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ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 8: Measuring the Economy’s Performance Materials include ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 8: Measuring the Economy’s Performance Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Learning Objectives Describe the circular flow of income and output n Define gross domestic Learning Objectives Describe the circular flow of income and output n Define gross domestic product (GDP) n Understand the limitations of using GDP as a measure of national welfare n 2

Learning Objectives Explain the expenditure approach to tabulating GDP n Explain the income approach Learning Objectives Explain the expenditure approach to tabulating GDP n Explain the income approach to computing GDP n Distinguish between nominal GDP and real GDP n 3

National Income Accounting n National Income Accounting ¨A measurement system used to estimate national National Income Accounting n National Income Accounting ¨A measurement system used to estimate national income and its components 4

The Simple Circular Flow Figure 8 -1 5 The Simple Circular Flow Figure 8 -1 5

The Simple Circular Flow Figure 8 -1 6 The Simple Circular Flow Figure 8 -1 6

The Simple Circular Flow Figure 8 -1 7 The Simple Circular Flow Figure 8 -1 7

The Simple Circular Flow Figure 8 -1 8 The Simple Circular Flow Figure 8 -1 8

The Simple Circular Flow n Two observations ¨ ¨ In every economic exchange, the The Simple Circular Flow n 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. 9

The Simple Circular Flow n Profits explained ¨ Question n ¨ Why is profit The Simple Circular Flow n Profits explained ¨ Question n ¨ Why is profit a cost of production? Answer n Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities 10

The Simple Circular Flow n Product Markets ¨ Transactions in which households buy goods The Simple Circular Flow n Product Markets ¨ Transactions in which households buy goods 11

The Simple Circular Flow n Final Goods and Services ¨ Goods and services that The Simple Circular Flow n 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 12

The Simple Circular Flow n Factor Markets ¨ Transactions in which businesses buy resources The Simple Circular Flow n Factor Markets ¨ Transactions in which businesses buy resources 13

The Simple Circular Flow n Total Income ¨ The yearly amount earned by the The Simple Circular Flow n Total Income ¨ The yearly amount earned by the nation’s factors of production 14

The Simple Circular Flow n Question ¨ n Why must total income be identical The Simple Circular Flow n Question ¨ n Why must total income be identical to the dollar value of total output? Answer ¨ Every transaction simultaneously involves an expenditure and a receipt 15

National Income Accounting n Gross Domestic Product (GDP) ¨ The total market value of National Income Accounting n 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 16

National Income Accounting n Observations ¨ GDP measures the dollar value of final output National Income Accounting n 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 17

National Income Accounting n Intermediate Goods ¨ Goods used up entirely in the production National Income Accounting n Intermediate Goods ¨ Goods used up entirely in the production of final goods 18

Sales Value and Value Added at Each Stage of Donut Production Stage of Production Sales Value and Value Added at Each Stage of Donut Production Stage of Production Dollar Value of Sales Stage 1: Fertilizer and Seed Value Added $. 03 Stage 2: Growing . 06 Stage 3: Milling . 12 Stage 4: Baking . 30 Stage 5: Retailing $. 03 . 45 Total dollar value of all sales $. 96 $. 06 $. 18 $. 15 Total value added $. 45 19

National Income Accounting n Exclusion of financial transactions, transfer payments, and secondhand goods ¨ National Income Accounting n Exclusion of financial transactions, transfer payments, and secondhand goods ¨ Numerous transactions occur that have nothing to do with final goods and services being produced. 20

National Income Accounting n Financial transactions ¨ Securities n Stocks and bonds ¨ Government National Income Accounting n Financial transactions ¨ Securities n Stocks and bonds ¨ Government n n Social Security Unemployment compensation ¨ Private n n transfer payments Individual gifts Corporate gifts 21

National Income Accounting n Transfer of secondhand goods ¨ Why not count the sale National Income Accounting n Transfer of secondhand goods ¨ Why not count the sale of a used car, stereo, or snowboard as part of GDP? n Other excluded transactions ¨ Household production ¨ Legal underground transactions ¨ Illegal underground transactions 22

Recognizing GDP Limitations n GDP’s limitations ¨ Excludes non-market production ¨ Different countries have Recognizing GDP Limitations n 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 23

Two Main Methods of Measuring GDP n Expenditure Approach ¨A way of computing national Two Main Methods of Measuring GDP n Expenditure Approach ¨A way of computing national income by adding up the dollar value at current market prices of all final goods and services 24

Two Main Methods of Measuring GDP Expenditure Approach 25 Two Main Methods of Measuring GDP Expenditure Approach 25

Two Main Methods of Measuring GDP n Income Approach ¨A way of measuring national Two Main Methods of Measuring GDP n Income Approach ¨A way of measuring national income by adding up income received by all factors of production 26

Two Main Methods of Measuring GDP Income Approach 27 Two Main Methods of Measuring GDP Income Approach 27

Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Consumption n Durables ¨ n Life span of more than three years Nondurables ¨ n Expenditure (C) Life span of less than three years Services ¨ Intangible commodities 28

Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Gross Private Domestic Investment (I) n The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future 29

Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Government Expenditures n State, local, and federal n Valued at cost (G) 30

Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Two Main Methods of Measuring GDP n Deriving GDP by the expenditure approach ¨ Net Exports (Foreign Expenditures) Net exports (X) = total exports - total imports 31

Two Main Methods of Measuring GDP n Mathematical representation using the expenditure approach GDP Two Main Methods of Measuring GDP n Mathematical representation using the expenditure approach GDP = C + I + G + X 32

GDP and Its Components Figure 8 -4 33 GDP and Its Components Figure 8 -4 33

Two Main Methods of Measuring GDP n Depreciation and net domestic product ¨ Deducting Two Main Methods of Measuring GDP n Depreciation and net domestic product ¨ Deducting for depreciation (capital consumption allowance) n 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 34

Two Main Methods of Measuring GDP n n n GDP = C + I Two Main Methods of Measuring GDP n n n 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 n NDP = C + net I + G + X 35

Two Main Methods of Measuring GDP n Deriving GDP by the income approach 36 Two Main Methods of Measuring GDP n Deriving GDP by the income approach 36

Deriving GDP by the Income Approach n Gross Domestic Income (GDI) ¨ The sum Deriving GDP by the Income Approach n Gross Domestic Income (GDI) ¨ The sum of all income—wages, interest, rent, and profits—paid to the four factors of production 37

Two Main Methods of Measuring GDP n Gross Domestic Income (GDI) ¨ Wages ¨ Two Main Methods of Measuring GDP n Gross Domestic Income (GDI) ¨ Wages ¨ Interest ¨ Rent ¨ Profits 38

Two Main Methods of Measuring GDP Gross domestic product equals gross domestic income plus Two Main Methods of Measuring GDP Gross domestic product equals gross domestic income plus indirect business taxes and depreciation. n These last items are called nonincome expense items. n 39

Gross Domestic Product and Gross Domestic Income, 2005 (in billions of 2005 dollars per 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. 40

Other Components of National Income Accounting n National Income (NI) ¨ The total of Other Components of National Income Accounting n National Income (NI) ¨ The total of all factor payments to resource owners n Personal Income (PI) ¨ The amount of income that households actually receive before they pay personal income taxes 41

Other Components of National Income Accounting n Disposable Personal Income (DPI) ¨ Personal income Other Components of National Income Accounting n Disposable Personal Income (DPI) ¨ Personal income after personal income taxes have been paid 42

Going from GDP to Disposable Income, 2005 Source: U. S. Department of Commerce, and Going from GDP to Disposable Income, 2005 Source: U. S. Department of Commerce, and author’s estimates Table 8 -2 43

Distinguishing Between Nominal and Real Values n Nominal Values ¨ Measurements in terms of Distinguishing Between Nominal and Real Values n Nominal Values ¨ Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars 44

Distinguishing Between Nominal and Real Values n Real Values ¨ Measurements after adjustments have Distinguishing Between Nominal and Real Values n Real Values ¨ Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars 45

Example: Correcting GDP for Price Index Changes n Correcting GDP for price index changes Example: Correcting GDP for Price Index Changes n Correcting GDP for price index changes ¨ Nominal (current) dollars GDP ¨ Real (constant) dollars GDP nominal GDP x 100 Real GDP = price level* *Price level: measured by the GDP deflator 46

Example: Correcting GDP for Price Index Changes Table 8 -3 Source: U. S. Department Example: Correcting GDP for Price Index Changes Table 8 -3 Source: U. S. Department of Commerce, Bureau of Economic Analysis, and author’s estimates 47

Nominal and Real GDP Figure 8 -6 Source: U. S. Department of Commerce 48 Nominal and Real GDP Figure 8 -6 Source: U. S. Department of Commerce 48

Distinguishing Between Nominal and Real Values n Per capita GDP ¨ Adjusting for population Distinguishing Between Nominal and Real Values n Per capita GDP ¨ Adjusting for population growth real GDP Per capita real GDP = population 49

Nominal and Real GDP n n The Bureau of Economic Analysis now uses a Nominal and Real GDP n n 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. 50

Distinguishing Between Nominal and Real Values n Some issues ¨ The distribution of output Distinguishing Between Nominal and Real Values n Some issues ¨ The distribution of output ¨ Changes in leisure time ¨ Increased traffic congestion ¨ Air pollution ¨ Crime ¨ Housework 51

Comparing GDP Throughout the World n Example ¨ France $1. 25 = 1 euro Comparing GDP Throughout the World n Example ¨ France $1. 25 = 1 euro n Per capita income = 23, 168. 80 euros n ¨ France per capita income in terms of dollars equals 23, 168. 80 x 1. 25 = $28, 961. 52

Comparing GDP Throughout the World n True purchasing power ¨ Accounting for goods and Comparing GDP Throughout the World n True purchasing power ¨ Accounting for goods and services that are not traded in the world market ¨ Purchasing Power Parity n Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries 53

International Example: Purchasing Power Parity Comparisons of Incomes Table 8 -4 Source: World Bank International Example: Purchasing Power Parity Comparisons of Incomes Table 8 -4 Source: World Bank 54

Summary Discussion of Learning Objectives n The circular flow of income and output ¨ Summary Discussion of Learning Objectives n 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 n 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 55

Summary Discussion of Learning Objectives n The limitations of using GDP as a measure Summary Discussion of Learning Objectives n The limitations of using GDP as a measure of national welfare ¨ Excludes non-market transactions ¨ Does not measure national well-being n The expenditure approach to tabulating GDP ¨ GDP =C+I+G+X 56

Summary Discussion of Learning Objectives n The income approach to computing GDP ¨ The Summary Discussion of Learning Objectives n The income approach to computing GDP ¨ The sum of wages, rent, interest, profit, depreciation, and indirect business taxes n 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. 57

ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 8: Measuring the Economy’s Performance Materials include ECON 151 – PRINCIPLES OF MACROECONOMICS Chapter 8: Measuring the Economy’s Performance Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.