Introduction. Learning Objectives. Chapter 8. Measuring the Economy s Performance

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1 Copyright 2012 Pearson Addison-Wesley. All rights reserved. Chapter 8 Measuring the Economy s Performance Introduction Does a general increase in the level of a nation s economic activity and the resulting rise in the capability of a person to buy more goods and services tend to make that person happier? To answer this question, economists have to measure not only the level of happiness but also the level of the country s economic activity This chapter will help you understand the measurement of a nation s overall economic performance. Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-2 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-3

2 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-4 Chapter Outline The Simple Circular Flow National Income Accounting Two Main Methods of Measuring GDP Other Components of National Income Accounting Distinguishing Between Nominal and Real Values Comparing GDP Throughout the World Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-5 Did You Know That... U.S. economic activity declined by a greater percentage during the first 18 months of the Great Recession of the late 2000s than during any other 18-month period since World War II? To measure the nation s overall economic performance, the government utilizes the concept of national income accounting. Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-6

3 The Simple Circular Flow The concept of the circular flow of income involves two principles: 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-7 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-8 Figure 8-1 The Circular Flow of Income and Product Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-9

4 The Simple Circular Flow (cont'd) Product Markets Transactions in which households buy goods Factor Markets Transactions in which businesses buy resources Copyright 2012 Pearson Addison-Wesley. All rights reserved The Simple Circular Flow (cont'd) Total Income The yearly amount earned by the nation s resources (factors of production) Includes wages, rent, interest payments, and profits received by workers, landowners, capital owners, and entrepreneurs, respectively Copyright 2012 Pearson Addison-Wesley. All rights reserved 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-12

5 The Simple Circular Flow (cont'd) Question Why must the dollar value of total output equal total income? Answer Every transaction simultaneously involves an expenditure and a business receipt Copyright 2012 Pearson Addison-Wesley. All rights reserved National Income Accounting National Income Accounting A measurement system used to estimate national income and its components 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-15

6 National Income Accounting (cont'd) Stress on final output What is a final good? Wheat? Steel? Crude oil? Bread? Automobile? Gasoline? Copyright 2012 Pearson Addison-Wesley. All rights reserved 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved Table 8-1 Sales Value and Value Added at Each Stage of Donut Production Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-18

7 National Income Accounting (cont'd) Numerous transactions occur that have nothing to do with final goods and services being produced: Financial transactions Transfer of secondhand goods Others excluded transactions Copyright 2012 Pearson Addison-Wesley. All rights reserved National Income Accounting (cont'd) Financial transactions Securities Stocks and bonds Government transfer payments Social Security Unemployment compensation Private transfer payments Individual gifts Corporate gifts Copyright 2012 Pearson Addison-Wesley. All rights reserved National Income Accounting (cont'd) Transfer of secondhand goods 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-21

8 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved 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 Is not a measure of a nation s overall welfare Copyright 2012 Pearson Addison-Wesley. All rights reserved International Example: The French Government Seeks to De-emphasize GDP The president of France, Nicolas Sarkozy, endorsed a report that proposes the development of an alternative measure of economic performance. Similar to the United Nation s Human Development Index, that alternative measure considers GDP per person along with measures of health and knowledge. Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-24

9 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Income Approach Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Deriving GDP by the expenditure approach Consumption Expenditure (C) Durable Consumer Goods Items that last more than three years (automobiles, furniture) Nondurable Consumer Goods Goods that are used up in three years (gasoline, food) Services Mental or physical help Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-27

10 Two Main Methods of Measuring 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 includes changes in business inventories and repairs made to machines, buildings Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved Example: Is Failing to Include Intangibles Depressing Measured Business Fixed Investment? Some economists suggest that because investment is broadly defined as the use of current resources to expand productive capabilities, business fixed investment should also include intangible investment, such as research and employee education. Economist Leonard Nakamura has estimated that if intangible investment had been counted as part of business fixed investment, business fixed investment as a percentage of GDP would have been nearly doubled in recent years. Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-30

11 Two Main Methods of Measuring Deriving GDP by the Expenditure Approach Government Expenditures (G) State, local, and federal Valued at cost Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Deriving GDP by the Expenditure Approach Net Exports (Foreign Expenditures) Net exports (X) = Total exports Total imports Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Presenting the expenditure approach GDP = C + I + G + X where C = I = G = X = consumption expenditures investment expenditures government expenditures net exports Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-33

12 Figure 8-2 GDP and Its Components Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Net Domestic Product (NDP) Allowing for depreciation (capital consumption allowance) The amount that businesses would have to save in order to take care of deteriorating machines and other equipment NDP = GDP Depreciation Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Because NDP = GDP Depreciation, and GDP = C + I + G + X NDP = C + I + G + X Depreciation NDP = C + net I + G + X where net I (net investment ) = I Depreciation Domestic investment minus an estimate of the wear and tear on the existing capital stock The change in the capital stock over a one-year period Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-36

13 Two Main Methods of Measuring GDP (cont d) 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Deriving GDP by the Income Approach Gross Domestic Income (GDI) Wages: salaries and labor income Rent: farms, houses, stores Interest: savings accounts Profits: sole proprietorships, partnerships, corporations Copyright 2012 Pearson Addison-Wesley. All rights reserved Two Main Methods of Measuring Deriving GDP by the Income Approach Gross domestic product equals gross domestic income plus indirect business taxes and depreciation These last items are called non-income expense items Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-39

14 Two Main Methods of Measuring Deriving GDP by the Income Approach Indirect business taxes All business taxes except the tax on corporate profits Include sales and business property taxes Copyright 2012 Pearson Addison-Wesley. All rights reserved Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2011 (in billions of 2005 dollars per year) Copyright 2012 Pearson Addison-Wesley. All rights reserved Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2011 (in billions of 2005 dollars per year) (cont d) Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-42

15 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved Other Components of National Income Accounting (cont'd) Disposable Personal Income (DPI) Personal income after personal income taxes have been paid Copyright 2012 Pearson Addison-Wesley. All rights reserved Table 8-2 Going from GDP to Disposable Income, 2011 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-45

16 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 Real Values Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars Copyright 2012 Pearson Addison-Wesley. All rights reserved Distinguishing Between Nominal and Real Values (cont'd) Constant Dollars Dollars expressed in terms of real purchasing power This price-corrected GDP is the real GDP Copyright 2012 Pearson Addison-Wesley. All rights reserved Example: Correcting GDP for Price Index Changes, Correcting GDP for price index changes Nominal (current) dollars GDP Real (constant) dollars GDP Nominal GDP Real GDP = x 100 Price index* *Price index: measured by the GDP deflator Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-48

17 Table 8-3 Correcting GDP for Price Index Changes Copyright 2012 Pearson Addison-Wesley. All rights reserved Figure 8-4 Nominal and Real GDP Copyright 2012 Pearson Addison-Wesley. All rights reserved Why Not always use the most recent completed calendar year as the base year for computing real GDP? In principle, the government could update its base year every year. However, the government s national income accountants typically revise the real GDP figure a number of times before settling on a final amount. Thus, the government usually waits until those accountants feel certain about the GDP measurement for a given year before establishing that year as the base year. Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-51

18 Distinguishing Between Nominal and Real Values (cont'd) Per capita real GDP Real GDP divided by total population Per capita real GDP = Real GDP Population Copyright 2012 Pearson Addison-Wesley. All rights reserved Comparing GDP Throughout the World Foreign Exchange Rate The price of one currency in terms of another Example: $1.25 = 1 euro, or $1 =.80 euros French income per capita = 28,944 euros French per capita income in terms of dollars equals 28,944 euros x $1.25 = $36,180 Copyright 2012 Pearson Addison-Wesley. All rights reserved Comparing GDP Throughout the World (cont'd) Purchasing Power Parity Adjustment in exchange rate conversions that takes into account differences in the true cost of living across countries Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-54

19 International Example: Purchasing Power Parity Comparisons of World Incomes The International Monetary Fund accepted the purchasing power parity approach a few years ago It started presenting the statistics on each country s GDP relative to others and based on the purchasing power parity relative to the dollar Why is China s per capita GDP higher based on purchasing power parity? Copyright 2012 Pearson Addison-Wesley. All rights reserved Table 8-4 Comparing GDP Internationally Copyright 2012 Pearson Addison-Wesley. All rights reserved You Are There: Questioning China s Official Real GDP Statistics Some economists argue that China s government has overstated its real GDP growth rate since 2008 as electricity production has indeed declined. Paul Cavey of Macquarie Securities notes, however, that the decline in aluminum and steel production accounted for the lower electricity usage, while production of other items might have contributed to a net increase in real GDP. Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-57

20 Issues & Applications: Can More Per Capita Real GDP Buy Additional Happiness? A 1974 study by economist Richard Easterlin suggests that above a relatively low level of real GDP, further increases in real GDP do not make people happier. A recent study by Betsey Stevenson and Justin Wolfers, however, found that an increase in a person s purchasing power by itself does not necessarily make people happier, but it enables the person to pay for activities that lead to greater satisfaction. Copyright 2012 Pearson Addison-Wesley. All rights reserved 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-60

21 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 Copyright 2012 Pearson Addison-Wesley. All rights reserved. 8-61