Chapter 2 The Measurement of Income Prices and

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The Circular Flow of Income and Expenditure • The circular flow of income and expenditure model is a simple representation of the macro economy • In the following graphs, convince yourself that: – The value of output produced by firms equals the value of expenditures by participants in the economy – The value of output produced by firms equals the total income generated in the economy Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 2

Defining GDP • GDP (Y) is the value of all final goods and services that are currently produced and sold (but not resold) through the market during the current time period – The GDP of a country is often referred to as the country’s output and/or income Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4

Keeping Track of GDP and other U. S. Data • The National Income and Product Accounts (NIPA) is the official U. S. government accounting of all the U. S. flows of income and expenditures. • The “Big Three” agencies for U. S. economic data – The Bureau of Economic Analysis (BEA) – The Bureau of Labor Statistics (BLS) – The Federal Reserve Board (Fed) • Other sources of data – The Bureau of the Census – International data: OECD, the World Bank, and the IMF Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5

Types of Investment (I) • Inventory Investment is the change in the stock of raw materials, parts, and finished products held by businesses. – Any goods that are unsold automatically are counted as part of unplanned inventory investment. • Fixed Investment includes all final goods (mainly structures and equipment) purchased by businesses not intended for resale. – Houses and condominiums owned by households are also counted as fixed investment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6

Relation of Investment and Saving • Personal Saving (S) is that part of personal income that is not consumed or paid out in taxes – Also referred to as Private Saving – Algebraically: S = (Y-T) - C (where T = Net Taxes) • Funds from savings are channeled to firms in two basis ways: – Households buy bonds and stocks issued by firms – Households deposit savings in banks and other financial institutions that in turn lend money to firms • Firms use the money channeled from savings to buy investment goods Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7

Net Exports and Net Foreign Investment • Exports are goods produced within one country and shipped to another • Imports are goods consumed within one country but produced in another country • Net Exports (NX) are equal to the excess of exports over imports • Net Foreign Investment (NFI) is equal to U. S. purchases of foreign financial assets minus foreign purchases of U. S. financial assets – Interesting connection: NX = NFI Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9

The Government Sector • • Government Purchases (G) is the value of goods and services purchased by the government at the federal, state and local levels Transfer Payments (F) are payments from the government to households that do not require the recipient to provide a service in return – Examples: Social Security, Medicare, and Food Stamps • • Government Spending = G + F The Government pays for its spending by collecting Taxes (R) or by borrowing and/or printing money Net Taxes (T) = R – F Budget Surplus = T – G Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10

Deriving the “Magic” Equation (1) • The income accounting identity states that an economy’s income must equal its expenditures: Y ≡ E Y = C + I + G + NX • Now, use the fact that household income must equal (2) household outlays (and recall that T = R - F): Y+F=C+S+R Y=C+S+T • Equating (1) and (2) yields the “Magic Equation” C + S + T = C + I + G + NX S + T = I + G + NX Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12

Interpreting the “Magic Equation” Recall the “Magic Equation: ” S + T = I + G + NX • Leakages (S + T) describe the portion of total income that is not available for consumption • Injections (I + G + NX) is a term for nonconsumption expenditures • The “Magic Equation” shows how leakages and injections are connected by definition! Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13

“Magic Equation” Application: Twin Deficits Recall the “Magic Equation”: S + T = I + G + NX (1) • Rearranging (1) yields T - G = (I + NX) – S – If T - G < 0 possibly NX < 0 – This suggests that a budget deficit and trade deficit might be observed at the same time! – Note that the “magic equation” only suggests the possible connections that may be observed in these variables. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15

Nominal GDP, Real GDP, and the GDP Deflator • Nominal GDP is the value of gross domestic product in current (actual) prices. • Real GDP is the measure of gross domestic product using prices of an arbitrarily chosen base year. • The GDP deflator is a price index that measures the aggregate economy’s price level. – Algebraically: GDP Def = Nominal GDP / Real GDP * 100 – The percentage change in the GDP deflator gives a measure of the economy’s inflation rate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16

Figure 2 -4 Nominal GDP, Real GDP, and the Implicit GDP Deflator, 1900– 2007 Source: Appendix Table A-1. See explanation in Appendix C-4 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 17

Appendix Table: Calculation of Fixed-weight and Chainweighted Real GDP and GDP Deflators in an Imaginary Economy Producing Only Oranges and Apples Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 19