1. Measuring the Economy

2. The Economy as a Circular Flow Resources FirmsHouseholds Goods and Services Expenditures Income

3. Saving and Investment FirmsHouseholds Income Expenditures Financial Markets Savings Borrowings

4. Real and Nominal Rates Nominal interest rates are rates unadjusted for the effect of inflation or deflation. Real rates are adjusted for price level changes.

5. Interest Rates: Facts Interest rates serve many roles: Interest rates are a premium paid to forego consumption. Interest rates are the price of credit. Interest rates are the return to capital as a factor of production.

6. Inflation and Interest Rates Nominal variables are not adjusted to reflect changes in the price level. They are the percentage by which the money a borrower pays back exceeds the money he borrowed, making no adjustment for any change in purchasing power.

7. Inflation and Interest Rates Real interest rates are the percentage increase in purchasing power that the borrower pays to the lender for the privilege of borrowing. Real interest rates are nominal interest rates minus the rate of inflation. Real interest rates may be positive, zero, or negative.

8. Nominal Rates: The Fisher Effect THE FISHER EFFECT: NOMINAL RATE = REAL RATE + EXPECTED INFLATION

9. Circular Flow with Government Savings Borrowing Investment Government HouseholdsFirms Financial Markets Income Expenditures Government Salaries and Transfers Government Purchases of Goods and Services Subsidies Taxes Government Borrowing Government Saving

10. Saving and Investment Economists make a clear distinction between saving and investment. Saving is the act of abstaining from consumption. Investment is the result of purchasing a new capital good.

11. Saving and Investment: Closed Economy Y = C + I + G G = I G + C G Y = C N + I N C N = C + C G I N = I + I G Y – C N = I N S N = I N

12. Savings = Investment: Closed Economy In a closed economy, savings must just equal investment. If S > I, interest rates will fall and I will rise. If S < I, interest rates will rise and I will fall.

13. Circular Flow with Government and the Rest of the World SavingsBorrowing Investment Foreign BorrowingForeign Savings Foreign Countries Government Households Firms Financial Markets Income Expenditures Exports Imports Government Salaries and Transfers Government Purchases of Goods and Services Subsidies Taxes Government Borrowing Government Saving

14. The Rest of the World An economy has two basic kinds of economic interactions with the rest of the world. Buying and selling goods and services Buying and selling assets.

15. Exports are those goods we produce for sale in the rest of the world. Imports are those goods we buy from the rest of the world. We also lend to the rest of the world and borrow from them. The Rest of the World

16. Saving and Investment: Open Economy Y = C N + I N + NX NX = Exports – Imports Y – C N – I N = NX S N – I N = NX If S N = I N, NX =0, trade balance If S N > I N, NX >0, trade surplus If S N < I N, NX <0, trade deficit

17. Looking at X - M X represents the exports of a country. X is the income a country receives from the rest of the world through exporting goods and services. M represents the imports of a country. M is a country’s consumption of goods and services produced by the rest of the world.

18. Looking at X - M X – M then is income minus consumption vis a vis the rest of the world. If X > M, a country has excess funds to lend to the ROW, or S > I. If X < M, the country’s trading partner has excess funds to lend to it or domestically S < I.

19. S – I = NX Net foreign investment (S – I) always equals the trade balance (NX). The international flow of funds to finance capital accumulation and the international flow of goods and services are two sides of the same coin.

20. Government and the Private Sector YD = Y + TR – T S = YD – C YD = C + I + G + NX + TR – T YD = S + C Set YD = YD and solve for NX S + C = C + I + G + NX + TR – T S + C – C – I – G – TR + T = NX (S – I) + (T – TR – G) = NX

21. Government and the Private Sector (S – I) + (T – TR – G) = NX (S – I) = Private saving (T – TR – G) = Government saving There are two sources from which the government can raise funds if G + TR > T. It can borrow at home, if S > I or It can borrow from the ROW if NX < 0.

22. Government Budget Surplus (S – I) + (T – TR – G) = NX Rearrange the equation: T – G – TR = (I + NX ) – S There are three ways a government budget surplus can be used: Private saving can decline without requiring a decrease in private investment The surplus can stimulate domestic investment through lower interest rates. Dependence on foreign investment can be reduced.

23. Measuring GDP

24. What Is GDP? GDP, Gross Domestic Product, is the total dollar value of all final goods and services produced in a country during a year. Current market prices are used to aggregate different outputs to a dollar total. Government purchases, many of which do not occur in markets, are valued at their cost of production.

25. Only final goods and services are included. Intermediate goods are not included to avoid double counting. The measure is an annual flow, a rate of production. A GDP of $10 trillion implies that the economy is producing $10 trillion worth of goods and services per year. GDP measures production by U.S. citizens and foreigners alike inside the geographic borders of the USA and thus unequivocally reflects economic activity in the USA. What Is GDP?

26. Real and Nominal GDP Nominal GDP The market value of a nation’s final output based on current prices for the goods and services produced during the year. Nominal GDP in 2003 = the sum of all the goods and services produced in 2003 multiplied by their 2003 prices Real GDP An estimate of the value of a nation’s final products adjusted for changes in prices since a certain base year.

27. Calculating Changes in Real GDP GDP =  PQ We are interested in measuring Q when we measure GDP. Therefore, changes in P must be eliminated. This is accomplished by using a price index to deflate nominal GDP.

28. Price Indexes: Use GDP in 2000 = P 2000 times Q 2000 GDP in 2002 = P 2002 times Q 2002 If we wish to compare GDP in 2002 with GDP in 2000, we must remove any price changes that have occurred. Why?

29. Price Indexes: Use GDP 2002 = P 2002 x Q 2002 Divide by a price index = P 2002 /P 2000 P 2002 Q 2002 P 2002 = P 2002 Q 2002 x P 2000 = Q 2002 P 2000 P 2000 P 2002

30. Components of GDP: Expenditure and Income Expenditure GDP = C + I + G + (X-M) Income NI (Y) = W + i + R + profits Since NI and GDP measure aggregate production, they must be equal.

31. GDP = NI 2001 Consumption6,987.1 Durable Goods 835.9 Nondurables 2,041.3 Services 4,109.9 Investment1,586.0 Nonresidential 1,201.6 Residential 444.7 Inventory Change -60.3 Government1,858.0 Federal 628.1 State & Local 1,229.9 Net Exports -348.9 Exports 1,034.1 Imports 1,383.0 GDP 10,082.2 Employee Compensation5874.9 Corporate Profits 731.6 Proprietors’ Income 727.9 Net Interest 649.8 Rental Income 137.9 National Income 8,122.1 + CCA 1329.3 + Indirect Business Taxes 774.8 + Business Transfers 42.5 - Subsidies 47.3 +Statistical Discrepancy -117.3 GNP 10,104.1 +Net Foreign Payments -21.9 GDP 10,082.2

32. GDP Components ConceptLeakage/SavingLeakage/TaxesGovernment Transfers GDP LessDepreciation = NDP LessIndirect business taxes =Domestic Income LessUndistributed Social Security profitstaxes PlusTransfer Payments and interest =PI LessPersonal income taxes =PYD Divided amongPersonal saving Personal consumption Interest payments

34. Components of GDP: Expenditure Viewpoint Consumption Non-durable Goods (last less than 3 years) Durable Goods (last more than 3 years) Services Gross Domestic Investment Non-residential lnvestment (plant and equipment) Inventory Change Residential Investment

35. Government Spending Local and State Federal Net Exports Exports Minus Imports Components of GDP: Expenditure Viewpoint

36. Components of GDP: Income Viewpoint Employee Compensation Income from the sale of labor services during the year. It includes wages, salaries, and fringe benefits such as employer provided insurance and employer contributions to pension funds.

37. Net Interest The portion of business receipts used to pay for borrowed funds that finance investment purchases. Components of GDP: Income Viewpoint

38. Rental Income Rental income is earned by those who supply the services of land, mineral rights, and buildings for use by others. Also included in rental income is an estimate of the imputed rent earned by homeowners who live in their own homes less the expenses of maintaining their homes.

39. Profits. Profits of corporations and unincorporated business Profits = Total revenues – Indirect business taxes – Capital consumption allowance – Labor costs – Net interest – Rents paid Components of GDP: Income Viewpoint