1. Chapter 8 Measuring the Economy’s Performance

2. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-2 Introduction Economists and financial news media anticipate the latest measure of total output by the Bureau of Economic Analysis (BEA). How does the BEA attempt to gauge the economy’s performance? You will find out in this chapter.

3. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-4 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

5. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-5 Chapter Outline The Simple Circular Flow National Income Accounting Two Main Methods of Measuring GDP Other Components of National Income Accounting Other Components of National Income Accounting Distinguishing Between Nominal and Real Values Distinguishing Between Nominal and Real Values Comparing GDP Throughout the World

6. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-6 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?

7. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-7 The Simple Circular Flow Two observations 1. In every economic exchange, the seller receives exactly the same amount that the buyer spends. 2. Goods and services flow in one direction and money payments flow in the other.

8. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-8 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.

9. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-9 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

10. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-10 Figure 8-1 The Circular Flow of Income and Product

11. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-11 The Simple Circular Flow (cont'd) Product Markets  Transactions in which households buy goods

12. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-12 The Simple Circular Flow (cont'd) Factor Markets  Transactions in which businesses buy resources

13. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-13 The Simple Circular Flow (cont'd) Total Income  Wages, rent, interest, profits

14. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-14 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.

15. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-15 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)

16. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-16 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

17. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-17 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.

18. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-18 National Income Accounting (cont'd) Stress on final output  What is a final good?  Wheat?  Steel?  Oil?  Bread?  Automobile?  Gasoline?

19. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-19 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

20. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-20 Table 8-1 Sales Value and Value Added at Each Stage of Donut Production

21. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-21 National Income Accounting (cont'd) Exclusion of financial transactions, transfer payments, and secondhand goods  Numerous transactions occur that have nothing to do with final goods and services being produced.

22. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-22 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

23. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-23 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

24. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-24 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.

25. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-25 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.

26. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-26 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

27. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-27 Two Main Methods of Measuring GDP (cont'd) Expenditure Approach

28. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-28 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

29. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-29 Two Main Methods of Measuring GDP (cont'd) Income Approach

30. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-30 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

31. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-31 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

32. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-32 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

33. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-33 Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the expenditure approach  Government Expenditures (G)  State, local, and federal  Valued at cost

34. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-34 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

35. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-35 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

36. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-36 Figure 8-2 GDP and Its Components

37. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-37 NDP = GDP – Depreciation Two Main Methods of Measuring GDP (cont'd) 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

38. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-38 Two Main Methods of Measuring GDP (cont'd) NDP = GDP – Depreciation 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

39. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-39 Two Main Methods of Measuring GDP (cont'd) Deriving GDP by the income approach

40. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-40 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

41. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-41 Two Main Methods of Measuring GDP (cont'd) Gross Domestic Income (GDI)  Wages: salaries and labor income  Rent: farms, houses, stores  Interest: savings accounts  Profits: sole proprietorships, partnerships, corporations

42. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-42 Two Main Methods of Measuring GDP (cont'd) Gross domestic product equals gross domestic income plus indirect business taxes and depreciation These last items are called nonincome expense items

43. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-43 Two Main Methods of Measuring GDP (cont'd) Indirect business taxes  All business taxes except the tax on corporate profits  Include sales and business property taxes

44. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-44 Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year) Source: U.S. Department of Commerce. First quarter preliminary data annualized.

45. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-45 Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

46. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-46 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

47. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-47 Other Components of National Income Accounting (cont'd) Disposable Personal Income (DPI)  Personal income after personal income taxes have been paid

48. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-48 Table 8-2 Going from GDP to Disposable Income, 2007

49. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-49 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

50. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-50 Distinguishing Between Nominal and Real Values (cont'd) Real Values  Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars Constant Dollars  Dollars expressed in terms of real purchasing power

51. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-51 *Price level: measured by the GDP deflator Real GDP =  x 100 Nominal GDP Price level* Example: Correcting GDP for Price Index Changes Correcting GDP for price index changes  Nominal (current) dollars GDP  Real (constant) dollars GDP

52. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-52 Table 8-3 Correcting GDP for Price Index Changes

53. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-53 Per capita real GDP = Real GDP Population Distinguishing Between Nominal and Real Values (cont'd) Per capita GDP  Adjusting for population growth

54. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-54 Source: U.S. Department of Commerce Figure 8-4 Nominal and Real GDP

55. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-55 Comparing GDP Throughout the World Foreign Exchange Rate  The price of one currency in terms of another

56. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-56 Comparing GDP Throughout the World (cont'd) Foreign exchange rate  $1.25 = 1 euro, or $1 = 0.80 euros  French per capita income = 23,168.80 euros  French per capita income in terms of dollars equals 23,168.80 euros x $1.25 = $28,961

57. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-57 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

58. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-58 Table 8-4 Comparing GDP Internationally

59. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-59 Issues and Applications: The Art of Estimating GDP Often Requires Touch-Ups The Bureau of Economic Analysis gives an advance estimate of quarterly GDP. The estimate receives considerable attention from the news media. Nevertheless, the estimate is updated at least two times. How different is the final result?

60. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-60 Figure 8-5 Effects of Revisions in GDP Estimates on Measured GDP Growth Rates

61. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-61 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

62. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-62 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

63. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-63 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.

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