1. Chapter 8 Measuring the Economy’s Performance

2. Slide 8-2 Introduction Gross domestic product is the statistic most often used to indicate the economy’s overall performance. What is included and what is omitted from GDP?

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 Flow The Simple Circular Flow National Income Accounting National Income Accounting Two Main Methods of Measuring GDP Other Components of National Income Accounting Other Components 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

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 Figure 8-1

10. Slide 8-10 The Simple Circular Flow Figure 8-1

11. Slide 8-11 The Simple Circular Flow Figure 8-1

12. Slide 8-12 The Simple Circular Flow Figure 8-1

13. Slide 8-13 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.

14. Slide 8-14 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

15. Slide 8-15 The Simple Circular Flow Product Markets –Transactions in which households buy goods

16. Slide 8-16 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

17. Slide 8-17 The Simple Circular Flow Factor Markets –Transactions in which businesses buy resources

18. Slide 8-18 The Simple Circular Flow Total Income –The yearly amount earned by the nation’s factors of production

19. Slide 8-19 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

20. Slide 8-20 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

21. Slide 8-21 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

22. Slide 8-22 National Income Accounting Stress of final output –What is a final good? Wheat? Steel? Oil? Bread? Automobile? Gasoline?

23. Slide 8-23 National Income Accounting Intermediate Goods –Goods used up entirely in the production of final goods

24. Slide 8-24 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

25. Slide 8-25 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.

26. Slide 8-26 National Income Accounting Financial transactions –Securities Stocks and bonds –Government transfer payments Social Security Unemployment compensation –Private transfer payments Individual gifts Corporate gifts

27. Slide 8-27 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

28. Slide 8-28 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

29. Slide 8-29 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

30. Slide 8-30 Two Main Methods of Measuring GDP Expenditure Approach

31. Slide 8-31 E-Commerce Example: Using the Internet to Reduce Business Inventory Levels With access to internet auctions, firms find it easier to follow a just-in-time inventory practice. The ratio of inventories to sales in manufacturing has dropped since 1990. How does this change affect the investment component of GDP?

32. Slide 8-32 Two Main Methods of Measuring GDP Income Approach –A way of measuring national income by adding up income received by all factors of production

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

34. Slide 8-34 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

35. Slide 8-35 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

36. Slide 8-36 Two Main Methods of Measuring GDP Deriving GDP by the expenditure approach –Government Expenditures (G) State, local, and federal Valued at cost

37. Slide 8-37 Two Main Methods of Measuring GDP Deriving GDP by the expenditure approach –Net Exports (Foreign Expenditures) Net exports (X) = total exports - total imports

38. Slide 8-38 Two Main Methods of Measuring GDP Mathematical representation using the expenditure approach GDP = C + I + G + X

39. Slide 8-39 GDP and Its Components Figure 8-4

40. Slide 8-40 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

41. Slide 8-41 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

42. Slide 8-42 Two Main Methods of Measuring GDP Deriving GDP by the income approach

43. Slide 8-43 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

44. Slide 8-44 Two Main Methods of Measuring GDP Gross Domestic Income (GDI) –Wages –Interest –Rent –Profits

45. Slide 8-45 Two Main Methods of Measuring GDP Gross domestic product equals gross domestic income plus indirect business taxes and depreciation. These last items are called nonincome expense items.

46. Slide 8-46 Gross Domestic Product and Gross Domestic Income, 2005 (in billions of 2005 dollars per year) Figure 8-5 Source: U.S. Department of Commerce. First quarter preliminary data annualized.

47. Slide 8-47 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

48. Slide 8-48 Other Components of National Income Accounting Disposable Personal Income (DPI) –Personal income after personal income taxes have been paid

49. Slide 8-49 Source: U.S. Department of Commerce, and author’s estimates Going from GDP to Disposable Income, 2005 Table 8-2

50. Slide 8-50 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

51. Slide 8-51 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

52. Slide 8-52 Example: Correcting GDP for Price Index Changes 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*

53. Slide 8-53 Example: Correcting GDP for Price Index Changes Source: U.S. Department of Commerce, Bureau of Economic Analysis, and author’s estimates Table 8-3

54. Slide 8-54 Distinguishing Between Nominal and Real Values Questions –Why is the price index greater than 100 for 2002? –Why is the price index less than 100 for 1996? –Why is real GDP greater than nominal GDP for 1996 and less than nominal GDP for 2002?

55. Slide 8-55 Nominal and Real GDP Figure 8-6 Source: U.S. Department of Commerce

56. Slide 8-56 Distinguishing Between Nominal and Real Values Per capita GDP –Adjusting for population growth Per capita real GDP = real GDP population

57. Slide 8-57 Nominal and Real GDP The Bureau of Economic Analysis now uses a chain-weighted measure of real GDP. This means that changes in the prices and output levels of a certain good will contribute to overall changes in GDP to the extent that the good accounts for a significant share of overall economic activity.

58. Slide 8-58 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

59. Slide 8-59 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

60. Slide 8-60 Example: Real GDP Really Lightens Up The value of real GDP has increased dramatically over the past century. The physical weight of GDP has increased only slightly over this time frame. Think about the contributions of pharmaceuticals, software, and other information goods.

61. Slide 8-61 Distinguishing Between Nominal and Real Values Question –Is real per capita GDP a good indicator of social well-being?

62. Slide 8-62 Distinguishing Between Nominal and Real Values Some issues –The distribution of output –Changes in leisure time –Increased traffic congestion –Air pollution –Crime –Housework

63. Slide 8-63 Comparing GDP Throughout the World Example –France $1.25 = 1 euro Per capita income = 23,168.80 euros –France per capita income in terms of dollars equals 23,168.80 x 1.25 = $28,961.

64. Slide 8-64 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

65. Slide 8-65 Source: World Bank International Example: Purchasing Power Parity Comparisons of Incomes Table 8-4

66. Slide 8-66 Social scientists attempt to measure general levels of personal satisfaction, and to compare them on an international basis. There is a positive correlation between self- reported measures of life satisfaction and per capita real GDP. Some economists point to this as evidence that GDP is a good proxy measure for overall well-being. Issues and Applications: Does More GDP Make People Happier?

67. Slide 8-67 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

68. Slide 8-68 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

69. Slide 8-69 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.

70. End of Chapter 8 Measuring the Economy’s Performance