1. Chapter 8 Measuring the Economy’s Performance Roger LeRoy Miller Economics Today Twelfth Edition Copyright © 2004 Pearson Addison Wesley. All rights reserved.

2. Slide 8-2 Introduction Measures of economic performance exclude output generated by the underground economy. Can you explain why the relative size of the underground economy varies internationally?

3. Slide 8-3 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. Slide 8-4 Learning Objectives Explain the expenditure approach to tabulating GDP Explain the income approach to computing GDP Distinguish between nominal GDP and real GDP

5. Slide 8-5 The Simple Circular FlowSimple Circular Flow National Income AccountingIncome Accounting Two Main Methods of Measuring GDP Two Main Methods of Measuring GDP Other Components of National Income AccountingComponents of National Income Accounting Chapter Outline

6. Slide 8-6 Chapter Outline Distinguishing Between Nominal and Real Values Distinguishing Between Nominal and Real Values Comparing GDP Throughout the World Comparing GDP Throughout the World

7. Slide 8-7 Did You Know That... Decisions on how to categorize business expenses will affect the relative size of an increase or a decrease in economic activity? Statisticians measuring our national economic performance strive for consistency in constructing their measures across time?

8. Slide 8-8 National Income Accounting –A measurement system used to estimate national income and its components

9. Slide 8-9 The Simple Circular Flow

10. Slide 8-10 The Simple Circular Flow

11. Slide 8-11 The Simple Circular Flow

12. Slide 8-12 The Simple Circular Flow

13. Slide 8-13 The Simple Circular Flow Figure 8.1 Households Businesses

14. Slide 8-14 The Simple Circular Flow Two observations –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.

15. Slide 8-15 The Simple Circular Flow 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

16. Slide 8-16 The Simple Circular Flow Product Markets –Transactions in which households buy goods

17. Slide 8-17 The Simple Circular Flow 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

18. Slide 8-18 The Simple Circular Flow Factor Markets –Transactions in which businesses buy resources

19. Slide 8-19 The Simple Circular Flow Total Income –The yearly amount earned by the nation’s factors of production

20. Slide 8-20 The Simple Circular Flow Question –Why must total income be identical to the dollar value of total output? Answer –Every transaction simultaneously involves an expenditure and a receipt

21. Slide 8-21 National Income Accounting 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

22. Slide 8-22 National Income Accounting 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

23. Slide 8-23 National Income Accounting Stress of final output –What is a final good? Wheat? Steel? Oil? Bread? Automobile? Gasoline?

24. Slide 8-24 National Income Accounting Intermediate Goods –Goods used up entirely in the production of final goods

25. Slide 8-25 Stage 1: Fertilizer and Seed$.03 Stage 2: Growing.06 Stage 3: Milling.12 Stage 4: Baking.30 Stage 5: Retailing.45 Total value added $.45 Stage of ProductionDollar Value of SalesValue Added $.03 $.06 $.18 $.15 Sales Value and Value Added at Each Stage of Donut Production Total dollar value of all sales$.96

26. Slide 8-26 National Income Accounting Exclusion of financial transactions, transfer payments, and secondhand goods –Numerous transactions occur that have nothing to do with final goods and services being produced.

27. Slide 8-27 National Income Accounting Financial transactions –Securities Stocks and bonds –Government transfer payments Social Security Unemployment compensation –Private transfer payments Individual gifts Corporate gifts

28. Slide 8-28 National Income Accounting Transfer of secondhand goods –Why not count the sale of a used car, stereo, or snowboard as part of GDP? Other excluded transactions –Household production –Legal underground transactions –Illegal underground transactions

29. Slide 8-29 International Example: What has been the impact of the Internet on U.S. GDP? Business-to-business transactions –Many of these are exchanges of intermediate inputs Consumer-to-consumer transactions –Many of these are exchanges of secondhand goods Business-to-consumer transactions –These retail transactions count directly in GDP

30. Slide 8-30 Recognizing GDP Limitations GDP’s limitations –Excludes non-market production –Different countries have different legal versus illegal activities –Quality of life is not measured –GDP poorly measures a nation’s well- being

31. Slide 8-31 Policy Example: Replacing GDP with GPI? The Genuine Progress Indicator imputes the value of beneficial non- market activities such as housework and includes them in a measure of well-being. The GPI also deducts from economic activity the amount of spending devoted to alleviating social ills, such as crime prevention.

32. Slide 8-32 Two Main Methods of Measuring GDP Expenditure Approach –A way of computing national income by adding up the dollar value at current market prices of all final goods and services

33. Slide 8-33 Two Main Methods of Measuring GDP Expenditure Approach

34. Slide 8-34 Two Main Methods of Measuring GDP Income Approach –A way of measuring national income by adding up income received by all factors of production

35. Slide 8-35 Two Main Methods of Measuring GDP Income Approach

36. Slide 8-36 Two Main Methods of Measuring GDP Deriving GDP by the expenditure approach –Consumption Expenditure (C) Durables –Life span of more than three years Nondurables –Life span of less than three years Services –Intangible commodities

37. Slide 8-37 Two Main Methods of Measuring GDP 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

38. Slide 8-38 Two Main Methods of Measuring GDP Deriving GDP by the expenditure approach –Gross Private Domestic Investment (I) Fixed investment Inventory investment New residential structures

39. Slide 8-39 Two Main Methods of Measuring GDP Deriving GDP by the expenditure approach –Government Expenditures (G) State, local, and federal Valued at cost

40. Slide 8-40 Two Main Methods of Measuring GDP Deriving GDP by the expenditure approach –Net Exports (Foreign Expenditures) Net exports (X) = total exports - total imports

41. Slide 8-41 Two Main Methods of Measuring GDP Mathematical representation using the expenditure approach GDP = C + I + G + X

42. Slide 8-42 GDP and Its Components Figure 8-3

43. Slide 8-43 Two Main Methods of Measuring GDP Depreciation and net domestic product –Deducting for depreciation (capital consumption allowance) Reduction in the value of capital goods over a one-year period due to physical wear and tear, and also to obsolescence NDP = GDP - depreciation

44. Slide 8-44 Two Main Methods of Measuring GDP GDP = C + I + G + X NDP = C + I + G + X - depreciation Net Investment = I - depreciation –Domestic investment minus an estimate of the wear and tear on the existing capital stock NDP = C + net I + G + X

45. Slide 8-45 Two Main Methods of Measuring GDP Deriving GDP by the income approach

46. Slide 8-46 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

47. Slide 8-47 Two Main Methods of Measuring GDP Gross Domestic Income (GDI) –Wages –Interest –Rent –Profits

48. Slide 8-48 Two Main Methods of Measuring GDP Gross Domestic Income (GDI) –Accounting for non-income expense items Indirect Business Taxes –All business taxes except the tax on corporate profits (i.e., sales and business property taxes) Depreciation

49. Slide 8-49 Gross Domestic Product and Gross Domestic Income, 2003 (in billions of 2003 dollars per year) Figure 8-4 Source: U.S. Department of Commerce. First quarter preliminary data annualized.

50. Slide 8-50 Expenditure Point of View—Product Flow Expenditures by Different Sectors: Gross Domestic Product and Gross Domestic Income, 2003 (in billions of 2003 dollars per year)

51. Slide 8-51 Income Point of View—Cost Flow Domestic Income (at factor cost): Gross Domestic Product and Gross Domestic Income, 2003 (in billions of 2003 dollars per year)

52. Slide 8-52 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

53. Slide 8-53 Other Components of National Income Accounting Disposable Personal Income (DPI) –Personal income after personal income taxes have been paid

54. Slide 8-54 Billions of Dollars Source: U.S. Department of Commerce Going from GDP to Disposable Income, 2003 Gross domestic product (GDP)11,174.8 Minus depreciation–1,405.0 Net domestic product (NDP)9,769.8 Minus indirect business taxes and other adjustments–884.1 National income (NI)8,885.7 Minus corporate taxes, Social Security contributions, corporate retained earnings–1,402.9 Plus government and business transfer payments+1,823.0 Personal income (PI)9,305.8 Minus personal income tax and nontax payments–1,421.8 Disposable personal income (DPI)7,884.0

55. Slide 8-55 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

56. Slide 8-56 Distinguishing Between Nominal and Real Values Real Values –Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars

57. Slide 8-57 Distinguishing Between Nominal and Real Values Correcting GDP for price index changes –Nominal (current) dollars GDP –Real (constant) dollars GDP *Price level: measured by the GDP deflator Real GDP =  x 100 nominal GDP price level*

58. Slide 8-58 (1)(2)(3) (4) = [(2)/(3)] x 100 Nominal GDPReal GDP (billions of(billions of dollars dollarsPrice Level Indexper year Yearper year)(base year 1996 = 100)in constant 1996 dollars ) Correcting GDP for Price Changes Source: U.S. Department of Commerce, Bureau of Economic Analysis

59. Slide 8-59 Distinguishing Between Nominal and Real Values Example –Base Year = 1996 –Price Index = 100

60. Slide 8-60 Distinguishing Between Nominal and Real Values Real GDP = nominal GDP in the base year Real 1996 GDP =  x 100 nominal GDP price index Real 1996 GDP =  x 100 = $7,813.20 billion $7,813.20 100

61. Slide 8-61 Distinguishing Between Nominal and Real Values 1997 –Price Index = 102.2 Real 1997 GDP =  x 100 = $8,159.5 billion $8,318.40 101.9

62. Slide 8-62 Distinguishing Between Nominal and Real Values 1993 –Price Index = 94.1 Real 1993 GDP =  x 100 = $7,062.60 billion $6,642.30 82.7

63. Slide 8-63 Distinguishing Between Nominal and Real Values Questions –Why is the price index greater than 100 for 2000? –Why is the price index less than 100 for 1996? –Why is Real GDP greater than Nominal GDP for 1993 and less than Nominal GDP for 2000?

64. Slide 8-64 Nominal and Real GDP Figure 8-5 Source: U.S. Department of Commerce

65. Slide 8-65 Distinguishing Between Nominal and Real Values Per capita GDP –Adjusting for population growth Per capita real GDP = real GDP population

66. Slide 8-66 Distinguishing Between Nominal and Real Values Question –Is real per capita GDP a good indicator of social well-being?

67. Slide 8-67 Distinguishing Between Nominal and Real Values Some issues –The distribution of output –Changes in leisure time –Increased traffic congestion –Air pollution –Crime –Housework

68. Slide 8-68 Distinguishing Between Nominal and Real Values A new chain-weighted measure of the growth in real GDP –Prior to 1996 U.S. Department of Commerce Bureau of Economic Analysis (BEA) used a fixed weight measure for real GDP

69. Slide 8-69 Distinguishing Between Nominal and Real Values A new chain-weighted measure of the growth in real GDP –1996 BEA converted to a chain-weighted real GDP that measures GDP by considering relative price and share changes

70. Slide 8-70 Comparing GDP Throughout the World Adjusting for different currencies –Foreign Exchange Rates The price of one currency in terms of another

71. Slide 8-71 Comparing GDP Throughout the World Example –France $1 = 5 francs Per capita income = 100,000 francs –France per capita income in terms of dollars 100,000/5 = $20,000

72. Slide 8-72 Comparing GDP Throughout the World True purchasing power –Accounting for goods and services that are not traded in the world market –Purchasing Power Parity Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries

73. Slide 8-73 Sources: International Monetary Fund; World Bank; Organization for Economic Cooperation and Development International Example: Comparing GDP Internationally

74. Slide 8-74 The underground economy is the market of exchanges undertaken outside the purview of government. People take their exchanges “underground” when the activities are illegal or when they wish to avoid paying taxes associated with these transactions. Economic theory would predict that higher tax rates would encourage growth of the underground economy. Issues and Applications: The Underground Economy

75. Slide 8-75 The Underground Economy and Income Tax Rates International empirical evidence supports the prediction of economic theory.

76. Slide 8-76 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

77. Slide 8-77 Summary Discussion of Learning Objectives 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

78. Slide 8-78 Summary Discussion of Learning Objectives The income approach to computing GDP –The sum of wages, rent, interest, profit, depreciation, and indirect business taxes Distinguishing between nominal GDP and real GDP –Nominal GDP is the value of newly produced final output in the current year measured in current market prices. –Real GDP adjusts nominal GDP into constant dollars by correcting for price level changes.

79. Chapter 8 Measuring the Economy’s Performance End of Chapter Copyright © 2004 Pearson Addison Wesley. All rights reserved.