + T = C + I + G + NX  S + T = I + G + NX Y = C + I + G + NX Y = C + S + T (1) (2)

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-15 Interpreting the “Magic Equation” Recall the “Magic Equation:” S + T = I + G + NX Leakages (S + T) describe the portion of total income that is not available for consumption Injections (I + G + NX) is a term for non- consumption expenditures The “Magic Equation” shows how leakages and injections are connected by definition!

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-16 “Magic Equation” Application: Twin Deficits Recall the “Magic Equation:” S + T = I + G + NX Rearranging (1) yields  T - G = (I + NX) – S –If T - G < 0  possibly NX < 0 –This suggests that a budget deficit and trade deficit might be observed at the same time! –Note that the “magic equation” only suggests the possible connections that may be observed in these variables. (1)

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-17 The “Magic Equation” in Recent Years (as % of GDP)

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-18 Table 2-2 Households Get What Remains After All the Leakages

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-19 Nominal GDP, Real GDP and the GDP Deflator Nominal GDP is the value of gross domestic product in current (actual) prices. Real GDP is the measure of gross domestic product using prices of an arbitrarily chosen base year. The GDP deflator is a price index that measures the aggregate economy’s price level. –Algebraically: GDP Def = Nominal GDP / Real GDP * 100 –The percentage change in the GDP deflator gives a measure of the economy’s inflation rate.

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-20 Figure 2-4 Nominal GDP, Real GDP, and the GDP Deflator, 1900–2010 Source: Appendix Table A-1. See explanation in Appendix C-4.

21. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-21 How to Calculate Growth Rates The general formula for the percentage annual growth rate of any variable X at time t beginning from time s: (where LN is the natural log function) Inflation and GDP growth rates are just two applications of this formula!

22. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-22 Measuring Unemployment The unemployed are those without who either are on temporary layoff or have taken specific action to look for work The total labor force is total of the civilian employed, the armed forces and the unemployed The actual unemployment rate (U) is defined below: Each month 1,500 census workers interview a random sample of 60,000 households to estimate unemployment

23. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-23 Flaws in the Definition of Unemployment U is not a measure of social distress –Much worse for the head of a household to be unemployed compared to a 16-year old teenage –Other common situations: College graduates looking for first jobs Women reentering the labor market after maternity leave People who voluntarily quit jobs and are now looking again U misses “forced part time workers” U misses “discouraged workers” who are not actively seeking jobs and therefore are not in the labor force –See chart on next slide!

24. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 2-24 Millions Impacted by Recessions but Not Counted as Unemployed