1. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 14: The Overall Performance of Economic Systems

2. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 28 Chapter 14 Outline Introduction Gross Domestic Product GDP or GNP? GDP as Total Income Created in the Domestic Economy GDP is not a Measure of All Purchases in the Economy

3. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 28 Chapter 14 Outline GDP as Total Value Added Is Value Added Always Positive? Loose Ends: Unsold Inventories and Used Goods Aggregate Fluctuations Inflation

4. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 28 Chapter 14 Outline The Difficulties of Monetary Calculation Recession and Inflation Since 1960 What Causes Aggregate Fluctuations? Appendix: Limitations of National Income Accounting Appendix: The Dangers of Aggregation: A Methodological Approach

5. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 28 Introduction Microeconomic Analysis – supply and demand in a particular market or industry. Macroeconomic Analysis – performance of the overall economy. Gross Domestic Product – best indicator of overall economic performance.

6. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 28 Gross Domestic Product GDP – market value of final goods and services produced within a country in a particular time period. –Market values. –Final good – purchased by ultimate user. –Within a country. –Time period is usually a year.

7. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 28 GDP or GNP? GDP – performance of the domestic economy. GNP – performance of the nation’s citizens. –Regardless of where they are producing.

8. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 28 GDP as Total Income Created in the Domestic Economy GDP –Purchases of final goods. –Measure of national income. Value of national output = value of national income –Every dollar paid for output = income for someone Sales taxes = income for government

9. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 28 GDP Is Not a Measure of All Purchases in the Economy GDP –Purchases of final goods. –All income created in the economy. –Not all expenditures. –Excludes intermediate goods. –All expenditures would be double counting.

10. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 28 GDP as Total Value Added GDP –Expenditures of final goods and services. –Total income generated in the economy. –Total value added in the economy.

11. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 28 Is Value Added Always Positive? Nominal wages, rents and interest will be positive. Profit is positive, loss is negative. A loss is “added” as negative amount.

12. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 28 Loose Ends: Unsold Inventories and Used Goods Unsold Inventories = gross business inventory investment. –Estimate market values of unsold goods. –Revise GDP with actual market values. Used Goods – GDP accounts for added value / market value of the sale.

13. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 28 Aggregate Fluctuations Economic growth occurs through cycles of expansion and contraction. Fluctuations in output and income are significant.

14. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 28 Aggregate Fluctuations The Great Depression – 1929-1933 –Real GDP fell by 30%. –1933 GDP – 40% less than would have been forecasted in 1929 (assume 3% growth). –Unemployment 1929 – 3.2% 1933 – 24.9%

15. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 28 Inflation Nominal GDP –Product of prices and quantities (P x Q). –If prices increase and quantities remain unchanged nominal GDP increases. Question –If prices increase and quantities remain the same, has the real output of the economy increased?

16. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 28 Inflation Adjusting GDP for Price Changes –Real GDP The value of all final goods and services produced in a year stated in unchanging prices.

17. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 28 Inflation GDP Deflator –Most comprehensive measure of prices. Consumer Price Index (CPI) –Measures the price level of goods and services that enter in the budgets of typical urban consumers.

18. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 28 Inflation –A fall in the value or purchasing power of money. Deflation –A rise in the value or purchasing power of money. Disinflation –A slowing down of the inflation rate.

19. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 28 The Difficulties of Monetary Calculation Inflation, deflation and disinflation make monetary calculations difficult. –Expected consequences –Financial activities

20. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 28 Recession and Inflation Since 1960 Recessions –1960, 1970, 1974, 1975, 1980, 1982, 1990, and 1991 Inflation –1960’s – 2.5% / year –1970’s – 7.5% / year

21. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 28 Recession and Inflation Since 1960 Stagflation – a stagnating economy with inflation. Inflation can occur during recession. 1974 – 1975 –Severe recession –10% inflation Recession and Inflation not simple opposites.

22. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 28 What Causes Aggregate Fluctuations? Fluctuations may reflect the natural adjustment of markets to external shocks. Fluctuations may be driven by relatively small changes in one sector of the economy that multiplies through many sectors.

23. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 28 Appendix: Limitations of National Income Accounting GDP –Only attempts to measure economic performance. –Ignores all non-market forms of production. –Ignores illegal production. –Ignores economic profits and losses.

24. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 28 Appendix: The Dangers of Aggregation GDP – measure of overall economy –Difficult task –Imperfect –Emphasis on statistical aggregates Aggregate variables –Price level –Unemployment rate –Etc.

25. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 28 Appendix: The Dangers of Aggregation Since 1980’s more macroeconomists –Believe aggregate analysis is limited. –Rediscovered the value of supply and demand analysis.

26. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 28 Once Over Lightly Gross Domestic Product – GDP GDP Measurements (3) Unsold Goods Market Values of Services Inflation is a decrease in purchasing power of money Deflation is a sustained rise in purchasing power of money.

27. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 28 Once Over Lightly Disinflation is a slowing down of the rate of inflation. GDP Deflator is a measure of inflation Economic growth Recession Aggregate Fluctuations Limitations of GDP measurement

28. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 28 End of Chapter 14